Literature Currency Management

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CURRENCY MANAGEMENT

International diversification of stocks is greatly advantaged by at least a rudimentary knowledge

of currency. Many asset managers feel relatively comfortable in translating their knowledge of

how to invest in their own home country to investing in other countries. But they feel

uncomfortable with the currency portion of their investment. This paper introduces basic

currency ideas that can provide a solid foundation for understanding currency and the

opportunities it presents for enhancing return and reducing risk in international diversification.

Currency return is the percentage change in thespotexchange rate. For example, if the price of a

dollar quoted in yen rate moves from 100 to 120 as the yen weakens, one calculates the dollar

currency return as 20%. (The yen currency return is -16.67%.) There is also aforwardrate fordelivery of currency at a time a few months in the future. If you own a foreign security, you

could imagine hedging against changes in its currency by selling short an amount of currency

equivalent to the securitys current value. In practice, this is done by entering into a contract to

sell the foreign currency at a fixed rate in terms of the home currency at some definite point in

the future. There is an active futures market for currency; however, most hedging transactions

are done on a customized basis with bank counter-parties.

It is usually not possible to precisely offset currency returns by hedging. Instead, one receives a

hedging return that reflects the difference between the current forward rate, say 90 days out, and

the future spot rate. Arbitrage with short-term interest rates makes this the percentage change in

the spot rate plus the interest-rate differential in favor of the home country. Thus, an accurate

measure of the performance of currency management must be based on hedging return rather

than on currency return. Assume you are a US investor in Japanese securities for a year and US

interest rates were 4% higher than Japanese rates. Then a move in the yen from 100 to 120

would create a hedging return of approximately 24%.

Suppose you hedge all foreign currency exposure. The return that results is the total foreign

return including currency, plus the hedging return. The currency return cancels out, and you are


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left with the home country interest rate plus the excess of the foreign stock return over the

foreign interest rate.

Currency management efforts can usefully be split into better return enhancement and better risk

control. An effective process will do both.

Risk Control:

Currency risk is best controlled at the portfolio levelotherwise too many diversification

benefits are left untapped. The key challenge here is to prevent small errors in estimation from

becoming big errors in allocation. It is important to limit the size of apparently offsetting long

and short positions. It is also important to take into account inherent risk that may be apparent in

the history of one currency pair that may not yet have appeared in the volatility of another, but is

still latent. The ability to forecast bursts of volatility can be useful if one does not become so

enmeshed in statistical technique that the essential unreliability of the past to forecast the future

is forgotten. In the short-term, currency risks can also be converted into new forms through the

passive use of options. However, active option management is essentially an attempt at return

enhancement through another means.

Return Enhancement:

In contrast to the literature on stocks, much less has been written about currency market

efficiency and inefficiency. It is our experience that the structured investor interested in

currency management is in the enviable position of working in a field where the prevailing views

are largely pre-scientific. It appears that one can add value best through combining a large

degree of fundamental analysis with a smaller portion of technical analysis.

As we have already seen, on average and over a long period of time, cumulative hedging returns

have followed trends. The problem for the currency manager is that these trends are highly


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clustered both by currency pair and by time period. For example, in recent years the British

pound and the US dollar have moved more or less together relative to continental Europe and to

the Japanese yen. To the extent that the British government makes an effort to maintain a stable

dollar/pound relationship, one will observe more counter-trending, or reversion to the mean, than

trending. The challenge is to discriminate when trends are most likely. This circumstance will

reflect both any government intervention that may cause under-reaction to news, and the extent

to which speculators have already built into the current price an expectation of trend

continuance.

If the essence of hedging is a decision not to lend, then relative interest rates and relative

creditworthiness are the factors of most interest. (Trade-related indicators such as purchasingpower parity, the ability to buy the same goods at the same real cost in different countries, are

also important. But these can be viewed as additional ingredients in the ability to repay.)

Relative interest rates are critical but tend to be impounded in prices very quickly indeed,

especially for major currencies. The better opportunity for most active investors is to become

specialists in discerning changes in perceived creditworthiness, and, better, to forecast these

changes. In our experience, the key ingredients are of two kindseconomic expansion and

recession on the one hand, and accumulated government mistakes or deliberate inflationary

tactics on the other. The classic currency deterioration comes when economic recession exposes

an accumulation of economic problems. The government comes under pressure to lower interest

rates or otherwise devalue the currency in order to satisfy domestic political needs.

Conventional measures of accumulating problems include a poor current account balance, but

better active returns are likely to come from unconventional measures. For example, one might

note the extent to which government or international agencies have subsidized the

economy. Another important source of information is the stock market, which can reveal

information about coming recessions far ahead of actual events.


