Description
This is a PPT that includes topics like economic exposure,hedging methods,currency derivatives,swaps,currency futures
Transaction and Operating Exposure
Background to Hedging Currency Risk
? ?
What is the objective of any business ?
? To maximise wealth of owners
One aspect of wealth maximisation
? Realising all assets at stated or higher values and ? Paying off all liabilities at stated or lower values
? ?
This involves
? ensuring that cash flows occur at stated values
Cash Flows could be
? Already contracted leading to Transaction Exposure ? Yet to be contracted leading to Economic Exposure
Transaction Exposure
Deals with impact on contracted future cash flows due to currency fluctuations ? Contracted future cash flows may arise from
?
? Imports and exports ? Redemption of investments and repayment of borrowing in foreign currency ? Other foreign assets and liabilities to be paid in foreign currencies
? (eg) dividends, repatriation of equity, royalty
Transaction Exposure Example 1
?
Company A exports goods
? Sale Value : ? Billed in USD @ INR 40 25,000 ? Net profit margin for exports : ? Net profit on above export : 50,000 or ? On payment date, USD is at 35 ? Cash realisation : 25,000 ? Impact on profit : 75,000 INR 10,00,000 USD 5% INR USD INR 1,250
USD
INR 8,75,000 (-) INR
Transaction Exposure Example 2
?
Company A borrows in USD
? Amount borrowed 50,00,000 ? In USD terms @ INR 40 1,25,000 ? Tenor ? Interest rate ? Terms of repayment repayment ? Terms of paying interest tenor ? Interest INR
USD 1 year 6% p.a. Bullet At end of
USD
Example 2 (contd.)
?
Projected rate after one year 41
? Repayment in INR 1,25,000 X 41 51,25,000 ? Payment of Interest 7,500 X 41 3,07,500 ? Additional cash outflow 1,25,000 + USD INR
INR
INR
INR
INR
Exchange rate at end of one year
Resultant effect on cost
INR 41 INR 41 + INR 41-
Nil Higher Cost Lower Cost
Example 2 (contd.)
Hedging Transaction Exposure
?
Protecting the quantum of contracted cash flows so that adverse impact on wealth of owners is eliminated or reduced
? Use of derivatives like
? Forward contracts, Futures, Options and Swaps
? Money Market hedging
back
Economic Exposure
?
Impact on the projected wealth of the owners due to unanticipated or unplanned for changes in exchange rates that impacts projected cash flows
? These are not contracted cash flows
Understanding Economic Exposure
? ?
Objective of a firm
? Maximisation of wealth of owners
In a balance sheet,
? wealth of owners is represented by
? equity on the liabilities side
? Assets – Third Party Liabilities = Equity
?
Wealth of owners reduces if
? value of equity reduces i.e.
? value of assets reduces OR ? value of third party liabilities increases
Understanding Economic Exposure (contd.)
? ?
The argument extends to projected Balance Sheet also The projected size of a balance sheet could be impacted by changes in economic conditions and other related conditions
? The changes could include change in exchange rates
? (eg) if exports is projected at USD n and the exchange rate varies, the ‘n’ could move either way. Consequently, the wealth of the owners is impacted ? (eg) due to changes in political conditions, if a firm has to exit from a foreign country and set up operations in another, the different exchange rates for the two currencies will impact the wealth of the owners
Economic Exposure Example 1
?
Example of reduction in value of assets
? Consider a B/S with Indian and foreign assets (say USD)
? If USD depreciates against INR, at the time of realisation of the foreign asset, the value of realisation will be lower than that stated in the B/S
? (eg) if the B/S shows an asset at INR 1,00,000 @ INR 45 and USD depreciates to INR 40, the asset will realise only Rs. 40 instead of Rs. 45
? The value of assets having come down, while value of liabilities remains constant, value of equity is adversely affected
Economic Exposure Example 2
?
Example of increase in value of liabilities
? Consider a B/S with Indian and foreign liabilities (say USD)
? If USD appreciates against INR, at the time of settling of the foreign liability, the value will be higher than that stated in the B/S
? (eg) if the B/S shows a liability at INR 1,00,000 @ INR 45 and USD appreciates to INR 50, to settle the liability, payment will be Rs. 50 instead of Rs. 45
? The value of liabilities having gone up, while value of assets remains constant, value of equity is adversely affected
Hedging Economic Exposure
?
Eliminating or reducing the negative impact of currency fluctuations in the Balance Sheet by creating offsetting assets or liabilities in the same currency
? (eg) if there is a liability to be settled in say USD and if USD appreciates against INR, more INR will be required to settle the debt
? This can be offset by creating an asset that is valued in USD
? When USD appreciates against INR, the value of asset (in INR terms) will also go up
Hedging Economic Exposure Example
?
Asset : $25,000 20,000
Liability : $
?
