Strategies using Exchange Traded Currency Derivatives — hedging, spreads, straddles and arbitrage

Where this chapter sits

Chapter 5 carries 10% of the paper. It is the applied chapter — everything from Chapters 3 and 4 is now put to work.

Three things dominate: the three hedging decisions, the four vertical spreads, and the arbitrage arithmetic.

5.1 The three participants

Hedgers

Hedgers are traders who wish to protect themselves from the risk involved in price movements of underlying i.e. foreign currency. These types of participants have a real exposure to foreign currency risk on account of their underlying business.

Where the exposure comes from: imports/exports of goods/services, foreign investments or foreign expenditure on account of travel, studies or any other type of need resulting in FX exposure.

In other words, anyone having a mismatch in foreign exchange earnings and expenses has an actual exposure to currency risk.

Their objective: to reduce the volatility in future cash flows by locking in the future currency rates.

The workbook's shoe exporter: a shoe exporter from India buys all its raw material domestically and sells all its goods to Europe. For him, the expenditure is in INR while revenue is in EUR. With an order of EUR 1 million for which payment will be received after 3 months, he bears the risk of EURINR price movement and is interested in hedging the currency price risk in case the EUR depreciates against INR. Hence, the shoe exporter will go short the EURINR futures contracts or buy EURINR put options.

Speculators

This set of market participants does not have a real exposure to foreign currency risk. These participants assume FX risk by taking a view on the market direction and hope to make returns by taking the price risk.

And they are essential, not incidental: speculators play a vital role in the futures markets. Futures are designed primarily to assist hedgers in managing their exposure to price risk; however, this would not be possible without the participation of speculators. Speculators, or traders, assume the price risk that hedgers attempt to lay off in the markets.

Hedgers often depend on speculators to take the other side of their trades (i.e. act as counterparty) and to add depth and liquidity to the markets that are vital for the functioning of a derivatives market.

The wheat illustration: a farmer wanting to sell forward needs a buyer. This buyer may be someone who needs wheat after three months, such as a flour mill or a bakery. However, most of the times, there is a demand supply mismatch in the market and the trader fills the gap between demand and supply.

And in the currency case: the shoe exporter will require someone who wants to take a long position in EURINR futures. The trader, say "AD Category-I Bank," has the opposite view i.e. he believes that the EUR will appreciate against INR three months down the line.

Arbitragers

A third type of participants called arbitragers serve as a link between the spot and derivatives markets. These arbitragers continuously hunt for the profit opportunities across the markets and products and seize those by executing trades in different markets and products simultaneously.

What distinguishes them from the other two: importantly, arbitragers generally lock in their profits unlike traders who trade naked contracts... Unlike the hedgers, arbitragers have no underlying exposure. Unlike the speculators, arbitragers are not willing to assume risk for the prospect of large profits. Arbitragers lock in a profit by simultaneously entering opposite side transactions in two or more markets.

And the opportunity is self-destroying: as more and more market players discover this opportunity, they may also implement the arbitrage strategy and in the process bring the market to a level of equilibrium and the arbitrage opportunity may cease to exist.

The worked example. Market price of underlying asset (in Rs.) 100 · March futures 110 · Lot size 50.

Here an arbitrageur will buy in the cash market at Rs. 100 and sell in the Futures market at Rs. 110, thereby locking Rs. 10 as his profit on each unit.

At expiry price 108: cash Buy 100, Sell 108, +8; futures Sell 110, Buy 108, +2. *Total profit would therefore be 10 (8+2)50 = Rs. 500.

At expiry price 95: cash Buy 100, Sell 95, -5; futures Sell 110, Buy 95, +15. *Total profit is 10 (-5+15)50 = Rs. 500.

The same Rs. 500 either way — that is what "locking in" means.

One honest caveat from the workbook: we have not considered the transaction costs, impact cost, carry cost/opportunity cost/borrowing cost, etc. while computing the arbitrage gain in this example. All these costs have to be considered in real life.

And arbitrage is not risk-free in practice: even if the systems are seamless and electronic and both the legs of transaction are liquid, there is a real possibility of a time gap between the execution of both the orders. If either leg of the transaction is illiquid then the arbitrage strategy is highly risky as one leg may be executed and the other may not. This would lead to the arbitrager having a naked position instead of a hedged position.

What they contribute: these profit-focused traders and arbitragers fetch enormous liquidity to the products traded on the exchanges. This liquidity in turn results in better price discovery, lower transaction costs and lesser market manipulation.

