CHAPTER 6: FOREIG! MANAGEMENT THROUGH FINANCIAL DERIVATIVES ON THE FOREIGN EXCHANGE MARKET. 6.1 Overview of foreign exchange market International trade activities have raised demand for exchanging different currencies with each other, and the basis for those exchanges is the exchange rate, But how can these exchanges take place? The foreign exchange market (FOREX) can help people wishing to purchase a currency and people wishing to sell the same currency at a certain rate even if they can be anywhere in world. This section introduces the concept, characteristics, functions, and transactions of the foreign exchange market in order to help students understand the characteristics and functions of the foreign exchange market, and trading mechanisms to understand and know how to calculate profits and losses of the exchange trading, 6.1.1 Concept Foreign exchange market is the international market in which participants are able to buy, sell, exchange and speculate on currencies ~ [According to Investopedia] In other words, the foreign exchange market is where specializes in foreign exchange trading, through friction between demand and supply of foreign currency to meet the needs of economic entities and identify trading conditions i.e. price and quantity of foreign currency trading. Center of the foreign exchange market is the inter-bank market, via inter-bank market all foreign exchange transactions may be carried out directly with cach other. The foreign exchange market is not actually a specific location but is an inter-bank electronic communication network, associated with foreign exchange brokers. The foreign exchange market is not located in a place but scatteres throughout the center of the financial world, such as London, New York, Paris, Hong Kong. Currently in VN there are two exchange centers located in Hochiminh Vietcombank and the Department of Vietcombank HaNoi called dealing room. 6.1.2 Features + The Forex market operates 24 hours a day. This is possible since trading happens on all continents and the time zone differences among countries, except for traditional holidays (Saturday, Sunday and official holiday). This continuity is unique, and it allows dealers to act without any time limits. ‘* Globalization without geography: 163Contrary to stock markets and other markets, geography doesn’t play a role in the Forex market. Anyone can trade anywhere. As long as you have an agency, you can trade Most traders don’t even need a physical trading agency at their country. They open an account online, over the Intemet, deposit money via credit card (or Paypal) and start trading with an agency that resides overseas. Thus, the Forex market is totally globalized — it really doesn’t matter where you are * Prices are determined on the supply and demand of foreign currencies. * Transactions with large volume: according to the BIS (Bank for Intemational Settlements) forex trading activity in the globe in April 2010 reached 4,000 billion / day, in September 2011 it reached 5,000 billion / day. + Transactions are made on freely convertible foreign currencies. The major currencies are often USD, BUR, JPY, CHF, GBP, ... which hold the market position, particularly the U.S dollar. Currency distribution on the FX market. 70.0% 60.0% 50.0% 7 39%. aon +” 30.0% 200% 10.0% 9.0% 250% 15.086 Stissct so-so DB (Nga: BES Pralpminany Dieroricl Surgy 2010) uso The US dollar is the most traded currency, accounting for 84.9% of all transactions. Second is Euro 39.1%, and third is Yen with 19.0%. * Invisible: the trading on the foreign exchange market only takes place in a closed 100m, contacted by telephone, telex,,,, through the broker. 6.1.3 Functions The basic function of the foreign exchange market is the result of a natural development of the basic functions of commercial banks, which are: to help clients implement the international trade. 164Eg: One company wishing to import goods and services from abroad will have demand for foreign currencies if the bill of goods or services are denominated in foreign currencies. Or, exporters need to convert foreign currencies into domestic currency if the export bill of goods or services in foreign currency. In addition, the foreign exchange market also has a number of other functions, such as: * Helping the capital flow between countries effectively. «The extemal value of the currency being determined in an objective way * Insuring export proceeds, import payments, investments, and borrowings in foreign currencies * Tools for the State bank to capture market information ‘© Creating the conditions for integration with international financial markets 6.1.4 Types of foreign exchange market + In the process of formation and development , there are two systems: - American ~ British Exchange Rate System: is a place where the foreign exchange market is only symbolic, just transacts forex trading regularly between some banks and brokers, and through telephone, telex - European Exchange Rate System: a system of exchange that has specific locations, everyday foreign exchange transactors come to transact and sign contracts, + According to the nature of market activity ~ Spot foreign exchange market: is a place where foreign currencies are traded with the exchange rate determined at the time of transaction. = Deposit market: is a place where borrowing and lending transactions in foreign currency are done with the determined time and interest rate «According to business operations ~ Spot market: Trading in foreign currency is made at one given time, according to the market price. - Forward market: the market for trading time foreign exchange contracts, a contract of sale that the transfer of foreign currency exchange is done after a certain period of time after the contract agreement. = Options market: is a combination of spot market and futures market through contracts signed in the form of options. The market is not buying and selling foreign currency, financial assets but purchase call options, put options of the above goods at prices determined at one point or at the end of one period. 