Introduction to Foreign Exchange Derivatives : Introduction to Foreign Exchange Derivatives Derivative: Definition : Derivative: Definition Contingent contracts
Values derived from future value of an underlying asset/index
Commodities Derivative: Definition : IAS 39 : Derivative: Definition : IAS 39 Derivative Defined in RBI Act : Derivative Defined in RBI Act Derivative –Definition-SCRA : Derivative –Definition-SCRA In Indian context SCRA,1956 defines derivatives to include-
A security derived from
loan whether secured unsecured
risk instrument or contract for difference or any other form of security
A contract which derives its value from the price or index of prices of underlying security
Derivatives are securities under SCRA Derivative Instruments: Types : Derivative Instruments: Types Exchange traded
In substance there are only two types of derivatives:
Options Forex Derivatives : Forex Derivatives Derivative- Characteristics : Derivative- Characteristics Gearing
Small initial expenditure helps in dealing in large volumes
Shifts risk from buyer to the seller
Effective risk mgt tool
Improves liquidity of underlying
Increases depth of market
Lowest credit risk as settlement of difference only
Helps in price discovery
Better estimation of future price of the underlying; helps in decision making
Used Speculatively :
Can be very risky : highly leveraged & often more volatile than underlying
With value of underlying moving speculative derivative positions can show greater movements with consequent large swing in profit and loss Users : Users Hedgers
Desire stability in cash flows
Aim at preventing fall in value of the underlying
Offer two way quotes
Want to make quick money from volatility in the underlying price
Underlying not owned
Not interested in stability of cash flows
Earns risk free profit by taking advantage of difference in price of different markets
Larger the number of such trades remove this difference OTC and Exchange Traded : OTC and Exchange Traded OTC
Structured to suit the individual needs – any product, any time, any amount
Higher transaction costs
Difficulty in matching / counterparties BIS survey : BIS survey Derivative financial instruments traded on organised exchanges (Trillion US$) : Source- BIS Survey Derivative financial instruments traded on organised exchanges (Trillion US$) Derivative volume –Indian Banks : Derivative volume –Indian Banks Spurt in OBS exposure mainly due to derivative segment
Share of derivatives in OBS exposures: 82.%5 (March 2002) =>90.7%( Dec2004)
Composition of derivative portfolio of banks in India undergone transformation
Forward forex contract : 79.6%(March 2002); 49.3% (Dec2004)
Single currency SWAP: 14.6%=>46.6%
Maturity profile of derivatives changed
1 Yr horizon: 84.6% (March 2002) => 51.3%(Dec2004)
Corresponding increase in 2 to 3 yr segment
Foreign banks have largest share (63.7%)in derivative segment, New Pvt. Banks(18.1%), PSU banks(16.3%) Indian market volume :FRA/IRS : Indian market volume :FRA/IRS Outstanding notional principal:
April 2005: Rs 13,58,487 crore
March 2006: Rs 21,94,637 crore
Select foreign banks ,PDs private sector banks major participants
Interest rate derivative market OTC Forward Contract : Forward Contract A forward is an agreement entered into today,
Either to sell or to buy a certain quantity of a certain asset
At a specified future date for a specified price decided today.
Terms are very flexible. Forward Contract : Forward Contract The party that buys the underlying asset in the contract is said to have a long position
The party that sells has a short position.
The specified future date when the delivery is to take place is called the maturity
And the contract is settled on that date.
The specified price is called the delivery price. Forward Contract : Forward Contract Value of forward contract =0 at the time it is entered into
No upfront payment by either party
Delivery price is usually set equal to the market forward price at the initiation
Later stage value may be negative or positive
Both buyers and sellers are committed to the contract
Pay off of the buyer/seller is linear to the price of underlying
Presence of credit risk in forward contract Characteristics of Forward Contracts : Characteristics of Forward Contracts A forward transaction is a private contract between two parties.
A transaction can be entered into at any place and at any time, as long as the two parties to the transaction agree (assuming that there are no regulatory issues).
