Unit-IV: Currency Risk Management

By:

Dr. A.K.Singh

Management of Currency Risk

Using

• currency forwards,

• currency futures,

• currency options and

• currency swaps.

3

FORWARD CONTRACTS

• A forward contract is customised contract between two entities where settlement takes place on a specific date in the future at today’s pre agreed price

• Two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity

• No money changes hands

4

LIMITATIONS OF FORWARD CONTRACTS

• Private Bilateral agreement, Involves Counter Party Risk

• Cannot take Reverse Position, Lack of Liquidity

• Lack of Standardization

These limitations can be overcome by use of Future Contracts

5

Futures Contracts

• A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. These are special types of forward contracts in the sense that the former are standardised exchange- traded contracts.

• Traded over an Exchange

• Standardized Forward Contract

• Contract to buy or sell a specified asset at a specified price on a specific date

6

COMPARISON OF FORWARDS AND FUTURES

BASIS FORWARDS FUTURES

Standardization Non standardized

products

Standardized

Liquidity No liquidity Highly liquid

Risk Risk of non

performance

No such risk

Margin Money Nil Paid to clearing

corporation

P & L Settlement At the time of

maturity

Daily cash

settlement

Governing Body RBI & SEBI Parties involved in

contract

7

OPTIONS CONTRACTS

• Options may be defined as a contract, between two parties whereby one party obtains the right, but not the obligation, to buy or sell a particular asset, at a specified price, on or before a specified date

• Give the buyer the right but not the obligation to buy/sell a specified underlying asset

• At a set price • On or before a specified period • One who receives the right is the Option

buyer/holder • One who is obliged to perform the contract is the

Option seller/writer

8

COMPARISON OF FUTURES AND OPTIONS

BASIS FUTURES OPTIONS

Obligatory Obligatory on both

the parties

Not obligatory for

the buyer/holder

Premium No premium paid Buyer pays

premium to seller

Risk – Return

Exposure

Buyer exposed to

entire downside

risk and potential

for upside returns

Downside risk

limited for buyer

but infinite

potentials for

upside returns

Performance of

the contract

Obligatory to

perform on the

expiry date

Can be on or before

the maturity date

depending upon

whether option is

american or

european

Currency Futures • A transferable standard contract in which two

parties commit to buy or sell a specified amount of currency at a specified exchange rate on future date or maturity date.

• Specific exchange rate may be different from

current exchange rate because specific exchange rate is decided by negotiation between the parties before the contract while the current exchange rate is the instant exchange value of currency determined by the market demand and supply forces.

Examples of Foreign exchange markets for trade in Currency Futures Contract

• Intercontinental Exchange (ICE Future Europe)

• NYSE (New York Stock exchange) Euronext

• Tokyo stock exchange (TSE)

• Dubai Mercantile exchange (DME)

• International Monetary Market (IMM)

• Singapore International Monetary Exchnage (SIMX)

Importance of Currency Futures Contract

• Easy Accessibility

• High liquidity

• International exposure to investors

• Management of credit risk and exposure associated with assets involved in futures contract

• Reduced chances of money laundering and market risk because only registered members can trade.

Limitations

• Highly volatile

• Subject to market risk

• Focus on large scale organization only

Currency Futures - Example

Mr. X purchases $1000 at Rs 62/$ (on 1st April, 2014) in 3- months futures market and the due date of contract is 30 June, 2014. Now, as per the terms of the contract, irrespective of actual relationship between Rupee and dollar on 30th June,2014, Mr. X would get $ 1000 at Rs 62/$. If the actual price of a dollar on 30th June,2014 is Rs 65, Mr. X would make gain of Rs 3000. However, if the actual price of a dollar happens to be Rs 60/$ , Mr. X would be having loss of Rs 2000.

Illustration

A software company in India expects to get $10000 three months from now. The prevailing price of dollar in terms of rupees in the currency market is Rs 61/$. It is being anticipated that rupee will get strengthen against dollar and the relationship between is expected to be Rs 59/$. Explain the impact on the earning of the company and advise suitable strategy to protect fall in earning of the company.

Illustration

In case the actual price of dollar happens to be Rs 59 at the time of receipt of dollar, the company would suffer forex loss of Rs (61 – 59) x 10000 = Rs 20,000.