165© According to the scope of the market - International Monetary Market: the prestige market in the world with large-scale operations, growing business volume as London, Paris, Tokyo. - Regional Monetary Market: the market which implements some certain transactions and currencies. For example, Saudi Arabian market only converts the Dinar. 6.2. Spots 6.2.1 Concepts Currency spot trading is the most popular foreign currency instrument around the world, making up 37 percent of the total activity. The fast-paced spot market is not for the fainthearted, as it features high volatility and quick profits (and losses). A spot deal consists of a bilateral contract whereby a party delivers a specified amount of a given currency against receipt of a specified amount of another currency from a counterparty, based on an agreed exchange rate, within two business days of the deal date. This time period was necessary to check out all transaction’s details among counterparties, This is a popular business and makes up a large proportion of transactions in the foreign exchange market, 6.2.2 Participants = Commercial banks - Brokers - Customers of commercial banks 6.2.3 Use cases The major traders in the spot market are the commercial banks and the investment banks, followed by hedge funds and corporate customers. In the interbank market, the majority of the deals are international, reflecting worldwide exchange rate competition and advanced telecommunication systems. However, corporate customers tend to focus their foreign exchange activity domestically, or to trade through foreign banks operating in the same time zone. Although the hedge funds’ and corporate customers’ business in foreign exchange has been growing, banks remain the predominant trading force. For corporate customers, they often use spot transactions for the purpose of covering costs, making payment for goods, food and speculating foreign exchange. E.g.: One export company wants to sell foreign currency to take VND to cover the domestic cost after getting payment in foreign currency from an export contract. 166Meanwhile, one import company wishes to buy foreign currency at transaction date for payment of a due export contract. Thus, the bank can use spot transaction to satisfy the needs of two clients. 6.2.4 How to implement Spot transactions. Study the following example: One Vietnamese importer needs USD 1,000,000 to pay for the American exporter. The procedure is as follows: ~The importer contacts a bank. - The importer specifies account to debit (his account) and account to credit (exporter’s account) - Both parties make agreement on the exchange rate and payment method. ~The bank signs a contract to sell foreign currency to the importer. - The bank will contact his correspondent bank in the U.S. to transfer USD 1,000,000 fiom his Nostro account to exporter’s one. - On value date, the bank debits the importer’s account. 6.2.5 Strengths and weaknesses * Strengths: transactions are provided for - Exporters who have demand for selling foreign currency at once - Importers who have demand for buying foreign currency at once * Weaknesses: unable to provide transactions for the buyer or seller on demand with future transaction time. 6.3 Forwards 6.3.1 Concepts A forward transaction is a transaction in which two parties undertake to buy or sell an amount of foreign currency at a specific exchange rate and the payment will be made at a specified time in the future. That is, the two sides will make agreement on transferring a certain amount of foreign currency, after a certain period of time from the date of signing the contract, the exchange rate is determined at the time of signing. 6.3.2 Participants - Traders = Hedgers = Speculators 6.3.3 Use cases 167+ Customers often apply Forward transactions for the purpose of hedging (the act of reducing exchange rate risk). E.g. One export company has a contract of USD 200,000 with the payment period of 3 months later. We know the spot rate of USD/VND is 20,000. Thus, export contract value at present is VND 4,000,000,000. The export company cannot predict how the future exchange rate changes. + If the dollar appreciates against USD, assuming the exchange rate USD / VND. 21,000, the company will collect about USD 4,200,000,000 (21,000 x USD 200,000) => The export company will get profit of VND 200,000,000 (compared with VND 4,000,000,000) + If the dollar goes down against the USD, assuming the exchange rate USD / VND 19,000, the company will collect about USD 3,800,000,000 (19,000 x USD,000) => The export will lose VND 200,000,000 (compared with 4,000,000,000 VND) To avoid losses due to the down fluctuation of the forex rate between USD and VND, exporters can sell dollars to banks under the Forward contract with the agreed rate at ND 21,000 per USD. The Bank buys dollars of the exporter at the forward rate of 21,000 which is fixed during the term of transaction. Thus, the exporter can avoid risks of exchange rate fluctuations, For example: + If the price of USD goes down to VND 19,000 per USD => the company still gets profits because it can sell dollars at the price of 21,000. In contrast to exporters, importers can contact and purchase forward contract from banks to avoid currency appreciation, which makes the costs of imports inerease. 63.4 Formula Forward rate is determined on the basis of spot rate, and transaction duration of 2 currencies (A/B) line General formula: Fu= Fs x Itn.ra - Fa: Forward rate of currency A against currency B(A/B) ~ Fs Sport rate (A/B) - nm: Time, duration of agreement (day, month, year) - FA interest rate of A (commodity currency) - _ri:: interest rate of B (terms currency) Forward rate depends on Spot rate, interest rate of commodity and term currencies. Today, a simpler formula is often used in international exchange transactions: 168= FetFex nx (re=a) We need to calculate both ask and bid rate for forward transactions. Let: - Fm, Sm are bid rates of forward and spot transactions respectively. - Fb, Sb are ask rates of forward and spot transactions respectively. =D re, L ra are deposit rate and loan rate of commodity currency. - Dra, L re are deposit rate and loan rate of terms currency - nis the number of days of the forward contract. Sb [Drp—Lra}n Forward Bid rate: Fb=Sb+ 100360 oe Sa[Lre—Dra}n 100 x 360 sign a forward contract. 