FOREIGN EXCHANGE DERIVATIVES

Definition Any financial instrument that locks in a future foreign exchange rate. These can be used by currency or forex traders, as well as large multinational corporations. The latter often uses these products when they expect to receive large amounts of money in the future but want to hedge their exposure to currency exchange risk. Financial instruments that fall into this category include: currency options contracts, currency swaps, forward contracts and futures contracts. In international finance, derivative instruments imply contracts based on which you can purchase or sell currency at a future date. The three major types of foreign exchange (FX) derivatives: forward contracts, futures contracts, and options. They have important differences, which changes their attractiveness to a specific FX market participant. FX derivatives are contracts to buy or sell foreign currencies at a future date. The table summarizes the relevant characteristics of three types of FX derivatives: forward contracts, futures contracts, and options. Because the types of FX derivatives closely correspond to the identity of the FX market participant, the table is based on the derivative type-market participant relationship. An Overview of the Relevant FX Derivatives Forward Contracts Standardized regarding amount of currency the No Future Contracts Yes Options

Yes

Obligation to engage in the transaction on the specified day Traded

Yes

Yes

No, but premium must be paid CME GLOBEX ISE OTC Yes Yes Group

No

CME Group GLOBEX OTC

Useful for MNCs Useful for speculators

Yes No

Yes Yes

Definition of 'Forex Hedge': A transaction implemented by a forex trader to protect an existing or anticipated position from an unwanted move in exchange rates. By using a forex hedge properly, a trader who is long a foreign currency pair can be protected from downside risk, while the trader who is short a foreign currency pair can protect against upside risk. Investopedia explains 'Forex Hedge': The primary methods of hedging currency trades for the retail forex trader is through spot contracts and foreign currency options. Spot contracts are the run-of-the-mill trades made by retail forex traders. Because spot contracts have a very short-term delivery date (two days), they are not the most effective currency hedging vehicle. In fact, regular spot contracts are usually the reason why a hedge is needed.

Foreign currency options are one of the most popular methods of currency hedging. As with options on other types of securities, foreign currency options give the purchaser the right, but not the obligation, to buy or sell the currency pair at a particular exchange rate at some time in the future. Regular options strategies can be employed, such as long straddles, long strangles, and bull or bear spreads, to limit the loss potential of a given trade.

DEFINITION OF 'CURRENCY OPTION':

A contract that grants the holder the right, but not the obligation, to buy or sell currency at a specified exchange rate during a specified period of time. For this right, a premium is paid to the broker, which will vary depending on the number of contracts purchased. Currency options are one of the best ways for corporations or individuals to hedge against adverse movements in exchange rates. An option contract in which the underlying asset is a foreign currency. The option gives the holder the right but not the obligation to buy(for a call) or sell (for a put) a set amount of the currency at a certain exchange rate on or before the expiration date. They are largely used when international corporations wish to hedge against the possibility of adverse movements in foreign exchange rates. Investopedia explains 'Currency Option' Investors can hedge against foreign currency risk by purchasing a currency option put or call. For example, assume that an investor believes that the USD/EUR rate is going to increase from 0.80 to 0.90 (meaning that it will become more expensive for a European investor to buy U.S dollars). In this case, the investor would want to buy a call option on USD/EUR so that he or she could stand to gain from an increase in the exchange rate (or the USD rise).

FOREIGN CURRENCY OPTIONS

A Foreign Currency Option enables you to protect your business from adverse exchange rate fluctuations whilst allowing you to take advantage of any favourable movements. The value of a Foreign Currency Option is in having the right, but not the obligation, to exchange currency on a fixed date. What is a Foreign Currency Option? Foreign Currency Options offer a wide range of methods for limiting the risks associated with foreign exchange exposure. Option holders can obtain 'Insurance' against adverse movements in exchange rates while maintaining the ability to profit should the exchange rate move favourably. Definition: A Foreign Currency Option grants a customer the right, but not the obligation, to buy or sell foreign currency at a specified price within a specified period of time (American Option) or on a fixed date (European Option). The most common Foreign Currency Option is the European style. The agreed price at which the exchange of currencies may occur is called the exercise or strike price. The date on which the option expires is called the expiry date. The buyer of the option pays a premium. Upon payment of the premium the option buyer has no further obligation in the contract, but has the right to exchange currencies at the agreed Strike Price. Foreign Currency Options within Australia would normally involve conversion from or to Australian Dollars. As such, the Australian Dollar is the underlying currency. If you are an importer, you would have a need to SELL Australian Dollars (purchase a PUT option). If you are an exporter, you would have a need to BUY Australian Dollars (purchase a CALL option). Upon expiry of the option, if the strike price is 'Out of the Money' (ie it is more favourable to convert at the prevailing market exchange rate) you would allow your option to lapse. Consequently, the maximum cost of the option is the premium paid and the associated funding cost for this premium. The conversion at the more favourable exchange rate on the expiry date effectively reduces the 'cost' of the option. If the option is 'In the Money' it is likely you will exercise your right to exchange currencies under the option. Unlike a Forward Exchange Contract, where each party is always obliged to execute, an option contract enables you to take advantage of favourable exchange rate movements, by

