Professional Documents
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TERMINOLOGY IN FOREX
þ Spot
Buying 1 currency for another with immediate delivery. Settlement ² T + 2
þ Forward Outright
Exchange one currency for another on any day after spot (Future date)
* USD/CAD is an exception
þ Tick
The minimum trading increment or price differential at which traders are able to enter bids and offers
þ USD-INR : Tick size shall be 0.25 paise or 0.0025 Rupee.
E.g. If a trader buys a contract @ Rs. 42.2500 & USD 1000 being value of the contract
ë One tick movement will translate to Rs. 42.2475 or 42.2525
ë Value on each contact = Rs. 2.50 (1000 * 0.0025)
TERMINOLOGY«
þ BaseCurrency ² 1st currency in currency pair
þ Term Currency ² 2nd currency
E.g. USD-INR: Dollar quoted in rupee terms
þ Strengthening/Weakening ² change in value of 1
currency vis-a-vis other
When base buys more of term ² base has
strengthened/appreciated
E.g. USD-INR moves from 43 to 43.25 - $ appreciated
þ Exchange rate ² Price
The number of units of one nation·s currency that must be
surrendered in order to acquire one unit of another nation·s
currency.
Market price determined by demand-supply of that currency
TERMINOLOGY«
þ Contract cycle
þ Value Date/Final Settlement Date
þ Expiry date
þ Cost of carry
þ Initial margin
þ Marking to market
MAJOR CURRENCIES IN THE WORLD
þ USD, EUR, GBP, JPY, Swiss franc etc.
INTRODUCTION - DERIVATIVES
þ Derivative is a product K
,
called bases (underlying asset, index, or
reference rate), in a contractual manner.
þ Derivatives are synthetic instruments
þ Asset classes range from financial instruments
to commodities to even classes such as weather
and industrial effluents
þ Underlying theme of derivatives - leveraged
products
þ Derivatives are not always priced at respective
asset value (fair value)
UNDERLYING ASSET CLASS
Underlying Asset
Class
F = S (1 + p )
PRICING OF FUTURES
Forward rate - A function of the spot rate and the interest rate
differential between the two currencies, adjusted for time.
PARTICIPANTS
þ Speculators
þ Hedgers
þ Arbitragers
SPECULATION: LONG FUTURE
SPECULATION: SHORT FUTURE
HEDGING
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þ Long hedge:
þ Short hedge:
Underlying position: long in the foreign currency
Hedging position: short in currency futures
Corporate Hedging
LONG HEDGE
LONG HEDGE«
SHORT HEDGE
SHORT HEDGE«
TRADING SPREADS USING CURRENCY
FUTURES
þ Spread refers to difference in prices of two futures contracts.
þ Spread movement is based on following factors:
ë Interest Rate Differentials
ë Liquidity in Banking System
ë Monetary Policy Decisions (Repo, Reverse Repo and CRR)
ë Inflation
þ "6m"*&7
-: An intra-currency pair spread
consists of one long futures and one short futures contract.
Both have the same underlying but different maturities.
þ "6m"*&7
-: An inter²currency pair spread
is a long-short position in futures on different underlying
currency pairs. Both typically have the same maturity.
