- Currency derivatives are considered to be one of the best options to manage any risk against foreign currency exchange rate volatility.
About currency derivatives
- Currency derivatives are exchange-based futures and options contracts that allow one to hedge against currency movements.
- One can use a currency future contract to exchange one currency for an another at a future date at a price decided on the day of the purchase of the contract.
- Corporate with a significant exposure to imports or exports use these contracts to hedge against their exposure to a certain currency.
- Currency future contracts allow investors to hedge against foreign exchange risk.
- Till January 2010, exchange rate futures were available only for US Dollar vis-à-vis Indian Rupee.
- Now, currency Derivatives are available on four currency pairs viz. US Dollars (USD), Euro (EUR), Great Britain Pound (GBP) and Japanese Yen (JPY).
- While all such currency contracts are cash-settled in rupees, the Securities and Exchange Board of India (SEBI), gave a go-ahead to start cross currency contracts as well on euro-dollar, pound-dollar and dollar-yen.
- Currencies are often traded in by banks and financial trading institutions.
- But individual investors can also trade in currency derivatives to take advantage of variations in currency exchange rates.
- The market for currency trading is one of the biggest and fastest growing in the world.
- It was first introduced at the Chicago Mercantile exchange (CME) in 1972.
- The currency segment in India was unveiled in 2008 and since then, the volumes had registered a steady rise.
- NSE was the first stock exchange in India, permitted by the SEBI to set up a separate currency derivatives segment in 2008.
- Following which, the BSE and MCX started trading the currency futures in same year.
- The two national-level stock exchanges, BSE and the National Stock Exchange (NSE), have currency derivatives segments.
- The Metropolitan Stock Exchange of India (MSEI) also has such a segment but the volumes are a fraction of that witnessed on the BSE or the NSE.
- In June, BSE reported an average daily turnover of ₹33,961 crore on its currency derivatives platform while NSE clocked ₹29,161 crore. MSEI reported a daily average turnover of only ₹239 crore in June.
- The growth in the segment can further be ascertained from the steady rise in the turnover over the years.
- The Exchange Traded Currency Derivative market is regulated by SEBI through the recognized stock exchanges.
- The Foreign Exchange Management Act regulates the Foreign Exchange market and the regulatory authority for the Indian Foreign Exchange Market is the Reserve Bank of India (RBI).
Trade in currency derivatives
- One can trade in currency derivatives through brokers.
- Incidentally, all the leading stock brokers offer currency trading services too.
- It is just like trading in equity or equity derivatives segment and can be done through the trading app of the broker.
- You can trade through futures trading contracts for different foreign currencies through leading stock exchanges in India.
- However, foreign institutional investors and non-resident Indians cannot trade in this market.
- Traders have to pay only a certain percentage value of the contracts to trade, and not the full contract value, which makes these contracts lucrative.
- Brokers get guidelines from exchanges to help decide the margins.
- Usually, they have to pay about 3%-5% of the value of the contracts for buying currency derivatives.
Need of currency derivatives
- Prior to the introduction of currency derivatives on exchanges, there was only the OTC – over the counter – market to hedge currency risks and where forward contracts were negotiated and entered into.
- It was kind of an opaque and closed market where mostly banks and financial institutions traded.
- With the changing dynamics and increasing volatility of exchange rates across the globe, companies exposed to currency risk face the challenge of maintaining continued profit margins.
- In recent years, the Indian foreign exchange system encountered increasing levels of fluctuations with high volatility rates, which lead to needs of hedging instruments in the market and in order to advance Indian foreign exchange market to international standards, a well-developed foreign exchange derivative market was essential.
- In such situation, currency Derivatives provides one of the best options to manage any related exchange rate risk and be free from the worries of market uncertainties.
- Exchange-based currency derivatives segment is a regulated and transparent market that can be used by small businesses and even individuals to hedge their currency risks.