Currency Derivatives
Comprehensive Study Guide
A highly detailed, exam-focused reading guide meticulously extracting deep theoretical frameworks, exact regulatory limits, and rigorous step-by-step mathematical models from the official NISM workbook.
Chapter 1: Introduction to Currency Markets
1.1 History and Evolution of Foreign Exchange
The currency rate mechanism evolved from barter to the Gold Standard, and then to the Bretton Woods System (1944-1971) where currencies were pegged to the US Dollar, which was in turn pegged to gold. Today, major currencies operate under a Floating Exchange Rate regime, where values are determined by supply and demand. This makes them Fiat money (government-issued currency not backed by a physical commodity, but by government order).
Some developing nations use a dirty float (managed float) system, where the exchange rate is neither entirely free nor fixed. Central banks intervene from time to time by buying or selling large lots of currency to manage excessive volatility and maintain trade competitiveness.
1.2 Quotation Mechanics: Base vs Quote Currency
In currency pairs, the first currency is the Base Currency (BC) and the second is the Quotation/Term Currency (QC). In USDINR, USD is the BC (always 1 unit) and INR is the QC. The quoted price is the price of 1 unit of BC expressed in QC.
Market Quote Example: USDINR 82.0525 / 82.0575
- Bid Price (82.0525): The price at which the Bank/Market Maker BUYS the Base Currency (USD). If you are a customer selling USD, you receive this lower rate.
- Ask/Offer Price (82.0575): The price at which the Bank SELLS the Base Currency. If you are a customer buying USD, you pay this higher rate.
- Appreciation/Depreciation: If USDINR moves from 82 to 83, the Base Currency (USD) has appreciated (strengthened) and buys more INR. The Quote Currency (INR) has depreciated (weakened).
1.3 Value Dates & FBIL Reference Rate
Depending on the gap between trade and value date, spot forex trading is categorized as:
- Cash/Ready: Settlement occurs on the same day as trade date (T).
- Tom (Tomorrow): Settlement is on the next business day (T+1).
- Spot: Settlement occurs on the second business day (T+2).
- Forward: Any settlement date after the spot value date.
The Financial Benchmarks India Private Limited (FBIL) computes and disseminates daily reference rates around 13:30 hours. The highly testable methodology is:
- Data is sourced from actual spot transactions on electronic platforms (Refinitiv/CCIL).
- The data collection window is exactly one hour: 11:30 to 12:30 hours.
- A random 15-minute window is selected within that hour.
- The threshold criterion is exactly 10 transactions with an aggregate amount of USD 25 million. If the first 15-min window fails this, a second is drawn (up to 5 times).
- A +/- 3 Standard Deviation (SD) rule is applied to remove outliers.
- The final rate is the volume-weighted average of the surviving transactions.
1.4 Exchange Rate Arithmetic - Cross Rates
When direct prices are unavailable, they are derived by "crossing" underlying pairs. In the exam, pay close attention to whether you are calculating the Bid or Ask for the cross rate.
Given: EURUSD = 1.1125 / 1.1150 | USDINR = 75.64 / 75.65
To find the EURINR Offer (Ask) Rate (Cost to BUY 1 EUR):
- You need to buy 1 EUR. You buy EURUSD at the bank's Offer rate: 1.1150 USD.
- To get 1.1150 USD, you must buy USD using INR at the Offer rate: 75.65 INR.
- Calculation: 1.1150 × 75.65 = 84.3498 INR.
To find the EURINR Bid Rate (Proceeds from SELLING 1 EUR):
- You sell 1 EUR. You sell EURUSD at the bank's Bid rate: 1.1125 USD.
- You sell the 1.1125 USD for INR at the bank's Bid rate: 75.64 INR.
- Calculation: 1.1125 × 75.64 = 84.1495 INR.
Final EURINR Quote: 84.1495 / 84.3498
Given: USDJPY = 115.08 / 115.09 | USDINR = 75.64 / 75.65
Note: USD is the base currency in both underlying pairs. However, market convention dictates JPYINR must be quoted per 100 JPY.
To BUY 100 JPY (Finding Offer):
- Sell INR to buy USD (Pay Ask): 75.65 INR.
- Sell USD to buy JPY (Bank buys USD at Bid): 115.08 JPY.
