A Report on Exposure and Risk

in International

FinanceSubmitted to

Prof. Navin Rego

Faculty for International Finance

Mulund College of Commerce

Submitted by

Students of TYBMS

Niraj Biyani Roll

No. 7303

Prakarsh GagdaniRoll

No. 7308

Pooja Indurkar Roll

No. 7312

Pooja Joshi Roll

No. 7315

Tilottama Sen Roll

No. 7333

Anuya Ukidway Roll

No. 7338

Chapter No. 7 Exposure and Risk in

International Finance

Concepts

1 & 2. Exposure and Risk

Exposure is a measure of the sensitivity of the value of a

financial item (asset, liability or cash flow) to changes in the relevant

risk factor while risk is a measure of variability of the value of the

item attributable to the risk factor. Let us understand this distinction

clearly. April 1993 to about July 1995 the exchange rate between

rupee and US dollar was almost rock steady. Consider a firm whose

business involved both exports to and imports from the US. During

this period the firm would have readily agreed that its operating

cash flows were very sensitive to the rupee-dollar exchange rate,

i.e.; it had significant exposure to this exchange rate; at the same

time it would have said that it didn’t perceive significant risk on this

account because given the stability of the rupee-dollar fluctuations

would have been perceived to be minimal. Thus, the magnitude of

the risk is determined by the magnitude of the exposure and the

degree of variability in the relevant risk factor.

3. Hedging:

Hedging means a transaction undertaken specifically to offset

some exposure arising out of the firm’s usual operations. In other

words, a transaction that reduces the price risk of an underlying

security or commodity position by making the appropriate offsetting

derivative transaction.

In hedging a firm tries to reduce the uncertainty of cash flows

arising out of the exchange rate fluctuations. With the help of this a

firm makes its cash flows certain by using the derivative markets.

4. Speculation

Speculation means a deliberate creation of a position for the

express purpose of generating a profit from fluctuation in that

particular market, accepting the added risk. A decision not to hedge

an exposure arising out of operations is also equivalent to

speculation.

Opposite to hedging, in speculation a firm does not take two

opposite positions in the any of the markets. They keep their

positions open.

5. Call Option:

A call option gives the buyer the right, but not the obligation,

to buy the underlying instrument. Selling a call means that you have

sold the right, but not the obligation, to someone to buy something

from you.

6. Put Option:

A put option gives the buyer the right, but not the obligation,

to sell the underlying instrument. Selling a put means that you have

sold the right, but not the obligation, to someone to sell something

to you.

7. Strike Price:

The predetermined price upon which the buyer and the seller

of an option have agreed is the strike price, also called the ‘exercise

price’ or the striking price. Each option on an underlying instrument

shall have multiple strike prices.

8. Currency Swaps:

In a currency swap, the two payment streams being

exchanged are denominated in two different currencies. Usually, an

exchange of principal amount at the beginning and a re-exchange at

termination are also a feature of a currency swap.

A typical fixed-to-fixed currency swaps work as follows. One

party raises a fixed rate liability in currency X say US dollars while

the other raises fixed rate funding in currency Y say DEM. The

principal amounts are equivalent at the current market rate of

exchange. At the initiation of the swap contract, the principal

amounts are exchanged with the first party getting DEM and the

second party getting dollars. Subsequently, the first party makes

periodic DEM payments to the second, computed as interest at a

fixed rate on the DEM principal while it receives from the second

party payment in dollars again computed as interest on the dollar

principal. At maturity, the dollar and DEM principals are re-

exchanged.

A floating-to-floating currency swap will have both payments at

floating rate but in different currencies. Contracts without the

exchange and re-exchange do exist. In most cases, an intermediary-

a swap bank- structures the deal and routes the payments from one

party to another.

A fixed-to-floating currency swap is a combination of a fixed-to-

fixed currency swaps and a fixed-to-floating interest rate swap.

Here, one payment stream is at a fixed rate in currency X while the

other is at a floating rate in currency Y.

