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What are currency derivatives (Relevant for GS Prelims, GS Mains Paper III; Economics)

Currency derivatives are considered to be one of the best options to manage any risk against foreign currency exchange rate volatility. Here is a low-down on this hedging instrument:

What are currency derivatives?

Currency derivatives are exchange-based futures and options contracts that allow one to hedge against currency movements. Simply put, one can use a currency future contract to exchange one currency for an another at a future date at a price decided on the day of the purchase of the contract. In India, one can use such derivative contracts to hedge against currencies like dollar, euro, U.K. pound and yen. Corporates, especially those with a significant exposure to imports or exports, use these contracts to hedge against their exposure to a certain currency.

While all such currency contracts are cash-settled in rupees, the Securities and Exchange Board of India (SEBI), early this year, gave a go-ahead to start cross currency contracts as well on euro-dollar, pound-dollar and dollar-yen.

How can one trade in currency derivatives?

The two national-level stock exchanges, BSE and the National Stock Exchange (NSE), have currency derivatives segments. The Metropolitan Stock Exchange of India (MSEI) also has such a segment but the volumes are a fraction of that witnessed on the BSE or the NSE. One can trade in currency derivatives through brokers. Incidentally, all the leading stock brokers offer currency trading services too.

It is just like trading in equity or equity derivatives segment and can be done through the trading app of the broker. While a dollar-rupee contract size is $1,000, one can trade by just providing the 2-3% margin.

 

Why were such derivatives introduced on exchange platforms?

Prior to the introduction of currency derivatives on exchanges, there was only the OTC – over the counter – market to hedge currency risks and where forward contracts were negotiated and entered into. It was kind of an opaque and closed market where mostly banks and financial institutions traded. Exchange-based currency derivatives segment is a regulated and transparent market that can be used by small businesses and even individuals to hedge their currency risks.

Are the derivatives popular?

The currency segment was unveiled in 2008 and since then, the volumes had registered a steady rise. In June, BSE reported an average daily turnover of Rs. 33,961 crore on its currency derivatives platform while NSE clocked Rs. 29,161 crore. MSEI reported a daily average turnover of only Rs. 239 crore in June. The growth in the segment can further be ascertained from the steady rise in the turnover over the years. For instance, the average daily turnover of the currency segment of NSE was Rs. 12,705 crore in 2014-15, which rose to Rs. 18,603 crore in 2015-16 and thereafter to Rs. 20,779 crore in 2017-18. In the current financial year till date, the average daily turnover is pegged at Rs. 29,008 crore.

(Adapted from The Hindu)



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