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Foreign Exchange Risk

Foreign exchange risk is the possibility of a gain or loss to a firm that occurs due to unanticipated

changes in exchange rate. It is linked to unexpected fluctuations in the value of currencies. A

strong currency can very well be risky, while a weak currency may not be risky. The risk level

depends on whether the fluctuations can be predicted. Short and long- term fluctuations have a

direct impact on the profitability and competitiveness of business.

The high volatility of exchange rates is a fact of life faced by any company engaged in

international business. For example, if an Indian firm imports goods and pays in foreign currency

(say dollars), its outflow is in dollars, thus it is exposed to foreign exchange risk. If the value of

the foreign currency rises (i.e., the dollar appreciates), the Indian firm has to pay more domesticcurrency to get the required amount of foreign currency.

Typically, a Foreign exchange risks, therefore, pose one of the greatest challenges to a

multinational companies. These risks arise because multinational corporations operate in

multiple currencies. Infact, many times firms who have a diversified portfolio find that the

negative effect of exchange rate changes on one currency are offset by gains in others i.e. -

exchange risk is diversifiable.

Types of Exposure

Translation Exposure

It is the degree to which a firms foreign currency denominated financial statements are affected

by exchange rate changes. All financial statements of a foreign subsidiary have to be translated

into the home currency for the purpose of finalizing the accounts for any given period. If a firm

has subsidiaries in many countries, the fluctuations in exchange

rate will make the assets valuation different in different periods. The changes in asset valuation

due to fluctuations in exchange rate will affect the groups asset, capital structure ratios,

profitability ratios, solvency rations, etc.


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The Company records the gain or loss on effective hedges in the foreign currency fluctuation

reserve until the transactions are complete. On completion, the gain or loss is transferred to the

profit and loss account of that period.

The following procedure has been followed:

Assets and liabilities are to be translated at the current rate that is the rate prevailing at the time

of preparation of consolidated statements.

All revenues and expenses are to be translated at the actual exchange rates prevailing on the

date of transactions. For items occurring numerous times weighted averages for exchange rates

can be used.

Translation adjustments (gains or losses) are not to be charged to the net income of the

reporting company. Instead these adjustments are accumulated and reported in a separate account

shown in the shareholders equity section of the balance sheet, where they remain until the equity

is disposed off.

Measurement of Translation exposure

Translation exposure = (Exposed assets - Exposed liabilities) (change in the exchange rate)

Example

Current exchange rate $1 = Rs 47.10

Assets Liabilities Assets Liabilities

Rs. 15,300,000 Rs. 15,300,000

$ 3,24,841 $ 3,24,841

In the next period, the exchange rate fluctuate to $1 = Rs 47.50

Assets Liabilities Assets Liabilities

Rs. 15,300,000 Rs. 15,300,000

$ 3,22,105 $ 3,22,105


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Decrease in Book Value of the assets is $ 2736

The various steps involved in measuring translation exposure are:

First, Determine functional currency.

Second, Translate using temporal method recording gains/ losses in the income statement as

realized.

Third, Translate using current method recording gains/losses in the balance sheet and as

realized.

Finally, consolidate into parent company financial statements.

Transaction Exposure

This exposure refers to the extent to which the future value of firms domestic cash flow is

affected by exchange rate fluctuations. It arises from the possibility of incurring foreign

exchange gains or losses on transaction already entered into and denominated in a foreign

currency.

The degree of transaction exposure depends on the extent to which a firms transactions are in

foreign currency: For example, the transaction in exposure will be more if the firm has more

transactions in foreign currency. Unlike translation gains and loses which

require only a bookkeeping adjustment, transaction gains and losses are realized as soon as

exchange rate changes. The exposure could be interpreted either from the standpoint

of the affiliate or the parent company. An entity cannot have an exposure in the currency in

which its transactions are measured.

Transaction risk is associated with the change in the exchange rate between the time an

enterprise initiates a transaction and settles it. For Example, an exporter may quote a price of $

10,000 based on exchange rate of Rs. 30 per dollar. He hopes to receive Rs. 3,80,000 on

executing the order. If the contract is executed after three months, and the exchange rate is at Rs.

34 per dollar, the exporter receives only Rs. 3,40,000 short of his expectations by Rs. 40,000. It

is this uncertainty about the amount to be received on conversion that leads to transaction


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exposure. The Transaction losses or gain absorbed in the profit and loss account for the year

concerned , and thus affect the profit of the enterprise.

