Financial derivatives effective instrument to hedge exchange rate risk in Vietinbank BRVT branch Luận văn thạc sĩ

---- j --- LUC THAO PHUONG HA FINANCIAL DERIVATIVES INSTRUMENT TO HEDGE EXCHANGE RATE RISK IN VIETINBANK BRVT BRANCH In Banking and Finacial Ology code: 60.31.12 MASTER’S THESIS Supe

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LUC THAO PHUONG HA

FINANCIAL DERIVATIVES INSTRUMENT TO HEDGE EXCHANGE RATE RISK IN VIETINBANK BRVT BRANCH

In Banking and Finacial Ology code: 60.31.12

MASTER’S THESIS Supervisor : Dr.TRAN HUY HOANG

Ho Chi Minh City – 2010

0DECLARATION

I assure that this thesis is my research This thesis has not already been submitted for any degree and is not being currently submitted for any other degree The extracts and data from the other studies have been cited clearly I bear full responsibilities for whatever un-honest of this thesis

Luc Thao Phuong Ha

August, 2010

1ACKNOWLEDGMENTS

It is a good opportunity to participate to the master’s course of Banking in English, which is conducted by the University of Economic Hochiminh City, Faculty of Banking Course I have achieved a lot of knowledge, methodology, techniques and new ideas from this course This thesis is a part of my accumulative knowledge that I have gathered from the teachers, classmates and the colleagues

First of all, I would like to express my grateful and indebtedness to my supervisor, Associate Professor Ph.D Tran Huy Hoang who provided me the precious methodology He helped me a lot in construction of the thesis structure, and gave me the new ideas in analysis This thesis could not be done without his contribution

I also would like to extend my sincere thanks to all the teachers, who have improved

my knowledge of development economics and other social economics understanding

I am grateful for the help from the board of director of Vietinbank Baria Vungtau branch, Mr Tu Nhu Phong, Mr Nguyen Huu Son, Ms Thu Ha, and all my colleagues, who have facilitated me in this research

I highly appreciate the helps from Mr Kien Quoc, Mr Manh Ha, Mr Thanh Hai and all classmates of class of Banking, course 16, who have made a good condition for my study I would like to give my thanks to all of them

Finally, I express my love to all members of my family, who have encouraged me in the progress of my studying and completing this thesis

Luc Thao Phuong Ha

Abstract

Based on the theory of foreign exchange (forex) market and foreign exchange risk management, this thesis focuses on the involved banking products used to manage risks in trading forex operation They are financial derivatives

Financial derivatives are rare in Vietnam although they are widely used in international market An overview of Vietnam forex market from 2007 to now demonstrated to give the reasons why it is necessary to manage foreign exchange risk and what can be done

to mitigate risks? Finally, suggestions for applying financial derivative instruments in Vietnam Bank for Industry and Trade (Vietinbank), Baria Vungtau Branch as a new banking transaction are discussed to enhance its position in local province

TABLE OF CONTENT Page

INTRODUCTION 1

1 The rational of the study 1

2 Statement of the research problem 2

3 Research questions and objective 3

3.1 Research questions 3

3.2 Research objectives 3

4 Research methodology 4

5 Signification of the study 4

6 Structure of the study 5

CHAPTER ONE: FINANCIAL DERIVATIVES IN FOREIGN EXCHANGE TRADING IN COMMERCIAL BANKS 1.1 Foreign exchange trading in commercial banks 6

1.1.1 What is a commercial bank? 6

1.1.2 Banking transactions – foreign exchange trading 7

1.1.3 Risks in foreign exchange trading 8

1.1.4 The necessity of managing foreign exchange risk 14

1.2 Financial derivatives in foreign exchange trading in commercial banks 14

1.2.1 What are financial derivatives? 14

1.2.2 Types of financial derivatives in exchange trading 15

1.2.3 Functions of financial derivatives 19

1.3 Conditions to apply and develop financial derivatives of foreign currency 22

1.3.1 Commercial banks’ internal conditions 22

1.3.2 Commercial banks’ external conditions 23

Conclusion 24

CHAPTER TWO: RESEARCH METHODOLOGY

2.1 Introduction 25

2.2 Research design 26

2.3 Data collection 27

2.3.1 Sample 27

2.3.2 Data collection 27

2.3.3 Hypothesis 31

2.3.4 Scope of the research and data analysis 33

2.4 Conclusion 34

CHAPTER THREE: CURRENT SITUATION IN FOREIGN EXCHANGE TRADING IN VIETINBANK BARIA VUNGTAU BRANCH 3.1 Background of Vietnam’s forex market 35

3.1.1 Characteristics of Vietnam’s forex market 35

3.1.2 Forex trading in BRVT province and Vietinbank BRVT branch 39

3.2 Analysis results 41

3.2.1 Unexpected movement of foreign currency impact on businesses’ activites 42

3.2.2 Business’ demand for using derivatives 47

3.3 Vietinbank Baria Vungtau branch and perceptions about application of derivatives 51

3.3.1 Forward and option contract 52

3.3.2 Combining financial derivatives with credit policy 53

3.3.3 Reasons why derivatives are not popular used in BRVT province 54

Conclusion 57

CHAPTER FOUR : CONCLUSION AND RECOMMENDATION

4.1 Conditions for developing foreign exchange derivatives 59

4.2 Recommendation 62

4.3 Limitation of study and suggestion for further ones 64

4.4 Conclusion 65

LIST OF REFERENCES 66

APPENDIXES 68

ABBREVIATION

CBI : Central Bank Intervantion

CPI: Customer purchase Index

EUR: Europe dollar

Forex market = FX: Foreign exchange market

GBP: Greatain Bristish Pound

GDP: Gross domestic product

IMF: International Monetary Fund

SBV: The state bank of Vietnam

SOCB: The state-owned commercial banks

USD: United States dollar

VND: Vietnam dong

Vietinbank: Vietnam Bank for Industry and Trade

WTO: World Trade Oragnization

LIST OF CHART

Chart 1.1: AUD/USD rate’s movement 10 years 9

Chart 2.1: Outline of Research methodology 25

Chart 2.2: Outline of Hypothesis and variables 32

Chart 3.1: Density inward of foreign currencies 35

Chart 3.2: The movement of VND/USD period 1999 – 2009 37

Chart 3.3: Import – Export turover in BRVT province 39

Chart 3.4: Volume of USD trading in Vietinbank BRVT branch 40

Chart 3.5: USD transferred to Vietinbank from exporters, remittance and demand for USD from importers 51

