Foreign Currency Risk Management

FOREX

How to Convert How Currency Types of Foreign Risk Hedging Methods

Currency Fluctuates

RISK MANAGEMENT

EXCHANGE RATE CONVERSION

Bid Offer/ask
Bank Buy Bank Sell
1.2320 $/£ 1.2324 $/£

When dealing with converting Foreign currency, it is important to consider the following points
 Always consider yourself at Adverse Position

In case of Receipt (Lower In case of Payments (Higher

Receipt) Payment)

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  In Currency Division

In case of Receipt, Sell Currency, Exports, Gain or Income

In case of Payment, Buy Currency, Import, Loss or Expense

TRANSACTION RISK - EXTERNAL HEDGING METHOD

Forward Contract :
A forward contract is an agreement made today between a buyer and seller to exchange a specified
quantity of an underlying asset at a predetermined future date, at a price agreed upon today.

Example
Home Currency is British Pound £ , Exports receipts = $ 500,000 after six months

Spot Rate = 1.30 – 1.31 $/£

Six month forward rate = 1.32 – 1.33 $/£

Expected Net Receipt if Forward Contract is taken = $500,000/1.33 = £ 375,940

Adjustment:
3 month forward 1.28 $/£
8 month forward 1.38 $/£
6 month forward ?

TRANSACTION RISK - EXTERNAL HEDGING METHOD

Money Market Hedging:

Foreign Currency Receipts / Exports

Steps:
a) Calculate present value of foreign currency using borrowing rate of foreign currency and take loan of
this amount.
Present Value = Foreign Currency amount
(1+ borrowing rate of FCY)

a) Convert that present value into home currency using spot exchange rate.
b) Deposit the home currency at the deposit rate of home currency.
Total receipts= Home currency × ( 1 + lending rate of HCY )

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 FOREIGN CURRENCY PAYMENTS / IMPORTS
Steps:
a) Calculate present value of foreign currency using lending rate of foreign currency and deposit that
amount.
Present Value = Foreign Currency amount
(1+ lending rate of FCY)

a) Convert that present value into home currency using spot exchange rate.
b) Borrow the home currency at the borrowing rate of home currency.
Total payment= Home currency × (1 + borrowing rate of HCY )

TRANSACTION RISK - EXTERNAL HEDGING METHOD

Derivatives:
• Future Settlement
• Initial amount to be paid is nil or low
• Drive their value from some underlying
• Traded in two types of market
• (Over the counter Market & Exchange Traded)

Over-the-Counter Derivatives Exchange-Traded Derivatives

Customized Contracts
Any Amount
Available in any Currency
Settlement on any date
No Initial margin requirement
Gain or Loss settled on daily basis using ‘Mark
Gain or Loss settled at maturity
High Risk of Default
Counter Party is another Investor
E.G FORW ARD CONTRACTS
Standardized Contracts
Standardized Contract Size (e.g. $ 62,500)
Major Currencies
Settlement Date – Mar/Jun/Sept/Dec
Initial Margin Requirement
to Market”
No Risk of Default
Counter Party is clearing house.
E.G FUTURE CONTACTS

TRANSACTION RISK - EXTERNAL HEDGING METHOD

FUTURE CONTRACT
• Futures are standardized contracts traded on a regulated exchange to make or take delivery of a
specified quantity of a foreign currency, or a financial instrument at a specified price, with delivery or
settlement at a specified future date.
• They are Exchange Traded derivatives contracts.
• Standardized contract sizes and are available in only major currencies
• There are four settlement dates MAR/JUNE/SEPT/DEC.

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 FUTURE CONTRACT
Step 1:
Identify the amount of currency to be hedged

Step 2:
Decide whether to buy or sell future
If you want to buy currency Buy that currency future
If you want to sell currency Sell that currency future
Think according to the contract size currency

Step 3:
Identify the settlement date expiring immediately after the payment is due to be paid or received

Step 4:
Calculate no of contracts  Transaction Amount/Contract Size

If transaction currency is different from the contract size currency then using future rate convert
that transaction amount currency into the same currency of contract size.