Economic Exposure

Economic exposure refers to the degree to which a firms present value of future cash flows can

be influenced by exchange rate fluctuations. Economic exposure is a more managerial concept

than an accounting concept. A company can have an economic exposure to say Pound/Rupee

rates even if it does not have any transaction or translation exposure in the British currency. This

situation would arise when the companys competitors are using British imports. If the Pound

weakens, the company loses its competitiveness (or vice versa if the Pound becomes

strong).Thus, economic exposure to an exchange rate is the risk that a variation in the rate will

affect the companys competitive position in the market and hence its profits. Further, economic

exposure affects the profitability of the company over a longer time span than transaction or

translation exposure. Under the Indian exchange control, economic exposure cannot be hedged

while both transaction and translation exposure can be hedged.

Credit Risk

This type of risk includes the likelihood that a counter party may fail to repay an outstanding

currency position on purpose or unintentionally. There are several types of credit risk, such as:

Replacement risk - results when the counterparties who should pay the refunds are not able to

pay their due.

Settlement risk - caused by geographic differences in time. As a result the trading of a currency

may occur at different price at different times during one and the same trading day.

Country Risk

This type of risk is related to governments that participate in foreign exchange market by

interfering in the exchange market.

Derivatives and Other Instrument


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The foreign exchange (currency, forex or FX) market is where currency trading takes place. FX

transactions typically involve one party purchasing a quantity of one currency in exchange for

paying a quantity of another. The FX market is one of the largest and most liquid financial

markets in the world, and includes trading between large banks, central banks, currency

speculators, corporations, governments, and other institutions. The average daily volume in the

global forex and related markets is continuously growing. Traditional turnover was reported to

be overUS$ 3.2 trillion in April 2007 by the Bank for International Settlement. Since then, the

market has continued to grow. According to Euromoney's annual FX Poll, volumes grew a

further 41% between 2007 and 2008.

This approximately $3.21 trillion in main foreign exchange market turnover was broken down as

follows:

$1.005 trillion in spot transactions $362 billion in outright forwards $1.714 trillion in forex swaps $129 billion estimated gaps in reporting

TOP CURRENCY TRADERS AS ON MAY 2008

Rank Name Volume

1 Deutsche Bank 21.7%

2 UBS AG 15.8%

3 Barclays Capital 9.12%

4 Citi 7.49%

5 Royal Bank of Scotland 7.30%

6 JPMorgan 4.19%

7 HSBC 4.1%

Spot Exchange Market

Spot transactions in the foreign exchange market are increasing in volume. This trade represents

a direct exchange between two currencies, has the shortest time frame, involves cash rather
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than a contract; and interest is not included in the agreed-upon transaction. It is estimated that

about 90 percent of spot transactions are done exclusively for banks. The rest are for covering

the orders of the clients of banks, which are essentially enterprise. The exchange of currency

takes place within 48 hours and it works round the clock. According to BIS estimate, the daily

volume of spot exchange transactions is about 50 percent of the total transactions of exchange

markets. Major participants on the spot market are commercial banks, dealers, brokers,

arbitrageurs, speculators and central banks.

The exchange rate is the price of one currency expressed in another currency. There is always

one rate for buying (bid rate) and another for selling (ask of offered rate) for a currency. The bid

rate is the rate at which the quoting bank is ready to buy a currency. Selling rate is the rate at

which it is ready to sell a currency. For Example, if dollar is quoted as Rs 50.0012-50.0030, it

means that the bank is ready to buy dollar (bid rate) at Rs 50.0012 and ready to sell dollar at Rs

50.0030. The positive difference between selling and buying constitutes the profit made by the

bank. There are two types of quotes:

Direct quote : It takes the value of foreign currency as 1 unit. India uses this type ofquote. $1=Rs 50.

Indirect quote : It takes the value of home currency as 1 unit. UK , Ireland & SouthAfrica are some of the example. In UK, 1= Rs70.

The difference between the bid price and the ask price is called a spread. If we were to look at

the following quote: EUR/USD = 1.2500/03, the spread would be 0.0003 or 3 pips, also known

as points. The pip is the smallest amount a price can move in any currency quote. In the case of

the U.S. dollar, euro, British pound or Swiss franc, one pip would be 0.0001. With the Japanese

yen, one pip would be 0.01, because this currency is quoted to two decimal places. So, in a forex

quote of USD/CHF, the pip would be 0.0001 Swiss francs. Most currencies trade within a range

of 100 to 150 pips a day.

When a currency quote is given without the U.S. dollar as one of its components, this is called across currency. The most common cross currency pairs are the EUR/GBP, EUR/CHF and

EUR/JPY. These currency pairs expand the trading possibilities in the forex market, but it is

important to note that they do not have as much of a following (for example, not as actively

traded) as pairs that include the U.S. dollar, which also are called the majors.


