Forex Risk Management through Derivatives- Futures and Options

By

Ankit Kapoor 234 Gaurav Palkar 256 Sneha Saraf 304 Ashutosh Saxena - 307 Ashwani Saraswat - 348

Foreign exchange risk: meaning

Value of a currency changes frequently Affects firms engaged in international transactions Assets, liabilities and cash flows are affected through changes in exchange rates Possibility of unfavorable changes - Risk

Types of risk/ exposure

Accounting/ translation exposure: financial statements Economic exposure to foreign exchange risk: - Transaction exposure - change in value of monetary assets & liabilities - Operating exposure - change in value of real assets

Translation exposure
Occurs on consolidation of financial statements of different units of MNCs When the value of currency of a subsidiary changes, its translated value in the domestic currency of the parent company changes This change represents translation exposure It is only an accounting exposure

Transaction exposure
Impact of exchange rate fluctuations on present cash flows From transactions already entered into
Export and import Borrowing and lending in foreign currency Intra firm fund flow in an international company

Real operating exposure

Changes in exchange rates alter future operating revenues and cost streams of a company Changes in future cash flows from changes in exchange rates

Foreign exchange risk: techniques of management

Translation risk: accounting risk Current/Noncurrent Method
Current accounts use current exchange rate for conversion Income statement accounts use average exchange rate for the period

Monetary/Nonmonetary Method
Monetary accounts use current rate and pertains to
Cash accounts receivable\payable long term debt

Nonmonetary accounts use historical rates which pertains to

inventory Fixed assets Long term investments

Foreign exchange risk: techniques of management

Transaction risk (short term):
Hedging using currency forwards or futures Risk shifting
Firm will invoice exports in strong currency, import in weak currency

Currency risk sharing

Parties would share the currency risk beyond a neutral zone of exchange rate changes

Real operating risk (long term):

Take advantage of the MNCs ability to respond to differences in real foreign exchange rates
Market selection: Shift marketing efforts toward countries with higher demand or overvalued currencies Product sourcing: Shift production to countries with low real costs

 What is Foreign Exchange Market? Futures What are Futures? Features Forex Futures v/s Traditional Futures Forward Contracts v/s Future Contracts Margin, Settlement and Regulation of Futures Use of Forex Hedging, Speculation and Arbitrage

FOREIGN EXCHANGE MARKET

What is Foreign Exchange Market ?

Its the Market in which currencies are traded It is the domain of Government Central banks and Commercial and Investment banks, not to mention hedge funds and massive international corporations The forex offers trading 24-hours a day five days a week The daily dollar volume of currencies traded in the currency market exceeds $5 trillion, making it the largest and most liquid market in the world

Participants in Foreign Market

Primary Price Makers or Professional Dealers eg. Commercial Banks and Investment dealers Secondary Price Makers eg. Tourists Hotels

Foreign Currency Brokers who are middle men between two market-makers
Price Takers are those who take the prices quoted by the primary price makers eg. Individuals and Corporates

Structure of the Forex Market

FX MARKET

Retail Market

Wholesale Market

Traveller's Cheque

Currency Notes

Banks

Institutions

Futures Contract

Asset Investment Class

Commodities
Fixed Income

Equities
Foreign Exchange
Futures Contract

Futures Contract

A FUTURES CONTRACT FIXES THE PRICE NOW FOR A TRANSACTION THAT WILL TAKE PLACE IN FUTURE

Futures Contract
A futures contract is a binding agreement between two parties

to buy or sell a fixed amount of a financial instrument for delivery on a fixed date in the future at a fixed price

Futures - Main Features

Traded in Specific Exchanges (IMM, LIFFE etc.) Specific periods (Mar, Jun, Sept, Dec) Standardized amounts for each contract Open Cry trading in the Exchanges Guaranteed by the Clearing House Initial and variable Margins Provides Opportunities to Trade, Speculate, & Hedge Exchange provides Liquidity

Currency Futures Exchanges

USA UK IMM - International Monetary Market LIFFE- London International Financial Futures Exchange

Singapore
Australia

SIMEX- Singapore Mercantile Exchange

SFE - Sydney Futures Exchange

** There are many other Exchanges

Currency Futures Exchanges

e.g LIFFE
Contract Amounts: GBP 25,000 DEM 125,000 CHF 125,000 JPY 12.5 March, June, September, December Third Wednesday of every month

Contract Periods

Delivery

Margin
A margin is cash or marketable securities such as Treasury bills or in some cases bank letters of credit deposited by an investor with his or her broker (Initial Margin-2.5 to 10% of the value of contract paid by both Buyer and Seller) The balance in the margin account is adjusted to reflect daily settlement (Maintenance Margin based on Mark to Market price) Margins minimize the possibility of a loss through a default on a contract

Minimum margin varies if price volatility increases

Settlement
Settlement is a act of consummating the contract
Settlement can be done by two ways
Physical Delivery Cash Settlement

Convergence of Futures to Spot

Futures Price

Spot Price
Futures Price

Spot Price

Time

Time

(a)

(b)

The futures price, normally, converges towards the settlement price on the delivery date.

