43 forex hedging

8/10/2019 43 Forex Hedging

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Forex hedging vehicles

INTRODUCTION

As the requirements of the foreign exchange market grew manifold, so did the

complexity of its operation. This triggered of a simultaneous evolution of various

financial instruments. One of the most significant developments in the foreign exchange

market, occurred in Chicago on May !, "#$ when the %nternational Monetary Market

&%MM', a division of the Chicago Mercantile (xchange &CM(', introduced the world)s

first futures contract in foreign currencies. The %MM was therefore the first exclusive

currency futures exchange. *ate on, %nterest rate futures were introduced in "#+ at the

Chicago oard of Trade &COT' with -overnment ational Mortgage Association

certificate &-MAs' and Treasury ills.

Owing in to the esta/lishment of two main commodity exchanges in Chicago, vi0,

the Chicago oard of Trade &COT' in 121 and Chicago Mercantile (xchange &CM('in 1"1, large scale trading in commodity futures commenced much /efore the start of

trading in financial futures. 3owever, with the introduction of currency futures at the

%MM, for the first time money was formally regarded as commodity in "#$. The

phenomenon growth of deals in financial futures have already made them a vital and

integral part of the world)s financial markets.
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The man generally regarded as the father of currency futures contract is *eo

Melamed, who in "!", as a Chairperson of CM( realised the need to diversity Chicago

exchanges out of agricultural commodities. %t look, however, some time for the financial

world outside America to realise the potential of futures market as tool to cover adverse

interest rate and exchange rate movements. The first ma4or non567 financial future

marker place was therefore esta/lished in "1$ in the 68. %t is known as *ondon

%nternational 9inancial 9utures (xchange &*%99('. *ater on several other countries, such

as, Canada, 3ong 8ong, :apan and the financial super market of 9ar (ast, 7ingapore, also

started financial futures exchanges. 9or many /ankers, hedgers, traders and speculators,

financial futures are now more cost effective in covering interest rate and exchange

exposure than cash market alternatives such as forward contract, etc.

Short Hedge and Long H edge:

The terms short term hedge and long hedge distinguish hedges that involves short

and long positions in the futures contract, respectively. A hedger who holds the

commodity and is concerned a/out a decrease in its price might consider hedging it with

a short position in futures. %f the spot price and futures price move together, the hedge

will reduce some of the risk. 9or example, if the spot price decreases, the futures pricesalso will decrease. 7ince the hedge is short the futures contract;the futures transaction

produces a profit that at least partially offsets the loss on the spot position. This is called a

short hedge /ecause the hedger is short futures.

Another type of short hedge can /e used in anticipation of the future sale of an

asset. An example of this occurs when a firm decides that it will need to /orrow money at

a later date. orrowing money is equivalent to issuing or selling a /ond or promissory

note. %f interest rates increase /efore the money is /orrowed , the loan will /e more

expensive. A similar risk exists risk exists if a firm has issued a floating rate lia/ility.

7ince the rate is periodically reset, the firm has contracted for a series of future loans at

unknown rates. To hedge this risk, the firm might short an interest rate future contract. %f

rates increase, the futures transaction will generate a profit that will at last partially offset

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the higher interest rate on the loan. ecause it is taken out in anticipation of a future

transaction in the spot market, this type of hedge is known as an anticipatory hedge.

Another type of anticipatory hedge involves an individual who plans to purchase a

commodity at a later date. 9earing an increases in the commodity)s price, the investor

might /uy a futures contract. Then, if the price of the commodity increases, the futures

price also will increases and produce a profit on the futures position. That profit also will

at least partially offset the higher cost of purchasing the commodity. This is long hedge,

/ecause the hedger is long in the future market.

%n each of these cases, the hedger held a position in the spot market that was

su/4ect to risk. The futures transaction served as a temporary su/stitute for a spot

transaction. Thus, when one holds the spot commodity and is concerned a/out a price

decrease /ut does not want to sell it, one can execute a short futures trade. 7elling the

futures contract would su/stitute for selling the commodity.


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FORWARD OO!IN" CONTRACT

The choice of futures contract actually consists of three decision=5

>hich futures commodity

>hich expiration month

>hether to /e long or short

Which #$t$res co%%odit&

%t is important to select a future contract on a commodity that is highly correlated

with the underlying commodity /eing hedged. %n many cases the choice is o/vious, /ut in

some it is not. 9or example, suppose one wishes to hedge the rate on /ank C?s, which

are short term money market instrument issued /y commercial /anks. There is no /ank

C?s future contract so the hedger must choose from among some other similar contracts.

*iquidity is important, /ecause the hedger must /e a/le to close the contract easily. %f the

future contract lacks the necessary liquidity, the hedger should select a contract that has

sufficient liquidity and is highly correlated with the spot commodity /eing hedged. 7ince

/oth treasury /ills and (urodollars are short5term money market instruments, their futures

contracts, which are quite liquid, would seem appropriate for hedging /ank C?s rates. Of

course, if the hedger wanted the hedging instruments to /e identical to the underlying

3edging Technology

9orward ookingContract

Currency 9uture Currency Option Currency 7wap

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spot asset, he or she could go to the over5counter5market and request a forward contract,

/ut that would entail some other considerations.

