Instruments for hedging against exchange rate risk in the ...
Hedging Instruments
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Transcript of Hedging Instruments
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Types of Exposures
Risks in Forex Operations &
Management
Hedging Strategies
Hedging Products
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Types of Exposures
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Balance sheet Segment Type of Exposures
1. Revenue Exposures Imports, Exports
2. Other Exposures(Non-revenue Inflow /
Outflow)
Royalty, FDI, Misc. payments /receipts, capital goods
3. Other Exposures
(Assets & Liabilities)
Loans, Deposits
4. Interest Rate Exposures Loans, Deposits
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Risks in Forex Operations &Management of Risk
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High volatility is the distinctive feature of foreign
exchange market.
Only a small percentage of foreign exchange
transactions are for commercial import/exportpurposes while the major chunk is traded for
speculative gains.
Globalization of Indian economy is increasingly
exposing the Indian corporate to greater forex risks.The uncertainty of the moves and lack of clear trend
rules the market.
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Depending on nature of exposure two types of risks
may be associated with the forex exposure:
1. Risk of Exchange Rate2. Risk of Intt. Rate Index (LIBOR) Movement
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Foreign Currency exposure in USD, EURO, JPY etc. Loans linked
to 6M USD LIBOR, 6M EURIBOR, 6M JPYLIBOR etc.
Exposure risk on two parameters:
1. Currency Risk: EURO and / or JPY appreciation against USD (with / without
USD appreciation against INR)
USD appreciation against INR
2. Interest Rate Risk:
6M JPYLIOBOR and / or 6M USD LIBOR and / or 6M EURIBOR
moving upwards over the tenor of the loan
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Company placed an order for purchase of some
machinery:
Time of placing order Time of paymentCost : USD 10.00 mio To Pay : USD 10.00 mio
USD/INR : 61.80 USD/INR : ????
What would be the conversion rate at the time ofpayment?
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One of the fundamental requirement for any business isMONEY and Corporate may not like to lose MONEY on
account of fluctuations in Currency Market.
With increased volatility, management of the financialrisks is necessary to gain competitive advantage.
More and more corporate are moving towards raising
foreign currency loans to reduce their interest cost andthey may not like to lose it on account of fluctuations in
currency market as well as interest rate.
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Hedging Strategies
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Hedging may be termed as a Risk Management
Strategy used in limiting or offsetting probability ofloss from adverse fluctuations in the prices of
commodities, currencies, or securities. In effect,
hedging is a transfer of risk; of course for a price.
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Unique to the company depending upon exposure and
Risk Management Policy.
May be of three types:
1.Complete Hedging2.Part Hedging
3.Do Nothing (No Hedging)
No best practice and a dynamic process, needs
flexibility depending upon varying company exposure
and varying market conditions.
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Is this a risk? Borrowing Rupees with a fixed rate of interest for 5
years
Borrowing Dollars with a floating rate of interest for 5
years Borrowing JPY with a floating rate of interest for 5
years
Depositing money for 6 months at a fixed rate with a
bankConcept: Can changes in market prices affect the value
of the contract?
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Why Have a Policy?
Formalises a thought process that may otherwise be
people dependent. Helps the Board of Directors articulate their
strategic view in terms of risk management.
Facilitates approval from Regulators wheresoever
necessary
Concept: Formalises a process.
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What is Risk?
The likelihood that your company will face a loss
owing to market movements.
Measurement of Risk
Factor Sensitivity
Calculation of the change in the market value of aportfolio of contracts for a given scenario, e.g. interest
rates moving up 1 bp, FX rates moving up 1%, etc.
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Financial instruments whose value is derived fromsome other asset.
Typically returns are based on movement in the value
of that asset.
DERIVATIVES
EXCHANGE TRADED
EX. EQUITY & FX
FUTURES
EQUITY & FX OPTIONS
OVER THE COUNTER(OTC)
EX. FORWARDS
OPTIONS
CURRENCY SWAPS
INTEREST RATE SWAPS
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Hedging Options forECB of JPY 9.12
billion
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Amount of ECB : JPY 9.12 billion
Costing : 6M JPY LIBOR + 57 bps
Repayment : 10 half-yearly instalment
Instalment Start Date : 18.04.2014Instalment End Date : 18.10.2018
Risks
1. Exchange risk on Principal repayment2. Exchange risk on Interest payment
3. Interest risk due to movement in JPY LIBOR
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SWAP is a contractual agreement to exchange specified
cash flows at future dates
Contracts constructed as multiple forward contracts
Advantages:
Hedging of risk beyond 3 years
Long term forwards are not available beyond 3 years
One rate for entire period of exposure or variable
rates for various maturities
Cost payable could be amortized over the life of
swap
Disadvantages:
Exit cost inflexible and less transparent.
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Swaps may be broadly categorised into:-
IRS Interest Rate Swap
POS Principal Only Swap
CIRS Currency and Interest Rate Swap
COS Coupon Only Swap
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An agreement between two parties (known as
counterparties) where one stream of future interestpayments is exchanged for another based on a specified
principal amount.
