TFM session Five FX Management (1).pptx

7/30/2019 TFM session Five FX Management (1).pptx

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Treasury & Fund Management

Szabist Islamabad

By Muhammad Ahmed Khan


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Session Five Foreign Exchange

Management


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Session Five Agenda International Monetary Fund. The Balance of Payments &

Balance of Trade. Concept of FOREX

Management.

Scope And Significance ofFOREX Management. Role of FOREX Treasurer. Foreign Exchange Market. Determinants of Foreign

Exchange Rates. Exchange Rate Quotations-

Direct And Indirect. FOREX Market Risk. Currency Exposure

Management

Managing Foreign ExchangeRate Risk.

Exchange Rate Forecasting. Mechanics of FOREX

Trading.

Cross- Border Payments AndReceipts. Capital Account

Convertibility. Managing Multinational

Operations. Interest Rate And Currency

Swaps. Foreign Exchange Market In

Pakistan.


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Balance of Trade & Balance of Payments

Two Commonly Used Terms In International Economics

That Are Different Yet Closely Related To Each Other.

Balance of Trade (BOT)

A component of balance of

payments arising frommerchandising of tangible goodsand services.

Included as a current item inbalance of payments

Represents the difference

between the value of goods andservices exported out of a countryand the value of goods andservices imported into the country.

Favorable bot means exports

exceed imports.

Balance of Payment (BOP)

Method used to monitorIntl

monetary transactions for a periodof time.

Determines how much money ismoving in and out of the countrythrough trades conducted byprivate & public sectors.

Three components:

Current Account Capital Account Financial Account


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FOREX Management - Introduction Unlike other markets Foreign Exchange (FX) market is not linked to

any stock exchange.

Value of currency is generically reflective of a countrys economy.

FX Trading Platform : Network of banks (Interbank or OTC market). Brokers on electronic dealing platforms or bilateral contacts.

Through interaction currencies are:

Valued and traded in relation to each other. Rates are determined through interaction of market forcesinfluencing the supply demand.

Global market is dominated by investment players, Commercialbanks; Portfolio managers; large corporations; money brokers, etc.


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FOREX Management - Introduction

How A Currency Dealer Makes Money:

Sale & purchase of currencies (spot and forward).

Keeping stock of currencies to meet companys business

needs as well as capitalize on projected future outlook.

Exotic products, i.e., Swaps, derivatives, options, etc.

Motives For Currency Trading: Reactive trading- In response to a commercial transaction or

political and / or economic event.

Speculative tradingIn anticipation of certain event

Off late speculation for profit has become a major consideration for

individuals and big time participants..


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Scope of FX Management

Mutual interdependence of countries around the worldneeds an efficient cross-currency settlementmechanism.

Global trade integration underscores the important ofsmooth international trade regime.

Development of international trade owes a lot to freemovement of funds from one financial centre to another.

However benefits of trade and swift FX movement alsobring to fore country, political and exchange rate risks.


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A currency can be sold or bought in one transaction. Trading is done in pairs of currencies where the currency bought (Top) is

mentioned first followed by sold (Bottom) currency.

Trading carried out either on Spot or Forward basis.

Commonlytraded

Currncies

USD

EUR

GBP

JPY

SFR

SGD/AUD/CAD

/AED


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Typical FX Inflows and Outflows for a country

Inflows:

Workers emigrants send foreign

exchange back home for familymaintenance or savings. Inwards remittances. Receipts of proceeds against

exports made. Unfinished goods imported into

the country for value additionand re-export at a premium.

Receipts from internationaldonors as loan, grants, etc.

Foreign investment into the

country.

Outflows:

Issuance of foreign currency for

personal or business travel toforeign countries. Purchase of foreign books;

magazines; or subscriptions toforeign technical, educational &professional bodies

Payments for imports into thecountry

Payment of loans with interest tointernational donors

Payment of royalties and dividend.

Private Remittances.


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Role of A Foreign Exchange Manager

Typ ical FX Inf low s and Outf low s for a country

Distinctly different from that of Financial or Treasury Managers.

Dealing with numerous counterparts in many currencies, manycountries.

Exposed to special kind of risks, opportunities and challenges.

Essential Prerequis i tes For Effect ive FX Management:

Awareness about historical development of world trade. Ability to forecast future trends. Comparative analysis skills. In-depth knowledge of local and international fx market. Knowledge of interest rates. Readiness to take risks. Hedging skills to avoid possible losses and exploit the potential.