Before change in currency value
? Asset in INR @ USD 40 : 10,00,000 ? Liability in INR @USD 40 : 8,00,000 Rs. Rs.
?
After change in currency value
? Asset in INR @ USD 50 : Rs.
More Methods for Hedging Economic Exposure
?
If cash inflow is from exports
? arrange for import of raw materials in the same currency ? arrange for borrowings in same currency so that servicing of the debt can be met out of the inflows
?
If cash outflow is due to imports, find avenues for export in the same currency
Hedging Economic Exposure (contd.)
?
Other methods
? Risk Sharing ? Back-to-back and Parallel Loans ? Currency Swaps
?
(the 1st two topics are for self-study)
back
Hedging
Hedging Methods
?
Internal methods
? ? ? ? Changing the invoicing currency Mixed Currency Invoicing Lead and lag techniques Exposure netting
?
External methods
? Money Market Hedging ? Currency Derivatives
Changing the Invoice Currency
An Indian exporter invoices in say USD ? If USD is expected to depreciate against INR, he will receive less in INR on conversion ? To avoid this, he can consider invoicing in INR
?
? Exchange rate risk is transferred to importer
? Will the importer agree ?
? Imports become costlier
? Can the exporter do this ?
? There is heavy competition, he may lose the customer
? Market practice or customary practice should also be taken into account
Changing the Invoice Currency (contd.)
An Indian exporter invoices in say USD ? If USD is expected to depreciate against INR, he can consider invoicing in a currency other than USD or INR say EURO or GBP
?
? This is feasible if INR is appreciating only against USD and not against other currencies and if the importer agrees
Mixed Currency Invoicing
?
The importer and exporter may agree to invoice partly in one currency and partly in another
Lead and lag techniques
?
A little background
? Hard Currency
? A currency that is widely accepted in many countries as payment for goods and services ? Is relatively stable in the short run ? Has good liquidity
? (eg) USD and GBP
? Soft Currency
? A currency that is not widely accepted in many countries because
? It fluctuates frequently in the short run ? Lacks sufficient liquidity
Lead and lag techniques (contd.)
?
When there are receivables in both hard and soft currencies, it is better to speed up receiving the soft currencies and speed up paying the hard currencies
? This is applicable when
? soft currencies are expected to depreciate against home currency and ? hard currencies are expected to appreciate against home currency
?
Speeding up is ‘lead’ and delaying is ‘lag’
Exposure Netting
?
When there are both payable and receivable exposure in same currency, they can be netted off and the net exposure may be hedged
? This is known as a natural hedge
?
Contrary view to the above i.e. exposures should not be netted and that exposures should be hedged separately is gaining ground
? But, this argument is based on the premise that ‘gross hedging’ as against ‘net hedging’ will yield some profits from hedging ? This line of argument is against the basic premise that currency hedging is for protecting shareholders’ wealth and not for increasing it
Money Market Hedge
?
Company A has borrowed INR 50,00,000 in USD @ INR 40
? Ignore interest
Hedging of currency risk is possible by creating a corresponding USD denominated asset ? Assuming that the Company invests in a USD denominated asset to the extent of INR 50,00,000 ? And the date of repayment of borrowing and redemption of asset are same
?
? The adverse currency movement in the case of repayment will be offset by favourable currency movement in the redemption of asset
? (eg) if USD rate is INR 41, the company has to pay INR 51,25,000 but it will also receive INR 51,25,000 from its investment
Money Market Hedge (contd.)
?
But, there is a cost involved for the investment
? Interest on borrowed funds for the investment or opportunity cost of own funds used for the investment
? Less interest earned on the investment (but we have ignored interest)
? ?
Is money market hedging method useful ? Yes
? It eliminates or reduces the currency risk ? If cost of funds used for investments abroad is less than the anticipated loss on account of currency fluctuation, money market hedge is beneficial
Class Exercise
Money market hedge for hedging export receivables ? Money market hedge for hedging import payables
?
Currency Derivatives
Recap of Derivatives in general
Basic Derivatives
Forward Contracts Futures Options Swaps
?
Derivatives ? Exchange Traded or ? Over the Counter (OTC) contracts
?
Exchange Traded –
? Futures and ? Options
?
OTC contracts –
? Forward contracts and ? Swaps
Derivatives based on underlying
Stock derivatives Index derivatives Currency derivatives Interest rate derivatives Credit derivatives
Forwards and Futures
About Forwards and Futures
?
Contracts
? Set of obligations at a future date ? Contract is binding on both parties
? Both parties to perform
? Profit of one party = Loss of other party
Terminology
? Party
who agrees to buy the underlying
? Holder of a long position ? Also, party is going long
? Party
who agrees to sell the underlying
? Holder of a short position ? Also, party is going short
OPTIONS
About Options
?
