Forex hedging

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Forex hedging

  1. 1. Forex hedging vehicles INTRODUCTION As the requirements of the foreign exchange market grew manifold, so did the complexity of its operation. This triggered of a simultaneous evolution of various financial instruments. One of the most significant developments in the foreign exchange market, occurred in Chicago on May 16, 1972 when the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange (CME), introduced the world’s first futures contract in foreign currencies. The IMM was therefore the first exclusive currency futures exchange. Late on, Interest rate futures were introduced in 1975 at the Chicago Board of Trade (CBOT) with Government National Mortgage Association certificate (GNMAs) and Treasury Bills. Owing in to the establishment of two main commodity exchanges in Chicago, viz, the Chicago Board of Trade (CBOT) in 1848 and Chicago Mercantile Exchange (CME) in 1898, large scale trading in commodity futures commenced much before the start of trading in financial futures. However, with the introduction of currency futures at the IMM, for the first time money was formally regarded as commodity in 1972. The phenomenon growth of deals in financial futures have already made them a vital and integral part of the world’s financial markets. 1
  2. 2. Forex hedging vehicles The man generally regarded as the father of currency futures contract is Leo Melamed, who in 1969, as a Chairperson of CME realised the need to diversity Chicago exchanges out of agricultural commodities. It look, however, some time for the financial world outside America to realise the potential of futures market as tool to cover adverse interest rate and exchange rate movements. The first major non-US financial future marker place was therefore established in 1982 in the UK. It is known as London International Financial Futures Exchange (LIFFE). Later on several other countries, such as, Canada, Hong Kong, Japan and the financial super market of Far East, Singapore, also started financial futures exchanges. For many bankers, hedgers, traders and speculators, financial futures are now more cost effective in covering interest rate and exchange exposure than cash market alternatives such as forward contract, etc. Short Hedge and Long H edge: The terms short term hedge and long hedge distinguish hedges that involves short and long positions in the futures contract, respectively. A hedger who holds the commodity and is concerned about a decrease in its price might consider hedging it with a short position in futures. If the spot price and futures price move together, the hedge will reduce some of the risk. For example, if the spot price decreases, the futures prices also will decrease. Since the hedge is short the futures contract/the futures transaction produces a profit that at least partially offsets the loss on the spot position. This is called a short hedge because the hedger is short futures. Another type of short hedge can be used in anticipation of the future sale of an asset. An example of this occurs when a firm decides that it will need to borrow money at a later date. Borrowing money is equivalent to issuing or selling a bond or promissory note. If interest rates increase before the money is borrowed , the loan will be more expensive. A similar risk exists risk exists if a firm has issued a floating rate liability. Since the rate is periodically reset, the firm has contracted for a series of future loans at unknown rates. To hedge this risk, the firm might short an interest rate future contract. If rates increase, the futures transaction will generate a profit that will at last partially offset 2
  3. 3. Forex hedging vehicles the higher interest rate on the loan. Because it is taken out in anticipation of a future transaction in the spot market, this type of hedge is known as an anticipatory hedge. Another type of anticipatory hedge involves an individual who plans to purchase a commodity at a later date. Fearing an increases in the commodity’s price, the investor might buy a futures contract. Then, if the price of the commodity increases, the futures price also will increases and produce a profit on the futures position. That profit also will at least partially offset the higher cost of purchasing the commodity. This is long hedge, because the hedger is long in the future market. In each of these cases, the hedger held a position in the spot market that was subject to risk. The futures transaction served as a temporary substitute for a spot transaction. Thus, when one holds the spot commodity and is concerned about a price decrease but does not want to sell it, one can execute a short futures trade. Selling the futures contract would substitute for selling the commodity. 3
  4. 4. Forex hedging vehicles FORWARD BOOKING CONTRACT The choice of futures contract actually consists of three decision:- • Which futures commodity • Which expiration month • Whether to be long or short  Which futures commodity It is important to select a future contract on a commodity that is highly correlated with the underlying commodity being hedged. In many cases the choice is obvious, but in some it is not. For example, suppose one wishes to hedge the rate on bank CDs, which are short term money market instrument issued by commercial banks. There is no bank CDs future contract so the hedger must choose from among some other similar contracts. Liquidity is important, because the hedger must be able to close the contract easily. If the future contract lacks the necessary liquidity, the hedger should select a contract that has sufficient liquidity and is highly correlated with the spot commodity being hedged. Since both treasury bills and Eurodollars are short-term money market instruments, their futures contracts, which are quite liquid, would seem appropriate for hedging bank CDs rates. Of course, if the hedger wanted the hedging instruments to be identical to the underlying Hedging Technology Forward Booking Contract Currency Future Currency Option Currency Swap 4
  5. 5. Forex hedging vehicles spot asset, he or she could go to the over-counter-market and request a forward contract, but that would entail some other considerations. Another factor one should consider is whether the contract is correctly priced. A short hedger will be selling futures contracts and therefore should look for contracts that are overpriced or, in the worst case, correctly priced. A long hedger should hedge by buying under priced contracts or, in the worst case correctly priced contracts. Sometimes the best hedge can be obtained by using more than one futures commodity.  Which Expiration month Once one has selected the future commodity, one must decide on the expiration month. As we know, only certain expiration month trade at a given time. If the Treasury bond future contracts is the appropriate hedging vehicle, the contract used must come from this group of expirations. In the most cases there will be a time horizon over which the hedge remains in effect. To obtain the maximum reduction in basis risk, a hedger should hold the future position until as close as possible to expiration. Thus an appropriate contract expiration would be one that corresponded as closely as possible to the expiration date. However, the general rule of thumb is to avoid holding a futures position in the expiration month. This is because unusual price movements sometimes are observed in the expiration month and this would pose an additional risk hedgers. Thus, the hedger should choose an expiration month that is as close as possible to but after the month in which the hedge is terminated. However, this rule used not always be strictly followed since all contract don’t exhibit unusual price behaviour in the expiration month .Infect, the longer time expiration, the less liquid is the contract. Therefore, the selection of a contract according to this criterion may need to be overruled by the necessity of using a liquid contract. If this happens, one should use a contract with shorter expiration. When the contract moves into its expiration month, the future position is closed out and a new position is opened in the next expiration month. 5