Regulation of Futures
Regulation is designed to protect the public interest Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups

Use of Futures Contract

Hedging

Speculation
Arbitrage

Using Futures for Hedging

Covering against adverse movement of Currency An exporter is expecting to receive payment from his US client $1,00,000 after 3 months. Current Spot Rate of USD is Rs.45 in July At current exchange rate if exporter sells $1,00,000 then he will receive Rs 45,00,000 If after 3 months USD falls to Rs 43 then the exporter will receive only Rs 43,00,000

Currency Futures
Situation To cover DEM requirement for September (DEM 1,250,000) Present Spot 1.5050 (in July) View DEM is likely to strengthen Aim To lock into present exchange rate Action Buy Sept DEM Futures Contract Date Today Sept Spot 1.5050 1.4500 Futures 0.6645 0.6895 Action Buy 10 Sept Contracts Sell 10 Sept Contracts

Currency Futures
Result: 10 x 125,000 x 0.6645 10 x 125,000 x 0.6895

= USD 830,625 = USD 861,875 -------------------Profit = USD 31,250

Increased cost of purchasing DEM in September at cash market price of 1.4500 is offset by profit made in Futures market

Using Futures for Speculation

It means buying or selling foreign currency contracts with the sole aim of earning money through correct anticipation of movement of exchange rate.

High Risk

Using Futures for Arbitrage

Arbitrage is done to utilize the opportunities provided by the market due to differentials in Bid and Ask rates in the same markets or in different markets like Spot and Futures.

Using Futures for Arbitrage

Forward Rate Mispricing If futures price < 0.65625 e.g. $0.64
Actions to take today 1. Buy a futures price at $0.64 per Deutsche Mark. 2. Borrow the spot rate in the German market @4%. + 1 DM 3. Convert the Deutsche Marks into Dollars at spot rate. - 1 DM/ $ 0.65 4. Invest dollars in the U.S. market @ 5%. -$0.65

Using Futures for Arbitrage

Actions at expiration of futures contract 1. Collect on Dollar investment. +$ 0.6825 2. Convert dollars at futures price. - $ 0.6825 /+1.0664 DM 3. Repay DM borrowing with interest. (1.04 DM) Profit = 1.0664-1.04 = 0.0264 DM

Observations
Forex futures operate similarly to traditional stock and commodity futures Forex futures market is only 1/100th the size of Forex

Used as a convenient tool for hedging, speculation or arbitrage against price risk and as a way of betting on price movements rather than as a means of physical acquisition of the underlying asset

EXOTIC OPTIONS STRATEGIES PRICING

OPTION

BASICS

WHAT IS AN OPTION ?
An option is a contract that confers on the buyer the Right But not the obligation

To buy or sell a specific asset at pre agreed price in the future

4 ESSENTIALS OF OPTION
GIVES OPTION BUYER THE RIGHT, BUT NOT THE OBLIGATION
TO BUY OR TO SELL AN AGREED AMOUNT OF ONE CURRENCY IN EXCHANGE FOR OTHER CURRENCY (NOTIONAL VALUE) ON OR BEFORE AN AGREED FUTURE DATE (EXPIRY DATE)

AT AN AGREED EXCHANGE RATE (STRIKE PRICE)

IN EXCHANGE FOR A FEE (OPTION PREMIUM)

CALL & PUT OPTION

CALL OPTION
OPTION TO BUY AT AGREED PRICE

PUT OPTION
OPTION TO SELL AT AGREED PRICE

FOREX OPTION : CALL = PUT ?

