Risk Management & Forex Derivatives


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Presentation on various risk management strategies using forex derivatives.

Published in: Economy & Finance
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Risk Management & Forex Derivatives

  1. 1. Foreign Exchange Market & Derivatives Risk = Grammar of Business Finance = Language of Business
  2. 2. Introduction <ul><li>Give & take principal gave rise to four business transactions i.e., </li></ul><ul><ul><li>Sale </li></ul></ul><ul><ul><li>Purchase </li></ul></ul><ul><ul><li>Lend </li></ul></ul><ul><ul><li>Borrow </li></ul></ul><ul><li>Interest rates differ while borrowing in foreign currency due to time value of money. </li></ul><ul><li>For sustainable development & long term growth the mantra is to “control the cost or reducing it” </li></ul><ul><li>Carry trade transaction: Buying or borrowing foreign currency at lower interest rate & then lending in the home country at high interest rate. </li></ul><ul><li>Cost of hedging is more than the rate of interest on foreign currency. </li></ul>
  3. 3. <ul><li>Every currency has three values: </li></ul><ul><ul><li>Internal value: Purchasing power of currency which depends on “inflation” </li></ul></ul><ul><ul><li>External value: Value against some foreign currency. Depends purely on “demand-supply”. </li></ul></ul><ul><ul><li>Time value: Given by LIBOR & LIBID. </li></ul></ul><ul><li>Currency with lower interest rate will always be at premium whereas it will be at discount if interest rate is higher for a currency. </li></ul><ul><li>Premium Position is always better for exporter & vice versa. </li></ul><ul><li>Premium is always added and discount is always deducted. </li></ul><ul><li>Forward = Spot + Premium/Discount </li></ul><ul><li>Spot rate is the function of demand & supply. </li></ul><ul><li>Premium/discount is the function of interest rates. </li></ul>
  4. 4. Risk <ul><li>Exposure & risks are inter-related but simultaneously differs from each other. </li></ul><ul><li>Risk is created by exchange rates. </li></ul><ul><li>Hedging is used for controlling & minimizing the risk </li></ul><ul><li>Hedging is part of failure management & not that of success management. </li></ul><ul><li>Hedging is not used to make profit; but for keeping the current position safe. </li></ul><ul><li>Longer the period, more the risk & vice versa. </li></ul><ul><li>Risk can be covered by: </li></ul><ul><ul><li>Derivatives </li></ul></ul><ul><ul><li>Operational Hedging </li></ul></ul>
  5. 5. Derivatives <ul><li>Derivatives are agreements which derive their values from underlying variable. </li></ul><ul><li>Spread on loan for borrowing company depends upon: </li></ul><ul><ul><li>Size of the Company </li></ul></ul><ul><ul><li>Business Profile of the company </li></ul></ul><ul><ul><li>Risk profile </li></ul></ul><ul><ul><li>Tenure of the loan etc. </li></ul></ul>
  6. 6. Some information… <ul><li>Subprime financial crisis leads to loss of 50 trillion Dollars. </li></ul><ul><li>CHIPS : Clearing House Interbank Payment system used for Dollar clearing. </li></ul><ul><li>SWIFT: Social Wide International Financial Telecommunication. </li></ul><ul><li>Dollar has the least LIBOR </li></ul><ul><li>Structured financing is most important these dyas. </li></ul><ul><li>When one currency appreciates, competitiveness of that country declines. </li></ul><ul><li>e.g., 1 $ = 100 Yen </li></ul><ul><li>If Yen appreciates, </li></ul><ul><li> 1 $ = 80 Yen </li></ul><ul><li>so to earn 100 Yen Exporter has to increase the price in dollar which make him less competitive. </li></ul>
  7. 7. Forex Derivatives <ul><li>Hedging is not done while using forward contract. </li></ul><ul><li>Hedging means no loss & no gain & make uncertain things, certain. </li></ul><ul><li>Currency carrying lower rate of interest will always be at premium. </li></ul>
  8. 8. Stop loss order to maximize profit & minimization of loss Book the Contract Cancel the contract Demand – Supply Curve
  9. 9. Swaps <ul><li>Four types of swaps: </li></ul><ul><ul><li>Forex Swaps </li></ul></ul><ul><ul><li>Interest Rate Swaps </li></ul></ul><ul><ul><li>Currency Swaps </li></ul></ul><ul><ul><li>CIRCUS Swaps (Combined Interest Rate & Currency Swap) </li></ul></ul><ul><li>Swaps are governed by comparative advantage. </li></ul><ul><li>Swap transactions come only in footnotes to the balance sheet. They don’t deteriorate the balance sheet. </li></ul><ul><li>Swap turnover is the highest than spot turnover in the forex market. </li></ul>