Step 5:
Calculate Basis Risk.
BASIS = Current Spot rate – Opening Future Rate

Remaining Basis =( Difference/Total months)* remaining months

Basis Risk – It’s the risk that current spot will not reduce over the time to exactly match the opening future
rate.

Lock in Rate= opening future rate ± Remaining Basis ( opposite to normal rule )

Convert the foreign currency into home currency using Lock in rate.

OPTION CONTRACT
• Currency options give the buyer the right but not the obligation to buy or sell a specific amount of
foreign currency at a specific exchange rate (the strike price) on or before a predetermined future
date.
• For this protection, the buyer has to pay a premium.
• A currency option may be either a call option or a put option
• Currency option contracts limit the maximum loss to the premium paid up-front and provide the buyer
with the opportunity to take advantage of favorable exchange rate movements.

TYPES:
CALL OPTION  Right to buy at a specified rate
PUT OPTION  Right to sell at a specified rate

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 OPTION CONTRACT
Step 1:
Identify the amount of currency to be hedged

Step 2:
Decide whether to buy Call or Put
If you want to buy any currency in future  call
If you want to sell any currency in future  put
Think according to the contract size currency

Step 3:
Identify the settlement date expiring immediately after the payment is due to be paid or received

Step 4:
Identify the exercise price

Step 5:
Calculate the no of contracts =
(Foreign Currency Amount/ Exercise Price) / Contract Size

Step 6:
Calculate the premium cost = No of contract x Contract size x Premium
If premium answer is not in your home currency then using current spot rate convert it into home
currency.

Step 7:
NOTE: It is assumed that option will be exercised.
Exercise the option ×××
Over or under hedge amount × ××
Premium ×××
Net Amount ××

Interest Rate Risk Management

Interest rate risk (IRR) can be explained as the impact on an institution’s financial condition if it is exposed
to negative movements in interest rates.

This risk can either be translated as an increase of interest payments that it has to make against
borrowed funds or a reduction in income that it receives from invested funds.

METHODS OF HEDGING INTEREST RATE RISK

• Forward rate Agreement (FRA)

• Interest Rate Future
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 • Options
• Interest Rate Swaps
• CAP, FLOOR & COLLAR

FORWARD RATE AGREEMENT (FRA)

• FRA is a contract in which two parties agree on interest rate to be paid on a notional amount at a
specified future time.
• The “buyer” of FRA is partly wishing to protect itself against a rise in rates while the “seller” is a party
protecting itself against an interest rate decline.
• FRAs can be used to hedge transactions of any size or maturity and offer an alternative ta interest
rate futures for hedging purpose.
• FRAs do not involve any margin requirements.

Forward Rate Agreement (FRA)

A co, can enter into a FRA with a bank that fixes the rate
Of interest for borrowing at a certain time in the futures.

If the actual interest rate proves to be

Higher than the rate agreed lower than the rate agreed

The bank pays the co, the The co, pays the bank the
difference difference

FORWARD RATE AGREEMENT

It is 30 June. Lynn plc will need a £10 million 6 month fixed rate from 1 October. Lynn wants to hedge
using an FRA. The relevant FRA rate is 6% on 30 June.
a) State what FRA is required

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 b) What is the result of the FRA and the effective loan rate if the 6 month FRA benchmark rate has
moved to
1. 5%
2. 9%

Solution
a) The forward rate agreement required is 3-9.
b)
(i) At 5% because interest rates have fallen, Lynn plc will pay the bank:

£
FRA payment £10 million x (6% - 5%) x 6/12 (50,000)
Payment on underlying loan 5% x £10 million x 6/12 (250,000)
Net payment on loan (300,000)
Effective interest rate on loan 6%

(ii) At 9% because interest rates have risen, the bank will pay Lynn plc

£
FRA receipt £10 million x (9% - 6%) x 6/12 150,000
Payment on underlying loan at market rate 9% x £10
(450,000)
million x 6/12
Net payment on loan (300,000)
Effective interest rate on loan 6%

