Foreign Exchange Derivatives — forwards, futures, options, swaps and the OTC/exchange divide

Where this chapter sits

Chapter 2 carries 5% of the paper. It is short, definitional, and it sets up everything from Chapter 3 onwards.

Three things dominate: the four criteria that make something a derivative, the forward-versus-futures comparison, and novation by the clearing corporation.

2.1 What a derivative is

Derivative is something that is derived from another called the underlying. The underlying is independent, and the derivative is dependent on and derived from the underlying. The derivative cannot exist without the underlying.

The workbook's plain example: wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the "underlying".

The four criteria

Accounting standards like FAS 133 (in the US), IAS 39 (in the EU) and AS 30 (in India) impose more qualifications for derivatives.

IAS 39 and AS 30 require three:

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

FAS 133 requires an additional qualification:

4. Trade must settle (or capable of being settled) on net basis and not on gross basis.

What each one means.

The first requirement implies that the price of derivatives is determined by the price of underlying, and not by the demand-supply for derivative. The underlying is the raw material and derivative is the finished product. If the underlying price goes up (or down), the derivative price will go up (or down) regardless of demand-supply for derivative.

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.

Note the subtlety — later than the underlying's settlement, not merely later than today. A USDINR spot trade settles T+2, so a USDINR derivative must settle after T+2.

The third requirement provides "leverage": ability to buy the underlying without fully paying for it immediately or sell it without delivering it immediately.

The classification that runs through the exam

Derivatives are classified into five asset classes: interest rate, credit, equity, forex and commodity. In each asset class, there are four generic products: forward, futures, swap and option.

Five asset classes × four generic products. Learn this grid and the whole chapter falls into place.

A brief history: derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post 1970 period due to growing instability in the financial markets. By the 1990s, they accounted for about two thirds of total transactions in derivative products.

Four ways to treat risk

Derivatives are tools to manage price risk. How you manage risk depends on your approach to risk. If you want to take risk, you will trade in derivatives which is called speculation. When you want to avoid risk, you manage it one of the three ways: elimination (called hedging); insurance and minimization (called diversification).

The line between hedging and insurance is the examinable one. Hedging locks in the future return at a known level — you give up the upside along with the downside. Insurance selectively eliminates the negative return but retains the positive return, at an explicit upfront cost, and requires a particular derivative called option.

Forwards and futures hedge. Options insure.

2.2 What derivatives do for the economy

While the primary function of derivatives is risk management, the derivatives market also performs the following functions:

Hedging risk exposure — an investor may purchase a derivative contract whose value moves in the opposite direction to the value of an asset the investor owns. In this way, profits in the derivative contract may offset losses in the underlying asset.

Price discovery — derivative market serves as an important source of information about prices. Prices of derivative instruments such as futures and forwards can be used to determine what the market expects future spot prices to be... Thus, the futures and forwards markets are especially helpful in price discovery mechanism.

Market efficiency — by using derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.

Access to unavailable assets or markets — by employing interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates available from direct borrowing.

Price stability — central banks of many countries use derivatives for stabilizing the currency prices. In India, RBI also intervenes in the forex market through derivatives for INR stability.

Deeper cash markets — with the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.

Speculation — and the workbook is careful here: this is not the only use, and probably not the most important use, of financial derivatives. Financial derivatives are considered to be risky. If not used properly, these can lead to financial destruction in an organization. However, these derivatives act as a powerful instrument for knowledgeable traders to expose them to calculated and well understood risks in search of a reward.

Formalising speculation — derivatives market helps shift of speculative trades from unorganized market to organized market. Risk management mechanism and surveillance of activities of various participants in organized space provide stability to the financial system.

The risks

Market Participants must understand that derivatives, being leveraged instruments, have risks like:

counterparty risk (default by counterparty) · price risk (loss on position because of price move) · leverage risk (magnifying the gain and losses) · liquidity risk (inability to exit from a position) · legal or regulatory risk (enforceability of contracts) · operational risk (fraud, inadequate documentation, improper execution, etc.)

And a suitability caution: derivatives may not be an appropriate avenue for someone of limited resources, less trading experience and low risk tolerance. A market participant should therefore carefully consider whether such trading is suitable for him/her based on these parameters.

