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Foreign Exchange

Markets

Instruments
&
Mechanisms

1
Our FX Market - From Fixed To
Market Based Exchange Rate
Mechanism
 Before 1998, the country had a Managed Exchange Rate Regime.
 In 1998 we switched to a composite ERM whereby all commercial
transactions were covered both from the interbank and SBP at a
fixed ratio.
 In May 1999 the country switched to a Market Based Exchange
Rate Regime.
 Banks are free to quote their own exchange rates.
 The exchange rate is determined by the market forces of demand
& Supply.
2
ntroduction to interbank FX activitie
 What is a foreign exchange transaction /
Exposure
 Any financial transaction that involves more than one
‘convertible’ currency is a foreign exchange
transaction.
 Most important characteristic of a foreign exchange
transaction is that it involves foreign exchange
risk/Exposure.

3
ntroduction to interbank FX activitie
Exchange Rate is the price of one currency in terms of
another.
Currencies are traded both in spot and forward.

Spot Transaction.
Sale or purchase of currency for settlement usually in two
working days.

Forward Transaction.
Sale or purchase of a currency for settlement at some future date,
other than spot, at rate determined on the deal date.
4
ntroduction to interbank FX activitie
Fx swap Transaction.

“An FX swap is a contract to buy an amount of currency for one


value date at an agreed rate, and to simultaneously resell the same
amount of currency for a later value date, also at an agreed rate, to the
same counter party”.

FX swaps is essentially a ‘funding’ or ‘Money Market’ transaction


and does not involve exchange risk. Fx swap is an alternative to
borrowing/lending the currencies which are swapped and may be
used to take advantage of any ‘arbitrage’ between the two currencies.
(Some Mechanics to be done)

5
ntroduction to interbank FX activitie
 Components of a standard FX transaction.
 Base Currency (USD/PKR)
 ‘Dealt’ or ‘Variable’ Currency
 Exchange Rate
 Amount
 Deal Date
 Value Date

6
ntroduction to interbank FX activitie
 Value date conventions.

 Ready
 Tom
 Spot
 Split value transactions

7
ntroduction to interbank FX activitie
In the forex market rates are always quoted ‘two way’.
Two way quote gives both ‘Bid’ and ‘Offer’.
e.g.
USD/PKR= 58.55/60 (57.90/10 ??)
Bid/Offer
‘Big Figure’ and the ‘small figure’ or ‘Points’ and
‘Pips’.

Why two way Quotes??


8
ntroduction to interbank FX activitie
‘Base Currency’ Vs. ‘Dealt Currency’

Number of variable or dealt currency unit in one unit of


base currency.

In international quotes base currency comes first.

BC/VC
USD/PKR= 58.55/60

9
ntroduction to interbank FX activitie
Price maker Vs. Price Taker

The bank quoting the price is ‘price maker’ or


‘market maker’.

The bank asking for the price or ‘quote’ is the


‘price taker’ or ‘user’.

10
ntroduction to interbank FX activitie
Prices for ‘market maker’ and ‘market
taker’.

JPY= 117.85/90 Direct Quote

Market taker or user will buy JPY (or sell USD) at


117.85 and will sell JPY (or buy USD) at 117.90
11
ntroduction to interbank FX activitie
Prices for ‘market maker’ and ‘market
taker’.

GBP= 1.8063/68 Indirect or


reciprocal

Market taker or user will buy GBP (or sell USD) at


1.8068 and will sell GBP (or buy USD) at 1.8063

12
ntroduction to interbank FX activitie
Prices are quoted in terms of USD.

e.g.
GBP= 1.7220/30
EUR= 1.2090/91
JPY=108.98/9.03

13
ntroduction to interbank FX activitie
Currencies quoted in indirect or reciprocal
way.

GBP=
AUD=
EUR=
NZD=

14
ntroduction to interbank FX activitie
Almost all other currencies are quoted in ‘direct
quote’.

e.g.
JPY=
SFR=
TRL=
AED=

15
ntroduction to interbank FX activitie
Forward Transaction

Out right sale/purchase of a currency against the other


for settlement at a future date at the predetermined
exchange rate.

