Introduction to Foreign

Exchange Derivatives
Derivative: Definition

• Contingent contracts
• Values derived from future value of
an underlying asset/index
– Currency
– Bonds
– stock indices
– Interest rates
– Commodities
Derivative: Definition : IAS
39
Derivative Defined in RBI
Act
Derivative –Definition-SCRA
• In Indian context SCRA,1956 defines
derivatives to include-
– A security derived from
• Debt instrument
• share
• loan whether secured unsecured
• risk instrument or contract for difference or
any other form of security
– A contract which derives its value from the
price or index of prices of underlying security
– Derivatives are securities under SCRA
Derivative Instruments:
Types
• Exchange traded
• OTC
– In substance there are only two types of
derivatives:
– Forwards
– Options
Forex Derivatives
Derivative- Characteristics
• Gearing
– Small initial expenditure helps in dealing in large
volumes
• Shifts risk from buyer to the seller
• Effective risk mgt tool
• Improves liquidity of underlying
• Increases depth of market
• Lowest credit risk as settlement of difference only
• Helps in price discovery
– Better estimation of future price of the underlying;
helps in decision making
• Used Speculatively :
– Can be very risky : highly leveraged & often more
volatile than underlying
– With value of underlying moving speculative derivative
positions can show greater movements with consequent
large swing in profit and loss
Users
• Hedgers
– Desire stability in cash flows
– Aim at preventing fall in value of the underlying
• Traders
– Offer two way quotes
• Speculators
– Want to make quick money from volatility in the underlying
price
– Underlying not owned
– Not interested in stability of cash flows
• Arbitrageurs
– Earns risk free profit by taking advantage of difference in price
of different markets
– Larger the number of such trades remove this difference
OTC and Exchange Traded

• OTC
– Structured to suit the individual needs –
any product, any time, any amount
– No margins
– Credit risk
– Higher transaction costs
– Difficulty in matching / counterparties
BIS survey

As at end Notional Principal of

outstanding OTC counters
in trillion $

December 2003 197

June 2004 220

June 2005 271

Dec 2005 285
Derivative financial instruments
traded on organised exchanges
(Trillion US$)

Amount Turnover
outstanding
Dec20 June 2004 2005
03 2006
Future 13.75 26.03 840.18 1005.8
s 1

Option 23.04 57.95

Source- BIS Survey 312.07 402.59
Derivative volume –Indian
Banks
• Spurt in OBS exposure mainly due to derivative
segment
• Share of derivatives in OBS exposures: 82.%5
(March 2002) =>90.7%( Dec2004)
• Composition of derivative portfolio of banks in
India undergone transformation
• Forward forex contract : 79.6%(March 2002);
49.3% (Dec2004)
• Single currency SWAP: 14.6%=>46.6%
• Maturity profile of derivatives changed
– 1 Yr horizon: 84.6% (March 2002) => 51.3%(Dec2004)
– Corresponding increase in 2 to 3 yr segment
• Foreign banks have largest share (63.7%)in
derivative segment, New Pvt. Banks(18.1%), PSU
banks(16.3%)
Indian market volume
:FRA/IRS

– Outstanding notional principal:

– April 2005: Rs 13,58,487 crore
– March 2006: Rs 21,94,637 crore
– Select foreign banks ,PDs private sector
banks major participants
– Interest rate derivative market OTC
Forward Contract

• A forward is an agreement entered

into today,
• Either to sell or to buy a certain
quantity of a certain asset
• At a specified future date for a
specified price decided today.
• Tailor-made transaction
• Terms are very flexible.
Forward Contract
• The party that buys the underlying
asset in the contract is said to have a
long position
• The party that sells has a short
position.
• The specified future date when the
delivery is to take place is called the
maturity
• And the contract is settled on that
date.
Forward Contract
• Value of forward contract =0 at the time it is
entered into
• No upfront payment by either party
• Delivery price is usually set equal to the market
forward price at the initiation
• Later stage value may be negative or positive
• Both buyers and sellers are committed to the
contract
• Pay off of the buyer/seller is linear to the price of
underlying
• Presence of credit risk in forward contract
Characteristics of Forward
Contracts
• A forward transaction is a private contract
between two parties.
• A transaction can be entered into at any place
and at any time, as long as the two parties to the
transaction agree (assuming that there are no
regulatory issues).
• Each party bears two types of risk to the other
counterparty
– credit risk and settlement risk.
• transaction can be tailor-made to suit exactly the
parties' requirements,
• Forward transaction can eliminate any
uncertainty about the price in the future. suitable
for hedging a specific price risk.
Advantages of Forward
Contracts
• Objectives of parties entering into a forward
contract :
• Certainty: secure income or stabilize cost
– guarantees to buy or sell a certain amount of an
underlying asset, at a fixed price, on a specified date in
the future.
– Cash flow advantages to protect margin erosion by
changes in market price.
• Secure availability (long-term supply
contract)
Advantages of Forward
Contracts

