When it currency trading, you typically trade in pairs. Typically, there is the principal currency in which the second currency is expressed. For example USDINR July 2018 futures is Rs.68.25 means that the market is willing to pay Rs.68.25/- per dollar. The second currency value is always expressed in terms of a single unit of the first currency. In the Indian markets we have such spread contracts of the INR with the US$, UK£, Euro and the Japanese Yen. In these four pairs, one can take positions in futures and in options. Before we understand spread in currency trading and spread trading strategies, let us understand with a screenshot how spreads work on futures and on options. Then we will also see how do spread contract work in currency and what are the payoffs.
The above snapshot from the NSE captures the USDINR June futures contract. The order book, as can be seen, is available in ticks of 25 basis points (0.0025 paisa). Here is there is no spot rate so the RBI reference rate is taken as the spot rate for the USDINR contract. Like in case of most futures contract, the USDINR futures is quoting at a small premium to the RBI reference rate; which is the cost of carry of the future. If you want to buy USDINR futures it is available at the best price of Rs.68.5275 and if you want to sell USDINR futures it is available at a best price of Rs.68.5250. This different of 25 basis points is the spread that the market marker earns.
Just as USDINR futures are a right and an obligation, the USDINR option is a right without an obligation. Look at the USDINR option snapshot below
This is the option snapshot for a USDINR call option contract with a strike price of Rs.68. The fact that the premium is up by over 100% means that the markets are betting on a sharp appreciation of the US Dollar. Here the holder of the call option has the right to buy the USDINR at Rs.68 but no obligation. How does this really work in practice.
The operation of the spread is quite simple. If you want to protect against a strengthening dollar then you must either buy the USDINR futures or you must buy the USDINR call option. Alternatively, if you want to protect against a weakening dollar then you must either sell the USDINR futures or you must buy the USDINR put option. An importer or foreign currency borrower wants to protect against a strengthening dollar while an exporter will want to protect against weakening dollar. Here is how it will work in practice.
Importer XFinancial DetailsExporter YFinancial DetailsPayable in 3 months$1 millionReceivable in 3 months$1 millionCurrency ValueRs.67/$Currency ValueRs.67/$Rupee amount payableRs.67,000,000Rupee amount to getRs.67,000,000If rupee weakens to…Rs.70/$If rupee strengthens to…Rs.64/$New Amount PayableRs.70,000,000New Amount you get…Rs.64,000,000Loss on CurrencyRs.3,000,000Loss on CurrencyRs.3,000,000Hedge by buying USDINR1000 lotsHedge by selling USDINR1000 lotsProfit on USDINR LongRs.3,000,000Profit on USDINR LongRs.3,000,000Net impact of currencyNILNet impact of currencyNIL
Of course, the actual hedging will not be so simple because there are hedge costs and statutory costs that you will have to bear. But the idea is that you can use currency futures to protect against losses on your currency exposure. You can protect your exposure to the US Dollar, UK£, Euro and to Japanese Yen. These positions can be taken either through currency futures or through currency options.
Currency futures and options are not only used for hedging but one can also trade in currency futures based on your view of the market. For example, if you expect that the dollar will strengthen due to the Fed increasing rates, then you can play your view by buying USD INR futures. Alternatively, if you believe that the dollar will weaken against the rupee due to strong FDI flows into India, then you can sell the USDINR futures. Of course, you can also use call and put options to replicate your view with limited loss.
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