3 & 4 chapter

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http://slidepdf.com/reader/full/3-4-chapter 1/82

11

Foreign ExchangeForeign ExchangeMarketsMarkets

Instruments&

Mechanisms

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Our FX Market - From Fixed ToOur FX Market - From Fixed ToMarket Based Exchange RateMarket Based Exchange Rate

MechanismMechanism Before 1998, the country had a Managed Exchange Rate Regime.Before 1998, the country had a Managed Exchange Rate Regime.

In 1998 we switched to a composite ERM whereby all commercialIn 1998 we switched to a composite ERM whereby all commercialtransactions were covered both from the interbank and SBP at atransactions were covered both from the interbank and SBP at afixed ratio.fixed ratio.

In May 1999 the country switched to a Market Based ExchangeIn May 1999 the country switched to a Market Based ExchangeRate Regime.Rate Regime.

Banks are free to quote their own exchange rates.Banks are free to quote their own exchange rates.

The exchange rate is determined by the market forces of demandThe exchange rate is determined by the market forces of demand& Supply.& Supply.

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What is a foreign exchange transaction /What is a foreign exchange transaction /ExposureExposure

Any financial transaction that involves more than oneAny financial transaction that involves more than one‘convertible’ currency is a foreign exchange‘convertible’ currency is a foreign exchangetransaction.transaction.Most important characteristic of a foreign exchangeMost important characteristic of a foreign exchangetransaction is that it involvestransaction is that it involves foreign exchangeforeign exchange

risk/Exposure.risk/Exposure.

ntroduction to interbank FX activiti

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Exchange Rate is the price of one currency in terms of Exchange Rate is the price of one currency in terms of another.another.

Currencies are traded both inCurrencies are traded both in spot sp

ot andand forward forward ..

Spot TransactionSpot Transaction ..Sale or purchase of currency for settlement usually in twoSale or purchase of currency for settlement usually in twoworking days.working days.

Forward Transaction.Forward Transaction.Sale or purchase of a currency for settlement at some future date,Sale or purchase of a currency for settlement at some future date,other than spot, at rate determined on the deal date.other than spot, at rate determined on the deal date.


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Fx swap TransactionFx swap Transaction ..

““An FX swap is a contract to buy an amount of currency for oneAn FX swap is a contract to buy an amount of currency for onevalue date at an agreed rate, and to simultaneously resell the samevalue date at an agreed rate, and to simultaneously resell the sameamount of currency for a later value date, also at an agreed rate, to theamount of currency for a later value date, also at an agreed rate, to thesame counter party”.same counter party”.

FX swaps is essentially a ‘funding’ or ‘Money Market’ transactionFX swaps is essentially a ‘funding’ or ‘Money Market’ transaction

and does not involve exchange risk. Fx swap is an alternative toand does not involve exchange risk. Fx swap is an alternative to borrowing/lending the currencies which are swapped and may be borrowing/lending the currencies which are swapped and may beused to take advantage of any ‘used to take advantage of any ‘ arbitragearbitrage ’ between the two currencies.’ between the two currencies.(Some Mechanics to be done)(Some Mechanics to be done)


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Components of a standard FX transaction.Components of a standard FX transaction.Base CurrencyBase Currency (USD/PKR)(USD/PKR)

‘‘Dealt’ or ‘Variable’ CurrencyDealt’ or ‘Variable’ Currency

Exchange RateExchange Rate

AmountAmount

Deal DateDeal DateValue DateValue Date


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Value date conventions.Value date conventions.

ReadyReady

TomTom

SpotSpot

Split value transactionsSplit value transactions


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In the forex market rates are always quoted ‘two way’.In the forex market rates are always quoted ‘two way’.Two way quote gives both ‘Bid’ and ‘Offer’.Two way quote gives both ‘Bid’ and ‘Offer’.

e.g.e.g.USD/PKR= 58.55/60USD/PKR= 58.55/60 (57.90/10 ??)(57.90/10 ??)

Bid/Offer Bid/Offer

‘‘Big Figure’ and the ‘small figure’ or ‘Points’ andBig Figure’ and the ‘small figure’ or ‘Points’ and

‘Pips’.‘Pips’.

Why two way Quotes??Why two way Quotes??


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‘‘Base CurrencyBase Currency ’ Vs. ‘’ Vs. ‘ Dealt CurrencyDealt Currency ’’

Number of variable or dealt currency unit in one unit of Number of variable or dealt currency unit in one unit of base currency. base currency.

In international quotes base currency comes first.In international quotes base currency comes first.

