This presentation was put together as information material for the purpose of assisting the Ontario credit union system in the proper usage and reporting of FX derivatives. At issue is the current regulations which prevent the usage of FX derivatives. It is the recommendation of this presentation that credit unions seek an exception on the usage of FX derivatives from the regulator provided they detail in their policies the intention of their usage of FX derivatives, the usage of derivatives as being prudent to the management their business and that an adequate set of controls and reporting is in place to ensure appropriate levels of risk management are in place around this activity.
Agenda as seen in the slide.
There are 4 major types of FX derivatives used by financial institutions. FX swaps, FX futures contracts, Currency swaps and outright forward purchases or sales. Credit union exposures should be limited to FX swaps and Outright forward transactions. FX swap transactions will be related to liquidity management and FX forwards will be related to offsetting member transactions.
An FX swap transaction is an agreement to sell (or buy) US$ at an agreed upon rate today against an offsetting purchase (or sale) at a future date at a rate determined today. The principal amounts of US$ are equivalent in the transaction. The difference in rates between the starting date (spot) and the future date (forward) is reflected in the C$ cash flows. The difference in C$ cash flows is not a gain or loss in FX income, but related to the interest rate differential between Canada and the US, which will be explained in a later slide. The terms of FX swaps can be as short as 1 day and as long as 5 years, but there are longer terms also available. Most activity is related to shorter terms and for credit unions shorter terms would be 3 months.
FX swaps are used by financials to transfer liquidity raised in one currency to another currency without engaging in currency risk. For credit unions, a great example would be US$ deposits. Credit unions tend to have US$ deposits and no US$ loans. To offset the deposit and currency exposure credit unions hold US$ investments. US$ investments are usually difficult to find and do not pay very good rates of interest as a result. US$ assets tend to be dead spots in the balance sheet in the sense that the return on the business is very low. To improve the return on business a credit union can use and FX swap to convert US$ into C$ on a fully hedged basis for a specific term and put those funds to work against higher yielding assets or reduce borrowing levels. Therefore FX swaps can boost income and reduce borrowing costs.
How does and FX swap work? Start by cashing in US$ investments into a current account. Then enter into an FX swap where you can sell US$ spot (tomorrow) or cash (today) for one rate, say 1.1000 and agree to buy the same value of US$ forward at a future rate of 1.1015. The US$ flow out of the current account on the front date, C$ flow into the current account. The C$ can be used in the business to pay down debt or lend out at higher rates. Then on the future date the US$ have to be purchased and C$ are needed. What if you don’t have C$? Well if you still have those US$ then you enter into a new FX swap of selling spot and buying forward to cover the buy US$ forward coming due. What happens if the rates on the FX buy coming due are less than the sell US rolling over the position? The gain or loss is just cash flow. If the C$ is rising in value then your sale of US$ at 1.05 versus a buy at 1.1015 will not generate a loss but just require some additional C$ liquidity.
Doing an FX swap involves buying and selling the same US$ principal at two different rates, which creates a gain or loss appearance in the transaction from a FX perspective. But the FX swap is related to liquidity management and the gain or loss on the swap is related to interest rate differentials in Canada and the US. The gain or loss is not an FX income or loss but an interest expense related to transferring liquidity from one currency to another currency on a fully hedged basis.
How are those forward rates determined? Consider this simple example and the math behind it. A credit union cashes in US$1 mil in deposits which yielded 0.20% at the time. The manager is giving up a return of 0.20% for 30 days or $US 167 (based on a 360 day year in the US calculation). The manager then sells $US 1 mil at 1.1000 into C$ 1.1 mil. The manager invests those C$ into a money market asset yielding 0.45% for 30 days and earns $406. The manager has given up US$167 or C$184 equivalent and gained $406. If the manager can enter into a contract to buy those US$ back at 1.1000 rate in 30 days time, there will be a $222 gain on the transaction and the manager will earn some riskless profits! However, the market does not hand out risk less profits, the market will price the forward purchase at such a rate to eliminate riskless profits or arbitrage. The forward price at which most of the profits would be eliminated would be 1.1002. This is the process by which the market determines the forward points. It prices the forwards until riskless profits are reduced.