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Forward Exchange Market

Unlike the spot market, the forwards markets do not trade actual currencies. Instead they deal in

contracts that represent claims to a certain currency type, a specific price per unit and a future

date for settlement. In the forwards market, are bought and sold OTC between two parties, who

determine the terms of the agreement between themselves. The forward market can be divided

into two parts:

Outright Market : It resembles the spot market, with the difference that the period ofdelivery is much greater than 48 hours. A major part of its operations is for client and

enterprise who decide to cover against exchange risks coming from trade operations.

Forward Swap Market : It consists of two separate operations of borrowing and oflending.

Major participants in the forward market are banks, arbitrageurs, speculators, exchange brokers

and hedgers. Hedgers are the financial institution who want to cover themselves against the

exchange risk.

Forward rates are quoted for different maturities such as one year, six month, three month. If the

forward rate is higher than the spot rate, the foreign currency is said to be in forward premium

with respect to the domestic currency. Otherwise it is called forward discount. Mathematically,

Where N is the number of months forward.

Covering Exchange risk on foreign marketThe enterprises that are exporting or importing take

to covering their operations in the forward market. If an importer anticipates eventual

appreciation of the currency in which the imports are taken, he can buy the foreign currency and

hold it up till maturity. Alternatively, the importer can buy the foreign currency forward at a rate

known and fixed today. This eliminates the exchange risk of the importer as the debt in foreign

currency is covered. Like wise an exporter can eliminate the risk of currency fluctuation by

selling his receivables forward.

Currency Futures


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Currency future, also FX future or foreign exchange future, is a futures contract to exchange one

currency for another at a specified date in the future at a price (exchange rate) that is fixed on the

purchase date. There are three types of participants on the currency futures market : floor traders,

floor brokers and broker- traders. A currency future contract is a commitment to deliver or take

delivery of a given amount of currency on a specific future date at a price fixed on the date of the

contract. The major distinguishing features from forward are:

1. Standardisation2. Organised exchanges3. Minimum Variation4. Clearing House5. Margins6. Marking to Market

Covering Risk on currency futures market In this a long position is covered by a short

position on futures market and vice versa. In order to have a perfect cover, it is necessary cover

that the value of the spot and future move by the same amount but in opposite directions. But,

not often the variation is one to one and the cover is perfect. There is risk for the basis.

This risk, however, is very small in comparison to the risk incurred due to the uncovered

position. On futures market, the basic principle of operating is that two parties that anticipate

opposite movements of rates agree to a exchange a certain amount of currencies on a future date

at an agreed price. If the anticipation about the future turns out to be correct, he would have

made a gain by compensating on the loss made on the spot market. Both parties, after entering

into the contract, are obliged to respond to the calls of clearing house for margin payments.

For example, Ram is a Indian-based investor who will receive $1,000,000 on December 1. The

current exchange rate implied by the futures is Rs50/$. He can lock in this exchange rate by

selling $1,000,000 worth of futures contracts expiring on December 1. That way, she is

guaranteed an exchange rate of Rs50/$ regardless of exchange rate fluctuations in the meantime.The future and spot rate are linked by the equation :

Where D is number of days to maturity.
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Currency Options

It is a derivative financial instrument where the owner has the right but not the obligation to

exchange money denominated in one currency into another currency at a pre-agreed exchange

rate on a specified date. Options are traded over the counter(OTC) as well as on organised

market. In terms of volume of transactions, USA, UK and Japan are on top.

When the right to use an option is exercised on a fixed date, the option is said to be a European

option. On the other hand, when the right to use an option can be exercised at any time during

the life of the option, up to the date of maturity, referred as American Option.

There are two types of options :

Call Option : The buyer of the option has the right, but not the obligation to buy an agreedquantity of a particularcommodity orfinancial instrument (the underlying instrument) fromthe seller of the option at a certain time (the expiration date) for a certain price (the strike

price). The seller (or "writer") is obligated to sell the commodity or financial instrument

should the buyer so decide. The buyer pays a fee (called a premium) for this right. The buyer

of a call option wants the price of the underlying instrument to rise in the future; the seller

either expects that it will not, or is willing to give up some of the upside (profit) from a price

rise in return for the premium (paid immediately) and retaining the opportunity to make a

gain up to the strike price (see below for examples).Call options are most profitable for the

buyer when the underlying instrument is moving up, making the price of the underlying

instrument closer to the strike price. When the price of the underlying instrument surpasses

the strike price, the option is said to be "in the money".