BC/VCBC/VCUSD/PKR= 58.55/60USD/PKR= 58.55/60


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Price makerPrice maker Vs.Vs. Price TakerPrice Taker

The bank quoting the price is ‘price maker’ or The bank quoting the price is ‘price maker’ or ‘market maker’.‘market maker’.

The bank asking for the price or ‘quote’ is theThe bank asking for the price or ‘quote’ is the‘price taker’ or ‘user’.‘price taker’ or ‘user’.


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Prices for ‘Prices for ‘ market makermarket maker ’ and ‘’ and ‘ marketmarkettakertaker ’.’.

JPY=JPY= 117.85/90117.85/90 Direct Quote Direct Quote

Market taker or user will buy JPY (or sell USD) atMarket taker or user will buy JPY (or sell USD) at117.85 and will sell JPY (or buy USD) at 117.90117.85 and will sell JPY (or buy USD) at 117.90


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Prices for ‘Prices for ‘ market makermarket maker ’ and ‘’ and ‘ marketmarkettakertaker ’.’.

GBP=GBP= 1.8063/681.8063/68 Indirect or Indirect or reciprocal reciprocal

Market taker or user will buy GBP (or sell USD) atMarket taker or user will buy GBP (or sell USD) at1.8068 and will sell GBP (or buy USD) at 1.80631.8068 and will sell GBP (or buy USD) at 1.8063


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Prices are quoted in terms of USD.Prices are quoted in terms of USD.

e.g.e.g.GBP=GBP= 1.1.722722 0/0/3030EUR=EUR= 1.1.2020 90/9190/91

JPY=JPY= 1010 88.98/.98/ 99.03.03


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Currencies quoted in indirect or reciprocalCurrencies quoted in indirect or reciprocalway.way.

GBP=GBP=AUD=AUD=EUR=EUR=

NZD= NZD=


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Almost all other currencies are quoted in ‘directAlmost all other currencies are quoted in ‘directquote’.quote’.

e.g.e.g.JPY=JPY=SFR=SFR=TRL=TRL=AED=AED=


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Forward TransactionForward Transaction

Out right sale/purchase of a currency against the other Out right sale/purchase of a currency against the other for settlement at a future date at the predeterminedfor settlement at a future date at the predeterminedexchange rate.exchange rate.

Forward rates are quoted as premium or discountForward rates are quoted as premium or discountover spot rateover spot rate

Forward rates are NOT future spot rates.Forward rates are NOT future spot rates.


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Forward Premium RatesForward Premium Rates

o Forward rates are not reflective of ‘depreciation’ or Forward rates are not reflective of ‘depreciation’ or ‘appreciation’ of the currency and have nothing to do‘appreciation’ of the currency and have nothing to dowith future forecasts of the spot rate.with future forecasts of the spot rate.

o What has interest rate to do with the forward rates??What has interest rate to do with the forward rates??

o The concept of ‘net carrying cost’.The concept of ‘net carrying cost’.


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Forward Premium RatesForward Premium Rates

Forward rates depend upon interest rateForward rates depend upon interest ratedifferential between the two currencies.differential between the two currencies.

o Currency with higher interest rates is at discountCurrency with higher interest rates is at discount

wrt currency having lower interest rate.wrt currency having lower interest rate.o Currency with lower interest rates is at premiumCurrency with lower interest rates is at premiumwrt currency having higher interest rate.wrt currency having higher interest rate.


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Calculating Forward Premiums/Discounts

Interest rate of USD = 1.25%Interest rate of PKR = 6%Spot Rate = 58.50DB for PKR = Actual/365DB for USD = Actual/360

Six month Forward Rate =spot rate x (1+ .06*181/365)/

(1+.0125*181/360)

=59.87


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Foreign Exchange Risk Foreign Exchange Risk

Exposure to exchange rate movement.Exposure to exchange rate movement.

Any sale or purchase of foreign currency entailsAny sale or purchase of foreign currency entailsforeign exchange risk.foreign exchange risk.

Foreign exchange transaction affects the net assetForeign exchange transaction affects the net assetor net liability position of the buyer/seller.or net liability position of the buyer/seller.

Carrying net assets or net liability position in anyCarrying net assets or net liability position in anycurrency gives rise to exchange risk.currency gives rise to exchange risk.


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NET OPEN POSITION- A measure of foreign exchange risk

• NOP is the Net Asset/Net Liability position in all FCstogether (Both B/S & Off B/S).

• Net Asset Position is also called “LONG” or“Overbought “ position.

• Net liability Position is also called “SHORT” or“Oversold “ position.

