NISM Series I | Currency Derivatives | Complete Study Guide (Chapters 1-10)
Introduction to Indian Currency Market
Initially, the trading of goods and services was by the barter system where goods were exchanged for each other. Such a system had its difficulties primarily because of the non-divisibility of certain goods, the cost of transporting such goods for trading, and the difficulty in valuing services. People tried various commodities as the medium of exchange ranging from food items to metals. The process of evolution of the medium of exchange further progressed into the development of paper currency. People would deposit gold/silver coins with a bank and get a paper promising that the value of that paper at any point in time would be equal to a certain number of gold coins.
With time, the growth in international trade resulted in the evolution of foreign exchange (FX), i.e., the value of one currency of one country versus the value of the currency of another country. Whenever there is a cross-border trade, there is a need to exchange one brand for another, and this exchange of two currencies is called “foreign exchange” or simply “forex” (FX). The smooth functioning of international trade required a universally accepted foreign currency to settle internal trade and a way to balance the trade imbalances amongst countries. Documented history suggests that sometime in 1870, countries agreed to value their currencies against the value of the currency of another country using gold as the benchmark for valuation.
During 1944–1971, countries adopted a system called the Bretton Woods System. As part of the system, all currencies were pegged to the USD at a fixed rate, and the USD value was pegged to gold. With the adoption of this system, the USD became the dominant currency of the world. Finally, the Bretton Woods system was suspended, and countries adopted a system of free-floating or managed float methods of valuing their currency. Developed countries gradually moved to a market-determined exchange rate, and developing countries adopted either a system of pegged currency or a system of managed rates.
Major Currency Pairs
The most traded currency pairs in the world are called the Majors. These currencies follow a free-floating method of valuation. The list includes the following:
USD (US Dollar): The US Dollar is by far the most widely traded currency. In part, the widespread use of the US Dollar reflects its substantial international role as an “investment” currency in many capital markets, a “reserve” currency held by many central banks, a “transaction” currency in many international commodity markets, an “invoice” currency in many contracts, and an “intervention” currency employed by monetary authorities in market operations to influence their own exchange rates.
EUR (Euro): Like the US Dollar, the Euro has a strong international presence and over the years has emerged as a premier currency, second only to the US Dollar.
JPY (Japanese Yen): The Japanese Yen is the third most traded currency in the world. It has a much smaller international presence than the US Dollar or the Euro. The Yen is very liquid around the world, practically around the clock.
GBP (Pound Sterling): Until the end of World War II, the Pound was the currency of reference. The nickname "Cable" is derived from the telegrams used to update the GBP/USD rates across the Atlantic.
CHF (Swiss Franc): The Swiss Franc is the currency of Switzerland. It is one of the most stable currencies in the world and is used as the reserve currency in many international transactions.
AUD (Australian Dollar)
CAD (Canadian Dollar)
Overview of International Currency Markets
For the currency market, the concept of a 24-hour market has become a reality. In financial centers around the world, business hours overlap; as some centers close, others open and begin to trade. Given this uneven flow of business around the clock, market participants often will respond less aggressively to an exchange rate development that occurs at a relatively inactive time of day, and will wait to see whether the development is confirmed when the major markets open.
At any moment, the exchange rates of major currencies tend to be virtually identical in all the financial centers where there is active trading. Rarely are there such substantial price differences among major centers as to provide major opportunities for arbitrage. In pricing, the various financial centers that are open for business and active at any one time are effectively integrated into a single market.
Basics of Currency Markets and Peculiarities in India
Currency Pair: The most significant part of the currency market is the concept of currency pairs. In the currency market, while initiating a trade, you buy one currency and sell another currency. Therefore, the same currency will have a very different value against every other currency. This peculiarity makes the currency market interesting and relatively complex. For major currency pairs, economic development in each of the underlying countries would impact the value of each currency, although to varying degrees.