5.2 Hedging — the three decisions

For hedging we must decide three parameters: (1) the derivative contract to be used as a hedge; (2) type of hedge, i.e. long or short hedge; and (3) Contract Month.

The logic behind the second row: in case the market participant is expected to receive EUR, it is exposed to the risk of depreciation in the value of EUR against INR. And a participant who has to make payment in USD, is exposed to the risk of appreciation of USD against INR.

The contract month example: an exporter who expects to receive EUR on 17th March, 2024, will choose the March futures contract as its expiration date (26th March) is closer to the expected date of receipt than that of the April or May futures contracts.

Close to, but after — never before.

The same three decisions apply to trading: for trading we must decide three parameters 1) the derivatives contract to be used; (2) type of trade, i.e. whether to buy or sell; and (3) contract month.

For e.g. a trader who expects the USD to appreciate against INR in next 2 months, will buy USDINR futures or buy USDINR call options maturing after 2 months. If a trader expects the rupee to appreciate against EUR... he will sell EURINR futures or buy EURINR put options maturing after 3 months.

5.2.1 An exporter's hedge, worked

An exporter of garments from India has contracted to export 10,000 pieces of shirt to a large retailer in US. The agreed price was USD 100 per shirt... The exporter had used the prevailing spot price of USDINR @ 81 as the budgeted price while signing the export contract. To avoid the FX risk, the exporter sells four-month futures at the price of 81.75... The exporter receives USD on March 15, 2024... and he converts USD to INR in the OTC market at the then prevailing price of 83 and also squares up the futures contract at the same time at the price of 83.05.

The effective price would be summation of effect of change in USDINR price on the underlying trade transaction and the effect of change in future price on the currency futures contract.

Underlying trade transaction: Against the budget of 81, the exporter realizes the price of 83 and therefore there is a net positive change of Rs 2 Futures contract: Against the contracted price of 81.75, the exporter had to square up the contract at 83.05, thus resulting in a net negative change of Rs 1.30 Combined effect: (Rs 2) + (- Rs 1.30) = + Rs 0.70 Effective price: 81 (budgeted price) + 0.70 = Rs 81.70

Now reverse the market. Suppose that the INR appreciated against USD. At the time of converting USD to INR the spot was 80 and the futures contract was wound up at 80.05, the effective exchange rate for the exporter would still be 81.70. This is because while the exporter receives Re.1 less than his budgeted price in the spot market, he also makes a gain of Rs.1.70 (Rs.81.75-Rs.80.05) on the squaring up of the futures contract.

The conclusion: the futures contract enables the exporter to lock in a price of 81.70 irrespective of any depreciation or appreciation of INR. However, not using currency futures would have resulted in an effective rate of 83 (in the first case when INR depreciated from 81 to 83) and an effective rate of 80 (in the second case when INR appreciated from 81 to 80).

5.2.2 A partial hedge, worked

An importer of pulses buys 1000 tons of chickpea at the price of USD1600 per ton. On the day of finalizing the contract, USDINR spot price was 81... He decides to hedge half of the total exposure using currency futures and contracted a rate of 81.50 using two months futures contract. In the next two months, INR depreciated to 82 at the time of making import payment. On the day of making import payment, the futures contract price was at 82.05.

Futures contract: Against the contracted price of 81.50, the importer settled the contract at 82.05, thereby resulting in a net positive change of Rs 0.55. Since importer hedged only half of the total exposure, the net inflow from hedging would be available for half of total exposure.

Effective price computation: Therefore, the effective price would be 82 (final remittance price) for the unhedged part and 81.45 (= 82 – 0.55) for the balance half which was hedged... Therefore, final effective price would be: (82.00 x 0.5) + (81.45 x 0.5) = Rs.81.725.

And note the direction of the adjustment: since it is an import payment, a lower USDINR exchange rate would be beneficial for the importer. Therefore, a positive inflow from the futures contract is reduced from the remittance price to compute the effective price for the hedged part.

The comparison: as against the effective price of 81.725, the price would have been Rs.81.45 had the importer decided to hedge the total exposure. Also note that without hedging, the effective price would have been 82.

