43 Forex Hedging

Forex hedging vehicles
INTRODUCTION
As the requirements of the foreign exchange market grew manifold, so did the
complexity of its operation. This triggered of a simultaneous evolution of various
financial instruments. One of the most significant developments in the foreign exchange
market, occurred in Chicago on May !, "#$ when the %nternational Monetary Market
&%MM', a division of the Chicago Mercantile (xchange &CM(', introduced the world)s
first futures contract in foreign currencies. The %MM was therefore the first exclusive
currency futures exchange. *ate on, %nterest rate futures were introduced in "#+ at the
Chicago ,oard of Trade &C,OT' with -overnment .ational Mortgage Association
certificate &-.MAs' and Treasury ,ills.
Owing in to the esta/lishment of two main commodity exchanges in Chicago, vi0,
the Chicago ,oard of Trade &C,OT' in 121 and Chicago Mercantile (xchange &CM('
in 1"1, large scale trading in commodity futures commenced much /efore the start of
trading in financial futures. 3owever, with the introduction of currency futures at the
%MM, for the first time money was formally regarded as commodity in "#$. The
phenomenon growth of deals in financial futures have already made them a vital and
integral part of the world)s financial markets.

The man generally regarded as the father of currency futures contract is *eo
Melamed, who in "!", as a Chairperson of CM( realised the need to diversity Chicago
exchanges out of agricultural commodities. %t look, however, some time for the financial
world outside America to realise the potential of futures market as tool to cover adverse
interest rate and exchange rate movements. The first ma4or non567 financial future
marker place was therefore esta/lished in "1$ in the 68. %t is known as *ondon
%nternational 9inancial 9utures (xchange &*%99('. *ater on several other countries, such
as, Canada, 3ong 8ong, :apan and the financial super market of 9ar (ast, 7ingapore, also
started financial futures exchanges. 9or many /ankers, hedgers, traders and speculators,
financial futures are now more cost effective in covering interest rate and exchange
exposure than cash market alternatives such as forward contract, etc.
Short Hedge and Long H edge:
The terms short term hedge and long hedge distinguish hedges that involves short
and long positions in the futures contract, respectively. A hedger who holds the
commodity and is concerned a/out a decrease in its price might consider hedging it with
a short position in futures. %f the spot price and futures price move together, the hedge
will reduce some of the risk. 9or example, if the spot price decreases, the futures prices
also will decrease. 7ince the hedge is short the futures contract;the futures transaction
produces a profit that at least partially offsets the loss on the spot position. This is called a
short hedge /ecause the hedger is short futures.
Another type of short hedge can /e used in anticipation of the future sale of an
asset. An example of this occurs when a firm decides that it will need to /orrow money at
a later date. ,orrowing money is equivalent to issuing or selling a /ond or promissory
note. %f interest rates increase /efore the money is /orrowed , the loan will /e more
expensive. A similar risk exists risk exists if a firm has issued a floating rate lia/ility.
7ince the rate is periodically reset, the firm has contracted for a series of future loans at
unknown rates. To hedge this risk, the firm might short an interest rate future contract. %f
rates increase, the futures transaction will generate a profit that will at last partially offset
$
the higher interest rate on the loan. ,ecause it is taken out in anticipation of a future
transaction in the spot market, this type of hedge is known as an anticipatory hedge.
Another type of anticipatory hedge involves an individual who plans to purchase a
commodity at a later date. 9earing an increases in the commodity)s price, the investor
might /uy a futures contract. Then, if the price of the commodity increases, the futures
price also will increases and produce a profit on the futures position. That profit also will
at least partially offset the higher cost of purchasing the commodity. This is long hedge,
/ecause the hedger is long in the future market.
%n each of these cases, the hedger held a position in the spot market that was
su/4ect to risk. The futures transaction served as a temporary su/stitute for a spot
transaction. Thus, when one holds the spot commodity and is concerned a/out a price
decrease /ut does not want to sell it, one can execute a short futures trade. 7elling the
futures contract would su/stitute for selling the commodity.
<
FORWARD OO!IN" CONTRACT
The choice of futures contract actually consists of three decision=5
>hich futures commodity
>hich expiration month
>hether to /e long or short
Which #$t$res co%%odit&
%t is important to select a future contract on a commodity that is highly correlated
with the underlying commodity /eing hedged. %n many cases the choice is o/vious, /ut in
some it is not. 9or example, suppose one wishes to hedge the rate on /ank C?s, which
are short term money market instrument issued /y commercial /anks. There is no /ank
C?s future contract so the hedger must choose from among some other similar contracts.
*iquidity is important, /ecause the hedger must /e a/le to close the contract easily. %f the
future contract lacks the necessary liquidity, the hedger should select a contract that has
sufficient liquidity and is highly correlated with the spot commodity /eing hedged. 7ince
/oth treasury /ills and (urodollars are short5term money market instruments, their futures
contracts, which are quite liquid, would seem appropriate for hedging /ank C?s rates. Of
course, if the hedger wanted the hedging instruments to /e identical to the underlying
3edging Technology
9orward ,ooking
Contract
Currency 9uture Currency Option Currency 7wap
2
spot asset, he or she could go to the over5counter5market and request a forward contract,
/ut that would entail some other considerations.
Another factor one should consider is whether the contract is correctly priced. A
short hedger will /e selling futures contracts and therefore should look for contracts that
are overpriced or, in the worst case, correctly priced. A long hedger should hedge /y
/uying under priced contracts or, in the worst case correctly priced contracts. 7ometimes
the /est hedge can /e o/tained /y using more than one futures commodity.
Which 'x(iration %onth
Once one has selected the future commodity, one must decide on the expiration
month. As we know, only certain expiration month trade at a given time. %f the Treasury
/ond future contracts is the appropriate hedging vehicle, the contract used must come
from this group of expirations.
%n the most cases there will /e a time hori0on over which the hedge remains in effect.
To o/tain the maximum reduction in /asis risk, a hedger should hold the future position
until as close as possi/le to expiration. Thus an appropriate contract expiration would /e
one that corresponded as closely as possi/le to the expiration date. 3owever, the general
rule of thum/ is to avoid holding a futures position in the expiration month. This is
/ecause unusual price movements sometimes are o/served in the expiration month and
this would pose an additional risk hedgers. Thus, the hedger should choose an expiration
month that is as close as possi/le to /ut after the month in which the hedge is terminated.
3owever, this rule used not always /e strictly followed since all contract don)t exhi/it
unusual price /ehaviour in the expiration month .%nfect, the longer time expiration, the
less liquid is the contract. Therefore, the selection of a contract according to this criterion
may need to /e overruled /y the necessity of using a liquid contract. %f this happens, one
should use a contract with shorter expiration. >hen the contract moves into its expiration
month, the future position is closed out and a new position is opened in the next
expiration month.
+
Long or Short
After selecting the future commodity and expiration month, the hedger must
decide whether to /e long or short. This decision is critical and there is a/solutely no
room for a mistake here. %f a hedger goes long &or short' when he should have /een short
&or long' he has dou/le the risk. The end result will /e a gain or twice the amount of the
gain or loss of the un hedged position.
The decision of whether to go long or short requires a determination of which
type of market move will result in a loss in the spot market. %t then requires esta/lishing a
future position that will /e profita/le while the spot position is losing. The first method
requires that the hedger identify the worst case scenario and then esta/lish future position
that will profit if the worst case does occur. The second method requires taking a future
position that is opposite to the current spot position. This is a simple method, /ut in some
cases it is difficult to identify the current spot position. The third method identifies the
spot transaction that will /e conducted when the hedge is terminated.
!
FORWARD RAT' A"R'')'NT *FRA+
9@A is an off5/alance sheet contract /etween two counterparties to pay &5' or receive &A'
the difference &called settlement amount' /etween=
An agreed fixed rate &the 9@A rate'
The interest rate prevailing on a stipulated future date &the 9ixing date'
,ased on a notional amount for an agreed period &the contract period'
%n short, in an 9@A interest rate is fixed now for a future period. The special feature
of 9@A is that the interest payment are calculated on the notional principal and the only
payment is the difference /etween the 9@A rate and @eference @ate and hence are single
#
settlement contracts. ,y entering into an 9@A one can swap from floating rates to fixed
rates or vice versa for the term of the 9@A. They can /e used to hedge /orrowing costs of
investment returns in foreign currencies and can /e tailored to suit exact requirements of
its users. As mentioned earlier, in an 9@A agreement, no principal amounts are
exchanged initially. Thus, /y /uying an 9@A, one can guarantee the future /orrowing
cost against a rise in interest rates. On the other hand, a seller of an 9@A can protect
himself against a drop in interest rates.
