Analyzing Statements on Financial Derivatives

The question asks us to evaluate two statements related to financial derivatives, specifically focusing on forward contracts and currency futures, and determine if they are correct or incorrect.

Evaluating Statement I: Speculator's Gain under Forward Contract

Statement I says: A speculator will gain, if he sells foreign currency under a forward contract, when the spot price is higher than the forward price.

Let's consider a speculator who sells foreign currency under a forward contract. This means the speculator agrees today to sell a specific amount of foreign currency at a future date at a predetermined price, known as the forward price (let's call it \(F\)).

At the future date, the speculator must deliver the foreign currency. The price they effectively receive is the forward price \(F\) they agreed upon. However, if they had not entered the forward contract, they would have sold the currency at the prevailing spot price on that future date (let's call it \(S\)).

The gain or loss for the speculator who sells foreign currency forward is the difference between the forward price they locked in and the spot price at maturity.

Gain/Loss per unit = \(F - S\)

For the speculator to gain, the Gain/Loss must be positive. This means \(F - S > 0\), which simplifies to \(F > S\). In other words, the forward price must be higher than the spot price at maturity.

Statement I claims that the speculator will gain when the spot price is higher than the forward price (i.e., \(S > F\)). If \(S > F\), then \(F - S < 0\), which means the speculator would incur a loss, not a gain.

Therefore, Statement I is incorrect.

Evaluating Statement II: Intra Currency Spread in Currency Futures

Statement II says: In currency futures, intra currency spread exists when a speculator buys/sells the same currency for two delivery dates.

Currency futures are standardized contracts traded on exchanges to buy or sell a specific amount of foreign currency at a predetermined price on a future date.

A "spread" in futures trading generally refers to taking simultaneous long and short positions in related futures contracts to profit from changes in the price difference between them.

An "intra-currency spread," often called a "calendar spread" or "time spread," involves taking opposite positions (one long, one short) in futures contracts on the same underlying asset (in this case, the same currency) but with different delivery or maturity dates.

For example, a speculator might buy a futures contract for USD/INR expiring in March and simultaneously sell a futures contract for USD/INR expiring in June. This fits the description in Statement II: buying/selling the same currency pair (USD/INR) for two different delivery dates (March and June).

Therefore, Statement II correctly describes the concept of an intra currency spread in currency futures.

Statement II is correct.

Conclusion on the Statements

• Statement I: Incorrect (Selling forward gains when spot price is lower than forward price)
• Statement II: Correct (Intra currency spread involves the same currency, different delivery dates)

Based on our analysis, Statement I is incorrect, and Statement II is correct. We now look at the options to find the one that matches this conclusion.

The option that states "Statement II is correct, but I is incorrect" aligns with our findings.

Revision Table: Key Financial Derivative Concepts

Additional Information: Types of Currency Risk Management and Speculation

Financial derivatives like forward contracts and currency futures are used for two main purposes: hedging and speculation.

• Hedging: Businesses or individuals use these instruments to protect themselves against unfavorable movements in exchange rates. For example, an importer who needs to pay foreign currency in the future might buy a forward contract to lock in the exchange rate today, thereby removing the uncertainty of future spot rates.
• Speculation: Speculators use these instruments to profit from anticipated price movements. They take positions (buy or sell) based on their prediction of whether the future spot price will be higher or lower than the current forward or futures price. The gain/loss calculation discussed for Statement I is an example of how a speculator might profit (or lose) from their prediction about the relationship between forward and future spot prices.

Different types of spreads exist in futures markets, including inter-commodity spreads (different but related assets), inter-market spreads (same asset on different exchanges), and inter-delivery or calendar spreads (same asset, different delivery months), which is what Statement II describes for currencies as an intra currency spread.