enabling you to buy/sell the currency at the prevailing rate of exchange rather than the strike price of the option. Currency Options Option is a right but not liability to acquire or sell foreign currency in the future at an exchange rate fixed in advance. Advantages of options:

This service is favourable for the option purchaser as it entitles to the unlimited gain and the maximum possible loss would be the premium-size amount; Hedging against possible changes in the rate and related loss; Transaction is enforceable only at the purchaser's request; No forward limit is required for the option.

During the time of option the purchaser pays a commission fee (premium) to the option seller and acquires the right to purchase or sell currency. Option seller has to execute the transaction if it is required so by the purchaser. During the time of option the option purchaser himself chooses the price for the execution of the option based on which the option premium is determined. Option types:

Call option - right to purchase currency. Call option is enforceable if market rate is higher than the option rate. In that case the holder of call option shall be able to purchase currency at a lower than market price. In case the rate is not acceptable and the holder of call option can buy cheaper on the market the option shall not be used; Put option - right to sell currency. Put option is enforceable if the market rate is lower than the option rate. In that case the holder of put option shall be able to sell currency at a higher than market price. In case the rate is unacceptable and the holder of put option can sell at a higher price in the market the option shall not be used.

CURRENCY FORWARD
Definition of 'Currency Forward' A binding contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of a currency on a future date. A currency forward is essentially a hedging tool that does not involve any upfront payment. The other major benefit of a currency forward is that it can be tailored to a particular amount and delivery period, unlike standardized currency futures. Currency forward settlement can either be on a cash or a delivery basis, provided that the option is mutually acceptable and has been specified beforehand in the contract. Currency forwards are over-the-counter (OTC) instruments, as they do not trade on a centralized exchange. Also known as an outright forward. Investopedia explains 'Currency Forward': Unlike other hedging mechanisms such as currency futures and options contracts which require an upfront payment for margin requirements and premium payments, respectively currency forwards typically do not require an upfront payment when used by large corporations and banks. However, a currency forward has little flexibility and represents a binding obligation, which means that the contract buyer or seller cannot walk away if the locked in rate eventually proves to be adverse. Therefore, to compensate for the risk of non-delivery or non-settlement, financial institutions that deal in currency forwards may require a deposit from retail investors or smaller firms with whom they do not have a business relationship. The mechanism for determining a currency forward rate is straightforward, and depends on interest rate differentials for the currency pair (assuming both currencies are freely traded on the forex market). For example, assume a current spot rate for the Canadian dollar of US$1 = C$1.0500, a one-year interest rate for Canadian dollars of 3%, and one-year interest rate for US dollars of 1.5%. After one year, based on interest rate parity, US$1 plus interest at 1.5% would be equivalent to C$1.0500 plus interest at 3%. Or, So US$1 (1 + = 0.015) = C$1.0500 or x US$1 (1 = + 0.03). C$1.0655.

