Introduction to Foreign Exchange Derivatives
Derivative: Definition • Contingent contracts • Values derived from future value of an underlying asset/index – – – – –
Currency Bonds stock indices Interest rates Commodities
Derivative: Definition : IAS 39
Derivative Defined in RBI Act
Derivative –Definition-SCRA • In Indian context SCRA,1956 defines derivatives to include-
– A security derived from • Debt instrument • share • loan whether secured unsecured • risk instrument or contract for difference or any other form of security – A contract which derives its value from the price or index of prices of underlying security – Derivatives are securities under SCRA
Derivative Instruments: Types • Exchange traded • OTC – In substance there are only two types of derivatives: – Forwards – Options
Forex Derivatives
Derivative- Characteristics • Gearing • • • • • •
– Small initial expenditure helps in dealing in large volumes
Shifts risk from buyer to the seller Effective risk mgt tool Improves liquidity of underlying Increases depth of market Lowest credit risk as settlement of difference only Helps in price discovery – Better estimation of future price of the underlying; helps in decision making
• Used Speculatively :
– Can be very risky : highly leveraged & often more volatile than underlying – With value of underlying moving speculative derivative positions can show greater movements with consequent large swing in profit and loss
Users • Hedgers • •
•
– Desire stability in cash flows – Aim at preventing fall in value of the underlying Traders – Offer two way quotes Speculators – Want to make quick money from volatility in the underlying price – Underlying not owned – Not interested in stability of cash flows Arbitrageurs – Earns risk free profit by taking advantage of difference in price of different markets – Larger the number of such trades remove this difference
OTC and Exchange Traded • OTC – Structured to suit the individual needs – any product, any time, any amount – No margins – Credit risk – Higher transaction costs – Difficulty in matching / counterparties
BIS survey As at end
Notional Principal of outstanding OTC counters in trillion $
December 2003
197
June 2004
220
June 2005 Dec 2005
271 285
Derivative financial instruments traded on organised exchanges (Trillion US$) Amount outstanding Dec20 June 03 2006 Future 13.75 26.03 s Option 23.04
Turnover 2004
2005
840.18 1005.8 1
57.95 Source- BIS Survey 312.07 402.59
Derivative volume –Indian Banks • Spurt in OBS exposure mainly due to derivative • • • • •
segment Share of derivatives in OBS exposures: 82.%5 (March 2002) =>90.7%( Dec2004) Composition of derivative portfolio of banks in India undergone transformation Forward forex contract : 79.6%(March 2002); 49.3% (Dec2004) Single currency SWAP: 14.6%=>46.6% Maturity profile of derivatives changed
– 1 Yr horizon: 84.6% (March 2002) => 51.3%(Dec2004) – Corresponding increase in 2 to 3 yr segment
• Foreign banks have largest share (63.7%)in
derivative segment, New Pvt. Banks(18.1%), PSU banks(16.3%)
Indian market volume :FRA/IRS – – – –
Outstanding notional principal: April 2005: Rs 13,58,487 crore March 2006: Rs 21,94,637 crore Select foreign banks ,PDs private sector banks major participants – Interest rate derivative market OTC
Forward Contract • A forward is an agreement entered into today, • Either to sell or to buy a certain quantity of a certain asset • At a specified future date for a specified price decided today. • Tailor-made transaction • Terms are very flexible.
Forward Contract • The party that buys the underlying
asset in the contract is said to have a long position • The party that sells has a short position. • The specified future date when the delivery is to take place is called the maturity • And the contract is settled on that date.
Forward Contract • Value of forward contract =0 at the time it is • • • • • •
entered into No upfront payment by either party Delivery price is usually set equal to the market forward price at the initiation Later stage value may be negative or positive Both buyers and sellers are committed to the contract Pay off of the buyer/seller is linear to the price of underlying Presence of credit risk in forward contract
Characteristics of Forward Contracts • A forward transaction is a private contract • • • •
between two parties. A transaction can be entered into at any place and at any time, as long as the two parties to the transaction agree (assuming that there are no regulatory issues). Each party bears two types of risk to the other counterparty – credit risk and settlement risk. transaction can be tailor-made to suit exactly the parties' requirements, Forward transaction can eliminate any uncertainty about the price in the future. suitable for hedging a specific price risk.