169= Two parties transfer foreign currencies on the mature date. E.g.: On 4th April, 2012, Lotus Co. contacted Bank XNZ to sell EUR 100,000, 3- month term. To meet the demand of Lotuc Co., XNZ offered 3-month forward rate. State all steps to perform the transaction? + XNZ collects all necessary information to determine the forward rate: © Spot rate USD/VND: 20,780 — 20,850 * Spot rate EUR/USD : 1.3200 - 1.3212 + 3-month interest rate of VND and BUR as follows: Term EUR (Ziyear) VND(%iyear) Deposit Loan Deposit Loan ‘3 months 2.40 42 1 17 On the agreement date, XNZ bank determines and offers forward rates basing on the above interest rates and exchange rates: Spot rate EUR/VND = EUR/USD x USD/VND = 1.3200 x 20,780 =27,430 XNZ offers 3-month bid forward rate for EUR/VND: Sb[Dr.VND - Lr.EUR] n Fb=Sb + 100 x 360 27,430 [11 - GO) Two parties sign 3-month forward contract if they come to an agreement and on = 27,430 + = 27,896 100 the mature date, they will transfer foreign currencies as follows: Lotus Co. will deliver EUR 100,000 for XNZ XNZ Bank will pay for Lotus Co. EUR 100,000 x 27,896 = VND 2,789,600,000 6.3.6 Strengths and weaknesses Strengths: - Satisfying the demand for trading foreign currencies that are transferred in the future. Weaknesses: - Forward transaction is a compulsory transaction so on the maturity date two parties have to implement the contract despite the disadvantage exchange rate —L - Unable to meet the current demand. 1706.4 Options Options contracts traded on the exchange rate were first launched in Philadelphia Stock Exchange in 1983. In VN, Options were launched by Eximbank in early 2002 and now commercial banks such as ACB, Techcombank, Citibank ... also provide this transaction. 6.4.1 Concepts Option is a transaction between an option holder’ buyer and an option writer/ seller, in which the option holder has the right, but not the obligation, to buy or sell a specific amount of foreign currency at a predetermined price (strike price) during a predetermined period of time or on a specific date (exercise date). If the option holder exercises his option, the writer has the obligation to sell or buy that amount of foreign currency with the exchange rate stated in the agreed contract. Generally speaking, the writer commits to exercise the holder’s option if the holder requests, The holder has the right to request the writer to exercise his option if the option has value or does not perform if the option has no value, So the holder has benefits when exercising the option, but the seller accepts disadvantage if he exercise the option of the purchaser. In return, the writer is paid a certain fee by the holder whether or not to exercise the option. ‘An option contract has some elements as follows: = Holder: who buys the option ~ Writer: who sells the option - Base assets: foreign currencies as EUR, CHF, CAD - Premium: the price of the option - Exercise rate, strike rate, or striking rate: the price at which the underlying currency will be delivered upon exercise = Spot rate - Maturity. 6.4.2. Types of Options - Call option: the right to buy foreign currency at the agreed exchange rate during a certain period of time. ~ Put option: the right to sell foreign currency at the agreed exchange rate during a certain period of time In addition to types of options, we need to consider option styles: - Buropean option style: only allow to exercise the option at the maturity date 71- American option style: allow to exercise the option at any time before and until the maturity date. 6.4.3 Use cases - For speculation At present, the exchange rate of EUR/USD is 1.3200-1.3212. Assuming that customer A forecasts EUR to go up. He can buy 200,000 EUR as a speculation to get profits after 3 months if the price of EUR increases. However, USD 264,240 (EUR 200,000 x 1.3212) is a big sum of money that is difficult to have. What should Customer A do to perform his wish of speculation? > Customer A contacts Bank B to buy a call option contract with terms as follows: - Option writer: Bank B - Option holder: A - Option type: call option - Option style: American - Amount of foreign currency: EUR 200,000 ~ Exercise rate: 1.3250 - Maturity: 90 days - Premium: 0.02 USD for each EUR With the option contract, customer A doesn’t need to buy EUR 200,000 and thus, he doesn’t need to take USD 262,240. He just buys a call option for EUR 200,000 at the rate of 1.3250 USD for each EUR and the cost for this option is 200,000 x 0.02 = USD 4,000 instead of USD 264,240 to do speculation. Customer A needs to follow, calculate and consider the fluctuation of the rate between EUR and USD to make right decisions. Firstly, he needs to consider breakeven point. Break-even point (BEP): 1.3250 + 0.02 = 1.3450 At this rate, customer A can get enough money to cover the premium, without profits. At any time later, if: «EUR increases in price against USD: + The price of BUR < BEP (1.3450) => A can wait for the ongoing increase of EUR if the contract is not due. If the contract is due and the spot rate at this time is 1.3350, Therefore: (1.3350 — 1.3250) x 200,000 = 2,000 > IFA exercises the contract, he will lose 2,000 USD (USD 4,000 - USD 2,000) > If A doesn’t exercise the contract, he will lose 4,000 USD (the premium) 172+ The price of BUR > BEP (1.3450) > A can exercise the contract immediately although it isn’t due in order to get profit from the difference between spot rate and strike rate being multiplied by the contract value and then deducting the premium of 4,000 USD. The spot rate at this time can be 1.3750. (1.3750 — 1.3250) x 200,000 — USD 4,000 = USD 6,000 > A can wait for the appreciation of EUR to get more profits. EUR decreases in price against USD: -> If the option is not due, A can wait and keep track of the exchange rate fluctuation, => If the option is due, A doesn’t need to exercise the contract, he still loses USD 4,000 for the premium. Thus, if the exchange rate EUR / USD is higher than breakeven point, customers will eam a profit equal to the difference between the spot rate and the real exchange rate after subtracting the cost of buying