Another factor one should consider is whether the contract is correctly priced. A

short hedger will /e selling futures contracts and therefore should look for contracts that

are overpriced or, in the worst case, correctly priced. A long hedger should hedge /y

/uying under priced contracts or, in the worst case correctly priced contracts. 7ometimes

the /est hedge can /e o/tained /y using more than one futures commodity.

Which 'x(iration %onth

Once one has selected the future commodity, one must decide on the expiration

month. As we know, only certain expiration month trade at a given time. %f the Treasury

/ond future contracts is the appropriate hedging vehicle, the contract used must come

from this group of expirations.

%n the most cases there will /e a time hori0on over which the hedge remains in effect.

To o/tain the maximum reduction in /asis risk, a hedger should hold the future position

until as close as possi/le to expiration. Thus an appropriate contract expiration would /e

one that corresponded as closely as possi/le to the expiration date. 3owever, the general

rule of thum/ is to avoid holding a futures position in the expiration month. This is

/ecause unusual price movements sometimes are o/served in the expiration month and

this would pose an additional risk hedgers. Thus, the hedger should choose an expiration

month that is as close as possi/le to /ut after the month in which the hedge is terminated.

3owever, this rule used not always /e strictly followed since all contract don)t exhi/it

unusual price /ehaviour in the expiration month .%nfect, the longer time expiration, the

less liquid is the contract. Therefore, the selection of a contract according to this criterion

may need to /e overruled /y the necessity of using a liquid contract. %f this happens, one

should use a contract with shorter expiration. >hen the contract moves into its expiration

month, the future position is closed out and a new position is opened in the next

expiration month.

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Long or Short

After selecting the future commodity and expiration month, the hedger mustdecide whether to /e long or short. This decision is critical and there is a/solutely no

room for a mistake here. %f a hedger goes long &or short' when he should have /een short

&or long' he has dou/le the risk. The end result will /e a gain or twice the amount of the

gain or loss of the un hedged position.

The decision of whether to go long or short requires a determination of which

type of market move will result in a loss in the spot market. %t then requires esta/lishing a

future position that will /e profita/le while the spot position is losing. The first method

requires that the hedger identify the worst case scenario and then esta/lish future position

that will profit if the worst case does occur. The second method requires taking a future

position that is opposite to the current spot position. This is a simple method, /ut in some

cases it is difficult to identify the current spot position. The third method identifies the

spot transaction that will /e conducted when the hedge is terminated.

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FORWARD RAT' A"R'')'NT *FRA+

9@A is an off5/alance sheet contract /etween two counterparties to pay &5' or receive &'

the difference &called settlement amount' /etween=

An agreed fixed rate &the 9@A rate'

The interest rate prevailing on a stipulated future date &the 9ixing date'

ased on a notional amount for an agreed period &the contract period'

%n short, in an 9@A interest rate is fixed now for a future period. The special feature

of 9@A is that the interest payment are calculated on the notional principal and the only

payment is the difference /etween the 9@A rate and @eference @ate and hence are single

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settlement contracts. y entering into an 9@A one can swap from floating rates to fixed

rates or vice versa for the term of the 9@A. They can /e used to hedge /orrowing costs of

investment returns in foreign currencies and can /e tailored to suit exact requirements of

its users. As mentioned earlier, in an 9@A agreement, no principal amounts are

exchanged initially. Thus, /y /uying an 9@A, one can guarantee the future /orrowing

cost against a rise in interest rates. On the other hand, a seller of an 9@A can protect

himself against a drop in interest rates.

Feat$res o# FRAs

,- Flexi.ilit&:9@As can /e priced for a variety of commencement and maturity date

which offers the flexi/ility to choose the exposure a firm will have at any point of

time. 9or example, there may /e times when a /orrower may /e happy with

floating rate exposure, /ut is concerned that in six months it will change. 9@A can

cover exposure in six months time for the client as per his discretion.

/- Reversi.ilit&: ?espite /eing a very effective tool in managing short term interest

rate exposures, having entered into 9@A once, one is locked into the agreement

whether rates moves in favour or against. One can terminate 9@A agreement only

at a cost /y reim/ursing the arranging /ank a payment /ased on current market

rates.

0- alance Sheet I%(lication1 9@A provide off5/alance sheet financial engineering

as there are no principal amounts amounts exchanged in 9@As and hence the does

not incur additional assets;lia/ilities on its /alance sheet. 9@A therefore does

affect gearing or leverage ratios of firm. The only interest rate exposure arising

from an 9@A is the differential /etween the 9@A rate and floating rates

represented /y the prevailing @eference @ate &@@'such as *%O@ &*ondon %nter

ank Offered @ate' in the international market and 7(5M%O@ &Mum/ai %nter

ank Offered @ate'in the @upee market in %ndia.

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2- Transaction date: The settlement sum for 9@A is calculated on the fixing date /y

discounting /ack the difference /etween the previously contracted 9@A rate and

the then prevailing @eference rate. %n such deals money changes hand only on

settlement date, therefore there are no payment either on the transaction date or,

on the maturity date.

