Foreign Exchange Risk

111

Chapter 8

Foreign Exchange Risk

8.1 Identifying Forex Risk
8.2 Analysing Forex Risk
8.3 Managing Forex Risk
8.4 Hedging of Forex Risk Through Derivatives
8.5 Solved Problems
8.6 Practice Problems
8.7 Questions
 Vipul'sM Risk
112 Management (8FM Foreign Exchange Risk
113

8.1 IDENTIFYING FOREX RISK: preparation of its financial statements. In case foreign
It refers to sensitivity of changes in real domes currency gets depreciated, value of deposit would

currency value of assets and

liabilities or
domestic
operating inComa. reduce which can affect financial statements of the
es
rates.
to unanticipated changes in exchange company.

The first stage of Forex risk management involves thee icl Operating Exposure: This risk refers to extent to which
identification of items and amounts that are exposed th future cash flows of a firmn will get affected due to
Forex risk. Assets, liabilities, profits or expected cash fo fluctuation in value of foreign currency. A firm's value
streams can all be exposed to Forex risk if changes in th depends upon its expected future cash flow. Hence this
he
risk will affect value of a firm.
exchange rate would alter their home currency value.
Three Types of Exchange Rate Risk

8.2 ANALYZING FOREX RISK:

Once the different types of Forex risk exposure have
Transaction Exposure Translation Exposure Operating Exposure been identified, the extent to which the company is
(a) Transaction Exposure: This risk arises from foreign exposed needs to be measured before an appropriate
currency denominated transactions which an entityis risk management strategy can be devised.
committed to complete. This kind ofrisk affects present Managing transaction exposure requires that the
profits ofa firm. For e.g. a company has imported 1000 company's treasury collects all information on the
computers from U.S. when prevailing prices of 1 US $ is volume and timing of the exposure. In order to obtain
Rs. 40. However after a month when actual delivery this information, the company may set up a system to
takes place US $ appreciates to Rs. 50. In this scenario log all transactions that give rise to transaction
company will have to pay Rs. 10, 000 more to purchase exposure. This can be based on monthly reports sent to
1000 computers from American firm. Similarly f the treasury by all entities detailing incoming payments
company has exported 1,000 computers it will suffer a and disbursements in foreign currency, the currency
loss of Rs. 10,000 in case $ depreciates to Rs. denomination and any existing covers (hedges). The
(b) Translation Exposure: Translation exposure anse consolidation of the data from all subsidiaries enables
irom the need to convert the group treasury to determine the group's overall net

denominated in
values of assets and liabilites ransaction exposure and manage it in the most
a foreign currency into the domesu
currency. appropriate way.
For e.g. a
company having a foreign currency where economic and translation risk exposures are
aep
would need to translate its
value into its
stic concerned, measuring Forex risk exposure can prove
dome of
currency for the
purpose of reporting at the um e difficult. Translation risk is typically measured by the
 Vipul'sM Risk Managem
114 (BFM Foreign Exchange Risk 115

net assets (asseto

exposure of foreign-denominated less appreciate in payments c a n be delayed
uture and in

potential exchange
rate developmen
liabilities) to
sensitivity analyses o r value-at
ents, case firm expects curTency to depreciate in future.
Some firms use
isk and
a maximum loss for a i. Hil Hedging through Derivatives: Forwards, futures
(VaR) models, which define given be used to hedge currency risk. A firm
options can
exposure over a specified time period with a certa rtain make payments in foreign currency
to
which have
degree of confidence (eg 95%). should take long position in derivatives and firm having
Economic exposure analysis involves measuring the
foreign currency receivables should take short position
potential impact of an exchange rate deviation from a in derivatives to hedge exchange risk.
budget or benchmark rate used to forecast revenue
Unlike transaction and translation exposure this risk
streams and costs over a given time period. The
affects future cash flows. Hence it is difficult to manage
currency effects on the various cash flows have to be
this kind of risk with currency derivatives. Rather it
netted over the company's operations and markets. The
more diversified a company is, the more these effects
requires various marketing, production and financial
management strategies to cope with the risk.
should cancel each other out and the net exposure may
be comparatively small. However, companies that have () Marketing Strategies: Marketing manager can
hedge economic or operating exposure by proper
invested heavily in one or two key foreign markets are market selection, using proper pricing, promotional
typically exposed to more significant economic FX risk.
and product strategy. For this it is necessary that
marketing manager should select country whose
8.3 MANAGING FOREX RISK: currency is likely to appreciate against domestic
Techniques to hedge transaction and translation currency. Also marketing manager should ensure
exposure: proper expenditure on promotional and product

(i) Exposure Netting: This strategy requires creating an strategies.

opposite exposure in the currency in which firm have ii) Production Strategies: Economic exposure can be
original exposure. For e.g. a firm has sold goods wort reduced by proper selection of input mix, plant
$1,000 than location etc. Production manager should select
it should also buy goods worth $1,000
This will multiple facilities overseas. In case of appreciating
create a natural
hedge for firm and origina"
exposure gets net off. currency cost of production will increase and under
(ii) Leading and Lagging: Leading ce such scenario production manager should shift
means to make adva production to some other country. Also proper
payment and lagging means to delay a
pay
ent.

Advance payments can be made in case a firm e»p

ects
input mix can help production manager reduce this
currency (in which payment are to be to risk. In case of appreciating domestic currency
made)
 Foreign Exchange Risk 117
116 Vipul'sM Risk Management (BFMI
taking long or short position in currency futures individuals
for production can be purchas.
inputs required can fix incoming and outgoing cash flows in
from outside rather than trom domestic markets or corporate
one currency w.r.t. another currency. In order to hedge
This strategy involves
(iii) Financial Management: Currency risk through currency futures a person who have
creating liabilities in the currency to which
which foreign currency receivables should take short position in
earnings are exposed. This is much similar to futures and a person having foreign currency payables
exposure netting. For e.g consider a firm whict
had sold goods worth $ 1,000 to a Uis. firm. Than should take long position in currency futures. Thus
currency futures are an effective tool to hedge currency
firm should also buy goods of same amount from
risk. However one major disadvantage associated with
U.S. to hedge its risk. This strategY requires
currency futures is that it is available only for few selected
somewhat lesser time for implementation as currencies.