US$1.0115

C$1.0815,

The one-year forward rate in this instance is thus US$ = C$1.0655. Note that because the Canadian dollar has a higher interest rate than the US dollar, it trades at a forward discount to the greenback. As well, the actual spot rate of the Canadian dollar one year from now has no

correlation on the one-year forward rate at present. The currency forward rate is merely based on interest rate differentials, and does not incorporate investors expectations of where the actual exchange rate may be in the future. How does a currency forward work as a hedging mechanism? Assume a Canadian export company is selling US$1 million worth of goods to a U.S. company and expects to receive the export proceeds a year from now. The exporter is concerned that the Canadian dollar may have strengthened from its current rate (of 1.0500) a year from now, which means that it would receive fewer Canadian dollars per US dollar. The Canadian exporter therefore enters into a forward contract to sell $1 million a year from now at the forward rate of US$1 = C$1.0655. If a year from now, the spot rate is US$1 = C$1.0300 which means that the C$ has appreciated as the exporter had anticipated by locking in the forward rate, the exporter has benefited to the tune of C$35,500 (by selling the US$1 million at C$1.0655, rather than at the spot rate of C$1.0300). On the other hand, if the spot rate a year from now is C$1.0800 (i.e. the C$ weakened contrary to the exporters expectations), the exporter has a notional loss of C$14,500.

Currency Forward Contracts Foreign currency forward contracts are used as a foreign currency hedge when an investor has an obligation to either make or take a foreign currency payment at some point in the future. If the date of the foreign currency payment and the last trading date of the foreign currency forwards contract are matched up, the investor has in effect "locked in" the exchange rate payment amount. By locking into a forward contract to sell a currency, the seller sets a future exchange rate with no upfront cost. For example, a U.S. exporter signs a contract today to sell hardware to a French importer. The terms of the contract require the importer to pay euros in six months' time. The exporter now has a known euro receivable. Over the next six months, the dollar value of the euro receivable will rise or fall depending on fluctuations in the exchange rate. To mitigate his uncertainty about the direction of the exchange rate, the exporter may elect to lock in the rate at which he will sell the euros and buy dollars in six months. To accomplish this, he hedges the euro receivable by locking in a forward. This arrangement leaves the exporter fully protected should the currency depreciate below the contract level. However, he gives up all benefits if the currency appreciates. In fact, the seller of a forward rate faces unlimited costs should the currency appreciate. This is a major drawback for many companies that consider this to be the true cost of a forward contract

hedge. For companies that consider this to be only an opportunity cost, this aspect of a forward is an acceptable "cost". For this reason, forwards are one of the least forgiving hedging instruments because they require the buyer to accurately estimate the future value of the exposure amount. Like other future and forward contracts, foreign currency futures contracts have standard contract sizes, time periods, settlement procedures and are traded on regulated exchanges throughout the world. Foreign currency forwards contracts may have different contract sizes, time periods and settlement procedures than futures contracts. Foreign currency forwards contracts are considered over-the-counter (OTC) because there is no centralized trading location and transactions are conducted directly between parties via telephone and online trading platforms at thousands of locations worldwide.

Key Points:

Developed and grew in the late '70s when governments relaxed their control over their currencies Used mainly by banks and corporations to mange foreign exchange risk Allows the user to "lock in" or set a future exchange rate. Parties can deliver the currency or settle the difference in rates with cash.

Example: Currency Forward Contracts Corporation A has a foreign sub in Italy that will be sending it 10 million euros in six months. Corp. A will need to swap the euro for the euros it will be receiving from the sub. In other words, Corp. A is long euros and short dollars. It is short dollars because it will need to purchase them in the near future. Corp. A can wait six months and see what happens in the currency markets or enter into a currency forward contract. To accomplish this, Corp. A can short the forward contract, or euro, and go long the dollar. Corp. A goes to Citigroup and receives a quote of .935 in six months. This allows Corp. A to buy dollars and sell euros. Now Corp. A will be able to turn its 10 million euros into 10 million x .935 = 935,000 dollars in six months. Six months from now if rates are at .91, Corp. A will be ecstatic because it will have realized a higher exchange rate. If the rate has increased to .95, Corp. A would still receive the .935 it originally contracts to receive from Citigroup, but in this case, Corp. A will not have received the benefit of a more favourable exchange rate.

