Course: Treasury Management (Module III: Derivatives) NIBM, Pune

Module III: Derivatives

Chapter 4: Over-the-counter Forex Derivatives in India -

Product Structures, Pricing and Applications for Trading and Hedging
Dr. Tasneem Chherawala

Objectives

Structure
1. Introduction
1.1. FX forwards
1.1.1. Trading positions and Payoffs in FX Forwards
1.1.2. Applications of FX Forwards / Outrights
1.1.3. Computing the FX Forward / Outright Rates
1.1.4. Marking-to-Market FX Forwards / Outrights
1.2. FX swaps
1.2.1. Applications of FX Swaps
1.2.2. Distinction between FX outrights and FX swaps
1.2.3. Trading in FX swaps
1.3. Cross Currency interest rate swaps
1.3.1. Customization of CCS
1.3.2. Applications and benefits
1.3.3. Pricing and Valuation of the CCS
1.4. OTC currency options
1.4.1. Garman Kohlhagen Model for Pricing Currency Options

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1. Introduction

In India, Banks and financial institutions (Authorised Dealers) are permitted to structure
over-the-counter (OTC) forex derivatives for their clients who may require these products
to hedge the exchange rate risks in their foreign currency transactions. OTC forex derivatives
are also quoted and traded in the inter-bank market.

This chapter will discuss the structure, pricing and applications of the following OTC forex
derivative products:

 FX Forwards
 FX Swaps
 Currency Interest Rate Swaps
 FX Options

Illustrations will be provided primarily from the Indian markets.

1.1 FX Forwards

A FX forward contract is a bilateral (OTC) agreement between two counterparties, to

exchange a pre-specified amount of one currency for another currency, at a pre-specified
Forward Exchange Rate at a pre-determined date in the future. In the inter-bank trading
parlance, FX Forwards are also known as FX Outrights.

Value date

The contractual terms which specify the FX forward contract are

• Deal date (date of origination of the contract)

• Currency Pair (Base and Variable currency)
• Notional Amount in one currency (usually the base currency)
• Forward exchange rate (delivery price for base currency in terms of the variable
currency)
• Counterparty 1: Base Currency Buyer
• Counterparty 2: Base Currency Seller
• Value date (date on which contract expires)
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• Settlement date (date on which the currencies are actually exchanged)

• Settlement type: Physical (involving actual delivery of both currencies) or Cash (net
settlement in any one currency)
• Locations for payment and delivery
FX forwards help investors manage the risk inherent in currency markets by predetermining
the rate and date on which they will purchase or sell a given amount of foreign exchange.
Using FX forwards, one can:
· Protect costs on products and services purchased abroad
· Protect profit margins on products and services sold abroad
· Lock-in exchange rates as much as a year in advance

1.1.1 Trading positions and Payoffs in FX Forwards

Depending on the need for the hedge or the view about the exchange rate, a long (buy) or
short (sell) position in the FX forward contract can be taken. By market convention, the buy
/ sell in an FX Forward corresponds to the base currency. For example, the buyer of USD in
a USDINR forward contract has a long position in the USDINR forward contract whereas the
seller of USD in the USDINR forward contract has a short position in the contract.
Long positions in FX forwards / outrights give rise to gains if the underlying exchange
rate increases relative to the Forward rate in the contract and give rise to losses if the
exchange rate falls relative to the Forward rate in the contract. Short positions in FX
forwards / outrights give rise to gains (losses) if the underlying exchange rate falls (rises).

1.1.2 Applications of FX Forwards / Outrights

1. Hedging of Exchange Rate Risk: any entity which has an exposure to a foreign
currency can use FX forward contracts to hedge that risk. Thus, an Indian company
which has a long position in a foreign currency (for example, foreign currency
receivables due to exports, or an investment in foreign currency denominated assets)
faces the risk of the rupee appreciating against that currency. Selling the foreign
currency forward in the appropriate FX forward contract can efficiently hedge the
exchange rate risk of the company. Similarly, an Indian company which has a short
position in a foreign currency (for example, FX payables due to imports or a foreign
currency denominated liability) faces the risk of the rupee depreciating against that
currency, and can buy an FX forward to hedge the risk.

