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Understanding Derivatives


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So we understand the market and what makes it work, we have met the bank that is banker to the banks and now it's time to bring in the high rollers or the players who ensure the money keeping rolling, literally!

As we know, the currency markets in India, despite being nascent, are showing promising growth despite the ongoing global crises. Now more than ever, players in the Indian markets have reason to play, hedge and invest their resources into growing their wealth and capital. Reminiscent of 1991, the Indian Rupee is once again poised on a possible revolution in terms of perception and regaining its strength and position as a fast growing currency.

As with every market place, the direction of the wind is dependent on the players who influence key factors that matter. As a country's purchasing power is based on the strength its currency and determined by its demand in relation to the availability of its supply, it also follows that maintaining and managing this strength comes from the soundness and the expertise of the players in its markets. The players who define the Indian markets are broadly divided into six major categories -

  • Government - By far the biggest and strongest player of them all. Every government is entrusted with the task of balancing the books and catering for revenue to meet expenses in the next financial year. Their exposure to imports and foreign exchange defines subsequent monetary policy, reforms and changes in taxation structures and restrictions in investment. Give their role as long term enablers of national and economic growth, the government can often be disruptive as a force as well, especially to curb upcoming crises or insulate against adverse global trends with respect to currency.

  • Central Banks - After the Government, it is the RBI that comes in next in its dual role of controlling and facilitating the moment of the rupee and various other currencies, Indian businesses are exposed to. Entrusted with ensuring liquidity and curbing inflation and other factors that may adversely impact the Rupee, they usually stabilize the money markets with timely interventions and restrictions via policy decisions. The RBI is also responsible for India's FOREX reserves, balancing payments, managing deficits and creating a financial environment conducive to foreign investment in India.

  • Commercial Banks - The other major player in Indian currency markets are the commercial and investment banks that facilitate funds for their customers to do business with global counterparts. Small, medium, large private and public banks in India participate in FOREX trading - either themselves or on behalf of their customers to offset exposure and risk, or as an investment tool to multiply their current invested capital. With dedicated dealing desks and customised risk management strategies, banks also offer due diligence in global M&A deals and profit on investment for HNI customers. Given their access to information both from the markets and as defined by their clients' interests, banks have the distinction of offering unique insights into possible market trend and possible price movements, often making them responsible for market sentiment and equally subject to market volatility.

  • Investment Firms and Hedge Funds - For Ultra HNI families and for large corporate clients, FOREX trading is not limited to managing risk exposure. Currency trading is also considered an alternate investment avenue for raising capital to cater to provisions, pension, gratuities and endowments. Investment firms and Hedge Funds facilitate FOREX trading for domestic as well as global players while hedging risk and maximising profits through either hedging or arbitrage strategies or while employing combinations of both. FII's and NRI's who usually would not be allowed to trade in Indian markets, often have Hedge Funds to represent their interests.

  • Inter-bank Forex Brokers - They deal with various banks and are not allowed to trade with corporate clients.

  • India Inc - All corporate that function as India Inc, having significant exports or imports play the currency markets to manage risk and increase efficacy of invested capital. These companies participate directly or indirectly through banks and exchange brokers to represent their interests and goals.

  • Speculators - This segment of players who have no commercial interest in FOREX and are only participating in currency trading to increase their capital gains from price movements of currencies. Given their high appetite for risk, speculators offer liquidity to the marketplace, which is key for hedgers to hedge their price risk effectively. Due to RBI regulation, such players are mostly restricted to the exchange traded currency derivatives market.

  • Retail Investors - They are the latest entrants into the FOREX space and still grappling with the intricacies and technicalities that form the currency markets. This segment is fast seeing growth in numbers given the increasing interest that retail investors are displaying with regards the currency space and more specifically the exchange traded currency derivative space.
As with any financial instruments, trading in currency and currency derivatives comes replete with risk even if used to hedge exposure and adverse movements. Thus, what matters most is to keep your ears to the ground and pulse on calls made by key market players. As investors, players, participants or voyeurs of the currency marketplace, we all need to ensure that the homework is done and the dots are connected to ensure our goals effectively. Following these key market players effectively is key to becoming apt at understanding under currents and being ably capable of playing the game, the all star way!