So why do FX swaps if the forward prices eliminate the pick up? The forward rates only eliminate the pick up to the money market rates. If your conversion of US$ to C$ goes into an asset yielding in excess of the money market rate, then you can earn excess returns. If for example your C$ are used to pay down borrowings at 0.75% then the FX swap will reduce expenses by 0.30% cost above the money market rate of 0.45%. If the C$ funds are used to lend mortgage money at 3%, then your income will be boosted by 2.55%, which is the difference between C$ yield of 3% and your money market yield of 0.45%. How to determine how an FX swap will help you? Calculate the interest in US$ you would forego. Calculate the interest in C$ you would pick up and then add or subtract the cash value of the forward points or spread, which can be positive or negative multiplied by the US$ principal
Whether US rates are higher or lower than C$ rates the FX forward points will adjust to reduce riskless profits. In our example, C$ rates were higher than US$ rates and the forward points were at a premium. If the conditons change such that US$ rates move above C$ yields then the forward points will flip from being positive to negative and the FX points will represent a gain to the equation. Thus the big gains from using FX swaps should always be available, provided your balacne sheet has assets yielding higher than the money market rates.
FX swaps look like a winning solution, but lets consider some risk factors. We are in agreement that no FX risk exists? Actually there is a little bit of US$ risk to consider. Since you no longer have any US$ assets and only have US$ deposits your business will generate some net FX exposures from the interest expense accumulating each month. A purchase of US$ each month to cover interest expenses building on the US$ balances will be required. The second major risk to consider is counterparty default risk. If the counterpart on the other side of the forward purchase goes into default before the contract matures, the result would be an open currency position. To mitigate this risk deal with highly rated counterparts. Stay away from non-bank players, there are many sad stories around some non-bank FX dealers going bust. Another means of mitigating risk is to consider only short term swaps of 1-3 months.
Another factor for consideration is the possibility of some US$ deposits redeeming. If members redeem their deposits the C/A will go into overdraft. To mitigate this risk, you can take two approaches. The first would be to leave some cash in the Current Account t cover this possibiity. The second approach would be to enter into a buy and sell US$ contract, where the buy amount covers the cash requirement for the current account and the forward sell date matches the outstanding forward date for the initial swap. Also required would be some C$ balances to cover the spot US$ purchase, which may require a take down of some investments or usage of funds from C$ current account. There is as well some minor risk related to the change in forward points for this second transaction, but this risk can be mitigated by keeping the terms of the initial forward sale to less than 3 months. In fact, 1 month would be ideal.
How to account for FX swaps? Set up some off balance sheet accounts for the US$ forward purchases and sales, with C$ equivalents. When the forwards come due just reverse out the forward and credit or debit the current accounts in C$ and US$. If you keep the swaps to terms of 1 month, the FX difference from the transaction can be posted right to income or expense by as an FX related interest item. If you do swaps for 3 months, then accruing this FX difference into income over time may be the more acceptable approach. For example a 3 month FX swap which generates a $30,000 gain should have the gain accrued into margin at $10,000 per month. There will be some translation gains and losses to deal with under this system, which you haven’t dealt with before. For example, you have deposits and investments which are valued at one month end at 1.1000. The investments are then sold and converted to cash during the next month and you enter into a sell contract at 1.08 at mid month and a buy contract to mature following month at 1.0802. The spot rate at the end of the next month is 1.07. The deposits have a translation gain of 0.03 (1.10 – 1.07), the spot rate sale mid month generates a translation loss on the assets of .02 (1.10 – 1.08) and the forward purchase has a loss of 0.0102 (1.0802 – 1.07). Technically, the forward should be valued at the forward rate at the month end. To reduce the need to value this term, the best approach is to have the forward mature in the first week of the month. To reduce all the translation risk from month to month the easiest approach is to do 1 month swaps on the first day of the month to the first day of the next month.
To determine the past FX position, a manager added up the US$ investments, current account and subtracted US$ term deposits and savings accounts. The new measure with FX swaps requires a slight adjustment to the process. Using FX swaps requires the forward FX totals on purchases and sales to be included. Remember as well your business will pick up interest expenses from the deposits either accruing or actual which will require a currency conversion from time to time to reduce your FX exposure.