the option. Banks would then lose a fair amount of profit eared by investors. Chart 6.2: Income chart of the bid option holder 4 Profit oO BEP Unlimited x rate Exercise rate capability ‘ + 0 ; x A B Rate Premium: { Cost line 6 Limited loss 173Chart 6.3: Income chart of the bid option writer Limited profit BEP f Unlimited loss ; © sate fn y Exercise rate Chart 6.4: Income chart of the ask option holder profit. (+) Limited loss BEP me Exercise rate ol | J ¥ x Rate Premium —P Potential interest Transaction cost line t oO 174Chart 6.5: Income chart of the ask option writer Profit. (+) Limited profit Premium P x Rate Exercise rate - For hedging If the customer has an import contract which will be paid in the future, he should buy call options to hedge the exchange rate. The cost of buying call options may increase the cost of imports, but in return he will have a peace of mind, as the cost of (Garancs) If the customer has an export contract, he should buy put options to hedge the exchange rate. The cost of buying put options can reduce profits but in return he has a peace of mind like insurance costs. 6.4.4 How to implement Option transactions = Client contacts a bank if he/ she is in need of buying an Options contract. - The client and the bank make agreement on options type, options style, exercise rate, amount of money, premium, and validity period. - When the client wants to exercise the contract > send written request to the bank. 6.4.5 Strengths and weaknesses Strengths - It’s not obligatory to exercise the contract when it is due. - Options can be used to hedge against the unpredictable fluctuations of the exchange rate, - There are investment opportunities with limited cost, and unlimited profit, Weaknesses 175A certain amount of premium must be paid to be able to apply this tool to hedge forex risks. 6.5 Arbitrages 65.1 Concepts Arbitrage is the practice of taking advantage of inconsistent exchange rates in different markets by selling in one market and simultaneously buying in another. In its simple form, arbitrage is buying a foreign currency at a low price then immediately selling it on a different market for a higher price. Exchange rate arbitrage transactions may be classified in terms of the number of markets involved. Thus, we have two-point or three-point arbitrage. + Two-point arbitrage concerns two currencies in two geographically separated markets or two different monetary centers. Three-point arbitrage/ Triangular is the act of exploiting an arbitrage opportunity resulting from a pricing discrepancy among three different currencies in three different markets or three different monetary centers. 6.5.2. Use cases ~ Arbitrage is used in case that traders want to get profits from differentials in the price of a currency in different markets. For example: Consider the following market rates: * GBP/USD = 1.9809/39 in New York * USD/AUD = 1.6097/17 in Sydney * GBP/AUD =3.1650/70 in London. To get an arbitrage opportunity, arbitrageur can implement following transactions: + From New York, the arbitrageur sells USD 1,000,000 to get: 1,000,000 x 1.6097 = AUD 1,609,700 in Sydney. * Sell AUD 1,609,700 to buy GBP in London: 1,609,700 508,272.81 (GBP) 3.1670 © Then, sell GBP in New York: 508,272.81 x 1.9809 = 1,006,837.61 (USD) + Profit received from doing arbitrage: USD 1,006,837.61— USD 1,000,000 = 6,837.61 (USD) 176This attractive profit attracts more people to this business. As a result, AUD is overvalued against USD in Sydney and undervalued against GBP in London and then, opportunities for arbitrage disappear, but the exchange rates on these markets will be in equilibrium. Arbitrage is used in payment, For example: One Hongkong company receives payments of GBP 50,000 and SEK 3,500,000, but at the same time this company has to pay EUR 45,000 and CHF 1,000,000. Apply Arbitrages to make payment and define the changing value of its account in the trading day. Some information on the market is as follows: GBP/EUR: 1.4388 — 1.4528 GBP/CHF: 2.4021 — 2.4240 SEK/CHF: 0.1797 — 0.1849 HKD/CHF: 0.1521 - 0.1531 Step 1: Sell GBP/EUR under the bid rate of 1.4388 > The amount of GBP needs to be sold: 45,000 x (1/1.4388) = 31,276.0633 > The amount of GBP is left: 50,000 — 31,276.0633 = 18,723.9367 Buse 2 : Sell GBP/CHF under the bid rate of 2.4021 > The amount of CHF is aldready paid: 18,723.9367 x 2.4021 = 44,976.7683 > The amount of CHF left needs to be paid: 1,000,000 — 44,976.7683 = 955,023.2317 Step 3: Sell SEK/CHF under the bid rate of 0.1797 The amount of CHF is already paid: 3,500,000 x 0.1797 = 628,950 The amount of CHF left needs to be paid: 955,023.2317 — 628,950 = 326,073. 2317 Step 4: Sell HKD to pay the remaining amount of CHF: The amount of HKD needs to be sold: 326,073.2317 / 0.1521 = 2,143,808.229 > The account value in the trading day : - 2,143,808.229 (HKD) 6.5.3 How to implement Arbitrage transactions A. Simple Arbitrages (2 markets) = Step 1: Quote the rate according to one market. - Step 2: Define trading ways Condition: Ask rate (maket X) < Bid rate (market Y) © There is an arbitrage opportunity For example: Consider the following rates : In HCMC: USD/VND: 20,100 - 20,180 177AUD/VND: 21,275 ~ 21,529 In Sydney: USD/AUD: 1.6097 — 1.6117 Firstly, in HCMC we calculate the rate of USD agaisnt AUD 20,100 Bid rate USD/AUD = = 0.9336 21,529 20,180 Ask rate USD/AUD = = 0.9485 21275 Ask rate of USD/AUD in HCMC = 0.9485 < Bid rate of USD/AUD in Australia => There is an arbitrage opportunity. ‘We can determine the ways of trading as follows: in HCMC sell VND for USD, use USD to buy AUD in Australia, then sell AUD in HCMC to get profit. 