Market participants who trade in derivatives are advised to carefully read the Risk Disclosure Document, given by the broker to his clients at the time of signing agreement.

2.3 The four products, applied to currency

A foreign exchange derivative (currency derivative) is a financial derivative whose payoff depends on the exchange rates of two (or more) currencies.

The Indian legal definition, from the Foreign Exchange Management (Foreign exchange derivative contracts) Regulations, 2000:

"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 Indian Rupee, or which derives its value from the change in the interest rate of a foreign currency and which is for settlement at a future date, i.e. any date later than the spot settlement date, provided that contracts involving currencies of Nepal and Bhutan shall not qualify under this definition.

Two details examiners like: at least one of which is not Indian Rupee, and the Nepal and Bhutan carve-out.

And the exchange-traded version: "Exchange traded currency derivatives" 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.

Forwards

It is a contractual agreement between two parties to buy/sell an underlying asset at a certain future date for a particular price that is predetermined on the date of contract.

Both parties are bound: both the contracting parties are committed and are obliged to honour the transaction irrespective of the price of the underlying asset at the time of delivery.

Its features: since forwards are negotiated between two parties, the terms and conditions of contracts are customized. These are Over-the-counter (OTC) contracts. Contracts are mainly settled by delivery. However, in certain cases, they are settled in cash on the expiration date. Generally, no initial margin or mark-to-market margin is collected for such contracts.

The formal definition: '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.

Note "more than two business days later" — that is the derivative criterion of settling later than spot, written into the definition.

The workbook's cashew exporter. "XYZ" has exported cashews to the US and the total value of the shipment is $5,000,000 (Dollar 5 million) which is due after 3 months. The current rate (spot rate) for exchange is 1 USD = INR 75.10. "XYZ" enters into forward agreement with the bank to realize the proceeds after 3 months at the rate of INR 75.80 per dollar.

What XYZ gains:

Assurance that company will realise inflow of Rs. 37.90 Crs. (5,000,000*75.80)

If the rupee appreciates to Rs.74.50/USD or remain same at Rs 75.10/USD, does not have much to worry because they have already locked in the exchange forward rate of Rs.75.80/USD

Businesses generally have payables against their receivable. Company confident that the inflow will take care of the payable with minimum risk of cash flow uncertainty

And what it gives up: notional loss in case rupee weakens beyond Rs. 75.80/USD.

That last line is the definition of hedging in practice — the downside is gone and so is the upside.

Futures

A futures contract is similar to a forward, except that the deal is made through an organized and regulated exchange rather than being negotiated directly between two parties. Indeed, we may say futures are standardized exchange-traded forward contracts.

The futures contracts are standardized in terms of lot size, underlying, expiry date etc. Contracts are mainly settled in cash; however, in certain cases they are settled physically on the expiration date. Margins and mark to market are applicable for such contracts. Settlement guarantee is provided by the clearing corporation of the Exchanges.

The definition: 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.

Options

An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying on or before a stated date and at a stated price.

The asymmetry: while the buyer of an option pays the premium and buys the right, the writer/seller of the option receives the premium with the obligation to sell/ buy the underlying asset, if the buyer exercises his right.

A call option gives the buyer the call the right to buy the asset and a put option gives the buyer of the put the right to sell the asset.

And the contrast that matters: in case of futures/forwards it is an obligation for both buyer as well as seller to settle the contract, however in an option contract, the option buyer has the right but not the obligation to buy/sell the underlying asset.

The currency version: 'Foreign exchange option (Currency Option)' is an option that gives the buyer the right, but not the obligation, to buy or sell an agreed amount of a certain currency with another currency at a specified exchange rate on or before a specified date in the future.

Swaps

A swap is an agreement made between two parties, to exchange cash flows in the future, according to a prearranged formula. Swaps are, broadly speaking, a series of forward contracts.

Most swaps involve cash flows based on a notional principal amount such as a loan or bond... One cash flow is generally fixed (can be floating), while the other is variable and based on a benchmark interest rate, floating currency exchange rate, or index price etc.

Interest rate swap is a derivative contract that involves exchange of a stream of agreed interest payments on a 'notional principal' amount during a specified period. Such contracts generally involve exchange of a 'fixed to floating' or 'floating to floating' rates of interest.

