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Unit study guide · NISM Series I

Foreign Exchange Derivatives

13 questions in this unit

What this unit covers

Key ideas

From the practice bank · 1

A principal rationale for introducing exchange-traded currency derivatives in India was to:

The answer identifies risk transfer through standardised exchange-traded instruments. A business can face uncertain rupee receipts or payments because its contract is denominated in a foreign currency. A currency derivative can create an offsetting financial exposure. An organised exchange provides standard contract terms and a trading framework for that purpose. This is a risk-management role. It is different from accepting deposits, fixing the currency’s exchange rate or executing every business’s underlying payment. Remember: Identify risk management and market infrastructure as the role of currency derivatives.

Hint Common mistake: Confusing a currency hedge with the business’s actual foreign-currency payment.

I-006

From the practice bank · 2

A participant simultaneously buys a lower-priced currency futures contract on one exchange and sells an economically equivalent contract on another to capture the price difference. This activity is:

The trade seeks to capture a price difference between equivalent instruments. The purchase and sale have opposite economic exposures in equivalent contracts. The stated objective is to capture the difference between their prices. That describes arbitrage. Practical execution costs, timing, contract differences and settlement arrangements still matter. Calling a trade arbitrage does not prove that its implementation is risk-free. Remember: Classify the trade by its economic purpose, not simply by the fact that it includes both a purchase and a sale.

Hint Common mistake: Assuming every simultaneous buy and sell is a hedge of an existing business exposure.

I-007

From the practice bank · 3

Which statement correctly distinguishes an OTC currency forward from an exchange-traded currency future?

This answer captures negotiated OTC terms versus standardised listed terms. In an OTC forward, the parties can negotiate features such as the currency amount and settlement date. An exchange lists futures with specified contract sizes and maturities. A hedger chooses among those listed terms. Exchange standardisation can aid trading and offsetting positions, but it can leave a mismatch with a business’s exact cash flow. Remember: Use the customisation-versus-standardisation distinction before comparing other features.

Hint Common mistake: Assuming every currency derivative can be matched exactly to any invoice amount and payment date.

I-008

From the practice bank · 4

A company and a bank agree today to exchange INR for USD on a near date and reverse the same USD principal against INR three months later, at rates agreed today. No periodic interest payments are exchanged. Which instrument is described?

The linked near and far principal exchanges are the defining structure of the FX swap described. The arrangement has two linked principal exchanges. Their directions are opposite and both exchange rates are agreed at inception. This fits the FX-swap description. An outright forward has only the future exchange, while a currency-interest-rate swap involves periodic interest obligations and an option gives a right rather than the stated two-way obligation. Remember: Look for two opposite principal exchanges at different dates when identifying an FX swap.

Hint Common mistake: Treating every two-currency contract as an interest-rate swap or overlooking the near leg.

I-042

From the practice bank · 5

Relative to an exporter’s original rupee-receipt benchmark, an exchange-rate move increases the value of its dollar receivable by ₹40,000. Its matched currency hedge loses ₹40,000 over the same interval. Ignoring costs, what is the combined change relative to that benchmark?

The equal and opposite changes cancel on the assumptions stated. The receivable contributes +₹40,000 relative to the common benchmark. The hedge contributes −₹40,000. Combined change = ₹40,000 − ₹40,000 = ₹0. The hedge loss gives back the favourable currency movement rather than creating an additional ₹40,000 loss for the combined position. Remember: An offsetting derivative loss can be consistent with the economic purpose of a hedge.

Hint Common mistake: Calling a hedge unsuccessful merely because its derivative leg loses money.

I-054

From the practice bank · 6

At maturity, an outright FX forward and a purchased European FX call are both less favourable to the buyer than dealing at the spot rate. Ignoring negotiated cancellation, which contract permits the buyer simply not to exercise?

The call buyer holds an exercise right, whereas the outright forward buyer has an obligation. An unfavourable spot comparison does not by itself remove the forward buyer’s obligation. Closing or cancelling a forward is a separate transaction, not an option embedded in the contract. The purchased call can expire unexercised when exercising is unfavourable. Its premium remains a cost, so non-exercise does not imply a cost-free outcome. Remember: Distinguish the option buyer’s exercise choice from a forward party’s contractual obligation.

Hint Common mistake: Treating the ability to negotiate or offset a forward as the same as an option’s exercise right.

I-055

From the practice bank · 7

Which example fits the price-linked contract limb of the derivative definition in section 2(ac)(B) of the Securities Contracts (Regulation) Act?

This answer has the specified link to an index of prices of underlying securities. Look for a contractual value linked to underlying securities prices rather than direct ownership, deposit interest or a service fee. The index-linked contract has that defining relationship. This is one limb of an inclusive definition, not an exhaustive list of every type of derivative. Remember: Distinguish the underlying security from a contract whose value is derived from its price.