100,000,000 In TpHCM, use VND 100,000,000 to buy USD: |= __________ =4,955.4 USD 20,180 In Australia, use USD 4,955.4 to buy AUD: USD 4,955.4 x 1.6117 = 7,986.6 AUD Then, come back HCMC to sell AUD 7,986.6: AUD 7,986.6 x 21,275 = 169,915,349 (VND) Take VND 169,915,349 to minus the initial capital of VND 100,000,000 the remaining is VND 69,915,349 B. Complicated Arbitrages (more than 3 markets) Step 1: Choose a business plan: find an opportunity. Step 2: buy and sell currencies in accordance with the chosen plan to get profit from Axbitrages. For example: Assume we have following rate: * GBP/USD = 1.9809/39 in New York * USD/AUD = 1.6097/17 in Sydney * GBP/AUD = 3.1650/70 in London To exploit arbitrage opportunity, arbitrageur can implement transactions as follows: «In Sydney, arbitrageur sells USD 1,000,000 to get: 1,000,000 x 1.6097 = 1,609,700 (AUD) 178* Sell 1,609,700AUD to buy GBP in London: 1,609,700 508,272.81 (GBP) 3.1670 * Sell GBP in New York: 508,272.81 x 1.9809 = 1,006,837.61 (USD) + Profit from arbitrages: 1,006,837.61USD — 1,000,000USD = 6,837.61 (USD) This attractive profit attracts more people to this business. As a result, AUD is overvalued against USD in Sydney and undervalued against GBP in London and then, opportunities for arbitrage disappear, but the exchange rates on these markets will be in * Notes: ~ The exchange rate will eventually correct itself out of the arbitrage opportunity 80 you must act quickly to capitalize on the discrepancy. ~ In practice, it is very difficult to have arbitrages because of high articulation among markets, If any, differences are always less than transaction costs, which prevents arbitrage. 6.6 Futures 6.6.1 Concepts ‘A future transaction is a transaction to buy or sell an amount of foreign currency at a pre-determined exchange rate at the time the contract comes into effect. Transfer of foreign curreney is implemented in a future date. Unlike Forward contracts, futures contracts are only available for a few foreign currencies. Chicago Mercantile Exchange, for example, only offers futures contracts with 6 strong currencies that are GBP, CAD, EUR, JPY, CHF and AUD. In addition, futures contracts can be liquidated before the delivery date in the contract because parties can sell or buy the goods in the contract to the other side in the contrary position (previous buying or selling position). Thus, for this type of transaction, there is no delivery of goods, but parties complete their obligations by making cash payments based on changes in exchange rates. Movements in the exchange rates determine the gains and losses. Futures market is similar to forwards one, but is standardized in foreign currencies, amount and delivery date of toreign currencies. 179Participants in futures market include: «Floor traders: speculators or representatives of banks, companies that use futures markets to complement the forwards transactions. * Floor brokers: representatives of investment companies, companies that specialize in investment brokerage to get commission, 6.6.2 Use cases = For speculation purposes If one person does not have enough money to make the purchase or sale of foreign currency for speculation, he can take a futures contract by depositing a much smaller sum of money than the real value of the contract. Trader can buy a futures contract if he predicts the upward trend of a foreign currency. Conversely, he will sell a futures contract. With futures contracts, every day, if the exchange rate goes up exactly as predicted, the buyer of the future contract will get profit and be credited to the account an amount equal to the difference between the spot rate and the previous day's rate multiplied by the value of the contract. Conversely, if the exchange rate goes down, the customer's account will be debited an amount equal to the difference between the spot rate of the previous day and today’s rate multiplied by the value of the contract. If the trader’s deposit account balance goes under the standard minimum level regulated by the Futures Exchange after being debited many times, he must put sufficient money into the account to be continued to trade. For futures contract seller, if the exchange rate goes down, his account will be credited an amount equal to the difference between the spot rate of the previous day and. today’s rate multiplied by the value of the contract. If the exchange rate goes up, the account will be debited an amount equal to the difference between the spot rate and the previous day’s rate multiplied by the value of the contract. For example: Speculator in the futures market prediciS that EUR will overvalue against USD. To get money from this opportunity: + On Monday, he purchases a futures contract for 200,000 EUR with the rate of 0.76 USD per EUR. The contract will be due on Wednesday afternoon. Speculator makes a deposit of USD 2,565. > Payment does not happen on this morning, + At the end of the second day: EUR goes up to 0.765 USD 1 EUR > Speculator receives: EUR 200,000 x (0.765 — 0.76) = 1,000 (USD) 180+ At the end of the third day: EUR goes down to 0.7623 > Speculator pays: EUR 200,000 x (0.765-0.7623) = 540 (USD) + At the end of the fourth day (the contract is due): EUR goes down to USD 0.75 > Speculator has to pay two items: (1) EUR 200,000 x (0.7623 - 0.75) = 2,640 (USD) (2) EUR 200,000 x 0.75 = 150,000 (USD) = For hedging against the risks of foreign exchange When a price will increase whem has created two states of that fore buying that futures contract. With these has receivables, he should have reversed action. 6.6.3 Comparison between Fowards and Futures exon has liabilities in foreign currency and worties that this currency’s liabilities are due, he should buy a futures contract. Thus, he currency: negative for liabilities, and positive upon tates, he can prevent risks. If case a person ‘Table 6.1: Table of comparison between Foward and Future contracts Forward contract Future contract time, but usually multiples of 30 days | Type of contract ‘An agreement between the buyer | Details of contracts are and the seller. Terms and_| standardized by the Futures conditions are flexible. Exchange, Duration Parties can choose any period of | There are some periods of time regulated by the Exchange. Futures ‘Value of contract Generally Targe, averagely more than | million USD/ contract (according to the world level) ‘Small enough to attract traders. Safety agreement Customers must maintain. a minimum balance in the bank to guarantee the contract. All waders must maintain a deposit amount in percentage of the contract value. Payment No payment before the due date of the contract, Payment is made daily by debiting the loser and crediting the winner. [Last payment Over 90% of the contracts are made payment on due date Less than 2% of the contracts are made payment on due date, mostly through reversing the contracts. 