INTER-COMMODITY SPREAD
þ On Feb 12th
m8
8
-
m8
Spot 0.6642 0.6028 1.1019
March 0.6689 0.6050 1.1056
June 0.6632 0.5972 1.1105
September 0.6595 0.5897 1.1184
âRates imply Australian dollar to depreciate against Canadian dollar
over coming 7 months
âSpeculator views that AUD is undervalued relative to CAD
âTo profit: Buy cheap and sell dear
âBuy 1 September AUD contract @ 0.5897/AUD
â Sell 1 September CAD contract @ 0.6595/CAD
âSpread: 0.0698(=0.6595-0.5897)
INTER-COMMODITY SPREAD«
þ On Sep 10th : m8
8
-
m8
Spot 0.6475 0.5815 1.1118
Reverses theSeptember
0.6441 0.5795 1.1115
â position:
â Sell 1 September AUD contract @ 0.5795/AUD
â Buy 1 September CAD contract @ 0.6441/CAD
&9
m
Sold at 0.5795 0.6595
Bought at 0.5897 0.6441
Net -0.0102 +0.0154
Overall gain is $(125000 * 0.0052) = $650
Spread: 0.0646(=0.6441-0.5795) «.narrowed
INTER-COMMODITY SPREAD«
â On Sep 10th : m8
8
September 0.6685 0.5965
&9
m
Sold at 0.5965 0.6595
Bought at 0.5897 0.6685
Net +0.0068 -0.0090
Overall loss is $(125000 * 0.0022) = $275
Spread: 0.0720(=0.6685-0.5965) «widened
INTRA-CURRENCY PAIR SPREAD
þ On Sep 08
ë USD appreciates from current quotes i.e. spread widen
ë Buys December currency future @ 47.00
ë Sells October futures @ 46.80
ë Spread: 0.20
INTRODUCTION
Currency options are contracts that give the buyer the right, but not the
obligation, to buy or sell one currency against the other, at a
predetermined price and on or before a predetermined date
Category of Options:
â Call Option
â Put Option
Type of Options:
â American Option
âEuropean Option
In-the-money Out-of-money
At-the-money
(PROFIT) (LOSS)
âIntrinsic Value:
how much you could get from exercising the option immediately
the amount it is ITM
Call= St-X Put= X-St
âTime Value :
difference between premium & intrinsic value
Call= C- Max(0,St-X) Put= P- Max(0,X-St)
CURRENCY OPTIONS IN INDIA
â Started from July 7, 2003
â OTC Product
â Customers can only purchase call or put options & is not allowed to write
options
â Customers can also enter into packaged products involving cost reduction
structures provided the structure does not increase the underlying risk and
does not involve customers receiving net premium
Combination
Normal Strategy
Strategy
:
8
+&
Spot (S) = INR/USD = 43 S > K ² Buyer exercises the Option
:
8
+&
m 7 7 7
- * *
"8:
Spot (S) = INR/USD = 46 S > K1 ² Buyer Exercises
-
the Put Option & call
Strike (K1) put = INR/USD Option exercises without 44 0 0.3 -1 0.2 0.1 -1.1
= 45 value
45 0 0.3 0 0.2 0.1 -0.1
Strike (K2) call = INR/USD S is between K1 & K2 ²
= 47 Both Option Expires 46 0 0.3 0 0.2 0.1 -0.1
without value
47 0 0.3 0 0.2 0.1 -0.1
Expiry = Dt of Payment =
3mth 48 1 0.3 0 0.2 0.1 0.9
Amount = USD 1000 S < K2 ²Call Option 49 2 0.3 0 0.2 0.1 1.9
Exercises & the Put Option
Premium (Call) = 0.3/USD
exercises without any
Premium (Put) = 0.2/USD value.
LONG STRADDLE :
Buy a Put & Buy a Call with the same Strike , same Maturity & same
Amount
:
8
+&
m 7 7 7
- 7- *
"8:
Spot (S) = INR/USD = 46 S > K ² Exercise the Call
Option & Put Option
exercises without value 44. 0 0.3 1 0.2 0.5 0.5
5
Strike (K) = INR/USD = S = K ² Option Expires
45.5 without value 46 0.5 0.3 0 0.2 0.5 0
Expiry = Dt of Payment = 46. 1 0.3 0 0.2 0.5 0.5
3mth 5
Amount = USD 1000 S < K ²Call Option 47 1.5 0.3 0 0.2 0.5 1
Exercises without value &
Premium (Call) = 0.3/USD
the Put Option is exercised 47. 2 0.3 0 0.2 0.5 1.5
Premium (Put) = 0.2/USD 5
LONG STRANGLE :
Buy a Put & Buy a Call with the Different Strike , but same Maturity &
same Amount
:
8
+&
m 7 7 7
Spot (S) = INR/USD = 46 S > K1 ² Exercises the Call - * *
"8:
Option & Put Option -
Strike (K1) put = INR/USD exercises without value 44 0 0.3 1 0.2 0.5 0.5
= 45
S is between K1 & K2 ² 45 0 0.3 0 0.2 0.5 -0.5
Strike (K2) call = INR/USD
= 47 Both Option Expires
46 0 0.3 0 0.2 0.5 -0.5
without value
47 0 0.3 0 0.2 0.5 -0.5
Expiry = Dt of Payment =
3mth 48 1 0.3 0 0.2 0.5 0.5
Amount = USD 1000 S < K2 ²Put Option
49 2 0.3 0 0.2 0.5 1.5
Exercises & the Call Option
Premium (Call) = 0.3/USD
exercises without any
Premium (Put) = 0.2/USD value.