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While we have understood what comprises money, it is time now to understand what constitutes the world where money is traded - every second, every minute and every day!

As money is the medium of exchange for global transactions, it does follow that money itself would have a unique marketplace that would lend itself to the unique vagaries and volatilities of the Derivative market. Given high economic growth and liberalisation of capital flows, trading one currency for another lends itself to high risk exposure and hence, creates demand for risk management and hedging instruments as provided by Derivative Contracts. This special arena to make the best of what Currency Derivatives has to offer is what we call the Currency Derivative Marketplace.

Currency Derivatives primarily perform as efficient risk management tools for FOREX Trading and fulfil the need to protect players from global volatility and exposure. The Currency Derivatives Market in India is broadly segmented into the Over-The-Counter (OTC) Contracts and Exchange Traded Currency Futures. The OTC segment comprises Spot Trades, Forward Contracts and Swaps.

OTC Contracts are contracts or negotiations directly between two parties, without the formality of an Exchange. Most Currency Derivatives such as Spots, Forwards etc are usually traded in such a manner. The OTC Market is by far the largest contributor to the Currency Derivative market place with banks and other focused currency players. While the global OTC market is highly unregulated and high risk, in India, the OTC landscape has evolved in a fairly regulated, ethical and transparent manner. The RBI has also indicated that works in progress for designing a centralised trade reporting system for all OTC derivatives for better systemic oversight and market transparency. Clearing Corporation of India Ltd (CCIL) guarantees the settlement of all trades done in the OTC forwards market in India. OTC Derivatives offers flexibility of customisation in size to size and structure, thereby catering to specific risk management needs of banks and corporations.

Exchange Traded Currency (ETC) Derivative in India, were introduced to bring the Indian Currency Markets in line with their International counterparts. In adherence to global standards, there was a need to regulate the Indian market with appropriate guidelines for governance and transparency. Exchange traded derivatives in India is attaining popularity as average daily turnover in ETC is nearly 20 percent of the average daily turnover in the OTC. There are three exchanges where the derivatives on currency are traded, they are: the National Stock Exchange, the USE and on the MCX-SX.

Exchange Traded Currency Futures are an extension of the erstwhile OTC markets, simply with added risk management measures, reduced exposure to currency volatility and more number of participants. Exchange Traded Futures also provide for high levels of transparency, liquidity and standardization of Contracts. Trading of such Contracts on the Exchange has also opened up avenues for retail participation in Currency Derivatives, thereby increasing the number of players and participants significantly.

As with every market place, the Currency Derivative Market Place also has its own set of jargon. To begin with, the current rate of exchange at which you can buy a currency in lieu of another is known as the Spot Exchange Rate while the Forward Exchange Rate refers to a future rate of exchange for delivery of underlying currency assets.

Currency Derivative Contracts are known as Forwards which are based on Currency Exchange rates that usually take into consideration the possible price of a currency on a specified date. Forward Contracts are usually preferred by Corporations and Individuals who trade in goods and services that leave them highly exposed to price volatility. In a Forward Contract parties agree on a particular price estimated on a date in the future. On the said date, parties will have to honour the Contract and pay the difference in the prevailing market price and Contract price, if any. Forwards are prevalent in the OTC Markets.

An extension of the Forwards Contract is the Futures. Similar to the Forwards, Futures have one main distinction - they are traded on the Exchanges thereby having the added benefits of being regulated and transparent with a larger number of possibilities and participants.

