Risk Management in Forex Markets - Basic and Emerging

1
Risk Management in Forex Markets
- Basic and Emerging concerns
By Sitarama Murthy_at_ Prmia, Hyderabad
2
Market Players

• Commercial Banks
• Central Banks
• Corporates
• Individuals

3
Market

• Global
• 24 hours (Never sleeps)
• Through telex, telephone, fax, computer
  networks
• Simultaneous trading in all currencies

4
Features

• Risks similar to any commodity
• Profits from exchange rates
• Exchange exposure/funds position

5
Role of Central Bank

• Management of money Supply / inflation
• Management of exchange rates
• Ensuring orderly markets

6
Quotes in Forex markets

• Spot, Cash, tom, forward
• (- 1.2000 -Price in terms of local
  currency (USA)
• (- 0.8333 -Reverse in home country (Europe)
• (- 1.2000 -Cross rate in a third country
  (England)
• Bid/Offer rates. (- 1.2000/05
• 40.6500/25
• (Unless indicated, quotes are good for standard
  market lots)
• Bid/offer in money markets. (5 1/8 -1/4.)
• -Period/amount are given in advance
• Positions squared by money market or forex deals.

7
Forward Markets

• Forward rates mechanism
• Forward quotes 10/5 or 5/10
• Linkage between forex and money
• Forward rates are influenced by interest rates
• Eg /INR quote in forwards
• Buy spot sell the same 1 month fwd
• Invest the s for a month and earn lesser than
  in INR
• Sells fwd s at premium (give lesser dollars)

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Forward markets (Cont..)

• Forward exchange rate differentials
• Premiums/discounts
• Swaps
• The gain or loss in swaps is determined by the
  forward differentials and not exchange rates. If
  interest rates are stable swaps do not involve
  any rate movement risks.
• Fwd exchange rate differential / FR-SR X
  12 x 100
• interest rate differential
  SR no of month
• Cash flows/mismatches
• A deal results in inflow in one currency but out
  flow in another. The mismatches can be squared
  through money market deals. They are also squared
  thro forex swap deals.

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Factors Effecting Rates, Short Term

• Time scale in forex
• Supply/demand position
• Movement of funds
• Entry of a large Banks / Corporates
• Political crises, wars, oil price
• Central Bank intervention

10
Factors Effecting Rates, Long Term

• Economic fundamentals/data
• Balance of payments
• Govt.s economic policies
• Interest rate changes
• Capital movements
• Technical/psychological factors
• Purchase power parity
• Interest rate parity

11
Risks

• Exchange risk
• Credit risk
• Liquidity risk
• Settlement risk
• Operational risk
• Compliance Risk

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Identifying, Measuring, Monitoring Managing
Risks

• Use of Derivatives in Risk Management
• I
• Derivatives are contracts whose values are to be
  derived from the assets covered by them
• Exchange Rate Risk Forwards, Options, Futures,
  Range
• forwards
  (Floors,Collars, Caps)
• Interest Rate risk FRAs, Options, Futures,
  IRS
• Liquidity/Currency
• Risks Currency Swaps/ swaptions,
• Concept of value at risk in foreign
  exchange

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Identifying, Measuring, Monitoring Managing
Risks

• II
• Forward/Future Rate Agreement
• Cash settled forward contracts on notional
  amounts
• A mechanism to cover against adverse interest
  rate movements
• Available in all major currencies
• Flexibility of amount and period
• Fine spreads available on quotes

14
Identifying, Measuring, Monitoring Managing
Risks

• III
• Options
• A stipulated privilege to receive/deliver a
  security commodity / currency, at a given price,
  with in /on a specified date.
• Confers a right with no obligation whereby the
  buyer can demand a purchase or sale by the writer
  of a specified amount of currency / number of
  bonds / shares, commodities
• Call option gives a right to purchase and a put
  option, to sell
• Premium paid on spot basis (2 days).
• Terminology strike price, maturity date,
  premium,
• American / European options

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Identifying, Measuring, Monitoring Managing
Risks

• Options (contd.)
• Price dependent on
• i. Difference between the strike
• and the market price
• ii. Interest rate differential
• iii. Term of the option
• iv. Volatility of the currency

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Identifying, Measuring, Monitoring Managing
Risks

• IV
• Engineered Options / FRAs
• Cap Insurance against rise in currency price or
  short term interests on liabilities
• Floor For protection of income on an asset
  against fall in interest rates or currency
  prices.
• Collar -A range product, where simultaneously a
  cap is bought and a floor is sold on a liability
  and vice-versa on an asset/currency

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Identifying, Measuring, Monitoring Managing
Risks

• V
• FRA in credit portfolio
• A bank has 100 Mio mortgage loans _at_ a fixed rate
  of 7 when LIBOR is 5 by loading 2
• Rates expected to go up and earnings have to be
  protected.
• An FRA bought at LIBOR (floating) 1, for 5
  years at a fixed rate of 6.5
• Current receipts on FRA at 6 and payments at
  6.5.
• Net margin on loans Loan rate funding cost
  FRA receipts- FRA payments, i.e. (7-56-6.5)
  1.5
• If LIBOR goes up by 1, to 6 Receipts 7 and
  payment 6.5 on FRA. Funding cost 6. Net
  margin (7-67-6.5) 1.5
• If LIBOR goes up by 2, to 7 Receipts 8 and
  payments 6.5 on FRA. Funding cost 7. Net
  margin (7-78-6.5) 1.5
• If LIBOR comes down by 1, to 4 Receipts 5 and
  payments 6.5 on FRA. Funding cost 4. Net
  margin (7-45-6.5) 1.5

