NPTEL International Finance Vinod Gupta School Managemant , IIT. Kharagpur .

Module 10 Foreign Exchange Contracts: Swaps and Options

Developed by: Dr. Prabina Rajib Associate Professor (Finance & Accounts) Vinod Gupta School of Management IIT Kharagpur, 721 302 Email: prabina@vgsom.iitkgp.ernet.in

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Session 10 Foreign Exchange Contracts: Swaps and Options Highlight & Motivation:
Forex market players can trade foreign exchange in differing maturities and using different type of instruments i.e, cash, tom , spot, forward, futures, swaps and options contracts. In this session, foreign currency swaps and options are discussed. Though Indian companies are buying/selling options in the OTC market (with banks as counterparties), exchange traded options have started in India very recently. The contract specifications of options contract trading United Stock Exchange of India has also been discussed in detail. Indian companies have incurred major derivatives loss by entering into zero cost derivatives. The structure of zero cost derivatives has been also discussed.

Learning Objectives
Hence the objective of this module is to understand: Foreign currency swaps Foreign currency options o Long/short call and put options o American and European option o ATM/OTM/ITM options. Exchange traded option contact specifications : A detailed discussion o Zero cost derivatives.

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10.1: Primer to Foreign currency swaps, and options:

Besides spot, forward and futures contracts, companies also regularly enter into currency swaps, and option contracts to mitigate foreign exchange risk. In the following sections, very briefly details about foreign currency swaps and options have been discussed as these would be discussed in greater detail in subsequent modules.

10.2 Foreign Currency Swaps:

Very briefly, currency swap works like this: An Indian company, XYZ Co. took an ECB (External Commercial Borrowing) loan of USD 250mn for 6 years at a fixed interest rate of 5.5%. After two years, remaining time to maturity is 4 years. XYZ Co. wants to shift this USD obligation and wants to pay the interest and principal in INR. The Indian company fears that INR to depreciate hence increasing its INR expenditure to service the foreign currency denominated interest as well as principal. It approaches different banks for swapping its USD obligations. BBK bank agrees to be the counterparty for this swap at an 8.5% per annum. Once both parties agree, the following swap payment happens between XYZ Co. and BBK Bank. In the beginning of the contract, XYZ Co. gives 250mn USD to BBK Bank. BBK Bank pays INR 11750 mn (equivalent of 250mn USD at a rate of INR 47/USD) to XYZ CO. For the next 4 years, BBK bank pays USD 13.75mn (5.5% of USD 200mn) to XYZ Co. In return, XYZ Co. pays INR 998.75mn (8.5% of INR 11750mn) to BBK Bank. After the 4th year, BBK bank pays USD 250mn to XYZ Co. XYZ Co. returns INR 11750mn to BBK Bank.

The following figure, Figure 10.1 indicates the three steps in swap contract graphically.

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Figure: 10.1 Currency Swap

Step 1: At swap origination

USD 250 mn XYZ co. INR 11750 mn BBK Bank

Step 2: Annual Interest payment (4 years)

USD 13.75 mn XYZ co. INR 998.75 mn BBK Bank

Step 3: At maturity
INR 11750mn XYZ co. USD 250 mn BBK Bank

Hence due to the swap agreement, the USD interest and principal repayment exposure of the Indian company is shifted to the BBK bank. In other words, swap helped the Indian company to shift its USD obligation to INR obligation. Of course, one may ponder, why BBK bank would like to take such exposure. In fact BBK bank may not be taking the exposure at all as BBK bank may be exactly taking an opposite swap contract with some other counterparty. In the first swap agreement with Indian Bank, BBK bank was paying USD and was receiving INR. BBK bank can mitigate this risk by entering into a swap contract with another counterparty where it receives USD and pays INR. Of course, all swap contracts are not structured in a manner as given in Figure 10.1. As swaps are OTC contracts, swaps can be structured in different formats. The swap contract can be used to only pay the interest payment only. In such types of swap, step 1 and step 3 are redundant. The swap contract can be used to cover the principal repayment and not the periodic interest payment. At times, the principal is swapped in two different currencies. The company may pay USD in step 1(receive INR) and receive Euro in step
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3 (pay INR). Depending upon the clients requirement, banks structure swaps with varying features. 10.3: Foreign Currency Options: Brief Introduction to Call and Put Option. Companies buy and sell call and put options to hedge their foreign times exchange exposure as well as at times indulge in speculative activities. Options on foreign currency are offered by banks as OTC product or can be bought and sold in exchanges. Before we proceed to understand foreign currency options in greater details, let us understand the 4 building blocks of options, namely long call, short call, long put and short put. However, if a reader has not been exposed to these concepts earlier, then it is advisable to read a derivative text book on options to get a deeper understanding of options before proceeding with the remaining part of this session. In a call option, the option buyer (long call position holder) has the right to buy the underlying currency at the maturity at the exercise price. For example, an importer wanting to hedge the USD risk, enters into long call option for 20,000 USD at INR 44.45/USD with contract maturing after 15 days from today. The counterparty to the importer takes a short call option. On T+15 day, the spot rate is INR 43.80/USD. Whether the importer will exercise his option to buy USD from the counterparty or not? In this case, the option will not be exercised as the importer is better off buying the USD from spot market than from the short call position holder. The importer will exercise call option, when the spot price is higher than INR 44.45/USDwhen INR depreciates. In a put option, the option buyer (long put position holder) has the right to sell the underlying currency at the maturity at the exercise price. For example, an exporter wanting to hedge the USD risk, enters into long put option for 18950 USD at INR 44.45/USD with contract maturing after 15 days from today. The counterparty to the exporter takes a short put option. On T+15 day, the spot rate is INR 43.80/USD. Whether the exporter will exercise his option to sell USD to the counterparty or not? In this case, the option will be exercised as the exporter can sell USD at INR44.45 per USD due to the option contract. Without the option, the exporter would have sold USD at INR 43.80/USD. The exporter will exercise his put option, when the spot price is lesser than INR 44.45/USDwhen INR appreciates.

