What is currency futures?
The act of hedging a currency risk against price fluctuations in the currency market by entering into a futures contract is called currency futures. Currency futures are also known as future contracts.
In India, the National Stock Exchange of India (NSE) allowed currency futures trading for the first time back in 2008. Later on, other exchanges, such as United Stock Exchange, Bombay Stock Exchange (BSE), and MCX-SX also allowed traders to trade currency futures in India. Like currencies, futures are also traded in the form of pairs. For example; you can buy the Indian Rupee against the USD, EUR, GBP, and JPY. Cross currency are also allowed for EUR/USD, GBP/USD, and USD/JPY.
How To Trade Currency Futures In India?
Suppose a US-based company that deals in electronics appliances anticipate payment in Indian Rupee. It fears that if the value for Indian Rupee increases in the currency market, then it might lose some profits or incur a loss. Therefore, the company wishes to hedge the currency risk by entering into a futures contract.
Say the current or the spot rate of the Indian Rupee is 70 INR against 1 USD. The company buys future contracts at the spot price. If the Indian Rupee strengthens against the U.S. Dollars, increasing the INR-USD value to 60. The company stays unharmed. It can manage the risk of loss by exercising the future contract. Similarly, a local company can also hedge the currency risk using the currency futures against the USD or other currencies.
Why Does the Currency Fluctuate?
The value of currencies tends to change due to multiple factors, such as supply and demand, foreign reserves, central bank policies, and other geopolitical factors. A stable currency is likely to attract more investors than a volatile currency.
Unlike other currencies, the U.S Dollar (USD) is known to be more stable. Traders prefer to hold more U.S Dollars than any other currency. That makes the demand for the U.S Dollar to increase. Therefore the increased demand of the U.S. Dollar automatically devalues the Indian currency.
Here the role of the central bank becomes crucial. For example, the Reserve Bank of India (RBI) intervenes to manage the demand and supply element of the Indian Rupee in the market against the U.S. Dollar and protects the domestic currency from devaluation.
Effects of Currency Fluctuations on Economy and Role of Currency Futures
Frequent currency fluctuation can hurt the country’s economy. For example, if the INR depreciates against the U.S Dollar, the cost of imports increases. India is one of the major importers of crude oil.
As an average estimate, India fulfills nearly 80 percent of its domestic demand for crude oil via import. The increase in the cost of imports means more cash outflows needed to buy the required quantity of crude oil to meet national consumption. The country will witness a surge in the prices of oil-related products, such as petrol, gasoline, diesel, etc. Resultantly, the prices of all other commodities will also increase due to the transportation cost.
On the other hand, if the INR strengthens against the U.S Dollar, it results in an increased cost of exports. In such a case, the country’s information technology sector will suffer. The currency futures help investors to limit the risk of currency fluctuations by entering into a futures contract.