CURRENCY SWAP
A currency swap is a foreign-exchange agreement between two institutions to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency; see foreign exchange derivative. Currency swaps are motivated by comparative advantage. A currency swap should be distinguished from a central bank liquidity swap. Hedging example For instance, a US-based company needing to borrow Swiss francs, and a Swiss-based company needing to borrow a similar present value in US dollars, could both reduce their exposure to exchange rate fluctuations by arranging any one of the following:

If the companies have already borrowed in the currencies each needs the principal in, then exposure is reduced by swapping cash flows only, so that each company's finance cost is in that company's domestic currency. Alternatively, the companies could borrow in their own domestic currencies (and may well each have comparative advantage when doing so), and then get the principal in the currency they desire with a principal-only swap. Currency Swaps Like an interest rate swap, a currency swap is a contract to exchange cash flow streams from some fixed income obligations (for example, swapping payments from a fixed-rate loan for payments from a floating rate loan). In an interest rate swap, the cash flow streams are in the same currency, while in currency swaps, the cash flows are in different monetary denominations. Swap transactions are not usually disclosed on corporate balance sheets. As we stated earlier, the cash flows from an interest rate swap occur on concurrent dates and are netted against one another. With a currency swap, the cash flows are in different currencies, so they can't net. Instead, full principal and interest payments are exchanged. Currency swaps allow an institution to take leverage advantages it might enjoy in specific countries. For example, a highly-regarded German corporation with an excellent credit rating can likely issue euro-denominated bonds at an attractive rate. It can then swap those bonds into, say, Japanese yen at better terms than it could by going directly into the Japanese market where its name and credit rating may not be as advantageous. At the origination of a swap agreement, the counterparties exchange notional

principals in the two currencies. During the life of the swap, each party pays interest (in the currency of the principal received) to the other. At maturity, each makes a final exchange (at the same spot rate) of the initial principal amounts, thereby reversing the initial exchange. Generally, each party in the agreement has a comparative advantage over the other with respect to fixed or floating rates for a certain currency. A typical structure of a fixed-for-floating currency swap is as follows:

Calculating Let's

the

Payments consider

on

a an

Currency

Swap example:

Firm A can borrow Canadian currency at a rate of 10% or can borrow U.S. currency at a floating rate equal to six-month LIBOR. Firm B can borrow Canadian currency at a rate of 11% or U.S. currency at a rate of floating rate equal to six-month LIBOR. Although Firm A can borrow Canadian currency at a cheaper rate than Firm B, it needs a floating-rate loan. Additionally, Firm B needs a fixed-rate Canadian dollar loan. The loan is for US$20 million, and will mature in two years. Who has the comparative advantage? To determine who has the comparative advantage, consider the fixed rates for each firm for the currency required. In this case, Firm A's rate of 10% is less than Firm B's rate of 11%, so Firm A has a comparative advantage in the fixed currency. That leaves Firm B to have a comparative advantage with respect to the floating rate.

CURRENCY FRA:
Characteristics of Forward Rate Agreements (FRAs) An FRA is a contract in which the underlying rate is simply an interest payment, not a bond or time deposit, made in dollars, euribor or any other currency at a rate that is appropriate for that currency. A forward rate agreement is a forward contact on a short-term interest rate, usually LIBOR, in which cash flow obligations at maturity are calculated on a notional amount and based on the difference between a predetermined forward rate and the market rate prevailing on that date. The settlement date of an FRA is the date on which cash flow obligations are determined.

The structure is the same for all currencies. FRAs mature in a certain number of days and are based on a rate that applies to an instrument maturing in a certain number of days, measured from the maturity of the FRA. The structure is as follows: The short party or dealer and the long party or end-user will agree on an interest rate, a time interval and a "hypothetical" contract amount. The end-user benefits if rates increase (she has locked-in a lower rate with the dealer). Because the end-user is long, the dealer must be short the interest rate and will benefit if rates decrease. The contact covers a notional amount but only interest rate payments on that amount are considered. It is important to note that even though the FRA may settle in fewer days than the underlying rate (i.e. the number of days to maturity in the underlying instrument), the rate that the dealer quotes has to be evaluated in relation to the underlying rate. Because there are two-day figures in the quotes, participants have come up with a system of quotes such as 3 x 9, which means the contract expires in three months and in six months, or the nine months from the formation of the contract, interest will be paid on the underlying Eurodollar time deposit upon which the contract's rate is based. Other examples include 1 x 3 with the contract expiring in one month based on a 60day LIBOR, or 6 x 12, which means the contract expires in six months based on the underlying rate of a 180 day LIBOR. Usually based on exact months such as 30 day LIBOR or 60 day LIBOR not 37 days and 134 day LIBOR. If a client wants to tailor an FRA, it is likely that a dealer will do it for the client. When this occurs, it is considered to bean off-the-run contract

The best way to see it is through an example, which we will cover in the next section.

