Currency Risk

&
Derivatives

 Success is how high you

bounce when you hit bottom
- General Patton

Exchange Risk
The foreign exchange business is by its
nature risky, because it deals primarily in
risk measuring it, pricing it, accepting it
when appropriate, and managing it.
The success of a bank or other institution
trading in the foreign exchange market
depends critically on how well it assesses,
prices, and manages risk, and on its ability
to limit losses from particular transactions
and to keep its overall exposure controlled.

Exchange Risk

Airbus is the worlds largest plane maker

The global market is $60 bn annually in sales
Airbus like all plane maker sells its plane in $
About 30 % of the Airbuss costs are in euros
The principal handicap at airbus is one of the
competitiveness due to the fact the $ has
fallen vis-a-via with
Gulf Opec Members worried about falling $
As they sell oil in $ and imports goods and
commodities from Europe
$ is now at =$1.96 and = $1.3235

Forex Risk
Forex risk is the risk that a bank or corporate
may suffer losses as a result of adverse
exchange rate movements during a period.
Forex or currency risk is the variance in
expected cash flows from unexpected
exchange rate changes.
For a bank the risk may arise on account of
an open position either in spot or forward.
For a firm, the risk may arise from
outstanding financial obligations, changes in
expected future cash flows.

Forex Exposure
Exposure is a measure of the sensitivity
of the value of a performance measure
to changes in the relevant risk factor
i.e.
Exposure is measured by the value of
the assets and liabilities or transaction
denominated in Forex
Exposure arises because the enterprise
denominates transactions in Fx or it
operates in a foreign market

Types of Exposures
Foreign Exchange
Exposure

Transaction or
Conversion
Exposure

Translation or
Accounting
Exposure

Economic or
Operating/Strategic
Exposure

Derivatives - What are They?

Derivatives are financial contracts which
provide hedge against a particular type of
risk.
The risk may be exchange rate risk, credit
risk, interest rate risk etc.
A derivative is a financial instrument
whose value depends on the value of
another asset / instrument called
underlying ( basic ) variable.
Derivatives are also known as contingent
claims.

Derivatives - What are They?

The commonly used derivatives are
Currency Forwards
Currency Options
Currency Futures
Options on Futures
Currency and Interest rate Swaps and
FRA

Currency Forwards
Forward Transactions
The transaction in which the exchange
of currencies takes place at a specified
future date subsequent to the spot
date is known as Forward Transaction.
The exchange rate of settlement is
called as forward rate
The forward rate has two components
Spot rate
Forward Points

Currency Forwards
Bank Buys At

Bank Buys At

Spread

Spot

44.8400

44.8500

0.0100

1Mth

44.9000

44.9200

0.0200

Premium

0.06

0.07

3Mth

45.0900

45.1200

Premium

0.25

0.27

6Mth

45.4000

45.4300

Premium

0.56

0.58

12Mth

45.8700

45.9000

Premium

1.03

1.05

Source-UTI Bank Published in ET on 12/12/2006

0.0300
0.0300
0.0300

Currency Forwards
Factors Determining Forward Margin

Rate of Interest
Demand and Supply
Speculation of Spot rate
Exchange Regulations

Currency Options
A currency options arrangement between an
option holder (buyer) and an option writer
(Seller)
A currency option gives the buyer the right
,but not the obligation to either buy or sell a
specified quantity of one currency in
exchange for another at a predetermined
exchange rate known as strike price
Option holder has no obligation to exercise an
option ,the writer of the option must comply
with its terms and should be prepared to buy
or sell the underlying currency when a holder
decides to exercise an option

Currency Options
To acquire the right the buyer pays a
premium to the seller
The potential loss to an option seller is
unlimited while to the buyer it is limited
to the premium paid.
There are Two Types of Options
Call Option
Put Option

Option Terminology
Call Option The right to buy specific amount
of one currency against another currency is
known as call option
Put Option The right to sell specific amount
of one currency against another currency is
known as put option
Buyer The person who buys the right to
buy or sell specified amount of currency
against another currency
Seller (Writer) The person who sells the
right to buy or sell specified amount of a
currency against another currency

Option Terminology
Premium The amount paid by the buyer of
an option to the seller is called premium
Strike Price This represents
predetermined price at which the option
can be exercised
Exercise Date For effecting delivery of
Forex the buyer of the option must notify
the seller about his decision for taking or
giving delivery and this is known as
exercising the option.
The date on which the option can be
exercised is called as exercised date

Option Terminology
Expiration Date The last date upto
which the option can be exercised
American Option An option which can
be exercised at a any time between the
initial deal date and the expirary date.
European Option - An option which can
be exercised only at the expirary date.

