Foreign exchange derivative contract
Also written FX derivative contract · Forex derivative contract · Foreign exchange derivative · Currency derivative contract
Under the FEMA regulations, a financial contract that derives its value from a change in the exchange rate of two currencies, at least one of which is not the rupee, and settles later than the spot date.
In plain language
A derivative gets its value from something else. That something else is the underlying. The derivative cannot exist without it.
For currency derivatives, the underlying is an exchange rate — or, in one branch, a foreign currency interest rate.
India does not leave this to general description. There is a legal definition, and it is worth reading slowly. A foreign exchange derivative contract means a financial contract which:
- derives its value from the change in the exchange rate of two currencies, at least one of which is not the Indian Rupee; or
- derives its value from the change in the interest rate of a foreign currency; and
- is for settlement at a future date, that is, any date later than the spot settlement date.
There is one carve-out. Contracts involving the currencies of Nepal and Bhutan do not qualify under this definition.
The definition comes from the Foreign Exchange Management (Foreign exchange derivative contracts) Regulations, 2000, made under FEMA.
A separate definition covers the exchange traded version: a standardised foreign exchange derivative contract traded on a recognised stock exchange, to buy or sell one currency against another on a specified future date, at a price specified on the date of the contract.
How it works
Pull the definition apart (Chapter 2, section 2.3 and its footnote):
| Element | What it requires |
|---|---|
| Value source | Change in the exchange rate of two currencies, at least one of which is not INR — or change in the interest rate of a foreign currency |
| Settlement | Any date later than the spot settlement date |
| Exclusion | Contracts involving the currencies of Nepal and Bhutan |
| Source | Foreign Exchange Management (Foreign exchange derivative contracts) Regulations, 2000 |
The settlement clause is the one that does real work. A spot deal is not a derivative, because it settles on the spot date and not later. Chapter 1 fixes the spot date at T+2 business days, subject to both centres being open, so a derivative is anything settling after that. Cash (T) and tom (T+1) are also not derivatives — they settle earlier than spot.
The general accounting test, for contrast. The same section notes that accounting standards impose more qualifications. IAS 39 and AS 30 require three criteria: the value of the derivative is linked to the value of the underlying; the trade is settled on a future date; and on the trade date there is no full cash outlay. FAS 133 adds a fourth: the trade must settle, or be capable of settling, on a net basis and not on a gross basis. The third criterion is what produces leverage — the ability to buy the underlying without fully paying for it, or sell it without delivering it.
The taxonomy. Derivatives are classified into five asset classes — interest rate, credit, equity, forex and commodity — and in each class there are four generic products: forward, futures, swap and option. For currency pairs the four are the FX forward or currency forward, FX futures or currency futures, FX swap and currency swap, and FX option or currency option.
Who may enter one. A person resident in India or resident outside India may enter into a foreign exchange derivative contract or an exchange traded currency derivative contract in accordance with FEMA, 1999, the Foreign Exchange Management (Foreign exchange derivative contracts) Regulations, 2000, and guidelines of regulators including RBI, SEBI, IRDAI and PFRDA or any other statutory authority empowered to regulate a financial institution under Indian laws.
One duty attached to the OTC version. While offering a foreign exchange derivative contract involving INR other than a non-deliverable derivative contract to a user, and during the life of the contract, Authorised Dealers shall ensure that the contract is for the purpose of hedging. And all OTC foreign exchange derivative contracts are settled through delivery except NDDCs.
A worked example
Which of these is a foreign exchange derivative contract? Apply the three tests — non-rupee currency involved, value from an exchange rate or foreign currency interest rate, settlement later than spot.
| Contract | Qualifies? | Why |
|---|---|---|
| USDINR futures on NSE expiring in March, USD 1,000 a lot | Yes | USD is not INR; value from the rate; settles after spot |
| A bank's USDINR spot deal for value T+2 | No | Settles on the spot date, not later |
| A cash deal for USD 50,000, value today | No | Settles before spot |
| A 3-month EURINR forward at Rs 89 | Yes | EUR is not INR; settles after spot |
| EURUSD futures, 1,000 euro a lot | Yes | Neither leg is INR, and the definition needs only one non-INR currency |
| A forward on Nepalese rupees | No | Expressly excluded |
| A swap on a USD interest rate with no exchange rate leg | Yes | Value from the interest rate of a foreign currency |
The exchange traded version, sized. A garment exporter expecting USD 1,00,000 in March hedges on the exchange.
| Step | Working |
|---|---|
| Exposure | USD 1,00,000 |
| Lot size of a USDINR contract | USD 1,000 |
| Contracts needed | 1,00,000 / 1,000 = 100 |
| Sells 100 March futures at | 83.50 |
| Notional locked | 100 x 1,000 x 83.50 = Rs 83,50,000 |
That contract is standardised, traded on a recognised stock exchange, and for settlement on a specified future date at a price specified today — which is the workbook's definition of an exchange traded currency derivative, word for word.