Here is an example of a situation when the CU encounters some redemption activity on US$ deposits. Consider a CU with $1 mil in US$ deposits and the manager enters into a sell and buy FX swap for $1 mil. The FX position is an on-balance sheet US$ liability of $1 mil and a off balance sheet purchase of $1 mil. Suddenly, $600k of deposits are redeemed by members. The US$ current account is overdrawn. The manager enters into a buy $US600k spot and sell US$600k forward to the initial maturity date of the $1 mil purchase. The manager may need to raise some C$ liquidity to cover the spot purchase or not. The FX position is still zero as there is $400k in deposits remaining and a net FX forward position of $400k between the two outstanding deals. If the spot rate changes in the mean time is there any FX gains or losses? Since the FX risk position has not changed, there should not be any gains or losses in income. There may be some timing issues in income reporting, but there should not be any losses. By keeping the term structure on the FX swaps to shorter terms all of these issues are reduced.
If FX swaps are used then what policy amendments should occur? First requirement is the approval to hold FX positions outstanding for a future date. The second requirement would require some limits on the amount of FX and the maximum term outstanding for FX swaps. My recommendation would be for FX swaps no larger than 90% of total US$ deposits and accounts, which gives you some US$ balances for current account and float. Secondly the maximum term to maturity of FX swaps should be set to a maximum of 3 months. The 90% of total deposits could be converted to a dollar amount provided it was reviewed annually. A board reporting package should be delivered each quarter at a minimum which should detail the outstanding FX swaps and the exposure relative to limits. This should cover the requirements for FX swaps. The next section looks at FX outright transactions with members.
The second type of FX derivative used by credit unions should be FX outright sales or purchases. These types of transactions should only exist for transactions done to offset member business. Commercial members who are exporters or importers usually require purchases or sales of US$ to operate their business. Prudent operators will often buy or sell US$ forward to protect the margins in their business. Under the terms of an outright forward position, the commercial concern can enter into a contract today for delivery in the future with a rate which is fixed today. The delivery date can also be optioned for a 30 day period, allowing the operator the ability to Credit unions can engage their corporate members interested in hedging forward transactions and earn additional returns on their member relationship with a little extra work. Hey its all about service. Right?
Along with the rewards of doing FX forward business with clients are the risks. First off if the client goes bankrupt, there are big risks to income if the contracts are out of the money – which they will be – guaranteed if it happens. To mitigate this risk only due short terms with members or request collateral – just like you would ask for a security deposit on a riskier mortgage. There is a second more minor risk which occurs if the FX purchased or sold with the member is not needed at the time contracted. The client may not want to take or make delivery and request the contract be rolled over. This request can be accommodated easily at market rates. However, the member may wish to have the contract rolled over at historical rates, which becomes slightly more complicated by adding in some interest costs to the new forward rate. Call us for assistance if required.
FX forwards with commercial members are an excellent means of generating higher returns on business with members and helping members to be more successful in operating their businesses. Call us or Central One for further assistance in this area, either of us would be glad to help. For risk management purposes around FX outrights, it is recommended to match terms and size exactly with Central One offsetting transaction. Anything less than an exact match will require some adjustment to market risk policy to cover mismatching FX forwards. For credit risk purposes with members a limit on the total amount of forwards and longest terms should be set in place. Doing long term FX forwards should result in earning higher income from clients than shorter terms due to the higher level of risk exposure over time. Care also has to be taken to ensure that your member is not engaging in excessive risk taking on their side.
If you plan to engage in forward outright transactions for the purpose of assisting members with commercial foreign exchange transactions you need to incorporate this activity into your market risk policy. Specifically, maximum terms for FX transactions is required. Limits on the level of mismatch risk must be set. It is suggested that zero term mismatch be tolerated. Credit administration and review must be taken up with commercial accounts. Limits per client on total FX volumes and term structure must be created and monitored for compliance. Fortunately, all of this information can be put together and monitored in a simple excel spreadsheet. Call for assistance.
If you decide to engage in both FX derivative transaction types then your reporting of FX risk should be in the following format: A summary of on balance sheet assets and liabilities, followed by a sum of off-balance sheet FX swaps used for liquidity management followed by a sum of all FX Outright forwards done to hedge FX risk are required. For reporting to the board, the information package should contain a gap report showing FX buys and sells by month for as far a term as business is done. There should be a net difference column which shows the mismatch risk relative to limits. There should be some comments from credit administration that all member limits are in compliance. For added information a weighted average FX rate per bucket could be included.