Option Terminology
In the Money Option If by exercising
option ,the buyer has advantage then it is
called as ITM Option
Out of the Money Option If by exercising
option ,the buyer has disadvantage then it
is called as OTM Option
At the Money Option If by exercising
option, the buyer has neither advantage
nor disadvantage then it is called as OTM
Option. The strike price in this case is equal
to spot or future rate. This option has no
Intrinsic Value

Option Terminology
Status of an option
a. In-the-money
Call:
Spot(44.95) > strike(44.88)
Put:
Spot (44.95)< strike(45.05)
b. Out-of-the-money
Call:
Spot (44.95)< strike(45.00)
Put:
Spot (44.95)> strike(44.88)
c. At-the-money
Spot = the strike

Option Quotes in India

spot: 45.1325
Expiry
strike

Premiums (INR/USD)
1m

3m

6m

12m

44.75

44.75

44.75

45.00

call

0.48

0.60

0.74

0.80

put

0.06

0.14

0.22

0.41

45.00

45.00

45.00

45.25

call

0.30

0.44

0.58

0.66

put

0.13

0.22

0.31

0.51

strike

Source- e-Mecklai Website Last Updated on 31/10/2005

Option Quotes in India

spot: 45.1325
expiry
ATM strike

premiums (INR/USD)
1m

3m

6m

12m

45.15

45.18

45.22

45.31

Call

0.21

0.34

0.46

0.63

Put

0.19

0.30

0.41

0.54

45.25

45.25

45.25

45.50

call

0.17

0.31

0.45

0.54

put

0.24

0.34

0.42

0.63

45.50

45.50

45.50

45.75

call

0.08

0.20

0.34

0.44

put

0.41

0.48

0.55

0.76

strike

strike

Source- e-Mecklai Website Last Updated on 31/10/2005

Contingency Graphs for Call Options

For sellers of
British pound call options
exercise price = $1.95
premium = $0.02

+$.06

+$.06

+$.04

+$.04

+$.02

- $.02
- $.04
- $.06

$1.91

$1.95

$1.99

Future spot rate

Net profit per unit

Net profit per unit

For purchasers of
British pound call options
exercise price = $1.95
premium = $0.02

+$.02

- $.02
- $.04
- $.06

$1.91

$1.95

$1.99

Future spot rate

How to use Option

Buy call option
expect currency to appreciate
exercise option if price increases
beyond strike price
buy at strike price and sell at spot rate
Sell (write) call option
expect currency to decline in value
obligated to sell a currency at a
specified price
make money if option not exercised

Contingency Graphs for Put Options

For sellers of
British pound put options
exercise price = $1.95
premium = $0.03

+$.06

+$.06

+$.04

+$.04

+$.02

- $.02
- $.04
- $.06

$1.91

$1.95

$1.99

Future spot rate

Net profit per unit

Net profit per unit

For purchasers of
British pound put options
exercise price = $1.95
premium = $0.03

+$.02

- $.02
- $.04
- $.06

$1.91

$1.95

$1.99

Future spot rate

Option in India
Authorised dealers having adequate internal
control, risk monitoring/ management systems,
mark to market mechanism and fulfilling the
following criteria will be allowed to run an option
book after obtaining a one time approval from
the Reserve Bank
i. Continuous profitability for at least three years
ii. Minimum CRAR of 9 per cent
iii. Net NPA's at reasonable levels (not more than 5
per cent of net advances)
iv. Minimum Net worth not less than Rs. 200 crores
Initially, authorized dealers can offer only plain
vanilla European options.

Futures Brief History

Chicago Becomes the Junction of Rail &
Telegraph in USA. So it becomes Hub of
East USA in 1840
Bumper crop of wheat in East USA.
everyone rush to Chicago as Brokers,
Agents were present their to distribute
wheat across USA
The problem was Chicago was not having
proper storage facilities, weighing
equipments of standard quality, every
thing has to be settled in cash.

Futures Brief History

Many times farmers use to come without
full quantity of wheat also brokers do not
have full amount many times to settled the
transaction.
Hence it is decided that transaction will be
settled at a particular date in future so on
particular date farmer will bring a
particular quantity of wheat and
broker/buyer will come with amount and
deal will be settled

Futures Players
Hedgers
Farmers, manufacturers, importers and
exporters can all be hedgers.
A hedger buys or sells in the futures market
to secure the future price of a commodity
intended to be sold at a later date in the
cash market.
This helps protect against price risks

Futures Players
Speculators
These People do not aim to minimize risk
but rather to benefit from the inherently
risky nature of the futures market.
These are the speculators, and they aim to
profit from the very price change that
hedgers are protecting themselves against.
Hedgers want to minimize their risk no
matter what they're investing in, while
speculators want to increase their risk and
therefore maximize their profits.