Contracts
? one party has the right to enforce the contract ? other party has the obligation to perform but no right to enforce the other person to perform
Terminology
Person originating contract - buyer of the option ? Other Party - seller or writer of the option ? Buyer has right to ask for performance ? Seller has duty to perform
?
Some more terminology
For a Call Option i.e. option to buy the underlying asset, ? In-the-money
?
? Spot price > strike price
?
Out-the-money
? Spot price < strike price
?
At-the-money
? Spot price = strike price
Some more terminology (contd.)
?
American option – facility to close the contract on any date before the agreed upon date of expiry / performance of contract European option – can be closed only on agreed upon date of expiry / performance of contract
?
Swaps
Contracts ? Two parties involved ? Both parties have obligations ? Involves substituting one set of underlying assets / obligations with another set ? Usually involves a series of cash flows by both parties ? Usually long term
?
Currency Forwards
Currency Forwards
? ?
Two parties are involved One party agrees with the other to
? buy or sell a defined sum of a foreign currency ? at a future date ? at a price fixed now (exchange rate)
? ? ?
Both parties have to perform the contract Profit made by one party = loss made by other party The obligations of either party cannot be transferred or assigned to a third party
Currency Forwards (contd.)
Terms of the contract are fixed by the parties to the contract ? Contract can be customised to the requirements of the parties
?
? Quantum of currency ? Date of entering into the contract ? Date of delivery of the contract
?
Normally, currency forwards do not involve any additional costs such as commission
? But, lack of transparency may lead to larger spreads resulting in higher costs
? ?
An OTC product Counterparty risk present
Currency Forwards Example
An importer has to pay after 3 months USD 10,000 ? Current rate is say 1 USD = Rs. 48 ? Forward Contract can be entered into for say 1 USD = Rs. 48.50 ? The importer can buy USD 10,000 from the other party after 3 months on the agreed date at 1 USD = Rs. 48.50 irrespective of the spot exchange rate for USD/INR on that date
?
Currency Forwards Scenarios
?
Scenario 1
? Payment due in foreign currency at a later date ? Foreign currency expected to appreciate against local currency ? Action suggested : enter into a forward contract to buy foreign currency ? (eg) if USD 1 = INR 40 today and USD is likely to appreciate to USD 1 = INR 45, then more INR will be required to buy USD 1
?
Scenario 2
? Receipt of foreign currency expected at a later date ? Foreign currency expected to depreciate against local currency ? Action suggested : enter into a forward contract to sell foreign currency ? (eg) if USD 1 = INR 40 today and USD is likely to depreciate to USD 1 = INR 38, on conversion of foreign currency, lower amount of INR will be received
How is Forward Price Determined ?
? ? ?
? ? ? ?
Let party A convert INR 1 mn to USD today at a spot rate of USD 1 = INR 50 i.e. a total sum of USD 20,000 Let interest rate on USD be 6% p.a. and on INR be 10 % p.a. At the end of one year, party A would have earned an interest of USD (20,000 * 6%) = USD 1200 by investing the amount that it received If Party A had not converted, it would have earned INR (1 mn * 10%) = INR 0.1 mn Party A now has USD 20,000 + 1200 = USD 21,200 mn Party A could have had INR 1 mn + 0.1 mn = INR 1.1 mn The exchange ratio will be 1.1 / 0.0212 = 51.8868
Formulae for calculating Forward Rate
?
Basic Formula
? Forward Rate = S(1+rq)n / (1+rb)n ? Where S = Spot Price rq = Interest Rate of home Currency rb = Interest Rate of foreign Currency n = Number of Compounding Periods
?
Applying the formula (previous example)
? Forward Rate = 50 X (1.10/1.06) ? INR 51.8868 ? (compounding period is 1 year with yearly rest)
?
The currency of the country that has a lower interest rate will appreciate against the other currency
Formulae for calculating Forward Rate (contd.)
?
Continuous Compounding Formula
? Forward Rate = Spot Rate X e(rq-rb)n ? Where rq = Interest Rate of home Currency rb = Interest Rate of foreign Currency n = period e = 2.71828183
Reference
www.fxstreet.com ? http://www.fxstreet.com/ratescharts/forward-rates/
?
Currency Futures
Currency Futures Quick Overview
? ? ? ? ? ?
A contract between two parties to buy / sell currencies Similar in structure to a currency forward Available only through exchanges Available only in select currencies Subject to standardised terms and conditions Either party can exit the contract at any time before expiry by entering into an opposite contract
Currency Futures Features
Created in exchanges and traded in exchanges ? No counterparty risk
?
? Clearing house is the counterparty
Margin requirements ? Daily settlement based on MTM
?
Currency Futures Standard Features
?
Standard
? ? ? ? ? ? ? ? ? Size of contracts Number of contracts (delivery months) Months of settlement and delivery Dates of settlement and delivery Last date for trading Tick size Trading hours Settlement value Price limits and position limits
Currency Futures
Examples
Chicago Mercantile Exchange
http://www.cmegroup.com/trading/fx/g10/australian-dollar_contract_specifications.html
?