  6. 6. Forex hedging vehicles  Long or Short After selecting the future commodity and expiration month, the hedger must decide whether to be long or short. This decision is critical and there is absolutely no room for a mistake here. If a hedger goes long (or short) when he should have been short (or long) he has double the risk. The end result will be a gain or twice the amount of the gain or loss of the un hedged position. The decision of whether to go long or short requires a determination of which type of market move will result in a loss in the spot market. It then requires establishing a future position that will be profitable while the spot position is losing. The first method requires that the hedger identify the worst case scenario and then establish future position that will profit if the worst case does occur. The second method requires taking a future position that is opposite to the current spot position. This is a simple method, but in some cases it is difficult to identify the current spot position. The third method identifies the spot transaction that will be conducted when the hedge is terminated. 6
  7. 7. Forex hedging vehicles FORWARD RATE AGREEMENT (FRA) FRA is an off-balance sheet contract between two counterparties to pay (-) or receive (+) the difference (called settlement amount) between: • An agreed fixed rate (the FRA rate) • The interest rate prevailing on a stipulated future date (the Fixing date) • Based on a notional amount for an agreed period (the contract period) In short, in an FRA interest rate is fixed now for a future period. The special feature of FRA is that the interest payment are calculated on the notional principal and the only payment is the difference between the FRA rate and Reference Rate and hence are single 7
  8. 8. Forex hedging vehicles settlement contracts. By entering into an FRA one can swap from floating rates to fixed rates or vice versa for the term of the FRA. They can be used to hedge borrowing costs of investment returns in foreign currencies and can be tailored to suit exact requirements of its users. As mentioned earlier, in an FRA agreement, no principal amounts are exchanged initially. Thus, by buying an FRA, one can guarantee the future borrowing cost against a rise in interest rates. On the other hand, a seller of an FRA can protect himself against a drop in interest rates.  Features of FRAs 1. Flexibility: FRAs can be priced for a variety of commencement and maturity date which offers the flexibility to choose the exposure a firm will have at any point of time. For example, there may be times when a borrower may be happy with floating rate exposure, but is concerned that in six months it will change. FRA can cover exposure in six months time for the client as per his discretion. 2. Reversibility: Despite being a very effective tool in managing short term interest rate exposures, having entered into FRA once, one is locked into the agreement whether rates moves in favour or against. One can terminate FRA agreement only at a cost by reimbursing the arranging bank a payment based on current market rates. 3. Balance Sheet Implication; FRA provide off-balance sheet financial engineering as there are no principal amounts amounts exchanged in FRAs and hence the does not incur additional assets/liabilities on its balance sheet. FRA therefore does affect gearing or leverage ratios of firm. The only interest rate exposure arising from an FRA is the differential between the FRA rate and floating rates represented by the prevailing Reference Rate (RR)such as LIBOR (London Inter Bank Offered Rate) in the international market and NSE-MIBOR (Mumbai Inter Bank Offered Rate)in the Rupee market in India. 8
  9. 9. Forex hedging vehicles 4. Transaction date: The settlement sum for FRA is calculated on the fixing date by discounting back the difference between the previously contracted FRA rate and the then prevailing Reference rate. In such deals money changes hand only on settlement date, therefore there are no payment either on the transaction date or, on the maturity date.  Advantages of FRA A typical case where firms/banks may wish to utilize FRA as a short term hedging instruments is around the announcement of the next Credit policy, and the concern that market may become extremely volatile at that time. In such a case the firm can either an FRA agreement now to ensure that borrowing costs or investment returns do not because of this volatility. The advantages of FRA deals may be summarized as:- 1. FRAs can be tailored to one’s requirements by date and amount. 2. Are simpler then a financial future as no fees, initial and variation margin require to be paid in FRAs. 3. Good alternative to forward cash transaction without affecting balance sheet. 4. Can be used to fix interest rates on all or part of money market positions. 5. FRAs and cash may be used for generating opportunities more efficiently. 6. Low utilization of bank’s credit line. 7. Counterparty risk in the form of settlement risk only with exposure only to interest variation as the principal amount is just notional. 8. Positions can easily be reversed by buying and selling an equal and offsetting FRA.  Limitations of FRAs FRAs do not remove interest rate or exchange rate exposure; rather they are a means of adjusting or exchanging these exposures on a short term basis. If the treasury term picks the market correctly, it may very well limit costs or improve returns, but there will still be market risk and the risk that the yield curve will change shape. Anyone 9
  10. 10. Forex hedging vehicles involved in treasury operations will be very aware that managing interest rate and exchange rate exposure is an on going task.  FRAs for taking a view on rates One of the most common application of FRA is to swap floating rate borrowings or investments to fixed for a short period of time. This can be achieved through buying an FRA. A firm may wish to do this from time to guard against volatility in floating rates. Alternatively, firms having huge fixed rate exposure may decide to use FRAs to swap to floating for a short period of time; this may be in line with a view that floating rate are on the way down (or up for those who wish to protect investment returns), or because it more closely matches the interest rates basis of other commitments over a certain period. In this case the firm would sell an FRA. Suppose for example, a firm has fixed rate investments and is planning to lease some equipment in order to expand operations in two months time, for a period of six months. The lease payments will be based on floating interest rates. The firm can hedge this future exposure by selling a 2s 8s FRA today to swap the appropriate amount of fixed rate investments to floating. The investments returns will then match firm’s floating rate obligation on the lease transaction. When the lease expires, firm’s investment will once again be on a fixed basis.  How to know when to Use FRAs Whether a firm will benefit from FRAs or not can be judged by conducting a thorough examination of funding requirement and the investment strategies of the firm; both current and future. While firm’s view on interest rates is fundamental to the consideration of whether an FRA is appropriate, some more vital questions that need to be adequately looked at are: a. Are funding/deposits of long or short term nature? b. Are funding/deposits of fixed or floating rate of interest? c. Do funding/deposits requirements vary in maturity and value or are they fairly? d. What is the firm’s view on interest rates? 10
  11. 11. Forex hedging vehicles e. Are there any projects/expansions in future which will require additional funding ? Is there likely to be any excess funds arising which will need to be deposited? CURRENCY FURURES INTRODUCTION The liberalisation and integration of world capital markets in the 1980s was inspired by a combination of hope and necessity. The hope lay in the expectation of more efficient allocation of saving and investment, both within national markets and across the world at large. The necessity stemmed from the macroeconomic and financial instability – the instability engendered government deficits and external imbalances that required financing on a scale unprecedented in peace time and that exceeded the capacity or willingness of the traditionally fragmented financial markets to cover. These financing needs joined with advances in technology and communications to spawn a host of innovations, ranging from securitisanon in place of intermediated bank credit to new derivative instruments. Taken together, innovation technology and deregulation have smashed the barriers both within and among national financial markets. Currency Future Export (Long on Foreign Currency) Import (Short On Foreign Currency Short Currency Future Hedge Long Currency Future Hedge 11
