117398767 Currency Derivatives

7/29/2019 117398767 Currency Derivatives

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CURRENCY DERIVATIVESAND HEDGING


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INTRODUCTION TO CURRENCYMARKETS

Foreign exchange rate is the value of a foreigncurrency relative to domestic currency.

The exchange of currencies is done in the foreignexchange market.

The participants of the market are banks,corporations, exporters, importers etc.

The foreign exchange contract typically statesthe currency pair, the amount of contract, theagreed rate of exchange etc.


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EXCHANGE RATE

A foreign exchange deal is always done incurrency pairs, for example US Dollar- IndianRupee (USD-INR), Japanese Yen- US Dollar

(JPY-USD). In a currency pair, the first currency is referred

to as the base currency and the second isreferred to as the counter/terms/quotecurrency.

The exchange rate tells the worth of the basecurrency in terms of the terms currency.


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For example, a USD-INR rate of Rs. 48.0530implies that Rs. 48.0530 must be paid to

obtain one US Dollar. Foreign exchange rates are highly volatile and

fluctuate on a real time basis.

A change of USD-INR from 48 to 48.50 impliesthat USD has strengthened/ appreciated andINR has weakened/ depreciated, since a buyer

of USD will now have to pay more INR to buy1 USD than before.


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METHODS TO DETERMINE VALUE OF DOMESTICCURRENCY VIS--VIS OTHER CURRENCIES

FIXED EXCHANGE RATE REGIME OR PEGGEDEXCHANGE RATE, is when a currencys value is

maintained at a fixed ratio to the value ofanother currency or to a basket of currenciesor to any other measure of value e.g. gold.


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In order to maintain fixed exchange rate, a

government participates in open currencymarket.

Another method of maintaining a fixedexchange rate is by making it illegal to tradecurrency at any other rate.

However, this is difficult to enforce and oftenleads to a black market in foreign currency.


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FLOATING RATE REGIME

It is determined by a market mechanismthrough supply and demand for the currency.

Also termed self-correcting, as anyfluctuation in the value caused by differencesin supply and demand will automatically becorrected by the market.


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FACTORS AFFECTING EXCHANGE RATES

FUNDAMENTAL FACTORS

TECHNICAL FACTORS Interest rate

Inflation rate

Exchange rate policy and Central Bank interventions

POLITICAL FACTORS

SPECULATIVE FACTORS


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QUOTES

In currency markets, the rates are generallyquotes in terms of USD.

The price of currency in terms of anothercurrency is called a quote.

A quote where USD is the base currency isreferred to as a direct quote(e.g.1 USD = INR

48.5000) while a quote where USD is referredto as the terms currency is an indirect quote

(e.g. 1 INR=0.021 USD)


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TICK-SIZE Refers to the minimum price differential at which

traders can enter bids and offers.

For example, the Currency Futures contractstraded at NSE have a tick size of Rs.0.0025.

So, if the prevailing futures price is Rs.48.5000,the minimum permissible price movement cancause the new price to be either Rs.48.4975 or

Rs.48.5025. Tick value refers to the amount of money that is

made or lost in a contract with each pricemovement.


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SPREADS

Dealers margin or spread is the difference

between bid price (the price at which a dealer iswilling to buy a foreign currency) and ask price

(the price at which a dealer is willing to sell aforeign currency).

The quote of bid will be lower than ask, which

means the amount to be paid in counter currencyto acquire a base currency will be higher than theamount of counter currency that one can receiveby selling a base currency.


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SPOT TRANSACTION

Spot market transaction does not implyimmediate exchange of currency, rather thesettlement takes place on a value date, which is

usually two business days after the trade date. The price at which deal takes place is known as

the spot rate.

The two- day settlement period allows the partiesto confirm the transaction and arrange paymentto each other.


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FORWARD TRANSACTION

It is a currency transaction wherein actualsettlement date is at a specified future date,which is more than two working days after the

deal date. The date of settlement and the rate of

exchange is specified in the contract.


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CURRENCY DERIVATIVE

Contract between the seller and buyer whosevalue is derived from the underlying which isin this case is the Exchange rate.

