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CURRENCY DERIVATIVESAND HEDGING
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INTRODUCTION TO CURRENCYMARKETS
Foreign exchange rate is the value of a foreigncurrency relative to domestic currency.
The exchange of currencies is done in the foreignexchange market.
The participants of the market are banks,corporations, exporters, importers etc.
The foreign exchange contract typically statesthe currency pair, the amount of contract, theagreed rate of exchange etc.
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EXCHANGE RATE
A foreign exchange deal is always done incurrency pairs, for example US Dollar- IndianRupee (USD-INR), Japanese Yen- US Dollar
(JPY-USD). In a currency pair, the first currency is referred
to as the base currency and the second isreferred to as the counter/terms/quotecurrency.
The exchange rate tells the worth of the basecurrency in terms of the terms currency.
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For example, a USD-INR rate of Rs. 48.0530implies that Rs. 48.0530 must be paid to
obtain one US Dollar. Foreign exchange rates are highly volatile and
fluctuate on a real time basis.
A change of USD-INR from 48 to 48.50 impliesthat USD has strengthened/ appreciated andINR has weakened/ depreciated, since a buyer
of USD will now have to pay more INR to buy1 USD than before.
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METHODS TO DETERMINE VALUE OF DOMESTICCURRENCY VIS--VIS OTHER CURRENCIES
FIXED EXCHANGE RATE REGIME OR PEGGEDEXCHANGE RATE, is when a currencys value is
maintained at a fixed ratio to the value ofanother currency or to a basket of currenciesor to any other measure of value e.g. gold.
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In order to maintain fixed exchange rate, a
government participates in open currencymarket.
Another method of maintaining a fixedexchange rate is by making it illegal to tradecurrency at any other rate.
However, this is difficult to enforce and oftenleads to a black market in foreign currency.
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FLOATING RATE REGIME
It is determined by a market mechanismthrough supply and demand for the currency.
Also termed self-correcting, as anyfluctuation in the value caused by differencesin supply and demand will automatically becorrected by the market.
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FACTORS AFFECTING EXCHANGE RATES
FUNDAMENTAL FACTORS
TECHNICAL FACTORS Interest rate
Inflation rate
Exchange rate policy and Central Bank interventions
POLITICAL FACTORS
SPECULATIVE FACTORS
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QUOTES
In currency markets, the rates are generallyquotes in terms of USD.
The price of currency in terms of anothercurrency is called a quote.
A quote where USD is the base currency isreferred to as a direct quote(e.g.1 USD = INR
48.5000) while a quote where USD is referredto as the terms currency is an indirect quote
(e.g. 1 INR=0.021 USD)
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TICK-SIZE Refers to the minimum price differential at which
traders can enter bids and offers.
For example, the Currency Futures contractstraded at NSE have a tick size of Rs.0.0025.
So, if the prevailing futures price is Rs.48.5000,the minimum permissible price movement cancause the new price to be either Rs.48.4975 or
Rs.48.5025. Tick value refers to the amount of money that is
made or lost in a contract with each pricemovement.
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SPREADS
Dealers margin or spread is the difference
between bid price (the price at which a dealer iswilling to buy a foreign currency) and ask price
(the price at which a dealer is willing to sell aforeign currency).
The quote of bid will be lower than ask, which
means the amount to be paid in counter currencyto acquire a base currency will be higher than theamount of counter currency that one can receiveby selling a base currency.
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SPOT TRANSACTION
Spot market transaction does not implyimmediate exchange of currency, rather thesettlement takes place on a value date, which is
usually two business days after the trade date. The price at which deal takes place is known as
the spot rate.
The two- day settlement period allows the partiesto confirm the transaction and arrange paymentto each other.
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FORWARD TRANSACTION
It is a currency transaction wherein actualsettlement date is at a specified future date,which is more than two working days after the
deal date. The date of settlement and the rate of
exchange is specified in the contract.
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CURRENCY DERIVATIVE
Contract between the seller and buyer whosevalue is derived from the underlying which isin this case is the Exchange rate.