And the same exposure done OTC. The exporter instead books a 3-month forward with his bank at 83.50 on the full USD 1,00,000. Same economics, but now the bank must satisfy itself that the contract is for the purpose of hedging, and the contract will be settled through delivery — neither of which applies to the exchange traded route.
Why NISM asks about it
Chapter 2, section 2.3 (Derivative Products), carries the FEMA definition and its footnote citing the Foreign Exchange Management (Foreign exchange derivative contracts) Regulations, 2000, immediately followed by the definition of exchange traded currency derivatives. Section 2.1 gives the AS 30 / IAS 39 / FAS 133 criteria and the five-asset-class, four-product taxonomy; section 2.5 gives the FEMA route for residents and non-residents; section 2.6 gives the hedging-purpose duty and the NDDC exception. Expect a definition question, and in particular one that turns on "at least one of which is not Indian Rupee" or on the Nepal and Bhutan exclusion.
Common exam traps
- "At least one of which is not Indian Rupee." A cross-currency contract such as EURUSD qualifies; the definition does not require a rupee leg at all.
- Settlement must be later than the spot settlement date. Spot, cash and tom deals are not derivatives under this definition.
- Nepal and Bhutan currencies are expressly excluded. This is the kind of carve-out a paper asks about directly.
- The interest-rate limb is real: a contract deriving value from the interest rate of a foreign currency is a foreign exchange derivative contract too.
- Currency futures "does not include a forward contract" — the workbook says so in terms. The two definitions are deliberately exclusive.
- The three accounting criteria (AS 30 / IAS 39) are not the FEMA definition. FAS 133 adds a fourth about net settlement. A question can ask which standard requires which.
- The hedging-purpose duty falls on the Authorised Dealer, applies to INR contracts other than NDDCs, and runs during the life of the contract, not only at inception.
Check yourself
1.Which of the following derivative contracts is traded only on exchanges?
- a)Currency futures
- b)Currency options
- c)Currency swaps
- d)FX swaps
Show the answer
Answer: (a) Currency futures
Futures alone is exchange-only.
The workbook's summary table gives the market for each generic derivative: Forward — OTC · Futures — Exchange · Swap — Mainly OTC · Option — OTC and Exchange.
And the definition builds the exchange in: Currency Futures means a standardized foreign exchange derivative contract traded on a recognized stock exchange to buy or sell one currency against another on a specified future date, at a price specified on the date of contract, but does not include a forward contract.
Option B is wrong because options trade in both venues — Options are traded both OTC as well as on Exchanges, as Chapter 1 also noted while listing where each Indian product trades.
Options C and D are both OTC. 'Foreign exchange swap' means an OTC derivative involving the actual exchange of two currencies (principal amount only)... and 'Currency swap' (also known as cross currency swap) means an OTC derivative which commits two counterparties to exchange streams of interest payments and/or principal amounts in different currencies.
What being exchange-traded brings: the futures contracts are standardized in terms of lot size, underlying, expiry date etc. Contracts are mainly settled in cash... Margins and mark to market are applicable for such contracts. Settlement guarantee is provided by the clearing corporation of the Exchanges.
And how that guarantee is created: the trade guarantee is provided by Clearing Corporation becoming a common party, called central counterparty (CCP), to the buyer and seller through the process of novation — so that Clearing Corporation becomes the buyer to the seller; and the seller to the buyer.
2.A USDINR contract settles on T+2. Under the derivative criteria, this contract:
- a)Is a derivative because it settles in the future
- b)Is not a derivative — the settlement of a derivative must be later than that for the underlying, and USDINR spot itself settles T+2
- c)Is a derivative only if margin is collected
- d)Is a derivative because no full cash outlay is required on trade date
Show the answer
Answer: (b) Is not a derivative — the settlement of a derivative must be later than that for the underlying, and USDINR spot itself settles T+2
The "future" date in the second requirement means that the settlement of the derivative must be later than that for underlying. For example, if the underlying settles on two business days after trade date (T+2), the derivative on that underlying must settle later than T+2; if the underlying settles in T+5, the derivative on that underlying must settle later than T+5; and so on.
