(2) currency derivatives

7/29/2019 (2) Currency Derivatives

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Currency Derivatives

Madhav M.Mehta


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Financial Derivatives Phenomenal growth

Forces driving the growth

1. Interest rate contracts. Dominates

2. Currency contracts, second position

3. Equity indexed contracts. Nowdeveloping

Growth Explosive


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Reasons for growth1. Sustained shifts and temporary surges in market

volatility

2. Emergence of important cash markets for Govt.Bonds and growth of OTC derivatives fostered ademand for liquidity provided by exchange tradedinterest rate futures

3. Interest rate risks- demand for risk-transferring OTCinterest rate contracts

4. Global diversification of institutional equity portfoliosled to a demand for risk-transferring OTC stock

index options


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Major classes of risk in

derivative trading1. Credit Risk

2. Market Risk

3. Liquidity Risk4. Legal Risk

5. Settlement Risk

6. Operations Risk

1. Credit to counter parties

2. Effect of changes in the price

underlying instrument3. Unable to liquidate or offset a

position due to lack of counterparties

4.

Unenforceable contracts5. Counter party fails to provide

funds at the agreed time

6. 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 thingelse.


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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 andthe 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 forprotection against interest rate risk


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Introduction 3/3

In the beginning derivatives offered coveragainst commodities.

Later extended to financial assets like stocks

and debts. Subsequently extended to currencies also

Financial position of derivative user could be

better or worseAlso extended to intangibles like electricity or

weather derivatives.


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Foreign Exchange Exposure

Transaction Exposure:- HowExchange rate fluctuation affect thevalue of anticipated cash flows inforeign currency relating to transactions

already entered into. Translation Exposure:-arises as a

result of consolidation of foreign

currency items into group financialstatements denominated in thecurrency of the parent company.


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Corporate Practice in managingExchange risk

Transaction exposure more important. Companies have no definite policy.

Forward exchange contract is regarded

as most useful.

Companies not aware of hedgingtechniques.

Companies feel they are not intospeculation on foreign exchangemovement.


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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 inparent currency changes following

exchange rate movement.


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Features of derivatives1. It is a financial instrument, giving rise to

rights and obligations in monetary terms;

2. It is executable on a future date;3. Its value is dependent on the value of any

other basic variable;

4. The value is determined as the gain or lossto the buyer on the due date as compared toopen position.


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Types of derivatives1. Whether they are traded on a specific

exchange or not; Exchange Traded

(standardized size and maturity, clearinghouse and counter party risk minimized e.g.futures and options ) and OTC ( tailor madeand so flexible e.g. forwards and options);

2. The basic variable on which the derivativesderive its value; and

3. The nature of instrument.


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Forward Contract

Forward (FC): FC is an arrangement wherebyan agreed amount of foreign exchange is

bought or sold for a specified future delivery ata predetermined rate of exchange. Parties tothe may be bank and its customer. Thecontract may also be between two banks. It is

OTC product. e.g. exporter has receivables duesix months. He may hedge his position if hefeels 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 inMarch, June, September and December

More secure, cheaper and more gain

possible. Trading by members, marginsrequired 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 executethe contract on due date.

Option gives buyer a right to buy or sell acertain amount of specified FC on a specified

future date, rate but without obligation to doso. Call (buyer right to buy) and put option(buyer right to sell)

It is available at a premium, payable upfrontwhich is not refundable.

Strike price is the rate at which currenciesagreed to be exchanged


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Swaps

Financial streams are exchanged betweentwo parties. Capital risk, Asset/Liability risk.

Can be Financial, Currency or interest rateswaps

Example banks offer product wherebyborrowers can exchange fixed interestborrowings into floating rates and vice versa

Exchange can also be financial stream in twocurrencies.


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Management of ForeignExchange Exposure

Forward Market Hedge:-A net liability (asset)position is covered by an asset (liability) in forwardmarket. Even in third currencies now possible. Crosscurrency call or put option possible.

Rollover Contracts:-Forward contracts over 6months not permitted so roll over for longer durationcontracts. Basic Exchange rate fixed. Premium ordiscount.

Financial Swaps:- Exchange of one set of financial

obligations with another. Interest rate and currencyswaps most important. Money Market hedge:- Exposed position in a

foreign currency is covered through borrowing orlending in money market.


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Forward Contract

One to one bipartite contract which is to beperformed in future at the terms decided to day.

Used in India on a large scale in foreign exchangemarket to hedge currency risk.

Negotiated by the parties on one to one basis,offers tremendous flexibility regarding terms ofprice, 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 perunit at a specified time in the future.


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Swaps

Forward trades can be classified as outrightor swap transactions.

Swap transaction between currencies A and

B consists of simultaneous sale (orpurchase) of spot foreign exchange againsta forward purchase (or sale) ofapproximately an equal amount of foreigncurrency.

Rate for forward and spot will be differentand it is called swap margin whichcorresponds to the forward premium ordiscount.


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Swaps ( Continued)

In interbank market forwards are done inthe form of swaps

The reason for this is that it is very difficultto find counterparties with matchingopposite needs to cover the original positionby an opposite outright forward whereasswap positions can be easily offset bydealing 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.

1. 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)

Swap involves exchange of interest orforeign currency exposures or a

combination of both by two or moreborrowers.

No legal swapping of actual debts

Swaps of two types1. Interest rate swaps

2. Currency swaps


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Swaps ( Continued)

Two main types ofinterest rate swaps:-

1. Coupon swap:- Converts interest flows

from a fixed rate to floating rate basis orreverse in the same currency.

2. Basis swap:- Converts interest flows from a

floating rate calculated to one formula to afloating rate calculated according toanother.


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Swaps ( Continued)

Currency swaps:- Counterparty Aexchanging fixed rate interest in one

currency with counterparty B in return forfixed rate interest in another Currency.

1. Initial exchange of principal

2. Ongoing exchange of interest

3. Re-exchange of principal amounts onmaturity.


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Futures Contract

These are organized/standard contracts interms 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 thecounter party to all the trades or providesthe unconditional guarantee for theirsettlement.


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Difference between Forwardand Future contracts

Forward contract is; tailormade between two parties

Contract specification differsfrom trade to trade

Not Exchange traded; OTC

Counter party risk exists

Size tailor-made

Not specific delivery months No such system

Future contract isstandardized

Contracts are standardized

Exchange traded

Exists but assumed by theclearing corporation/house

Size standardized Specific delivery

dates/months

Initial margin of say 4% tobe deposited


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Difference between Forwardand Future contracts

No clearing House

No daily adjustment

No such

Price discovery notefficient

Futures; deal throughclearing. House

Marked to market every

day and adjustedThrough margin a/c

Liquidity; buyer neednot hold till maturity

Price discovery efficient,as all buyers/sellerscome to a commonplatform


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Role of different players infutures market

Derivatives facilitate the transfer of riskfrom hedgers to speculators

Three players1. Hedgers Long hedgers, short hedgers, cross

hedger

2. Speculators; Accept risk in pursuit of profit.Ability to foresee future price

3. Arbitrageurs; Lock their non speculative profit byoperating 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 theoption 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 optiongiven. If he decides to exercise the option, optionseller has no option but to honor the obligation.

Call and Put options

(2) currency derivatives

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