Exchange Rate Derivatives

Presented By: Yatendra Bihani Mohnish Jain Laksh Maggoo Vinita Pandya Deepali Jain Satya Ranjan

102 110 366 310 303 308

Foreign Currency Derivatives

Understanding how currency derivative can be used for hedging or speculative purposes. The profits and losses earned on futures and option contracts, as well as those earned on forward contracts, depend on how the spot exchange rate evolves over time, all these instruments are considered derivative securities. Derivative securities are securities whose values depend on the values of other, more basic underlying variablesin this case, the spot exchange rate.

Currency Derivatives Futures

Currency futures began trading in the International Money Market (IMM) of the Chicago Mercantile Exchange (CME) in 1972. Regulators permitted the exchanges to launch currency derivatives contracts to start with USDINR currency pair in 2nd half of 2008. Later on three more currency pairs EURINR, GBPINR & JPYINR were allowed in February 2010.

Currency Futures

Currency futures are standardized contracts that trade like conventional commodity futures on the floor of a futures exchange orders to buy or sell a fixed amount of foreign currency are received by brokers or exchange members. At the exchange, orders to buy a currency long positions - are matched with orders to sell short positions. The exchange, or more precisely, its clearing corporation, guarantees both sides of each two-sided contract, that is, the contract to buy and the contract to sell.

The willingness to buy versus the willingness to sell moves future prices ups and downs to maintain a balance between the numbers of buy and sell order. All currency futures must be honored by both parties involved. There is no option allowing a party to settle only if it is to that partys advantage.

Currency futures are a linear product. It means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. As the date of expiration comes near, the basis reduces - there is a convergence of the futures price towards the spot price. On the date of expiration, the basis is zero. In determining profits and losses in futures trading, it is essential to know both the contract size and also the value of tick. All settlements go through the exchange.

A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. The standardized items in a futures contract are:

Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change Location of settlement

Rationale for Currency Futures Market

Both residents and non-residents purchase domestic currency assets. If the exchange rate remains unchanged from the time of purchase of the asset to its sale, no gains and losses are made out of currency exposures. But if domestic currency depreciates (appreciates) against the foreign currency, the exposure would result in gain (loss) for residents purchasing foreign assets and loss (gain) for non residents purchasing domestic assets. Unpredicted movements in exchange rates expose investors to currency risks. Currency futures enable them to hedge these risks.

Initially, only banks and large corporates used to enter into currency market. Now independent traders, large financial institutions, trading companies, importers, exporters, and commercial hedgers can buy and sell currency. It gives hedging opportunities to:
Importers and exporters: can hedge their future

payables and receivables Borrowers: can hedge foreign currency loans for interest and principal payments Resident Indians: can hedge their offshore investments Commodity traders: can hedge against unfavorable movements of gold, crude

Clearing & Settlement

A Clearing Member's open position is arrived by aggregating the open position of all the Trading Members (TM) and all custodial participants clearing through him. A TM's open position in turn includes his proprietary open position and clients open positions. Proprietary / Clients Open Position

While entering orders on the trading system, TMs are required to

identify them as proprietary (if they are own trades) or client (if entered on behalf of clients) through 'Pro / Cli' indicator provided in the order entry screen. The proprietary positions are calculated on net basis (buy - sell) and client positions are calculated on gross of net positions of each client i.e., a buy trade is off-set by a sell trade and a sell trade is off-set by a buy trade.

Open Position
Open position for the proprietary positions are calculated

separately from client position.

Daily Mark-to-Market Settlement

The positions in the futures contracts for each member is

marked-to-market to the daily settlement price of the futures contracts at the end of each trade day. The profits/ losses are computed as the difference between the trade price or the previous days settlement price, as the case may be, and the current days settlement price. The CMs who have suffered a loss are required to pay the mark-to-market loss amount to Clearing Corporation which is passed on to the members who have made a profit. This is known as daily markto-market settlement. CMs are responsible to collect and settle the daily mark to market profits/losses incurred by the TMs and their clients clearing and settling through them. The pay-in and pay-out of the mark-to-market settlement is on T+1 day (T = Trade day). The mark to market losses or profits are directly debited or credited to the CMs clearing bank account.

Final Settlement
On the expiry of the futures contracts, Clearing

Corporation marks all positions of a CM to the final settlement priceand the resulting profit / loss is settled in cash. The final settlement profit / loss is computed as the difference between trade price or the previous days settlement price, as the case may be, and the RBI reference rate of the such futures contract on the last trading day. Final settlement loss/ profit amount is debited/ credited to the relevant CMs clearing bank account on T+2 day (T= last trading day). Open positions in futures contracts cease to exist after their last trading day.

