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Currency futures… “Feather In The Cap Of Indian Derivative Market”

Recent launch of Rupee futures on the NSE is a matter of great jubilation for the all participant in the derivative market. MCX and BSE also got the approval to launch the Rupee futures from the RBI. By seeing the warm response of the Rupee futures launched by NSE, it seems that it will witness huge response and going to prove yet another milestone in the Indian derivative market illustrious golden period. The volatility that has been characterized the FX markets in recent months is also one of its key attractions to investors, coupled with its high liquidity and low costs per transaction.

Recent movement in Rupee has been very volatile as it gained more than 12 percent against the dollar in 2007 but later on shed 10 percent till now in this year. As this volatility in rupee is giving sleepless nights to the exporters and importers but the launch of rupee futures gave another platform to hedge their currency risks thereby giving sigh of relief to them.

It is quite remarkable to notice that the foreign exchange market is known to be the largest financial market in the world, as measured by daily turnover. Trading volumes in the Indian rupee have risen close to four times between 2004 and 2007, and its share of world currency transactions has more than doubled from about 1.5% to 3.5% during the period. At present, the average daily turnover of the global forex market is estimated at around $3 trillion. Of this, spot forex trading volume is $932 billion or 31 percent, and the remaining is contributed by derivatives such as forwards, exchange traded futures, Over-The-Counter (OTC) options and swaps. In India, currently the inter-bank forex market (spot, swap and forwards) has an average daily turnover of $40 billion, of which spot forex trading volume is $20 billion or 50 percent of the forex market volume. The balance 50 percent is accounted by derivatives such as swaps and currency forwards. Thus, unlike the global forex market where market share is split in the ratio of 30 to 70 between spot and derivative market, the market share between spot and derivative market is split 50:50 in India.

Before the launch of the Indian Rupee futures contract in Dubai earlier this year, the NDF provided foreign players with the only offshore hedging tool to manage Indian Rupee risks. It is quite remarkable to notice that non deliverable forward market is the key platform where the trade is carried out in Rupee NDF since 1990 and in 2007-08 so far, transaction volumes in the NDF market for the Rupee has reportedly soared to over $750 million a day from about $100 million a day in 2003-04. The NDF market is typically an offshore market, free from regulatory control of the currency’s home monetary authority. New York, Singapore, Hong Kong and London are major centers. For the Indian Rupee, NDF are traded primarily in Singapore and Hong Kong along with Dubai and Bahrain.

RBI rules now allow importers and exporters to buy forward contracts up to their previous year’s turnover or previous 3 years’ average import or export, whichever is higher, but at least 80% of their forward cover should be in the form of deliverables. FIIs are allowed to hedge their equity and debt exposures. FDI investors can have forward cover not exceeding six months.

Now lets have a glance at the key features, which make currency market unique:
Its trading volume, extreme liquidity of the market, large number of, and variety of, traders in the market, geographical dispersion, long trading hours: 24 hours a day (except on weekends), variety of factors that affect exchange rates, low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes).

Main factors, which influence the value of currency, are: -
Government budget deficits or surpluses: Widening government budget deficits have negative  imapct on currencies and vice versa.
Balance of trade levels and trends:Trade deficits may have a negative impact on a nation’s currency and viceversa.
Inflation levels and trends: Rising nflation levels are perceived negative for the currency becase it erodes purchasing power. However, a currency may sometimes strengthen when inflation rises due to expectations that rise in short-term interest rates to combat rising inflation by central bank.
Economic growth and health: GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country’s economic growth and health. The more healthy and robust a country’s economy, the better its currency will perform, and the more demand for it there will be.
Political conditions:Internal, regional, and international political conditions and events can have a profound effect on currency markets.Political turmoil and instability can have a negative impact on a nation’s economy.
Market psychology: Market psychology and trader perceptions also effect the foreign exchange market .
Stock market: Stock market indices also affect currency rates.
Economic data: Economic data such as labor reports (payrolls, unemployment rate and average hourly earnings), CPI, PPI,GDP, international trade, productivity, industrial production, consumer confidence etc., also affect fluctuations in currency exchange rates.

Following are the features of Rupee futures launched by NSE
Only ‘persons resident in India’ may purchase or sell currency futures to hedge an exposure to foreign exchange rate risk or otherwise, contract size is $1000,the maturity shall not exceed 12months,the contract will be quoted in Indian rupees and the settlement price shall be the Reserve Bank’s Reference Rate on the last trading day.

Advantages of Rupee futures
· Dollar-rupee MTM obligations are settled on a daily basis, unlike a forward contract, which is an agreement to transact at a forward price on a future date and no money changes hands except on the maturity date.
· Lot size of dollar-rupee futures contract in NSE is $1,000, which is much smaller compared to OTC forward and swap contract.
· Dollar-rupee futures contract eliminates counter-party risk as the clearing corporation guarantees the trades.
· Transactions are executed on a price time priority, ensuring that the best price is available to all categories of market participants.
· Ensures greater transparency, efficiency, speed and accessibility. Exchange-traded futures provide transparency when compared to the prevailing OTC market for foreign currency derivatives. In an OTC market, deals are done over the telephone and the transactions lack the transparency of an exchange-traded contract whose value is reflected in the price at which it trades on the exchange.
· Small investors will also benefit because now they have to pay only a margin of about two percent to brokers for derivative deals, but banks charge a margin of 10 percent or more.

Limitations of Rupee dollar futures in NSE
The trading limit for individuals is $5 million and for trading members $25 million which will keep serious forex users like importers and exporters of reasonable size out of the markets for now.

Participants of forex market
Banks: -Banks do perform major role in the currency market. The inter bank market caters for both the majority of commercial turnover as well as enormous amounts of speculative trading every day. It is not uncommon for a large bank to trade billions of dollars on a daily basis.
Central Banks: -Central banks seek to control money supply and often have official or unofficial target rates for their currencies.
Hedge Funds: -Hedge funds also invest huge chunk of money in currencies.
Commercial Companies: -Commercial companies also play major role in the currency market.
Investors and Speculators: -Investors take advantage due to excessive leverage and 24 hour market in forex markets and speculators also provide depth.

Conclusion
The Indian forex derivatives market is still in a nascent stage of development but it offers huge growth potential. The development of a vibrant forex derivatives market in India would depend on the growth in the underlying spot/forward markets, growth in the rupee derivative markets along with the evolution of a supporting regulatory structure. Thus the launch of rupee futures is the key significant step, which make Indian derivative market more dynamic but still it has long way to go.