Compared to previous two strategies.

To understand hedging through currency futures
consider a following simple case:
8.4 HEDGING OF FOREX RISK THROUGH Ms. Poonam an Indian exporter had exported goods
DERIVATIVES: worth $1,000 to a US client on 1 Aug for which she will
(1) Hedging with futures: receive payment on 20 Nov. On 1 Aug, 1 US$ = Rs. 45.

Primary objective of hedging through futures is to protect Since she is having foreign currency receivable she need to
the value of any financials asset owned owed hedge herself against falling US$ scenario. Hence she takes
or
against
price changes. Long and short hedging are widely used short position in 1 US $-INR contract (1 contract is for 1,
technique to protect portfolio from unexpected change in000 US$) having November expiry. On 20 Nov US$
price or interest rates. Long hedging involves buying futures depreciates to Rs.40. So she suffers a loss of Rs.5, 000 in
contract to hedge against increase in value of asset and cash market. However she can offset this loss from futures
short hedging involves selling futures contract to hedge where she had sold $ contract and hence have
hedge her
against decline in value of asset. risk.
Exports and imports are exposed to currency risk Important Characteristics of Futures:
Exporters and importers can hedge currency risk by sellinga Exchange traded: Futures are exchange traded, hence
or buying futures. Unlike options, futures market does " counterparty risk dont exist.
require any premium to be paid for taking positions. Hen (b) Standardised in nature: standardised in
They are
many times it is a cheaper source for investors to dg nature where all
nc terms related to contracts are decided
risk when compared to of
options. The main advantage by exchange.
futures is that it allows trader to lock-in on
exchange rate
future currency transaction thereby By
hedge their ris
 118 Vipul'sM Risk Management (BFMI Foreign Exchange Risk
119
(c) Cash or delivery based settlement: Final settement
ment cost plus interest that is paid to finance the asset less
can either be cash based or delivery based.
the income earned on the asset.
Advantages of Futures:
hl Initial margin: The amount that must be deposited in
(a) Exchange traded: As futures are exchange traded
the margin account at the time a futures contract is
counterparty risk does not exist.
first entered into is known as initial margin.
(b) Electronie trading platfornm: As most stock exchanges ) Marking-to-market: In the future market, at the end of
provide electronic trading platform it is possible for
each trading day, the margin account is adjusted to
people to easily take positions in futures contract. reflect the investor's gain or loss depending upon the
(c) Low cost means to hedge risk: It is possible to take future closing price. This is called marking-to-market.
positions in futures by merely paying initial margin and Maintenance margin: It ensures that margin account
hence it is cheaper means to hedge risk never become negative and is always somewhat less than
Futures Terminology: initial margin. If the balance in the margin account falls
(a) Spot price: Prices at which asset is traded in cash below the maintenance margin, the investor receives a
market. margin call and is expected to top up the margin account to
the initial margin level before
(b) Future prices: Prices at which asset is traded in trading commences on the
next day.
futures market.
(c) Contract eycle: It means period over which contract
(2) Exchange rate swap:

are traded. Futures expire on last Thursday of every Exchange rate swaps also knowm as currency swaps is
month. On next Friday following last Thursday a new reement whereby two parties agree to exchange
contract is introduced for trading. curTencies on a future date according to a pre decided
Iormula. With this it is possible for fims to raise funds in
(d) Expiry date: It is last date on which contract w1u
traded Currency of their choice in much cheaper way.
(e) Contract size: The amount of asset that has to D 1s defined as an agreement between two parties to
delivered under one contract. ACnange interest payments on loan in one currency to an
quvalent loan in another currency. In currency swaps
( Basis: Basis is defined as
difference between ures

and spot prices. In normal

futu ncipal amount may or may not be exchanged. (ln most
1s
market conditions basis rency swaps principal amount is exchanged and is re-
always positive which means futures
market prices.
price exceeds XChanged at expiry of agreement
(g) Cost of carry: Cost of hip
carry explains relatio
between futures and spot rage
prices. It measures
 Vipul Risk Management (BFM Foreign Exchange Risk 121
120

shows the working mechanism of A&%B raise funds as per their requirement without a
Following diagram
agreement then cost of borrowing will be
currency swaps: aD
Swap

Exchange of Principal 2+9 21%.

However if A & B enter into a swap agreement and raise

Exchange of Interest Aund in currency which is cheaper for them, then cost of
8 + 10 18%.
Firm A Fim B raising will be:
into a swap agreement they can raise
Hence by entering
Re-exchange of Principal fund 3% cheap. If they share profit equally then they can
earn 1.5% each. Steps
involved in swap will be as follows:

borrows rupee denominated fund at 10% and

(a) Firm A
It involved three basic steps: lend it to B.
(a) Initial exchange of principal. (b) Firm B borrow $S denominated fund at 8% and lend it

(b) Exchange of interest installments. to A.

(c) Re-exchange of principal. In above example if we assume that deal was arranged
To understand the working of currency swap let us by a swap dealer than dealer will have share in profit from
consider a following simple example: deal. If share of dealer is 1% than profit from deal available
There are two firm A&B. Firm A wants to borrow in to firm A&B will be 1 % each. In that case firm A will

whereas firm B in Rupees. borrow rupee denominated funds at 10% and lend it to B at
arate where total cost of borrowing for A is 11%. While firm
Firm A wants to borrow 1, 000 $ and firm B R45,000
Bborrows $ denominated fund at 8% and lend it to A at a
Additionally 1$ R45.
Tate where total cost of borrowing for B is 8%.
Following are the interest rates provided to them by a
Valuation of Currency swaps: Valuation of currency
bank:
Swap can be done considering the swap as a portfolio of two
Firm $Rate (%)| R rate (%) DOnds. So value of swap will be difference between present
A 12 10
valuesof these bonds:

V Pf-Pl
B 8 9
Where V =Value of swap
It can that firm A wants funds in $ but t can
be seen
1 Pf = Value of foreign currency bond
raise funds cheaper in R whereas firm Bwants
B wants to
to raise
funds in R but it can raise funds PI = Value of local currency bord.
cheaper in $.
 122 Vipul'sM Risk Management Foreign Exchange Risk 123