For example, NHPC has to repay loans linked to 6M
JPY LIBOR to the lender. To hedge the exposure on
account of movement in 6M JPY LIBOR, NHPC may
enter into a swap where NHPC will receive applicable6M JPY LIBOR on its hedged loan and pay the fixed
swap rate over the period of hedging.
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NHPC SBI
PAYS SWAP RATE
(x%)
PAYS LIBOR 6M
PAYSLIBOR
6M
LENDER
Effectively , NHPC pays fixedinterest rate of x% on the loan
linked to 6M LIBOR. So,
irrespective of where the LIBOR
is fixed on the respective LIBOR
setting dates, the company pays a
fixed interest rate for the tenor of
loan.
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Advantage
The risk of LIBOR moving upwards is completely
hedged.
Risks
NHPC will not be able to take advantage of lower
LIBOR if it moves below the present rates.
NHPC is open to USDJPY & USDINR exchange
rate.
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A POS involves two parties that exchange principal(notional or actual) with one another in order to gain
exposure to a desired currency. Periodic cash flows are
exchanged in the appropriate currency as per the
repayment schedule.
For example, NHPC has to repay loans in JPY to the
lender as per the repayment schedule. To hedge the
exposure on account of movement in JPY/INR, NHPC
may enter into a swap where NHPC will receive JPY
and pay INR at the swap rate.
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NHPC SBI
On repayment dates, INR at fixed rate
and x% fixed on o/s INR amount
JPY (As per repayment schedule)
JPY (as
per
repayment
schedule)
LENDER
Effectively , NHPC hedges itselfagainst the fluctuations in JPY/INR
for JPY loan. So, irrespective of
where the JPY/INR trades on
repayment dates, the company paysa fixed amount of INR at todays
spot ref and pays x% on o/s INR
amount instead of JPY.
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Advantage The risk of JPY/INR moving upwards is completely
hedged.
Risks
NHPC will not be able to take advantage of lower
rates if JPY/INR moves lower than the present
rates.
NHPC is open to LIBOR rate moving upwards.NHPC is open to JPY/INR movements on interest
portion.
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CIRS involves two parties that exchange principal(notional or actual) as also interest rate with one another
in order to gain exposure to a desired currency & interest
rate.
For example, NHPC has to repay a JPY loan linked to 6M
JPY LIBOR to the lender as per the repayment schedule.
To hedge the exposure on account of movement in
JPY/INR as also LIBOR, NHPC may enter into a swap
where NHPC will receive JPY at 6M JPY LIBOR and
pay INR at fixed interest rate as per the schedule.
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NHPC SBI
INR at fixed interest rate of X% (as
per repayment schedule)
USD AT 6M JPY LIBOR (as per
repayment schedule)
JPY at 6MJPY LIBOR
(as per
repayment
schedule)
LENDER
Effectively , NHPC hedges itselfagainst the fluctuations in
JPY/INR and 6M JPY LIBOR.
So, irrespective of where the
JPY/INR trades on repayment
dates or where 6M JPY LIBOR isfixed on resetting dates, the
company pays a fixed amount of
INR at a fixed interest rate.
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Advantage
The risk of JPY/INR & 6M JPY LIBOR
moving upwards is completely hedged.
Risks
NHPC will not be able to take advantage of
lower rates in JPY/INR &/or 6M JPYLIBOR rate moves lower than the present
rates.
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Coupon Only Swap involves two parties thatexchange interest payments from one currency to
another currency.
For example, NHPC has to repay JPY loan at
LIBOR 6M. If NHPC exchanges the interest
payments from JPY LIBOR 6M to INR Fixed, the
liability on account of interest payments shift toINR.
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NHPC SBI
Intt. payments in INR at x% at spot
(as per repayment schedule)
JPY LIBOR 6M (as per repayment
schedule)
JPY LIBOR
6M (as perrepayment
schedule)
LENDER
Effectively , NHPC converts its
interest liability from JPY
LIBOR to INR FIXED.
Principal payments, however,
are open to market fluctuations.
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Advantage The risk of 6M JPY LIBOR moving upwards is and
JPY/INR appreciation (on interest amount) is completely
hedged.
Disadvantages
JPY/INR exposure on principal amount has not been
hedged.
NHPC will not be able to take advantage of lower rates if
6M JPY LIBOR rate moves lower than the present rates.
NHPC will not be able take advantage of INR appreciation
against JPY on the intt. portion as rate it is already fixed.
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Type of
Structure
Exchange Risk
on Principal
Exchange Risk
on Interest
Interest Rate
Risk
CIRS Yes Yes Yes
POS Yes No No
IRS No No Yes
COS No Yes Yes
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Type of Structure NHPC Receives NHPC Pays
CIRS 6M JPY LIBOR + 0.57% 8.7975%
POS - 7.7975%
IRS 6M JPY LIBOR + 0.57% 0.9125%
COS 6M JPY LIBOR + 0.57% 1.0775%
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Other Hedging Products
Forward Contract
Options
Combinations
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Contract to buy or sell a specified amount ofcurrency at a specified price on a specified
future date.
