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International Finance

Currency Forward, Currency Futures, Currency swaps , FRA , Hedging & Valuation of currency Derivatives

Dr. A.L.Saini

Agenda for the Session

1. 2. 3. 4. 5. 6. Forward contract in Currency. Forward Rate Agreement ( FRA) in Currency Future contract in Currency Swaps in Currency/Interest Hedging strategy in Currency & Commodity Valuation of currency derivatives

International Financial Mgt. & Derivatives

1.Derivatives came into being primarily as risk management products to manage either the current or potential exposure to cash markets. 2.A farmer is worried about the prices of soybean that he is expecting to harvest from his farm. 3. A Person may have bought equity stock ( a cash market exposure at present) and is worried about stock price going down. 4.A Company has borrowed on fixed rate/floating rate basis ( a cash market exposure at present), and is worried about interest rates going down/going up.

International Financial Mgt. & Derivatives

5.An American Company expects to receive UK pounds after three months ( a cash market exposure in future), and is worried about value of UK pounds going down. 6. A bank has given a loan to a big corporate and is worried about the repayment of the loan and the interest thereon.

Currency Derivatives -Importance

Limitation of cash market 1.Higher Investment required 2.Limited ability to take position 2. .Lessor transaction costs 3.Higher Transaction costs 3. Ease of creating positions 4.Difficulty in creating long and short position. Advantages of Derivatives

1. Leveraged Position

How are Derivatives looked at

We view them as time bombs both for the parties that deal in them and the economic system. In our view derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. Warren Buffet Although the benefits and costs of derivatives remain the subject of spirited debate, the performance of the economy and the financial system in recent years suggests that those benefits have materially exceeded the costs. Alan Greenspan

Types of Currency/Foreign Exchange Rate Derivatives

Currency Derivatives
Cash Market Derivative markets

2.Fixed Income Securities 3.Foreign Exchange 4.Commodities

Currency Forwards Currency Futures Currency Options Currency swaps

Forward Contract in currency

Forward Contract in Currencies

Forward Contract-Meaning Forward Contract A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price.

Forward Contract

The salient features of forward contracts are: They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset.

How Forward Contract works ? How Forward Contract works?

An agreement between two parties to Buy or Sell, as the case may be, an underlying instrument at a particular future date at a price quantity and quality agreed when the contract is entered into. Money BUYER Asset SELLER

Case Study : On 1st April, Mr. X enters into a forward contract with Mr. Y and agrees to purchase 1000 shares of TCS Ltd. for a predetermined price of Rs. 10 ,three months forward. Here on the fixed future date, Mr. X will get the 1000 shares and will pay the price i.e. Rs. 10,000 and Mr. Y will deliver the shares and will receive the money.

Specified Price


Derivatives Currency
Case Study Forward contract A forward to buy $500 for 300 in 1 year

Forward Contract Case Study Entity X enters into a forward contract to purchase one million tonnes of copper. Copper is traded on the London Metals Exchange and is readily convertible to cash. The contract permits X to take physical delivery of the copper at the end of 12 months( to use to manufacture finished goods) or to pay or receive a net settlement in cash, based on the change in fair value of copper.

Forward Contract-currency Case study Entity A enters into a forward purchase agreement with Entity B to buy 100 units of a commodity at CU1.00 per unit. Entity A defaults on the forward when the prevailing market price of the commodity is CU0.75 per unit. Under the non-performance penalty provisions incorporated into the contract, Entity A has to pay Entity B a penalty of CU25, i.e. 100 x (CU1.00 CU0.75).

Case Study An entity enters into a forward contract to purchase wheat. The contract meets the definition of a derivative, but does not meet the expected purchase, sale or usage requirements scope exception as the entity has a history of net cash settling similar contracts.

Forward Rate Agreement ( FRA) In Currency


Forward Rate Agreement ( FRA)-Currency

Forward Rate Agreement (FRA) is a forward contract on interest rate in which one party, the long, agrees to pay a fixed interest payment at a future date and receives an interest payment at a rate to be determined at expiration To hedge the interest rate risk Traded in OTC market FRAs are for shorter duration Accounting Features involved are Trade date, Fixing date, Notional amount, Marking to market, cash flow exchange

Forward Rate Agreement ( FRA)

Case study Trade Date: Fixing / Start: End Date: Notional Principal: Fixed Leg Fixed Leg Payer:Fixed Rate: Floating Leg Floating rate payer :Dec 30, 2010 Date June 30, 2011 Dec 30, 2011 USD 100 Mio Mr. A 7% p.a. Mr.B

Floating Rate Benchmark:6 month USD LIBOR Such a FRA is denoted as a 6x12 FRA, and the difference between the two numbers 12-6 represents the duration of the FRA which is 6 months.

Future Contracts In Currency


Future Contract-in Currency

Future Contract
A contract to buy or sell, a standard amount of a standardized or predetermined underlying instrument at price-determined locations, on a pre-determined future date at a pre-agreed price. Long V/s Short position Settlement guaranteed by the clearing corporation of the exchange.




Difference Between forward contract and Future Contract

Forwards V/s Futures Forwards Futures

Size and Maturity of contract

Counterparty Credit risk

Any entity Exists

Clearing house Assumed by clearing House.

Liquidity Margins

Poor Not required

Very high Margins are received/paid on a daily basis All contracts are marked to market on a daily basis


Not done

Case Study No.: On 1st September, Mr. X enters into a futures contract to purchase 100 equity shares of TCS Ltd. at an agreed price of Rs. 100 in December. If on the maturity date (as determined by the rules of the exchange for the month of December) the price of the equity stock rises to Rs. 120 , Mr. X will receive Rs. 20 per share and otherwise if the price of the share falls to Rs. 90, Mr. X will pay Rs. 10 per share.

If market price falls to Rs. 90Rs. 10 per share


Futures- Specifications
Key Terminologies Futures Spot Price : Price at which underlying asset trades in spot market Futures Prices : agreed upon price at the time of delivery for a specified future date. Contract Cycle : the period over which the contract trades. Expiry Date : date of the final settlement, the date at which the trading ceases for the futures contract. Contract Size : market lot or lot size or trading unit Net open position Initial Margin Mark to Market

Futures- Specifications
Pricing of Futures

Futures are priced according to the cost of carry model As per this model, the futures price should be equal to the spot price of the underlying asset compounded at relevant interest rate for a time period equal to the futures expiry period. Thus the factors which affect the value of futures are:
1. Underlying Asset Price: Futures price fluctuates as spot asset price changes 2. Interest Rate: If interest rates go up, cost of carry leading to higher futures price 3. Time period Futures which mature later will have greater value

Future Trading
Participants in Futures Trading Hedgers Those with underlying interest in specific delivery or ready delivery contracts, and use futures to insure against adverse price movements To minimize/control the risk (risk averseness) Offsetting in the physical market Speculators May not have an interest in ready contract, but see opportunity of price movement favorable to them Tendency to get maximum profits form the transactions Risk taking Arbitrageurs To take the risk profits and to gain from the price difference between the markets

Difference between Options & Futures

Futures Options Futures V/s Options Option buyer has right (call or put), no obligation Options may be exercised at the buyers discretion. Options have a strike (contingency) price Options expire Call (put) sellers maximum potential loss is unlimited Options buyers maximum loss potential is the amount of the premium Options buyer pays premium

Futures buyer and seller have obligations Futures must be settled physically or cash basis Futures trade price is contractual Futures mature at delivery Future sellers maximum potential loss is unlimited Future buyer's maximum potential loss is the contract value based on the purchase price. Futures do not trade with premiums

Questions & Answers Thank You