Finally then – how to deal with the issue surrounding the new regulations which state the usage of FX derivatives is prohibited. Obviously, the regulations have all of a sudden become very prescriptive for some reason. When the regulations were being drafted, all FX needs were not considered. To meet the regulations, we suggest a written request for an ‘Exception for FX Derivatives’ be sent to the Regulator. The letter should state the purpose for usage of FX derivatives as not being for speculation purposes but for the purposes of managing liquidity from US$ deposits and engaging in member demands for forward currency hedging. The letter should also state in some detail the adjustments made to the policies including a statement of limits for spot and forward exposure and the sample of reporting to account for this activity. These conditions have been discussed privately with the Regulator and it appears, but is not confirmed , the requests will be accepted and an exception granted if the conditions are met.
FX swaps can be a very powerful strategy to improve profitability levels. The FX swap market is very safe and efficiently priced for short term swaps. The usage of FX swap strategy does require some additional work by management in the areas of reporting and accounting; however, keeping to some specific limitations around the volume (90% of total deposits as a maximum) and term ( 1 month) and settlement days (first of each month) should result in reducing any deficiencies around reporting FX swaps. For Outright forwards, keeping positions completely matched for risk, having some additional security in place and some credit administration around term and volume limits for clients will represent an appropriate amount of risk management to ensure stable and predictable returns from this activity.
Foreign Exchange (Fx) Derivatives
Foreign Exchange (FX) Derivatives Information Session on Usage of FX Derivatives in Credit Union Operations – Picuz Solutions Sept/09
Today’s Agenda <ul><li>Define Foreign Exchange (FX) Derivatives </li></ul><ul><li>Usage of FX Swaps </li></ul><ul><li>Pricing/Math on FX Swaps </li></ul><ul><li>Risk Factors </li></ul><ul><li>Accounting Considerations </li></ul><ul><li>Risk Management / Policy Adjustments </li></ul><ul><li>Clearance from Regulations </li></ul>
FX Derivative <ul><li>4 major types of FX derivatives for financial institutions </li></ul><ul><ul><li>FX Swaps </li></ul></ul><ul><ul><li>FX Futures Contracts </li></ul></ul><ul><ul><li>FX Currency Swap </li></ul></ul><ul><ul><li>Outright Forward Purchases or Sales </li></ul></ul><ul><li>Credit Unions’ exposure should be limited to FX swaps and Outright Forwards related to member business </li></ul>
FX Swaps <ul><li>Definition – an agreement to sell US$ today against an offsetting purchase of US$ at a future date </li></ul><ul><li>US$ principals are equal </li></ul><ul><li>The FX rate today versus a FX rate in the future is established today </li></ul><ul><li>Short terms to long terms (1 day to 5 yrs) </li></ul><ul><li>Most activity inside 3 months for credit unions </li></ul>
Why are FX Swaps Used? <ul><li>Used to transfer liquidity (cash) from one currency to another without engaging in currency risk </li></ul><ul><li>Example – credit union has US$ deposits and no US$ loans – forced to invest in US$ investments </li></ul><ul><li>With FX swaps CU converts US$ into C$ and lends funds out at higher rate than US$ investment level or pays down C1 borrowings </li></ul><ul><li>FX swaps can boost income or reduce borrowing costs! </li></ul>
How to do an FX swap? <ul><li>Cash in US$ investments into C/A </li></ul><ul><li>Sell US$ value cash (today, spot is actually next business day) at 1.1000 </li></ul><ul><li>Agree to Buy US$ value 1 month from today at a future rate 1.1015 </li></ul><ul><li>On the future date US$ back into C/A and need to pay back C$ </li></ul><ul><li>Do a new FX swap (rollover) on that date </li></ul>
