Forex Markets & Managing Risks in Forex Business

Exchange Rate Arithmetic

Exchange Rate

It reflects how much a currency values to another currency. It is the rate at which one currency is converted in to another currency.

Exchange rate codes are expressed in 6 letter currency codes.

e. g.; USD/CHF ; GBP/USD; USD/ INR

In the first place : it is base currency code and quotations are expressed in units of the second currency against one unit of the first currency.

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Currency Quotes

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Currency QuotesWhat are Direct Quotes & Indirect Quotes ?

Direct Quote : system of expressing exchange rate for 1 unit of foreign currency in units of home currency i.e USD/INR = 52.50/52

Indirect Quote : system of expressing exchange rate of a unit of local currency in units of foreign currency i.e EUR/USD = 1.5930/ 35

Currency Quotes-combined CurrencyAll currencies are valued against the US Dollar.

A EUR / INR trade involves two legs since Euro cannot be directly converted to INR and vice-versa.EUR / INR = (EUR/USD)*(USD/INR)

If market quotes:

EUR / USD=1.2579 / 1.2582 & USD / INR=55.67 / 55.68then spot conversion rate of Euro to Rupee will be:

For an import transaction: 1.2582 * 55.68 = 70.0565

For an export transaction: 1.2579* 55.67 = 70.0273*

Currency Quotes-combined Currency CONTDAll currencies are valued against the US Dollar.

A JPY / INR trade involves two legs since JPY cannot be directly converted to INR and vice-versa

JPY / INR = (USD / INR) / (USD / JPY)

If market quotes:USD/JPY=79.44/79.45 USD/INR=55.67/55.68

then spot conversion rate of JPY to Rupee will be:

For an import transaction: (55.68/79.44)*100 = 70.09

For an export transaction: (55.67/79.45)*100 = 70.07*

Value Date - Time ScaleTime Scale

CashTomSpotForward MaturitiesCash Deal is done today for delivery TodayTom Deal is done today for delivery TomorrowSpot Deal is done today for delivery on 2nd Business DayForward Deal is done today for delivery beyond Spot Date

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Forward Premium/DiscountWhen settlement date is beyond the spot date, it is called a forward transaction.In an exchange rate pair, the currency with lower interest rate will be at premium In an exchange rate pair, the currency with higher interest rate will be at a discount Forward premiums are a function of interest rate differential between the two currencies of the pairSince USD/INR spot & fwd rates are not purely market determined, they also depend upon the demand and supplyMore dollar inflow than outflow leads to a stronger rupee while net dollar outflow leads to a weaker rupee.More demand from importers in the forward market raises the forward premium whereas, presence of more number of exporters leads to softening of forward premiums

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Communication/ConventionImport transaction: Customer to buy outwardExport transaction: Customer to sell inward

In a currency pair, its the base currency that is traded

Eg.1 Mio EUR/USD means 1 mio euro 1 Mio USD/JPY means 1 mio US dollar

Mine I Buy from youYours I sell to youOff - Rate no more valid

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Forward Rate CalculationIf the current market quote on 1st June,12 is

Spot USD/INR= 55.75/55.76Swap Cash spot= 2.00/2.50 Tom Spot= 1.00/1.50 June = 7.00/8.00

Value Date Import Txn Export Txn03.06.2012 55.76 55.750030.06.2012 55.84 55.820002.06.2012 55.75 55.735001.06.2012 55.74 55.7250 *

Forward Rate CalculationSpot USD/INR= 55.75/55.76 EUR/USD= 1.2579/1.2582Swap INR-June= 7.00/8.00 EUR-June= (-)0.0001/(-)0.0002

EUR/INR Forward rate for value date 30.06.2011

For import transaction: (1.2582 - 0.0001) * (55.76+0.08) = 70.2523

For export transaction:(1.2579-0.0002)* (55.75 +0.07) = 70.2048*

Why need hedging ??

USD/INR

Gained by 12% from June02 level of 49.07 to 43.28 in Apr04

Crest and Troughs of USDINR

Gained by 17% from July06 level of 47.04 to 39.23 in Nov07Lost by 33% from Feb08 level of 39.33 to 52.18 in Mar09Lost by 24% from Jul11 level of 43.86 to 54.30 in Dec11*

USD 6-M LIBOR

INR-SENSEX

INR-NIFTY

WHY DO THEY MOVECauses for VolatilityNature Of MarketSize, Market Place, Regulatory Control, Technical Analysis ModelsEconomic FactorsData, Events, FundamentalsInterest Rates; Carry TradesLocal Factors ( $/INR)Demand & Supply; Capital FlowsRBI, Political Climate

DERIVATIVESEXCHANGE TRADEDCURRENCY- FUTURES

OVER THE COUNTER(OTC)FOREX- FWDS-OPTIONS-SWAPSCREDIT CDS

DERIVATIVE PRODUCTS

HEDGING PRODUCTS

Common Derivative ProductsForwards-USD/INR, Cross, Options-Put, Call & CombinationsSwaps -Principal, Interest & BothFutures-Currency, EquityCredit Derivatives-CDS

Common Underlying AssetsCommodities, Equity SharesForeign Exchange Revenue Flows ( Imports, Exports )Assets & Liabilities ( Foreign Currency Loans & Deposits)Interest Rate Exposures ( Foreign Currency Loans & Deposits)