Base Currency (BC) / Quotation Currency (QC): Every trade in the FX market is a currency pair: one currency is bought with or sold for another currency. The BC is the currency that is priced, and its amount is fixed at one unit. The other currency is the QC, which prices the BC, and its amount varies as the price of the BC varies in the market. What is quoted throughout the FX market anywhere in the world is the price of the BC expressed in QC.
Interbank Market and Merchant Bank Market: The interbank market is the market between banks where dealers quote prices at the same time for both buying and selling the currency (two-way quotes). In the majority of the “merchant” market, merchants are price takers and banks are price givers. Although, a few large merchants or corporates may ask banks to quote two-way prices as such merchants may have both-side interest (interest to sell, buy, or both).
Two-Way Quote: The price quoted for buying is called the bid price, and the price quoted for selling is called the offer or ask price. Market norms for two-way quotes dictate that the bid price (lower price) is quoted first, followed by the offer price (higher price). The offer price is generally quoted in an abbreviated form. If the currency pair is quoted up to four decimal places, the offer price is quoted in terms of the last two decimal places. If quoted in two decimal places, the offer price is quoted in terms of two decimal places.
Appreciation / Depreciation: Changes in rates are expressed as strengthening/weakening of one currency to the other currency. Whenever the base currency buys more of the quotation currency, the base currency has appreciated and the quotation currency has weakened/depreciated.
Market Timing: In India, the OTC market is open from 9:00 AM to 5:00 PM. However, for merchants, the market is open from 9:00 AM to 4:30 PM, and the last half hour is meant only for interbank dealings for banks to square off excess positions.
Price Benchmarks: Banks price large-value merchant transactions from the Interbank Rate (IBR). IBR is the price available to the bank in the interbank market and could differ from bank to bank. For small-value transactions, banks publish a standard price for the day called a card rate, which is usually the same for the whole day.
Price Discovery: Gradually, the market discovers an equilibrium price at which it clears buy and sell orders. This process is called price discovery.
RBI Reference Rate: This is the rate published daily by the RBI for spot rates for various currency pairs. The Reserve Bank periodically reviews the procedure for selecting the banks and the methodology of polling to ensure the reference rate truly reflects market activity. There is an increasing trend of large-value FX transactions done at the RBI rate even on the OTC market.
Settlement Date or Value Date: Unlike the currency futures market, settlement in the OTC spot market happens by actual delivery of currency. Gross settlement is when each counterparty exchanges the goods traded on maturity. Net settlement is when participants only settle the difference in value. The value date is when counterparties actually exchange currency, which is different from the trade date. The most important value date is the “spot” value date, which is a settlement after two business days.
OTC Forward Market: The forward OTC market can provide quotes for booking a forward contract for any maturity, though liquidity is high for maturities under one year. Participants can decide to settle via gross or net settlement. A unique feature of the OTC forward market is the requirement of an underlying trade contract before executing the forward contract.
Exchange Rate Arithmetic ‐ Cross Rate
For some currency pairs, prices are not directly available and are instead derived by crossing the prices of underlying currency pairs. Crossing the prices to arrive at the price of the currency pair could involve either multiplication or division of the underlying prices. In market parlance, the price of a currency pair for which direct prices are not available is called a cross rate.
Let us start the computation of a cross rate using the buy-side argument (i.e., the price of buying 1 EUR in terms of INR). As understood from underlying currency pairs, the price of EUR is directly available only in terms of USD. Therefore, you need to sell INR to buy USD, and further sell the USD received to buy EUR. It is important to identify this FX conversion path of selling one currency and buying another to calculate the cross rate.
Impact of Economic Factors on Currency Prices
There are multiple factors impacting the value of a currency at any given point in time. Some factors are local to the country, while others could be from global markets. For example, the value of INR against USD is a function of local Indian factors like Gross Domestic Product (GDP) growth rate, balance of payment situation, deficit situation, inflation, interest rate scenario, and policies related to the inflow and outflow of foreign capital. It is also a function of global factors like the price of crude oil, the value of USD against other currency pairs, and geopolitical situations.
To assess the impact of economic factors on the currency market, it is important to understand key economic concepts, data releases, their interpretations, and their impact on the market. Since the currency market is globalized and the value of a currency is always determined against another currency, the analysis in the FX market also means an analysis of economic conditions in other major countries of the world.
