Every country has a currency, and its value relative to other currencies keep changing all the time. The value of a country’s currency depends on a host of things – the state of the economy, its foreign exchange reserves, supply and demand, central bank policies, and so on. A stable and robust currency attracts investors. This can be done through currency futures .
So, how does it work? A currency like the US Dollar is considered strong because of the strength of the US economy, and the faith investors have in it. Investors, therefore, prefer to hold more dollars against other currency, and according to the laws of demand and supply, higher the demand, higher the price.
The value of a country’s currency vis-à-vis other currency will depend on the factors that we have mentioned above, and these keep changing because of domestic and international factors. For example, higher growth in Europe vs the US will lead to the Dollar becoming cheaper than the Euro. So each unit of the Euro will fetch more of the dollar.
A country’s central bank too can play a role. For example, if the Indian rupee is weak against the dollar, the Reserve Bank of India (RBI) can sell dollars in the currency market. This increased supply of dollars vis-à-vis the rupee will reduce their price, and so the dollar will weaken against the rupee.
Effects of currency fluctuations
Massive currency fluctuations can affect any economy. If, for example, the Rupee weakens against the US Dollar, it will make imports costlier and exports cheaper. This will hurt importers, but benefit exporters. Since India is a major oil importer, this will lead to more expensive oil imports, and lead to price increases in fuels like diesel and petrol. These higher fuel prices have an inflationary effect since they will affect every commodity that has to be transported. If, however, the Rupee strengthens against the US Dollar, it will make exports more expensive. Exporters, therefore, will earn less. This will affect sectors like information technology. These fluctuations in-turn encourage investors to opt for currency futures trading. Let’s see what it is and how it works.
What is currency futures?
As we have seen, changes in the value of currency affect both importers and exporters. Naturally, they will want to protect themselves against such currency risk. To do so, they resort to futures contracts .
Currency futures in India were introduced in India in 2008 on the National Stock Exchange (NSE) and subsequently extended to other exchanges like the Bombay Stock Exchange (BSE), MCX-SX and United Stock Exchange. Currency options were introduced in 2010.
Since the value of one currency is relative to another, these futures are available in pairs. For example, you can get them in Indian rupees against the US dollar (USD), Euro (EUR), Great Britain pound (GBP) or Japanese Yen (JPY).
Let’s look at how to trade in currency futures. Let’s say an information technology company wants to hedge against currency risk in case the IND strengthens against the USD. If the spot or current rate of INR is Rs 70 to the USD, it may purchase 1 lakh worth of futures contracts at that price. So if the value of the Rupee goes up, and the rate is Rs 65 to the USD, the company will be able to exercise its contract, and save a loss of Rs 5 lakh! Similarly, an importing company may bet against the value of the Rupee falling against the USD.
Currency futures trading isn’t just for hedging purposes. Most of it is accounted for by speculators. Here, they are not interested in holding the futures contracts till the expiry date; the positions are squared off before that.
How to trade currency futures
You can set up a currency trading account with any broker. You will have to pay something called an initial margin, which is a percentage of the total transactions you carry out. For example, if the margin is 4 percent and you carry out these transactions worth Rs 1 crore, you will have to pay margin money of Rs 4 lakh to the broker.
So for a small amount, you will be able to take significant positions in currency futures. Of course, the more significant the position, the higher the potential for profit, and loss. If you get your bets right, you will make handsome profits. If you are wrong, you could lose a lot of money. If you want to play it safe, you can always go in for currency options, which are less risky since it gives you the choice of not exercising the contract at the strike price.
Currency futures contracts in India are available on the NSE in contract sizes of 1000 for most currencies. In the case of the Japanese Yen, it is 1 lakh. Both currency and options are cash settled at the end of the month. That is, actual currencies are not exchanged.