Advantages of Forward Contracts • Objectives of parties entering into a forward •
contract : Certainty: secure income or stabilize cost – guarantees to buy or sell a certain amount of an underlying asset, at a fixed price, on a specified date in the future. – Cash flow advantages to protect margin erosion by changes in market price.
• Secure availability (long-term supply contract)
Advantages of Forward Contracts • Certainty: secure income or
stabilize cost • Secure availability (long-term supply contract) • Obtain the price risk of an asset without holding that asset • Cash flow modification
Disadvantages of Forward Contracts • While forward contracts can fix anticipated revenue or cost, they cannot minimize cost or maximize revenue. • liquidity.
– tailor-made contracts-often suffer from poor liquidity. – This contrasts with the futures market, where liquidity is much higher, but the contracts are standardized.
Non- Deliverable Forward (NDF) Market • Market for forward dollar against rupees
exists in major international centers • Singapore the biggest centre • Absence of off-shore Indian rupee market • Delivery of forward rupee not possible • On expiry contract cancelled and difference in settled in USD • Such contracts known as NDF • Participants are speculators; not permitted to participate in domestic forward market
Definition of Swaps • A swap is a contract between two
counterparties to exchange a quantity of one thing for a different quantity of another thing at regular intervals over some agreed upon period of time • usually with the amounts of at least one of the streams dependent upon the level of a specified market price or rate applied to a notional principal amount.
Swap • More accurately, a swap is a series
of forward transactions that are bound together in one contract. • The exchange of a payment against a receipt at some distant future date is a forward contract
Swap • 6 forward •
•
• •
contracts at sixmonth intervals Value of each of the 6 forward contracts forming the swap above not necessarily zero. The diagram shows arrows representing two notional payments made by the swap counterparties. In practice each payment is netted .
Basic Characteristics of Swaps • The net present value (NPV) of all the
cash flows paid by one party = NPV of all the cash flows paid by the other party at the time a swap contract is entered. • NPV of a swap at the time of contract is zero (except for any profit for the swap intermediary). • If this does not hold, there will be an arbitrage opportunity.
Basic Characteristics of Swaps • Payment Dates :Between the effective
date and the termination date, there is a series of payment dates. • Floating rate payment dates - dates on which floating rate payments are made • Fixed rate payment dates - dates on which fixed rate payments are made by the fixed rate payer • Swap payments made on a net basisactual payments are made by only one of the parties as long as the fixed rate payment date and floating rate payment date same dates and in the same
Basic Characteristics of Swaps • Term Sheet – Defines the basic terms and conditions of a swap. – Defines who the counterparties are and which side of the transaction they are on, that is, fixed rate payer vs. floating rate payer. – Notional amount: Amount based on which floating and fixed amounts are calculated. – Effective date : Date on which the swap transaction payments begin to accrue. – The termination date: end date of a swap transaction same as the maturity.
Uses of Swaps • swap not a source of funds • Does not provide with any funds beyond the periodic cash flows or eliminate the obligation to pay an underlying liability.
• Cash flow modification: Change from one form of cash stream to another more desirable form of cash stream. • Elimination of uncertainty: To eliminate or reduce exposure to market rates or prices. • Capital market or market arbitrage: To reduce cost or improve returns by taking advantage of a particular market in which the entity has relative advantage (capital market arbitrage) or taking advantage of an arbitrage that exists between two different markets (market arbitrage).
Uses of Swaps • 4) Investment: (having price exposure to an asset
without physically owning it): Create or reduce exposure to a desired asset without buying or selling the asset.