Forward rates are quoted as premium or discount


over spot rate

Forward rates are NOT future spot rates.


16
ntroduction to interbank FX activitie
Forward Premium Rates
o Forward rates are not reflective of ‘depreciation’ or
‘appreciation’ of the currency and have nothing to do
with future forecasts of the spot rate.

o What has interest rate to do with the forward rates??

o The concept of ‘net carrying cost’.

17
ntroduction to interbank FX activitie
Forward Premium Rates
Forward rates depend upon interest rate
differential between the two currencies.
o Currency with higher interest rates is at discount
wrt currency having lower interest rate.
o Currency with lower interest rates is at premium
wrt currency having higher interest rate.

18
ntroduction to interbank FX activitie
Calculating Forward
Premiums/Discounts
Interest rate of USD = 1.25%
Interest rate of PKR = 6%
Spot Rate = 58.50
DB for PKR = Actual/365
DB for USD = Actual/360

Six month Forward Rate =


spot rate x (1+ .06*181/365)/
(1+.0125*181/360)
=59.87 19
ntroduction to interbank FX activitie
 Foreign Exchange Risk
 Exposure to exchange rate movement.

 Any sale or purchase of foreign currency entails

foreign exchange risk.


 Foreign exchange transaction affects the net asset

or net liability position of the buyer/seller.


 Carrying net assets or net liability position in any

currency gives rise to exchange risk.

20
ntroduction to interbank FX activitie
NET OPEN POSITION- A measure of
foreign exchange risk
• NOP is the Net Asset/Net Liability position in all FCs
together (Both B/S & Off B/S).
• Net Asset Position is also called “LONG” or
“Overbought “ position.
• Net liability Position is also called “SHORT” or
“Oversold “ position.
• NOP is a single statistic that provides a fairly good
idea about exchange risk assumed by the bank.
• Its major flaw is that FX exposures in third currencies
remain hidden. 21
ntroduction to interbank FX activitie
Foreign Exchange Exposure
FX Exposure is the higher of the long and short
positions in FCs.
EXAMPLE
Currency-wise NOP in equivalent PKR
CURRENCY SHORT LONG
Dollar -10
Yen 50
Euro -10
Pound 10
Total -20 60
Net Open Position is 40 while exposure is 60.
22
State Bank is the single
most important player in
both kerb as well as
interbank market

23
SBP’s role in the forex market
 To manage the exchange rate mechanism.
 Regulate inter-bank forex transactions and
monitoring the foreign exchange risk of the banks.
 Keep the exchange rate at desirable levels.
 Manage and maintain country's foreign exchange
reserves.

24
SBP’s role in the forex
market
• SBP has imposed foreign exchange
exposure limits on banks (FE 12 of
1999).

• The limits are tied with the Paid up


capital of the bank. (Risk Adjusted)

• Previously banks had NOP limit,


which was based on foreign
exchange volume handled by the
bank. 25
NOP Vs FX EXPOSURE – Cont’d

• NOP is a single statistic that


provides a fairly good idea about
market liquidity.

• NOP’s major flaw is that FX


exposures in third currencies
remain hidden.

• FEEL vs NOP
26
How does SBP manages
exchange rate in the interbank
market?

• Quantitative Tools

• Non-Quantitative Tools

27
Physical intervention

• Direct selling or buying of foreign exchange


by State Bank in the interbank market.
• Such sale/purchase can be in spot or forward
value
• It can have two objectives
To provide support to the market for
lumpy payments
To manage the Rs/$ parity

• Intervention may be direct or indirect.


Currently SBP only indirectly intervenes in
the market.
28
Non-Quantitative Tools

• Moral suasion
• facilitating large commercial outflows
• Relaxation in FEEL

29
Derivative Products

30
DERIVATIVES
Derivative Instrument

“A derivative instrument is one whose performance is


based (or derived), on the behavior of the price of an
underlying asset (Equity, FX, Commodities, Interest Rates,
etc), which is often simply known as the ‘underlying. The
underlying itself does not need to be bought or sold.