Put Option : The put allows its buyer the right but not the obligation to sell a commodity orfinancial instrument (the underlying instrument) to the writer (seller) of the option at a certain

time for a certain price (the strike price). The writer (seller) has the obligation to purchase the

underlying asset at that strike price, if the buyer exercises the option. The put buyer either

believes it's likely the price of the underlying asset will fall by the exercise date, or hopes to

protect a long position in the asset. The advantage of buying a put over shorting the asset is

that the risk is limited to the premium. The put writer does not believe the price of the

underlying security is likely to fall. The writer sells the put to collect the premium.
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The premium is composed of two values:

Intrinsic ValueFor Call Option

Intrinsic Value = Spot RateExercise price (American Call option)

Intrinsic Value = Forward RateExercise price (European Call option)

For Put Option

Intrinsic Value = Exercise priceSpot Rate (American Call option)

Intrinsic Value = Exercise priceForward Rate (European Call option)

Options

In-the-money : When the underlying exchange rate is superior to the exercise price(incase of call) and inferior to the exercise price(in case of put option).

Out-of-money : When the underlying exchange rate is inferior to the exercise price(incase of call) and superior to the exercise price(in case of put option).

At-the-money : When the exchange rate is equal to the exercise price.Example, an American type Call option that enables purchase of US Dollar at the rate of Rs

50.50(exercise price) while the spot exchange rate on the market is Rs 51 is in-the-money. If the

rate is Rs 50.50 then it is at-the-money and if the rate is Rs 50 then it is out-of-money.

Time ValueTime Value of Option = PremiumIntrinsic Value

Option Price = Intrinsic value + Time value

Strategy for using options

An option strategy is implemented by combining one or more option positions and possibly an

underlying stock position. Options strategies can favour movements in the underlying stock that

are bullish, bearish or neutral.

Bullish Strategies
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Bullish options strategies are employed when the options trader expects the underlying stock

price to move upwards. It is necessary to assess how high the stock price can go and the time

frame in which the rally will occur in order to select the optimum trading strategy. The most

bullish of options trading strategies is the simple call buying strategy used by most novice

options traders.

Buying of a call option may result into a net gain if market rate is more than the strike price plus

the premium paid. Call option will be exercised only if the exercise price is lower than spot

price.

Profit = StXc for St > X

= -c for St < X

Where St = spot price

X = strike price

c = premium paid

Bearish Strategies

Bearish options strategies are the mirror image of bullish strategies. They are employed when the

options trader expects the underlying stock price to move downwards. It is necessary to assess

how low the stock price can go and the time frame in which the decline will happen in order to

select the optimum trading strategy. The most bearish of options trading strategies is the simple

put buying strategy.

Buying of a put option may result into a net gain if market rate plus the premium paid is less than

the strike price.

Profit = X - Stp for St < X

=p for St > X

Where

St = spot price X = strike price p = premium paid

Neutral or Non-Directional Strategies

Neutral strategies in options trading are employed when the options trader does not know

whether the underlying stock price will rise or fall. Also known as non-directional strategies,

they are so named because the potential to profit does not depend on whether the underlying

stock price will go upwards or downwards. Rather, the correct neutral strategy to employ

depends on the expected volatility of the underlying stock price.


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Examples of neutral strategies are:

1. Straddle: A Straddle strategy involves holding a position in both a call and put with thesame strike price and expiration. The position is profitable (to the buyer) if the underlying

stock changes value in a significant way, either higher or lower. The premium paid is the

sum of the premium paid for each of them.

Profit = X - St( p + c ) for St < X (I)

Profit = StX( p + c ) for St < X (II)

The equation (I) is the combination of the use of put option and non use of call option

whereas the equation (II) is the combination of use of call option and non use of put

option.

2. Strangle: It is similar to straddle but with a difference. It is the combination of buying acall with strike price above the current spot rate, and put with strike price below the

current spot rate. Gains are made for larger movement of the currency and moderate

losses for moderate movement.

3. Butterfly: Long butterfly spread means buying two calls with middle strike price (X2)and selling each with lower (X1) and higher (X3) strike price respectively. Similarly, a

short butterfly involves selling two calls with middle strike price (X2) and buying each

with lower (X1) and higher (X3) strike price respectively.

4. Spread: It refers to the simultaneous buying of an option and selling of another in respectof the same underlying currency. A spread is said to be vertical spread if it is composed

of buying and selling of an option of the same type with the same maturity with different

strike prices. Horizontal spread combines simultaneous buying and selling of options of

different maturities with the same strike price.

Covering Exchange Risk With Options Effective exchange rate guaranteed through the useof options is a certain minimum rate for exporters and a certain maximum rate for importers.

Exchange rates can be more profitable in case of their favourable evolution.


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Exotic Options

We have already talked about so-called "plain vanilla options", the simple puts and calls that are

priced in the exchange-traded markets and the over-the-counter markets for equities, fixed

income, foreign exchange and commodities. Exotic options are either variations on the payoff

profiles of the plain vanilla options or they are wholly different kinds of products with optionally

embedded in them. An exotic option is a derivative which has features making it more complex

than commonly traded products (vanilla options). These products are usually traded over-the-

counter (OTC), or are embedded in structured notes.