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What is Foreign Exchange Market ?

An over the counter marketplace where one currency is traded foranother.

Commercial banks are the market makers.

Corporates use the market for their operations, e.g., payments of: Imports. Principle & interest on FCY loans. Export receipts. Conversion of currencies. Hedging. Fund placements.

Speed and efficiency in settlement is reflected in extreme thintrade margins.


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What is Foreign Exchange (FX) Market ?

Retail Market

Spot Market

InterbankMarket


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Just like Treasury, FX Market also operates at three

levels.

i. Retail market - Currency Dealers/ Exchangecompanies

It is also referred as Open Market & used for:

1. Encashment of Travelers Cheques.

2. Sale / purchase of currencies for travelers.


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Spot Market.

1. Sale / purchase at spot rate of currencies held inaccounts.

2. Spot exchange rate is driven by demand supply

equations and other market forces.3. Delivery (settlements) through accounts is (spot),i.e., within two business days.

4. A deal results in taking a position at the deal ratewhich may be squared afterwards at a rate

prevailing then.5. Open (unadjusted) positions are rolled over next

day until settled.6. The process results in eventual gain / loss on

trading.


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iii. Interbank Market.

The Largest FinancialMarket In The World

Linkage throughElectronic Dealing

platform,Telephone, Fax,

SWIFT.

Turnover is fargreater thanglobal stock

markets.

An Informal ArrangementOf Large CommercialBanks And FX Brokers

Average dailyturnover inSeptember

2010 was USD:4.00 Trillion


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FX Rates

Price of one currency in terms of another.

Rate of USD/ PKR: 99.50 mean that one unit of US Dollar costs

PKR: 99.50.

Question: What would be the impact if the rate moves to:i. 99.60

ii. 99.40

Why all currencies in the world are not traded against each

other?

Book keeping and reconciliation issues.

Exchange rate complexities and their volatility.

Problems in Payment and settlement mechanism


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FX Rates

Determinants of Foreign Exchange Rates.

Basic economic and fiscal policies of the host government withregard to:

o Fiscal and monitory policy.o Inflation.o Trade policieso Balance of payment position.

Countries with a consistently lower inflation rate exhibit a risingcurrency value, as their purchasing power increases relative to

other currencies.

Other things remaining same, sound economic policies result instronger currencies.

Political and psychological factors- e.G., US dollar is a safeheaven.


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FX Rates

Technical Factors:

Capital movement

Relative inflation rates

Exchange rate policy.- Free float or managed

Interest rates - By manipulating interest rates, central banks exertinfluence over both inflation and exchange rates, and changinginterest rates impact inflation and currency values.

Speculative moves and profit taking

Balance of payments

Demand and supply


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FX Rates

Exchange Rate Quotations- Direct And Indirect

In a currency pair, the first currency in the pair is called theBase currency and the second the quote or counter

currency.

Direct quote:

The domestic currency is the base currency, while theforeign currency is the quote currency. e.g.,

EUR 0.7210 = USD 1.00 (in the Euro zone).

Direct quotes formula is used by most countries. For a USA dealer the above direct quote would read as

USD/EUR: 1.3869 ( $ 1.00 /0.7210)


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FX RatesIndirect quotes:

Just the opposite of a Direct quote. Here:

Foreign currency is the base currency. Domestic currency the quote currency.

For a dealer in USA, the EUR/USD quote is an indirect one. Indirect quote of 0.7210 EUR/USD means that it takes 0.7210

euros to purchase US$1.00 It is used in UK, Australia, New Zealand & Canada.

General Rules.

All cross-currency rates contain four decimal points, e.g.,USD/ GBP rate would appear as 1.5729.

For deals involving JPY, rate will contain two decimal points, e.g.,USD/ JPY : 114.14

Spreads in pricing are quoted in pip, i.e., counted from fourth decimal

place.


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FX RatesBid Price:

Rate at which a market maker is ready to buy a unit ofcurrency A, against currency B, or vice versa.

It reflects what the trader of currency A will receive for sale(shortening) of a position.

Ask Price: Rate at which a market player is ready to sell a unit of

currency A, against currency B or vice-versa.

It is the price a trader will pay to buy (Long) currency B.