  12. 12. Forex hedging vehicles Today world financial markets are growing in size, sophistication and global integration. According to an estimate, the international securities transactions amounted to $6 trillion per quarter in the second half of 1993 – about five to six times the value of international trade-in six group of seven countries. This increased volume of portfolio capital movements has made foreign exchange markets much more sensitive to changes in financial markets. These markets have acquired clout as an indicator of the credibility of the government’s actual or prospective policies, as a disciplining mechanism for industrial and developing countries alike. Futures Markets In the past several years, derivatives market has attached many new and inexperienced entrants. The spectacular growth of the new futures markets in interest rates and stock markets indexes has generated a demand for a unified economic theory of the effects of futures markets – in commodities, financial instruments, stock market indexes and foreign exchange – upon the intertemporal allocation of resources. The basic assumption of the investment theory is that investors are risk averse. If risk is to be equated with uncertainly, can we question the validity of this assumption ? What evidence is there ? As living, functional proof of the appropriateness of the risk aversion assumption, there exists entire market whose sole underlying purpose is to allow investors to display their uncertainties about the future. These particular markets, with primary focus on the future, are called just that future markets. These markets allow for the existence of futures markets is the balance between the number of hedgers and operators who are willing to transfer and accept risk. What are Financial Futures A ‘Futures’ contract is a standardized agreement between two parties to buy or sell specific commodity, financial instrument or currencies, at a specific time and place in the future, at a price established through open outcry in a central, Generally high open interest is related to greater liquidity. Technical analyst in the futures market use both 12
  13. 13. Forex hedging vehicles Trading Volume and open interest to measure the direction of futures prices and possible liquidity position. Thus an increase in both open interest and Trading Volume is said to be hinting at a strong market and a weaker market is represented by fall in both of them. Similarly, high Trading Volume coupled with low open interest denotes volatility and riskiness of the market. Benefits of Financial Futures In recent years, interest rates and currency exchange rates have become highly volatile, Financial futures were set up to provide a means of lessening the impact of these-fluctuations. Accordingly, benefits of financial futures can be summed up as under. 1. Hedge Against Unanticipated Price Rise and Falls : A futures contract is used to hedge against unanticipated rise or fall in price of an instrument. Thus an investor who wishes to buy $100,000 in T-notes in four months can buy a T-Note contract and lock in the price. 2. Speculation on price movements : A future contract can be speculate on the price movement of underlying instrument. In futures contract one need not hold the instrument to benefit from price movements. For example : An investor who believes that prices of T-Notes are going to rise, he can buy futures contracts rather than the actual instruments. This helps investors to speculate in merkat movements without owning the T-Notes. 3. Speculation on Interest Rate Movements: Like speculation on price movements, one can use futures contract even to speculate on the interest rate movements without owning in the instruments. Thus, if a speculator thinks that interest rates are likely to go up, he can sell the futures contract since there exists an inverse relationship between price of an instruments and interest rates. 13
  14. 14. Forex hedging vehicles 4. Fixing Long Term Returns : An investor who wishes to lock in a long term return on an instrument can buy or go ‘long’ term (generally two years) futures contract. 5. Fixing Return on Floating Rate Investments : Futures allow investors to fix a rate in floating rate assets. This can be done by buying short term futures contract. For example : an investor owns T-Note worth $1 million with floating rate coupon of 3 months LIBOR + 50 basis points. The investor can lock in a rate by buying a 3-months Eurodollar contract which coincides with coupon payments. This converts investors floating rate payments into fixed rate payment. 6. Scope of Arbitrage : Since future prices are based on cash market prices, sometimes it is possible to benefit from the mismatch in these two markets. Presence of arbitragers in the market ensures liquidity and price relationship. Users of Futures Contract Apart from individuals as speculators and investors, futures contracts are used by corporate bodies and institutional investors. Financial institutions, being the primary users of financial futures, transact in future contracts to hedge their position. Firms on the other hand generally use futures contracts to hedge their exposure in financial and commodity markets. Hedging through financial futures can help these firms to achieve a wide variety of objectives such as predetermining the interest and exchange rates or protecting returns from fixed or floating instruments. Although perfect hedges are rarely achieved by using financial future due to maturity date mismatch or daily movements, sophisticated firms use futures market extensively to cover their exposed asset and liabilities. Trading in Currency Futures Two main objectives for trading in currency futures are position trading or speculation to take advantage from price fluctuation and as an alternative to the forward market for hedging specific business transaction. Foreign currencies in futures exchanges 14
  15. 15. Forex hedging vehicles are treated as a commodity. Thus, the buyer in a currency futures contract is buying a commodity today for delivery at a later date. The seller will deliver the contract to the buyer at the contract rate. It price of a particular currency rises above the contract rates, the buyer realizes gain since he receives the currency by paying a lower price than the market price at that time. Similarly, if the exchange rate of a particular currency is far below the contract price, the seller realizes a gain. Strategies for hedging in the currency futures market can be summarized as under : Hedging Rules Risk of Strategy Increase in price Buy (long) Futures Decrease in price Sell (long) Futures For example, a British Importer has to pay $150,000 to an exporter from USA on 30th April. The British importer is worried about adverse movements in the exchange rates for US dollar against pound and hence decides to cover the exchange risk in the futures market at LIFFE. The £ 25,000 and the maturity is 2nd Wednesday of June. The current spot rate is assumed to be $1,5200 and the June contract is being traded at $1,5000. Since the importer is apprehending a depreciation in the pound sterling, he decided to sell four June contract at $1,5000 to cover his exposure of $150,000. On 30th April, the spot rate in the cash market is $1,4800 per pound sterling and the June futures contract is now trading at $1,4600. In the futures price market he can buy back his four contract sold at $1,5000 at the current futures price as $1,4600 and thus making a profile of four cents per sterling contract £25,000 each, this total profile would be $4,000 or £2,702 as per the current spot rate of $1,4800. Had he decided not to hedge the risk, his loss would have been £2,667. This is because purchase of $150,000 at the current price will 15
  16. 16. Forex hedging vehicles cost him £101,351 ($150,000/1.48) compared to the £98,684 ($150,000/1.52) calculated at the spot rate ruling when he decided for hedge the risk. Currency futures, as shown here, may not provide the perfect hedge since the amounts and maturity date may not always coincide. This provides one of the greatest limitations of using currency futures for hedging exposed deals. 16
