Currency Derivatives are exchange-traded contracts through which an investor agrees to buy or sell certain units of the underlying currency at the expiry of the contracted period. Currency derivatives include currency futures, currency options and currency swaps. A currency derivative is similar to stock futures. But instead of stocks, the underlying asset is a currency pair. The most actively traded currency derivatives in India have the following currency pairs as the underlying asset –
- US Dollar and Indian Rupee (USD INR)
- Euro and Indian Rupee (EUR INR)
- Japanese Yen and Indian Rupee (JPY INR) and
- Great Britain Pound and Indian Rupee (GBP INR).
In addition to the above, currency derivatives are also available in cross-currency pairs like –
- EUR USD
- GBP USD
- USD JPY
In India, currency derivatives are traded on the following stock exchanges –
Let us understand what are currency derivatives?
What are Currency Derivatives?
A currency derivative is a contract between a buyer and a seller to exchange fixed quantity of currency on a pre-decided date and rate in the future.
These contracts are standardised in nature and are actively traded on the stock exchange. Currency derivatives are mostly used by importers and exporters to hedge against appreciation or depreciation of domestic currency.
But the high volume and price spread (difference between buy and sell price) has managed to attract retail investors and speculators to the currency derivatives market too.
Now that you understand what are currency derivatives, let us take a look at the evolution of currency derivatives in India.
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Introduction of Currency Futures in India
The introduction of currency futures trading effective August 29, 2008, on the NSE was a major milestone in the evolution of the Indian financial markets. Subsequently, Reserve Bank of India (RBI) and Securities and Exchange Board of India (SEBI) permitted trading in USD INR currency futures in other stock exchanges, albeit with some control. Currency futures in India are cash-settled and not physically settled. This means that actual delivery of the currency does not take place on expiry.
Currency futures allow investors to buy or sell the underlying currency on a future date at a pre-fixed price. Trading of currency futures on stock exchanges has facilitated an additional avenue and greater flexibility to investors and corporates in India to hedge their foreign currency exposure. Currency derivatives also ensures more transparency in dealing.
Currency Derivatives trading on stock exchanges is still at a nascent stage. Hence, the lot size has been pegged at 1,000 units of the overseas currencies in case of USD, EUR & GBP and 1,00,000 units in the case of JPY, with a maximum tenor of 12 months. Currency derivatives have to be mandatorily settled in local currency – Indian Rupee. Foreign Institutional Investors (FIIs) and Non-Resident Individuals (NRIs) cannot directly participate in currency derivatives trading.
Types of Currency Derivatives in India –
There are three main types of currency derivatives in India –
- Currency Futures contract allow investors to buy and sell underlying currency at a future date. However, the buyer and seller are able to lock-in the exchange rate today itself. This makes them immune from adverse currency depreciation. Currency futures are mostly used by banks, importers and exporters etc.
- Currency Options contract gives the buyer the right but not the obligation to buy or sell the underlying currency pairs on expiry. Currency options are flexible compared to futures as there is no obligation to buy or sell the underlying asset. Currency options are of two types –
- Call Option – This gives the buyer the right but not the obligation to BUY the underlying currency on expiry.
Watch this video to learn the basics of call options.
- Put Option – This gives the buyer the right but not the obligation to SELL the underlying currency on expiry.
|Option Strategy||Expectation of Currency Movement|
|Buying a call option||The price of the currency is expected to rise in the future|
|Selling a call option||The price of the currency is expected to fall in the future|
|Buying a put option||The price of the underlying currency is expected to fall|
|Selling a put option||The price of the underlying currency is expected to rise.|
Buying a call option or selling a put option is done when the price of the currency is expected to rise. The decision on which option to buy or sell is dependent on the premium.
Watch this video to learn when to buy or sell call and put options.
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- Currency Swaps involves exchanging interest rates in one currency for another currency. It helps the two parties change their interest rates from fixed to floating and floating to fixed.
