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Derivatives Session 5

Derivatives Session 5. Foreign Currency Derivatives. Financial management of the MNE in the 21 st century involves financial derivatives . These derivatives, so named because their values are derived from underlying assets, are a powerful tool used in business today.

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Derivatives Session 5

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  1. Derivatives Session 5

  2. Foreign Currency Derivatives • Financial management of the MNE in the 21st century involves financial derivatives. • These derivatives, so named because their values are derived from underlying assets, are a powerful tool used in business today. • These instruments can be used for two very distinct management objectives: • Speculation – use of derivative instruments to take a position in the expectation of a profit • Hedging – use of derivative instruments to reduce the risks associated with the everyday management of corporate cash flow

  3. The Nature of Derivatives A derivative is an instrument whose value depends on the values of other more basic underlying variables called bases (underlying asset, index, or reference rate), in a contractual manner

  4. The Nature of Derivatives • The underlying asset can be equity, forex, commodity or any other asset. • For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such • a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”.

  5. Examples of Derivatives • Forward Contracts • Futures Contracts • Swaps • Options

  6. The Players in a Derivative Market • The following three broad categories of participants • Hedgers • Speculators • Arbitrageurs Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators

  7. Why are they used? • To discover price • To hedge risks • To speculate (take a view on the future direction of the market) • To lock in an arbitrage profit • To change the nature of a liability • To change the nature of an investment without incurring the costs of selling one portfolio and buying another

  8. Derivatives in India • In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines “derivative” to include – 1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices, of underlying securities.

  9. Derivatives in India • Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A.

  10. Currency Forwards • A forward contract is an agreement between a firm and a commercial bank to exchange a specified amount of a currency at a specified exchange rate (called the forward rate) on a specified date in the future. • Forward contracts are often valued at $1 million or more, and are not normally used by consumers or small firms.

  11. Currency Forwards • When MNCs anticipate a future need for or future receipt of a foreign currency, they can set up forward contracts to lock in the exchange rate. • The % by which the forward rate (F ) exceeds the spot rate (S) at a given point in time is called the forward premium (p). F = S (1 + p) • F exhibits a discount when p < 0.

  12. Currency Forwards ExampleS = $1.681/£, 90-day F = $1.677/£ annualized p =F – S 360 Sn =1.677 – 1.681 360= –.95% 1.681 90 • The forward premium (discount) usually reflects the difference between the home and foreign interest rates, thus preventing arbitrage.

  13. Foreign Currency Futures • A foreign currency futures contract is an alternative to a forward contract that calls for future delivery of a standard amount of foreign exchange at a fixed time, place and price. • It is similar to futures contracts that exist for commodities such as cattle, lumber, interest-bearing deposits, gold, etc. • In the US, the most important market for foreign currency futures is the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange.

  14. Currency Forwards • A swap transaction involves a spot transaction along with a corresponding forward contract that will reverse the spot transaction. • A non-deliverable forward contract (NDF) does not result in an actual exchange of currencies. Instead, one party makes a net payment to the other based on a market exchange rate on the day of settlement.

  15. April 1 July 1 Expect need for 100M Chilean pesos. Negotiate an NDF to buy 100M Chilean pesos on Jul 1. Reference index (closing rate quoted by Chile’s central bank) = $.0020/peso. Buy 100M Chilean pesos from market. Index = $.0023/peso  receive $30,000 from bank due to NDF. Forward Market • An NDF can effectively hedge future foreign currency payments or receipts: Index = $.0018/peso  pay $20,000 to bank.

  16. Currency Futures • Currency futures contracts specify a standard volume of a particular currency to be exchanged on a specific settlement date. • They are used by MNCs to hedge their currency positions, and by speculators who hope to capitalize on their expectations of exchange rate movements.

  17. Currency Futures • The contracts can be traded by firms or individuals through brokers on the trading floor of an exchange (e.g. Chicago Mercantile Exchange), automated trading systems (e.g. GLOBEX), or the over-the-counter market. • Brokers who fulfill orders to buy or sell futures contracts typically charge a commission.

  18. Foreign Currency Futures • Contract specifications are established by the exchange on which futures are traded. • Major features that are standardized are: • Contract size • Method of stating exchange rates • Maturity date • Last trading day • Collateral and maintenance margins • Settlement • Commissions • Use of a clearinghouse as a counterparty

  19. Foreign Currency Futures • Foreign currency futures contracts differ from forward contracts in a number of important ways: • Futures are standardized in terms of size while forwards can be customized • Futures have fixed maturities while forwards can have any maturity (both typically have maturities of one year or less) • Trading on futures occurs on organized exchanges while forwards are traded between individuals and banks • Futures have an initial margin that is market to market on a daily basis while only a bank relationship is needed for a forward • Futures are rarely delivered upon (settled) while forwards are normally delivered upon (settled)

  20. Comparison of the Forward & Futures Markets Forward MarketsFutures Markets Contract size Customized Standardized • Delivery date Customized Standardized • Participants Banks, brokers, Banks, brokers, • MNCs. Public MNCs. Qualified • speculation not public speculation • encouraged. encouraged. • Security Compensating Small security • deposit bank balances or deposit required. • credit lines needed. • Clearing Handled by Handled by • operation individual banks exchange • & brokers. clearinghouse. • Daily settlements • to market prices.