- 1 JPY = 75.65 / 115.08 = 0.6574 INR. → For 100 JPY = 65.74 INR
To SELL 100 JPY (Finding Bid):
- Sell JPY to buy USD (Bank sells USD at Ask): 115.09 JPY.
- Sell USD to buy INR (Bank buys USD at Bid): 75.64 INR.
- 1 JPY = 75.64 / 115.09 = 0.6572 INR. → For 100 JPY = 65.72 INR
1.5 Economic Indicators and Market Impact
Currency prices are impacted by macro factors. A highly tested concept is how these variables shift exchange rates:
- Real Interest Rates: Generally, high real interest rates attract foreign capital, appreciating the domestic currency.
- Trade Deficit: A widening trade deficit usually depreciates the domestic currency as it signifies higher imports (selling domestic currency) than exports (buying domestic currency).
- Non-Farm Payrolls (NFP): US jobs data excluding farming/government. A positive number signifies economic strength, leading to a stronger USD.
- Consumer Price Index (CPI): Rising CPI means rising inflation. High inflation eventually hurts economic growth, weakening the currency in the long run.
Chapter 2: Foreign Exchange Derivatives
Derivatives derive their value from an underlying asset. Under accounting standards (IAS 39/AS 30), financial derivatives must satisfy three exact criteria:
- Its value is linked to an underlying asset.
- The trade settles on a "future" date (later than the standard T+2 spot date).
- There is no full cash outlay on the trade date (leverage).
| Derivative Type | Key Characteristics (Exam Focus) |
|---|---|
| Forward | OTC, customized contracts, settled by physical delivery, carries high counterparty credit risk and settlement risk. |
| Futures | Exchange-traded, highly standardized, daily Mark-to-Market (MTM) margin requirements, no counterparty risk (guaranteed by Clearing Corp through Novation). |
| Options | Provides the right, but not the obligation, to buy (Call) or sell (Put). Asymmetrical risk profile (buyer has limited risk, seller has unlimited risk). |
| FX Swap | Simultaneous spot exchange of currencies (short leg) and a forward reverse exchange of the same two currencies at a date further in the future (long leg). |
The RBI-SEBI Standing Technical Committee recommended ETCDs over OTC derivatives because: 1) Price Transparency (OTC markets are opaque), 2) Elimination of Counterparty Risk (via Clearing Corporation Novation), 3) Greater reach/accessibility to all retail and institutional players (democratization of hedging without relying on credit profile), and 4) Better price discovery due to centralized order matching.
Chapter 3: Exchange Traded Currency Futures
Currency futures are standardized exchange-traded contracts. Futures have linear (symmetrical) payoffs, meaning both long and short positions have unlimited profit/loss potential.
3.1 Contract Specifications (Memorize for Exam)
- Lot Size: 1000 units of Base Currency (except JPYINR which is 100,000 JPY).
- Tick Size: Re. 0.0025 for INR pairs. USD 0.0001 for EURUSD/GBPUSD. JPY 0.01 for USDJPY.
- Expiry Day: Two working days prior to the last business day of the expiry month at 12:30 PM. (If the last business day is Thursday, expiry is Tuesday).
- Settlement: Daily Mark-to-Market (MTM) on T+1. Final settlement is Cash Settled in INR based on FBIL reference rate on T+2.
- Trading Cycle: 11 serial weekly cycles and 12 serial monthly trading cycles.
1. Value of INR Pairs (e.g., USDINR):
- Trade Price: INR 83.00. Lot Size: 1000.
- Contract Value per lot: 83.00 × 1000 = INR 83,000.
- Tick Value Impact: 0.0025 × 1000 = INR 2.50 per lot.
2. Value of Cross Currency Pairs in INR (e.g., EURUSD):
- Trade Price: 1.08 USD. Lot Size: 1000. FBIL USDINR Ref Rate: 82.95.
- Contract Value in USD: 1.08 × 1000 = USD 1080.
- Contract Value in INR: 1080 × 82.95 = INR 89,586.
- Tick Value Impact: 0.0001 × 1000 = USD 0.10 per lot.
3.2 Interest Rate Parity (Pricing Futures)
The fundamental pricing of currency futures prevents risk-free arbitrage and is based on Interest Rate Parity. Key Rule: The future value of a currency with a high interest rate trades at a discount to the currency with a low interest rate (which trades at a premium).