• Hedging Foreign Currency Transaction Risk using FX forward. Consider an Indian

Exporter who sells goods in Europe and will receive Euro denominated payments in
3 months. If EURINR exchange rate falls (rupee appreciates against the Euro), the
rupee denominated revenues of the exports will fall, all else being equal. Thus, the

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firm’s profits will fall. In order to hedge the risk of a rupee appreciation, the firm can
enter into a short position in an FX forward contract that allows it sell the specified
Euro amount at the end of 3 months at a forward EURINR exchange rate lock-in today.

Hedged Item Hedging Instrument

Exporter to Eurozone will receive EUR 1 mio in
3 months
Underlying: Long position in EUR 1 mio
Spot rate EUR/INR: 75.4, Exporter believes
EURINR will fall within next 3 months
(EUR/INR ↓)
Exporter sells EUR 1 mio forward at forward
EUR/INR rate of 78. 5
Hedge: Short position in EUR/INR forward
If EUR/INR is unfavourable in 3 months (i.e., <
78.5), Exporter still receives Rs. 78.5 per Euro,
that is Rs. 78.5 mio

• Unhedged Company Effect of Hedging

• If at the end of 3 months, spot rate Hedged Company has already sold EUR forward
EUR/INR is 75.00… Hedged Company will receive:
– Unhedged Company will 78.5 x 1,000,000 = Rs.
receive: 78,500,000
– 75.00 x 1,000,000 = Money Saved by to Hedging: 78,500,000 –
– Rs. 75,000,000 75,000,000 = Rs 3,500,000

2. Trading based on views on Exchange Rates: Rs Fx3,500,000

outrights can be traded much in the
same way as currency futures in order to make speculative gains based on views
about the exchange rate movements. For example, a trader who expects USDINR to
increase (decrease) in the future would buy (sell) a USDINR FX outright.

1.1.3 Computing the FX Forward / Outright Rates

The general formula for the calculation of the FX forward rate / FX outright rate is given as

 D
1   iv  
F S 
B
 D
1   ib  
 B
F = Forward FX Rate for a particular currency pair, for a particular tenor, expressed as
amount of Variable Currency (v) in terms of Base Currency (b). For example, in a 3-month
forward rate for USDINR, INR is the Variable Currency and USD is the Base Currency.
S = Spot Exchange Rate of the particular currency pair
D = number of days in the forward contract
B = number of days in the year

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The choice of D and B depends on the day count basis associated with the respective
currencies.
ib = interest rate p.a., base currency
iv = interest rate p.a., variable currency
For example, if we want to determine a 3-month USDINR forward rate (F), we need the
following information:
• Spot USDINR = 64.2000
• Rupee Interest Rate (% per annum, discrete) = 6%
• Dollar Interest Rate (% per annum, discrete) = 2%

 3
1   6%  
F  64.20  
12 
 64.8388
 3
1   2%  
 12 

We can see from the above formula that the FX forward rates are influenced by both the spot
exchange rate and the interest rates in the two currencies. If the forward rate is lower than
the spot rate, the base currency is at a discount and if the forward rate is higher than the spot
rate, the base currency is at a premium. Whether a base currency is quoting in the Forward
Market at a premium or discount depends on the interest rate differential in the two
currencies.
 interest rate base currency < interest rate variable currency  forward
premium
 interest rate base currency > interest rate variable currency  forward
discount

In the above example, the difference between the 3-month USDINR forward Rate and the
USDINR spot rate is given by
F – S = 64.20- 64.8388 = 0.6388
 Thus, the 3 month forward premium on USDINR is 63.88 paise or 6388 points

