Back to Chapter List
Chapter 2

Currency Forward and Futures Market

If your daughter has got admission into a reputed university in the US or UK what is the first thing that you would do. Of course, your primary focus will be to arrange the funds and to ensure that your daughter has enough foreign currency to carry with her when she goes abroad. The easiest thing for you to do will be to go to the bank and buy the forex by giving a cheque for the rupee amount. The banks fix the bid/ask rates for each currency on a daily basis based on the RBI reference rate for the previous day.

Currency Forwards and Currency Futures

Forwards and futures contracts are both agreements to buy or sell a quantity of a financial or physical commodity at given price, on a specific future date. A currency forward contract is a private over-the-counter (OTC) transaction between counterparties known to each other, on terms agreed between them. The word private and OTC are important here because forwards are not traded on any recognized stock exchange. Hence the forward markets are generally open only to very large institutions, where there is an assurance that they will not default. Most small and medium sized traders and investors are outside the purview of the forward market.

A currency futures contract is an enhanced forward contract that is traded on a public stock exchange or currency exchange. In India, NSE and BSE are two of the major exchanges for trading currency futures. Structurally, the payoffs of a future and forward are the same. Both have scope for unlimited profits on the favourable side and unlimited losses on the unfavourable side. Then where do they really differ?

A futures contract will have standardised features, such as units of trading, delivery and settlement dates and minimum price increments. The futures exchange itself acts as the counterparty through the provision of clearance and settlement facilities to safeguard the interests of the parties. However, futures and forward contracts are binding on the parties (the buyer and the seller) at expiry, where one party receives and another delivers. However, investors can buy or sell back their contracts before expiry at the prevailing offer and bid prices respectively.

Futures obviously have some advantages over forwards but let us start off by looking at the most popular forward transaction on the US dollar which is the Dollar Forward cover offered by banks. Currently, in India all exchange traded derivatives on currencies (including futures and options) are all cash settled and there is no physical delivery of currency entailed.

Dollar forward cover offered by banks; how does it work?

As we are aware, a forward contract is a contract that obligates the holder to buy or sell an asset at a set price on a specified date in the future. The spot rate becomes the basis for the forward rate. In technical parlance, Spot rate is the rate applicable for delivery on 2nd business day, and forward rate is the rate fixed for a forward contract. How does forward cover really help? Here is a structured approach.

Illustration 1

Let us start off with a hypothetical illustration. For example: Rajesh Metals Ltd. has exported manganese ore to the US and the total value of the shipment is $1,000,000 (Dollar 1 million) which is due after 3 months. The current rate (spot rate) for exchange is $1 = INR 70.25. Therefore, Rajesh Metals enters into an agreement with the bank to realize the proceeds after 3 months at the rate of INR 70.50 per dollar. Agreed rate of $1=INR 70.50 shall be the forward rate for the particular transaction, and the entire transaction is a “Forward Contract”. How does this type of forward cover benefit Rajesh Metals Ltd.? This forward contract will offer the following benefits to Rajesh Metals:

  • It will give an assurance to Rajesh that he will realize Rs.70.50/dollar taking the total value of the inflow to Rs.7.05 crore. This is the assured inflow for Rajesh Metals irrespective of which way the USD/INR moves.
  • If the rupee appreciates to Rs.68.50/$, then Rajesh Metals does not have much to worry because they have already locked in the exchange forward rate of Rs.70.50 and that is what they will realize on the date of receipt.
  • If the rupee weakens to Rs.72.50, then one can argue there is a notional loss for Rajesh Metals. But that is not the focus of Rajesh Metals anyways. As a manufacturer, they prefer assured value to trading on value.
  • This forward cover is useful because most businesses have payables against their receivable. Suppose payables to suppliers after 3 months is Rs.7 crore, then the company CFO can be rest assured that the inflow will take care of the same with minimum risk of cash flow uncertainty.

But, how are forward rates calculated?

Data Source: Kantox

Illustration 2:

Let us now look at how the 3-month = Forward rate will be calculated using the above formula.

Spot price – Rs.72/$ | INR interest rate = 6% | USD interest rate = 3%

Numerator = (1 + 6%) x (90 / 360) = (1.06 x 0.25) = 0.2650

Denominator = (1 + 3%) x (90 / 360) = (1.03 x 0.25) = 0.2575

Forward Rate = Spot x (Numerator / Denominator)

Forward Rate = 72 x (0.2650 / 0.2575)

Forward Rate = Rs.74.0971

The above should be the fair value of the USD/INR 3-month forward contract.

