Forex Market

Forex Market

FOREX MARKET

The foreign exchange market is the market where the currency of one

country is exchanged for that of another country and where the rate of

exchange is determined. The genesis of Foreign Exchange (FE) market

can be traced to the need for foreign currencies arising from:

International trade;

Foreign investment; and

Lending to and borrowing from foreigners.

In order to maintain an equilibrium in the FE market, demand for foreign

currency (or the supply of home currency) should equal supply of foreign

currency (or the demand for home currency). In operational terms, the

demand for an supply of home currency should be equal. In the event of a

disequilibrium venues/steps in the bring out the desired balance by:

Variation in the exchange rate; or

Changes in official reserves; or

both.

Participants in the FE market

Major participants in the FE market are :

Large commercial banks (through their campsites or dealers) operating

either at retail level for individual exporters and corporations, or at

wholesale level in the interbank market;

Central banks of various countries that intervene in order to maintain or

to influence the exchange rate of their currencies within a certain range,

and also to execute the orders of government;

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Forex Market

Individual brokers or corporations. Bank dealers often use brokers to

stay anonymous since the identity of banks can influence short-term

quotes.

Exchange markets primarily function through telephone and telex.

Currencies with limited convertibility play a minor role in the FE market.

And, only a small number of countries have established full convertibility of

their currencies for all transactions.

Foreign exchange rates are quoted either for immediate delivery (spot rate)

or for delivery on a future date (forward rate). In practice, delivery in spot

market is made two days later.

A FE quotation is the price of a currency expressed in the units of another

currency. The quotation can be either direct or indirect. It is direct when

quoted as “so many units of local currency per unit of foreign currency”. For

example, Rs. 35 = US$ 1, is direct quotation for US dollars in India.

Similarly, a quotation in the USA will be $ 0.22 = Ffr1 whereas in France, it

would be Ffr 3.3 = DM 1, etc.

On the other hand, an indirect quotation is the one where exchange rate is

given in terms of variable units of foreign currency as equivalent to a fixed

number of units of home currency. For example, in India, US$ 2.857 = Rs.

100 is an indirect quotation. This type of quotation is made in the UK. For

example, in London a quotation may be made a $ 1.55 = £ 1.

Since 1 August 1993, all quotations in India use the direct method of

quotation. Some currencies are quote as so many rupees against one unit

while others as so many rupees against 100 units.

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Forex Market

Foreign Currencies Quoted against their one Unit

1. Australian dollar

(A$)

10. Finnish mark (FM) 19. Qatar riyal

2. Austrian schilling

*Sch)

11. French franc (Ffr) 20. Saudi riyal (SR)

3. Bahrain dinar 12. Hong Kong dollar

(HK$)

21. Singapore dollar

(S$)

4. Canadian dollar

(Can$)

13. Irish pound (I£) 22. Sterling pound (£)

5. Danish kroner (Dkr) 14. Kuwaiti dinar 23. Swadish knroner

(Skr)

6. Deutschmarket

(DM)

15. Malaysian ringgit 24. Swiss franc (Sfr)

7. Dutch guilder (F1) 16. New Zealand dollar

NZ$)

25. Thai baht (Bt)

8. Egyptian pount 17. Norwegian kroner

Nkr)

26. UAE Dihram

9. European Currency

Unit (ECU)

18. Omani riyal 27. US Dollar ($)

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Forex Market

Foreign Currencies Quoted against their 100 Units

1. Belgian franc (BFr) 3. Italian lira 5. Kenyan shilling

2. Burmese kyat 4. Japanese yen 6. Spanish peseta

Asian Clearing Union Currencies Quoted against their 100 Units

1. Bangladesh take 3. Iranian riyal 5. Sri Lanka rupee

2. Burmese kyat Pakistani rupee

Foreign exchange rates are always quoted a two-way price, i.e. a rate at

which the bank (dealer) is willing to buy foreign currency (buying rate) or

bid price and a rate at which the bank sells foreign currency (selling rate or

bank price). Dealers do expect, some profit in exchange operations and

hence there is always some difference in buying and selling rates.

However, the maximum spread available to dealers may be restricted by

their central bank. All exchange rates by authorized dealers are quoted in

terms of their capacity as buyer or seller.

Spread means the difference between a bank’s (bid) and selling (offer or

ask) rates in an exchange rate quotation or an interest quotation. It

fluctuates according to the level of stability in the market, the currency in

question, and the volume of the business. Thus, if there is a degree of

volatility in an exchange rate, and if business to be unsustainable, the

dealer will protect himself by widening the quote. That is, he will offer less

currency while selling currency while selling but demand more when buying

. The spread represents the gross return to the dealer of the risks inherent

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Forex Market

in “making a market”. The spread can also be expressed as a percentage.

That is,

Per cent SpreadAsk price Bid price

Ask priceX

100

Cross rate : is the price of any currency other than the home currency. In

other words, it is the direct relationship between two non-home currencies

in a foreign exchange market concerned with or used in transactions in a

country to which none of the currencies belongs. Thus, in India, a cross

rate is any exchange rate which excludes rupees, for example, US$/FFr,

DM/BFr, etc.

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Financial ‘risk’ or ‘exposure’ : can be defined as sensitivity to any

outcome which could alter the valuation of assets or liabilities on an entity’s

balance sheet.

Given the interlinkages in any economic system, business entities are

exposed to risks arising from diverse parts of the national and international

economies.

Ideally, however, an economic entity should only be exposed to those ‘risk’

that are intrinsic to its core businesses since its ‘returns’ accrue from these

core activities.

Risk Management ...

Thus it is necessary to ‘manage’ the total risk to which a

corporate/institution is exposed, in order to eliminate ‘unwanted’ risk.

Managing away ‘unwanted’ risk involves setting up ‘hedge’ positions, which

essentially offset the cashflows arising from the ‘unwanted’ exposure, thus

neutralising the potential of the latter to affect the balance sheet.

Exchange rate risk (ERR) : is inherent in the business of all multinational

enterprises as they are to make or receive payments in foreign currencies.

This risk means eventual lossed incurred by these enterprises due to

adverse movements of exchange rates between the dates of contract and

payment However, ERR does not imply that it will result into losses only.

Gains may also accrue if the movement of rates is favourable. Thus the

appreciation of dollar in 1985, for example, was beneficial for those

enterprises that exported to the USA and billed in US dollars. Conversely,

the American companies exporting outside and billion in other currencies

suffered losses. Similarly, the depreciation of US dollar in 1995 caused

losses to the non-USA companies whose exports were billed in US dollars

and proved profitable for the USA companies exporting and billing in non-

US dollar currencies.

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Forex Market

In view of the substantial and significant stake in foreign countries, foreign

exchange risk has become an integral part of the management must be

aware of the various techniques of dealing with ERR. Covering the foreign

exchange risk is also known as hedging the risk. If a company in its wisdom

does not want to hedge, it tantamounts to have the view that the future

movements of exchange rates will be in its favour. On the contrary, the

conservative enterprises may adopt the policy of hedging everything.

Hedging decision : companies are constantly confronted with the decision

of whether to hedge future payables and receivebles in foreign currencies.

Whether a firm hedges may be determined by its forecasts of foreign

currency values.

Short-term financing decision : When large corporations borrow, they

have access to several different currencies. The currency they borrow will

ideally (1) exhibit a low interest rate and (2) weaken in value over the

financing period.

Short-term investment decision : Corporations sometimes have a

substantial amount of excess cash available for a short term. Large

deposits can be established in several currencies. The ideal currency for

deposits would (1) exhibit a high interest rate and (2) strengthen in value

over the investment period.

Capital budgeting decision : When a Company attempts to determine

whether to establish a subsidiary in a given country, a capital budgeting

analysis is conducted. Forecasts of the future cash flows used within the

capital budgeting process will be dependent on future currency values.

This dependency can be due to (1) future inflows or outflows denominated

in foreign currencies that will require conversion to the home currency and /

or (2) the influence of future exchange rates on demand for the

corporation’s products. There are several additional ways by which

exchange rates can affect the estimated cash flows, but the main point

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Forex Market

here is that accurate forecasts of currency values will improve the

estimates of the cash flows, and therefore enhance the company decision-

making abilities.

Long-term financing decision : Corporations that issue bonds to secure

long-term funds may consider denominating the bonds in foreign

currencies. As with short-term financing, corporations would prefer the

currency borrowed to depreciate over time against the currency they are

receiving from sales. To estimate the cost of issuing bonds denominated in

a foreign currency, forecasts of exchange rates are required.