Barrier Options

A barrier option is like a plain vanilla option but with one exception: the presence of one or two

trigger prices. If the trigger price is touched at any time before maturity, it causes an option withpre-determined characteristics to come into existence (in the case of a knock-in option) or it will

cause an existing option to cease to exist (in the case of a knock-out option).

There are single barrier options and double barrier options. A double barrier option has barriers

on either side of the strike (i.e. one trigger price is greater than the strike and the other trigger

price is less than the strike). A single barrier option has one barrier that may be either greater

than or less than the strike price. Why would we ever buy an option with a barrier on it? Because

it is cheaper than buying the plain vanilla option and we have a specific view about the path that

spot will take over the lifetime of the structure.

Intuitively, barrier options should be cheaper than their plain vanilla counterparts because they

risk either not being knocked in or being knocked out. A double knockout option is cheaper than

a single knockout option because the double knockout has two trigger prices either of which

could knock the option out of existence. How much cheaper a barrier option is compared to the

plain vanilla option depends on the location of the trigger.

First, let us think of the case where the barrier is out-of-the-money with respect to the strike.

Consider the example of a plain vanilla 1.55 US dollar Call/Canadian dollar put that gives the

holder the right to buy USD against Canadian dollars at a rate of 1.55 for 1 month's maturity.

Spot is currently trading at 1.54. Consider now the 1.55 US dollar call/Canadian dollar put

expiring in 1 month that has a knockout trigger at 1.50. The knockout option will be cheaper than

the plain vanilla option because it might get knocked out and the holder of the option should be
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compensated for this risk with a lower up front premium. However, it is not very likely that 1.50

will trade, so the difference in price is not that great. If we move the trigger to 1.53, the knockout

option becomes considerably cheaper than the plain vanilla option because 1.53 is much more

likely to trade in the next month.

The reverse logic applies to knock-in options. The knock-in 1 month 1.55 US dollar call with a

trigger of 1.53 will be more expensive than the 1 month 1.55 US dollar call with a knock-in

trigger of 1.50 because 1.53 is more likely to trade. If we own the 1 month 1.55 US dollar

call/Canadian dollar put that knocks out at 1.53 and we also own the 1 month 1.55 US dollar

call/Canadian dollar put that knocks in at 1.53, the combined position is equivalent to owning the

plain vanilla 1 month 1.55 US dollar call.

Compound Options

A compound option is an option-on-an-option. It could be a call-on-a-call giving the owner the

right to buy in 1 month's time a 6 month 1.55 US dollar call/Canadian dollar put expiring 7

months from today (or 6 months from the expiry of the compound). The strike price on the

compound is the premium that we would pay in 1 month's time if we exercised the compound for

the option expiring 6 months from that point in time. It could be a put-on-a-call giving the owner

the right to sell in 1 month's time a 6 month 1.55 US dollar call/Canadian dollar put expiring 7

months from today.

These types of products are often used by corporations to hedge the foreign exchange risk

involved with overseas acquisitions when the success of the acquisition itself is uncertain.

Basket Options

A basket option is an option whose payoff is linked to a portfolio or "basket" of underlier values.

The basket can be any weighted sum of underlier values so long as the weights are all positive.

Basket options are usually cash settled. A call option on France's CAC 40 stock index is an

example of a basket option.

Basket options are popular for hedging foreign exchange risk. A corporation with multiple

currency exposures can hedge the combined exposure less expensively by purchasing a basket

option than by purchasing options on each currency individually.

Basket options are often priced by treating the basket's value as a single underlier and applying

standard option pricing formulas. An error is introduced by the fact that a weighted sum of

lognormal random variables in not lognormal, but this is generally modest.
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Lookback Options

A lookback option is a path dependent option settles based upon the maximum or minimum

underliervalue achieved during the entire life of the option. Essentially, at expiration, the holder

can "look back" over the life of the option and exercise based upon the optimal underlier value

achieved during that period. Lookback can be structured as puts orcalls and come in two basic

forms:

A fixed strike lookback option is cash settled and has a strike set in advance. It is exercisedbased upon the optimal underlier value achieved during the life of the option. In the case of a

call, this is the highest underlier value achieved, so the call has a payoff equal to the greater

of: zero or the difference between that highest value and the fixed strike. In the case of a put,

the optimal value is the lowest underlier value achieved, and the payoff is the greater of: zero

or the difference between the strike and that lowest value.

