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The foreign exchange market is the market where the currency of one country is exchanged for that of another country and where the rate of exchange is determined. The genesis of Foreign Exchange (FE) market can be traced to the need for foreign currencies arising from: • • • International trade; Foreign investment; and Lending to and borrowing from foreigners.
In order to maintain an equilibrium in the FE market, demand for foreign currency (or the supply of home currency) should equal supply of foreign currency (or the demand for home currency). In operational terms, the demand for an supply of home currency should be equal. In the event of a disequilibrium venues/steps in the bring out the desired balance by: • • • Variation in the exchange rate; or Changes in official reserves; or both.
Participants in the FE market Major participants in the FE market are : • Large commercial banks (through their campsites or dealers) operating either at retail level for individual exporters and corporations, or at wholesale level in the interbank market; • Central banks of various countries that intervene in order to maintain or to influence the exchange rate of their currencies within a certain range, and also to execute the orders of government;
MALA GRAPHICS 1
Individual brokers or corporations. Bank dealers often use brokers to stay anonymous since the identity of banks can influence short-term quotes.
Exchange markets primarily function through telephone and telex. Currencies with limited convertibility play a minor role in the FE market. And, only a small number of countries have established full convertibility of their currencies for all transactions. Foreign exchange rates are quoted either for immediate delivery (spot rate) or for delivery on a future date (forward rate). In practice, delivery in spot market is made two days later. A FE quotation is the price of a currency expressed in the units of another currency. The quotation can be either direct or indirect. It is direct when quoted as “so many units of local currency per unit of foreign currency”. For example, Rs. 35 = US$ 1, is direct quotation for US dollars in India. Similarly, a quotation in the USA will be $ 0.22 = Ffr1 whereas in France, it would be Ffr 3.3 = DM 1, etc. On the other hand, an indirect quotation is the one where exchange rate is given in terms of variable units of foreign currency as equivalent to a fixed number of units of home currency. For example, in India, US$ 2.857 = Rs. 100 is an indirect quotation. This type of quotation is made in the UK. For example, in London a quotation may be made a $ 1.55 = £ 1. Since 1 August 1993, all quotations in India use the direct method of quotation. Some currencies are quote as so many rupees against one unit while others as so many rupees against 100 units.
Foreign Currencies Quoted against their one Unit 1. Australian (A$) 2. Austrian *Sch) 3. Bahrain dinar 12. Hong Kong dollar 21. (HK$) 4. Canadian (Can$) 5. Danish kroner (Dkr) 14. Kuwaiti dinar 23. Swadish knroner (Skr) 6. Deutschmarket (DM) 7. Dutch guilder (F1) 16. New Zealand dollar 25. Thai baht (Bt) NZ$) 8. Egyptian pount 17. Norwegian kroner 26. UAE Dihram Nkr) 9. European Currency 18. Omani riyal Unit (ECU) 27. US Dollar ($) 15. Malaysian ringgit 24. Swiss franc (Sfr) dollar 13. Irish pound (I£) Singapore (S$) 22. Sterling pound (£) dollar schilling 11. French franc (Ffr) 20. Saudi riyal (SR) dollar 10. Finnish mark (FM) 19. Qatar riyal
Foreign Currencies Quoted against their 100 Units 1. Belgian franc (BFr) 2. Burmese kyat 3. Italian lira 4. Japanese yen 5. Kenyan shilling 6. Spanish peseta
Asian Clearing Union Currencies Quoted against their 100 Units 1. Bangladesh take 2. Burmese kyat 3. Iranian riyal Pakistani rupee 5. Sri Lanka rupee
Foreign exchange rates are always quoted a two-way price, i.e. a rate at which the bank (dealer) is willing to buy foreign currency (buying rate) or bid price and a rate at which the bank sells foreign currency (selling rate or bank price). Dealers do expect, some profit in exchange operations and hence there is always some difference in buying and selling rates. However, the maximum spread available to dealers may be restricted by their central bank. All exchange rates by authorized dealers are quoted in terms of their capacity as buyer or seller. Spread means the difference between a bank’s (bid) and selling (offer or ask) rates in an exchange rate quotation or an interest quotation. It fluctuates according to the level of stability in the market, the currency in question, and the volume of the business. Thus, if there is a degree of volatility in an exchange rate, and if business to be unsustainable, the dealer will protect himself by widening the quote. That is, he will offer less currency while selling currency while selling but demand more when buying . The spread represents the gross return to the dealer of the risks inherent in “making a market”. The spread can also be expressed as a percentage. That is,
price − Bid Ask price
Cross rate : is the price of any currency other than the home currency. In other words, it is the direct relationship between two non-home currencies in a foreign exchange market concerned with or used in transactions in a country to which none of the currencies belongs. Thus, in India, a cross rate is any exchange rate which excludes rupees, for example, US$/FFr, DM/BFr, etc.
Ideally. This risk means eventual lossed incurred by these enterprises due to adverse movements of exchange rates between the dates of contract and payment However. Gains may also accrue if the movement of rates is favourable. Managing away ‘unwanted’ risk involves setting up ‘hedge’ positions. an economic entity should only be exposed to those ‘risk’ that are intrinsic to its core businesses since its ‘returns’ accrue from these core activities. Risk Management . in order to eliminate ‘unwanted’ risk. for example. was beneficial for those enterprises that exported to the USA and billed in US dollars. the depreciation of US dollar in 1995 caused losses to the non-USA companies whose exports were billed in US dollars and proved profitable for the USA companies exporting and billing in nonUS dollar currencies. Given the interlinkages in any economic system. Thus the appreciation of dollar in 1985. ERR does not imply that it will result into losses only. business entities are exposed to risks arising from diverse parts of the national and international economies. Similarly. Exchange rate risk (ERR) : is inherent in the business of all multinational enterprises as they are to make or receive payments in foreign currencies.. the American companies exporting outside and billion in other currencies suffered losses.Forex Market Financial ‘risk’ or ‘exposure’ : can be defined as sensitivity to any outcome which could alter the valuation of assets or liabilities on an entity’s balance sheet. Conversely. thus neutralising the potential of the latter to affect the balance sheet. which essentially offset the cashflows arising from the ‘unwanted’ exposure. Thus it is necessary to ‘manage’ the total risk to which a corporate/institution is exposed. however. MALA GRAPHICS 6 ..
Whether a firm hedges may be determined by its forecasts of foreign currency values. they have access to several different currencies. There are several additional ways by which exchange rates can affect the estimated cash flows. Short-term financing decision : When large corporations borrow. foreign exchange risk has become an integral part of the management must be aware of the various techniques of dealing with ERR. Forecasts of the future cash flows used within the capital budgeting process will be dependent on future currency values. but the main point MALA GRAPHICS 7 . Covering the foreign exchange risk is also known as hedging the risk. This dependency can be due to (1) future inflows or outflows denominated in foreign currencies that will require conversion to the home currency and / or (2) the influence of future exchange rates on demand for the corporation’s products. Hedging decision : companies are constantly confronted with the decision of whether to hedge future payables and receivebles in foreign currencies.Forex Market In view of the substantial and significant stake in foreign countries. Capital budgeting decision : When a Company attempts to determine whether to establish a subsidiary in a given country. The ideal currency for deposits would (1) exhibit a high interest rate and (2) strengthen in value over the investment period. Short-term investment decision : Corporations sometimes have a substantial amount of excess cash available for a short term. If a company in its wisdom does not want to hedge. the conservative enterprises may adopt the policy of hedging everything. On the contrary. Large deposits can be established in several currencies. The currency they borrow will ideally (1) exhibit a low interest rate and (2) weaken in value over the financing period. it tantamounts to have the view that the future movements of exchange rates will be in its favour. a capital budgeting analysis is conducted.
appreciation of the Swiss franc will boost the Swiss subsidiary’s earnings when reported in (translated to )US dollars. and may allow the firm to borrow at lower interest rates (because the perceived risk MALA GRAPHICS 8 . Hedging can reduce the firm’s volatility of cash flows because the firm’s payments and receipts are not forced to fluctuate in accordance with currency movements. subsidiary earnings are consolidated and translated into the currency representing the parent firm’s home country. The British subsidiary’s earnings in pounds must also be measured by translation to US dollars. Using the scenario just described. The Swiss subsidiary’s earnings in Swiss francs must be measured by translation to US dollars. corporations would prefer the currency borrowed to depreciate over time against the currency they are receiving from sales. which is more costly than slow stable growth. This can reduce the possibility of bankruptcy. For example. consider a comapny with its home office in the United State and subsidiaries in Switzerland and Great Britain. forecasts of exchange rates are required. Why Exchange Rate Risk is Relevant Volatile foreign earnings can also cause more volatile growth and downsizing cycles within a firm. As with short-term financing. and therefore enhance the company decision- Long-term financing decision : Corporations that issue bonds to secure long-term funds may consider denominating the bonds in foreign currencies. To estimate the cost of issuing bonds denominated in a foreign currency. improve the estimates of the cash flows. which allows the firm easier access to credit from creditors or suppliers. Earnings assessment : When earnings of a company are reported. “Translation” does not suggest that the earnings are physical converted to US dollars.Forex Market here is that accurate forecasts of currency values will making abilities. It is simply a recording process to periodically report consolidated earnings in a single currency.
