Rupee creating a history every day and touching new lows, currency
derivatives as a hedging tool has gained a lot of ground. The general
definition of derivatives of course is that it is a contract whose value
depends on the value of some underlying asset; because of currency
derivatives, the underlying asset is a foreign currency rather than
being a share in a company or a commodity, says Forex Expert, AV
Rajwade.
The essential characteristic of a derivative is its value moves in the opposite direction to that of the underlying asset, he adds. An individual cannot do without derivatives if he or she is looking at hedging any currency exposure, explains Rajwade.
There are two types of players in this market, one who want to hedge exposures which arise out of their normal business, company having imports or exports or foreign currency borrowings, he says. The others, the speculators, there is also or at least there used to be until recently a third category of players which were the arbitragers who would continuously arbitrage between prices on exchanges and prices in the over the counter which is basically into bank and bank versus client market, he adds. So if there is a price difference between the two, the arbitrager would buy in one market and sell in the other, he says.
Below is the verbatim transcript of AV Rajwade's interview on CNBC-TV18
Q: We will start a little bit with the basics, what are currency derivatives, who is suited for this product?
A: The general definition of derivatives of course is that it is a contract whose value depends on the value of some underlying asset because of currency derivatives, the underlying asset is a foreign currency rather than being a share in a company or a commodity. So the basic definition remains that its value depends on the value of a variable, an asset like a currency. That is why you call them currency derivatives.
One basic difference between currency and equity derivatives, which we need to keep at the back of our minds is that currency derivatives are traded both on exchanges as well as what is known as over-the-counter (OTC) market that is between businesses wanting to buy or sell dollars and their bankers. So there is a very large OTC market and of course the exchange traded market has also grown, there are positive and negative features to both those markets.
Q: A lot of the viewers watching this show whether they are lay investors, students looking to study abroad, businesses of different sizes in the import/export business area especially would want to know who are currency derivatives suited for, who all can take advantage of it?
A: Essentially you cannot hedge any price risk except by using a derivative and for hedging a price risk, the derivative needs to have a particular characteristic namely its value moves in the opposite direction to that of the underlying asset. That is why we call it a hedge. So that what you gain or lose on one side, you lose or gain on the other. So you cannot do without derivatives if you are looking at hedging any currency exposures, which are arising out of your basic business.
The other users of currency derivatives or in principle only exchange traded currency derivatives would be those who want to you said investors, I would call them more bluntly as speculators trying to profit speculation by definition means that taking a longer short position in the hope of profiting from price movements. Now that is what they are glorified by a being called investors, but I think essentially they are speculators.
Speculation is a very high risk high reward game so essentially there are two types of players, one who want to hedge exposures which arise out of their normal business, company having imports or exports or foreign currency borrowings. The others, the speculators, there is also or at least there used to be until recently a third category of players which were the arbitragers who would continuously arbitrage between prices on exchanges and prices in the over the counter which is basically into bank and bank versus client market. So if there is a price difference between the two, the arbitrages would buy in one market, sell in the other.
Q: We hear a lot more about the rupee’s fall against the dollar and the movement there. But what are the different currencies which can be traded in the derivatives market in India?
A: Theoretically there are contracts in other major currencies like euro and yen and so on. But we need to keep two perspectives in mind. One, there is very little liquidity in those contracts. The basic liquidity in exchange traded derivatives market is in dollar rupee and that too for the nearer maturity one-three months. There isn’t much of liquidity in longer term maturities.
The second perspective which we need to keep in mind is that there is no such thing really as a euro-rupee or yen-rupee exchange rate. In fact that is a combination of the dollar-euro exchange rate in the global markets and dollar rupee exchange rate in the Indian markets. So it is a multiplication of the two. And it is not an independent variable. Once again that price is derived in a way you can call it a derivative of the dollar-euro or dollar-yen global market and dollar-rupee market in India.
Q: You were speaking about how there is a big OTC market for currency and currency derivatives in India and then there is currency traded on the exchanges. What is the reason for having two such avenues and should they not actually be combined into one?