The regular tenors for FX outrights are the straight months (resp. weeks) up to 1 year e.g.:
1w, 2w, 3w, 1m, 2m, 3m, 4m…12m. For the major currencies terms of up to 5 years are
possible. The term of an outright deal is measured starting with the spot value date. For the
end / end deals (outrights with spot value dates on the last working day of a month), the
value date of the outright is the last working day. Market quotes are available for the regular
tenors in the form of bid and ask forward points / paise as per market convention, as shown
in the table below.
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U.S. Dollar/Indian Rupee (USDINR) Spot 63.9890

Spot Bid 63.9900
Spot Ask 64.003
USDINR Forward Rates for Wed, Sep 13rd, 2017
Name Bid Ask Mid Price
1-Month Forward 18.8 20.2 19.5
2-Month Forward 46.1 48.1 47.1
3-Month Forward 53.8 56.2 55
4-Month Forward 93 95 94
5-Month Forward 115.8 117.8 116.8
6-Month Forward 137.4 139.4 138.4
7-Month Forward 162.5 164.5 163.5
8-Month Forward 186.2 188.2 187.2
9-Month Forward 213.1 215.1 214.1
10-Month Forward 233.6 235.6 234.6
11-Month Forward 255.9 257.9 256.9
1-Year Forward 278.3 280.3 279.3

Using the Spot exchange rates (bid and ask) and the forward paise (bid and ask), traders can
determine the quoted forward rate for any tenor. So from the above table, if we wish
compute the 1 month USDINR forward bid rate
Fbid = Spotbid + 1-M Forwardbid/100 = 63.99 +18.8/100 = 64.178

If we wish to compute the 3 month USDINR forward ask rate:

Fask = Spotask + 1-M Forwardask/100 = 64.003 +139.4/100 = 65.387

When banks and authorized dealers structure FX forward deals to hedge the foreign
currency exposures of their clients, the forward contracts are customized to meet the specific
hedging needs of the underlying exposures, in terms of the currency pair, the notional
amount, the tenor of the contract and the type of settlement required. The FX forward rates
may therefore be calculated for broken periods (which are not multiples of months)
depending on the future date on which the client may need to pay or receive the foreign
currency. The broken period FX forward quotes are calculated by method of interpolation as
shown in the example below.

Say on 13th of September, a bank has quoted the USDINR spot and forward rates as given in
the table above. However a corporate customer wants to buy 100,000 USD on 21st October
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(1 month and 8 days forward) to hedge the exchange rate risk of dollar payables on an import
contract. The bank has to quote a USDINR forward ask rate for this date.

ForwardAsk for 13th October = 20.2

ForwardAsk for 13th November = 48.1
One-Month (31 day) difference = 27.9
8 day difference = 27.9 *(8/31) = 7.2
ForwardAsk for 21st October = ForwardAsk for 13th October + 7.2 = 27.4
Thus Forward Rate at which Bank will sell USD to the customer on 21st October is = SpotAsk
+ ForwardAsk for 21st Oct/100 = 64.277.
Similar interpolation calculations are done to estimate the Forward rate bid rate for a broken
period using the spot bid and the interpolated forward bid quotes.
Marking-to-Market FX Forwards / Outrights

If FX outright positions of a bank are held in the trading book, these positions have to be
marked-to-market at periodic intervals and the resultant gain / loss has to be carried into
the P&L account. Also, if a bank has entered into an FX forward deal with a client, and the
client wishes to cancel the deal, prior to its maturity date, a mark-to-market settlement has
to be effected between the bank and the client. For both these reasons, determination of the
mark-to-market value of the FX outright / FX forward becomes important.
The mark-to-market value of a long position in an FX forward contract at the valuation date
t, is given by:

( Ft ,T  F0,T )  NotionalAmount
Vt 
1  it ,T  D / B

The mark-to-market value of a short position in an FX forward contract at valuation date t,

is given by:

( F0,T  Ft ,T )  NotionalAmount
Vt 
1  it ,T  ( D / B)

Where, Vt represents the mark-to-market value, F0,T represents the Forward Rate agreed at
origination (time 0) of the contract, maturing at time T, Ft,T represents the forward rate
applicable for the remaining time to maturity (T-t) of the forward contract from the date of
valuation and itT represents the variable currency interest rate used for discounting the
future cashflows.

