DRM Chapter 5

Derivatives and Risk ManagementBy Rajiv SrivastavaCopyright © Oxford University Press

• Foreign Exchange Preliminaries• Currency Forwards• Non – Deliverable Forward (NDF)• Currency Futures

Chapter 5 Currency Forwards and Futures

Derivatives and Risk ManagementBy Rajiv Srivastava 2

Copyright © Oxford University Press

Globalization

Globalization of business has made financial decisions complex as the framework for decision making is not confined to single/domestic currency, and instead involves wider understanding of global markets, economic conditions, and Understand behaviour of exchange rates.




Foreign Exchange Risk

MNCs dealing in currencies other than domestic face additional risk of exchange rate and need to understand nuances of foreign exchange markets.

Despite foreign exchange markets being OTC the prices behave much in the same way as stocks. Information gathering and negotiation skills become predominant.




Foreign Exchange Rates Foreign exchange rates are always a two-way

quote, one for buying foreign currency – the bid rate, and other for selling – the ask rate.

The difference between ask and bid rate is the profit for the bank, called spread. It is the amount of money that bank would earn in buying one unit of foreign currency and selling it.



x100Rate Mid

Rate Bid-Rate Ask=Spread %


Forward Rate

Forward contracts in foreign exchange, like any other forward contract, fix the exchange rate today for settlement at some future date.

Foreign currency at premium/discount means that forward rate is higher/lower than the spot rate (when quoted under direct rate convention).



x100months) (in Period Forward

12x

Rate SpotRate Spot-Rate Forward

=

scount(%)Premium/Di Forward Annualised

mid

midmid


Forward Premium/Discount Consider following rates of foreign exchange for euro

Spot (Rs per €) 57.90 58.101-month Forward (Rs per €) 57.50 57.80Calculate the annualised premium or discount for euro.



-7.24%=x12x10058.00

58.00-57.65

x100months) (in Period Forward

12xRate Spot

Rate Spot-Rate Forward=

scount(%)Premium/Di Forward Annualised

mid

midmid

=


Forward Contract

Forward contracts are settled at a later date but at the rates negotiated in advance. These rates are usually available in advance for whole number of months.

Forward contract provide hedge against foreign exchange risk which importers and exporters face alike.

Importers fear depreciation of local currency while exporters detest appreciation of local currency.




Swap Transaction

A swap transaction consists of two legs, usually one spot and another forward. The contracts are equal in size but opposite to one another i.e. A spot buy followed by forward sell, or A spot sell followed by forward buy.

It is a composite transaction that is equivalent to two independent contracts - one spot and another forward on “outright” basis.




Swap Transaction

A swap transaction is cheaper than the equivalent combination of spot and “outright” forward contracts.

Banks usually enter a swap transaction amongst themselves while with its customers the banks enter forward contract on “outright” basis.




Option Forwards Forward contracts are fixed date contracts.

They have to be honoured irrespective whether underlying transaction matures or not.

Option forward contracts provide a time window called option period (a range of dates) during which the commitments under forward contracts can be fulfilled.

Option forwards are expensive but provide flexibility to merchants because they do not know exact timing but have only approximate idea of timing of receipt/payment of foreign currency.




Hedging with Forward

Currency forward is an agreement to buy or sell foreign currency in exchange of domestic currency at a specified date in future but at an exchange rate determined today.

Forward contract in foreign exchange can be used to remove the uncertainty of the exchange rates in future by buying and selling them now.

Forward contract freezes the cash flow in local currency.




Hedging Receivable Exporters can sell foreign currency forward at a

price determined today eliminating risk of fall in the value of the asset due to decline in exchange rate.

1. Asset in foreign currency is created at t = 0 maturing at time t = T

2. Compare the expected spot rate at T, ST with the forward rate, F

3. If ST < F, sell forward4. At t = T deliver foreign currency and receive local

currency at fixed rate, F




Hedging Payable Importer can book a forward contract to buy the

foreign currency at a price determined today eliminating risk of rise in the value of the liability due to increase in exchange rate.1. Liability in foreign currency is created at t = 0

maturing at time t = T2. Compare the expected spot rate at T, ST with the

forward rate, F3. If ST > F sell forward4. At t = T deliver local currency and receive foreign

currency at fixed rate, F




Features – Forward Contract

Forward contracts on currency are 1. OTC, 2. settled with delivery, 3. independent from underlying contract and 4. have counter-party risk.