Similarly. MALA GRAPHICS 9 . the value of a firm’s cash outflows in various currencies will be dependent on the respective exchange rates of these currencies. but the firms can at least measure its exposure to exchange rate fluctuations. Transaction Exposure The value of a firm’s cash inflows received in various currencies will be affected by respective exchange rates of these currencies when converted into the currency desired. Exchange rates cannot be forecasted with perfect accuracy. and (2) determining the overall risk of exposure to those currencies. Exposure to exchange rate fluctuations comes in three forms : • • • Transaction exposure Economic exposure Translation exposure. Two steps are involved in measuring transaction exposure: (1) determining the projected net amount of inflows or outflows in each foreign currency. which can enhance its cash budgeting decisions. the firm should first measure its degree of exposure. Hedging may also allow the firm to more accurately forecast future payments and receipts. If the firm is highly exposed to exchange rate fluctuations. The degree to which the value of future cash transitions can be affected by exchange rate fluctuations in referred to as transactions can be affected by exchange rate fluctuations is referred to as transaction exposure. Before choosing these techniques.Forex Market is lower). it can consider techniques to reduce its exposure in the following chapter.
Forex Market Transaction exposure based on currency correlations Measurement of Currency Correlations : The Correlations among currency movement can be measured by their correlation coefficients. MALA GRAPHICS 10 .00. reflection an inverse relationship between individual movements. Correlations can also be negative. thus.1. the extreme case being .00. The extreme case is perfect positive correlation. which indicate the degree to which two currencies move in relation to each other. MNCs could use such information when deciding their degree of transaction exposure. which is represented by a correlation coefficient equal to 1.
Transaction exposure is a subset of economic exposure. Economic Exposure to Exchange Rate Fluctuations Variables That Influence the Impact of Local Currency Appreciation on Variables Local sales (relative to foreign competition in local markets) Firm’s exports denominated in Decrease Increase Decrease Impact of Local Currency Depreciation on Variables Increase Firms’s Local Currency Inflows local currency Firm’s exports denominated in Decrease Increase foreign currency Interest received from foreign Decrease Increase investments Variables That Influence the Firm’s Local Currency Outflows Firm’s imported supplies No Change No Change denominated in local currency Firm’s imported supplies Decrease Increase denominated in foreign currency Interest owed on foreign funds borrowed Decrease Increase The economic exposure refers to the change in expected cash flows as a result of an unexpected change in exchange rates. the influence of exchange rate fluctuations on a firm’s cash flows is not always due to transaction of currencies. However. For example. an American exporter who operates in French market can increase his market share merely by reducing the French Company which is a potential MALA GRAPHICS 11 .Forex Market Economic Exposure The degree to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations is referred to as economic exposure to exchange rates.
are difficult to quantify and perhaps unhedgable.Forex Market competitor to the American firm can profit indirectly from currency losses of the American company. if the assets or liabilities of the MNC’s subsidiaries are translated at something other than historical exchange rates. the larger will be the percentage of a give financial statement item that is susceptible to translation exposure. The greater the percentage of an Degree of Foreign Involvement : MNC’s business conducted by its foreign subsidiaries. the balance sheet will be affected by fluctuations in currency values over time. since the financial MALA GRAPHICS 12 . Thus it can be se en that though the French company is not directly exporting but business competition can be generated on account of the strength of the currency of competitors. Translation Exposure The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations is known as translation exposure. In addition. Locations of Foreign Subsidiaries : The locations of the subsidiaries can also influence the degree of translation exposure. which can be termed as economic exposure. subsidiary earnings translated into the reporting currency on the consolidated income statement are subject to changing exchange rates. For example. Economic risks cannot be managed as they are not reported in accounts. Determinates of Translation Exposure Translation exposure is dependent on • • • The degree of foreign involvement by foreign subsidiaries The locations of foreign subsidiaries The accounting methods used.
Transaction exposure : exists when the future cash transactions of a firm are affected by exchange rate fluctuations. While it may know exactly how many marks it will need. This uncertainly occurs because the exchange rate between marks and dollars fluctuates over time. Then a centralized group consolidates subsidiary reports in order to identify for the MNC as a whole. the firm faces three major tasks. it must decide whether to hedge this exposure. a US firm that purchases German goods may need marks to buy the goods.based MNC that will be receiving a foreign currency. Second. The term “net” here refers to the consolidation of all expected inflows and outflows for a particular time and currency. If transaction exposure does exist. if it decides to hedge part or all of the exposure it must choose among the various hedging techniques available. it should identify the individual net reansaction exposure on a currency-by-currency basis. the expected net positions in each foreign currency during several upcoming periods. The MNC can identify its exposure by reviewing this consolidation of subsidiary positions. Also consider a US . it doesn’t know how many dollars will be needed to be exchanged for those marks. Accounting Methods : Degree of accounting exposure can be greatly affected by the accounting procedures it uses to translate when consolidating financial statement data. Identifying Net Transaction Exposure Before the MNC makes any decision related to hedging. Finally. For example. First it must identify the degree of transaction exposure. Its future receivebles are exposed since it is uncertain of the dollars it will obtain when exchanging the foreign currency received. The management at each subsidiary plays a vital role in the process of reporting its expected inflows and outflows.Forex Market statement items of each subsidiary are typically measured by the country’s home currency. MALA GRAPHICS 13 .
then the company will save money by hedging its net payables (as opposed to no hedge). On the average.Forex Market Is Hedging Worthwhile? If a firm decides to hedge its periodic future payables denominated in a foreign currency. The main responsibility is to (1) measure the potential exposure to exchange rate movements. how much to hedge. In addition they my hedge future receivables if they forsee depreciation in the currency denominating the receivables. companies that are more conservative tend to hedge more of their exposure. The forward contract is a common heeding device against this foreign currency position. Thus is normally inappropriate for the foreign exchange management group to set a profit MALA GRAPHICS 14 . it will not reduce the company cost. and (3) determine how the exposure should be hedged. That is they may hedge future payables that they foresee appreciation in the currency denominating the payables. If the spot rate in the future exceeds today’s forward rate. In general. which is necessary to assess the risk (2) determine whether the exposure should be hedged. then the company will lose money by hedgings its net payables. If the spot rate in the future is less than today’s forward rate. and its forecasts of exchange rates. decisions on whether to hedge. If the company choose to hedge only in those situations in which they expect the currency to move in a direction that will make hedging feasible. and how to hedge will vary with the company management’s degree of risk aversion. Most company do not perceive their foreign exchange management as a profit center. In this case periodic hedging with the forward rate will be more costly in some periods and less costly in other periods. A forward rate that serves as an unbiased forecast of the future spot rate will underestimate and overestimate the future sport rate with equal frequency. Thus it could be argued that hedging is not worth while. if at all.