Bid/ ask quotation is a TWO way quote where the bid priceis always mentioned first, e.g., for USD/ GBP deal, the

quote will be 1.5726/29. (Here the sp read is 3 pips )*


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FX Rates

Example:

Base currency: USDQuote currency: GBPDeal amount: GBP: 100

Bid : 100 x 1.5726 = USD :157.26Ask: 100 x 1.5729 = USD :157.29

Here a trader pays $ 1.5726 fo r one GBP bought and

receives $ 1.5729 fo r each un it of GBP so ld.

Percentage Spread = Ask Bid x100Ask


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Cross Rate Exchange rate for a currency that is based on exchange rate

of two other currencies.

Direct Direct Indirect Indirect

Quotes Bid Ask Bid Ask

GBP 1.9712 1.9717 0.5072 0.5073

EUR 1.4739 1.4744 0.6783 0.6785

FX Rates


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GBP 1.9712 1.9717 0.5072 0.5073

EUR 1.4739 1.4744 0.6783 0.6785

Example A.

A bank customer wants to sell 1,000 for EURO. The Bank will sell $ (to buy

) @ $1.9712.

The sale yields Bank Customer: 1,000 x 1.9712 = $1,972.

The Bank will buy $ (and sell EURO) @ 0.6783.

The sale of $ yields Bank Customer: $1,972 x0.6783 =:1,337.

Bank Customer has effectively sold British pounds at/ bid price of

1,337/ 1,000 =1.3371/ 1.00.


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GBP 1.9712 1.9717 0.5072 0.5073

EUR 1.4739 1.4744 0.6783 0.6785

Example B

A bank customer wants to sell1,000 for GBP. The Bank will sell $ (to buy)

@0.6785.

The sale yields Bank Customer: 1,000 .6785 = $1,474.

The Bank will buy $ (to sell ) @ $1.9717.

The sale of $ yields Bank Customer: $1,474 1.9717 = 747.

Here the customer has effectively bought GBP at a/ ask price of1,000,000/747,497 =1.3378/1.00.

Currency against currency bid-ask spread for GBP is1.3371-1.3378.


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FX RatesForward Rate:

A quotation used in forward market to deliver one currency in futureagainst another currency based on the exchange rate determined at thetime of conclusion of contract.

Delivery is made according to the choice of the customer, e.G., 1,3,6,9and 12 months.

Depending on market trends and future outlook, forward rate may behigher or lower that the spot rate.

If forward rate is higher than the spot rate then currency is said to betrading at a premium and vice-versa.

Calculation of premium or discount percentage:= (Forward rate- Spo t rate) x 12 x100

Spo t rate n

(Where n is the number of months till maturity)


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Intermediate Arrangements ForDetermination Of Exchange Rates

Domestic currency pegged to a foreigncurrency

A currency pegged to a basket of

currenciesFlexibility limited in terms of asingle currency

Independent / free float.

Managed / Dirty float


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Foreign Exchange Market Risk.

Risk that the value of an asset or liability will change becauseof a change in exchange rates.

Because these international obligations span time, foreignexchange risk can arise.

Types of Risk:

Transaction Exposure: The risk that the domestic cost orproceeds of a transaction may change, i.e., Rate, Credit or

liquidity risk, etc.

contd


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Foreign Exchange Market Risk.

Types of Risk:

Translation Exposure: Risk in translation of value offoreign-currency-denominated assets affected byexchange rate changes.

Economic Exposure: Risk that exchange rate changesmay affect the present value of future income streams.

Hedging A tool for offsetting the exposure to risk.


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Currency Exposure Management


Foreign Exchange Position- Balances ofbanks FXassets and liabilities that generates the risk of obtainingadditional revenues or expenditures upon modification ofexchange rates.

Open Foreign Exchange Position - Represents thedifference between the amount of FX assets in a certaincurrency and the amount of FX liabilities in the respective

currency.

contd


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Long & Short Position


Foreign Exchange Position- Balances ofbanks FXassets and liabilities that generates the risk of obtainingadditional revenues or expenditures upon modification ofexchange rates.

Open Foreign Exchange Position - Represents thedifference between the amount of FX assets in a certaincurrency and the amount of FX liabilities in the respective

currency.

contd


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The Open Foreign Exchange PositionIs Long:

If the sum of FX assets in a certain currency exceedsthe sum of FX liabilities in the respective foreigncurrency.