Futures on AUD / USD
? ? ? ? ? ? ? ? ? ? ? Contract Size : AUD 100,000 Months of delivery : March, June, September, December Number of contracts at a time : 6 Performance Bond / Margin : Initial USD 3375 : Maintenance : USD 2500 Settlement day: 3rd Wednesday of the calendar month Settlement method : Physical Delivery Settlement Price : Volume weighted average price between 1.59.30 p.m. and 1.59.59 p.m. Last day of trading : Second business day immediately preceding settlement day Tick size : $0.0001 per Australian Dollar or $10 per contract Trading Systems : Open Outcry and Electronic Trading Trading hours :
? for open outcry from 7.20 a.m. to 2 p.m ? for electronic trading : 5 p.m. to 4 p.m. (next day)
Example of Hedging using a CME Future
?
U.S. Exporter exports in December, 2009
? Exports worth ? Expected realisation in GBP 10 mn 3 months
?
He enters into a future contract in CME for settlement in March, 2010
? ? ? ? Future rate : USD 1.6820 Settlement date will be 17.3.2010 Contract size is GBP 62,500 No. of contracts required is 10 mn / 62,500 = 160
? ?
?
? ?
He waits till 17th March, 2010 On 17th March, 2010 the contract matures He delivers GBP 10 mn and receives equivalent USD @ 1.6820 Spot price on 17th March, 2010 is USD 1.6800 Notional Profit : USD 20,000 (USD 1.6820 – 1.6800 per GBP)
Example Explained
Assume that he did not receive the export proceeds on the due date ? He has to honour the future contract ? So, he buys GBP from spot market and settles the contract at the exchange ? In the spot market, he buys GBP 10 mn @ USD 1.6800 ? In the exchange, he delivers GBP 10 mn @ USD 1.6820 ? He makes a profit of USD 20,000
?
MCX – SX
http://www.mcx-sx.com/products.htm
?
Futures on INR / USD
? ? ? ? ? ? ? ? ? ? ? Contract Size : USD 1000 Months of delivery : All calendar months in a year Number of contracts at a time : 12 Performance Bond / Margin : Initial 1.75% : Maintenance 1% Settlement day: Last working day (excluding Saturdays) of the expiry month Settlement method : Cash Settlement in INR Settlement Price : RBI reference rate Last day of trading : Two working days prior to the last business day of the expiry month at 12 noon Tick size : 25 paise Trading Systems : Electronic Trading Trading hours : 9 a.m. to 5 p.m.
Physical Delivery vis a vis Cash Settlement
?
In CME
? settlement method
? physical settlement
? i.e. delivery of currency is required
?
In MCX
? settlement method
? cash settlement
? i.e. delivery of currency is not required
? i.e.
? difference between future price and settlement price on settlement day is paid / received and the contract is settled
Previous Example with Cash Settlement
?
In the previous example
? if CME followed cash settlement in USD ? and the settlement price was USD 1.6800 (same as spot price)
? the exporter would receive USD 20,000 from the exchange ? go to the spot market and convert GBP 10 mn @ USD 1.6800
Early Exit from Future
Let’s say that the exporter receives his export proceeds on 10th March, 2010 ? So, he exits from the future contract on the same day i.e. before settlement date of 17th March, 2010
?
? on 10th March, he exits at the future price on that day
? this future price usually will not be equal to his contracted future price i.e. USD 1.6820 ? it may be above or below the contracted future price
? he exits with accumulated profit / loss based on MTM
?
As a result, he may not be able to cover fully his loss on realisation, if any, in the spot
When to Exit from a Future Contract ?
The settlement date of a Future Contract and the maturity date of currency exposure (desired date of hedging) may not be the same ? Which contract should one use ?
?
? A contract that has
? an earlier settlement date than the maturity date of exposure or ? one that has a later settlement date ?
Example
Export of goods in : November, 2009 ? Export proceeds receipt on :7th February, 2010 ? Settlement dates of Future : 17th March, 2010 16th December, 2009 ? What contract should be entered into ?
?
Example (contd.)
?
Choices available
? Use March contract
? wait till settlement date or ? exit on 7th February
? Use December contract, roll over, if permitted ? Use December contract
? Settle cash on settlement date ? wait till 7th February for spot market ? Possible only if cash settlement
? Use a later month contract like June or September
?
Refer Photocopies of pages 233 and 234 from book by P.G. Apte
References
?
Currency Futures in India
? FOR STUDY MATERIAL ON CURRENCY FUTURES
? http://nismcertify.mcxsx.com/downloads/NISMSICD_Workbook_July _16_2009.pdf
?
