Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation. This blog is currently suspended.

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Thu, 04 Sep 2008

Indian Currency Futures

Ajay Shah’s blog post yesterday provides a lot of interesting data about liquidity and trading in India’s nascent currency futures market. The contract is doing quite well for a newly introduced product, but clearly it is miniscule compared to the OTC market. What are the prospects of this market really becoming mainstream?

How does an illiquid market grow and take liquidity away from an established market? One important factor based on lessons from the well known battle for bund futures (see for example Cantillon and Yin) is the ability of the market to attract a different group of traders into the new market. New markets get their initial momentum from new entrants and not from switchers from old markets. This group of new entrants who value the liquidity of the old market less than the other characteristics that the new market offers start trading and gradually build up liquidity in the new market to the point where it can start attracting switchers.

For currency futures in India, there are several such groups available:

The restrictions in the currency futures market (position limit and absence of FIIs) do not bite at this stage because they do not by and large affect this group of new entrants.

The real battle for market share would begin when the market builds up reasonable depth and liquidity to attract participants from the inter-bank market (as opposed to the customer market from which the initial traders would come).

Globally, we know that the currency futures have a role in price discovery that is disproportinate to its share in trading (Rosenberg and Traub) though improved transparency in the OTC market has reduced this role quite sharply between 1996 and 2006. In India, the price discovery role of currency futures is potentially greater because of regulatory restrictions on the OTC market. An additional complication is that since covered interest parity does not yet hold in India, there is information content in the forward/futures market distinct from what is there in the spot market. Globally, one assumes that the information in futures and spot markets is the same.

Posted at 17:49 on Thu, 04 Sep 2008     View/Post Comments (0)     permanent link