Feat$res o# FRAs
,- Flexi.ilit&: 9@As can /e priced for a variety of commencement and maturity date
which offers the flexi/ility to choose the exposure a firm will have at any point of
time. 9or example, there may /e times when a /orrower may /e happy with
floating rate exposure, /ut is concerned that in six months it will change. 9@A can
cover exposure in six months time for the client as per his discretion.
/- Reversi.ilit&: ?espite /eing a very effective tool in managing short term interest
rate exposures, having entered into 9@A once, one is locked into the agreement
whether rates moves in favour or against. One can terminate 9@A agreement only
at a cost /y reim/ursing the arranging /ank a payment /ased on current market
rates.
0- alance Sheet I%(lication1 9@A provide off5/alance sheet financial engineering
as there are no principal amounts amounts exchanged in 9@As and hence the does
not incur additional assets;lia/ilities on its /alance sheet. 9@A therefore does
affect gearing or leverage ratios of firm. The only interest rate exposure arising
from an 9@A is the differential /etween the 9@A rate and floating rates
represented /y the prevailing @eference @ate &@@'such as *%,O@ &*ondon %nter
,ank Offered @ate' in the international market and .7(5M%,O@ &Mum/ai %nter
,ank Offered @ate'in the @upee market in %ndia.
1
2- Transaction date: The settlement sum for 9@A is calculated on the fixing date /y
discounting /ack the difference /etween the previously contracted 9@A rate and
the then prevailing @eference rate. %n such deals money changes hand only on
settlement date, therefore there are no payment either on the transaction date or,
on the maturity date.
Advantages o# FRA
A typical case where firms;/anks may wish to utili0e 9@A as a short term hedging
instruments is around the announcement of the next Credit policy, and the concern that
market may /ecome extremely volatile at that time. %n such a case the firm can either an
9@A agreement now to ensure that /orrowing costs or investment returns do not /ecause
of this volatility.
The advantages of 9@A deals may /e summari0ed as=5
,- 9@As can /e tailored to one)s requirements /y date and amount.
/- Are simpler then a financial future as no fees, initial and variation margin require
to /e paid in 9@As.
0- -ood alternative to forward cash transaction without affecting /alance sheet.
2- Can /e used to fix interest rates on all or part of money market positions.
3- 9@As and cash may /e used for generating opportunities more efficiently.
4- *ow utili0ation of /ank)s credit line.
5- Counterparty risk in the form of settlement risk only with exposure only to
interest variation as the principal amount is 4ust notional.
6- Bositions can easily /e reversed /y /uying and selling an equal and offsetting
9@A.
Li%itations o# FRAs
9@As do not remove interest rate or exchange rate exposureC rather they are a
means of ad4usting or exchanging these exposures on a short term /asis. %f the treasury
term picks the market correctly, it may very well limit costs or improve returns, /ut there
will still /e market risk and the risk that the yield curve will change shape. Anyone
"
involved in treasury operations will /e very aware that managing interest rate and
exchange rate exposure is an on going task.
FRAs #or ta7ing a vie8 on rates
One of the most common application of 9@A is to swap floating rate /orrowings
or investments to fixed for a short period of time. This can /e achieved through /uying an
9@A. A firm may wish to do this from time to guard against volatility in floating rates.
Alternatively, firms having huge fixed rate exposure may decide to use 9@As to swap to
floating for a short period of timeC this may /e in line with a view that floating rate are on
the way down &or up for those who wish to protect investment returns', or /ecause it
more closely matches the interest rates /asis of other commitments over a certain period.
%n this case the firm would sell an 9@A.
7uppose for example, a firm has fixed rate investments and is planning to lease
some equipment in order to expand operations in two months time, for a period of six
months. The lease payments will /e /ased on floating interest rates. The firm can hedge
this future exposure /y selling a $s 1s 9@A today to swap the appropriate amount of fixed
rate investments to floating. The investments returns will then match firm)s floating rate
o/ligation on the lease transaction. >hen the lease expires, firm)s investment will once
again /e on a fixed /asis.
Ho8 to 7no8 8hen to Use FRAs
>hether a firm will /enefit from 9@As or not can /e 4udged /y conducting a
thorough examination of funding requirement and the investment strategies of the firmC
/oth current and future. >hile firm)s view on interest rates is fundamental to the
consideration of whether an 9@A is appropriate, some more vital questions that need to
/e adequately looked at are=
a- Are funding;deposits of long or short term natureD
.- Are funding;deposits of fixed or floating rate of interestD
c- ?o funding;deposits requirements vary in maturity and value or are they fairlyD
d- >hat is the firm)s view on interest ratesD
E
e- Are there any pro4ects;expansions in future which will require additional
funding D %s there likely to /e any excess funds arising which will need to /e
depositedD
CURR'NC9 FURUR'S
INTRODUCTION
The li/eralisation and integration of world capital markets in the "1Es was
inspired /y a com/ination of hope and necessity. The hope lay in the expectation of more
efficient allocation of saving and investment, /oth within national markets and across the
world at large. The necessity stemmed from the macroeconomic and financial insta/ility
F the insta/ility engendered government deficits and external im/alances that required
financing on a scale unprecedented in peace time and that exceeded the capacity or
willingness of the traditionally fragmented financial markets to cover. These financing
needs 4oined with advances in technology and communications to spawn a host of
innovations, ranging from securitisanon in place of intermediated /ank credit to new
derivative instruments. Taken together, innovation technology and deregulation have
smashed the /arriers /oth within and among national financial markets.
Currency 9uture
(xport &*ong on 9oreign Currency' %mport &7hort On 9oreign Currency
7hort Currency 9uture 3edge *ong Currency 9uture 3edge

Today world financial markets are growing in si0e, sophistication and glo/al
integration. According to an estimate, the international securities transactions amounted
to G! trillion per quarter in the second half of ""< F a/out five to six times the value of
international trade5in six group of seven countries. This increased volume of portfolio
capital movements has made foreign exchange markets much more sensitive to changes
in financial markets. These markets have acquired clout as an indicator of the credi/ility
of the government)s actual or prospective policies, as a disciplining mechanism for
industrial and developing countries alike.
F$t$res )ar7ets
%n the past several years, derivatives market has attached many new and
inexperienced entrants. The spectacular growth of the new futures markets in interest
rates and stock markets indexes has generated a demand for a unified economic theory of
the effects of futures markets F in commodities, financial instruments, stock market
indexes and foreign exchange F upon the intertemporal allocation of resources.
The /asic assumption of the investment theory is that investors are risk averse. %f
risk is to /e equated with uncertainly, can we question the validity of this assumption D
>hat evidence is there D As living, functional proof of the appropriateness of the risk
aversion assumption, there exists entire market whose sole underlying purpose is to allow
investors to display their uncertainties a/out the future. These particular markets, with
primary focus on the future, are called 4ust that future markets. These markets allow for
the existence of futures markets is the /alance /etween the num/er of hedgers and
operators who are willing to transfer and accept risk.
What are Financial F$t$res
A H9utures) contract is a standardi0ed agreement /etween two parties to /uy or
sell specific commodity, financial instrument or currencies, at a specific time and place in
the future, at a price esta/lished through open outcry in a central, -enerally high open
interest is related to greater liquidity. Technical analyst in the futures market use /oth
$
Trading Iolume and open interest to measure the direction of futures prices and possi/le
liquidity position. Thus an increase in /oth open interest and Trading Iolume is said to /e
hinting at a strong market and a weaker market is represented /y fall in /oth of them.