Chart 3.6: Derivatives trading in Vietinbank BRVT branch and Other banks in BRVT province 52

LIST OF TABLE Table 3.1: Summary of the kind of investigated companies 41

Table 3.2: Descriotive statistic about impact of forex on companies’ activities 43

Table 3.3: Correlation and coefficient of Q7, Q8, Q9 and Q18 44

Table 3.4: Correlation and coefficient of Q10, Q11, Q12, Q13, Q14 and Q18 45

Table 3.5: Correlation and coefficient of Q15, Q16, Q17 and Q18 46

Table 3.6: Frequency analysis of Q19, Q21, Q22 47

Table 3.7: Frequency analysis of Q23, Q24, Q25, Q26, Q27 48

Table 3.8: Frequency analysis of Q28, Q29 and Q29B 50

INTRODUCTION

1 The rationale of the study

In the recent years, the foreign exchange market in Vietnam has been formed and developed This is actually necessary for Vietnam in the process of integrating into the international economy Vietnamese businesses as well as commercial banks have recently improved their operating abilities to run the business in the global field The operation of the foreign exchange market plays an important role in promoting the international foreign trade and economic cooperation among countries Foreign exchange transaction not only has been now considered as one of important banking services of commercial banks, but also marked a new step forward of banking – modernizing movement Transactions conducted in the foreign exchange market determine the rate at which currencies are exchanged The major transactions in foreign exchange market are spot, forward, swap, future contract and currency option The basic of those transactions is the exchange rate Exchange rate affects the relative price of domestic and foreign goods, hence exchange rate volatility strongly affects the foreign trade activities between countries

The year 2008 was coming with the pessimistic image of the global economy It started with the American sub-prime crisis, the international fluctuating price of oil – up and down rapidly, the high inflation and the global economic slowdown… therefore, the forex market around the world has been operating on unexpected movement Since the event that Vietnam became the official member of WTO, we are directly impacted by these turmoil tendencies, influencing deeply in our country’s emerging economy The more Vietnam integrates into global economy, the riskier in currency exchange rate the businesses have to exposure In order to support local import-export enterprises, commercial banks have to develop many kinds of derivatives in foreign currency transaction for hedging exchange rate risk Vietnam commercial banking system has recently increased its’ abilities to meet the

2 Statement of the research problem

Foreign exchange risk management is crucial for businesses frequently trading in the international market There are many kinds of financial instruments used to risk management, in which financial derivatives have been most popularly used in hedging Financial derivatives include four main types: forward, future, swap and option They have been widely used for hundreds of years in international market such as stock market, commodity market, foreign exchange market … Speculators use them to implement their arbitrage transactions to gain profit in financial market However, the most important effect of financial derivatives is hedging risks – fluctuant changing in prices of goods In the foreign exchange market, this effect is more important to prevent investors from the rate’s volatility

Firstly, this thesis analyzes risks derived from forex market, and the importance of forex risks management Then it aims to explain why derivatives have not implied widely in Vietnam yet, and how to encourage this kind of financial instruments as new banking services in Vietnam banks – especially in Vietinbank BariaVungtau branch The current Vietnamese foreign exchange market will be generally demonstrated, giving its changes affected by outside factors and its influences on local import-export businesses Then some conditions for development of derivative instruments for hedging foreign exchange rate in Vietnam are analyzed in detail,

3 Research questions and objectives

3.1: Research questions:

The aim of this thesis is to learn about the foreign exchange risk in general and the importance of currency exposure management in BariaVungtau enterprises by using

currency derivatives The research question is formulated as follow: How can

financial derivatives’ instruments be developed as crucial banking transactions

in Vietinbank BariaVungtau in order to enhance the bank’s competitiveness?

To answer for this question, this thesis will analyze following aspects:

(1) The importance of hedging risks in international trading of import – export enterprises as well as banking transactions in terms of foreign exchange

(2) Reasons of financial derivatives not been popular used in BariaVungtau’s enterprises as well as in Vietinbank BariaVungtau branch

(3) Perception of foreign currency exposure management in Vietinbank and what financial derivatives – products and services – the bank can provide customers (4) How to use financial derivatives instruments as a managerial method to strengthen Vietinbank Baria Vungtau Branch’s competitiveness and protect the bank from foreign exchange risk

To launch some kinds of financial derivatives in term of foreign exchange to meet market’s demand as well as increase Vietinbank BRVT branch’s ability as the best commercial bank in BRVT province

4 Research methodology

The scope of this thesis is to study about import-export enterprises in BariaVungtau province, but not to cover Vietsovpetro Joint-venture because this enterprise’s output (mainly from crude oil export) has large proportion in total foreign trade turn-over in BariaVungtau province In this thesis, observing method is employed to expose volatility of foreign exchange rate which causes risk in international trade From data of forex transactions traded in 2006 to the first quarter of 2010 in Vietnam and global forex market, the trend of exchange rate in Vietnam toward the international movement will reflect the severely impact on import – export operations in local province The threat of foreign exchange risk will be evaluated

by questionnaire sent to enterprises in BRVT province in order to find out what can

be done to mitigate the foreign currency risk; whether it is necessary to apply the financial derivatives instrument for hedging risk and how Vietinbank BRVT can do

to introduce new financial banking instruments to their customers

5 Signification of the study

The goal of this thesis is to develop financial derivatives in foreign exchange transaction in Vietinbank BariaVungtau branch While financial derivatives are popularly being used in the world, it is new and strange for Vietnam businesses and banks In order to enhance Vietinbank’s competitive ability, provide sufficient banking services to its customers, Vietinbank should study and launch new products that give the bank competitive advantage against its competitors in the global play-field BariaVungtau province has a large of import-export turn-over, therefore there are previously problems of foreign exchange rate which rarely remains stable over long period of time However, financial derivative instrument is not popularly used

for both of hedging risks and financial investment Operating from 1988, Vietinbank Baria Vungtau plays an important position in international payment serving local enterprises, so it would be a good chance for the bank to learn and develop new banking transactions to serve its customers as well as attract more potential ones in local area