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Example: On 1st June, a bank agreed to buy USD100,000, 6 months forward (value date 1st of
December), against INR, at a contractual USDINR forward rate of F0,T = 65.951. The bank thus
has a long position in the 6-month USDINR forward contract. On 30 th September 2017, the
bank wishes to determine the mark-to-market value of this deal. On this date, there are 62
days (approximately 2 months) left to maturity of the original contract. The INR 2-month
Mibor rate is 6.75% and the 2-month USDINR forward rate is Ft,T =65.8244. The cash
gain/loss that will apply to the bank is given by:

(Ft,T – F0,T)x Notional Amount = (65.8244-65.951)x100,000 = - INR 12,661 (cash loss)

The above cash loss would accrue to the bank on the maturity date of the contract. Thus, the
present value of this future cash loss on the valuation date is obtained by discounting the
loss at the INR interest rate. The discounted value of this cash loss, discounted at Mibor
6.75% for 2 months is given by

Vt 
( Ft ,T  F0,T )  NotionalAmount

65.8244  65.951  100,000  12,518INR
1  it ,T  ( D / B) 1  6.75%  (2 / 12)

Thus, the bank makes a mark-to-market loss of the FX forward deal of Rs. 12,518. This loss
has arisen because the bank has a long position in the FX forward contract and the market
forward rate for the remaining maturity has fallen below the contractual forward rate. If this
long position in the FX forward was held by the bank in its trading book, the P&L account
would be debited by INR 12,518. If this long position in the FX forward contract was
structured by the bank with a client, and the client came to the bank to cancel the forward
contract on 30th September, then the bank would have to pay INR 12,518 to the client to
settle the deal and cancel the contract.

1.2 FX Swaps
Definition: An FX swap is a contract to buy (sell) a specified amount of one currency at an
agreed exchange rate at an early value date (near leg settlement) and in the same deal, to sell
(buy) the same amount of currency for a later value date (far leg settlement) to the same
counterparty, also at an agreed exchange rate.
A regular FX swap a combination of a spot deal (near leg is settled on the spot date) and a
reverse outright deal (far leg is settled at an agreed forward date). However, FX swaps can
be customized to have both the near and far leg settlements at two different forward dates.
These are known as forward-forward FX swaps.
In a regular FX swap the base currencies amount both for the near and far leg settlements is
the same. However FX swaps can be structured with uneven amounts as well.
Thus, in general, FX Swaps are a pair of offsetting FX transactions for different value dates,
concluded at the same time and on the same deal ticket with the same counterparty.
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Positions in FX Swaps are described either as

• buy-and-sell / sell-and-buy; or

• Sell / Buy, where the “sell/buy” term refers to the forward leg.

So for example, if a dealer buys (sell-and-buy) a regular USDINR FX Swap, he sells USD spot
against INR and buys USD forward against INR and if the dealer sells (buy-and-sell) a USDINR
FX Swap, he buys USD spot against INR and sells USD forward against INR.

If a dealer buys a 1 month EURUSD FX Swap for EUR 10million, he will effectively sell EUR
(and receive USD) at the spot EURUSD rate, settled on the spot date and simultaneously buy
EUR (and pay USD) at the 1-month forward EURUSD rate, settled at the end of 1 month. The
dealer is actually lending EUR for 1-month time and simultaneously, borrowing USD over the
same period without FX risk.

