Foreign Exchange Preliminaries Currency Forwards Non Deliverable Forward (NDF) Currency Futures
Globalization
Globalization of business has made financial decisions complex as the framework for decision making is not confined to single/domestic currency, and instead involves
wider understanding of global markets, economic conditions, and Understand behaviour of exchange rates.
The difference between ask and bid rate is the profit for the bank, called spread. It is the amount of money that bank would earn in buying one unit of foreign currency and selling it.
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Forward Rate
Forward contracts in foreign exchange, like any other forward contract, fix the exchange rate today for settlement at some future date. Foreign currency at premium/discount means that forward rate is higher/lower than the spot rate (when quoted under direct rate convention).
Annualised Forward Premium/Di scount(%) = Forward Rate mid - Spot Rate mid 12 x x100 Spot Rate mid Forward Period (in months)
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Forward Premium/Discount
Forward Contract
Forward contracts are settled at a later date but at the rates negotiated in advance. These rates are usually available in advance for whole number of months. Forward contract provide hedge against foreign exchange risk which importers and exporters face alike. Importers fear depreciation of local currency while exporters detest appreciation of local currency.
Swap Transaction
A swap transaction consists of two legs, usually one spot and another forward. The contracts are equal in size but opposite to one another i.e.
A spot buy followed by forward sell, or A spot sell followed by forward buy.
It is a composite transaction that is equivalent to two independent contracts - one spot and another forward on outright basis.
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Swap Transaction
A swap transaction is cheaper than the equivalent combination of spot and outright forward contracts. Banks usually enter a swap transaction amongst themselves while with its customers the banks enter forward contract on outright basis.
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Option Forwards
Option forward contracts provide a time window called option period (a range of dates) during which the commitments under forward contracts can be fulfilled. Option forwards are expensive but provide flexibility to merchants because they do not know exact timing but have only approximate idea of timing of receipt/payment of foreign currency.
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Hedging Receivable
Exporters can sell foreign currency forward at a price determined today eliminating risk of fall in the value of the asset due to decline in exchange rate.
Asset in foreign currency is created at t = 0 maturing at time t = T 2. Compare the expected spot rate at T, ST with the forward rate, F 3. If ST < F, sell forward 4. At t = T deliver foreign currency and receive local currency at fixed rate, F
1.
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Hedging Payable
Importer can book a forward contract to buy the foreign currency at a price determined today eliminating risk of rise in the value of the liability due to increase in exchange rate.
1. Liability in foreign currency is created at t = 0
maturing at time t = T 2. Compare the expected spot rate at T, ST with the forward rate, F 3. If ST > F sell forward 4. At t = T deliver local currency and receive foreign currency at fixed rate, F
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Forward contract is firm price contract providing the protection from downside in return for foregoing potential for upside.
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Ultra Films Limited has imported raw materials worth US $ 2 million for which the payment is due after 3 months. Following rates are quoted by the bank: Spot (Rs/US $) 47.00 47.45 3-m Forward 47.50 48.00 The firm is expecting appreciation of US dollar by more than 5% in 3 months time.
1. 2. 3.
Should it hedge its payable? What rate would be paid by it if it decides to hedge? What would be the gain or loss if the actual spot rates after 3 months turn out to be i) Rs 46.50 47.00 ii) Rs 49.30 49.85?
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2. 3.
The forward rates indicate an appreciation of dollar of 1% in 3 months time while the firm expects 5%. It should go hedge to save about 4% by buying US dollar forward. Firm buys $ 2 million at forward ask rate of Rs 48.00. If the spot rates at the end of 3 months were 46.50 47.00 the firm would fulfil its requirement at Rs 47.00. As compared to forward the firm loses Rs 2 m (Rs 20 lacs). If the spot rates at the end of 3 months were 49.30 49.85 the firm would fulfil its requirement at Rs 49.85. As compared to forward the firm gains Rs 1.85 x 2 million = Rs 3.70 million (Rs 37 lacs).