Margin Requirements
Initial Margin Cash/collateral deposited against short term price movement. Initial Margin for each contract is set by the Exchange. Calendar Spread Margin When a currency future position at one maturity is hedged by offsetting position at a different maturity. Extreme Loss Margin Computed at 1% on the MTM value of the gross open position. Marked to Market Value Discussed later.

Example

An edible oil refiner wants to import soya beans worth USD 100,000. The importer is exposed to risk of INR depreciation against USD. This could potentially increase his import bill. The importer places an order on July 15, with delivery and payment dates being three months ahead, i.e., in October. The spot rate of USD/INR at the time of booking the import in July is 43.50. The uncertainty of the movement of the USD/INR is the extent of risk for the importer. The importer decides to hedge against USD/INR volatility using exchange-traded currency futures.

Trading strategy:
Spot rate of USD/INR on July 15, is 43.50
MCX-SX Oct USD/INR futures is trading at 43.50 Hedge Strategy: Buys 100 lots of MCX-SX Oct

USD/INR futures contracts on July 15 @ 43.50, which is expiring on October 24

NSE Currency Futures Specifications

What is a Currency Option Contract?

How does it compare to Forward?

Definitions

Type of Options

Terminology

Unlike futures and forward positions, you have to pay for an option. The amount you pay is known as the Option Premium The Intrinsic value of an option is how much you could get from exercising the option immediately. An American option premium, of course, will always at least as great as the options intrinsic value. The different between the option premium and the intrinsic value is known as the Time Value

Terminology

An Option is in-the-money if its intrinsic value is positive, and out-of-the-money otherwise. An at-the-money option is one with a strike price close to the underlying asset price.

Hedging

Option can be used as investments, or to hedge the downside risk of an existing foreign currency exposure. In both cases, it is common to work with payoff diagram, which show what is the terminal payoff from holding a (European) option conditional on where the spot exchange rate ends up. That terminal payoff depends upon whether the spot exchange rate ends up above or below the strike price, and whether the option is a call or put.

Hedging

Buying options can offset the downside foreign currency risk of a position, while retaining the upside potential at a cost. Options are insurance against bad realizations of the exchange rate. Buying call options ensures the right to acquire foreign currency at a prespecified price (e.g., to pay off a future liability), while allowing you to forego that right if you can get a cheaper price in the spot market.

Hedging

Buying put options ensures the right to sell foreign currency (future accounts receivable) at a pre-specified price, while allowing you to sell at a higher price in the spot market if chance permits.

Four Basic Option Payoff

What would an importer do?

Buy European USD Call

P/L at Expiry (Buy European USD Call)

Sell European USD Put

P/L at Expiry (Sell European USD Put)

What would an exporter do?

Options Sample Problem

Ford

buys a Franc put option (contract size: FF250,000) at a premium of $.01/FF. If the exercise price is $.21 and the spot at expiration is $.216, what is Fords profit (loss)?

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Solution
REVENUES: Sell at .21

COSTS: If exercised Buy at .216 Premium + .01 Total .226 Loss: If exercised: $4,000 Loss: If not exercised: $2,500 (the original premium)
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Nature of Swaps
A swap is an agreement to exchange cash flows at specified future times according to certain specified rules

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Example
A soybean farmer agrees to receive $10 per bushel and pay cash market price for 100,000 bushels for the next 10 years Soybean processor agrees to pay fixed and receive market Example: market price in 2012 is $12, then farmer gives the processor $200,000

Example

Homebuyer agrees to pay fixed and receive variable Bank does the opposite Agree on 10% on $200,000 for 20 years Actual rate is 12% in 2012 Homebuyer gets 2% times $200,000 from the bank Note that the homebuyer will probably have to pay a higher rate on their variable mortgage and that the bank will be earning a higher rate on loans

Interest Rate Swaps

Plain Vanilla" interest rate swap

A company agrees to pay cash flows equal to interest at a

predetermined fixed rate on a notional principal for a number of years. In return, it receives interest at a floating rate on the same notional principal for the same period of time.