A: There are two reasons why at least in the Indian context they cannot be combined together. One reason is that we have what is known as Foreign Exchange Management Act (FEMA). What it means is that any resident can do an actual currency exchange transaction only with an authorised dealer. You might be an exporter and I might be an importer, we cannot sell to each other. You have to sell to your bank, I have to sell to my bank. This is part of the FEMA. Also the interbank market, the jargon is authorised dealers in foreign exchange, that market is very tightly controlled by the central bank, while exchanges do not come directly under the purview of the central bank, they are regulated by Sebi.
The third thing, one corollary following from what I said is that all the exchange traded contracts are settled not by delivery, but as contract for differences, that is you exchange the difference in prices. You have bought dollars at Rs 60, settlement price is Rs 59, you pay Rs 1 and settle the contract. While in the OTC market, in principle, contracts are settled by actual exchange of one currency for another and any resident can undertake derivative transaction in the OTC market only if that firm, unlikely that individuals will have, that firm has a genuine underlying commercial exposure, so the export contract and import contract or a foreign currency borrowing.
The other major difference between the two markets is that like all exchange traded products the performance is guaranteed by clearing company. The clearing company is a subsidiary of the exchange. Nowadays, there is a move that they should become independent companies, but it is guaranteed by a clearing company. Transactions in the OTC market are not guaranteed, so there is what is known in the jargon as a counterparty exposure, the risk that the party with whom you are contracting to buy and sell might go insolvent, might fail before the contract matures.
You do not have that kind of a problem at least in principle on exchanged traded derivatives because they are guaranteed by the clearing company at the global level. You all know that there was a major financial crisis in 2008 arising out of mortgage derivatives. These are also derivatives, but of a different kind. Thereafter the group of 20 largest economies became active, they started meeting at the head of government level. Group of 20 has been in existence since earlier, but it was meeting at the Finance Minister level or central bank governor level, at the summit level that is at for instance Prime Minister Manmohan Singh is one of the members of the G20 Summit Group now.
One of the resolution of the G20 after the mortgaged derivatives crisis in western markets in 2008 has been that they are urging all member countries to move as much derivatives trading from OTC markets to exchanges, because exchanges through a system of initial and mark-to-market (MTM) daily margins they eliminate the counterparty exposures and through the margining system are able to guarantee the deliveries by the seller, in effect the clearing company steps in between the buyer of a contract and the seller of a contract.
Q: The question that arises is like you said that there is a thriving OTC market that we have. We have exchange traded derivatives available. For someone who is watching this show, who has an import export exposure of a very small nature, but obviously the currency fluctuations like we have seen in the second half of August impact them greatly. How do they decide how much exposure they should take on the exchange-traded fund (ETF), because like you said OTC the risk is there is no counterparty to guarantee, safeguard or eliminate that risk which is the first dharma of anyone who is hedging? How does it work?
A: As I mentioned earlier, under FEMA any resident can do a foreign currency transaction only with an authorised dealer. Authorised dealers are banks and the way banking has been supervised in our country, to the best of my knowledge last 17-18 years there has been no bank exposure as such. There the counterparty exposure is far more live issue for the banks on the company rather than for the company on the bank, but there is a downside to using derivatives in the OTC market. The downside is that there is no price transparency in the OTC market. At the same point of time, a bank dealer may quote price to you, one to me, one price for a million dollar trade, another for a USD 10,000 trade. While on exchanges there is a great deal of price transparency because you can see it on the screen what price you can sell or buy a particular contract.
The other basic difference between the two is that in the exchange traded derivatives market, maturities are fixed. Futures contracts for instance, they all mature on the last working day of the month that is when they are settled. So the maturities cannot be customised to suite the requirements of an exporter or importer.
For instance, my payment may be due on the 15th of a month. I can have a forward contract or an options contract with a bank which matures on 15th. If I want to do that same hedging on the exchange I will probably have to buy the contract which is expiring nearest to that date or something like that. So customisation is not possible. The cost of customisation in the OTC market is there is no price transparency and you could be paying a much higher margin. Margin means the wholesale market price and the retail market price difference, not margin in terms of initial margin and MTM margins.