1.2.1. Applications of FX Swaps

i. FX swaps are often employed if an existing asset (liability) in one currency needs to
be transformed into an asset (liability) in another currency for a specified period.
a. For example, an Indian firm currently has INR 6,00,000 liquid cash available.
It also needs USD 10,000 for a limited period of three months. One option to
the company is to buy USD 10,000 in the spot market using its INR liquid funds.
However, at the end of three months, the company will be exposed to USDINR
exchange rate risk when it goes to the market to convert the dollars back to
rupees. Alternately, the company can sell a 3-month USDINR Fx Swap, in which
it buys USD spot against INR (by utilizing the INR liquid cash) and
simultaneously sells USD 3-months forward against INR, at an agreed 3-month
USDINR forward rate. In the FX swap, since the forward USDINR rate is fixed,
the company does not incur and FX risk.
ii. FX swaps are also used to efficiently roll over existing FX hedging contracts to later
maturities. Say a company has used an FX forward contract to hedge an expected
currency payment or receipt on a particular future date. But the payment / receipt
has been subsequently postponed, requiring that the maturity of the FX forward also
needs to be extended. The FX swap is an efficient derivative to allow the company to
simultaneously cancel the original forward contract and instate a new forward hedge
for the postponed currency cash flow.
a. Example: An Indian company purchased some machinery priced in USD in the
month of April. It expected to make a payment of USD 5 million to the supplier
when the goods are delivered in 3 months at the end of July. It enters into a 3-
month forward contract to buy USD against INR for value 31 July at a forward
rate of USDINR = 60.08. In late June, the supplier advises the company that
delivery of the machinery will be delayed by 2 months to the end of September.
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As a result, the company does not need the original forward contract (where
dollars will be delivered on 31st of July), which needs to be cancelled.
Furthermore, the company needs to enter into a new USDINR forward
contract to hedge the dollar payables arising on the extended date at end of
September. In June, the company can enter into a sell-and-buy forward-
forward USDINR FX Swap, with the near leg settlement involving selling 5
million USD at end July (to offset the dollar receivables from the original
forward contract) and the far leg settlement involving buying 5 million USD at
end September (to offset the import payables on the extended date). The FX
swap has effectively rolled over the original hedge contract end-September.
This application of the FX swap is also known as “Comp and Extend: An FX
swap deal to compensate and extend.
iii. The Pricing Advantage of FX Swaps: in the FX Swap, both spot and forward
transaction are agreed on the same spot basis, which is usually the current mid-rate
(mid-point of the spot bid and spot ask exchange rate). For example, if the spot
USDINR bid-ask quote is 63.99-64.003, and the 3 month forward USDINR bid-ask
quote (in paise) is 53.8-56.2, then the spot basis is 63.9965 (=(63.99+64.003)/2) and
the forward leg quotes of the FX Swap are 64.5345 – 64.4485 (Spot mid-rate +
forward bid / ask).

1.2.2. Distinction between FX outrights and FX swaps

 An FX outright contract is exposed to exchange rate risk for the full nominal amount.
 In an FX swap contract the FX risk of the spot transaction is offset by the forward
transaction (except a small residual risk). Thus FX swaps are exposed to an interest
rate risk rather to exchange rate risk.

1.2.3. Trading in FX Swaps

Traders use FX Swaps to make speculative gains based on their views about the changes to
interest rate differentials of two currencies. A buy-and-sell FX swap gains value when the
interest rate differential between the variable and base currency narrows. A sell-and-buy FX
swap gains when the interest rate differential between the variable and base currency
broadens. Thus, for example, if a trader’s view is that the interest rate differential between
INR and USD is going to narrow (either because INR interest rates will fall or USD interest
rates will rise or both), the trader will enter into a buy-and-sell USDINR FX Swap. If his view
materializes, the forward premium will fall and the trader will gain due to the increase in the
value of the sell position in the far leg of the FX swap.

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1.3 Cross Currency Interest Rate Swaps

A Cross Currency Interest Rate swap (CCS) is a bilateral derivative contract by which two
counterparties exchange, over an agreed period, two streams of interest payments in
different currencies and, at the end of the period, the corresponding principal amounts at an
exchange rate agreed at the start of the contract.