“A true derivative instrument requires no movement of


principal funds. It is this characteristic that makes them such
useful tools to both hedge and to trade and therefore, they
were also known as Off-Balance Sheet Instruments.”

31
Development of Derivative Market

 Derivatives emerged in the developed


economies many decades ago

 Derivative trading became more organized


with the introduction of derivative exchange in
1973

32
DERIVATIVES
Type of Derivative contracts
Assurance Contracts
 Guarantee a price
 Obligation on both parties
 Protect fully against “downside” risk
 No flexibility for “upside” benefit
Examples :
Forward contracts, Futures Contracts, Currency Swaps,
FRAs (Forward Rate Agreements) , Interest Rate Swaps

33
DERIVATIVES
Type of Derivative Contracts

Insurance Contracts
Derivatives are like insurance contracts. For small
premium, businesses can protect themselves against
shocks and adverse market conditions.

Options are the most common type:

Examples:
Foreign Exchange Calls, Puts, Collars, Interest Rate
Caps, Floors & Collars 34
Benefits of Using Derivatives
 Tailor-made Instrument: Derivatives could either be
standardized or customized, over-the-counter (OTC)
instruments. The OTC derivatives are extremely flexible and
can be designed to cater any individual need.

 Hedging Instrument: Derivatives are an effective tool that


could be used to hedge against future uncertainties, such as
interest rate and exchange rate fluctuations, etc.

 Efficient Balance Sheet Management: By increasing the


certainty of cash flows, it provides more room for corporates
to effectively manage their balance sheet. Hence, top
management can easily take better strategic decisions.

 Risk Sharing: It allows risk sharing among two parties.


Therefore, with the use of derivative products, corporates can
transfer their risk and exposure to other parties, such as banks.35
Benefits of Using Derivatives
 Concentration on Core Business: It allows corporates to
pass-on their financial risk to banks and concentrate on their
core business. With derivatives they can carry only those risks
that they are trained for and competent to manage.

 Optimizing on Competitive Advantage: Companies can


exchange their respective competitive advantages through
derivatives.

 Insurance Contract: Derivatives can be used to hedge only


downside risk and taking advantage of upside potential. So,
they could also be used as an insurance against adverse
movement of interest and exchange rates.

 Leverage: Most of the derivatives are transacted on notional


amount. Hence require minimum or no liquidity. This is
beneficial for corporates as well as for banks. 36
Benefits of Using Derivatives
 Yield Enhancement: They are off-balance sheet transaction. Corporates
can enhance their asset yields or reduce their liability costs without
actually inflating the balance sheet.

 Improved Credit Rating: Use of derivatives will improve the credit


rating of the companies.

 Low Credit Risk: Because of the notional amount, a derivative


transaction carries a fractional amount of credit risk as compared to any
normal cash transaction. Therefore, it only uses only a fractional amount
of per-party limit.

 Synthetic Liquidity: They provide synthetic liquidity in the market and


hence give banks and corporates a broader spectrum to work with.

37
Benefits of Using Derivatives
 Lower Transaction Cost: Derivatives either have very lower
or no transaction cost at all.

 Easy Entrance and Exit: It is easy to entered into and exist


from a derivative transaction as many derivatives can be
cancelled at any time by paying a very nominal cancellation
fee.

38
Derivative Products for Hedging
Interest rate & Exchange rate
Foreign Exchange Derivatives
 Forwards
 Futures
 Options
Interest Rate Derivatives
 Forward Rate Agreements
 Interest Rate Swap
 Futures
39
 Options
Derivatives – A New Era
 SBP has allowed only three broad categories
of Derivative instruments

 Interest Rate Swap


 Forward Rate Agreements &
 Currency Options

40
Forward Rate Agreements

Forward rate agreements, or FRAs, are forward


contracts on interest rates.

A Forward Rate Agreement (FRA)


conceptually is very similar to an FX
Forward, except that the later hedges FX
volatilities and the FRA hedges against the
“Interest Rate” volatilities.”