Q: For the lay investor we have a student community, a tourist community, tourism agencies now with the rupee losing a substantial amount of ground especially over the last couple of weeks how do they hedge themselves if you want to go to the exchange do you need to have any particular profile or can any Indian resident take a position?
A: Unlike over-the-counter (OTC) market, as far as exchange traded derivatives are concerned, anybody can go to the exchange. All he would need is to pay an initial margin. There will be daily mark-to-market margin on that contract, so he will have to be prepared to pay the initial margin and the mark to market margin everyday but anybody can take that position.
In terms of the kind of people, the kind of end users mentioned for instance students going abroad or their parents or whatever, we need to distinguish between two types of exchange traded derivatives. First one is the Futures. Futures is like a forward contract except that it is standardised as to amount and maturity. The other is currency options. Options is a completely different animal.
In my teaching I often compare the Forward or Futures contracts as a Hindu marriage because once you have done those seven pheras round the agni, there is no way to get out of that contract. So, the negative side of the derivatives in the forward family, forward contracts futures, contract swaps etc, is that one cannot benefit from a favourable price movement.
For instance, yesterday if one bought Futures Contract at 63, now if tomorrow the rupee goes to 60 then one cannot benefit from that. One is locked into that 63 and one has to live with it. This is something totally different from an Option contract for which one pays an upfront fee for buying an Option.
What Option allows one to do is that if the price is worse than the strike of the Option, one can exercise the Option. If the market price is there, one can tear off the option so option has no opportunity cost but it has an upfront cost.
Upfront cost can also be reduced significantly by buying what is known as out of the money Options, that is where the strike rate is much worse than today’s market rate. Let’s say today’s market rate for the September end contract is 63, but I could buy an Option without much of a fee. There will be some fee which gives me the right to buy dollars at 66 which is much worst than today’s price. But then, our exercise is if it goes to 68, I do not exercise if their price is below 66 so Option has certain advantages.
In fact, Options need to be looked at by the end user like insurance. One pays a fee, buy an insurance, one buy car you have a comprehensive insurance. One has life insurance, if one is managing a factory, one has insurance against earthquake, riots, strikes etc so one pays a fee and one is protected against adverse happenings.
Q: It is available with the exchange, it is available in demat form, you can log into your account and trade it. How are things like contract size decided, margins decided and like we have in equities- in the money, at the money, out of the money, different strike prices available how does that work for currency?
A: The money Options means that the strike price is more favourable than the forward rate. The example that I gave was that Septembe-end Futures contract is trading at 63 now 61, if I have the right to buy dollar is at 61 now that is in the money strike, if it is at 63 it is at the money, if it is at 66 then it is out of the money.
Out of the money Options will cost much less than either at the money and the costliest of course will be in the money Options where the minimum price will be what is known as the intrinsic value that is the difference between the strike and today’s price. I think it depends on how much upfront money one wants to pay for buying an option.
Q: The question that is there in the top of mind for everyone is that the rupee has lost so much of ground to the dollar and there does not seem to be anything to suggest it will stop here it might go further for businesses how would you advice them because they would have obviously like over the counter requirement. Can they make a portfolio where they have over the counter exposure as well as exchange traded exposure so that the volatility hits them a little?
A: I would not advise them to run both the portfolios simultaneously. They should be looking at very closely particularly the SME segment is doing the hedge on the exchange primarily because of price transparency. There is except one fact that in the OTC market the small people get much worse rates than the Reliance ’s of this world. The small garment exporter from Tirupur gets a far worse price than a company like Reliance in Mumbai. That is the reality of that market.
While on exchange trading there is a price on the screen and one can buy or sell at the screen price. One thing they can look at very closely is doing the hedging part on the exchange but on the date of maturity of ones underlying exposure, cancel the hedge in the exchange and simultaneously do a trade in the OTC market because then the OTC trade will be in the spot market not in the derivative market so combining the two maybe useful. I think that is part of our corporate culture we haven’t really got around to the fact that Options are like insurance that one is much better off paying a fee and buying protection rather than trying to look at zero cost products which can turn out to have risk and pricing which one is not able to understand properly.
