Part 4: NISM Series I – Chapter 4: Strategies Using Currency Futures

NISM Series I Currency Derivatives – Chapter 4: Strategies Using Currency Futures

Welcome to Part 4 of our NISM Series I Currency Derivatives short notes series on PassNISM.in. This is one of the most practical and frequently examined chapters. It covers how different market participants — hedgers, speculators, and arbitrageurs — use currency futures to manage risk, generate returns, and exploit pricing inefficiencies.

Missed Part 3? Read it here: Chapter 3 – Exchange Traded Currency Futures.

Three Types of Market Participants in Currency Futures 1. Hedgers

Hedgers have a real, underlying exposure to foreign exchange risk because of their actual business operations. An importer paying USD, an exporter receiving EUR, or a student paying tuition in foreign currency — all of these people face FX risk. Their goal in using currency futures is not to profit from the derivatives market but to lock in an exchange rate and remove uncertainty from their future cash flows.

2. Speculators

Speculators take positions in currency futures purely to profit from anticipated price movements. They have no underlying FX exposure. Speculators play a vital role — they provide the liquidity and the other side of the trade that hedgers need. Without speculators, hedgers would find it difficult to find counterparties. The leverage available in futures markets amplifies both gains and losses for speculators.

3. Arbitrageurs

Arbitrageurs identify pricing mismatches between markets — for instance, between the currency futures price on an exchange and the forward rate available in the OTC market for the same maturity. They simultaneously take opposite positions in both markets to lock in a risk-free profit. Unlike speculators, arbitrageurs take on no net directional risk.

Real-World Hedging Examples Using Currency Futures Example 1: Hedging Foreign Travel / Education Payments

A student going abroad for a year needs to pay USD 20,000 for tuition. They currently hold INR and are worried about the rupee depreciating before they make the payment. By going long on USDINR futures (buying USD futures), they lock in today's exchange rate. Even if the rupee depreciates significantly by the time payment is due, they have protected themselves from that loss.

Example 2: Exporter Hedge

An Indian exporter expects to receive USD 500,000 in three months for goods already shipped. They fear the rupee might appreciate (meaning their USD will convert to fewer INR). To hedge, they short USDINR futures (sell USD futures). If the rupee appreciates as feared, the loss on their USD remittance is offset by the profit on their short futures position.

Example 3: Importer Hedge

An Indian importer has to pay USD 200,000 for imported goods in two months. They fear the rupee might depreciate (making their USD payment more expensive). To hedge, they go long on USDINR futures. If the rupee depreciates, the higher cost of buying USD is offset by the profit on their long futures position.

Example 4: Hedging a Foreign Currency Loan

A company that has borrowed in USD must make regular principal and interest payments. To protect against rupee depreciation making these payments more expensive in INR terms, the company can use USDINR currency futures as a rolling hedge for each payment date.

Example 5: Investment in Gold ETF – Removing Currency Risk

Consider a high-net-worth investor who buys a gold ETF listed in India (priced in INR). Gold globally is priced in USD. If gold rises 15% in USD terms but the INR appreciates 5% against the USD, the ETF only gains 10% in INR terms — the investor "loses" 5% due to currency movement.

To remove this embedded currency risk, the investor can short USDINR currency futures for an amount equal to the ETF investment and for the same time period they plan to stay invested. This neutralizes the INR/USD exchange rate risk from the investment, leaving only the pure gold price exposure.

Example 6: Overseas Investment and Repatriation

An Indian investor puts ₹6.7 crore into US equities when USDINR was 67. The US portfolio grows from USD 100,000 to USD 115,000. However, when the investor sells and tries to repatriate, the exchange rate has fallen to 64 (rupee has appreciated). Instead of ₹7.5+ crore, the investor converts at a lower rate.

To protect against this, the investor could have shorted USDINR futures for one year when they first made the investment. This would have locked in the higher conversion rate and removed the currency risk from the overseas investment.

Rule of Thumb for Hedgers:
— If you will RECEIVE foreign currency (exporter, repatriation), you fear appreciation of INR. Short the currency futures.
— If you will PAY foreign currency (importer, student, borrower), you fear depreciation of INR. Go long on the currency futures. Currency Futures for Speculation

Speculators use currency futures to profit from directional views on exchange rates. Here is a typical example:

Scenario: A trader believes that given strong economic conditions in India and falling inflation, the INR will appreciate from its current level of 66 to around 64 over the next six months. To profit from this view:

• The trader shorts 100 USDINR futures contracts at 67.50
• At expiry, the settlement price is 64.50
• Since the settlement price (64.50) is lower than the entry price (67.50), and the trader was short, they earn a profit
• Profit = 67.50 – 64.50 = ₹3 per USD
• Total profit = ₹3 × lot size × 100 contracts

The leverage in futures means the trader did not need to put up the full value of USD — only the initial margin — making the return on capital extremely high if the trade works as expected.