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No exchange of money at the time of contract; settlement on
end date;
An obligation to buy/sell on settlement date at the contracted
rate;
Cancellation, partial or early delivery allowed as per relevant
guidelines;
Transparent Pricing;
Used to hedgeas also to Trade/Speculatei.e. profit from
currency movements as per relevant guidelines.
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At the time of booking a forward contract the customer can
choose for:
1. A fixed delivery date;
2. A period called option period (up to 1 calendar month)
within which the customer can deliver his part of thecontract on any date.
In both the cases, however, the forward rate is fixed.
However, in the latter case, as the customer is buying the
option to take delivery anytime during the contracted
month, the forward rate will be worse than that of a fixed
date delivery.
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ILLUSTRATION
FORWARD
IMPORT
CONTRACT
64
FORWARD
USD/INR
66
65
61
62
60
63
-
FORWARD
CONTRACT
PRO IT
LOSS
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Advantages of Forward Contract
Simple
Easy to use
Liquid
Transparent
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Disadvantages of Forward Contract..
No chance of participating in market
volatility.
The upside and downside (opportunity profit /
loss) theoretically unlimited.
INR based forwards demand and supply
dependent.
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An option is a financial contract in which
the buyer of the option has the right but
not the obligation, to buy or sell an asset,
at a pre- specified price, on or up to a
specified date.
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Buying Call option: Gives right to buy
Buying Put option: Gives right to sell
Strike Price: Rate at which option is to be exercised
Premium: Amount paid for buying the option
At the money: Strike price is equal to price of asset
In the money: Call option where asset price is higher than
strike price or put option where asset price is lower than strike
price.
Out of money: A call option where asset price is lower than
strike or put option where asset price is higher than strike.
The maximum loss to a holder of an option is the premium
paid which is to be paid upfront.
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The current rate
The strike rate
The time to expiration
The volatility of underlying
The Interest rates
Premium of Call Put
Higher strike price Lower Higher
Higher volatility Higher Higher
Longer option Higher Higher
time period
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Derivative Products : Options
nn
Buy CallBuy the right to Purchase
Optionto Buy
Profit potential unlimited
Loss limited to Premium
Must Pay a Premium
Sell CallSell the right to purchase
Obligationto Deliver
Profit potential limited to Premium
Loss unlimited
Receivesa Premium
Buy Put
Buy the Right to Sell
Optionto Sell
Profit potential unlimitedLoss limited to Premium
Must Pay Premium
Sell Put
Sell a right to Sell
Obligationto Purchase
Profit potential limited to PremiumLoss unlimited
Receivesa Premium
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Confidence High Low
View Buyer of USD Seller of USD Buyer of USD Seller of USD
INR Firming Keep exposure open Book Forward Buy a Call Buy a Put
INR Weakening Book Forward Keep exposure open Buy a Call Buy a Put
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Plane Vanilla Call Option
NHPC buys USD Call INR Put for USD 1mio @ 62.00
Benefit for Customer : NHPC is fully protected
against depreciation of INR beyond 62.00, at the sametime they can take benefit of appreciation of INR below
62.00.
Offers full hedge against currency movement.
Cost to Customer : Upfront premium paid by
customer to buy the option.
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Range Forward
NHPC Buy USD Call INR Put for USD 1 mio @ 70.00
NHPC Sell USD Put INR Call for USD 1 mio @ 61.00
Analysis:
By the structure NHPC has ensured that for it the rate will
not be worse than 70.00 or better than 61.00 and in between
NHPC is open to the market. By entering the structure NHPC will be able to reduce the
premium cost vis-a-vis the premium on Plain Call Option.
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Call Spread
NHPC Buy USD Call INR Put for USD 1.00 mio @ 65.00
NHPC Sell USD Call INR Put for USD 1.00 mio @ 75.00
Analysis:
Offers partial hedge and full opportunity.
On INR depreciation NHPC has limited his gain to
maximum of difference between the chosen levels,however, below 65.00 NHPC is open to market for
unlimited gain as no option will be exercised.
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Seagull
NHPC Buy USD Call INR Put for USD 1.00 mio @ 65.00
NHPC Sell USD Call INR Put for USD 1.00 mio @ 75.00
NHPC Sell USD Put INR Call for USD 1.00 mio @ 61.00
Analysis:
NHPC has limited its gain on INR depreciation to the
difference between levels of two Calls and for INRappreciation has limited its gain to the level of sold Put. In
other words its rate cantbe better than sold Put level (61.00).
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Plain Vanilla Option
(+)offers protection
(+) opportunity of participation in INR Appreciation
(-) Initial Cash Outflow
Call Spread
(+) protection up to certain level
(+) opportunity of participation in INR Appreciation
(-) Initial Cash Outflow
Seagull
(+) protection up to certain level
(-) No opportunity to participate in INR appreciation
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Customer Should Have:1. Board Approval
2. Risk Policy & Procedures
3. Exposures: Size And Tenor
4. Understanding Of Risks
5. No Net receipt of Premium
6. ISDA Documentation
7. For ECB: Loan Regn. No.
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Thank You