Each party bears two types of risk to the other counterparty
credit risk and settlement risk.
transaction can be tailor-made to suit exactly the parties' requirements,
Forward transaction can eliminate any uncertainty about the price in the future. suitable for hedging a specific price risk. Advantages of Forward Contracts : Advantages of Forward Contracts Objectives of parties entering into a forward contract :
Certainty: secure income or stabilize cost
guarantees to buy or sell a certain amount of an underlying asset, at a fixed price, on a specified date in the future.
Cash flow advantages to protect margin erosion by changes in market price.
Secure availability (long-term supply contract) Advantages of Forward Contracts : Advantages of Forward Contracts Certainty: secure income or stabilize cost
Secure availability (long-term supply contract)
Obtain the price risk of an asset without holding that asset
Cash flow modification Disadvantages of Forward Contracts : Disadvantages of Forward Contracts While forward contracts can fix anticipated revenue or cost, they cannot minimize cost or maximize revenue.
tailor-made contracts-often suffer from poor liquidity.
This contrasts with the futures market, where liquidity is much higher, but the contracts are standardized. Non- Deliverable Forward (NDF) Market : Non- Deliverable Forward (NDF) Market Market for forward dollar against rupees exists in major international centers
Singapore the biggest centre
Absence of off-shore Indian rupee market
Delivery of forward rupee not possible
On expiry contract cancelled and difference in settled in USD
Such contracts known as NDF
Participants are speculators; not permitted to participate in domestic forward market Definition of Swaps : Definition of Swaps A swap is a contract between two counterparties to exchange a quantity of one thing for a different quantity of another thing at regular intervals over some agreed upon period of time
usually with the amounts of at least one of the streams dependent upon the level of a specified market price or rate applied to a notional principal amount. Swap : Swap More accurately, a swap is a series of forward transactions that are bound together in one contract.
The exchange of a payment against a receipt at some distant future date is a forward contract Swap : Swap 6 forward contracts at six-month intervals
Value of each of the 6 forward contracts forming the swap above not necessarily zero.
The diagram shows arrows representing two notional payments made by the swap counterparties.
In practice each payment is netted
. Basic Characteristics of Swaps : Basic Characteristics of Swaps The net present value (NPV) of all the cash flows paid by one party = NPV of all the cash flows paid by the other party at the time a swap contract is entered.
NPV of a swap at the time of contract is zero (except for any profit for the swap intermediary).
If this does not hold, there will be an arbitrage opportunity. Basic Characteristics of Swaps : Basic Characteristics of Swaps Payment Dates :Between the effective date and the termination date, there is a series of payment dates.
Floating rate payment dates - dates on which floating rate payments are made
Fixed rate payment dates - dates on which fixed rate payments are made by the fixed rate payer
Swap payments made on a net basis- actual payments are made by only one of the parties as long as the fixed rate payment date and floating rate payment date same dates and in the same currency.
The calculation period : period of time Basic Characteristics of Swaps : Basic Characteristics of Swaps Term Sheet
Defines the basic terms and conditions of a swap.
Defines who the counterparties are and which side of the transaction they are on, that is, fixed rate payer vs. floating rate payer.
Notional amount: Amount based on which floating and fixed amounts are calculated.
Effective date : Date on which the swap transaction payments begin to accrue.
The termination date: end date of a swap transaction - same as the maturity. Uses of Swaps : Uses of Swaps swap not a source of funds
Does not provide with any funds beyond the periodic cash flows or eliminate the obligation to pay an underlying liability.
Cash flow modification: Change from one form of cash stream to another more desirable form of cash stream.
Elimination of uncertainty: To eliminate or reduce exposure to market rates or prices.
Capital market or market arbitrage: To reduce cost or improve returns by taking advantage of a particular market in which the entity has relative advantage (capital market arbitrage) or taking advantage of an arbitrage that exists between two different markets (market arbitrage). Uses of Swaps : Uses of Swaps 4) Investment: (having price exposure to an asset without physically owning it): Create or reduce exposure to a desired asset without buying or selling the asset.