Advantages o# FRA

A typical case where firms;/anks may wish to utili0e 9@A as a short term hedging

instruments is around the announcement of the next Credit policy, and the concern that

market may /ecome extremely volatile at that time. %n such a case the firm can either an

9@A agreement now to ensure that /orrowing costs or investment returns do not /ecause

of this volatility.

The advantages of 9@A deals may /e summari0ed as=5

,- 9@As can /e tailored to one)s requirements /y date and amount.

/- Are simpler then a financial future as no fees, initial and variation margin require

to /e paid in 9@As.

0- -ood alternative to forward cash transaction without affecting /alance sheet.

2- Can /e used to fix interest rates on all or part of money market positions.

3- 9@As and cash may /e used for generating opportunities more efficiently.

4- *ow utili0ation of /ank)s credit line.

5- Counterparty risk in the form of settlement risk only with exposure only to

interest variation as the principal amount is 4ust notional.

6- Bositions can easily /e reversed /y /uying and selling an equal and offsetting

9@A.

Li%itations o# FRAs

9@As do not remove interest rate or exchange rate exposure rather they are a

means of ad4usting or exchanging these exposures on a short term /asis. %f the treasury

term picks the market correctly, it may very well limit costs or improve returns, /ut there

will still /e market risk and the risk that the yield curve will change shape. Anyone

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involved in treasury operations will /e very aware that managing interest rate and

exchange rate exposure is an on going task.

FRAs #or ta7ing a vie8 on rates

One of the most common application of 9@A is to swap floating rate /orrowings

or investments to fixed for a short period of time. This can /e achieved through /uying an

9@A. A firm may wish to do this from time to guard against volatility in floating rates.

Alternatively, firms having huge fixed rate exposure may decide to use 9@As to swap to

floating for a short period of time this may /e in line with a view that floating rate are on

the way down &or up for those who wish to protect investment returns', or /ecause it

more closely matches the interest rates /asis of other commitments over a certain period.

%n this case the firm would sell an 9@A.

7uppose for example, a firm has fixed rate investments and is planning to lease

some equipment in order to expand operations in two months time, for a period of six

months. The lease payments will /e /ased on floating interest rates. The firm can hedge

this future exposure /y selling a $s 1s 9@A today to swap the appropriate amount of fixed

rate investments to floating. The investments returns will then match firm)s floating rate

o/ligation on the lease transaction. >hen the lease expires, firm)s investment will once

again /e on a fixed /asis.

Ho8 to 7no8 8hen to Use FRAs

>hether a firm will /enefit from 9@As or not can /e 4udged /y conducting a

thorough examination of funding requirement and the investment strategies of the firm

/oth current and future. >hile firm)s view on interest rates is fundamental to the

consideration of whether an 9@A is appropriate, some more vital questions that need to

/e adequately looked at are=a- Are funding;deposits of long or short term natureD

.- Are funding;deposits of fixed or floating rate of interestD

c- ?o funding;deposits requirements vary in maturity and value or are they fairlyD

d- >hat is the firm)s view on interest ratesD

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e- Are there any pro4ects;expansions in future which will require additional

funding D %s there likely to /e any excess funds arising which will need to /e

depositedD

CURR'NC9 FURUR'S

INTRODUCTION

The li/eralisation and integration of world capital markets in the "1Es was

inspired /y a com/ination of hope and necessity. The hope lay in the expectation of more

efficient allocation of saving and investment, /oth within national markets and across the

world at large. The necessity stemmed from the macroeconomic and financial insta/ility

F the insta/ility engendered government deficits and external im/alances that required

financing on a scale unprecedented in peace time and that exceeded the capacity or

willingness of the traditionally fragmented financial markets to cover. These financing

needs 4oined with advances in technology and communications to spawn a host of

innovations, ranging from securitisanon in place of intermediated /ank credit to new

derivative instruments. Taken together, innovation technology and deregulation have

smashed the /arriers /oth within and among national financial markets.

Currency 9uture

(xport &*ong on 9oreign Currency' %mport &7hort On 9oreign Currency

7hort Currency 9uture 3edge *ong Currency 9uture 3edge


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Today world financial markets are growing in si0e, sophistication and glo/al

integration. According to an estimate, the international securities transactions amounted

to G! trillion per quarter in the second half of ""< F a/out five to six times the value of

international trade5in six group of seven countries. This increased volume of portfolio

capital movements has made foreign exchange markets much more sensitive to changes

in financial markets. These markets have acquired clout as an indicator of the credi/ility

of the government)s actual or prospective policies, as a disciplining mechanism for

industrial and developing countries alike.

F$t$res )ar7ets

%n the past several years, derivatives market has attached many new and

inexperienced entrants. The spectacular growth of the new futures markets in interest

rates and stock markets indexes has generated a demand for a unified economic theory of

the effects of futures markets F in commodities, financial instruments, stock market

indexes and foreign exchange F upon the intertemporal allocation of resources.

