Title of the topic: Derivatives

Trading in India

Volume: 12/2021

SSL Research Centre, Educate Yourself, Volume: 12/2021, 29th January, 2021

1

Currency Derivatives Trading in India

Introduction

Currency Derivatives are futures and options contract where you can buy or sell specific quantities of a particular currency pair at a pre-determined future date. Currency trading is often referred as foreign exchange or Forex Trading. In this uncertain world, when most of the global central banks have kept their interest rates low for a longer period of time, the most attractive avenue in financial markets is turning out to be forex trading.

Different are traded or exchanged across countries in a decentralised market through electronic means, such market is known as ‘’. The International currency market involves participants from the world like banks, corporations, central banks, hedge funds, investment management firms, retail forex brokers, and retail investors. These participants buy and sell different currencies in the Forex market. Such buying and selling of currency is done in the pairs of currencies all over the world.

Admittedly, currency trading requires one to dive deeper into various aspects of monetary and fiscal policies of the economy for the currency one is dealing with. The opportunities in forex trading are immense based on the round-the- clock trading window in various time zones across the world. Currency markets are technically opened for 24 hours and only closed from Friday evening to Sunday evening. But the 24-hour trading session is divided into further three sessions: Asian, European and United States Trading Session. On the contrary, there are challenges of doing forex trading in India, as our currency derivatives market window is open only from 9 am to 5 pm, which hardly captures the liquidity window for mid-London and early New York sessions. Plus, we have only four-rupee pairs to trade against numerous direct USD and non-USD pairs traded worldwide.

The currency market helps investors to take positions on different currencies. Investors around the world use currency futures contract for trades. Currency futures allow investors to buy or sell a currency at a future date, at a previously fixed price. In India currency futures are settled in cash. Currency futures are traded on platforms offered by exchanges like the BSE, NSE, MCX-SX. Currency futures in India were introduced in India in 2008 on the National Stock Exchange (NSE) and subsequently extended to other exchanges like the Bombay Stock Exchange (BSE), MCX-SX and United Stock Exchange. Currency options were introduced in 2010.For trading in currency market, one needs to open a forex trading account with a broker like SHCIL Services Limited.

The major challenge of getting into currency derivatives is the volume it attracts on a daily basis. The big chunk of it goes to forex hedging and into merchandise trade in forward and spot markets. The volume-based turnover in the spot market can change the daily and weekly trends of the currency futures, notably in the USD-INR pair, which is the most tradable currency pair in India. Despite these challenges, volumes in the currency segment of Indian exchanges have risen substantially since inception. Additionally, the USD-INR pair contracts provide tremendous opportunities to customize one's currency trades. On top of it, liquidity in near-month contracts is now sufficient to absorb big orders without distorting bid-ask spreads. That creates an attraction option to trade financial instruments, and with timely information and ability to see through the price actions, one can make a great deal of money in currency derivatives in the long term.

Base Currency / Terms Currency: In foreign exchange markets, the base currency is the first currency in a currency pair. The second currency is called as the terms currency. Exchange rates are quoted in per unit of the base currency. For example, the expression US Dollar–Rupee, tells you that the US Dollar is being quoted in terms of the Rupee. The US Dollar is the base currency and the Rupee is the terms currency. If US Dollar–Rupee moved from 43.00 to 43.25, the US Dollar has appreciated and the Rupee has depreciated.

SSL Research Centre, Educate Yourself, Volume: 12/2021, 29th January, 2021

2

Let’s look at how to trade in currency futures. Let’s say an information technology company wants to hedge against currency risk in case the IND strengthens against the USD. If the spot or current rate of INR is Rs 70 to the USD, it may purchase 1 lakh worth of futures contracts at that price. So if the value of the Rupee goes up, and the rate is Rs 65 to the USD, the company will be able to exercise its contract, and save a loss of Rs 5 lakh! Similarly, an importing company may bet against the value of the Rupee falling against the USD.

Currency futures trading isn’t just for hedging purposes. Most of it is accounted for by speculators. Here, they are not interested in holding the futures contracts till the expiry date; the positions are squared off before that.

Trading in currency futures requires margin money, the contracts will be traded in quote currency and the margin will be converted into the quote currency. In India for futures trading customer need to pay initial margin and extreme loss margin and for options trading, additional assignment margin along with the initial margin and extreme loss margin is required. Trades placed before 2 PM use the reference rate (given by RBI) of the previous day, while the trades placed after 2 PM, use the reference rate of the trading day.

