CURRENCYDERIVATIVES

What is a derivative?

• A derivative is a financial instrument (or, more simply, an agreement between two parties) that has a value, based on the expected future price movements of the asset to which it is linked—called the underlying asset, such as a share or a currency. There are many kinds of derivatives, with the most common being swaps, futures, and options

• Currency derivatives can be described as contracts between the sellers and buyers, whose values are to be derived from the underlying assets, the currency amounts. These are basically risk management tools in forex and money markets.

FORWARD CONTRACT• A forward contract or simply a forward is a non-standardized agreement between two parties to buy or sell an asset at a certain future time for a certain price agreed today

• The forward market facilitates the trading of forward contracts on currencies

• MNCs use forward contracts to hedge based on anticipated exchange rate movements. Further it can also be used to hedge against various other kinds of risks like price fluctuations in the real estate market or in the prices of gold etc. It can be used for speculative purposes as well.

• The party agreeing to buy the underlying asset in the future assumes long position, and the party agreeing to sell the asset in the future assumes a short position

• The price specified in the forward contract is called the delivery price

• The time specified is called the delivery time

• If forward rate > existing spot rate then it contains a premium and if forward rate < existing spot rate then it contains a discount

• NON DELIVERABLE FORWARD CONTRACT(NDFs) An NDF represents an agreement regarding a position in specified amount of a specified currency , a specified exchange rate and a specified future settlement date. However an NDF does not result into an actual exchange of currencies at the future date, Instead a payment is made by one party in the agreement to the other party based on the exchange rate at the future date

CLOSING OF FORWARD CONTRACT

• The mutual obligation under the forward contract have to be fulfilled on maturity

• Sometimes the customers may feel incapable of fulfilling the obligation (i.e., delivery or receipt of foreign currency) due to cancellation of import/export orders or delay in the completion of the export/import trade etc.

• Customer here would want to either delay or cancel the contract(i.e., closing out from the contract)

• The closing out procedure involves adjusting or reversing the transaction at the prevailing spot rate and paying the difference

CURRENCY FUTURES

• A currency future is a futures contract to exchange one currency for another at a specified date in the future at a predetermined price(exchange rate)

• A currency future is also known as foreign exchange future or FX Future and has foreign currencies as the underlying assets

• A currency futures contracts are contracts specifying a standard volume of a particular currency to be exchanged on a particular settlement date

• They are commonly traded on the trading floor of the Chicago Mercantile Exchange(CME)

• Other exchanges are LIFFE, IMM, DGCX

HOW THE CURRENCY FUTURES MARKET WORKS?

FIRM/ INDIVIDUAL

COUNTER PARTY

BROKERAGE FIRM 2

BROKERAGE FIRM 1

CME/CLEAR-ING

HOUSES

CONTRACT SIZE OF CURRENCY FUTURES

UNDERLYING CURRENCY

EXCHANGE CONTRACT SIZE

POUND STERLING LIFFE 500,000

JAPANESE YEN IMM 12,500,000

POUND STERLING CME 62,500

CANADIAN DOLLAR CME 100,000

AUSTRALIAN DOLLAR

CME 100,000

EURO CME 125,000

SWISS FRANC CME 125,000

EURO DGCX 50,000

POUND STERLING DGCX 50,000

JAPANESE YEN DGCX 5,000,000

PRICING OF CURRENCY FUTURES

• The price of currency futures normally would be similar to the forward rate for a given currency and settlement date EXAMPLE

• Firms may attempt to purchase forward contract and sell currency futures on the same date and hence earn assured profits of $0.02 per unit

• These actions would put downward pressures on currency future prices bringing its prices down

CURRENCY FUTURESPRICED ON THE POUND AT $ 1.50

FORWARD CONTRACT FOR SIMILAR PERIOD AVAILABLE FOR $ 1.48

CLOSING OUT A FUTURES POSTION

• If a firm holding a currency futures contract decides before settlement dates that it no longer wants to maintain such a position , it can close out its position by selling an identical futures contract

• The gain/ loss to the firm from its previous futures position is dependent on the price of purchasing futures versus selling futures

FORWARDS v/s FUTURES

• Size of contract Tailored to individual needs Standardized

• Delivery date Tailored to individual needs Standardized

• Participants Banks, Brokers and MNCs Banks, Brokers, MNCs Qualified public speculators allowed• Market Place Over the telephone worldwide Central Exchange floor with worldwide communication • Regulation Self Regulating Commodity futures Trading Commission, Nationals Futures Assoc.• Liquidation Most settled by actual delivery Most are offset , very few Some are offset at cost are delivered• Transaction Set by “Spread” between bank’s Negotiated brokerage Cost buy and sell prices fees

CURRENCY OPTIONS

• An option basically involves a choice. Such a choice may or may not be free . It may carry some price or a condition attached for its use. Such an option gives a right to the buyer of the option and forms a subject matter of an agreement or contract between the parties involved . This is known as an options contract

• There are two types of options- Call Option and Put Option

• The call option gives the right to buy a specified asset and the put option gives the right to sell a particular asset