The /asic assumption of the investment theory is that investors are risk averse. %f

risk is to /e equated with uncertainly, can we question the validity of this assumption D>hat evidence is there D As living, functional proof of the appropriateness of the risk

aversion assumption, there exists entire market whose sole underlying purpose is to allow

investors to display their uncertainties a/out the future. These particular markets, with

primary focus on the future, are called 4ust that future markets. These markets allow for

the existence of futures markets is the /alance /etween the num/er of hedgers and

operators who are willing to transfer and accept risk.

What are Financial F$t$res

A H9utures) contract is a standardi0ed agreement /etween two parties to /uy or

sell specific commodity, financial instrument or currencies, at a specific time and place in

the future, at a price esta/lished through open outcry in a central, -enerally high open

interest is related to greater liquidity. Technical analyst in the futures market use /oth

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Trading Iolume and open interest to measure the direction of futures prices and possi/le

liquidity position. Thus an increase in /oth open interest and Trading Iolume is said to /e

hinting at a strong market and a weaker market is represented /y fall in /oth of them.

7imilarly, high Trading Iolume coupled with low open interest denotes volatility and

riskiness of the market.

ene#its o# Financial F$t$res

%n recent years, interest rates and currency exchange rates have /ecome highly

volatile, 9inancial futures were set up to provide a means of lessening the impact of

these5fluctuations. Accordingly, /enefits of financial futures can /e summed up as under.

,- Hedge Against Unanticipated Price Rise and Falls : A futures contract is

used to hedge against unanticipated rise or fall in price of an instrument. Thus an

investor who wishes to /uy GEE,EEE in T5notes in four months can /uy a T5ote

contract and lock in the price.

/- Speculation on price movements :A future contract can /e speculate on the

price movement of underlying instrument. %n futures contract one need not holdthe instrument to /enefit from price movements. 9or example = An investor who

/elieves that prices of T5otes are going to rise, he can /uy futures contracts

rather than the actual instruments. This helps investors to speculate in merkat

movements without owning the T5otes.

0- Speculation on Interest Rate Movements: *ike speculation on price

movements, one can use futures contract even to speculate on the interest rate

movements without owning in the instruments. Thus, if a speculator thinks that

interest rates are likely to go up, he can sell the futures contract since there exists

an inverse relationship /etween price of an instruments and interest rates.


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2- Fixing Long Ter% Ret$rns :An investor who wishes to lock in a long term

return on an instrument can /uy or go Hlong) term &generally two years' futures

contract.

3- Fixing Ret$rn on Floating Rate Invest%ents :9utures allow investors to fix a

rate in floating rate assets. This can /e done /y /uying short term futures contract.

9or example = an investor owns T5ote worth G million with floating rate coupon

of < months *%O@ +E /asis points. The investor can lock in a rate /y /uying a


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are treated as a commodity. Thus, the /uyer in a currency futures contract is /uying a

commodity today for delivery at a later date. The seller will deliver the contract to the

/uyer at the contract rate.

%t price of a particular currency rises a/ove the contract rates, the /uyer reali0es gain

since he receives the currency /y paying a lower price than the market price at that time.

7imilarly, if the exchange rate of a particular currency is far /elow the contract price, the

seller reali0es a gain. 7trategies for hedging in the currency futures market can /e

summari0ed as under =

Hedging R$les

Ris7 o# Strateg&

%ncrease in price uy &long' 9utures

?ecrease in price 7ell &long' 9utures

For example, a British Importer has to pay $150,000 to an exporter from

USA on 30thApril. The British importer is worrie a!o"t a#erse mo#ements in

the exhan%e rates for US ollar a%ainst po"n an hene eies to o#er the

exhan%e ris& in the f"t"res mar&et at 'IFF(. The ) *5,000 an the mat"rity is

*n

+enesay of "ne. The "rrent spot rate is ass"me to !e $1,5*00 an the"ne ontrat is !ein% trae at $1,5000.

Sine the importer is apprehenin% a epreiation in the po"n sterlin%,

he eie to sell fo"r "ne ontrat at $1,5000 to o#er his expos"re of

$150,000. -n 30thApril, the spot rate in the ash mar&et is $1,/00 per po"n

sterlin% an the "ne f"t"res ontrat is now train% at $1,00. In the f"t"res

prie mar&et he an !"y !a& his fo"r ontrat sol at $1,5000 at the "rrent

f"t"res prie as $1,00 an th"s ma&in% a profile of fo"r ents per sterlin%

ontrat )*5,000 eah, this total profile wo"l !e $,000 or )*,0* as per the

"rrent spot rate of $1,/00. 2a he eie not to he%e the ris&, his loss wo"l

ha#e !een )*,. This is !ea"se p"rhase of $150,000 at the "rrent prie will

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ost him )101,351 $150,00041./ ompare to the )6/,/ $150,00041.5*

al"late at the spot rate r"lin% when he eie for he%e the ris&.

7"rreny f"t"res, as shown here, may not pro#ie the perfet he%e sine

the amo"nts an mat"rity ate may not always oinie. This pro#ies one of the

%reatest limitations of "sin% "rreny f"t"res for he%in% expose eals.