Economic Indicators
GDP: GDP represents the total market value of all final goods and services produced in a country during a given year. A GDP growth rate higher than expected may mean relative strengthening of the currency of that country, assuming everything else remains the same.
Retail Sales: It is a coincident indicator and shows how strong consumer spending is. A retail sales number higher than expected may mean relative strengthening of the currency of that country.
Consumer Price Index (CPI): CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. The indicator measures the level of inflation in the economy for the basket of goods and services generally bought by the people.
Non-Farm Payrolls: Non-farm payrolls represent the number of jobs added or lost in the economy over the last month, not including jobs relating to the farming industry, government jobs, household jobs, and employees of non-profit organizations that provide assistance to individuals.
Import/Export Growth: For a country like India, figures pertaining to import/export, current account deficit, and balance of payments are very important. During periods of risk aversion, any development resulting in a widening current account deficit results in the weakening of INR.
Central Bank Meeting and Key Decisions: The market tracks the minutes of central bank meetings and key policy decisions. Important announcements include interest rate decisions and the Cash Reserve Ratio (CRR). The market also actively looks forward to the central bank’s perspective on the state of the economy.
💱 Foreign Exchange Derivatives
A derivative is a financial product whose value is derived from one or more basic variables, known as bases.
The Underlying Asset: Can be equity, foreign exchange, a commodity, or any other asset.
A Brief History: Derivative products initially emerged as hedging devices against fluctuations in commodity prices. For almost 300 years, commodity-linked derivatives were the sole form of such products.
The Modern Era: Financial derivatives came into the spotlight in the post-1970 period due to growing instability in global financial markets. Since their emergence, these products have become immensely popular. By the 1990s, they accounted for about two-thirds of total transactions in all derivative products.
📜 Legal Definition in India
In the Indian context, the Securities Contracts (Regulation) Act, 1956 [SC(R)A] defines a "derivative" to include:
A security derived from a debt instrument, share, loan (whether secured or unsecured), risk instrument, contract for differences, or any other form of security.
A contract which derives its value from the prices, or index of prices, of underlying securities.
🛠️ Key Derivative Products
Here is a breakdown of the primary types of derivative contracts:
🤝 Forwards: A customized Over-The-Counter (OTC) contract between two parties, where settlement takes place on a specific date in the future at a price agreed upon today.
📈 Futures: Similar to a forward contract, except that it is an Exchange-traded product.
Terminology Note: The term “futures” refers to the derivative product itself, while the term “future” refers to a later point in time. Thus, the “futures price” is the current price of the derivative, and the “future price” is the price that will prevail at a later date.
⚖️ Options: An option does not buy or sell the underlying asset directly. Instead, it buys or sells the right (without the obligation) to transact the underlying asset.
Call Option: The right to buy.
Put Option: The right to sell.
🔄 Swaps: Agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:
Interest Rate Swaps: Entail swap
ping only the interest-related cash flows between the parties in the same currency. Currency Swaps: Entail swapping both principal and interest between the parties, with the cash flows in one direction being in a differe
nt currency than those in the opposite direction.
🚀 Growth Drivers of Derivative Products
The rapid expansion of the derivatives market can be attributed to several key factors:
📈 Increased Volatility: Greater fluctuations in financial markets create a higher need for risk management.
🌍 Increased Integration of Markets: Global financial markets are more interconnected than ever before.
📡 Improved Communication & Lower Costs: A marked improvement in communication facilities and a sharp decline in their associated costs.
🧮 Sophisticated Risk Management: The development of more advanced risk management tools and models.
💡 Continuous Innovations: Ongoing innovations within the derivatives markets themselves.
🎭 Market Players & Market Dynamics
The derivatives market is driven by three broad categories of participants:
🛡️ Hedgers: Face risks associated with the price of an underlying asset and use derivative markets to reduce or eliminate this risk.