• NOP is a single statistic that provides a fairly goodidea about exchange risk assumed by the bank.

• Its major flaw is that FX exposures in third currenciesremain hidden.


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Foreign Exchange ExposureFX Exposure is the higher of the long and shortpositions in FCs.EXAMPLE

Currency-wise NOP in equivalent PKRCURRENCY SHORT LONGDollar -10

Yen 50

Euro -10Pound 10Total -20 60Net Open Position is 40 while exposure is 60 .


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State Bank is the single

most important player inboth kerb as well asinterbank market

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SBP’s role in the forex marketSBP’s role in the forex market To manage the exchange rate mechanism.To manage the exchange rate mechanism.

Regulate inter-bank forex transactions andRegulate inter-bank forex transactions and

monitoring the foreign exchange risk of the banks.monitoring the foreign exchange risk of the banks.

Keep the exchange rate at desirable levels.Keep the exchange rate at desirable levels.

Manage and maintain country's foreign exchangeManage and maintain country's foreign exchangereserves.reserves.

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• SBP has imposed foreign exchangeexposure limits on banks (FE 12 of 1999).

• The limits are tied with the Paid upcapital of the bank. (Risk Adjusted)

• Previously banks had NOP limit,which was based on foreignexchange volume handled by the

bank.

SBP’s role in the forex

market

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• NOP is a single statistic thatprovides a fairly good idea about

market liquidity.

• NOP’s major flaw is that FXexposures in third currenciesremain hidden .

• FEEL vs NOP

NOP Vs FX EXPOSURE – Cont’d

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How does SBP managesexchange rate in the interbank

market?

• Quantitative Tools

• Non-Quantitative Tools

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Physical intervention

• Direct selling or buying of foreign exchangeby State Bank in the interbank market.

• Such sale/purchase can be in spot or forward

value• It can have two objectivesTo provide support to the market for

lumpy paymentsTo manage the Rs/$ parity

• Intervention may be direct or indirect.Currently SBP only indirectly intervenes inthe market.

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Non-Quantitative Tools

•Moral suasion• facilitating large commercial outflows

• Relaxation in FEEL

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Derivative ProductsDerivative Products

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Derivative InstrumentDerivative Instrument

“A derivative instrument is one whose performance isbased (or derived), on the behavior of the price of anunderlying asset (Equity, FX, Commodities, Interest Rates,

etc), which is often simply known as the ‘underlying. Theunderlying itself does not need to be bought or sold.

“A true derivative instrument requires no movement of

principal funds. It is this characteristic that makes them suchuseful tools to both hedge and to trade and therefore, they

were also known as Off-Balance Sheet Instruments.”Off-Balance Sheet Instruments.”

DERIVATIVESDERIVATIVES

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Development of Derivative MarketDevelopment of Derivative Market

Derivatives emerged in the developedDerivatives emerged in the developedeconomies many decades agoeconomies many decades ago

Derivative trading became more organizedDerivative trading became more organizedwith the introduction of derivative exchange inwith the introduction of derivative exchange in

19731973

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Type of Derivative contractsType of Derivative contractsAssurance ContractsAssurance Contracts

Guarantee a priceGuarantee a price

Obligation on both partiesObligation on both partiesProtect fully against “downside” riskProtect fully against “downside” risk

No flexibility for “upside” benefitNo flexibility for “upside” benefit

Examples :Examples :

Forward contracts, Futures Contracts, Currency Swaps,Forward contracts, Futures Contracts, Currency Swaps,

FRAs (Forward Rate Agreements) , Interest Rate SwapsFRAs (Forward Rate Agreements) , Interest Rate Swaps


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Type of Derivative ContractsType of Derivative Contracts

Insurance ContractsInsurance ContractsDerivatives are like insurance contracts. For smallpremium, businesses can protect themselves againstshocks and adverse market conditions.

Options are the most common type:

Examples:

Foreign Exchange Calls, Puts, Collars, Interest RateForeign Exchange Calls, Puts, Collars, Interest Rate

Caps, Floors & CollarsCaps, Floors & Collars


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Benefits of Using DerivativesBenefits of Using DerivativesTailor-made InstrumentTailor-made Instrument : Derivatives could either be: Derivatives could either be

standardized or customized, over-the-counter (OTC)standardized or customized, over-the-counter (OTC)instruments. The OTC derivatives are extremely flexible andinstruments. The OTC derivatives are extremely flexible andcan be designed to cater any individual need.can be designed to cater any individual need.