181Risk Payment is not made daily so risks can occur when one party can not implement the contract. There are less risks, for payment is made through the clearing house. However, risks can also occur between brokers and clients. ‘Quotation ¥ Banks quote the selling price and buying price with the difference between the selling and buying price. + European style The difference between the selling price and the buying price is quoted on the Futures Exchange. + American style | Commodities All kinds of commodities Some commodities limited by the Futures Exchange, | Exchange rate Exchange rate is fixed during the period of the contract, Exchange rate is changed every day. Commission ‘On the basis of the difference | Customers pay commission for between the selling price and the | brokers. Brokers. and buying price. speculators pay fees for the Future Exchange. Regulation Parties reach an agreement. Regulations are ruled by the Futures Exchange. 6.6.4 How to implement Future operations All Futures contracts are done in the Exchange that provide an institutional framework for standardizing contract terms and mitigating credit risk. Members can be individuals, representatives of companies, commercial banks. Futures contracts are created when an order is executed on the floor of the exchange. The order can originate with a member of the exchange trading for his or her own account in pursuit of profit, Alternatively, it can originate with a trader outside the exchange who enters an order through a broker, who has a member of the exchange execute the trade for the client. These outside orders are transmitted electronically to the floor of the exchange, where actual trading takes place in an area called a pit. A trading pit is a special location on the exchange floor designated for the trading of a particular contract, The trading are consists of an oval made up of different levels, like stairs, around a central open space. 182Traders stand on the steps or in the central part of the pit, which allows them to see each other with relative ease. Any offer to buy or sell must be made by gpen outcry to all other traders in the pit, in which traders literally “cry out” their bids to go long and offers to go short in a physical trading pit”. This process helps ensure that all traders in a pit have access to the same information about the best available prices. In recent years, there have been several attempts to replicate the trading pit with online computer networks. Replicating the interactions of traders has proven to be a difficult task and computer-based trading has not grown as fast as many industry professionals forecast a decade ago. Each futures exchange has a clearing house, which is a well-capitalized financial institution that guarantees contract performance to both parties. As soon as the trade is the cles consummate ing house interposes itself between the buyer and seller. The clearing house acts as a seller to the buyer and as the buyer to the seller. At this point, the original buyer and seller have obligations to the clearing house, and no obligations to each other. The clearing house guarantees that goods will be delivered to the buyer and that funds will be delivered to the seller. The traders need to trust only the clearing house, instead of each other. After all the transactions are completed, the clearing house will have neither funds nor goods. It only acts to guarantee performance to both parties, 6.6.5 Strengths and weaknesses © Strengths: ~ Available for small-valued contracts. Dan be assigned to other at any time before the due date of the contract. © Weaknesses: ~ Limited to relatively few currencies, and have a few fixed expirations ) - Unlike Options, with Futures contract, it’s compulsory to implement the contract on due date. 6.7 Swaps In large part, the swaps market has emerged because swaps escape many of the limitations inherent in futures and options markets. 6.7.1 Concepts A swap that involves the exchange of principal and interest in one currency for the same in another currency, The swap arises when one party provides a certain principal in 183one currency to its counterparty in exchange for an equivalent amount of a different currency. For example, Party C may have euros and be anxious to swap those euros for US. dollars. Similarly, Party D may hold U.S. dollars and be willing to exchange those dollars for euros. With these needs, Parties C and D may be able to engage in a currency swap. Some other complicated examples: For example 1; Hongkong Bank uses HKD to buy USD of another bank with the spot rate, at the same time Hongkong bank sells those dollars for that bank with the forward rate to get HKD. Difference between the spot rate and the forward rate is swap rate For example 2 : Bank A signs a contract with Bank B to buy 10 million GBP by USD. Then, Bank A will loan 10 million GBP in a period of 3 months. Spot rate of GBP/USD = 1.6125-30 Interest rate IA: 3.25% year — 4.50%year Interest rate IB: 4.75% year — 4.8% year. How many profits does Bank A get after doing SWAP transaction? Answer: - Bank A buys 10 million GBP with an amount of capital of: 10,000.000 x 1.6130 = 16,130,000 USD - Bank A lends Client A 10 million GBP, after 3 months, Bank A gets: 10,000,000 + 10,000,000 x 3 x 4.50 %/12 = 10,112,500 GBP. - 3-month forward rate of GBP/USD is FR = 1.6125 + 1.6125 x 3 (4.75%/12 — 4.59/12) = 1.6135 ~The initial capital that Bank A recovers is: 10,112,500 GBP x 1.6135 = 16,316,518.75 USD - Thus afer doing swap, Bank A get a profit of: 16,316,518.75 — 16,130,000 = 186,518.7SUSD Swap was officially presented in Viet Nam since the State bank had issued Regulations on foreign exchange transactions, together with Decision No. 17/1998/QD- NHINN7 dated 10/01/1998. 