Forex Market

FOREX MARKET

The foreign exchange market is the market where the currency of one
country is exchanged for that of another country and where the rate of
exchange is determined. The genesis of Foreign Exchange (FE) market
can be traced to the need for foreign currencies arising from:

• International trade;

• Foreign investment; and

• Lending to and borrowing from foreigners.

In order to maintain an equilibrium in the FE market, demand for foreign

currency (or the supply of home currency) should equal supply of foreign
currency (or the demand for home currency). In operational terms, the
demand for an supply of home currency should be equal. In the event of a
disequilibrium venues/steps in the bring out the desired balance by:

• Variation in the exchange rate; or

• Changes in official reserves; or

• both.

Participants in the FE market

Major participants in the FE market are :

• Large commercial banks (through their campsites or dealers) operating

either at retail level for individual exporters and corporations, or at
wholesale level in the interbank market;

• Central banks of various countries that intervene in order to maintain or

to influence the exchange rate of their currencies within a certain range,
and also to execute the orders of government;

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• Individual brokers or corporations. Bank dealers often use brokers to

stay anonymous since the identity of banks can influence short-term
quotes.

Exchange markets primarily function through telephone and telex.

Currencies with limited convertibility play a minor role in the FE market.
And, only a small number of countries have established full convertibility of
their currencies for all transactions.

Foreign exchange rates are quoted either for immediate delivery (spot rate)
or for delivery on a future date (forward rate). In practice, delivery in spot
market is made two days later.

A FE quotation is the price of a currency expressed in the units of another

currency. The quotation can be either direct or indirect. It is direct when
quoted as “so many units of local currency per unit of foreign currency”. For
example, Rs. 35 = US$ 1, is direct quotation for US dollars in India.
Similarly, a quotation in the USA will be $ 0.22 = Ffr1 whereas in France, it
would be Ffr 3.3 = DM 1, etc.

On the other hand, an indirect quotation is the one where exchange rate is
given in terms of variable units of foreign currency as equivalent to a fixed
number of units of home currency. For example, in India, US$ 2.857 = Rs.
100 is an indirect quotation. This type of quotation is made in the UK. For
example, in London a quotation may be made a $ 1.55 = £ 1.

Since 1 August 1993, all quotations in India use the direct method of
quotation. Some currencies are quote as so many rupees against one unit
while others as so many rupees against 100 units.

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Foreign Currencies Quoted against their one Unit

1. Australian dollar 10. Finnish mark (FM) 19. Qatar riyal

(A$)

2. Austrian schilling 11. French franc (Ffr) 20. Saudi riyal (SR)
*Sch)

3. Bahrain dinar 12. Hong Kong dollar 21. Singapore dollar

(HK$) (S$)

4. Canadian dollar 13. Irish pound (I£) 22. Sterling pound (£)
(Can$)

5. Danish kroner (Dkr) 14. Kuwaiti dinar 23. Swadish knroner

(Skr)

6. Deutschmarket 15. Malaysian ringgit 24. Swiss franc (Sfr)

(DM)

7. Dutch guilder (F1) 16. New Zealand dollar 25. Thai baht (Bt)
NZ$)

8. Egyptian pount 17. Norwegian kroner 26. UAE Dihram

Nkr)

9. European Currency 18. Omani riyal 27. US Dollar ($)

Unit (ECU)

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Foreign Currencies Quoted against their 100 Units

1. Belgian franc (BFr) 3. Italian lira 5. Kenyan shilling

2. Burmese kyat 4. Japanese yen 6. Spanish peseta

Asian Clearing Union Currencies Quoted against their 100 Units

1. Bangladesh take 3. Iranian riyal 5. Sri Lanka rupee

2. Burmese kyat Pakistani rupee

Foreign exchange rates are always quoted a two-way price, i.e. a rate at
which the bank (dealer) is willing to buy foreign currency (buying rate) or
bid price and a rate at which the bank sells foreign currency (selling rate or
bank price). Dealers do expect, some profit in exchange operations and
hence there is always some difference in buying and selling rates.
However, the maximum spread available to dealers may be restricted by
their central bank. All exchange rates by authorized dealers are quoted in
terms of their capacity as buyer or seller.

Spread means the difference between a bank’s (bid) and selling (offer or
ask) rates in an exchange rate quotation or an interest quotation. It
fluctuates according to the level of stability in the market, the currency in
question, and the volume of the business. Thus, if there is a degree of
volatility in an exchange rate, and if business to be unsustainable, the
dealer will protect himself by widening the quote. That is, he will offer less
currency while selling currency while selling but demand more when buying
. The spread represents the gross return to the dealer of the risks inherent
in “making a market”. The spread can also be expressed as a percentage.
That is,

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Ask price − Bid price

Per cent Spread = X 100
Ask price

Cross rate : is the price of any currency other than the home currency. In
other words, it is the direct relationship between two non-home currencies
in a foreign exchange market concerned with or used in transactions in a
country to which none of the currencies belongs. Thus, in India, a cross
rate is any exchange rate which excludes rupees, for example, US$/FFr,
DM/BFr, etc.

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Financial ‘risk’ or ‘exposure’ : can be defined as sensitivity to any

outcome which could alter the valuation of assets or liabilities on an entity’s
balance sheet.

Given the interlinkages in any economic system, business entities are

exposed to risks arising from diverse parts of the national and international
economies.

Ideally, however, an economic entity should only be exposed to those ‘risk’

that are intrinsic to its core businesses since its ‘returns’ accrue from these
core activities.

Risk Management ...

Thus it is necessary to ‘manage’ the total risk to which a

corporate/institution is exposed, in order to eliminate ‘unwanted’ risk.

Managing away ‘unwanted’ risk involves setting up ‘hedge’ positions, which

essentially offset the cashflows arising from the ‘unwanted’ exposure, thus
neutralising the potential of the latter to affect the balance sheet.

Exchange rate risk (ERR) : is inherent in the business of all multinational

enterprises as they are to make or receive payments in foreign currencies.
This risk means eventual lossed incurred by these enterprises due to
adverse movements of exchange rates between the dates of contract and
payment However, ERR does not imply that it will result into losses only.
Gains may also accrue if the movement of rates is favourable. Thus the
appreciation of dollar in 1985, for example, was beneficial for those
enterprises that exported to the USA and billed in US dollars. Conversely,
the American companies exporting outside and billion in other currencies
suffered losses. Similarly, the depreciation of US dollar in 1995 caused
losses to the non-USA companies whose exports were billed in US dollars
and proved profitable for the USA companies exporting and billing in non-
US dollar currencies.

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In view of the substantial and significant stake in foreign countries, foreign

exchange risk has become an integral part of the management must be
aware of the various techniques of dealing with ERR. Covering the foreign
exchange risk is also known as hedging the risk. If a company in its
wisdom does not want to hedge, it tantamounts to have the view that the
future movements of exchange rates will be in its favour. On the contrary,
the conservative enterprises may adopt the policy of hedging everything.

Hedging decision : companies are constantly confronted with the decision

of whether to hedge future payables and receivebles in foreign currencies.
Whether a firm hedges may be determined by its forecasts of foreign
currency values.

Short-term financing decision : When large corporations borrow, they

have access to several different currencies. The currency they borrow will
ideally (1) exhibit a low interest rate and (2) weaken in value over the
financing period.

Short-term investment decision : Corporations sometimes have a

substantial amount of excess cash available for a short term. Large
deposits can be established in several currencies. The ideal currency for
deposits would (1) exhibit a high interest rate and (2) strengthen in value
over the investment period.

Capital budgeting decision : When a Company attempts to determine

whether to establish a subsidiary in a given country, a capital budgeting
analysis is conducted. Forecasts of the future cash flows used within the
capital budgeting process will be dependent on future currency values.
This dependency can be due to (1) future inflows or outflows denominated
in foreign currencies that will require conversion to the home currency and /
or (2) the influence of future exchange rates on demand for the
corporation’s products. There are several additional ways by which
exchange rates can affect the estimated cash flows, but the main point

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here is that accurate forecasts of currency values will improve the

estimates of the cash flows, and therefore enhance the company decision-
making abilities.

Long-term financing decision : Corporations that issue bonds to secure

long-term funds may consider denominating the bonds in foreign
currencies. As with short-term financing, corporations would prefer the
currency borrowed to depreciate over time against the currency they are
receiving from sales. To estimate the cost of issuing bonds denominated in
a foreign currency, forecasts of exchange rates are required.