  17. 17. Forex hedging vehicles CURRENCY OPTIONS Currency option overview Options on foreign exchange? It's really no different to options on shares or real estate. The basic premise is that the buyer of an option has the right but not the obligation to enter into a contract with the seller. Naturally the option owner exercises this right when it is to his/her advantage. Currency options specify a foreign exchange contract and give the owner the right to enter into the specified contract during a pre-agreed period of time. Currency Options have gained acceptance as invaluable tools in managing foreign exchange risk. They are used extensively and make up between 5 - 10 % of total turnover. Currency options bring a much wider range of hedging alternatives to portfolio managers and corporat treasuries. Currency Option Call Option (Right to buy the currency) Put Option (Right & not Obligation to sell the currency) Purchase put option Selling put optionPurchase of call option Selling of call option 17
  18. 18. Forex hedging vehicles This area of OzForex is devoted to furthering the understanding of what currency options are, how they are priced and how they can be used. In the near future we will be bringing options pricing tools onto the site and also a section that simplifies the mathematics behind options pricing. Currency option defination In every foreign exchange transaction, one currency is purchased and another currency is sold. Consequently, every currency option is both a call and put. An option to buy Australian dollars against United States dollars is both an Australian dollar call and a United States dollar put. Conversely, an option to sell Australian dollars against United States dollars is an Australian dollar put and call More Currency Option Basics  Definition A currency option is the right - but not the obligation - to buy (in the case of a call) or sell (in the case of a put) a set amount of one currency for another at a predetermined price at a predetermined time in the future. The two parties to a currency option contract are the option buyer and the option seller/writer. The option buyer may, for an agreed upon price called the premium, purchase from the option writer a commitment that the option writer will sell (or purchase) a specified amount of a foreign currency upon demand. The option extends only until the expiration date. The rate at which one currency can be purchased or sold is one of the terms of the option and is called the exercise price or strike price. The total description of a currency option includes the 18
  19. 19. Forex hedging vehicles underlying currencies, the contract size, the expiration date, the exercise price and another important detail: that is whether the option is an option to purchase the underlying currency - a call - or an option to sell the underlying currency - a put. There are two types of option expirations - American-style and European- style. American-style options can be exercised on any business day prior to the expiration date. European-style options can be exercised at expiration. Currency options may be quoted in one of two ways: American-terms, in which a currency is quoted in terms of the U.S. dollar per unit of foreign currency; and European-terms (inverse terms), in which the dollar is quoted in terms of units of foreign currency per dollar. The same logic can be applied to currency pairs in which the U.S. dollar is not one of the currencies. Either currency can be expressed in terms of the other.  Trading & Speculation Currency options offer some unique features to the speculator. Purchasing an option you know that your downside is limited to the premium you invest. Sounds great and it is. However you should also know that the probability of make a profit depends on where the option strike is. If USD/JPY spot is 120.00 and you buy a 1 month 140.00 strike USD Call, the premium will be small but the probability of losing it all is very high. On the other hand if you sell options you receive premium but you also are exposed to unlimited loss if the market moves against your position.  Hedging With Options Options offer some very interesting features for hedging. There are a wide variety of different types of options to match the full spectrum of risks that companies and fund managers inherit as part of their international trade and investment. It is important that risk managers understand the products they are buying and exactly how they perform under different scenarios. The goal being to negate the existing risks of the business. 19
  20. 20. Forex hedging vehicles  Where to trade Never trade with someone that has "cold called" you. Go with a reputable broker. Do your homework and ensure that you are trading with a reputable broker with solid references and a solid background. These days there are a lot of companies claiming enormous returns through trading currency options but you would be wise to remember that nothing is certain and there is definitely no such thing as a "sure bet". As always it pays to speak to a financial advisor to ensure that this investment is right for you.  Where to hedge Your local banks Treasury division should have the ability to offer you currency options. They generally have minimum deal sizes - generally over USD. Don't be afraid to ask your bank how they arrived at a price for an option. It is made up of the spot rate, strike, forward points and volatility. If you have these variables you can use our option to check the Currency options can also be bought on various exchanges such as the IMM. To transact these you will need to set up a relationship with a company that can execute the trades on the behalf. As always stick to somebody that has a good reputation. 20
  21. 21. Forex hedging vehicles CURRENCY SWAPS INTRODUCTION Currency and interest rate swaps are considered to be one of the earliest and widely accepted innovative products in the international financial market place. They have found acceptance worldwide due to their versatile application. In the past ten years, interest rate and currency swaps have become well established risk management techniques. They are now being used extensively by the banking and corporate sectors, including governments to reduce borrowing cost and to manage their interest rate and currency exposures. The development of interest and currency swap now provides a tool no financial manager can ignore. It has also triggered off innovation of a whole range of derivative products like swaptions and others that have greatly expanded the opportunities for financial management. There are many reasons for the growth of swap market. It was originally developed for easier access to international markets by MNCs in “vehicle 21
  22. 22. Forex hedging vehicles currencies” and swap them into their desired currencies. Vehicle currencies are those currencies in which MNCs can borrow cheaply, but are actually not interested in carrying any such debt. By swapping vehicle currency to the desired currency, MNCs try to reduce their borrowing cost. Besides, the ability of the swap market to meet growing needs of a vast number of potential users with different requirement has also made swap a tool which perhaps no other financial instrument can match. All these have resulted in creative and dynamic integration of world’s securities, money and foreign exchange markets. Swap also helped in widening of the choice available to users for borrowing, investing, hedging and arbitraging in different markets. The currency swap market gained legitimacy from the swap between IBM and world bank in 1981. Since then, the volume of swap transactions have grown manifold to an estimated US$ 7.5 trillion by March 2001.  The Basic Swap Structure A swap is denied as a contractual agreement between the parties to exchange a series of cash payments for an agreed term. It is a powerful tool for manipulating cross currency cash flows without creating a net exchange position. Since its inception, swap structure have undergone tremendous changes due to the ingenuity and imagination of swap managers and arrangers. The primary swap market consists of swaps of new debt risks. Nearly 40 to 60 percent of all Eurobond issue are swap related. The secondary market on swap consists primarily of interbank trading and corporate hedging transactions. Two basic swap structures are referred as Interest rate swap and currency swap. They are discussed in the following sections. a) The Interest Rate Swap By far the most common type of swap is interest rate or coupon swap. An interest rate swap is an agreement for the exchange of interest liabilities of differing character between two counterparties. For example, exchange of fixed 22