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Depending upon whether options can be exercised only on maturity date or on or before maturity date, options are categorized as European and American respectively. An option is in-the-money (ITM) if it is profitable to exercise. For a call option, if the spot exchange rate is higher than the strike exchange rate, then it is an ITM option. For an ITM put option, the spot exchange rate is lesser than the strike exchange rate. An option is out-of-money (OTM) when it is not profitable to exercise these options. For a call option, when the spot exchange rate is lesser than the strike exchange rate, it is an OTM option. For a put option, when the spot exchange rate is higher than the strike exchange rate, it is an OTM option. An at-the-money (ATM) option is when the exercise price is at par with the spot price.

10.4: Currency Options in India:

Foreign currency options are available both in OTC market as well as traded in Indian exchanges. OTC options are offered by banks with banks taking one taking one side in each option contract. Though little dated, details given in Box 10.4 explain the call and option concepts as well as highlight the popularity of currency options offered by Indian Banks.

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Box 10.4 Rupee options a hit among corporates

http://www.thehindubusinessline.com/2004/11/23/stories/2004112303180300.htm The rupee options market has seen increased activity with leveraged options finding favour with corporates in recent times. Daily volumes have increased by nearly 50 % to reach a turnover of about $50 million to $100 million, compared to a daily turnover of $25 million to $50 million a month or two back, dealers said. The reason for the popularity of these instruments over forwards is that options do not confer an obligation on the buyer to perform a contract, dealers said. An option is a contract, which gives the buyer a right but not an obligation to fulfill the contract on a due date; a premium is required to be paid to the `writer' or seller of the option for this contract. If an exporter books a forward contract, he is bound to fulfil it at the due date, while they are not tied down to an exchange rate in an option. In a forward contract, merchants cannot take advantage of a subsequent movement of exchange rates in their favour. According to traders, earlier a secular movement in the rupee was observed but now there is inter-day volatility. So corporates are getting edgy about the direction of the rupee. Even with the rupee appreciating uni-directionally to 45.04/05 levels from the 45.75 levels seen in mid-October, volatility has increased, as the rupee moves into the 10-15 paise band in a day. According to dealers, the view on the rupee has changed, as now the expectation is of a 44.00 level against the anticipation of a 47.50 level nearly two months ago. With the dollar weakening across all major currencies, the rupee is expected to appreciate, but this has failed to assuage sentiments given the high volatility in the dollar-rupee exchange market. "Rupee options are increasing in popularity, as the view on the domestic currency is changing," said Mr Abhishek Chaudhary, forex options trader, ICICI Bank. He said ICICI Bank was an active player in the rupee options market and volumes transacted by the bank had doubled recently. Over the last couple of months, nearly a 300-per cent jump in business had been recorded with about $1.5 billion worth of deals being transacted. Not only have the plain vanilla options, active up to one year, gained popularity, options having a time period of over a year have also seen a demand. "Deals have been struck for five-year options too, with two to three years instruments also being traded in large amounts," Mr Chaudhary said. Plain vanilla options are the put or call options, which can be exercised by corporates. A put option is a right to sell - so purchase of a USD put will give a corporate the right but not the obligation to sell dollars at a particular date, at a pre-determined rate, known as the strike price. An exporter, who would want to sell dollars if the market moves against him but does not want to sell dollars if the market exchange rate is in his favour, would normally buy a USD put. A call option, on the other hand, is a right to buy - so a USD call option would give the buyer a right but not an obligation to buy dollars at a strike price, at a particular exercise date.