7imilarly, high Trading Iolume coupled with low open interest denotes volatility and
riskiness of the market.
ene#its o# Financial F$t$res
%n recent years, interest rates and currency exchange rates have /ecome highly
volatile, 9inancial futures were set up to provide a means of lessening the impact of
these5fluctuations. Accordingly, /enefits of financial futures can /e summed up as under.
,- Hedge Against Unanticipated Price Rise and Falls : A futures contract is
used to hedge against unanticipated rise or fall in price of an instrument. Thus an
investor who wishes to /uy GEE,EEE in T5notes in four months can /uy a T5.ote
contract and lock in the price.
/- Speculation on price movements : A future contract can /e speculate on the
price movement of underlying instrument. %n futures contract one need not hold
the instrument to /enefit from price movements. 9or example = An investor who
/elieves that prices of T5.otes are going to rise, he can /uy futures contracts
rather than the actual instruments. This helps investors to speculate in merkat
movements without owning the T5.otes.
0- Speculation on Interest Rate Movements: *ike speculation on price
movements, one can use futures contract even to speculate on the interest rate
movements without owning in the instruments. Thus, if a speculator thinks that
interest rates are likely to go up, he can sell the futures contract since there exists
an inverse relationship /etween price of an instruments and interest rates.
<
2- Fixing Long Ter% Ret$rns : An investor who wishes to lock in a long term
return on an instrument can /uy or go Hlong) term &generally two years' futures
contract.
3- Fixing Ret$rn on Floating Rate Invest%ents : 9utures allow investors to fix a
rate in floating rate assets. This can /e done /y /uying short term futures contract.
9or example = an investor owns T5.ote worth G million with floating rate coupon
of < months *%,O@ A +E /asis points. The investor can lock in a rate /y /uying a
<5months (urodollar contract which coincides with coupon payments. This
converts investors floating rate payments into fixed rate payment.
4- Scope of Arbitrage : 7ince future prices are /ased on cash market prices,
sometimes it is possi/le to /enefit from the mismatch in these two markets.
Bresence of ar/itragers in the market ensures liquidity and price relationship.
Users o# F$t$res Contract
Apart from individuals as speculators and investors, futures contracts are used /y
corporate /odies and institutional investors. 9inancial institutions, /eing the primary
users of financial futures, transact in future contracts to hedge their position. 9irms on the
other hand generally use futures contracts to hedge their exposure in financial and
commodity markets. 3edging through financial futures can help these firms to achieve a
wide variety of o/4ectives such as predetermining the interest and exchange rates or
protecting returns from fixed or floating instruments. Although perfect hedges are rarely
achieved /y using financial future due to maturity date mismatch or daily movements,
sophisticated firms use futures market extensively to cover their exposed asset and
lia/ilities.
Trading in C$rrenc& F$t$res
Two main o/4ectives for trading in currency futures are position trading or
speculation to take advantage from price fluctuation and as an alternative to the forward
market for hedging specific /usiness transaction. 9oreign currencies in futures exchanges
2
are treated as a commodity. Thus, the /uyer in a currency futures contract is /uying a
commodity today for delivery at a later date. The seller will deliver the contract to the
/uyer at the contract rate.
%t price of a particular currency rises a/ove the contract rates, the /uyer reali0es gain
since he receives the currency /y paying a lower price than the market price at that time.
7imilarly, if the exchange rate of a particular currency is far /elow the contract price, the
seller reali0es a gain. 7trategies for hedging in the currency futures market can /e
summari0ed as under =
Hedging R$les
Ris7 o# Strateg&
%ncrease in price ,uy &long' 9utures
?ecrease in price 7ell &long' 9utures
For example, a British Importer has to pay $150,000 to an exporter from
USA on 30
th
April. The British importer is worrie a!o"t a#erse mo#ements in
the ex$han%e rates for US ollar a%ainst po"n an hen$e e$ies to $o#er the
ex$han%e ris& in the f"t"res mar&et at 'IFF(. The ) *5,000 an the mat"rity is
*
n
+enesay of ,"ne. The $"rrent spot rate is ass"me to !e $1,5*00 an the
,"ne $ontra$t is !ein% trae at $1,5000.
Sin$e the importer is apprehenin% a epre$iation in the po"n sterlin%,
he e$ie to sell fo"r ,"ne $ontra$t at $1,5000 to $o#er his expos"re of
$150,000. -n 30
th
April, the spot rate in the $ash mar&et is $1,./00 per po"n
sterlin% an the ,"ne f"t"res $ontra$t is now train% at $1,.000. In the f"t"res
pri$e mar&et he $an !"y !a$& his fo"r $ontra$t sol at $1,5000 at the $"rrent
f"t"res pri$e as $1,.000 an th"s ma&in% a profile of fo"r $ents per sterlin%
$ontra$t )*5,000 ea$h, this total profile wo"l !e $.,000 or )*,10* as per the
$"rrent spot rate of $1,./00. 2a he e$ie not to he%e the ris&, his loss wo"l
ha#e !een )*,001. This is !e$a"se p"r$hase of $150,000 at the $"rrent pri$e will
+
$ost him )101,351 3$150,00041../5 $ompare to the )6/,0/. 3$150,00041.5*5
$al$"late at the spot rate r"lin% when he e$ie for he%e the ris&.
7"rren$y f"t"res, as shown here, may not pro#ie the perfe$t he%e sin$e
the amo"nts an mat"rity ate may not always $oin$ie. This pro#ies one of the
%reatest limitations of "sin% $"rren$y f"t"res for he%in% expose eals.
!
CURREC! "P#I"S
7"rren$y option o#er#iew
-ptions on forei%n ex$han%e8 It9s really no ifferent to options on shares
or real estate. The !asi$ premise is that the !"yer of an option has the ri%ht !"t
not the o!li%ation to enter into a $ontra$t with the seller. :at"rally the option
owner exer$ises this ri%ht when it is to his4her a#anta%e. 7"rren$y options
spe$ify a forei%n ex$han%e $ontra$t an %i#e the owner the ri%ht to enter into the
spe$ifie $ontra$t "rin% a pre;a%ree perio of time.
7"rren$y -ptions ha#e %aine a$$eptan$e as in#al"a!le tools in mana%in%
forei%n ex$han%e ris&. They are "se extensi#ely an ma&e "p !etween 5 ; 10 <
of total t"rno#er. 7"rren$y options !rin% a m"$h wier ran%e of he%in%
alternati#es to portfolio mana%ers an $orporat treas"ries.
Currency Option
Call Option &@ight to /uy the currency' But Option &@ight J not O/ligation to sell the currency'
Burchase put option 7elling put option Burchase of call option 7elling of call option
#
This area of -=Forex is e#ote to f"rtherin% the "nerstanin% of what $"rren$y
options are, how they are pri$e an how they $an !e "se.
In the near f"t"re we will !e !rin%in% options pri$in% tools onto the site an also a
se$tion that simplifies the mathemati$s !ehin options pri$in%.
Currenc$ option defination
In e#ery forei%n ex$han%e transa$tion, one $"rren$y is p"r$hase an
another $"rren$y is sol. 7onse>"ently, e#ery $"rren$y option is !oth a $all an
p"t.
An option to !"y A"stralian ollars a%ainst Unite States ollars is !oth an
A"stralian ollar $all an a Unite States ollar p"t. 7on#ersely, an option to sell
A"stralian ollars a%ainst Unite States ollars is an A"stralian ollar p"t an $all
)ore C$rrenc& O(tion asics
De#inition
A $"rren$y option is the ri%ht ; !"t not the o!li%ation ; to !"y 3in the $ase of
a $all5 or sell 3in the $ase of a p"t5 a set amo"nt of one $"rren$y for another at a
preetermine pri$e at a preetermine time in the f"t"re.
