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Chapter 4

Currency Futures For Traders And Hedgers

A. HOW ARE CURRENCY FUTURES USEFUL FOR TRADERS AND HEDGERS?

Today if you try to buy spot currency from a bank or an authorized dealer, there are a large number of restrictions on buying and selling of currencies. You need to show the purpose, submit copies of your passport, other documentary details etc. What do you do if you have a view that the dollar is going to weaken or strengthen? Do you still need to buy currencies from the bank?

How can Traders in currency benefit from currency futures?

When you take a view in the future, you can do it best with futures. As a trader if you have a view on the currency then you can buy or sell the futures as the case may be. You only need to pay the nominal margin on such positions and it works out much cheaper than locking money in spot transactions. In a futures transaction, you are basically taking a view on the expected spot price of the currency. Let us see how it works.

Example 1:

Ajay Sahni is a trader in stocks and commodities. He has seen that foreign investors have been continuously infusing investments into India. His judgement was that the rupee should appreciate in value. How can he play this view with the help of futures?

Since Ajay expects the rupee to strengthen he also expects the dollar to weaken vis-à-vis the INR. That is tantamount to a short position in the dollar. Effectively, he will short the dollar by selling the USD-INR futures. He sells 1 lot of USD-INR futures worth $1000 at a price of Rs.70.80/$ for a 2 month contract. During the next 1 month, the value of the rupee appreciates to Rs.69.20/$. At this price he covers his short USD-INR position at the price of Rs.69.20/$. This will result in a profit of Rs.1600 ($1000 x 1.60). Here this is purely a trading view and one can participate in the trading view by selling USD-INR futures.

Example 2:

Malay Krishna is an Indian businessman who frequently travels to the US. On his recent visit, he learnt from business colleagues that since the Federal Reserve (US equivalent of RBI) was going to raise the interest rates, the dollar was bound to appreciate. Can he trade this view?

Here Malay expects the dollar to strengthen that means the dollar should appreciate vis-à-vis the Indian rupee. That means he has to go long on the dollar. He can replicate that position in the currency futures market by buying the USD-INR currency futures. Let us say he buys 1 lot of USD-INR currency futures at Rs.70.20 mid-month contract. After 15 days the Fed actually hikes the interest rates by 50 bps and that leads to a sharp rise in the dollar index. The USD appreciates to Rs.72/$. Now Malay can book profits on his position and take home a clear profit of Rs.1800 ($1000 x 1.80).

In both the illustrations above, it needs to be remembered that the risks if the currency moves in the opposite direction can be unlimited. That is why, like in any short term trade, such trades must be put with strict stop losses only.

How to hedge with currency futures where there is underlying exposure?

What do we understand by hedging? It basically means an insurance or protection against any adverse price movement. A hedger is different from a trader. As we saw earlier, the trader does not necessarily have an underlying exposure. The trader purely trades on a view that the Indian rupee could strengthen or weaken versus any of the currencies. What do we mean by an underlying exposure here? Here are some instances of underlying exposure:

  • An importer who imports goods from the US and has to pay in dollars will want to protect against any sharp weakening of the Indian rupee versus the dollar
  • An exporter who exports to Europe and has receivables in Euro will want to protect against any sharp strengthening of the Indian rupee versus the Euro
  • A manufacturer who has borrowed loans in the UK market denominated in GBP, will want to ensure that the INR does not weaken against the GBP
  • A parent whose child is studying in the US will want to ensure that the rupee does not weaken too much against the dollar

All the above are instances of persons with genuine underlying exposure to a foreign currency. They are interested in protecting themselves against adverse movements in the rupee. All of them would classify as hedgers as the intent is to only cover the risk and not make profits out of the currency markets.

B. APPLICATIONS OF CURRENCY FUTURES IN INDIA

We have already seen the practical application of currency futures when you need to take a view on the currency and trade. We shall now dwell on a much more serious aspect of currency futures i.e. hedging or insuring the risk of adverse currency movements. In India, the largest component of currency market participation is by hedgers looking to manage their import risk, export risk, foreign currency borrowing risk etc. Let us look at how these practically work out.

Example 3:

Let us understand hedging from the perspective of an exporter. An exporter has exported iron ore from its plant in Goa to the US and the total value of the shipment is $1,000,000 (Dollar 1 million) which is due to be received after 3 months as per the credit terms offered to the client. The current dollar rate (spot rate) for exchange is $1 = INR 70.25. What are the risks that the exporter faces and how can he hedge the risk?

As an exporter the receipts are in dollars (dollar amount is fixed, rupee amount is not). It is therefore in the interest of the exporter that the dollar remains strong and the rupee remains weak so that he can realize more rupees per dollar after 3 months. The risk is if the rupee strengthens then the exporter gets less rupees per dollar and that could upset his local calculations. That is where the exporter can use currency futures. The export risk can be hedged by selling USD-INR futures (short on dollars). Since the lot size is $1000, he will need to sell 1000 lots to get a perfect hedge. He has sold 1000 lots of USD-INR futures at 70.50/$. Let us look at what happens to the exporter on the dollar receipt under different price assumptions.