Pricing an FX swap <ul><li>Selling and buying at two different rates creates a loss/gain – Why do FX swap? </li></ul><ul><li>The gain or loss on FX swap is related to the interest rate differential between Cdn and US 1 month yields </li></ul><ul><li>Think interest rate costs not FX gains or losses when doing FX swap </li></ul>
Math of FX Swap <ul><li>Cash in US$1 mil deposits yielding 0.20% give up $167 on 30 days of interest </li></ul><ul><li>Sell US$1 mil at 1.10 for $1.1 mil C$ </li></ul><ul><li>Invest $1.1 mil at 0.45% and earn $406 </li></ul><ul><li>Give up $US167 at 1.10 = $184 vs $406 </li></ul><ul><li>Cost of buying US$ back will be higher than spot rate to claw back the $222 gain </li></ul><ul><li>If FX swap rates are 1.10 and 1.1002 most gains will be lost </li></ul>
Beating the FX Swap Market <ul><li>Beating the FX market </li></ul><ul><ul><li>Find higher C$ yield than money market </li></ul></ul><ul><ul><ul><li>Reduce C1 loan = savings 0.30% (0.75% - 0.45%) </li></ul></ul></ul><ul><ul><ul><li>Lend funds to members at Prime = bigger savings </li></ul></ul></ul><ul><li>Calculate the potential gain to CU </li></ul><ul><ul><li>US$ 1 mil * 0.20% * 30 / 360 = -C$184 </li></ul></ul><ul><ul><li>C$ 1.1 mil * 3.00% * 30 / 365 = C$ 2,712 </li></ul></ul><ul><ul><li>Less forward pts .0002 * $ 1 mil = -C$200 </li></ul></ul><ul><ul><li>Pick up from FX swap strategy = $2,339 </li></ul></ul><ul><ul><li>Annual gains $27,939 per million!!! </li></ul></ul>
FX Swap Factors <ul><li>If US rates > Cdn Rates forward yields at a discount to spot (ex. 1.10 & 1.0998) </li></ul><ul><ul><li>Sell and Buy results in a FX gain </li></ul></ul><ul><li>If US rates < Cdn Rates forward yields at a premium to spot (ex 1.10 and 1.1002) </li></ul><ul><li>Gains or Losses on FX swap not FX losses but interest costs </li></ul>
Risk Factors <ul><li>US$ deposit expenses will build up if not offset with US$ spot purchases </li></ul><ul><li>Default Risk </li></ul><ul><ul><li>If counterpart fails = result = open currency position </li></ul></ul><ul><ul><li>Mitigate risk by dealing with highly-rated counterparts </li></ul></ul><ul><ul><li>Consider only doing short term swaps 1 to 3 months </li></ul></ul>
Risk Factors <ul><li>US$ depos redeem before FX swap purchase </li></ul><ul><ul><li>Members draw down US$ deposits and put C/A into overdraft </li></ul></ul><ul><ul><li>Enter into Buy and Sell US$ Contract </li></ul></ul><ul><ul><ul><li>Buy US$ for cash to cover overdraft </li></ul></ul></ul><ul><ul><ul><li>Sell US$ forward to match date of previous purchase </li></ul></ul></ul><ul><ul><ul><li>Sell C$ investments to buy US$ today </li></ul></ul></ul><ul><ul><li>Potential Risk to income from the change in forward points on the outstanding buy and sell </li></ul></ul><ul><ul><li>Mitigate risk by keeping terms to less than 3 months </li></ul></ul>
Internal Issues <ul><li>Set Up Off balance Sheet accounts for US$ and counter C$ balances </li></ul><ul><ul><li>US$ forward purchases and forward sales </li></ul></ul><ul><li>FX Translation effects to understand </li></ul><ul><ul><li>Month end spot rate 1.10 </li></ul></ul><ul><ul><li>Sell FX at 1.08 on first of next month 1.0802 </li></ul></ul><ul><ul><li>Close current month end at 1.07 </li></ul></ul><ul><ul><li>Gain .03 on deposits, Loss of .02 FX Sale (1.10 vs 1.08) </li></ul></ul><ul><ul><li>Outstanding FX Buy at 1.0802 vs 1.07 (loss of .0102) </li></ul></ul>
Calculation of FX Position <ul><li>Old FX position calculation </li></ul><ul><ul><li>Sum (Investments, Current Account) less deposit terms and accounts = Net FX position </li></ul></ul><ul><li>New FX position calculation </li></ul><ul><ul><li>Old FX position add US$ forward Purchases and Sales </li></ul></ul><ul><li>Remember US$ deposit interest will exist without US$ investment income using FX swaps – requiring the occasional US$ purchase </li></ul>