Currency Futures in CME
? http://www.cmegroup.com/education/inter active/CME_FX/Flash9ForWeb/index.html
doc_588301867.pptx
This is a PPT that includes topics like economic exposure,hedging methods,currency derivatives,swaps,currency futures
Transaction and Operating Exposure
Background to Hedging Currency Risk
? ?
What is the objective of any business ?
? To maximise wealth of owners
One aspect of wealth maximisation
? Realising all assets at stated or higher values and ? Paying off all liabilities at stated or lower values
? ?
This involves
? ensuring that cash flows occur at stated values
Cash Flows could be
? Already contracted leading to Transaction Exposure ? Yet to be contracted leading to Economic Exposure
Transaction Exposure
Deals with impact on contracted future cash flows due to currency fluctuations ? Contracted future cash flows may arise from
?
? Imports and exports ? Redemption of investments and repayment of borrowing in foreign currency ? Other foreign assets and liabilities to be paid in foreign currencies
? (eg) dividends, repatriation of equity, royalty
Transaction Exposure Example 1
?
Company A exports goods
? Sale Value : ? Billed in USD @ INR 40 25,000 ? Net profit margin for exports : ? Net profit on above export : 50,000 or ? On payment date, USD is at 35 ? Cash realisation : 25,000 ? Impact on profit : 75,000 INR 10,00,000 USD 5% INR USD INR 1,250
USD
INR 8,75,000 (-) INR
Transaction Exposure Example 2
?
Company A borrows in USD
? Amount borrowed 50,00,000 ? In USD terms @ INR 40 1,25,000 ? Tenor ? Interest rate ? Terms of repayment repayment ? Terms of paying interest tenor ? Interest INR
USD 1 year 6% p.a. Bullet At end of
USD
Example 2 (contd.)
?
Projected rate after one year 41
? Repayment in INR 1,25,000 X 41 51,25,000 ? Payment of Interest 7,500 X 41 3,07,500 ? Additional cash outflow 1,25,000 + USD INR
INR
INR
INR
INR
Exchange rate at end of one year
Resultant effect on cost
INR 41 INR 41 + INR 41-
Nil Higher Cost Lower Cost
Example 2 (contd.)
Hedging Transaction Exposure
?
Protecting the quantum of contracted cash flows so that adverse impact on wealth of owners is eliminated or reduced
? Use of derivatives like
? Forward contracts, Futures, Options and Swaps
? Money Market hedging
back
Economic Exposure
?
Impact on the projected wealth of the owners due to unanticipated or unplanned for changes in exchange rates that impacts projected cash flows
? These are not contracted cash flows
Understanding Economic Exposure
? ?
Objective of a firm
? Maximisation of wealth of owners
In a balance sheet,
? wealth of owners is represented by
? equity on the liabilities side
? Assets – Third Party Liabilities = Equity
?
Wealth of owners reduces if
? value of equity reduces i.e.
? value of assets reduces OR ? value of third party liabilities increases
Understanding Economic Exposure (contd.)
? ?
The argument extends to projected Balance Sheet also The projected size of a balance sheet could be impacted by changes in economic conditions and other related conditions
? The changes could include change in exchange rates
? (eg) if exports is projected at USD n and the exchange rate varies, the ‘n’ could move either way. Consequently, the wealth of the owners is impacted ? (eg) due to changes in political conditions, if a firm has to exit from a foreign country and set up operations in another, the different exchange rates for the two currencies will impact the wealth of the owners
Economic Exposure Example 1
?
Example of reduction in value of assets
? Consider a B/S with Indian and foreign assets (say USD)
? If USD depreciates against INR, at the time of realisation of the foreign asset, the value of realisation will be lower than that stated in the B/S
? (eg) if the B/S shows an asset at INR 1,00,000 @ INR 45 and USD depreciates to INR 40, the asset will realise only Rs. 40 instead of Rs. 45
? The value of assets having come down, while value of liabilities remains constant, value of equity is adversely affected
Economic Exposure Example 2
?
Example of increase in value of liabilities
? Consider a B/S with Indian and foreign liabilities (say USD)
? If USD appreciates against INR, at the time of settling of the foreign liability, the value will be higher than that stated in the B/S
? (eg) if the B/S shows a liability at INR 1,00,000 @ INR 45 and USD appreciates to INR 50, to settle the liability, payment will be Rs. 50 instead of Rs. 45
? The value of liabilities having gone up, while value of assets remains constant, value of equity is adversely affected
Hedging Economic Exposure
?
Eliminating or reducing the negative impact of currency fluctuations in the Balance Sheet by creating offsetting assets or liabilities in the same currency
? (eg) if there is a liability to be settled in say USD and if USD appreciates against INR, more INR will be required to settle the debt
? This can be offset by creating an asset that is valued in USD
? When USD appreciates against INR, the value of asset (in INR terms) will also go up
Hedging Economic Exposure Example
?
Asset : $25,000 20,000
Liability : $
?