So for a small amount, you will be able to take significant positions in currency futures. Of course, the more significant the position, the higher the potential for profit, and loss. If you get your bets right, you will make handsome profits. If you are wrong, you could lose a lot of money. If you want to play it safe, you can always go in for currency options, which are less risky since it gives you the choice of not exercising the contract at the strike price.

What will be the lot size? & what is PIP?

Currency is traded in various lot sizes. The standard lot size is 100,000 units, mini lot is of 10,000 units and the micro lot is of 1,000 units. Unlike stock markets, where we buy or sell single stock; in currency market, trading is done in pairs. In simple words, in forex market we have to buy one currency and sell another currency.

What is PIP?

All the currencies are priced up to the fourth decimal point. In forex market “percentage in point” (PIP) represents a tiny measure of the change in a currency pair. Retail traders often trade in micro lots, because one pip in micro lot represents only 10 percent move in the price. This makes losses manageable if a trade doesn’t give the planned results. Profit and loss of currency trades are shown in quote currency, and then after it is converted to INR at the end of the trading day at the reference rate given by the Reserve Bank of India.

What are the different currency pairs available?

Currency Derivative Trading is similar to Stock Futures and Options trading. However, the underlying asset are currency pairs (such as USDINR or EURINR) instead of Stocks. Currency Options and Currency Futures trading is done in the Foreign Exchange markets. Forex rates are the value of a foreign currency relative to domestic currency. The major participants of Currency Trading in India are banks, corporations, exporters and importers.

Currency futures in India were introduced in India in 2008 on the National Stock Exchange (NSE) and subsequently extended to other exchanges like the Bombay Stock Exchange (BSE), MCX-SX and United Stock Exchange. Currency options were introduced in 2010.On Indian exchanges, currency derivatives segment provides trading in derivative instruments like currency futures on 4 currency pairs, cross-currency futures & options on 3 currency pairs - GBP-USD, EUR-USD and USD-JPY. Majority of currency pairs traded in the world have US dollar on the one side. The is commonly traded with USD, EUR, GBP and JPY. The INR is the 20th most traded currency in the world.

SSL Research Centre, Educate Yourself, Volume: 12/2021, 29th January, 2021

3

Features of Indian currency derivatives:

• Hedging – exporters and importers can use currency derivatives as the hedging tool. • Less volatile – as compared to the other financial markets’ currency markets are less volatile. • High liquidity – as compared to equity and the commodity derivatives markets, currency markets are highly liquid for the USD, GBP, EUR and JPY. • Contract size – contracts have monthly expiry with maximum of 12 months period. Therefore, at any given period of time there will be 12 contracts outstanding on the exchange.

Effects of currency fluctuations:

Massive currency fluctuations can affect any economy. If, for example, the Rupee weakens against the US Dollar, it will make imports costlier and exports cheaper. This will hurt importers, but benefit exporters. Since India is a major oil importer, this will lead to more expensive oil imports, and lead to price increases in fuels like diesel and petrol. These higher fuel prices have an inflationary effect since they will affect every commodity that has to be transported. If, however, the Rupee strengthens against the US Dollar, it will make exports more expensive. Exporters, therefore, will earn less. This will affect sectors like information technology. These fluctuations in-turn encourage investors to opt for currency futures trading.

Risk involved in currency trading:

• risk – this risk is caused by changes in value of currency. • Settlement Risk – settlement risk occurs majorly because of the difference in time zone • Counterparty default risk – forward contracts and over the counter spot trades in currency are not traded on exchange hence such trades are subject to counterparty default risk.

In India currency trading is not the popular segment like equity. But with proper understanding and right trading strategy it is possible to generate good profits through currency trading. One must pay attention to the risk profile before staring trading in currency, because the risk profile of every individual is different.

Factors Influencing the Indian Currency Market:

There are several factors that influence the currency market. Some of the important ones among them, which have impacted the market recently, are discussed below:

Change of Interest Rate: The value of the currency of any country depends on the interest rate of that country. In case of upward movement of interest rate in the United States, the US Dollar (USD) appreciates against other currencies as well as against the Indian Rupee (INR). Any change of interest rate by the Federal Reserve Bank of New York (FED) through the Federal Open Market Committee (FOMC) has a great impact on the currency market.