Currency Futures can be bought and sold on the Currency Exchanges through members of the Exchange. In India, FIIs and NRIs are not permitted to trade in Currency Futures, but can limit their trades only to Interest Rate Futures. Currency Futures Contracts can be traded through MCX SX, NSE and USE and are usually executed in the following permutations -
  • US Dollar - Indian Rupee (USD INR)
  • Euro - Rupee (EUR INR)
  • Great Britain Pound - Indian Rupee (GBP INR)
  • Japanese Yen - Indian Rupee (JPY INR)
Exchange traded Currency Derivative Contracts have many significant characteristics -
  • You can undertake small Contracts up to USD 1000 or one single Contract at a time without additional costs
  • The Markets - both OTC and Exchange Traded - are extremely transparent with easy access to information regards price etc
  • As a trader, you are not exposed to FOREX exposure. Your participation is limited only to the terms of the specified Contract
  • The Indian Markets are in line with the governance and other norms of the International Markets
  • The Indian Market for Exchange traded Currency Derivatives is one of the largest such Market in the world.
The Markets are new and exciting for all investors to participate and avail of the benefits of making money out of money. How to do this? - We will find out more in our next post.

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When we need money, we go to the bank and when our banks need money, they usually turn to the RBI or the Reserve Bank of India.

Similarly to deepen international co-operation and make the business of money simple, all banks the world across, turn to one single entity to regulate currency, prices and subsequent transactions - The Bank of International Settlements (BIS).

Post World War I, under the Treaty of Versailles, following defeat, Germany and its Allies were held responsible for all the "loss and damage" suffered by the Allies and were required to make payments and transfers of property to make good such a loss. The plan for such repayments was formulated by an American - Owen D. Young and was overlooked by a committee set up in 1930 which included eminent banker J.P. Morgan and Thomas W. Lamont. Although the plan was presented in June 1929, it was formally adopted in January 1930, with the establishment of an International Bank of Settlements to handle such transfers. Thus, the BIS was established in 1930 in Hague and is the world's oldest financial organisation promoting international trade and co-operation.

Although established in Hague by countries such as the US, UK, Belgium, France, Germany, Italy and Japan, the location for the BIS was eventually moved to Basel, Switzerland, given the prevalent issues of connectivity faced by the Banks of London, Brussels or Amsterdam. Switzerland, by nature of being independent and neutral, offered the BIS freedom from the influences of the erstwhile superpowers, thereby ensuring unbiased working free from manipulation while Basel as a location, offered excellent connectivity to all members in every direction.

Although it was established primarily to deal with post war payments, the Great Depression of 1929, quickly changed the role of the BIS to being a more active member of global banking and focus on ensuring co-operation amongst the central banks of the world - a role that defines the BIS till date.

Post World War II, came the Bretton-Woods International Monetary System - a system of payments that allowed currency exchange at fixed but adjustable rates of exchange. Through the rise and fall of this System, the BIS played an important role as the key technical advisor to getting the European Union back to having all its currencies fully convertible by abolishing the various stringent foreign exchange protocols and controls. As money is the medium of exchange for global transactions, it soon followed that the BIS would also control and regulate FOREX transactions globally and be in charge of disseminating information to member countries regarding currency strength, future prices, expected changes in the economic climates etc to members who comprise Central Banks such as the RBI, representing different countries and diversities.

The BIS also offered assistance in times of crisis given price fluctuations of bullion and currency, checking reserves and other imbalances that would adversely affect the International Monetary System both in the era of fixed valuations and then, in the time of floating currencies, starting in 1973.

Today, the BIS have consolidated its role as the Central Bank for Central Banks the world over. From ensuring co-operation on transactions and monetary policy, the BIS has also provided traditional banking services to member banks including acting as agents and trustees. The BIS has also being instrumental in regulating the International Markets through the 1988 Basel Capital Accord and the more recent Basel II revision that India amongst other countries is now implementing across banks and financial services in the country.