The essential characteristic of a derivative is its value moves in the opposite direction to that of the underlying asset, he adds. An individual cannot do without derivatives if he or she is looking at hedging any currency exposure, explains Rajwade.
There are two types of players in this market, one who want to hedge exposures which arise out of their normal business, company having imports or exports or foreign currency borrowings, he says. The others, the speculators, there is also or at least there used to be until recently a third category of players which were the arbitragers who would continuously arbitrage between prices on exchanges and prices in the over the counter which is basically into bank and bank versus client market, he adds. So if there is a price difference between the two, the arbitrager would buy in one market and sell in the other, he says.
Below is the verbatim transcript of AV Rajwade's interview on CNBC-TV18
Q: We will start a little bit with the basics, what are currency derivatives, who is suited for this product?
A: The general definition of derivatives of course is that it is a contract whose value depends on the value of some underlying asset because of currency derivatives, the underlying asset is a foreign currency rather than being a share in a company or a commodity. So the basic definition remains that its value depends on the value of a variable, an asset like a currency. That is why you call them currency derivatives.
One basic difference between currency and equity derivatives, which we need to keep at the back of our minds is that currency derivatives are traded both on exchanges as well as what is known as over-the-counter (OTC) market that is between businesses wanting to buy or sell dollars and their bankers. So there is a very large OTC market and of course the exchange traded market has also grown, there are positive and negative features to both those markets.
Q: A lot of the viewers watching this show whether they are lay investors, students looking to study abroad, businesses of different sizes in the import/export business area especially would want to know who are currency derivatives suited for, who all can take advantage of it?
A: Essentially you cannot hedge any price risk except by using a derivative and for hedging a price risk, the derivative needs to have a particular characteristic namely its value moves in the opposite direction to that of the underlying asset. That is why we call it a hedge. So that what you gain or lose on one side, you lose or gain on the other. So you cannot do without derivatives if you are looking at hedging any currency exposures, which are arising out of your basic business.
The other users of currency derivatives or in principle only exchange traded currency derivatives would be those who want to you said investors, I would call them more bluntly as speculators trying to profit speculation by definition means that taking a longer short position in the hope of profiting from price movements. Now that is what they are glorified by a being called investors, but I think essentially they are speculators.
Speculation is a very high risk high reward game so essentially there are two types of players, one who want to hedge exposures which arise out of their normal business, company having imports or exports or foreign currency borrowings. The others, the speculators, there is also or at least there used to be until recently a third category of players which were the arbitragers who would continuously arbitrage between prices on exchanges and prices in the over the counter which is basically into bank and bank versus client market. So if there is a price difference between the two, the arbitrages would buy in one market, sell in the other.
Q: We hear a lot more about the rupee’s fall against the dollar and the movement there. But what are the different currencies which can be traded in the derivatives market in India?
A: Theoretically there are contracts in other major currencies like euro and yen and so on. But we need to keep two perspectives in mind. One, there is very little liquidity in those contracts. The basic liquidity in exchange traded derivatives market is in dollar rupee and that too for the nearer maturity one-three months. There isn’t much of liquidity in longer term maturities.
The second perspective which we need to keep in mind is that there is no such thing really as a euro-rupee or yen-rupee exchange rate. In fact that is a combination of the dollar-euro exchange rate in the global markets and dollar rupee exchange rate in the Indian markets. So it is a multiplication of the two. And it is not an independent variable. Once again that price is derived in a way you can call it a derivative of the dollar-euro or dollar-yen global market and dollar-rupee market in India.
Q: You were speaking about how there is a big OTC market for currency and currency derivatives in India and then there is currency traded on the exchanges. What is the reason for having two such avenues and should they not actually be combined into one?