Advantages of Currency Swaps: A Derson having foreign currency receivable can hedge
bearish position in options. To take bearish
(a) Termination of contract: Here one
party defan. risk by taking investor can either sell call buy
position in options
an or
the other party can terminate the contract and claime
damages.
mfo out. Similarly a person having foreign currency payable can

It does not appear as hedge risk by taking

bullish long position in options.
(b) No effect on balance sheet:
a Investor can be bullish in options either by buying call or
liability on the balance sheet as it is not a loan.
One major disadvantage associated with
selling put.
(c) Higher liquidity: Currency swaps have higherliquidih
hedging through currency options is that here buyer needs
and hence many banks participate in swap transaction to seller in order to take positions
to pay upfront premium
Due to these benefits currency swaps is a widely use in options. Hence currency options can prove to be costly

technique to hedge currency risk. compared to futures where no such premium is required to

(3) Hedging with options: be paid for taking position.

Risk management through options is much similar Trading in currency options began in the country with
risk management through futures. Any client buying i US$ in 2010.
cash can hedge risk by taking bearish position in optionImportant Characteristic of Options:
and client selling in cash can hedge risk by taking bulisa) Exchange traded: Like futures, options are also
position in options. exchange traded hence counterparty risk don't exist.
Investors can take bullish position in options by buyi Standardised in nature: Again like futures, options are
call (as it gives holder right
buy) or selling put (as it gns
to standardised in nature where all terms related to

buyer right sell). Similarly investors can take bear

to contract are decided by exchange.
position in option by selling call or buying put. (e) Gives right but not obligations: Options gives its
Currency options gives buyer of option right but not holder right but not obligation to buy or sell given
obligation to buy or sell
quantity of foreign currun
a fixed quantity of asset on a future date.
on a future date on or befom
predetermined price on be
at a
Advantages of options:
expiration day. Currency options can be call or put pption

Call option gives right but not an

op bu
Exchange traded: As options are exchange traded
obligation to buyer to
fixed quantity of counterparty risk does not exist.
a
foreign currency on future date 4 (D) Electronic trading platform: As most stock exchanges
at

predetermined price on or before expiration day. Put or optian

gives right but not an obligation to buyer to sell ll aa fixe provide electronic trading platform it is possible for
people to easily take positions in options contract.
quantity of
foreign currency on future date at
predetermined price on or before expiration day.
 Vipul'sM Risk
124
Management (BFM Foreign Exchange Risk
125

Options Terminology: Out-of-the-money-option (OTM): These are options

(k)
(a) Buyer of option: Buyer also known as holder is which lead to negative cash flow for holder if they are

person who pays premium to seller and buys right ha the exercised immediately. Put option is OTM if spot is
sell given quantity of asset but gr
reater than strike and call is OTM if strike is greater
not obligation to buy or ona
on a
future date at a pre determined price. than spot.

Seller also known At-the-money-option (ATM): These are options which

(b) Seller of option: as writer is the lead to zero cash flow for holder if they are exercised
person who receives premium and hence is obliged t
buy or sell asset if buyer exercises the option. immediately. Both call and put will be ATM if spot is
equal to strike.
(c) Call option: Call option gives buyer or holder rightbut
not obligation to buy underlying asset on a future date m ) Intrinsic value of option: It is amount by which an
option is ITM. If option is OTM than intrinsic value is
at a pre determined prices.
zero.
(d) Put option: Put option gives right but not obligation to
sell (n) Time value of option: It is difference between option
underlying asset on a future date at a pre
determined prices. price and intrinsic value of option.

(e) Option price: Option price (4) Hedging with eurrency forwards:
or option premium is
amount paid by option buyer to option seller to buy the Currency forwards is also termed as an outright forward
option. currency transaction, forward outright or FX forward. It
enables an investor to lock-in a foreign exchange rate now
(Expiration date: It is last date on which options will bef1or a
traded. future payment or receipt that is denominated in a

ditterent currency. It is defined as a contract under which a

(g) Strike price: It is price specified in option contract aand
is also known as exercise
currency be bought or sold on a future date at a
can
price. predetermined price. Hence currency forwards eliminate
(h) American option: American option is one which can currency risk completely. Forwards are much similar to
exercised on any day up to maturity. arure except that former is mainly an OTC contract
() European options: These
options can be exercised om Wnereas latter is exchange traded. As forward contracts are
on expiration day.
aded OTC there is high possibility of default by
G) In-the-money-option (ITM): These are options wn ch Ounterparty and hence credit risk for such contracts are
lead to positive
cash flow for holder if
they are exercised y high. However currency forwards are customised in
immediately. Call option is ITM han
r e and hence terms and conditions of contract are
strike and put is ITM if strike if spot is greater u determ
is greater than spot. ermined as per requirements of parties involved.
 Vipul'sM Risk Management (BFM Foreign Exchange Risk
127
126
20 Nov. Firn wants to hedge its positions by trading in $
8.5 sOLVED PROBLEMS:
futures. ollowing
F o are rates available on 20 Nov:
lustration 8.1:
market Rs./$= 44
worth $ 1, 00, Cash
An Indian importer buys goods oo
000 market Rs./$ =
45.5
payment terms 3 month credit). 3 months futures Putures

1 Dec there is
60% probability that prices will be:
1 S brought futures @ 46.00. Calculate the
Rs. 46. He On
is 1'$ =Rs, 47 46
gain/loss if spot on expiry (after 3 months) Rs./$
=

Cash
(futures is settled at 47). Rs./$= 47
Futures market

(April 11) On 1 Dec there

is 40% probability that prices will be:

Solution: Cash market Rs./$ =

42
Since client have taken long position in futures and 42.5
Futures market Rs./$=
S have appreciated, client will earn a profit. On expiry basis Find out:
is zero i.e. spot closing price
=
futures closing price. Hence
to be adopted by firm.
is Rs. 47. (a) Strategy
on expiry futures closing price
No of futures contract firm should take position if 1
Profit to client = (47 - 46) x 1,00,000 (b)
contract is for 50, 000$.
Rs. 1,00,000
to firm. And expected payments to be
(c) Profit/loss
Iustration 8.2: made
Mr. A an importer buys goods worth $ 50, 000 (payment
Solution:
terms 3 months credit)
Since firm have payable it should take
foreign currency
Spot rate is 1$ =
Rs. 46 market.
long position in futures to hedge risk in spot
Calculate the gain/loss if spot after 3 months b) No of future contract 1,00,000
1$ Rs. 47.
=

