Presentation on risk in international finance

REFLECTION OF INTEREST DIFFERENTIAL IN FOREX FORWARD PREMIAIn the case of Forward exchange rate, it may be presumed that the forward currency required is purchased or sold in the Spot ma

Praveen Kumar Dangi

B.Com(H), CAIIB, AICWA, MBA (B&F)

Senior Manager / Faculty - IMAGE

Meaning – Financing of international trade and effecting transactions.

Cross border cross currency transactions

Export requires payment in the currency of the exporter’s country but

importer can pay only in the currency of the importer’s country.

What is Foreign exchange?

mechanism by which the currency of one country is converted into the currency of another country

FEMA defines Fx =Fc includes

deposits, credits and balance payable in any foreign currency

DD, TC, LC, B/E expressed or drawn in Indian currency but payable in any foreign currency

DD, TC, LC, B/E expressed or drawn by banks, institutions or persons outside India payable in Indian currency

 Protecting from the future uncertainty

 Why textile industry is in trouble?

 Why bollywood is using the hedging techniques?

 Why TCS profits have come down?

 Delay in execution of order

 Despatch inferior goods

 Inability to ship goods

 Fails to execute – Lehman brothers

 Advantage of time zone - Herstatt

 Country Risk

 Legal / regulatory – license cancel, restrictions

 Political- war, change of regime

 Economic- Chinese goods

 Opinion on buyer – ECGC, D&B

 ECGC policy for commercial and country risk

 Individual buyer-wise policy

 LC

 Export production finance Gtee

 Insurance cover for transit loss

 Forward contract / option etc

HEDGING TOOLS - DERIVATIVES

 Defined –

A financial instrument giving rise to right and obligation in monetary terms

Executable on a future date

Value is dependent on the value of an underlying asset

 OTC – forwards, options, swaps

 Exchange – future, options

 Quotations :

 Direct – when FC is fixed

 Indirect – when local currency is fixed

 Transaction based:

 Buying Rate – when bank takes FC in exchange of rupees

 TT rate – bank gets credit without delay

 Bills rate – when transaction involves sometime

 Selling Rate – When bank gives FC in exchange of rupees

 Time based:

 Cash – Payment and receipt of currencies same day value today

 TOM – Deal today at today’s rate settlement tomorrow

 Spot – Deal today at today’s rate settlement within 48 hours

 Forward – Deal today transaction on pre-determined future date

 Types of rates:

 Interbank – Quoted in interbank markets

 Bid – where a bank quotes a rate to buy a currency

 Offer – where a bank quotes a rate to sell a currency

 Card – Bank loads its margin on exchange rates and offered through its branches

 Types of account:

 NOSTRO – Our account with you

 VOSTRO – Your account with us

 LORO – Their account with you

 Mirror – account of foreign bank in books of bank in India

 Value date:

 On which purchased currency gets credited to NOSTRO account abroad

 Two way quotation: USD 1 =Rs 48.8525/8650

 Direct quotation : USD 1 = Rs 48.8525/8650 rule buy low sell high

 Indirect quotation : Rs.100/- = USD 2.0470/0490 rule buy high sell low

 Spot : USD 1 = Rs 48.8000/8200 which is buying and which is selling?

 Spot / Nov 2000/2100

 Spot /Dec 3500/3600 these are premiums Remember buy high sell low

 Oct forward buying = 48.8000

 Spot / Nov 2100/2000

 Spot / Dec 3600/3500 these are discounts

ADD least premium while buying & highest premium while selling.

DEDUCT highest discount while buying and lowest discount while selling

 TT rate for : DD, MT, TT drawn on bank where nostro

account is already credited

FBC payment to exporter only when importer pays and nostro account is credited

Cancellation of Fx sold earlier

Example: Spot USD 1 = Rs 48.8500/8700 on 17th Oct Spot / Nov 2200/2300

Exchange margin 0.08%

Solution: 48.8500 less 0.0391 = 48.8101 say 48.8100

 Bill buying rate for : FBP Transit period and usance period

Round off to lower month- when premium

Example: Spot USD 1 = Rs 48.8500/8700 on 17th Oct

Example: US$/Rupee Exchange rate

Exchange rate a year before US$ 1 = Rs 47.65

Year-on-year inflation USA = 2%

Therefore, depreciation of rupee is Rs 49.05-47.65 = Rs 1.40

Forward Premia – Inflation differential

REFLECTION OF INTEREST DIFFERENTIAL IN FOREX FORWARD PREMIA

In the case of Forward exchange rate, it may be

presumed that the forward currency required is

purchased or sold in the Spot market and carrying the funds in the money markets

Eg 1 If you buy USD forward, bank borrows INR in

Indian money market converts at spot rate and invests

in US money market for you

2 If you sell USD forward, bank borrows the

contracted amount in US money market converts at

spot rate and kept invested in Indian money market for you

Therefore, ‘the cost of carry’ or time value of money

gets reflected in the forward premia loaded

REFLECTION OF INTEREST DIFFERENTIAL IN FOREX FORWARD PREMIA

After one year maturity = 10000 x 4.5 x 1 =

450+10000

100

= GBP 10450Convert back GBP 10450 into dollar @ 1.7815

Dollar receivables = 10450 x 1.7815=

18616.70

Interest payable on the dollar

borrowing = 17815 x 4% = $ 712.60Principal + interest = 17815 + 712.60 =18527.60

Received on investment = $ 18616.70

Arbitrage gain = $ 89.00 (rounded)