In forex there are two, and the distinction is examinable: in forex market there are two kinds of swaps namely, foreign exchange swap and currency swap. The two are basically the same but there are slight differences.

'Foreign exchange swap' means an OTC derivative involving the actual exchange of two currencies (principal amount only) on a specified date (the short leg) and a reverse exchange of the same two currencies at a date further in the future (the long leg), at rates agreed at the time of the contract.

Principal only, two legs — the short leg and the long leg. In the workbook's illustration, the spot rate for the short leg is Rs.73 while the rate agreed upon for the long leg is Rs.73.50.

'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 on specified dates over the duration of the swap at a pre-agreed exchange rate.

Interest payments as well as principal, over a duration.

The workbook's worked case: a customer in India with a long-term USD borrowing is typically exposed to exchange rate risk between the USD and the INR as well as USD interest rate risk. The company can eliminate the risk by entering into a USD/INR currency swap with a bank at the spot exchange rate of Rs.74. The customer receives from the bank USD floating interest rate payments and USD principal amortisations. Simultaneously, the customer pays the bank fixed interest rate in INR and the equivalent INR principal amortisations at an exchange rate based on a spot rate (or forward rate) prevailing at the time of the transaction and locked in for the entire tenure of the swap.

And a detail: at the start, initial principal is exchanged, though not obligatory.

The summary grid

Note that only futures is exchange-only. Options trade in both venues; forwards and swaps are OTC.

By underlying:

And the fifth asset class: additionally, "Credit" risk as underlying, Credit Default Swaps (CDS) are also very popular in the financial market. One counterparty in the CDS contract (the "buyer of protection") makes a regular periodic payment to the other counterparty (the "seller of protection"); in exchange the protection seller agrees to pay the protection buyer any loss in value on the specified reference obligation if a "credit event" (e.g., default) were to occur during the life of the CDS contract.

2.4 Why the market grew

Some of the factors driving the growth of financial derivatives are:

1. Increased volatility in asset prices in financial markets 2. Increased integration of national financial markets with the international financial markets 3. A significant growth of derivative instruments has been driven by technological breakthrough. Advances in this area include the development of high-speed processors, network systems and improved methods of data entry 4. Development of more sophisticated risk management tools, providing a wider choice of risk management strategies 5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk and lower transactions costs as compared to individual financial assets

The size of the market — notional amount outstanding in OTC derivatives, June 2023 (USD billion):

Interest rate contracts dominate; foreign exchange is second.

Exchange traded derivatives (USD billion), Oct–Dec 2022 open interest and 2022 daily average turnover:

And in India, average daily turnover of exchange traded currency derivatives for FY 2022-23: Futures Rs. 60,803 Crs and Options (Notional) Rs. 1,21,198.14 Crs.

Options notional is roughly double futures in India.

2.5 Who is in the market

There are broadly three types of participants in the currency derivatives market - hedgers, traders (also called speculators) and Arbitrageurs. Market participants may play different roles in different market circumstances.

Hedgers. They face risk associated with the prices of underlying assets and use derivatives to reduce their risk.

The Indian legal definitions: "hedging" means the activity of undertaking a foreign exchange derivative transaction to manage currency risk and "currency risk" means the potential for loss on account of movement in exchange rates of the rupee against a foreign currency or on account of movement in exchange rates of one foreign currency against another or on account of movement of interest rate applicable to a foreign currency.

Three sources of currency risk in that definition — rupee against foreign currency, one foreign currency against another, and foreign currency interest rates.

Both directions need hedging: an importer in India is exposed to the risk of rupee weakening against other currencies, and wants to hedge this risk. On the other hand, an exporter who expects to receive money in foreign currency, is faced with a risk of rupee strengthening against other currencies, and so the exporter will hedge against strengthening of INR.

Importer fears a weaker rupee. Exporter fears a stronger rupee.

Speculators/Traders. They try to predict the future movements in prices of underlying assets and based on the view, take positions in derivative contracts.

Why derivatives rather than the underlying: they offer leverage, are less expensive (cost of transaction is lower than that of the underlying) and are faster to execute in size (high volumes market).

And the direction convention: a participant who expects the base currency to appreciate (i.e. quote currency to depreciate), takes a long position. On the other hand, a participant expecting the base currency to depreciate (i.e. quote currency to appreciate) takes a short position.