6.1.2 Use cases a, Lower costs of borrowing money: by many ways: - Taking relative advantage of borrowing. For example: Thanks to the good relations with Bank X, company X can borrow USD from this bank with lower interest rate than that in the market. Similarly, company 184Y can borrow CHF with lower interest rate from Bank Y. However, company X is in need of CHF and company Y for USD. In this situation, company X borrows USD from Bank X, company Y borrows CHF from Bank Y, then use swaps to get the desired currency with lower costs. - Lowering costs through hedging. Hedging can reduce adverse changes in cash flow, help companies increase credibility in bulk loans > contribute to lower costs by taking advantage of economy of scale. - Exploiting the differences in regulations and taxes ‘A company wants to avoid the provisions of its nation which bind itself to do business on only one particular currency, it can move on to do business on another currency, then do swaps to obtain the desired foreign currency. - Developing new markets Do business on new-developed market with high profi ,, then use swaps to obtain the desired products. b, Hedge Swaps have a great impact on financing and hedging, allow companies to have a breakthrough in a new market and take their advantages to increase business without risks. Through swaps, risks can be transferred from this market or commodity to another market or another nation. In addition, through swaps, participants get the desired foreign currencies with the same rate without purchasing from bank, so they can avoid the risk of exchange rate fluctuations and difference between the bid rate and the ask rate. 6.7.3 How to implement Swaps Procedure to do Swaps is as follows: ~ Client who is in need of doing Swaps contacts a bank. - Basing on the demand and supply of foreign currency, the foreign currency sales department will offer a specific price and term for the clients. = Two parties will sign a contract if the client agrees on the price and term given. 6.7.4 Strengths and weaknesses * Strengths: - Overcome the disadvantages of spot transaction which is not to meet the client's demand on foreign currency in the future and of forward transactions which is not to meet the client's demand in the present, 185- For banks, they can mect the clients’ demand and get profits from the difference of the bid rate and the ask rate. * Weaknesses: Although the swaps market evolved to avoid limitations in futures and options markets, the swaps market also has inherent limitations. - Because a swap agreement is a contract between two counterparties, the swap can not be altered or terminated early without the agreement of both parties. - The clearing houses of futures and options exchanges effectively guarantee performance on the contracts for all parties. By its very nature, the swaps market has no such guarantor. - Only two times are concerned in Swaps: the effective and maturity time, without regard to the exchange rate fluctuations during those two times. Thus, any time after reaching an agreement when the exchange rate is on the profitable movement, traders still do not benefit from the contract because it is immature. Unfortunately, this benefit may not exist on the due date, CHAPTER SUMMARY This chapter provided a brief overview of financial derivatives, their markets and application. Spots, Forwards, Options, Futures, Arbitrages, or Swaps are introduced. All of these struments play an important role in risk management and some simple examples of how traders can use derivatives to manage risks. - A spot deal consists of a bilateral contract whereby a party delivers a specified amount of a given currency against receipt of a specified amount of another currency from counterparty, based on an agreed exchange rate, within two business days of the deal date. - A forward transaction is a transaction in which two parties undertake to buy or sell an amount of foreign currency at a specific exchange rate and the payment will be made at a specified time in the future. sp - Option is a transaction between an option holder/ buyer and an option writer/ seller, in which the option holder has the right, but not the obligation, to buy or sell a specific amount of foreign currency at a predetermined price (strike price) during a predetermined period of time or on a specific date (exercise date). If the option holder exercises his option, the writer has the obligation to sell or buy that amount of foreign currency with the exchange rate stated in the agreed contract, 186= Arbitrage is the practice of taking advantage of inconsistent exchange rates in different markets by selling in one market and simultaneously buying in another. = A future transaction is a transaction to buy or sell an amount of foreign currency at a pre-determined exchange rate at the time the contract comes into effect. Transfer of foreign currency is implemented in a future date. - A.swap that involves the exchange of principal and interest in one currency for the same in another currency. REVISION QUESTIONS 1, What is a spot foreign exchange transaction? In what cases do customers use spot transaction? 2. Drawbacks of spot transaction? How to overcome these drawbacks? 3. What is a forward transaction? What are the benefits that the bank and customer have when they perform forward transactions? 4, Drawbacks of forward transaction? How to overcome these drawbacks? 5. What are the differences and s rities of Swaps and Forwards? Why do banks offer Swaps besides Forwards? 6. What is Futures contract? What is the difference between Futures contract and Forwards contract? 7. What are strengths and weaknesses of Futures? How to use Futures in speculation and hedging? 