Currency Derivatives

Madhav M.Mehta

Financial Derivatives
Phenomenal growth Forces driving the growth 1. Interest rate contracts. Dominates 2. Currency contracts, second position 3. Equity indexed contracts. Now developing Growth Explosive

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Reasons for growth

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Sustained shifts and temporary surges in market volatility Emergence of important cash markets for Govt. Bonds and growth of OTC derivatives fostered a demand for liquidity provided by exchange traded interest rate futures Interest rate risks- demand for risk-transferring OTC interest rate contracts Global diversification of institutional equity portfolios led to a demand for risk-transferring OTC stock index options Madhav M.Mehta 3

Major classes of risk in derivative trading

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Credit Risk Market Risk Liquidity Risk Legal Risk Settlement Risk Operations Risk

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Credit to counter parties Effect of changes in the price o underlying instrument Unable to liquidate or offset a position due to lack of counter parties Unenforceable contracts Counter party fails to provide funds at the agreed time Human error of deficiencies
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Derivatives

These are all financial instruments whose value is derived from the value of some other underlying financial contract or asset. It does not have any independent value. This underlying can be securities, commodity, bullion, currency or any thing else.
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Introduction 1/3

It is a risk management tool Now available for almost all types of risks in business In foreign exchange also corporate used forward contracts to hedge currency exposures. Now options, futures and swaps have been added.
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Introduction 2/3

Facilitate creation of new financial products, financial innovations Caters to the specific need of the issuer and the investor Derivative is any other hybrid product/contract Currency futures and options are designed to afford protection from exchange risk. Swaps and interest rate futures are used for protection against interest rate risk
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Introduction 3/3

In the beginning derivatives offered cover against commodities. Later extended to financial assets like stocks and debts. Subsequently extended to currencies also Financial position of derivative user could be better or worse Also extended to intangibles like electricity or weather derivatives.
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Foreign Exchange Exposure

Transaction Exposure:- How Exchange rate fluctuation affect the value of anticipated cash flows in foreign currency relating to transactions already entered into. Translation Exposure:-arises as a result of consolidation of foreign currency items into group financial statements denominated in the currency of the parent company.
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Corporate Practice in managing Exchange risk

Transaction exposure more important. Companies have no definite policy. Forward exchange contract is regarded as most useful. Companies not aware of hedging techniques. Companies feel they are not into speculation on foreign exchange movement.
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Foreign Exchange Exposure

Economic or Operating Exposure:Relates to entire investment. Concerned with present value of future cash flows. How this present value, expressed in parent currency changes following exchange rate movement.

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Features of derivatives
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It is a financial instrument, giving rise to rights and obligations in monetary terms; It is executable on a future date; Its value is dependent on the value of any other basic variable; The value is determined as the gain or loss to the buyer on the due date as compared to open position.
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Types of derivatives
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Whether they are traded on a specific exchange or not; Exchange Traded (standardized size and maturity, clearing house and counter party risk minimized e.g. futures and options ) and OTC ( tailor made and so flexible e.g. forwards and options); The basic variable on which the derivatives derive its value; and The nature of instrument.
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Forward Contract

Forward (FC): FC is an arrangement whereby an agreed amount of foreign exchange is bought or sold for a specified future delivery at a predetermined rate of exchange. Parties to the may be bank and its customer. The contract may also be between two banks. It is OTC product. e.g. exporter has receivables due six months. He may hedge his position if he feels currency will depreciate in future.
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Futures

Standardized form of forward contract; Size and due date fixed. E.g. Euro in Chicago, size EUR 100,000 delivery in March, June, September and December More secure, cheaper and more gain possible. Trading by members, margins required to be kept( 2.5% to 10%) Marked to market every day
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Options

Both forwards and futures bestow right to buy or sell FC but also impose obligation to execute the contract on due date. Option gives buyer a right to buy or sell a certain amount of specified FC on a specified future date, rate but without obligation to do so. Call (buyer right to buy) and put option (buyer right to sell) It is available at a premium, payable upfront which is not refundable. Strike price is the rate at which currencies agreed to be exchanged
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Swaps

Financial streams are exchanged between two parties. Capital risk, Asset/Liability risk. Can be Financial, Currency or interest rate swaps Example banks offer product whereby borrowers can exchange fixed interest borrowings into floating rates and vice versa

Exchange can also be financial stream in two currencies.