Designed for hedging purpose.
Also used as instruments for speculation.
Market participant may enter into a spottransaction and exchange the currency at afuture date.
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FORWARD CONTRACT
Agreement to exchange currencies at anagreed rate on a specified future date.
Actual settlement is more than 2 working daysafter the deal date.
Agreed rate is forward rate and the differencebetween the spot rate and forward rate is
called forward margin.
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FUTURE CONTRACT
Contracts to buy or sell a specific underlyingcurrency at a specific time in the future, for aspecific price.
Currency futures are exchange-tradedcontracts and they are standardized in termsof delivery date, amount and contract terms.
Currency future contracts allow investors tohedge against foreign exchange risk.
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PRICING OF FUTURE CONTRACT
According to Interest Rate Parity Theory, thecurrency margin dependent mainly onprevailing interest rate (for investment for
given period of time) in the two currencies.
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Forward rate can be calculated by:
F / S = 1+Rh / 1+Rf
Where:F and S = Future and Spot Currency rate.
R h and R f = simple interest rate in the home andforeign currency.
If Continuously Compounded interest rate:
F = S * e ( r h r
f)* T
Where:
r h and r f= continuously compounded interest ratefor the home currency and foreign currency.
T = time to maturity
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STRATEGIES USING CURRENCY
FUTURE
The party taking a long(buy) position agree tobuy the base currency at the future rate bypaying the term currency.
The party with a short (sell) position agree tosell the base currency and receive the termscurrency at the pre specified exchange rate.
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K
Profit for the long party
and loss for the short
party
Spot rate of USD-INRexchange rate onsettlement date
Profit
Loss
Profit for the shortparty and loss for thelong party
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HEDGING USING CURRENCY FUTURE
SHORT HEDGE:
Involve taking a short position in the futuremarket.
In a currency market, short hedge is taken bysomeone who already know the base currencyor is expecting a future receipt of the base
currency.
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Example:An exporter is expecting a payment of USD 1,000,000 after
3 months. Suppose the spot exchange rate is INR 48.000:1 USD
If USD strengthens and the exchange rate becomes INR49.000: 1 USD.
Spot Market
EXP will get INR 49,000,000 by selling 1 million USD in thespot market.
Future Market
EXP will lose INR ( 48-49)*1000 = INR 1000 per contract.The total loss in 1000 contract will be INR 1,000,000.
Net Receipt in INR
49 million 1 million = 48 million
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If USD weakens and the exchange ratebecomes INR 47.000 : 1 USD
Spot Market
EXP will get INR 47,000,000 by selling 1 millionUSD In the spot market.
Future marketEXP will gain INR (48-47)*1000 = INR 1000 per
contract. The total gain in 1000 contract will
be INR 1,000,0000.Net Receipt in INR
47 million + 1 million = 48 million
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LONG HEDGE:
Involve holding a long position in the futuremarket.
A long position holder agree to buy the base
currency at the expiry date by paying theagreed exchange rate.
This strategy is used by those who will need to
acquire base currency in the future to pay anyliability in the future.
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EXAMPLE:An importer ordered computer hardware from abroad
and has to make a payment of USD 1,000,000 after 3
months. Suppose the spot exchange rate is INR 48.000: 1USD
If USD strengthens and the exchange rate becomesINR 49.000: 1 USD
Spot MarketIMP has to pay more i.e. INR 49,000,000 for buying 1million USD in the spot market.
Future Market
IMP will gain INR ( 49-48)*1000 = 1000 per contract.The total profit in 1000 contract will be INR1,000,000.
Net Payment in INR
-49 million + 1 million = 48 million
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If USD weakens and the exchange ratebecomes INR 47.000 : 1 USD
Spot Market
IMP will have to pay less i.e. 47,000,000 foracquiring 1 million USD in the spot market.
Future Market
IMP will lose INR ( 48-47)*1000 = INR 1000 percontract. The total loss in 1000 contract will be
INR 1,000,000.Net Payment in INR
-47 million 1 million = 48 million.
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