A floating strike lookback option can have cash or physical settled. It settles based upon astrike that is set equal to the optimal value achieved by the underlier over the life of the

option. In the case of a call, that optimal value is the lowest value achieved by the underlier,

so the call has a payoff equal to the difference between the value of the underlier at

expiration and the lowest value achieved by the underlier over the life of the option. In the

case of a put, the payoff is the difference between the highest value achieved by the underlierand the value of the underlier at expiration.

Lookback options have obvious appeal, but they are expensive. Their structure doesn't mimic

typical business liabilities, so they are largely a speculative device.
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Quanto Options

A quanto (or cross-currency derivative) is a cash settled derivative (such as a future oroption)

that has an underlierdenominated in one ("foreign") currency, but settles in another ("domestic")

currency at a fixed exchange rate. For example, the Chicago Mercantile Exchange (CME) trades

futures on Japan's Nikkei 225 stock index that settles forUSD 5.00 for each JPY .01 of value in

the Nikkei index. If you hold a future, and the Nikkei rises JPY 12 (or 12 points), you earn USD

6000.

Quantos are attractive because they shield the purchaser from exchange rate fluctuations. If a US

investor were to invest directly in the Japanese stocks that comprise the Nikkei, he would be

exposed to both fluctuations in the Nikkei index and fluctuations in the USD/JPY exchange rate.

Essentially, a quanto has an embedded currency forward with a variable notional amount. It is

those variable notional amounts that give quantos their name"quanto" is short for "quantity

adjusting option."

Quanto options have both the strike price and underlierdenominated in the foreign currency. At

exercise, the value of the option is calculated as the option's intrinsic value in the foreign

currency, which is then converted to the domestic currency at the fixed exchange rate.

EXOTIC OPTIONS -DIFFERENCE BETWEEN EXOTIC OPTIONS &STANDARD OPTIONS

Exotic Options Plain Vanilla Options

Customised Standardized

OTC Traded Publicly Traded

Many Types Single Type

More Expensive Cheaper

No Standard Pricing Standardized Pricing Model
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Currency Swaps

A currency swap (or cross currency swap) is a foreign exchange agreement between two parties

to exchange a given amount of one currency for another and, after a specified period of time, to

give back the original amounts swapped. Initial loan was given at the spot rate, reimbursement of

principle as well as interest took into account forward rate.

Typical currency swaps involves three steps;

1. Initial exchange of principal amount: In the first step, the counterparties exchange theprincipal amounts of the swap at an agreed exchange rate. This rate is generally based on the

spot exchange rate however, a forward rate set in advance of the swap commencement date

may also be used. The principal amounts may be exchanged on physical or notional, without

any physical change, basis.

2. Exchange of interest: It is the second key step for a currency swap. The counterpartiesexchange interest payments on agreed dates based on outstanding principal amounts at the

fixed interest rates agreed at the beginning of transaction.

3. Re-exchange of principal maturity: This step involves re-exchange of the principal sum atthe maturity date by the counterparts. In order to determine the actual sums involved

generally the original spot rate is used.

Participants in swap markets are

Financial Institutions: It enables them to make loans and accept deposits in the currency oftheir customers choice. It can involve as broker, counterparty or an intermediary.

Big enterprises: They are mostly multinationals. They may also be big and mediumenterprises with good ratings such as SNCF and EDF.

International organisations: Institutions like World Bank and nation states.

SWAPPING A USDLOAN INTO AN AUDLOAN
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By entering into a swap with a third party, a corporation can convert an USD loan into anAUD loan.

Currency swaps can be divided into three categories :

Fixed-to-fixed currency swap: An arrangement between two parties (known ascounterparties) in which both parties pay a fixed interest rate that they could not otherwise

obtain outside of a swap arrangement.

US Company UK Company

US Dollar 5% 7%

Sterling 7.5% 8%

Comparative Advantage $-2% & -0.5%

Take a loan $ 10 million from 5.0% 15 million from 8.0%

Exchange Rate = $1.50 = $1.50

Principle Exchange 15 million from 7% $ 10 million from 6.5%

Interest Paid 7.0% for loan 6.5% for $ loan

Interest received 5.0% for $ loan 8.0% for loan


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Coupon Payment 5.0% for $ loan 8.0% for loan

Net Interest Paid 7% 6.5%

Interest gains 0.5% 0.5%

The above table shows that a US company is able to borrow from low fixed rates in US bond

market. On the other side, a UK company is also able to raise low fixed rates funds from UK

bond market. In case of both the companies wish to raise funds denominated by other countrys

currency, first, each will borrow from its own domestic market by using the comparative

advantage. Second, via fixed-to-fixed swap each will be able to raise lower cost of their funds in

terms of foreign currency. However, the case is such that the US companys credibility is better

in each market, the swap transaction would be as it is shown in the above Table.