5) Trading: change in market conditions - the expected cash flows of at least one side of a swap (the floating side) change. - value of the swap fluctuates.
The value of an interest rate swap behaves like a bond price relative to a par value
Par value of a swap is zero
There are people who trade swaps if they believe a particular type of swap is cheap or expensive relative to their expectation of market movements. This is pure speculation on the market. Floating to Fixed Interest Rate Swaps : Floating to Fixed Interest Rate Swaps The most common type of swap is a 'plain vanilla' interest rate swap
One party pays a floating interest rate and the other party pays a fixed interest rate.
ABC (a relatively new company) wants to raise fixed rate funds of USD 10,000,000 for 5 years by issuing a bond
Unable to do so in the market because of their credit status
Can borrow money from their bank at 6-month LIBOR plus 1% p.a.
Bank is willing to lend only at a floating rate.
They decide to borrow money from their bank and simultaneously enter into an interest rate swap agreement with another bank for 5 years Interest Rate Swaps : Interest Rate Swaps Example :
Comparative advantage argument
A- 10.00%(fixed) 6-month LIBOR+0.30%
B- 11.20% (fixed) 6-month LIBOR+1.00%
A borrows fixed from market & pay LIBOR to B
B borrows LIBOR+1% pays 9.95% fixed to A Interest Rate Swaps : Interest Rate Swaps LIBOR+1% A converted fixed rate to floating LIBOR+.05% as against LIBOR+0.30% B converted floating to fixed at 10.95% as against 11.20% Comparative advantage shared equally A- 10.00%(fixed) 6-month LIBOR+0.30%
B- 11.20% (fixed) 6-month LIBOR+1.00% Interest Rate Swaps: with Bank intermediation : Interest Rate Swaps: with Bank intermediation A Bank B LIBOR+1% 10% LIBOR LIBOR 9.90% 10% A converted fixed rate to floating LIBOR+0.10% as against LIBOR+0.30% B converted floating to fixed at 11.00% as against 11.20% Bank earned 0.10% Currency Swap : Currency Swap Two counterparties agree to exchange interest and principal in one currency for interest and principal of another currency
Exchange generally done at ruling spot rate the time of entering into the contract
Initial exchange of principal in two currency
Exchange of interest +repayment instalments or bullet payment
Debt service obligation alone i.e 2 alone
Interest rates for two currencies may differ and may be fixed or floating Currency Swaps : Currency Swaps Exchange of principal+ fixed rate interest payment of a loan in one currency for payment on an equivalent loan in another currency+ fixed rate interest thereon
Principals exchanged at the beginning and end
Principals chosen to be equivalent using exchange rate at beginning
A- 8.00%(Dollar) 11.6%(Sterling)
B- 10.00% (Dollar) 12.00%(Sterling)
A borrows in 8%dollar & pay 11%Sterling to bank-bank pays dollar8% to A
B borrows 12% sterling pays 9.4% Dollar to Bank – Bank pays12% sterling to B Currency Swap : Currency Swap Motivated by comparative advantage
A can borrow at $5% or AUD 12.6%
B can borrow at $7% or AUD 13% $ 5% $ 5% AUD 11.9% AUD 13% AUD 13% $ 6.3% Comparative advantage: How arise? : Comparative advantage: How arise? Acceptability of the borrower in the market
Too many recent flotation (scarcity value)( world bank-IBM-1981-Swiss market)
Special facilities available to borrower