The two parties to a $"rren$y option $ontra$t are the option !"yer an the option
seller4writer. The option !"yer may, for an a%ree "pon pri$e $alle the premi"m,
p"r$hase from the option writer a $ommitment that the option writer will sell 3or
p"r$hase5 a spe$ifie amo"nt of a forei%n $"rren$y "pon eman. The option
extens only "ntil the expiration ate. The rate at whi$h one $"rren$y $an !e
p"r$hase or sol is one of the terms of the option an is $alle the exer$ise
pri$e or stri&e pri$e. The total es$ription of a $"rren$y option in$l"es the
1
"nerlyin% $"rren$ies, the $ontra$t si=e, the expiration ate, the exer$ise pri$e
an another important etail? that is whether the option is an option to p"r$hase
the "nerlyin% $"rren$y ; a $all ; or an option to sell the "nerlyin% $"rren$y ; a
p"t. There are two types of option expirations ; Ameri$an;style an ("ropean;
style. Ameri$an;style options $an !e exer$ise on any !"siness ay prior to the
expiration ate. ("ropean;style options $an !e exer$ise at expiration.
7"rren$y options may !e >"ote in one of two ways? Ameri$an;terms, in whi$h a
$"rren$y is >"ote in terms of the U.S. ollar per "nit of forei%n $"rren$y@ an
("ropean;terms 3in#erse terms5, in whi$h the ollar is >"ote in terms of "nits of
forei%n $"rren$y per ollar. The same lo%i$ $an !e applie to $"rren$y pairs in
whi$h the U.S. ollar is not one of the $"rren$ies. (ither $"rren$y $an !e
expresse in terms of the other.
#rading % Speculation
Currency options offer some unique features to the speculator. Burchasing an option
you know that your downside is limited to the premium you invest. 7ounds great and it is.
3owever you should also know that the pro/a/ility of make a profit depends on where
the option strike is. %f 67?;:BK spot is $E.EE and you /uy a month 2E.EE strike 67?
Call, the premium will /e small /ut the pro/a/ility of losing it all is very high. On the
other hand if you sell options you receive premium /ut you also are exposed to unlimited
loss if the market moves against your position.
Hedging &it' "ptions
-ptions offer some #ery interestin% feat"res for he%in%. There are a wie
#ariety of ifferent types of options to mat$h the f"ll spe$tr"m of ris&s that
$ompanies an f"n mana%ers inherit as part of their international trae an
in#estment. It is important that ris& mana%ers "nerstan the pro"$ts they are
!"yin% an exa$tly how they perform "ner ifferent s$enarios. The %oal !ein% to
ne%ate the existin% ris&s of the !"siness.
"
&'ere to trade
:e#er trae with someone that has A$ol $alleA yo". Bo with a rep"ta!le
!ro&er. Co yo"r homewor& an ens"re that yo" are train% with a rep"ta!le
!ro&er with soli referen$es an a soli !a$&%ro"n. These ays there are a lot
of $ompanies $laimin% enormo"s ret"rns thro"%h train% $"rren$y options !"t
yo" wo"l !e wise to remem!er that nothin% is $ertain an there is efinitely no
s"$h thin% as a As"re !etA. As always it pays to spea& to a finan$ial a#isor to
ens"re that this in#estment is ri%ht for yo".
&'ere to 'edge
Do"r lo$al !an&s Treas"ry i#ision sho"l ha#e the a!ility to offer yo"
$"rren$y options. They %enerally ha#e minim"m eal si=es ; %enerally o#er USC.
Con9t !e afrai to as& yo"r !an& how they arri#e at a pri$e for an option. It is
mae "p of the spot rate, stri&e, forwar points an #olatility. If yo" ha#e these
#aria!les yo" $an "se o"r option to $he$& the 7"rren$y options $an also !e
!o"%ht on #ario"s ex$han%es s"$h as the IEE. To transa$t these yo" will nee
to set "p a relationship with a $ompany that $an exe$"te the traes on the !ehalf.
As always sti$& to some!oy that has a %oo rep"tation.
$E
CURREC! S&APS
I#R"(UC#I"
7"rren$y an interest rate swaps are $onsiere to !e one of the earliest
an wiely a$$epte inno#ati#e pro"$ts in the international finan$ial mar&et
pla$e. They ha#e fo"n a$$eptan$e worlwie "e to their #ersatile appli$ation.
In the past ten years, interest rate an $"rren$y swaps ha#e !e$ome well
esta!lishe ris& mana%ement te$hni>"es. They are now !ein% "se extensi#ely
!y the !an&in% an $orporate se$tors, in$l"in% %o#ernments to re"$e
!orrowin% $ost an to mana%e their interest rate an $"rren$y expos"res. The
e#elopment of interest an $"rren$y swap now pro#ies a tool no finan$ial
mana%er $an i%nore. It has also tri%%ere off inno#ation of a whole ran%e of
eri#ati#e pro"$ts li&e swaptions an others that ha#e %reatly expane the
opport"nities for finan$ial mana%ement.
There are many reasons for the %rowth of swap mar&et. It was ori%inally
e#elope for easier a$$ess to international mar&ets !y E:7s in F#ehi$le
$
$"rren$iesG an swap them into their esire $"rren$ies. Hehi$le $"rren$ies are
those $"rren$ies in whi$h E:7s $an !orrow $heaply, !"t are a$t"ally not
intereste in $arryin% any s"$h e!t. By swappin% #ehi$le $"rren$y to the esire
$"rren$y, E:7s try to re"$e their !orrowin% $ost. Besies, the a!ility of the
swap mar&et to meet %rowin% nees of a #ast n"m!er of potential "sers with
ifferent re>"irement has also mae swap a tool whi$h perhaps no other finan$ial
instr"ment $an mat$h. All these ha#e res"lte in $reati#e an ynami$ inte%ration
of worlIs se$"rities, money an forei%n ex$han%e mar&ets. Swap also helpe in
wienin% of the $hoi$e a#aila!le to "sers for !orrowin%, in#estin%, he%in% an
ar!itra%in% in ifferent mar&ets.
The $"rren$y swap mar&et %aine le%itima$y from the swap !etween IBE
an worl !an& in 16/1. Sin$e then, the #ol"me of swap transa$tions ha#e %rown
manifol to an estimate US$ 1.5 trillion !y Ear$h *001.
#'e )asic S*ap Structure
A swap is enie as a $ontra$t"al a%reement !etween the parties to
ex$han%e a series of $ash payments for an a%ree term. It is a powerf"l tool for
manip"latin% $ross $"rren$y $ash flows witho"t $reatin% a net ex$han%e position.
Sin$e its in$eption, swap str"$t"re ha#e "ner%one tremeno"s $han%es "e to
the in%en"ity an ima%ination of swap mana%ers an arran%ers. The primary
swap mar&et $onsists of swaps of new e!t ris&s. :early .0 to 00 per$ent of all
("ro!on iss"e are swap relate. The se$onary mar&et on swap $onsists
primarily of inter!an& train% an $orporate he%in% transa$tions.
Two !asi$ swap str"$t"res are referre as Interest rate swap an $"rren$y swap.
They are is$"sse in the followin% se$tions.
a+ #'e Interest Rate S*ap
By far the most $ommon type of swap is interest rate or $o"pon swap. An
interest rate swap is an a%reement for the ex$han%e of interest lia!ilities of
ifferin% $hara$ter !etween two $o"nterparties. For example, ex$han%e of fixe
$$
rate interest for floatin% rate interest lia!ility in the same $"rren$y. This is
$al$"late !ase on a m"t"ally a%ree national prin$ipal amo"nt. Th"s, in
interest rate swap one party may pay a fixe rate of interest, while the other pays
floatin% rate, s"$h as three month 'IB-J re;fixe e#ery three months. The
prin$ipal, !"t national amo"nt is appli$a!le solely for the $al$"lation of interest to
!e ex$han%e "ner the swap. At no time prin$ipal amo"nt is physi$ally "s"ally
passe !etween the $o"nterparties. +ith the help of this swap str"$t"re, the
$o"nterparties are a!le to $on#ert fixe rate interest !"ren to a floatin% rate
interest an #i$e #ersa. Three main types of interest rate swap are @
b+ Coupon S*aps ?