Other hedgeable exposures

Some of the common purposes/transactions, in addition to import/export, which could use currency futures for the purpose of hedging:

Payment in foreign currency for travel abroad, for education, for medical treatment, payment for employees based abroad, etc. Payment of loan availed in foreign currency Investment in assets outside India or repatriation of capital invested outside India Payment of loan installments in INR by a person earning in foreign currency

5.2.3 Gold ETF

Suppose that an investor invested in a gold ETF contract priced in INR. Within three months of his investment, gold appreciated by 15% in dollar terms while the ETF appreciated by only 10%. The low appreciation of ETF was because of a 5% appreciation in INR against USD.

The solution: the investor could short USDINR currency futures/buy USDINR put option for an amount equal to the amount of investment in ETF and for a tenor for which he intends to stay invested in gold ETF. This would reduce the USDINR risk embedded in the gold ETF.

With one honest qualification: the price of currency futures is a function of spot price and also premium/discount between the currency pair. Therefore, in the above example use of currency futures may not completely remove USDINR spot risk as the price of currency futures would also depend on change in USDINR premium over the contracted period.

5.2.4 Investment abroad

A person has invested USD 100,000 in US equities... In the next one year, his investments in US equities appreciated in value to USD 115,000... at the time of converting USD to INR, he received an exchange price of 81 as against 83.

Return in USD: (115,000 - 100,000)/100,000 = 0.15 and in percentage terms it would be 15%.

Return in INR: the value of investment at the beginning was 83,00,000 and at maturity it is 93,15,000 (81 x 115,000). Therefore, the return in INR is: (93,15,000-83,00,000)/(83,00,000) = 12.23%.

Thus, the return decreased from 15% to 12.23% due to INR appreciation from 83 to 81. However, if INR had depreciated from 83 to 85 the return would have increased to 17.77%.

The fix: the investor may short a one-year USDINR currency futures or buy a one-year USDINR put option. This would allow him to sell USD to INR at a contracted price via the derivatives contract and thus remove currency risk from the portfolio.

5.2.5 Multiple transactions

An international trading company has export revenue in USD. It uses part of the revenues to make import payments in EUR and the balance is converted in INR. The company is concerned about EURUSD risk for its import payments. The company can go long on EURUSD futures contract for hedging the risk. In case EURUSD contract is illiquid and there is no price advantage, the company can short USDINR futures and long EURINR futures to hedge EURUSD.

And on netting: a company in India has both imports and exports in USD. In such a case the company may hedge only the residual currency risk provided there is no significant gap between remittances receivable and payable. In the case of imports being more than the exports, the company can hedge the residual USDINR risk by going long on USDINR futures and vice versa.

5.2.6 An education payment

A person is required to pay the education fee for his son in USD after 6 months. The current USDINR is trading at 82 and the premium for 6 months is 2%. The person invested Rs. 200,000 in Indian fixed income securities for 6 months @ rate of 6% p.a.

Fixed Income investment = Rs. 200000 **Interest on Fixed Income investment = 2000006%6/12 = Rs. 6000 Total amount available after 6 months = Rs. 206000 *6-month USDINR Future rate = 82+2%82 = Rs.83.64 USD available after 6 months = 206000/83.64 = USD 2462.94

5.3 Option strategies

The only limiting factor for strategies is the thought of the trader / strategy designer... Exotic products (or 'exotics') are nothing but a combination of different derivative products.

Spreads

Spreads involve combining options of the same type (call/put) on the same underlying asset but with different strikes and maturities. These are limited profit and limited loss positions.

They are primarily categorized into three sections as: Vertical Spreads · Horizontal Spreads · Diagonal Spreads.

Vertical spreads are created by using options having the same expiry but different strike prices.

5.3.1.1 Bullish Vertical Spread using Calls (Bull Call Spread)

A bull spread is created when the underlying view on the market is positive, but the trader would also like to reduce his cost on position. So, he takes one long call position with a lower strike and sells a call option with a higher strike.

As the lower strike call costs more than the premium earned by selling a higher strike call, the cost of executing the position reduces, but the position still results in an initial net cash outflow.

And the trade-off: as the higher strike call is sold, all gains on the long call beyond the strike price of the short call would get negated by losses of the short call. To generate larger profits from his long call, the trader can short a call with as high a strike as possible, but this will result in only a marginal reduction in his cost, as the higher strike call will fetch lesser and lesser premium.

The workbook's example: long an 83 strike call option by paying a premium of 0.10 and shorts a call option with a strike price of 83.50 and receives a premium of 0.04.