Forward contract is firm price contract providing the protection from downside in return for foregoing potential for upside.




Hedging Payable - Example Ultra Films Limited has imported raw materials worth US $

2 million for which the payment is due after 3 months. Following rates are quoted by the bank:

Spot (Rs/US $) 47.00 47.453-m Forward 47.50 48.00

The firm is expecting appreciation of US dollar by more than 5% in 3 months time. 1. Should it hedge its payable?2. What rate would be paid by it if it decides to hedge?3. What would be the gain or loss if the actual spot rates after 3

months turn out to be i) Rs 46.50 – 47.00 ii) Rs 49.30 – 49.85?




Hedging Payable - Example1. The forward rates indicate an appreciation of dollar of 1%

in 3 months time while the firm expects 5%. It should go hedge to save about 4% by buying US dollar forward.

2. Firm buys $ 2 million at forward ask rate of Rs 48.00.3. If the spot rates at the end of 3 months were 46.50 –

47.00 the firm would fulfil its requirement at Rs 47.00. As compared to forward the firm loses Rs 2 m (Rs 20 lacs).

If the spot rates at the end of 3 months were 49.30 –49.85 the firm would fulfil its requirement at Rs 49.85. As compared to forward the firm gains Rs 1.85 x 2 million = Rs 3.70 million (Rs 37 lacs).




Cost of Forward Hedge

Cost of the forward hedge is judged by the premium/ discount of forward rates over spot rates

Cost of hedging = Premium or Discount (+/-)= (F1 – S0)/S0

Real cost of forward hedge = (F1 – S1)/S0




Speculation with Forwards Forward contracts can be used for speculation in

the currency exchange rate markets by holding a view contrary to the market and taking a position.

Unlike hedging, where one has exposure in the underlying, there exists no physical position.

Speculation is executed as below If currency is expected to appreciate more than the

forward premium buy forward now and sell later/spot. If currency is expected to appreciate less than the

forward premium sell forward now and buy later/spot.




Arbitrage with Forward Different currency exchange rates by different

banks for a currency also may provide arbitrage opportunities.

It is difficult to execute the arbitrage with forwards because forward rates are not publicly available, forwards being an OTC product. Also arbitrage is not possible because of the spread of the bid and ask rates.

However, arbitrage argument places limits on the forward bid and ask rates.




Determining Forward Rates Arbitrage argument is used in finding the

a) lower bound for the ask rate, and b) upper bound for the bid rate.

Consider the following spot rates and interest rates:

Spot rate (Rs/€) 60.00 61.00Interest rate Rs: 8.00% 8.50%

€: 5.00% 5.50%Find out a) lower bound to 6-m forward ask rate.

b) upper bound to 6-m forward bid rate.




Determining Forward Ratesa) To find lower bound on the ask rate, we do as

follows:1. Borrow foreign currency € 1.00 at 5.50% for 6

months Amount to repay = € 1.02752. Convert to rupees at spot bid and get Rs 60.003. Invest for 6 months at 8% and get Rs 1.04 x 60 = Rs

62.40 at maturity4. Sell at forward ask rate Fa to get € 62.40/Fa

5. For no arbitrage we must have 62.40/Fa ≤ 1.0275Or Fa ≥ Rs 60.7299




Determining Forward Ratesb) To find upper bound on the bid rate we do as

follows:1. Borrow local currency Rs 1.00 at 8.50% for 6 months

Amount to repay = Rs 1.04252. Convert to euro at spot ask, get € 1/61.00 = € 0.01643. Invest for 6 months at 5% and get € 1.025 x 1/61

= € 0.0168 at maturity4. Sell at forward bid rate Fb to get = Fb x 0.01685. For no arbitrage we must have Fb x 0.0168 ≤ 1.0425

Or Fb ≤ Rs 62.0415




• Evolution & Growth• Features of NDFs• How NDF works• NDF and Interest Rate Parity• Desirability of NDF




Non-Deliverable Forward

Governments of some nations exercise capital controls in order to prevent volatility in the exchange rates of their currencies or for any other political or economic reason.

Non-Deliverable Forwards (NDFs) are forward contracts normally entered off-shore and cash settled for currencies that have capital control.