50,000 =2
Solution: Firm should take long position in two tutures

$ have appreciated by Rs. 1 (47 46). Hence client w" contract to hedge risk.
have to pay Rs. 1 more for each $ C) If prices on 1 Dec are:
Total loss to client after 3 months = (47 46) x 50,000 Cash market Rs./$ = 46
= Rs. 50,000
Futures market Rs./$= 47
rllustration 8.3: payable and
nce client have foreign currency
An Indian firm
oods

$ha
ave appreciated client will suffer loss in
cash market
M/s Pranjal and Co have imported it i
worth $ 1,00,000 which is payable on 1 Dec. Today which will be
 Vipul'sM Risk Foreign Exchange Risk
128 Management (8FM 129
1,00,000 Total Payments to be made
(46 44) x

= 2,00,000
=
(42 x
1,00,000) +
3,00,000
However client will make profit in futures 45,00,000
= (47 - 45.5) x 1,00,000 Hence there is 40%% probability that client will have
to pay 45,00,000
1,50,000
Expected payment to be made by client on 1 Dec
Total loss
=(44,50,000x 0.6) + (45,00,000 x 0.4)
= 2,00,000 1,50,000
= 44,70,000
= (50,000)

Total payment to be made

Expected profit/loss

1,00,000) 1,50,000
=
(50,000 x 0.6) + (1,00,000 x 0.4)
=
(46 x
-

= (70,000
44,50,000
Illustration 8.4:
Hence there is 60% probability that client will have Consider an Indian firm which needs to pay $ 1,00,000
to pay 44,50,000
after 3 months. Following are the options available with it.
If prices on 1 Dec are:
(a) It can leave the position open.
Cash market Rs./$ = 42
(b) It can book a forward contract at Rs. 45.4 per $.
Futures market Rs./$ = 42.5
c) It can buy a futures contract at Rs. 45.4 per $.
Here $ have and since client have
depreciated S
(d) It can buy a call option at a strike price of Rs. 45.4, the
payable it will earn profit in cash market
premium being Rs. 0.5 per $.
=
(44 42) x
1,00,000
t
buy a call option at a strike price
can if Rs. 44.8, the
2,00,000 e
premium being Rs. 0.6 per $.
However loss in futures to client
9 I t can buy a call option at strike price of Rs. 46.8 the
(45.5-42.5) x 1,00,000
premium being Rs. 0.4 per s.
3, 00, 000
Consider probability of actual spot rate after 3 months
Total loss to client are as follows:

=
2,00,000-3,00,000
(1,00,00o)
Price 45.00 45.2 45.8 46 46.2

25
Probability (%) 20 20 10 25
 Vipul'sM Risk Management (8F Foreign Exchange Risk
131
130
In case
e of option with strike of Rs. 46.8 client will
of
Solution:
the option only when spot prices are greater than
45.2 45.8 46 46.2 e x e r c i s e

Price after 3 years 45 price. Hence option will not be exercised in any
strike price.

20 10 25 25 Price enario as prices are always less than 46.8.

Probability (%) 20o
Technique (Probability
x Prices a6 PRACTICE PROBLEMS:
8.6
Unhedged 45.0 45.2 45.8 |46.0 46.2 45.67 dl Consider an Indian firm which needs to pay $ 2,00,0o00

45.4 45.4 45.4 45.4 45.4 45.4 after 3 months. Following are the options available with
Forward contract
it.
Futures contract 45.4 45.4 45.4 45.4 45.4 45.4
(a) It can leave the position open.
Call option (45.4) 45.5 45.7 45.9 45.9|45.9 45.78
(b) It can book a forward contract at Rs. 45.7 per $.
Call Option (44.8) 45.4 45.4 45.4 45.4 45.4 |45.4 c) It can buy a futures contract at Rs. 46.4 per$.
Call Option (46.8) 45.4 45.6 46.2 46.4 46.6 46.07 (d) It can buy a call option at a strike price of Rs. 44.4,
the premium being Rs. 0.4 per $.
Explanation:
will have to
(e) It can buy a call option at a strike price if Rs. 44.8,
In case of unhedged position client pay
prevailing market prices.
the premium being Rs. 0.7 per $.

In case of forward and futures contract client will have to ( It can buy a call option at strike price of Rs. 47.8
pay price at which it had entered into contract. the premium being Rs. 0.4 per $.
In case of options contract, client will exercise contract Consider probability of actual spot rate after 3

only if buying through option is cheaper than months are as follows:

market
prices. Call option with strike price of Rs. 45.4 will not k Price 45.2 46.8 47 48.2
44.00
exercised when market price is Rs. 45, 45.2. In this case
client will lose premium paid and will Probability (%) 20 20 10 25 25
buy $ from marke
However when price is 45.8, 46, 46.2, client will buy $ fro 4 An Indian firm M/s Kavya and Co have imported goods
options rather than from market 30 Dec. Today it
Worth $ 5, 00, 000 which is payable on

In case of option with

strike price of 44.8, client w 1S 30 Nov. Firm wants to hedge its positions by trading
exercise option only when market in $ futures. Following are rates available on 30 Nov:
44.8 or else client will let
prices are greater uhana

go the option and buy from Cash market Rs./$ = 46

market. Hence option will be
exercised in all scenarios. Futures market Rs./$ = 46.5
 Vipul'sM Risk Management (8 nterest Rate Market

133
On 1 Dec prices are:
Cash Rs./$ = 444 MODULE IV
P u t u r e s market R s . / $ = 45

Find out
firm.
Chapter 9
(a) Strategy to be adopted by
(b) No of futures contract firm should take positionit

l contract is for 50,000 S. Interest Rate Market

(c) Profit/loss to firm.

s.7 QUESTIONS: 9.1 Basics of Bonds

(1) Discuss ldentification of Forex Risk. 9.2 Debt Versus Equity

9.3 Bond Market Characteristics
(2) Write a note on Analyzing Forex Risk.
9.4 Different Types of Bonds
(3) Briefly discuss methods to manage Forex Risk.
9.5 Bond Rating
(4) Expiain how futures, forwards, swaps an options can be used to 9.6 International Bond Market
manage for. 9.7 Reasons for Investing in debt Market
9.8 Debt Market Segments
9.9 Participants in the Debt Markets
9.10 Introduction to Fixed Income Pricingg
9.11 Solved Problems
9.12 Unsolved Problems
9.13 Questions
 Vipul'sM Risk Management nterest Rate Market

134 135
DEBT V/S EQUITY:
9.1 BASICS OF BONDS: 9.2
Bonds are ebt, whereas stocks are equity. This is the
Why Bond Market?
distinction between the two securities.
money
both need
to important.