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CURREC! "P#I"S

7"rreny option o#er#iew

-ptions on forei%n exhan%e8 It9s really no ifferent to options on shares

or real estate. The !asi premise is that the !"yer of an option has the ri%ht !"t

not the o!li%ation to enter into a ontrat with the seller. :at"rally the option

owner exerises this ri%ht when it is to his4her a#anta%e. 7"rreny options

speify a forei%n exhan%e ontrat an %i#e the owner the ri%ht to enter into the

speifie ontrat "rin% a pre;a%ree perio of time.

7"rreny -ptions ha#e %aine aeptane as in#al"a!le tools in mana%in%

forei%n exhan%e ris&. They are "se extensi#ely an ma&e "p !etween 5 ; 10 "es. They are now !ein% "se extensi#ely

!y the !an&in% an orporate setors, inl"in% %o#ernments to re"e

!orrowin% ost an to mana%e their interest rate an "rreny expos"res. The

e#elopment of interest an "rreny swap now pro#ies a tool no finanial

mana%er an i%nore. It has also tri%%ere off inno#ation of a whole ran%e of

eri#ati#e pro"ts li&e swaptions an others that ha#e %reatly expane the

opport"nities for finanial mana%ement.

There are many reasons for the %rowth of swap mar&et. It was ori%inally

e#elope for easier aess to international mar&ets !y E:7s in #ehile

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"rreniesG an swap them into their esire "rrenies. Hehile "rrenies are

those "rrenies in whih E:7s an !orrow heaply, !"t are at"ally not

intereste in arryin% any s"h e!t. By swappin% #ehile "rreny to the esire

"rreny, E:7s try to re"e their !orrowin% ost. Besies, the a!ility of the

swap mar&et to meet %rowin% nees of a #ast n"m!er of potential "sers with

ifferent re>"irement has also mae swap a tool whih perhaps no other finanial

instr"ment an math. All these ha#e res"lte in reati#e an ynami inte%ration

of worls se"rities, money an forei%n exhan%e mar&ets. Swap also helpe in

wienin% of the hoie a#aila!le to "sers for !orrowin%, in#estin%, he%in% an

ar!itra%in% in ifferent mar&ets.

The "rreny swap mar&et %aine le%itimay from the swap !etween IBE

an worl !an& in 16/1. Sine then, the #ol"me of swap transations ha#e %rown

manifol to an estimate US$ .5 trillion !y Earh *001.

#'e )asic S*ap Structure

A swap is enie as a ontrat"al a%reement !etween the parties to

exhan%e a series of ash payments for an a%ree term. It is a powerf"l tool for

manip"latin% ross "rreny ash flows witho"t reatin% a net exhan%e position.Sine its ineption, swap str"t"re ha#e "ner%one tremeno"s han%es "e to

the in%en"ity an ima%ination of swap mana%ers an arran%ers. The primary

swap mar&et onsists of swaps of new e!t ris&s. :early 0 to 0 perent of all

("ro!on iss"e are swap relate. The seonary mar&et on swap onsists

primarily of inter!an& train% an orporate he%in% transations.

Two !asi swap str"t"res are referre as Interest rate swap an "rreny swap.

They are is"sse in the followin% setions.

a+ #'e Interest Rate S*ap

By far the most ommon type of swap is interest rate or o"pon swap. An

interest rate swap is an a%reement for the exhan%e of interest lia!ilities of

ifferin% harater !etween two o"nterparties. For example, exhan%e of fixe

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rate interest for floatin% rate interest lia!ility in the same "rreny. This is

al"late !ase on a m"t"ally a%ree national prinipal amo"nt. Th"s, in

interest rate swap one party may pay a fixe rate of interest, while the other pays

floatin% rate, s"h as three month 'IB-J re;fixe e#ery three months. The

prinipal, !"t national amo"nt is applia!le solely for the al"lation of interest to

!e exhan%e "ner the swap. At no time prinipal amo"nt is physially "s"ally

passe !etween the o"nterparties. +ith the help of this swap str"t"re, the

o"nterparties are a!le to on#ert fixe rate interest !"ren to a floatin% rate

interest an #ie #ersa. Three main types of interest rate swap are @

b+ Coupon S*aps ?

These swaps relate to exhan%e of floatin% rate e.%. 'IB-J for fixe rate of

interest lia!ilities an #ie #ersa. For example, a AAA rate ompany a%rees to

raise f"ns at floatin% 'IB-J to swap with a fixe rate of interest !"ren.

c+ )asis S*aps :

A !asis rate swap is an a%reement to exhan%e similar o!li%ations, al"late

on ifferent roll;o#er ates, for an a%ree term. For example, two o"nterparties

may a%ree to exhan%e their lia!ilities for perioi payments !ase on ifferent

inies K one payin% months 'IB-J in exhan%e for 3 months 'IB-J.Th"s,

!asis rate swap is essentially for the exhan%e of floatin% interest rates of

ifferent roll;o#er ates in ifferent "rrenies. The examples of !asis rate swaps

are ? 3 months 'IB-J, Base #s months 'IB-J, 7ommerial paper #s 'IB-J,

Lrime Jate #s 'IB-J, Base rate #s 'IB-J an few more.7ross "rreny interest

rate swap. These swaps relate to exhan%e of fixe rate flows in one "rreny for

floatin% rate flows in another.