9. Futures

Futures are exchanged traded contracts to sell or buy financial

instruments or physical commodities for future delivery at an agreed

price. There is an agreement to buy or sell a specified quantity of

financial instrument/commodity in a designated future month at a

price agreed upon by the buyer and seller. The contracts have

certain standardized specification.

10. Transaction Exposure

This is a measure of the sensitivity of the home currency value

of the assets and liabilities, which are denominated, in the foreign

currency, to unanticipated changes in the exchange rates, when the

assets or liabilities are liquidated. The foreign currency values of

these items are contractually fixed, i.e.; do not vary with exchange

rate. It is also known as contractual exposure.

Some typical situations, which give rise to transactions exposure,

are:

(a) A currency has to be converted in order to make or

receive payment for goods and services;

(b) A currency has to be converted to repay a loan or make

an interest payment; or

(c)A currency has to be converted to make a dividend payment,

royalty payment, etc.

Note that in each case, the foreign value of the item is fixed;

the uncertainty pertains to the home currency value. The important

points to be noted are (1) transaction exposures usually have short

time horizons and (2) operating cash flows are affected.

11. Translation Exposure

Also called Balance Sheet Exposure, it is the exposure on

assets and liabilities appearing in the balance sheet but which is not

going to be liquidated in the foreseeable future. Translation risk is

the related measure of variability.

The key difference is the transaction and the translation

exposure is that the former has impact on cash flows while the later

has no direct effect on cash flows. (This is true only if there are no

tax effects arising out of translation gains and losses.)

Translation exposure typically arises when a parent

multinational company is required to consolidate a foreign

subsidiary’s statements from its functional currency into the

parent’s home currency. Thus suppose an Indian company has a UK

subsidiary. At the beginning of the parent’s financial year the

subsidiary has real estate, inventories and cash valued at, 1000000,

200000 and 150000 pound respectively. The spot rate is Rs. 52 per

pound sterling by the close of the financial year these have changed

to 950000 pounds, 205000 pounds and 160000 pounds respectively.

However during the year there has been a drastic depreciation of

pound to Rs. 47. If the parent is required to translate the

subsidiary’s balance sheet from pound sterling to Rupees at the

current exchange rate, it has suffered a translation loss. The

translation value of its assets has declined from Rs. 70200000 to Rs.

61805000. Note that no cash movement is involved since the

subsidiary is not to be liquidated. Also note that there must have

been a translation gain on subsidiary’s liabilities, ex. Debt

denominated pound sterling.

12. Contingent Exposure

The principle focus is on the items which will have the impact

on the cash flows of the firm and whose values are not contractually

fixed in foreign currency terms. Contingent exposure has a much

shorter time horizon. Typical situation giving rises to such exposures

are

a. An export and import deal is being negotiated and

quantities and prices are yet not to be finalized. Fluctuations

in the exchange rate will probably influence both and then it

will be converted into transactions exposure.

b. The firm has submitted a tender bid on an equipment supply

contract. If the contract is awarded, transactions exposure

will arise.

c. A firm imports a product from abroad and sells it in the

domestic market. Supplies from abroad are received

continuously but for marketing reasons the firm publishes a

home currency price list which holds good for six months

while home currency revenues may be more or less certain,

costs measured in home currency are exposed to currency

fluctuations.

In all the cases currency movements will affect future cash

flows.

13. Competitive exposure

Competitive exposure is the most crucial dimensions of the

currency exposure. Its time horizon is longer than of transactional

exposure – say around three years and the focus is on the future

cash flows and hence on long run survival and value of the firm.

Consider a firm, which is involved in producing goods for exports

and /or imports substitutes. It may also import a part of its raw

materials, components etc. a change in exchange rate gives rise to

no. of concerns for such a firm, example,

1. What will be the effect on sales volumes if prices are

maintained? If prices are changed? Should prices be changed?

For instance a firm exporting to a foreign market might benefit

from reducing its foreign currency priced to foreign customers.

Following an appreciation of foreign currency, a firm, which

produces import substitutes, may contemplate in its domestic

currency price to its domestic customers without hurting its

sales. A firm supplying inputs to its customers who in turn are

exporters will find that the demand for its product is sensitive

to exchange rates.