Earnings assessment : When earnings of a company are reported,

subsidiary earnings are consolidated and translated into the currency
representing the parent firm’s home country. For example, consider a
comapny with its home office in the United State and subsidiaries in
Switzerland and Great Britain. The Swiss subsidiary’s earnings in Swiss
francs must be measured by translation to US dollars. The British
subsidiary’s earnings in pounds must also be measured by translation to
US dollars. “Translation” does not suggest that the earnings are physical
converted to US dollars. It is simply a recording process to periodically
report consolidated earnings in a single currency. Using the scenario just
described, appreciation of the Swiss franc will boost the Swiss subsidiary’s
earnings when reported in (translated to )US dollars.

Why Exchange Rate Risk is Relevant

Volatile foreign earnings can also cause more volatile growth and
downsizing cycles within a firm, which is more costly than slow stable
growth. Hedging can reduce the firm’s volatility of cash flows because the
firm’s payments and receipts are not forced to fluctuate in accordance with
currency movements. This can reduce the possibility of bankruptcy, which
allows the firm easier access to credit from creditors or suppliers, and may
allow the firm to borrow at lower interest rates (because the perceived risk

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is lower). Hedging may also allow the firm to more accurately forecast
future payments and receipts, which can enhance its cash budgeting
decisions.

Exchange rates cannot be forecasted with perfect accuracy, but the firms
can at least measure its exposure to exchange rate fluctuations. If the firm
is highly exposed to exchange rate fluctuations, it can consider techniques
to reduce its exposure in the following chapter. Before choosing these
techniques, the firm should first measure its degree of exposure.

Exposure to exchange rate fluctuations comes in three forms :

• Transaction exposure

• Economic exposure

• Translation exposure.

Transaction Exposure

The value of a firm’s cash inflows received in various currencies will be

affected by respective exchange rates of these currencies when converted
into the currency desired. Similarly, the value of a firm’s cash outflows in
various currencies will be dependent on the respective exchange rates of
these currencies. The degree to which the value of future cash transitions
can be affected by exchange rate fluctuations in referred to as transactions
can be affected by exchange rate fluctuations is referred to as transaction
exposure.

Two steps are involved in measuring transaction exposure: (1) determining

the projected net amount of inflows or outflows in each foreign currency,
and (2) determining the overall risk of exposure to those currencies.

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Transaction exposure based on currency correlations

Measurement of Currency Correlations : The Correlations among

currency movement can be measured by their correlation coefficients,
which indicate the degree to which two currencies move in relation to each
other. thus, MNCs could use such information when deciding their degree
of transaction exposure. The extreme case is perfect positive correlation,
which is represented by a correlation coefficient equal to 1.00. Correlations
can also be negative, reflection an inverse relationship between individual
movements, the extreme case being - 1.00.

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Economic Exposure

The degree to which a firm’s present value of future cash flows can be
influenced by exchange rate fluctuations is referred to as economic
exposure to exchange rates. Transaction exposure is a subset of economic
exposure. However, the influence of exchange rate fluctuations on a firm’s
cash flows is not always due to transaction of currencies.

Economic Exposure to Exchange Rate Fluctuations

Variables That Influence the Impact of Local Impact of Local

Firms’s Local Currency Inflows Currency Appreciation Currency Depreciation
on Variables on Variables

Local sales (relative to foreign Decrease Increase

competition in local markets)

Firm’s exports denominated in Decrease Increase

local currency

Firm’s exports denominated in Decrease Increase

foreign currency

Interest received from foreign Decrease Increase

investments

Variables That Influence the Firm’s Local Currency Outflows

Firm’s imported supplies No Change No Change

denominated in local currency

Firm’s imported supplies Decrease Increase

denominated in foreign currency

Interest owed on foreign funds Decrease Increase

borrowed

The economic exposure refers to the change in expected cash flows as a

result of an unexpected change in exchange rates. For example, an
American exporter who operates in French market can increase his market
share merely by reducing the French Company which is a potential

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competitor to the American firm can profit indirectly from currency losses of
the American company. Thus it can be se en that though the French
company is not directly exporting but business competition can be
generated on account of the strength of the currency of competitors, which
can be termed as economic exposure. Economic risks cannot be managed
as they are not reported in accounts, are difficult to quantify and perhaps
unhedgable.

Translation Exposure

The exposure of the MNC’s consolidated financial statements to exchange

rate fluctuations is known as translation exposure. For example, if the
assets or liabilities of the MNC’s subsidiaries are translated at something
other than historical exchange rates, the balance sheet will be affected by
fluctuations in currency values over time. In addition, subsidiary earnings
translated into the reporting currency on the consolidated income
statement are subject to changing exchange rates.

Determinates of Translation Exposure

Translation exposure is dependent on

• The degree of foreign involvement by foreign subsidiaries

• The locations of foreign subsidiaries

• The accounting methods used.

Degree of Foreign Involvement : The greater the percentage of an

MNC’s business conducted by its foreign subsidiaries, the larger will be the
percentage of a give financial statement item that is susceptible to
translation exposure.

Locations of Foreign Subsidiaries : The locations of the subsidiaries can

also influence the degree of translation exposure, since the financial

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statement items of each subsidiary are typically measured by the country’s

home currency.

Accounting Methods : Degree of accounting exposure can be greatly

affected by the accounting procedures it uses to translate when
consolidating financial statement data.

Transaction exposure : exists when the future cash transactions of a firm

are affected by exchange rate fluctuations. For example, a US firm that
purchases German goods may need marks to buy the goods. While it may
know exactly how many marks it will need, it doesn’t know how many
dollars will be needed to be exchanged for those marks. This uncertainly
occurs because the exchange rate between marks and dollars fluctuates
over time. Also consider a US - based MNC that will be receiving a foreign
currency. Its future receivebles are exposed since it is uncertain of the
dollars it will obtain when exchanging the foreign currency received.

If transaction exposure does exist, the firm faces three major tasks. First it
must identify the degree of transaction exposure. Second, it must decide
whether to hedge this exposure. Finally, if it decides to hedge part or all of
the exposure it must choose among the various hedging techniques
available.

Identifying Net Transaction Exposure

Before the MNC makes any decision related to hedging, it should identify
the individual net reansaction exposure on a currency-by-currency basis.
The term “net” here refers to the consolidation of all expected inflows and
outflows for a particular time and currency. The management at each
subsidiary plays a vital role in the process of reporting its expected inflows
and outflows. Then a centralized group consolidates subsidiary reports in
order to identify for the MNC as a whole, the expected net positions in each
foreign currency during several upcoming periods. The MNC can identify its
exposure by reviewing this consolidation of subsidiary positions.

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Is Hedging Worthwhile?

If a firm decides to hedge its periodic future payables denominated in a

foreign currency. The forward contract is a common heeding device against
this foreign currency position. If the spot rate in the future exceeds today’s
forward rate, then the company will save money by hedging its net
payables (as opposed to no hedge). If the spot rate in the future is less
than today’s forward rate, then the company will lose money by hedgings
its net payables. A forward rate that serves as an unbiased forecast of the
future spot rate will underestimate and overestimate the future sport rate
with equal frequency. In this case periodic hedging with the forward rate
will be more costly in some periods and less costly in other periods. On the
average, it will not reduce the company cost. Thus it could be argued that
hedging is not worth while.

If the company choose to hedge only in those situations in which they

expect the currency to move in a direction that will make hedging feasible.
That is they may hedge future payables that they foresee appreciation in
the currency denominating the payables. In addition they my hedge future
receivables if they forsee depreciation in the currency denominating the
receivables.

In general, decisions on whether to hedge, how much to hedge, and how to

hedge will vary with the company management’s degree of risk aversion,
and its forecasts of exchange rates. companies that are more conservative
tend to hedge more of their exposure.

Most company do not perceive their foreign exchange management as a

profit center. The main responsibility is to (1) measure the potential
exposure to exchange rate movements, which is necessary to assess the
risk (2) determine whether the exposure should be hedged, and (3)
determine how the exposure should be hedged, if at all. Thus is normally
inappropriate for the foreign exchange management group to set a profit

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goal, as it may even use some hedges that will likely result in slightly worse
outcomes than no hedges at all, just to avoid the possibility of a major
adverse movement in exchange rates.