If the firm MALA GRAPHICS 15 . By holding this contract. A firm that buys a currency futures contract is entitled to receive a specified amount in a specified currency for a stated price on a specified date.Forex Market goal. A futures contract hedge is very similar to that of a forward contract except that forward contracts are common for large transactions. whereas futures contracts may be more appropriate for firms that prefer to hedge in smaller amount. it may select from the following hedging techniques : • • • • Future hedge Forward hedge Money market hedge Currency option hedge. While currency futures can reduce the firm’s transaction exposure. they sometimes backfire on the firm. just to avoid the possibility of a major adverse movement in exchange rates. Futures Hedge Currency futures can be used by firms that desire to hedge transaction exposure.. To hedge payment on future payables in a foreign currency. the firm may desire to purchase a currency futures contract representing the currency it will need in the near future. as it may even use some hedges that will likely result in slightly worse outcomes than no hedges at all. Techniques to Eliminate Transaction Exposure If the company decides to hedge part or all of its transaction exposure. If the firm is hedging payables the locked in futures price for the currency could end up being higher than the future spot rate of the currency (if the currency depreciates over time). it locks in the amount of its home currency needed to make payment on the payables.
For example.000 francs in 30 day. The bank agrees to provide the Swiss francs to the MNC in 30 days in exchange for US dollars. Du Pont Company often has the equivalent of $ 300 million to $ 500 million in forward contracts at any one time. Many MNCs commonly implement the forward hedging technique. A firm that sells a currency futures contract is entitled to sell a specified amount in a specified currency for a stated price on a specified data. the firm may desire to sell a currency futures contract representing the currency it will be receiving. This way the firm knows how much of its home currency it will receive after converting the foreign currency. it now knows the number of dollars it will need to exchange for francs. To use the forward contract hedge. To hedge the home currency value of future receivable in a foreign currency. it would not purchase a currency futures contract.based MNC must pay a Swiss supplier 1. Thus. a request for a forward sale of Swiss francs is appropriate. Money Market Hedge MALA GRAPHICS 16 . to cover open currency positions. if a US . Forward Hedge Forward contracts are commonly used by large corporations that desire to hedge. the MNC purchases that currency denominating the payables forward. it insulates the value of its future receivables from the fluctuations in the foreign currency’s spot rate over time. the firm may desire to sell a currency future receivable in a foreign currency. For example. it can re quest from a bank a forward contract to accommodate this future payment.000. The MNC hedges its position by locking in the rates it will pay for Swiss francs in 30 days.Forex Market expected the currency’s value to depreciate by the time it would need to make payment.based MNC expects receivable in Swiss francs in 30 days. it would like to lock in the rate at which it can sell these francs for dollars. In this case. If the US .
a firm must assess whether the advantages of a currency option hedge are worth the price (premium) paid for it.Forex Market A money market hedge involves taking a money market position to cover a future payables or receivable position. In these situations. Currency Option Hedge Firms recognize that hedging techniques such as the forward hedge and money market hedge can backfire when a payables currency depreciates or a receivable currency appreciates over the hedged period. However. Currency options exhibit these attributes. MALA GRAPHICS 17 . an unhedged strategy would likely outperform the forward hedge or money market hedge. The ideal type of hedge would insulate the firm against adverse exchange rate movements but allow the firm to benefit from favourable exchange rate movement.
Sell amount Borrow denominating a forward related the the contract to the contracts) representing the related to the payables. Purchase a currency put option (or options) representing the currency and amount related to the receivables. while in other quarters the forward purchase would have been preferable. currency receivable. contract representing the related to the payables Borrow local currency and convert to currency payables denominating representing the currency and receibvables. Futures hedge To Hedge Payables Purchase futures currency 2. convert it to the local currency. From the importer’s perspective the results were mixed. and invest it. 4.Forex Market Review or Techniques for Hedging Transaction Exposure Hedging Technique 1. Money hedge market a currency (or amount forward amount contract and a and To Hedge Receivable Sell a currency futures contract (or contracts) representing the currency and amount related to the reveivables. Hedging Performance of Currency Options Versus Forwards A recent study by Madura simulated a process of hedging a position in each of five major currencies. Forward hedge Purchase currency 3. Then pay off the loan with cash inflows from the receivable. In some quarters the importer would have been better off with currency call options. Invest these funds until they are needed to cover the payables. Currency hedge option Purchase a currency call option (or options) representing the currency and amount related to the payables. Of course the superiority of one technique over another would not have been determined until after the periods were MALA GRAPHICS 18 . The study was conducted first from the perspective of a US importing firm and then from that of US exporting firm. to study the effectiveness of hedging with currency options as opposed to forward contracts in each quarter.
From the US exporter’s perspective. in which the unheeded strategy was superior. From an importer’s perspective. On average. there was on average no significant difference between using currency put options and using forward sales to hedge receivable for four of the currencies . there was no significant difference in the amount paid of imports between hedging with currency call options and doing so with forward purchases. there was no significant difference on average in the amount paid between using currency call options and using an unheeded strategy. On exception was the German mark. The results of this study suggest that currency options should be given serious consideration. currency options generally performed about as well as for ward contracts or the unheeded strategy. A comparison was also conducted between currency options and an unheeded strategy. MALA GRAPHICS 19 . For the Japanese yen the dollar value of the receivable was significantly higher when using put options than it was when using put options than it was when using for ward sales. One exception was the British pound. Overall. and they may alleviate any convernms managers have about exchange rate movements.Forex Market over. This result held for each of the five currencies. Further-more they offer the opportunity to benefit if exchange rates move in a favorable direction. in which the unheeded strategy and superior. From an exporter’s perspective there was no significant difference on average in the amount received between hedging with currency put options and using an unheeded strategy.
One type of currency swap accommodates two firms that have different long-term needs. Consider a US firm.Forex Market Hedging Long . Canadian dollars. commonly exposure : • Long-term forward contract • Currency swap • Parallel loan. Currency Swap A currency swap is a second technique for hedging long-term transaction exposure to exchange rate fluctuations. and Swiss francs. The US firm will be receiving British pounds in five years and the British firms will be receiving US dollars in five years. At the same time. hired to build an oil pipeline in Great Britain that expects to receive payment in British pounds in five years when the job is completed. These two firms could range a currency swap that allows for an exchange of pounds for dollars in five years at some negotiated exchange of pounds for dollars in five years at MALA GRAPHICS 20 there are three transaction used techniques to hedge such long-term .Term Transaction Exposure For firms that can acurately estimate foreign currency payables or receivables that will occur several years from now. Long-Term Forward Contract Most large international banks routinely quote forward rates for terms of up to five years for British pounds. German marks. a British firm is hired by a US bank for a longterm consulting project. Assume that payment to this British firm will be in US dollars and that much of the payment will occur in five years. It can take many forms. Long forwards are especially attractive to firms that have set up fixed-price exporting or importing contracts over a long period of time and want to protect their cash flow from exchange rate fluctuations.
ALTERNATIVE HEDGING TECHNIQUES When a perfect hedge is not available (or is too expensive) to eliminate transaction exposure. Likewise. one swap at the inception of the loan contract and another swap at the specified future date. firms need to find other firms that can accommodate their needs. There are brokers employed by large banks and investment firms that act as middlemen for swaps. Using this information. they can match up firms when one firms needs the currency the other firms wants to dispose of (and vice versa). The brokers receive a fee for their service. the US firm could lock in the number of US dollars the British pound payment will convert to in five years. Such methods include • Leading and Lagging • Cross-hedging • Currency diversification MALA GRAPHICS 21 .Forex Market some negotiated exchange rate. A parallel loan is interpreted by accountants as a loan and is therefore recorded on financial statements. with a promise to re-exchange currencies at a specified exchange rate and future date. To create a currency swap. In this way. the firm should consider methods to at least reduce exposure. Parallel Loan A parallel loan (or “back-to-back loan”) involves an exchange of currencies between two parties. It represents two swaps of currencies. They are notified by those corporations that want to eliminate transaction exposure to specific currencies at certain future dates. the British firm could lock in the number of British pounds the US dollar payments will convert to in five years.