)enefits of Interest Rate S*aps

-ne of the reasons for the phenomenal %rowth of interest rate swap has !een

its i#erse "se. They are !ein% inreasin%ly "se for mana%in% lia!ilities s"h as

he%e a%ainst a#erse rate mo#ements or to ahie#e a hosen !len of fixe

an floatin% rate e!t. Eany in#estors now "se swap to reate hi%h yielin% fixe

$


24/48


rate instr"ments or to on#ert their fixe rate ash flow to a systemati floatin%

rate ash flow. Some of the !enefits of interest rate swaps are as follows ?

Tailor mae interest payments ? Interest payment on swap an also !e time to

s"it a lients re>"irement of payin% lower interest in the earlier years an a

hi%her rate in the later years.

'ower ost of f"ns ? 'ar%e n"m!er of interest rate swap eals are str"& for

re"in% interest ost an expos"res. The a!ility of interest rate swap

transations to transfer fixe rate ost a#anta%e to floatin% rate lia!ilities has le

to many hi%h reit ratin% firms or !an&s iss"in% fixe rate ("ro!ons. All s"h

iss"es are mainly "se for swap an o!tain, in many ase, 'IB-J;less f"nin%. It

is not s"rprisin% to fin many "sers !ein% a!le to re"e thro"%h swap their

!orrowin% ost in floatin% rate !y as m"h as 50 to 5 !asis points !elow 'IB-J.

S"h ost sa#in%s an !e #ery s"!stantial on a lar%e swap eal.

Attrati#e rates ? It is >"ite possi!le for any swap mar&et ma&er to fin

hi%hly attrati#e rate. This an !e ahie#e !y aref"lly timin% the ("ro!on

iss"es for ens"rin% its s"ess at the !est rate an also !y ens"rin% the !est

possi!le swap terms for the iss"er.

Aess to lar%e n"m!er of mar&ets ? In aition to the ost a#anta%e,

interest rate swaps pro#ie an exellent opport"nities for firms or !an&s to tap

mar&et whih are otherwise inaessi!le to them "e to their poor reit >"ality,

la& of rep"tation, "n;familiarity of the forei%n mar&et, or e#en exessi#e "se of

the finanial mar&et. It also helps firms to raise from attrati#e mar&ets witho"t

any nee f"lfill omplex re>"irements s"h as prospet"s, islos"res, reit

ratin%s, roa shows et. The %rowin% "se of ommerial paper as he "nerlyin%

floatin% rate !asis in the swap mar&et f"rther re;affirms the flexi!ility an

importane of interest rate swaps.

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25/48


Eana%in% interest rate expos"re ? Interest rate swaps allow firms to

mana%e their interest rates expos"res more ati#ely. They ena!le firms to swith

o#er from floatin% rate to fixe an !a& a%ain, !ase on the o"tloo& of the

mo#ements. The interest rate swap an also !e "se !y treas"rers in a elinin%

interest rate en#ironment. For example, a ompany may swap its fixe rate e!t

at 1*< to o!tain 'IB-J at the !e%innin% of interest rare eline. C"rin% the

perio of interest rate eline, this firm may lea#e the swap eal intat to wait for

f"rther fall. -ne the interest rate has finally eline to say 10< the firm may

enter into a seon swap to lo& intoG the new lower fixe rates of 10


26/48


The "rreny swap emer%e primarily to ir"m#ent restritions !y a"thorities

on iss"in% e!t an remittane of f"ns !etween o"ntries. It %aine le%itimay

from the swap !etween worl !an& an IBE in 16/1. C"e to its a!ility to lin&

apital mar&et with finanial mar&et, "rreny swap has %aine rei!ility o#er

years. (#er sine its aoption in 16/1, swap has fo"n "ni#ersal reo%nition "e

to its #ersatile appliation.

7"rreny swaps operate on the same ar!itra%e prinipal as interest rate

swaps. A "rreny swap is an a%reement to exhan%e prinipal an interest

payments in ifferent "rrenies for a state perio. If two !orrowers are

perei#e to !e of ifferent reit ris&s in ifferent "rreny mar&ets an

!orrowe at ifferent mar&et spreas, a "rreny swap may allow them to o!tain

heaper f"ns than !y iss"in% iretly in the "rreny they re>"ire. 'i&e interest

rate swaps, it is not neessary for an iss"er to ha#e a!sol"te a#anta%e in one

mar&et. -ne iss"er an ha#e an a!sol"te a#anta%e in !oth mar&et, pro#ie it

has a omparati#e a#anta%e in one mar&et. In orer to !enefit from "rreny

swap, the new iss"e sprea ifferential !etween the two iss"ers in eah "rreny

m"st !e ifferent.

Eost fixe to floatin% "rreny swaps are a om!ination of an interest rate

swap in one "rreny an a floatin% to floatin% ross "rreny swap. In some

"rrenies it is possi!le to o a fixe to floatin% rate "rreny swap iretly.