The CCS involves multiple exchanges of interest amounts in two different currencies. This
principal amount may be exchanged at the start of the swap and at the end as well or it may
be exchanged only at the end of the swap period. Cash flows are not netted and are made in
different currencies.

The diagram below describes a CCS where a company X initially pays USD 13 million and
receives EUR 10 million in the swap contract based on the spot EURUSD exchange rate
(=1.3). For company X, this exchange is like investing in a USD denominated bond (USD asset)
and issuing a EUR denominated bond (EUR liability). In subsequent four years, company X
receives USD interest (on the USD investment) and pays EUR interest (on the EUR bond). At
the end of the period (swap termination/maturity date), the company receives USD 13
million and pays EUR 10 million based again on the single EUR/USD exchange rate
determined upfront (=1.3).

The grey Euro cash flows are economically equivalent to issuing a Euro bond; the USD cash
flows are equivalent to investing in a USD bond. A cross currency swap can thus be described
as a combination of a long position in a bond in one currency and a simultaneous short
position in a bond in another currency.

If the company has an existing USD borrowing against which CCS is paired, then effectively,
the CCS has converted the USD borrowing into a synthetic EUR borrowing. If the CCS is paired
with an existing EUR investment, then the CCS converts the EUR asset into a synthetic USD
one.

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1.3.1 Customization of CCS

Being OTC contracts, Cross currency swaps can be customized in terms of

 Swap size (amounts involved)
 The exchange of principal amounts involved, that is whether the principal amounts will
be exchanged at the beginning and / or at the end of the swap deal.
 The frequency of interest exchanges
 The reference interest rates of the two currencies used to determine the interest
payments
 The fixed / floating reference rates in line with the currencies involved
o Fixed versus Fixed
o Fixed versus Floating
o Floating versus Fixed
o Floating versus Floating – Basis Swaps
 Amortization of Principal
 Coupon Only
1.3.2 Applications and Benefits

 Cross-currency swaps can be used to transform the currency denomination of assets and
liabilities. Firms often raise capital in currencies in which they do not possess significant
revenues or other natural cash flows (a significant reason for this being cost). Similarly,
firms also make investments in foreign currency denominated securities but incur costs
in domestic currency. The usual motivation for a CCS is to eliminate exchange rate risk of
the foreign currency asset / liability and replace cash flows scheduled in an “undesired”
currency with flows in a “desired” currency. The desired currency is very often the home
currency of the firm, in which the firm’s future operating revenues (inflows) will be
generated or operating costs will be incurred.
 CCS provide effective hedges for exchange rate and interest rate risk of long dated foreign
currency debt or foreign currency investments, which involve multiple future cash flows.
 By giving firms the flexibility to fund themselves in a currency different from their
currency of need (and/or to invest in assets denominated in a different currency), cross-
currency swaps also enable firms to alter expected funding costs (and/or investment
returns).

Hedging Application of CCS

Consider a Company which needs to raise INR 64 million debt funds for 4 years. As per the
table below, the Company faces a lower interest cost of borrowing in USD as compared to
borrowing in INR.

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Rs. Borrowing
Company $. Borrowing Cost Preference
Cost

Indian Corporate 7% (Libor + 3.00%) 12% Rupee Loan

So the Company raises USD denominated debt funds (=$ 1 million = Rs. 64 million as per the
spot USDINR exchange rate of 64.00) at Libor + 3% to be repaid as per the structure below:

Period Underlying USD Liability

0 +1000,000

1 -(Libor + 3%)* 1000,000

2 -(Libor + 3%)* 1000,000

3 -(Libor + 3%)* 1000,000

- (1+ Libor + 3%)*

4 1000,000

If the Company generates revenues primarily in INR, it faces the risk of USDINR exchange
rate rising over the life of the loan. The Company also faces the risk of increase in Libor,
which will make the interest cost of the dollar debt higher. To hedge these two risks
simultaneously, the Company can enter into a CCS with a counterparty Bank to achieve its
preferred currency of funding (that is, rupee funding, by eliminating exchange rate risk) with
a lower cost.

