Currency Risk & Derivatives

Success is how high you bounce when you hit bottom - General Patton

The foreign exchange business is by its nature risky, because it deals primarily in risk measuring it, pricing it, accepting it when appropriate, and managing it.

The success of a bank or other institution trading in the foreign exchange market depends critically on how well it assesses, prices, and manages risk, and on its ability to limit losses from particular transactions and to keep its overall exposure controlled.Exchange Risk

Exchange RiskAirbus is the worlds largest plane makerThe global market is $60 bn annually in salesAirbus like all plane maker sells its plane in $About 30 % of the Airbuss costs are in eurosThe principal handicap at airbus is one of the competitiveness due to the fact the $ has fallen vis-a-via with Gulf Opec Members worried about falling $As they sell oil in $ and imports goods and commodities from Europe$ is now at =$1.96 and = $1.3235

Forex risk is the risk that a bank or corporate may suffer losses as a result of adverse exchange rate movements during a period.

Forex or currency risk is the variance in expected cash flows from unexpected exchange rate changes.

For a bank the risk may arise on account of an open position either in spot or forward.

For a firm, the risk may arise from outstanding financial obligations, changes in expected future cash flows.

Forex Risk

Exposure is a measure of the sensitivity of the value of a performance measure to changes in the relevant risk factor i.e.

Exposure is measured by the value of the assets and liabilities or transaction denominated in Forex

Exposure arises because the enterprise denominates transactions in Fx or it operates in a foreign market

Forex Exposure

Types of Exposures

Derivatives are financial contracts which provide hedge against a particular type of risk.

The risk may be exchange rate risk, credit risk, interest rate risk etc.

A derivative is a financial instrument whose value depends on the value of another asset / instrument called underlying ( basic ) variable.

Derivatives are also known as contingent claims.

Derivatives - What are They?

The commonly used derivatives are

Currency Forwards

Currency Options

Currency Futures

Options on Futures

Currency and Interest rate Swaps and FRADerivatives - What are They?

Forward TransactionsThe transaction in which the exchange of currencies takes place at a specified future date subsequent to the spot date is known as Forward Transaction.

The exchange rate of settlement is called as forward rate

The forward rate has two components Spot rateForward PointsCurrency Forwards

Currency Forwards Source-UTI Bank Published in ET on 12/12/2006

Bank Buys AtBank Buys AtSpreadSpot44.840044.85000.01001Mth44.900044.92000.0200Premium0.060.073Mth45.090045.12000.0300Premium0.250.276Mth45.400045.43000.0300Premium0.560.5812Mth45.870045.90000.0300Premium1.031.05

Factors Determining Forward Margin

Rate of InterestDemand and SupplySpeculation of Spot rateExchange Regulations

Currency Forwards

A currency options arrangement between an option holder (buyer) and an option writer (Seller)

A currency option gives the buyer the right ,but not the obligation to either buy or sell a specified quantity of one currency in exchange for another at a predetermined exchange rate known as strike price

Option holder has no obligation to exercise an option ,the writer of the option must comply with its terms and should be prepared to buy or sell the underlying currency when a holder decides to exercise an option

Currency Options

To acquire the right the buyer pays a premium to the seller

The potential loss to an option seller is unlimited while to the buyer it is limited to the premium paid.

There are Two Types of Options

Call Option Put OptionCurrency Options

Call Option The right to buy specific amount of one currency against another currency is known as call option

Put Option The right to sell specific amount of one currency against another currency is known as put option

Buyer The person who buys the right to buy or sell specified amount of currency against another currency

Seller (Writer) The person who sells the right to buy or sell specified amount of a currency against another currencyOption Terminology

Premium The amount paid by the buyer of an option to the seller is called premium

Strike Price This represents predetermined price at which the option can be exercised

Exercise Date For effecting delivery of Forex the buyer of the option must notify the seller about his decision for taking or giving delivery and this is known as exercising the option.

The date on which the option can be exercised is called as exercised date

Option Terminology

Expiration Date The last date upto which the option can be exercised

American Option An option which can be exercised at a any time between the initial deal date and the expirary date.