2. Since a part of inputs are imported material cost will increase

following a depreciation of the home currency. Even if all

inputs are locally purchased, if their production requires

imported inputs the firms material cost will be affected

following a change in exchange rate.

3. Labour cost may also increase if cost of living increases and

the wages have to be raised.

4. Interest cost on working capital may rise if in response to

depreciation the authorities resort to monetary tightening.

5. Exchange rate changes are usually accompanied by if not

caused by difference in inflation across countries. Domestic

inflation will increase the firm’s material and labour cost quite

independently of exchange rate changes. This will affect its

competitiveness in all the markets but particularly so in

markets where it is competing with firms of other countries

6. Real exchange rate changes also alter income distribution

across countries. The real appreciation of the US dollar vis-à-

vis deutsche mark implies and increases in real incomes of US

residents and a fall in real incomes of Germans. For an

American firm, which sells both at home, exports to Germany,

the net impact depends upon the relative income elasticities in

addition to any effect to relative price changes.

Thus, the total impact of a real exchange rate change on a

firm’s sales, costs and margins depends upon the response of

consumers, suppliers, competitors and the government to this

macroeconomic shock.

In general, an exchange rate change will effect both future

revenues as well as operating costs and hence exchange rates

changes, relative inflation rates at home and abroad, extent of

competition in the product and input markets, currency composition

of the firm’s costs as compared to its competitors’ costs, price

elasticities of export and import demand and supply and so forth.

Descriptive

1. What is currency risk? Enumerate the different types of

currency risks with examples.

Ans. Currency risk arises due to exposures explained in concepts 10

to 13

2. Discuss the exposure and risk occurring due to the

changes in

a) Interest rates

b) Exchange rates

Ans.

a) Interest rate uncertainty exposes a firm to the following kinds of

risks:

1. If the firm has borrowed on a floating rate basis, at very reset

date, the rate for the following period would be set in line with

the market rate. The firm’s future interest payments are

therefore uncertain. An increase in rates will adversely affect

the cash flows.

2. Consider a firm, which wants to undertake a fixed investment

project. Suppose it requires foreign currency financing and is

forced to borrow on a floating rate basis. Since its cost of

capital is uncertain, an additional element of risk is introduced

in project appraisal.

3. On the other hand, consider a firm, which has borrowed on a

fixed rate basis to finance a fixed investment project.

Subsequently inflation rate in the economy slows down and the

market rate of interest declines. The cash flows from the

project may decline as a result of the fall in the rate of inflation

but the firm is logged into high cost borrowing.

4. A fund manager expects to receive a sizable inflow of funds in

three months to be invested in five –year interest rate will have

declined thus reducing the return on his investments.

5. A bank has invested in a six-month loan at 18% and financed it

by means of a three-month deposit at 16.5%. At the end of

three months it must refinance its investment. If deposits rates

go up in the mean while its margin will be reduced or may

even turn negative.

6. A fund manager is holding a portfolio fixed income securities

such as government and corporate bonds. Fluctuations in

interest rates expose into two kinds of risks. The first is that

the market value of his portfolio varies inversely with interest

rates. This is the risk of capital gains or losses. Secondly he

receives periodic interest payments on his holdings, which

have to be reinvested. The return he can obtain on these

reinvestments in uncertain.

In each of these cases, an adverse movement in interest rates

hurts the firm by either increasing the cost of borrowing or by

reducing the return on investment or producing capital losses on its

assets portfolio. During the early 80’s investor’s preferences shifted

towards floating rate instruments thus exposing borrowers to

substantial interest rate risks.

For most Indian companies the idea of interest rate risk is

relatively new. In an environment of administered rates and

fragmented, compartmentalized capital markets, neither investors

nor borrowers felt the need to worry fluctuations in interest rates.

With increasing resort to external commercial borrowings,

Indian companies have had to recognize and learn to manage

interest rate risk. Also, the Indian financial system is gradually

moving in the direction of market determined interest rate risk. Also,

the Indian financial system is gradually moving in the direction of

market determined interest rates. During the last few years the

environment has changed drastically. In particular, the steep rise in

interest rates during 1995-1996 has led to the painful realization

that careful management of the interest rate risk is crucial to a

firm’s financial health.