• The specific price at which the option is exercised is known as the strike price or the exercise price

• An options contract is initiated by the seller of the option and hence the seller of the option is known as the writer of the option and hence the act of selling an option is known as writing an option

CURRENCY CALL OPTION •A currency call option grants the right to buy a specific currency at a designated price within a specific time period

• A call option is desirable when one wishes to lock in maximum price to be paid for a currency in the future. If the spot rate of the currency rises above the strike price, owner of the call option can “exercise” their option by purchasing the currency at the strike price, which will be cheaper than the prevailing spot price

•This strategy is somewhat similar to the futures except the fact that options do not come with an obligation to execute the contract. In case of non- exercising of the contract the owners of the expired call option will lose only the premium initially paid by them

FACTORS AFFECTING CALL OPTION PREMIUM

1. Level of existing spot price relative to strike price

2. Length of time before the expiration date

3. Potential variability of the currency

HEDGING WITH CURRENCY CALL OPTIONS

•Supposing there is a firm which bids on a project required by the Canadian government . Hence the firm anticipates a possible need of foreign currency but is not certain of that need as the bid may or may not be accepted

•If the bid is accepted then the firm would need C$ 500,000 to purchase Canadian materials and services, however the firm does not know the bid result until 3 months.

•Assume that the exercise price on the Canadian dollar is $ 0.70 and call option premium is $0.02 per unit

•The firm will have to pay $10,000($0.02*500,000)

•With the options, the maximum amount necessary to purchase the C$500,000 is $350,000($0.70*$500,000)

•Amount of US$ needed could be less if the Canadian dollar spot rate were below the strike rate

•Even if the project’s bid is rejected, the currency call option can be exercised if the Canadian dollar spot rate exceeds the exercise price before the option expires. Any gain from this kind of exercising can partially for fully offset the premium paid for the options

CURRRENCY PUT OPTION

•The owner of the currency put option is granted the right to sell a currency at a specific price(the strike price) within a specified period of time

•The owner of the put option is not under any kind of obligation to exercise the option. Hence the maximum loss to be borne being the premium paid for the options contract

•A currency put option is classified as *in the money- if present exchange rate < strike price *at the money -if present exchange rate = strike price *out of the money- present exchange rate > strike price

FACTORS AFFECTING CURRENCY PUT OPTIONS PREMIUM

1. Spot rate of a currency relative to the strike price

2. Length of the time until the expiration date

3. Variability of the currency

HEDGING WITH CURRENCY PUT OPTION

•Assume that a US firm has exported some goods to Canada and invoiced the products in Canadian dollars

•The firm may suffer losses if the Canadian dollar depreciates over time

•Canadian dollar put option entitles the firm to sell the Canadian dollar at a specific strike price

•If the Canadian dollar appreciates during this time then the firm could let the put option expire and sell the Canadian dollars received at the prevailing spot rate

FINANCIAL SWAPS

•Swaps basically refers to exchange. A swap basically is a private agreement between two parties to exchange cash flows in the future according to a pre- arranged formula •Financial swaps are basically used for asset liability management and risk management

•Financial swaps basically enable or facilitate the exchange of assets or liabilities

FINANCIAL SWAPS

•Financial swaps are not funding instruments but are devices that enable a businessman to acquire the desired forms of financing or investment through exchange of liabilities or assets

•Financial swaps are of two kinds – interest rates swaps and currency swaps

•Swaps are not traded in the organised exchanges

INTEREST RATE SWAP •In an interest rate swap a party which has taken a fixed interest rate loan exchanges it or a floating exchange rate loan or vice-versa•Two kinds of interest rate swaps – fixed to floating(plain vanilla coupon swap) and floating to fixed interest rate swap•They are basically used for hedging

Borrower AFloating rate Payer

Lender x

Intermediary party(fixed rate

payer)

Floating interest rate

Fixed interest rate

Fixed interest rate

Currency swaps

•A currency swap can be used to transform the loan in one currency into a loan into another currency

•Such a need arises when a firm has liability denominated in one currency and an income stream denominated in another currency

MECHANISM OF CURRENCY SWAPS

LOAN(YEN)

INDIAN FIRM PRINCIPAL YEN PRINCIPAL(YEN) COUNTER PARTY

PRINCIPAL DOLLAR PRINCIPAL (DOLLAR)

LENDER OF JAPANESE YEN

BANK

EXCHANGE OF PRINCIPAL

MECHANISM OF CURRENCY SWAPS

INTEREST(YEN)

INDIAN FIRM INTEREST(YEN) PRINCIPAL(YEN) COUNTER PARTY

INCOME(DOLLAR) INTEREST (DOLLAR)

LENDER OF JAPANESE YEN

BANK

EXCHANGE OF INTEREST

INTEREST($)

MECHANISM OF CURRENCY SWAPS

PRINCIPAL(YEN)

INDIAN FIRM PRINCIPAL YEN PRINCIPAL(YEN) COUNTER PARTY

PRINCIPAL DOLLAR PRINCIPAL (DOLLAR)

LENDER OF JAPANESE YEN

BANK

EXCHANGE OF PRINCIPAL

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