• 5) Trading: change in market conditions - the expected • • •
cash flows of at least one side of a swap (the floating side) change. - value of the swap fluctuates. The value of an interest rate swap behaves like a bond price relative to a par value Par value of a swap is zero There are people who trade swaps if they believe a particular type of swap is cheap or expensive relative to their expectation of market movements. This is pure speculation on the market.
Floating to Fixed Interest Rate Swaps • The most common type of swap is a 'plain vanilla' • • • • • • •
interest rate swap One party pays a floating interest rate and the other party pays a fixed interest rate. An example. ABC (a relatively new company) wants to raise fixed rate funds of USD 10,000,000 for 5 years by issuing a bond Unable to do so in the market because of their credit status Can borrow money from their bank at 6-month LIBOR plus 1% p.a. Bank is willing to lend only at a floating rate. They decide to borrow money from their bank and
Interest Rate Swaps • Example : • Comparative advantage argument • A- 10.00%(fixed) 6-month
LIBOR+0.30% • B- 11.20% (fixed) 6-month LIBOR+1.00% • A borrows fixed from market & pay LIBOR to B • B borrows LIBOR+1% pays 9.95%
Interest Rate Swaps A- 10.00%(fixed) 6-month LIBOR+0.30% B- 11.20% (fixed) 6-month LIBOR+1.00% LIBOR
10% A
LIBOR+1% B
9.95% A converted fixed rate to floating LIBOR+.05% as against LIBOR+0.30%
B converted floating to fixed at 10.95% as against 11.20%
Comparative advantage shared equally
Interest Rate Swaps: with Bank intermediation LIBOR
10% A
LIBOR Bank
9.90%
LIBOR+1% B
10%
A converted fixed rate to floating LIBOR+0.10% as against LIBOR+0.30% B converted floating to fixed at 11.00% as against 11.20% Bank earned 0.10%
Currency Swap • Two counterparties agree to exchange interest • •
and principal in one currency for interest and principal of another currency Exchange generally done at ruling spot rate the time of entering into the contract May involve 1. Initial exchange of principal in two currency 2. Exchange of interest +repayment instalments or bullet payment 3. Debt service obligation alone i.e 2 alone
• Interest rates for two currencies may differ and may be fixed or floating
Currency Swaps • Exchange of principal+ fixed rate interest payment of a • • • • • •
loan in one currency for payment on an equivalent loan in another currency+ fixed rate interest thereon Principals exchanged at the beginning and end Principals chosen to be equivalent using exchange rate at beginning A- 8.00%(Dollar) 11.6%(Sterling) B- 10.00% (Dollar) 12.00%(Sterling) A borrows in 8%dollar & pay 11%Sterling to bank-bank pays dollar8% to A B borrows 12% sterling pays 9.4% Dollar to Bank – Bank pays12% sterling to B
Currency Swap • Motivated by comparative advantage • A can borrow at $5% or AUD 12.6% • B can borrow at $7% or AUD 13% AUD 13%
AUD 11.9%
$ 5%
Bank
A $ 5%
B $ 6.3%
AUD 13%
Comparative advantage: How arise? • Acceptability of the borrower in the market • Too many recent flotation (scarcity value)( world •
bank-IBM-1981-Swiss market) Special facilities available to borrower
– HDFC could cheap dollar debt under the guarantee of United State Agency for International Development (USAID) as per law housing finance co. of developing country entitled – HDFC raised floating dollar loan and swapped them for Indian rupee with Indian banks in the process counter parties have secured floating rate dollar at a rate they would not have been able to raise
Currency Swap Quotation EURO 1-year 2-year 3-year 4-year