The table illustrates that the US Company has a comparative advantage in both bond markets,

but it will also prefer swap. Because by sharing the gain among the parties, the US Company and

the UK Company, each of them may raise funds with lower costs and saves 0.5% each.

Therefore, each company borrows from the domestic markets and exchanges the principals from

the rate of 7.0% for sterling and 6.5% for US dollar. During the life of swap UK and US

companies will service each others debt.

Fixed-to-Floating rate currency swap : It follows the same sequence of steps as do fixed-to-fixed rate swaps, with the difference that one currency has fixes rate while the other has

floating rate. While the fixed rate is charged over the entire period of the swap, the floating

rate is re-calculated every six months. Thus, if the UK company can raise capital at a fixed

rate on UK market but prefers to obtain dollars at floating rate, it have to find borrowers who

is highly rated on American market and who can borrow on that market on floating rate with

better conditions but who like to borrow sterlings at fixed rate.

Floating-to-Floating rate currency swap : In this both the currency has floating rate. Itenables both parties to draw benefit from the difference of interest rates existing on

segmented markets.


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Hedging Exchange Risk Swapping one currency liability with another is a way ofeliminating exchange rate risk. For example, if a company (in India) expects certain inflows of

dollars, it can swap a Rupee liability into dollar liability.

Interest Rate Swap

An agreement between two parties (known as counterparties) where one stream of future interest

payments is exchanged for another based on a specified principal amount. Interest rate swaps

often exchange a fixed payment for a floating payment that is linked to an interest rate (most

often the LIBOR). A company will typically use interest rate swaps to limit, or manage, its

exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than itwould have been able to get without the swap. Interest rate swaps are simply the exchange of one

set of cash flows (based on interest rate specifications) for another. Because they trade OTC,

they are really just contracts set up between two or more parties, and thus can be customized in

any number of ways. With an interest rate swap, cash flows occurring on concurrent dates are

netted.

Generally speaking, swaps are sought by firms that desire a type of interest rate structure that

another firm can provide less expensively. For example, let's say Cory's Tequila Company (CTC)

is seeking to loan funds at a fixed interest rate, but Tom's Sports Inc. (TSI) has access to

marginally cheaper fixed-rate funds. Tom's Sports can issue debt to investors at its low fixed rate

and then trade the fixed-rate cash flow obligations to CTC for floating-rate obligations issued by

TSI. Even though TSI may have a higher floating rate than CTC, by swapping the interest

structures they are best able to obtain inexpensively, the combined costs are decreased - a benefit

that can be shared by both parties.

Vanilla currency swaps are quoted both for fixed-floating and floating-floating (basis swap)

structures. Fixed-floating swaps are quoted with the interest rate payable on the fixed sidejust

like a vanilla interest rate swap. The rate can either be expressed as an absolute rate or a spread

over some government bond rate. The floating rate is always "flat"no spread is applied.

Floating-floating structures are quoted with a spread applied to one of the floating indexes.

Currency Risk Management
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In managing currency risk, multinational firms utilize different hedging strategies depending on

the specific type of currency risk. These strategies have become increasingly complicated as they

try to address simultaneously transaction, translation and economic risks. As these risks could be

detrimental to the profitability and the market valuation of a firm, corporate treasurers, even of

smaller-size firms, have become increasingly proactive in controlling these risks. Thereby, a

greater demand for hedging protection against these risks has emerged and, in response, a greater

variety of instruments has been generated by the ingenuity of the financial engineering industry.

Companies can successfully manage currency risk by following five steps:

Risk Definition

Risk Definition refers to the type of risk to be measured. A company engaged in currency risk

has basically four types of exposure :-

Transaction Exposure Translation Exposure Forecasted Exposure Economic Exposure

Each exposure effects company in different way as explained below


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Measurement Methodology

Measuring and managing exchange rate risk exposure is important for reducing a firms

vulnerabilities from major exchange rate movements, which could adversely affect profit

margins and the value of assets. After defining the types of exchange rate risk that a firm is

exposed to, a crucial aspect of a firms exchange rate risk management decisions is themeasurement of these risks. Measurement Methodology create a model to measure the currency

exposure to be managed. Measuring currency risk may prove difficult, at least with regards to

translation and economic risk.

Some of the methodology usually employed by corporate are :-


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Exposure Gathering Techniques

After methodology has been defined by the company, next step is to gather data and calculate

exposure of currency risk. The process can be best described as below :-

Covering Strategy

Once exposure has been calculated , the companies need to decide on covering strategies which

will determine to what extent and how exposure will be measured. Various Covering strategies

are :-


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Hedge Execution

Once companies identifies exposure and decide to hedge it , there are series of ways by which

hedge exposure is carried through trade execution and other techniques. The flow of the process

is as following :-

Literature Currency Management

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