Techniques to Eliminate Transaction Exposure

If the company decides to hedge part or all of its transaction exposure, it

may select from the following hedging techniques :

• Future hedge

• Forward hedge

• Money market hedge

• Currency option hedge.

Futures Hedge

Currency futures can be used by firms that desire to hedge transaction

exposure. A futures contract hedge is very similar to that of a forward
contract except that forward contracts are common for large transactions,
whereas futures contracts may be more appropriate for firms that prefer to
hedge in smaller amount.

A firm that buys a currency futures contract is entitled to receive a specified

amount in a specified currency for a stated price on a specified date. To
hedge payment on future payables in a foreign currency, the firm may
desire to purchase a currency futures contract representing the currency it
will need in the near future. By holding this contract, it locks in the amount
of its home currency needed to make payment on the payables,.

While currency futures can reduce the firm’s transaction exposure, they
sometimes backfire on the firm. If the firm is hedging payables the locked in
futures price for the currency could end up being higher than the future
spot rate of the currency (if the currency depreciates over time). If the firm

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expected the currency’s value to depreciate by the time it would need to

make payment, it would not purchase a currency futures contract.

A firm that sells a currency futures contract is entitled to sell a specified

amount in a specified currency for a stated price on a specified data. To
hedge the home currency value of future receivable in a foreign currency,
the firm may desire to sell a currency future receivable in a foreign
currency, the firm may desire to sell a currency futures contract
representing the currency it will be receiving. This way the firm knows how
much of its home currency it will receive after converting the foreign
currency, it insulates the value of its future receivables from the fluctuations
in the foreign currency’s spot rate over time.

Forward Hedge

Forward contracts are commonly used by large corporations that desire to

hedge. To use the forward contract hedge, the MNC purchases that
currency denominating the payables forward. For example, if a US - based
MNC must pay a Swiss supplier 1,000,000 francs in 30 day, it can re quest
from a bank a forward contract to accommodate this future payment. The
bank agrees to provide the Swiss francs to the MNC in 30 days in
exchange for US dollars. The MNC hedges its position by locking in the
rates it will pay for Swiss francs in 30 days. Thus, it now knows the number
of dollars it will need to exchange for francs.

If the US - based MNC expects receivable in Swiss francs in 30 days, it

would like to lock in the rate at which it can sell these francs for dollars. In
this case, a request for a forward sale of Swiss francs is appropriate. Many
MNCs commonly implement the forward hedging technique. For example,
Du Pont Company often has the equivalent of $ 300 million to $ 500 million
in forward contracts at any one time, to cover open currency positions.

Money Market Hedge

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A money market hedge involves taking a money market position to cover a

future payables or receivable position.

Currency Option Hedge

Firms recognize that hedging techniques such as the forward hedge and
money market hedge can backfire when a payables currency depreciates
or a receivable currency appreciates over the hedged period. In these
situations, an unhedged strategy would likely outperform the forward hedge
or money market hedge. The ideal type of hedge would insulate the firm
against adverse exchange rate movements but allow the firm to benefit
from favourable exchange rate movement. Currency options exhibit these
attributes. However, a firm must assess whether the advantages of a
currency option hedge are worth the price (premium) paid for it.

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Review or Techniques for Hedging Transaction Exposure

Hedging Technique To Hedge Payables To Hedge Receivable
1. Futures hedge Purchase a currency Sell a currency futures contract
futures contract (or (or contracts) representing the
contracts) representing the currency and amount related to
currency and amount the reveivables.
related to the payables.
2. Forward hedge Purchase a forward Sell a forward contract
contract representing the representing the currency and
currency and amount amount related to the
related to the payables receibvables.
3. Money market Borrow local currency and Borrow the currency
hedge convert to currency denominating the receivable,
denominating payables convert it to the local currency,
Invest these funds until they and invest it. Then pay off the
are needed to cover the loan with cash inflows from the
payables. receivable.
4. Currency option Purchase a currency call Purchase a currency put option
hedge option (or options) (or options) representing the
representing the currency currency and amount related to
and amount related to the the receivables.
payables.

Hedging Performance of Currency Options Versus Forwards

A recent study by Madura simulated a process of hedging a position in

each of five major currencies, to study the effectiveness of hedging with
currency options as opposed to forward contracts in each quarter. The
study was conducted first from the perspective of a US importing firm and
then from that of US exporting firm. From the importer’s perspective the
results were mixed. In some quarters the importer would have been better
off with currency call options, while in other quarters the forward purchase
would have been preferable. Of course the superiority of one technique
over another would not have been determined until after the periods were

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over. On average, there was no significant difference in the amount paid of

imports between hedging with currency call options and doing so with
forward purchases. This result held for each of the five currencies. From
the US exporter’s perspective, there was on average no significant
difference between using currency put options and using forward sales to
hedge receivable for four of the currencies . For the Japanese yen the
dollar value of the receivable was significantly higher when using put
options than it was when using put options than it was when using for -
ward sales.

A comparison was also conducted between currency options and an

unheeded strategy. From an importer’s perspective, there was no
significant difference on average in the amount paid between using
currency call options and using an unheeded strategy. On exception was
the German mark, in which the unheeded strategy was superior.

From an exporter’s perspective there was no significant difference on

average in the amount received between hedging with currency put options
and using an unheeded strategy. One exception was the British pound, in
which the unheeded strategy and superior.

Overall, currency options generally performed about as well as for ward

contracts or the unheeded strategy, and they may alleviate any convernms
managers have about exchange rate movements. Further-more they offer
the opportunity to benefit if exchange rates move in a favorable direction.
The results of this study suggest that currency options should be given
serious consideration.

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Hedging Long - Term Transaction Exposure

For firms that can acurately estimate foreign currency payables or

receivables that will occur several years from now, there are three
commonly used techniques to hedge such long-term transaction
exposure :

• Long-term forward contract

• Currency swap

• Parallel loan.

Long-Term Forward Contract

Most large international banks routinely quote forward rates for terms of up
to five years for British pounds, Canadian dollars, German marks, and
Swiss francs. Long forwards are especially attractive to firms that have
set up fixed-price exporting or importing contracts over a long period of
time and want to protect their cash flow from exchange rate fluctuations.

Currency Swap

A currency swap is a second technique for hedging long-term transaction

exposure to exchange rate fluctuations. It can take many forms. One type
of currency swap accommodates two firms that have different long-term
needs. Consider a US firm, hired to build an oil pipeline in Great Britain that
expects to receive payment in British pounds in five years when the job is
completed. At the same time, a British firm is hired by a US bank for a long-
term consulting project. Assume that payment to this British firm will be in
US dollars and that much of the payment will occur in five years. The US
firm will be receiving British pounds in five years and the British firms will
be receiving US dollars in five years. These two firms could range a
currency swap that allows for an exchange of pounds for dollars in five
years at some negotiated exchange of pounds for dollars in five years at

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some negotiated exchange rate. In this way, the US firm could lock in the
number of US dollars the British pound payment will convert to in five
years. Likewise, the British firm could lock in the number of British pounds
the US dollar payments will convert to in five years.

To create a currency swap, firms need to find other firms that can
accommodate their needs. There are brokers employed by large banks and
investment firms that act as middlemen for swaps. They are notified by
those corporations that want to eliminate transaction exposure to specific
currencies at certain future dates. Using this information, they can match
up firms when one firms needs the currency the other firms wants to
dispose of (and vice versa). The brokers receive a fee for their service.

Parallel Loan

A parallel loan (or “back-to-back loan”) involves an exchange of currencies

between two parties, with a promise to re-exchange currencies at a
specified exchange rate and future date. It represents two swaps of
currencies, one swap at the inception of the loan contract and another
swap at the specified future date. A parallel loan is interpreted by
accountants as a loan and is therefore recorded on financial statements.

ALTERNATIVE HEDGING TECHNIQUES

When a perfect hedge is not available (or is too expensive) to eliminate

transaction exposure, the firm should consider methods to at least reduce
exposure. Such methods include

• Leading and Lagging

• Cross-hedging

• Currency diversification

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Leading and Lagging

The act of leading and lagging represents an adjustment in the timing of

payment request or disbursement to reflect expectations about future
currency movements. For example, consider a multinational corporation
based in the United State that has subsidiaries dispersed around the world.
The focus here will be on a subsidiary in Great Britain that purchases some
of its supplies from a subsidiary in Germany. Assume these supplies are
denominated in German marks. If the British subsidiary expects the pound
will soon depreciate against the mark, it may attempt to accelerate the
timing of its payment before the pound depreciates. This strategy is
referred to as leading.