6 Structure of the study

This essay includes three major parts The first section will introduce theoretical background of foreign exchange risk and foreign exchange exposure management

by using financial derivatives The second section gives a view of Vietnam foreign exchange, especially the period of time between 2007-2009 – the period of the rate

of USD and VND continuously unexpected up and down and the adverse effect to import-export companies as well as banking sector in BariaVungtau province The third section studies more details of necessary conditions for developing financial derivatives as banking services as well as applying financial derivatives instruments

CHAPTER ONE: FINANCIAL DERIVATIVES IN FOREIGN EXCHANGE

TRADING IN COMMERCIAL BANKS

1.1 Foreign exchange trading in commercial banks

1.1.1 What is a commercial bank?

Banks are financial institutions that accept deposits and make loans Included under term banks are firms such as commercial banks, savings and loan associations, mutual savings banks, and credit unions A commercial bank known as business banking is a type of financial intermediary and a type of bank It is a bank that provides checking accounts, savings accounts, and money market accounts and that accepts time deposits It also provides credit line to kinds of individuals and enterprises in economy With the role of financial intermediary institutions, the commercial bank mobilizes fund from people who have surplus to others who have lack of fund It is also called traditional banking services

Nowadays, traditional banking services are no longer banks’ essential ones, larger proportion of banks’ income is from modern banking services, such as: debit – credit cards, money transfer, properties- safe keeping, bank guarantee, international payment, foreign exchange transaction, etc In the world, banking system has long development history, along with the fast movement of technologies, banking transactions have been diversified to meet customers’ need; and gradually become important players in international payment system of the global economy, especially

in current economic globalization

In order to take a position in the global field, commercial banks have to modernize their technology system to carry out modern banking transaction to meet their customers’ needs which are more and more demand on quality and complexity Especially, in foreign trade payment, international currency exchange transaction, commercial banks play an important role between customers in different countries

1.1.2 Banking transactions – foreign exchange trading

Foreign exchange rate

Most countries in the world have their own currencies; for example the United States has dollar (USD), the European Monetary Union – the euro (EUR), the Great Kingdom – the pound (GBP), India – the rupee, … Trade between countries involves the mutual exchange of different currencies Foreign Exchange is the simultaneous buying of one currency and selling of another (transfer of purchasing power) The price of one currency in terms of another is called the exchange rate The world's currencies are on a floating exchange rate and are always traded in pairs, for example VND/USD or USD/EUR.1

The trading of currency and bank deposits denominated in particular currencies takes place in the foreign exchange market – the financial market where exchange rates are determined The Foreign Exchange market, also referred to as the

"FOREX" market, is the largest financial market in the world, with a daily average turnover of approximately $1.5 trillion The foreign exchange market is geographically dispersed, extending from Australia to Asia, from Europe to America The market is relatively thin when trading begins in the Far East and is far more liquid when the last hours of trading in Europe coincide with trading in the United States due to differences in the time zones

Evolution of the international financial system – foreign exchange rate

Before World War 1, the world economy operated under the gold standard, meaning that the currency of most countries was convertible directly into gold As long as countries aided by the rules under the gold standard and kept their currencies backed by and convertible into gold, exchange rates remained fixed However, adherence to the gold standard meant that a country had no control over its monetary policy, because its money supply was determined by gold flows between countries Furthermore, monetary policy throughout the world was greatly influenced by the production of gold and gold discoveries World War 1 caused

massive trade disruptions, countries could no longer convert their currencies into gold and the gold standard collapsed

After World War II, a new international monetary system – known as Bretton Woods system - was developed to promote world trade Under the Bretton Woods system, each national currency was kept its exchange rate fixed at a certain level – fixed exchange rate regime Because the United States emerged from the World War II as the world’s largest economy power, the Bretton Woods system of fixed exchange rates was based on the convertibility of USD into gold Thus an important feature of the Bretton Woods system was the establishment of the US as the reserve currency country, event after the breakup of the Bretton Woods system, the USD has kept its position as the reserve currency in which most international financial transactions are conducted However, because there were several weaknesses of the Bretton Woods system involving with deficit international reserves, the system collapsed in 1971 After that, America and its trading partners had agreed to allow exchange rates to float

Although exchange rates are currently allowed to change daily in response to market forces, central banks have not willing to give up their option of intervening

in the foreign exchange market Nowadays, the current international financial system is a hybrid of a fixed and a flexible exchange rate system Rates fluctuate in response to market forces but are not determined solely by them With the purpose

of stabilizing national social and economic index, such as GDP, CPI, inflation, customer’s confidence, …, central banks often use their political power to adjust unexpected changes from forex market

1.1.3 Risks in foreign exchange trading

Under system of fixed exchange rate regime, involved parties did not face exchange rate risk However, the managed – floating exchange rate causes uncertainty of national currency in future Volatility in the foreign exchange rate is the one of the major sources of macroeconomic uncertainty that affects the enterprises and

national economy Foreign exchange rate volatility influences the value of the company since the future cash flows of the company will change with the fluctuations in the foreign exchange rates The deepening of globalization process has led to an increase in foreign exchange transactions in international financial markets This has determined a higher volatility of exchange rates, and, implicitly,

an increased foreign exchange risk

Nowadays, the value and volume of international trade continues increasing year by year In order to effect international payment fluently, banks have been playing as

an important role for import and export enterprises to enter into global market Forex trading is one of the most important banking transactions It not only services import-export firms who can efficiently operate their businesses, but also do businesses themselves to get profit Therefore, banks always ehance their capabilities to deeply supply more and more kinds of forex transactions However, along with advantages of forex trading, forex market also holds many types of potential risks

Chart No.1.1 : AUD/USD rate’s movement 10 years

(http://www.exfin.com/historical-forex-aud)

There are also many definitions of foreign exchange risks The risk that the

investor such that the value of the investment is reduced For example, if an investor residing in the United States purchases a bond denominated in Japanese yen, deterioration in the rate at which the yen exchanges for dollars will reduce the investor's rate of return, since he or she must exchange the yen for dollars