Later than the underlying's own settlement — not merely later than today.
Since USDINR spot is the settlement after two business days, a T+2 contract is simply a spot trade.
Options A and D each pick one criterion and ignore the others. All three must hold: 1. Value of derivative is linked to the value of underlying. 2. Trade settled on a "future" date. 3. On trade date, there should be no full cash outlay.
Option C invents a requirement. Margin is a feature of exchange-traded products — generally, no initial margin or mark-to-market margin is collected for forwards, which are derivatives all the same.
The rule is written into the legal definitions. A 'Foreign exchange forward' means an OTC derivative involving the exchange of two currencies on a specified date in the future (more than two business days later) at a rate agreed on the date of the contract.
And the statutory definition says the same: a foreign exchange derivative contract is for settlement at a future date, i.e. any date later than the spot settlement date.
Under FAS 133 there is a fourth criterion: trade must settle (or capable of being settled) on net basis and not on gross basis — which IAS 39 and AS 30 do not require.
3.Which of the following may trade in currency futures?
- a)All of the above
- b)Individuals
- c)NRIs
- d)Corporates
Show the answer
Answer: (a) All of the above
Participation is deliberately open. It is important to have participation from all categories of investor (resident as well as non-resident) in ETCD.
The reasoning: both residents and non-residents are exposed to currency risk when residents purchase foreign currency assets and non-residents purchase domestic currency assets... Against this backdrop, unpredicted movements in exchange rates expose investors to currency risks.
The legal basis: a person, whether resident in India or resident outside India, may enter into a foreign exchange derivative contract or exchange-traded currency derivative contract in accordance with provisions contained in this regulation — the Foreign Exchange Management (Foreign Exchange Derivative Contracts Regulations, 2000).
And the Chapter 7 position limit tables confirm the breadth, naming Domestic Clients, Non-Resident Indians (NRIs) and FPI Cat II (Individuals, family offices and corporates) as one category and Trading Member (Banks and Non-Banks)... Domestic Institutional Investors (DIIs)... AD-Category I Bank, FPI Category I & II as another.
But each faces its own terms. Residents and FPIs may trade up to a single limit of USD 100 million equivalent across all currency pairs involving INR. Applicable NBFCs shall participate... as clients... only for the purpose of hedging their underlying forex exposures. And SPDs shall trade only on their own account.
Plus a general condition: all regulated entities shall participate in ETCD with the permission of and subject to the terms and conditions, if any, fixed by their respective regulator.
One clarification applies to everyone taking an INR position: while users of currency derivatives are not required to provide evidence of underlying exposure while entering into a currency derivatives contract, they must have such exposure in place.
Where this is taught
Free preparation for NISM Series IRelated terms
- Currency Derivatives SegmentThe separate stock exchange segment where exchange-traded currency futures and options, and interest rate derivatives, are traded — with membership separate from the exchange's other segments.
- Currency futuresA standardised exchange-traded contract to buy or sell one currency against another on a future date at a price fixed today; in India, cash-settled in rupees, USD 1,000 a lot for USDINR.
- Currency optionAn option giving the buyer the right, but not the obligation, to buy or sell an agreed amount of one currency against another at a specified exchange rate, on or before a specified future date.
- Foreign exchange forwardAn OTC derivative involving the exchange of two currencies on a specified future date more than two business days away, at a rate agreed on the date of the contract.
- Foreign exchange swapAn OTC derivative in which two currencies are actually exchanged on one date (the short leg) and re-exchanged at a later date (the long leg), at rates agreed at the time of the contract.
- Non-deliverable forwardA cash-settled, usually short-term currency forward in which the notional amount is never exchanged — only the difference between the contracted rate and the reference rate changes hands.
- Spot value dateThe settlement date of a standard spot FX deal — the second business day after the trade, provided both currency centres are open; earlier dates are cash (T) and tom (T+1).
- Authorised personTwo different entities share this name: under SEBI, an agent appointed by a stock broker to give clients access to the trading platform; under FEMA, a dealer authorised by RBI to deal in foreign exchange.