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Forward contracts can be used for speculation in the currency exchange rate markets by holding a view contrary to the market and taking a position. Unlike hedging, where one has exposure in the underlying, there exists no physical position. Speculation is executed as below
If currency is expected to appreciate more than the
forward premium buy forward now and sell later/spot. If currency is expected to appreciate less than the forward premium sell forward now and buy later/spot.
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Different currency exchange rates by different banks for a currency also may provide arbitrage opportunities. It is difficult to execute the arbitrage with forwards because forward rates are not publicly available, forwards being an OTC product. Also arbitrage is not possible because of the spread of the bid and ask rates. However, arbitrage argument places limits on the forward bid and ask rates.
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Borrow foreign currency 1.00 at 5.50% for 6 months Amount to repay = 1.0275 Convert to rupees at spot bid and get Rs 60.00 Invest for 6 months at 8% and get Rs 1.04 x 60 = Rs 62.40 at maturity Sell at forward ask rate Fa to get 62.40/Fa For no arbitrage we must have 62.40/Fa 1.0275 Or Fa Rs 60.7299
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Borrow local currency Rs 1.00 at 8.50% for 6 months Amount to repay = Rs 1.0425 Convert to euro at spot ask, get 1/61.00 = 0.0164 Invest for 6 months at 5% and get 1.025 x 1/61 = 0.0168 at maturity Sell at forward bid rate Fb to get = Fb x 0.0168 For no arbitrage we must have Fb x 0.0168 1.0425 Or Fb Rs 62.0415
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Evolution & Growth Features of NDFs How NDF works NDF and Interest Rate Parity Desirability of NDF
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Non-Deliverable Forward
Governments of some nations exercise capital controls in order to prevent volatility in the exchange rates of their currencies or for any other political or economic reason. Non-Deliverable Forwards (NDFs) are forward contracts normally entered off-shore and cash settled for currencies that have capital control.
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Evolution of NDF
NDFs evolved in 70s when Australian dollar was subjected to capital restrictions. NDFs began trading obviating the requirement of delivery and yet providing effective hedging. NDF market primarily consist of 6 Asian currencies namely Chinese renminbi, Indian rupee, Korean won, Indonesian rupiah, Philippine peso and Taiwanese dollar, all of which have capital controls in varying degree.
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Features of NDF
NDFs provide much needed liquidity and depth to non convertible currencies NDF rates are considered better because they are market determined away from controls and regulations. Most NDFs are cash settled in US dollars on a notional principal amount.
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Interest rate parity (IRP) links the forward price to the spot as follows: (1+ rh )n
Fn = S 0 (1+ rf )n
Capital account controls restrict lending and borrowing off-shore distorting the IRP. Therefore forward premium/discount in local market may not reflect truly the interest rate differential. The rate of NDF would imply an interest rate differential that is not same as the differential reflected in the deliverable forward markets on-shore. Since NDF is not subject to capital controls the validity of IRP tends to be greater.
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Desirability of NDF
from controlled regime to full convertibility, as they serve as intermediate bridge for the interim period 2. provide skills and expertise developed in the NDF markets to be adapted in the deliverable forward market as and when capital controls are lifted or full convertibility of the currency achieved.
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Contract Specifications Pricing Hedging with Currency Futures Speculation with Currency Futures Arbitrage with Currency Futures
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Futures Contract
Currency futures are the derivatives based on the exchange rate that are exchange traded and are a substitute to forward contracts. Futures on currencies like any other futures contracts, are standardized in terms of
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Today is December 12 and January futures would expire on 28 Jan. Spot rate in the exchange market for dollar is Rs 45.45. The yields in the T-bills markets of India and USA are 5.90% and 2.45% respectively. 1. At what price Jan futures would be traded? 2. What would be the price of Feb futures if its expiry is on 24 Feb.?