Foreign exchange risk is commonly defined as the additional variability experienced by a multinational corporation in its worldwide consolidated earning that results from unexpected currency fluctuations It is generally understood that this considerable earnings variability can be eliminated – partially or fully – at a cost, the cost of Foreign exchange risk management” (Jacques, 1981, p81-82)

Eitman and Stonehill (1986) and Shapiro (1991) define the three types of foreign exchange exposure as:

Transaction exposure Transaction exposure occurs when an enterprise trades,

borrows, or lends in a foreign currency, or sells fixed assets of its subsidiaries in a foreign country During the time between the commitment of the transaction and the payment’s receipt, the involved exchange rate that maybe change will make the enterprise carry unexpected exposure with actual cash flows In other word, transaction exposure is defined as the impact of the unexpected change in the exchange rate on the cash flow arising from all the contractual relationships entered prior to the change in exchange rate at time t0 to be settled after the change in exchange rate at time t1

Economic exposure Economic exposure measures the change in the present value

of the firm resulting from any change in the future cash flows of the company caused by an unexpected change in the exchange rates Future cash flows can be divided into cash flows resulting from contractual commitments and cash flows from anticipated future transactions In a way, economic exposure includes transaction exposure in itself Transaction exposure is the part of economic exposure comprising future cash flows resulting from contractual commitments and denominated in foreign currency However, transaction exposure arises from company contractual commitments and the amounts to be paid or received are

known Economic exposure whose amounts are uncertain and based on estimates can be defined as the future effect of foreign exchange changes on liquidity, operations, financial structure and profit

Translation exposure Translation exposure arises from converting financial

statements expressed in foreign currency into the home currency It is also defines the unexpected change in exchange rates on the balance sheet of the subsidiary as translated for consolidation purposes into the parent company’s currency Translation risk recognizes only items already on an accounting balance sheet and income statements from the currency of the operating units offshore to that of the parent potentially changes its equity

In general there are also another definitions of risks: market risk, operating risk and settlement risk

Market risk Market risk is also referred to as replacement risk Market risk means

“What will it cost to replace the trade with counterparty at the currently prevailing rate in the market?” On a spot FX transaction the risk is less than with forwards, since there is only two days until settlement Usually, in any market, the greater the maturity of the transaction is, the higher the degree of risk

In order to recognize market risk, a market to market process is employed to evaluate outstanding deals on financial institutions’ books A current market price is used to calculate the profit or loss of each deal on the books In this way, institutions can better understand their actual exposure to counterparties It is important to note that institutions usually are most interested in deals that they are making money on, as opposed to deals in which they are losing money

Operating risk The exposure to the multi-period future cash flows arising due to

an unexpected change in exchange rate is referred to as an economic or operating exposure In this scenario the present value of the future cash flows is affected as a result of an unexpected change in the exchange rate The transaction exposure is the effect of unexpected change in the nominal exchange rate on the cash flow associated with the monetary assets and liabilities and is usually short term The

operating exposure, however, is related to the impact of the unexpected change in the exchange rate on future cash flows associated with the real assets and liabilities Therefore, it is long term in nature

Settlement risk This arises as a result of the timing differences in the payments

due on a FX trade On the settlement day of the FX deal between AYZ Bank and XYZ bank, XYZ bank are due to pay AYZ bank 15 million DEM while receiving

10 million USD The problem for XYZ bank is that they must make the payment to AYZ bank’s correspondent in Frankfurt several hours before they receive the 10 million USD in New York The dangers of this gap in time were clearly demonstrated by the Bank Herstatt case The closure of the private German bank in June 1974 took place late in the afternoon, after payments of DEM had been received by Herstatt, but before the corresponding USD payments in New York were due to be made Settlement risk is therefore often referred to as “Herstatt risk” Banks manage settlement risk by establishing a settlement limit, which restricts the total USD volume of deals that are to settle on any given day While this would not stop a bank from being exposed to a Herstatt disaster, it at least puts a cap on potential losses

When a spot FX trade is done, the full value of the deal is applied against the settlement limit for the value date of the trade Credit is usually replenished at the close of business of the settlement or maturity date

Political risk This is a kind of risk deriving from the intervention of national

central bank or state bank, it is also called central bank interventions (CBIs)

The foreign exchange market is the market where the price of a currency is determined by supply and demand forces for the independently floating currencies While government intervention has been limited to extreme cases involving events triggering a shot down of the market, CBI in the foreign exchange market to maintain an exchange rate within a desirable range, whether such attempts prove successful or not For example, the central bank can weaken its domestic currency

by selling its currency to buy other ones or vice versus Moreover, it is proved that

intervention by individual central banks may not avoid from being futile if there is not monetary coordinated policy in realigning currency value

Other

Several risks need to be considered in interest rate and currency swaps These risks include basis risk due to the mismatch of the cash flow created, the counterparty or credit exposure, and sovereign risk

Basis risk stems from the mismatch of the cash flows in the interest rate or currency

swaps The interest rate index used may not be perfectly correlated with the floating rate interest rate in the swap For example, the LIBOR index used in floating rate notes may go up by 0.8 percent, while the cost of borrowing by a financial institution pegged to an index of money market funds increases by 1 percent over the same period The swap cash flow for the financial institution receiving LIBOR and paying based on money market index would be adversely affected as a result of basis risk as the financial institution exposure to interest rate risk would not be completely eliminated

Counterparty risk is due to the failure of one of the parties to the swap to meet its

financial obligations; therefore, the financial institution has to pick up the offsetting position of the party that failed to make a payment The financial institution assumes the counterparty risk by charging a fee directly or indirectly to both parties

in the swap; the swap dealer takes the offsetting position in both fixed for floating and floating for fixed interest rate swaps

Sovereign risk reflects the political fallout and its impact on the stability of the

sovereign nation in meeting its financial obligations in a swap transaction The sovereign country may impose exchange controls and block access by the counterparty to foreign exchange, causing the counterparty to default in its financial obligations