The structure of the CCS is as follows:

• The spot USDINR exchange rate at the time of entering into the swap is 64 Rs./ $
• At the time of entering into the CCS, the Company pays $ I million (and receives Rs. 64
million (based on spot USDINR).
• The Company receives USD Libor + 3.00% on $1 million from Bank for four years and
simultaneously pays fixed INR interest rate (11.00% say) on Rs. 64 million to Bank for
four years.
• At the end of the swap maturity, Corporate receives $ 1 million and pays Rs. 64 million to
Bank.
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The cashflows to Corporate under the CCS would look like the following:

Period USD Cash Flows in the CCS INR Cash Flows in the CCS

0 -1000,000 +64,000,000

1 + (Libor + 3%)* 1000,000 -7,040,000

2 + (Libor + 3%)* 1000,000 -7,040,000

3 + (Libor + 3%)* 1000,000 -7,040,000

4 + (1+ Libor + 3%)* 1000,000 -71,040,000

As can be seen from the above table, the USD cash flows in the CCS completely cancel out the
USD cashflows of the underlying dollar denominated loan of the company. The company is
thus left with the INR cash flows of the CCS, which resemble a rupee loan of INR 64.00 million,
to be serviced at 11% fixed interest rate over 4 years.

The Company has thus achieved funding in its preferred currency (INR), without taking
exchange rate risk (as hedged by the CCS) and at a lower cost of 11% as compared to 12% if
the Company had directly borrowed in Rupees.

The impact on the Company’s balance sheet after entering into the CCS deal will look as
follows:

Currency Assets Income Liabilities Cost

INR 64 million (CCS) 11.00%

USD 1 million (CCS) Libor + 3% 1 million (direct Libor + 3%

loan)

Net Cost of Rupee Liabilities 11.00%

1.3.3 Pricing and Valuation of the CCS

The following table provides an example of how CCS are quoted by market-making
authorized dealers.

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Thus, if a Company wishes to enter into a CCS where it receives 6m US Libor for 3 years
(semi-annually) and pay fixed INR interest, the INR interest cost will be the 3years Offer rate
of 6.55%. Similarly, if a Company wishes to enter into a CCS where it pays 6m US Libor for 5
years (semi-annually) and receive INR interest, the INR interest rate as per the quotes above
will be the 5 years Bid rate of 6.25%.

Like single-currency Interest Rate Swaps, CCS can be valued as the difference between the
prevent values of two bonds denominated in different currencies, but measured in a common
currency using the spot exchange rate St, as shown in the formula below

𝑉𝑡 = 𝑃𝑉𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦1 − 𝑆𝑡 × 𝑃𝑉𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦 2

CCS are structured to have zero value at origination, that is V0 = 0, in the above equation. This
implies that the interest rates for the pay and receive legs are set such that the value of
currency swap to both the parties at initiation is zero. This means that it costs nothing to
either party initially to enter into a swap if the swap rates are fair.
Subsequently, the value of the CCS at a future date depends on the interest rates in the two
currencies and the foreign exchange rate. Since the exchange rate is more variable than the
underlying interest rates, much of a swap's risk comes from exchange rate changes.

1.4 OTC Currency Options

In India, customized OTC currency options can be traded in the inter-bank market and
offered to clients to hedge their exchange rate risks by Authorized Dealers. Both Call Options
and Put Options on currency pairs (cross currency and INR-Foreign Currency) are available
in the OTC markets. Currency Call and Put options in the OTC markets (as defined in Chapter
3) have the additional advantage that they can be customized in terms of the notional
amounts, strike exchange rates and the tenors as per the requirements of the dealers /
clients.