41
Forward Rate Agreements
 They are a simplified version of forward lending or
borrowing with the difference that on the settlement
date only the difference between prevailing and
contractual interest rates is exchanged.

“A Forward Rate Agreement is a contract between


two parties who wish to protect themselves from
interest rate movements. The agreement is specific
for the notional principal, the period, the currency and
the rate.”

42
FRAs
 A counterparty entering into an FRA enters into a
forward-forward transaction.
 He agrees to pay / receive the difference between the
interest payout calculated using a Market Reference Rate
and the Forward Contract Rate.
 The tenor and contract rate is fixed.
 FRAs are transacted on Notional Amounts with no
principal exchanging hands.
 The differential is paid upfront or at the end of the deal.
43
FRA -Features
 Customized short term interest rate future of any
amount up to two years final maturity.
No obligation to borrow or to lend.
Compensation calculated on difference between
FRA price and market benchmark rate, example
KIBOR
Minimal dealing lines required; counter-party
risk is only on differential amount only.
BUY the FRA expecting Interest rates to rise.
SELL the FRA expecting interest rates to fall.
44
FRA Payoff

45
FRA Convention
 3x6
Means 3 months rate 3 months forward
 3x9
Means 6 months rate 3 months forward
 6x9
 1 x 7

 9 x 12

46
FRA Contd.

Consider a Borrower who has a rolling


PKR 3 month facility, based on
KIBOR
Concern – interest rate going up in next reset
Invest

0 1 2 3 4 5 6
Borrow Gap
3 months 3 months

47
If they have a strong view that interest rates
will rise
They should buy a “3 x 6” FRA
Current 3 Month KIBOR = 7.50%
Current 6 Month KIBOR = 8.40%
3 x 6 FRA rate = 9.12%

Borrower hedges through an FRA at 9.12%

Today 3 months 6 months

 While Client has successfully protected his downside


 Client has given up the benefit of interest rate softening
48
FRA - diagram
KIBOR on Bank
Borrowing From
Lending Bank

Floating Rate (KIBOR)


FRA
BORROWER
BANK
Fixed Rate (9.12%)

While Client has successfully protected his downside

Client has given up the benefit of interest rate softening

49
FRA - Calculation
 A forward KIBOR rate is determined using the following formula:
 
 
 RL × Days   RS × Days   F×Days 

1 +
L

=1 + S
×1 + F

 365   365   365

 
 

  RL × D ays  
 
 1 + L

 
  365 −   365 
F = the long period 1 × 

RL = spot KIBOR for RS × D ays   
Days 

R =spot1 +
KIBOR for the short period
S
 
F

KIBOR 365 
S

F =
forward 

DAYSL = number of days in the long period
DAYSS = number of days in the short period
DAYSF = number of days covered by the forward period

50
FRA Calculation
 3 month KIBOR = 7.50%  Borrower locked in at 9.12%
 6 month KIBOR = 8.40%
 3 month forward for 3 months
 If 3 months later KIBOR = 9.5%
 “3 x 6” FRA = 9.12%  FRA buyer receives the
following:
  8.40% × 181   Rate Differential is 9.5%-9.12%
 1 +  
 365
 Present value is 0.38%/
F=   365  
−1 ×  (1+9.5%*91/365)

  1 + 7.50% × 90    91   =0.3712%
  365  
   Settlement amount is
 Principle * 0.3712%
 If KIBOR is below FRA contract
F = 9.12% rate then FRA buyer will pay
under the same calculations.

51
FRAs
Worked Example
Suppose Citibank Buys “3 vs. 6” FRA from NBP

Notional Amount Rs. 100m


Rate 9%
Deal Date 6th June
Settlement Date 6th July
Settlement Rate 6 Month KIBOR

Now suppose that at the settlement date, KIBOR is 9.5%, the difference
between the contract rate and current rate comes to 0.5%. Difference
payable by Citibank comes to;
=100,000,000*(.005*181/365)
=Rs. 247,945.205 52
FRAs
Worked Example Cont’d