Maximum profit in this position is Rs.0.44 (83.50-83.00-0.06), which will be achieved when both options get exercised i.e. at and above Rs. 83.50 and the maximum loss is Rs. 0.06 (0.10-0.04) when both options remain unexercised i.e. at or below Rs.83.00 and the BEP for this is Rs. 83.06 (83.00+0.10-0.04).

5.3.1.2 Bullish Vertical Spread Using Puts (Bull Put Spread)

A trader is bullish on the USD against INR, hence, he would like to short a put option on the USDINR. If prices go up, the trader will end up pocketing the premium on sold puts. However, if prices decline, the trader would be facing the risk of unlimited losses as he has sold a put option. In order to protect his downside, he may buy a put option with a lower strike.

While this would reduce his overall upfront premium, the benefit would be the embedded insurance against unlimited potential loss on short put. This is a net premium receipt strategy.

The example: short in a put option of strike 83.00 and receives a premium of 0.07 and goes long in a put option of strike 82.50 and pays a premium of 0.05.

Maximum profit in this position is 0.02 (0.07-0.05) and the maximum loss is 0.48... The BEP for this spread is 82.98 (83.00-0.02). This strategy will result in the maximum profit when both the options expire unexercised, and the maximum loss will occur when both the options get exercised.

A note on the workbook's own arithmetic here. It prints the maximum loss as 0.48 (83.00-83.50-0.02), but the two strikes in this example are 83.00 and 82.50, and the payoff table confirms -0.48 as the floor. The correct working is 83.00 − 82.50 − 0.02 = 0.48 — the strike difference less the net premium received. Learn the method, and the printed "83.50" reads as a typographical slip for 82.50.

5.3.1.3 Bearish Vertical Spread using Calls (Bear Call Spread)

The trader is bearish on the USDINR... and so he shorts a low strike high premium call option. The risk in a naked short call is that if prices rise, losses could be unlimited. So, to prevent his unlimited losses, he buys a higher strike call with a lower premium. Thus, in this strategy, he starts with a net inflow.

The example: short call at 83.00 for 0.10, long call at 83.50 for 0.04.

The maximum profit in this position is Rs. 0.06 (0.10-0.04) and maximum loss is Rs.0.44 (83.50-83.00-0.06). The BEP for this position is 83.06 (83.00+0.06). This strategy results in the maximum profit when the USDINR closes at or below the lower strike price of 83 so that both options expire worthless. The maximum loss occurs when USDINR closes at or above the higher strike price of 83.50 and both options are exercised.

5.3.1.4 Bearish Vertical Spread using Puts (Bear Put Spread)

The trader is bearish on the USDINR... and so goes long in one USDINR put option by paying a premium. The trader shorts another put option at a lower strike price and receives a premium which reduces his overall cost.

The maximum profit in this position is Rs. 0.48 (83.00-82.50-0.02) and the maximum loss is Rs.0.02 (0.07-0.05). The BEP for this position is 82.98 (83.00-0.02). This strategy results in the maximum profit when the USDINR closes at or below the lower strike price of 82.50 and both options are exercised. The maximum loss occurs when USDINR closes at or above the higher strike price of 83 and both options expire worthless.

Notice the symmetry across all four. The bull call and bear put are net premium outflow strategies; the bull put and bear call are net premium receipt strategies. Each bull spread mirrors a bear spread exactly.

5.3.2 Horizontal Spread

A horizontal spread involves positions in options of the same type and the same strike price, but different expiry dates. This is also known as time spread or calendar spread.

Here, it is not possible to draw the payoff chart as the expiry dates of the options forming the spread are different.

The rationale for executing horizontal spreads is that these two options would have different time values and the trader believes that the difference in the time values of these two options would shrink or widen. This is essentially a play on the shrinking or widening of the difference between the premium of both the options.

5.3.3 Diagonal spread

A diagonal spread involves a combination of options on the same underlying but having different expiry dates as well as different strikes. Again, as the two legs of the spread have different maturities, it is not possible to draw a payoff diagram. These are much more complicated in nature and in execution.

5.3.4 Straddle

This strategy involves two options with the same strike price and same maturity. A long straddle position is created by buying a call and a put option of the same strike and same expiry whereas a short straddle is created by shorting a call and a put option with the same strike and same expiry.

Long straddle. If a person buys both a call and a put at the same strike price, then his maximum loss will be equal to the sum of these two premiums paid and any price movement from here (in either direction) would first result in that person recovering his premium and then making a profit.

When to use it: this position is undertaken when the trader's view about the direction of the currency price movement is uncertain, but he thinks that the currency would move significantly in some direction.