Here S0 = 45.45, rd = 5.90%, rf = 2.45% and t = 57 days (From 12 Dec to 28 Jan). The fair value of futures is Rs 45.6991 given by F1 = S0 x e(r -r )t = 45.45 x e(0.059-0.024)57/365 For Feb futures the time to expiry is 57 + 27 = 84 days. The price of Feb futures = Rs 45.8176
d f
F = S0 x e 1
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(rd - rf )t
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Importers Hedge
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In June 2008 an Indian importer buys a machine at US $ 50,000. Payment is due after 6 months in December 2008. The spot exchange rate is Rs 45.5625 while Dec. Futures is trading at Rs 46.6500 indicating an appreciation of dollar by 2.4% in 6 months. The importer feels that dollar will appreciate much more. What shall he do? Assume futures contract in rupee is available for US $ 1,000.
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Having bought 50 futures the importer would cancel the position in the futures by selling the futures at a date close to the actual date of payment in December.
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When US $ appreciates to Rs 47.5600 and futures sells for Rs 47.5700 The importer exits the futures contract at Rs 47.5700 and buys the foreign currency in the spot market at spot rate.
1. 2. 3. 4. 5.
Cost = 50,000 x 47.5600 = Rs 23,78,000 Sells 50 future contracts booked earlier at Rs 47.5700; Net gain on futures (47.5700 46.6500) x 50,000 = Rs 46,000 Net rupee amount paid = Rs 23,32,000 Effective exchange rate (23,32,000/50,000) = Rs 46.6400
As against spot price of Rs 47.5600 the importer ends up buying dollar at Rs 46.6400.
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When US $ depreciates to Rs 44.5625 and futures sells for Rs 44.5700 The importer exits the futures contract at Rs 44.5700 and buys the foreign currency in the spot market at spot rate.
1. 2. 3. 4. 5.
Cost = 50,000 x 44.5625 = Rs 22,28,125 Sells 50 future contracts booked earlier at Rs 47.5700; Net loss on futures (46.6500 - 47.5700) x 50,000 = Rs 1,04,000 Net rupee amount paid = Rs 23,32,125 Effective exchange rate (23,32,125/50,000) = Rs 46.6425
As against spot price of Rs 44.5625 the importer ends up buying dollar at Rs 46.6425.
Derivatives and Risk Management Copyright Oxford University Press Chapter 5 By Rajiv Srivastava Currency Forwards and Futures
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Exporters Hedge
he goes short on the futures contract. 3. It is called the Short Hedge. 4. At maturity the short position in futures is nullified by buying the futures contract. Short hedge for exporter can be executed in the similar manner as that of Long Hedge for importer.
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We may speculate with currency futures if investor does not agree with the premium or the discount at which the futures trades. We buy futures first and sell later
If foreign currency is expected to a) appreciate
more than the premium, or b) depreciate less than the discount at which futures trades.
less than the premium, or b) depreciate more than the discount at which futures trades.
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At maturity of futures 1. Deliver local currency against the futures sold 2. Receive foreign currency against the futures bought 3. Pay for the borrowed foreign currency
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Example - Arbitrage
The fair price of 6-m futures is Rs 50.6912. Is there any arbitrage opportunity? If yes how the arbitrage can be executed?
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Example - Arbitrage
Actual future trading at Rs 50.40 as against its fair price of Rs 50.69, is underpriced.
Now $ Rs Borrow US dollar 1,000.00 Convert to rupee in spot -1,000.00 49,500.00 Invest rupee at 10% for 6 m - 49,500.00 Buy dollar futures maturing after 180 days for Rs 51,941 Cash flow Now 0.00 0.00 At maturity Receive invested rupee 51,941.00 Deliver rupee against futures -51,941.00 Receive dollars against futures (51,941/50.40) 1,030.58 Pay dollar borrowed at 5% -1,024.66 Cash flow 5.92 At the maturity of the futures contract the arbitrageur can make a profit of $ 5.92 for every $ 1,000 borrowed.
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