As a second possibility, consider a scenario in which the British subsidiary

expects the pound will soon appreciate against the mark. In this case, the
British subsidiary may attempt to stall its payment until after the pound
appreciates. In this way it could use fewer pounds to obtain the marks
needed for payment. This strategy is referred to as lagging. General
Electric and other well-known MNCs commonly use leading and lagging
strategies in countries that allow them.

Cross-hedging

Cross-hedging is a common method of reducing transaction exposure

when the currency cannot be hedged. Assume a US firm has payables in
Currency X 90 days from now. Because it is worried that Currency X may
appreciate against the US dollar, it may desire to hedge this position. If
forward contracts and the other hedging techniques are not possible for
this currency the firm may consider cross-hedging in which case it needs to
first identify a currency that can be hedged and is highly correlated with
Currency X. It could then set up a 90-day forward contract on this currency.
If two currencies are highly correlated relative to the US dollar (that is, they
move in a similar direction against the US dollar), then the exchange rate

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between these two currencies should be somewhat stable over time. When
purchasing the one currency 90 days forward the US firm can then
exchange that currency for Currency X. The effectiveness of this strategy
depends on the degree to which these two currencies are positively
correlated. The stronger the positive correlation, the more effective will be
the cross-hedging strategy.

Swaps in Foreign Currencies

Swap is an agreement reached between two parties which exchange a

predetermined sum of foreign currencies with a condition to surrender that
sum on a predecided date. It always involves two simultaneous operations:
one spot and the other on a future date.

There are various types of swaps such as cross-credit swaps, back-to-back

credit swaps, and export swaps, etc.

Cross-Credit Swaps

In this kind of swap, there is an exchange of foreign currencies between a

parent company and say, a bank in a foreign country. Let us say an
American parent company wishing to finance its subsidiary in India may
enter into an agreement with an Indian bank. The American parent
company will deposit a sum in US dollars with the Indian bank, equivalent
to the sum that it wants to lend in Indian rupees to the subsidiary for a
fixed period. Suppose this sum is US$ 1 million at a 10 per cent rate of
interest. The Indian bank will lend to the subsidiary a sum of Indian Rs. 32
million (assuming the exchange rate is Indian Rs. 32 = US$ 1), say at 12
per cent p.a. rate of interest. If the period of the swap is one year, then at
the end of the swap period, the American parent company will receive from
the Indian bank a sum of US$ 1.1 million (= 1 + 1 X 0.1) while the bank will
receive from the subsidiary a sum of Indian Rs. 35.84 million [ = 32 X (1 +
0.12)].

MALA GRAPHICS 23
 Forex Market

Suppose, in the meantime, the exchange rate has evolved to Indian Rs.
35/US$ 1, then the loss to the bank would be $ 0.076 million ( = 35.84/35-
1.1). Thus the exchange management risk got shifted to the Indian bank
while both the American parent company and the Indian subsidiary were
dealing in their respective currencies without any uncertainty about the
sums to be received or paid. The bank would have made a gain in case the
exchange rate had evolved in the opposite direction.

Back-to-back Credit Swaps

In a back-to-back credit swap, two companies located in two different

countries may agree to exchange loans in their respective currencies for a
fixed period. For example, KODAK (An American multinational) may lend in
US dollars to the USA based subsidiary of FUJI while the latter (a
Japanese multinational) may lend in Japanese yen to the Japan-based
subsidiary of KODAK. The cost of swaps will depend on the rate of interest
and the exchange rate chosen by the two parties.

Basic strategy for hedging transactions exposure

Basically, the strategy involves increasing hard currency (likely to

appreciate) assets and decreasing soft currency (likely to depreciate)
assets, while simultaneously decreasing hard currency liabilities and
increasing soft currency liabilities. For example, if a depreciation is likely to
take place the basic hedging strategy would be as follows: reduce the level
of cash, decrease accounts receivable by tightening credit terms, increase
local currency borrowing delay accounts payable, and sell the weak
currency forward.

MALA GRAPHICS 24
 Forex Market

Basic Strategy for Hedging Transactions Exposure

Assets Liabilities

Hard currencies (likely to appreciate) Increase Decrease

Soft currencies (likely to depreciate) Decrease Increase

In concrete terms, the basic strategies can be implemented by taking

appropriate measures, depending upon the anticipated depreciation or
appreciation of local currency.

EXTERNAL TECHNIQUES FOR COVERING EXCHANGE

RATE RISK

The major techniques in this regard are:

• Covering risk in the forward market;

• Covering in the money market;

• Advances in foreign currency;

• Covering in financial futures market;

• Covering in the options market;

• Covering through currency swaps;

• Recourse to specialised organisations.

COVERING RISK IN THE FORWARD MARKET

Covering a Transaction Exposure

In order to cover himself against an exchange rate risk, arising from an

eventual depreciation of the currency in which he has invoiced his exports,
an exporter will sell his foreign exchange in the forward market.

MALA GRAPHICS 25
 Forex Market

Conversely, an importer wanting to cover himself against the eventual

appreciation of foreign currency, will buy foreign exchange forward.

Covering a Consolidation Exposure

The magnitude of exposure depends on the method of translation used by

the parent company.

MALA GRAPHICS 26
 Forex Market

COVERING IN FOREIGN EXCHANGE FUTURES (OR FINANCIAL

FORWARD) CONTRACT MARKET

Initially, futures markets were engaged in merchandise business only, e.g.

eggs, butter, cereals, raw material and so on. The currency futures were
launched for the first time in 1972 on the International Money Market.
(IMM) of Chicago, (presently a division of the Chicago Mercantile
Exchange).

Futures Markets and Contracts

Currency futures markets are now functioning at Chicago, New York,

London, Singapore, Tokyo, Sydney, etc. The most important of them is the
IMM of Chicago.

A currency futures contract is a commitment to buy or to sell a specified

quantity of a currency on a future date, at the pre-determined/decided price
existing on the date of the contract. These contracts have the following
characteristics:

• Transactions are traded in standard lots.

• Quotations are made in terms of US$ per unit of another currency.

• Fluctuations differ according to currencies. The smallest variation (also

called ‘tick’) is 0.01 per cent. So if the contract is of the value DM

0.01
125,000, the value of minimal fluctuation is 125,000 X = DM
100
12.50.

• Maturity periods are also standardised, say, March, June, September

and December.

MALA GRAPHICS 27
 Forex Market

• A guarantee deposit is required to be made for selling or buying of a

contract. This deposit is of the order of US$ 1,000 and is made with the
Clearing House.

Call Option

The holder of a call option acquires a right but not an obligation to buy a
certain quantity of foreign currency at a predetermined price (also called
exercise or strike price). A writer (or seller) of a call option has an obligation
to sell a certain amount of foreign currency at a predetermined price.

Put Option

The holder of a put option acquires a right but not an obligation to sell a
certain quantity of foreign currency at a predetermined strike price. The
writer of a put option has an obligation to buy a certain amount of foreign
currency at a predetermined price. Thus, it is the holder (buyer or owner) of
an option who has a choice to use or abandon the exercise of the option
who has a choice to use or abandon the exercise of the option whereas the
seller of an option should be ready to sell (in case of call) or buy (in case of
put) the amount agreed upon. The latter has no choice of his own.

Covering against Exchange Risk by Purchasing Tunnel with a Zero

Premium

Since premium represents a non-negligible cost, banks propose to their

clients the option with zero premium called tunnel, but protection is
available only within certain limits. For example, let us consider the data of
the Table given below. An Indian importer buys a 1 month tunnel with zero
premium of narrow range. This means that if after a month’s time the dollar
rate in Indian Rs. 35.70, he would pay only Rs. 35.60 per dollar. But, on the
other hand if the rate is Rs. 34.90, he would have to pay Rs. 35.00 per
dollar. If the dollar price is established somewhere within the range, then
he would have to pay the actual market price.

MALA GRAPHICS 28
 Forex Market

Besides the tunnels of narrow range, there are tunnels of wider range too.
One would choose between the two depending upon the anticipations of
future rates.

The importance of tunnels lies in the fact that one does not have to pay
premium but at the same time they do not allow the operator to get the full
advantage of a favourable evolution of rates.