Two break-even points: they would lie at "Strike – Total Premium" for the long put position and "Strike + Total Premium" for the long call position.

The example: 83 strike call at 0.20 and 83 strike put at 0.15, total premium 0.35.

Maximum loss of Rs. 0.35 would occur if the USDINR expires at the strike price of Rs. 83.00. Further, as long as the USDINR expires between Rs.82.65 and Rs.83.35, the trader would always incur a loss... Here, the trader is bullish on volatility.

Short straddle. Here, the trader's view is that the currency prices would not move much or remain stable... So, he sells a call and a put so that he can profit from the premiums.

As the position of short straddle is just opposite of that of the long straddle, the payoff chart would be inverted.

And a warning: this strategy results in a limited profit but unlimited loss and should be undertaken with significant care. Further, it will incur a loss if the exchange rate moves significantly in either direction – up or down.

5.3.5 Strangle

This strategy is similar to the straddle in its outlook but different in implementation, aggression and cost.

Long strangle. As in the case of a long straddle, the outlook of a long strangle is that the exchange rate will move substantially in either direction, but while in a straddle, both options have the same strike price, in case of a strangle, the strikes are different. Both the options (call and put) in this case are out-of-the-money and hence the premium required is low.

The example: USDINR spot is Rs.83. Rs. 83.25 strike call is available at 0.17 and 82.75 put is trading at a premium of 0.12. Both these options are out-of-the-money.

The maximum profit for the trader would be unlimited in both the directions – up or down while the maximum loss would be limited to Rs. 0.29, which would occur if the USDINR closes at any price between 82.75 and 83.25. This position would have two BEPs at 82.46 and 83.54.

Note where the BEPs come from: the put strike minus total premium (82.75 − 0.29 = 82.46) and the call strike plus total premium (83.25 + 0.29 = 83.54).

Short strangle. Requires the selling of two out-of-the-money options (call and put). As with the short straddle, the trader's view is that the USDINR will remain stable over the life of the options.

The maximum loss for the trader would be unlimited in both the directions up or down while the maximum profit would be limited to Rs. 0.29, which would occur if the USDINR expires at any price between 82.75 and 83.25. The short strangle position would have two BEPs at 82.46 and 83.54.

5.3.6 Butterfly Spread

A butterfly spread is an options strategy that combines both bull and bear spreads. These are neutral strategies that come with a fixed risk and capped profits and losses. These spreads use four options and three different strike prices.

Long Call Butterfly is a neutral strategy where the trader expects very low volatility in the underlying price. The strategy is a combination of Bull Spread and Bear Spread. It involves buying 1 ITM call, selling 2 ATM calls and buying 1 OTM call. The strike prices of all options should be at equal distance from the current price.

The risk is limited to the net premium paid and the profit is limited to the difference between adjacent strikes minus net premium paid.

The example: long 82.50 call at 0.6 · short 2 × 83.00 calls at 0.3 · long 83.50 call at 0.2, spot 83.00.

The cost of creating a long call butterfly spread = (0.30*2)-0.60-0.20 = -0.20 Lower BEP = 82.50+0.2 = 82.70 Upper BEP = 83.50-0.2 = 83.30

Maximum payoff is 0.30, at the middle strike of 83.00; maximum loss is 0.20, beyond either wing.

And it can be built other ways: this position can also be created with the help of only puts or a combination of calls and puts. The family includes long call butterfly spreads, Short call butterfly spreads, Long put butterfly spread, Short put butterfly spread, Iron Butterfly Spread etc.

5.3.7 Hedging with options

Protective put

The idea behind the purchase of puts is to compensate for the loss associated with the potentially declining value of a currency with the rising intrinsic value of the puts. As the exchange rate declines, puts go deeper and deeper in-the-money, permitting the put holder to exercise the options for a profit.

Of course, if the exchange rate should rise instead, the puts become out-of-the-money. However, since the put holder's loss is limited to the premium paid a favorable underlying price movement should work to the benefit of the hedger.

Case 1 — an export company is expecting a receipt of 1 million USD after one month. The company can short USDINR futures to hedge its dollar receivables. However, a short futures position, while hedging the company against a decline in the USDINR, does not allow the company to benefit from a potential rise in the USDINR.

Buying puts with a strike price of Rs. 83 at a premium of Rs.0.20, the company finds that if the USDINR keeps rising, the company will be able to sell its dollars in the market at higher and higher prices but its losses on the long put will be restricted to the premium paid. On the other hand, in case of USDINR depreciation... these losses will be offset with the profits on the long put position.