These swaps relate to ex$han%e of floatin% rate 3e.%. 'IB-J5 for fixe rate of
interest lia!ilities an #i$e #ersa. For example, a AAA rate $ompany a%rees to
raise f"ns at floatin% 'IB-J to swap with a fixe rate of interest !"ren.
c+ )asis S*aps :
A !asis rate swap is an a%reement to ex$han%e similar o!li%ations, $al$"late
on ifferent roll;o#er ates, for an a%ree term. For example, two $o"nterparties
may a%ree to ex$han%e their lia!ilities for perioi$ payments !ase on ifferent
ini$es K one payin% 0 months 'IB-J in ex$han%e for 3 months 'IB-J.Th"s,
!asis rate swap is essentially for the ex$han%e of floatin% interest rates of
ifferent roll;o#er ates in ifferent $"rren$ies. The examples of !asis rate swaps
are ? 3 months 'IB-J, Base #s 0 months 'IB-J, 7ommer$ial paper #s 'IB-J,
Lrime Jate #s 'IB-J, Base rate #s 'IB-J an few more.7ross $"rren$y interest
rate swap. These swaps relate to ex$han%e of fixe rate flows in one $"rren$y for
floatin% rate flows in another.
)enefits of Interest Rate S*aps
-ne of the reasons for the phenomenal %rowth of interest rate swap has !een
its i#erse "se. They are !ein% in$reasin%ly "se for mana%in% lia!ilities s"$h as
he%e a%ainst a#erse rate mo#ements or to a$hie#e a $hosen !len of fixe
an floatin% rate e!t. Eany in#estors now "se swap to $reate hi%h yielin% fixe
$<
rate instr"ments or to $on#ert their fixe rate $ash flow to a systemati$ floatin%
rate $ash flow. Some of the !enefits of interest rate swaps are as follows ?
Tailor mae interest payments ? Interest payment on swap $an also !e time to
s"it a $lients re>"irement of payin% lower interest in the earlier years an a
hi%her rate in the later years.
'ower $ost of f"ns ? 'ar%e n"m!er of interest rate swap eals are str"$& for
re"$in% interest $ost an expos"res. The a!ility of interest rate swap
transa$tions to transfer fixe rate $ost a#anta%e to floatin% rate lia!ilities has le
to many hi%h $reit ratin% firms or !an&s iss"in% fixe rate ("ro!ons. All s"$h
iss"es are mainly "se for swap an o!tain, in many $ase, 'IB-J;less f"nin%. It
is not s"rprisin% to fin many "sers !ein% a!le to re"$e thro"%h swap their
!orrowin% $ost in floatin% rate !y as m"$h as 50 to 15 !asis points !elow 'IB-J.
S"$h $ost sa#in%s $an !e #ery s"!stantial on a lar%e swap eal.
Attra$ti#e rates ? It is >"ite possi!le for any swap mar&et ma&er to fin
hi%hly attra$ti#e rate. This $an !e a$hie#e !y $aref"lly timin% the ("ro!on
iss"es for ens"rin% its s"$$ess at the !est rate an also !y ens"rin% the !est
possi!le swap terms for the iss"er.
A$$ess to lar%e n"m!er of mar&ets ? In aition to the $ost a#anta%e,
interest rate swaps pro#ie an ex$ellent opport"nities for firms or !an&s to tap
mar&et whi$h are otherwise ina$$essi!le to them "e to their poor $reit >"ality,
la$& of rep"tation, "n;familiarity of the forei%n mar&et, or e#en ex$essi#e "se of
the finan$ial mar&et. It also helps firms to raise from attra$ti#e mar&ets witho"t
any nee f"lfill $omplex re>"irements s"$h as prospe$t"s, is$los"res, $reit
ratin%s, roa shows et$. The %rowin% "se of $ommer$ial paper as he "nerlyin%
floatin% rate !asis in the swap mar&et f"rther re;affirms the flexi!ility an
importan$e of interest rate swaps.
$2
Eana%in% interest rate expos"re ? Interest rate swaps allow firms to
mana%e their interest rates expos"res more a$ti#ely. They ena!le firms to swit$h
o#er from floatin% rate to fixe an !a$& a%ain, !ase on the o"tloo& of the
mo#ements. The interest rate swap $an also !e "se !y treas"rers in a e$linin%
interest rate en#ironment. For example, a $ompany may swap its fixe rate e!t
at 1*< to o!tain 'IB-J at the !e%innin% of interest rare e$line. C"rin% the
perio of interest rate e$line, this firm may lea#e the swap eal inta$t to wait for
f"rther fall. -n$e the interest rate has finally e$line to say 10< the firm may
enter into a se$on swap to Flo$& intoG the new lower fixe rates of 10<. The net
effe$t of the a!o#e swap a sa#in% of *< for the firms on its fixe $ost of f"ns.
Eat"rity of the lon% term e!t ? Interest rate swaps $an !e "se !y firms to
exten or shorten interest ris& asso$iate with the mat"rity of its lon% term e!t
!y presentin% the firm to mana%e the term str"$t"re of the e!t more effe$ti#ely.
'o$&in%;in of finan$ial $ost ? Thro"%h interest ratw swaps a firm $an also
lo$&;in its f"t"re !orrowin% $ost. This is parti$"larly essential when the interest
rates are expe$te to rise in the f"t"re.
Usef"l for In#estors ? As a part of their in#estment strate%y, many in#estors
are now "sin% swaps for in$reasin% their ret"rn. Eost of the interest rate swap
eals offer a s"!stantially hi%her yiel than %o#ernment se$"rities of a similar
term.
Simpli$ity of eal ? An lastly, simpli$ity an strai%ht forwar pro$ess are
few more a#anta%es of interest rate swap eals. -ften these eals are
$on"$te !y telephone an s"!se>"ently $onfirme !y telex a a$$epta!le
o$"mentation. All these pro#ie %reat relief from enormo"s paperwor& an
o$"mentation. Also, the $reit ris& atta$he to interest rate swap is less than the
ris& atta$he to a ire$t f"nin% operation.
Currenc$ S*aps
$+
The $"rren$y swap emer%e primarily to $ir$"m#ent restri$tions !y a"thorities
on iss"in% e!t an remittan$e of f"ns !etween $o"ntries. It %aine le%itima$y
from the swap !etween worl !an& an IBE in 16/1. C"e to its a!ility to lin&
$apital mar&et with finan$ial mar&et, $"rren$y swap has %aine $rei!ility o#er
years. (#er sin$e its aoption in 16/1, swap has fo"n "ni#ersal re$o%nition "e
to its #ersatile appli$ation.
7"rren$y swaps operate on the same ar!itra%e prin$ipal as interest rate
swaps. A $"rren$y swap is an a%reement to ex$han%e prin$ipal an interest
payments in ifferent $"rren$ies for a state perio. If two !orrowers are
per$ei#e to !e of ifferent $reit ris&s in ifferent $"rren$y mar&ets an
!orrowe at ifferent mar&et spreas, a $"rren$y swap may allow them to o!tain
$heaper f"ns than !y iss"in% ire$tly in the $"rren$y they re>"ire. 'i&e interest
rate swaps, it is not ne$essary for an iss"er to ha#e a!sol"te a#anta%e in one
mar&et. -ne iss"er $an ha#e an a!sol"te a#anta%e in !oth mar&et, pro#ie it
has a $omparati#e a#anta%e in one mar&et. In orer to !enefit from $"rren$y
swap, the new iss"e sprea ifferential !etween the two iss"ers in ea$h $"rren$y
m"st !e ifferent.
Eost fixe to floatin% $"rren$y swaps are a $om!ination of an interest rate
swap in one $"rren$y an a floatin% to floatin% $ross $"rren$y swap. In some
$"rren$ies it is possi!le to o a fixe to floatin% rate $"rren$y swap ire$tly.
Fi,ed Rate Currenc$ S*ap
A fixe rate $"rren$y swap $onsist of the ex$han%e !etween two
$o"nterparties of fixe rate interest in one $"rren$y in ret"rn for fixe rate interest
in another $"rren$y. The followin% three !asi$ steps are $ommon to all $"rren$y
swaps ?
3a5 Intial (x$han%e of Lrin$ipal ? -n the $ommen$ement of the swap the
$o"nterparties ex$han%e the prin$ipal amo"nts of the swap at an a%ree rate of
$!
ex$han%e. Altho"%h this rate is "s"ally !ase on the spot ex$han%e rate, a
forwar rate set in a#an$e of the swap $ommen$ement ate $an also !e "se.