FOREX FORWARD PREMIA

In an integrated market, the arbitrage opportunity does

Not exist

The market adjusts the forward rate in such a way that

no arbitrage gain exists on transfer of funds from

Money Market to forex market

Forward rate = Dollar one year payables

Pound sterling one year receivables

= 18527.60 = 1.7729 (one year forward exchange rate)

10450

ROLE OF INTEREST IN FORWARD

PREMIA

IN INDIAN MARKET

FOREX FORWARD PREMIA

Forward Premia= Spot Rate x (CCy.Int.- BCy Int) x No

of days

360 x 100

= 1.7815 x (4 – 4.5) x 360 = (-)0.0086

360 x 100

GBP/USD one year forward rate = 1.7729

One year forward differential = 0.0086

(ie Spot rate to be adjusted by)The money market interest differential reflectas a premium on the currency where interest

rate is lower between the two

 Contract to buy or sell a fixed amount of foreign currency

on a specified future date at a predetermined rate of

exchange

 Fixed forward contract: transit period / usance period /

forward period

Spot buying rate = 48.6000

Add Forward premium = 1.1500

Less exchange margin 0.10% on 49.7500 = 0.04975 2month forward rate for 60 day bill = 49.70025 Or

Exchange margin 0.10%

Calculate for 2 months buying rates for 60 day usance bill

 Option forward contract gives customer to deliver any day

during option period Hence if FC is at premium apply earliest delivery date rate for a buy contract

 On 15 th Oct Exporter requested the bank to book a Fx contract delivery Dec for a 30 day sight bill for USD 10000 prevailing rates are:

Spot USD 1 = Rs 48.5675 / 5750 spot Oct 800 / 900 spot Nov 1700 / 1800 spot Dec 2250 / 2325 spot Jan 3200 / 3300 spot Feb 4100 / 4200 spot Mar 5150 / 5250 Exchange margin 0.10% Transit period 25 days.

Add premium for June = 0.2250

Less margin @ 0.10% = 0.04879

Rate to be quoted = 48.84129 or 48.8410

Forward contract when cancelled by the customer the reverse transaction at spot or remaining period forward Customer may request for cancellation after maturity but before 15 th day If remains undelivered automatic cancellation on 7 th working day

Exporter requested after 2 months of entering into a 3

month forward contract for USD 10000 at 49.2500 for

cancellation Prevailing rates are:

Spot USD 1 = Rs 49.3000 / 3500

1 month 1500 / 1700

2months 2250 / 2325

3 months 3200 / 3300

Rs payable to exporter by bank as per contract = 4,92,500

Customer will pay on cancellation (spot + 1 month selling) = 4,95,200

Amount payable by exporter = 2,700

 Buyer / Seller

 Call – right to purchase

 Put – right to sell

 ONLY RIGHTS to purchaser of option

 American option – option buyer can exercise the right any day during the currency of contract

 European option – the buyer can exercise his right only on maturity date.

An Option gives the buyer

the “right”, but not the “Obligation”,

to buy or to sell an agreed amount of

Financial Instrument (Call/Put)

on or before an Agreed Future Date

(expiry)

at an Agreed Price (strike)

in exchange for a Fee (Premium)

Exporter expecting Fx receipt 6 month hence enters into a put option for 6 months getting the right to sell the foreign currency on maturity at predetermined rates

On maturity if rate is high he may choose not to exercise his right under the option and sell in the market at spot rates

OPTION TERMINOLOGY

USD/INR Call Option at Rs 40.00

Buyer of the option has the right to purchase USD at Rs

40.00 (irrespective of spot market price on that day)

If the SPOT market price of USD is Rs 40.50 that day, he

could then exercise his option and

 buy USD at Rs 40.00

 immediately sell in the cash market at Rs.40.50

 thus making a profit of Rs.0.50 per USD

If the SPOT market price is below Rs 40.00, the buyer:

 doesn’t exercise his right

 loss is restricted to the initial premium paid

OPTION TERMINOLOGY

Similarly USD/INR Put Option on USD at Rs 40.00 means Buyer of the option has the right to sell USD at Rs 40.00 (irrespective of spot market price on that day)

If the spot market price of USD is Rs 39.50 that day, he could then exercise his option and buys in the spot market

at Rs.39.50

Exercises the put option to sell at Rs.40.00

thus making a profit of Rs.0.50 per USD

If the cash market price is above Rs 40.00, the buyer doesn’t exercise his right loss is restricted to the initial premium paid