Hedging Instrument:Hedging Instrument: Derivatives are an effective tool thatDerivatives are an effective tool that

could be used to hedge against future uncertainties, such ascould be used to hedge against future uncertainties, such asinterest rate and exchange rate fluctuations, etc.interest rate and exchange rate fluctuations, etc.

Efficient Balance Sheet Management:Efficient Balance Sheet Management: By increasing theBy increasing thecertainty of cash flows, it provides more room for corporatescertainty of cash flows, it provides more room for corporates

to effectively manage their balance sheet. Hence, topto effectively manage their balance sheet. Hence, topmanagement can easily take better strategic decisions.management can easily take better strategic decisions.

Risk Sharing:Risk Sharing: It allows risk sharing among two parties.It allows risk sharing among two parties.Therefore, with the use of derivative products, corporates canTherefore, with the use of derivative products, corporates cantransfer their risk and exposure to other parties, such as banks.transfer their risk and exposure to other parties, such as banks.

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Benefits of Using DerivativesBenefits of Using DerivativesConcentration on Core Business:Concentration on Core Business: It allows corporates toIt allows corporates to

pass-on their financial risk to banks and concentrate on their pass-on their financial risk to banks and concentrate on their core business. With derivatives they can carry only those riskscore business. With derivatives they can carry only those risksthat they are trained for and competent to manage.that they are trained for and competent to manage.

Optimizing on Competitive Advantage:Optimizing on Competitive Advantage: Companies canCompanies canexchange their respective competitive advantages throughexchange their respective competitive advantages throughderivatives.derivatives.

Insurance Contract:Insurance Contract: Derivatives can be used to hedge onlyDerivatives can be used to hedge onlydownside risk and taking advantage of upside potential. So,downside risk and taking advantage of upside potential. So,they could also be used as an insurance against adversethey could also be used as an insurance against adversemovement of interest and exchange rates.movement of interest and exchange rates.

Leverage:Leverage: Most of the derivatives are transacted on notionalMost of the derivatives are transacted on notionalamount. Hence require minimum or no liquidity. This isamount. Hence require minimum or no liquidity. This is

beneficial for corporates as well as for banks. beneficial for corporates as well as for banks.

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Benefits of Using DerivativesBenefits of Using DerivativesYield Enhancement:Yield Enhancement: They are off-balance sheet transaction. CorporatesThey are off-balance sheet transaction. Corporatescan enhance their asset yields or reduce their liability costs withoutcan enhance their asset yields or reduce their liability costs withoutactually inflating the balance sheet.actually inflating the balance sheet.

Improved Credit Rating:Improved Credit Rating: Use of derivatives will improve the creditUse of derivatives will improve the creditrating of the companies.rating of the companies.

Low Credit Risk:Low Credit Risk: Because of the notional amount, a derivativeBecause of the notional amount, a derivativetransaction carries a fractional amount of credit risk as compared to anytransaction carries a fractional amount of credit risk as compared to anynormal cash transaction. Therefore, it only uses only a fractional amountnormal cash transaction. Therefore, it only uses only a fractional amountof per-party limit.of per-party limit.

Synthetic Liquidity:Synthetic Liquidity: They provide synthetic liquidity in the market andThey provide synthetic liquidity in the market andhence give banks and corporates a broader spectrum to work with.hence give banks and corporates a broader spectrum to work with.

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Benefits of Using DerivativesBenefits of Using DerivativesLower Transaction Cost:Lower Transaction Cost: Derivatives either have very lower Derivatives either have very lower or no transaction cost at all.or no transaction cost at all.

Easy Entrance and Exit:Easy Entrance and Exit: It is easy to entered into and existIt is easy to entered into and existfrom a derivative transaction as many derivatives can befrom a derivative transaction as many derivatives can becancelled at any time by paying a very nominal cancellationcancelled at any time by paying a very nominal cancellationfee.fee.

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Derivative Products for HedgingDerivative Products for Hedging

Interest rate & Exchange rateInterest rate & Exchange rateForeign Exchange DerivativesForeign Exchange Derivatives

ForwardsForwards

FuturesFuturesOptionsOptions

Interest Rate DerivativesInterest Rate DerivativesForward Rate AgreementsForward Rate AgreementsInterest Rate SwapInterest Rate Swap

FuturesFutures

OptionsOptions

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DerivativesDerivatives – A New Era – A New Era

SBP has allowed only three broad categoriesSBP has allowed only three broad categoriesof Derivative instrumentsof Derivative instruments

Interest Rate SwapInterest Rate Swap

Forward Rate Agreements &Forward Rate Agreements &

Currency OptionsCurrency Options

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Forward Rate AgreementsForward Rate Agreements

Forward rate agreements, or FRAs, are forwardForward rate agreements, or FRAs, are forwardcontracts on interest rates.contracts on interest rates.