As a second possibility. Because it is worried that Currency X may appreciate against the US dollar. they move in a similar direction against the US dollar). the British subsidiary may attempt to stall its payment until after the pound appreciates. It could then set up a 90-day forward contract on this currency. For example. General Electric and other well-known MNCs commonly use leading and lagging strategies in countries that allow them. In this way it could use fewer pounds to obtain the marks needed for payment. The focus here will be on a subsidiary in Great Britain that purchases some of its supplies from a subsidiary in Germany. Assume a US firm has payables in Currency X 90 days from now. This strategy is referred to as leading. If the British subsidiary expects the pound will soon depreciate against the mark. This strategy is referred to as lagging. In this case. consider a scenario in which the British subsidiary expects the pound will soon appreciate against the mark. Cross-hedging Cross-hedging is a common method of reducing transaction exposure when the currency cannot be hedged.Forex Market Leading and Lagging The act of leading and lagging represents an adjustment in the timing of payment request or disbursement to reflect expectations about future currency movements. consider a multinational corporation based in the United State that has subsidiaries dispersed around the world. Assume these supplies are denominated in German marks. If forward contracts and the other hedging techniques are not possible for this currency the firm may consider cross-hedging in which case it needs to first identify a currency that can be hedged and is highly correlated with Currency X. it may desire to hedge this position. If two currencies are highly correlated relative to the US dollar (that is. then the exchange rate MALA GRAPHICS 22 . it may attempt to accelerate the timing of its payment before the pound depreciates.
If the period of the swap is one year.84 million [ = 32 X (1 + 0. the American parent company will receive from the Indian bank a sum of US$ 1.1) while the bank will receive from the subsidiary a sum of Indian Rs. etc. the more effective will be the cross-hedging strategy. equivalent to the sum that it wants to lend in Indian rupees to the subsidiary for a fixed period. then at the end of the swap period.Forex Market between these two currencies should be somewhat stable over time. Cross-Credit Swaps In this kind of swap. 35. MALA GRAPHICS 23 . and export swaps. The Indian bank will lend to the subsidiary a sum of Indian Rs.12)].a. There are various types of swaps such as cross-credit swaps. The American parent company will deposit a sum in US dollars with the Indian bank. back-to-back credit swaps. say at 12 per cent p. 32 = US$ 1). 32 million (assuming the exchange rate is Indian Rs. rate of interest. a bank in a foreign country. When purchasing the one currency 90 days forward the US firm can then exchange that currency for Currency X.1 million (= 1 + 1 X 0. Swaps in Foreign Currencies Swap is an agreement reached between two parties which exchange a predetermined sum of foreign currencies with a condition to surrender that sum on a predecided date. there is an exchange of foreign currencies between a parent company and say. Suppose this sum is US$ 1 million at a 10 per cent rate of interest. Let us say an American parent company wishing to finance its subsidiary in India may enter into an agreement with an Indian bank. The effectiveness of this strategy depends on the degree to which these two currencies are positively correlated. The stronger the positive correlation. It always involves two simultaneous operations: one spot and the other on a future date.
For example. then the loss to the bank would be $ 0. two companies located in two different countries may agree to exchange loans in their respective currencies for a fixed period. The cost of swaps will depend on the rate of interest and the exchange rate chosen by the two parties. Back-to-back Credit Swaps In a back-to-back credit swap. KODAK (An American multinational) may lend in US dollars to the USA based subsidiary of FUJI while the latter (a Japanese multinational) may lend in Japanese yen to the Japan-based subsidiary of KODAK. if a depreciation is likely to take place the basic hedging strategy would be as follows: reduce the level of cash.Forex Market Suppose.076 million ( = 35. For example. The bank would have made a gain in case the exchange rate had evolved in the opposite direction. 35/US$ 1. Basic strategy for hedging transactions exposure Basically. in the meantime. the exchange rate has evolved to Indian Rs. while simultaneously decreasing hard currency liabilities and increasing soft currency liabilities. the strategy involves increasing hard currency (likely to appreciate) assets and decreasing soft currency (likely to depreciate) assets. Thus the exchange management risk got shifted to the Indian bank while both the American parent company and the Indian subsidiary were dealing in their respective currencies without any uncertainty about the sums to be received or paid. decrease accounts receivable by tightening credit terms. MALA GRAPHICS 24 .1). and sell the weak currency forward.84/351. increase local currency borrowing delay accounts payable.
an exporter will sell his foreign exchange in the forward market.Forex Market Basic Strategy for Hedging Transactions Exposure Assets Hard currencies (likely to appreciate) Soft currencies (likely to depreciate) Increase Decrease Liabilities Decrease Increase In concrete terms. the basic strategies can be implemented by taking appropriate measures. EXTERNAL TECHNIQUES FOR COVERING EXCHANGE RATE RISK The major techniques in this regard are: • Covering risk in the forward market. MALA GRAPHICS 25 . depending upon the anticipated depreciation or appreciation of local currency. • Advances in foreign currency. • Covering in the options market. • Covering in the money market. COVERING RISK IN THE FORWARD MARKET Covering a Transaction Exposure In order to cover himself against an exchange rate risk. arising from an eventual depreciation of the currency in which he has invoiced his exports. • Recourse to specialised organisations. • Covering in financial futures market. • Covering through currency swaps.
MALA GRAPHICS 26 . will buy foreign exchange forward.Forex Market Conversely. an importer wanting to cover himself against the eventual appreciation of foreign currency. Covering a Consolidation Exposure The magnitude of exposure depends on the method of translation used by the parent company.
the value of minimal fluctuation is 125. eggs.Forex Market COVERING IN FOREIGN EXCHANGE FUTURES (OR FINANCIAL FORWARD) CONTRACT MARKET Initially. etc. The currency futures were launched for the first time in 1972 on the International Money Market. raw material and so on. e. (presently a division of the Chicago Mercantile Exchange). Futures Markets and Contracts Currency futures markets are now functioning at Chicago. So if the contract is of the value DM 125. butter. MALA GRAPHICS 27 . • Fluctuations differ according to currencies. Singapore. Sydney. New York.0 1 10 0 = DM • Maturity periods are also standardised.50.000. • Quotations are made in terms of US$ per unit of another currency. futures markets were engaged in merchandise business only.000 X 12.g. The most important of them is the IMM of Chicago. March. September and December. cereals. London. A currency futures contract is a commitment to buy or to sell a specified quantity of a currency on a future date. at the pre-determined/decided price existing on the date of the contract. June. These contracts have the following characteristics: • Transactions are traded in standard lots. say. 0.01 per cent. The smallest variation (also called ‘tick’) is 0. (IMM) of Chicago. Tokyo.
he would have to pay Rs. he would pay only Rs. it is the holder (buyer or owner) of an option who has a choice to use or abandon the exercise of the option who has a choice to use or abandon the exercise of the option whereas the seller of an option should be ready to sell (in case of call) or buy (in case of put) the amount agreed upon.000 and is made with the Clearing House.Forex Market • A guarantee deposit is required to be made for selling or buying of a contract. An Indian importer buys a 1 month tunnel with zero premium of narrow range. MALA GRAPHICS 28 .60 per dollar.00 per dollar. Covering against Exchange Risk by Purchasing Tunnel with a Zero Premium Since premium represents a non-negligible cost. But. The writer of a put option has an obligation to buy a certain amount of foreign currency at a predetermined price. For example. 35. 35. 35.70. banks propose to their clients the option with zero premium called tunnel. Thus. let us consider the data of the Table given below. If the dollar price is established somewhere within the range. but protection is available only within certain limits. then he would have to pay the actual market price. on the other hand if the rate is Rs. The latter has no choice of his own.90. This deposit is of the order of US$ 1. Put Option The holder of a put option acquires a right but not an obligation to sell a certain quantity of foreign currency at a predetermined strike price. 34. This means that if after a month’s time the dollar rate in Indian Rs. A writer (or seller) of a call option has an obligation to sell a certain amount of foreign currency at a predetermined price. Call Option The holder of a call option acquires a right but not an obligation to buy a certain quantity of foreign currency at a predetermined price (also called exercise or strike price).