  • If the rupee appreciates to Rs.68.50/$, then the exporter does not have much to worry because they have already locked in the exchange forward rate of Rs.70.50 and that is what they will realize on the date of receipt. In other words, the loss on the dollar on conversion will be compensated by the profit on the short USD-INR futures.
  • If the rupee weakens to Rs.72.50, one can argue it is a notional loss for the exporter to the extent of Rs.2/$ because he is locked in at $70.50. But, the exporter out here is a hedger and not a trader. The focus is not to make profit but to protect his underlying dollar receivable from wild fluctuations. That purpose has been served.
  • In this case, the exporter gets predictability on his earnings. For example if the exporter has a payout of Rs.7 crore after 3 months, then he can be sure that he will receive Rs.7.05 crore (70.50 x $1 million) and his liability is covered. This predictability is one of the major advantages of hedging.

Example 4:

Let us now understand hedging from the perspective of an importer. An importer has imported spare parts for its machinery manufacturing unit in Bellary from Germany and the total value of the shipment is €1,000,000 (Euro 1 million) which is due to be paid after 3 months as per the credit terms offered by the supplier. The current Euro rate (spot rate) for exchange is €1 = INR 80.25. What are the risks that the importer faces and how can he hedge the risk?

As an importer the payables are in Euros (€ amount is fixed, rupee amount is not). It is therefore in the interest of the importer that the Euro remains weak and the rupee remains strong so that he has to pay lesser rupees per Euro after 3 months. The risk is if the rupee weakens then the importer has to pay more rupees per Euro and that could upset his local calculations. That is where the importer can use currency futures. The import risk can be hedged by buying EUR-INR futures (long on Euro). Since the lot size is €1000, he will need to buy 1000 lots to get a perfect hedge. He has bought 1000 lots of EUR-INR futures at 80.50/€. Let us look at what happens to the importer on the Euro payable under different price assumptions.

  • If the rupee depreciates to Rs.82.50/€, then the importer does not have much to worry because they have already locked in the exchange forward rate of Rs.80.50 and that is what they will pay on the date of receipt. In other words, the loss on the Euro on conversion will be compensated by the profit on the long EUR-INR futures.
  • If the rupee appreciates to Rs.78.50/€, one can argue it is a notional loss for the importer to the extent of Rs.2/€ because he is locked in at $80.50. But, the importer out here is a hedger and not a trader. The focus is not to make profit but to protect his underlying dollar payables from wild fluctuations. That purpose has been served.

In the above cases, the exporter and the importer get predictability on earnings. This enables them to easily match with local rupee payables or receivables as the case may be. This predictability is one of the major advantages of hedging.

Just as an exporter can hedge risk by selling USD-INR futures, an importer can hedge risk by buying EUR-INR futures. An exporter needs to be protected from a strong rupee and an importer needs to be protected from a weak rupee.

C. TRADING, SPECULATION AND HEDGING IN CURRENCY FUTURES

We have already seen the difference between trading and hedging. Let us recapitulate the key differences between trading and hedging before we move to speculation.

  • Trading is based on a view on the currencies. This can either be a bullish view or it can be a bearish view. The currency futures are either bought or sold based on the view. In case of hedging there is no scope for any view on currencies. There is an underlying exposure to the currency risk and the goal is to manage that risk.
  • Trading is intended to make profits. This may be small profits or large profits but the main intent is to take a view on the currencies and make profit out of it. Hedging is not intended to make profit. The only intent is to protect risk.
  • Hedging is just done based on offsetting against actual exposure to an underlying. Trading is done based on a mix of fundamentals, technical, news and data flows. Traders extensively use charts to identify ideal entry and exit levels in currencies.
  • Most traders operate with stop losses and their position is based on a risk-reward ratio. The focus is to churn capital as fast as possible. In case of hedgers, the currency futures position is backed by an underlying position and hence question of stop losses and profit booking does not arise.

We often tend to confuse trading with speculation. Trading is based on scientific bases like technicals, fundamentals, news flows etc. Speculation is purely based on odds. If the odds of making profit are more than the odds of making a loss, the speculator is willing to bet. Speculation is a high risk game whereas in case of trading the risk can be effectively managed.

D. RISKS IN CURRENCY TRADING

To an extent, the risks of currency trading are similar to the risks of trading in equities and commodities. However, being a pair trade and being vulnerable to vagaries of global shifts and movements, there are also some unique risks in currency trading.

  • Exchange rate risk is the risk caused by changes in the value of currency. It is based on the effect of continuous and usually volatile shifts in the worldwide supply and demand.
  • Interest Rate Risk refers to the profit and loss generated by fluctuations in the forward spreads, along with forward amount mismatches and maturity gaps among transactions.
  • Credit Risk refers to the possibility that an outstanding currency position may not be repaid as agreed, due to a voluntary or involuntary action by the counterparty. This is not a real problem in currency futures as there is clearing corporation guarantee.
  • Replacement Risk occurs when counter-parties of a failed bank or Forex broker find they are at risk of not receiving their funds from the failed bank. We saw this risk play out during the defaults by Bear Sterns and Lehman in 2008.
  • Settlement Risk can occur because of difference of time zones on different continents. Consequently, currencies may be traded at different prices at different times during the trading day creating a mismatch.
  • Liquidity Risk may not be there practical in OTC markets, but theoretically it does exist. Several countries or groups of nations have in the past imposed trading limits or restrictions on the amount by which the price of certain foreign exchange rates may vary during a given time period. Such restrictions may impede free trade in currencies.
  • Leverage Risk is a big risk in the forex market. Since it is a low volatility market, forex trading requires low margins. But it also means that the leverage is too high. That can multiply the risk when the price movement is against you.
  • Transactional risk refers to hygiene risks pertaining to errors in communication, handling and confirmation of a trader's orders resulting in unforeseen losses. Even where a bad trade is substantially the fault of the dealer, the customer's recourse is limited.
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