A: There are two reasons why at least in the Indian context they cannot be combined together. One reason is that we have what is known as Foreign Exchange Management Act (FEMA). What it means is that any resident can do an actual currency exchange transaction only with an authorised dealer. You might be an exporter and I might be an importer, we cannot sell to each other. You have to sell to your bank, I have to sell to my bank. This is part of the FEMA. Also the interbank market, the jargon is authorised dealers in foreign exchange, that market is very tightly controlled by the central bank, while exchanges do not come directly under the purview of the central bank, they are regulated by Sebi.
The third thing, one corollary following from what I said is that all the exchange traded contracts are settled not by delivery, but as contract for differences, that is you exchange the difference in prices. You have bought dollars at Rs 60, settlement price is Rs 59, you pay Rs 1 and settle the contract. While in the OTC market, in principle, contracts are settled by actual exchange of one currency for another and any resident can undertake derivative transaction in the OTC market only if that firm, unlikely that individuals will have, that firm has a genuine underlying commercial exposure, so the export contract and import contract or a foreign currency borrowing.
The other major difference between the two markets is that like all exchange traded products the performance is guaranteed by clearing company. The clearing company is a subsidiary of the exchange. Nowadays, there is a move that they should become independent companies, but it is guaranteed by a clearing company. Transactions in the OTC market are not guaranteed, so there is what is known in the jargon as a counterparty exposure, the risk that the party with whom you are contracting to buy and sell might go insolvent, might fail before the contract matures.
You do not have that kind of a problem at least in principle on exchanged traded derivatives because they are guaranteed by the clearing company at the global level. You all know that there was a major financial crisis in 2008 arising out of mortgage derivatives. These are also derivatives, but of a different kind. Thereafter the group of 20 largest economies became active, they started meeting at the head of government level. Group of 20 has been in existence since earlier, but it was meeting at the Finance Minister level or central bank governor level, at the summit level that is at for instance Prime Minister Manmohan Singh is one of the members of the G20 Summit Group now.
One of the resolution of the G20 after the mortgaged derivatives crisis in western markets in 2008 has been that they are urging all member countries to move as much derivatives trading from OTC markets to exchanges, because exchanges through a system of initial and mark-to-market (MTM) daily margins they eliminate the counterparty exposures and through the margining system are able to guarantee the deliveries by the seller, in effect the clearing company steps in between the buyer of a contract and the seller of a contract.
Q: The question that arises is like you said that there is a thriving OTC market that we have. We have exchange traded derivatives available. For someone who is watching this show, who has an import export exposure of a very small nature, but obviously the currency fluctuations like we have seen in the second half of August impact them greatly. How do they decide how much exposure they should take on the exchange-traded fund (ETF), because like you said OTC the risk is there is no counterparty to guarantee, safeguard or eliminate that risk which is the first dharma of anyone who is hedging? How does it work?
A: As I mentioned earlier, under FEMA any resident can do a foreign currency transaction only with an authorised dealer. Authorised dealers are banks and the way banking has been supervised in our country, to the best of my knowledge last 17-18 years there has been no bank exposure as such. There the counterparty exposure is far more live issue for the banks on the company rather than for the company on the bank, but there is a downside to using derivatives in the OTC market. The downside is that there is no price transparency in the OTC market. At the same point of time, a bank dealer may quote price to you, one to me, one price for a million dollar trade, another for a USD 10,000 trade. While on exchanges there is a great deal of price transparency because you can see it on the screen what price you can sell or buy a particular contract.
The other basic difference between the two is that in the exchange traded derivatives market, maturities are fixed. Futures contracts for instance, they all mature on the last working day of the month that is when they are settled. So the maturities cannot be customised to suite the requirements of an exporter or importer.
For instance, my payment may be due on the 15th of a month. I can have a forward contract or an options contract with a bank which matures on 15th. If I want to do that same hedging on the exchange I will probably have to buy the contract which is expiring nearest to that date or something like that. So customisation is not possible. The cost of customisation in the OTC market is there is no price transparency and you could be paying a much higher margin. Margin means the wholesale market price and the retail market price difference, not margin in terms of initial margin and MTM margins.