This initial ex$han%e may !e on a FnationalG !asis 3i.e. no physi$al ex$han%e of
prin$ipal amo"nts5 or alternati#ely a Fphysi$alG ex$han%e.
+hether the initial ex$han%e, is on physi$al or national !asis its sole
importan$e is to esta!lish the >"ant"m of the respe$ti#e prin$ipal amo"nts for the
p"rpose of (a) $al$"latin% the on%oin% payments of interest an (b) the re;
ex$han%e of prin$ipal amo"nts "ner the swap.
3!5 -n%oin% (x$han%e of Interest ? -n$e the prin$ipal amo"nts are esta!lishe,
the $o"nterparties ex$han%e interest payments !ase on the o"tstanin%
prin$ipal amo"nts at the respe$ti#e fixe interest rates a%ree at the o"tset of the
transa$tion.
3$5 Je;ex$han%e of Lrin$ipal Interest ? -n the mat"rity ate the $o"nterparties re;
ex$han%e the prin$ipal amo"nts esta!lishe at the o"tset. This strai%htforwar,
three;step pro$ess is stanar pra$ti$e in the swap mar&et an res"lts in the
effe$ti#e transformation of a e!t raise in one $"rren$y into a f"llyKhe%e
fixe rate lia!ility in another $"rren$y.
In prin$ipal, the fixe $"rren$y swap str"$t"re is similar to the $on#entional
lon%;ate forwar forei%n ex$han%e $ontra$t. 2owe#er, the $o"nterparty nat"re
of the swap mar&et res"lts in a for %reater flexi!ility in respe$t of !oth mat"rity
perios an si=e of the transa$tions whi$h may !e arran%e. A $"rren$y swap
str"$t"re also allows for interest rate ifferentials !etween the two $"rren$ies #ia
perioi$ payments rather than the l"mp;s"m refle$te !y forwar points "se in
the forei%n ex$han%e mar&et. This ena!les the swap str"$t"re to !e $"stomi=e
to fit the $o"nterparties exa$t re>"irements at attra$ti#e rates. For example, the
$ash flows of an "nerlyin% !on iss"e may !e mat$he exa$tly an in#aria!ly.
$#
Salient Features of Currenc$ S*ap
The $"rren$y swap 3or $ross $"rren$y swap5 as shown in the pre#io"s two
example, is $hara$teri=e y the followin% feat"res ?
a+ F"ll ex$han%e of prin$ipal ta&es pla$e either at the start of the swap eal
or M"st on mat"rity.
b+ Benerally prin$ipal is ex$han%e at the spot ex$han%e rate, !oth at the
start or mat"rity of the eal. Sometimes a forwar rate may also !e sent
ri%ht in the !e%innin% of the eal for final ex$han%e of $"rren$ies.
c+ Lerioi$ interest payments are mae for o"tstanin% amo"nt on ea$h
rollo#er ate in ifferent $"rren$ies. This feat"re of $"rren$y swap
ifferentiates it from forwar $ontra$t where l"mp;s"m are ex$han%e at
the en.
d+ The swap eal may ha#e a tailore a%reement to mat$h the re>"irement
for "nerlyin% eal !ein% he%e.
e+ The $"rren$y swap eal $an !e reser#e witho"t "psettin% the "nerlyin%
transa$tion.
#'us- t'e t'ree basic information re.uired for a currenc$ s*ap deal are ?
+hi$h $"rren$y to !e pai an whi$h one to !e re$ei#e.
The ex$han%e rate to !e "se for swap an,
+hether the ex$han%e of prin$ipal will ta&e pla$e at the start or on
mat"rity of the $ontra$t.
Users and sellers of currenc$ s*ap :
$1
Besies %o#ernment a%en$ies, asset mana%ers an re%ional !an&s, firms
with hi%h $reit ratin% 3sin%le A or a!o#e5 with the a!ility to iss"e ("ro!on are
the "sers of $"rren$y swap in the primary mar&et. +hereas, firms with si%nifi$ant
forei%n operation an expos"re are the se$onary mar&et "sers of $"rren$y
swap. Few re%ional !an&s an %o#ernment a%en$ies also "se $"rren$y swaps to
re"$e their $ost on lin% term fixe !ons. Asset mana%ers "se $"rren$y swap to
i#ersity their portfolios to in$l"e $ompanies that o not iss"e e!t in US ollars
witho"t exposin% themsel#es to ex$han%e ris&. In#estment !an&s howe#er "se
$"rren$y swaps to eliminate ex$han%e ris& an to help sell forei%n $"rren$y
!ons to in#estors.
The sellers of $"rren$y swaps are %enerally in#estment !an&s an
$ommer$ial !an&s@ with their wie networ& in the !"siness, in#estment an
$ommer$ial !an&s ha#e wie information on "sers of $"rren$y swap. As a res"lt,
finin% $o"nterparties on a %i#en $"rren$y is not always a iffi$"lt tas& for them.
)enefit of currenc$ s*aps
In $ommon with the interest rate swap, few maMor a#anta%es of $"rren$y
swap are as "ner ?
I/ Credit arbitrage ? 7"rren$y swaps are "se for re"$in% !orrowin% $ost
of "sers. it allows $o"nterparties to ta&e a#anta%e of ifferent $reit
per$eption !etween mar&ets, espe$ially ("romar&ets where name
re$o%nition is perhaps more #ital than $reit ratin%. This ena!les firms with
relati#ely !etter rep"tation to raise f"ns at finer rates omesti$ mar&et.
II/ &ider access to mar0ets : In aition to $ost a#anta%e, $"rren$y
ar!itra%e ena!les firms to ha#e a$$ess to e#en those money mar&ets
whi$h wo"l !e otherwise iffi$"lt or not $ost effe$ti#e. In this way
$"rren$y swaps inte%rate the $apital mar&ets of the entire worl. It is not
s"rprisin%, therefore to fin as A"stralian Bon iss"e !ein% swappe
$"
$ompletely for US ollar. In fa$t a lar%e n"m!er of A"stralian an :ew
Nealan !on iss"e are swappe.
III/ Fle,ibilit$ in deal : Immense flexi!ility of the $"rren$y swap str"$t"res
an also lon%er mat"rities of a#aila!le f"ns ma&e this te$hni>"e an
in#al"a!le tool.
I1/ Meeting Investor Preferences : In#estors ha#e ifferent in#estin%
re>"irements. Sometimes they may prefer one metho to another.
7"rren$y swap pro#ies #ariety of in#estment opport"nities for in#estment
witho"t any ex$han%e ris&.
1/ Hedge currenc$ e,posures : If a !orrower has iss"e e!t witho"t
he%in% $o"pon an prin$ipal repayments, $"rren$y swaps may !e "se
to he%e all or part of the expos"res, there!y re"$in% expos"re ris&.
1I/ International (ebt Management : 7"rren$y swaps are "se !y firm in
one $"rren$y into another !ase on the expe$tation of $"rren$y
mo#ements. Swap $an !e "se to lo$& in a %ain on a forei%n $"rren$y
!orrowin% or to limit a loss in$"rre.
1II/ #a, Management : 7"rren$y swaps $an !e "se to lo$& in %ain on a
forei%n !orrowin% while eferrin% the tax re$o%nition of that %ain.
1III/ #o e,pand mar0et : +hen an instit"tion "ses the same mar&et to raise
f"ns time an a%ain, the $reit mar&et sat"rates. 7"rren$y swap allows
them to tap new mar&ets.
<E
S&AP#I"S
A swaption is an option on a swap which can /e written on interest rate swaps,
currency swaps, commodity swaps or equity swaps. The concept is almost identical to an
optional cap. The end user and the swap dealer agrees to the terms of a swap. 3ence, a
swaption &also known as a swapoption' is an option to enter into an interest rate swap. %n
return for a premium paya/le in advance, the /orrower has the right /ut not the
o/ligation, to enter a swap at the pre5agreed fixed rate level.
A swaption is a valua/le tool when a customer may require a swap /ut is
uncertain with regard to timing etc. The typical structure would /e for a /orrower to /uy
a six month or one year option to conclude an interest rate swap at near current market
levels. This type of product can /e particularly useful in situations where the corporate or
institution is quoting on new /usiness which involves a considera/le or material exposure
/ut where the firm is uncertain as to the tender outcome. The maximum loss the customer
faces is this the premium amount.