Forward rates are extensively used by exporters and importers to “hedge” their foreign currency payables and receivables. Exporters hedge against a weakening of the dollar whereas importers hedge themselves against strengthening of the dollar. It needs to be noted here that the spot rate and the forward rates are determined by demand and supply forces, in addition to the macro-economic determinants like political conditions, monetary policy, fiscal policies etc.

If the forward rate (F) is higher than the spot rate (S), the denominator currency is said to be a forward premium and if it is lower it is said to be at a discount to spot. The dollar has typically been at a premium to the rupee.

How to calculate the premium / discount on an annualized basis on the forward cover? This is useful for costing of the export or import. Consider this illustration. For example: Say spot rate is $1=70.50 and 6-months forward rate is 73.30, therefore annualized premium on $ = {(73.30 – 70.50)/70.50}*100*12/6 = 7.94%. Therefore, the USD is at an annualized premium of 7.94% in the forward market with respect to the INR; likewise the INR is at a forward discount in the forward market with respect to the USD. You can state this either ways.

The difference between the spot rate and forward rate is called as “Swap Point”. And now the question arises why we have to use forward contract. The very basic reason is to manage the risk and to cover the probable loss that may arise in the course of execution. Forward cover is about protection not about making on the forex exposure.

Currency futures and how they score over currency forwards

Dollar forward contracts still continue to be the preferred mode of hedging for any dollar exposures. However, the interest in hedging through the use of exchange traded futures is gradually building up. Here are some of the structural advantages that currency futures possess over currency forwards.

Forwards have to be backed by an underlying exposure

Currency forwards being an over-the-counter (OTC) product it does not have a ready secondary market. One can only participate in the currency forward market in a bank if there is a genuine underlying forex exposure; not otherwise. There are no restrictions in the futures market and one can enter the currency futures market both for speculative, trading and hedging purposes.

Forwards entail a minimum economic size

Since forward contracts are tailor made for specific customers, they have to be of a minimum size; otherwise the bank will not be keen to write the forwards contract as the returns will not justify the cost for the bank. In the currency futures, there is really no minimum size.

Forwards are non-standardized while futures are standardized

Forwards are structured on a case by case basis and hence one’s unique personality gets reflected here. However, currency futures are structured. For example, there is standardization of contract sizes, lot sizes, contract maturities, etc. This provides secondary market liquidity to currency futures which is not available in the case of forwards. Also this expands the market much wider in case of futures as compared to forwards.

Forwards are vulnerable to counterparty risk

What do we understand by counterparty risk? It is the risk that the opposite party in the contract could default. In a forward contract, if there is default by one party then the other party only has legal recourse, which can be quite long winded. Forward Contracts do not have any clearing house or other institutional agents in the contract and hence exposure to counterparty risk is substantial. Moreover forward contracts are not marked to market on a daily basis; instead they are agreed to be settled at a future date at an agreed price; this leads to the high volume of risk. That is where futures contracts actually score. Futures carry a counter guarantee by the clearing corporation of the exchange where the futures contracts are traded. In fact, the counter guarantee works in such a way that the clearing corporation on the NSE and the BSE actually become the counter party to each transaction. So if X buys a USD-INR future and Y sells the future, then both actually transact with the clearing corporation. In the case of default, the clearing corporation honours the contract and then takes steps to recovers the due from the defaulter. The contract, per se, is not at stake.

How are currency futures contracts priced?

Because a forward or futures contract involves delivery and settlement at a future date, the forward/futures and spot exchange rates will be numerically different, albeit related to one another. In other words, the value of dollar after 3 months will be different from the value of the dollar today.

The relationship between the spot and the forward / futures rate is determined by the difference in the rates of interest earned on the respective currencies in the pair, which are also known as the "cost of carry" or the carrying cost. The fair price is the rate that prevents an investor from making a riskless profit by "round tripping" and exploiting the interest rate differential. This is an interesting concept and let us understand how this round tripping works and how risk less profit can be earned if the spot and futures are at the same level.

Illustration 3:

Assume that a non resident Indian (NRI) settled in California has $100,000 surplus available with him. He has a choice of putting the money in a deposit in the US at 1.50% per annum for three months or converting it into INR, investing it at 4.50% per annum for three months and simultaneously enter into a forward or futures contract for delivery and settlement in three months.

If the spot and the forward/futures rates are the same, then our investor could:

Borrow USD at 1.50% for three months and sell USD for INR at the prevailing spot rate in the market. Once that is done, since the borrowing and deposit is for 3 months, he can hedge his risk by entering into a forward / futures contract to buy back USD for INR at the same rate, since there is not discount or premium.