Future Markets
CBOT

- Chicago board of Trade in 1848

CME

- Chicago Mercantile Exchange

NYMEX

- The New York Mercantile Exchange

LME

- The London Metal Exchange

TOCOM

- Tokyo Commodity Exchange

MCX
- Multi Commodity Exchange (India)
NCDEX - National Commodities and Derivatives
Exchange Mumbai (India)
NMCE - National Multi Commodities Exchange
Ahmedabad (India)

Currency Futures
A futures contract is a form of forward
contract
In that it conveys the right to purchase or
sell a specified quantity of a Forex at a fixed
exchange rate on a specified future date,
Whereas in a forward contract the quantum
of foreign currency and the due date are
determined by the customer,

Currency Futures
In futures contract may be defined as an
agreement entered with into with the
specified futures exchange to buy or sell a
standard amount of Forex at a specified
price for delivery on a specified future date
A forward contract can be entered into with
any bank and hence termed an over the
counter product.
A future contract can be traded only on a
recognized future exchange.i.e.IMM
(International Money Market) a part of CME
and London International Financial Futures
Exchange (LIFFE) or Euro Next

Features of Currency Futures

Size of
Contract
GBP 62,500
Euro 125,000
CAD 100,000
JPY 12,500,000
CHF 125,000
Aus $ 100,000

Delivery Dates at CME

March,June,September&Dec
ember
Deliver date is third
Wednesday of respective
month.
The month during which a
contract expires is referred
to as the spot month.
All trading stops two
business days prior to
delivery date to enable the
participants deliver the
currencies

Features of Currency Futures

Price Movement The price for the futures is
quoted as so many units of US $ per unit of
foreign Currency.
i.e. 1 CAD = $0.8800(Incase of Fwd 1$=CAD
1.1366)
The value of the futures will be the price per unit
of foreign currency multiplied by the size of the
contract.
One Bought a CAD $ at a price of US $ 0.8800
The exchange may fix the minimum size of price
movement called as tick .
If price changed to 0.8801 that means buyer
gains 0.0001 x 100,000 = $ 10

Features of Currency Futures

Trading by members Demand supply ,Open
out Cry electronically on the CME Globex
trading platform
Clearing House Acts as a counter party
Margins
Mark to Market

Features of Currency Futures

LiquidityThe buyer of the future need not hold up till
maturity.
On any intermediary date he can sell to another
and wind up his position with the exchange.
Similarly a seller can enter into a purchase deal
before the due date and square his position
It is the reason that future is sometimes
described as a bet on the future price of the
currency, rather than an obligation to buy the
currency.
Most of futures contracts are not delivered on
the due date, but extinguished by counter deals.

Price Movement
Future

1 GBP
2 Yen

Quantity

62,500
12,500,000

Amount of
tick $

Value of each
point change

0.0001

6.25 $

0.000001

12.50 $

3 Euro

125,000

0.0001

12.50 $

4 CHF

125,000

0.0001

12.50 $

5 CAD

100,000

0.0001

10.00 $

6 AUS $

100,000

0.0001

10.00 $

Marking The Market - Futures

Settlement Price
Opening Price 1CAD =0.90$

Wed.
0.8950

Thurs
0.8900

Friday
0.8975

Monday
0.9025

Contract Value on 12/12

Tuesday
90,000

89,500

89,000

89,750

90,250

MM A/C of Buyer
Opening Balance
Amt Adj.for change in value
Adjusted balance
Amount Dep / (-Withdrawn)
Closing Balance

4,500
-500
4000
500
4500

4500
-500
4000
500
4500

4500
750
5250
-750
4500

4500
500
5000
-500
4500

MM A/C of Seller
Opening Balance
Amt Adj.for change in value
Adjusted balance
Amount Dep/ (-Withdrawn)
Closing Balance

4500
500
5000
-500
4500

4500
500
5000
-500
4500

4500
-750
3750
750
4500

4500
-500
4000
500
4500

In Nut Shell
Fwd
Contracts

Currency Futures

Currency Options

Delivery

Generally

Less than %

Buyers Discretion.
Seller must honour if
buyer exercises

Maximum
Length

Several
Years

12 Months

3/6/9 Months

Contracte
d Amount

Any value

62500
Can$100,00.etc.

31,250,
Can$50000.etc.

Maturity
Date

Any Date

Third Wednesday of Friday before 3rd

March, June, Sept
Wednesday of March,
or Dec
June, Sept, or Dec on
regular Options. Last
Friday of month on
end-of-month options

In Nut Shell
Fwd
Contracts

Currency Futures

Currency Options

Secondary
Market

Must
Can Sell Via
Offset
Exchange
with Bank

Can Sell Via

Exchange

Margin

Fees

Margin3-20%

Premium

Guarantor

None

Futures Clearing
Corporation

Options Clearing
Corporation

Major Users

Primarily
Hedgers

Primarily
Speculators

Hedgers and
Speculators

Thank You