Commonly Used Terms in Currency Derivatives Trading
- Exchange rate: This is the price at which the buyer and seller decide to exchange units of the underlying currency. It is one unit of currency expressed in the units of other currency which are offered for exchange.
- Spot price: The value of one currency offered or accepted for delivery or settlement. In the case of USD INR, spot value is T + 2.
- Futures price: The price at which the currency futures contract trades in the futures market.
- Contract cycle: The currency futures contracts on SEBI recognized exchanges have monthly expiry with a maximum tenure of 12 months. Hence, these exchanges can have 12 contracts outstanding at any given point in time.
- Final settlement date: This is the last business day of the contract cycle.
- Expiry date: It is the last working day on which the final trade has to take place in the specified contract cycle period. Since for USD INR trades, trade needs 2 days for settlement, the expiry date for such contracts is two working days before the final settlement date or value date.
- Contract size: In the case of USD INR it is USD 1,000; EUR INR it is EUR 1,000; GBP INR it is GBP 1,000, and in the case of JPY INR it is JPY 1,00,000.
- Spread: This is the difference between futures price and the spot price. In a normal market, the spread is positive.
- Initial margin: Currency derivatives are transacted through a broker. Investors have to deposit a certain amount with the broker before initiation of the trades. This amount is known as initial margin. The margin requirement for currency trading is quite low which makes these trades highly leveraged but even a small move could wipe out your entire capital.
You can check out the Span Margin Requirements for Currency Futures and options on the SAMCO Span Margin Calculator.
- Mark-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor’s gain or loss depending on the closing price of the futures. This is known as marking-to-market. Depending on the profit and loss, the investors have to replenish the account to maintain the initial margin.
- Leverage: Intraday currency segment leverage (MIS) ranges from 3X to 15X depending on the underlying currency pair. MIS trades are allowed at almost half the normal margins. Intraday cover order (CO) / Bracket order trades which have compulsory built-in stop loss order can have higher leverage than normal.
[Read More: How Leverage Works in Forex Trading]
Advantages of Currency Derivatives in India –
- Hedging: This is the biggest advantage of currency derivatives. It is especially important for banks, importers and exporters as they need to hedge against an adverse movement in underlying currency pairs.
- Speculating: Forex market is highly liquid. In fact, the world wide liquidity of forex market is much greater than the stock markets. This liquidity helps speculators make money from even the smallest price movement in currencies.
- Trading Leverage: The movement in currencies are much smaller compared to the stock market. A pip is 1/4th of a paisa. Hence, traders would need substantial capital to make higher profits. This is where leverage comes into the picture. Majority of brokers provide high currency trading leverage so that investors can take exposure to huge trades with a small initial margin.
- Arbitrage Facility: Arbitrage is a trading strategy which works on the difference in price of the same asset in different exchanges. Currency traders can buy currency derivatives on NSE and sell them on BSE (or vice-a-versa) to take advantage of the short-term price difference.
Brokerage while Trading Currency Futures
Unlike traditional brokers, at Samco, currency traders are charged flat Rs. 20 per executed order or 0.02%, whichever is lower. You can check out the Currency Brokerage Calculator Here.
Why is currency futures trading in USD INR/ GBP INR/ EUR INR/ JPY INR emerging as a popular tool for traders, scalpers, jobbers?
There are 2 primary reasons why currency futures are emerging as a popular instrument for trading.
- Low Transaction Costs – Unlike equities or commodities derivative trading where STT and CTT are respectively applicable, no STT is applicable while trading in currency derivatives. This means lower transaction costs and therefore higher profitability for traders.
- Small Tick Size and High Liquidity – The tick size in trading currency options is 1/4th of a paise i.e. 0.0025 and the contracts are extremely liquid as well. So, traders can make higher profits by a small movement in underlying currencies.
[Read More: Best Forex Trading Platform in India] With the basics of currency derivatives trading done, the next step is to start currency derivatives trading with Samco – India’s best forex broker. Open a free Forex trading account with Samco today and start leveraging the currency derivatives market to create wealth.