Ans. 2. b) Same as descriptive question no. 1

3. Discuss the available tools to manage risk involved due to

fluctuations in exchange rates and interest rates.

Ans.

A firm may be able to reduce or eliminate currency exposure

by means of internal and external hedging strategies.

INTERNAL HEDGING STARTEGIES Invoicing

A firm may be able to shift the entire risk to another party by

invoicing its exports in its home currency and insisting that its

imports too be invoiced in its home currency, but in the presence of

well functioning forwards markets this will not yield any added

benefit compared to a forward hedge. At times, it may diminish the

firm’s competitive advantage if it refuses to invoice its cross-border

sales in the buyer’s currency.

In the following cases invoicing is used as a means of hedging:

1. Trade between developed countries in manufactured products

is generally invoiced in the exporter’s currency.

2. Trade in primary products and capital assets are generally

invoiced in a major vehicle currency such as the US dollar.

3. Trade between a developed and a less developed country

tends to be invoiced in the developed country’s currency.

4. If a country has a higher and more volatile inflation rate than

its trading partners, there is a tendency not to use that

country’s currency in trade invoicing.

Another hedging tool in this context is the use of “currency

cocktails” for invoicing. Thus for instance, British importer of

fertilizer from Germany can negotiate with the supplier that the

invoice is partly in DEM & partly in Sterling. This way both the

parties share exposure. Another possibility is to use one of the

“standard currency baskets” such as the SDR or the ECU for

invoicing trade transactions.

Basket invoicing offers the advantage of diversification and

can reduce the variance of home currency value of the payable or

receivable as long as there is no perfect correlation between the

constituent currencies. The risk is reduced but not eliminated. Also,

there is no way by which the exposure can be hedged since there is

no forward markets I these composite currencies. As a result, this

technique has not become very popular.

Netting and Offsetting :

A firm with receivables and payables in diverse currencies can

net out its exposure in each currency by matching receivables with

payables. Thus a firm with exports to and imports from say Germany

need not cover each transaction separately; it can use a receivable

to settle all or part of a payable and take a hedge only for the net

DEM payable or receivable. Even if the timings of the two flows do

not match, it might be possible to lead or lag one of them to achieve

a match.

To be able to use netting effectively, the company must have

continuously updated information on inter-subsidiary payments

position as well as payables and receivables to outsiders. One way

of ensuring efficient information gathering is to centralise cash

management.

Leading and lagging: Another internal way of managing

transactions exposure is to shift the timing of exposures by leading

or lagging payables and receivables. The general rule is lead, i.e.

advance payables and lag, i.e. postpone receivables in “strong”

currencies and, conversely, lead receivables and lag payables in

weak currencies. Simply shifting the exposure in time is not enough;

it has to be combined with a borrowing/lending transaction or a

forward transaction to complete the hedge.

Both these tools exist as a response to the existence of market

imperfections.

External Tools

A. Using hedging for forwards market:

In the normal course of business, a firm will have several

contractual exposures in various currencies maturing at various

dates. The net exposure in a given currency at a given date is

simply the difference between the total inflows and the total

outflows to be settled on that date. Thus suppose ABC Co. has the

following items outstanding:

Item Value Dates to

maturity

1.USD receivable 800,000 60

2.NLG payable 2,000,000 90

3.USD interest payable 100,000 180

4.USD payable 200,000 60

5.USD purchased forward 300,000 60

6.USD loan installment due 250,000 60

7.NLG purchased forward 1,000,000 90

Its net exposure in USD at 60 days is:

(800,000+300,000)-(200,000+250,000)=+USD 650,000

Whereas it has a net exposure in NLG of –1,000,000 at 90 days.

The use of forward contracts to hedge transactions exposure at

a single date is quite straightforward. A contractual net inflow of

foreign currency is sold forward and a contractual net outflow is

bought forward. This removes all uncertainty regarding the domestic

currency value of the receivable or payable. Thus in the above

example, to hedge the 60 day USD exposure, ABC Co. can sell

forward USD 650,000 while for the NLG exposure it can buy NLG

1,000,000 90 day forward.