Evolution of NDF

NDFs evolved in 70s when Australian dollar was subjected to capital restrictions. NDFs began trading obviating the requirement of delivery and yet providing effective hedging.

NDF market primarily consist of 6 Asian currencies namely Chinese renminbi, Indian rupee, Korean won, Indonesian rupiah, Philippine peso and Taiwanese dollar, all of which have capital controls in varying degree.




Features of NDF

NDFs provide much needed liquidity and depth to non convertible currencies

NDF rates are considered better because they are market determined away from controls and regulations.

Most NDFs are cash settled in US dollars on a notional principal amount.




How NDF Works

NDF works in the same manner as a deliverable forward contract from the perspective of hedging.

The settlement of NDF is done in foreign currency in cash with the difference of the forward price and settlement price over a notional principal as follows:Settlement Amount =(1 - Forward rate/Settlement Rate) x Notional Principal




NDF and IRP Interest rate parity (IRP) links the forward price to the

spot as follows:

Capital account controls restrict lending and borrowing off-shore distorting the IRP. Therefore forward premium/discount in local market may not reflect truly the interest rate differential.

The rate of NDF would imply an interest rate differential that is not same as the differential reflected in the deliverable forward markets on-shore.

Since NDF is not subject to capital controls the validity of IRP tends to be greater.



nf

nh

0n )r1()r1(SF

+

+=


Desirability of NDF

It is believed that NDF market 1. facilitates smoother transition of an economy

from controlled regime to full convertibility, as they serve as intermediate bridge for the interim period

2. provide skills and expertise developed in the NDF markets to be adapted in the deliverable forward market as and when capital controls are lifted or full convertibility of the currency achieved.




• Contract Specifications• Pricing• Hedging with Currency Futures• Speculation with Currency Futures• Arbitrage with Currency Futures




Futures Contract

Currency futures are the derivatives based on the exchange rate that are exchange traded and are a substitute to forward contracts.

Futures on currencies like any other futures contracts, are standardized in terms of 1. Size, 2. Delivery, 3. Tick size, 4. Settlement, etc




Currency Futures at MCX




Pricing Currency Futures

Price of currency forward depends upon the spot price and the interest rate differential of the interest rates in two currencies.

Price of the forward/futures contract is also equal to spot value + cost of carry.

Interest rate differential reflects the net cost of carry.

IRP and cost of carry model would lead to the same conclusion.




Currency Futures – Fair Value Today is December 12 and January futures would expire on 28 Jan.

Spot rate in the exchange market for dollar is Rs 45.45. The yields in the T-bills markets of India and USA are 5.90% and 2.45% respectively.

1. At what price Jan futures would be traded?2. What would be the price of Feb futures if its expiry is on 24

Feb.?

Here S0 = 45.45, rd = 5.90%, rf = 2.45% and t = 57 days (From 12 Dec to 28 Jan). The fair value of futures is Rs 45.6991 given by For Feb futures the time to expiry is 57 + 27 = 84 days. The price of Feb futures = Rs 45.8176



650.024)57/3-(0.059)tr-(r01 e x 45.54e x S=F fd =

650.024)84/3-(0.059)tr-(r e x .4e x 0S=1Ffd 455=


Hedging – Currency Futures

We use the same principle of taking position in the futures market opposite to that of physical market. Later we enter in to another futures contract offsetting the initial contract.

The final price in the hedge through futures depends upon the prices at the time of

1. Initiating the futures contract, 2. Cancellation of futures contract, and 3. Spot price at the end.




Importer’s Hedge

An importer fears appreciation of foreign currency (depreciation of local currency).1. An importer is short on foreign currency. 2. To hedge against appreciating foreign currency

he goes long on the futures contract.3. It is called the Long Hedge.




Importer’s Hedge - Example In June 2008 an Indian importer buys a machine

at US $ 50,000. Payment is due after 6 months in December 2008.

The spot exchange rate is Rs 45.5625 while Dec. Futures is trading at Rs 46.6500 indicating an appreciation of dollar by 2.4% in 6 months.

The importer feels that dollar will appreciate much more. What shall he do?

Assume futures contract in rupee is available for US $ 1,000.




Importer’s Hedge - ExampleHedging Strategy: As hedging strategy the importer buys the futures

contract now selling at Rs 46.6500 and sells close to delivery date before December.