Tunnel with Zero Premium Maturity 1-month 3-months 6-month Narrow range 35.50-36.Forex Market Besides the tunnels of narrow range.25 34.80-36. there are tunnels of wider range too.50 MALA GRAPHICS 29 .25-36.00 35.00-36.35 Wider range 34.30 33.75-36.60 35.00-35. The importance of tunnels lies in the fact that one does not have to pay premium but at the same time they do not allow the operator to get the full advantage of a favourable evolution of rates. One would choose between the two depending upon the anticipations of future rates.
e. Doing a single ‘outright forward’ transaction maturing on the distant delivery date. currency transactions for value ‘cash’/’tod’. In this case. Outright forward transactions can be used. the next day or two days later. This can be done by : Doing a ‘near-delivery’ transaction and then rolling the position forward to the desired ‘distant delivery’ maturity date. These come in two basic varieties : Market Rate Rollovers An initial spot transaction in done. by means of a ‘swap’.Forex Market EXCHANGE RATE RISK MANAGEMENT STANDARD SOLUTIONS SPOTS/FORWARDS Near Delivery Cash Flows To cover exposures maturing the same day. Long-term Forwards These are the category of transactions where more than one ‘rollover’/’swap’ becomes necessary. the rates applied on both legs of the swap (s) are ‘at-themarket’ i. b. the ‘near’ leg corresponds to the market spot rate and the ‘far’ MALA GRAPHICS 30 . Short-term forwards To cover exposures maturing in more distant dates than ‘spot’ value. and the position is periodically rolled over through swaps. Distant Delivery Cash Flows a. ‘tom’ or ‘spot’ can be entered into.
In this case the ‘spot’ leg of the periodic swaps likely to always be ‘off – market’ (unless the spot rate doesn’t move at all between the swap dates). To adjust for this ‘offmarket feature. The effect of this mechanism is to avoid cash flow in between the initial spot transaction and the first maturity of the contract. in this type of contract. actual cash flows occur) of profit/losses.Forex Market leg corresponds to the market forward rate derived from applying market ‘swap differences’ to the market spot rate. This leads over the life of the contract to the period of realisation (i. on the date of the ‘current’ swap. reflecting the cumulative profit/loss after adjusting for the time value of money.e. This profit/loss is obviously a function of the movement of the spot rate since the time of the initial transaction. Specially. the spot leg for all future swaps is set equal to the rate on the initial spot transaction. as a function of the movement of the spot rate between the date on the initial spot transaction or the previous swap at the date of the ‘current’ swap. MALA GRAPHICS 31 . a final lump-sum ‘net’ payment is made at maturity of the contract by one of the parties. Historic Rate Rollovers An initial spot transaction is following by period ‘rolling over’ of the position by means of swaps.
95 6.55 11.50-1.40 .85-3.70 In an American option.5500 1.10 2. in Pfennigs per USD.75-2. while in a European option this right can be exercised only at maturity.15 2.05-12.90-12.5750 1. Options Value 7-Jan-93 USD Calls 1.00 2.65-13. The above table shows prices of European style USD Calls and USD Puts against the Deutschemark.45 13-Dec-93 14.6175 15-Mar-93 9.80-15.50 1.65 2.70-2.65-8.25-7.55 13-Sep-93 13.5750 1. this right can be exercised at any time upto the term to maturity.35-3.40 USD/DEM Date : 5-Jan-93 Spot level 1.5250 1.90 2.90 14-Jun-93 11.65-.45-9.80 1.10 10. MALA GRAPHICS 32 .35 10.70-3.95 .05-1.95 7.10-4.5500 1.10 13.75 7.20-2.40-10.95 12.00-6.Forex Market NON-STANDARD SOLUTIONS Basic Options Position A currency option gives the holder the right (with-out the holder having the obligation) to buy a specified amount (the ‘call’ amount) of a specific currency (the ‘call’ currency) against selling a specific currency (the ‘put’ currency) at a specified exchange rate (the ‘strike’ rate) within or on a specified date (the option’s term to maturity).10-2.80-12.20 10.35 3.6000 1.65 2.50 8.00 4.80-3.55-10.15-9.10-1.40 1.85 9.25-13.5000 1.40 3.30 4.65-7.10-2.60-3.20-10.05 1.60-4.35-.6250 USD PUTS 1.
An option is said to be ‘In the money’ (ITM)/At the money (ATM)/ out of the money (OTM) depending on whether the immediate exercise of the option would lead to positive / zero/negative profit.000.000 maturing 14 June 1993 at a strike rate of 1. 1992). for USD 1. will cost DEM 89. Option prices are also quoted as a percentage of the call Amount. two business days after the deal date. i.000 X 0. Long and Short Thus there are 4 basic option positions Long Call Long Put Short Call Short Put There is a certain symmetricity in currency options in that (in this case) a USD Call is the same as a DEM Put and vice versa. In addition to this method of quoting a price in terms of one of the currencies. with the premium to be paid on 7th January 1993* (Spot value. There are two basic option type The Call option and the put option There are two basic positions in options (or any other asset). 5th January.500 (1.000.6000..089).e.Forex Market It can be seen that a USD Call/DEM Put. respectively (ignoring the cost of the option). MALA GRAPHICS 33 .
Spot/Forward positions are not sensitive to ‘volatility’/time (ignoring ‘swap differences’). even if correct. In contrast. MALA GRAPHICS 34 . 2. In fact the (un)limited nature of risk/reward for any instrument is really more a matter of money-management and trading tactics. This leads to High Leverage in option positions. By buying/selling options. 1.Forex Market Advantages of Currency Options It is often said that the limited risk/unlimited reward feature of an option makes it a unique instrument. Option position allow for the Exact Implementation of extremely sophisticated views on the movement of the spot price with respect to time.is the potential profit from exercising the option and is given by the difference between the ‘strike’ price of option and the market price. Option premia increases with increases in intrinsic value. this only applies to the buyer of the option. one can implement strategies addressing not only the ‘direction’ of the movement in the ‘spot’ but also the ‘volatility’ of that movement and the time period in which the movement will occur. Option prices show greater percentage movement relative to the spot price of the underlying asset. Therefore the above is not really a unique feature of options. The risk-reward ratio of any option position can be recreated in the spot or futures markets by adjusting position size and stop-loss and take-profit levels. The price (or premium) of a currency option depends on the following factors : • The intrinsic value of the option . However.
Naked Strategies These are option position (long or short) that are not matched by corresponding (opposite) positions in the underlying asset. Thus there can be 4 types of Naked positions : Long Call. with DEM interest rates higher than USD interest rates. only an option position. is that volatile estimate which is consistent with the current value of calls and puts being traded in the market place. there is no ‘spot’ position. Short Call and Long Put.Increasing the interest rate differential increase/decreases the prices of call/put options on the long interest rate currency. For instance in the case of USD/DEM option since the “intrinsic value” is calculated in DE the prices of both USD/DEM calls and puts rise/fall as DEM interest rates (of the same matter as the term of the option) fall/ rise.Forex Market • • The term to maturity of the higher-option premium.e. • The relative interest rate levels in the two currencies . Strategies using Basic Option Positions There are 5 broad categories of Basic Option Strategies. (Implied Volatility a commonly used term in the options market.. Short Put. • The absolute level of interest rates in the currency in which the “intrinsic value” of the option is calculated. i. as the interest rate difference widens the prices of USD/DEM calls rise and prices of USD/DEM puts fall. MALA GRAPHICS 35 . The expected volatility of the exchange rate of the life of the option The higher this volatility estimate. a. the higher option premium. For instance.
is an Indian importer with a liability of USD 50 million maturing in 3 months. The outright forward rate for that maturity is 3 months. Specifically. Break Forward Contracts The Break Forward contract is a type of ‘covered strategy’ developed by combining the features of an option and a forward contract.Forex Market b. Covered Strategies These option positions are matched (in part or full) by opposite spot positions in the underlying asset.9100. The common types of Covered Positions are − Long asset & Short calls − Short asset & Long calls − Long asset & Long puts − Short asset & Short puts The above examples assume a 1:1 ratio between the amounts of the underlying asset and the option. By varying this ratio. This is the rate at which ABC Inc. asks SCB from a 3% markup over the forward rate to arrive at the fixed rate. ABC Inc. The fixed rate is thus 2. Example : ABC Inc. MALA GRAPHICS 36 . The outright forward rate for that maturity is 3. the Break Forward Contract belongs to the subclasses of ‘Long Asset and long Puts’ or Short Asset and Long Calls’ depending on which currency is the asset/liability.0000 (per INR 100). less perfect hedge positions can be constructed.