USD
Bid Ask Bid Ask 2.19 2.21 1 1.42 .39 2.54 2.58 2 2.09 .06 2.90 2.94 2 2.66 .63 3.22 3.25 3 3.12 .09
YEN Bid 0 .06 0 .13 0 .24 0 .39
Ask 0 .09 0 .16 0 .27 0 .42
Currency Swap Quotation • USD quote-actual/360 against 3M LIBOR • Pound& Yen quoted –semi-annual actual/365 against 6m LIBOR • Euro/Swiss frank quoted –annual basis against 6M Euribor/LIBOR • : exception one year rate quoted against three month bench mark • Fixed rate quoted against each currency
Currency Swap market • Mostly OTC • London Financial Future Exchange (LIFFE)& CBoT introduced future contract on 2,5,10 year swap rate • Not found enough tkers
Cancellation of swap • • • • • • • • • • • • •
Example: $:Yen swap done when spot rate was JPY100 Amount swapped JPY 125m payable in 3 yrs from now; interest 8% on $ & 6%yen payable annually Cash flow remaining to be exchanged; Yr 1 : $80,000 Y7,500000 YR2 : $80,000 Y7,500000 YR3 :$1,080,000 Y7132,500,000 Current spot exchange rate= Y110 Three year swap rate 7% for $ & 8% for Y PV of USD =1026,243(disc. Rate ruling swap rate) PV of Y= 118,557,258 converted to $=1077793 If Y paying party defaults risk to other party= $51,550 This is the amount payable by Y payer to $ payer for unwinding or cancellation swap at today’s rates
Swap market in India • Interest rate derivative started in 1999-00 • Swap /FRA popular • Commonly used floating rate bench mark • MIBOR • MITOR MIFOR • Currency swap with one currency leg being Indian rupee introduced-January 2000
Cross currency and Fx interest rate swap in India • Banks in India act as intermediaries :
international market and corporate customers • Banks works on a full hedge basis • Charge a spread over quote given by correspondent abroad
USD:INR swaps • • • •
Bench mark rate MIOCS Activity growing but market not still a very Liquid Outflow under the swap
– Interest on notional principal in $ calculated at spot exchange rate at LIBOR+ principal in$ at the end
• Inflow • Int. in RS at X% payable half-yearly on notional principal + • •
principal at the end Hedge strategy: Borrow rupee to buy dollar-invest $ at LIBOR-Pay $ interest –service Rs borrowing with Rs receipt-
MIFOR Swap Market • Inter-bank term-money market not very liquid • The forward market not liquid beyond one year • Interest rate parity with forward margin prevails always • Forward margin function of demand supply
MIFOR Swap • Pay MIFOR receive fixed • Hedge : – – – – – –
A. borrow 3 yr money B. Buy USD spot C. Deposit in one year LIBOR D. sell $ forward one year E . Roll over transaction twice repeating B,C& D F. At the end use rupee out of dollar to repay borrowing at A
Principal only swap • In effect hedge (or create) exchange risk on the • • •
principal amount alone leaving interest payment in original currency USD 100 5-year bullet payment loan INR/USD spot=50 Initial exchange – Bank pays Rs 5000 – Client pays USD100
• On loan maturity – –
Bank pays USD100 Clint pays Rs 5000
Principal only swap • • • • • • • •
How to hedge? Conceptual frame work Invest a part of USD100 for 5yrs ZCB of FV=USD100- Cost say (X) Remaining amount USD (100-X) convert into rupee= (100-X)* 50= Y (say) Borrow Rs (5000-Y) Repayment obligation on borrowing on maturity =Z(say) On maturity return USD from proceeds of ZCB Repay borrowing obligation Z out of Rs 5000 Diff=(Z-5000) may be recovered by pricing the swap
Using MIFOR SWAP • MIFOR SWAP used to hedge long term USD/INR Currency
SWAP even in the absence of long term forward exchange market
• • • • • • • • •