Fi,ed Rate Currenc$ S*ap

A fixe rate "rreny swap onsist of the exhan%e !etween two

o"nterparties of fixe rate interest in one "rreny in ret"rn for fixe rate interest

in another "rreny. The followin% three !asi steps are ommon to all "rreny

swaps ?

a Intial (xhan%e of Lrinipal ? -n the ommenement of the swap the

o"nterparties exhan%e the prinipal amo"nts of the swap at an a%ree rate of

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27/48


exhan%e. Altho"%h this rate is "s"ally !ase on the spot exhan%e rate, a

forwar rate set in a#ane of the swap ommenement ate an also !e "se.

This initial exhan%e may !e on a nationalG !asis i.e. no physial exhan%e of

prinipal amo"nts or alternati#ely a physialG exhan%e.

+hether the initial exhan%e, is on physial or national !asis its sole

importane is to esta!lish the >"ant"m of the respeti#e prinipal amo"nts for the

p"rpose of (a) al"latin% the on%oin% payments of interest an (b) the re;

exhan%e of prinipal amo"nts "ner the swap.

! -n%oin% (xhan%e of Interest ? -ne the prinipal amo"nts are esta!lishe,

the o"nterparties exhan%e interest payments !ase on the o"tstanin%

prinipal amo"nts at the respeti#e fixe interest rates a%ree at the o"tset of the

transation.

Je;exhan%e of Lrinipal Interest ?-n the mat"rity ate the o"nterparties re;

exhan%e the prinipal amo"nts esta!lishe at the o"tset. This strai%htforwar,

three;step proess is stanar pratie in the swap mar&et an res"lts in the

effeti#e transformation of a e!t raise in one "rreny into a f"llyKhe%e

fixe rate lia!ility in another "rreny.

In prinipal, the fixe "rreny swap str"t"re is similar to the on#entional

lon%;ate forwar forei%n exhan%e ontrat. 2owe#er, the o"nterparty nat"re

of the swap mar&et res"lts in a for %reater flexi!ility in respet of !oth mat"rity

perios an si=e of the transations whih may !e arran%e. A "rreny swap

str"t"re also allows for interest rate ifferentials !etween the two "rrenies #ia

perioi payments rather than the l"mp;s"m reflete !y forwar points "se in

the forei%n exhan%e mar&et. This ena!les the swap str"t"re to !e "stomi=e

to fit the o"nterparties exat re>"irements at attrati#e rates. For example, the

ash flows of an "nerlyin% !on iss"e may !e mathe exatly an in#aria!ly.

$#


28/48


Salient Features of Currenc$ S*ap

The "rreny swap or ross "rreny swap as shown in the pre#io"s two

example, is harateri=e y the followin% feat"res ?

a+ F"ll exhan%e of prinipal ta&es plae either at the start of the swap eal

or M"st on mat"rity.

b+ enerally prinipal is exhan%e at the spot exhan%e rate, !oth at the

start or mat"rity of the eal. Sometimes a forwar rate may also !e sent

ri%ht in the !e%innin% of the eal for final exhan%e of "rrenies.

c+ Lerioi interest payments are mae for o"tstanin% amo"nt on eah

rollo#er ate in ifferent "rrenies. This feat"re of "rreny swap

ifferentiates it from forwar ontrat where l"mp;s"m are exhan%e at

the en.

d+ The swap eal may ha#e a tailore a%reement to math the re>"irement

for "nerlyin% eal !ein% he%e.

e+ The "rreny swap eal an !e reser#e witho"t "psettin% the "nerlyin%

transation.

#'us- t'e t'ree basic information re.uired for a currenc$ s*ap deal are ?

+hih "rreny to !e pai an whih one to !e reei#e.

The exhan%e rate to !e "se for swap an,

+hether the exhan%e of prinipal will ta&e plae at the start or on

mat"rity of the ontrat.

Users and sellers of currenc$ s*ap :

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29/48


Besies %o#ernment a%enies, asset mana%ers an re%ional !an&s, firms

with hi%h reit ratin% sin%le A or a!o#e with the a!ility to iss"e ("ro!on are

the "sers of "rreny swap in the primary mar&et. +hereas, firms with si%nifiant

forei%n operation an expos"re are the seonary mar&et "sers of "rreny

swap. Few re%ional !an&s an %o#ernment a%enies also "se "rreny swaps to

re"e their ost on lin% term fixe !ons. Asset mana%ers "se "rreny swap to

i#ersity their portfolios to inl"e ompanies that o not iss"e e!t in US ollars

witho"t exposin% themsel#es to exhan%e ris&. In#estment !an&s howe#er "se

"rreny swaps to eliminate exhan%e ris& an to help sell forei%n "rreny

!ons to in#estors.

The sellers of "rreny swaps are %enerally in#estment !an&s an

ommerial !an&s@ with their wie networ& in the !"siness, in#estment an

ommerial !an&s ha#e wie information on "sers of "rreny swap. As a res"lt,

finin% o"nterparties on a %i#en "rreny is not always a iffi"lt tas& for them.

)enefit of currenc$ s*aps

In ommon with the interest rate swap, few maMor a#anta%es of "rreny

swap are as "ner ?I/ Credit arbitrage ? 7"rreny swaps are "se for re"in% !orrowin% ost

of "sers. it allows o"nterparties to ta&e a#anta%e of ifferent reit

pereption !etween mar&ets, espeially ("romar&ets where name

reo%nition is perhaps more #ital than reit ratin%. This ena!les firms with

relati#ely !etter rep"tation to raise f"ns at finer rates omesti mar&et.