Even an expectation of change of interest rate has a great impact on currency market. Whenever there is any such expectation, the market reacts sharply. The possibility of changes in interest rate is a speculative move, and the market reacts only for a short period of time. The market generally discounts some portion of such expectations well in advance, before they actually happen.

Inflow of Foreign Funds: The exchange rate depends on demand and supply of currency. Strong economic fundamentals and good ratings by international rating agencies have boosted foreign investors’ confidence in the Indian

SSL Research Centre, Educate Yourself, Volume: 12/2021, 29th January, 2021

4

market. During the last one to one and- a-half years, the Indian rupee has shown a tendency to appreciate due to a huge inflow of foreign funds in the Indian market by FIIs or through FDIs in the form of External Commercial Borrowings (ECB) and Foreign Currency Convertible Bonds (FCCBs). A direct relationship may be drawn between the USD–INR exchange rate and the BSE index. Considering all other factors to be constant, whenever overseas FIIs buy shares from the Indian market, there is an upward movement of the BSE index.

At the same time, due to inflow of foreign funds (foreign investors have USD to sell—they will buy INR to invest in Indian market against USD) in the Indian market, the supply of USD increases in the market and it depreciates against INR, or INR appreciates against USD. On the other hand, if there is any negative flow of funds by FIIs, there would be a downward movement of the BSE index, and consequently USD would appreciate against INR.

Price of Oil: A large portion of India’s import payment is mainly for payment of oil. Internationally, crude prices are named as BRENT, NYMEX, and Dubai Crude. Whenever there is any hike in the oil price per barrel, the Indian Rupee depreciates against the US Dollar. As such, the Indian Government buys more USD against INR to honour the import liability, resulting in heavy demand for USD. Consequently, the Indian rupee depreciates against USD.

The Indian currency market largely depends on the price of Dubai Crude. Whenever FIIs book profits by selling their shares, the BSE index falls, and at the same time INR depreciates against the USD. On April 12, 2006, the BSE index fell by more than 300 points due to heavy selling by FIIs, and on the same day the crude price also shot up to around USD70 per barrel. The Indian Rupee depreciated by 45- 50 paise on the same day, owing to the impact of these two important factors.

Comments from Political Leaders: Comments from political leaders and top bureaucrats do influence the market, but this is very short-term. It is quite common in India, particularly when it comes to comments from political leaders or the Governor of the Reserve Bank of India (RBI). We know that the Japanese economy is export-oriented, and that Japanese exporters welcome any move that depreciates the . It has been observed that Whenever the Yen strengthens against the USD; Japanese politicians tend to pass comments on economy that allows the Yen to slip back to its original level.

Political unrests can also strongly influence the currency market, but again only for a short period of time. Extended periods of political uncertainty can, however, cause the rest of the world to lose confidence in that country, and could finally result in a steep fall in the value of that country’s currency.

Release of Economic Data: The economic data or surveys released by various national and international agencies, including FED, RBI, Moody’s, etc. can influence market sentiments and lead to movement in exchange rates. Some data from the US, such as Non-Form Payroll, Jobless Claim, US trade deficit and GDP growth rate are known to influence the currency market.

Annual economic review, RBI credit policy, monetary policy, etc. also strongly influence the currency market. Understanding, interpretation and correlation of different data are important to gain a thorough understanding of the exchange rate movement by any corporate. Any mistake in the interpretation of data released could cause heavy loss to an organization.

SSL Research Centre, Educate Yourself, Volume: 12/2021, 29th January, 2021

5

RBI Intervention: The RBI, which regulates the Indian currency market, does intervene whenever it feels it is required to stabilize the market, or to keep market volatility under control. It is the responsibility of the RBI to keep the exchange rate unaffected at a time of volatility in the foreign currency market. It has been observed that RBI intervenes in the currency market whenever there is any abnormal movement in the exchange rate, either upward or downward. The RBI buys foreign currency (USD) to depreciate the domestic currency, and sells foreign currency when the domestic currency depreciates abnormally. Sometimes the RBI does not intervene at all. In April and May 2006, the Indian Rupee depreciated heavily in the wake of the fall of the BSE Index, but the RBI did not intervene, much as previously the Indian Rupee had appreciated (in January and February 2006) to such a level that it needed to be depreciated solely by market forces.