  10. 10. 1. Forex Swap <ul><li>Two opposite sale & purchase at the same time of foreign currency. </li></ul><ul><ul><li>In Swap: (Specific date & different rates) </li></ul></ul><ul><ul><li>Buy $1000,000 Value Spot </li></ul></ul><ul><ul><li>Sell $1000,000 Value 1 month forward </li></ul></ul><ul><ul><ul><li>Used to arrange foreign currency funds. </li></ul></ul></ul><ul><ul><li>Out Swap: </li></ul></ul><ul><ul><ul><li>To use foreign currency resources </li></ul></ul></ul><ul><ul><ul><li>Have surplus dollar </li></ul></ul></ul><ul><ul><ul><li>Used as investment. </li></ul></ul></ul>
  11. 11. 2. Interest Rate Swap <ul><li>To reduce the cost of borrowing </li></ul><ul><li>For interest risk management </li></ul><ul><li>Illustration: </li></ul>Company Funds Duration Conditions X 100 Million 5 Years On fixed rate Y 100 Million 5 Years On floating rate Company Rating Interest rate in Fixed market Interest rate in Floating rate X BBB 8.5% 6 LIBOR + 0.50% Y AAA 7% 6 LIBOR
  12. 12. 2. Interest rate swap contd… <ul><li>Investment Banker Quotes (for 6 LIBOR): </li></ul><ul><ul><li>Citibank – 7.25%/7.30% (Borrowing/Lending) </li></ul></ul><ul><ul><li>HSBC – 7.50%/7.80% (Borrowing/Lending) </li></ul></ul><ul><li>Since Citibank is offering least rates so both the parties choose Citibank as their merchant banker. </li></ul><ul><li>On the basis of above requirements, Citibank suggests Co. X to borrow money from Floating Market and to Co. Y to borrow from Fixed Market at the interest rate of 6 LIBOR + 0.50% & 7% respectively. Because Co. X has comparative advantage in floating market and that of Co. Y is in Fixed market. </li></ul><ul><li>But Co. X agenda says to borrow on fixed rate and that of Co. Y says to borrow on floating rate. </li></ul><ul><li>Now, let’s see the process of this swap arranged by Citibank to fulfill their customized wishes. </li></ul>
  13. 13. 2. Interest rate swap contd… Company Y Company X 7.30% Fixed Rate 6 LIBOR Floating Rate 6 LIBOR Floating Rate 7.25% Fixed Rate Use $ 100 Mio Use $ 100 Mio 6 LIBOR + 0.50% Floating Rate $100 MiO for 5 Years $100 MiO for 5 Years 7.0% 0.05% Profit Citibank Floating Market Fixed Market
  14. 14. 3. Currency Swap <ul><li>Company wants a particular currency to meet its requirement for the subsidiary in foreign country. </li></ul><ul><li>Objectives: </li></ul><ul><ul><li>Currency of desired choice </li></ul></ul><ul><ul><li>No exchange risk </li></ul></ul><ul><ul><li>Reduced interest cost </li></ul></ul>
  15. 15. 3. Currency Swap contd… <ul><li>Illustration: </li></ul><ul><li>Both the companies have comparative advantage in their respective home countries. </li></ul><ul><li>Citibank agrees at the brokerage of 0.01% </li></ul>Company Funds Duration Interest rate in USA Interest Rate in Japan X (USA Co.) 10000 MiO Yen 5 years $ = 6% Yen = 5% Y (Japenese Co.) $ 100 MiO 5 Years $ = 8% Yen = 4%
  16. 16. 3. Currency Swap contd… T 0 T 1 T 2 T 0 T 1 T 2 T 3 T 4 T 5 T 3 T 4 T 5 X Y Borrow $ 100 MiO @ 6% Borrow 10000 MiO Yen@ 6% Give It to X Give It to Y Y will give $100 MiO to its US subsidiary X will give 10000 MiO Yen to its Japenese Subsidiary $100 MiO 10000 MiO Yen Y will pay Interest in $ @ 6% X will pay interest in Yen @ 4% Y will pay Interest in $ @ 6% X will pay interest in Yen @ 4% Y will pay Interest in $ @ 6% X will pay interest in Yen @ 4% Y will pay Interest in $ @ 6% X will pay interest in Yen @ 4%
  17. 17. 4. CIRCUS Swap <ul><li>Illustration: </li></ul>Company Funds Mode € $ X 100 MiO € Fixed Rate 5% 6 LIBOR + 0.10% Y $ 150 MiO Floating Rate 4% 6 LIBOR + 0.50%
  18. 18. 4. CIRCUS Swap contd… T 0 $150 MiO T 0 150 MiO € T 1 -T 5 Int. @ 4% T 1 -T 5 6 LIBOR + 0.10% T 0 $150 MiO 6 LIBOR + 0.10% T 0 100 MiO € T 1 -T 5 Int. @ 4% Co. X Co. Y Floating Market Fixed Market
  19. 19. T 5 100 MiO € T 5 $150 MiO T 5 100 MiO € T 5 $150 MiO Co. X Co. Y Floating Market Fixed Market
  20. 20. Futures Derivatives <ul><li>In India $/INR exchange is allowed because of dollar’s huge liquidity & it is the direct function of demand & supply. </li></ul><ul><li>Other exchanges are not allowed because determination of cross rates is a complex procedure and it will increase the economy’s exposure. </li></ul><ul><li>Contract is for 12 month. </li></ul><ul><li>Charges is equal to $ 1000. </li></ul><ul><li>No individual can’t access more than $5 MiO exchange in a day. </li></ul><ul><li>Daily turnover more than 1200 Crores. </li></ul><ul><li>Major players in futures market are speculators. </li></ul>