Currency Swaps – Both principal and interest is swapped

X co in US can borrow in USD @ 6% and in GBP @ 9%

Y co in London can borrow in USD @ 8% and in GBP @ 7%

Commission paid to financial intermediary =1% by both

WIN-WIN situation

 Only interest outflows are swapped

 X can borrow at fixed rates = 11% and floating rates +1%

 Y can borrow at fixed rates = 10% floating at +0.75%

 X wants fixed interest rate loan

 Y wants floating rate loan

 Y borrows fixed rate and gives to X at 10.25% He swaps it with X’s floating rate which X gives him at +0.75%

 Both are benefitted

 Seller agrees to lend to the buyer a specified amount in a specified currency for a specified period starting at a

specified future date at predetermined interest rates.

 The rates on the settlement date (starting date) determines who gains

 Minimum amount is 5M

Tradedate

Fixingdate

Settlementdate

Term date

TIME

Fixing date = Settlement date – 2 working days

3/6 Forward Rate Agreement (5.15/40)

FRAs are expressed in terms of giving or receiving the fixed rate vs short term interest rate index (reference rate) and are quoted numerically.

The 3 months rate starting in 3 months time is 3/6

The 3 months rate starting in 6 months time 6/9

The 6 months rate starting in 3 months time is 3/9

The market maker gives two way quote (5.15/40)

The lower rate is the bid rate at which the bank is ready to pay fixed and the higher rate will be the offer rate at which the bank is ready to receive fixed

Wipro wishes to enter into a 3 x 6 FRA with Bank A where Wipro would pay fixed against 3 month CP rate

Interest payable

25 crore x 6.50 x 91 = Rs 40,51,369.90

100 x 365 Interest receivable

CURRENCY FUTURES

one currency against the other

Foreign Exchange Derivative

Contract

Why to trade in Currency Futures

Advantages of exchange traded Currency Futures

 Efficiency, reliable price discovery and transparency as the

transactions are carried out through state of the art

electronic trading infrastructure of the recognized

exchanges

 Performance guarantees of recognized exchanges and

hence elimination of counter party default risks

 Access to large variety of market participant that may

include small traders, importers/ exporters, multinational corporations, banks and financial institutions

Quick guide on currency futures trading on NSE

 Exchange Timing: 9.00 am to 5.00 pm

 Currency Pairs: Initially only USD/INR currency pair

would be available

 Contract Size: Size is set at $ 1000 per lot (contract)

 Contract Maturity: period from one month to 12

months period (total 12 monthly contracts)

 Quote: in INR with a tick size (incremental value) of

0.25 Paisa

 Margins: (Presently 1%-) margins based on the daily

volatility in the foreign exchange currency markets

Quick guide on currency futures trading on NSE- (contd.)

 MTM (Mark to Market): involve daily MTM (mark to

market) margins

 Settlement of MTM would take place on T +1 basis

 NSCCL (National Securities Clearing Corporation

Limited) would be responsible for the entire clearing, settlement and risk management functions

 Settlement Price: Final settlement price of the

currency future contract would be decided as per the exchange rate fixed by RBI on the last trading day of the contract Settlement would take place in cash in terms of INR

 Position Limits: capped at 25 mio

 Permissibility: Initially only resident Indians are

allowed to trade in currency futures

Getting Started

 Get in touch with your broker permitted to trade in currency futures on NSE

 Price Limits : +/- 3% for the first six monthly

contracts and +/- 5% for the next six monthly

contracts

 No price band

 Base price - theoretically derived price on the first day of the contract

 DSP (Daily Settlement Price) - based on last half

an hour weighted average price

 Final Settlement Day - Last working day of the

expiry month

 Settlement Mode - Cash

for one month)

 STT

 Service tax

 Education tax on brokerage fees

Many of the brokers have offered brokerage free

transaction as a promotional scheme for one month

Example on calculation of profit and loss

1000 (lot size) = 0.0025 x 1000 = 2.5 INR

 In short every tick move signifies gain/loss of 2.5 INR for each lot OR for every 1 Rupee rise/ fall, one will

gain/lose 1000 INR.

1000 (lot size) = 0.100 x 1000 = 100 INR

This is one’s net MTM gain for a particular day that would be credited to one’s ledger

account by the broker If your MTM position

is in loss then the broker would debit that much amount from one’s ledger balance

Differences between a currency futures contract and a forward contract

of the exchange unlike forwards contract

where the contracted parties may default on their commitments

with a fixed maturity date and a fixed quantity

or lot size or contract size Forwards contract can have maturity date and size as per the

mutual agreement between the concerned

parties

Advantages of currency futures trading over forex currency forwards contracts

 Currency futures thru

are most suitable for

small investors and

businesses

FX forwards contracts traded on OTC markets are suitable for banks, financial institutions and corporate

customers due to large size of the contracts

less flexible,

less liquid

less transparent