  23. 23. Forex hedging vehicles rate interest for floating rate interest liability in the same currency. This is calculated based on a mutually agreed national principal amount. Thus, in interest rate swap one party may pay a fixed rate of interest, while the other pays floating rate, such as three month LIBOR re-fixed every three months. The principal, but national amount is applicable solely for the calculation of interest to be exchanged under the swap. At no time principal amount is physically usually passed between the counterparties. With the help of this swap structure, the counterparties are able to convert fixed rate interest burden to a floating rate interest and vice versa. Three main types of interest rate swap are ; b) Coupon Swaps : These swaps relate to exchange of floating rate (e.g. LIBOR) for fixed rate of interest liabilities and vice versa. For example, a AAA rated company agrees to raise funds at floating LIBOR to swap with a fixed rate of interest burden. c) Basis Swaps : A basis rate swap is an agreement to exchange similar obligations, calculated on different roll-over dates, for an agreed term. For example, two counterparties may agree to exchange their liabilities for periodic payments based on different indices – one paying 6 months LIBOR in exchange for 3 months LIBOR.Thus, basis rate swap is essentially for the exchange of floating interest rates of different roll-over dates in different currencies. The examples of basis rate swaps are : 3 months LIBOR, Base vs 6 months LIBOR, Commercial paper vs LIBOR, Prime Rate vs LIBOR, Base rate vs LIBOR and few more.Cross currency interest rate swap. These swaps relate to exchange of fixed rate flows in one currency for floating rate flows in another.  Benefits of Interest Rate Swaps One of the reasons for the phenomenal growth of interest rate swap has been its diverse use. They are being increasingly used for managing liabilities such as hedge against adverse rate movements or to achieve a chosen blend of fixed and floating rate debt. Many investors now use swap to create high yielding fixed 23
  24. 24. Forex hedging vehicles rate instruments or to convert their fixed rate cash flow to a systematic floating rate cash flow. Some of the benefits of interest rate swaps are as follows : Tailor made interest payments : Interest payment on swap can also be timed to suit a clients requirement of paying lower interest in the earlier years and a higher rate in the later years. Lower cost of funds : Large number of interest rate swap deals are struck for reducing interest cost and exposures. The ability of interest rate swap transactions to transfer fixed rate cost advantage to floating rate liabilities has led to many high credit rating firms or banks issuing fixed rate Eurobonds. All such issues are mainly used for swap and obtain, in many case, LIBOR-less funding. It is not surprising to find many users being able to reduce through swap their borrowing cost in floating rate by as much as 50 to 75 basis points below LIBOR. Such cost savings can be very substantial on a large swap deal. Attractive rates : It is quite possible for any swap market maker to find highly attractive rate. This can be achieved by carefully timing the Eurobond issues for ensuring its success at the best rate and also by ensuring the best possible swap terms for the issuer. Access to large number of markets : In addition to the cost advantage, interest rate swaps provide an excellent opportunities for firms or banks to tap market which are otherwise inaccessible to them due to their poor credit quality, lack of reputation, un-familiarity of the foreign market, or even excessive use of the financial market. It also helps firms to raise from attractive markets without any need fulfill complex requirements such as prospectus, disclosures, credit ratings, road shows etc. The growing use of commercial paper as he underlying floating rate basis in the swap market further re-affirms the flexibility and importance of interest rate swaps. 24
  25. 25. Forex hedging vehicles Managing interest rate exposure : Interest rate swaps allow firms to manage their interest rates exposures more actively. They enable firms to switch over from floating rate to fixed and back again, based on the outlook of the movements. The interest rate swap can also be used by treasurers in a declining interest rate environment. For example, a company may swap its fixed rate debt at 12% to obtain LIBOR at the beginning of interest rare decline. During the period of interest rate decline, this firm may leave the swap deal intact to wait for further fall. Once the interest rate has finally declined to say 10% the firm may enter into a second swap to “lock into” the new lower fixed rates of 10%. The net effect of the above swap a saving of 2% for the firms on its fixed cost of funds. Maturity of the long term debt : Interest rate swaps can be used by firms to extend or shorten interest risk associated with the maturity of its long term debt by presenting the firm to manage the term structure of the debt more effectively. Locking-in of financial cost : Through interest ratw swaps a firm can also lock-in its future borrowing cost. This is particularly essential when the interest rates are expected to rise in the future. Useful for Investors : As a part of their investment strategy, many investors are now using swaps for increasing their return. Most of the interest rate swap deals offer a substantially higher yield than government securities of a similar term. Simplicity of deal : And lastly, simplicity and straight forward process are few more advantages of interest rate swap deals. Often these deals are conducted by telephone and subsequently confirmed by telex ad acceptable documentation. All these provide great relief from enormous paperwork and documentation. Also, the credit risk attached to interest rate swap is less than the risk attached to a direct funding operation.  Currency Swaps 25
  26. 26. Forex hedging vehicles The currency swap emerged primarily to circumvent restrictions by authorities on issuing debt and remittance of funds between countries. It gained legitimacy from the swap between world bank and IBM in 1981. Due to its ability to link capital market with financial market, currency swap has gained credibility over years. Ever since its adoption in 1981, swap has found universal recognition due to its versatile application. Currency swaps operate on the same arbitrage principal as interest rate swaps. A currency swap is an agreement to exchange principal and interest payments in different currencies for a stated period. If two borrowers are perceived to be of different credit risks in different currency markets and borrowed at different market spreads, a currency swap may allow them to obtain cheaper funds than by issuing directly in the currency they require. Like interest rate swaps, it is not necessary for an issuer to have absolute advantage in one market. One issuer can have an absolute advantage in both market, provided it has a comparative advantage in one market. In order to benefit from currency swap, the new issue spread differential between the two issuers in each currency must be different. Most fixed to floating currency swaps are a combination of an interest rate swap in one currency and a floating to floating cross currency swap. In some currencies it is possible to do a fixed to floating rate currency swap directly. Fixed Rate Currency Swap A fixed rate currency swap consist of the exchange between two counterparties of fixed rate interest in one currency in return for fixed rate interest in another currency. The following three basic steps are common to all currency swaps : (a) Intial Exchange of Principal : On the commencement of the swap the counterparties exchange the principal amounts of the swap at an agreed rate of 26