Alternatively, the Continuous Compounding Theoretical Price Computation is used by Indian exchanges to price futures algorithmically:
Where r is the interest rate of the quote currency, and rf is the interest rate of the base currency. 't' is time till expiration in years.
Given: USDINR Spot (S) = 83.00.
India Interest Rate (RQuote) = 7% (0.07).
US Interest Rate (RBase) = 5% (0.05).
Time = 6 months (0.5 years).
Exact Calculation:
F = 83.00 × [ (1 + (0.07 × 0.5)) / (1 + (0.05 × 0.5)) ]
F = 83.00 × [ 1.035 / 1.025 ]
F = 83.00 × 1.009756 = 83.8097
Shortcut (Rule of Thumb for exams):
Forward Premium ≈ Spot × (Interest Difference) × Time
F ≈ S + [S × (RQuote - RBase) × Time]
F ≈ 83 + [83 × (0.07 - 0.05) × 0.5]
F ≈ 83 + 0.83 = 83.83
Chapter 4: Exchange Traded Currency Options
An Option gives the buyer the right, but not the obligation, to buy (Call) or sell (Put). Exchange-traded options in India are European style (exercisable only on expiry, though they can be squared off in the secondary market). Option Premium = Intrinsic Value + Time Value.
4.1 Moneyness and Valuation
- In-the-Money (ITM): Immediate exercise yields positive cash flow. (Call: Spot > Strike | Put: Spot < Strike). Has both Intrinsic and Time value.
- At-the-Money (ATM): Spot = Strike. Has only Time value.
- Out-of-the-Money (OTM): Immediate exercise yields negative cash flow. Has only Time value.
Let X = Strike Price, P = Premium Paid/Received
| Position | Breakeven (BEP) | Max Risk (Loss) | Max Reward |
|---|---|---|---|
| Long Call | X + P | Premium Paid (P) | Unlimited |
| Short Call | X + P | Unlimited | Premium Received (P) |
| Long Put | X - P | Premium Paid (P) | Strike - Premium |
| Short Put | X - P | Substantial (Strike - P) | Premium Received (P) |
Options are primarily priced using two models. The theoretical difference between them is highly testable:
- Black-Scholes Model (1973): Uses 5 determinants: Spot Price (S), Strike Price (X), Volatility (σ), Time to expiry (t), and Risk-free rate (r). It was designed for options exercised only at maturity on assets that do not pay dividends. Indian exchanges use this to price currency options.
- Black (1976) Model: A critical variation of Black-Scholes that substitutes Spot prices with Forward/Futures prices (F) to bypass the "negative cost of carry" issue. Indian exchanges use this model for pricing interest rate options (where the underlying is government securities).
- Implied Volatility (IV): Discovered by running the Black-Scholes model in reverse using the traded market premium. It represents the market's expectation of future volatility. IV generally increases in bearish/uncertain markets and decreases in bullish markets.
4.2 The Options Greeks
Greeks measure the risk dimensions of an option position. This is heavily tested mathematically.
- Delta (Δ): Rate of change of premium for every 1-unit change in spot price. Long Call is 0 to 1. Long Put is -1 to 0.
- Gamma (γ): Rate of change of Delta. It measures acceleration. It is always positive for both long calls and long puts. Gamma is highest for At-The-Money (ATM) options.
- Theta (Θ): Sensitivity to time decay. Represents points lost per day. Options are "wasting assets". Theta is negative for option buyers and positive for option sellers.
- Vega (v): Sensitivity to implied volatility. Positive for both long calls and long puts. The effect of volatility is highest when there are more days left to expiry.
- Rho (ρ): Sensitivity to risk-free interest rates. Call is positive (rising rates increase call value), Put is negative (rising rates decrease put value).
1. Delta (Δ) Calculation:
If Call Delta = +0.55, Spot = 82.80, Call Premium = 0.45.
If Spot rises to 83.00 (Change = +0.20), New Premium = 0.45 + (0.20 × 0.55) = 0.56.
2. Gamma (γ) Calculation:
If Put Delta = -0.50, Gamma = 0.004. Spot moves DOWN by 10 points.