A Forward Rate Agreement (FRA)conceptually is very similar to an FXForward, except that the later hedges FX

volatilities and the FRA hedges against the“Interest Rate” volatilities.”

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Forward Rate AgreementsForward Rate Agreements

They are a simplified version of forward lending or They are a simplified version of forward lending or borrowing with the difference that on the settlement borrowing with the difference that on the settlementdate only the difference between prevailing anddate only the difference between prevailing andcontractual interest rates is exchangedcontractual interest rates is exchanged ..

“A Forward Rate Agreement is a contract betweentwo parties who wish to protect themselves from

interest rate movements. The agreement is specificfor the notional principal, the period, the currency andthe rate.”

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Customized short term interest rate future of any

amount up to two years final maturity.No obligation to borrow or to lend.

Compensation calculated on difference betweenFRA price and market benchmark rate, example

KIBOR Minimal dealing lines required; counter-party

risk is only on differential amount only.BUY the FRA expecting Interest rates to rise.

SELL the FRA expecting interest rates to fall.

FRA -FeaturesFRA -Features

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FRA Payoff FRA Payoff

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FRA ConventionFRA Convention

3 x 63 x 6Means 3 months rate 3 months forwardMeans 3 months rate 3 months forward

3 x 93 x 9

Means 6 months rate 3 months forwardMeans 6 months rate 3 months forward6 x 96 x 91 x 71 x 7

9 x 129 x 12

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FRAFRA Contd.Contd.

Consider a Borrower who has a rollingConsider a Borrower who has a rollingPKR 3 month facility, based onPKR 3 month facility, based onKIBOR KIBOR

ConcernConcern – interest rate going up in next reset – interest rate going up in next reset

Invest

Borrow Gap

3 months 3 months

0 1 2 3 4 5 6

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If they have a strong view that interest ratesIf they have a strong view that interest rates

will risewill rise

They should buy a “3 x 6” FRAThey should buy a “3 x 6” FRA

Current 3 Month KIBOR Current 3 Month KIBOR = 7.50%= 7.50%

Current 6 Month KIBOR Current 6 Month KIBOR = 8.40%= 8.40%

3 x 6 FRA rate3 x 6 FRA rate = 9.12%= 9.12%

While Client has successfully protected his downsideWhile Client has successfully protected his downsideClient has given up the benefit of interest rate softeningClient has given up the benefit of interest rate softening

Borrower hedges through an FRA at 9.12%

Today 3 months 6 months

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FRA - diagramFRA - diagram

While Client has successfully protected his downsideWhile Client has successfully protected his downside

Client has given up the benefit of interest rate softeningClient has given up the benefit of interest rate softening

FRABANK

Floating Rate (KIBOR)Floating Rate (KIBOR)

Fixed Rate (9.12%)Fixed Rate (9.12%)

BORROWER BORROWER

KIBOR on BankBorrowing From

Lending Bank

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FRA CalculationFRA Calculation

Borrower locked in at 9.12%Borrower locked in at 9.12%3 month forward for 3 months3 month forward for 3 monthsIf 3 months later KIBOR = 9.5%If 3 months later KIBOR = 9.5% FRA buyer receives theFRA buyer receives the

following:following:Rate Differential is 9.5%-9.12%Rate Differential is 9.5%-9.12%Present value is 0.38%/Present value is 0.38%/(1+9.5%*91/365)(1+9.5%*91/365)

=0.3712%=0.3712%Settlement amount isSettlement amount isPrinciple * 0.3712%Principle * 0.3712%If KIBOR is below FRA contractIf KIBOR is below FRA contractrate then FRA buyer will payrate then FRA buyer will payunder the same calculations.under the same calculations.