Earnings assessment : When earnings of a company are reported,

subsidiary earnings are consolidated and translated into the currency

representing the parent firm’s home country. For example, consider a

comapny with its home office in the United State and subsidiaries in

Switzerland and Great Britain. The Swiss subsidiary’s earnings in Swiss

francs must be measured by translation to US dollars. The British

subsidiary’s earnings in pounds must also be measured by translation to

US dollars. “Translation” does not suggest that the earnings are physical

converted to US dollars. It is simply a recording process to periodically

report consolidated earnings in a single currency. Using the scenario just

described, appreciation of the Swiss franc will boost the Swiss subsidiary’s

earnings when reported in (translated to )US dollars.

Why Exchange Rate Risk is Relevant

Volatile foreign earnings can also cause more volatile growth and

downsizing cycles within a firm, which is more costly than slow stable

growth. Hedging can reduce the firm’s volatility of cash flows because the

firm’s payments and receipts are not forced to fluctuate in accordance with

currency movements. This can reduce the possibility of bankruptcy, which

allows the firm easier access to credit from creditors or suppliers, and may

allow the firm to borrow at lower interest rates (because the perceived risk

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Forex Market

is lower). Hedging may also allow the firm to more accurately forecast

future payments and receipts, which can enhance its cash budgeting

decisions.

Exchange rates cannot be forecasted with perfect accuracy, but the firms

can at least measure its exposure to exchange rate fluctuations. If the firm

is highly exposed to exchange rate fluctuations, it can consider techniques

to reduce its exposure in the following chapter. Before choosing these

techniques, the firm should first measure its degree of exposure.

Exposure to exchange rate fluctuations comes in three forms :

Transaction exposure

Economic exposure

Translation exposure.

Transaction Exposure

The value of a firm’s cash inflows received in various currencies will be

affected by respective exchange rates of these currencies when converted

into the currency desired. Similarly, the value of a firm’s cash outflows in

various currencies will be dependent on the respective exchange rates of

these currencies. The degree to which the value of future cash transitions

can be affected by exchange rate fluctuations in referred to as transactions

can be affected by exchange rate fluctuations is referred to as transaction

exposure.

Two steps are involved in measuring transaction exposure: (1) determining

the projected net amount of inflows or outflows in each foreign currency,

and (2) determining the overall risk of exposure to those currencies.

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Transaction exposure based on currency correlations

Measurement of Currency Correlations : The Correlations among

currency movement can be measured by their correlation coefficients,

which indicate the degree to which two currencies move in relation to each

other. thus, MNCs could use such information when deciding their degree

of transaction exposure. The extreme case is perfect positive correlation,

which is represented by a correlation coefficient equal to 1.00. Correlations

can also be negative, reflection an inverse relationship between individual

movements, the extreme case being - 1.00.

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Economic Exposure

The degree to which a firm’s present value of future cash flows can be influenced by exchange rate

fluctuations is referred to as economic exposure to exchange rates. Transaction exposure is a subset

of economic exposure. However, the influence of exchange rate fluctuations on a firm’s cash flows

is not always due to transaction of currencies.

Economic Exposure to Exchange Rate Fluctuations

Variables That Influence the

Firms’s Local Currency Inflows

Impact of Local

Currency Appreciation

on Variables

Impact of Local

Currency Depreciation

on Variables

Local sales (relative to foreign

competition in local markets)

Decrease Increase

Firm’s exports denominated in

local currency

Decrease Increase

Firm’s exports denominated in

foreign currency

Decrease Increase

Interest received from foreign

investments

Decrease Increase

Variables That Influence the Firm’s Local Currency Outflows

Firm’s imported supplies

denominated in local currency

No Change No Change

Firm’s imported supplies

denominated in foreign currency

Decrease Increase

Interest owed on foreign funds

borrowed

Decrease Increase

The economic exposure refers to the change in expected cash flows as a

result of an unexpected change in exchange rates. For example, an

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American exporter who operates in French market can increase his market

share merely by reducing the French Company which is a potential

competitor to the American firm can profit indirectly from currency losses of

the American company. Thus it can be se en that though the French

company is not directly exporting but business competition can be

generated on account of the strength of the currency of competitors, which

can be termed as economic exposure. Economic risks cannot be managed

as they are not reported in accounts, are difficult to quantify and perhaps

unhedgable.

Translation Exposure

The exposure of the MNC’s consolidated financial statements to exchange

rate fluctuations is known as translation exposure. For example, if the

assets or liabilities of the MNC’s subsidiaries are translated at something

other than historical exchange rates, the balance sheet will be affected by

fluctuations in currency values over time. In addition, subsidiary earnings

translated into the reporting currency on the consolidated income

statement are subject to changing exchange rates.

Determinates of Translation Exposure

Translation exposure is dependent on

The degree of foreign involvement by foreign subsidiaries

The locations of foreign subsidiaries

The accounting methods used.

Degree of Foreign Involvement : The greater the percentage of an

MNC’s business conducted by its foreign subsidiaries, the larger will be the

percentage of a give financial statement item that is susceptible to

translation exposure.

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Locations of Foreign Subsidiaries : The locations of the subsidiaries can

also influence the degree of translation exposure, since the financial

statement items of each subsidiary are typically measured by the country’s

home currency.

Accounting Methods : Degree of accounting exposure can be greatly

affected by the accounting procedures it uses to translate when

consolidating financial statement data.

Transaction exposure : exists when the future cash transactions of a firm

are affected by exchange rate fluctuations. For example, a US firm that

purchases German goods may need marks to buy the goods. While it may

know exactly how many marks it will need, it doesn’t know how many

dollars will be needed to be exchanged for those marks. This uncertainly

occurs because the exchange rate between marks and dollars fluctuates

over time. Also consider a US - based MNC that will be receiving a foreign

currency. Its future receivebles are exposed since it is uncertain of the

dollars it will obtain when exchanging the foreign currency received.

If transaction exposure does exist, the firm faces three major tasks. First it

must identify the degree of transaction exposure. Second, it must decide

whether to hedge this exposure. Finally, if it decides to hedge part or all of

the exposure it must choose among the various hedging techniques

available.

Identifying Net Transaction Exposure

Before the MNC makes any decision related to hedging, it should identify

the individual net reansaction exposure on a currency-by-currency basis.

The term “net” here refers to the consolidation of all expected inflows and

outflows for a particular time and currency. The management at each

subsidiary plays a vital role in the process of reporting its expected inflows

and outflows. Then a centralized group consolidates subsidiary reports in

order to identify for the MNC as a whole, the expected net positions in each

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foreign currency during several upcoming periods. The MNC can identify its

exposure by reviewing this consolidation of subsidiary positions.

Is Hedging Worthwhile?

If a firm decides to hedge its periodic future payables denominated in a

foreign currency. The forward contract is a common heeding device against

this foreign currency position. If the spot rate in the future exceeds today’s

forward rate, then the company will save money by hedging its net

payables (as opposed to no hedge). If the spot rate in the future is less

than today’s forward rate, then the company will lose money by hedgings

its net payables. A forward rate that serves as an unbiased forecast of the

future spot rate will underestimate and overestimate the future sport rate

with equal frequency. In this case periodic hedging with the forward rate

will be more costly in some periods and less costly in other periods. On the

average, it will not reduce the company cost. Thus it could be argued that

hedging is not worth while.

If the company choose to hedge only in those situations in which they

expect the currency to move in a direction that will make hedging feasible.

That is they may hedge future payables that they foresee appreciation in

the currency denominating the payables. In addition they my hedge future

receivables if they forsee depreciation in the currency denominating the

receivables.

In general, decisions on whether to hedge, how much to hedge, and how to

hedge will vary with the company management’s degree of risk aversion,

and its forecasts of exchange rates. companies that are more conservative

tend to hedge more of their exposure.

Most company do not perceive their foreign exchange management as a

profit center. The main responsibility is to (1) measure the potential

exposure to exchange rate movements, which is necessary to assess the

risk (2) determine whether the exposure should be hedged, and (3)

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determine how the exposure should be hedged, if at all. Thus is normally

inappropriate for the foreign exchange management group to set a profit

goal, as it may even use some hedges that will likely result in slightly worse

outcomes than no hedges at all, just to avoid the possibility of a major

adverse movement in exchange rates.