SWAP-3 yr- Pay USD LIBOR every year &USD principal at end Receive INR fixed rate every year & INR principal at end HEDGE Steps : A. Buy USD forward 1yr B. Use MIFOR SWAP –receive one year floating & pay fixed rate C. Rollover (A) twice Premium on USD & LIBOR payment will be received at “B”: Fixed rate payment under “B” will be based on quoting INR fixed rate to counter party
Coupon only swap • USD:INR coupon only swap • Considered by companies with rupee debts : to • • •
reduce cost of funds Both short & medium term in vogue Exchange of interest payment in one currency (INR) for interest payment in another currency (USD) Example: – Maturity –one year – Banks pays 11%p.a on notional INR – Bank receives 12 m LIBOR+ 7% in USD on notional converted swap exchange rate( spot rate at the start)
Credit Risk in SWAP • Chance that one party in financial
difficulties/default • Financial institution has credit risk exposure from swap only when value of swap to it is positive • Potential loss from swap default much less than potential loan default with same principal • Potential losses from currency swap is greater than IRS
Futures • Simultaneous right and obligation to buy and sell • Standard quantity of specific financial instrument /commodity/currency • At a specific future date • At price agreed between the parties when contract entered into • Exchange traded forward
Futures • Future rarely provide perfect hedge • Some significant advantage over OTC
product • Price transparency • Ease of unwinding position • Absence of counter party risk: margin system • Marked to market daily • To reflect the price change • Liquidity in the exchange • Cash flow by way of margin through process of M to M
Currency future: hedging tool • • • • • • • • • • • • • •
Importer has to pay UDS 160000 in April 20 Feb worried that USD may appreciate against £ Wants to cover the exchange risk in future market LIFFE selling £ : USD future size £25000 Maturity second week of June Current spot rate USD1.50per £ Forward rate delivery April , 20 USD1.48 June contract being traded at USD 1.45 Sells 4 June contract: at USD1.45 On April, 20 : spot rate in cash market:1.40; Future:1.36 Purchase of USD 160000 cost £114 285.71 Loss of £6177.61compared to ruling rate when hedging done Buy back four future contract at current price (1.36) Profit USD 9000 equivalent £6428.57 at current spot rate compensate for loss
Characteristics of Futures market • There is no credit risk and transactions are transparent unlike OTC contracts • Liquidity is high • Settlement is easy • Contracts is standardized and hence exact hedge not possible as there could be
– Amount mismatch – Product mismatch – Mismatch between spot & futures price (known as basis risk)
Interest Future • Most popular contract ; 3M Euro Dollar contract • Future contract on 3M LIBOR expected rule on • •
maturity On Chicago Mercantile Exchange such contract have maturity up to 10 years Under $1M – 3M future contract:
– Seller undertakes to find a bank for the buyer to accept buyer’s $1M -3M at interest now agreed – Buyer undertakes to place the deposit
• Price quotes as (100- the rate on maturity) • Contract pricing based on 90/360 interest •
convention 0.01% change in in the price leads to change in
Options • Fundamentally different from forwards,
futures and swaps and provide greater flexibility in risk management than any other derivative contract. • Holder or the buyer of option has a right to buy or sell an underlying without concomitant obligation to do so i.e. only seller has the obligation.