Long Position: A situation where a quote currency is purchased at a

price with a motive to sell it afterwards at a profit.Also referred as the notion of Buy low sell high.

contd


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Managing Foreign Exchange Rate Risk

In foreign exchange transactions the rate risk appears intwo forms:Net exchange positions. If the position is long or overbought and there is a

depreciation of the currency, a loss is sure to occur.

The opposite result would occur if the net exchangeposition is short or oversold in that currency

Swap positions or mismatched maturities By definition, a swap involves a simultaneous buyand sale of currency for two different maturities.

A swap transaction does not affect the net

exchange position


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The Open Foreign Exchange Position Is Short:

If the sum of FX liabilities in a certain currency exceedsthe sum of FX assets in the respective currency.

Short Position Just the opposite of long position. If one currency in pair is rising and the other is

falling and trend is likely to continue The dealer will sell the falling currency (short)

with an objective to buy it back later(cover) at alower rate.

Every trader has long position on one currency of thepair and short on another currency.

contd


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Managing Foreign Exchange


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Managing Foreign ExchangeRate Risk

Usual Risk Management

Measures.

Exchange Risk hedging

Internationally diversified portfolio

Cost of HEDGING risk vs.

UNCOVERED EXPOSURE.


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Exchange RiskProductsIn PakistamForward rate

agreement

Interestrate Swap

ForeignCurrencyoptions

Currency

Derivatives

Swap transaction

Currency swap

Forward contract

fixed and option


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Exchange Risk Hedginga. Forward Contract Fixed And Option.

A forward contract (Deal) is:

A binding agreement between the bank and itscustomer.

For purchase and / or sale of a specified amountof foreign currency.

At a rate (forward rate) fixed at the time thecontract is taken up.

For delivery in future.

Deals having a delivery period of more than twobusiness days from the date of the deal (generally onemonth onwards) are classified as forward deals.

contd


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Exchange Risk Hedging

a. Forward contract fixed and option.

Forward rate is:

The exchange rate fixed on the date of deal. Delivery against which will take place on a fixed

date, or between two dates in future.

Forward contracts:

Can be arranged to cover periods for as long as 10years ahead in some major currencies.

But generally for periods between one and twelvemonths.

contd


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Exchange Risk Hedgingb. Swap Transaction.

It entails: Simultaneous sale and purchase or vice versa

of the same foreign currency.

With the same counter-party as a singletransaction with two different value dates at theagreed exchange rates.

The bank to pay and receive the same (or

nearly the same) amount of foreign currency,the difference in rates represents the interestdifferential of the foreign exchange currenciesinvolved for the period of the swap.

contd


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b. Swap Transact ion .

It enables a company to utilize funds held in onecurrency towards meeting obligations

denominated in another currency, withoutincurring foreign exchange risk.

It is an effective and efficient Cash Managementtool for companies that have assets andliabilities denominated in different currencies.

contd


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c. Currency Swap.

Is similar to a parallel or back-to-back loan.

The counter-parties do not lend currencies to each

other but: Sell them to each other with a simultaneousagreement to reverse the exchange ofcurrencies.

At a fixed date in future at the same price.

Interest rates for the two currencies are not reflected inthe two exchanges but are paid separately.

contd


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Exchange Risk Hedgingc. Currency Swap.

It is a useful financial tool utilized by banks,multinational corporations and institutional investors,under which: The bank exchanges with the customer notional

amounts of different currencies initially, and a seriesof interest payments on the initial cash flows.

Quite often, one party may have to pay a fixed interestrate, while the other pays a floating exchange rate.

At the maturity of the swap, the principal amounts areexchanged back.

Unlike an interest rate swap, the principal and interestare both exchanged in full in a currency swap.

contd


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Generally, both interest rate and currency swaps have the samebenefits for a company.

Currency Swap:

Essentially helps to manage exposure to fluctuations in interestrates or to acquire a lower interest rate than a company wouldotherwise be able to obtain.

Often used because a domestic firm can usually receive betterrates than a foreign firm.

Help companies hedge against interest rate exposure byreducing the uncertainty of future cash flows.

Allow companies to revise their debt conditions to take

advantage of current or expected future market conditions


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ExampleCompanyAis located in the USA and companyBoperates inUK. Company Aneeds a loan denominated in GBP andcompanyBneeds a loan in USD.