  21. An Option is…. • A contract where the buyer has the right, but not the obligation to • Buy/Sell • Specified quantity of a currency • At a specified price (strike price) • By a particular date (expiry date) • For this right, the buyer pays the seller(writer) of the option an upfront fee (called option premium)

  22. Forwards  Options • Forwards – most common & and popular derivative instrument for hedging forex exposures. • Offers best protection against adverse exchange rate movements BUT carries risk of opportunity loss in the event of favorable movements. • An Option offers the protection of a forward contract but without its commitment.

  23. Options v/s Forwards • Options give the buyer a right but no obligation. • Good instrument to hedge adverse price moves & avoiding opportunity loss. • Upfront premium • Can choose the strike price • Forwards are fixed price contracts wherein the buyer/seller is obligated to the price • Opportunity loss • No upfront premium • Cannot choose the price

  24. Option Terminologies Call Option: Gives the holder the right but not the obligation to BUY an underlying at a fixed price from the writer of the option. Put Option: Gives the holder the right but not the obligation to SELL an underlying at a fixed price to the writer of the option

  25. Two types of option American Option May be exercised at any time during the life of a contract. European Option. May be exercised only at maturity or expiry date.

  26. Options - specifications Strike Price or Exercise price The fixed price at which the option holder has the right to buy or sell the underlying currency. Expiry Date The last day on which the option may be exercised. Life or Exercise Period The period of time during which the option holder enjoys the purchased option contracts.

  27. Advantage of Option over Forwards Forward Contract On April 01, importer A buys USD forward at 43.75 with an expiry date May 31. Currency Option Same day, importer B buys a USD call option, with a strike price of 44.00 at same expiry on 31st May and pays a premium of 15 paisa. His worst effective rate is now 44.15. On May 31 USD/INR trades at 43.50. Importer A buys Dollars at 43.75. Importer B can ignore the option and buy USD at the current market rate of 43.50. His net cost now works out to 43.50+0.15 = 43.65.

  28. Options example… • USD imports - due 31st May • Company buys an USD call option with a strike price of 43.70 when spot rate is 43.60. • 2 business days before the expiry date, the company has to decide whether or not to exercise the option. • So on 29th May at the specified cut-off time, if spot USD is over 43.70, the company will exercise the option and buy USD at 43.70 • However, if spot rate is less than 43.70, then the company can let the option lapse and instead fix the spot rate for the transaction on 29th May.

  29. Options example… • USD exports - due 31st May • Company buys an USD put option with a strike price of 43.70 when spot rate is 43.60. • 2 business days before the expiry date, the company has to decide whether or not exercise the option. • So on 29th May at the specified cut-off time, if spot USD is below 43.70, the company will exercise the option and Sell USD at 43.70 • However, if spot rate is morethan 43.70, then the company can let the option lapse and instead fix the spot rate for the transaction on 29th May.

  30. Risk / Profit Profile Buyer Seller Profit Unlimited Premium Risk Premium Unlimited

  31. Option strike price In the money (ITM) • The option is In the Money when the Strike Price is favourable to the option holder(buyer) than the current forward rate. Eg: USD put option with strike 43.80 – current fwd rate 43.75 – option in the money Out of the money (OTM) • The option is Out of the Money when the Strike Price is unfavourable to the option holder(/buyer) than the current forward rate. Eg: USD call option with strike 43.90 – current fwd rate 43.75 – option out of the money At the money (ATM) • The option is At the Money when the Strike Price is equal to the current forward rate.

  32. Option, Forwards & Open Position • A call option will outperform a forward contract when spot rate at maturity plus option premium is less than the forward rate. • A put option will outperform a forward contract when spot rate at maturity less the option premium is greater than the forward rate. • As to unhedged positions, a call option will be better than an unhedged position only if the strike price plus premium is less than the spot at maturity. • Likewise, a put option will be better than an unhedged position only if the strike price less the option premium is greater than the spot at maturity.

  33. Price of an Option • Can the Option buyer have the cake & eat it too? • Not really - since the option seller charges the buyer an upfront premium payable in cash. • And the upfront premium can be as high as 1% or even more depending on the strike price and the maturity period.

