Derivatives Session 5

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

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

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.

Examples of Derivatives
Forward Contracts Futures Contracts Swaps Options

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

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

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.

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.

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.

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.

Currency Forwards
Example S = $1.681/, 90-day F = $1.677/
S n

annualized p = F S 360

= 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.

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.

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.

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

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.

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-thecounter market. Brokers who fulfill orders to buy or sell futures contracts typically charge a commission.

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

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)

Comparison of the Forward & Futures Markets

Contract size Delivery date Participants Forward Markets Customized Customized Banks, brokers, MNCs. Public speculation not encouraged. Compensating bank balances or credit lines needed. Handled by individual banks & brokers. Futures Markets Standardized Standardized Banks, brokers, MNCs. Qualified public speculation encouraged. Small security deposit required.

Security deposit

Clearing operation

Handled by exchange clearinghouse. Daily settlements to market prices.

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)

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.

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 price the strike Forwards are fixed price contracts wherein the buyer/seller is obligated to the price Opportunity loss No upfront premium Cannot choose the price

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

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.

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.

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.

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.

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 more than 43.70, then the company can let the option lapse and instead fix the spot rate for the transaction on 29th May.

Risk / Profit Profile

Buyer Profit Unlimited Seller Premium

Risk

Premium

Unlimited

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.

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.

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.

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.

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

Factors determining Premium value

Volatility Strike Price

Life or Exercise Period

Interest Rates - domestic & foreign Current Market Rate

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.

Change in premium with change in volatility

0.025

0.02

0.015

0.01 X axis - Volatility in % Y axis - Option Premium 0.005

0 1 2 3 4 5 6 7 8 9 10

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 cant 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.

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
6 month Dollar Put Strike Price 43.90 43.80 43.70 43.60 43.50 Premium 0.450 0.400 0.354 0.311 0.273 Fall in Premium 0.050 0.046 0.043 0.038 Protection Sacrificed 0.10 0.10 0.10 0.10

It is seen that the reduction in premium is less than the protection sacrificed.

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)

Comparison between Strike Price & WCR Pay off Profile

43.7000
Strike 43.70

43.6000

Strike 43.86

43.5000

X axis - Spot at maturity Y axis - Effective rate

43.4000

43.3000
Strike 43.70 --> premium 0. 35 --> WCR 43.35 --> If bearish on Rupee.

43.2000
Strike 43.70 Strike 43.86

Strike 43.86 --> premium 0.41--> WCR 43.45 --> If bullish on Rupee.

43.54 43.35 43.45

43.70 43.35 43.45

43.86 43.51 43.45

44.02 43.67 43.61

Option Strategies

Long USD Call Option

Profit
Profit Unlimited
Strike Price

43.90
Loss Area

Price of underlying (USD/INR)

Break-even price 43.90+0.45 = 44.35

Cost of Premium

Loss

Short USD Call Option

Profit

Premium Income or Profit

Break-even price 43.90+0.45

= 44.35
Price of underlying USD/INR

43.90
Strike Price

Loss Unlimited

Loss

Long USD Put Option

Profit unlimited
43.90 - 0.45 = 43.45 Break-even price

Price of underlying USD/INR

Strike Price

43.90

Cost of Premium

Loss

Short USD Put Option

Profit
43.90 - 0.45 = 43.45 Break-even price

Premium Income or Profit

Loss Unlimited

Price of underlying

Strike Price

43.90

Loss

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 instrument forward contract. developments in the

Corporate was allowed to cancel & rebook forward contracts.

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.

Rupee options why now?

RBIs 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

Issues in pricing
Different banks will use different pricing models, although FEDAI is already polling banks for implied volatility, which will be available on their web-site

Spread between theoretical price and quoted price can be quite high

Need to shop around

Your Portfolio
USD/INR Spot 43.50

6 month fwd rate 43.86

You are an importer

Worst Case Rate (WCR) 44.40

6 month USD/INR volatility 3% / 3.5%

Diff based on Risk free rate 1.65%

Low Cost Option Strategies

An option buyer can reduce his premium cost by selling another option. The combination can reduce the cost as the premium received on the option sold could either partially or fully offset the cost of option bought.