🎲 Speculators: Wish to bet on future movements in the price of an underlying asset. Derivatives give them the ability to buy the underlying without paying for it fully (leverage) or to sell it without owning it or delivering it immediately. This amplifies both potential gains and potential losses.
⚖️ Arbitrageurs: Are in business to take advantage of price discrepancies between two different markets, locking in risk-free profits.
🌟 Benefits & Impact of an Organized Derivatives Market
Price Discovery: Prices reflect the perception of market participants about the future and lead the prices of the underlying asset to that perceived future level.
Risk Transfer: The market efficiently helps to transfer risks from those who want to avoid it to those willing to take it.
Increased Volumes: With the introduction of derivatives, the underlying cash market often witnesses higher trading volumes and liquidity.
Controlled Speculation: Speculative trades shift from unregulated environments to the more controlled, transparent environment of the derivatives market.
Entrepreneurial Catalyst: Derivatives trading acts as a catalyst for new entrepreneurial activity and financial innovation.
A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying asset or an instrument at a certain date in the future, at a specified price. Both parties of the futures contract must fulfill their obligations on the settlement date. Currency futures are a linear product, and calculating profits or losses on these instruments is similar to calculating profits or losses on Index futures. In determining profits and losses in futures trading, it is essential to know both the contract size (the number of currency units being traded) and also the “tick” value.
Futures Terminology
Spot price: The price at which the underlying asset trades in the spot market.
Futures price: The current price of the specified futures contract.
Contract cycle: The period over which a contract trades. The currency futures contracts on the SEBI recognized exchanges have one-month, two-month, and three-month up to twelve-month expiry cycles.
Value Date/Final Settlement Date: The last business day of the month will be termed as the Value date of each contract. The rules for Inter-bank Settlements, including those for ‘known holidays’ and ‘subsequently declared holiday’ would be those as laid down by the Foreign Exchange Dealers’ Association of India (FEDAI).
Expiry date: Also called the Last Trading Day, it is the day on which trading ceases in the contract; and is two working days prior to the final settlement date.
Contract size: The amount of asset that has to be delivered under one contract. It is also called lot size.
Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as the initial margin.
Marking-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 upon the futures closing price. This is called marking-to-market.
Distinction between futures and forward contracts
Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the probability of future price uncertainty. However, futures have some distinct advantages over forward contracts as they eliminate counterparty risk and offer more liquidity and price transparency.
Advantages and Limitations of Futures
Advantages:
Price transparency.
Elimination of Counterparty credit risk.
Access to all types of market participants. The OTC market is restricted to Authorized Dealers (banks which are licensed by RBI to deal in FX), individuals, and entities with forex exposures. Retail speculators with no exposure to FX cannot trade in the OTC market.
Futures offer a low cost of trading as compared to the OTC market.
Limitations:
The benefit of standardization, though it improves liquidity in futures, leads to imperfect hedges since the amount and settlement dates cannot be customized.
While margining and daily settlement is a prudent risk management policy, some clients may prefer not to incur this cost in favor of OTC forwards, where collateral is usually not demanded.
Interest Rate Parity
This concept of the difference between the future exchange rate and spot exchange rate being approximately equal to the difference in domestic and foreign interest rates is called the “Interest rate parity”. An alternative way to explain interest rate parity is that it says the spot price and futures price of a currency pair incorporates any interest rate differentials between the two currencies assuming there are no transaction costs or taxes.
Please go through the example in the NISM book to get a better understanding of the concept.
IV. Strategies Using Currency Futures
Market Participants
Hedgers: These types of participants have a real exposure to foreign currency risk on account of their underlying business and their objective is to remove the FX risk using currency futures. The objective of hedgers is to reduce the volatility in future cash flows by locking in the future currency rates.
Speculators: Speculators play a vital role in the futures markets. Futures are designed primarily to assist hedgers in managing their exposure to price risk; however, this would not be possible without the participation of speculators. Speculators, or traders, assume the price risk that hedgers attempt to lay off in the markets.
Arbitragers: This set of market participants identify mispricing in the market and use it for making a profit. They have neither exposure to risk nor do they take the risk. Arbitrageurs lock in a profit by simultaneously entering opposite side transactions in two or more markets.