Change in Delta = Gamma × Change in Underlying = 0.004 × (-10) = -0.04.
New Delta = -0.50 + (-0.04) = -0.54. (Put Delta becomes more negative as price drops).
3. Vega (v) Calculation:
If Option Vega = 0.02, Volatility = 10%, Premium = 0.10.
If Volatility drops 2% to 8% (Change = -2%), New Premium = 0.10 - (2 × 0.02) = 0.06.
4.3 Put-Call Parity
Put-call parity shows the relationship that has to exist between European put and call options with the same underlying asset, expiration, and strike prices. A violation of this parity allows for riskless arbitrage.
Chapter 5: Strategies using ETCD
5.1 Hedging Strategies & Effective Exchange Rates
Hedgers lock in rates to protect actual business exposure. Exams frequently ask to calculate the "Effective Rate" after a hedge is squared off.
Scenario: Exporter sells USDINR futures at 81.75 to hedge receivables. At maturity, Spot is 83.00 and futures are squared up (bought back) at 83.05.
- Underlying Cash Market: Exporter sells USD at Spot = 83.00.
- Futures P&L: Sold at 81.75, Squared up at 83.05. Loss = -1.30.
- Effective Exchange Rate: 83.00 (Spot realization) - 1.30 (Futures Loss) = 81.70.
Scenario: Importer needs to pay USD. Spot = 81. Hedged 50% of exposure using futures at 81.50. At maturity, Spot = 82.00, Futures = 82.05.
- Futures P&L: Bought at 81.50, Settled at 82.05. Profit = +0.55.
- Effective Price for Hedged Half: 82.00 (Spot Cost) - 0.55 (Futures Profit) = 81.45.
- Effective Price for Unhedged Half: 82.00.
- Overall Effective Exchange Rate: (82.00 × 0.5) + (81.45 × 0.5) = 81.725.
5.2 Option Spreads & Combinations
Spreads combine options to cap maximum profit and loss, significantly reducing the overall cost of trades.
1. Bull Call Spread (Buy Low Strike K1, Sell High Strike K2):
- Net Premium Paid: Premium(K1) - Premium(K2)
- Max Loss: Net Premium Paid
- Max Profit: (K2 - K1) - Net Premium Paid
- Breakeven: K1 + Net Premium Paid
2. Long Straddle (Buy Call & Put at same Strike K):
- View: Extreme volatility in either direction.
- Total Premium Paid (P): Call Premium + Put Premium
- Max Loss: Total Premium Paid (occurs if Spot = K at expiry)
- Max Profit: Unlimited
- Breakevens (Two): Upper = K + P | Lower = K - P
3. Long Strangle (Buy OTM Call (K2) & OTM Put (K1)):
- View: Extreme volatility, but cheaper to execute than a Straddle.
- Total Premium Paid (P): Call Premium + Put Premium
- Max Loss: Total Premium Paid (occurs if Spot is between K1 and K2 at expiry)
- Breakevens (Two): Upper = K2 + P | Lower = K1 - P
4. Long Call Butterfly Spread (Neutral Strategy):
Buy 1 ITM Call (K1), Sell 2 ATM Calls (K2), Buy 1 OTM Call (K3).
- Net Premium Paid: Premium(K1) + Premium(K3) - [2 × Premium(K2)]
- Max Risk: Net Premium Paid
- Max Profit: (K2 - K1) - Net Premium Paid (Occurs if Spot = K2)
- Lower BEP: K1 + Net Premium Paid | Upper BEP: K3 - Net Premium Paid
5.3 Arbitrage
Arbitrage originates when a trader purchases an asset cheaply in one location and simultaneously sells it at a higher price in another. Exam questions often ask for exact arbitrage profit.
Given: EURUSD = 1.09, USDINR = 82.89, EURINR = 90.11.
- Start with 1000 EUR. Convert to USD: 1000 × 1.09 = USD 1090.
- Convert USD to INR: 1090 × 82.89 = INR 90,350.10.
- Convert INR back to EUR: 90,350.10 / 90.11 = EUR 1002.67.
- Arbitrage Profit: 1002.67 - 1000 = 2.67 EUR.
Chapter 6: Trading Mechanism in ETCD
The Currency Derivatives Segment (CDS) operates on a fully automated, transparent, anonymous order-matching system ensuring price-time priority. Best buy is the highest price; best sell is the lowest price.