Tunnel with Zero Premium

Maturity Narrow range Wider range

1-month 35.00-35.60 34.25-36.25

3-months 35.50-36.00 34.00-36.30

6-month 35.75-36.35 33.80-36.50

MALA GRAPHICS 29
 Forex Market

EXCHANGE RATE RISK MANAGEMENT

STANDARD SOLUTIONS

SPOTS/FORWARDS

Near Delivery Cash Flows

To cover exposures maturing the same day, the next day or two days later,
currency transactions for value ‘cash’/’tod’, ‘tom’ or ‘spot’ can be entered
into.

Distant Delivery Cash Flows

a. Short-term forwards

To cover exposures maturing in more distant dates than ‘spot’ value.

Outright forward transactions can be used. This can be done by :

- Doing a ‘near-delivery’ transaction and then rolling the position forward

to the desired ‘distant delivery’ maturity date, by means of a ‘swap’.

- Doing a single ‘outright forward’ transaction maturing on the distant

delivery date.

b. Long-term Forwards

These are the category of transactions where more than one

‘rollover’/’swap’ becomes necessary. These come in two basic varieties :

Market Rate Rollovers

An initial spot transaction in done, and the position is periodically rolled

over through swaps.

In this case, the rates applied on both legs of the swap (s) are ‘at-the-
market’ i.e. the ‘near’ leg corresponds to the market spot rate and the ‘far’

MALA GRAPHICS 30
 Forex Market

leg corresponds to the market forward rate derived from applying market
‘swap differences’ to the market spot rate.

This leads over the life of the contract to the period of realisation (i.e. actual
cash flows occur) of profit/losses, on the date of the ‘current’ swap, as a
function of the movement of the spot rate between the date on the initial
spot transaction or the previous swap at the date of the ‘current’ swap.

Historic Rate Rollovers

An initial spot transaction is following by period ‘rolling over’ of the position

by means of swaps.

In this case the ‘spot’ leg of the periodic swaps likely to always be ‘off –
market’ (unless the spot rate doesn’t move at all between the swap dates).
Specially, in this type of contract, the spot leg for all future swaps is set
equal to the rate on the initial spot transaction.

The effect of this mechanism is to avoid cash flow in between the initial
spot transaction and the first maturity of the contract. To adjust for this ‘off-
market feature, a final lump-sum ‘net’ payment is made at maturity of the
contract by one of the parties, reflecting the cumulative profit/loss after
adjusting for the time value of money. This profit/loss is obviously a
function of the movement of the spot rate since the time of the initial
transaction.

MALA GRAPHICS 31
 Forex Market

NON-STANDARD SOLUTIONS

Basic Options Position

A currency option gives the holder the right (with-out the holder having the
obligation) to buy a specified amount (the ‘call’ amount) of a specific
currency (the ‘call’ currency) against selling a specific currency (the ‘put’
currency) at a specified exchange rate (the ‘strike’ rate) within or on a
specified date (the option’s term to maturity).

Options USD/DEM Date : 5-Jan-93

Value 7-Jan-93 Spot level 1.6175

USD Calls 15-Mar-93 14-Jun-93 13-Sep-93 13-Dec-93

1.5500 9.45-9.75 11.90-12.20 13.65-13.95 14.80-15.10

1.5750 7.65-7.95 10.20-10.50 12.05-12.35 13.25-13.55

1.6000 6.00-6.30 8.65-8.95 10.55-10.85 11.80-12.10

1.6250 4.60-4.90 7.25-7.55 9.15-9.45 10.40-10.70

USD PUTS

1.5750 1.75-2.05 2.80-3.10 3.60-3.90 4.10-4.40

1.5500 1.10-1.40 2.10-2.40 2.85-3.15 3.35-3.65

1.5250 .65-.95 1.50-1.80 2.20-2.50 2.70-3.00

1.5000 .35-.65 1.05-1.35 1.70-2.00 2.10-2.40

In an American option, this right can be exercised at any time upto the term
to maturity, while in a European option this right can be exercised only at
maturity.

The above table shows prices of European style USD Calls and USD Puts
against the Deutschemark, in Pfennigs per USD.

MALA GRAPHICS 32
 Forex Market

It can be seen that a USD Call/DEM Put, for USD 1,000,000 maturing 14
June 1993 at a strike rate of 1.6000, will cost DEM 89,500 (1,000,000 X
0.089), with the premium to be paid on 7th January 1993* (Spot value; two
business days after the deal date, i.e., 5th January, 1992). In addition to
this method of quoting a price in terms of one of the currencies, Option
prices are also quoted as a percentage of the call Amount.

There are two basic option type

The Call option and the put option

There are two basic positions in options (or any other asset).

Long and Short

Thus there are 4 basic option positions

Long Call Short Call

Long Put Short Put

There is a certain symmetricity in currency options in that (in this case) a

USD Call is the same as a DEM Put and vice versa.

An option is said to be ‘In the money’ (ITM)/At the money (ATM)/ out of the
money (OTM) depending on whether the immediate exercise of the option
would lead to positive / zero/negative profit, respectively (ignoring the cost
of the option).

MALA GRAPHICS 33
 Forex Market

Advantages of Currency Options

It is often said that the limited risk/unlimited reward feature of an option

makes it a unique instrument. However, even if correct, this only applies to
the buyer of the option.

In fact the (un)limited nature of risk/reward for any instrument is really more
a matter of money-management and trading tactics. The risk-reward ratio
of any option position can be recreated in the spot or futures markets by
adjusting position size and stop-loss and take-profit levels.

Therefore the above is not really a unique feature of options.

1. Option prices show greater percentage movement relative to the spot

price of the underlying asset. This leads to High Leverage in option
positions.

2. Option position allow for the Exact Implementation of extremely

sophisticated views on the movement of the spot price with
respect to time. By buying/selling options, one can implement
strategies addressing not only the ‘direction’ of the movement in the
‘spot’ but also the ‘volatility’ of that movement and the time period in
which the movement will occur.

In contrast. Spot/Forward positions are not sensitive to ‘volatility’/time

(ignoring ‘swap differences’).

The price (or premium) of a currency option depends on the following

factors :

• The intrinsic value of the option - is the potential profit from exercising
the option and is given by the difference between the ‘strike’ price of
option and the market price. Option premia increases with increases in
intrinsic value.

MALA GRAPHICS 34
 Forex Market

• The term to maturity of the higher-option premium.

• The expected volatility of the exchange rate of the life of the option The
higher this volatility estimate, the higher option premium. (Implied
Volatility a commonly used term in the options market, is that volatile
estimate which is consistent with the current value of calls and puts
being traded in the market place.

• The relative interest rate levels in the two currencies - Increasing the
interest rate differential increase/decreases the prices of call/put options
on the long interest rate currency. For instance, with DEM interest rates
higher than USD interest rates, as the interest rate difference widens
the prices of USD/DEM calls rise and prices of USD/DEM puts fall.

• The absolute level of interest rates in the currency in which the “intrinsic
value” of the option is calculated.

For instance in the case of USD/DEM option since the “intrinsic value” is
calculated in DE the prices of both USD/DEM calls and puts rise/fall as
DEM interest rates (of the same matter as the term of the option) fall/ rise.

Strategies using Basic Option Positions

There are 5 broad categories of Basic Option Strategies.

a. Naked Strategies

These are option position (long or short) that are not matched by
corresponding (opposite) positions in the underlying asset, i.e., there is no
‘spot’ position, only an option position.

Thus there can be 4 types of Naked positions : Long Call, Short Call and
Long Put. Short Put.

MALA GRAPHICS 35
 Forex Market

b. Covered Strategies

These option positions are matched (in part or full) by opposite spot
positions in the underlying asset.

The common types of Covered Positions are

− Long asset & Short calls

− Short asset & Long calls

− Long asset & Long puts

− Short asset & Short puts

The above examples assume a 1:1 ratio between the amounts of the
underlying asset and the option.

By varying this ratio. less perfect hedge positions can be constructed.

Break Forward Contracts

The Break Forward contract is a type of ‘covered strategy’ developed by

combining the features of an option and a forward contract. Specifically, the
Break Forward Contract belongs to the subclasses of ‘Long Asset and long
Puts’ or Short Asset and Long Calls’ depending on which currency is the
asset/liability.

Example : ABC Inc. is an Indian importer with a liability of USD 50 million

maturing in 3 months.

The outright forward rate for that maturity is 3 months.

