The introduction of exchange-traded currency futures (ETCF) on the National Stock Exchange (NSE) from August 29 is a reflection of two important points. First, it is evidence of the seriousness of efforts demonstrated by players across the board to sustain investors’ interest in the markets, though the odds are quite stiffly against it at this time. Second, and the crucial one: can you, as an investor, take advantage of currency futures as an asset class? And if yes, what are the things you need to bear in mind to beat the fluctuations?

In fact, this is, perhaps, the best time to understand ETCF, considering that, NSE apart, the Bombay Stock Exchange, the country’s second largest bourse, is also planning to launch this and there is also news that MCX, the commodities bourse, has decided to float a new stock exchange for currency futures trading.

As this race develops and a full-blown trading hub for currency futures comes into being, what you need to ensure is that you don’t lag behind in terms of cashing in on this investment option. Hence, it is worthwhile to analyse how risky or lucrative exchange-traded currency futures are, as an investment option for you.

?It may not be called an asset class because it is an instrument, which derives its value from an underlying asset that is currency, and that cannot be held for a long term, say five to seven years. It would be useful for traders, and not real investors,? points out Zankhana Shah of MoneyCare Financial Planning. Hence, it may not be as simple as an exposure to stock futures and options. It involves a deeper understanding of the conversion rate, while applying strategies, as it involves more than one currency. One has to pay margins and other costs, which range between 2% to 3%.

Currencies like the dollar, the euro, and the yen, which are the major currencies traded in the world, are linked to the macro economy. Their rates are affected due to various economic factors like high inflation level, higher import bill, government budget deficit, among others. The same argument applies to the rupee. It is difficult for investors to know these indicators and forecast the exchange rate. Before getting into details, it is important to understand the meaning of currency derivatives before simplifying it to whether exchange-traded currency futures can be used as a diversification strategy. The caveats and the risk associated with it also need to be understood clearly. Another important question which should be asked is whether it is required/important to take exposure in currency futures, when an investor has already invested in equity, debt and property.

Understanding currency futures

Currency futures is a standardised exchange-traded contract, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price and the underlying instrument is a foreign exchange rate. Other types of currency derivative products are currency swaps and options, just like we have futures and options in the equity market. Swaps, on the other hand, are altogether a different product, wherein a currency is exchanged with another, like the rupee with the yen, for a fixed period and a specified exchange rate. Ideally, one would take exposure in this market for the purpose of hedging and speculation.

Hedging is undertaken to protect one’s inflow and outflow of funds. This is ideally done by investors who receive or send regular or one-time money in foreign currency, maybe in dollars or euro. If someone is getting $1,000 every month from the US and the dollar-rupee rate is 42, he would get Rs 42,000. Now if the dollar depreciates to Rs 41, then the loss would be Rs 1,000. So to get a fixed inflow of Rs 42,000, which may be the minimum requirement, he may take exposure by going short for the near month and that would ensure he receives a similar amount. Hedging is much more important to an exporter or importer as the margins could be hurt badly. Exporter margins have gone down due to appreciation of the rupee against the dollar. On the other hand, this is beneficial for importers, as the product ultimately becomes cheaper.

Speculation, on the other hand, is a type of trading activity ideally done by a trader in a stock market. It increases liquidity in the market, which is important for any market to develop. Speculation is ideally done by large traders and institutional players. Internationally, speculation is done by a host of players like hedge funds.

The facts

Globally, the foreign exchange market’s daily turnover is $3.98 trillion and mostly done over-the-counter (OTC). In India, however, the average daily turnover is $34 billion and after the launch of exchange-traded currency futures, the OTC market will work simultaneously and this would give an option to the players.

“Internationally, the proportion of OTC and exchanged-traded is approximately 90% to 10%,” says Ramesh Kumar of Asit C Mehta Forex. We may see a similar scenario in India too, as it is convenient for banks to trade through OTC ,who are market makers for the exchange rate.

However, regulators and policymakers say while large firms had been using the OTC option thus far, the exchange-traded option will be beneficial, since it will impart a much larger degree of transparency, and facilitate better price discovery, factors which would come in handy for smaller players, particularly small and medium enterprises (SMEs). In the case of a single platform, banks would be one of many players.

But collectively, banks can influence the ETCF market and can create liquidity. The major advantage of having an exchange-traded market is a mark-to-market (MTM) margin facility (settled on daily basis to avoid default risk)unlike forwards, where banks do not provide MTM margins because banks are willing to take credit risk. On the other hand regulated exchange s provide credit risk for the investor but not market risk. This became inconvenient for companies that took exposure in exotic derivative options and made huge mark-to-market (MTM) losses. The margins in currency futures are similar to stock futures, like the initial margin and the extreme loss margin.

Opportunities

As the currency futures market evolves, you would see different opportunities in it. The opportunities in forex could be spread trading and cross-spreading, other than arbitrage and speculation. Spread trading consists of calendar trades, where one buys one expiration month and sells another. Cross-spreading is where one buys one futures contract and sells another. The opportunity is quite lucrative in case of spread trading in the initial part of the launch, when there is less liquidity. But over a period, the opportunity diminishes, as the difference gets limited.

The players involved in currency markets have different objectives. There are exporters, importers, speculators, market-makers and arbitrageurs. RBI, which understands the importance of the export-import trade, ensures a balance of the exchange rate by regular interventions in the forex market, which would not make the rate move one-sided. This makes the currency market much more speculative and unpredictable and hence forecasting becomes difficult. Hence, if you expect that the rupee to appreciate from Rs 42 to Rs 39 due to foreign institutional flows within the next six months, that actually may not happen because RBI could intervene to ensure that exporters stay afloat.

If one compares India’s exchange market four to five years ago with the situation now, one has seen increasing forex reserves due to continuous foreign institutional flows. Hence, the rupee strengthened from Rs 48-levels to Rs 42. The exchange rate can also depend on inflows and outflows by foreign institutions. But the global slowdown and negative signals on GDP growth have resulted in drying of inflows. And it could continue ahead in this year.

Also, one can note here that the volatility in the trend seen in the dollar and the rupee in the last six months may not be seen in the days ahead. So one cannot say the same factors could affect the exchange rate all the time and one has to watch the macro economy very closely to understand the dynamics of the ETCF market.

ETCF as an asset class

One can debate the use of currency futures as a diversified asset class. Firstly, exposure in currency futures entails a holding cost in terms of margin, unlike in equity and property, where there is no holding cost. If one holds a foreign currency for long-term investment as a physical asset in cash, it makes sense. But in India, as one cannot hold foreign currency, the contract has to be settled and squared-off in cash rupees i.e., if one gains or loses one will receive or pay in rupees only. It is to be noted that currently, foreign institutional players are not allowed to take exposure in currency derivatives. Also, it must be noted that only USD currency has been allowed to trade in exchange-traded futures.

Another reason for not investing in exchange currency futures could be the business and actual investment-focus of an investor. If an investor has an India-focus, then there is little or no reason why he would expose himself to an international currency fluctuation risk by trading in currency futures.

An investor can expose himself to ETCF if he has some clear view on the economy or forecasting ability and is confident about a predictable trend in the exchange rate. An investor having property or debt investment overseas can go for currency futures.

However, this comes with a direct impact of currency fluctuations, which would devalue the asset. To derive short-term profits, if an investor exposes himself to currency futures, it could be much riskier. Also, one would have to understand the calculations involved in currency market futures thoroughly, considering several transactions could be involved

In sum, as the ETCF market evolves, sections of investors would see value in it. But the usual dictum for all investments – that of cautious, informed investing – will hold specially true for this segment.