Computing payoffs from a portfolio of futures and trade remittances
The market participants may undertake various kinds of currency positions and it is important to understand the payoff from these positions. There are different combinations of positions in the futures market on a standalone basis and futures positions combined with cash positions in the OTC market. Examples of such positions would be:
Combined position of futures and underlying export trade remittance
Combined position of futures and underlying import trade remittance
Go through the examples given in the NISM book to understand the payoff of the above position under different circumstances.
Currency Futures are used for hedging for the following purposes:
Payment in foreign currency for travel abroad, for education, etc.
Payment of loan availed in foreign currency.
Investment in assets outside India or repatriation of capital invested outside India.
Payment of loan installments in INR by a person earning in foreign currency.
Investment in Gold
A high net worth individual in India is keen to invest in gold with a view of rising gold prices against USD. He invested via an ETF gold contract which is exchange-traded and priced in INR. After three months of investment in ETF, gold appreciated by 15% against USD while the ETF appreciated by only 10%. The low appreciation of the ETF was because of a 5% appreciation in INR against USD in the last three months. Thus, to remove the USDINR risk in the ETF contract, the investor could short USDINR currency futures for an amount equal to the amount of investment in ETF and for a tenor for which he intends to stay invested in the gold ETF. This would reduce the USDINR risk embedded in the gold ETF.
Investment in assets outside India and repatriation of profit and capital
Currency futures could also be effectively used to hedge the currency risk when investing abroad. A person has invested USD 100,000 in US equities with a view of appreciation of the US stock market. In the next one year, his investments in US equities appreciated in value to USD 115,000. The investor decided to sell off his portfolio and repatriate the capital and profits to India. However, at the time of converting USD to INR, he received an exchange price of 64 as against 67 which was the price at which he had converted INR to USD at the time of investing abroad.
The investor may short USDINR currency futures for one year. This would allow him to sell USD to INR at a contracted price via futures contact and thus remove currency risk from the portfolio.
Use of currency futures for speculation
A trader has a view that given the buoyant economic condition in India and the likelihood of a drop in inflation, the INR may appreciate in the next six months from the current level of 66 to 64. To execute the view, he shorts 100 contracts at a price of 67.5. As expected, INR appreciated. At the expiry of the contract, the settlement price was 64.5. Since the settlement price was lower than the contracted price and the trader had shorted the futures, he made a profit. The amount of profit would be equal to the difference in the contracted price and the settlement price. Thus the trader made a profit of Rs 3 per USD.
Use of currency futures for arbitrageurs
A trader notices that 6 month USDINR currency futures was trading at 65.98/66.00 while 6 month forward in the OTC market, for the same maturity as that of the currency futures contract, was available at 65.85/65.86. The trader would short currency futures at a price of 65.98 and go long in currency forward at 65.86. At the time of settlement, the trader loses 1.02 on futures and makes a profit of 1.14 on the OTC forward contract. Thus he makes an arbitrage profit of 0.12 per USD.
Triangular Arbitrage
Triangular arbitrage involves identifying and exploiting the arbitrage opportunity resulting from price differences among three different currencies in the forex market. It involves three trades: exchanging the first currency for a second currency, exchanging the second currency for a third currency, and exchanging the third currency for the first currency.
Like all other arbitrage opportunities, this triangular arbitrage is also possible only when the exchange rates are not aligned with the implicit cross exchange rate. Please note that profitable triangular arbitrage is very rarely possible because when such an opportunity arises, traders execute trades that take advantage of the imperfections and prices adjust up or down until the opportunity disappears. Even when those opportunities appear for a very brief period of time, the opportunity (price disparity) may be very small (around 1 basis point or so in many cases) making it not a profitable opportunity after factoring in the transaction costs and taxes. Moreover, there is also a risk of adverse price movement while the arbitrageur is still setting up the arbitrage position.
Trading spreads using currency futures
Spread refers to the difference in prices of two futures contracts. A good understanding of spread relation in terms of pair spread is essential to earn profit.