HDFC could cheap dollar debt under the guarantee of United State Agency for International Development (USAID) as per law housing finance co. of developing country entitled
HDFC raised floating dollar loan and swapped them for Indian rupee with Indian banks in the process counter parties have secured floating rate dollar at a rate they would not have been able to raise Currency Swap Quotation : Currency Swap Quotation Currency Swap Quotation : Currency Swap Quotation USD quote-actual/360 against 3M LIBOR
Pound& Yen quoted –semi-annual actual/365 against 6m LIBOR
Euro/Swiss frank quoted –annual basis against 6M Euribor/LIBOR
: exception one year rate quoted against three month bench mark
Fixed rate quoted against each currency
Two rates bid & offer Currency Swap market : Currency Swap market Mostly OTC
London Financial Future Exchange (LIFFE)& CBoT introduced future contract on 2,5,10 year swap rate
Not found enough tkers Cancellation of swap : Cancellation of swap Example:
$:Yen swap done when spot rate was JPY100
Amount swapped JPY 125m payable in 3 yrs from now; interest 8% on $ & 6%yen payable annually
Cash flow remaining to be exchanged;
Yr 1 : $80,000 Y7,500000
YR2 : $80,000 Y7,500000
YR3 :$1,080,000 Y7132,500,000
Current spot exchange rate= Y110
Three year swap rate 7% for $ & 8% for Y
PV of USD =1026,243(disc. Rate ruling swap rate)
PV of Y= 118,557,258 converted to $=1077793
If Y paying party defaults risk to other party= $51,550
This is the amount payable by Y payer to $ payer for unwinding or cancellation swap at today’s rates Swap market in India : Swap market in India Interest rate derivative started in 1999-00
Swap /FRA popular
Commonly used floating rate bench mark
Currency swap with one currency leg being Indian rupee introduced-January 2000 Cross currency and Fx interest rate swap in India : Cross currency and Fx interest rate swap in India Banks in India act as intermediaries : international market and corporate customers
Banks works on a full hedge basis
Charge a spread over quote given by correspondent abroad USD:INR swaps : USD:INR swaps Bench mark rate MIOCS
Activity growing but market not still a very
Outflow under the swap
Interest on notional principal in $ calculated at spot exchange rate at LIBOR+ principal in$ at the end
Int. in RS at X% payable half-yearly on notional principal + principal at the end
Borrow rupee to buy dollar-invest $ at LIBOR-Pay $ interest –service Rs borrowing with Rs receipt- MIFOR Swap Market : MIFOR Swap Market Inter-bank term-money market not very liquid
The forward market not liquid beyond one year
Interest rate parity with forward margin prevails always
Forward margin function of demand supply MIFOR Swap : MIFOR Swap Pay MIFOR receive fixed
A. borrow 3 yr money
B. Buy USD spot
C. Deposit in one year LIBOR
D. sell $ forward one year
E . Roll over transaction twice repeating B,C& D
F. At the end use rupee out of dollar to repay borrowing at A Principal only swap : Principal only swap In effect hedge (or create) exchange risk on the principal amount alone leaving interest payment in original currency
USD 100 5-year bullet payment loan
Bank pays Rs 5000
Client pays USD100
On loan maturity
Bank pays USD100
Clint pays Rs 5000 Principal only swap : Principal only swap How to hedge?