Calculation of Payment at Expiration of FRA Let's set up the transaction:

Dealer quotes a rate of 4% on this instrument and end user agrees. He is hoping that rates will increase. Expiration is in 90 days. The notional amount is $ 5 million. The underlying interest rate is the 180 LIBOR time deposit. In 90 days the 180-day LIBOR is at 5%. That 5% interest will be paid 180 days later.

So: 5,000,000

((0.05 1

0.04) +

(180/360)) = 0.05

47,600 (180/360)

Because rates increased, the long party or the end user will receive $47,600 from the short party or the dealer. If the rates were to decrease, the long party or the end user would have to pony up a payment that would be the difference between the quoted rate and the 180-day LIBOR rate. In written terms, the formula looks like this for the party going long:

Formula 16.1 ((Underlying rate at expiration - Forward contract rate)(days in underlying rate/360)) 1 + underlying rate (days in underlying rate/360)

Forward contract rate = rate the two parties agree will be paid Days in underlying rate = number of days to maturity on the underlying instrument

In the numerator, we see that the contract is paying the difference between the actual rate that exists in the marketplace on the expiration date and the agreed-upon rate at the beginning of

the contract. It is adjusted for the fact that the rate applies to a 180-day rate multiplied by the notional amount. The divisor is there because when the rates are quoted in the market, they are based on the assumption that they will accrue interest, which will be paid at a certain time. So the FRA payoff needs to be adjusted to reflect the fact that the rate implies a payment that will occur in the future, say 180 days using our above example. Discounting the payment at the current LIBOR does the adjustment. Definition of 'Forward Rate Agreement - FRA' An over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used along with the termination date and notional value. On this type of agreement, it is only the differential that is paid on the notional amount of the contract. Also known as a "future rate agreement". Investopedia explains 'Forward Rate Agreement - FRA': Typically, for agreements dealing with interest rates, the parties to the contract will exchange a fixed rate for a variable one. The party paying the fixed rate is usually referred to as the borrower, while the party receiving the fixed rate is referred to as the lender. For a basic example, assume Company A enters into an FRA with Company B in which Company A will receive a fixed rate of 5% for one year on a principal of $1 million in three years. In return, Company B will receive the one-year LIBOR rate, determined in three years' time, on the principal amount. The agreement will be settled in cash in three years. If, after three years' time, the LIBOR is at 5.5%, the settlement to the agreement will require that Company A pay Company B. This is because the LIBOR is higher than the fixed rate. Mathematically, $1 million at 5% generates $50,000 of interest for Company A while $1 million at 5.5% generates $55,000 in interest for Company B. Ignoring present values, the net difference between the two amounts is $5,000, which is paid to Company B.

HEDGING THROUGH CURRENCY FUTURES:

Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price. The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price. The ultimate goal of an investor using futures contracts to hedge is to perfectly offset their risk. In real life, however, this is often impossible and, therefore, individuals attempt to neutralize risk as much as possible instead. For example, if a commodity to be hedged is not available as a futures contract, an investor will buy a futures contract in something that closely follows the movements of that commodity. When a company knows that it will be making a purchase in the future for a particular item, it should take a long position in a futures contract to hedge its position. For example, suppose that Company X knows that in six months it will have to buy 20,000 ounces of silver to fulfill an order. Assume the spot price for silver is $12/ounce and the six-month futures price is $11/ounce. By buying the futures contract, Company X can lock in a price of $11/ounce. This reduces the company's risk because it will be able close its futures position and buy 20,000 ounces of silver for $11/ounce in six months.

If a company knows that it will be selling a certain item, it should take a short position in a futures contract to hedge its position. For example, Company X must fulfill a contract in six months that requires it to sell 20,000 ounces of silver. Assume the spot price for silver is $12/ounce and the futures price is $11/ounce. Company X would short futures contracts on silver and close out the futures position in six months. In this case, the company has reduced its risk by ensuring that it will receive $11 for each ounce of silver it sells.

Futures contracts can be very useful in limiting the risk exposure that an investor has in a trade. The main advantage of participating in a futures contract is that it removes the uncertainty about the future price of an item. By locking in a price for which you are able to buy or sell a particular item, companies are able to eliminate the ambiguity having to do with expected expenses and profits.