As a Central Bank to Central Banks, BIS has the following objectives - a well-designed financial safety net supported by strong prudential regulation and supervision, effective laws that are enforced, sound accounting and disclosure regimes

The other roles performed by the BIS are -
  • Providing a central and neutral platform for discussion and decision making
  • Supervision and Regulatory Control
  • Providing research and information to member banks on international trends, factors and possible issues that may affect currency price
  • Being and agent or trustee, representing central banks in international transactions or operations
  • Being a counterparty or clearing house for financial transactions between central banks the world over

The BIS has three global offices. Headquartered in Basel, Switzerland, it has regional offices in Hong Kong and Mexico. The BIS is further divided into three departments that function towards international financial stability - Monetary and Economic Department responsible for research and statistics, Banking Department providing essential banking services to central banks and the General Secretariat that provides corporate services and support to the BIS itself.

The BIS is also the meeting place of the G10 comprising France, Germany, Belgium, Italy, Japan, Netherlands, Sweden, UK, US and Canada that meet at the BIS every second month to debate on matters of international finance.

The BIS is also home to several committees that work towards its primary goal of financial stability. These are the Basel Committee on Banking Supervision, the Committee on the Global Financial System, the Committee on Payment and Settlement Systems and the Markets Committee.

With 140 customers and two linked trading rooms, the BIS works at offering safety and liquidity across all financial transactions to all its members which now include several financial institutions in addition to central banks. Thus, it is biz at BIS that makes money go around the world over!

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There is nothing more conducive to change than the power of money.

Money is what makes the world go round, or more technically, currency is what makes the world spin on its axis. From being the medium of exchange for goods and services to being the backbone of your retirement plan, currency is what defines your work, life and bank balance.

So what is currency?

Every country is the world chooses the medium of exchange for transactions. Simply put, this is what we call currency. Each country hence would have its purchasing power based on the strength its currency wields in terms of other currencies. This purchasing power of any currency is determined and decided similar to any other commodity in the market - by understanding its demand in relation to the availability of its supply. If there are many people vying to buy a particular currency in relation to its supply, the position of that currency would strengthen. If however, its supply exceeds demand, then the position would weaken.

A currency's demand is created by two factors, the country's exports and its attractiveness as an investment destination for global players and financial institutions. Rising exports and greater foreign capital inflows would lead to rising demand of that currency and its consequent strengthening. In the same way, rising imports, reduced exports or capital outflows would impact the currency position adversely.

Given its volatile nature in an equally dynamic and challenging global marketplace, currency offers itself to be an ideal underlying asset for its own class of Derivatives. As we all know, a financial Derivative is a Contract of future price movements of an underlying asset. Given the fast growing and fast changing global economy, currency prices fluctuate almost daily, requiring players to continuously hedge positions to minimize risk, or encourage speculation to maximize profit.

Thus, Currency Derivatives are Contracts between the seller and the buyer, whose value is to be derived from the underlying currency asset. A derivative based on currency exchange rates is a future contract which stipulates the rate at which a given currency can be exchanged for another currency as at a future date.

Exchange Traded Currency Derivatives were first created and traded on the Chicago Mercantile Exchange (CME) in 1972. The FX Contract emphasized the U.S. rejection of the Bretton Woodsagreement which had fixed world exchange rates to a gold standard after World War II. By creating another type of market in whichFutures could be traded, CME Currency Futures expanded the reach of risk managementbeyond commodities, which were till then, the main Derivative Contracts being traded.When some commodity traders at the CME did not have access to inter-bank exchange markets in the early 1970s, they established the International Monetary Market (IMM) and launchedtrading in seven currency futures on 16th May, 1972. Ten years later, in December 1982, the Philadelphia Stock Exchange (PHLX)listed the first Currency Options Contract - Pound Sterling/USD.

The Forex market in India can be broadly segmented into the OTC (spot, forwards and swaps) Contracts and Exchange-Traded Currency Futures. Of this, Spot Forex trading volume constitutes around 50% of total trading turnover while the remaining is contributed by Forwards, Exchange-Traded Futures, OTC Options and Swaps.

Out of the total turnover of USD 24/27 billion, the OTC market chips in more than 75% in terms of trading volume. Non Deliverable Forwards (NDF), which came into existence in the 1990s, and has since grown in size. NDFs were mainly designed for emerging markets with capital controls where currencies could not be delivered offshore. Exchange-Traded derivatives generate 25% of the total turnover in Indian markets.