Companies and governments

needs funds to expand
fulf archasing equity (stock) an investor becomes an
their requirements. A company
need money for evervh
into By
a corporation. Ownership comes with voting rights
new markets, while governments
hing er inright to share in any future profits. By purchasing
infrastructure to social programs. Many
a time's and the right
from
than large (bonds) an investor becomes a creditor to the
corporations need much more money what the debt

average bank can provide. For this purpose corporates rai

raise
corporation (or government).

money by issuing
bonds to a public
market.
The primary advantage of being creditor is that a

Thousands of investors then each lend a portion of the higher than shareholders.
claim on assets
vestor has
a

is a kind of loan for which the

in the case of bankruptcy, a bondholder will get
capital needed. A bond Thatis,
investors are the lenders. The organization that sells a nd naid before a shareholder. However, the bondholder does
p a

is known as the issuer. eat share in the company does well the investor
profits if a

is entitled only
to the principal plus interest.
The issuer of a bond must pay the investor something or
This payment comes in the form of In terms, there is generally less risk in owning
simple
using his or her money.
this at the cost of
bonds than in owning stocks, but
comes
interest payments, which are made at a predetermined rate

and schedule. The interest rate is often referred to as the a lower return.

coupon. The date on which the issuer has to repay the

amount borrowed (known as face value) is called the BOND MARKET CHARACTERISTICS:
9.3
maturity date. Bonds are known as fixed-income securities
Bonds have a number of characteristics of which we
because the investor knows the exact amount of cash he or
need to be aware of. All of these factors play a role in
she will get back if they hold the security until maturity.
value of bond and the extent to which it
determining the a

For example, investor buys a bond with a face

an
value fits in investor's portfolio.
of Rs. 1,000, a coupon of 10%, and a maturity of 10 years.
9.3.1 Face Value/Par Value:
This means the investor will receive a total of Rs. 100 The face value (also known as the par value or principal)
(Rs. 1,000 x
10%) of interest per year for the next 10 years
holder will get back once a bond
bonds pay interest investor receives two
semi-annually,
S
the amount
of money a
the par
matures. A newly issued bond usually sells at
payments of Rs. 50 a year for 10 years. When the bond value of
value. Corporate bonds normally have a par
matures after a decade, investor will get Rs. 1,000 back.
be much greater tor
can
AS 1,000, but this amount

gOvernment bonds.
 136
Vipul'sTM Risk Management interest Rate Market

137
(BFM
the of the matures in one year is much more
that
However the par value is not
price bonaA A bond

A redictable and
le a n d thus less risky than a bond that
bond's price fuctuates throughout
its life in
response to a matures in
trades at a price abou
r S , Therefore, in general, the longer the time to
number of factors. When a bond ove the maturity, the higher the interest rate. Also, all things being
face value, it is saidto be selling at a premium. When
aen a a longer term bond will fluctuate more than
bond sells below face value, it is said to be selling
at a
equal,
a
shorter
term b o n d .
discount.
9.3.2 Coupon (The Interest Rate): 9.3.4 I s s u e r :

The coupon is the amount the bondholder will receive. The issuer of a bond is a crucial factor to consider, as
as
interest payments. It's called a "coupon because in Das he issuer's stability is investors main assurance of getting
he
there were physical coupons on the bond that investorpaid back. For example, the government security is
needed to tear off and redeem for interest. Nowadays.considered far more secure than any corporation. Its
records are more likely to be kept electronically. default risk (the chance of the debt not being paid back) is
Most bonds pay interest every six months, but ithextremely small s o small that government securities are
possible for them to pay monthly, quarterly or known as risk-free assets. The reason behind this is that a
annually,
The coupon is government will always be able to bring in future revenue
expressed as a percentage of the par value. If
bond pays through taxation.
a a coupon of 10% and its par value is
Rs. 1,000, then it will pay Rs. 100 of interest a year. A company, on the other hand, must continue to make
A rate that stays fixed of the par value profits, which is far from guaranteed. This added risk
as a
percentage
like this is a fixed-rate bond. Another possibility is an means corporate bonds must offer a higher yield in order to
adjustable interest payment, known as a floating-rate bond. attract investors.
In this case the interest rate is tied to market rates through
an index, such as the rate on
Treasury bills/Mibor. 9.4 DIFFERENT TYPES OF BONDS:
Investors will likely pay more for a high coupon
more
Government Bonds: In general, fixed-income securities
than for low coupon. All
a
things being equal, a lower are classified according to the length of time before
coupon means that the price of the bond will fluctuate
more.
Higher maturity. These are the three main categories:
coupon bring more stability in bond prices. than
debt securities maturing in less
one
9.3.3 Maturity: a Balls:

The year.
maturity date is the date in the future on which to 10 years.
Notes: debt securities maturing in
one
investor's principal will be 0
repaid. Maturities can rang in more than 10
from as little as one (C) Bonds: debt securities maturing
day to as long as 30 years
terms of 100
years have been
(thouE years.
issued).