European Option - An option which can be exercised only at the expirary date.

Option Terminology

In the Money Option If by exercising option ,the buyer has advantage then it is called as ITM Option

Out of the Money Option If by exercising option ,the buyer has disadvantage then it is called as OTM Option

At the Money Option If by exercising option, the buyer has neither advantage nor disadvantage then it is called as OTM Option. The strike price in this case is equal to spot or future rate. This option has no Intrinsic ValueOption Terminology

Status of an optiona.In-the-moneyCall:Spot(44.95) > strike(44.88)Put:Spot (44.95)< strike(45.05)

b.Out-of-the-moneyCall:Spot (44.95)< strike(45.00)Put:Spot (44.95)> strike(44.88)

c.At-the-moneySpot = the strikeOption Terminology

Option Quotes in IndiaSource- e-Mecklai Website Last Updated on 31/10/2005

spot: 45.1325Premiums (INR/USD)Expiry1m3m6m12mstrike44.7544.7544.7545.00call0.480.600.740.80put0.060.140.220.41strike45.0045.0045.0045.25call0.300.440.580.66put0.130.220.310.51

Option Quotes in IndiaSource- e-Mecklai Website Last Updated on 31/10/2005

spot: 45.1325premiums (INR/USD)expiry1m3m6m12mATM strike45.1545.1845.2245.31Call0.210.340.460.63Put0.190.300.410.54strike45.2545.2545.2545.50call0.170.310.450.54put0.240.340.420.63strike45.5045.5045.5045.75call0.080.200.340.44put0.410.480.550.76

Contingency Graphs for Call Options

Buy call option

expect currency to appreciateexercise option if price increases beyond strike pricebuy at strike price and sell at spot rate

Sell (write) call option

expect currency to decline in valueobligated to sell a currency at a specified pricemake money if option not exercised

How to use Option

Contingency Graphs for Put Options

Authorised dealers having adequate internal control, risk monitoring/ management systems, mark to market mechanism and fulfilling the following criteria will be allowed to run an option book after obtaining a one time approval from the Reserve Bank

i. Continuous profitability for at least three yearsii. Minimum CRAR of 9 per centiii. Net NPA's at reasonable levels (not more than 5 per cent of net advances)iv. Minimum Net worth not less than Rs. 200 crores

Initially, authorized dealers can offer only plain vanilla European options.

Option in India

Chicago Becomes the Junction of Rail & Telegraph in USA. So it becomes Hub of East USA in 1840

Bumper crop of wheat in East USA. everyone rush to Chicago as Brokers, Agents were present their to distribute wheat across USA

The problem was Chicago was not having proper storage facilities, weighing equipments of standard quality, every thing has to be settled in cash.Futures Brief History

Many times farmers use to come without full quantity of wheat also brokers do not have full amount many times to settled the transaction.

Hence it is decided that transaction will be settled at a particular date in future so on particular date farmer will bring a particular quantity of wheat and broker/buyer will come with amount and deal will be settled Futures Brief History

Hedgers

Farmers, manufacturers, importers and exporters can all be hedgers.

A hedger buys or sells in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market.

This helps protect against price risks

Futures Players

Speculators

These People do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market.

These are the speculators, and they aim to profit from the very price change that hedgers are protecting themselves against.

Hedgers want to minimize their risk no matter what they're investing in, while speculators want to increase their risk and therefore maximize their profits. Futures Players

CBOT - Chicago board of Trade in 1848

CME - Chicago Mercantile Exchange

NYMEX - The New York Mercantile Exchange

LME - The London Metal Exchange

TOCOM - Tokyo Commodity Exchange

MCX - Multi Commodity Exchange (India)NCDEX - National Commodities and Derivatives Exchange Mumbai (India)NMCE - National Multi Commodities Exchange Ahmedabad (India)Future Markets

A futures contract is a form of forward contract

In that it conveys the right to purchase or sell a specified quantity of a Forex at a fixed exchange rate on a specified future date,

Whereas in a forward contract the quantum of foreign currency and the due date are determined by the customer,

Currency Futures

In futures contract may be defined as an agreement entered with into with the specified futures exchange to buy or sell a standard amount of Forex at a specified price for delivery on a specified future date

A forward contract can be entered into with any bank and hence termed an over the counter product.