1.1.4 The necessity of managing foreign exchange risk

In practice, the risks deriving from foreign exchange trade can bring a big loss to company’s value, especially in the period of crisis Historical forex data shows that the currency tendency is difficult to forecast, in a day of transaction the value of exchange rate can continuously change down and up with a big amplitude The key

to successful trading in forex market is understanding and managing risk

Risk-management and gambling may look similar, but they are different For example, what would happen if the investor who wants to buy other currency did not know anything about movement of foreign market? If such an investor merely went out without studying the underlying economics of forex market and what the potential for demand would be in the future, that would not be risk management but gambling On the other hand, if the investor went out and looked at forecasts about the tendency of this currency, he is managing the risk he is taking with regard to buying the rights to use the currency He would still be obligated to pay for the right

to invest, but he is forecasting that there will be a lot of demand for this currency, and he will make profit

Understanding foreign exchange, trade and hedging is increasingly becoming an integral element for all import and export businesses Should importers and exporters hedge their foreign currency exposures or subject themselves to the vagaries of the international currency markets? The answer is of course yes The lessons from international financial crises have proved that understanding, forecasting, and managing forex risk is one of the keys for enterprises’ success

1.2 Financial derivatives in foreign exchange trading in commercial banks

1.2.1 What are financial derivatives?

A derivative can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic, underlying variables Financial derivatives are instruments that allow financial risks to be traded directly because each derivative is linked to a specific instrument or indicator commodity The

derivative is a contract which gives one party a claim on an underlying asst or cash value of the asset, at some fixed date in the future The other party is bound by the contract to meet corresponding liability A derivative is said to be a contingent instrument because its value will depend on the future performance of the underlying asset The traded derivatives that are sold in well-established markets give both parties more flexibility than the exchange of the underlying asset or commodity

In the financial and currency exchange markets, derivatives play a significant role in transferring risk form those who happen to dislike risk (risk averse) to those who will take it for a profit They are considered as risk-management financial tools, however, if not managed correctly they can be risky Financial derivatives are so effective in reducing risk because they enable financial institutions to hedge risks – involving engaging in a financial transaction that offsets a long position by taking

an additional short position, or offsets a short position by taking an additional long position

Financial derivatives are designed to manage risks; but the pool of risk associated with them must be well understood These tools can quickly create a lot of wealth for individuals, but just as quickly, if not managed properly, can cause loss

1.2.2 Types of financial derivatives in exchange trading

Derivatives can be traded OTC or on exchanges OTC derivatives are created by an agreement between two individual counterparties Most of these contracts are held

to maturity by the original counterparties, but some are altered during their life or offset before termination Financial derivatives include four basic types: forwards, futures, options and swaps, and these can be combined with each other of traditional securities and loan in order to create hybrid instruments or structured securities

- Forwards The forwards contract determines the buying or the selling of a given

quantity of a specific asset at a specified future date at a pre-determined price

Forwards is part of Over the Counter Derivatives and is trading and negotiated privately

Suppose that a company in Vietnam has a plan to import goods from USA This company signs a sale contract with his counterparty, in which amount of contract will be paid after 3 months from goods delivery If exchange rate VND/USD will appreciate in the future, the import company has to disburse a higher VND in the mature, and it may cost this company a substantial capital loss In this case, the company can purchase a forward that a specific amount of foreign currency will be exchanged 3 months from today at a stated rate By locking in the future rate, the company has eliminated the risk it faces from the foreign exchange rate

The advantage of forward contracts is that they can be as flexible as the parties involved want them to be This means that an counterparty may be able to hedge completely the foreign exchange risk for the exact currency but with opposite positions However, forward contracts suffer from two problems that severely limit their usefulness The first is that it may be very hard for an institution to find another party to make the contract with The second problem is that they are subject

to default risk, because there is no outside organization guaranteeing the contract, the counterparty may default on the forward contract if there are significant difference between spot rate and forward contract’s one The presence of default risk in forward contract means that parties to these contracts must check each other out to be sure that the counterparty is both financially sound and likely to be honest and live up to its contractual obligations Because this type of investigation is costly and all the adverse selection and moral hazard problems, default risk is a major barrier to the use of exchange risk forward contracts and makes it less usefulness to financial institutions

- Futures They function like forwards but are standardized and traded publicly on

exchanges A financial futures contract is similar to a forward contract, in that if specifies that a financial instrument must be delivered by one party to another on a stated future date However, it differs from forward contract in several ways that

overcome some of the liquidity and default problems of forward contract Financial futures contracts are traded on organized exchanges that are highly competitive and have their own design contracts and rules in order to increase the amount of futures trading on its exchange

- Options They are contracts that give the purchaser the option, or right – not

obligation, to buy or sell the underlying financial instrument at a specified price, called the exercise price or strike price, within a specific period of time – expiration The seller (called the writer) of the option is obligated to buy or sell the financial instrument to the purchaser of the owner of the option exercises the fight to sell or buy These option contract features are important enough to be emphasized: the buyer of an option does not have to exercise the option, he can let the option expire without using it Hence the owner of an option is not obligated to take any action, but rather has the right to exercise the contract if he so chooses The seller of an option, by contrast, has no choice in the matter, he must buy or sell the financial instrument if the owner exercises the option Because the right to buy or sell a financial instrument at a specified price has value, the owner of an option is willing

to pay an amount for it called a premium

- Swaps They are agreements to exchange one stream of cash flows for another For

instance an investor could switch financing a currency for financing in another It could also be used in the case of interest rates One could swap a floating rate for a fixed rate, and the other would be vice verse

It is highly unlikely that two parties to interest rate or currency swaps would take an offsetting position in exactly the same notional principal and over the same time horizon In practice, the market maker in the swap or the swap bank (the financial institution) may not be able to find a party willing to take the offsetting position in the swap Therefore, financial institutions are likely to warehouse the swap and use

a forward rate agreement or futures contract to manage their exposure until a suitable party is located that is willing to take the offsetting position but may not wish to swap for exactly the same amount of notional principal and the same

maturity that the financial institution has entered in its first swap transaction In this case, the financial institution may have residual and basis exposure as the small bid-ask spread of 3 to 5 basis points in the interest rate swap reduces the profitability of such a transaction unless basis and residual exposure are properly mitigated This swap is called three way swaps There are also four parties to three-way swaps, the swap dealer and the three parties The swap dealer has a bilateral agreement with each party, paying (bid rate) and receiving (ask rate) in a given currency