INTEREST RATE FUTURE

IMPORTANT TERMS
a) BUY FUTURE RIGHT TO RECEIVE INTEREST (DEPOSIT)
SELL FUTURE RIGHT TO PAY INTEREST (BORROW

b) PRICE OF THE CONTRACT IS DETERMINED AS (100 – r)

r = Libor interest rate
If Libor 11% = (100-11) =89
If Libor 5% = (100-5) =95

c) TICK VALUE=CONTRACT SIZE X 0.01 % x 3/12

d) Settlement date = March, June, September & December
e) Contract size= standardized normally in £500000, £1000000.
f) Basis risk = Current spot rate( current Libor) – opening future rate

Remaining Basis =( Difference/Total months)* remaining months

Closing future = Closing Spot ( closing Libor) ± Remaining Basis ( based on Trend )
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 Basis Risk – It’s the risk that current spot will not reduce over the time to exactly match the opening future
rate.
g) No. of contracts
= amount of loan /deposit x time period of loan
Contract size 3

METHODS OF HEDGING INTEREST RATE RISK

STEPS:
• Identify the borrowing or lending amount.
• Decide whether to buy or sell future
If you want to receive interest = buy future=Lender
If you want to pay interest = sell future=Borrower
• Identify the settlement date expiring immediately after the loan is taken
• No of Contracts = amount of loan /deposit x time period of loan
Contract size 3
• Basis risk = Current spot rate( current Libor) – opening future rate
Remaining Basis =( Difference/Total months)* remaining months
Closing future = Closing Spot (closing Libor) ± Remaining Basis ( based on Trend )
• Close the future contract by comparing opening future with the closing future and calculate gain or
loss.
Opening future rate xx
Closing future rate xx
Gain/Loss xx
• Borrow from market
(Actual Interest + Spread) x months/12 x loan amount
Actual Amount Borrowed = xx
Gain/Loss Future = xx/(xx)
Effective Cost xx

Advantages of futures
• An important advantage of futures as a hedging instrument is the flexibility of closing a position at any
time before delivery date, so that the hedge can be timed to match exactly the underlying borrowing,
lending or investment transaction. In contrast, the settlement date or exercise date for FRAs and
European-style interest rate options is set for an exact date when the transaction is arranged; giving
the user no timing flexibility should the loan or investment date be slightly delayed or brought forward.
• The user of futures also has the opportunity to benefit from current market prices, should these seem
particularly favorable, by closing a position before the loan or investment takes place.

Disadvantages of futures
• Initial margins and variation margins tie up cash in deposits for the sale or purchase transaction until
the futures position is closed.
• There can be a considerable amount of administrative work to manage futures positions efficiently.
• Futures are a short-term hedging method, and most contracts traded on an exchange are for the next
one or two delivery dates. The range of available interest rate contracts is fairly limited and restricted
to the major currencies.

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 OPTION ON INTEREST RATE FUTURE
An interest rate option is an option on a notional borrowing or a deposit which guarantees a minimum or a
maximum rate of interest (called strike price) for the option holder. The option is settled in cash.
This product is available on payment of an upfront fee called a premium.

STEPS:
• Identify the amount of borrowing/lending
• Decide whether to Buy Call or Put Option
Call option=Right to buy= Buy future=If you want to receive interest=Lender
Put option= Right to Sell= Sell future=If you want to pay interest =Borrower
• Identify the settlement date expiring immediately after the loan is taken
• Identify the best Exercise Price
Select lower Put Option  Exercise Price interest rate + Premium Cost
Select higher Call Option  Exercise Price interest rate - Premium Cost
• No of Contracts = Amount/Contract Size x Duration / 3
• Calculate Premium Cost = ticks x tick value x number of contracts
• Decide whether to exercise the option or not by comparing strike price with basis adjusted closing
future price.
• Actual Borrowing or lending in market
(Closing libor + Spread) =xx
Gain on option = xx/(xx)

Premium Cost =x

Effective Cost xx

Saad Jawed
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