Conceptual frame work
Invest a part of USD100 for 5yrs ZCB of FV=USD100- Cost say (X)
Remaining amount USD (100-X) convert into rupee= (100-X)* 50= Y (say)
Borrow Rs (5000-Y)
Repayment obligation on borrowing on maturity =Z(say)
On maturity return USD from proceeds of ZCB
Repay borrowing obligation Z out of Rs 5000 Diff=(Z-5000) may be recovered by pricing the swap Using MIFOR SWAP : Using MIFOR SWAP MIFOR SWAP used to hedge long term USD/INR Currency SWAP even in the absence of long term forward exchange market
SWAP-3 yr- Pay USD LIBOR every year &USD principal at end
Receive INR fixed rate every year & INR principal at end
A. Buy USD forward 1yr
B. Use MIFOR SWAP –receive one year floating & pay fixed rate
C. Rollover (A) twice
Premium on USD & LIBOR payment will be received at “B”:
Fixed rate payment under “B” will be based on quoting INR fixed rate to counter party Coupon only swap : Coupon only swap USD:INR coupon only swap
Considered by companies with rupee debts : to reduce cost of funds
Both short & medium term in vogue
Exchange of interest payment in one currency (INR) for interest payment in another currency (USD)
Maturity –one year
Banks pays 11%p.a on notional INR
Bank receives 12 m LIBOR+ 7% in USD on notional converted swap exchange rate( spot rate at the start) Credit Risk in SWAP : Credit Risk in SWAP Chance that one party in financial difficulties/default
Financial institution has credit risk exposure from swap only when value of swap to it is positive
Potential loss from swap default much less than potential loan default with same principal
Potential losses from currency swap is greater than IRS Futures : Futures Simultaneous right and obligation to buy and sell
Standard quantity of specific financial instrument /commodity/currency
At a specific future date
At price agreed between the parties when contract entered into
Exchange traded forward Futures : Futures Future rarely provide perfect hedge
Some significant advantage over OTC product
Ease of unwinding position
Absence of counter party risk: margin system
Marked to market daily
To reflect the price change
Liquidity in the exchange
Cash flow by way of margin through process of M to M Currency future: hedging tool : Currency future: hedging tool Importer has to pay UDS 160000 in April 20
Feb worried that USD may appreciate against £
Wants to cover the exchange risk in future market
LIFFE selling £ : USD future size £25000
Maturity second week of June
Current spot rate USD1.50per £
Forward rate delivery April , 20 USD1.48
June contract being traded at USD 1.45
Sells 4 June contract: at USD1.45
On April, 20 : spot rate in cash market:1.40; Future:1.36
Purchase of USD 160000 cost £114 285.71
Loss of £6177.61compared to ruling rate when hedging done
Buy back four future contract at current price (1.36)
Profit USD 9000 equivalent £6428.57 at current spot rate compensate for loss Characteristics of Futures market : Characteristics of Futures market There is no credit risk and transactions are transparent unlike OTC contracts
Liquidity is high
Settlement is easy
Contracts is standardized and hence exact hedge not possible as there could be
Mismatch between spot & futures price (known as basis risk) Interest Future : Interest Future Most popular contract ; 3M Euro Dollar contract
Future contract on 3M LIBOR expected rule on maturity
On Chicago Mercantile Exchange such contract have maturity up to 10 years
Under $1M – 3M future contract:
Seller undertakes to find a bank for the buyer to accept buyer’s $1M -3M at interest now agreed
Buyer undertakes to place the deposit
Price quotes as (100- the rate on maturity)
Contract pricing based on 90/360 interest convention
0.01% change in in the price leads to change in value of $25(=1000000*0.01*0.01*0.25) Options : Options Fundamentally different from forwards, futures and swaps and provide greater flexibility in risk management than any other derivative contract.
Holder or the buyer of option has a right to buy or sell an underlying without concomitant obligation to do so i.e. only seller has the obligation. Some terms : Some terms Strike price – the price at which the right to buy or sell is exercised / agreed
Expiry Date – The date on which option contract expires or becomes invalid
Call Option – the right to buy an underlying
Put Option – the right to sell an underlying
American Option – right can be exercised at any time during the life of an option
European Option – right can be exercised only at the end of the option contract Option Premium : Option premium is the price for the option
Premium is payable upfront which is the gain realized by the option writer
Option buyer has unlimited profit potential but loss is limited to the premium paid
Option writer has no right but face unlimited obligation
Option writer covers his option contracts with customers on back to back basis either in the domestic market or in overseas market Option Premium Pay off Profile of call option : Pay off Profile of call option Profit