What about exposures at different date? One obvious solution

is to hedge each exposure separately with a forward sale or

purchase contract as the case may be. Thus in the example, the firm

can hedge the 60 day USD exposure with a forward sale and the 180

day USD exposure with a forward purchase.

B. Hedging with the money market:

Firms, which have access to international money markets for

short-term borrowing as well as investment, can use the money

market for hedging transactions exposure.

E.g.: Suppose a German firm ABC has a 90 day Dutch Guilder

receivable of NLG 10,000,000. It has access to Euro deposit markets

in DEM as well as NLG. To cover this exposure it can execute the

following sequence of transactions:

1. Borrow NLG in the euroNLG market for 90 days.

2. Convert spot to DEM.

3. Use DEM in its operations, e.g. to pay off a short-term bank

loan or finance inventory.

4. When the receivable is settled, use it to pay off the NLG loan.

Suppose the rates are as follows:

NLG/DEM Spot: 101025/35 90day forward: 1.1045/65

EuroNLG interest rates: 5 1/4/5 ½

EuroDEM interest rates: 4 3/4/5.00

Comparing the forward cover against the money market cover.

With forward cover, each NLG sold will give an inflow of DEM

(1/1.064)= DEM 0.9038, 90 days later. The present value of this (at

4.74%) is

0.9038/[1+ (0.0475/4)]= DEM 0.8931

To cover using the money market, for each NLG of receivable,

borrow NLG 1/[1+ (0.055/4)]

= NLG 0.9864, sell this spot to get DEM (0.9864/1.1035)

=DEM 0.8939

Pay off the NLG loan when the receivables mature. Thus the

money markets cover; there is a net gain of DEM 0.0008 per NLG of

receivable or DEM 8000 for the 10 million-guilder receivable.

Sometimes the money market hedge may turn out to be the

more economical alternative because of some constraints imposed

by governments. For instance, domestic firms may not be allowed

access to the Euromarket in their home currency or non-residents

may not be permitted access to domestic money markets. This will

lead to significant differentials between the Euromarket and

domestic money market interest rates for the same currency. Since

forward premia/ discounts are related to Euromarket interest

differentials between two currencies, such an imperfection will

present opportunities for cost saving.

E.g. A Danish firm has imported computers worth $ 5 million

from a US supplier. The payment is due in 180 days. The market

rates are as follows:

DKK/USD Spot: 5.5010/20

180 days forward: 5.4095/ 5.4110

Euro $: 9 1/2/ 9 ¾

Euro DKK: 6 1/4/ 6 ½

Domestic DKK: 5 1/4/ 5 ½

The Danish government has imposed a temporary ban on non-

residents borrowing in the domestic money market. For each dollar

of payable, forward cover involves an outflow of DKK 5.4110, 180

days from now. Instead for each dollar of payable, the firm can

borrow DKK 502525 at 5.5%, acquit $ 0.9547 in the spot market and

invest this at 9.50% in a Euro $ deposit to accumulate to one dollar

to settle the payable. It will have to repay DKK 5.3969 [=5.2525*

1.0275], 180 days later. This represents a saving of DKK 0.0141 per

dollar of payable or DKK 70,500 on the $5 million payable.

From the above example it is clear that from time to time cost

saving opportunities may arise either due to some market

imperfection or natural market conditions, which an alert treasurer

can exploit to make sizeable gains. Having decided to hedge an

exposure, all available alternatives foe executing the hedge should

be examined.

C. Hedging with Currency Options:

Currency options provide a more flexible means to cover

transactions exposure. A contracted foreign currency outflow can be

hedged by purchasing a call option (or selling a put option) on the

currency while an inflow can be hedged by buying a put option. (Or

writing a call option. This is a “covered call” strategy).