TYPES OF EXPOSURE AND HEDGING PRODUCT

EXPOSURERISKHEDGING PRODUCTECB/ BUYERS CREDIT/FCTLEXCHANGE RISKPOS, CALL SPREAD, CALL OPTION, FORWARD CONTRACT, RANGE FORWARD ETCINTEREST RATE RISKIRS, FRA, CAPEXPORTSEXCHANGE RISKFORWARDS/PUT OPTION/RANGE FORWARDSIMPORTS/FCDLEXCHANGE RISKFORWARDS/CALL OPTIONS/ RANGE FORWARD

FORWARD CONTRACTS

A CONTRACT TO BUY OR SELL A SPECIFIED AMOUNT OF CURRENCY AT A SPECIFIED PRICE FOR A SPECIFIC FUTURE DATE.BOTH A RIGHT AND AN OBLIGATION TO BUY OR SELLADVANTAGE:SIMPLE , LIQUID , TRANSPARENT REQUIRES NO OUTLAY OF FUNDS UPFRONT.WINDOW OPTION OF 30 DAYSDISADVANTAGE: NO PARTICIPATION IN MARKET VOLATILITYPROFIT AND LOSS ONLY CRYSTALLIZED ON DUE DATEOPPORTUNITY PROFIT / OPPORTUNITY LOSS UNLIMITED

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FORWARD CONTRACTS47.5052.0050.50EXPORTER: SPOT: 50.00 + 3M FWD 0.50 PsRIGHT: PROTECTED RANGEOBLIGATION:OPPORTUNITY LOSS RANGE

Rate Calculation:Exports/Imports Bid / AskCash/Tom/SpotForward RatesExample: Spot Rate:50.00/01

FORWARD CONTRACTS

PERIODPREMIUMFWD. RATE1 MONTH0.30/0.3150.30/50.322 MONTHS0.40/0.4150.40/50.423 MONTHS0.50/0.5150.50/50.52

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OPTIONS

OPTIONSA CONTRACT WHEREBY THE BUYER ACQUIRES RIGHT BUT NOT OBLIGATION TO PURCHASE / SELL A SPECIFIED ASSET AT A PRE-DETERMINED PRICE ON A SPECIFIED DATE. (EUROPEAN OPTION)ADVANTAGE: OPPORTUNITY PROFIT UNLIMITEDOPPORTUNITY LOSS LIMITED TO THE PREMIUM PAIDDISADVANTAGE:PRICING LESS TRANSPARENT THAN FORWARD.

FACTOR OF A) SPOT B) STRIKE C) MATURITY D) INT. DIFF E) VOLATILITY UPFRONTPREMIUM PAYMENT.SPECIFIC DATE MATURITY- NOWINDOW OPTION

OPTION47.5052.0050.50ATM1.00

RIGHT: PROTECTED RANGENO OBLIGATION:OPPORTUNITY PROFIT RANGEEXPORTER: SPOT: 50.00 + 3M FWD 0.50 Ps

OPTIONS- GLOSSARYCALL OPTION

PUT OPTION

OPTION BUYER

OPTION SELLER

EXPIRATION

STRIKE RATE

IN THE MONEY

OUT OF MONEY

AT THE MONEY

AMERICAN OPTION

EUROPEAN OPTION

PREMIUM

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HOW TO CHOOSE?

ConfidenceHighLowViewBuyer of USDSeller of USDBuyer of USDSeller of USDINR Appreciating against USDKeep exposure openBook forwardBuy a CallBuy a PutINR Depreciating against USDBook forwardKeep exposure openBuy a CallBuy a Put

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RANGE FORWARD OPTION FOR IMPORTERS44.5045.8248.5047.65RANGE FORWARD45.35SpotSell putBuy call

Scenario Analysis : If, on maturity date-USD/INR is between 45.35 and 47.65 , Customer buys USD at market rates.USD/INR is above 47.65, Customer has the right to buy the USD notional at 47.65USD/INR is below 45.35, Customer has to buy the USD notional at 45.35

SWAPSExchange of future cash flows at pre-determined ratesBank meets Customers obligations of principal & / or interest in the designated currency as per amortizationCustomer pays the Bank in INR for the obligations at a pre-determined rate and thus is hedged against risksCommon Swap: FCNB loans, where customer is exchanging his INR cash flows to Foreign Currency cash flows (Assumes FC risk and if hedged exchanging USD cash flows to INR cash flows)

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Bank AUSD Cash FlowsCorporateUSDLiabilityINR Cash Flows @ spot(pays premium %)PRINCIPAL ONLY SWAP

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BankBank PaysFloating Interest Rate6mL(1.20)+300Corp Pays Fixed $ Interest Rate5.00%CorporateINTEREST RATE SWAP

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USD Cash Flows

USD Liability(FCL)INR Cash Flows @ spotCIRSPays Floating Interest Rate (L+450) Corp Pays Rs Fixed Interest Rate9.50%BANKCORPORATEUSD loan converted into a INR loan synthetically

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INR- Foreign Currency SwapCompany should have a natural hedge.If natural hedge is not their than INR-FCY swap is restricted to listed companies or unlisted companies with a minimum net worth of Rs 200 crore.Once cancelled, shall not be rebooked Leveraged structure not allowedNotional Principal amount of swap should not exceed the outstanding amount of underlying.Maturity of swap should not exceed remaining maturity of underlying

Cost reduction structureRestricted to listed companies and their subsidaries/joint ventures/associates having common treasury & consolidated balance sheet Or unlisted companies with minimum net worth of Rs 200 crore.Accounting standards with the princip