  27. 27. Forex hedging vehicles exchange. Although this rate is usually based on the spot exchange rate, a forward rate set in advance of the swap commencement date can also be used. This initial exchange may be on a “national” basis (i.e. no physical exchange of principal amounts) or alternatively a “physical” exchange. Whether the initial exchange, is on physical or national basis its sole importance is to establish the quantum of the respective principal amounts for the purpose of (a) calculating the ongoing payments of interest and (b) the re- exchange of principal amounts under the swap. (b) Ongoing Exchange of Interest : Once the principal amounts are established, the counterparties exchange interest payments based on the outstanding principal amounts at the respective fixed interest rates agreed at the outset of the transaction. (c) Re-exchange of Principal Interest : On the maturity date the counterparties re- exchange the principal amounts established at the outset. This straightforward, three-step process is standard practice in the swap market and results in the effective transformation of a debt raised in one currency into a fully–hedged fixed rate liability in another currency. In principal, the fixed currency swap structure is similar to the conventional long-date forward foreign exchange contract. However, the counterparty nature of the swap market results in a for greater flexibility in respect of both maturity periods and size of the transactions which may be arranged. A currency swap structure also allows for interest rate differentials between the two currencies via periodic payments rather than the lump-sum reflected by forward points used in the foreign exchange market. This enables the swap structure to be customized to fit the counterparties exact requirements at attractive rates. For example, the cash flows of an underlying bond issue may be matched exactly and invariably. 27
  28. 28. Forex hedging vehicles Salient Features of Currency Swap The currency swap (or cross currency swap) as shown in the previous two example, is characterized y the following features : a) Full exchange of principal takes place either at the start of the swap deal or just on maturity. b) Generally principal is exchanged at the spot exchange rate, both at the start or maturity of the deal. Sometimes a forward rate may also be sent right in the beginning of the deal for final exchange of currencies. c) Periodic interest payments are made for outstanding amount on each rollover date in different currencies. This feature of currency swap differentiates it from forward contract where lump-sum are exchanged at the end. d) The swap deal may have a tailored agreement to match the requirement for underlying deal being hedged. e) The currency swap deal can be reserved without upsetting the underlying transaction. Thus, the three basic information required for a currency swap deal are : • Which currency to be paid and which one to be received. • The exchange rate to be used for swap and, • Whether the exchange of principal will take place at the start or on maturity of the contract. Users and sellers of currency swap : 28
  29. 29. Forex hedging vehicles Besides government agencies, asset managers and regional banks, firms with high credit rating (single A or above) with the ability to issue Eurobond are the users of currency swap in the primary market. Whereas, firms with significant foreign operation and exposure are the secondary market users of currency swap. Few regional banks and government agencies also use currency swaps to reduce their cost on ling term fixed bonds. Asset managers use currency swap to diversity their portfolios to include companies that do not issue debt in US dollars without exposing themselves to exchange risk. Investment banks however use currency swaps to eliminate exchange risk and to help sell foreign currency bonds to investors. The sellers of currency swaps are generally investment banks and commercial banks; with their wide network in the business, investment and commercial banks have wide information on users of currency swap. As a result, finding counterparties on a given currency is not always a difficult task for them. Benefit of currency swaps In common with the interest rate swap, few major advantages of currency swap are as under : I. Credit arbitrage : Currency swaps are used for reducing borrowing cost of users. it allows counterparties to take advantage of different credit perception between markets, especially Euromarkets where name recognition is perhaps more vital than credit rating. This enables firms with relatively better reputation to raise funds at finer rates domestic market. II. Wider access to markets : In addition to cost advantage, currency arbitrage enables firms to have access to even those money markets which would be otherwise difficult or not cost effective. In this way currency swaps integrate the capital markets of the entire world. It is not surprising, therefore to find as Australian Bond issue being swapped 29
  30. 30. Forex hedging vehicles completely for US dollar. In fact a large number of Australian and New Zealand bond issue are swapped. III. Flexibility in deal : Immense flexibility of the currency swap structures and also longer maturities of available funds make this technique an invaluable tool. IV. Meeting Investor Preferences : Investors have different investing requirements. Sometimes they may prefer one method to another. Currency swap provides variety of investment opportunities for investment without any exchange risk. V. Hedge currency exposures : If a borrower has issued debt without hedging coupon and principal repayments, currency swaps may be used to hedge all or part of the exposures, thereby reducing exposure risk. VI. International Debt Management : Currency swaps are used by firm in one currency into another based on the expectation of currency movements. Swap can be used to lock in a gain on a foreign currency borrowing or to limit a loss incurred. VII. Tax Management : Currency swaps can be used to lock in gain on a foreign borrowing while deferring the tax recognition of that gain. VIII. To expand market : When an institution uses the same market to raise funds time and again, the credit market saturates. Currency swap allows them to tap new markets. 30
  31. 31. Forex hedging vehicles SWAPTIONS A swaption is an option on a swap which can be written on interest rate swaps, currency swaps, commodity swaps or equity swaps. The concept is almost identical to an optional cap. The end user and the swap dealer agrees to the terms of a swap. Hence, a swaption (also known as a swapoption) is an option to enter into an interest rate swap. In return for a premium payable in advance, the borrower has the right but not the obligation, to enter a swap at the pre-agreed fixed rate level. A swaption is a valuable tool when a customer may require a swap but is uncertain with regard to timing etc. The typical structure would be for a borrower to buy a six month or one year option to conclude an interest rate swap at near current market levels. This type of product can be particularly useful in situations where the corporate or institution is quoting on new business which involves a considerable or material exposure but where the firm is uncertain as to the tender outcome. The maximum loss the customer faces is this the premium amount. A swaption is not directly comparable to a cap, since the period of protection is very different. For example a one year option to enter into a four year swap gives the right to exercise within one year; after one year the borrower has either exercised the swaption. In which case he is locked into a swap, or has allowed the swaption to expire, in which case no protection is in place for the next four years. The swaption is a valuable however, and has a useful; role in liability management – particularly where a borrower prefers the certainly of paying fixed rate through a swap. Option on interest rate swaps are referred as swaptions. The buyer of a swaption has the right to enter an interest rate swap agreement by some specified date in the future. The swaption agreement will specify whether the buyer of the swaption will be a fixed- rate receive or a fixed-rate payer. The writer of the swaption becomes the counterparty to the swap if the buyer exercises. If the buyer of the swaption has the right to enter into a 31