Options are particularly useful for hedging uncertain cash

flows, i.e. Cash flows those are contingent on other events. Typical

situations are:

a. International tenders: Foreign exchange inflows will materialise

only if the bid is successful. If execution of the contract also

involves purchase of materials, equipments, etc. from third

countries, there are contingent foreign currency outflows too.

b. Foreign currency receivables with substantial default risk or

political risk, e.g. the host government of a foreign subsidiary

might suddenly impose restrictions on dividend repatriation.

c. Risky portfolio investment: A funds manager say in UK might

hold a portfolio of foreign stocks/bonds currently worth say

DEM 50 million, which he is planning to liquidate in 6 months

time. If he sells Dem 50 million forward and the portfolio

declines in value because of a falling German stock market and

rising interest rates, he will find himself to be over insured and

short in DEM.

E.g. On June 1, a UK firm has a DEM 5,00,000 payable due on

September 1. The market rates are as follows:

DEM/GBP Spot: 2.8175/85

90-day Swap points: 60/55

September calls with a strike of 2.82 (DEM/GBP) are available

for a premium of 0.20p per DEM. Evaluating the forward hedge

versus purchase of call options both with reference to an open

position.

i. Open position: Suppose the firm decides to leave the

payable unhedged. If at maturity the pound sterling/ DEM

spot rate is St., the sterling value of the payable is

(5,00,000) St.

ii. Forward hedge: If the firm buys DEM 5,00,000 forward at

the offer rate of DEM 2.8130/PS or PS0.3557/ DEM, the value

of the payable is PS (5,00,000 * 0.3557)=PS 1,77,850.

iii. A Call option: Instead the firm buys call options on DEM

5,00,000 for a total premium expense of PS 1000.

At maturity, its cash outflow will be

PS [(5,00,000)St +1025] for St<= 0.3546

and PS[5,00,000)(0.3546)+1025]

= PS 178325 for St>=0.3546.

Here it is assumed here that the premium expense is

financed by a 90 day borrowing at 10%.

D. Hedging with currency futures:

Hedging contractual foreign currency flows with currency

futures is in many respects similar to hedging with forward

contracts. A receivable is hedged by selling futures while a payable

is hedged by buying futures.

A futures hedge differs from a forward hedge because of the

intrinsic features of future contracts. The advantages of futures are,

it easier and has greater liquidity. Banks will enter into forward

contracts only with corporations (and in rare cases individuals) with

the highest credit rating. Second, a futures hedge is much easier to

unwind since there is an organized exchange with a large turnover.

A firm may be able to reduce or eliminate interest rate

exposure by mean of following hedging strategies.

Forward rate Agreements:

A FRA is an Agreement between two parties in which one of

them (The seller of FRA), contracts to lend to other (Buyer), a

specified amount of funds, in a specific currency, for a specific

period starting at a specified future date, at an interest rate fixed at

the time of agreement. A typical FRA quote from a bank might look

like this:

USD 6/9 months: 7.20 – 7.30% P.a.

This is to be interpreted as follows.

The bank is willing to accept a three month USD deposit

starting six months from now, maturing nine months from now,

at an interest rate of 7.20% P.a. (Bid Rate).

The bank is willing to lend dollars for three months, starting six

months from now at a interest rate of 7.30% P.a. (Ask Rate).

The important thing to note is that there is no exchange of

principal amount.

Interest rate futures:

Interest rate futures are one of the most successful financial

innovations in recent years. The underlying asset is a debt

instrument such as a treasury bill, a bond, and a time deposit in a

bank and so on. For e.g. the International Monetary Market (a part of

Chicago Mercantile Exchange) has a futures contract on US

government treasury bills, three-month Eurodollar time deposits and

US treasury notes and bonds. The LIFFE has contracts on Eurodollar

deposits, sterling time deposits and UK government bonds. The

Chicago Board of Trade offers contracts on long-term US treasury

bonds.

Interest rate futures are used by corporations, banks and

financial institutions to hedge interest rate risk. A corporation

planning to issue commercial paper for instance can use T-Bill

futures to protect itself against an increase in interest rate. A

corporate treasurer who expects some surplus cash in near future to

be invested in short-term instruments may use the same as

insurance against a fall in interest rates. A fixed income fund

manager might use bond futures to protect the value of her fund

against interest rate fluctuations. Speculators bet on interest rate

movements or changes in the term structure in the hope of

generating profits.