8. What is an Option contract? What are advantages of Options in comparison with Forwards and Futures? EXERCISES FORWARDS Answer question by using following information: Spot Rate Bid ‘Ask JPY/VND 213 215 One exporter wants to sell 2m JPY to take VND under a 3-month forward contract with a bank, How much VND will the exporter re The spot rate follows the above table: eive after 3 months? Interest rate of JPY : deposit 2%/ year; lending 3%/year , of VND : deposit 7.5%/ year ; lending 8.5%/year OPTIONS 187Exercise 1: Ms. Jennifer buys a call option at ACB with transaction terms in the contract as follows: © Option writer: ACB © Option holder: Ms. Jennifer * Option type: call © Option style: America © Amount of foreign currency: 100,000 EUR © Strike rate: 1.2302 © Maturity: 90 days from the contract date * Premium: 0.01 USD for each EUR. Spot rate at the present is EUR/USD = 1.2228 and the option contract is still in its validity. According to you: Should Ms. Jennifer exercise the contract now? If so, what benefit does she get? If not, what should she do with her option? What does Ms. Jennifer expect from the exchange rate of the spot market? At what rate on the spot market should she exercise the contract? Give one example for the rate at which Ms. Jennifer can exercise the contract and determine her profits? If the above rate does not happen and the contract is due, how much loss will Ms. Jennifer get? Exercise 2: Mr. Johnathan buys a Put option at ACB with transaction terms in the contract as follows: © Option writer: ACB © Option holder: Ms. Johnathan © Option type: put © Option style: America Amount of foreign currency: 100,000 EUR © Strike rate: 1.2302 © Maturity: 90 days from the contract date © Premium: 0.01 USD for each EUR. Spot rate at the present is EUR/USD = 1.2228 and the option contract is still in its validity. According to you: 188,1. Should Mr.Johnathan exercise the contract now? If'so, what benefit does he get? Ifnot, what should he do with his option? 2. What does Mr.Johnathan expect from the exchange rate of the spot market? At what rate on the spot market should he exercise the contract? Give one example for the rate at which Mr.Johnathan can exercise the contract and determine his profits? 4. Ifthe above rate does not happen and the contract is due, how much loss will MrJohnathan get? Exercise 3: ABC Bank provides information about Option transaction as follows: Contract’s content Call Option Put Option Value | 100,000 USD 100,000 USD. Exercise rate (USD/VND) 20,840 20,830 Duration 2 months 2 months Option style ‘Amecian ‘American Premium per each USD 30 VND 20 VND On 5" July, customer X wanted to buy one call option and customer Y wanted to buy one put option, a. Base on the above information, determine the option premium that customer X and Y have to pay. b, To what exchange rate can customer X and Y exercise the options? ©. Assume that on 20" July, the exchange rate of USD/VND is 20,865, what can customer X and Y do with their options? 4, Assume that on maturity date, the exchange rate of USD/VND is 20,890, what can customer X and Y do with their options? ARBITRAGES Exercise 1: Bank A quotes the exchange rate of GBP/USD: 1.52 - 1.54 Bank B quotes the exchange rate of GBP/USD: 1.51 - 1.52 Ifa businessman has $100,000 to do investment, what should he do to take advantage of local arbitrage and how much profit does he earn? Exercise 2: National Bank quotes the exchange rate of EUR/USD: $1.15 - %1.17 City Bank quotes the exchange rate of EUR/USD: $1.10 - $1.14 189If you have $1,000,000 and wish to do investment, How much profits do you earn from arbitrage? © Exercise 3: ‘At bank A: GBP/USD = 1.50 At bank B: CHE/USD = 0.75 ‘At bank C: GBP/CHE = 2.02 If you have $100,000 to do investment, what should you do to take advantage of three-point (triangular) arbitrage and how much profit will you eam? (Assume that Bid rate and Ask rate are equal) FUTURE: © Exercise 1: Information on exchange rates and interest rates at ABC Bank is as follows: Forex rate of USD/VND 15,930 15,961 Interest rate of USD 3.55%l year 4.55%) year Interest rate of VND 0.65%) month 0.85%) month Present steps taken place between the bank and Hong Long company when Hong Long company carries out a swap agreement for 86,000 USD in 3 months with the bank. There are two cases: a. Hong Long sells spot and buys forward. b, Hong Long buys spot and sells forward. 4 Exercise 2: In Viet Nam, 02” Jan 2012, company A buys, whereas company B sells a future contract of 50,000 USD with the agreed exchange rate of 20,730 VND/USD. The exchange rate fluctuations are presented as below. Present all daily transactions which occur at the clearing house and the account balance of two companies at the end of 08" Jan, The required first deposit is 2 million dong and must be maintained a minimum of 1.5 million dong. Time Exchange rate ‘At the beginning of 02 Tan 20,730 ‘Atthe end of 02 Jan 20,740 [Atthe end of 03 Jan—_| 20,755, [Atthe endof04Jan | 20,775 [Atthe end of 05Jan | 20,770 At the end of 06 Jan 20,750 190‘At the end of 07 Jan 20,790 ‘At the end of 08 Jan 20,775 ;ENERAL # Exercise 1: On 8" Sep 200x, ABC Co., signs an import contract worth 1,000,000 CNY. The spot rate is | CNY =1,910 VND. Turnover of the company is in VND. The board of director worties that the exchange rate can fluctuate disadvantageously and takes 3 following solutions into consideration: a, Buy CNY under Forward contract for 07" Dec 200x, the rate offered by the bank is ICNY = 1,922 VND. b, Buy Options contract with the strike rate of ICNY = 1,920 VND on 08" Sep 200x. Each option is equal to 6,250 CNY. The premium for each option is 70,000 VND. ¢, Borrow a sum of money in VND from a Vietnam bank, then exchange into CNY and deposit it into a China bank. Calculate the amount of money which needs to be borrowed on 08" Sep 200x. Requirements: Calculate each solution, then make your own decision. Where, Interest rate Deposit Lending ND 0.5%/month 0.6%/month CNY 0.7%/month 0.8%/ month The exchange rate of CNY/VND on the market 07" Dec 200x: 1 CNY = 1,923 VND Notice: Interest rate is calculated on the compound interest basis. Exercise 2: On 12" July, the exchange rate of EUR and VND is as follows: EUR/YND = 29,160 — 29,510 5% - T%l year, VND = 8% - 12%/ year The interest rate per year: EUR Company A in HCMC is going to receive 2,500,000 EUR for its export on 12" Dec. The premium of Put option with maturity of 5 months is 530 VND/EUR, The strike rate in put option contract is also the spot rate at the contract date. Assumption: on 12" Dec, the exchange rate in HCMC: EUR/VND = 31,850 - 32,670 Requirements: Consider Forward transaction, and Option transaction to hedge the exchange rate risks and cam interests if they predict exactly the trend of the exchange rate 191as the above assumption? Present those solutions and calculate profits (losses) of the company for each transaction 192