The long put hedge allows one to lock-in a floor return while still retaining a great deal of the upside potential... the exporter has locked in a minimum USDINR rate at 82.80 (83.00-0.20) with an unlimited upside potential.

Put options are more suited as a hedging tool for contingent cash flow receivable.

Case 2 — the mango pulp exporter. It receives confirmed orders 6 months in advance at a fixed price in USD. Sometimes the company is not able to fulfill the order quantity... In the past the company has faced huge losses on account of FX hedging when it could not complete the orders and the USD strengthened significantly.

The answer: this company could hedge a part of its exposure using currency options, specifically by buying puts. This would ensure that the company's losses are limited to the premium paid and not beyond that in a case when they are not able to supply the goods.

Case 3 — the bidding process. When a firm bids for an overseas project which involves foreign exchange risk, it may quote its bidding price and at the same time protect itself from foreign exchange risk by buying put options. If the bidding is successful, the firm is protected from a depreciation of the foreign currency. However, if the bidding is unsuccessful and the currency appreciates, then the firm may just let the contract expire.

And the crucial contrast: in the case of hedging with forwards or futures, the firm would be automatically placed in a speculative position in the event of an unsuccessful bid, without any limit to its downside losses.

Case 4 — a cheaper alternative to a plain put. A jewellery exporter believing INR would appreciate from its current level of 83 to 82 but that the rupee will not go beyond 82 could buy an ATM or ITM put option on the USDINR and reduce its cost by selling OTM put option... This is called a bear put spread. The company could achieve a similar pay off using call options and that strategy is called a bear call spread.

Case 5 — unwinding a put hedge. An exporter hedged 20,000 USD by buying USDINR put options at a strike of Rs 83 when the available price was Rs 0.35/0.37... The available price at the time of unwinding was Rs 0.48/0.49... At the time of converting USD into INR, the exporter's bank quoted him a price of Rs 82.45/75.

Premium paid at the time of buying the put option: Rs. 0.37 Premium received at the time of unwinding of the put position: Rs. 0.48 Net gain from transaction: Rs.0.11 (0.48-0.37) Rate received from Bank: 82.45 Effective net rate/price per USD for exporter: Rs. 82.45 + Rs. 0.11 = Rs. 82.56.

Note every quote is read from the customer's disadvantage — bought at 0.37 (the offer), sold at 0.48 (the bid), converted at 82.45 (the bank's bid).

Protective call

Case 1 — XYZ Ltd. is an importer... has to make payment of USD 100,000 at the end of the month. The company can go long USDINR futures to hedge its dollar payable. However, buying USDINR futures locks in the purchase price of USD for the company and does not allow the company to benefit from a decline in the USDINR.

Buying call options with a strike price of Rs.82.80 at a premium of Rs.0.30: if the USDINR falls sharply below 82.80, the company will benefit as it will purchase dollars at a lower rate in the open market. Although the call options expire worthless, the loss on the long call position will be restricted to the premium already paid. On the other hand, if the USDINR appreciates over the month, the company will end up buying dollars at higher prices, but these losses will be offset by the profits on its long call position.

The long call hedge allows the importer to lock-in a maximum payable amount while still enjoying the benefits from a decline in the exchange rate... the importer has locked in a maximum purchase price of Rs.83.10 (82.80+0.30).

Case 2 — the edible oil importer wanting a cheaper alternative to buying plain vanilla call options could buy an ATM or ITM call option on USDINR and reduce its cost by selling an OTM call option... This is called a bull call spread. The company could achieve a similar pay off using put options and that strategy is called as bull put spread.

Case 3 — sizing a hedge. A student going abroad for higher studies gets a loan of Rs 15,00,000 sanctioned from his bank. He has to make the payment to the University after one month... he wants to buy an exchange-traded call option with a strike price of Rs. 83.00. How many lots of call options should he buy?

Amount in USD = (1500000/83) = USD 18072 1 lot = 1000 USD No. of Lots = 18 (18072/1000)

5.4 Speculation

Case 1 — a short. A trader expecting the rupee to strengthen shorts 100 lots of the 6-months USDINR futures contract at a price of 83.90... At the expiry of the contract, the final settlement price is 81.20.

The profit is Rs. 2.70 per USD. Since he had shorted 100 contracts and each contract is of 1000 USD, the absolute profit made on the transaction was Rs.2,70,000 (2.70 x 100 x 1000).