Before change in currency value
? Asset in INR @ USD 40 : 10,00,000 ? Liability in INR @USD 40 : 8,00,000 Rs. Rs.
?
After change in currency value
? Asset in INR @ USD 50 : Rs.
More Methods for Hedging Economic Exposure
?
If cash inflow is from exports
? arrange for import of raw materials in the same currency ? arrange for borrowings in same currency so that servicing of the debt can be met out of the inflows
?
If cash outflow is due to imports, find avenues for export in the same currency
Hedging Economic Exposure (contd.)
?
Other methods
? Risk Sharing ? Back-to-back and Parallel Loans ? Currency Swaps
?
(the 1st two topics are for self-study)
back
Hedging
Hedging Methods
?
Internal methods
? ? ? ? Changing the invoicing currency Mixed Currency Invoicing Lead and lag techniques Exposure netting
?
External methods
? Money Market Hedging ? Currency Derivatives
Changing the Invoice Currency
An Indian exporter invoices in say USD ? If USD is expected to depreciate against INR, he will receive less in INR on conversion ? To avoid this, he can consider invoicing in INR
?
? Exchange rate risk is transferred to importer
? Will the importer agree ?
? Imports become costlier
? Can the exporter do this ?
? There is heavy competition, he may lose the customer
? Market practice or customary practice should also be taken into account
Changing the Invoice Currency (contd.)
An Indian exporter invoices in say USD ? If USD is expected to depreciate against INR, he can consider invoicing in a currency other than USD or INR say EURO or GBP
?
? This is feasible if INR is appreciating only against USD and not against other currencies and if the importer agrees
Mixed Currency Invoicing
?
The importer and exporter may agree to invoice partly in one currency and partly in another
Lead and lag techniques
?
A little background
? Hard Currency
? A currency that is widely accepted in many countries as payment for goods and services ? Is relatively stable in the short run ? Has good liquidity
? (eg) USD and GBP
? Soft Currency
? A currency that is not widely accepted in many countries because
? It fluctuates frequently in the short run ? Lacks sufficient liquidity
Lead and lag techniques (contd.)
?
When there are receivables in both hard and soft currencies, it is better to speed up receiving the soft currencies and speed up paying the hard currencies
? This is applicable when
? soft currencies are expected to depreciate against home currency and ? hard currencies are expected to appreciate against home currency
?
Speeding up is ‘lead’ and delaying is ‘lag’
Exposure Netting
?
When there are both payable and receivable exposure in same currency, they can be netted off and the net exposure may be hedged
? This is known as a natural hedge
?
Contrary view to the above i.e. exposures should not be netted and that exposures should be hedged separately is gaining ground
? But, this argument is based on the premise that ‘gross hedging’ as against ‘net hedging’ will yield some profits from hedging ? This line of argument is against the basic premise that currency hedging is for protecting shareholders’ wealth and not for increasing it
Money Market Hedge
?
Company A has borrowed INR 50,00,000 in USD @ INR 40
? Ignore interest
Hedging of currency risk is possible by creating a corresponding USD denominated asset ? Assuming that the Company invests in a USD denominated asset to the extent of INR 50,00,000 ? And the date of repayment of borrowing and redemption of asset are same
?
? The adverse currency movement in the case of repayment will be offset by favourable currency movement in the redemption of asset
? (eg) if USD rate is INR 41, the company has to pay INR 51,25,000 but it will also receive INR 51,25,000 from its investment
Money Market Hedge (contd.)
?
But, there is a cost involved for the investment
? Interest on borrowed funds for the investment or opportunity cost of own funds used for the investment
? Less interest earned on the investment (but we have ignored interest)
? ?
Is money market hedging method useful ? Yes
? It eliminates or reduces the currency risk ? If cost of funds used for investments abroad is less than the anticipated loss on account of currency fluctuation, money market hedge is beneficial
Class Exercise
Money market hedge for hedging export receivables ? Money market hedge for hedging import payables
?
Currency Derivatives
Recap of Derivatives in general
Basic Derivatives
Forward Contracts Futures Options Swaps
?
Derivatives ? Exchange Traded or ? Over the Counter (OTC) contracts
?
Exchange Traded –
? Futures and ? Options
?
OTC contracts –
? Forward contracts and ? Swaps
Derivatives based on underlying
Stock derivatives Index derivatives Currency derivatives Interest rate derivatives Credit derivatives
Forwards and Futures
About Forwards and Futures
?
Contracts
? Set of obligations at a future date ? Contract is binding on both parties
? Both parties to perform
? Profit of one party = Loss of other party
Terminology
? Party
who agrees to buy the underlying
? Holder of a long position ? Also, party is going long
? Party
who agrees to sell the underlying
? Holder of a short position ? Also, party is going short
OPTIONS
About Options
?