II/ &ider access to mar0ets : In aition to ost a#anta%e, "rreny

ar!itra%e ena!les firms to ha#e aess to e#en those money mar&ets

whih wo"l !e otherwise iffi"lt or not ost effeti#e. In this way

"rreny swaps inte%rate the apital mar&ets of the entire worl. It is not

s"rprisin%, therefore to fin as A"stralian Bon iss"e !ein% swappe

$"


30/48


ompletely for US ollar. In fat a lar%e n"m!er of A"stralian an :ew

Nealan !on iss"e are swappe.

III/ Fle,ibilit$ in deal : Immense flexi!ility of the "rreny swap str"t"res

an also lon%er mat"rities of a#aila!le f"ns ma&e this tehni>"e an

in#al"a!le tool.

I1/ Meeting Investor Preferences : In#estors ha#e ifferent in#estin%

re>"irements. Sometimes they may prefer one metho to another.

7"rreny swap pro#ies #ariety of in#estment opport"nities for in#estment

witho"t any exhan%e ris&.

1/ Hedge currenc$ e,posures : If a !orrower has iss"e e!t witho"t

he%in% o"pon an prinipal repayments, "rreny swaps may !e "se

to he%e all or part of the expos"res, there!y re"in% expos"re ris&.

1I/ International (ebt Management : 7"rreny swaps are "se !y firm in

one "rreny into another !ase on the expetation of "rreny

mo#ements. Swap an !e "se to lo& in a %ain on a forei%n "rreny

!orrowin% or to limit a loss in"rre.

1II/ #a, Management :7"rreny swaps an !e "se to lo& in %ain on a

forei%n !orrowin% while eferrin% the tax reo%nition of that %ain.

1III/ #o e,pand mar0et : +hen an instit"tion "ses the same mar&et to raise

f"ns time an a%ain, the reit mar&et sat"rates. 7"rreny swap allows

them to tap new mar&ets.


31/48


S&AP#I"S

A swaption is an option on a swap which can /e written on interest rate swaps,

currency swaps, commodity swaps or equity swaps. The concept is almost identical to an

optional cap. The end user and the swap dealer agrees to the terms of a swap. 3ence, a

swaption &also known as a swapoption' is an option to enter into an interest rate swap. %n

return for a premium paya/le in advance, the /orrower has the right /ut not the

o/ligation, to enter a swap at the pre5agreed fixed rate level.

A swaption is a valua/le tool when a customer may require a swap /ut is

uncertain with regard to timing etc. The typical structure would /e for a /orrower to /uy

a six month or one year option to conclude an interest rate swap at near current market

levels. This type of product can /e particularly useful in situations where the corporate or

institution is quoting on new /usiness which involves a considera/le or material exposure

/ut where the firm is uncertain as to the tender outcome. The maximum loss the customer

faces is this the premium amount.

A swaption is not directly compara/le to a cap, since the period of protection is

very different. 9or example a one year option to enter into a four year swap gives the

right to exercise within one year after one year the /orrower has either exercised the

swaption. %n which case he is locked into a swap, or has allowed the swaption to expire,

in which case no protection is in place for the next four years. The swaption is a valua/le

however, and has a useful role in lia/ility management F particularly where a /orrower

prefers the certainly of paying fixed rate through a swap.

Option on interest rate swaps are referred as swaptions. The /uyer of a swaption

has the right to enter an interest rate swap agreement /y some specified date in the future.

The swaption agreement will specify whether the /uyer of the swaption will /e a fixed5

rate receive or a fixed5rate payer. The writer of the swaption /ecomes the counterparty to

the swap if the /uyer exercises. %f the /uyer of the swaption has the right to enter into a


32/48


swap as a fixed5rate payer, the swap is called a Lcall swaption. The writer therefore

/ecomes the fixed5rate receive;floating5rate payer. %f the /uyer of swaption has the right

to enter into a swap as floating5rate payer, the swap is called as Lput swaption The

writer of the swaption therefore /ecomes the floating5rates receive fixed5rate payer. The

strike rate of the swaption indicates the fixed rate that will /e swapped versus the floating

rate. The swaption will also specify the maturity date of the swap. A swaption may /e

(uropean or American. Of course, as in all options, the /uyer of a swaption pays the

writer a premium, although the premium can /e structured into the swap terms so that no

upfront fee has to /e paid. A swaption can /e used to hedge a portfolio strategy that uses

an interest rates swap /ut where the cash flows of the underlying assets or lia/ility are

uncertain. The cash flows of the assets will /e uncertain if it &i'is called, as in the case of

calla/le /onds, converti/le /onds , a loan that can /e prepaid etc, and ;or&ii'expose the

investors;lendor to default risk.


33/48


CAS;FLOORS;COLLARS

Interest Rate Ca(s

An interest rate cap is an arrangement where/y the sellar of the cap undertakes to

compensate the /uyer of the cap /y whatever percentages reference interest rate &for eg.

43 forex hedging

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