The two companies could arrange to swap currencies byestablishing an interest rate, an agreed upon amount and acommon maturity date for the exchange.

These companies could receive interest rate savings bycombiningthe privileged access they have in their respectivemarkets.

Swap maturities are negotiable for long periods, e.g. up to 10years, making them a very flexible method of foreign exchange.


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Exchange Risk Hedgingd. Financial Derivatives:

Under this category the following products are offered by banks inPakistan:

i. Foreign Currency Options

Foreign Currency (FX) options are contracts that give the buyer theright, but not the obligation, to buy or sell one currency against another,at a pre-determined price and on or before a pre-determined date.

Buyer of a call (put) FX option has the right to buy (sell) a currency

against another at a specified rate. If this right can only be exercised ona specific date, then the option is said to be European, whereas if theoption can be exercised on any date prior to its maturity, the option issaid to beAmerican.

Maximum tenor of the option may not exceed one year.

contd



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d. Financial Derivatives:ii. Forward Rate Agreement

A Forward Rate Agreement (FRA) is:

An interest rate contract between twoparties.

It allows an entity to position itself in theinterest rate market. Economically.

FRA is similar to forward borrowing or

lending transactions, however, in case ofFRA, the actual lending / borrowing does nottake place.

contd



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d. Financial Derivatives:ii. Forward Rate Agreement

The parties enter into a contract at a rate for a

Notional Principal amount.

On settlement date, the transactions are Net

Settled against a pre-determined Benchmarkor Reference rate.

The party incurring a negative interest ratedifferential under the transaction settles this bypaying the counter-party the difference amount.

FRAs are off-balance sheet transactions.contd



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d. Financial Derivatives:

ii. Forward Rate Agreement

The payment of the interest differential is usuallysettled "upfront", i.e. on settlement date, with theinterest differential "discounted back" to the present

value.

This discount is calculated by using the settlementinterest rate.

The party quoting the future rate agreement is calledthe "quoter" and the party receiving the quote iscalled the "receiver".

contd



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d. Financial Derivat ives:

i i . Forw ard Rate Agreement

The party quoting the future rate agreement is calledthe "quoter" and the party receiving the quote is called

the "receiver".

Either party can be called the "seller/ lender" or the"buyer/ borrower".

Dealing in FRA is permitted in Pak Rupee only, andwhile there is no restriction on the minimum tenor, themaximum tenor of the FRA is restricted to twenty fourmonths.

E h Ri k H d i


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Exchange Risk Hedginge. Interest Rate Swap

It is a financial contract between two parties exchanging orswapping a stream of interest paymentsfora no tion al

principalamount on multiple occasions during a specif iedper iod.

The principal amount is the same for both sides and notactually exchanged.

On each payment date during the swap period, the cashpayments, based on the difference in fixed/ floating or floating

/ floating rates, are exchanged by the parties with one another.

The party incurring a negative interest rate differential for thatleg pays the other counter-party.

Contd

E h Ri k H d i


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Exchange Risk Hedginge. Interest Rate Swap

There are two types of interest rate swaps:

Single currency interest rate swap Plain Vanilla fixed-for-floating swaps often

called Interest rate swaps.

Cross-Currency interest rate swap.

fixed for fixed rate debt service in two (or more)

currencies which is also called a currency swap.Contd


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e. Interest Rate Swap

A company typically uses interest rate swap to: Limit or manage its exposure to fluctuations

in interest rates. To obtain a marginally lower interest ratethan it would have been able to get.

While there is no restriction on the minimum or

maximum size of notional principal amounts ofinterest rate swap or tenor, the maximum tenorof the interest rate swap is restricted to 5 years.


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Exchange Rate Forecasting

WHY & HOW?

Study of Exchange rates behaviour is crucial tohave an ability to forecast exchange rates.

A forecast represents an expectation about afuture value or values of a variable.

The expectation is constructed using an

information set selected by the forecaster.

Based on the information set used by theforecaster, there are two pure approaches toforecasting foreign exchange rates:


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Exchange Rate ForecastingWHY & HOW?

Study of Exchange rates behaviour is crucial to have anability to forecast exchange rates.

A forecast represents an expectation about a future value

or values of a variable.

The expectation is constructed using an information setselected by the forecaster.