The option premium is added to the market outright forward rate to arrive at the fixed rate of the break forward contract.1500 (a saving of 24 cents over the fixed rate of 2. which is the rate at which ABC Inc. In this case ABC Inc. still covers at 2.1500..0500 (decided by SCB).9100. however. the story does not end here. ABC Inc. could also have chosen the break rate and had SCB specifying the markup of the forward rate.0500) is built into the forward rate. buys USD from SCB @ 2. markup over outright forward rate) and SCB supplied the corresponding break rate. chose the fixed rate (i. can opt to sell USD to SCB at the end of 3 months. The Break Forward contract also incorporates a break-rate in this case 3. An important feature of the break-forward is that unlike conventional options. no premium outlay is required . Thus the break-forward contract is effectively a combination of Boston option and a standard forward contract.* If the USD strengthens against the INR and the spot rate 3 months later is 2.9100 and benefits.0500 say 3.9100. covers at 2.Forex Market agrees to buy USD (sell INR) from SCB in 3 months time.8000. sells LSD to SCB @ 3.9100 and 3.9100).the cost of the option ( in the above case ABC’s option to sell USD @ 3. then the forward is broken. If the spot is anywhere between 2. though he is not benefiting in this case. ABC Inc. MALA GRAPHICS 37 .e. So obviously the break rate and the fixed rate cannot be determined independently.0500 (thus realizing a 14 cent loss) per dollar but is able to cover its exposure at 3. then ABC Inc. If the spot is greater than 3.0500 ABC Inc.
e.Here the options have the same expiration dates but different strike prices..e. Position size can be as large as capital and market conditions allow) • Bullish spread with Calls Here a call with a lower exercise price is purchased and a call with a higher exercise price is sold. • Bearish spread with puts Sell the put with the lower exercise price and buy the put with the higher exercise price. (Examples are given for the basic position unit i. This strategy reflects a bullish view on market direction hence the name ‘Bullish Spread’.Forex Market c. 1 option short and 1 option long. Spread Strategies These are portfolios incorporating two or more options of the same type (i.. • Bullish spread with Puts Buy the put with the lower exercise price and sell the put with the higher exercise price. all puts or all calls) with some options held short and some long. A special variety of Vertical spread is the ‘Butterfly Spread’ or ‘Sandwich spread’ which consists of 4 options two options bought / sold with different MALA GRAPHICS 38 . There are four basic types of money spreads. • Bearish spread with Calls Sell the call with the lower exercise price and buy the call with the higher exercise price. The common spread strategies are as follows: Money spreads/Price spreads / vertical spreads ..
. Time spreads/Calendar spreads/Horizontal Spreads . [Not including the net premium to be paid to open the long butterfly position]... The maximum profit occurs when the underlying market finishes at the inside exercise price (here $ 330) and zero profit occurs when the market finishes outside either of the extreme exercise prices (here $320 and $340). • • • • Long Butterfly with Calls Short Butterfly with Calls Long Butterfly with Puts Short Butterfly with Puts An example of the Long Butterfly spread with calls.Forex Market strike prices and two options sold/bought with the same strike price (the latter strike lying between the two former strikes). • • • Long time spreads with Calls Long time spreads with Puts Short time spreads with Puts MALA GRAPHICS 39 ... There are 4 types of Butterfly spreads possible .here the options have the same strike prices but different expiration dates. is given below : Long Butterfly Spread with Calls Spot Gold = $ 330 Sell 2 calls at strike price of $ 330 Buy 1 call at a strike price of $ 320 Buy 1 call at a strike price of $ 340 The range of expiration values for butterfly spreads is between zero and the amount between consecutive strike prices. The four basic types of time spreads are .
Forex Market • Short time spreads with Calls In long time spreads. MALA GRAPHICS 40 . d.. calls and puts) with all the options short or long. A condor which is a composite of two basic combination positions. The outcome occurs when actual volatility picks up implied volatility drops. Strictly speaking this definition applies only to basic or building block combination position. A short straddle position behaves symmetrically ( opposite to the nature exposure of the long straddle). If the options are bought/sold.e. The following Combination Strategies are common: Straddle Buy/Sell a call and a put with the same strike price and time to expiry. Straddles are essentially volatility plays. it is called a Long/Short Straddle respectively. Combination strategies These are portfolios containing different type of options (i. does not satisfy this definition. The ideal outcome for this positions is a reduction in actual market volatility combined with an increase in implied utility. Such agonal spreads have different exercise prices and different expiration dates. the longer term option is bought and the shorter term option is sold. Diagonal Spreads It is also possible to do spreads which combine features of money spreads and time spreads. A long straddle position benefits/suffers from increase / decrease in volatility. In short time spreads the shorter term option bought and the longer term option is sold.
one bought and the other sold. For instance with Spot Sterling at 1.Forex Market The strike price in the Straddle is usually chosen to be at-the-money. buy a 1.6240 put and a 1. The long/short strangle represents a bullish view on impending market volatility. When a strangle has both calls and puts in-the money it is called a GUTS. a purchase/sale of a 1. Condor There is some degree of ambivalence in the market about the definition of a CONDOR. The common understanding is that a condor is constructed by means of two strangles. The exposure of the strangle to volatility is essentially similar to that of the straddle. This creates a long strangle position. because at-the money options have the highest sensitivity to changes in volatility. albeit implying a more aggressively bullish/bearish view on volatility than a Straddle trade. With spot USD/DEM at 1. and comes in two basic varieties. with both the call strike and the put strike being equally out-of-the-money. on Mar 23.6540 call MALA GRAPHICS 41 .6440 call. 1993. Strangle A Strangle is a close cousin of the Straddle.4810. Then sell a 1. A Strangle is also a volatility play. The standard strangle is constructed with out of the money calls and puts. Example: (All options expire June 1993. Call/Put implies USD Call/Put). the short strangle (options sold) and the long strangle (options bought).4710 put creates a long/short strangle.6340.4910 call and 1. A strangle costs less than a straddle.
6440 call and buying the 1.6540 call. The long condor is just the reverse (short straddle plus long strangle). This creates a short strangle position.6140 put. The two basic strip varieties are the long strip (options bought) and short strip (options sold). The long/Short strip can be seen as a long/short straddle plus one long/short put and is essentially a bet on an increase / decrease in volatility albeit with a leaning towards a bearish/bullish view on market direction.6340 call and put (long straddle) and selling the 1. The ambivalence in nomenclature need not be a significant problem. a short condor per this alternative view is constructed by buying the 1.Forex Market and 1.6140 put and 1. MALA GRAPHICS 42 . This strategy reflects a view that “a sharp move is expected in the spot though the direction of the move is unknown.6440 call and 1. Continuing with the USD/DEM example.6340 put (short strangle).6240 put and 1. Some practitioners also refer to a condor as a combination of a straddle and strangle.” Similarly if one has a view that the “spot market will be very quiet” one can implement a “long condor strategy” by selling the 1. Strip Buy/Sell two puts and a call with the same strike and expiration.money) and a short strangle (short out of the money call and put). A short condor is a combination of a long straddle (struck at the . because the implied market views for long/short condors are identical for both definitions. Together these two positions have created a “short condor”.