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Besides OTC contracts, currency options for many currency pairs are available for trading through exchanges. Annexure 10.2 highlights US Dollar INR options contracts specifications trading at United Stock exchanges of India. In Section 10.5, the contract specification is explained in detail. Size of each contract is for 1000 USD i.e, a long call (put) option gives the buyer the right to buy (sell) 1000 USD. The option premium is quoted in INR terms. All options traded are European style. The option premium tick size is in INR 0.0025. At a given point of time, three monthly contracts and three quarterly contracts are available. For example, in the month of August 2011, contract maturing on August 2011, September 2011, October 2011 as well as December 2011, March 2012 and June 2012 contracts are available. Hence at a given point of time, a trader can buy/sell options upto a maximum period of 9 months. Strike price indicates at a given point of time, 12 ITM, 12 OTM and 1 ATM option will be available for trading. Strike price interval indicates the price the difference between consecutive two strike prices. Options strike price are in the multiple of INR 0.25. Exercise at expiry indicates that open positions results in delivery of both currencies. For example, if a trader as 15 open long call options at an exercise price of INR 40.20, then on the maturity date, the trader pays INR 603,000 and receives USD 15000 from the short call position holder. Position limit indicates the maximum open position a member can take depending on the category of the trader. Initial margin and extreme moss margin is calculated in a similar manner as that of currency futures explained in Session 9. Settlement of premium indicates that option premium is paid by the buyer in cash on day T and paid out to seller on T+1 day. Table 10.1 shows a snapshot of options order book (USD/INR) at United Stock Exchange of India.

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Table 10.1: Option Trading details at United Stock Exchange of India http://www.useindia.com/markets_opt.php on 23rd August 2011 at 13:33:45
Product Buy Quantity Column 0 USDAUG11 C 45.5 USDAUG11 C 45.75 USDAUG11 C 46 USDAUG11 C 45.25 USDAUG11 C 45 USDAUG11 P 45.75 1 5 5 4 10 10 0 Buy Premium 2 0.235 0.0825 0.02 0.0525 0.075 0 Sell Premium 3 0.26 0.09 0.0325 0 0 0 Sell Quantity 4 6 5 4 0 0 0 5 0.025 0.0075 0.0125 -0.0525 -0.075 0 6 0.245 0.085 0.0275 0.73 0.9775 0.06 Spread LTP Number of Trades 7 73 65 37 0 0 0

Column 0 of Table 10.1 indicates the contract maturity date along with whether the option is a call (c) or put (p) option along with exercise price ranging from INR 45.5 to INR in the multiple of INR 0.25. Columns 1 and 4 indicate the buy and sell quantity respectively. Columns 2 and 3 indicate the buy and sell premium quoted by different traders. Column 5 represents the spread which is calculated as the sell premium buy premium. Column 6 indicates LTP (last traded price). The LTP of 0.245 indicates that both buyer and seller of (USDAUG11 C 45.5) option have agreed on an option premium of INR 0.245. This means that a long call option holder has paid INR 0.245 for having the right to buy 1 USD at an exercise price of INR 45.5. As the contract size is for 1000 USD, the long call option holder pays INR 245 as option premium. Though exchange traded plain vanilla options (long/short call/put) options are available to Indian companies, many Indian companies have entered into exotic currency option contracts in the OTC market. One such exotic option currency is a zero-cost option contract. Many companies bought sold call options and used the option premium to buy call options. This ensured that the companies need not have to pay any upfront premium. Hence these combinations were known as zero-cost derivatives/cost reduction structures. However many companies incurred massive losses when exchange rate moved beyond certain levels. RBI had banned these contracts in November 2009. Details given in Box 10.5 shows the structure of a zero cost derivatives.

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Box 10.5: Zero Cost Options:

http://www.livemint.com/2010/12/28191552/Firms-can-use-zerocost-option.html The buyer of a put option has the right but not the obligation to sell a specified amount of an underlying asset at a set price within a specified time. Similarly, the buyer of a call option has the right but not the obligation to buy an asset in a similar manner. When a company enters into a foreign exchange option transaction with a bank, the structure is such that the bank sells a call option to the company, which, in turn, sells a put option to the bank. This nullifies the cost of entering into such a transaction. It is known as a zero-cost structure, for which no premium income is earned. RBI had in November 2009 banned this product but allowed importers and exporters to write and sell put options both in foreign currency-rupee and cross-currencies and earn premium on them. RBI, in its final guideline in December 2010, on over-the-counter foreign exchange derivatives said companies having a minimum net worth of Rs. 200 crore and an annual export and import turnover exceeding Rs. 1,000 crore and satisfying other risk management criteria, are allowed to use cost reduction structures.