  34. Why Option Premium? • An option buyer never loses money with reference to the strike price but may make or save money. • The option seller is in an opposite position – he can have windfall losses. • Based on the probability distribution of spot prices at maturity, there is an ‘expected’ gain or profit to the buyer. • This is charged as upfront premium. • Option seller – always incurs a loss, while he hedges his short option position using mathematical hedging techniques • The loss is recovered by way of the upfront premium.

  35. Option premium - Quotations • Points of the second currency/terms currency or • Premiums are quoted as a flat percentage of the base currency Principal amount Example: USD/INR put 1m $ USD/INR strike price = 43.90 Premium quoted as 0.33 INR Or 0.33*1,000,000 = 3,30,000 INR 330,000 INR = 7,569 $ (330,000/43.60 spot) 7,569 $ is 0.75% of 1m $ principal

  36. Factors determining Premium value • Volatility • Strike Price • Life or Exercise Period • Interest Rates - domestic & foreign • Current Market Rate

  37. Volatility – historic v/s implied • Volatility is defined as the standard deviation over the mean on the returns on prices. • Historic volatility is the volatility calculated using a set of historical data (usually the set of data corresponds to the period of the option). • Implied volatility is the market expectation of future volatility. • Traders in the option market quote the option premium, which is then used as an input in the Black & Scholes option pricing formula to calculate the implied volatility. • Research has proved that option trading affects the volatility of the underlying market, causing a reduction in most cases.

  38. Change in premium with change in volatility

  39. Strike Price Dynamics • The option premium can be quite high for ATM options. • Is there a way to reduce the premium ? • There is one golden rule. You can’t get anything in the market for free. • So to reduce the premium, you have to give up some protection. • To reduce the premium, you have to raise the strike price and consider buying an OTM option thereby giving up some protection. The more OTM the option is, the lower will be the premium. Conversely, the more ITM an option is, the higher will be the premium.

  40. Strike Price • The more otm the option is, the lower will be the premium. Conversely, the more itm an option is, the higher will be the premium. For eg: USD/INR Spot = 43.50 • It is seen that the reduction in premium is less than the protection sacrificed.

  41. Choosing the right strike price • USD/INR spot = 43.50; 6 months ATM = 43.86 • Worst case rate = 43.35 You have USD exports • Fix the worst case rate (WCR) Bearish on Rupee • You buy an OTM Put with lowest strike so that the strike minus premium is above WCR • Strike = 43.70 Premium = 0.35 WCR = Strike - Premium = 43.35 Bullish on Rupee • You buy ATM USD Put • Strike = 43.86 Premium = 0.41, WCR= Strike - Premium = 43.45, which is more than 43.35 (WCR)

  42. Comparison between Strike Price & WCR Pay off Profile X axis - Spot at maturity Y axis - Effective rate Strike 43.70 --> premium 0. 35 --> WCR 43.35 --> If bearish on Rupee. Strike 43.86 --> premium 0.41--> WCR 43.45 --> If bullish on Rupee.

  43. Option Strategies

  44. Long USD Call Option Profit Profit Unlimited Strike Price Price of underlying (USD/INR) 43.90 Loss Area Break-even price Cost of Premium 43.90+0.45 = 44.35 Loss

  45. Short USD Call Option Profit Break-even price 43.90+0.45 = 44.35 Premium Income or Profit Price of underlying USD/INR 43.90 Loss Unlimited Strike Price Loss

  46. Long USD Put Option Profit unlimited 43.90 - 0.45 = 43.45 Break-even price Price of underlying USD/INR Cost of Premium Strike Price 43.90 Loss

  47. Short USD Put Option Profit 43.90 - 0.45 = 43.45 Break-even price Premium Income or Profit Price of underlying Loss Unlimited Strike Price 43.90 Loss

  48. Indian Scenario • In the pre-liberalization era, the insular economic environment felt no scope for the derivative market to develop. • Indian corporate depended on term lending institutions for their project financing & commercial banks for working Capital. • Forward contract was the only derivative product to hedge financial risk. • Post-liberalization India saw developments in the instrument – forward contract. • Corporate was allowed to cancel & rebook forward contracts.

  49. Why Rupee options? • Rupee options would enable an Indian corporate to hedge against downside risk on FC/INR while retaining the upside, by paying a premium upfront – better competitiveness. • Hedge against uncertainty of cash flows – due to NON LINEAR payoff of option – for eg. – Indian company bidding for an international contract – bid quote in Dollars but cost in Rupees – Risk of USD/INR falling till the contract is awarded – forwards will bind the company even if the overseas contract not allotted – Option contract will freeze the liability only to the option premium paid upfront. • Attract more forex investment due to availability of another mechanism for hedging forex risk.

  50. Rupee options – why now? • RBI’s earlier concerns • Poor risk management skills at banks, who would be selling options to customers • Options market may impact the spot rupee • Current considerations • Increasing volatility in the rupee makes it difficult for corporates to manage risk • Exchange rate policy appears looser; strong reserves provides comfort • Option use is getting more commonplace

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