In the ordinary course, interest is settled on


maturity, but in FRA the difference is settled
upfront on the settlement (starting date) date.
Therefore, this amount will be discounted back, at
the prevailing KIBOR and the actual amount to be
received from Citibank would be;
=247,945.205/(1+ 9.5% *181/365)
=Rs. 236,792.03
53
FRA
 Find 6 month rate 3 month forward
 Term Structure is:
Tenor Bid Offer
1 month 6.50 7.00
3 months 7.50 8.00
6 months 8.40 8.90
9 months 8.70 9.20
12 months 9.20 9.70
54
FRA Advantage
 Ability to hedge the position and offset gaps
 Helps customers in accurate forecasting and planning
process
 Fixing the cost of funds for accurate price settings
 Smaller bid / offer spreads than cash markets
 Customer is not restricted to entering into the cash
market transaction with the FRA counterparty.
 Lower transaction costs
 Off-balance sheet transactions
 Lower credit risk than cash transactions 55
FRA - Disadvantages
 Opportunity cost in case of favorable price
movement.
 MTM payments are more transparent then in
Cash Market which may reflect badly on seniors
discouraging traders from using FRAs.
 While making payments, customer may feel that
bank has taken him for a ride not realizing that it
would probably be making payment for its hedge
also.

56
LINKAGE BETWEEN
Forward Rate Agreement
and interest rate Swaps, ;

57
FRAs & IRS
Interest Rate Swaps (IRS)
 Whereas, FRA is single exchange of rates, a generic, standard or
Plain vanilla swap is an agreement between two parties to
exchange streams of interest payments one of which could be
fixed and the other could be floating.

58
FRAs & IRS
Interest Rate Swaps

The Payment are to be exchanged

 On predetermined set of dates in futures


 Based on notional principal amount
 Denominated in the same currency

Usually,
One party is the fixed rate payer (agreed at the
inception of the swap).
The other party is floating rate payer. (prevailing
rate indexed to a benchmark) 59
FRAs & IRS

Interest Rate Swaps

 Interest rate swaps are very similar to a portfolio


or collection of FRAs.
 Simply stated, an IRS is multiple FRAs in
sequence with a common index and strike rate.
 Through IRS, one can convert its ‘fixed’ asset or
liability into ‘floating’ one.

60
FRAs & IRS
Interest Rate Swap
A typical interest rate swap:
Fixed Rate
Company A Swap Bank
6 Month KIBOR
2.0%
KIBOR +
6 Month

Effective Cost of Loan:


Fixed Rate + 2.00%
Bank A

61
Interest Rate Swap
IRS could be for exchange of :

Fixed Vs. Floating


Floating Vs. Fixed
Floating Vs. Floating

62
Interest Payments
Calculations
 The Fixed Rate payer calculates the interest
payment by multiplying the notional principal
(though never exchanged) with the Fixed
Rate, while Floating
the Fixed Rate receiver(Floating
Rate Interest Payments
Rate payer) uses the Floating Rate

Fixed Rate Interest Payments

63
Plain Vanilla Interest Rate
Swap
Exchange of fixed interest rate
payments for floating
 Notional Amount: PKR 500,000,000
 Tenor: 3 Years
 Floating Rate: 6 Mth KIBOR
 Fixed Rate: 11.00%

Corp. pays fixed @ 11%

Corporate IRS Swap Bank


Bank pays floating @ 6M KIBOR

64
Futures or Futures contrac
What are future contracts ?.
Future contracts are highly standardized
forward contracts, traded on exchanges.
Parties involved in a future trade.
Buyer
Seller
Broker
Exchange
Clearing House.

65
Futures or Futures contrac
What are future contracts ?.
Specification of a standard contract:
Gold
Commodity name
Exchange Name (COMEX)
Size of Contract : 100 troy ounce
Delivery month: Feb/April/June/Aug/Oct/Dec
First delivery date, First notice date, last
delivery date.

66
Futures or Futures contrac

Different kinds of future


contract ?.

Commodity futures
Currency futures
Financial futures.