Example : An Indian importer who has a liability of USD 10. Alternatively if the ‘sold option’ is worth more / less than the ‘bought option’. If the strike prices of the call & put are so chosen that the two options cost the same. e. For all USD/INR levels between 3. the importer is obliged to cover at 3. the long/short strap is effectively a long/short straddle plus one long/short call and represents a bet on an increase/decrease in volatility combined with a bullish / bearish view on market direction.000.2000 but if the USD wakens beyond 3.2800.2800.000 in 3 months time. ‘Cylinder’ Strategies These strategies combine the flexibility of the ‘Spread’ and ‘combination’ strategies. the importer can still cover at 3.2800 and 3. Both options are for the same amounts and maturates. Similar to the case of the strip.2000. To help pay for the cost of this option purchase he sells a put option on the USD against the INR at a strike price of 3.2800.2000. he buys a call option on the USD against the INR (Indian Rupee) with a strike price at USD 3. MALA GRAPHICS 43 . A cylinder consists of a long/short position in a call/put combined with a short/long position in a put/call. If the USD strengthens beyond 3. then this strategy is called a ‘zero-premium cylinder’. the importer would cover at market rates.Forex Market Strap Buy/Sell two calls and a put with the same strike and expiration. The two basic strap varieties are the long strap (options bought) and short strap (options sold).2000 (per INR 100).
and are used mainly because of their relatively lower cost. thereby creating a ‘Participating Cylinder’ with a 50% participation rate. (This benefit comes at the cost of a lower premium for the sold option and hence a higher net cost for the cylinder). ‘Exotic’ Option strategies The following types of ‘Exotic’ option strategies are common : − Compound Options − Chooser Options − Path – Dependent Options − Barrier Options a.2 to maintain the net premium cost of the strategy at zero. are different. The importer can thus enjoy a 50% participation in any USD weakness beyond 3.e. Another common variety of Cylinder Strategies is the ‘Participating Cylinder’ which is a cylinder where the currency amounts underlying the two options. Compound options are especially useful in situations where the currency asset/liability is not certain. alternatively the USD/INR put could be sold at a lower strike rate of say 3.Forex Market the strategy is referred to as a ‘credit cylinder’/ debit cylinder’.2800. The Indian importer discussed above could have bought the USD/INR calls for an amount equal to his total liability i.000.000. USD 10.000. MALA GRAPHICS 44 .000 by sold the USD/INR puts for an amount of only USD 5. The zeropremium cylinder is also often referred to as a “Range Forward”. Compound Options These are options on options.
Chooser Options Chooser Options allow holders to decide on the rate of option they have purchased (i.6000. MALA GRAPHICS 45 .XYZ Corp. The above call compound option is said to be the-money because the strike rate equals the current market price of the underlying option. may need to buy USD/sell DEM 1 month from 8th April.Forex Market Example : On 8 April 1993.6250 (atthe-money-forward).39 pfenning per USD. XYZ Corp.option @ 2. but it will be sure of its position only 2 weeks from 8th April. Example : XYZ Corp. buy a 3 month choose option on USD/DEM for USD 5 million at a standard price of 1. This upfront paying will give XYZ Corp. Instead of paying pfenning per USD for an option it may not even -. 1 month USD call/DEM put at a strike rate of 1.39 pfennig per USD to buy a European style. can decide whether what it has bought is a USD put or USD call. the option to buy a USD DEM put @ 2. call or put) at a rate later than the date of option purchase.e. it would have cost 2. Can buy an at-the-money. with a 15 day choosing deal-Depending on how the spot moves over the next days XYZ Corp.39 pfennigs per USD. There are 4 basic varieties of compound options: − Call options on Calls − Put options on Calls − Call options on Calls − Put options on Puts b. (this is the standard rate for the compound options) 1 month from 8th April 1993. call comp-.
000.Forex Market These options are more flexible than convention options and therefore cost more. expiring 15 June 1993. Lookback Options In these options the pay-off to the holder is the highest intrinsic value of the option during its life. Thus the pay .6000. Path-Dependent Options These currency options have 3 main varieties − Asian or Average Rate options − Lookback options − Average Strike options Asian Options These options are struck on an average of the spot price rather than on the spot price itself (as is case for conventional options).1. On 15 June 1993. Due to their added flexibility. struck on the 15 day simple moving average of USD/DEM (calculated on the New York closing prices) with a strike rate of 1.6500 .000).000. c. Since the effect of focusing on a moving due to the smoothing effect of the average these options cots less than conventional options.6500. Obviously. An example of an Asian call option on USD/DEM would be a USD Call/DEM put.6000 X 1. Lookback Options cost more than conventional options.off for the holder would be = (1.000. MALA GRAPHICS 46 . on USD 1. this can only be determined in retrospect after the expiration of the option. the 15 day moving average of USD/DEM stands at 1.
Use calls and puts ii.110.6000 DEM (spot) for an amount of USD 10 million.000]. d. buys a 6 month.5 million Yen. Place the ‘barrier’ between the strike price and the current sport price MALA GRAPHICS 47 . Example : ABC Inc. (In an average strike option. These options cost less than conventional options.Forex Market Example : ABC Inc. a total of DEM 1 million. buys a 3 month Lookback call on USD/DEM with a strike price at 1.000 X 115.e.50 . This clearly defined moving average itself functions as the strike price). Average Strike Options The pay-off for an Average Strike Option is determined by taking the difference. ABC Inc. Barrier Options In addition to parameters present in a conventional option. Use short and long positions iii. The highest spot market level of USD/DEM in the next three months is 1. these options have a ‘barrier’ and a specification of how the terms of the options change depending on the movement of the sport price with respect to the barrier.50 ABC Inc. average strike USD/JPY put option. [5. at expiry between the ‘spot’ price of the underlying asset and the value of a specified ‘moving average’ of the ‘spot’ price.7000. is paid a profit of 27. The basic rules for generating alternative barrier option positions are: i. instead of a strike price. [with the strike price equal to the 15 day simple moving average (SMA) of New York closing prices (spot)] for USD 5 million 6 months later spot USD/JPY is at 110. the option buyer specifies the type and period of the moving average.000. is compensated after 3 months to the extent of 10 pfennigs for every dollar i.00 and the value of the 15 day SMA is 115.
Due to their limitations.5500 DEM. this option starts to behave like a standard USD/DEM call. As soon as the spot rate crosses 1. barrier options cost less than conventional. iv.’ Example : An ‘up and in’ USD call/DEM put. MALA GRAPHICS 48 . struck at 1.5000 with a barrier at 1.500 and 1.5500.5500. Change the terms of the option from up-and-in to up-and-out to ‘downand-out. will have no value as long as the sport is between 1. Such a strategy is consistent with a view that significant USD upside can only be expected if it rises over 1.5500.Forex Market or Place the strike between the ‘barrier’ and the current spot price.
Fixed/Fixed Currency Swaps / Synthetic.Such swaps have floating rates on both legs. forward FX.e. MALA GRAPHICS 49 . These are also known as Circus Swaps. They are interest Rate Swaps and Currency Swaps.Forex Market INTEREST RATE OF RISK MANAGEMENT Interest rate and currency swaps A swap is a legal agreement between two parties to exchange cash flows over a period of time.). Swaps fall into two broad categories. a.e. These swaps involve two currencies but only one type of interest rate (i. Floating /Fixed or Fixed/Floating Interest Rate Swaps .These involve one floating interest rate (“floating leg”) and one fixed interest rate (“fixed leg”). b. b. c. Interest Rate Swaps These (involving only one currency) can again be classified as follows. Cross Currency Interest Rate Swaps These swaps involve two currencies and two types of interest rates (i. fixed rates on both legs. Cross Currencies and one type of interest rate in this case both legs have floating rates. one floating leg and one fixed leg). depending on the nature of the risk they are designed to alter. Currency Swaps Currency swaps have three basic varieties : a. Interest Rate “Basis” Swaps .
Forex Market Interest Rate Swaps The floating /Fixed or fixed/floating Interest Rate Swap and the Interest Rate basis swap are ‘standard’ swap structures in that : • • They have ‘at-the-market’ swap rates. The Delayed Libor Swap is undertaken in a positive (upwardly sloping) yield curve scenario by borrowers who feel that the implied forward rates derived from the yield curve. DEM and most other currencies and the same date as the trade date for GBP). each party praying interest on the ‘basis’ of its choice. Basis Swaps In Basis Swap booth swap counterparts receive floating rate payments. wherein one or more of the above conditions applicable to ‘standard’ swaps are violated. MALA GRAPHICS 50 . Become effective from the spot date (the spot date is two business days after the trade date for USD. The other swap variations listed in here and their combinations can be seen as non-standard swap structures. • The National Principal Amount (NPA) and the swap rate remain constant over the term of the swap. An interesting type of Basis Swap is the LIBOR-IN-ARREARS SWAP or DELAYED LIBOR SWAP. overestimate the future Libor fix for short term interest rates. • These are no call/put or extension provisions in the swap agreement and • Swap counterparts do not deposit collateral with the intermediary.
