CURRENCIES AND INTEREST RATE DERIVATIVES

CURRENCY DERIVATIVES
Currency Forwards

Currency Futures
Currency Options

Importer- Exporter positions

The exporters who receive foreign currencies will have to sell

foreign currencies in exchange for the Indian rupee. The importers who have to make payment in the foreign currencies have to purchase foreign currencies. Importers are likely to suffer when the foreign currency appreciate and exporters suffer when foreign currencies depreciate. An importer who has to buy foreign currency to meet his payment can buy foreign currency forward to avoid the risk on account of exchange rate fluctuations. Similarly an exporter can hedge his risk by selling forward the currency expected to be received in future.

Currency forwards
Currency forwards are used by exporters and importers

to hedge the risk involved in their foreign currency transactions on account of foreign exchange fluctuations. It is also called Forward exchange contract .
A forward exchange contractalso called a forward

currency contractis an agreement between exporter or importer and bank in which the bank agrees to buy or sell a certain amount in a foreign currency at a fixed rate of exchange on, or during a period up to, a particular date.

Currency forwards
These are agreements to buy or sell foreign currencies at a

specified date in the future at a specified exchange rate known as the forward rate. This forward rate may quoted at premium or discount to the spot rate.
Foreign Exchange forward contracts are transactions in

which counterparties agree to exchange a specified amount of different currencies at some future date, with the exchange rate being set at the time the contract is entered into. The user is protected from adverse movements in future FX rates, but he also does not benefit from favourable movements.

CERTAIN TERMS
Foreign currencies Exchange rate

Exchange rate quotations

Bid and Offer rates Spot market and forward market

Spot rate and forward rate: The exchange rate in a

forward market(forward exchange rate) may be at a discount or a premium to the spot exchange rate. Forward rate differential is the difference between forward rate and the spot rate. Forward premium and discount Forward rate quotations

Exchange rate quotes

Type of market
Spot 1 month 3 month 6 month

Bid
1.5634 1.5629 1.5620 1.5608

Ask
1.5637 1.5632 1.5624 1.5610

Pricing of Currency Forwards

Forward exchange rate quoted for a foreign currency is the

forward price of the foreign currency underlying the forward contract.

Two theories / views:

Interest rate parity theory Expectations theory

Interest Rate Parity (IRP) Theory

Theory postulates that the forward rate differential in the

exchange of two currencies would equal the interest rate differential between two currencies. The forward premium or discount for one currency relative to another should be equal to the ratio of nominal interest rates on securities of equal risk (and duration denominated in the two currencies).

F= S

(1+rh ) (1+rf)

Expectations theory
The forward exchange rates equal to the Forex markets

future spot rate.

If we disregard risk and transaction cost , the forward

exchange rates would depend on what people expected the future spot rate to be, i.e. the spot rate at the time of delivery.
Forward exchange rates = Expected future spot rate

Currency futures
Currency future is a future contract to exchange one currency for another

currency at a specified date in the future (exchange rate)

at a

predetermined price

It is a contract that allows market participants to trade the underlying

exchange rate for a period of time in the future. The underlying asset/ instrument of currency futures contract is rate of exchange between two currencies. It is also known as foreign exchange futures or FX future and has foreign currencies as the underlying asset.
Currency futures contracts are characterized by certain specifications known

as the contract size, trading hours, expiry dates, pricing limits, etc. These contracts are settled though clearing houses and a margining system with daily marking- to market process is adopted by the clearing house to ensure that the contracts are fulfilled with out default.

Currency options
A currency option is an agreement whereby the option buyer gets the

right to buy or sell an underlying foreign currency in exchange for a base currency, which may generally be the home currency of the option buyer or an international currency such as US dollar.
It is an agreement which gives the holder of the option the right to

buy or sell the foreign currencies at a predetermined price within a specified future period.
Currency options are used to hedge the foreign exchange risk and

can also be used to make short term gains by speculating on the future movement of exchange rates.

Interest rate derivatives

Interest rate forwards Interest rate futures Interest rate options

INTEREST RATE FUTURES

These are derivative instruments designed to help

borrowers and lenders to hedge interest rate risk. It is an agreement to buy or sell the underlying security in the future at a predetermined rate. The underlying assets are interest bearing securities such as bonds, government securities , commercial papers , CDs, treasury bills etc. Two classification:
Short term interest rate futures (money market securities) Long term interest rate futures (capital market securities)

Forward rate agreement

A forward rate agreement (FRA) is an agreement that a certain

rate will apply to a certain principal during a certain future time period. An FRA is equivalent to an agreement where interest at a predetermined rate, RK is exchanged for interest at the market rate. A FRA is a forward contract on an interest rate. The buyer of a FRA profits from an increase in interest rates. The seller of a FRA profits from a decline in rates.
A FRA is essentially equivalent to a one-period plain vanilla

interest rate swap .

Forward rate agreement

FRAs are over the counter derivatives. FRA transactions are entered as

a hedge against interest rate changes.

Agreements dealing with interest rates, the parties to the contract will

exchange a fixed rate for a variable one. The party paying the fixed rate is usually referred to as the borrower, while the party receiving the fixed rate is referred to as the lender.
A FRA differs from a swap in that a payment is only made once at maturity.

FRAs are cash settled.

FRA (Example)
Company A enters into an FRA with Company B in which Company

A will receive a fixed rate of 5% for one year on a principal of $1 million in three years. In return, Company B will receive the oneyear LIBOR rate, determined in three years' time, on the principal amount. The agreement will be settled in cash in three years. If, after three years' time, the LIBOR is at 5.5%, the settlement to the agreement will require that Company A pay Company B. This is because the LIBOR is higher than the fixed rate. Mathematically, $1 million at 5% generates $50,000 of interest for Company A while $1 million at 5.5% generates $55,000 in interest for Company B. Ignoring present values, the net difference between the two amounts is $5,000, which is paid to Company B .

Swaps
A swap is an agreement between two parties to

exchange cash flows in the future. Under this agreement , various terms like the dates when the cash flows are to be paid, the currency in which to be paid and the mode of payment are determined and finalized by the parties. These are asset- liability management tools. Two types:
Currency swaps Interest rate swaps

Options (interest rate)

Interest Rate Options are a form of Exchange Traded

Derivative whose underlying value is the rate on various Financial Interest rates including treasury bills, and bonds. An Interest rate is similar to an equity option. There are two types, Calls and Puts. Calls give the bearer the right, but not the obligation, to benefit off a rise in interest rates. A put gives the bearer the right, but not the obligation, to profit off a decrease in interest rates. The underlying assets are interest bearing securities such as bonds, government securities , commercial papers , CDs, treasury bills etc.

Swaptions
Swaptions are options to buy or sell a swap that will

become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

Yield to Maturity Curve--Term Structure

Pure Expectations Theory Forward Interest Rate = Expected Future Spot Rate Market Segmentation Theory
Liquidity Preference Theory

Forward Interest Rate > Expected Future Spot Rate

Theories of Term Structure

Liquidity Preference
Upward

bias over expectations Fails to explain downward sloping yield curve

S5

Expectations Market Segmentation

Preferred

S S10 10 S5 D
5

S15

S15 DD10 10 D15

Habitat
D5

Explains both

downward and upward sloping yield curves

5

D15

10

15

Maturity

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