Tr7
 vipul'sM Risk Management (BE
I n t e r e s tR a t e M a r k e t

139
138
M
bond with a Rs.
1,000 par value and 10
Municipal bonds, known as "mn
vn as "munis c o u p o n

years
(2) Municipal Bonds: to maturity is ading at Rs. 600. This means paying
are more common ies.
in developed countries. The major
Rs. 600 today for a bond that will be worth Rs. 1,000 in
advantage to munis is that the
returns are free f
irom 10 years
federal tax. Furthermore, local governments wi
sometimes make their debt non-taxable for residen.
bonds completely tax
lents,
s. 9.5 BOND RATING:
thus making some municipal free.
Because of these tax savings, the yield on a muni rhe bond rating system helps investors determine a
s
usually lower than that of a taxable bond. Dependin. company's credit risk. Consider a bond rating as the report
on investor's personal situation, a muni can be a great
ding
ard for
card
a company's credit rating. Blue-chip firms, which
investment on an after-tax basis. high rating, while risky
investments, have a
are
a r
safer
(3) Corporate Bonds: A company can issue bonds just as have a low rating. The chart below in figure 1.1
companies
it can issue stock. Large corporations have a lot of iltustrates the different.bond rating scales from the major
flexibility as to how much debt they can issue. The limit Standard and Poor's and Fitch
rating agencies: Moody's,
is whatever the market will bear. Generally, a
short Ratings.
term corporate bond is less than five years; Bond Rating Grade Risk

intermediate is five to 12 years, and long term is over

Moody's S&P/Fitch
12 years. AAA Investment Highest Quality
AAA
Corporate bonds are characterized by higher yields Investment High Quality
AA
because there is a higher risk of a company defaulting Investment Strong
than a government. The major advantage of corporate BBB Investment Medium Grade
BAA
bonds is that they offer higher returns (in most cases Speculative
BA, B BB, B |Junk
than other debt instruments. Highly Speculative
CAA/CA/C CCC/cC/C Junk
The company's credit quality is very important, the In Default
C Junk
higher the quality, the lower the interest rate the
Figure 9.1
investor receives.
Other variationns on corporate bonds include
9.6 INTERNATIONAL BOND MARKET:
convertible bonds, which the holder can convert into
stock, and callable bonds, which allow the company toTypes of International Bonds:
in a domestic
redeem issue prior that is issued
an to maturity. 4 Foreign Bonds: A bond market's
the domestic
(4) Zero-Coupon Bonds: This is a type of bond that makes entity, in
foreign
arket by a
most often issued by a

no bond is
coupon payments but instead is issued a rency. A foreign
considerable discount to par value. For example, a *e r o
 interest Rate M a r k e t

140 Vvipul'sM Risk Management (BE 141

gulatory traints. They may also

constra
foreign firm to raise capital in a domestic market denominate their
that ohond in
Eurobond in their preferred
currency. Eurobonds are
would be most interested
For foreign firms doing a large amount of businese
firm's debt.
in purchasing the firm's.
ractive to investors as they have small
attra
par values
the domestic market, issuing foreign
in siness
bonds
and high liquidity.
1S a
common bonds include
practice. Types of foreign bonds includa
Features:

bulldog bonds (issued in UK), Yankee bonds (issued lal It is offered in a

currency that is alien
in
to investors.
US) and samurai bonds (issued in Japan).
(b Multinationality underwriting syndicate.
of
Foreign bonds are regulated by the domestic marea
et tc These bonds are otfered simultaneously to various
authorities and are usually given nicknames that re er investors in number of countries.
to the domestic market in which they are being offered
Types:
Since investors in foreign bonds are
usually the lal Conventional or
Straight Eurobonds have
residents of the domestic country, investors find them
a fixed
Lem coupon (usually paid on an annual basis) and
attractive because they can add foreign content to
their maturity date when the entire
principal is
portfolios, without the added exchange rate repaid.
exposure.
(b) Floating rate bond notes (FRN) are usually short to
Features:
medium term bond issues, with a coupon interest
(a Denominated in the currency of the
country of rate that "loats," i.e. goes up or down in relation to
issue.
a benchmark rate plus some additional
"spread" of
(b) Underwritten& sold exclusively by a syndicate of basis points (each basis point being one hundredth
domestic banks in the lending of one percent). The reference benchmark rate is
country.
(2) Euro Bonds: A bond issued in a usually LIBOR (London interbank offered rate) or
currency other than
the currency of the EURIBOR (Euro interbank offered rate). The
country or market in which it is
issued. Usually, a Eurobond is "spread" added to that reference rate is a function
issued by an
international syndicate and of the credit quality of the issuer.
categorized according to the
currency in which it is denominated. A Eurodollar bond cZero-coupon bonds do not have interest payments.
that is denominated in
U.S. dollars and issued in Japan The investor in this type of Eurobond may be
by Australian company would be an
an
example ord looking for some kind of tax advantage.
Eurobond. The Australian
could company in this exampie (d) Convertible bonds can be exchanged for another
issue the Eurodollar
bond in any country o
than the U.S. instrument, usually an ordinary share or shares
Eurobonds are attractive financing too
as
they give issuers (fixed ahead of time with a predetermined price) of
the
in which
flexibility to choose the counuy the The bondholder decides
issuing organisation.
to offer their bond according to the convertible bonds,
counuy whether to convert the bond. In
 Vipul's Risk
Management (B5
n t e r e s tR a t e M a r k e t

142 143

is usually lower than CCBs appear on the liabilities side of the

issuing
the coupon payable t than FC

otherwise would be. Because

convertible bondo.
ds o nany's balance heet. Foreign currency convertible
shares than bondo bonds r e equity linked
are
a debt securities that are to be
be viewed more as equity the
credit and interest rate risks 1or investors onverted into equity or depository receipts after a
C o n