A swaption is not directly compara/le to a cap, since the period of protection is
very different. 9or example a one year option to enter into a four year swap gives the
right to exercise within one yearC after one year the /orrower has either exercised the
swaption. %n which case he is locked into a swap, or has allowed the swaption to expire,
in which case no protection is in place for the next four years. The swaption is a valua/le
however, and has a usefulC role in lia/ility management F particularly where a /orrower
prefers the certainly of paying fixed rate through a swap.
Option on interest rate swaps are referred as swaptions. The /uyer of a swaption
has the right to enter an interest rate swap agreement /y some specified date in the future.
The swaption agreement will specify whether the /uyer of the swaption will /e a fixed5
rate receive or a fixed5rate payer. The writer of the swaption /ecomes the counterparty to
the swap if the /uyer exercises. %f the /uyer of the swaption has the right to enter into a
<
swap as a fixed5rate payer, the swap is called a Lcall swaptionM. The writer therefore
/ecomes the fixed5rate receive;floating5rate payer. %f the /uyer of swaption has the right
to enter into a swap as floating5rate payer, the swap is called as Lput swaptionM The
writer of the swaption therefore /ecomes the floating5rates receive fixed5rate payer. The
strike rate of the swaption indicates the fixed rate that will /e swapped versus the floating
rate. The swaption will also specify the maturity date of the swap. A swaption may /e
(uropean or American. Of course, as in all options, the /uyer of a swaption pays the
writer a premium, although the premium can /e structured into the swap terms so that no
upfront fee has to /e paid. A swaption can /e used to hedge a portfolio strategy that uses
an interest rates swap /ut where the cash flows of the underlying assets or lia/ility are
uncertain. The cash flows of the assets will /e uncertain if it &i'is called, as in the case of
calla/le /onds, converti/le /onds , a loan that can /e prepaid etc, and ;or&ii'expose the
investors;lendor to default risk.
<$
CA:S;FLOORS;COLLARS
Interest Rate Ca(s
An interest rate cap is an arrangement where/y the sellar of the cap undertakes to
compensate the /uyer of the cap /y whatever percentages reference interest rate &for eg.<
month *%,O@'exceeds a pre5agreed maximum interest rate. ,y this structure, a cap
provides a multi period hedge against increases in interest rates.%t is important to note that
even though Caps are one of the types of multi period option as it provides hedge against
risk exposure that spans multiple periods, one following another, the full premiums are
ordinarily paid up front.
9or this insurance the seller would charge a front5end premium which may vary
from N to <N of the notional agreed amount. 9or example, @eliance %ndustries /orrows
67G+E mm in the euro market at < month *%,O@ and also /uys a EN cap from Citi/ank
/y paying front5end fee of $N. %f on the reset date < month *%,O@ moves upto N
Citi/ank would compensate @eliance /y N on the agreed amount and if *%,O@ goes
down to "N @eliance will still pay "N only.
As seen, here, /uyer of the cap has the advantage of paying rate agreement in the
agreement irrespective of the prevailing rate in the market. %n our previous example,
@eliance %ndustries will pay nothing more than the contracted 9@A rate irrespective of
what the market rate is. O/viously, for this privilege, /uyer of the cap compensate the
seller for offering one5sided arrangement and this is achieved through the initial payment
of the premium /y the /uyer. The cost of premium depends on the period for which the
cover is required and the difference /etween the contracted 9@A rare and the prevailing
interest rate.
7ince caps are multi period options, the simplest way to price a cap is to split it
into the actual series of single period options which is also know as a strip. The fair value
<<
of each of the options can /e determined /y using any appropriate pricing models. The
sum of these fair values is the fair value of cap.
As seen earlier there are many users of interest rate caps /ut the most common is
to impose upper limit to the cost of floating rate de/t. %nvestment /ankers often com/ine
caps with interest rates swaps or currency swaps to produce a product called rate F
capped swaps. These products can reduce /orrowing costs if the /orrower /orrows at the
fixed rate, swaps it for floating rate payments with the swap dealer, and then caps it
floating rate payments with an interest rate cap.
Advantages o# (artici(ation ca(s are :
i+ The protection if rates rise similar to that for cap /ut with no up5front
premium paya/le.
ii+ 6nlike a 0ero cost collar, there is continued a/ility to /enefit it rates fall.
iii+ The may well /e easier for a /ank to hedge than a collar and can consequently
represent /etter value to the customer.
Disadvantages o# (artici(ation ca(s are :
i+ %f there is an immediate sharp rise in *i/or it would still have /een /etter to
have done a swap.
ii+ %t rates stay the same or go down it would pro/a/ly have /een /etter to have
/ought.
iii+ As with swaps and collars the floor element uses a /ank)s limits.
Interest rate #loors
An interest rates floors is identical to a cap except that the floor writer pays the
floor purchaser when the reference rate drops /elow the contract rate, called the floor
rate. Many firms generate cash surpluses from their investments and therefore need to
guarantee a minimum return on funds i.e. their concern is that interest rates may fail. %n
this type of circumstance an interest rate floor may /e the appropriate product. >hereas
an interest rate cap guarantees a maximum rate for a reference rate over a chosen period,
<2
an interest rate floor guarantees a minimum rate. The mechanism of payment is similar to
that for a cap, in other words the /uyer of an interest rate floor pays a premium on the
deal date, and receive payments at the end of each interest period during the life of the
floor if the rate for that period was /elow the floor rate.
%nvestment /ankers find many users for interest rate floors as well. The most
common use is to place a floor on the interest income from a floating rate assets. 9or
example, consider an insurance company which has o/tained funds /y selling #Nten year
fixed rate annuities. As these annuities constitute fixed rate lia/ilities, and if the interest
rates are likely to go down, floors can /e used for guaranteeing minimum return for the
insurance company.
Interest Rate Collar
An interest rate collar is a com/ination of a cap and a floor in which the purchaser
of a collar /uys a cap and simultaneously sells a floor. A collar has the effect of locking
the collar purchaser into a floating rate of interest that is /ounded on /oth high side and
lower side. This is sometimes called Llocking into a /and or swapping into a /andM
Advantages o# Interest Rate Collar :
i+ %t is always cheaper than an interest rate cap /ecause the /uyer is giving up
the a/ility to /enefit if rates fall /elow the floor rate.
ii+ %t is possi/le to constructed L0ero costsM collars provided that the cap is a/ove
the swap rate.
Disadvantages o# and Interest Rate Collar :
i+ A collar negates the principal of /uying an option to achieve unlimited
/enefits and limited downside potential. This is /ecause as well as /uying an
option &the cap', the /orrower also selling an option &the floor'.
ii+ The floor from the /anks perspective must /e viewed as a credit risk. %n
practice this means that the fair value if the floor will imply this perceived
credit risk, in a similar manner to the swap market.
<+
iii+ %n an interest rate environment involving a positively sloping yield curve, the
value of the floor can /e very low and hence the cost saving over a cap will
not /e very great.
<!
HEDGING FOREIGN EXCHANGE RISK-
ISNT IT ALSO RISK?
The concept of Risk
Risk is the possibility of actual out come being diferent from the
expected outcome. It includes both downside and upside potential.
Downside potential is the possibility of actual results being adverse
compared to the expected results and upside potential is the possibility
of actual results being better than the expected results.
Fo!ei"n E#ch$n"e E#pos%!e & Risk
It is the change in the domestic currency value of assets and
liabilities to the changes in the exchange rates. This may be positive or
negative. Positive exposure gives rise to ain and negative exposure
gives rise to loss.
Ho' it is (e$s%!e)
!oreign exchange risk is measured by the variance of the
domestic currency value of asset" liability or an operating income"
which can be related to unexpected changes in the exchange rates.
He)"in" Fo!ei"n E#ch$n"e Risk
#edging refers to process" whereby one can protect the price of
$nancial instrument at a date in the future by taking an opposite
position in the present by using derivatives like %urrency &ptions"
%urrency !utures" !orward %ontracts"
%urrency 'waps" (oney (arkets" etc.