In order to protect itself from this loss, the company shall sell $ 10,000 in the 3 months futures market at a current price of Rs 61. The company would be required to make delivery of dollars after three months which will be made through the receipt of payment due to the company.

Currency Futures

• Futures are traded on organised future exchange.

• It helps in price discovery process.

• M to M (i.e., mark to market): daily M to M to avoid credit risk.

• Initial Margin.

An Indian importer will be paying USD 40,000 on May 30th, 2015, since the

payment of USD will be after 3-months the importer is facing transaction exposure

for USD against INR. He wanted to do future contract for USD against INR. The

spot exchange rate as on 1st March is Rs. 50.6680 in USD and future which will be

delivered on 30th May, 2015 is trading at Rs. 53.6685. How many contracts the

importer would buy to immune the position and also what is the pay off? If the

May future contract are traded at Rs. 53.6825 and on May 30th the spot exchange

rate is Rs. 53.6800/$. The Rupee Future has contract size of $1,000.

Question

1st March, 2015

Spot Rate Rs. 53.6680/$

3 months future rate Rs. 53.6685/$

30th May, 2015

Spot Rate Rs. 53.6800/$

Payment Amount (F + O) $40,000

If not hedge, the transaction exposure is

= Rs. 53.6680 – Rs. 53.6800

= Rs. 0.012

Total = Rs. 480

Size of contract = $1,000

Number of contract need to purchase = $40,000/$1,000 = 40 (Future Contract)

As on March 1st

3 months future contract = Rs. 53.6685/$

As on May 30th, prize of 30th may future is Rs. 53.6825/$

So, the gain on future contract is Rs. 560 and net gain is Rs. 80.

Note: Gain on future contract = $40,000 (Rs.53.6825 – Rs. 53.6685) = Rs. 560`

Currency Options

• Financial derivatives in which buyer of the option contract gets the right but no obligation to exchange one type of currency into another at a pre-determined exchange rate on a particular date.

• In currency options, buyer usually buys the contract when the exchange rate of currency is favorable. E.g. if an indian buyer needs to buy dollars, then he would buy when the exchange rate falls and becomes cheaper. In such a situation buyer can buy more dollars for a specific amount of indian rupees.

Types of currency options market Listed currency option market- Here buyer of

contract has the privelege of either exercising the option or letting it expire. Both parties have to deposit margin money with the exchange and the options are marked to market.

Over the counter option market- here options are tailored to the clients’ needs. Instead of clearing house, commercial/investment banks write or the options for the client. It is a two-tier market; the retail market (representing non-bank customers dealing with banks) and the wholesale market (representing transaction among banks)

Example

Q: A Pound option call contract has strike price of $1.820/£ and a premium of $0.08. Spot price on maturity is $1.920.Find gain / loss to option buyer/option seller.

Ans: Option buyer will exercise the option.

Gain to option buyer= $1.920-1.820-0.08 = $ 0.02/£

Total gain= $0.02* 62500= $1250

Loss to option seller= $(0.10- 0.08)*62500= $1250 NOTE: The standard size of a pound option contract = £62500.

Example( Hedging with currency options)

Q: An American importing goods from UK fears an appreciation in pound. Pound options are available at a strike price of $1.830/£ with a premium of $0.03/£. The spot rate on maturity rises to $1.930/£. How will he compensate his loss?

Ans: Importer will buy a call and sell a put.

Gain from call= 1.930-1.830-0.03= $0.07/£ (exercise call)

Gain from put= $0.03/£ (not exercise put)

Total amount of risk reduced= $0.10/£ = $0.10*62500= $ 6250

Swaps

A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price.

Currency Swap

• Involves exchange of currency.

• Two currencies are exchanged in the beginning and again at maturity the two currencies are reexchanged.

• The exchange of currencies is necessitated by the fact that one counter party is able to borrow a particular currency at a lower interest rate than the other counter-party is able to borrow.

Swaps - Example Consider the following case Three Parties involved:

Company A ( Low rating) Company B ( High rating A Bank (AA rated)

Starting Positions: Company A has low credit rating and wants to raise long term funds which are available at high cost. Company B has good crediting rating have easy access to long term funds at lower cost but requires short term funds.