Different Strategies:
1. Range Forward 2. Participating Forward

3. Seagull
4. Leveraged forward

Zero Cost Range Forward (RF)

Range Forward - involves buying an out of the money call/put option with the worst case rate as the strike price and selling an out of the money put/call option with such a strike price (best case rate) that the net premium is zero If price at maturity is beyond the wcr the bought option will be exercised If the price at maturity is beyond bcr the sold option will be exercised If price at maturity is between the wcr & bcr you buy or sell at spot Although entry is painless, exit could be painful

Range Forward
44.60 44.40

Net effective Rate

44.20 44.00 43.80 43.60 43.40 43.20

Buy USD Call at 44.40, Sell USD Put at 43.50

43.00
43 .0 0 43 .1 0 43 .2 0 43 .3 0 43 .4 0 43 .5 0 43 .6 0 43 .7 0 43 .8 0 43 .9 0 44 .0 0 44 .1 0 44 .2 0 44 .3 0 44 .4 0 44 .5 0 44 .6 0 44 .7 0 44 .8 0

spot at maturity

Participating Forward (PF)

Participating forward - involves buying an out of the money call/ put option with the worst case rate as the strike price and selling an in the money put/call option for a reduced amount and with the same strike price so that the net premium is zero In effect there is a synthetic OTM forward contract for the amount of the ITM option sold and a free OTM option for the balance amount

Participating Forward
44.60 44.40 44.20

Net Effective rate

44.00 43.80 43.60 43.40 43.20 43.00 42.80 42.60

Buy USD Call at 44.40, Sell USD Put at 44.40 for 31% of Call amount

42 .7 0

42 .9 0

43 .1 0

43 .3 0

43 .5 0

43 .7 0

43 .9 0

44 .1 0

44 .3 0

44 .5 0

Spot at Maturity

44 .7 0

Seagull (S)
Involves buying an out of the money call/put option (A) and selling an out of the money put/call option (B) & also selling a far-of-the-money call/put option (C ) so that the net premium of the whole portfolio is zero If price at maturity is between the strikes of (A) and (C), only (A) will be exercised If the price at maturity is beyond the strike of (B), only (B) will be exercised If the price at maturity is beyond the strike of (C), both (A) and (C) will be exercised. If price at maturity is between the strikes of (A) & (B) you buy or sell at spot This a a variant of the range forward as a far-out-of-the-money call/put is sold with the range forward to improve the best case rate or the strike of (B).

Seagull
45

44.5

Net Effective rate

44

43.5

43
Buy USD Call at 44.40, Sell USD Put at 43.25, Sell USD Call at 44.80

42.5
.7 0 .9 0 .1 0 .3 0 .5 0 .7 0 .9 0 .1 0 .3 0 .5 0 .7 0 .9 0 44 42 42 43 43 43 43 43 44 44 44 44 45 .1 0

Spot at Maturity

Leveraged Forward (PF)

Leveraged forward - involves buying an in the money call/ put option and selling an out of the money put/call option for an increased amount and with the same strike price so that the net premium is zero

In effect there is a synthetic in the money forward contract for the full amt with a leveraged loss beyond the synthetic ITM forward rate (strike price).

Leveraged Forward
44.40 44.20
Net Effective Rate

44.00 43.80 43.60 43.40

Buy USD Call at 43.65, Sell USD Put at 43.65 for 200% of Call amount

43.20
43 .0 0 43 .1 0 43 .2 0 43 .3 0 43 .4 0 43 .5 0 43 .6 0 43 .7 0 43 .8 0 43 .9 0 44 .0 0 44 .1 0 44 .2 0 44 .3 0 44 .4 0 44 .5 0

Spot at Maturity

Rupee Options Product specifications

Vanilla European options & combinations thereof at introduction. This will continue till banks have sophisticated systems & risk management frameworks to hedge this new non-linear product. Over the counter contracts.

Can be tailored to suit the corporates need.

FC-INR where foreign currency may be the ccy desired by the corporate.

No minimum amt recommended by RBI.

Premium payable on spot basis.

Rupee Options Product specifications..

Settlement would be either by delivery on spot basis or net cash settlement in Rupees on Spot basis, depending on the FC-INR spot rate on maturity date. (specs will be specified in the contract) RBI reference rate could be the reference rate for settlement. Strike Price & Maturity could be tailored to suit counterparties needs typical maturities are 1 week, 2weeks, 1, 2, 3, 6, 9 & 12 months. Exercise style: European.

Uses of Rupee options

To hedge genuine FX exposures arising out of trade/business (Banks may book transactions based on estimated exposure for uncertain amounts) To hedge FC loans. To hedge GDR after the issue price is finalised. Balance in EEFC accounts. Special cases & contingent exposures. Derived FX exposure viz FX exposure generated due to a asset/liability coupon &/or P+I swap.

One hedge for one exposure

Only one hedge may be booked against a particular exposure for a given time period. For eg Exporter with USD receivables after 6 months, can sell a forward for 3 month & after 3 month square the forward & book an option for another 3 months. But the exporter cannot book a forward & an option for the same exposure at the same time.