Nos. of contracts bought = Exposure amount/Value of 1 contract = 50,000/1,000 = 50

Having bought 50 futures the importer would cancel the position in the futures by selling the futures at a date close to the actual date of payment in December.




Lifting the Hedge - Importer When US $ appreciates to Rs 47.5600 and futures

sells for Rs 47.5700The importer exits the futures contract at Rs 47.5700 and buys the foreign currency in the spot market at spot rate. 1. Cost = 50,000 x 47.5600 = Rs 23,78,0002. Sells 50 future contracts booked earlier at Rs 47.5700;3. Net gain on futures (47.5700 – 46.6500) x 50,000 = Rs 46,000 4. Net rupee amount paid = Rs 23,32,0005. Effective exchange rate (23,32,000/50,000) = Rs 46.6400

As against spot price of Rs 47.5600 the importer ends up buying dollar at Rs 46.6400.




Lifting the Hedge - Importer When US $ depreciates to Rs 44.5625 and futures

sells for Rs 44.5700The importer exits the futures contract at Rs 44.5700 and buys the foreign currency in the spot market at spot rate. 1. Cost = 50,000 x 44.5625 = Rs 22,28,1252. Sells 50 future contracts booked earlier at Rs 47.5700;3. Net loss on futures (46.6500 - 47.5700) x 50,000 = Rs 1,04,000 4. Net rupee amount paid = Rs 23,32,1255. Effective exchange rate (23,32,125/50,000) = Rs 46.6425

As against spot price of Rs 44.5625 the importer ends up buying dollar at Rs 46.6425.




Exporter’s Hedge

An exporter fears depreciation of foreign currency (appreciation of local currency).1. An exporter is long on foreign currency. 2. To hedge against depreciating foreign currency

he goes short on the futures contract.3. It is called the Short Hedge.4. At maturity the short position in futures is

nullified by buying the futures contract.Short hedge for exporter can be executed in the similar manner as that of Long Hedge for importer.




Speculation with Currency Futures We may speculate with currency futures if

investor does not agree with the premium or the discount at which the futures trades.

We buy futures first and sell later If foreign currency is expected to a) appreciate

more than the premium, or b) depreciate less than the discount at which futures trades.

We sell the futures first and buy later If foreign currency is expected to a) appreciate

less than the premium, or b) depreciate more than the discount at which futures trades.




Arbitrage with Currency FuturesWhen future is overpriced Actions Now

1. Borrow local currency for period of futures maturity2. Convert to foreign currency using spot market3. Invest in foreign currency for the period of futures4. Sell futures equal to the matured foreign currency

investment At maturity of futures

1. Deliver foreign currency against the futures sold2. Receive local currency against the futures sold3. Pay for the borrowed local currency




Arbitrage with Currency Futures

When future is underpriced Actions Now

1. Borrow foreign currency for period of futures maturity2. Convert to local currency using spot market3. Invest in local currency for the period of futures4. Buy futures equal to the matured local currency

investment

At maturity of futures1. Deliver local currency against the futures sold2. Receive foreign currency against the futures bought3. Pay for the borrowed foreign currency




Example - Arbitrage Following data from financial markets is

available1. Spot exchange rate (Rs/$) 49.50002. 180-day futures 50.40003. Rupee interest rate (T-bill yield) 10%4. Dollar interest rate (T-bill yield) 5%

The fair price of 6-m futures is Rs 50.6912. Is there any arbitrage opportunity? If yes how the arbitrage can be executed?




Example - Arbitrage Actual future trading at Rs 50.40 as against its fair price of Rs

50.69, is underpriced. Now $ Rs

Borrow US dollar 1,000.00 -Convert to rupee in spot -1,000.00 49,500.00Invest rupee at 10% for 6 m - 49,500.00Buy dollar futures maturing after 180 days for Rs 51,941Cash flow Now 0.00 0.00At maturityReceive invested rupee 51,941.00Deliver rupee against futures -51,941.00Receive dollars against futures (51,941/50.40) 1,030.58Pay dollar borrowed at 5% -1,024.66Cash flow 5.92 -

At the maturity of the futures contract the arbitrageur can make a profit of $ 5.92 for every $ 1,000 borrowed.




Documents

DRM Chapter 5