Interest Rate Swaps:

A standard fixed-to-floating interest rate swap, known in the market

jargon as a plain vanilla coupon swap (also referred to as “exchange

of borrowings”) is an agreement between two parties in which each

contracts to make payments to the other on particular dates in the

future till a specified termination date. One party, known as the

fixed ratepayer, makes fixed payments all of which are determined

at the outset. The other party known as the floating ratepayer will

make payments the size of which depends upon the future evolution

of a specified interest rate index (such as the 6-month LIBOR). The

key feature of this is:

The Notional Principal:

The fixed and floating payments are calculated if they were interest

payments on a specified amount borrowed or lent. It is notional

because the parties do not exchange this amount at any time; it is

only used to compute the sequence of payments. In a standard

swap the notional principal remains constant through the life of the

swap.

Interest rate Options:

A less conservative hedging device for interest rate exposure is

interest rate options. A call option on interest rate gives the holder

the right to borrow funds for a specified duration at a specified

interest rate, without an obligation to do so. A put option on interest

rate gives the holder the right to invest funds for a specified

duration at a specified return without an obligation to do so. In both

cases, the buyer of the option must pay the seller an up-front

premium stated as a fraction of the face value of the contact.

As interest rate cap consists of a series of call options on

interest rate or a portfolio of calls. A cap protects the borrower from

increase in interest rates at each reset date in a medium-to-long-

term floating rate liability. Similarly, an interest rate floor is a series

or portfolio of put options on interest rate, which protects a lender

against fall in interest rate on rate dates of a floating rate asset. An

interest rate collar is a combination of a cap and a floor.

4.

5. Explain the importance and relevance of hedging in

foreign exchange market.

Ans.

Foreign Exchange Market

The foreign exchange market is the market in which currencies

are brought and sold against each other. It is the largest market in

the world. Foreign exchange market is an over the counter market.

This means there is no single market place or an organized market

place or an organized exchange (like a stock exchange) where

traders meet and exchange currency. The traders sit in the offices

(foreign exchange dealing rooms) of major commercial banks

around the world and communicate with each other through

telephones, telex, computer terminals and other electronic means of

communication.

Hedging:

Hedging means a transaction undertaken specifically to offset

some exposure arising out of the firm’s usual operations. In other

words, a transaction that reduces the price risk of an underlying

security or commodity position by making the appropriate offsetting

derivative transaction.

Different types of exposures

Refer to concept questions 10 to 13.

Conclusion

Hence after looking at the different types of exposures, traders

faces it is very clear that Hedging with the help of derivatives will

ensure a safe transaction in Foreign exchange market.

6. Is it possible to hedge the foreign exchange risk in the

forwards market?

Ans. It is not possible to hedge forex risk fully.

This is so because as long as there exists currency as a

medium of exchange the person holding the currency is exposed to

different types of risks e.g. political, financial, …

This can be explained with the help of example of an Indian

exporter. If he has contracted for exports worth 1000 USD and the

spot rate was 45 Rs./$ for a period of 6months with a co. in USA. He

would receive his payments 6 months from now, the commercial risk

involved here is with respect to the fluctuations in exchange rates. If

the rates 6 months from now become 50 Rs/$ then he would receive

50000 USD i.e. he incurs a profit of 5000 USD and vice a versa when

the value of Rs. appreciate.

In above case, if we hedge our position the cash flow would be

certain, but still we have Rs. i.e. a currency in our hand with which

risk prevails.

Here comes in the political risk i.e. even when the Indian

exporter has the home currency. In case the country’s economy

crashes the currency will loose all it value throughout the world.

Thus, with the help of above e.g. it can be proved that as long

as currency is involved we have risk.

7. Explain with an example how to cover exchange risk in the

forwards market.

Ans. Please refer to answer 3 (A)

8. What factors determine the value of an option?

Ans. The factors are

a. Maturity of an option: higher the price higher the value of

an option and vice a versa

b. Spot price of underlying assets:

c. Strike price of underlying assets:

d. Interest rate structure in the market: higher the

interest rate structure in the market higher the value of an

option and vice a versa

e. Volatility: higher the volatility in the market higher the

value of an option and vice a versa. This is so because

higher the volatility in the market, higher the potential for

earning more, thus the buyer of an option has to pay more

premium.