Techniques to Eliminate Transaction Exposure

If the company decides to hedge part or all of its transaction exposure, it

may select from the following hedging techniques :

Future hedge

Forward hedge

Money market hedge

Currency option hedge.

Futures Hedge

Currency futures can be used by firms that desire to hedge transaction

exposure. A futures contract hedge is very similar to that of a forward

contract except that forward contracts are common for large transactions,

whereas futures contracts may be more appropriate for firms that prefer to

hedge in smaller amount.

A firm that buys a currency futures contract is entitled to receive a specified

amount in a specified currency for a stated price on a specified date. To

hedge payment on future payables in a foreign currency, the firm may

desire to purchase a currency futures contract representing the currency it

will need in the near future. By holding this contract, it locks in the amount

of its home currency needed to make payment on the payables,.

While currency futures can reduce the firm’s transaction exposure, they

sometimes backfire on the firm. If the firm is hedging payables the locked in

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futures price for the currency could end up being higher than the future

spot rate of the currency (if the currency depreciates over time). If the firm

expected the currency’s value to depreciate by the time it would need to

make payment, it would not purchase a currency futures contract.

A firm that sells a currency futures contract is entitled to sell a specified

amount in a specified currency for a stated price on a specified data. To

hedge the home currency value of future receivable in a foreign currency,

the firm may desire to sell a currency future receivable in a foreign

currency, the firm may desire to sell a currency futures contract

representing the currency it will be receiving. This way the firm knows how

much of its home currency it will receive after converting the foreign

currency, it insulates the value of its future receivables from the fluctuations

in the foreign currency’s spot rate over time.

Forward Hedge

Forward contracts are commonly used by large corporations that desire to

hedge. To use the forward contract hedge, the MNC purchases that

currency denominating the payables forward. For example, if a US - based

MNC must pay a Swiss supplier 1,000,000 francs in 30 day, it can re quest

from a bank a forward contract to accommodate this future payment. The

bank agrees to provide the Swiss francs to the MNC in 30 days in

exchange for US dollars. The MNC hedges its position by locking in the

rates it will pay for Swiss francs in 30 days. Thus, it now knows the number

of dollars it will need to exchange for francs.

If the US - based MNC expects receivable in Swiss francs in 30 days, it

would like to lock in the rate at which it can sell these francs for dollars. In

this case, a request for a forward sale of Swiss francs is appropriate. Many

MNCs commonly implement the forward hedging technique. For example,

Du Pont Company often has the equivalent of $ 300 million to $ 500 million

in forward contracts at any one time, to cover open currency positions.

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Money Market Hedge

A money market hedge involves taking a money market position to cover a

future payables or receivable position.

Currency Option Hedge

Firms recognize that hedging techniques such as the forward hedge and

money market hedge can backfire when a payables currency depreciates

or a receivable currency appreciates over the hedged period. In these

situations, an unhedged strategy would likely outperform the forward hedge

or money market hedge. The ideal type of hedge would insulate the firm

against adverse exchange rate movements but allow the firm to benefit

from favourable exchange rate movement. Currency options exhibit these

attributes. However, a firm must assess whether the advantages of a

currency option hedge are worth the price (premium) paid for it.

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Review or Techniques for Hedging Transaction Exposure

Hedging Technique To Hedge Payables To Hedge Receivable

1. Futures hedge Purchase a currency

futures contract (or

contracts) representing the

currency and amount

related to the payables.

Sell a currency futures contract

(or contracts) representing the

currency and amount related to

the reveivables.

2. Forward hedge Purchase a forward

contract representing the

currency and amount

related to the payables

Sell a forward contract

representing the currency and

amount related to the

receibvables.

3. Money market

hedge

Borrow local currency and

convert to currency

denominating payables

Invest these funds until they

are needed to cover the

payables.

Borrow the currency

denominating the receivable,

convert it to the local currency,

and invest it. Then pay off the

loan with cash inflows from the

receivable.

4. Currency option

hedge

Purchase a currency call

option (or options)

representing the currency

and amount related to the

payables.

Purchase a currency put option

(or options) representing the

currency and amount related to

the receivables.

Hedging Performance of Currency Options Versus Forwards

A recent study by Madura simulated a process of hedging a position in

each of five major currencies, to study the effectiveness of hedging with

currency options as opposed to forward contracts in each quarter. The

study was conducted first from the perspective of a US importing firm and

then from that of US exporting firm. From the importer’s perspective the

results were mixed. In some quarters the importer would have been better

off with currency call options, while in other quarters the forward purchase

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would have been preferable. Of course the superiority of one technique

over another would not have been determined until after the periods were

over. On average, there was no significant difference in the amount paid of

imports between hedging with currency call options and doing so with

forward purchases. This result held for each of the five currencies. From

the US exporter’s perspective, there was on average no significant

difference between using currency put options and using forward sales to

hedge receivable for four of the currencies . For the Japanese yen the

dollar value of the receivable was significantly higher when using put

options than it was when using put options than it was when using for -

ward sales.

A comparison was also conducted between currency options and an

unheeded strategy. From an importer’s perspective, there was no

significant difference on average in the amount paid between using

currency call options and using an unheeded strategy. On exception was

the German mark, in which the unheeded strategy was superior.

From an exporter’s perspective there was no significant difference on

average in the amount received between hedging with currency put options

and using an unheeded strategy. One exception was the British pound, in

which the unheeded strategy and superior.

Overall, currency options generally performed about as well as for ward

contracts or the unheeded strategy, and they may alleviate any convernms

managers have about exchange rate movements. Further-more they offer

the opportunity to benefit if exchange rates move in a favorable direction.

The results of this study suggest that currency options should be given

serious consideration.

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Hedging Long - Term Transaction Exposure

For firms that can acurately estimate foreign currency payables or

receivables that will occur several years from now, there are three

commonly used techniques to hedge such long-term transaction

exposure :

Long-term forward contract

Currency swap

Parallel loan.

Long-Term Forward Contract

Most large international banks routinely quote forward rates for terms of up

to five years for British pounds, Canadian dollars, German marks, and

Swiss francs. Long forwards are especially attractive to firms that have

set up fixed-price exporting or importing contracts over a long period of

time and want to protect their cash flow from exchange rate fluctuations.

Currency Swap

A currency swap is a second technique for hedging long-term transaction

exposure to exchange rate fluctuations. It can take many forms. One type

of currency swap accommodates two firms that have different long-term

needs. Consider a US firm, hired to build an oil pipeline in Great Britain that

expects to receive payment in British pounds in five years when the job is

completed. At the same time, a British firm is hired by a US bank for a long-

term consulting project. Assume that payment to this British firm will be in

US dollars and that much of the payment will occur in five years. The US

firm will be receiving British pounds in five years and the British firms will be

receiving US dollars in five years. These two firms could range a currency

swap that allows for an exchange of pounds for dollars in five years at

some negotiated exchange of pounds for dollars in five years at some

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negotiated exchange rate. In this way, the US firm could lock in the number

of US dollars the British pound payment will convert to in five years.

Likewise, the British firm could lock in the number of British pounds the US

dollar payments will convert to in five years.

To create a currency swap, firms need to find other firms that can

accommodate their needs. There are brokers employed by large banks and

investment firms that act as middlemen for swaps. They are notified by

those corporations that want to eliminate transaction exposure to specific

currencies at certain future dates. Using this information, they can match

up firms when one firms needs the currency the other firms wants to

dispose of (and vice versa). The brokers receive a fee for their service.

Parallel Loan

A parallel loan (or “back-to-back loan”) involves an exchange of currencies

between two parties, with a promise to re-exchange currencies at a

specified exchange rate and future date. It represents two swaps of

currencies, one swap at the inception of the loan contract and another

swap at the specified future date. A parallel loan is interpreted by

accountants as a loan and is therefore recorded on financial statements.

ALTERNATIVE HEDGING TECHNIQUES

When a perfect hedge is not available (or is too expensive) to eliminate

transaction exposure, the firm should consider methods to at least reduce

exposure. Such methods include

Leading and Lagging

Cross-hedging

Currency diversification

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Leading and Lagging

The act of leading and lagging represents an adjustment in the timing of

payment request or disbursement to reflect expectations about future

currency movements. For example, consider a multinational corporation

based in the United State that has subsidiaries dispersed around the world.