In addition, there are also several combinations of derivatives as follow:

- Contracts for Difference, CFD are also pretty similar to futures, only they cannot

be settled at delivery Two parties agree to pay a certain amount of money depending on the change in some numbers Many investors consider CFD as another form of gambling

- Hybrid derivatives

There are hybrids of the financial instruments discussed above Variable coupon facilities, including floating rate notes, note issuance facilities and swaptions, fall into this category A swaption is an option on a swap: the holder has the right, but not the right, but not the obligation, to enter into a swap contract at some specified dates As long as the repricing reflects the current interest rate level, this type of security will be less volatile than one with a fixed rate coupon The floating rate notes have an intermediate term, whereas other instruments in this category will have different maturities Note issuance facilities ate a type of financial guarantees such as letters of credit, credit line and revolving loan commitments

These instruments can be regrouped into two main categories: the first category contains instruments such as currency forwards and futures, and money market contracts This kind of instrument the exchange rate is fixed at the moment when the risk appears The main disadvantage with these instruments is that they cannot benefit from a favorable movement of the exchange rate The second category contains instruments such as currency options that protect the company from an

unfavorable movement of the exchange rate and at the same time keep the possibility of benefiting from a favorable movement of exchange rates

1.2.3 Functions of financial derivatives

Derivatives are extremely sophisticated financial They are financial contracts between two parties, whose value is linked to an underlying security The underlying security can be many things: an asset (equity, commodity), or an index (stock market indices, interest rates) etc Markets for financial derivatives provide some valuable functions in an economy such as: risk management, speculation, leverage, reduced transaction cost and increased efficiency, price discovery and regulatory arbitrage Transactions in the financial market allow participants to perform various functions, for example speculating, financing, hedging, …

Speculating Speculating is where the short seller borrows the underlying asset to be

shorted and sells with an explicit agreement to buy the asset back later at a lower or higher price in a speculative transaction In this case the short seller expects the price to drop so it can buy the asset back at a lower price than it sold the asset for If its expectation materializes, the short seller makes a profit; otherwise it incurs a loss Technically short sellers are required to provide some money (margin) In essence, the derivatives market provides an opportunity to leverage one’s position

in the market Leveraging can cut both way, leading to higher profits and higher losses

Financing Short selling can be viewed as a means of financing For example

government security dealers buy Treasury securities in the regularly scheduled treasury auction To finance the purchase, the security dealer sells the underlying asset - for example, T-bills – to a municipality for one week and agrees to repurchase the security after one week at a slightly higher price This short selling can be viewed as a means of financing at a fully collateralized basis The spread between selling and buying price is the interest rate that the dealer paid for financing the purchase of T-bills and is called a repo rate

Hedging Hedging is a financial strategy designed to minimize one's exposure by

providing end users the opportunity to reduce or transfer exposure to various types

of risks Hedging requires taking an offsetting position, so that an exposed position

is protected from rising/ falling interest rates or changing exchange rates in one direction of the other While hedging is essentially buying protection for have good reasons to engage in such activity Some of the reasons for hedging are obvious, while others are not

Short hedge involves selling derivatives, such as forwards, futures, and options, short to protect the long position that individuals or corporations have or expected

to have in the near future, such as receivables denominated in foreign currency Long hedge involves buying derivatives (taking long position) on forwards, futures and options to minimize future outlays, such as payables in the neat future denominated in foreign currency, or to lock in a price now for the foods a firm is expected to purchase some time in the near future

High risk investment On another side, high risk investment is a financial strategy

designed for investor making profit from unstable price on market Investors who participate in market forecast the movement of price on market, then they buy or sell stocks and hope to sell or buy back with a higher price The more volatile price

of stocks, the higher return they can get

High risk investment, high return By trading derivatives the investor in theory positioned to make much more profits then if he was trading the underlying asset This is speculation You assume that the value of the underlying asset will move in the direction you expect it to But because the reward is great, the risk taken is equally great Novice are setting themselves up to failure, and many who despite all warnings take the plunge have seen their savings disappearing in a puff of smoke

Reduced transaction cost The derivatives market provides opportunities to alter,

increase, or decrease and to adjust to the desired position the degree of sensitivity of the market value of assets (current or expected) or liabilities (payables, current, or

expected to be incurred in the future) to changes in market interest rates or changes

in market returns at substantially reduced cost

Regulatory Arbitrage The derivatives market allows individuals and corporations

to bypass regulatory requirements imposed by the regulatory agencies and to bypass regulatory restrictions on accounting standards and taxes For example, hedge funds sell calls on the underlying stocks they own This provides cash flow from the buyer

of the call, while maintaining the possession of the stock with the privilege of receiving dividends as will as the ability to exercise the voting right by forgoing the potential for the higher expected price in the near future This is an economical way

of selling stock that defers taxes and provide some payoff in the form of a premium received as opposed to simply selling the stock at the spot market

Alternatively, portfolio managers who receive a steady pension flow from various agencies sell put options and receive premiums that obligate them to purchase the underlying assets from the buyer of puts at the strike price Again, this is an economical way of purchasing the underlying assets, stocks, and bonds as opposed

to simply buying the assets for the portfolio

As a testament to their usefulness, derivatives have traded for thousands of years The first known occurrence of derivatives trading dates to 2000 B.C when merchants made consignment transactions for goods to be sold in India2 Derivatives trading in an exchange environment and with trading rules can be traced back to Venice in the 12th Century In the US, forward and futures contracts have been formally traded on the Chicago Board of Trade since 1849 As of 2003, the world’s largest derivative exchange is the Eurex which is an entirely electronic trading “exchange” that is based in Frankfurt, Germany Nowadays, the derivatives market has successfully developed under an effective regulatory regime All three prerequisites for well-functioning market: safety, efficiency and innovation are fulfilled Wile there is no need for structural changes on the framework under which

2 Future Industry Association in 1984 publication An Introduction to the Futures Markets, and in

OTV players and exchanges operate today, improvements are possible Particularly

in the OTC segment, increasing operating efficiency, market transparency, market transparency and enhancing counterparty risk mitigation and enhancing counterparty risk mitigation would help the global derivatives market to function even more effectively