9. Explain with examples how options are used to cover

exchange risks?

Ans. Currency options provide corporate treasurer another tool for

hedging foreign exchange risks arising out of firms operations.

Unlike forward contract, options allow the hedger to gain from

favorable exchange rate movements, while been unprotected from

unfavorable movements. However forward contracts are costless

while options involve up front premium cost.

a) Hedging a Foreign Currency with calls.

In late February an American importer anticipates a yen

payment of JYP 100 million to a Japanese supplier sometime late in

May. The current USD/JYP spot is 0.007739 (which implies a JYP/USD

rate of 129.22.). A June yen call option on the PHLX, with strike price

of $0.0078 per yen is available for a premium of 0.0108 cents per

yen or $0.000108 per yen. Each yen contract is for JPY 6.25 million.

Premium per contract is therefore: $(0.000108 * 6250000) = $675.

The firm decides to purchase 16 calls for a premium of $10800 .In

addition there is a brokerage fee of $20 per contract. Thus the total

expense in buying the option is $11,120.The firm has in effect

ensured that its buying rate for yen will not exceed $0.0078+

$(11120/100,000,000)= $0.0078112 per yen.

The price the firm will actually end up paying for yen depends

on the spot rate at the time of payment .For further clarification the

following 2 e.g. are considered:

1. Yen depreciates to $0.0075 per yen (Yen / $ 133.33) in late

May when the payment becomes due .The firm will not

exercise its options. It can sell 16 calls in the market provided

the resale value exceeds the brokerage commission it will have

to pay. (The June calls will still have some positive premium) .It

buys yen in the spot market .In this case the price per yen it

will have paid is $0.0075 + $0.0000112 - ${(Sale of value

options – 320) /100000000}

If the resale value of the options is less than $320, it will

simply let the options lapse .In this case the effective rate will

be $0.0075112 per yen or yen 133.13 per $. It would have

been better to leave the payable uncovered. The forward

purchase at $0.0078 would have fixed the rate at that value

and would be worse than the option.

2. Yen appreciates to $0.08

Now the firm can exercise the options and procure the yen at

the strike price of $0.0078.In addition, there will be transaction

cost associated with the exercise. Alternatively, it can sell the

option and buy the yen in the spot market. Assume that June

yen calls are trading at $0.00023per yen in late May. With the

latter alternative, the dollar will be $800000- $(0.00023 * 16*

6250000)+ $320= $777320. Including the premium, the

effective rate the firm has paid is $(0.0077732+0.0000112) =

$0.0077844.

b) Hedging a receivable with a put option

A German chemical firm has supplied goods worth Pound 26

million to a British customer. The payment is due in two months. The

current DEM/GBP spot rate is 2.8356 and two month forward rate is

2.8050. An American put option on sterling with 3 month maturity

and strike price of DEM 2.8050 is available in the inter bank market

with a premium of DEM 0.03 per sterling. The firm purchases a put

option on pound 26 million .The premium paid is DEM (0.03 *

26000000) = DEM 780000. There are no other costs.

Effectively the firm has put a floor on the value of its

receivable at approximately DEM 2.7750 per sterling (= 2.8050-

0.03). Again two e.g. are considered:

1. The pound sterling depreciates to DEM 2.7550 .The firm

exercises its put option and delivers pound 26 million to the

bank at the price of 2.8050. The effective rate is 2.7750. It

would have been better off with a forward contract.

Sterling appreciates to DEM 2.8575. The option has no secondary

market and the firm allows it to lapse. It sells the receivable in the

spot market. Net of the premium paid, it obtains an effective rate of

2.8275, which is better than forward rate. If the interest forgone on

premium payment is accounted for, the superiority of the option

over the forward contract will be slightly reduced.

10. Write a short note on currency swaps

Ans. Please refer to concept answer 8

11. What types of exchange exposure in a multinational

enterprise subject to?

Ans. Please refer to descriptive answer 1