The money borrowed at 1.50% in the US can be invested in the INR deposit at 4.50% for a deposit period of 3 months. At the end of 3 months, he can buy back the USD with INR after three months and repay the USD loan. How does the investor gain in this case? He has basically earned a riskless profit roughly equal to the interest differential over three months. That means he has earned 3% (4.5% - 1.5%) annualized difference for a period of 3 months. Obviously, this will create a huge demand for dollars because everyone will want to borrow in dollars and invest in the INR deposit to earn 3% annualized risk free spread. This situation will get automatically rectified when the forward premium will adjust itself to reflect this difference. How will it adjust itself? Generally speaking, currency futures and forwards should trade at a discount to the spot rate for the currency with a positive interest rate differential.

Illustration 4:

How can an exporter use currency futures to hedge risk of currency fluctuations in the market so that his business becomes more predictable? Let us understand this with the help of an illustration. Assume that Maruda Traders Ltd. has an export inward remittance that is receivable on 30th September for $50,000. While Maruda knows the dollar amount that they will get on 30th September, they are not too sure about how about how much INR that will translate into as it will depend on the USD-INR exchange rate on that particular date. For the purpose of our understanding let us assume that the exchange rate is Rs.70/$. That means at this rate it will actually translate into a rupee inflow of INR 35 lakhs on September 30th assuming that the USD/INR exchange rate remains constant during that period.

This is important because Maruda Traders has certain commitments on October 10th exactly 10 days after the remittance is received. The company is comfortable with the exchange rate of 70/$ on the settlement day. But the rates change and at times can change drastically. Now Maruda does not have a problem if the rupee weakens to 72/$ as that will mean they get more rupees for their $50,000. However, the company has been advised by their banker that due to heavy FPI inflows into India, the INR may actually appreciate to 67/$ by September 30th. That will mean that the export earnings of $50,000 will merely translate into Rs.33.50 lakhs in rupee terms. Maruda Traders is apprehensive that this will leave them with a shortfall in meeting their outflow commitment on October 10th. What can Maruda do and can they use currency futures to hedge their risk?

The company, therefore, needs to hedge its inward dollar risk. How can Maruda Traders do this? Simply put, Maruda Traders can hedge this risk by selling 50 lots (each lot is worth $1000) of the USD-INR pair at a price of Rs.70. This will give them a perfect protection. This is how it will work. On the inward remittance date of 30th September, let us assume that the INR has actually appreciated to 66/$. When Maruda receives its remittance of $50,000/- on September 30th, the converted value will be Rs.33 lakhs. However, Maruda, as advised by the banker, has already sold 50 lots of the USD-INR futures at Rs.70. Essentially, Maruda Traders is short on the USD vis-à-vis the Indian rupee. Since the price is now down to 66, Maruda Trades will make a profit of Rs.2 lakh (50 lots x $1000 lot value x Rs.4 profit) on that position. Thus the total receivable will now be Rs.35 lakh (Rs.33 lakh from conversion and Rs.2 lakh from the short USD-INR futures). Effectively, Maruda Traders has managed to hedge its conversion price at Rs.70/$. For the purpose of simplicity we have not considered transaction costs but that can be factored in and anyways these costs are quite marginal to really impact the profitability in a big way. At least the risk of a strong rupee is managed for Maruda traders using Currency Futures.

The moral of the story is that when you are an exporter having dollar receivables, you can hedge the risk of strong rupee by selling USD-INR futures at your target price. Logically, you may think as to what happens if the INR instead depreciates to Rs.73. In the normal course, Maruda Exports would have made a profit but due to the hedge it will be locked in at Rs.70/$. This will result in a notional loss of Rs.3, but the intent here is to protect the downside risk, not to make profits. There are two ways this can be overcome. Either, one can hold the USD-INR pair with a strict stop loss or the hedging can be done through put options instead of futures so that the maximum risk can be contained to the extent of the option premium. In fact, options trades have been seeing a rise in volumes as more and more traders are seeing the benefit of using options for hedging their currency risk. But that is a separate topic for discussion altogether.

Illustration 5:

We just saw how an exporter can benefit by selling USD INR futures and hedge their dollar inward remittance from any dollar depreciation or rupee appreciation. What if the person has a dollar payable at end of a certain period? For example, importers and foreign currency borrowers have dollar payable amounts in future. How can they use currency futures? Just as an exporter can use currency futures to hedge risk of currency fluctuations in the market so also an importer or foreign currency borrower can also use these currency futures to hedge risk. The only difference is that in case of dollar receivables (in the previous illustration) you wanted to protect against strengthening rupee whereas in case of dollar payable you want to protect against weakening rupee or strengthening dollar.