Based on the information set used by the forecaster, thereare two pure approaches to forecasting foreign exchangerates.

Two Approaches for Exch Rate Forecasting: Fundamental & Technical.


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1. Fundamental / Conventional Approach.

Based on a wide range of data of fundamental economic variablesthat determine exchange rates.

Economic variables included are GNP, consumption, trade

balance, inflation rates, interest rates, unemployment, productivityindexes, etc.

Structural model is used to generate equilibrium exchange rateswhich can be used for projections / generate trading signals.

A trading signal can be generated every time there is a significantdifference between the model-based expected or forecastedexchange rate and the exchange rate observed in the market.

h i


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(2) Technical Approach.

A forecaster collects data to estimate the forecastingequation.

The estimated forecasting equation is evaluated usingdifferent statistics or measures.

If the forecaster is happy with the model, he/ she will moveto the next step, the generation of forecasts.

The final step is the evaluation of the forecast.

h i f di


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Mechanics of FX Trading

On a normal business day:

Trading is done in Retail Market and wholesale market.

Dealings are via electronic platforms, SWIFT or telephone.

In wholesale dealing pricing for currency pair is quoted as a two way

quote, i.e., pricing to buy and sell.

If agreeable, deal is concluded and settlement details exchanged.

For payment / Receipts communication is channel is SWIFT .

Short position is covered through purchase of the currency & Longposition by sale of the currency.

Potential gain or loss from positions depends on the size of positionand exchange rate at which transactions are concluded.

C i l A C ibili


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Capital Account Convertibility

It is relatively a recent development and partly attributed

to growth of the international trading markets andFOREX markets in particular.

It implies freedom to convert local financial assets intoforeign financial assets and vice versa at marketdetermined rates of exchange.

In simple words language it means that CAC allowsanyone to freely move from local currency into foreign

currency and back.

Since value of the currencies is established incomparison to each other, the ready trade of currenciespotentially offers investors an opportunity for profit.


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Capital Account Convertibility

Relatively a recent development;partly attributed to growth ofIntl trading & FOREX markets inparticular.

Implies freedom to convert localfinancial assets into foreignfinancial assets & vice versa atmarket driven FX rates.

it means that CAC allows anyone

to freely move from local currencyinto foreign currency and back.

Since value of the currencies isestablished in comparison to each

other, the ready trade ofcurrencies potentially offersinvestors an opportunity forprofit.

Foreign Exchange Market In


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Foreign Exchange Market InPakistan Since 1948, Pakistans exchange rate policy has undergone

several changes.

Up until September 1971, exchange rate remained pegged toGBP; thereafter it was tied with the US Dollar which is nowPakistans reserve currency.

In January 1982, an exchange rate regime of managed float wasadopted which was based on a basket of currencies.

In 1991, with the onset of financial sector reforms, a liberalized

exchange regime was introduced with the objective of achievingcurrent account convertibility of the Pak Rupee, which wasrealized in 1993.

The reform process was finally completed in 2000-2001.Contd

i h k ki


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Foreign Exchange Market In Pakistan

Nominal value of Pak Rupee also went through various

changes.

In Sept, 1949, the decision was taken not to devalue theRupee in spite of the fact that the current account deficitin 1948-49 was around 2.5% of the countrys GDP.

Fortuitously, the Korean War helped Pakistan to come outof this deficit and in 1950-51 and Pakistan witnessed asurplus in its current account.

However, with the end of the Korean War in the latter half

of 1953, the tide was reversed and the country was againdrowned in the quagmire of current account deficit.

Contd

F i E h M k I P ki


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Foreign Exchange Market In Pakistan In July, 1955, the Rupee was devalued for the first time and

nominal exchange rate was fixed at PKR: 4.76 per USD.

In 1971, the Rupee was adjusted at PKR: 7.76, and in 1972 itwas again adjusted at PKR: 11.00 per USD.

In 1973, Rupee was devalued by 56.73%.

Pak rupee has depreciated by about 900% since 1971.

Positives Developments

During the 10 years the countrys foreign exchange market hasExhibited a degree of maturity.

Following SBP sponsored market reforms , close monitoring andoccasional market interventions by SBP has reduced the

instances of market jitters.


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TFM session Five FX Management (1).pptx

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Transcript of TFM session Five FX Management (1).pptx