CALL OPTION ON ONE CURRENCY IS PUT OPTION

ON OTHER CURRENCY ( FOR OPTION BUYER ) IN THE CURRENCY PAIR

BUY 1 MN USD AGAINST INR, AT 44.20 (USD CALL OPTION)

SELL 1 MN USD AGAINST INR, AT 44.20 (USD PUT OPTION)

BASIC OPTION TERMINOLOGY

EUROPEAN

EXERCISE TYPE
AMERICAN

BERMUDAN
EUROPEAN EXERCISED ON EXPIRY DATE ONLY AMERICAN CAN BE EXERCISED ON ANY DAY

BERMUDAN EXERCISED ON PRE-SPECIFIED DAYS ONLY

BASIC OPTION TERMINOLOGY

IN THE MONEY

STRIKE PRICE
OUT OF MONEY

AT THE MONEY
IN THE MONEY YOU ARE MAKING PROFIT. SO, EXERCISE OPTION AT THE MONEY YOU ARE BREAKING EVEN. STRIKE PRICE = SPOT PRICE

OUT OF MONEY YOU WILL MAKE LOSS IF YOU EXERCISE OPTION

CALL OPTION
P&L

PREMIUM, C 0 SPOT (S)

STRIKE (X)

PAY OFF = SPOT STRIKE PRICE PREMIUM OUT OF MONEY : S<X

AT THE MONEY :
IN THE MONEY :

S=X
S>X

OPTION VS FUTURE
Obligation to buy/sell
PAYOFF
0 S0 SPOT

FUTURE

Right to buy/sell
PAYOFF PREMIUM 0 SPOT

OPTION

Premium Preloaded

Upfront premium

EXOTIC OPTIONS STRATEGIES

PRICING
OPTION BASICS

FACTORS AFFECTING PREMIUM

TYPE OF OPTION DIFFERENCE BETWEEN STRIKE PRICE & SPOT PRICE

TIME PERIOD OF OPTION

CURRENCY VOLATILITY

TYPE OF OPTION
COMMODITY / CURRENCY / EQUITY
BUY / SELL CALL / PUT

EUROPEAN/BERMUDAN/AMERICAN
VANILLA / EXOTIC

STRIKE Vs SPOT PRICE

HIGHER THE DIFFERENCE, LESSER THE PROBABILITY OF EXERCISE SPOT PRICE - INR 45 EXAMPLE CALL OPTION
STRIKE PRICE INR 45.5 INR 46 INR 47 INR 48 PROB 95% 60% 10% 0.1% PREMIUM INR 0.40 INR 0.30 INR 0.10 INR 0.05

TIME PERIOD OF OPTION

LONGER THE TIME, GREATER THE CHANCES OF EXERCISE OF OPTION, SO HIGHER THE PRICE

P R I C E

TIME TO EXPIRY

VOLATILITY
.

SPOT PRICE

STRIKE PRICE

TIME

VOLATILE

STABLE

OPTION VALUE
OPTION VALUE
INTRINSIC VALUE DIFFERENCE BETWEEN STRIKE AND SPOT RATE

TIME VALUE TIME TILL MATURITY VOLATILITY

INT RATE DIFFERENTIAL

PRICING MODELS
BINOMIAL MODEL

BLACK SCHOLES

OPTION PRICE

GARMAN KOHLHAGEN

MONTE CARLO SIMULATION

BASIC PRICING PRINCIPLE

PRICE = DISCOUNTED EXPECTED CASH FLOWS

PRESENT VALUE

INFLOWS/OUTFLOWS PROBABILITY

OPTION GREEKS
CHANGE IN VOLATILITY CHANGE IN INT RATE CHANGE IN SPOT

CHANGE IN TIME DELTA

GAMMA

VEGA
RHO

THETA

CHANGE IN OPTION VALUE

OPTION GREEKS
A set of measures derived from the Black Scholes option pricing formula delta - a measure of an options sensitivity to changes in the price of the underlying asset gamma - a measure of deltas sensitivity to changes in the price of the underlying asset vega - a measure of an options sensitivity to changes in the volatility of the underlying asset theta - a measure of an options sensitivity to time decay rho - a measure of an options sensitivity to changes in the risk free interest rate

EXOTIC OPTIONS

STRATEGIES
PRICING OPTIONS BASICS

BASIC OPTION STRATEGIES

BUTTERFLY SPREAD RANGE FORWARD STRADDLE / STRANGLE

VANILLA

BULL/BEAR

OPTION STRATEGIES

PLAIN VANILLA CALL OPTION

SPOT: 46.85, SIX MONTHS FORWARD : 40 PAISE BUY USD CALL/ INR PUT AT STRIKE 47.25
2.00

1 .50

Gain/ (loss)

1 .00

writer
buyer

0.50

0.00

45.00

45.75

46.50

47.25

48.00

48.75

-0.50

-1 .00

49.50

BULL SPREAD
PURPOSE: MARKET : REDUCE PREMIUM SPOT: 46.20, CALL PREMIUM 40 PAISE STRATEGY: BUY USD CALL AT STRIKE 46.20, SELL USD CALL AT STRIKE 46.80; PREMIUM 10 PAISE
1.5