Contracts
? one party has the right to enforce the contract ? other party has the obligation to perform but no right to enforce the other person to perform
Terminology
Person originating contract - buyer of the option ? Other Party - seller or writer of the option ? Buyer has right to ask for performance ? Seller has duty to perform
?
Some more terminology
For a Call Option i.e. option to buy the underlying asset, ? In-the-money
?
? Spot price > strike price
?
Out-the-money
? Spot price < strike price
?
At-the-money
? Spot price = strike price
Some more terminology (contd.)
?
American option – facility to close the contract on any date before the agreed upon date of expiry / performance of contract European option – can be closed only on agreed upon date of expiry / performance of contract
?
Swaps
Contracts ? Two parties involved ? Both parties have obligations ? Involves substituting one set of underlying assets / obligations with another set ? Usually involves a series of cash flows by both parties ? Usually long term
?
Currency Forwards
Currency Forwards
? ?
Two parties are involved One party agrees with the other to
? buy or sell a defined sum of a foreign currency ? at a future date ? at a price fixed now (exchange rate)
? ? ?
Both parties have to perform the contract Profit made by one party = loss made by other party The obligations of either party cannot be transferred or assigned to a third party
Currency Forwards (contd.)
Terms of the contract are fixed by the parties to the contract ? Contract can be customised to the requirements of the parties
?
? Quantum of currency ? Date of entering into the contract ? Date of delivery of the contract
?
Normally, currency forwards do not involve any additional costs such as commission
? But, lack of transparency may lead to larger spreads resulting in higher costs
? ?
An OTC product Counterparty risk present
Currency Forwards Example
An importer has to pay after 3 months USD 10,000 ? Current rate is say 1 USD = Rs. 48 ? Forward Contract can be entered into for say 1 USD = Rs. 48.50 ? The importer can buy USD 10,000 from the other party after 3 months on the agreed date at 1 USD = Rs. 48.50 irrespective of the spot exchange rate for USD/INR on that date
?
Currency Forwards Scenarios
?
Scenario 1
? Payment due in foreign currency at a later date ? Foreign currency expected to appreciate against local currency ? Action suggested : enter into a forward contract to buy foreign currency ? (eg) if USD 1 = INR 40 today and USD is likely to appreciate to USD 1 = INR 45, then more INR will be required to buy USD 1
?
Scenario 2
? Receipt of foreign currency expected at a later date ? Foreign currency expected to depreciate against local currency ? Action suggested : enter into a forward contract to sell foreign currency ? (eg) if USD 1 = INR 40 today and USD is likely to depreciate to USD 1 = INR 38, on conversion of foreign currency, lower amount of INR will be received
How is Forward Price Determined ?
? ? ?
? ? ? ?
Let party A convert INR 1 mn to USD today at a spot rate of USD 1 = INR 50 i.e. a total sum of USD 20,000 Let interest rate on USD be 6% p.a. and on INR be 10 % p.a. At the end of one year, party A would have earned an interest of USD (20,000 * 6%) = USD 1200 by investing the amount that it received If Party A had not converted, it would have earned INR (1 mn * 10%) = INR 0.1 mn Party A now has USD 20,000 + 1200 = USD 21,200 mn Party A could have had INR 1 mn + 0.1 mn = INR 1.1 mn The exchange ratio will be 1.1 / 0.0212 = 51.8868
Formulae for calculating Forward Rate
?
Basic Formula
? Forward Rate = S(1+rq)n / (1+rb)n ? Where S = Spot Price rq = Interest Rate of home Currency rb = Interest Rate of foreign Currency n = Number of Compounding Periods
?
Applying the formula (previous example)
? Forward Rate = 50 X (1.10/1.06) ? INR 51.8868 ? (compounding period is 1 year with yearly rest)
?
The currency of the country that has a lower interest rate will appreciate against the other currency
Formulae for calculating Forward Rate (contd.)
?
Continuous Compounding Formula
? Forward Rate = Spot Rate X e(rq-rb)n ? Where rq = Interest Rate of home Currency rb = Interest Rate of foreign Currency n = period e = 2.71828183
Reference
www.fxstreet.com ? http://www.fxstreet.com/ratescharts/forward-rates/
?
Currency Futures
Currency Futures Quick Overview
? ? ? ? ? ?
A contract between two parties to buy / sell currencies Similar in structure to a currency forward Available only through exchanges Available only in select currencies Subject to standardised terms and conditions Either party can exit the contract at any time before expiry by entering into an opposite contract
Currency Futures Features
Created in exchanges and traded in exchanges ? No counterparty risk
?
? Clearing house is the counterparty
Margin requirements ? Daily settlement based on MTM
?
Currency Futures Standard Features
?
Standard
? ? ? ? ? ? ? ? ? Size of contracts Number of contracts (delivery months) Months of settlement and delivery Dates of settlement and delivery Last date for trading Tick size Trading hours Settlement value Price limits and position limits
Currency Futures
Examples
Chicago Mercantile Exchange
http://www.cmegroup.com/trading/fx/g10/australian-dollar_contract_specifications.html
?