Intra-Currency Pair Spread (also called “calendar spread”): An intra-currency pair spread consists of one long futures and one short futures contract. Both have the same underlying but different maturities.
Inter-Currency Pair Spread: An inter-currency pair spread is a long-short position in futures on different underlying currency pairs. Both typically have the same maturity.
Limitations of currency futures for hedgers
Exchange-traded currency futures contracts are standard contracts which are settled in cash i.e. without delivery of currencies. For hedgers, there might be a mismatch in the timing of settlement or cancellation of the futures contract and the timing of actual trade remittance. This timing mismatch may result in a small loss of value as compared to an OTC forward contract. However, the transparency, small lot size, and ease of trade execution may offset it.
V. Trading in Currency Futures
Currently, currency futures contracts on four INR pairs i.e., USDINR, EURINR, GBPINR, and JPYINR and on three cross-currency pairs i.e., EURUSD, GBPUSD, and USDJPY are being traded on the recognized stock exchanges.
The base price of the futures contracts on the first day of its life shall be the theoretical futures price. The base price of the contracts on subsequent trading days will be the daily settlement price of the previous trading day.
The closing price for a futures contract is currently calculated as the last half an hour weighted average price of the contract.
The tenor of a contract means the period when the contract will be available for futures trading, i.e. the "cycle” of the contract.
Entities in the Trading System
Trading Members: Trading members are members of an authorized Exchange. They can trade either on their own account or on behalf of their clients including participants. The exchange assigns a trading member ID to each trading member. Each user of a trading member must be registered with the exchange and is assigned a unique user ID. The unique trading member ID functions as a reference for all orders/trades of different users.
Clearing Members (CM): Clearing members are members of the Clearing Corporation. They carry out risk management activities and confirmation/inquiry of participant trades through the trading system.
Trading-cum-Clearing Member (TCM): A member with a right to trade on its own account as well as on account of its clients. He can clear and settle the trades for self and for others through the Clearing House.
Professional Clearing Members (PCM): A professional clearing member is a clearing member who is not a trading member. Typically, banks and custodians become professional clearing members and clear and settle for their trading members and participants.
Participants: A participant is a client of a trading member - like financial institutions. These clients may trade through multiple trading members but settle through a single clearing member.
Types of Orders
A. Time Conditions
Day order: A day order, as the name suggests is an order which is valid for the day on which it is entered.
Immediate or Cancel (IOC): An IOC order allows the user to buy or sell a contract as soon as the order is released into the system, failing which the order is cancelled from the system.
B. Price Conditions
Market Price: Market orders are orders for which no price is specified at the time the order is entered. For the buy order placed at market price, the system matches it with the readily available sell order in the order book. For the sell order placed at market price, the system matches it with the readily available buy order in the order book.
Limit Price: An order to buy a specified quantity of a security at or below a specified price, or an order to sell it at or above a specified price (called the limit price).
Stop Loss: This facility allows the user to release an order into the system, after the market price of the security reaches or crosses a threshold price.
C. Other Conditions
Pro: ‘Pro’ means that the orders are entered on the trading member's own account.
Cli: ‘Cli’ means that the trading member enters the orders on behalf of a client.
Price Limit Circuit Filter
With the view to ensure orderly trading and market integrity, SEBI prescribes stock exchanges to implement a mechanism of Dynamic Price Bands so as to prevent acceptance of orders placed beyond the price limits set by the stock exchanges. These dynamic price bands are applicable to all currency futures positions including the cross currency futures contracts.
Contracts with tenure up to 6 months: ± 3% of the theoretical price or the previous day closing price, as applicable
Contracts with tenure greater than 6 months: ± 5% of the theoretical price or the previous day closing price, as applicable
The exchanges relax the dynamic price bands in increments of 1% as and when a market-wide trend is observed.
🏦 VI. Clearing, Settlement, and Risk Management in Currency Futures
Clearing: Computing open positions and obligations of clearing members in the trading system.
Settlement: Honoring the actual pay-in or pay-out to settle the contract.
