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The Evolution and the Impact of Currency Futures in India

Currency futures trading started in India on August 29, 2008 on National Stock Exchange. This was the first time currency derivatives got listed on an exchange in India. Till this time, the currency futures trading took place over the counter and were unorganized.

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With the entry of the National Stock Exchange in the picture, currency trading became more organized with the NSE acting as a counter party to all the transactions. Soon after BSE and MCX also marked their entry into the currency derivatives market.

Currency futures is mainly using as a risk management tool by exporters and importers. There are three types of traders are in the market i. e Hedgers, Speculators and Arbitragers. Currency futures are mainly used as a hedging instrument by importers and exporters. A foreign exchange deal is always done in currency pairs, for example USD-INR, GBP-INR, JPY-INR etc. In a currency pair, the first currency is referred to as the base currency and the second currency is referred to as the counter/base currency. Foreign exchange prices are highly volatile and fluctuate in real time basis.

In foreign exchange contracts, the price fluctuation is expressed as appreciation/depreciation or the strengthening/weakening of a currency relative to other. The Currency futures contracts traded at the NSE have a tick size of Rs. 0025. tick value refers to the amount of money that is made or lost in a contract with each price movement. The spot market transaction does not imply immediate exchange of currency, rather the settlement (exchange of currency) takes place on a value date, which is usually two business days after the trade date.

The price at which the deal takes place is known as the spot rate (also known as benchmark price). The two-day settlement period allows the parties to confirm the transaction and arrange payment to each other. A forward transaction is a currency transaction wherein the actual settlement date is at a specified future date, which is more than two working days after the deal date. The date of settlement and the rate of exchange (called forward rate) is specified in the contract.

The difference between spot rate and forward rate is called “forward margin”. The pricing of currency futures can be done by using cost of carry model and interest rate parity principle. Importers are using long term strategy and exporters are using short term strategy. ` The trading can be done in NSE from 9. 00 am to 5 pm. Currency futures have a maximum expiration period of 12 months. Individuals, partnership firms, corporations and companies can participate in Currency future market. There are certain set of eligibility criteria for membership.

The trading system at NSE is known as NEAT-CDS(National Exchange for Automated Trading- Currency Derivative Segment). The final settlement of futures contracts is effected on T+2 day basis as per the timelines specified by the clearing corporation. The final settlement date is the contract expiry date. Since the final settlement is done on the contract expiry date, the last trading day is two working days prior to the last business day of the expiry month at 12 noon.

Derivative is a product whose value is derived from the value of one or more basic variables called base (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, foreign exchange, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”.

In the Indian context the Securities Contracts (Regulation) Act, 1956 [SC(R)A] defines “derivative” to include- 1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices, of underlying securities Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A.

The term derivative has also been defined in section 45U(a) of the RBI act as follows: An instrument, to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called “underlying”), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options or such other instruments as may be specified by the Bank from time to time.