3 month KIBOR = 7.50%3 month KIBOR = 7.50%

6 month KIBOR = 8.40%6 month KIBOR = 8.40%

““3 x 6” FRA = 9.12%3 x 6” FRA = 9.12%

×−

×+

×+

=91

3651

365

90%50.71

365

181%40.81

F

%12.9= F

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FRAsFRAs

Worked ExampleWorked ExampleSuppose Citibank Buys “3 vs. 6” FRA from NBPSuppose Citibank Buys “3 vs. 6” FRA from NBP

Notional AmountNotional Amount Rs. 100mRs. 100m

RateRate 9%9%Deal DateDeal Date 66 thth JuneJuneSettlement DateSettlement Date 66 thth JulyJulySettlement RateSettlement Rate 6 Month KIBOR 6 Month KIBOR

Now suppose that at the settlement date, KIBOR is 9.5%, the difference Now suppose that at the settlement date, KIBOR is 9.5%, the difference between the contract rate and current rate comes to 0.5%. Difference between the contract rate and current rate comes to 0.5%. Difference payable by Citibank comes to; payable by Citibank comes to;=100,000,000*(.005*181/365)=100,000,000*(.005*181/365)=Rs. 247,945.205=Rs. 247,945.205

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FRAsFRAs

Worked Example Cont’dWorked Example Cont’d

In the ordinary course, interest is settled onIn the ordinary course, interest is settled on

maturity, but in FRA the difference is settledmaturity, but in FRA the difference is settledupfront on the settlement (starting date) date.upfront on the settlement (starting date) date.Therefore, this amount will be discounted back, atTherefore, this amount will be discounted back, atthe prevailing KIBOR and the actual amount to bethe prevailing KIBOR and the actual amount to bereceived from Citibank would be;received from Citibank would be;=247,945.205/(1+ 9.5% *181/365)=247,945.205/(1+ 9.5% *181/365)==Rs. 236,792.03Rs. 236,792.03

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FRAFRA

Find 6 month rate 3 month forwardFind 6 month rate 3 month forwardTerm Structure is:Term Structure is:

Tenor Tenor BidBid Offer Offer 1 month1 month 6.506.50 7.007.003 months3 months 7.507.50 8.008.006 months6 months 8.408.40 8.908.909 months9 months 8.708.70 9.209.2012 months12 months 9.209.20 9.709.70

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FRA AdvantageFRA Advantage

Ability toAbility to hedgehedge the position and offset gapsthe position and offset gaps

Helps customers inHelps customers in accurate forecastingaccurate forecasting and planningand planning process process

Fixing the cost of funds for Fixing the cost of funds for accurate priceaccurate p rice settingssettingsSmaller Smaller bid / offer spreads bid / offer spr eads than cash marketsthan cash markets

Customer is not restricted to entering into the cashCustomer is not restricted to entering into the cash

market transaction with the FRA counterparty.market transaction with the FRA counterparty.Lower transaction costsLower transaction costs

Off-balance sheet transactionsOff-balance sheet transactions

Lower credit risk than cash transactionsLower credit risk than cash transactions

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FRA - DisadvantagesFRA - Disadvantages

Opportunity cost in case of favorable priceOpportunity cost in case of favorable pricemovement.movement.MTM payments are more transparent then inMTM payments are more transparent then in

Cash Market which may reflect badly on seniorsCash Market which may reflect badly on seniorsdiscouraging traders from using FRAs.discouraging traders from using FRAs.While making payments, customer may feel thatWhile making payments, customer may feel that

bank has taken him for a ride not realizing that it bank has taken him for a ride not realizing that itwould probably be making payment for its hedgewould probably be making payment for its hedgealso.also.

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LINKAGE BETWEENLINKAGE BETWEEN Forward Rate AgreementForward Rate Agreementand interest rate Swaps, ;and interest rate Swaps, ;

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FRAs & IRS FRAs & IRS Interest Rate Swaps (IRS)Interest Rate Swaps (IRS)

Whereas, FRA is single exchange of rates, a generic, standard or Whereas, FRA is single exchange of rates, a generic, standard or Plain vanilla swap is an agreement between two parties toPlain vanilla swap is an agreement between two parties toexchange streams of interest payments one of which could beexchange streams of interest payments one of which could be

fixed and the other could be floating.fixed and the other could be floating.

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FRAs & IRS FRAs & IRS

Interest Rate SwapsInterest Rate Swaps

The Payment are to be exchanged

On predetermined set of dates in futuresBased on notional principal amountDenominated in the same currency

Usually,One party is the fixed rate payer (agreed at theinception of the swap).

The other party is floating rate payer. (prevailing

rate indexed to a benchmark)

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Interest Rate SwapsInterest Rate Swaps

Interest rate swaps are very similar to a portfolioInterest rate swaps are very similar to a portfolioor collection of FRAs.or collection of FRAs.Simply stated, an IRS is multiple FRAs inSimply stated, an IRS is multiple FRAs insequence with a common index and strike rate.sequence with a common index and strike rate.

Through IRS, one can convert its ‘fixed’ asset or Through IRS, one can convert its ‘fixed’ asset or liability into ‘floating’ one.liability into ‘floating’ one.