Currency Derivatives Contracts usually work on the expected appreciation and depreciation of currency. What does this mean? Let us take for example that the Indian Rupee is currently trading at INR 50 per USD. Should the price of the INR drop versus the USD ie, should it drop to INR 45 per USD, we would say that the rupee has appreciated in value. However, should the price of the INR increase to INR 55 per USD that would mean that the price of the rupee has depreciated in value.

Because Futures Contracts in the currency market are marked-to-market daily, investors can exit their obligation to buy or sell the currency prior to the Contract's delivery date by closing out their positions. As with all Derivative Contracts, the price is determined when the Contract is signed and the currency is exchanged on an agreed delivery date, which is usually sometime in the distant future.

Currency Futures are mainly executed to hedge against foreign exchange risk. For companies and corporations that engage in regular imports and exports of goods and services, the risk exposure is extremely high and thus, executing these Contracts help minimize risk and maximize available productivity and profits.

The eligibility criteria for trading members in an Indian Currency Futures segment is subject to a balance sheet networth requirement of Rs. 1 crore while the clearing member is subject to a balance sheet networth requirement of Rs. 10 crores.

To minimize investor risk and to avoid extreme price fluctuations in India, the Foreign Exchange Management Act is the law which regulates the Forex market and the regulatory authority for the Indian Forex market is the Reserve Bank of India (RBI). The Exchange Traded Currency Futures market is regulated by SEBI through recognized Stock Exchanges. Only Authorized Dealers (ADs) as licensed by the RBI can participate directly in Forextrading and these are usually Scheduled Commercial Banks.

Everyone in India, except for FIIs and NRIs etc. is allowed to trade in the Currency Futures market and thus, there are many players in the market - from high net worth individuals to banks to corporations, everyone enters this market to take advantage of an ever changing environment to make profits or reduce risk... is this for you, we will learn more in the next session of Currency Derivatives!

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In this article of Understanding Derivatives, we shall go deep into Derivatives Investing and understand the most important part of Derivatives. - UNDERSTANDING DERIVATIVE INDICATORS!

Click on the following link to read the full article:

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We have understood Derivatives and their market landscape. We met the key players therein. Now let us introduce ourselves to the instruments that give Derivatives their flexibility and make them lucrative for traders.

As we already know, in a Derivative market, we can either deal with Futures or Options contracts.

In this chapter, we focus on understanding what do Options mean and how best to derive the most from trading in them.

Click on the following link to read the full article:

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We have understood Derivatives and their market landscape. We met the key players therein. Now let us introduce ourselves to the instruments that give Derivatives their flexibility and make them lucrative for traders.

As we already know, in a Derivative market, we can either deal with Futures or Options contracts.

In this chapter, we focus on understanding what do Futures mean and how best to derive the most from trading in them.

Click on the following link to read the full article:

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As we understood in the last article, Derivatives derive their values from the assets they represent. Given the constant volatility in today's market environment, there are always variations of price that asset holders have to deal with. In keeping with the demand and supply equation prevailing at the moment, your assets either increases in value or decreases, exposing your holdings to continued financial risk and loss.

This article covers more in detail about Hedgers, Speculators, and Arbitrageurs.

Click on the following link to read the full article:

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We hear or read about them every day. But however much we do read about them, they still seem daunting as ever, don't they? Welcome to the world of derivatives- a class of instruments that have held the interest of investors over the years. Derivatives are popular given their flexibility, returns and their potential to provide market watchers with indicators of market sentiments. As Indian markets are experiencing one of their cyclical volatile phases, derivatives, may to some of us, seem a lucrative option. But like every other investment decision, we need to understand them clearly and discover how best to use them to our advantage. Thus, in a series of articles that follow, we will discover and decipher the world of derivatives, the jargon used to communicate and the indicators that define possible successes or profits.
To begin with, let us understand derivatives and what they mean
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