Monday, September 1, 2008

Currency Futures are here!

Hindu Businessline, 1st September 2008, Co-author-Zohra Zabeen
Currency futures are derivative instruments that allow investors and companies to hedge against exchange rate volatility.

Ravini is in a gloomy mood. As usual, she feels let down by the management education system of which she is a part — as a student, that is. She has absolutely no clue about the recently launched currency futures on the NSE (National Stock Exchange). In the last few days, she was haunted by currency derivatives even in her sleep.
On her way to the library, Ravini tries to put together all that she had learnt about futures, and as luck would have it, she sees Prof. Nicky walking out of the library. The only link between Nicky and Ravini was that they happened to live in the same locality some ten years back, and now, Ravini was a student at the same B-School at which Nicky was a Professor of Finance. This connection in an Indian setting means, Ravini considers it her right to call on Nicky anytime, anywhere and for anything.
Professor Nicky smiles knowingly as she looks at Ravini who has a perpetual question mark on her face. Nicky wastes no time in pleasantries, before asking, “So what’s bothering you today?”
Ravini: Hello Professor! I was wondering if you had some time to discuss currency futures.
Nicky: Ah! Indeed…I should have guessed. What do you already know about it?
Ravini: As the name suggests, it must be a futures contract, with currencies as the underlying asset. Beyond that I know nothing!
Nicky: Yes. You are right. These contracts were first created at the Chicago Mercantile Exchange in 1972 to hedge the exchange rate risks faced by businesses. After the collapse of the Bretton Woods Agreement, most of the countries shifted to a floating exchange rate regime, making exchange rates volatile.
So exchange rates, which were not something that needed to be managed earlier, now became a matter of concern for many exporters and another avenue to bet on, for speculators. Last week, on August 29, they were launched for trading at the NSE as well.
Ravini: So, currency futures are derivative instruments that allow investors and companies to hedge against exchange rate volatility?
Nicky: Yes, it allows exchange of one currency with another at a specified date in future at a prefixed price. Currency futures work the same way as futures in stocks.
Ravini: We already had Over the Counter currency forwards amounting to a huge daily turnover of $34billion in India, right? Then why do we need currency futures?
Nicky: The purpose of both is to protect the investors or companies from unfavourable movements in exchange rates. But the difference lies in the contract specifications. Forwards are customisable in terms of the amount and time for which the hedge is required. On the other hand, futures are standardised as per the specifications of the exchange.
Ravini: But then wouldn’t everyone want a customised contract?
Nicky: No. Exchange-traded futures (ETFs) would be preferred by many as the default risks would be limited due to the daily mark-to-market settlement and the involvement of National Securities Clearing Corporation (NSCCL) as the legal counterparty to all the trades that are executed at the NSE. Also, while exchange traded currency futures would be very liquid in nature, forwards are not liquid, they cannot be bought and sold as and when desired. Also, in the case of forwards, trading takes place only between large players, typically between banks and corporations or between banks themselves. This causes lack of transparency in the pricing of the products.
Ravini: Oh! This means investors, fund managers, and companies can now hedge currency risk without the fear of default and illiquidity risks and with better price discovery mechanism.
Nicky: Absolutely. The step taken forward by the RBI and SEBI (Securities and Exchange Board of India) to introduce currency futures in India is indeed laudable and bears utmost importance keeping in mind current macroeconomic conditions. Fear of forex losses are haunting Indian corporates and this initiative is expected to bring some respite. Currency futures offer several advantages to companies with international operations, fund managers, individuals, exporters, importers, hedge funds, non-banking institutions and speculators alike.
From the corporate perspective, currency risk hedging has assumed greater importance in the wake of excess volatility in the foreign exchange market, which has impacted the export performance and balance-sheet of the companies.
Many reputed companies have reported huge foreign exchange losses in the quarter ended June 30, 2008.
Moreover, in the current scenario where Indian companies are acquiring or buying foreign companies and seeking loans and funds abroad, the risk of exposure to various currencies have increased all the more.
From the investor’s point of view, a well-balanced portfolio through diversification and low systematic risk is beneficial. According to a few empirical studies price fluctuations in currency futures have very low correlations with price movements in stock market values and interest rates. Hence, this low correlation can reduce portfolio risk when equities and bonds are in depressed state.
Ravini: I read that RBI’s working group has suggested the contract size of $1000 with a maximum maturity of 12 months only for these contracts. Is there any specific reason for doing so?
Nicky: Yes, a small-sized contract (in value) would encourage more participants with even small currency exposures to take advantage of these contracts.
Ravini: If the currency futures have so many benefits, why are the FIIs and NRIs being barred from entering the market?
Nicky: As of now, there are many apprehensions regarding the success of currency futures launch. Hence, RBI and SEBI are being cautious in order to reduce the fear of speculation and volatility. However, this is a big step by them and must be applauded.
I am sure this is the first step towards creating a full fledged foreign exchange derivative market in India and would take the country closer to full capital account convertibility. Now, if you excuse me please, I must rush for a class.
Ravini: Sure professor. Thanks you very much and I hope to see you soon if I have further queries.
Happy and contented with the answers of Prof. Nicky, Ravini takes a U-turn to the canteen to show off her newly acquired gyan to her friends!