Currency Futures for Arbitrage Cash-and-Carry Arbitrage Example

Scenario: A trader notices the following pricing for the same 6-month maturity:

• 6-month USDINR currency futures on exchange: 65.98 / 66.00
• 6-month OTC forward for same maturity: 65.85 / 65.86

The futures price is higher than the OTC forward price for the same maturity — a pricing mismatch. The arbitrageur's strategy:

1. Short the currency futures at 65.98 (sell high)
2. Go long in the OTC forward at 65.86 (buy low)
3. At settlement: loss of 1.02 on futures; gain of 1.14 on OTC forward
4. Net arbitrage profit = 0.12 per USD

This profit is locked in from the start — the arbitrageur takes no directional risk. As more arbitrageurs exploit this gap, the prices in both markets converge and the opportunity disappears.

Triangular Arbitrage

Triangular arbitrage involves exploiting price discrepancies among three different currencies in the forex market. The process involves three sequential trades:

1. Exchange Currency A for Currency B
2. Exchange Currency B for Currency C
3. Exchange Currency C back for Currency A

This is only profitable when the three exchange rates are not in alignment with each other's implied cross rate. However, in practice:

• Such opportunities are extremely rare and very short-lived
• When they do appear, the price disparity is tiny (often around 1 basis point or less)
• After transaction costs and taxes, the profit is usually negligible or even negative
• There is also execution risk — adverse price movement while the arbitrageur is still setting up all three legs of the trade

Spread Trading Using Currency Futures

A spread in futures trading refers to the difference in price between two futures contracts. Spread traders take simultaneous long and short positions to profit from changes in this price difference, rather than from the outright price level.

Intra-Currency Pair Spread (Calendar Spread)

This involves taking a long position in one expiry month and a short position in another expiry month of the same currency pair. The trader profits if the price difference (spread) between the two contracts moves in the expected direction. Both legs involve the same underlying currency pair but different maturities.

Inter-Currency Pair Spread

This involves taking a long-short position in futures on two different underlying currency pairs, usually with the same maturity. The trader profits from changes in the relative value between two different currency pairs.

Limitations of Currency Futures for Hedgers

While currency futures are powerful tools, they have specific limitations that hedgers should be aware of:

• Cash settlement only: Exchange-traded currency futures are settled in cash — there is no actual delivery of foreign currency. For hedgers who need physical currency, an additional transaction is required
• Timing mismatch: The standardized expiry dates of futures contracts may not perfectly align with the hedger's actual payment or receipt date. This can result in a small residual loss or gain compared to an OTC forward, which can be tailored to the exact date
• Despite these limitations, the benefits — lower cost, transparency, small lot size, and ease of execution — often outweigh the imperfect timing match

Summary Table: Currency Futures Strategies by Participant Type

Quick Revision: Must-Know Points for the Exam

• Hedgers: use futures to lock in exchange rates and reduce cash flow volatility
• Speculators: provide liquidity; assume risk that hedgers transfer; profit from price direction
• Arbitrageurs: exploit pricing gaps between two markets; lock in risk-free profit; no directional view
• Exporter = SHORT futures (fears INR appreciation = falling USDINR)
• Importer = LONG futures (fears INR depreciation = rising USDINR)
• Gold ETF investor with USD exposure → Short USDINR futures to remove currency risk
• Triangular arbitrage: exploits misalignment in three currency pairs; rarely profitable after costs
• Calendar spread = same currency pair, different maturities (long one, short another)
• Inter-currency pair spread = different underlying currency pairs, same maturity
• Futures limitation for hedgers: cash settlement only + standardized dates don't always match actual trade dates

Internal Links

• Chapter 3: Exchange Traded Currency Futures – Terminology and IRP
• Chapter 5: Trading in Currency Futures – Order Types and Entities
• Take a Free NISM Series I Mock Test
• Download NISM Series I Study Material
• NISM Derivatives Exams – Overview

This is Part 4 of our 7-part NISM Series I Currency Derivatives Short Notes series on PassNISM.in. Continue to Part 5 covering trading mechanics, order types, and participant roles.