Foreign Exchange Derivatives

Chapter 2: Foreign Exchange Derivatives

NISM Series I — Currency Derivatives | ~4% weightage | ~24 questions

What this chapter is about

The shortest chapter by question count but important as a conceptual bridge. This chapter answers: what are derivatives, why do they exist in currency markets, who uses them, and what's the difference between OTC and exchange-traded. If you've already studied Series VIII Equity Derivatives, 70% of this chapter is review — the definitions of hedgers, speculators, and arbitrageurs are identical. The currency-specific additions are the reasons why currency derivatives started in India and who pushed for it.

Key concepts

What is a derivative? A contract whose value is DERIVED from the value of an underlying asset. For currency derivatives, the underlying is an exchange rate (USDINR, EURINR, GBPINR, JPYINR).

Types of currency derivatives:

• Forwards — OTC, bilateral, customised, settled between two parties
• Futures — standardised forwards, exchange-traded, guaranteed by clearing corporation
• Options — right but not obligation, buyer pays premium
• Swaps — series of forward contracts, exchange cash flows in different currencies (mostly OTC)

OTC vs Exchange Traded:

| Feature | OTC | Exchange Traded | |---------|-----|-----------------| | Counterparty risk | Yes — bilateral | No — clearing corp guarantees | | Standardisation | Customised | Standardised | | Transparency | Opaque pricing | Transparent, all can see prices | | Settlement | Bilateral, delivery-based | Centralized, cash-settled | | Risk management | Decentralized | Centralized (clearing corp) | | Liquidity | Depends on counterparty | Exchange provides liquidity |

Three market participants — same as Series VIII:

| Participant | What they do | Risk appetite | |------------|-------------|--------------| | Hedger | Has real exposure (exports/imports), uses derivatives to REDUCE risk | Low | | Speculator | Takes directional view on currencies, has NO underlying exposure | High | | Arbitrageur | Exploits price differences between OTC and exchange, or between currency pairs | Zero (risk-free) |

Key distinction: Hedgers have REAL underlying exposure (an exporter who will receive USD). Speculators have NO real exposure — they're purely taking a view. If someone is trading currency futures purely based on their analysis with no actual import/export business, they are a speculator.

Why currency futures came to India

The Committee on Fuller Capital Account Convertibility first recommended introducing exchange-traded currency futures in India. Following this:

• RBI Working Group on Currency Futures was set up in 2007-08
• SEBI-RBI Standing Technical Committee was formed to recommend product design, margin requirements, membership norms, surveillance mechanisms
• NSE launched the first USDINR currency futures contract in August 2008

Growth of derivatives — reasons tested

1. Increased volatility in asset prices (currencies, commodities, interest rates) 2. Increased integration of national financial markets with international markets 3. Technological breakthrough — high-speed processors, networks, data systems 4. Development of more sophisticated risk management tools 5. Innovations in derivative products — wider choice of risk management strategies

Not a reason: "Easier to make profits in derivatives than spot markets" — this is a trap answer. Derivatives are risk management tools, not profit-making shortcuts.

Real market example

A Hyderabad IT company exports software to the US and receives USD 5 million every quarter. The CFO is worried that INR might appreciate (USDINR might fall from 84 to 82) before they can convert the dollars — this would reduce their INR revenue by Rs 1 crore.

They approach their bank and buy USDINR put options — this is HEDGING. The bank takes the other side and is willing to absorb the risk for a premium.

A trader who reads the same economic data and sells USDINR futures expecting INR to appreciate is a SPECULATOR — no underlying exposure, purely a view.

An algo fund that spots USDINR futures quoting at 84.50 while the OTC forward is at 84.00 for the same maturity simultaneously buys in OTC and sells in futures — this is ARBITRAGE. Zero directional risk, locked profit of 50 paise per USD.

Trap Alert

Trap 1: "OTC derivatives have centralized counterparty risk management" — FALSE OTC = decentralized. Individual parties bear each other's counterparty risk. Only exchange-traded derivatives have centralized clearing.

Trap 2: "Derivatives are only available for currencies and equity stocks" — FALSE Derivatives exist for currencies, equity, interest rates, commodities, credit, weather — almost any asset class.

Trap 3: "Futures contracts differ from options in rights and obligations" — TRUE Futures = BOTH parties have obligations. Options = buyer has RIGHT, seller has OBLIGATION.

Trap 4: "OTC settlement is cash-settled like exchange-traded" — FALSE OTC spot market settlement = actual delivery of currency (delivery-based). Exchange-traded currency futures = always cash-settled in INR.

Must-remember rules

• Derivative value = derived from underlying (exchange rate for currency derivatives)
• Hedger = real FX exposure, wants to reduce risk
• Speculator = no underlying exposure, takes directional view
• Arbitrageur = exploits price differences, risk-free profit
• OTC = counterparty risk, customised, delivery-based settlement
• Exchange-traded = no counterparty risk, standardised, cash-settled
• Fuller Capital Account Convertibility Committee = first recommended FX futures
• SEBI-RBI Standing Technical Committee = recommends norms (not "special committee formed by SEBI")
• Derivatives market → higher volumes in underlying market (more participants)

Weightage note

~4% = ~24 questions. Lightest chapter. Mostly definitions and True/False. Know the OTC vs exchange-traded table cold, know who the three participants are, know which committee recommended what. 20 minutes of study should secure full marks here.

Quick revision — 60 second scan

• Derivative = value from underlying
• Hedger (real exposure, reduce risk) | Speculator (no exposure, take view) | Arbitrageur (no risk, exploit misprice)
• OTC = customised, delivery, counterparty risk
• Exchange traded = standardised, cash-settled, CC guarantees
• Fuller Capital Account Convertibility = first recommended FX futures in India
• SEBI-RBI Standing Technical Committee = recommends product design + margins + membership
• Futures = obligations for both | Options = right for buyer, obligation for seller