Arbitragers. Arbitrage is a deal that produces profit by exploiting a price difference in a product in two different markets. Arbitrage originates when a trader purchases an asset cheaply in one location and simultaneously arranges to sell it at a higher price in another location.

And it is self-correcting: such opportunities are unlikely to persist for very long, since arbitragers would rush in to profit from these transactions, thus closing the price gap at different locations.

Where currency arbitrage arises: between underlying and derivatives market and/or within derivatives market between OTC and Exchange traded Derivatives market and/or between futures and option market and/or between various currency pairs.

The legal framework governing all of them: in India, 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 Foreign Exchange Management Act (FEMA), 1999, Foreign Exchange Management (Foreign exchange derivative contracts) Regulations, 2000 and any other guideline/regulations etc. provided by financial sector regulators like Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI), Insurance Regulatory and Development Authority of India (IRDAI), Pension Fund Regulatory and Development Authority (PFRDA).

2.6 Exchange-traded versus OTC

Based on the style in which a transaction is negotiated and settled, the market can be classified into two segments: over-the-counter (OTC) and Exchange.

OTC derivatives (OTCD) are privately negotiated and settled contracts between two parties whereas Exchange-traded derivatives (ETD) are screen-based order matching platform and settled contracts with the aid of Exchange (which provides platform for trade execution) and Clearing Corporation (which conducts the settlement). This makes ETD more transparent as compared to OTCD.

The differences:

Customisation — OTCDs can be customized to the specific requirements of the parties where are ETDs are "standardized" in the sense that the trade amount (called "market lot" or "Contract Amount") and the settlement date (called "expiry date") are pre-determined by the Exchange.

Risk — OTCDs have counterparty credit risk (which is the risk of failure of the counterparty before settlement date) and settlement risk (which is the risk of default by the counterparty on settlement date), but both risks do not arise in ETDs because of "trade guarantee" by Clearing Corporation.

Note that these are two distinct risks: counterparty credit risk is failure before the settlement date; settlement risk is default on the settlement date.

Novation

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... We say that both buyer and seller novated the original trade to Clearing Corporation so that Clearing Corporation becomes the buyer to the seller; and the seller to the buyer.

The two roles, stated plainly by the workbook:

Role of Exchange is to bring a buyer and seller together and enable a trade between them.

Role of Clearing Corporation is to settle trade with trade guarantee by becoming CCP.

And how the CCP protects itself: Clearing Corporation protects itself from the counterparty credit risk and settlement risk from both buyer and seller by implementing two processes called margining and mark-to-mark, which are discussed in chapter 7.

One practical advantage of the exchange route: the exchange traded market can offer hedging solution to even small size requirements whereas in OTC market, hedging a very small size requirement may not be possible, or the transaction cost may be prohibitive.

But ETDs are not perfect

Though ETD has advantages in terms of transparency, elimination of counter party risk, access to all types of market, low cost of trading, credit agnostic etc. there are certain limitations.

While standardization improves liquidity, it may lead to imperfect hedge as the amount and settlement dates cannot be customized. Similarly, cash settlement in ETD may not be helpful to actual hedgers, and daily MTM and margin may create operational issues to market participants.

Three real costs of standardisation: imperfect hedge, cash settlement where the hedger wanted currency, and the operational burden of daily margining.

The two are converging

Due to increased competition between OTC and Exchange markets, the differences between them are slowly fading.

From the exchange side: many derivatives Exchanges abroad offers customized contracts through the facilities of request-for-quote (RFQ) and Exchange-for-Physical (EFP).

From the OTC side: OTC market offers both standardized (called "vanilla" products) and customized (called "exotic" products). There are electronic communication networks called "e-trading" platforms in OTC market that does the functions of an Exchange for price discovery and trade execution.

The definition follows the practice: Master Direction – Reserve Bank of India (Market-makers in OTC Derivatives) Directions, 2021 define 'Over-the-counter (OTC) derivative' as a derivative (deliverable and non-deliverable) other than those which are traded on exchanges and shall include those traded on electronic trading platforms (ETPs).