Hint Common mistake: Treating every financial agreement or every security as the same kind of derivative.

I-079

From the practice bank · 8

With market access and hedging costs unchanged, which change most directly increases a company’s need to manage currency risk? Assume it has no offsetting foreign-currency cash flows.

More unoffset foreign-currency payments increase the amount of cash flow exposed to exchange-rate movements. A future foreign-currency payment has an uncertain INR cost until the exchange rate is fixed or the exposure is otherwise offset. Increasing such payments increases the amount at risk under the stated assumptions. The other changes reduce exposure or create a natural offset. This explains a possible increase in hedging demand. It does not imply that a derivative must be used or that market turnover will rise by an identical amount. Remember: Look at the size of the net foreign-currency exposure, not merely the number of international transactions.

Hint Common mistake: Confusing greater cross-border activity with greater currency risk when the cash flows are already matched or INR-denominated.

I-080

From the practice bank · 9

Two parties exchange principal in different currencies at inception, exchange interest payments in those currencies each quarter, and reverse the principal exchange at maturity. Which instrument matches this structure?

This answer matches both the two-currency principal structure and the periodic interest legs. The principal is in two currencies, so this is not merely an exchange of interest in one currency. The quarterly interest legs distinguish the arrangement from a standard FX swap containing only the initial and final currency exchanges. That combination identifies a cross-currency swap. No particular current is needed to identify the structure. Remember: Look for periodic interest legs when distinguishing a cross-currency swap from a standard FX swap.

Hint Common mistake: Treating every arrangement with two currency exchanges as the same instrument.

I-103

From the practice bank · 10

An exporter shorts USD-INR futures against a dollar receipt due in two months. USD-INR rises today, creating a daily futures settlement loss. The export proceeds are not yet available. Which risk is illustrated most directly?

Daily settlement can require money now even though the offsetting business receipt comes later. The short futures position loses when its settlement price rises. That loss is settled under the daily futures mechanism. A higher USD-INR rate would increase the rupee value of the later dollar receipt, but the exporter cannot yet use that future receipt as cash. The immediate issue is therefore or funding timing, not proof that the economic hedge has failed. Remember: Distinguish reduction of price exposure from the ability to fund interim hedge cash flows.

Hint Common mistake: Treating a future offsetting gain as cash already available to meet today’s settlement.

I-104

From the practice bank · 11

A firm will receive USD 80,000 and pay USD 15,000 on the same date. It can use that receipt to make the payment, and has no other USD exposure or hedge. What is its remaining economic USD exposure?

The matching payment absorbs USD 15,000 and leaves USD 65,000 to be received net. USD 15,000 of the receipt can fund the equal-currency payment. That part does not need to be converted into INR. Net USD remaining = 80,000 − 15,000 = USD 65,000 receivable. The net receipt still loses INR value when USD-INR falls, other things equal. Offsetting some cash flows does not eliminate the residual exposure. Remember: Net available receipts against same-currency payments before measuring the unmatched economic cash flow.

Hint Common mistake: Adding receipts and payments, or treating any opposite cash flow as a complete hedge.

I-128

From the practice bank · 12

Under RBI’s definition, which settlement feature identifies a non-deliverable foreign exchange derivative contract (NDDC)?

This combines both elements of the definition: no underlying-notional delivery and cash settlement. RBI defines an NDDC as an OTC foreign exchange derivative with no delivery of the notional amounts of the underlying currencies. It is cash-settled. The word non-deliverable therefore does not mean that a loss produces no payment obligation. Remember: Distinguish notional currency delivery from payment of a cash-settlement amount.

Hint Common mistake: Reading non-deliverable as meaning no money can be payable.

I-129

From the practice bank · 13

A currency derivative is entered into on an electronic trading platform, not traded on a Recognised Stock Exchange. Under RBI’s definition, which statement about its classification is correct?

Electronic-platform execution is expressly compatible with the OTC definition. RBI’s definition of OTC derivatives excludes derivatives traded on Recognised Stock Exchanges and expressly includes derivatives traded on electronic trading platforms. The facts specify electronic-platform execution outside a Recognised Stock Exchange. The electronic medium alone does not make the contract exchange-traded. The definition also includes both deliverable and non-deliverable OTC derivatives. Settlement form is not the electronic-versus-exchange test. Remember: Identify the venue’s regulatory status rather than inferring OTC or exchange status from the screen used.

Hint Common mistake: Treating every electronically executed or reported derivative as exchange-traded.

I-130
Base Rate

The base rate is how often an outcome occurs.

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Liquidity

Liquidity describes how easily a given quantity can be traded.

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