Orders lying unmatched in the system are 'passive' orders. Incoming orders that match existing orders are called 'active' orders. Crucial Exam Rule: Orders are always matched at the passive order price. Quantity is not a factor considered for matching; price and time dictate priority.
6.1 Order Management
- Market Order: Executed immediately at the best available price.
- Stop-Loss Order: Remains dormant until the market hits a "Trigger Price." Used to limit losses on an open position.
- IOC (Immediate or Cancel): Executes what it can instantly, cancels the rest.
- Cancel on Logout (COL): If a user logs out, all outstanding orders get cancelled automatically.
6.2 Risk Management at Trading Level
- Risk Reduction Mode: Triggered if collateral utilization reaches 90%. All unexecuted orders are cancelled, and only risk-reducing IOC orders are allowed until utilization drops below 85%.
- IRRA (Investor Risk Reduction Access): A joint platform developed by exchanges to give individual investors an opportunity to square off/close open positions in case the Trading Member faces a technical glitch/disruption. It does not allow initiating new positions, and it is not for institutional or algo clients.
6.3 Spread Order Book
Exchanges provide a specialized order book for Calendar Spreads to avoid execution risk. A Buy Spread Order (e.g., MAR-MAY) implies selling the near-month (MAR) and buying the far-month (MAY). Trades execute based on the price difference.
6.4 Trading Costs & Circuit Filters
Brokerage limits: For futures, maximum brokerage chargeable is 2.5% of contract value. For options, it cannot exceed 2.5% of premium amount or Rs. 100/- per lot (whichever is higher).
Price Bands: For futures, operating ranges are kept at +/- 3% of the base price for contracts up to 6 months, and +/- 5% for > 6 months. Relaxed in increments of 1% during market-wide trends. Options price bands are based on Delta.
Chapter 7: Clearing, Settlement & Risk Management
The Clearing Corporation (CC) guarantees financial settlement through Novation (acting as central counterparty). A multilateral netting procedure is adopted to determine net settlement obligations.
- Interoperability: SEBI enabled a framework where a Clearing Member can select the Clearing Corporation of its choice to clear and settle trades executed across multiple exchanges.
- Default Waterfall (Highly Testable): In the event of a member default, the CC utilizes the Settlement Guarantee Fund in a specific order:
1. Monies of defaulting member
2. Insurance (if any)
3. CC resources (5% of segment MRC)
4. Core SGF (Penalties, CC contribution, then non-defaulting members’ contributions)
5. Proportion of remaining CC resources.
Scenario: Sold 1 lot (1000 units) of USDINR futures at 74.9000.
| Day | Daily Settle Price | Calculation | MTM P&L (INR) |
|---|---|---|---|
| Day 1 | 74.6925 | (74.9000 - 74.6925) * 1000 | +207.50 |
| Day 2 | 74.6225 | (74.6925 - 74.6225) * 1000 | +70.00 |
| Day 3 | 74.8425 | (74.6225 - 74.8425) * 1000 | -220.00 |
Note: For cross-currency MTM (like EURUSD), the profit/loss is calculated in USD, then converted to INR using the FBIL USDINR reference rate of that day.
7.1 Margining Framework (SPAN)
- Initial Margin: Computed using SPAN based on 99% Value at Risk (VaR). It generates 16 "what-if" scenarios. The Price Scan Range (PSR) varies (e.g., USDINR 1.50%, EURINR 2.15%). The Volatility Scan Range is 25% of annualized EWMA.
- Extreme Loss Margin (ELM): Collected in addition to initial margin.
- Futures ELM: USDINR 0.50%, EURINR 0.15%, GBPINR 0.25%, JPYINR 0.35%.
- Options ELM: 0.75% of the notional value of open short positions.
- Calendar Spread Margin: Fixed INR charges for hedging offsets. E.g., USDINR spread is Rs 500 for 1-month, Rs 600 for 2-months.
- Net Option Value: MTM gains/losses for options are not cash-settled daily. They are adjusted against the Liquid Net Worth of the member.
- Liquid Assets: The cash component must be at least 50% of the total liquid assets.