LIBOR
London Interbank Offered Rate floating rate in most interest rate swap agreements

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An Example of a Plain Vanilla Interest Rate Swap

An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million

Intel

Microsoft

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Cash Flows to Microsoft

---------Millions of Dollars--------LIBOR FLOATING Date Rate FIXED Net Cash Flow Cash Flow Cash Flow +2.10 2.50 0.40

Mar.5, 2012
Sept. 5, 2012

4.2%
4.8%

Mar.5, 2013
Sept. 5, 2013 Mar.5, 2014

5.3%
5.5% 5.6%

+2.40
+2.65 +2.75

2.50
2.50 2.50

0.10
+0.15 +0.25

Sept. 5, 2014
Mar.5, 2015

5.9%
6.4%

+2.80
+2.95

2.50
2.50

+0.30
+0.45

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Typical Uses of an Interest Rate Swap

Converting a liability from

fixed rate to floating rate floating rate to fixed rate

Converting an investment from

fixed rate to floating rate floating rate to fixed rate

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Quotes By a Swap Market Maker (Table 7.3, page 153)

Maturity
2 years 3 years 4 years

Bid (%)
6.03 6.21 6.35

Offer (%)
6.06 6.24 6.39

Swap Rate (%)

6.045 6.225 6.370

5 years
7 years 10 years

6.47
6.65 6.83

6.51
6.68 6.87

6.490
6.665 6.850

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Currency Swaps
Involves exchanging principal and interest payments in one currency for principal and interest payments in another Requires the principal to be specified in each of the two currencies

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An Example of a Currency Swap

An agreement to pay 5% on a sterling principal of 10,000,000 & receive 6% on a US$ principal of $18,000,000 every year for 5 years

Dollars 6%

IBM
Sterling 5%

British Petroleum

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Exchange of Principal
In an interest rate swap the principal is not exchanged In a currency swap the principal is usually exchanged at the beginning and the end of the swaps life

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The Cash Flows

Dollars Pounds $ ------millions-----18.00 +10.00 +1.08 0.50 +1.08 0.50 +1.08 0.50 +1.08 0.50 +19.08 10.50

Year 2004 2005 2006 2007 2008 2009

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Typical Uses of a Currency Swap

Conversion from a liability in one currency to a liability in another currency Conversion from an investment in one currency to an investment in another currency

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Comparative Advantage Arguments for Currency Swaps (Table 7.8, page 165)
General Electric wants to borrow AUD Qantas wants to borrow USD
USD
General Motors Qantas 5.0% 7.0%

AUD
7.6% 8.0%

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Vinita Pandya 310 MBA Tech Marketing

How to buy & sell futures

Futures contract is a standardized contract between two parties to exchange a specified asset of standard quantity and quality for a price agreed today The party agreeing to buy is said to be "long", "seller" of the contract, is said to be "short Buyer hopes that the asset price is going to increase, while the seller hopes or expects that it will decrease Purpose of the futures exchange institution is to act as intermediary & minimize the risk of default

marking to market

Exchange requires both parties to put up an initial amount of cash, the margin Since the futures price changes daily, the difference in the prior agreed-upon price and the daily futures price is settled daily The exchange will draw money out of one party's margin account and put it into the other's so that each party has the appropriate daily loss or profit If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account.

Futures

Pricing

When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a futures contract is determined via arbitrage arguments Arbitrage arguments /Rational pricing apply when the deliverable asset exists in plentiful supply, or may be freely created Here, the forward price represents the expected future value of the underlying discounted at the risk free rateas any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away Thus, for a simple, non-dividend paying asset, the value of the future/forward, F(t), will be found by compounding the present value S(t) at time t to maturity T by the rate of risk-free return r Pricing via expectation - When the deliverable commodity is not in plentiful supply Here the price of the futures is determined by today's supply and demand for the underlying asset in the futures.

International Fisher Effect

This holds that an interest rate differential will exist only if the exchange rate is expected to change in such a way that the advantage of the higher interest rate is offset by the loss on the foreign exchange transactions IFE implies that while an investor in a lowinterest country can convert funds into the currency of a high-interest country and earn a higher rate The gain (the interest rate differential) will be offset by the expected loss due to foreign exchange rate changes

Continued

An economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries' nominal interest rates for that time. Calculated as:

Where: "E" represents the % change in the exchange rate "i1" represents country A's interest rate "i2" represents country B's interest rate

Example

For example, if country A's interest rate is 10% and country B's interest rate is 5%, country B's currency should appreciate roughly 5% compared to country A's currency The rational for the IFE is that a country with a higher interest rate will also tend to have a higher inflation rate. This increased amount of inflation should cause the currency in the country with the high interest rate to depreciate against a country with lower interest rates.

Interest Rate Swaps

Floating Variable/adjustable Fixed Non adjustable

Do not have a fixed rate of interest over the life of the transaction
Marginally cheaper Higher risk

Have a fixed rate of interest over the life of the transaction

Expensive Lender takes the risk that the interest rate will not increase and interest revenue is less than the interest cost Risk that interest rates go down and therefore the borrower will be paying a higher rate than needed

Borrower takes the risk that interest rates might increase and the borrower will pay more money

Why go for floating rate

Life of the swap can range from 2 years to over 15 years Reason for this exchange is to take benefit from comparative advantage