  32. 32. Forex hedging vehicles swap as a fixed-rate payer, the swap is called a “call swaption”. The writer therefore becomes the fixed-rate receive/floating-rate payer. If the buyer of swaption has the right to enter into a swap as floating-rate payer, the swap is called as “put swaption” The writer of the swaption therefore becomes the floating-rates receive fixed-rate payer. The strike rate of the swaption indicates the fixed rate that will be swapped versus the floating rate. The swaption will also specify the maturity date of the swap. A swaption may be European or American. Of course, as in all options, the buyer of a swaption pays the writer a premium, although the premium can be structured into the swap terms so that no upfront fee has to be paid. A swaption can be used to hedge a portfolio strategy that uses an interest rates swap but where the cash flows of the underlying assets or liability are uncertain. The cash flows of the assets will be uncertain if it (i)is called, as in the case of callable bonds, convertible bonds , a loan that can be prepaid etc, and /or(ii)expose the investors/lendor to default risk. 32
  33. 33. Forex hedging vehicles CAPS,FLOORS,COLLARS  Interest Rate Caps An interest rate cap is an arrangement whereby the sellar of the cap undertakes to compensate the buyer of the cap by whatever percentages reference interest rate (for eg.3 month LIBOR)exceeds a pre-agreed maximum interest rate. By this structure, a cap provides a multi period hedge against increases in interest rates.It is important to note that even though Caps are one of the types of multi period option as it provides hedge against risk exposure that spans multiple periods, one following another, the full premiums are ordinarily paid up front. For this insurance the seller would charge a front-end premium which may vary from 1% to 3% of the notional agreed amount. For example, Reliance Industries borrows US$50 mm in the euro market at 3 month LIBOR and also buys a 10% cap from Citibank by paying front-end fee of 2%. If on the reset date 3 month LIBOR moves upto 11% Citibank would compensate Reliance by 1% on the agreed amount and if LIBOR goes down to 9% Reliance will still pay 9% only. As seen, here, buyer of the cap has the advantage of paying rate agreement in the agreement irrespective of the prevailing rate in the market. In our previous example, Reliance Industries will pay nothing more than the contracted FRA rate irrespective of what the market rate is. Obviously, for this privilege, buyer of the cap compensate the seller for offering one-sided arrangement and this is achieved through the initial payment of the premium by the buyer. The cost of premium depends on the period for which the cover is required and the difference between the contracted FRA rare and the prevailing interest rate. Since caps are multi period options, the simplest way to price a cap is to split it into the actual series of single period options which is also know as a strip. The fair value 33
  34. 34. Forex hedging vehicles of each of the options can be determined by using any appropriate pricing models. The sum of these fair values is the fair value of cap. As seen earlier there are many users of interest rate caps but the most common is to impose upper limit to the cost of floating rate debt. Investment bankers often combine caps with interest rates swaps or currency swaps to produce a product called rate – capped swaps. These products can reduce borrowing costs if the borrower borrows at the fixed rate, swaps it for floating rate payments with the swap dealer, and then caps it floating rate payments with an interest rate cap. Advantages of participation caps are : i) The protection if rates rise similar to that for cap but with no up-front premium payable. ii) Unlike a zero cost collar, there is continued ability to benefit it rates fall. iii) The may well be easier for a bank to hedge than a collar and can consequently represent better value to the customer. Disadvantages of participation caps are : i) If there is an immediate sharp rise in Libor it would still have been better to have done a swap. ii) It rates stay the same or go down it would probably have been better to have bought. iii) As with swaps and collars the floor element uses a bank’s limits.  Interest rate floors An interest rates floors is identical to a cap except that the floor writer pays the floor purchaser when the reference rate drops below the contract rate, called the floor rate. Many firms generate cash surpluses from their investments and therefore need to guarantee a minimum return on funds i.e. their concern is that interest rates may fail. In this type of circumstance an interest rate floor may be the appropriate product. Whereas an interest rate cap guarantees a maximum rate for a reference rate over a chosen period, 34
  35. 35. Forex hedging vehicles an interest rate floor guarantees a minimum rate. The mechanism of payment is similar to that for a cap, in other words the buyer of an interest rate floor pays a premium on the deal date, and receive payments at the end of each interest period during the life of the floor if the rate for that period was below the floor rate. Investment bankers find many users for interest rate floors as well. The most common use is to place a floor on the interest income from a floating rate assets. For example, consider an insurance company which has obtained funds by selling 7%ten year fixed rate annuities. As these annuities constitute fixed rate liabilities, and if the interest rates are likely to go down, floors can be used for guaranteeing minimum return for the insurance company.  Interest Rate Collar An interest rate collar is a combination of a cap and a floor in which the purchaser of a collar buys a cap and simultaneously sells a floor. A collar has the effect of locking the collar purchaser into a floating rate of interest that is bounded on both high side and lower side. This is sometimes called “locking into a band or swapping into a band” Advantages of Interest Rate Collar : i) It is always cheaper than an interest rate cap because the buyer is giving up the ability to benefit if rates fall below the floor rate. ii) It is possible to constructed “zero costs” collars provided that the cap is above the swap rate. Disadvantages of and Interest Rate Collar : i) A collar negates the principal of buying an option to achieve unlimited benefits and limited downside potential. This is because as well as buying an option (the cap), the borrower also selling an option (the floor). ii) The floor from the banks perspective must be viewed as a credit risk. In practice this means that the fair value if the floor will imply this perceived credit risk, in a similar manner to the swap market. 35
  36. 36. Forex hedging vehicles iii) In an interest rate environment involving a positively sloping yield curve, the value of the floor can be very low and hence the cost saving over a cap will not be very great. 36
  37. 37. Forex hedging vehicles HEDGING FOREIGN EXCHANGE RISK- ISN’T IT ALSO RISK? The concept of Risk – Risk is the possibility of actual out come being different from the expected outcome. It includes both downside and upside potential. Downside potential is the possibility of actual results being adverse compared to the expectedresults and upside potential is the possibility of actual results being better than the expected results. Foreign Exchange Exposure & Risk – It is the change in the domestic currency value of assets and liabilities to the changes in the exchange rates. This may be positive or negative. Positive exposure gives rise to Gain andnegative exposure gives rise to loss. How it is Measured – Foreign exchange risk is measured by the variance of the domestic currency value of asset, liability or an operating income, which can be related tounexpected changes in the exchange rates. Hedging Foreign Exchange Risk – Hedging refers to process, whereby one can protect the price of financial instrument at a date in the future by taking an opposite position in the present by using derivatives like Currency Options, Currency Futures, Forward Contracts, Currency Swaps, Money Markets, etc. It refers to technique of protecting the financial exposures in the underlying asset or liability due to volatility in the exchange rates by taking offsetting positions through derivatives to offset the losses in the cash market by a corresponding gain in the derivatives market. 37