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Identifying, Measuring, Monitoring Managing
Risks

• VI
• FRAs vs. Options in forex
• A Swiss importer has to pay 1 Million USD in a
  year.
•  
• Current market rate is 1 1.3000 CHF. The
  importer
• wants to protect against going up.
•  
• An FRA is available at 1.7000 CHF. Option premium
  for
• the same rate is CHF 80,000.
•  

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Identifying, Measuring, Monitoring Managing
Risks

• FRAs vs. Options in forex
• Comparison of No hedge, FRA and Option
  scenarios
•  
• Mkt. rate Liability in case of
  Gain over FRA/
• in one year No hedge FRA Option No
  he. Opt.
•  
• 1.3000 1.3000 1.7000 1.3800 0.40
  0.32
•  
• 1.5000 1.5000 1.7000 1.5800 0.20 0.12
•  
• 1.7000 1.7000 1.7000 1.7800 0 -0.08
•  
• 1.9000 1.9000 1.7000 1.7800 -0.20 -0.08
•  
• 2.1000 2.1000 1.7000 1.7800 -0.40
  -0.08
• Option is not exercised and market is
  accessed.

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Identifying, Measuring, Monitoring Managing
Risks

• VII
• Interest Rate Swaps
• Helps create the right mix of short term and long
  term assets and liabilities, while controlling
  the interest rates attached to them
• No exchange of principal but only interest
  difference on a notional amount
• Interest rate risk can be shifted, by converting
  a floating rate to fixed rate or vice-versa
• Interest payments made in the same currency

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Identifying, Measuring, Monitoring Managing
Risks

• Illustrations of IRS
• Bringing together two divergent minds
• A company A has issued fixed rate bonds and
  expects rates to come down or be stable. It opts
  for floating rate liability.
• Another company B anticipates the LIBOR to go
  up and
• is interested in switching over from floating
  to fixed rate.
•  
•  
• CP?--- (Com)--FRy-? (Bank)--FRy--? (Com)--?
  FR Bonds
• Liborx
• ( B)?--Liborx ( )?--Liborx( A)
  at y

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Identifying, Measuring, Monitoring Managing
Risks

• Bank as the Swap provider
• A US motor company has a 10 year floating rate
  borrowing and believes rates will go up. It
  seeks a fixed rate payment option.
•  
• (US Motor)?---- 6 month libor0.50
  -----------( Bank)
• ( Comp )------ USD Fixed Rate payments---
  ?( Bank )
• I
• I
• V
• 6 m Libor0.50 borrowing

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Identifying, Measuring, Monitoring Managing
Risks

• VIII
• Currency Swaps
• Currency swaps help hedge currency risk and
  companies can freely change the currencies in
  which they pay and receive
• Liabilities and assets can be restructured
• Balance sheet transaction risks can be hedged
• Surplus in one currency can be used to take care
  of funding in another currency
• Interest payments are made in two currencies
• Currencies and principal are exchanged at a
  pre-fixed rate at the beginning and end, of the
  contract period.

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Identifying, Measuring, Monitoring Managing
Risks

• Illustration of a currency swap
• A US company has need for Euros in Germany and a
  German company wants USD for it US operations.
•  
• US ?---Euros-------- German
• company ------USD-------? company
• I I
• V V
• Subsidiary in Subsidiary
  in
• Germany USA
• I I
• V V
• Uses ( and pays Uses and
• local interest pays interest
•  
• At the end of the contract period the companies
  return the principal amounts at a pre-agreed
  rate.

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Identifying, Measuring, Monitoring Managing
Risks

• IX
• Swaptions
• An arrangement/right to call on the counter party
  to enter into a swap at a pre-agreed rate and for
  an agreed period
• An asset swap can improve yield on bonds and
  avoid its selling.

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Identifying, Measuring, Monitoring Managing
Risks

• Swaptions - An illustration
• A USD 1 Bio loan floated by Air-India at Libor
  0.50
• Currently (- 0.7000
• An engineered product
• Air-India projects enough Euro income in 2 years.
• Loan converted into a Libor 5/8 payment, with
  an option
• to convert the loan in to euro loan at a rate of
  (- 0.8000 .

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Identifying, Measuring, Monitoring Managing
Risks

• X
• Futures
• An agreement to buy or sell a standard quantity
  of an asset at a future date at a price agreed
  through an open cry on the Futures exchange.
• Quantity, quality, date of delivery, units of
  price, minimum change in price, location for
  settlement are standardized
• American and European style.

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Identifying, Measuring, Monitoring Managing
Risks

• Futures An Example
• If an Indian exporter has to receive US 100
• million one year hence, he can buy 20 futures
• contracts of 5 mio at 41.
•  
• If the rate goes up (Rupee weakens) to say
• INR44, he will lose. If it goes down to INR
  38
• he would gain. As he builds in to his
  calculations
• a rate of 41, in both the cases he would retain
  his
• estimated margins.

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Policy interventions in risk mitigation

• Multi currency budgeting
• Cash and funds flow projections
• Multi currency pricing and invoicing
• Asset- liability management in a multi currency
  environment
• Dynamics of a multi currency balance sheet
• Appetite for risk

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• Managing risks in foreign exchange markets is
  complex!
• But it will be exciting and rewarding.

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• Thank You
• Sitarama Murthy
• Prmia, Hyderabad