Example US$ Deposit Redemption <ul><li>CU manager has $1 mil US$ deposits and enters into Sell/Buy FX swap </li></ul><ul><ul><li>On B/S = $1 mil US$ deposit (negative flow) </li></ul></ul><ul><ul><li>Off B/S = $1 mil Purchase (positive flow) </li></ul></ul><ul><li>CU manager pays out $600k in US$ deposits </li></ul><ul><ul><li>Manager Buys and Sells $US600k FX Swap </li></ul></ul><ul><ul><li>On B/S = $400k US$ deposit (negative flow) </li></ul></ul><ul><ul><li>Off B/S = $1 mil Buy and $600k sell = $400k (positive flow) </li></ul></ul>
Policy Amendments <ul><li>Allow FX swap transactions under Market Risk policy </li></ul><ul><li>Set maximum term from spot and maximum US$ dollar value </li></ul><ul><li>Review annually for appropriateness </li></ul><ul><li>Prepare Board reporting package </li></ul>
FX Outright Forwards <ul><li>Second type of FX derivative used by credit unions </li></ul><ul><li>Related to Corporate client business </li></ul><ul><ul><li>Importer or Exporter wish to hedge their exposure to US$ from their business </li></ul></ul><ul><ul><li>Buy or Sell US$ forward outright at a rate set today </li></ul></ul><ul><ul><li>Can provide Corporate Client with a option dated delivery (any time during a specific month at a specific rate) </li></ul></ul>
Risks to Income from Outright Forwards <ul><li>Counterparty risk </li></ul><ul><ul><li>Client defaults = big risk to income </li></ul></ul><ul><ul><li>Mitigate by shorter terms or collateral (deposits) </li></ul></ul><ul><li>Re-pricing risk </li></ul><ul><ul><li>Client doesn’t need FX when it matures </li></ul></ul><ul><ul><li>Client wants to roll over contract and use same rates </li></ul></ul><ul><ul><li>Client is borrowing money from credit union if same rate is used – must build interest costs into new forward rate </li></ul></ul>
Policy Amendments for Outright Forward Activity <ul><li>Great way of earning additional income on commercial credits </li></ul><ul><li>Require Assistance call us or Central One </li></ul><ul><li>Should match buys and sells with Central One or bank as close as possible </li></ul><ul><li>Should have maximum terms for transactions and fully matched for risk management reflected in market risk policy </li></ul>
Policy Amendments <ul><li>Forward Outrights require market risk policy amendments </li></ul><ul><li>Maximum terms, limits on levels of mismatch by time period, credit reviews and individual risk limits per client are important </li></ul><ul><li>Simple Excel solution should work for reporting and managing risk </li></ul>
FX Derivatives Reporting <ul><li>Sum On-B/S Assets and Liabilities </li></ul><ul><li>Sum Off-B/S FX Swap US$ Forward Purchases and Sales </li></ul><ul><li>Sum of FX Outright Forward Purchases and Sales </li></ul><ul><ul><li>Provide a gap report to board with US$ buys and sells outstanding by month with weighted average rate </li></ul></ul>
FX Derivatives and the Regulations <ul><li>Regulations prohibit the use of FX derivatives (very prescriptive…) </li></ul><ul><li>Request in writing an exception from Regulator on usage of FX derivatives </li></ul><ul><li>State the purpose of the usage of FX derivatives (FX swaps for liquidity management and FX outrights for customer business) </li></ul><ul><li>State the adjustments made to market policy to measure and report for this exposure </li></ul><ul><li>Receive response from Regulator </li></ul>
Conclusions <ul><li>Improved profitability levels </li></ul><ul><li>Swaps are safe and efficiently priced </li></ul><ul><li>Easy to account for and measure for risk management </li></ul><ul><li>Keep FX swap terms to 30 days and starting and maturing near start of the month will reduce any issues </li></ul><ul><li>Member business is profitable too, but be prepared for additional credit risk (collateral conditions, term and volume limits are required) </li></ul>