Case 2 — a long. A trader expecting the rupee to weaken goes long 3-months contracts of 500 USDINR futures at a price of 83.10... the final settlement price is 85.30.

The profit is Rs 2.20 per USD. Since he had bought 500 contracts and the contract size is 1000 USD, the absolute profit made on the transaction is Rs11,00,000 (2.25001000).

Case 3 — expressing a cross view through rupee pairs. A currency derivatives trader has a view that USD will depreciate against EUR... the trader will buy EURUSD futures or buy EURUSD call option. In case trader also assumes that the USDINR rate will remain same in this period, the trader can also execute his view by buying EURINR futures or buying EURINR call option (Cross rate arithmetic; EURINR = EURUSD * USDINR).

Similarly, if the trader believes that the JPY will weaken against the USD... he will buy USDJPY futures or buy USDJPY call option. In case trader also assumes that the USDINR rate will remain same... he can also execute his view by selling JPYINR futures or buying JPYINR put option.

And the reverse construction: a trader takes a view that the EUR will depreciate against the Dollar. He can short EURUSD futures contract. On the other hand, he can buy USDINR and sell EURINR futures contract for an equivalent amount to take the similar view (Cross rate arithmetic; EURUSD = EURINR/USDINR).

Case 4 — trading the premium itself. If a trader takes a view that the currency prices will remain the same in the future period, he will execute his view based on whether the currency is trading at a premium or discount. For e.g. USDINR futures trades at premium as USD interest rates are lower than the INR interest rate. Hence, if the trader has a view that USDINR prices will remain constant in futures, to execute the view, he will short USDINR futures. In such a scenario, if the trader's view is correct and USDINR prices remain constant, the profit of trader will be equal to the forward premium.

Case 5 — options. If a trader has the view that the USD will appreciate against the Rupee i.e. bullish on USDINR, he will buy USDINR call option. On the other hand, if he thinks that USD will depreciate against Rupee, he will buy USDINR put option.

And the alternative, with a warning: sometimes, traders may have a certain view but do not want to buy options as this requires payment of an initial premium. In such cases, the trader may sell options instead... However, in such cases the trader is exposed to unlimited loss with limited profit potential.

5.5 Arbitrage

Arbitragers look for mispricing in the market and execute simultaneous buy and sell trades to capture the mispricing and make a profit. They do not take any view on the market direction.

The worked example: the 6-month USDINR currency futures was trading at 83.2500/83.2600 while the 6-month forward in OTC market, was available at 83.1500/83.1600.

Ideally currency futures and currency forwards should be trading at the same level if their settlement dates are the same. A difference in pricing means mispricing and an opportunity... The arbitrage profit arises from selling in the market where the price is higher and buying in the market where the price is lower.

The trader could short currency futures and go long on currency forwards to capture the mispricing.

He shorts futures at 83.25 (the bid) and buys the forward at 83.16 (the offer) — locking 0.09.

Check it at two settlement prices. If both settled at 83.75: the trader loses 0.50 on futures but makes a profit of 0.59 on the forward contract. Thus, he makes an arbitrage profit of 0.09 per USD. If the currency futures and forward are both settled at 83, the trader would make a profit of 0.25 on the futures but lose 0.16 on the settlement of the forward contract. Thus, he would earn an arbitrage profit of 0.09 per USD.

Arbitrage profit would have been constant at 0.09 irrespective of final settlement price as long as both OTC contract and futures contract were settled at the same price.

Triangular arbitrage

Triangular arbitrage involves identifying and exploiting the arbitrage opportunity resulting from price differences among three different currencies in the forex market. It involves three trades: exchanging the first currency for a second currency, exchanging the second currency for a third currency and exchanging the third currency for the first currency.

Like all other arbitrage opportunities, this triangular arbitrage is possible only when the exchange rates are not aligned with the implicit cross exchange rate.

The example: EURUSD is trading at USD 1.09, the USDINR at Rs.82.89 and the EURINR at Rs.90.11.

An arbitrageur with 1000 EUR can exchange these for USD 1090. Then he can convert USD 1090 into Rs.90,350.10 at the current USDINR exchange rate. Finally, he can convert Rs.90,350.10 into EUR 1002.67, thus making an arbitrage profit of EUR 2.67.