1.3 Conditions to apply and develop financial derivatives of foreign currency

Businesses hedge and transfer risk to other parties to reduce the variability of their cash flows and probability of large losses that threaten company survival Since the cost of reorganization and eminent bankruptcy is high, lenders are unwilling to extend credit or require hefty premiums, inducing firms to hedge their business and financial risk, as dollar of loss in a shaky financial state can cost more than a dollar Risk averse managers always prefer to avoid a dollar of loss to a dollar of profit For

a risk averse individual, a dollar of loss is more painful than a dollar of gain The degree to which mangers of large publicly owned corporations are risk averse depends on the agency relationship between managers (the agent) and owners (the stockholders) The embedded options in the managers’ compensation packages induce them to increase the market value of the firm and of their own perks without raising the uncertainty of the future cash flows

However, hedging is costly; it entails transaction costs, costs of monitoring the transactions on derivatives, and managerial controls to prevent unauthorized trading

as will as costly bid/ ask spread in favor of the dealer

The use of derivatives has increased significantly since the start of a new floating rates arrangement in 1973 and rising inflation in the late 1970s in the USA3 as well

as rising oil and gas commodity prices, which prompted a new breed of financial and non financial products that transfer risk from one party to another Firms use forward contracts for firm commitments, while they use option involving contingent transactions to be executed when and if the actual contingencies arise

1.3.1 Commercial banks’ internal conditions

Commercial bank’s potential

Financial derivatives are the effective instruments to hedge risk for all involved parties If an investor uses bank’s transactions to manage their risk, for example he will sign a forward contract with the bank, in which he will sell USD for VND at a fixed rate in the future This means that he wants to change risk – the rate VND/USD may be depreciated – to the bank who agrees to buy this forward contract Of course, the bank will be faced with risk, and the bank also wants to hedge risks With the role of intermediary institution, the bank can transfer their risk

by re-selling this forward to other party, or combining some transactions to minimize the risk

Financial derivatives’ market is complicated and diversified, it requires bank staff has to be equipped knowledge of forex and their financial derivatives The staff is responsible for introducing products, consulting, convincing bank’s customers of taking derivatives’ functions in their business Moreover, with the role of intermediary institution to sell banking products, they will face with the risk transferred from their customers, therefore bank staff must have ability to flexibly employ forex hedging derivatives to manage risks of bank’s foreign portfolio

In addition, bank’s technology has been paid attention It is necessary condition in order to apply derivatives in general and forex ones in particular As we know, derivatives are all calculated base on complicated algorithm, attending to draw technology graph predicting possible movements of exchange rate in future Modern software is necessary to assistant bank’s processing as well as calculating fee of derivatives

1.3.2 Commercial banks’ external conditions

Legal framework National macroeconomic and monetary policy powerfully govern activities of forex trading Commercial banks operate under central bank’s rules, therefore financial derivatives are only just developed if monetary policy’s terms can create good conditions and environments for them

Demand and supply derivatives This is the integral factor in forex market If there

is not demand from customers, commercial banks can not sell their products On the contrary, derivatives’ suppliers have to provide useful products to satisfy the customer’s need

Perception of financial derivatives Financial derivatives are complicated instruments It not only plays a useful role in risk management, but also causes dangers to the stability of financial markets and thereby the overall economy So, it requires that all involved parties have knowledge to suitable applying to their operations

Conclusion

This chapter introduces commercial banks and their banking products and services, especially concentrating on foreign exchange trade and forex market With the development of globalization, international trade is increasingly diverse, national economics become depending on each other Consequently, any sign of a vulnerable economic factor will lead to any risk line, of course forex trade can not avoid risks Many types of risks are analyzed involving to businesses as well as banks’ activities, then this chapter introduces the main effective financial instruments used

to hedge risks is derivatives

Derivatives are the financial instruments which play a useful and important role in hedging and risk management in commerce and finance for thousands of years This chapter also studies how they are helpfully applied and developed by the banks as the banking products to their customers Despite of their utilities, they also pose several dangers to the stability of financial markets In Vietnam, furthermore, they are still infant Therefore, research and experience of derivatives in the developed and developing countries will help domestic banks create a suitable strategy in order

to build up a new banking service

CHAPTER TWO: RESEARCH METHODOLOGY

2.1 Introduction

Based on relevant literature review of banking transaction in foreign currency and its risks deriving from forex market, the paper would like to find out the utilities of financial derivatives which can be employed to hedge to foreign exchange risk and analyze why they has not been popularly used in Vietnam bank system, especially

in Baria Vungtau province The reasons will be carefully studied in order to suggest some conditions for applying financial derivatives as banking services in Vietinbank Baria Vungtau branch

2.2 Research design

INTRODUCTION

RESEARCH PROBLEM

RESEARCH QUESTION

RESEARCH OBJECTIVES LITERATURE REVIEW

HYPOTHESES AND DATA COLLECTION

SPSS PROCESSING

DESCRIPTIVE AND REGRESSION ANALYSIS

Chart 2.1: Outline of

research methodology

CONCLUSION, SUGGESTION

The purpose of this thesis is aiming to answer some questions stated on the introduction chapter as follow:

1 How is importance of hedging risks in international trading of export enterprises as well as banking transactions in terms of foreign exchange?

import-2 Why have financial derivatives not been popularly used in BariaVungtau’s enterprises as well as in Vietinbank BariaVungtau branch?

3 What is perception of foreign currency exposure management and what financial derivatives – products and services - do Vietinbank can provide to its customers?