The focus here will be on a subsidiary in Great Britain that purchases some

of its supplies from a subsidiary in Germany. Assume these supplies are

denominated in German marks. If the British subsidiary expects the pound

will soon depreciate against the mark, it may attempt to accelerate the

timing of its payment before the pound depreciates. This strategy is

referred to as leading.

As a second possibility, consider a scenario in which the British subsidiary

expects the pound will soon appreciate against the mark. In this case, the

British subsidiary may attempt to stall its payment until after the pound

appreciates. In this way it could use fewer pounds to obtain the marks

needed for payment. This strategy is referred to as lagging. General

Electric and other well-known MNCs commonly use leading and lagging

strategies in countries that allow them.

Cross-hedging

Cross-hedging is a common method of reducing transaction exposure

when the currency cannot be hedged. Assume a US firm has payables in

Currency X 90 days from now. Because it is worried that Currency X may

appreciate against the US dollar, it may desire to hedge this position. If

forward contracts and the other hedging techniques are not possible for

this currency the firm may consider cross-hedging in which case it needs to

first identify a currency that can be hedged and is highly correlated with

Currency X. It could then set up a 90-day forward contract on this currency.

If two currencies are highly correlated relative to the US dollar (that is, they

move in a similar direction against the US dollar), then the exchange rate

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Forex Market

between these two currencies should be somewhat stable over time. When

purchasing the one currency 90 days forward the US firm can then

exchange that currency for Currency X. The effectiveness of this strategy

depends on the degree to which these two currencies are positively

correlated. The stronger the positive correlation, the more effective will be

the cross-hedging strategy.

Swaps in Foreign Currencies

Swap is an agreement reached between two parties which exchange a

predetermined sum of foreign currencies with a condition to surrender that

sum on a predecided date. It always involves two simultaneous operations:

one spot and the other on a future date.

There are various types of swaps such as cross-credit swaps, back-to-back

credit swaps, and export swaps, etc.

Cross-Credit Swaps

In this kind of swap, there is an exchange of foreign currencies between a

parent company and say, a bank in a foreign country. Let us say an

American parent company wishing to finance its subsidiary in India may

enter into an agreement with an Indian bank. The American parent

company will deposit a sum in US dollars with the Indian bank, equivalent

to the sum that it wants to lend in Indian rupees to the subsidiary for a

fixed period. Suppose this sum is US$ 1 million at a 10 per cent rate of

interest. The Indian bank will lend to the subsidiary a sum of Indian Rs. 32

million (assuming the exchange rate is Indian Rs. 32 = US$ 1), say at 12

per cent p.a. rate of interest. If the period of the swap is one year, then at

the end of the swap period, the American parent company will receive from

the Indian bank a sum of US$ 1.1 million (= 1 + 1 X 0.1) while the bank will

receive from the subsidiary a sum of Indian Rs. 35.84 million [ = 32 X (1 +

0.12)].

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Forex Market

Suppose, in the meantime, the exchange rate has evolved to Indian Rs.

35/US$ 1, then the loss to the bank would be $ 0.076 million ( = 35.84/35-

1.1). Thus the exchange management risk got shifted to the Indian bank

while both the American parent company and the Indian subsidiary were

dealing in their respective currencies without any uncertainty about the

sums to be received or paid. The bank would have made a gain in case the

exchange rate had evolved in the opposite direction.

Back-to-back Credit Swaps

In a back-to-back credit swap, two companies located in two different

countries may agree to exchange loans in their respective currencies for a

fixed period. For example, KODAK (An American multinational) may lend in

US dollars to the USA based subsidiary of FUJI while the latter (a

Japanese multinational) may lend in Japanese yen to the Japan-based

subsidiary of KODAK. The cost of swaps will depend on the rate of interest

and the exchange rate chosen by the two parties.

Basic strategy for hedging transactions exposure

Basically, the strategy involves increasing hard currency (likely to

appreciate) assets and decreasing soft currency (likely to depreciate)

assets, while simultaneously decreasing hard currency liabilities and

increasing soft currency liabilities. For example, if a depreciation is likely to

take place the basic hedging strategy would be as follows: reduce the level

of cash, decrease accounts receivable by tightening credit terms, increase

local currency borrowing delay accounts payable, and sell the weak

currency forward.

MALA GRAPHICS 24

Forex Market

Basic Strategy for Hedging Transactions Exposure

Assets Liabilities

Hard currencies (likely to appreciate) Increase Decrease

Soft currencies (likely to depreciate) Decrease Increase

In concrete terms, the basic strategies can be implemented by taking

appropriate measures, depending upon the anticipated depreciation or

appreciation of local currency.

EXTERNAL TECHNIQUES FOR COVERING EXCHANGE

RATE RISK

The major techniques in this regard are:

Covering risk in the forward market;

Covering in the money market;

Advances in foreign currency;

Covering in financial futures market;

Covering in the options market;

Covering through currency swaps;

Recourse to specialised organisations.

COVERING RISK IN THE FORWARD MARKET

Covering a Transaction Exposure

In order to cover himself against an exchange rate risk, arising from an

eventual depreciation of the currency in which he has invoiced his exports,

an exporter will sell his foreign exchange in the forward market.

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Forex Market

Conversely, an importer wanting to cover himself against the eventual

appreciation of foreign currency, will buy foreign exchange forward.

Covering a Consolidation Exposure

The magnitude of exposure depends on the method of translation used by

the parent company.

MALA GRAPHICS 26

Forex Market

COVERING IN FOREIGN EXCHANGE FUTURES (OR FINANCIAL

FORWARD) CONTRACT MARKET

Initially, futures markets were engaged in merchandise business only, e.g.

eggs, butter, cereals, raw material and so on. The currency futures were

launched for the first time in 1972 on the International Money Market.

(IMM) of Chicago, (presently a division of the Chicago Mercantile

Exchange).

Futures Markets and Contracts

Currency futures markets are now functioning at Chicago, New York,

London, Singapore, Tokyo, Sydney, etc. The most important of them is the

IMM of Chicago.

A currency futures contract is a commitment to buy or to sell a specified

quantity of a currency on a future date, at the pre-determined/decided price

existing on the date of the contract. These contracts have the following

characteristics:

Transactions are traded in standard lots.

Quotations are made in terms of US$ per unit of another currency.

Fluctuations differ according to currencies. The smallest variation (also

called ‘tick’) is 0.01 per cent. So if the contract is of the value DM

125,000, the value of minimal fluctuation is 125,000 X = DM 12.50.

Maturity periods are also standardised, say, March, June, September

and December.

A guarantee deposit is required to be made for selling or buying of a

contract. This deposit is of the order of US$ 1,000 and is made with the

Clearing House.

MALA GRAPHICS 27

Forex Market

Call Option

The holder of a call option acquires a right but not an obligation to buy a

certain quantity of foreign currency at a predetermined price (also called

exercise or strike price). A writer (or seller) of a call option has an obligation

to sell a certain amount of foreign currency at a predetermined price.

Put Option

The holder of a put option acquires a right but not an obligation to sell a

certain quantity of foreign currency at a predetermined strike price. The

writer of a put option has an obligation to buy a certain amount of foreign

currency at a predetermined price. Thus, it is the holder (buyer or owner) of

an option who has a choice to use or abandon the exercise of the option

who has a choice to use or abandon the exercise of the option whereas the

seller of an option should be ready to sell (in case of call) or buy (in case of

put) the amount agreed upon. The latter has no choice of his own.

Covering against Exchange Risk by Purchasing Tunnel with a Zero

Premium

Since premium represents a non-negligible cost, banks propose to their

clients the option with zero premium called tunnel, but protection is

available only within certain limits. For example, let us consider the data of

the Table given below. An Indian importer buys a 1 month tunnel with zero

premium of narrow range. This means that if after a month’s time the dollar

rate in Indian Rs. 35.70, he would pay only Rs. 35.60 per dollar. But, on the

other hand if the rate is Rs. 34.90, he would have to pay Rs. 35.00 per

dollar. If the dollar price is established somewhere within the range, then

he would have to pay the actual market price.

Besides the tunnels of narrow range, there are tunnels of wider range too.

One would choose between the two depending upon the anticipations of

future rates.

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Forex Market

The importance of tunnels lies in the fact that one does not have to pay

premium but at the same time they do not allow the operator to get the full

advantage of a favourable evolution of rates.