Designed for hedging purpose.

Also used as instruments for speculation.

Market participant may enter into a spottransaction and exchange the currency at afuture date.


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FORWARD CONTRACT

Agreement to exchange currencies at anagreed rate on a specified future date.

Actual settlement is more than 2 working daysafter the deal date.

Agreed rate is forward rate and the differencebetween the spot rate and forward rate is

called forward margin.


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FUTURE CONTRACT

Contracts to buy or sell a specific underlyingcurrency at a specific time in the future, for aspecific price.

Currency futures are exchange-tradedcontracts and they are standardized in termsof delivery date, amount and contract terms.

Currency future contracts allow investors tohedge against foreign exchange risk.


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PRICING OF FUTURE CONTRACT

According to Interest Rate Parity Theory, thecurrency margin dependent mainly onprevailing interest rate (for investment for

given period of time) in the two currencies.


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Forward rate can be calculated by:

F / S = 1+Rh / 1+Rf

Where:F and S = Future and Spot Currency rate.

R h and R f = simple interest rate in the home andforeign currency.

If Continuously Compounded interest rate:

F = S * e ( r h r

f)* T

Where:

r h and r f= continuously compounded interest ratefor the home currency and foreign currency.

T = time to maturity


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STRATEGIES USING CURRENCY

FUTURE

The party taking a long(buy) position agree tobuy the base currency at the future rate bypaying the term currency.

The party with a short (sell) position agree tosell the base currency and receive the termscurrency at the pre specified exchange rate.


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K

Profit for the long party

and loss for the short

party

Spot rate of USD-INRexchange rate onsettlement date

Profit

Loss

Profit for the shortparty and loss for thelong party


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HEDGING USING CURRENCY FUTURE

SHORT HEDGE:

Involve taking a short position in the futuremarket.

In a currency market, short hedge is taken bysomeone who already know the base currencyor is expecting a future receipt of the base

currency.


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Example:An exporter is expecting a payment of USD 1,000,000 after

3 months. Suppose the spot exchange rate is INR 48.000:1 USD

If USD strengthens and the exchange rate becomes INR49.000: 1 USD.

Spot Market

EXP will get INR 49,000,000 by selling 1 million USD in thespot market.

Future Market

EXP will lose INR ( 48-49)*1000 = INR 1000 per contract.The total loss in 1000 contract will be INR 1,000,000.

Net Receipt in INR

49 million 1 million = 48 million


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If USD weakens and the exchange ratebecomes INR 47.000 : 1 USD

Spot Market

EXP will get INR 47,000,000 by selling 1 millionUSD In the spot market.

Future marketEXP will gain INR (48-47)*1000 = INR 1000 per

contract. The total gain in 1000 contract will

be INR 1,000,0000.Net Receipt in INR

47 million + 1 million = 48 million


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LONG HEDGE:

Involve holding a long position in the futuremarket.

A long position holder agree to buy the base

currency at the expiry date by paying theagreed exchange rate.

This strategy is used by those who will need to

acquire base currency in the future to pay anyliability in the future.


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EXAMPLE:An importer ordered computer hardware from abroad

and has to make a payment of USD 1,000,000 after 3

months. Suppose the spot exchange rate is INR 48.000: 1USD

If USD strengthens and the exchange rate becomesINR 49.000: 1 USD

Spot MarketIMP has to pay more i.e. INR 49,000,000 for buying 1million USD in the spot market.

Future Market

IMP will gain INR ( 49-48)*1000 = 1000 per contract.The total profit in 1000 contract will be INR1,000,000.

Net Payment in INR

-49 million + 1 million = 48 million


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If USD weakens and the exchange ratebecomes INR 47.000 : 1 USD

Spot Market

IMP will have to pay less i.e. 47,000,000 foracquiring 1 million USD in the spot market.

Future Market

IMP will lose INR ( 48-47)*1000 = INR 1000 percontract. The total loss in 1000 contract will be

INR 1,000,000.Net Payment in INR

-47 million 1 million = 48 million.


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117398767 Currency Derivatives

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