− The deferral period. but with a view to matching cash flows. does not want to ‘start’ the swap now. the pricing of a forward start swap relative to a ‘spot start’ swap will depend on: − Whether on is paying or receiving (the fixed rate).Forex Market Undertaking to pay Delayed Lobor in a positive yield curve scenario involves the risk that future Libor settings may actually be higher than what the yield curve is predicting. Forward Start/Delayed Start Swaps Such swaps are created by changing the ‘spot start’ feature of standard swaps. leating the customer to lose out on the swap. They are useful when the swap user wishes to lock in to a ‘good’ swap rate. Example : ABC Inc.start. Yen swap with a 6 month deferral period. MALA GRAPHICS 51 . and − The tenor of the swap. where it pays 3. enters into a 2 year forward .9% (fixed) and receives 6 months Yen Libor. − The terms structure of interest rates. This swap becomes ‘effective’ 6 months after the deal date and then runs for 2 years. Since a Forward Start swap is synthesized from two ‘spot start’ swaps of different tenors.
In general (for a swap without final exchange of principal) the counterpart paying interest (in the swap). For instance suppose ABC Inc. The working of a cross-currency interest rate swap is shown in from ABC Inc’s perspective. The standard currency swap features initiall exchange of principal as well as exchange of principal at maturity. However. MALA GRAPHICS 52 . would pay only 6. Even if a swap with no initial exchange of principal is desired the pricing of the swap will not change because the initial exchange can be duplicated by means of a ‘spot’ transaction to buy/sell the relevant currencies. Sterling is at a discount against the US Dollar in the 7 year maturity in the forward foreign exchange market. Cross Currency Interest Rate Swaps The incremental benefit (over the Interest rate swap) of the currency swap is that it allows the user to also alter the balance sheet’s currency exposure. If this name swap did not feature exchange of principal at maturity ABC Inc. in the case of a currency swap without any exchange of principal the pricing will differ from that of a standard swap. At the time of writing.Forex Market Currency Swaps Currency Swaps are designed to alter the current currency basis and/or interest rate basis of the counterparts exposure. was receiving 6 month USD Libor and paying 7. in the currency that is at a (forex) forward premium/discount (for the relevant swap tenor) would have its interest rate raisald/lowered with respect to the rate applicable in a swap featuring final exchange of principal.40% Fixed sterling. Like Interest Rate Swaps they can also be used as a financing tool where comparative borrowing advantages exist. For the sake of simplicity the swap arranger’ fee is not shown in the illustration.62% Fixed Sterling in a 7 year swap with exchange of principal at maturity.
the counterparts switch currencies but both pay fixed rates in the currency of their choice. such a swap is effectively a synthetic forward contract. £ 150 m Initial Exchange £ 150 m £ 100 m SCB £ 150 m US Dollar Bond XYZ Corp Sterling Debenture £ 10. £ 10.5% ABC Inc.5% SCB £ 10. Since forward rates are quoted according to the principle of Covered Interest Parity in currencies where arbitrage between the interest rate and forex markets is possible.5% Periodic Payments US Dollar Bond $ Libor + 50 bp £ 10.5% £ 10. The only difference MALA GRAPHICS 53 .5% $ 150 m ABC Inc. £ 100 m SCB $ 150 m SCB £ 100 m Fixed to Fixed Currency Swap/Synthetic Forward FX In a Fixed to Fixed Currency Swap.5% Exchange at Maturity US Dollar Bond £ 10.Forex Market FIXED-TO-FLOATING CROSS-CURRENCY SWAP Sterling Debenture £ 100 m £ 100 m ABC Inc.5% XYZ Corp Sterling Debenture £ 10.
Forward Rate Agreements (FRAs) An FRA allows the user to fix the interest rate on future borrowing / lending often substantially in advance of the sport market fixing of the relevant interest rate. An example of such a swap would be on where the counterparts pay fixed interest rates on Sterling and Dollar respectively. Fixed / Fixed currency swaps without final exchange of principal are known as “coupon swaps” Cross Currency Basis Swaps A close cousin of the Fixed to Fixed Currency Swap. this swap features floating rates of interest being paid to each other by the counterparts in two different currencies.Forex Market lies in the periodic (rather than at maturity) settlement of the interest differential in the case of the swap. In fact in tenors beyond 1 year interest rate swap each other just as in tenors upto 1 year forward points are derived from eurodeposit rates. MALA GRAPHICS 54 .
while the rupee immediately appreciated on increased supply of dollars. 5. the CRR hike.Forex Market RBI MAULS PUNTERS TO HALT RE SLIDE The indirect measures included a one percentage point increase in cash reserve ratio to 11 per cent three percentage point increase in its daily fixed rate repo and steps a large dose of direct intervention in the foreign exchange markets.70 against the dollar in mid day trade prompt impact on the markets with the rupee recovering to 42. Incremental investments made after June 11. The central banks sold about $250 million in the spot market. the move also sucked out $ 250 million worth of rupees (over Rs 1.80 – a 70 paise appreciation over Wednesday’s close. And the token today announced that foreign institutional investors (FIIs) would be allowed to hedge 15 per cent of their portfolio investment made before June 11. rupee had plunged to an all-time low of 43. This.70 before closing at 42.000 crore liquidity from the system. stop speculators selling rupees in the spot market the recent depreciation and buying dollars forward slight premium to today’s rate for getting delivery forward premia are also likely to induce exporters to bring in their dollars. thereby having to pay premia for receiving dollars at a future date. Second the move to bump up forward premia. The central bank today made small purchases of dollars in the forward market. This then will act as a disincentive to borrowing cheap from the money markets and arbitraging in the forex markets. MALA GRAPHICS 55 . the attempt to drain out the excess liquidity. is expected to suck out over Rs.000 crore) from the system in one day. which takes effect from August 29. combined with a 3-percentage point increase in repo rates from 5 to 8 percent. This had twin effects. First. is expected to push up interest rates.
feel that this has also resulted in the market becoming thinner since this kind of speculation provided some intraday liquidity in the market. Earlier. exporters have been warned that their entitlement in Exchange Earners Foreign Currency (EEFC) account will be reduced if they will fully delay repatriation of export proceeds. At the same time. exporters are allowed to keep 50 per cent of their proceeds in EEFC accounts. This will reduce the excess demand in the forward market and ensure that only genuine demand reaches the market. This has resulted in corporates willfully keeping forex abroad . however. The EEFC facility was introduced for exporters before currency account convertibility. To improve dollar inflows. The RBI has withdrawn the facility given to corporates in December 1993 to split their forward commitments into spot and forward legs. It was provided to enable exporters to skip the cumbersome process of obtaining sanctions for their forex requirements. However. waiting for further depreciation of the rupee in order to book profits. At the same time. market players are skeptical about the efficacy of the move given that FIIs find the present levels of premia unattractive from rebooking cancelled forward contracts. After issuing warning to banks the RBI has finally withdrawn this facility Bankers.Forex Market The RBI hopes that this will induce FIIs to start hedging their outstanding investments which means they will want to buy dollars forward at current prices to avoid taking a depreciation hit lead to increased demand for forward dollars and further hardening in premium rates. The RBI had earlier banned corporates without trade based exposures from doing the same. corporates were allowed to meet their dollar requirements by buying spot dollars on once day and forward covers on another day. At present. the central bank has also allowed exporters to used the EEFC funds for domestic businesses. the RBI has promised to consider extension of MALA GRAPHICS 56 . This resulted in corporates buying only spot dollars and then selling them off with out taking a forward cover.
finally in a small dose of moral suasion. MALA GRAPHICS 57 . the RBI has warned banks that it would be keeping an eagle eye on their forex operations and has asked all authorised dealers to report day end and peak intrsa-day position in the forex market.Forex Market repatriation of exporters dollar in exceptional cases. And.
Forex Market CONTENTS Acknowledgment Forex Market What is Risk ? Types of Risk Hedging Techniques Alternative Hedging Technique External Techniques for Covering ERR Exchange Rate Risk Management-Standard Solutions ERR-Non-Standard Solutions Interest Rate Risk Management Government Policies MALA GRAPHICS 58 .