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Management of Foreign Exchange Exposure

Forward Market Hedge:-A net liability (asset) position is covered by an asset (liability) in forward market. Even in third currencies now possible. Cross currency call or put option possible. Rollover Contracts:-Forward contracts over 6 months not permitted so roll over for longer duration contracts. Basic Exchange rate fixed. Premium or discount. Financial Swaps:- Exchange of one set of financial obligations with another. Interest rate and currency swaps most important. Money Market hedge:- Exposed position in a foreign currency is covered through borrowing or lending in money market.
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Forward Contract

One to one bipartite contract which is to be performed in future at the terms decided to day. Used in India on a large scale in foreign exchange market to hedge currency risk. Negotiated by the parties on one to one basis, offers tremendous flexibility regarding terms of price, quantity, quality, delivery time and place. Poor liquidity and default risks ( credit risk) Defined as a vehicle for buying or selling a stated amount of foreign exchange at a stated price per unit at a specified time in the future.
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Swaps

Forward trades can be classified as outright or swap transactions. Swap transaction between currencies A and B consists of simultaneous sale (or purchase) of spot foreign exchange against a forward purchase (or sale) of approximately an equal amount of foreign currency. Rate for forward and spot will be different and it is called swap margin which corresponds to the forward premium or discount.
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Swaps ( Continued)

In interbank market forwards are done in the form of swaps The reason for this is that it is very difficult to find counterparties with matching opposite needs to cover the original position by an opposite outright forward whereas swap positions can be easily offset by dealing in the euro deposit markets. Swap quotation is in points.
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Swaps ( Continued)

The bank must always make profit. General rule; bid-ask spread widens as we go farther into the future. It is narrowest at spot. Forward- Forward Swaps. It is a swap between two forward dates.
Sell A spot and buy 3 month forward against B 2. Buy A spot and sell 6 month forward against B In such deal both the spot forward swaps will be done off & spot transactions cancel out
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Swaps ( Continued)

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Swap involves exchange of interest or foreign currency exposures or a combination of both by two or more borrowers. No legal swapping of actual debts Swaps of two types Interest rate swaps Currency swaps
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Swaps ( Continued)
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Two main types of interest rate swaps:Coupon swap:- Converts interest flows from a fixed rate to floating rate basis or reverse in the same currency. Basis swap:- Converts interest flows from a floating rate calculated to one formula to a floating rate calculated according to another.
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Swaps ( Continued)

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Currency swaps:- Counterparty A exchanging fixed rate interest in one currency with counterparty B in return for fixed rate interest in another Currency. Initial exchange of principal Ongoing exchange of interest Re-exchange of principal amounts on maturity.
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Futures Contract

These are organized/standard contracts in terms of quantity, quality, delivery time and place for settlement on any date in future. These contracts are traded on the exchange These are very liquid Clearing corporation/house becomes the counter party to all the trades or provides the unconditional guarantee for their settlement.
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Difference between Forward and Future contracts

Forward contract is; tailor made between two parties Contract specification differs from trade to trade Not Exchange traded; OTC Counter party risk exists Size tailor-made Not specific delivery months No such system

Future contract is standardized Contracts are standardized Exchange traded Exists but assumed by the clearing corporation/house Size standardized Specific delivery dates/months Initial margin of say 4% to be deposited
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Difference between Forward and Future contracts

No clearing House No daily adjustment

No such Price discovery not efficient

Futures; deal through clearing. House Marked to market every day and adjusted Through margin a/c Liquidity; buyer need not hold till maturity Price discovery efficient, as all buyers/sellers come to a common platform
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Role of different players in futures market

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Derivatives facilitate the transfer of risk from hedgers to speculators Three players
Hedgers Long hedgers, short hedgers, cross hedger Speculators; Accept risk in pursuit of profit. Ability to foresee future price Arbitrageurs; Lock their non speculative profit by operating in various markets simultaneously. Long in one short in another. Link between 1&2
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Options

Option is the right given by the option seller to the option buyer to buy or sell a specific asset at a specified price on or before a specified date. Option buyer has the right and option seller has the obligation. Option buyer may or may not exercise the option given. If he decides to exercise the option, option seller has no option but to honor the obligation. Call and Put options
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