– By Ajay Krishnan,?Knowledge Partner & Educator, EZWealth?
In the previous module, we learned about the basics of the FX market and how it operates. Most information in that module were general in nature, to prime you up for the specifics of Indian currency markets. Though currency trading in India has existed for decades, the non-convertibility of the Indian Rupee (you could not take INR abroad or bring in foreign currency to India till 1991) made it very difficult for an active FX market to operate in India. Most foreign exchange transactions were limited to business houses (who had a license for it) or NRI businessmen. Draconian economic policies of a bygone centralised, socialist economy always restrained the potential for a vibrant and thriving FX market in India until the reforms of July 1991. Even after liberalisation, the FX market remained the stronghold of an elite few ? major banks, businesses and the government. Since it was a comparatively more complex trading environment to understand, and the lack of interest of the general public led FX markets to remain in its infancy till the early 2000s.
The Indian foreign exchange market is a decentralised multiple dealership market comprising two segments ? the spot and the derivatives market. The FX spot market operates same as the equity spot market on a T+2 deliver basis. The derivatives market encompasses forwards, swaps, and options. As in case of other Emerging Market Economies (EMEs), the spot market remains an important segment of the Indian foreign exchange market. With the Indian economy getting exposed to risks arising out of changes in exchange rates, the derivative segment of the foreign exchange market has also strengthened and the activity in this segment is gradually rising.
Until 2008, FX market was restricted to the OTC ? Over the Counter ? market, which is very different from an exchange. This market mainly exists between select entities like banks, businesses and government bodies. Most of the trades are initiated and settled by phone or meetings, prices are not publicised and display a general lack of transparency. Also, there are no standardised financial products or contracts ? market players design them according to their own convenience and requirements. These trades in the OTC markets could be spot-price based or future-price based. When they are based on a future-price, they are called forwards. In 2008, finally RBI felt the need to let the general public and smaller traders get involved in FX transactions and it was decided to introduce Currency Futures in select exchanges across the country. The reasons for this were mainly to increase the size and liquidity of the FX market and to help businesses ?hedge? their currency risk arising from export/import payments.
Later in 2010, RBI decided to introduce Currency Options in select exchanges in India thereby giving the Indian FX market a much-needed shot in the arm. Equity options were introduced four years prior in 2006 and by then the traders were beginning to fully understand the advantages and risk management potential of option contracts. The currency F&O segment is also called the Currency Derivative Segment (CDS). With the arrival of currency options, the FX market became more affordable to the retail trader with smaller lot sizes (unlike futures) and lesser cost of entry, while providing the opportunity to hedge risk effectively through premiums.
It is important to note that unlike the global currency markets, spot trading is not available in India through exchanges. Spot trading is done in the OTC market mainly by authorised dealers, RBI and select public sector units.
Fig 1. USDINR rates since Independence. Until 1991, Indian FX market was highly regulated.
Difference between Forwards and Futures
Any contract that is signed between two parties for a settlement date in the future is called a forward contract. A forward contract can be of any lot size with a maturity date decided arbitrarily by the parties. These types of contracts are usually seen in OTC markets.
A forward contract that is traded on a recognised exchange is called a futures contract. Though it achieves the same economic functions of allocating risk in the probability of future price uncertainty, a futures contract is distinct from a forward in the following ways:
- ?They reduce counter party risk (credit default is prevented by the exchange);
- ?They are standardised products with fixed lot sizes and maturity dates;
- ?They are accessible to retail traders;
- ?Lower cost of trading than the OTC market.
Major characteristics of Indian FX markets
In India, the FX markets (both OTC and exchanges) are open for business Mon ? Fri from 9.00 AM to 5.00 PM. The spot price published by the RBI (called the RBI reference rate) is considered the underlying price for the CDS and the value of futures and option premiums will move according to this. RBI updates this reference rate numerous times daily by averaging the different FX rates provided by the biggest banks in the country on a real-time basis.
In terms of value, the exchange traded derivatives still lag way behind the OTC market where the deals are much bigger in nature. The spot market in the OTC sector accounts for almost 50% of the total turnover, out of which Mumbai alone brings in 80%. Indian FX market had a 5-fold jump in turnover from $7 billion in 2004 to $34 billion in 2007. This clearly shows that Indian FX market is set to grow to be one of the largest in Asia soon. Hence, it is important that you get in the game early and stay in it while more and more traders will slowly flock to this market. The price transparency and lack of insider trading (no single entity, not even the RBI, can manipulate the currency markets over a short period of time) make the FX market very lucrative to the small, retail trader who has limited capital and time.
Fig 2. Chart showing RBI intervention in the USDINR market
The futures contracts are available for a 12-month trade cycle with the final settlement date (F) as the last business day of the month. The last trading day for a contract ending that month would be F-2 or two days prior to the settlement date. The expiry price would be the price at 12 noon on F-2. Similarly, option contracts are available as European options with a 3-month trade cycle. Expiry and settlement remain the same as futures.