Hedging Rupee Options

Authorized dealers to be allowed to hedge options by accessing the spot market.
Extent & frequency to be decided by dealers.

ADs to be allowed to hedge Greeks using options.

Clients as net receivers of premium

Earlier clients could not receive net premium. Now large corporates with aggressive treasury operations have been allowed to receive net premium as the market matures. They can buy as well sell option contracts.

Barrier options
These are two types of barriers in options: - Knock in barrier - Knock out barrier These can be single barrier or double barrier options Barriers are American in nature Main advantage is smaller upfront premium compared to Plain Vanilla option with same strike price

Barrier Options
A barrier option, also known as knock out option, is a type of financial option where the option to exercise depends on the underlying crossing or reaching a given barrier level. Barrier options were created to provide the insurance value of an option without charging as much premium. For example, if you believe that US Dollar will go up this year, but are willing to bet that it won't go above Rs45, then you can buy the barrier and pay less premium than the vanilla option.

Barrier Options
Barrier options are path-dependent exotics that are similar in some ways to ordinary options. There are put and call, as well as European and American varieties. But they become activated or, on the contrary, null and void only if the underlying reaches a predetermined level (barrier).

In and Out
"In" options start their lives worthless and only become active in the event a predetermined knockin barrier price is breached. "Out" options start their lives active and become null and void in the event a certain knock-out barrier price is breached. In either case, if the option expires inactive, then there may be a cash rebate paid out. This could be nothing, in which case the option ends up worthless, or it could be some fraction of the premium.

Four main types of barrier options

Up-and-out: spot price starts below the barrier level and has to move up for the option to be knocked out. Down-and-out: spot price starts above the barrier level and has to move down for the option to become null and void. Up-and-in: spot price starts below the barrier level and has to move up for the option to become activated. Down-and-in: spot price starts above the barrier level and has to move down for the option to become activated.

Barrier Options (Example)

A European call option may be written on an underlying with spot price of $100, and a knockout barrier of $120. This option behaves in every way like a vanilla European call, except if the spot price ever moves above $120, the option "knocks out" and the contract is null and void. Note that the option does not reactivate if the spot price falls below $120 again. Once it is out, it's out for good.

Knock out barrier options

Knock out options get knocked out (dead or cease to exist) only when the spot rate hits the specified barrier or either of the two barriers. There are two kinds of knock out barriers in India: - Up and out knock out

- Down and out knock out

Knock in barrier options

Knock in options get knocked in (come alive) only when the spot rate hits the specified barrier or either of the two barriers. There are two kinds of knock in barriers: - Up and in knock in - Down and in knock in

Knock out + Knock in options with same strike & barriers equals plain vanilla option.

Euro import portfolio

You have Euro imports EUR/USD Spot 1.2870 Worst case rate 1.31 Time 6 months 6M Forward rate 1.2920 Volatility 9.5% / 10% 6M USD Libor 2.99% 6M Euro Libor 2.19%

Smart Forward (SF)

Zero cost exotic hedge

Plain out of the money option as long as a specified in the money trigger is not hit
Option gets transformed into a out of the money synthetic forward contract if the trigger is hit If the market view turns out to be wrong, there can be an opportunity loss, and

The SMART BACKWARD

FORWARD

becomes

DUMB

Smart Forward
1.32 1.3
Net Effective Rate

1.28 1.26 1.24 1.22 1.2

Buy Euro Call at 1.31, Sell Euro Put at 1.31 with KI at 1.1925

1.18 1.16 1.14

1. 2 1. 21 1. 22 1. 23 1. 24 1. 25 1. 26 1. 27 1. 28 1. 29 1. 3 1. 31 1. 32 1. 33 1. 34 1. 35 1. 36 1. 36 1. 36

Spot at Maturity

Choice Forward (CF)

Zero cost exotic hedge

Involves buying an in-the-money option with two knock out barriers.

Also simultaneously buying an out-of-money option with the same two knock in barriers (A) Also selling in-the-money option with same two knock in barriers (B)

(A) & (B) put together constitute an out-of-money, double knock-in, synthetic, forward contract

Choice Forward
1.28 1.27 1.26 1.25 1.24 1.23 1.22 1.21 1.2 1.19 1.18
1. 15 1. 17

Net Effective Rate

Buy Euro Call at 1.27 with KO at 1.38 & 1.20, Sell Euro Put at 1.31 with KI at 1.38 & 1.20, Buy Euro Call at 1.31 with KI at 1.38 and 1.20
1. 19 1. 21 1. 23 1. 25 1. 27 1. 29 1. 31 1. 33 1. 35 1. 37 1. 39 1. 41

Spot at Maturity