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Interest Rate SwapInterest Rate SwapA typical interest rate swap:A typical interest rate swap:

Effective Cost of Loan:Effective Cost of Loan:Fixed Rate + 2.00%Fixed Rate + 2.00%

Company A

Bank A

Swap Bank

Fixed Rate

6 Month KIBOR6Month

KIBOR+

2.0%

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Interest Rate SwapInterest Rate Swap

IRS could be for exchange of :IRS could be for exchange of :

Fixed Vs. FloatingFixed Vs. Floating

Floating Vs. FixedFloating Vs. Fixed

Floating Vs. FloatingFloating Vs. Floating

Interest Payments

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Interest PaymentsCalculations

The Fixed Rate payer calculates the interestpayment by multiplying the notional principal(though never exchanged) with the FixedRate, while the Fixed Rate receiver(Floating

Rate payer) uses the Floating RateFloating Rate Interest Payments

Fixed Rate Interest Payments

S

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SwapExchange of fixed interest rate

payments for floatingNotional Amount: PKR 500,000,000 Tenor: 3 YearsFloating Rate: 6 Mth KIBORFixed Rate: 11.00%

Corporate Swap Bank

Corp. pays fixed @ 11%

Bank pays floating @ 6M KIBOR

I R S

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What are future contracts ?.Future contracts are highly standardizedforward contracts, traded on exchanges.Parties involved in a future trade.

BuyerBuyerSellerSellerBrokerBroker

ExchangeExchangeClearing HouseClearing House .

Futures or Futures contra

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What are future contracts ?.

Specification of a standard contract:

GoldCommodity nameExchange Name (COMEX)Size of Contract : 100 troy ounceDelivery month: Feb/April/June/Aug/Oct/Dec

First delivery date, First notice date, lastdelivery date.


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Different kinds of futurecontract ?.

Commodity futuresCurrency futures

Financial futures.


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TheThe World’s Leading Futures ExchangesWorld’s Leading Futures ExchangesChicago Board of TradeChicago Board of Trade(CBOT)(CBOT)Financial ExchangeFinancial Exchange(FINEX)(FINEX)

New York FuturesNew York FuturesExchange (NYFE)Exchange (NYFE)Marche a TermeMarche a TermeInternational De FranceInternational De France(MATIF)(MATIF)Singapore Exchange LTD.Singapore Exchange LTD.(SGX)(SGX)

Chicago MercantileChicago MercantileExchange (CME)Exchange (CME)London InternationalLondon InternationalFinancial FuturesFinancial FuturesExchange (LIFFE)Exchange (LIFFE)Sydney FuturesSydney FuturesExchangeExchange

Toronto FuturesToronto FuturesExchange (TFE)Exchange (TFE)

S C O S S ADISTINCTIONS BETWEEN FUTURES AND

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DISTINCTIONS BETWEEN FUTURES ANDDISTINCTIONS BETWEEN FUTURES ANDFORWARDS.FORWARDS.

ForwardsForwardsTraded in dispersedTraded in dispersedinterbank market 24 hr ainterbank market 24 hr aday. Lacks priceday. Lacks price

transparencytransparency

Transactions are customizedTransactions are customized

and flexible to meetand flexible to meetcustomers preferences.customers preferences.

FuturesFuturesTraded in centralizedTraded in centralizedexchanges duringexchanges duringspecified trading hours.specified trading hours.Exhibits priceExhibits pricetransparency.transparency.

Transactions are highlyTransactions are highlystandardized to promotestandardized to promotetrading and liquidity.trading and liquidity.

DISTINCTIONS BETWEEN FUTURES ANDDISTINCTIONS BETWEEN FUTURES AND

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DISTINCTIONS BETWEEN FUTURES ANDDISTINCTIONS BETWEEN FUTURES ANDFORWARDS.FORWARDS.

ForwardsForwardsCounter party risk isCounter party risk isvariablevariable

No cash flows take No cash flows take place until the final place until the finalmaturity of the contract.maturity of the contract.

FuturesFuturesBeing one of the twoBeing one of the two

parties, the clearing house parties, the clearing housestandardizes thestandardizes the

counterparty risk of allcounterparty risk of allcontracts.contracts.

On a daily basis, cash mayOn a daily basis, cash mayflow in or out of the marginflow in or out of the marginaccount, which is marked toaccount, which is marked tomarket..market..

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What is an Option?What is an Option?

½ An option is contract offering theAn option is contract offering theright, but not the obligation, toright, but not the obligation, tobuy or sell an asset at abuy or sell an asset at apredetermined price.predetermined price.