TUNNEL WITH ZERO PREMIUM

Maturity Narrow range Wider range

1-month 35.00-35.60 34.25-36.25

3-months 35.50-36.00 34.00-36.30

6-month 35.75-36.35 33.80-36.50

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Forex Market

EXCHANGE RATE RISK MANAGEMENT

STANDARD SOLUTIONS

SPOTS/FORWARDS

Near Delivery Cash Flows

To cover exposures maturing the same day, the next day or two days later,

currency transactions for value ‘cash’/’tod’, ‘tom’ or ‘spot’ can be entered

into.

Distant Delivery Cash Flows

a. Short-term forwards

To cover exposures maturing in more distant dates than ‘spot’ value.

Outright forward transactions can be used. This can be done by :

- Doing a ‘near-delivery’ transaction and then rolling the position forward

to the desired ‘distant delivery’ maturity date, by means of a ‘swap’.

- Doing a single ‘outright forward’ transaction maturing on the distant

delivery date.

b. Long-term Forwards

These are the category of transactions where more than one

‘rollover’/’swap’ becomes necessary. These come in two basic varieties :

Market Rate Rollovers

An initial spot transaction in done, and the position is periodically rolled

over through swaps.

In this case, the rates applied on both legs of the swap (s) are ‘at-the-

market’ i.e. the ‘near’ leg corresponds to the market spot rate and the ‘far’

MALA GRAPHICS 30

Forex Market

leg corresponds to the market forward rate derived from applying market

‘swap differences’ to the market spot rate.

This leads over the life of the contract to the period of realisation (i.e. actual

cash flows occur) of profit/losses, on the date of the ‘current’ swap, as a

function of the movement of the spot rate between the date on the initial

spot transaction or the previous swap at the date of the ‘current’ swap.

Historic Rate Rollovers

An initial spot transaction is following by period ‘rolling over’ of the position

by means of swaps.

In this case the ‘spot’ leg of the periodic swaps likely to always be ‘off –

market’ (unless the spot rate doesn’t move at all between the swap dates).

Specially, in this type of contract, the spot leg for all future swaps is set

equal to the rate on the initial spot transaction.

The effect of this mechanism is to avoid cash flow in between the initial

spot transaction and the first maturity of the contract. To adjust for this ‘off-

market feature, a final lump-sum ‘net’ payment is made at maturity of the

contract by one of the parties, reflecting the cumulative profit/loss after

adjusting for the time value of money. This profit/loss is obviously a

function of the movement of the spot rate since the time of the initial

transaction.

MALA GRAPHICS 31

Forex Market

NON-STANDARD SOLUTIONS

Basic Options Position

A currency option gives the holder the right (with-out the holder having the obligation) to buy a

specified amount (the ‘call’ amount) of a specific currency (the ‘call’ currency) against selling a

specific currency (the ‘put’ currency) at a specified exchange rate (the ‘strike’ rate) within or on a

specified date (the option’s term to maturity).

Options USD/DEM Date : 5-Jan-93

Value 7-Jan-93 Spot level 1.6175

USD Calls 15-Mar-93 14-Jun-93 13-Sep-93 13-Dec-93

1.5500 9.45-9.75 11.90-12.20 13.65-13.95 14.80-15.10

1.5750 7.65-7.95 10.20-10.50 12.05-12.35 13.25-13.55

1.6000 6.00-6.30 8.65-8.95 10.55-10.85 11.80-12.10

1.6250 4.60-4.90 7.25-7.55 9.15-9.45 10.40-10.70

USD PUTS

1.5750 1.75-2.05 2.80-3.10 3.60-3.90 4.10-4.40

1.5500 1.10-1.40 2.10-2.40 2.85-3.15 3.35-3.65

1.5250 .65-.95 1.50-1.80 2.20-2.50 2.70-3.00

1.5000 .35-.65 1.05-1.35 1.70-2.00 2.10-2.40

In an American option, this right can be exercised at any time upto the term

to maturity, while in a European option this right can be exercised only at

maturity.

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Forex Market

The above table shows prices of European style USD Calls and USD Puts

against the Deutschemark, in Pfennigs per USD.

It can be seen that a USD Call/DEM Put, for USD 1,000,000 maturing 14

June 1993 at a strike rate of 1.6000, will cost DEM 89,500 (1,000,000 X

0.089), with the premium to be paid on 7th January 1993* (Spot value; two

business days after the deal date, i.e., 5th January, 1992). In addition to

this method of quoting a price in terms of one of the currencies, Option

prices are also quoted as a percentage of the call Amount.

There are two basic option type

The Call option and the put option

There are two basic positions in options (or any other asset).

Long and Short

Thus there are 4 basic option positions

Long Call Short Call

Long Put Short Put

There is a certain symmetricity in currency options in that (in this case) a

USD Call is the same as a DEM Put and vice versa.

An option is said to be ‘In the money’ (ITM)/At the money (ATM)/ out of the

money (OTM) depending on whether the immediate exercise of the option

would lead to positive / zero/negative profit, respectively (ignoring the cost

of the option).

MALA GRAPHICS 33

Forex Market

Advantages of Currency Options

It is often said that the limited risk/unlimited reward feature of an option

makes it a unique instrument. However, even if correct, this only applies to

the buyer of the option.

In fact the (un)limited nature of risk/reward for any instrument is really more

a matter of money-management and trading tactics. The risk-reward ratio

of any option position can be recreated in the spot or futures markets by

adjusting position size and stop-loss and take-profit levels.

Therefore the above is not really a unique feature of options.

1. Option prices show greater percentage movement relative to the spot

price of the underlying asset. This leads to High Leverage in option

positions.

2. Option position allow for the Exact Implementation of extremely

sophisticated views on the movement of the spot price with

respect to time. By buying/selling options, one can implement

strategies addressing not only the ‘direction’ of the movement in the

‘spot’ but also the ‘volatility’ of that movement and the time period in

which the movement will occur.

In contrast. Spot/Forward positions are not sensitive to ‘volatility’/time

(ignoring ‘swap differences’).

The price (or premium) of a currency option depends on the following

factors :

The intrinsic value of the option - is the potential profit from exercising

the option and is given by the difference between the ‘strike’ price of

option and the market price. Option premia increases with increases in

intrinsic value.

MALA GRAPHICS 34

Forex Market

The term to maturity of the higher-option premium.

The expected volatility of the exchange rate of the life of the option The

higher this volatility estimate, the higher option premium. (Implied

Volatility a commonly used term in the options market, is that volatile

estimate which is consistent with the current value of calls and puts

being traded in the market place.

The relative interest rate levels in the two currencies - Increasing the

interest rate differential increase/decreases the prices of call/put options

on the long interest rate currency. For instance, with DEM interest rates

higher than USD interest rates, as the interest rate difference widens

the prices of USD/DEM calls rise and prices of USD/DEM puts fall.

The absolute level of interest rates in the currency in which the “intrinsic

value” of the option is calculated.

For instance in the case of USD/DEM option since the “intrinsic value” is

calculated in DE the prices of both USD/DEM calls and puts rise/fall as

DEM interest rates (of the same matter as the term of the option) fall/ rise.

Strategies using Basic Option Positions

There are 5 broad categories of Basic Option Strategies.

a. Naked Strategies

These are option position (long or short) that are not matched by

corresponding (opposite) positions in the underlying asset, i.e., there is no

‘spot’ position, only an option position.

Thus there can be 4 types of Naked positions : Long Call, Short Call and

Long Put. Short Put.

MALA GRAPHICS 35

Forex Market

b. Covered Strategies

These option positions are matched (in part or full) by opposite spot

positions in the underlying asset.

The common types of Covered Positions are

Long asset & Short calls

Short asset & Long calls

Long asset & Long puts

Short asset & Short puts

The above examples assume a 1:1 ratio between the amounts of the

underlying asset and the option.

By varying this ratio. less perfect hedge positions can be constructed.

Break Forward Contracts

The Break Forward contract is a type of ‘covered strategy’ developed by

combining the features of an option and a forward contract. Specifically, the

Break Forward Contract belongs to the subclasses of ‘Long Asset and long

Puts’ or Short Asset and Long Calls’ depending on which currency is the

asset/liability.

Example : ABC Inc. is an Indian importer with a liability of USD 50 million

maturing in 3 months.

The outright forward rate for that maturity is 3 months.