Loss Strike Price Buyer Seller Spot Price (Underlying) Break even Point Pay off Profile of put option : Pay off Profile of put option Profit
Loss Strike Price Buyer Seller Spot Price (Underlying) Break even Point Options : few variations : Options : few variations Average Rate Option/Asian Option: average rate over a set period used as strike price
Knock Out : option lapses if underlying price falls below a level or exceeds given level with reference to strike price
Knock In : option becomes operative if before expiry underlying price goes above or below given levels
Contingent Option: a call on pound at (say) USD1.50 but exercisable if pound LIBOR is (say) more than 6.5%
Binary Option: predetermined constant amount paid if on expiry option is in the money
Look back Option: gives right to buyer to sell/buy at best price during the life of the option Foreign currency option : Foreign currency option In India all currency options are OTC and European style option
Cross currency option was introduced in January, 1994
Foreign currency – Rupee option was introduced in July, 2003 Foreign currency option- zero cost structure : Foreign currency option- zero cost structure Range forward
Buy a call to hedge payable-sell a put to reduce /zeroise cost
Two strikes different : call-50/put -46
Both out of money
The min. exchange rate capped at strike of the call Foreign currency option- zero cost structure : Foreign currency option- zero cost structure Participating forward; USD 100000
Buy call –SP=50.00,premium=60 paise-out of money
Sell put: in the money put – SP=50, pre.= Rs1.20- sell ½ put to zeroise cost
If on maturity rate=51, call exercised : if on maturity rate=47 ; put exercised-buy $ 50000 at Rs50/$ and remaining at Rs 47/- average =48.50 Hedging : Options or Forwards? : Hedging : Options or Forwards? Option carry a upfront fees
No general definitive answer
Few worth noting points:
Option to be preferred for hedging contingent exposures
Forwards are not cost free- banks some times insist on margin against counter party risk
Opportunity cost inherent in forward: cannot take advantage of favourable movement
Option has up front cost but no opportunity cost
For SP= forward rate –option more expensive unless spot rate moves in favour by more than price paid Hedging : Options or Forwards? : Hedging : Options or Forwards? A= option premium –European call
F=Forward price /strike price
X= spot rate at maturity
X<= F : effective rates=F & X+A*
X> F : effective rate = F & F+A**
*Option cheaper only if F-X>A
** Option always costlier
Forward to be preferred if adverse movement expected
Option in case expected favourable movement
Protection bought against potential unfavourable movement
In that case buy out of money option to limit upfront cost Foreign Currency – Rupee Options : Foreign Currency – Rupee Options AD banks having a minimum CRAR of 9 per cent can offer foreign currency – rupee options on a back-to-back basis,
Allowed to run option book
adequate internal control, risk monitoring/ management systems, mark to market mechanism
Continuous profitability for at least three years
Minimum CRAR of 9 per cent
Net NPAs at reasonable levels (not more than 5 per cent of net advances)
Minimum Net worth not less than Rs. 200 crore
a one time approval from the Reserve Bank Slide 71: AD banks can offer only plain vanilla European options.
Customers can purchase call or put options.
Customers can also enter into packaged products
Cost reduction structures (provided the structure does not increase the underlying risk and does not involve customers receiving premium)
Writing of options by customers is not permitted.
Zero cost option structures can be allowed. Slide 72: undertaking from customers interested :clearly understood the nature of the product and its inherent risks.
Quote for option premium in Rupees or as a percentage of the Rupee/foreign currency notional.
Settled on maturity either by delivery on spot basis or by net cash settlement in Rupees on spot basis as specified in the contract.
In case of unwinding of a transaction prior to maturity, the contract may be cash settled based on the market value of an identical offsetting option. Slide 73: Only one hedge transaction against a particular exposure/ part for a given time period.
Option contracts cannot be used to hedge contingent or derived exposures (except exposures out of submission of tender bids in foreign exchange) RBI Draft Guidelines: Some Changes : RBI Draft Guidelines: Some Changes Option Trading Strategies : Option Trading Strategies Spread
Taking position in two or more options of the same type( two or more call or put)
Buy a call at SP=100
Sell the same call at SP=120
Buy a put at SP=100
Sell same put at SP=120 Option Trading Strategies : Option Trading Strategies Bear spread
Buy a put SP=100
Sell the same put SP= 90
Buy a call SP= 100
Sell the same call SP= 90