<#
It refers to techni)ue of protecting the $nancial exposures in the
underlying asset or liability due to volatility in the exchange rates by
taking ofsetting positions through derivatives to ofset the losses in
the cash market by a corresponding gain in the derivatives market.
He)"in" in*o+*es
!oreign exchange exposure identi$cation
*alue of exposure
%reation of ofsetting positions through derivatives
(easurement of #edge ratio
Degree of Risk acceptable to management
+xpectations regarding future movement of exchange rates.
Derivatives are hypothetical assets, they derive their value from the
underlying assets. &ne very fundamental )uestion - why do we need
derivatives.
!or risk management" there should be negative correlation between
the assets in a portfolio. Risks can still be managed" even if there is a
positive correlation between the asset in the portfolio and that is
through creation of hypothetical assets against those assets i.e.
/underlying asset0.
C%!!enc, Options are instruments" which give the buyer of the
option the right but not the obligation to execute a speci$ed
transaction in the underlying currency pair. This gives the buyer the
1exibility to execute settlement or not. They are diferent from other
derivatives in that they provide downside protection against risk and
<1
also an upside bene$t from favourable movements in the underlying
exchange rates.
Fo!'$!) Cont!$cts are a commitment to settle at a $xed forward
price. This provides only upside bene$t from a favourable movement in
the underlying exchange rates" but not downside protection.
C%!!enc, F%t%!es are one of the derivatives" where exporters and
importers can hedge their positions by selling and buying future
contracts. It provides a means to hedge the trader2s position who
wishes to lock in exchange rates on futures currency transactions. 3y
purchasing /long hedge0 or selling /short hedge0 currency futures"
a $rm can $x the incoming and outgoing cash 1ows in one currency
with respect to others.
He)"in"- is it Necess$!,?
To hedge or not to hedge is thus a very di4cult )uestion. !or
applying any hedging strategy Treasury managers must have correct
answers to these fundamental )uestions.
#ow well he understands and knows the $rms risk exposure.
If identi$ed" would hedging these risks make cash 1ows positive.
%orrect application and timing of hedging strategies must be in
line with exchange rate movement.
If yes" is it possible to hedge these risks ade)uately.
There is of course no 5set of rules2 that can provide perfect hedging
strategies" and thereby guarantees that there would be no wild
1uctuations in company2s cash 1ows. #owever" by using un6
<"
speculative strategies" with the calculation of optimal hedge ratios" one
can hedge its risk.
7dditionally" with the increased volume of international trade and
$nancing" increase in volatility of exchange rates and increased
exposure of foreign exchange gain and losses" hedging foreign
exchange risk has gained importance.
He)"in"- Ho' co%+) it .e Dest!%cti*e?
Speculation and Hedging
8hen speculation is mixed with hedging" it is destructive. There
is a thin line of diference between hedging and speculative activity.
'peculation means dealing in a commodity or $nancial asset with a
view to obtaining pro$t on the prospective changes in the market value
of the item under consideration. It involves contemplation of future
expectations and taking positions to gain" unlike hedging in which
ofsetting positions are taken" but not with the ob9ective of earning a
pro$t. 'peculation involves forecasting the evolution of supply and
demand" i.e. if exchange rate rises" when speculators are long and fall
when they are short" then they gain. They lose when forecasts turn out
to be wrong.
#edgers ofset their risks by taking ofsetting positions, it is
speculators who bear the risk transferred by the hedgers. It is for this
risk borne by them that they get a reward in the form of speculative
pro$ts.
Therefore the nature of speculative activity is such that to earn
speculative rewards" they must bear risk. #edging and speculation are
2E
not similar answers to a problem. They cannot be used
interchangeably for getting desired results or
to meet similar ob9ectives. #edging is a risk management or reducing
techni)ue" where the ob9ective is not to earn pro$ts" unlike
speculation. #edging when mixed with speculation can be disastrous
for the hedger.
/nce!t$int, $n) Risk of Oppo!t%nit, Loss
#ow to strike a balance between uncertainty and the risk of
opportunity loss.
The problem of settling an efective hedge ratio has two dimensions.
:ncertainty; If a $rm does not hedge the transaction" it cannot
know with certainty at what rate of exchange it can lock its
exposures. It could be a better rate or a worse rate.
&pportunity; If $rms enter into hedge transactions like forward
contracts" currency options etc" they would of course be certain
at a rate at which they are locking their exposures. 3ut now they
have taken an in$nite risk of <opportunity2 loss.
Perfect #edge Ratio - 'o construction of an exact opposite position
to the existing risk exposure results" in a perfect hedge" which is a
challenge.
There is yet another dimension to hedging. #edging has a cost. If
the expected risk does not materialise" hedging will prove an
inefective way of doing business. 7ll these complexities associated
with hedging through derivatives pose a great challenge to arrive at a
right #edge ratio.
2
*arious real life instances of how hedging has proved to be
destructive are enumerated alongside.
He)"e!s o0set thei! !isks ., t$kin" o0settin" positions1 it
is spec%+$to!s 'ho .e$! the !isk t!$nsfe!!e) ., the he)"e!s2 It
is fo! this !isk .o!ne ., the3 th$t the, "et $ !e'$!) in the
fo!3 of spec%+$ti*e p!o4ts2 The!efo!e the n$t%!e of spec%+$ti*e
$cti*it, is s%ch th$t to e$!n spec%+$ti*e !e'$!)s- the, 3%st
.e$! !isk2
S/R5E6 RE7ORT
2$
2<
22
2+
8%estione!s Fo! ((S2FOREX275T2LTD
I had visited ((S2FOREX275T2LTD and over there I met (!2 ($hesh
S$n"h*i" who is a manager of the (('.!&R+=.P*T.>TD. (r. (ahesh
helped me answered the few )uestions about forex hedging.
The )uestions answered by him are as follow.
?0 8hat is forex hedging.
#edging is to take a position in futures that @ofsetsA the price
change in the cash assets.
B0 8hich are the derivative instruments used in a forex market.
The instruments used are varied C include !utures" !orwards"
&ptions" 'wps in currency C combination of all of them.
D0 8hy C how does risk arise in a forex transaction.
The perceived volatility of any market" the greater the volatility
greater the risk.
E0 Does the 1uctuations in foreign exchange rate has impact on
forex hedging.
Fes
G0 7ccording to you what are the ma9or bene$t of forex hedging.
Reduce risk
Tax advantages
The proper functioning
>ong6term li)uidity
&pen interest of a !uture market
H0 8hich are the most popular instrument in forex hedging.
2!
!orward
CONCL/SION9
%n contrast to speculation hedging is done to reduce risk. ,ut is this desira/leD %f
everyone hedged, would we not simply end up with an economy in which no one takes
risksD This surely lead to economic stagnancy. Moreover, we must wonder whether
hedging can actually increase shareholder wealth. 3edging is to find a more accepta/le
com/ination of return and risk. There may /e other reasons why firms hedge, such as tax
advantages. *ow5income firms, for example those that are /elow the highest corporate
tax rate, can particularly /enefits from the interaction /eing also reduces the pro/a/ility
of /ankruptcy.
Many firms, such as financial institutions, are constantly trading over5the5counter
financial products like swaps and forwards on /ehalf of their clients. They offer these
services to help their client manage their risk. 3edging also is a tool use to offset the
market &systematic'risk of stock portfolios. Breviously, risk management for common
stocks concentrated on diversification to eliminate unsystematic risk , /ut until futures
and option contracts on stock index futures came into existence there was no effective
means for eliminating most of the systematic risk of a stock portfolio. 3edging is
extremely important for the proper functioning, long5term liquidity, and open interest of a
future markets. Thus, via/le futures contracts are linked to commercial hedging activity.
2#
ILIO"RA:H9
We.sites:<
www.google.com
www.forex.com
oo7s:<
=-! halla *Invest%ents o# %anage%ent+
=isited &:<
))S FOR'> :=T-LTD-

21

43 Forex Hedging

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

43 Forex Hedging

Uploaded by

Copyright:

Available Formats

Forex hedging vehicles

Forex hedging vehicles

Forex hedging vehicles

You might also like