The outright forward rate for that maturity is 3.0000 (per INR 100). ABC Inc.
asks SCB from a 3% markup over the forward rate to arrive at the fixed
rate. The fixed rate is thus 2.9100. This is the rate at which ABC Inc.

MALA GRAPHICS 36
 Forex Market

agrees to buy USD (sell INR) from SCB in 3 months time. however, the
story does not end here.

The Break Forward contract also incorporates a break-rate in this case

3.0500 (decided by SCB), which is the rate at which ABC Inc. can opt to
sell USD to SCB at the end of 3 months.*

If the USD strengthens against the INR and the spot rate 3 months later is
2.8000, then ABC Inc. covers at 2.9100 and benefits.

If the spot is anywhere between 2.9100 and 3.0500 ABC Inc. still covers at
2.9100, though he is not benefiting in this case.

If the spot is greater than 3.0500 say 3.1500, then the forward is broken.
ABC Inc. buys USD from SCB @ 2.9100, sells LSD to SCB @ 3.0500 (thus
realizing a 14 cent loss) per dollar but is able to cover its exposure at
3.1500 (a saving of 24 cents over the fixed rate of 2.9100).

In this case ABC Inc. chose the fixed rate (i.e., markup over outright
forward rate) and SCB supplied the corresponding break rate. ABC Inc.
could also have chosen the break rate and had SCB specifying the markup
of the forward rate.

An important feature of the break-forward is that unlike conventional

options, no premium outlay is required - the cost of the option ( in the
above case ABC’s option to sell USD @ 3.0500) is built into the forward
rate. So obviously the break rate and the fixed rate cannot be determined
independently.

Thus the break-forward contract is effectively a combination of Boston

option and a standard forward contract. The option premium is added to
the market outright forward rate to arrive at the fixed rate of the break
forward contract.

MALA GRAPHICS 37
 Forex Market

c. Spread Strategies

These are portfolios incorporating two or more options of the same type
(i.e. all puts or all calls) with some options held short and some long.

The common spread strategies are as follows:

Money spreads/Price spreads / vertical spreads - Here the options have

the same expiration dates but different strike prices.

There are four basic types of money spreads... (Examples are given for the
basic position unit i.e., 1 option short and 1 option long. Position size can
be as large as capital and market conditions allow)

• Bullish spread with Calls

Here a call with a lower exercise price is purchased and a call with a higher
exercise price is sold. This strategy reflects a bullish view on market
direction hence the name ‘Bullish Spread’.

• Bearish spread with Calls

Sell the call with the lower exercise price and buy the call with the higher
exercise price.

• Bullish spread with Puts

Buy the put with the lower exercise price and sell the put with the higher
exercise price.

• Bearish spread with puts

Sell the put with the lower exercise price and buy the put with the higher
exercise price.

A special variety of Vertical spread is the ‘Butterfly Spread’ or ‘Sandwich

spread’ which consists of 4 options two options bought / sold with different

MALA GRAPHICS 38
 Forex Market

strike prices and two options sold/bought with the same strike price (the
latter strike lying between the two former strikes).

There are 4 types of Butterfly spreads possible ....

• Long Butterfly with Calls

• Short Butterfly with Calls

• Long Butterfly with Puts

• Short Butterfly with Puts

An example of the Long Butterfly spread with calls, is given below :

Long Butterfly Spread with Calls

Spot Gold = $ 330

Sell 2 calls at strike price of $ 330

Buy 1 call at a strike price of $ 320

Buy 1 call at a strike price of $ 340

The range of expiration values for butterfly spreads is between zero and
the amount between consecutive strike prices. The maximum profit occurs
when the underlying market finishes at the inside exercise price (here $
330) and zero profit occurs when the market finishes outside either of the
extreme exercise prices (here $320 and $340). [Not including the net
premium to be paid to open the long butterfly position].

Time spreads/Calendar spreads/Horizontal Spreads - here the options

have the same strike prices but different expiration dates.

The four basic types of time spreads are ...

• Long time spreads with Calls

• Long time spreads with Puts

• Short time spreads with Puts

MALA GRAPHICS 39
 Forex Market

• Short time spreads with Calls

In long time spreads, the longer term option is bought and the shorter term
option is sold. The ideal outcome for this positions is a reduction in actual
market volatility combined with an increase in implied utility.

In short time spreads the shorter term option bought and the longer term
option is sold. The outcome occurs when actual volatility picks up implied
volatility drops.

Diagonal Spreads

It is also possible to do spreads which combine features of money spreads

and time spreads. Such agonal spreads have different exercise prices and
different expiration dates.

d. Combination strategies

These are portfolios containing different type of options (i.e., calls and puts)
with all the options short or long. Strictly speaking this definition applies
only to basic or building block combination position. A condor which is a
composite of two basic combination positions, does not satisfy this
definition.

The following Combination Strategies are common:

Straddle

Buy/Sell a call and a put with the same strike price and time to expiry.

If the options are bought/sold, it is called a Long/Short Straddle

respectively. Straddles are essentially volatility plays.

A long straddle position benefits/suffers from increase / decrease in

volatility. A short straddle position behaves symmetrically ( opposite to the
nature exposure of the long straddle).

MALA GRAPHICS 40
 Forex Market

The strike price in the Straddle is usually chosen to be at-the-money,

because at-the money options have the highest sensitivity to changes in
volatility.

Strangle

A Strangle is a close cousin of the Straddle, with both the call strike and the
put strike being equally out-of-the-money. The standard strangle is
constructed with out of the money calls and puts.

When a strangle has both calls and puts in-the money it is called a GUTS.

A Strangle is also a volatility play, albeit implying a more aggressively

bullish/bearish view on volatility than a Straddle trade. The exposure of the
strangle to volatility is essentially similar to that of the straddle.

A strangle costs less than a straddle, and comes in two basic varieties; the
short strangle (options sold) and the long strangle (options bought). The
long/short strangle represents a bullish view on impending market volatility.

For instance with Spot Sterling at 1.4810, a purchase/sale of a 1.4910 call

and 1.4710 put creates a long/short strangle.

Condor

There is some degree of ambivalence in the market about the definition of

a CONDOR.

The common understanding is that a condor is constructed by means of

two strangles, one bought and the other sold.

Example: (All options expire June 1993. Call/Put implies USD Call/Put).

With spot USD/DEM at 1.6340, on Mar 23, 1993, buy a 1.6240 put and a
1.6440 call. This creates a long strangle position. Then sell a 1.6540 call

MALA GRAPHICS 41
 Forex Market

and 1.6140 put. This creates a short strangle position. Together these two
positions have created a “short condor”.

This strategy reflects a view that “a sharp move is expected in the spot
though the direction of the move is unknown.”

Similarly if one has a view that the “spot market will be very quiet” one can
implement a “long condor strategy” by selling the 1.6240 put and 1.6440
call and buying the 1.6140 put and 1.6540 call.

Some practitioners also refer to a condor as a combination of a straddle

and strangle. A short condor is a combination of a long straddle (struck at -
the - money) and a short strangle (short out of the money call and put).

Continuing with the USD/DEM example, a short condor per this alternative
view is constructed by buying the 1.6340 call and put (long straddle) and
selling the 1.6440 call and 1.6340 put (short strangle).

The long condor is just the reverse (short straddle plus long strangle).

The ambivalence in nomenclature need not be a significant problem,

because the implied market views for long/short condors are identical for
both definitions.

Strip

Buy/Sell two puts and a call with the same strike and expiration.

The two basic strip varieties are the long strip (options bought) and short
strip (options sold).

The long/Short strip can be seen as a long/short straddle plus one

long/short put and is essentially a bet on an increase / decrease in volatility
albeit with a leaning towards a bearish/bullish view on market direction.

MALA GRAPHICS 42
 Forex Market

Strap

Buy/Sell two calls and a put with the same strike and expiration.

The two basic strap varieties are the long strap (options bought) and short
strap (options sold).

Similar to the case of the strip, the long/short strap is effectively a

long/short straddle plus one long/short call and represents a bet on an
increase/decrease in volatility combined with a bullish / bearish view on
market direction.

e. ‘Cylinder’ Strategies

These strategies combine the flexibility of the ‘Spread’ and ‘combination’

strategies.

A cylinder consists of a long/short position in a call/put combined with a

short/long position in a put/call.