A future contract can be traded only on a recognized future exchange.i.e.IMM (International Money Market) a part of CME and London International Financial Futures Exchange (LIFFE) or Euro Next

Currency Futures

Features of Currency FuturesSize of ContractGBP - 62,500Euro - 125,000CAD - 100,000JPY - 12,500,000CHF - 125,000Aus $ - 100,000Delivery Dates at CMEMarch,June,September&DecemberDeliver date is third Wednesday of respective month.The month during which a contract expires is referred to as the spot month.All trading stops two business days prior to delivery date to enable the participants deliver the currencies

Price Movement The price for the futures is quoted as so many units of US $ per unit of foreign Currency. i.e. 1 CAD = $0.8800(Incase of Fwd 1$=CAD 1.1366)

The value of the futures will be the price per unit of foreign currency multiplied by the size of the contract.

One Bought a CAD $ at a price of US $ 0.8800 The exchange may fix the minimum size of price movement called as tick .

If price changed to 0.8801 that means buyer gains 0.0001 x 100,000 = $ 10

Features of Currency Futures

Trading by members Demand supply ,Open out Cry electronically on the CME Globex trading platform

Clearing House Acts as a counter party

Margins

Mark to MarketFeatures of Currency Futures

Liquidity- The buyer of the future need not hold up till maturity.

On any intermediary date he can sell to another and wind up his position with the exchange.

Similarly a seller can enter into a purchase deal before the due date and square his position

It is the reason that future is sometimes described as a bet on the future price of the currency, rather than an obligation to buy the currency.

Most of futures contracts are not delivered on the due date, but extinguished by counter deals.

Features of Currency Futures

Price Movement

FutureQuantityAmount of tick $Value of each point change1GBP62,5000.00016.25 $2Yen12,500,0000.00000112.50 $3Euro 125,0000.000112.50 $4CHF 125,0000.000112.50 $5CAD 100,0000.000110.00 $6AUS $ 100,0000.000110.00 $

Marking The Market - Futures

Settlement PriceOpening Price 1CAD =0.90$Wed.0.8950Thurs0.8900Friday0.8975Monday0.9025Contract Value on 12/12 Tuesday 90,00089,50089,00089,75090,250MM A/C of BuyerOpening BalanceAmt Adj.for change in valueAdjusted balanceAmount Dep / (-Withdrawn)Closing Balance4,500 -500 4000 500 4500 4500 -500 4000 500 4500 4500 750 5250 -750 4500 4500 500 5000 -500 4500MM A/C of SellerOpening BalanceAmt Adj.for change in valueAdjusted balanceAmount Dep/ (-Withdrawn)Closing Balance4500 5005000-5004500 4500 500 5000 -500 4500 4500 -750 3750 750 4500 4500 -500 4000 500 4500

In Nut Shell

Fwd ContractsCurrency FuturesCurrency OptionsDelivery GenerallyLess than %Buyers Discretion. Seller must honour if buyer exercisesMaximum LengthSeveral Years12 Months3/6/9 MonthsContracted AmountAny value62500Can$100,00.etc.31,250,Can$50000.etc.Maturity DateAny DateThird Wednesday of March, June, Sept or DecFriday before 3rd Wednesday of March, June, Sept, or Dec on regular Options. Last Friday of month on end-of-month options

In Nut Shell

Fwd ContractsCurrency FuturesCurrency OptionsSecondary MarketMust Offset with BankCan Sell Via ExchangeCan Sell Via Exchange

MarginFeesMargin3-20%PremiumGuarantorNoneFutures Clearing Corporation Options Clearing Corporation Major UsersPrimarily HedgersPrimarily SpeculatorsHedgers and Speculators

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