67
The World’s Leading Futures Exchanges
 Chicago Board of Trade  Chicago Mercantile
(CBOT) Exchange (CME)
 Financial Exchange  London International
(FINEX)
Financial Futures
 New York Futures
Exchange (NYFE) Exchange (LIFFE)
 Sydney Futures
 Marche a Terme
International De France Exchange
(MATIF)  Toronto Futures
 Singapore Exchange LTD. Exchange (TFE)
(SGX)

68
DISTINCTIONS BETWEEN FUTURES AND
FORWARDS.
 Forwards  Futures
 Traded in dispersed  Traded in centralized
interbank market 24 hr a
day. Lacks price
exchanges during
transparency specified trading hours.
Exhibits price
transparency.
 Transactions are customized
and flexible to meet  Transactions are highly
customers preferences. standardized to promote
trading and liquidity.

69
DISTINCTIONS BETWEEN FUTURES AND
FORWARDS.

 Forwards  Futures
 Counter party risk is
 Being one of the two
parties, the clearing house
variable standardizes the
counterparty risk of all
contracts.

 On a daily basis, cash may


flow in or out of the margin
 No cash flows take account, which is marked to
place until the final market..
maturity of the contract.
70
What is an Option?
➼ An option is contract offering the
right, but not the obligation, to
buy or sell an asset at a
predetermined price.

➼ The price of an option is derived


from its underlying instrument.

71
European Options:

➼ European options can only be exercised


on their expiration date.

➼ The expiration, or maturity date, is the


day the option buyer’s right to exercise
the option (and the seller’s obligation to
perform) ends.

72
American Options:

➼ American options can be


exercised at any time up to, and
including, the expiration date.

73
Call Option: The Right to Buy an Asset:
A call option represents the right to buy an
asset at a predetermined price on or before
the expiration date.
Profit

Payoff

Profit
Strike
0 Price
Spot
Premium

Loss 74
Positions in Options
➼ A long call position has unlimited
upside potential. Downside risk is
limited to the option premium.
Profit

Strike
0 Price
Premium

Loss 75
➼ A short call position has upside
potential limited to the option
premium. Downside risk is unlimited.

Profit
Premium

0 Price
Strike

Loss 76
➼ A long put position has upside
potential limited because an asset price
cannot fall below zero. Downside risk is
limited to the option premium.

Profit

Strike
0 Price
Premium

Loss 77
➼ A short put position has upside
potential limited to the option
premium. Downside risk is limited
because an asset price cannot fall
below zero.
Profit
Premi um

0 Price
Strike

Loss 78
In, At- and Out-of-the-Money
➼ The type of option and the relationship between the spot
price of the underlying asset and the strike price of the
option determine whether an option is in-the-money, at-
the-money or out-of-the-money.
➼ Exercising an in-the-money call or in-the-money put will
result in a payoff. Neither a call nor put that is at-the-
money will produce a payoff.
Call Option Put Option
In-the-Money Spot > Strike Spot < Strike
At-the-Money Spot = Strike Spot = Strike
Out-of-the-Money Spot < Strike Spot > Strike
79
COMPARISON
FORWARD CONTRACTS CURRENCY OPTIONS
 No outlay of funds until maturity date  Premium is payable on the second business
day after the day on which the option is
granted
 Fixes in advance the amount payable/
receivable, facilitating costing exercises  Since the customer has the right and not
obligation to purchase/sell at the strike price,
only the worst amount payable/receivable is
known in advance.

 Once a forward contract is booked, the  While protection against downside risk is
customer is locked into a rate and cannot obtained, the customer can benefit to an
benefit from a favourable movement in the unlimited extent from any favourable
underlying currency thereafter. movement in the underlying currency.

80
COMPARISON
FORWARD CONTRACTS CURRENCY OPTIONS
Through management of Currency
Options, the customer can generate
additional profit in certain
circumstances
 When a forward contract is booked,
foreign exchange lines are blocked until  If customer buys option, no credit lines
maturity date. are required (after receipt of premium).
Credit lines required if customer sells
option.
 Should the underlying transaction not
materialise, closing out of the outstanding  The loss is limited to the premium
forward contract could entail losses paid.

81
Thank you.

82