Clearing Entities
Clearing Members: In the Currency Derivatives segment, trading-cum-clearing members clear their own trades as well as trades of other trading members (TMs). Additionally, Professional Clearing Members (PCM) clear and settle trades executed by TMs.
Clearing Banks: Funds settlement takes place through clearing banks. All clearing members are required to open a separate bank account with the Clearing Corporation’s designated clearing bank.
Clearing Mechanism
The clearing mechanism involves calculating the open positions and obligations of clearing members for exposure and daily margin purposes.
Aggregation: A Clearing Member's (CM) open position is the aggregate of the open positions of all TMs and custodial participants clearing through them.
TM Open Position: Summation of proprietary open positions and clients' open positions.
Pro/Cli Indicator: While entering orders, TMs must identify them as proprietary (
Pro) or client (Cli).Netting Rules: Proprietary positions are calculated on a net basis (buy − sell). Client positions are netted for each individual client and then summed together across all clients (not netted across different clients).
Settlement Mechanism
Mark-to-Market (MTM) Settlement: Futures contracts are marked to the daily settlement price at the end of each day.
Squared off positions: Difference between the buy price and sell price for the day.
Not squared off: Difference between the trade price and the day's settlement price.
Brought forward positions: Difference between the previous day's settlement price and the current day's settlement price.
Final Settlement: On the last trading day, positions are marked to the final settlement price (RBI reference rate), and the resulting profit/loss is settled in cash. The amount is debited/credited to the CM's bank account on the T+2 working day.
Margin Requirements and Types
Because futures are leveraged, an effective margining framework is imperative to avoid systemic failure and deter excessive speculation.
Initial Margin: The security deposit paid by a member, dictating allowable exposure limits based on a worst-case loss scenario.
Portfolio Based Margin: The SPAN (Standard Portfolio Analysis of Risk) methodology is used to take an integrated view of risk across a client's portfolio.
Real-Time Computation: Scenario contract values are applied to actual portfolio positions on a real-time basis.
Calendar Spread Margin: Extreme loss margin is charged on one-third of the mark-to-market value of the far month contract.
Extreme Loss Margin: Computed as a percentage of the MTM value of the Gross Open Position and deducted from the CM's liquid assets.
Liquid Net Worth: Must be at least Rs. 50 lacs at all points in time after adjusting for initial and extreme loss margins.
📈 VII. Exchange Traded Currency Options
Option: A contract between two parties to buy or sell a given amount of an asset at a pre-specified price (strike price) on or before a given date (expiration date).
Call Option: The right to buy the asset.
Put Option: The right to sell the asset.
Time to Maturity: The difference between the entry date and the expiration date.
Option Buyer (Long): Buys the right (no obligation) and pays the premium.
Option Seller/Writer (Short): Sells the right, receives the premium, and assumes the obligation.
Futures vs. Options
Futures: Both parties have the right and obligation, facing similar risks.
Options: The buyer has rights but no obligations (limited risk to premium paid, unlimited upside). The seller has obligations (unlimited risk, limited upside to premium received).
Options in Financial Markets
India Timeline: Equity index options began in June 2001; currency options on exchanges started on November 10, 2010.
OTC vs. Exchange-Traded: In OTC, select banks act as market makers, and resident Indians can only be net buyers of options. Exchange-traded options are restricted by open interest and volume, not underlying FX transactions.
European vs. American:
European: Exercised only on the expiration date (All currency options in India are European).
American: Exercised any time on or before expiration (Not currently allowed for currencies in India).
Moneyness & Value
In the Money (ITM): Results in a positive cash flow for the buyer.
Out of the Money (OTM): Results in a negative cash flow.
At the Money (ATM): Spot price equals the strike price.
Intrinsic Value: Difference between the spot price and the strike price.
Time Value: Difference between the option premium and intrinsic value (proportional to time until expiration).
The Option Greeks
Delta ($\Delta$): Rate of change of option price with respect to the underlying asset's price.
Vega ($\nu$): Sensitivity of option value to the volatility of the underlying asset.