½ The price of an option is derivedThe price of an option is derived

from its underlying instrument.from its underlying instrument.

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European Options:European Options:

½ European optionsEuropean options can only be exercisedcan only be exercisedon their expiration date.on their expiration date.

½ The expiration, or maturity date, is theThe expiration, or maturity date, is theday the option buyer’s right to exerciseday the option buyer’s right to exercisethe option (and the seller’s obligation tothe option (and the seller’s obligation toperform) ends.perform) ends.

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American Options:American Options:

½

American optionsAmerican options can becan beexercised at any time up to, andexercised at any time up to, andincluding, the expiration date.including, the expiration date.

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Positions in OptionsPositions in Options

Price PriceStrikeStrike

Loss Loss

Profit Profit

00

P r e m i u m

P r e m i u m

½ A long call position has unlimitedupside potential. Downside risk islimited to the option premium.

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Price PriceStrikeStrike

Loss Loss

Profit Profit

00

P r e m i u m

P r e m i u m

½ A short call position has upside

potential limited to the optionpremium. Downside risk is unlimited.

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Price Price

StrikeStrike

Loss Loss

Profit Profit

00

P r e m i u m

P r e m i u m

½ A long put position has upside

potential limited because an asset pricecannot fall below zero. Downside risk islimited to the option premium.

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Price Price

StrikeStrike

Loss Loss

Profit Profit

00

P r e m i u m

P r e m i u m

½ A short put position has upsidepotential limited to the optionpremium. Downside risk is limitedbecause an asset price cannot fallbelow zero.

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In, At- and Out-of-the-MoneyIn, At- and Out-of-the-Money½ The type of option and the relationship between the spotThe type of option and the relationship between the spot

price of the underlying asset and the strike price of theprice of the underlying asset and the strike price of theoption determine whether an option is in-the-money, at-option determine whether an option is in-the-money, at-the-money or out-of-the-money.the-money or out-of-the-money.

½ Exercising an in-the-money call or in-the-money put willExercising an in-the-money call or in-the-money put willresult in a payoff. Neither a call nor put that is at-the-result in a payoff. Neither a call nor put that is at-the-money will produce a payoff.money will produce a payoff.

Call Option Put Option

In-the-Money Spot > Strike Spot < StrikeAt-the-Money Spot = Strike Spot = Strike

Out-of-the-Money Spot < Strike Spot > Strike

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COMPARISONCOMPARISONFORWARD CONTRACTSFORWARD CONTRACTS

No outlay of funds until maturity date No outlay of funds until maturity date

Fixes in advance the amount payable/Fixes in advance the amount payable/receivable, facilitating costing exercisesreceivable, facilitating costing exercises

Once a forward contract is booked, theOnce a forward contract is booked, thecustomer is locked into a rate and cannotcustomer is locked into a rate and cannot

benefit from a favourable movement in the benefit from a favourable movement in theunderlying currency thereafter.underlying currency thereafter.

CURRENCY OPTIONSCURRENCY OPTIONS

Premium is payable on the second businessPremium is payable on the second businessday after the day on which the option isday after the day on which the option isgrantedgranted

Since the customer has the right and notSince the customer has the right and notobligation to purchase/sell at the strike price,obligation to purchase/sell at the strike price,

only the worst amount payable/receivable isonly the worst amount payable/receivable isknown in advance.known in advance.

While protection against downside risk isWhile protection against downside risk isobtained, the customer can benefit to anobtained, the customer can benefit to anunlimited extent from any favourableunlimited extent from any favourable

movement in the underlying currency.movement in the underlying currency.

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COMPARISONCOMPARISON

FORWARD CONTRACTSFORWARD CONTRACTS

When a forward contract is booked,When a forward contract is booked,foreign exchange lines are blocked untilforeign exchange lines are blocked untilmaturity date.maturity date.

Should the underlying transaction notShould the underlying transaction notmaterialise, closing out of the outstandingmaterialise, closing out of the outstandingforward contract could entail lossesforward contract could entail losses

CURRENCY OPTIONSCURRENCY OPTIONS

Through management of CurrencyThrough management of CurrencyOptions, the customer can generateOptions, the customer can generateadditional profit in certainadditional profit in certaincircumstancescircumstances

If customer buys option, no credit linesIf customer buys option, no credit linesare required (after receipt of premium).are required (after receipt of premium).Credit lines required if customer sellsCredit lines required if customer sellsoption.option.

The loss is limited to the premiumThe loss is limited to the premium paid. paid.

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