Some terms • Strike price – the price at which the right
to buy or sell is exercised / agreed • Expiry Date – The date on which option contract expires or becomes invalid • Call Option – the right to buy an underlying • Put Option – the right to sell an underlying • American Option – right can be exercised at any time during the life of an option • European Option – right can be exercised only at the end of the option contract
Option Premium • Option premium is the price for the option • Premium is payable upfront which is the
gain realized by the option writer • Option buyer has unlimited profit potential but loss is limited to the premium paid • Option writer has no right but face unlimited obligation • Option writer covers his option contracts with customers on back to back basis either in the domestic market or in overseas market
Pay off Profile of call option Buyer Profit Strike Price
0
Spot Price (Underlying)
Break even Point Loss
Seller
Pay off Profile of put option Buyer
Profit
Strike Price Spot Price (Underlying)
0
Break even Point Loss Seller
Options : few variations • Average Rate Option/Asian Option: average rate • • • • •
over a set period used as strike price Knock Out : option lapses if underlying price falls below a level or exceeds given level with reference to strike price Knock In : option becomes operative if before expiry underlying price goes above or below given levels Contingent Option: a call on pound at (say) USD1.50 but exercisable if pound LIBOR is (say) more than 6.5% Binary Option: predetermined constant amount paid if on expiry option is in the money Look back Option: gives right to buyer to sell/buy at best price during the life of the option
Foreign currency option • In India all currency options are OTC
and European style option • Cross currency option was introduced in January, 1994 • Foreign currency – Rupee option was introduced in July, 2003
Foreign currency option- zero cost structure • Range forward • Buy a call to hedge payable-sell a put to reduce /zeroise cost • Two strikes different : call-50/put -46 • Both out of money • The min. exchange rate capped at strike of the call
Foreign currency option- zero cost structure • Participating forward; USD 100000 • Buy call –SP=50.00,premium=60 paise-out of money • Sell put: in the money put – SP=50, pre.= Rs1.20- sell ½ put to zeroise cost • If on maturity rate=51, call exercised : if on maturity rate=47 ; put exercised-buy $ 50000 at Rs50/$ and remaining at Rs 47/average =48.50
Hedging : Options or Forwards? • • •
Option carry a upfront fees No general definitive answer Few worth noting points: – Option to be preferred for hedging contingent exposures – Forwards are not cost free- banks some times insist on margin against counter party risk – Opportunity cost inherent in forward: cannot take advantage of favourable movement – Option has up front cost but no opportunity cost – For SP= forward rate –option more expensive unless spot rate moves in favour by more than price paid
Hedging : Options or Forwards? • • • • • • • • • • •
A= option premium –European call F=Forward price /strike price X= spot rate at maturity X<= F : effective rates=F & X+A* X> F : effective rate = F & F+A** *Option cheaper only if F-X>A ** Option always costlier Forward to be preferred if adverse movement expected Option in case expected favourable movement Protection bought against potential unfavourable movement In that case buy out of money option to limit upfront cost
Foreign Currency – Rupee Options •
AD banks having a minimum CRAR of 9 per cent can offer foreign currency – rupee options on a back-to-back basis,
•
Allowed to run option book
•
– – – – –
adequate internal control, risk monitoring/ management systems, mark to market mechanism
Continuous profitability for at least three years
Minimum CRAR of 9 per cent Net NPAs at reasonable levels (not more than 5 per cent of net advances) Minimum Net worth not less than Rs. 200 crore a one time approval from the Reserve Bank
• AD banks can offer only plain vanilla European • • • • •
options. Customers can purchase call or put options. Customers can also enter into packaged products Cost reduction structures (provided the structure does not increase the underlying risk and does not involve customers receiving premium) Writing of options by customers is not permitted. Zero cost option structures can be allowed.
• undertaking from customers interested :clearly • • •
understood the nature of the product and its inherent risks. Quote for option premium in Rupees or as a percentage of the Rupee/foreign currency notional. Settled on maturity either by delivery on spot basis or by net cash settlement in Rupees on spot basis as specified in the contract. In case of unwinding of a transaction prior to maturity, the contract may be cash settled based on the market value of an identical offsetting option.
• Only one hedge transaction against a particular exposure/ part for a given time period. Option contracts cannot be used to hedge contingent or derived exposures (except exposures out of submission of tender bids in foreign exchange)
RBI Draft Guidelines: Some Changes
Option Trading Strategies • Spread • Taking position in two or more options of the • • • • • • •
same type( two or more call or put) Bull spread Example: Buy a call at SP=100 Sell the same call at SP=120 Example : Buy a put at SP=100 Sell same put at SP=120
Option Trading Strategies • Bear spread • Buy a put SP=100 • Sell the same put SP= 90 • Alternative: • Buy a call SP= 100 • Sell the same call SP= 90