Example : An Indian importer who has a liability of USD 10,000,000 in 3

months time. he buys a call option on the USD against the INR (Indian
Rupee) with a strike price at USD 3.2000 (per INR 100). To help pay for the
cost of this option purchase he sells a put option on the USD against the
INR at a strike price of 3.2800. Both options are for the same amounts and
maturates.

For all USD/INR levels between 3.2800 and 3.2000, the importer would
cover at market rates. If the USD strengthens beyond 3.2000, the importer
can still cover at 3.2000 but if the USD wakens beyond 3.2800, the
importer is obliged to cover at 3.2800.

If the strike prices of the call & put are so chosen that the two options cost
the same, then this strategy is called a ‘zero-premium cylinder’.
Alternatively if the ‘sold option’ is worth more / less than the ‘bought option’,

MALA GRAPHICS 43
 Forex Market

the strategy is referred to as a ‘credit cylinder’/ debit cylinder’. The zero-

premium cylinder is also often referred to as a “Range Forward”.

Another common variety of Cylinder Strategies is the ‘Participating

Cylinder’ which is a cylinder where the currency amounts underlying the
two options, are different.

The Indian importer discussed above could have bought the USD/INR calls
for an amount equal to his total liability i.e. USD 10,000,000 by sold the
USD/INR puts for an amount of only USD 5,000,000. thereby creating a
‘Participating Cylinder’ with a 50% participation rate. The importer can thus
enjoy a 50% participation in any USD weakness beyond 3.2800. (This
benefit comes at the cost of a lower premium for the sold option and hence
a higher net cost for the cylinder), alternatively the USD/INR put could be
sold at a lower strike rate of say 3.2 to maintain the net premium cost of the
strategy at zero.

‘Exotic’ Option strategies

The following types of ‘Exotic’ option strategies are common :

− Compound Options

− Chooser Options

− Path – Dependent Options

− Barrier Options

a. Compound Options

These are options on options, and are used mainly because of their
relatively lower cost. Compound options are especially useful in situations
where the currency asset/liability is not certain.

MALA GRAPHICS 44
 Forex Market

Example : On 8 April 1993, it would have cost 2.39 pfennig per USD to buy
a European style, 1 month USD call/DEM put at a strike rate of 1.6250 (at-
the-money-forward).

XYZ Corp. may need to buy USD/sell DEM 1 month from 8th April, but it
will be sure of its position only 2 weeks from 8th April. Instead of paying
pfenning per USD for an option it may not even -- XYZ Corp. Can buy an
at-the-money, call comp-- option @ 2.39 pfenning per USD. This upfront
paying will give XYZ Corp. the option to buy a USD DEM put @ 2.39
pfennigs per USD, (this is the standard rate for the compound options) 1
month from 8th April 1993.

The above call compound option is said to be the-money because the

strike rate equals the current market price of the underlying option.

There are 4 basic varieties of compound options:

− Call options on Calls

− Put options on Calls

− Call options on Calls

− Put options on Puts

b. Chooser Options

Chooser Options allow holders to decide on the rate of option they have
purchased (i.e. call or put) at a rate later than the date of option purchase.

Example : XYZ Corp. buy a 3 month choose option on USD/DEM for USD
5 million at a standard price of 1.6000, with a 15 day choosing deal--
Depending on how the spot moves over the next days XYZ Corp. can
decide whether what it has bought is a USD put or USD call.

MALA GRAPHICS 45
 Forex Market

These options are more flexible than convention options and therefore cost
more.

c. Path-Dependent Options

These currency options have 3 main varieties

− Asian or Average Rate options

− Lookback options

− Average Strike options

Asian Options

These options are struck on an average of the spot price rather than on the
spot price itself (as is case for conventional options).

An example of an Asian call option on USD/DEM would be a USD

Call/DEM put, expiring 15 June 1993, on USD 1,000,000, struck on the 15
day simple moving average of USD/DEM (calculated on the New York
closing prices) with a strike rate of 1.6000.

On 15 June 1993, the 15 day moving average of USD/DEM stands at

1.6500. Thus the pay - off for the holder would be = (1.6500 - 1.6000 X
1,000,000). Since the effect of focusing on a moving due to the smoothing
effect of the average these options cots less than conventional options.

Lookback Options

In these options the pay-off to the holder is the highest intrinsic value of the
option during its life. Obviously, this can only be determined in retrospect
after the expiration of the option.

Due to their added flexibility. Lookback Options cost more than

conventional options.

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 Forex Market

Example : ABC Inc. buys a 3 month Lookback call on USD/DEM with a

strike price at 1.6000 DEM (spot) for an amount of USD 10 million. The
highest spot market level of USD/DEM in the next three months is 1.7000.
ABC Inc. is compensated after 3 months to the extent of 10 pfennigs for
every dollar i.e. a total of DEM 1 million.

Average Strike Options

The pay-off for an Average Strike Option is determined by taking the

difference, at expiry between the ‘spot’ price of the underlying asset and
the value of a specified ‘moving average’ of the ‘spot’ price. (In an average
strike option, the option buyer specifies the type and period of the moving
average, instead of a strike price. This clearly defined moving average itself
functions as the strike price).

These options cost less than conventional options.

Example : ABC Inc. buys a 6 month, average strike USD/JPY put option,
[with the strike price equal to the 15 day simple moving average (SMA) of
New York closing prices (spot)] for USD 5 million 6 months later spot
USD/JPY is at 110.00 and the value of the 15 day SMA is 115.50 ABC Inc.
is paid a profit of 27.5 million Yen. [5,000,000 X 115.50 - 110.000].

d. Barrier Options

In addition to parameters present in a conventional option, these options

have a ‘barrier’ and a specification of how the terms of the options change
depending on the movement of the sport price with respect to the barrier.

The basic rules for generating alternative barrier option positions are:

i. Use calls and puts

ii. Use short and long positions

iii. Place the ‘barrier’ between the strike price and the current sport price

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 Forex Market

or Place the strike between the ‘barrier’ and the current spot price.

iv. Change the terms of the option from up-and-in to up-and-out to ‘down-
and-out.’

Example : An ‘up and in’ USD call/DEM put, struck at 1.5000 with a barrier
at 1.5500, will have no value as long as the sport is between 1.500 and
1.5500. As soon as the spot rate crosses 1.5500, this option starts to
behave like a standard USD/DEM call. Such a strategy is consistent with a
view that significant USD upside can only be expected if it rises over
1.5500 DEM.

Due to their limitations, barrier options cost less than conventional.

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INTEREST RATE OF RISK MANAGEMENT

Interest rate and currency swaps

A swap is a legal agreement between two parties to exchange cash flows

over a period of time.

Swaps fall into two broad categories, depending on the nature of the risk
they are designed to alter.

They are interest Rate Swaps and Currency Swaps.

Interest Rate Swaps

These (involving only one currency) can again be classified as follows.

a. Floating /Fixed or Fixed/Floating Interest Rate Swaps - These involve

one floating interest rate (“floating leg”) and one fixed interest rate
(“fixed leg”).

b. Interest Rate “Basis” Swaps - Such swaps have floating rates on both
legs.

Currency Swaps

Currency swaps have three basic varieties :

a. Cross Currency Interest Rate Swaps These swaps involve two

currencies and two types of interest rates (i.e. one floating leg and one
fixed leg). These are also known as Circus Swaps.

b. Fixed/Fixed Currency Swaps / Synthetic, forward FX. These swaps

involve two currencies but only one type of interest rate (i.e. fixed rates
on both legs.).

c. Cross Currencies and one type of interest rate in this case both legs
have floating rates.

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Interest Rate Swaps

The floating /Fixed or fixed/floating Interest Rate Swap and the Interest
Rate basis swap are ‘standard’ swap structures in that :

• They have ‘at-the-market’ swap rates.

• Become effective from the spot date (the spot date is two business days
after the trade date for USD, DEM and most other currencies and the
same date as the trade date for GBP).

• The National Principal Amount (NPA) and the swap rate remain
constant over the term of the swap.

• These are no call/put or extension provisions in the swap agreement

and

• Swap counterparts do not deposit collateral with the intermediary.

The other swap variations listed in here and their combinations can be
seen as non-standard swap structures, wherein one or more of the above
conditions applicable to ‘standard’ swaps are violated.

Basis Swaps

In Basis Swap booth swap counterparts receive floating rate payments,

each party praying interest on the ‘basis’ of its choice.

An interesting type of Basis Swap is the LIBOR-IN-ARREARS SWAP or

DELAYED LIBOR SWAP.