The hedging and trading applications of OTC Currency options are also similar to the
exchange traded options (as explained in Chapter 3).
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Garman Kohlhagen Model for Pricing Currency Options

The premiums on Currency Call and Put Options can be determined by the Garman
Kohlhagen Model as given below:

Premium for Call Option : C  Se  rbT N (d1 )  Ke  rvT N (d 2 )

Premium for Put Option : P  Ke  rvT 1  N (d 2 )  Se  rbT 1  N (d1 )
where
ln( S / K )  (rv  rb   2 / 2)T
d1 
 T
d 2  d1   T

In the above expressions, S represents the spot exchange rate, K is the strike exchange rate
in the option contract, rb and rv are the base currency and variable currency risk-free interest
rates respectively, σ represents the annualized standard deviation of the returns on the
currency pair and T represents the tenor of the options contract measured in years. N(.)
measures the cumulative probability under the standard normal distribution.

Example 1 Pricing of Call Options: Suppose a Bank has sold a 3 month USDINR Call Option
(right to buy USD against INR) to a Client with a notional amount of USD 200,000 and a strike
exchange rate of 64.00 USDINR. We can use the Garman Kohlhagen formula to determine the
per dollar premium that the Bank will charge to the client as given below:

Option Notations Call Option

Notional Amount (USD) N 200,000.00
Spot Exchange Rate (USDINR) SUSDINR 64.0000
Strike Exchange Rate (USDINR) KUSDINR 64.0000
INR Risk Free Rate (Continuously compounded, p.a.) rINR 6.50%
Tenor of the Option 3 months
Tenor of the Option (Fraction of Year) T 0.250
Standard Deviation of Returns on USDINR σ 20%
USD Risk Free Rate (Continuously compounded, p.a.) rUSD 3.00%
d1 0.14
d2 0.04
N(d1) 0.55
N(d2) 0.51

Premium Per Dollar (in Rs.) C 2.81

Total Premium (in Rs.) V 561,679.92

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Course: Treasury Management (Module III: Derivatives) NIBM, Pune

Thus, we see that the Bank would charge a premium of Rs. 2.81 per dollar, that is a total
premium of Rs. 561,679.92 to the client.

Example 2 Pricing of Put Options: Suppose a Bank has sold a 6 month USDINR Put Option
(right to sell USD against INR) to an Exporter with a notional amount of USD 100,000 and a
strike exchange rate of 64.00 USDINR.

Option Put
Notations Option
Notional Amount (USD) N 100,000.00
Spot Exchange Rate (USDINR) SUSDINR 64.0000
Strike Exchange Rate (USDINR) KUSDINR 64.0000
INR Risk Free Rate (Continuously compounded, p.a.) rINR 6.50%
Tenor of the Option 6 month
Tenor of the Option (Fraction of Year) T 0.500
Standard Deviation of Returns on USDINR σ 20%
USD Risk Free Rate (Continuously compounded,
p.a.) rUSD 3.00%

d1 0.19
d2 0.05

N(d1) 0.58
N(d2) 0.52

Premium Per Dollar (in Rs.) P 3.00

Total Premium (in Rs.) V 300,329.68

Thus, we see that the Bank would charge a premium of Rs. 3.00 per dollar that is a total
premium of Rs. 300,329.68 for the notional amount of USD 100,000 to the client.

From the Garman Kohlhagen Currency option pricing model, we can see that Premiums on
Call and Put options depend on a large number of factors. The table below summarises the
impact on Call and Put option premiums due to changes in any of these factors.

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Course: Treasury Management (Module III: Derivatives) NIBM, Pune

Call Put
Factor Premium Premium
Increase in the Spot Exchange Rate Increases Decreases
Increase in the Strike Exchange Rate Decreases Increases
Increase in the Volatility of the Exchange
Rate Increases Increases
Increase in the Option Tenor Increases Increases
Increase in the Variable Currency
Interest Rates Increases Decreases
Increase in the Base Currency Interest
Rates Decreases Increases

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