Currency Derivatives

Dr HK Pradhan
XLRI Jamshedpur
 Currency as an asset class
• Currency Trade: low margin
• There is no STT is currencies
• Global trade opportunities
• Currencies are way more stable compared to equities
• More predictable, make small gains and sum over time
• Small move a day, small losses/ so learning becomes
easier
• It is difficult to manipulate currencies unlike stocks
 Why Indian Market is Illiquid
• Regulatory resistance on speculative positions
• Transactions booked on back-to-back basis
• Indian currency market is not so integrated
with Global markets
• For asset class like Interest rates, HTM rule
requires no hedge
• Arbitrage is generally the key driver of
derivatives trade
 Currency Risk
• Effect of exchange rate movements between $/€ on a
borrower’s net income, when € appreciates from
$1.03/€ to $1.12/€ during the year

Earnings Payments Exchange Payments Net

($) (€) Rate $ Equiv. Income
($/€) $ Equiv.

Year 1 100 95 1.03 97.85 2.15

Year 2 100 95 1.12 106.40 -6.40
 Objectives of Hedging

• Hedging involves eliminating uncertainly

about future exchange rate and interest rate
movements
• Objective:
– To lock in today (or on the day of the contract) an
exchange rate or interest rate for future transactions
– To eliminate the uncertainly of future exchange rate and
interest rate movements
 Currency Derivatives
A. Explain how forward contracts are used to hedge
based on anticipated exchange rate movements
B. Describe how currency futures contracts are used
to speculate or hedge based on anticipated
exchange rate movements
C. Explain how currency option contracts are used to
speculate or hedge based on anticipated exchange
rate movements
 What is a Currency Derivative?
1. A currency derivative is a contract whose
price is derived from the value of an
underlying currency.
2. Examples include
forwards/futures/options/swaps contracts
3. Derivatives are used by companies to:
a. Hedge exposure to exchange rate risk
b. Speculate on future exchange rate
movements

7
 Hedging Alternatives
• Consider the case of the importer who expects to pay £ 1 million in one-
year from now.
• The importer currently has the following choices:
– Leave exposure open, and sales Rupees spot to buy £ 1 million
• Undertakes Rs- £ exposure as open position
– Cover exposure by selling Rs forward to buy pound
• Fully hedged against £
– Cover exposure by selling dollars forward to buy pound, and buys $ spot
• Subject to Rupee-Dollar spot risk, speculates on Rs/ $
– Undertakes a money market operation, by borrowing Rupees,
converting into £, and investing for one-Year
– Enter into a currency option to buy £ against $ or Rupees against £
 Hedging Alternatives

• Money Market Hedge

• Forward Market Hedge
• Futures Market Hedge
• Options Market Hedge
• Cross currency-Hedging
• Hedging Recurrent Exposure(swaps)
 Currency Forwards
• In the forward markets currencies are traded for
delivery in the future
• An agreement to buy or sell foreign exchange at
an agreed exchange rate on a future date
• Liquid forward contracts available up to one year
in international markets offered by major banks
• Longer dated forwards beyond one year are also
available, which can be at times costly
 Forward Contracts
• You entered into this forward contract to
buy $ 1 million by paying 66.48 million INR
in One Year.
Pay-offs • Your pay-offs looks as below:

65.00 67.00
0
66.48
▪ Such contracts help you to fix the
future Dollar costs of buying in
INR
 Forward Hedging

• Hedging involves eliminating uncertainly

about future exchange rate and interest rate
movements
• Objective:
– To lock in today (or on the day of the contract) an
exchange rate or interest rate for future transactions
– To eliminate the uncertainly of future exchange rate and
interest rate movements
Forward Rates
 Covered Arbitrage
(Interest Rate Parity)
• Forward exchange rate will be equal to interest differential:

(1 + rinr )
f t +1 = st
(1 + rusd )
• Forward rates approximately equals the foreign minus the
domestic interest rate. Value Date 11-11-2018

( rinr − rusd ) T
f t +1 = st
Expiry Date 29-03-2019
Maturity 138
Ref Rate 69.0292
INR 6.290% 3.223%
USD 1.9876% 1.018%
Forward/Future 70.56766
– Linear Approximation
E(St) = E(St)/St – 1  rinr – rusd
 Currency Forwards
• You entered into this forward contract to buy
USD 1 million by paying Rs 70.00 million in 6-
profit month time. Your pay-offs looks as below:
Unhedged

Rs 69/USD Rs 72/USD Forward

0
Rs 70/USD

▪ Such contracts help you to fix the

future Dollar costs of buying Pound
loss
 Range Forward
• Structured to reduce upfront premium (simultaneously a long and short)
• Provides protection against upside, with limiting downside (less attractive floor
than forward)

profit 70

69.0 72
ST

loss
• Strategy within the budget rate, and the same time taking advantage of the
favourable rate environment
• Combinations provide the net costs closer to zero
 Cross Currency Forwards
– Enables hedging against a currency other than INR and
currency of invoicing
– Speculating against the third currency
– When you import in £, ideally you could buy £/INR forward
– But you buy £/$ forward, and then buy USD/ INR spot
– What are you speculating?

Buy £-USD forward

Buy £-INR forward

Buy USD/ INR spot

Forward Cancellation
 Rs 91/ £1
Forwards Cancellation

Bank

£1 = $1.30 Rs 70 = $1
Profit of Rs 7 per £1

Rs 91/ £1
£1 = $1.30 Rs 70 = $1

Rs 98/ £1
Company
£1 = $1.40
Rs 70 = $1
Thank You