Futures on AUD / USD
? ? ? ? ? ? ? ? ? ? ? Contract Size : AUD 100,000 Months of delivery : March, June, September, December Number of contracts at a time : 6 Performance Bond / Margin : Initial USD 3375 : Maintenance : USD 2500 Settlement day: 3rd Wednesday of the calendar month Settlement method : Physical Delivery Settlement Price : Volume weighted average price between 1.59.30 p.m. and 1.59.59 p.m. Last day of trading : Second business day immediately preceding settlement day Tick size : $0.0001 per Australian Dollar or $10 per contract Trading Systems : Open Outcry and Electronic Trading Trading hours :
? for open outcry from 7.20 a.m. to 2 p.m ? for electronic trading : 5 p.m. to 4 p.m. (next day)
Example of Hedging using a CME Future
?
U.S. Exporter exports in December, 2009
? Exports worth ? Expected realisation in GBP 10 mn 3 months
?
He enters into a future contract in CME for settlement in March, 2010
? ? ? ? Future rate : USD 1.6820 Settlement date will be 17.3.2010 Contract size is GBP 62,500 No. of contracts required is 10 mn / 62,500 = 160
? ?
?
? ?
He waits till 17th March, 2010 On 17th March, 2010 the contract matures He delivers GBP 10 mn and receives equivalent USD @ 1.6820 Spot price on 17th March, 2010 is USD 1.6800 Notional Profit : USD 20,000 (USD 1.6820 – 1.6800 per GBP)
Example Explained
Assume that he did not receive the export proceeds on the due date ? He has to honour the future contract ? So, he buys GBP from spot market and settles the contract at the exchange ? In the spot market, he buys GBP 10 mn @ USD 1.6800 ? In the exchange, he delivers GBP 10 mn @ USD 1.6820 ? He makes a profit of USD 20,000
?
MCX – SX
http://www.mcx-sx.com/products.htm
?
Futures on INR / USD
? ? ? ? ? ? ? ? ? ? ? Contract Size : USD 1000 Months of delivery : All calendar months in a year Number of contracts at a time : 12 Performance Bond / Margin : Initial 1.75% : Maintenance 1% Settlement day: Last working day (excluding Saturdays) of the expiry month Settlement method : Cash Settlement in INR Settlement Price : RBI reference rate Last day of trading : Two working days prior to the last business day of the expiry month at 12 noon Tick size : 25 paise Trading Systems : Electronic Trading Trading hours : 9 a.m. to 5 p.m.
Physical Delivery vis a vis Cash Settlement
?
In CME
? settlement method
? physical settlement
? i.e. delivery of currency is required
?
In MCX
? settlement method
? cash settlement
? i.e. delivery of currency is not required
? i.e.
? difference between future price and settlement price on settlement day is paid / received and the contract is settled
Previous Example with Cash Settlement
?
In the previous example
? if CME followed cash settlement in USD ? and the settlement price was USD 1.6800 (same as spot price)
? the exporter would receive USD 20,000 from the exchange ? go to the spot market and convert GBP 10 mn @ USD 1.6800
Early Exit from Future
Let’s say that the exporter receives his export proceeds on 10th March, 2010 ? So, he exits from the future contract on the same day i.e. before settlement date of 17th March, 2010
?
? on 10th March, he exits at the future price on that day
? this future price usually will not be equal to his contracted future price i.e. USD 1.6820 ? it may be above or below the contracted future price
? he exits with accumulated profit / loss based on MTM
?
As a result, he may not be able to cover fully his loss on realisation, if any, in the spot
When to Exit from a Future Contract ?
The settlement date of a Future Contract and the maturity date of currency exposure (desired date of hedging) may not be the same ? Which contract should one use ?
?
? A contract that has
? an earlier settlement date than the maturity date of exposure or ? one that has a later settlement date ?
Example
Export of goods in : November, 2009 ? Export proceeds receipt on :7th February, 2010 ? Settlement dates of Future : 17th March, 2010 16th December, 2009 ? What contract should be entered into ?
?
Example (contd.)
?
Choices available
? Use March contract
? wait till settlement date or ? exit on 7th February
? Use December contract, roll over, if permitted ? Use December contract
? Settle cash on settlement date ? wait till 7th February for spot market ? Possible only if cash settlement
? Use a later month contract like June or September
?
Refer Photocopies of pages 233 and 234 from book by P.G. Apte
References
?
Currency Futures in India
? FOR STUDY MATERIAL ON CURRENCY FUTURES
? http://nismcertify.mcxsx.com/downloads/NISMSICD_Workbook_July _16_2009.pdf
?
Currency Futures in CME
? http://www.cmegroup.com/education/inter active/CME_FX/Flash9ForWeb/index.html
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