are ecified period. The price and the yield on the bond
higher than with conventional bonds.
e) High-yield bonds are also part of the Eurobon moves on the opposite direction. The higher the yield,
ond is the price.
markets, a class of bonds (rather than a tvne lower
of
bond) which individual investors may encounter 41 Global Bond: A global bond is a bond which is issued
High-yield bonds are those that are rated to b in several countries at the same time. It is typically
"below investment grade" by credit rating agencies issued by a large multinational corporation or sovereign
i.e. issuer has a credit rating below BBB). entity with a high credit rating. By offering the bond to
(3) FCCB: A type of convertible bond issued in a a large number of investors, a global issuance can
currencv
different than the issuer's domestic currency. In other reduce borrowing cost.
words, the money being raised by the issuing These bonds are usually issued by large
company
is in the form of a foreign currency. multinational organizations and sovereign entities, both
A convertible bond is a mix between a debt and of which regularly carry out large fund-raising
equity instrument. It acts like a bond by making exercises. By issuing global bonds, an issuing entity is
regular coupon and principal payments, but these able to attract funds from a vast set of investors and
bonds also give the bondholder the reduce its cost of
option to convert borrowing.
the bond into stock. These
types of bonds are attractive Global bonds are issued in different currencies and
to both investors and issuers.
distributed in the currency of the country where it is
The
investors receive the issued. For example, a global bond issued in the United
safety of guaranteed
payments on the bond and are also able to take States will be in US Dollars (UsD), while a global bond
advantage of any large price appreciation in the issued in the Netherlands will be in euros. Bonds are
company's stock.
(Bondholders
take advantage of this 0aned in terms of years; for example, a three-year $2
appreciation by means warrants attached to the bonds, DIllion USD global loan will be paid back by the country
which are activated when the the
price of the stock reacnc s loaned to within three years at face value plus
a certain point.)
interest rate.
Due to the
equity side of the bond, which adds
the coupon
payments on the bond are value
lower 1or the
company, thereby reducing its
debt-financing costs
144 Vipul's Risk
Management (BFM
nterest R a t e M a r k e t

145

9.7 REASONS FOR INVESTING

IN DEBT MARKE ttnlike equity for bonds
capital gains are
negligible.
In case of bonds cash flow is in form of coupon.
for investor's Money: In geDe.
A Safe
investing
Haven
in debt is safer than investing
in equity eneral, Historically stocks have performed bonds in the long
holders ae that debt However, bornds outperform stocks at
reason priority
for this is the n. certain times
over shareholders. If a company goes bankrupt, de, in the
economic cycle.
bt
holders ahead of shareholders in the line to be There are always conditions in which we need
are
paid
In a worst-case scenario, such as bankruptcy, he security and predictability. Retirees, for example, often
creditors (debt holders) usually get at least some.
of rely on the predictable income generated by bonds. If
their money back, while shareholders often lose their portfolio consisted solely of stocks, it would be quite

entire investment.
risking for the person retiring in two years.

In terms of safety, bonds from the government are By owning bonds, retirees are able to predict with a

considered "risk-free" (there are no "risk-free" stocks greater degree of certainty how much income they'1
While not exactly yielding high returns, if
capital have in their post-retirement period. An investor who
preservation is investor's primary goal, then a bond stil has many years until retirement has plenty of time
from a stable government is considered to be the best to make up for any losses from periods of decline in
bet. equities.
Better Than the Bank: Sometimes bonds are just the
Predictable Returns: Return refers to gain expected by
The interest rates bonds are
investor from investment made by him. Return broadly only decent option. on

the rates paid by banks on

comprises of two main parts. One is regular income typically greater than
which is in form of dividends or interest. Second is in savings accounts. As a result, if investors are saving
will give
form of capital and need the money in the short term, bonds
gains.
investors a relatively better return
without posing too
=t(P1-P2)
Rate of Return (R) P2 much risk.
Where, I = Cash flow in form of dividends or Interest
Portfolio Diversification: In investment management
to Safety" which
Pl Price of the there is a widely known term "Flight
=
security at the end of holding perio securities
in safer
neans investors tend to invest
more
P2 Purchase price of security. markets. Fixed Income
when there is downfall in equity
for
Returns considered to be safest
Decurities such as bond are
of entire
to reduce risk
nvestors. Such securities help
consider a simple
POrttolio. To understand
this let us

Dividends/Interest Capital Gains example.

146 Vipul'sM Risk Management (8F nteres
R t ate Market

BEM 147

paper of uarving maturities

A portfolio consists of shares of ABC and xy and is used
in by RBI as an
value of
equal proportion. Market
Rs. 10,000. On a particular day ABC and XYz
portiolio
portfolio is instrument ot monetary policy.
The instruments in this
segment are fixed coupon
decline by 10% than value ot portlolio will reduce commonly referred to as dated
Rs. 1,000 i.e. 10% of portfolio value. Now by bonds,
securities,
same treasury bills, loating rate bonds, zero
portfolio makes investment equally in equity and bon coupon bonds
onds and inflation index bonds. Both Central and State
than Rs. 5,000 is invested in shares of ABC and X
government securities comprise this segment of the
combined and Rs. 5,000 in fixed income securities
. debt market.
XYZ and ABC decline by 10%% then
portfolio will loge
lose 2 Public Sector Units (PSU) bonds: The PSU bonds are
Rs. 500 (10% 5,000),
of Rs. 5,000 invested
however Rs.
generally treated
substitutes of sovereign paper,
as
in bonds remain unchanged. Hence loss to portfolio i
Sometimes due to clear guarantee and often due to the
only Rs. 500 i.e. 5% of initial market valuue.
comfort of public ownership. Some of the PSU bonds
Hence it can be seen that by adding fixed income
are tax free, while most bonds including
security in portfolio loss reduces to 5% as compare government
to securities are not tax-free.
10% when portfolio consisted only of equity.
The issues by government sponsored institutions like
Development Financial Institutions, as well as the
9.8 DEBT MARKET SEGMENTS:
infrastructure-related bodies and the PSUs, who make
There are three main segments in the debt markets in regular entry into the market to raise medium-term
India, viz., Government Securities, Public Sector Units funds, constitute the second segment of debt markets.
(PSU) bonds, and corporate securities.
Banks, financial institutions and other corporates have
(1) Government Securities: The market for Government been the major subscribers to these issues.
Securities comprises the
Centre, State and State (3) Corporate securities: Corporate bond markets
sponsored securities. In the recent past, local bodies comprise of commercial paper and bonds. These bonds
such as
municipalities have also begun to tap the debt are structured to suit the requirements of
markets for funds. ypically
investors and the issuing corporate, and include a
The market for
government securities is the oldes variety of features with respect to interest payments
and most dominant in terms of market and redemption.
capitalisauo
outstanding securities, trading volume and number MOst corporate bonds are plain coupon payng
participants. It not only provides the
few variations in the form of
zero
resources to oas, though a
government for meeting its
short term and long term
discount bonds and secured
needs, but also sets pon securities, deep
benchmark for pricing corpo orate

promissory notes are issued.