Multiple Choice Questions and Fill in the blanks.

1. Foreign currency Swaps results in payment/receipt at _______, __________ and _________ dates. 2. An Indian exporter with foreign currency receivable (USD from export) would take __________ ____________ option contract available at NSE. a. b. c. d. e. Purchase, Call Purchase, Put Sell Call Sell Put None of these.

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3. If a call option has a strike price of INR 42.35/USD. If the spot rate on the maturity date is INR 43.35/USD. The call option is a. An ITM option b. An OTM option c. An ATM Option 4. If a put option has a strike price of INR 42.35/USD. If the spot rate on the maturity date is INR 43.35. The put option is a. An ITM option b. An OTM option c. An ATM Option

Short Questions:
1. A trader enters into long put options on USD/INR exchange rate and paid an option premium of Rs. 0.125. The exercise price is INR 45.20. At what spot rate, the long position holder will exercise his put options and what exchange rate, the long put option holder will make profit. 2. What are zero cost derivatives and why a company would invest in these instruments? 3. Explain why forward/futures/option contracts are zero-sum game? 4. Foreign Currency swap contracts help companies to shift their liabilities from one currency to another currency? Give an example to justify the above statement?

Answers to Multiple Choice Questions:

1. 2. 3. 4. Swap origination, Annual interest payment/receipt, At maturity. Purchase a put option to sell USD at a later stage. a b

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References:
Leading exporters unwinding forward contracts, The Economic Times, 23rd July 2008. http://economictimes.indiatimes.com/articleshow/msid-3266587,prtpage1.cms Rupee hit by an invisible force. DNA MONEY 16th June 2008. http://sify.com/finance/fullstory.php?id=1475907 Foreign Exchange Futures contract. http://www.nseindia.com Foreign Exchange options contract http://www.useindia.com

Annexure 10.1: US Dollar Rupee Currency Options Contract. http://www.useindia.com USDOPT Symbol OPTCUR Instrument Type 1 contract is for 1000 USD (Lot size) Size of Contract US Dollar - Indian Rupee spot rate Underlying Premium in Rupee terms. Outstanding position in USD term Quotation Premium styled European Call and Put options Type of option 0.25 paisa or INR 0.0025 Tick size Monday to Friday ( 9:00 a.m. to 5:00 p.m. ) Trading hours Three serial monthly contracts followed by three quarterly contracts of Available contracts the cycle March/June/September/December Two working days prior to the last business day of the expiry month at Last trading day 12 noon. Minimum of twelve in-the-money, twelve out-of the-money and one Strike price near-the-money strikes would be provided for all available contracts 25 paise or INR 0.25 Strike interval Last working day (excluding Saturdays) of the expiry month. The last working day would be taken to be the same as that for Interbank Final settlement day Settlements in Mumbai. The rules for Interbank Settlements, including those for known holidays and subsequently declared holiday would be those as laid down by FEDAI.

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On expiry date, all open long in-the-money contracts, on a particular strike of a series, at the close of trading hours would be automatically Exercise at Expiry exercised at the final settlement price and assigned on a random basis to the open short positions of the same strike and series Position limits Trading Clearing Member Clients Banks Members Level Higher of 6% ofHigher of 15% ofHigher of 15%The clearing member total openthe total openof the total openshall ensure that his interest or USDinterest or USDinterest or USDown trading position 10 million50 million across100 millionand the positions of across allall contractsacross alleach trading member contracts (both(both futures andcontracts (bothclearing through him futures andoptions) futures andis within the limits options) options) specified here The Initial Margin requirement would be based on a worst scenario loss of a portfolio of an individual client comprising his positions in options and futures contracts on the same underlying across different maturities and across various scenarios of price and volatility changes. In order to achieve this, the price range for generating the scenarios would be 3.5 standard deviation and volatility range for generating the scenarios would be 3%. The sigma would be calculated using the methodology Initial margin specified for currency futures in SEBI circular no. SEBI/DNPD/Cir38/2008 dated August 06, 2008 and would be the standard deviation of daily logarithmic returns of USD-INR futures price. For the purpose of calculation of option values, Black-Scholes pricing model would be used. The initial margin would be deducted from the liquid net worth of the clearing member on an online, real time basis. Extreme loss margin equal to 1.5% of the Notional Value of the open short option position would be deducted from the liquid assets of the Extreme loss margin clearing member on an on line, real time basis. Notional Value would be calculated on the basis of the latest available Reserve Bank Reference Rate for USD-INR Settlement ofPremium would be paid in by the buyer in cash and paid out to the seller in cash on T+1 day. Premium Mode of settlement Cash settled in Indian Rupees

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