4 Finally, in addition to consolidate Vietinbank BariaVungtau Branch’s position with its competitors and protect itself from foreign exchange risk, this thesis concentrates on how to use financial derivatives instruments as a managerial method

William Zikmund (1997) classified research methods into four basic types: surveys, experiments, observation, and secondary data studies In this research, observation, survey and experiment methods were employed

Observation method is chosen by collecting historical data of exchange rate, VND/USD and other currencies traded on Vietnam as well as global forex market,

to draw movement of foreign exchange rate from the past Then, this research also collected current volume of derivatives trading in Baria Vungtau province as well as Vietinbank Baria Vungtau branch in order to prove that derivatives seem be strange

in forex trading in this province The main advantage of the observation method is that it easily records from internet channel without relying on reports from respondents However, this method is just outlining the movement or events, it can not record attitudes, opinions, motivations and other intangible states

Survey method is employed to supplement the disadvantages of observation one A survey is a research technique in which information is gathered from a sample of

people by use of a questionnaire4 It is efficient to accurately collect customers’ opinions and attitudes in using derivatives as managerial method by create a questionnaire appropriately with the research’s purposes The questionnaire is sent

to respondents by email and in personal; then SPSS program will record collected data to statistic and analyze respondents’ views Although it is an inexpensive method, data collected might be error as respondents’ less concerns Therefore, some of bankers and foreign exchange managers in import – export companies are directly interviewed in order to understand visual aids and supplement the study with personal observations

2.3 Data collection

2.3.1 Sample of investigation

The main purpose of this study is finding out the reasons why financial derivatives are not widely used and suggesting how to apply it in Vietinbank Baria Vungtau branch as managerial instrument for forex risk Therefore, this study concentrates

on operations and forex attitudes of import – export enterprises and commercial banks in Baria Vungtau province Besides, forex trading in Vietinbank Baria Vungtau branch is also detail introduced in order to analyze conditions for effective development of new banking transactions

2.3.2 Data collection

Secondary data such as interbank exchange rate in the period of time between 2005 – 2009, cash flow of USD and VN , volume of international payment in Baria Vungtau province … are collected from internet, Baria Vungtau department of Industry and Trade, State Bank of Vietnam Baria Vungtau branch, Vietinbank Baria Vungtau branch and other sources These figures describe the movement of foreign exchange, especially VND/USD, which is suddenly abnormally changing and

4 William Zikmund, “Business Research Methods”, Oklahome State University, 1997, Fifth

causing risk in forex market Forex risk could be recognized affecting deeply to

businesses’ operations, which will be in detail analyzed in chapter 3

However, secondary data and description method just pointed out events and

subjective hypothesis In other to find out personal views in practice, a

questionnaire was designed and sent to respondents The answers were suitably

coded and then recorded to SPSS program to synthesize, analyze, then predicting

the trend of customers’ attitude about risk deriving from fluctuation of foreign

exchange

The questionnaire5 was designed base on some assumptions as follow:

- Banking products and services offered to customers are the same qualify and

price from all of commercial banks on Baria Vungtau province

- Macroeconomic economy’s factors such as interest rate, the government’s

preferential policy, … have the same affect to all kinds of enterprises

At first, the general information of companies is presented, consisting of some

questions:

Q1: Company’s sector Q4: Company’s yearly import – export turnover

Q2: Time of operating Q5: The major market

Q3: The interviewer’s position Q6: Currency in trading

These questions are coded as follow:

Q1 Seafood Consumer

goods Finance

nology

Tech-Customer Service

Oil &

gas

Health care Other Q2 < 2 y 2 – 5 y 6 – 10 y > 10 y - - - -

Q3 Owner Manager Chief

Q4 < 1 m 1 – 10 m 10 – 30 m 30 – 50m > 50 m - - -

Q5 USA Asia Europe Others - - - -

Then, the next questions were built to find out the attitude of interviewers about the importance of exchange risk management They include questions which are coded

as follow:

agree

Totally disagree

Q7 Im – Ex trading has been affected by unexpected

Q8 The exchange rate has negative impact on companies’

Q9 The company always finds the movement of exchange rate

traded in unofficial and global markets 1 2 3 4 5

Q10 Government’s exchange rate policy is one of your main

Q11

The company always pays attention to international

economic events and the macroeconomic policy of

Q15 You have been refused to buy/ sell foreign currency at the

stated rate by commercial banks 1 2 3 4 5Q16 You had to buy / sell foreign currency at much more

unprofitable rate than that was stated last time 1 2 3 4 5

Q17 There is a large gap of exchange rate bidden among

Q18 Foreign rate management is important 1 2 3 4 5

Q19 The company has ever thought about a way to hedge

Q20 You have ever heard about any kind of financial

Q23 The company has attended in a class specializing in

management risk in BRVT province 1 5

Q24 There is foreign exchange department or staff that is

Q25 Banking services for hedging forex risk are introduced in

In order to poll customers how forex trading between businesses and commercial

banks is in current situation, Q28 and Q29 are:

Code

Q28

How can the company

buy USD to pay for

import contracts?

Ask banks

Looking for exporter

Through other relationships

Unofficial forex market

Other

Code

Q29

The role of importers,

exporters and bankers

on unofficial forex

market?

negotiation between importers and exporters

Bankers play a role

as broker

There is no unofficial forex market

Other

Q29

b

In case bankers as

brokers, who is benefit

from difference of

buy-sell exchange rate?

Banks’

profit

Staff who

is responsible for forex

Other -

2.3.3: Hypothesis

Based on fluctuate movement of foreign exchange and difficulties in forex trading6,

the data analysis will prove some following hypothesizes:

+ Hypothesis 1: Unexpected movement of foreign currency rate last time

deeply affected to businesses’ activities

+ Hypothesis 2: The companies’ attitude to the rate management policy of

Vietnam as well as international market

6 These events have already mentioned in chapter 3 – current situation of foreign exchange risk that affects to

+ Hypothesis 3: Hedging forex risk is very important

Hypothesis 1 will be examined by the result of Q7, Q8, Q9 Q10 to Q14 present the concern of involved parties about the monetary policy, and their reactions to confront with difficulties in situation Finally, Q15, Q16 and Q17 investigate volume trading currency between commercial banks and enterprises in situation of shortage USD supply All hypothesis will prove if hedging exchange rate risk is necessary according to import – export enterprises’ views which represented by Q18 – dependent variable

H1

H2

H3

Chart 2.2: Outline of hypothesis and variables

In order to know why financial derivatives have not been popularly used, the interviewers give their opinions about derivatives and derivatives’ utilities The result from the interviews is presented through Q19 to Q27 The result of investigation is very important to conduct a poll on demand for derivatives - which

is integral factor to develop financial derivatives

In addition, questionnaire also collects information about the “black market”, and its adverse effect on foreign currency trading Through the period of time from 2007 to now, there has been shortage of USD occurred Import enterprises found difficult to