Swaps - Example Borrowing costs before swap (%):

Fixed Rate Floating Rate Company A 10.00 LIBOR + .80 Company B 8.85 LIBOR + .30 Difference 1.15 .50 Comparative advantage = ( 1.15 – 0.50) = 0.65 Company B enjoys a lower borrowing cost in both markets. But, Company A has relatively lower costs in floating rate mkt. The differences in cost (under fixed rate and floating rate) is a comparative advantage of 65 basis point (115 - 50). This 65 basis point comp. Advantage is the amount of potential savings from the swap.

Swaps - Example Process of Swap in this case

Company A will borrow at LIBOR + 0.80 and lend to B at LIBOR .This will help in gain of 0.30 to B ( otherwise B would have directly borrowed at LIBOR + 0.30) and loss of 0.80 to A ( since A has borrowed at LIBOR+0.80 and lended at LIBOR)

Company B will borrow at 8.85 and lend to A at 9% . This will help in saving of 1% to A and gain of 0.15 to B.

Total gain of B = 0.30 + 0.15 = 0.45 Total gain of A = 1.00 – 0.80 = 0.20

Thus , both the parties have been able to gain due to this transaction

Steps in Currency swap The currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated.

Ctd…… For example, Company C, a U.S. firm, and Company D, a European firm, enter into a five-year currency swap for $50 million. Let's assume the exchange rate at the time is $1.25 per euro (e.g. the dollar is worth 0.80 euro). First, the firms will exchange principals. So, Company C pays $50 million, and Company D pays 40 million euros. This satisfies each company's need for funds denominated in another currency (which is the reason for the swap).

Ctd…… Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their respective principal amounts. To keep things simple, let's say they make these payments annually, beginning one year from the exchange of principal. Because Company C has borrowed euros, it must pay interest in euros based on a euro interest rate. Likewise, Company D, which borrowed dollars, will pay interest in dollars, based on a dollar interest rate. For this example, let's say the agreed-upon dollar-denominated interest rate is 8.25%, and the euro-denominated interest rate is 3.5%. Thus, each year, Company C pays 40,000,000 euros * 3.50% = 1,400,000 euros to Company D. Company D will pay Company C $50,000,000 * 8.25% = $4,125,000.

Ctd….. As with interest rate swaps, the parties will actually net the payments against each other at the then-prevailing exchange rate. If, at the one-year mark, the exchange rate is $1.40 per euro, then Company C's payment equals $1,960,000, and Company D's payment would be $4,125,000. In practice, Company D would pay the net difference of $2,165,000 ($4,125,000 - $1,960,000) to Company C.

Finally, at the end of the swap (usually also the date of the final interest payment), the parties re-exchange the original principal amounts. These principal payments are unaffected by exchange rates at the time.

Benefits of swap The motivations for using swap contracts: commercial needs

and comparative advantage.

The normal business operations lead to certain types of interest rate or currency exposures that swaps can alleviate. For example, consider a bank, which pays a floating rate of interest on deposits (e.g. liabilities) and earns a fixed rate of interest on loans (e.g. assets). This mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floating-rate assets, which would match up with its floating rate liabilities.

Some companies have a comparative advantage in acquiring certain types of financing. For example, consider a well-known U.S. firm that wants to expand its operations into Europe, where it is less known. It will likely receive more favorable financing terms in the U.S. By then using a currency swap, the firm ends with the euros it needs to fund its expansion.

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Hedging of risk through SWAPS

Q: A can borrow floating rate funds from dollar market at 1 year LIBOR or it can borrow fixed-rate Euro at 7%. B can borrow floating rate funds from US dollar market at LIBOR +25 b.p or can borrow fixed rate funds from Euro market at 8.25%. B needs fixed rate euro. A needs floating rate dollar.

Can the currency swap be gainful to both of them???

Ctd…..

ANS: Cost of SWAP A= 7% +LIBOR-7.50% = LIBOR-0.50% B=( LIBOR+ 0.25)+ 7.5%- LIBOR= 7.75% IF SWAP Contract not entered A= LIBOR B= 8.25% Benefit of Swap: A=Paying 0.5% less B= Paying 7.75% instead of 8.25%