The outright forward rate for that maturity is 3.0000 (per INR 100). ABC Inc.

asks SCB from a 3% markup over the forward rate to arrive at the fixed

rate. The fixed rate is thus 2.9100. This is the rate at which ABC Inc.

MALA GRAPHICS 36

Forex Market

agrees to buy USD (sell INR) from SCB in 3 months time. however, the

story does not end here.

The Break Forward contract also incorporates a break-rate in this case

3.0500 (decided by SCB), which is the rate at which ABC Inc. can opt to

sell USD to SCB at the end of 3 months.*

If the USD strengthens against the INR and the spot rate 3 months later is

2.8000, then ABC Inc. covers at 2.9100 and benefits.

If the spot is anywhere between 2.9100 and 3.0500 ABC Inc. still covers at

2.9100, though he is not benefiting in this case.

If the spot is greater than 3.0500 say 3.1500, then the forward is broken.

ABC Inc. buys USD from SCB @ 2.9100, sells LSD to SCB @ 3.0500 (thus

realizing a 14 cent loss) per dollar but is able to cover its exposure at

3.1500 (a saving of 24 cents over the fixed rate of 2.9100).

In this case ABC Inc. chose the fixed rate (i.e., markup over outright

forward rate) and SCB supplied the corresponding break rate. ABC Inc.

could also have chosen the break rate and had SCB specifying the markup

of the forward rate.

An important feature of the break-forward is that unlike conventional

options, no premium outlay is required - the cost of the option ( in the

above case ABC’s option to sell USD @ 3.0500) is built into the forward

rate. So obviously the break rate and the fixed rate cannot be determined

independently.

Thus the break-forward contract is effectively a combination of Boston

option and a standard forward contract. The option premium is added to

the market outright forward rate to arrive at the fixed rate of the break

forward contract.

MALA GRAPHICS 37

Forex Market

c. Spread Strategies

These are portfolios incorporating two or more options of the same type

(i.e. all puts or all calls) with some options held short and some long.

The common spread strategies are as follows:

Money spreads/Price spreads / vertical spreads - Here the options have

the same expiration dates but different strike prices.

There are four basic types of money spreads... (Examples are given for the

basic position unit i.e., 1 option short and 1 option long. Position size can

be as large as capital and market conditions allow)

Bullish spread with Calls

Here a call with a lower exercise price is purchased and a call with a higher

exercise price is sold. This strategy reflects a bullish view on market

direction hence the name ‘Bullish Spread’.

Bearish spread with Calls

Sell the call with the lower exercise price and buy the call with the higher

exercise price.

Bullish spread with Puts

Buy the put with the lower exercise price and sell the put with the higher

exercise price.

Bearish spread with puts

Sell the put with the lower exercise price and buy the put with the higher

exercise price.

A special variety of Vertical spread is the ‘Butterfly Spread’ or ‘Sandwich

spread’ which consists of 4 options two options bought / sold with different

MALA GRAPHICS 38

Forex Market

strike prices and two options sold/bought with the same strike price (the

latter strike lying between the two former strikes).

There are 4 types of Butterfly spreads possible ....

Long Butterfly with Calls

Short Butterfly with Calls

Long Butterfly with Puts

Short Butterfly with Puts

An example of the Long Butterfly spread with calls, is given below :

Long Butterfly Spread with Calls

Spot Gold = $ 330

Sell 2 calls at strike price of $ 330

Buy 1 call at a strike price of $ 320

Buy 1 call at a strike price of $ 340

The range of expiration values for butterfly spreads is between zero and

the amount between consecutive strike prices. The maximum profit occurs

when the underlying market finishes at the inside exercise price (here $

330) and zero profit occurs when the market finishes outside either of the

extreme exercise prices (here $320 and $340). [Not including the net

premium to be paid to open the long butterfly position].

Time spreads/Calendar spreads/Horizontal Spreads - here the options

have the same strike prices but different expiration dates.

The four basic types of time spreads are ...

Long time spreads with Calls

Long time spreads with Puts

Short time spreads with Puts

Short time spreads with Calls

MALA GRAPHICS 39

Forex Market

In long time spreads, the longer term option is bought and the shorter term

option is sold. The ideal outcome for this positions is a reduction in actual

market volatility combined with an increase in implied utility.

In short time spreads the shorter term option bought and the longer term

option is sold. The outcome occurs when actual volatility picks up implied

volatility drops.

Diagonal Spreads

It is also possible to do spreads which combine features of money spreads

and time spreads. Such agonal spreads have different exercise prices and

different expiration dates.

d. Combination strategies

These are portfolios containing different type of options (i.e., calls and puts)

with all the options short or long. Strictly speaking this definition applies

only to basic or building block combination position. A condor which is a

composite of two basic combination positions, does not satisfy this

definition.

The following Combination Strategies are common:

Straddle

Buy/Sell a call and a put with the same strike price and time to expiry.

If the options are bought/sold, it is called a Long/Short Straddle

respectively. Straddles are essentially volatility plays.

A long straddle position benefits/suffers from increase / decrease in

volatility. A short straddle position behaves symmetrically ( opposite to the

nature exposure of the long straddle).

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Forex Market

The strike price in the Straddle is usually chosen to be at-the-money,

because at-the money options have the highest sensitivity to changes in

volatility.

Strangle

A Strangle is a close cousin of the Straddle, with both the call strike and the

put strike being equally out-of-the-money. The standard strangle is

constructed with out of the money calls and puts.

When a strangle has both calls and puts in-the money it is called a GUTS.

A Strangle is also a volatility play, albeit implying a more aggressively

bullish/bearish view on volatility than a Straddle trade. The exposure of the

strangle to volatility is essentially similar to that of the straddle.

A strangle costs less than a straddle, and comes in two basic varieties; the

short strangle (options sold) and the long strangle (options bought). The

long/short strangle represents a bullish view on impending market volatility.

For instance with Spot Sterling at 1.4810, a purchase/sale of a 1.4910 call

and 1.4710 put creates a long/short strangle.

Condor

There is some degree of ambivalence in the market about the definition of

a CONDOR.

The common understanding is that a condor is constructed by means of

two strangles, one bought and the other sold.

Example: (All options expire June 1993. Call/Put implies USD Call/Put).

With spot USD/DEM at 1.6340, on Mar 23, 1993, buy a 1.6240 put and a

1.6440 call. This creates a long strangle position. Then sell a 1.6540 call

MALA GRAPHICS 41

Forex Market

and 1.6140 put. This creates a short strangle position. Together these two

positions have created a “short condor”.

This strategy reflects a view that “a sharp move is expected in the spot

though the direction of the move is unknown.”

Similarly if one has a view that the “spot market will be very quiet” one can

implement a “long condor strategy” by selling the 1.6240 put and 1.6440

call and buying the 1.6140 put and 1.6540 call.

Some practitioners also refer to a condor as a combination of a straddle

and strangle. A short condor is a combination of a long straddle (struck at -

the - money) and a short strangle (short out of the money call and put).

Continuing with the USD/DEM example, a short condor per this alternative

view is constructed by buying the 1.6340 call and put (long straddle) and

selling the 1.6440 call and 1.6340 put (short strangle).

The long condor is just the reverse (short straddle plus long strangle).

The ambivalence in nomenclature need not be a significant problem,

because the implied market views for long/short condors are identical for

both definitions.

Strip

Buy/Sell two puts and a call with the same strike and expiration.

The two basic strip varieties are the long strip (options bought) and short

strip (options sold).

The long/Short strip can be seen as a long/short straddle plus one

long/short put and is essentially a bet on an increase / decrease in volatility

albeit with a leaning towards a bearish/bullish view on market direction.

MALA GRAPHICS 42

Forex Market

Strap

Buy/Sell two calls and a put with the same strike and expiration.

The two basic strap varieties are the long strap (options bought) and short

strap (options sold).

Similar to the case of the strip, the long/short strap is effectively a

long/short straddle plus one long/short call and represents a bet on an

increase/decrease in volatility combined with a bullish / bearish view on

market direction.

e. ‘Cylinder’ Strategies

These strategies combine the flexibility of the ‘Spread’ and ‘combination’

strategies.

A cylinder consists of a long/short position in a call/put combined with a

short/long position in a put/call.

Example : An Indian importer who has a liability of USD 10,000,000 in 3

months time. he buys a call option on the USD against the INR (Indian

Rupee) with a strike price at USD 3.2000 (per INR 100). To help pay for the

cost of this option purchase he sells a put option on the USD against the

INR at a strike price of 3.2800. Both options are for the same amounts and

maturates.