And clearing is converging too: many OTC markets are going through central counterparty (CCP) clearing for multilateral settlements, like in Exchange markets. In India, Clearing Corporation of India Ltd (CCIL) is offering CCP services for settlement with trade guarantee for USDINR forward contracts and USDINR swap contracts. The margining and mark-to-market processes of Exchange markets have proved so useful that OTC market implements them today.

The hedging requirement in OTC

In India, a person, whether resident in India or resident outside India, may enter into an OTC foreign exchange derivative contract with an authorized dealer.

And there is a purpose test: while offering a foreign exchange derivative contract involving INR, other than NDDCs (Non-deliverable derivative contract) to a user, and during the life of such contracts, Authorised Dealers shall ensure that the contract is for the purpose of hedging.

On settlement: all OTC foreign exchange derivatives contracts are settled through delivery except the Non-deliverable derivative contracts (NDDC).

Who may offer NDDCs: banks in India having an Authorised Dealer Category-1 license under FEMA, 1999, and operating International Financial Services Centre (IFSC) Banking Units (IBUs), shall be eligible to offer non-deliverable derivative contracts involving the Rupee, or otherwise, to persons not resident in India.

Why regulators prefer exchanges

The clearing, settlement, and risk management part of OTC contracts, if not managed well, could lead to unsustainable counter party credit risk exposure leading to rapid unwinding of positions during periods of sharp volatility and adverse movement in asset prices.

A default by one or two large counterparties may lead to domino effect of default by other counterparties as well, thereby making financial markets unstable. This phenomenon was observed during the financial crisis of 2008.

Regulators and governments all over the world are now trying to move more and more derivative contracts to be exchange-traded with centralized clearing and settlement.

2.7 Why India introduced exchange-traded currency derivatives

The rationale for introducing currency futures in the Indian context has been outlined in the Report of the Internal Working Group on Currency Futures (Reserve Bank of India, April 2008).

The core argument: both residents and non-residents purchase domestic currency assets. If the exchange rate remains unchanged from the time of purchase of the asset to its sale, no gains and losses are made out of currency exposures. But if domestic currency depreciates (appreciates) against the foreign currency, the exposure will result in gain (loss) for residents purchasing foreign assets and loss (gain) for non-residents purchasing domestic assets. In this backdrop, unpredicted movements in exchange rates expose investors to currency risks. Currency futures enable them to hedge these risks.

On the long run versus the planning horizon: nominal exchange rates are often random walks with or without drift, while real exchange rates over the long run are mean reverting. As such, it is possible that over the long run, the incentive to hedge currency risk may not be large. However, the financial planning horizon is much smaller than the long run, which is typically inter-generational in the context of exchange rates.

And on the low-correlation counter-argument: empirically, changes in exchange rates are found to have very low correlations with foreign equity and bond returns. This in theory should lower portfolio risk. Therefore, sometimes an argument is advanced against the need for hedging currency risks. But there is strong empirical evidence to suggest that hedging reduces the volatility of returns and indeed considering the episodic nature of currency returns, there are strong arguments to use instruments to hedge currency risks.

The advantages of futures over forwards, in the Group's own words: the main advantage of currency futures over its closest substitute product, viz. forwards which are traded over-the-counter lies in price transparency, elimination of counterparty credit risk and greater reach in terms of easy accessibility to all. Currency futures are expected to bring about better price discovery and also possibly lower transaction costs.

And beyond hedgers: apart from pure hedgers, currency futures also invite arbitragers, speculators and those traders who may take a bet on exchange rate movements or an economic exposure as a motivation for trading.

The economy-wide case: there is a large body of empirical evidence which suggests that exchange rate volatility has an adverse impact on foreign trade. Since there are first order gains from trade which contribute to output growth and consumer welfare, currency futures can potentially have an important impact on the real economy. And currency futures could be seen as a facilitator in promoting investment and aggregate demand in the economy, thus promoting growth.

What came after futures: in order to expand the exchange traded hedging tools, recognized stock exchanges were permitted to introduce currency options. Further, with a view to enabling direct hedging of exposures in foreign currencies and to permit execution of cross-currency strategies by market participants, exchange traded currency futures and options were introduced in three cross-currency pairs viz., EUR-USD, GBP-USD and USD-JPY.

Those three cross-currency pairs recur throughout the rest of the exam.