Let us understand this with the help of an illustration. Assume that Paterson Steel Ltd. has a dollar loan repayable on 30th September of $500,000/-. While Paterson knows the dollar amount that they will have to pay on 30th September, they are not too sure about how about how much INR that will translate into as it will depend on the USD-INR exchange rate on that particular date. For the purpose of our understanding let us assume that the exchange rate is Rs.70/$. That means at this rate it will actually translate into a rupee outflow of INR 3.50 crore on September 30th assuming that the USD/INR exchange rate remains constant during that period.

There is another slight complication to this. Paterson is expected to receive Rs.3.46 crore from an Indian client on 20th September. This amount will be used to repay the dollar loan but then it means that the dollar rate cannot really go awry as the additional burden will fall on the company. For example if the rupee weakens to Rs.76/$, then it is an additional burden of Rs.30 lakhs on Paterson Steel and that is what the company CFO is really worried about. The company is comfortable with the exchange rate of 70/$ on the settlement day as that will entail a payable of Rs.3.50 crore and can be almost fully met by the receipt on 20th September. But if the rates change and at times rates can change drastically then it is an issue. Paterson does not have a problem if the rupee strengthens to 68/$ as that will mean they need less rupees for repaying their $500,000. However, the company has been advised by their banker that due to an MSCI downgrade of India weight, there could be dollar outflows. That could mean the INR may actually weaken to 74/$ by September 30th. That will mean that the import payable of $500,000 will entail a rupee payable of into Rs.3.70 crore in rupee terms. Paterson is apprehensive that this will leave them with a shortfall in meeting their outflow commitment from the Rs.3.46 crore that they will receive on 20th September. What can Paterson do and can they use currency futures to hedge their risk?

The company, therefore, needs to hedge its outward dollar payable risk. How can Paterson Steel do this? Simply put, Paterson Steels can hedge this risk by buying 500 lots (each lot is worth $1000) of the USD-INR pair at a price of Rs.70. This will give them a perfect protection. This is how it will work. On the outward remittance date of 30th September, let us assume that the INR has actually depreciated to 74/$. Now Paterson has already received Rs.3.46 crore from its Indian client. When Paterson is due to pay its $500,000/- on September 30th, the converted value loss will be made up by the profit on the long currency futures on USD INR. Of course, Paterson has received Rs.3.46 crore from their Indian client and with the hedge, there is only a net difference of Rs.4 lakh that Paterson has to bridge. That is something Paterson was comfortable from day 1 itself. The only issue here is that if the dollar weakened instead of strengthening then there is a notional loss. In the normal course, Paterson would have made a profit but due to the hedge it will be locked in at Rs.70/$. This will result in a notional loss, but the intent here is to protect the downside risk, not to make profits. That is how currency futures can be effectively used irrespective of whether you have a dollar receivable or a dollar payable. We are only using dollar as the example. If you have a Euro payable or receivable or a Pound receivable or payable then the appropriate EUR-INR pair or the GBP-INR pair can be effectively used.

Cost of carry model and spread

To understand cost of carry, let us look at negative carry and positive carry in currency trading. The negative and positive carry are graphically illustrated as under. Let us then look at the concept in greater detail.

Source: CME Group

Negative carry is a situation in which the cost of holding a security exceeds the income earned. A negative carry situation is typically undesirable because it means the investor is losing money as long as the principal value of the investment remains the same. This is important when positions are financed by debt. To take a simple example, if you borrow money at 6% and invest the money at a bond at 5% then this investment has negative cost of carry as the investor loses 1% straight away. How do we apply this concept to currencies. In carry trade, traders typically borrow in low interest economies and invest in high interest economies. For example, borrowing in Yen (which has near zero interest rates) and invest in dollar bonds is an example of carry trade. However, borrowing in USD and investing in Japanese bonds will be an instance of negative cost of carry. Of course, carry trade only works when the currency remains stable, not otherwise.

Let us understand how to apply positive carry positions in the foreign exchange market? Positive carry is a strategy of holding two offsetting positions and profiting from a price difference. The first position generates an incoming cash flow that is greater than the obligation of the second.

Similar to arbitrage, positive carries often occur in the currency markets, where interest that investors receive in one currency is more than they have to pay to borrow in another currency. For example, Japan has long been a haven for carry traders because it was a stable currencies and interest were among the lowest. So traders borrowed in Yen at near 0% and invested in the US markets at yields of around 3%. Even if your round trip cost including currency fluctuations were around 1%, you would still be left with a spread of around 2%. That is a positive carry trade.

1 2 3 4 5 6 7 8 9 10