For all USD/INR levels between 3.2800 and 3.2000, the importer would

cover at market rates. If the USD strengthens beyond 3.2000, the importer

can still cover at 3.2000 but if the USD wakens beyond 3.2800, the

importer is obliged to cover at 3.2800.

If the strike prices of the call & put are so chosen that the two options cost

the same, then this strategy is called a ‘zero-premium cylinder’.

Alternatively if the ‘sold option’ is worth more / less than the ‘bought option’,

MALA GRAPHICS 43

Forex Market

the strategy is referred to as a ‘credit cylinder’/ debit cylinder’. The zero-

premium cylinder is also often referred to as a “Range Forward”.

Another common variety of Cylinder Strategies is the ‘Participating

Cylinder’ which is a cylinder where the currency amounts underlying the

two options, are different.

The Indian importer discussed above could have bought the USD/INR calls

for an amount equal to his total liability i.e. USD 10,000,000 by sold the

USD/INR puts for an amount of only USD 5,000,000. thereby creating a

‘Participating Cylinder’ with a 50% participation rate. The importer can thus

enjoy a 50% participation in any USD weakness beyond 3.2800. (This

benefit comes at the cost of a lower premium for the sold option and hence

a higher net cost for the cylinder), alternatively the USD/INR put could be

sold at a lower strike rate of say 3.2 to maintain the net premium cost of the

strategy at zero.

‘Exotic’ Option strategies

The following types of ‘Exotic’ option strategies are common :

Compound Options

Chooser Options

Path – Dependent Options

Barrier Options

a. Compound Options

These are options on options, and are used mainly because of their

relatively lower cost. Compound options are especially useful in situations

where the currency asset/liability is not certain.

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Forex Market

Example : On 8 April 1993, it would have cost 2.39 pfennig per USD to buy

a European style, 1 month USD call/DEM put at a strike rate of 1.6250 (at-

the-money-forward).

XYZ Corp. may need to buy USD/sell DEM 1 month from 8th April, but it

will be sure of its position only 2 weeks from 8th April. Instead of paying

pfenning per USD for an option it may not even -- XYZ Corp. Can buy an

at-the-money, call comp-- option @ 2.39 pfenning per USD. This upfront

paying will give XYZ Corp. the option to buy a USD DEM put @ 2.39

pfennigs per USD, (this is the standard rate for the compound options) 1

month from 8th April 1993.

The above call compound option is said to be the-money because the

strike rate equals the current market price of the underlying option.

There are 4 basic varieties of compound options:

Call options on Calls

Put options on Calls

Call options on Calls

Put options on Puts

b. Chooser Options

Chooser Options allow holders to decide on the rate of option they have

purchased (i.e. call or put) at a rate later than the date of option purchase.

Example : XYZ Corp. buy a 3 month choose option on USD/DEM for USD

5 million at a standard price of 1.6000, with a 15 day choosing deal--

Depending on how the spot moves over the next days XYZ Corp. can

decide whether what it has bought is a USD put or USD call.

MALA GRAPHICS 45

Forex Market

These options are more flexible than convention options and therefore cost

more.

c. Path-Dependent Options

These currency options have 3 main varieties

Asian or Average Rate options

Lookback options

Average Strike options

Asian Options

These options are struck on an average of the spot price rather than on the

spot price itself (as is case for conventional options).

An example of an Asian call option on USD/DEM would be a USD

Call/DEM put, expiring 15 June 1993, on USD 1,000,000, struck on the 15

day simple moving average of USD/DEM (calculated on the New York

closing prices) with a strike rate of 1.6000.

On 15 June 1993, the 15 day moving average of USD/DEM stands at

1.6500. Thus the pay - off for the holder would be = (1.6500 - 1.6000 X

1,000,000). Since the effect of focusing on a moving due to the smoothing

effect of the average these options cots less than conventional options.

Lookback Options

In these options the pay-off to the holder is the highest intrinsic value of the

option during its life. Obviously, this can only be determined in retrospect

after the expiration of the option.

Due to their added flexibility. Lookback Options cost more than

conventional options.

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Forex Market

Example : ABC Inc. buys a 3 month Lookback call on USD/DEM with a

strike price at 1.6000 DEM (spot) for an amount of USD 10 million. The

highest spot market level of USD/DEM in the next three months is 1.7000.

ABC Inc. is compensated after 3 months to the extent of 10 pfennigs for

every dollar i.e. a total of DEM 1 million.

Average Strike Options

The pay-off for an Average Strike Option is determined by taking the

difference, at expiry between the ‘spot’ price of the underlying asset and

the value of a specified ‘moving average’ of the ‘spot’ price. (In an average

strike option, the option buyer specifies the type and period of the moving

average, instead of a strike price. This clearly defined moving average itself

functions as the strike price).

These options cost less than conventional options.

Example : ABC Inc. buys a 6 month, average strike USD/JPY put option,

[with the strike price equal to the 15 day simple moving average (SMA) of

New York closing prices (spot)] for USD 5 million 6 months later spot

USD/JPY is at 110.00 and the value of the 15 day SMA is 115.50 ABC Inc.

is paid a profit of 27.5 million Yen. [5,000,000 X 115.50 - 110.000].

d. Barrier Options

In addition to parameters present in a conventional option, these options

have a ‘barrier’ and a specification of how the terms of the options change

depending on the movement of the sport price with respect to the barrier.

The basic rules for generating alternative barrier option positions are:

i. Use calls and puts

ii. Use short and long positions

iii. Place the ‘barrier’ between the strike price and the current sport price

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Forex Market

or Place the strike between the ‘barrier’ and the current spot price.

iv. Change the terms of the option from up-and-in to up-and-out to ‘down-

and-out.’

Example : An ‘up and in’ USD call/DEM put, struck at 1.5000 with a barrier

at 1.5500, will have no value as long as the sport is between 1.500 and

1.5500. As soon as the spot rate crosses 1.5500, this option starts to

behave like a standard USD/DEM call. Such a strategy is consistent with a

view that significant USD upside can only be expected if it rises over

1.5500 DEM.

Due to their limitations, barrier options cost less than conventional.

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Forex Market

INTEREST RATE OF RISK MANAGEMENT

Interest rate and currency swaps

A swap is a legal agreement between two parties to exchange cash flows

over a period of time.

Swaps fall into two broad categories, depending on the nature of the risk

they are designed to alter.

They are interest Rate Swaps and Currency Swaps.

Interest Rate Swaps

These (involving only one currency) can again be classified as follows.

a. Floating /Fixed or Fixed/Floating Interest Rate Swaps - These involve

one floating interest rate (“floating leg”) and one fixed interest rate

(“fixed leg”).

b. Interest Rate “Basis” Swaps - Such swaps have floating rates on both

legs.

Currency Swaps

Currency swaps have three basic varieties :

a. Cross Currency Interest Rate Swaps These swaps involve two

currencies and two types of interest rates (i.e. one floating leg and one

fixed leg). These are also known as Circus Swaps.

b. Fixed/Fixed Currency Swaps / Synthetic, forward FX. These swaps

involve two currencies but only one type of interest rate (i.e. fixed rates

on both legs.).

c. Cross Currencies and one type of interest rate in this case both legs

have floating rates.

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Forex Market

Interest Rate Swaps

The floating /Fixed or fixed/floating Interest Rate Swap and the Interest

Rate basis swap are ‘standard’ swap structures in that :

They have ‘at-the-market’ swap rates.

Become effective from the spot date (the spot date is two business days

after the trade date for USD, DEM and most other currencies and the

same date as the trade date for GBP).

The National Principal Amount (NPA) and the swap rate remain

constant over the term of the swap.

These are no call/put or extension provisions in the swap agreement

and

Swap counterparts do not deposit collateral with the intermediary.

The other swap variations listed in here and their combinations can be

seen as non-standard swap structures, wherein one or more of the above

conditions applicable to ‘standard’ swaps are violated.

Basis Swaps

In Basis Swap booth swap counterparts receive floating rate payments,

each party praying interest on the ‘basis’ of its choice.

An interesting type of Basis Swap is the LIBOR-IN-ARREARS SWAP or

DELAYED LIBOR SWAP.