Q: For the lay investor we have a student community, a tourist community, tourism agencies now with the rupee losing a substantial amount of ground especially over the last couple of weeks how do they hedge themselves if you want to go to the exchange do you need to have any particular profile or can any Indian resident take a position?
A: Unlike over-the-counter (OTC) market, as far as exchange traded derivatives are concerned, anybody can go to the exchange. All he would need is to pay an initial margin. There will be daily mark-to-market margin on that contract, so he will have to be prepared to pay the initial margin and the mark to market margin everyday but anybody can take that position.
In terms of the kind of people, the kind of end users mentioned for instance students going abroad or their parents or whatever, we need to distinguish between two types of exchange traded derivatives. First one is the Futures. Futures is like a forward contract except that it is standardised as to amount and maturity. The other is currency options. Options is a completely different animal.
In my teaching I often compare the Forward or Futures contracts as a Hindu marriage because once you have done those seven pheras round the agni, there is no way to get out of that contract. So, the negative side of the derivatives in the forward family, forward contracts futures, contract swaps etc, is that one cannot benefit from a favourable price movement.
For instance, yesterday if one bought Futures Contract at 63, now if tomorrow the rupee goes to 60 then one cannot benefit from that. One is locked into that 63 and one has to live with it. This is something totally different from an Option contract for which one pays an upfront fee for buying an Option.
What Option allows one to do is that if the price is worse than the strike of the Option, one can exercise the Option. If the market price is there, one can tear off the option so option has no opportunity cost but it has an upfront cost.
Upfront cost can also be reduced significantly by buying what is known as out of the money Options, that is where the strike rate is much worse than today’s market rate. Let’s say today’s market rate for the September end contract is 63, but I could buy an Option without much of a fee. There will be some fee which gives me the right to buy dollars at 66 which is much worst than today’s price. But then, our exercise is if it goes to 68, I do not exercise if their price is below 66 so Option has certain advantages.
In fact, Options need to be looked at by the end user like insurance. One pays a fee, buy an insurance, one buy car you have a comprehensive insurance. One has life insurance, if one is managing a factory, one has insurance against earthquake, riots, strikes etc so one pays a fee and one is protected against adverse happenings.
Q: It is available with the exchange, it is available in demat form, you can log into your account and trade it. How are things like contract size decided, margins decided and like we have in equities- in the money, at the money, out of the money, different strike prices available how does that work for currency?
A: The money Options means that the strike price is more favourable than the forward rate. The example that I gave was that Septembe-end Futures contract is trading at 63 now 61, if I have the right to buy dollar is at 61 now that is in the money strike, if it is at 63 it is at the money, if it is at 66 then it is out of the money.
Out of the money Options will cost much less than either at the money and the costliest of course will be in the money Options where the minimum price will be what is known as the intrinsic value that is the difference between the strike and today’s price. I think it depends on how much upfront money one wants to pay for buying an option.
Q: The question that is there in the top of mind for everyone is that the rupee has lost so much of ground to the dollar and there does not seem to be anything to suggest it will stop here it might go further for businesses how would you advice them because they would have obviously like over the counter requirement. Can they make a portfolio where they have over the counter exposure as well as exchange traded exposure so that the volatility hits them a little?
A: I would not advise them to run both the portfolios simultaneously. They should be looking at very closely particularly the SME segment is doing the hedge on the exchange primarily because of price transparency. There is except one fact that in the OTC market the small people get much worse rates than the Reliance ’s of this world. The small garment exporter from Tirupur gets a far worse price than a company like Reliance in Mumbai. That is the reality of that market.
While on exchange trading there is a price on the screen and one can buy or sell at the screen price. One thing they can look at very closely is doing the hedging part on the exchange but on the date of maturity of ones underlying exposure, cancel the hedge in the exchange and simultaneously do a trade in the OTC market because then the OTC trade will be in the spot market not in the derivative market so combining the two maybe useful. I think that is part of our corporate culture we haven’t really got around to the fact that Options are like insurance that one is much better off paying a fee and buying protection rather than trying to look at zero cost products which can turn out to have risk and pricing which one is not able to understand properly.