Theta ($\Theta$): Change in option value with respect to the passage of time (time decay).
Rho ($\rho$): Sensitivity of option value to the risk-free interest rate.
Pricing Methodology
Black-Scholes: Analytical, faster to compute, mainly used for European options.
Binomial Pricing: Computational, requires more processing power, mainly used for American options.
🧾 VIII. Accounting & Taxation
Clients must maintain two separate accounting heads:
Initial Margin - Currency Futures
Mark to Market - Currency Futures
Accounting Entries
For Pay-out (Loss/Margin posting): Debit the respective margin/MTM head; Credit the Bank account.
For Pay-in (Profit): Credit the MTM head; Debit the Bank account.
Expired/Cancelled Positions: Profit/loss is calculated as the difference between final settlement and contract prices, passing through the P&L statement. If a provision account exists, losses are charged there first.
Client Default: The unpaid amount is adjusted against the initial margin. (Debit MTM account, Credit Initial Margin account).
🏛️ IX. Regulatory Framework for Currency Derivatives
Securities Contracts (Regulation) Act, 1956 [SC(R)A]: Governs the trading of securities in India to prevent undesirable transactions.
RBI-SEBI Committee: Formed in February 2008 to oversee Exchange Traded Currency and Interest Rate Derivatives.
FEMA 1999: Amended in 2000 to officially define "Currency Futures" as standardized foreign exchange derivative contracts traded on recognized stock exchanges.
Framework for Exchanges & Clearing Corporations
| Entity | Key Requirements |
| Exchanges | • Online screen-based trading system. • Independent Clearing Corporation. • Real-time surveillance capabilities. • Minimum balance sheet net worth of Rs. 100 crores. • Real-time data dissemination to at least 2 networks. • Minimum 50 members to start trading. • Robust arbitration and investor grievance redressal. |
| Clearing Corps | • Ensure trades settle by matching buyers and sellers. • Enforce margin requirements and MTM settlement. • Maintain a separate settlement guarantee fund. |
🛡️ X. Codes of Conduct and Investor Protection Measures
SEBI Code of Conduct for Brokers
Integrity & Care: Exercise due skill, care, and honesty.
No Manipulation/Malpractices: Do not create false markets, spread rumors, or indulge in deceptive schemes.
Duty to Client: Fair execution of orders, proper issuance of contract notes, and avoiding breach of trust.
Business Restrictions: Do not encourage trading solely for generating commission. Do not transact for defaulting clients.
Cooperation: Work with other brokers to protect client interests and complete settlements.
Segment-Specific Guidelines
Disclosures: Ensure adequate disclosures and make no guarantees against losses.
Trading Principles: Prevent improper use of constituent funds/positions. Ensure transactions are not misrepresented.
General Rules: Do not shield rule-breakers, trade suspended contracts, or misuse fiduciary information.
Investor Protection Systems
SCORES (SEBI Complaints Redress System): A centralized, 24/7 web-based system enabling investors to lodge, follow up, and track complaints online. Physical complaints are scanned and uploaded to the system.
Arbitration: A quasi-judicial process governed by Exchange Bye-laws to settle disputes efficiently (usually within 4 months) between members, investors, and listed companies.
Combination Strategies
Combination strategies utilize multiple options with varying strikes and maturities depending on market view and risk appetite:
| Market View | Applicable Strategies |
| Moderately Bullish / Bearish | Bull Call Spread, Bull Put Spread, Bear Put Spread, Bear Call Spread |
| Range Bound / Break-out | Short Strangle, Short Straddle, Long Butterfly |
| Break-out (High Volatility) | Long Straddle, Short Butterfly |
| Complementing Futures | Covered Call, Covered Put, Protective Call, Protective Put |
Dhaval Visariya
AMFI Registered Distributor (ARN-327925) | Software Developer & Finance Enthusiast
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Disclaimer: I am an AMFI Registered Mutual Fund Distributor. Views expressed here are for educational purposes. Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
📧 Contact: info.apollofinancialservices@gmail.com
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