The Delayed Libor Swap is undertaken in a positive (upwardly sloping)

yield curve scenario by borrowers who feel that the implied forward rates

derived from the yield curve, overestimate the future Libor fix for short term

interest rates.

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Forex Market

Undertaking to pay Delayed Lobor in a positive yield curve scenario

involves the risk that future Libor settings may actually be higher than what

the yield curve is predicting, leating the customer to lose out on the swap.

Forward Start/Delayed Start Swaps

Such swaps are created by changing the ‘spot start’ feature of standard

swaps. They are useful when the swap user wishes to lock in to a ‘good’

swap rate, but with a view to matching cash flows, does not want to ‘start’

the swap now.

Since a Forward Start swap is synthesized from two ‘spot start’ swaps of

different tenors, the pricing of a forward start swap relative to a ‘spot start’

swap will depend on:

Whether on is paying or receiving (the fixed rate).

The terms structure of interest rates.

The deferral period, and

The tenor of the swap.

Example : ABC Inc. enters into a 2 year forward - start. Yen swap with a 6

month deferral period, where it pays 3.9% (fixed) and receives 6 months

Yen Libor. This swap becomes ‘effective’ 6 months after the deal date and

then runs for 2 years.

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Forex Market

Currency Swaps

Currency Swaps are designed to alter the current currency basis and/or

interest rate basis of the counterparts exposure. Like Interest Rate Swaps

they can also be used as a financing tool where comparative borrowing

advantages exist.

Cross Currency Interest Rate Swaps

The incremental benefit (over the Interest rate swap) of the currency swap

is that it allows the user to also alter the balance sheet’s currency

exposure. The working of a cross-currency interest rate swap is shown in

from ABC Inc’s perspective. For the sake of simplicity the swap arranger’

fee is not shown in the illustration.

The standard currency swap features initiall exchange of principal as well

as exchange of principal at maturity. Even if a swap with no initial

exchange of principal is desired the pricing of the swap will not change

because the initial exchange can be duplicated by means of a ‘spot’

transaction to buy/sell the relevant currencies.

However, in the case of a currency swap without any exchange of principal

the pricing will differ from that of a standard swap. For instance suppose

ABC Inc. was receiving 6 month USD Libor and paying 7.62% Fixed

Sterling in a 7 year swap with exchange of principal at maturity. If this

name swap did not feature exchange of principal at maturity ABC Inc.

would pay only 6.40% Fixed sterling. At the time of writing, Sterling is at a

discount against the US Dollar in the 7 year maturity in the forward foreign

exchange market. In general (for a swap without final exchange of

principal) the counterpart paying interest (in the swap), in the currency that

is at a (forex) forward premium/discount (for the relevant swap tenor) would

have its interest rate raisald/lowered with respect to the rate applicable in a

swap featuring final exchange of principal.

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Forex Market

FIXED-TO-FLOATING CROSS-CURRENCY SWAP

Sterling Debenture

Initial Exchange

US Dollar Bond

£ 100 m £ 150 m

ABC Inc.£ 100 m

£ 150 mSCB

£ 100 m

£ 150 mXYZ Corp

Sterling Debenture

Periodic Payments

US Dollar Bond

£ 10.5% $ Libor + 50 bp

ABC Inc.£ 10.5%

£ 10.5%SCB

£ 10.5%

£ 10.5%XYZ Corp

Sterling Debenture

Exchange at Maturity

US Dollar Bond

£ 10.5% £ 10.5%

ABC Inc.$ 150 m

£ 100 mSCB

$ 150 m

£ 100 mSCB

Fixed to Fixed Currency Swap/Synthetic Forward FX

In a Fixed to Fixed Currency Swap, the counterparts switch currencies but

both pay fixed rates in the currency of their choice, Since forward rates are

quoted according to the principle of Covered Interest Parity in currencies

where arbitrage between the interest rate and forex markets is possible;

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Forex Market

such a swap is effectively a synthetic forward contract. The only difference

lies in the periodic (rather than at maturity) settlement of the interest

differential in the case of the swap. In fact in tenors beyond 1 year interest

rate swap each other just as in tenors upto 1 year forward points are

derived from eurodeposit rates.

An example of such a swap would be on where the counterparts pay fixed

interest rates on Sterling and Dollar respectively.

Fixed / Fixed currency swaps without final exchange of principal are known

as “coupon swaps”

Cross Currency Basis Swaps

A close cousin of the Fixed to Fixed Currency Swap, this swap features

floating rates of interest being paid to each other by the counterparts in two

different currencies.

Forward Rate Agreements (FRAs)

An FRA allows the user to fix the interest rate on future borrowing / lending

often substantially in advance of the sport market fixing of the relevant

interest rate.

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Forex Market

RBI MAULS PUNTERS TO HALT RE SLIDE

The indirect measures included a one percentage point increase in cash

reserve ratio to 11 per cent three percentage point increase in its daily fixed

rate repo and steps a large dose of direct intervention in the foreign

exchange markets. rupee had plunged to an all-time low of 43.70 against

the dollar in mid day trade prompt impact on the markets with the rupee

recovering to 42.70 before closing at 42.80 – a 70 paise appreciation over

Wednesday’s close.

First, the attempt to drain out the excess liquidity; the CRR hike, which

takes effect from August 29, is expected to suck out over Rs. 5,000 crore

liquidity from the system. This, combined with a 3-percentage point

increase in repo rates from 5 to 8 percent, is expected to push up interest

rates. This then will act as a disincentive to borrowing cheap from the

money markets and arbitraging in the forex markets.

The central banks sold about $250 million in the spot market. This had

twin effects; while the rupee immediately appreciated on increased supply

of dollars, the move also sucked out $ 250 million worth of rupees (over Rs

1,000 crore) from the system in one day.

Second the move to bump up forward premia; stop speculators selling

rupees in the spot market the recent depreciation and buying dollars

forward slight premium to today’s rate for getting delivery forward premia

are also likely to induce exporters to bring in their dollars.

The central bank today made small purchases of dollars in the forward

market, thereby having to pay premia for receiving dollars at a future date.

And the token today announced that foreign institutional investors (FIIs)

would be allowed to hedge 15 per cent of their portfolio investment made

before June 11. Incremental investments made after June 11.

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Forex Market

The RBI hopes that this will induce FIIs to start hedging their outstanding

investments which means they will want to buy dollars forward at current

prices to avoid taking a depreciation hit lead to increased demand for

forward dollars and further hardening in premium rates. However, market

players are skeptical about the efficacy of the move given that FIIs find the

present levels of premia unattractive from rebooking cancelled forward

contracts. The RBI had earlier banned corporates without trade based

exposures from doing the same. This will reduce the excess demand in the

forward market and ensure that only genuine demand reaches the market.

The RBI has withdrawn the facility given to corporates in December 1993

to split their forward commitments into spot and forward legs. Earlier,

corporates were allowed to meet their dollar requirements by buying spot

dollars on once day and forward covers on another day. This resulted in

corporates buying only spot dollars and then selling them off with out taking

a forward cover. After issuing warning to banks the RBI has finally

withdrawn this facility Bankers, however, feel that this has also resulted in

the market becoming thinner since this kind of speculation provided some

intraday liquidity in the market.

To improve dollar inflows, exporters have been warned that their

entitlement in Exchange Earners Foreign Currency (EEFC) account will be

reduced if they will fully delay repatriation of export proceeds. At the same

time, the central bank has also allowed exporters to used the EEFC funds

for domestic businesses. The EEFC facility was introduced for exporters

before currency account convertibility. It was provided to enable exporters

to skip the cumbersome process of obtaining sanctions for their forex

requirements.

At present, exporters are allowed to keep 50 per cent of their proceeds in

EEFC accounts. This has resulted in corporates willfully keeping forex

abroad , waiting for further depreciation of the rupee in order to book

profits. At the same time, the RBI has promised to consider extension of

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Forex Market

repatriation of exporters dollar in exceptional cases. And, finally in a small

dose of moral suasion, the RBI has warned banks that it would be keeping

an eagle eye on their forex operations and has asked all authorised dealers

to report day end and peak intrsa-day position in the forex market.

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Forex Market

CONTENTS

Acknowledgment

Forex Market

What is Risk ?

Types of Risk

Hedging Techniques

Alternative Hedging Technique

External Techniques for Covering ERR

Exchange Rate Risk Management-Standard Solutions

ERR-Non-Standard Solutions

Interest Rate Risk Management

Government Policies

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