 148 Vipul'sM Risk Management I n t e r e s tR a t e M a r k e t

(BFM 149

After the de-regulation rates

of interest rates on COr Instit
titutional Investors:
and corporate 2
Institutiona
bonds in 1992
in
a variety

the corporate bond markets,

of structures

includ instruments
securitiz
Banks: Banks torm one of the largest single classes

af institutional bond investors. Banks holds an

products, corporate bond strips,
and a variet
et inventory of bond issues in their portfolios.
instruments with floors and caps
floating rate
were hl Pension funds: A pension fund is a pool of assets
introduced in our market. In the recent years, there
been an increase in issuance of corporate bonds with
has forming an independent legal entity that are bought
with the contributions to a pension plan for
embedded put and call options.
exclusive purpose of financing pension plan
benefits. Pension funds invest in bonds mainly for
9.9 PARTICIPANTS IN THE DEBT MARKETS:
capital gains and suit their cash flow needs.
The bond market can essentially be broken down c) Insurance companies: Insurance companies invest
into three main groups: issuers, underwriters and in international bonds mainly to manage various
purchasers. kind of risk associated with insurance. Investment
Purchaser/Investors: in international bonds also helps insurance
(1) Individual Investors: Main reasons for individual companies in ALM process.

investors investing in bonds are: Borrowers/Issuers:

(a) Diversification: International bonds offer (1) Governments: Government uses international bond
significant portfolio diversification because with market to fund a country's operations, such as social
international bonds, portfolio is spread over programs and other necessary expenses. Government
different countries. may borrow directly or through its agencies.
(b) Higher historical returns: Historical data Government may international bond market to fulfil
have use
needs.
shown that fixed income investors tend to
have a TS short term or long term foreign exchange
higher rate of return than most domestic bon 4Corporates: Corporates use international bond market
securities. to raise funds in foreign currency. Usually reputed

(c) Reduced risk: issues bonds in

bonds can help

Investing in companies with high credit ratings
large
offering the bond
to a
investors reduce market risk of portfolio whic ernational markets. By
otherwise can reduce borrowing
cannot be eliminated through nun ber of investors, corporates
investments in domestic that management of the
securities. However it is necessary
willingness
demonstrate a
corporation must
ng information at the time of
to o lis financial
adequate
the initial offerin8
150 vipul'sM Risk Management I n t e r e s tR a t e M a r k e t

(BFM 151

Underwriters: Semi-annual Cash flow PV discounting

The underwriting segment
of the bond
market is
mar. period (Rs.) @6%
made up of investment and banks 1 4
traditionally
financial institutions that help the issuer to sell other 3.88
the 2 3.77
bonds in the market. In general, selling debt is not
ot 3 4
it to the market. In most casses, 3.66
easy as just taking 4
are being transactoed 3.55
millions if not billions of dollars
ino n e offering. As a result, a lot of work needs to be 5 4 3.45
done such as creating a prospectus and other leoal 6 4 3.35
documents in order to sell the issue. In general, the 4 3.25
need for underwriters is greatest for the corporate debt
8 3.16
market because there are more risks associated with this
9 3.07
type of debt.
10 2.98
11 2.89
9.10 INTRODUCTION TO FIXED INcOME PRICING:
12 4 2.81
The simplest way of valuing a fix income instrument is to
13 2.72
discount all future cash flows and then add them. In case
of a plain vanilla bond, which we will first see, before 14 A 2.64
understanding the variations, the cash flows are pre 15 2.57
defined. The cash flows expected from a bond, which is not 16 104 64.81
expected to default are primarily made up of:
Value of the bond 112.56
(4) coupon payments, and
Based on above calculation price of the bond is
(ii) redemption of principal.
Rs. 112.56.
Therefore, the value of the bond can be stated in genera
terms as:
9.11 sOLVED PROBLEMS:
C1 C2 C3 Cn
(1 + r Tilustration 9.1:
A simple example of bond valuation is of bond
given beloW. n
investor invested in bond of XYZ Ltd. Coupon
Value o f a 11% bond with 8 years (coupon paid sem 10%. After a year bond will redeem at face value of

annually) to redemption at par is shown in table below: Rs. 100/ discount of 10% to
Investor bought bond at a
face value. Calculate Returns of investor
 152 Vipul'sM Risk Management ( I n t e r e s tR a t e M a r k e t

BFM 153

Solution: ill redeenm att

em a face value of Rs. 100.
will Investor bought
Return = P I : P2) bond at a discount of 10% to face value. Calculate
P2 Returns of investor?

interest received is Rs. 10 ut value of a bon with 6 years maturity and

Find face
Capital gains to investor is Rs. 10 (100-90). ) value of Rs. 100 Coupon rate is 13% and required rate
10+10 12%.
is 12 Further coupon is paid
Therefore, Rate of Return (R) 90 ofreturn semi-annually.
= 0.2222
9.13 QUESTIONS:

Hence, Rate of Return (R) for Investor is 22.22% a note on basics of bond market.
(Returns are expressed in percentage) 1) Write
between equity and debt
llustration 9.2: 2) Distinguish
A Write a note on bond market characteristics
Find out value of a bond with 5 years maturity and
face
value of Rs. 100. Coupon rate is 12% and required ratear 4 What are diferent types of bonds traded?

return is 14%. Further coupon is paid annually. 5) Discuss "Bond Rating".

Solution: 6) Write a note on International Bond Market.
Semi-annual Cash flow PV discounting 7)What are different debt market segments?
period (Rs.) (Rs.) (8) Discuss participants in debt markets.
12 10.53 (9) Brieflydescribe bond pricing.
2 12 9.23
3 12 8.10
4 12 7.10
112 58.17
Value of the bond 93.13
Based on above calculation price of the bond is
Rs. 93.13.

9.12 UNSOLVED PROBLEMS:

(1) An Investor invested in bond of ABC Ltd. Coupon bf
bond is 12% and
paid annually. After two yearsD