DELTA HEDGING
DELTA:
It is the measure of how the value of an option changes with respect to
changes in the value of the underlying contract
DELTA NEUTRAL:
â Total Delta (sum of all delta) Position of the portfolio is zero
âPortfolio position unbiased in terms of direction of any price movement of
the underlying contract
FORMULA
â Delta of Call= N(d1)
â Delta of Put= N(d1) - 1
EXOTIC OPTIONS
â Knock-Out Options
These are like standard options except that they extinguish or cease to
exist if the underlying market reaches a pre-determined level during the
life of the option. The knockout component generally makes them cheaper
than a standard Call or Put.
â Knock-in Options
These options are the reverse of knockout options because they don't come
into existence until the underlying market reaches a certain
predetermined level, at this time a Call or Put option comes into life and
takes on all the usual characteristics.
â Binary option
pays a lump sum of cash if the option is in-the- money at expiration
$!
CURRENCY SWAPS
þ The usual motivation for a currency swap is to
replace cash flows scheduled in an undesired
currency with flows in a desired currency.
þ The desired currency is probably the currency in
which the firm·s future operating revenues (inflows)
will be generated.
þ 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).
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CURRENCY SWAPS
þ + 9 Suppose a U.S. MNC, m
"&, wants to
finance a £10,000,000 expansion of a British plant.
â They could borrow dollars in the U.S. where they
are well known and exchange dollars for pounds.
This results in exchange rate risk, OR
â They could borrow pounds in the international bond
market, but pay a lot since they are not well known
abroad.
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EXAMPLE CONTD«
þ If m
"& can find a British MNC with a mirror-
image financing need, both companies may benefit from
a swap.
$$
EXAMPLE CONTD«
þ Company A is the U.S.-based MNC and
Company B is a U.K.-based MNC.
þ Both firms wish to finance a project of the same
size in each other·s country (worth £10,000,000
or $16,000,000 as S = 1.60 $/£). Their borrowing
opportunities are given below.
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COMPARATIVE ADVANTAGE«
â Ê is the more credit-worthy of the two.
â Ê pays 2% less to borrow in dollars than h
â Ê pays 0.4% less to borrow in pounds than h
â hhas a comparative advantage in borrowing in £.
â h pays 2% more to borrow in dollars than Ê
â h pays only 0.4% more to borrow in pounds than Ê
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POTENTIAL SAVINGS..
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EXAMPLE CONTD«
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CROSS CURRENCY SWAPTION
Swaption allowing one party the right to buy or
sell a cross-currency swap on a given date under
which a pre-agreed fixed or floating rate in one
currency is exchangeable for a floating or fixed
rate in another.
Uses:
To hedge a dual currency bond which offered the
investor the right to seek repayment
or conversion in the second currency
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CREDIT DERIVATIVES
þ Credit derivative can be defined as ´
arrangement that allows one party
(protection buyer or originator) to
transfer, for a premium ,the defined
credit risk , or all the credit risk ,
computed with reference to a
notional value , of a reference asset
or assets, which it may or may not
own, to one or more other parties
(the protection sellers).
þ 7
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wants to transfer the credit risk
þ 7
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" 6 The Party who
provides protection against the risk.
Funded Credit Unfunded
Credit
Derivatives Derivatives
Credit Credit
Linked Note Default Swap
Credit Spread
Option
CREDIT DEFAULT SWAP
þ This is a bilateral contract in which a periodic
fixed fee or premium is paid to a protection seller,
in return for which the seller will make a
payment on the occurrence of a specified credit
event.
þ Being structured, the CDS enables one party to
transfer its credit exposure to another party.
þ The maturity of the default swap does not have
to match with the maturity of reference asset.
EXAMPLE
5-year credit default swap, Notional Principal: $100 million,
buyer will pay $9,00,000 every year till life of contract or credit
event whichever is earlier.
Asset 1
Tranche 1
Asset 2 (equity)
Principal:$5
Asset 3 million
Return: 30%
Tranche 2
SPV (mezzanine)
Principal: $20
Asset n million
Return: 10%
Total
principal Tranche 3
$100 million (senior)
Principal: $75
million
Return: 6%
COLLATERAL DEBT OBLIGATION
´An investment-grade security backed by a pool of
bonds, loans and other assets.µCDOs are unique
they represent different types of debt and credit risk.
In the case of CDOs, these different types of debt are
often referred to as 'tranches' or 'slices¶.
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CREDIT-LINKED NOTES
þ The issuer receives the issue price for each CLN from
the investor and invests this in low-risk collateral.
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Underlying USD-INR
Expiry Day 2 working days prior to last working day of the expiry
month
Final Settlement Day Last working day (excld Saturdays) of the contract
month
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