Natural Calamities: Natural calamities may also affect the currency market for a short period of time. In August 2005, Hurricane Katrina affected the entire region around the Gulf of Mexico. This region contributes around one-third of US oil production and accounts for around half of the nation’s refining capacity. Besides, a large part of US oil imports reaches ports in this area. The hurricane caused a huge loss in production of crude oil and natural gas. It affected the prices of crude oil and prices shot up. Automatically, the oil price increased globally and at the same time affected the exchange rate.

Things to remember:

• Currency is traded in pairs and have standard format to include base currency and quotation currency. • The base currency is always fixed to one unit. • We can buy more units of quote currency when base currency is appreciated against the quote currency. • We buy less units of quote currency when base currency is depreciated against the quote currency. • Countries hiving higher interest rates tend to have more value to the currency. • Higher inflation makes country’s currency stronger. • Country’s trade deficit and the currency have inverse relation; lower the trade deficit of the country, stronger will be the currency.

SSL Research Centre, Educate Yourself, Volume: 12/2021, 29th January, 2021

6

SSL Research Centre

Head – Research S. Devarajan [email protected] 022-61778621 (Technical & Derivatives) Gauri Hanmantgad Research Associate [email protected] 022-61778600

Disclaimer DISCLAIMER: This is solely for information of clients of SHCIL Services Ltd. and does not construe to be an investment advice. It is also not intended as an offer or solicitation for the purchase and sale of any financial instruments. Any action taken by you on the basis of the information contained herein is your responsibility alone. SHCIL Services Ltd., its associate companies, and employees will not be liable in any manner for the consequences of such action taken by you. We have exercised due diligence in checking the correctness and authenticity of the information contained in this recommendation. SHCIL Services Ltd., its associate companies, and employees shall not be in any way responsible for any loss or damage that may arise to any person from any inadvertent error in the information contained in this recommendation or any action taken on basis of this information.

Disclosures: SSL is registered as Research Analyst with SEBI bearing registration number INH000001121 as per SEBI (Research Analysts) Regulations, 2014. SSL is primarily engaged in the business of providing broking services. SHCIL Services Limited is a SEBI registered Stock Broker providing services to institutional and retail clients. SEBI registration no: INZ000199936 Details of associates of SSL are as under: 1.Stock Holding Corporation of India Limited (SHCIL) : SHCIL is primarily engaged in the business of providing custodial services, post trading services, Sub-broking services in association with SHCIL Services Limited and depository related services. SHCIL is also registered as Research Analyst with SEBI bearing registration number INH000001303 as per SEBI (Research Analysts) Regulations, 2014. 2.StockHolding Document Management Services Limited: Stockholding DMS Limited is in the business of providing End to End Document Management Solutions and Information Technology Enabled Services. 3.StockHolding Securities IFSC Limited (SSIL): SSIL offers a comprehensive bouquet of service solutions to all eligible investors at IFSC, Gift City, Gandhinagar.

SSL or its Research Analyst or relatives or its associates do not have any financial interest in the company(ies). SSL, the Research Analyst or relatives or its associates collectively do not hold more than 1% of the securities of the company(ies) referred to in this document as of the end of the month immediately preceding the date of this document. SSL or its Research Analyst or relatives or its associates may from time to time have positions in, purchase or sell, or be interested in any of the securities mentioned herein. SSL, the Research Analyst or relatives or its associates do not have any other material conflict of interest in the above company. SSL, the Research Analyst or relatives or its associates have not received compensation or other benefits of any kind from the company(ies) referred to in this document or from any third party, in the past twelve months. SSL, the Research Analyst or relatives or its associates have not managed or co-managed in the previous twelve months, any offering of securities for the company(ies) referred to in this document. SSL, the Research Analyst or relatives or its associates have not served as an Officer, Director or employee of the company(ies) referred to in this document. SSL, the Research Analyst or relatives or its associates have not been engaged in market making activity for the company(ies) referred to in this document.

SHCIL Services Limited CIN NO: U65990MH1995GOI085602 Plot No. P-51, T.T.C. Industrial Area, MIDC Mahape Navi Mumbai – 400 710 www.shcilservices.com

SSL Research Centre, Educate Yourself, Volume: 12/2021, 29th January, 2021

7