The Delayed Libor Swap is undertaken in a positive (upwardly sloping)

yield curve scenario by borrowers who feel that the implied forward rates
derived from the yield curve, overestimate the future Libor fix for short term
interest rates.

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Undertaking to pay Delayed Lobor in a positive yield curve scenario

involves the risk that future Libor settings may actually be higher than what
the yield curve is predicting, leating the customer to lose out on the swap.

Forward Start/Delayed Start Swaps

Such swaps are created by changing the ‘spot start’ feature of standard
swaps. They are useful when the swap user wishes to lock in to a ‘good’
swap rate, but with a view to matching cash flows, does not want to ‘start’
the swap now.

Since a Forward Start swap is synthesized from two ‘spot start’ swaps of
different tenors, the pricing of a forward start swap relative to a ‘spot start’
swap will depend on:

− Whether on is paying or receiving (the fixed rate).

− The terms structure of interest rates.

− The deferral period, and

− The tenor of the swap.

Example : ABC Inc. enters into a 2 year forward - start. Yen swap with a 6
month deferral period, where it pays 3.9% (fixed) and receives 6 months
Yen Libor. This swap becomes ‘effective’ 6 months after the deal date and
then runs for 2 years.

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Currency Swaps

Currency Swaps are designed to alter the current currency basis and/or
interest rate basis of the counterparts exposure. Like Interest Rate Swaps
they can also be used as a financing tool where comparative borrowing
advantages exist.

Cross Currency Interest Rate Swaps

The incremental benefit (over the Interest rate swap) of the currency swap
is that it allows the user to also alter the balance sheet’s currency
exposure. The working of a cross-currency interest rate swap is shown in
from ABC Inc’s perspective. For the sake of simplicity the swap arranger’
fee is not shown in the illustration.

The standard currency swap features initiall exchange of principal as well

as exchange of principal at maturity. Even if a swap with no initial
exchange of principal is desired the pricing of the swap will not change
because the initial exchange can be duplicated by means of a ‘spot’
transaction to buy/sell the relevant currencies.

However, in the case of a currency swap without any exchange of principal

the pricing will differ from that of a standard swap. For instance suppose
ABC Inc. was receiving 6 month USD Libor and paying 7.62% Fixed
Sterling in a 7 year swap with exchange of principal at maturity. If this
name swap did not feature exchange of principal at maturity ABC Inc.
would pay only 6.40% Fixed sterling. At the time of writing, Sterling is at a
discount against the US Dollar in the 7 year maturity in the forward foreign
exchange market. In general (for a swap without final exchange of
principal) the counterpart paying interest (in the swap), in the currency that
is at a (forex) forward premium/discount (for the relevant swap tenor) would
have its interest rate raisald/lowered with respect to the rate applicable in a
swap featuring final exchange of principal.

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 Forex Market

FIXED-TO-FLOATING CROSS-CURRENCY SWAP

Sterling Initial US Dollar

Debenture Exchange Bond

£ 100 m £ 150 m

£ 100 m £ 100 m
ABC Inc. SCB XYZ Corp
£ 150 m £ 150 m

Sterling Periodic US Dollar

Debenture Payments Bond

£ 10.5% $ Libor + 50 bp

£ 10.5% £ 10.5%
ABC Inc. SCB XYZ Corp
£ 10.5% £ 10.5%

Sterling Exchange US Dollar

Debenture at Maturity Bond

£ 10.5% £ 10.5%

$ 150 m $ 150 m
ABC Inc. SCB SCB
£ 100 m £ 100 m

Fixed to Fixed Currency Swap/Synthetic Forward FX

In a Fixed to Fixed Currency Swap, the counterparts switch currencies but

both pay fixed rates in the currency of their choice, Since forward rates are
quoted according to the principle of Covered Interest Parity in currencies
where arbitrage between the interest rate and forex markets is possible;
such a swap is effectively a synthetic forward contract. The only difference

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 Forex Market

lies in the periodic (rather than at maturity) settlement of the interest

differential in the case of the swap. In fact in tenors beyond 1 year interest
rate swap each other just as in tenors upto 1 year forward points are
derived from eurodeposit rates.

An example of such a swap would be on where the counterparts pay fixed

interest rates on Sterling and Dollar respectively.

Fixed / Fixed currency swaps without final exchange of principal are known
as “coupon swaps”

Cross Currency Basis Swaps

A close cousin of the Fixed to Fixed Currency Swap, this swap features
floating rates of interest being paid to each other by the counterparts in two
different currencies.

Forward Rate Agreements (FRAs)

An FRA allows the user to fix the interest rate on future borrowing / lending
often substantially in advance of the sport market fixing of the relevant
interest rate.

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RBI MAULS PUNTERS TO HALT RE SLIDE

The indirect measures included a one percentage point increase in cash

reserve ratio to 11 per cent three percentage point increase in its daily fixed
rate repo and steps a large dose of direct intervention in the foreign
exchange markets. rupee had plunged to an all-time low of 43.70 against
the dollar in mid day trade prompt impact on the markets with the rupee
recovering to 42.70 before closing at 42.80 – a 70 paise appreciation over
Wednesday’s close.

First, the attempt to drain out the excess liquidity; the CRR hike, which
takes effect from August 29, is expected to suck out over Rs. 5,000 crore
liquidity from the system. This, combined with a 3-percentage point
increase in repo rates from 5 to 8 percent, is expected to push up interest
rates. This then will act as a disincentive to borrowing cheap from the
money markets and arbitraging in the forex markets.

The central banks sold about $250 million in the spot market. This had
twin effects; while the rupee immediately appreciated on increased supply
of dollars, the move also sucked out $ 250 million worth of rupees (over Rs
1,000 crore) from the system in one day.

Second the move to bump up forward premia; stop speculators selling

rupees in the spot market the recent depreciation and buying dollars
forward slight premium to today’s rate for getting delivery forward premia
are also likely to induce exporters to bring in their dollars.

The central bank today made small purchases of dollars in the forward
market, thereby having to pay premia for receiving dollars at a future date.
And the token today announced that foreign institutional investors (FIIs)
would be allowed to hedge 15 per cent of their portfolio investment made
before June 11. Incremental investments made after June 11.

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The RBI hopes that this will induce FIIs to start hedging their outstanding
investments which means they will want to buy dollars forward at current
prices to avoid taking a depreciation hit lead to increased demand for
forward dollars and further hardening in premium rates. However, market
players are skeptical about the efficacy of the move given that FIIs find the
present levels of premia unattractive from rebooking cancelled forward
contracts. The RBI had earlier banned corporates without trade based
exposures from doing the same. This will reduce the excess demand in the
forward market and ensure that only genuine demand reaches the market.

The RBI has withdrawn the facility given to corporates in December 1993
to split their forward commitments into spot and forward legs. Earlier,
corporates were allowed to meet their dollar requirements by buying spot
dollars on once day and forward covers on another day. This resulted in
corporates buying only spot dollars and then selling them off with out taking
a forward cover. After issuing warning to banks the RBI has finally
withdrawn this facility Bankers, however, feel that this has also resulted in
the market becoming thinner since this kind of speculation provided some
intraday liquidity in the market.

To improve dollar inflows, exporters have been warned that their

entitlement in Exchange Earners Foreign Currency (EEFC) account will be
reduced if they will fully delay repatriation of export proceeds. At the same
time, the central bank has also allowed exporters to used the EEFC funds
for domestic businesses. The EEFC facility was introduced for exporters
before currency account convertibility. It was provided to enable exporters
to skip the cumbersome process of obtaining sanctions for their forex
requirements.

At present, exporters are allowed to keep 50 per cent of their proceeds in

EEFC accounts. This has resulted in corporates willfully keeping forex
abroad , waiting for further depreciation of the rupee in order to book
profits. At the same time, the RBI has promised to consider extension of

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repatriation of exporters dollar in exceptional cases. And, finally in a small

dose of moral suasion, the RBI has warned banks that it would be keeping
an eagle eye on their forex operations and has asked all authorised dealers
to report day end and peak intrsa-day position in the forex market.

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CONTENTS

 Acknowledgment

 Forex Market

 What is Risk ?

 Types of Risk

 Hedging Techniques

 Alternative Hedging Technique

 External Techniques for Covering ERR

 Exchange Rate Risk Management-Standard Solutions

 ERR-Non-Standard Solutions

 Interest Rate Risk Management

 Government Policies

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