The no-arbitrage rate: had the EURINR been trading at 90.35 (instead of the 90.11 given in this example), there could be no arbitrage opportunity. But for the given EURUSD and USDINR rates, anything below 90.35 EURINR provides an arbitrage opportunity.

And a reality check: profitable triangular arbitrage is very rarely possible because when such an opportunity arises, traders execute trades that take advantage of the imperfections and prices adjust up or down until the opportunity disappears. Even when those opportunities appear for a very brief period of time, the price disparity may be very small (around 1 basis point or so in many cases) making it unprofitable after factoring in the transaction costs and taxes.

Arbitrage risks

If either leg of the transaction is illiquid then the risk on the arbitrage deal is huge as only one leg may get executed and the other may not, which would create a naked position for the arbitrageur instead of a hedged position.

And a settlement mismatch specific to this market: currency future market is cash settled while the currency forward market has delivery-based settlement. Hence, the arbitrageur will bear increased risk on settlement date to ensure that both contracts are settled at the same price or he should be able to reverse both transactions at the same price.

Plus: transaction cost like the brokerage, stamp duty, margin cost and impact cost etc. must be factored in before entering into any strategies.

5.6 Spread trading

Spread refers to the difference in prices of two futures/option contracts. A good understanding of spreads is essential to earn profits. Considerable knowledge of a particular currency pair and the interest rate parity is also necessary.

Spread movement is based on following factors: Interest rate differentials · Liquidity in the banking system · Monetary Policy Decisions (Repo, Reverse Repo and CRR).

Calendar Spread: A calendar spread is a contract where a trader buys/sells a particular month contract (Futures or Options) and sells/buys (take an opposite position) of the same contract of a different month. Both have the same underlying but different maturities.

Why it is cheaper to hold: in a calendar trade position, the trader does face the risk of underlying security/currency movement but is only exposed to the basis risk due to change in the spread between two contracts. Hence the margin applicable on such positions is much lower than the normal margin.

The worked example: a trader decides to sell March (Near month contract) USDINR futures @83 and at the same time buy April (mid-month) futures contract @83.20; the spread between the two contracts is Rs. 0.20. Suppose that the spread widens after 10 days and now the March futures contract is trading at 83.10 while the April futures contract is trading at 83.40, and as a result the spread now stands at Rs. 0.30. He decides to square off both the positions, making a gain of Rs. 100 per contract {(0.30 – 0.20) 1000}.*

And a practical risk with a practical fix: the issue with entering a calendar spread through 2 separate orders like in the above example is that there is a risk of adverse price movement during the order placement i.e. execution risk. Such risk can be avoided by using spread order facility provided by Exchanges.

A rate-view version: a trader has a view that interest rates in India may increase while those in the US may remain flat. This will increase the spread between short-term and long-term USDINR futures contract. Hence, the trader will buy far-month USDINR futures contract and at the same time sell the near-month USDINR futures contract.

And a compliance reminder that covers the whole chapter: while using exchange-traded currency derivatives for the purpose of hedging, speculating, arbitrage or calendar spread trading market participants must ensure that they are trading within the guidelines provided by The Foreign Exchange Management Act, 1999 (FEMA), RBI guidelines on foreign exchange trading, SEBI guidelines and their respective regulatory guidelines.

5.7 Limitations of ETCD for hedgers

Exchange-traded currency derivatives contracts are standard contracts which are mainly settled in cash i.e. without any delivery of currencies. This may lead to imperfect hedging and leads to basis risk for hedgers.

Date mismatch: the USDINR contract expires on every Friday of week and two working days prior to the last business day of the expiry month. If the exposure to be hedged matures on some other day in the week or month, there will be mismatch in the maturity dates which leads to imperfect hedging.

Size mismatch: the USDINR contract has a standard lot size of 1000 USD. If an importer has to make payment of USD 10500 after 3 months, he can hedge for either USD 10000 or USD 11000. Hence, there will be either over-hedging or under-hedging.

Settlement mismatch: as ETCD are cash settled, the importers and exporters must deal with Authorized Dealers for the actual underlying settlement. There might be a mismatch in the time/price of cancellation of contract in ETCD and the time/price of actual underlying settlement. This mismatch may result in a small loss of value.

Tenor limit: a company that has taken a loan for 5 years in foreign currency, will find it difficult to hedge their borrowing through ETCD as such contracts are generally available only for maturities up to 1 year.

But the balance: the transparency, small lot size, flexibility in trading, guaranteed settlement and ease of trade execution may offset the above limitations of ETCD.