Currency futures

Currency futures are the simplest contracts in the derivatives segment: one price, one lot size, cash settlement against a published rate. That simplicity is why the exam asks so many numeric questions on them. You must know the specifications well enough to convert a price move into rupees without thinking, and understand what drives the futures price above or below spot.

Contract specifications

NSE and BSE run currency derivatives segments under SEBI and RBI oversight. The pairs and their key features, as specified by the exchange and revised from time to time, are:

• USD/INR, EUR/INR, GBP/INR: lot size 1,000 units of the foreign currency; quoted in rupees per unit to four decimals; tick size ₹0.0025.
• JPY/INR: lot size 1,00,000 yen; quoted in rupees per 100 yen; tick ₹0.0025.
• Cross pairs EUR/USD, GBP/USD, USD/JPY: lot of 1,000 units of the base; quoted in the quote currency (dollars or yen); tick 0.0001; rupee settlement by converting through the reference rates.
• Expiry: monthly contracts; USD/INR has up to twelve serial months, others as specified. Weekly USD/INR contracts have also been introduced.
• Last trading day: two working days before the last business day of the month, trading closing at 12:30 pm that day. Final settlement day: the last working day of the month.
• Trading hours: 9:00 am to 5:00 pm, longer than the equity segment, as specified by the exchange.
• Settlement: daily mark-to-market in cash; final settlement in cash at the RBI reference rate (published by FBIL) on the last trading day. No delivery of currency.

The arithmetic that follows from the specs is the core of the chapter. One tick on a USD/INR lot is 0.0025 × 1,000 = ₹2.50. A move of one paisa (0.01) is ₹10 per lot. A full rupee move is ₹1,000 per lot. The contract value of one lot at 84.00 is ₹84,000, so a client with ₹1 lakh of margin money can control a large notional, which is why margins and position limits matter.

Notice that the daily MTM amounts add up to the total, which is exactly the point of mark-to-market: profit and loss are paid every day, so at any time the open position has no accumulated gain or loss sitting with the clearing corporation. The margin block is separate from MTM and is released when the position is closed.

How the futures price is set

A currency futures price is a forward price, so it follows interest rate parity. The dollar is bought today with borrowed rupees, parked in a dollar deposit, and sold forward. The cost of rupee borrowing minus the dollar interest earned is the carry, and the futures price equals spot plus that carry.

With spot 84.00, rupee rate 6.5%, dollar rate 4.5% and three months to expiry, F = 84 × 1.01625 ÷ 1.01125 = 84.4153. The futures sits about 41 paise above spot and that gap, the basis, shrinks to zero at expiry as T goes to zero. Because rupee rates exceed dollar rates, USD/INR futures normally trade above spot, with later months higher than nearer ones: a contango driven purely by interest differentials, not by expectations. When the gap between the market futures price and this fair value widens, arbitrageurs step in: buy spot and sell futures if futures are too high, and the reverse if too low.

Margins and position limits

The clearing corporation collects margins from the trading member, who collects them from the client, before the trade. The components are:

• Initial margin, computed by the SPAN system to cover the worst likely one-day loss at 99% confidence. For USD/INR it has typically been a low single-digit percentage of contract value, higher for the more volatile EUR, GBP and JPY pairs, as notified.
• Extreme loss margin, a flat percentage of contract value added on top, as notified by the exchange.
• Calendar spread margin, a reduced charge when a long and a short in different months offset each other.
• Mark-to-market, settled in cash daily, by the next working day.

Position limits exist at the client and member level and are expressed as the higher of a percentage of total open interest or a fixed dollar amount, as specified by SEBI and the exchange. RBI additionally requires that positions beyond a notified threshold be backed by an underlying exposure, with the user responsible for ensuring this; speculative positions are allowed only within the limit. Banks have their own net open position limits set by RBI.

Hedging with futures

The hedge rule is mechanical: match the direction of your fear. An exporter who will receive USD 50,000 in two months fears a lower USD/INR and sells 50 lots. Suppose she sells at 84.40 and the RBI reference rate at expiry is 83.60. Her futures gain is (84.40 − 83.60) × 50,000 = ₹40,000. She converts her dollars in the bank at about 83.60, receiving ₹41,80,000, and adds the ₹40,000 gain: ₹42,20,000 in total, or an effective rate of 84.40, which is what she locked in. Had the rupee weakened instead to 85.00, the futures would lose ₹30,000 but the bank conversion would fetch ₹42,50,000, again netting 84.40. A hedge removes both the loss and the gain.

An importer does the mirror image: buys futures. The residual risks are basis risk (the bank's spot rate on the day may differ slightly from the reference rate), timing (the receivable may arrive on a date that does not match expiry, requiring a roll), and cash flow (daily MTM losses must be funded even though the underlying gain is unrealised until the dollars arrive). Sales staff should warn clients about the third one; it is the most common reason small hedgers abandon a correct hedge.