Currency options: hits and misses4 min read . Updated: 02 Aug 2010, 08:22 PM IST
Currency options: hits and misses
Currency options: hits and misses
It’s been about two years since market regulator Securities Exchange Board of India (Sebi) and banking regulator Reserve Bank of India (RBI) allowed stock exchanges to launch currency futures on the dollar-rupee pair. The product was a runaway success, with average daily turnover hovering at around $5.2 billion.
Earlier this year, the two regulators allowed exchanges to launch new currency pairs such as euro-rupee, yen-rupee and pound-rupee. These products, understandably, haven’t done as well as the dollar-rupee contract, which accounts for well over 90% of total turnover.
Also Read Mobis Philipose’s earlier columns
Sebi and RBI have decided it’s now time for a new product—currency options. If exchanges had their way, they would have introduced this product long ago. They can now soon launch currency options on the dollar-rupee pair.
This should be another success story for two reasons. The high volumes in the currency futures market indicate a large number of market participants are expressing their view on the dollar-rupee pair. At the same time, many traders have developed skills in options trading in equity derivatives in the past two years. Options contracts now account for over 60% of the total turnover of equity derivatives.
In early 2008, options accounted for just 11% of total turnover. A reason traders have taken a fancy for options trading is the increase in volatility due to the financial crisis. Taking bets using the options marker are far less risky, since the downside of an option buyer is limited to the option premium being paid. Further, options can be used to structure different kinds of strategies and views on the market, which are not possible with the futures market.
These benefits of the options can now be had in the currency derivatives market. This is not to say that the product will only serve trader interest. Even genuine users such as firms needing to hedge their foreign exchange exposure can use the options market to contain risk.
But needless to say, it’s only when traders and speculators are present and volumes are reasonably high, that hedgers can participate and benefit from that liquidity. One criticism of the currency futures market is that volumes are artificially high, with a large proportion of proprietary trading, and that this is driven by the fact that there are hardly any trading costs involved. The securities transaction tax is not applicable, besides which exchanges don’t charge any fees for this segment. One feeling is that this has made it a punter’s den.
There’s some evidence of this, based on the recent trends in trading. Turnover in the currency futures market peaked at around $10 billion in May and averaged around $8 billion in the three months between April and June. In July, average daily turnover fell sharply to $5.2 billion. This was because of a Delhi government notification that proprietary trades will attract a stamp duty. The drop in turnover in the currency futures market has been among the highest, indicating that a large portion of trades was on account of the fact that trading costs were low in this segment.
Even so, this doesn’t entirely take away from the fact that the currency futures market has done rather well in the two years since its launch. This will provide a strong platform for the introduction of currency options.
One quibble, however, is the manner in which Sebi and RBI have gone about defining the product specifications for the current contract. They have laid out every detail of the product and exchanges have no freedom whatsoever to innovate and differentiate their offering. The contracts will be European style, with a notional size of $1,000 and will settle in cash based on the rupee-dollar spot rate.
If exchanges were given some freedom with product design, they would have been able to differentiate offerings and effectively compete. Without going into the merits and demerits of alternative product designs, they could have had US style options or options that settle into futures contracts, varying notional sizes and expiry dates. Given that competition in the segment is intense, it’s important that exchanges have some freedom with product design. Imagine the plight of United Stock Exchange, the new entrant in the space, which can neither compete on prices, since its competitors don’t charge fees, nor can it differentiate with innovative product design.
Sebi has made some progress in this area, having given exchanges freedom to decide on the equity market’s timing with a certain band. It followed this up giving them relatively more freedom in deciding on physical settlement of stock options and stock futures. Exchanges can decide on whether they want to have cash settlement or physical settlement for stock options and futures.
While this is an encouraging trend, one would like to see more of this, especially in product design. Perhaps it didn’t have many options on this front, given RBI’s involvement in currency derivatives.
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