  38. 38. Forex hedging vehicles Hedging involves • Foreign exchange exposure identification • Value of exposure • Creation of offsetting positions through derivatives • Measurement of Hedge ratio • Degree of Risk acceptable to management • Expectations regardingfuture movement of exchange rates. Derivatives are hypothetical assets; they derive their value from the underlying assets. One very fundamental question – why do we need derivatives? For risk management, there should be negative correlation between the assets in a portfolio. Risks can still be managed, even if there is a positive correlation between the asset in the portfolio and that is through creation of hypotheticalassets against those assets i.e. (underlying asset). Currency Options – are instruments, which give the buyer of the option the right but not the obligation to execute a specified transaction in the underlying currency pair. This gives the buyer the flexibility to execute settlement or not. They are different from other derivatives in that they provide downside protection against risk and alsoan upside benefit from favourable movements in the underlying exchange rates. Forward Contracts – are a commitment to settle at a fixed forward price. This provides only upside benefit from a favourable movement in the underlyingexchange rates, but not downside protection. Currency Futures – are one of the derivatives, where exporters and importers can hedge their positions by selling and buyingfuture contracts. It provides a means to hedge the trader’s position who wishes to lock in exchange rates on futures currency transactions. By purchasing (long hedge) or selling (short hedge) currency futures, a firm can fix the incoming and outgoing cash flows in one currency with respect to others. 38
  39. 39. Forex hedging vehicles Hedging, is it Necessary? To hedge or not to hedge is thus a very difficult question. For applying any hedging strategy Treasury managers must have correct answers to these fundamental questions. • How well he understands and knows the firms risk exposure. • If identified, would hedging these risks make cash flows positive? • Correct application and timing of hedgingstrategies must be in line with exchange rate movement. • If yes, is it possible to hedge these risks adequately? There is of course no 'set of rules’ that can provide perfect hedging strategies, and thereby guarantees that there would be no wild fluctuations in company’s cash flows. However, by using un-speculative strategies, with the calculation of optimal hedge ratios, one can hedge its risk. Additionally, with the increased volume of international trade and financing, increase in volatility of exchange rates and increased exposure of foreign exchange gain and losses, hedging foreign exchange risk has gained importance. Hedging, How could it be Destructive? Speculation and Hedging – When speculation is mixed with hedging, it is destructive. There is a thin line of difference between hedging and speculative activity. Speculation means dealing in a commodity or financial asset with a view to obtaining profit on the prospective changes in the market value of the item under consideration. It involves contemplation of future expectations and taking positions to gain, unlike hedging in which offsetting positions are taken, but not with the objective of earning a profit. Speculation involves forecasting the evolution of supply and demand, i.e. if exchange rate rises, when speculators are long and fall when they are short, then they gain. They lose when forecasts turn out to be wrong. 39
  40. 40. Forex hedging vehicles Hedgers offset their risks by taking offsetting positions; it is speculators who bear the risk transferred by the hedgers. It is for this risk borne by them that they get a reward in the form of speculative profits. Therefore the nature of speculative activity is such that to earn speculative rewards, they must bear risk. Hedging and speculation are not similar answers to a problem. They cannot be used interchangeably for getting desired results or to meet similar objectives. Hedging is a risk management or reducing technique, where the objective is not to earn profits, unlike speculation. Hedgingwhen mixed with speculation can be disastrous for the hedger. Uncertainty and Risk of Opportunity Loss – How to strike a balance between uncertainty and the risk of opportunity loss? The problem of settling an effective hedge ratio has twodimensions. • Uncertainty: If a firm does not hedge the transaction, it cannot know with certainty at what rate of exchange it can lock its exposures. It couldbe a better rate or a worse rate. • Opportunity: If firms enter into hedge transactions like forward contracts, currency options etc, they would of course be certain at a rate at which they are locking their exposures. But now they have taken an infinite risk of ‘opportunity’ loss. Perfect Hedge Ratio – So construction of an exact opposite position to the existing risk exposure results, in a perfect hedge, which is a challenge. There is yet another dimension to hedging. Hedging has a cost. If the expected risk does not materialise, hedging will prove an ineffective way of doing business. All these complexities associated with hedging through derivatives pose a great challenge toarrive at a right Hedge ratio. Various real life instances of how hedginghas proved to be destructive are enumerated alongside. 40
  41. 41. Forex hedging vehicles Hedgers offset their risks by taking offsetting positions; it is speculators who bear the risk transferred by the hedgers. It is for this risk borne by them that they get a reward in the form of speculative profits. Therefore the nature of speculative activity is such that to earn speculative rewards, they must bear risk. SURVEY REPORT Yes No 47% Yes 53% No Are you aware of the Forex Hedging option available? 41
  42. 42. Forex hedging vehicles Yes No 25% Yes 75% No Do you know how to deal in Forex Hedging? Yes No 20% Yes 60% No Do you think the Forex Hedging instruments are risky? 42
  43. 43. Forex hedging vehicles 1 Yes No 0% 10% 20% 30% 40% 50% 60% Yes No In future do you plan to deal in Forex Hedging? 43
  44. 44. Forex hedging vehicles Forward Future Option Swaps 40% Forward 32% Future 20% Option 8% Swaps Which Forex Hedging instruments do you prefer? 44
  45. 45. Forex hedging vehicles Questioners For MMS.FOREX.PVT.LTD I had visited MMS.FOREX.PVT.LTD and over there I met Mr. Mahesh Sanghvi, who is a manager of the MMS.FOREX.PVT.LTD. Mr. Mahesh helped me answered the few questions about forex hedging. The questions answered by him are as follow. 1) What is forex hedging? Hedging is to take a position in futures that “offsets” the price change in the cash assets. 2) Which are the derivative instruments used in a forex market? The instruments used are varied & include Futures, Forwards, Options, Swps in currency & combination of all of them. 3) Why &how does risk arise in a forex transaction? The perceived volatility of any market, the greater the volatility greater the risk. 4) Does the fluctuations in foreign exchange rate has impact on forex hedging? Yes 5) According toyou what are the major benefit of forex hedging? • Reduce risk • Tax advantages • The proper functioning • Long-term liquidity • Open interest of a Future market 6) Which are the most popular instrument in forex hedging? Forward CONCLUSION: 45
  46. 46. Forex hedging vehicles In contrast to speculation hedging is done to reduce risk. But is this desirable? If everyone hedged, would we not simply end up with an economy in which no one takes risks? This surely lead to economic stagnancy. Moreover, we must wonder whether hedging can actually increase shareholder wealth. Hedging is to find a more acceptable combination of return and risk. There may be other reasons why firms hedge, such as tax advantages. Low-income firms, for example those that are below the highest corporate tax rate, can particularly benefits from the interaction being also reduces the probability of bankruptcy. Many firms, such as financial institutions, are constantly trading over-the-counter financial products like swaps and forwards on behalf of their clients. They offer these services to help their client manage their risk. Hedging also is a tool use to offset the market (systematic)risk of stock portfolios. Previously, risk management for common stocks concentrated on diversification to eliminate unsystematic risk , but until futures and option contracts on stock index futures came into existence there was no effective means for eliminating most of the systematic risk of a stock portfolio. Hedging is extremely important for the proper functioning, long-term liquidity, and open interest of a future markets. Thus, viable futures contracts are linked to commercial hedging activity. BIBLIOGRAPHY 46
  47. 47. Forex hedging vehicles Websites:- www.google.com www.forex.com Books:- V.K Bhalla (Investments of management) Visited By:- MMS FOREX PVT.LTD. 47

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