0.5

0 45.90 46.20 46.50 46.80 45.00 45.30 45.60 47.10 47.40 47.70

-0.5

-1 USD Call/INR Put USD Call/INR Put Net Payoff

RANGE FORWARD
EXPECTATION: EXPLOIT RANGE BOUND MARKET MARKET: SPOT: 46.83; FORWARD = 47.20 STRATEGY: BUY USD CALL AT STRIKE 47.60, SELL USD PUT AT STRIKE 46.80. ZERO COST RANGE FORWARD=FORWARD+ITM PUT-OTM CALL
2 1.5 1 0.5

47.60

46.80

47.20

46.00

45.60

46.40

48.00

0 -0.5 -1 -1.5 -2 Exposure

48.40

48.80

Option Payoff

Net payoff

49.20

RANGE PLAY / STRANGLE

EXPECTATION: EXPLOIT RANGE BOUND MARKET MARKET: SPOT - 46.24, FORWARD - 46.40 STRATEGY: SELL USD PUT AT STRIKE 46.20 SELL USD CALL AT STRIKE 46.50
1

0.5

45.00

45.30

45.60

45.90

46.20

46.50

46.80

47.10

47.40

-0.5

-1

-1.5 USD Call/INR Put USD Put/INR Call

47.70

STRADDLE
SITUATION :MOVEMENT CERTAIN, BUT DIRECTION -?? MARKET : SPOT: 46.24, FORWARD - 46.40 STRATEGY: BUY USD PUT AT STRIKE 46.20 BUY USD CALL AT STRIKE 46.20
1.5

0.5

45.00

45.30

45.60

45.90

46.20

46.50

46.80

47.10

47.40

-0.5

-1 USD Call/INR Put USD Put/INR Call

47.70

BUTTERFLY SPREAD
SITUATION: LOSS MINIMUM, PROFIT LIMITED STRATEGY: BUY USD CALL AT STRIKE 46.20 BUY USD CALL AT STRIKE 46.80 SELL 2 USD CALL AT STRIKE 46.50
1.5 1 0.5 0

45.00

45.30

45.60

45.90

46.20

46.50

46.80

47.10

47.40

-0.5 -1

Net payoff

47.70

EXOTIC OPTIONS
STRATEGIES PRICING OPTIONS BASICS

WHAT IS AN EXOTIC OPTION

AN OPTION WITH MODIFIED TERMS/ CONDITIONS/CHARACTERISTICS - INTRODUCES MUTUALLY AGREED WHIMSICAL CONDITIONS CLASSIFICATION
PATH DEPENDENT - SHOUT/LADDER
TIME DEPENDENT - CLIQUET LIMIT DEPENDENT - BARRIER

MULTI-FACTOR - QUANTO
PAYOFF-MODIFIED - DIGITAL

SHOUT OPTION
OPTION TO RESET STRIKE PRICE AT ANY TIME WITH PROFIT AT THAT POINT LOCKED IN.

PROFIT LOCKED-IN

0
STRIKE 110

120

SHOUT AT 115

LADDER OPTION
OPTION WHERE PROFIT IS AUTOMATICALLY LOCKED AS SPOT PRICE CROSSES PRE-AGREED LEVELS. NO NEED TO SHOUT.

0
STRIKE 110 AUTO LOCK-IN POINTS

CLIQUET OPTION
A CLIQUET OPTION IS SETTLED AT SPECIFIED INTERVALS AND STRIKE IS RESET AT THE THEN SPOT LEVEL PURCHASED WHEN VOLATILITY IS EXPECTED TO INCREASE IN LATER PERIOD.

BARRIER OPTIONS
BARRIER OPTIONS GET ACTIVATED OR DEACTIVATED WHEN SPOT RATE CROSSES AN AGREED LEVEL. ONCE ACTIVATED, THEY BEHAVE LIKE PLAIN VANILLA OPTIONS.

QUANTOS OPTIONS
A CROSS-CURRENCY DERIVATIVE IN WHICH THE UNDERLYING ASSET IS DENOMINATED IN A CURRENCY OTHER THAN THE CURRENCY IN WHICH THE OPTION IS SETTLED. QUANTOS ARE SETTLED AT A FIXED RATE OF EXCHANGE, PROVIDING INVESTORS WITH SHELTER FROM EXCHANGE-RATE RISK

DIGITAL / BINARY OPTIONS

FIXED PROFIT AFTER SPOT PRICE CROSSES STRIKE PRICE IRRESPECTIVE LEVEL OF SPOT PRICE.
PROFIT 4 to 1 SPOT 108 PAYOFF (JPY 4)

PREMIUM (JPY 1) STRIKE 110

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