Chapter 8: Regulatory Framework for ETCD
ETCDs are jointly regulated by the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI). The RBI-SEBI Standing Technical Committee oversees product design and risk measures.
| Participant Category | USDINR Limit |
|---|---|
| Clients, NRIs, FPI Cat II | Higher of 6% of total OI or USD 20 million |
| Trading Members, DIIs, FPI Cat I | Higher of 15% of total OI or USD 100 million |
Exam Note: Users can take unhedged positions up to a single limit of USD 100 million equivalent across all currency pairs involving INR, combined across all exchanges, without having to establish underlying exposure.
8.2 Membership Criteria & Base Minimum Capital (BMC)
AD Category I Banks are permitted to become trading and clearing members subject to minimum prudential requirements: Net worth of Rs. 500 crores, CRAR of 10%, Net NPA below 3%, and net profit for the last 3 years.
BMC is the deposit given by the member against which no exposure is allowed.
- Prop trading without Algo: Rs 10 Lacs
- Trading on behalf of clients (no prop, no Algo): Rs 15 Lacs
- Prop + Client without Algo: Rs 25 Lacs
- All Brokers with Algo: Rs 50 Lacs
Chapter 9: Accounting and Taxation of ETCD
Under Ind AS 109, derivatives are measured at Fair Value Through Profit or Loss (FVTPL) unless in a strict hedging relationship. The three types of hedge accounting are:
- Fair Value Hedge: Hedges risk of a fair value change of assets/liabilities already recognized. Gains/losses go to P&L.
- Cash Flow Hedge: Hedges variability in highly probable future cash flows. Effective portion is recognized in Equity (Other Comprehensive Income - OCI), ineffective portion to P&L.
- Net Investment Hedge: Hedges foreign currency risk of a net investment in a foreign operation.
9.2 Taxation Rules
Under Section 43(5) of the Income-tax Act, trading in ETCD is explicitly excluded from being a "speculative transaction."
- Business Income: Gains/losses are treated as normal Non-Speculative Business Income (PGBP).
- Set-Off: Losses can be set off against any other business income (except salary) and carried forward for up to 8 assessment years.
- FPIs: Securities held by Foreign Portfolio Investors are always treated as Capital Assets (generating Capital Gains/Losses).
Turnover determination is tricky but highly tested. It is NOT the contract value.
Turnover = Absolute sum of (Profits + Losses) + Options Premium Received.
Example Scenario:
- Trade 1: Closed with Profit of Rs. 15,000
- Trade 2: Closed with Loss of Rs. -10,000
- Trade 3: Sold Option, Premium received = Rs. 5,000
- Turnover: 15,000 + |-10,000| + 5,000 = Rs. 30,000.
Tax Audit Trigger: A tax audit is mandatory if the turnover exceeds Rs. 3 Crore (subject to 95% digital receipts).
Chapter 10: Codes of Conduct and Investor Protection
- Suspicious Transaction Report (STR): Must be submitted to the Financial Intelligence Unit (FIU-IND) within 7 days of arriving at a conclusion that a transaction is suspicious. Non-Profit Organization Transaction Reports (NTRs) are due by the 15th of the succeeding month.
- Demat Debit and Pledge Instruction (DDPI): SEBI has mitigated the misuse of Power of Attorney (PoA) by replacing it with DDPI for the limited purpose of meeting pay-in obligations. PoA is explicitly optional and should not be insisted upon for account opening.
10.2 Online Dispute Resolution (ODR) & Arbitration
SEBI established the SMART ODR Portal. The process flows: Conciliation → Arbitration.
- Conciliation: A neutral conciliator conducts meetings to reach a consensual resolution within 21 calendar days (can be extended by 10 days by mutual consent).
- Arbitration: If conciliation fails, an arbitrator is appointed. For claims ≤ Rs. 1 Lakh, it is a document-only process and the award must be passed within 30 calendar days. If a Market Participant challenges the award, they must deposit 100% of the payable amount prior to the challenge.
- Initiation Delay: Conciliation initiated after 6 months from the transaction date attracts a Rs. 1000 late fee.
10.3 Investor Protection Fund (IPF)
Maintained by exchanges to meet legitimate non-speculative claims against defaulting Trading Members. Claims arising from purely speculative transactions are not eligible for IPF compensation. Stock Exchanges contribute 1% of listing fees to this fund.