• Certainty: secure income or

stabilize cost
• Secure availability (long-term
supply contract)
• Obtain the price risk of an asset
without holding that asset
• Cash flow modification
Disadvantages of Forward
Contracts

• While forward contracts can fix anticipated

revenue or cost, they cannot minimize
cost or maximize revenue.
• liquidity.
– tailor-made contracts-often suffer from poor
liquidity.
– This contrasts with the futures market, where
liquidity is much higher, but the contracts are
standardized.
Non- Deliverable Forward
(NDF) Market
• Market for forward dollar against rupees
exists in major international centers
• Singapore the biggest centre
• Absence of off-shore Indian rupee market
• Delivery of forward rupee not possible
• On expiry contract cancelled and
difference in settled in USD
• Such contracts known as NDF
• Participants are speculators; not permitted
to participate in domestic forward market
Definition of Swaps
• A swap is a contract between two
counterparties to exchange a quantity of
one thing for a different quantity of
another thing at regular intervals over
some agreed upon period of time
• usually with the amounts of at least one of
the streams dependent upon the level of a
specified market price or rate applied to a
notional principal amount.
Swap

• More accurately, a swap is a series

of forward transactions that are
bound together in one contract.
• The exchange of a payment against
a receipt at some distant future date
is a forward contract
Swap
• 6 forward
contracts at six-
month intervals
• Value of each of
the 6 forward
contracts forming
the swap above
not necessarily
zero.
• The diagram
shows arrows
representing two
notional payments
made by the swap
counterparties.
• In practice each
payment is netted
• .
Basic Characteristics of
Swaps
• The net present value (NPV) of all the
cash flows paid by one party = NPV of
all the cash flows paid by the other
party at the time a swap contract is
entered.
• NPV of a swap at the time of contract
is zero (except for any profit for the
swap intermediary).
• If this does not hold, there will be an
arbitrage opportunity.
Basic Characteristics of
Swaps
• Payment Dates :Between the effective
date and the termination date, there is a
series of payment dates.
• Floating rate payment dates - dates on
which floating rate payments are made
• Fixed rate payment dates - dates on which
fixed rate payments are made by the fixed
rate payer
• Swap payments made on a net basis-
actual payments are made by only one of
the parties as long as the fixed rate
payment date and floating rate payment
date same dates and in the same
Basic Characteristics of
Swaps
• Term Sheet
– Defines the basic terms and conditions of a swap.
– Defines who the counterparties are and which side of
the transaction they are on, that is, fixed rate payer vs.
floating rate payer.
– Notional amount: Amount based on which floating and
fixed amounts are calculated.
– Effective date : Date on which the swap transaction
payments begin to accrue.

– The termination date: end date of a swap transaction -

same as the maturity.
Uses of Swaps
• swap not a source of funds
• Does not provide with any funds beyond the periodic
cash flows or eliminate the obligation to pay an
underlying liability.

• Cash flow modification: Change from one form of cash

stream to another more desirable form of cash stream.
• Elimination of uncertainty: To eliminate or reduce
exposure to market rates or prices.
• Capital market or market arbitrage: To reduce cost
or improve returns by taking advantage of a particular
market in which the entity has relative advantage
(capital market arbitrage) or taking advantage of an
arbitrage that exists between two different markets
(market arbitrage).
Uses of Swaps
• 4) Investment: (having price exposure to an asset
without physically owning it): Create or reduce
exposure to a desired asset without buying or selling
the asset.

• 5) Trading: change in market conditions - the expected

cash flows of at least one side of a swap (the floating side)
change. - value of the swap fluctuates.
• The value of an interest rate swap behaves like a bond
price relative to a par value
• Par value of a swap is zero
• There are people who trade swaps if they believe a
particular type of swap is cheap or expensive relative to
their expectation of market movements. This is pure
speculation on the market.
Floating to Fixed Interest
Rate Swaps
• The most common type of swap is a 'plain vanilla'
interest rate swap
• One party pays a floating interest rate and the
other party pays a fixed interest rate.
• An example.
• ABC (a relatively new company) wants to raise
fixed rate funds of USD 10,000,000 for 5 years by
issuing a bond
• Unable to do so in the market because of their
credit status
• Can borrow money from their bank at 6-month
LIBOR plus 1% p.a.
• Bank is willing to lend only at a floating rate.
• They decide to borrow money from their bank and
Interest Rate Swaps

• Example :
• Comparative advantage argument
• A- 10.00%(fixed) 6-month
LIBOR+0.30%
• B- 11.20% (fixed) 6-month
LIBOR+1.00%
• A borrows fixed from market & pay
LIBOR to B
• B borrows LIBOR+1% pays 9.95%
Interest Rate Swaps
A- 10.00%(fixed) 6-month LIBOR+0.30%
B- 11.20% (fixed) 6-month LIBOR+1.00%

LIBOR
10% LIBOR+1%
A B

9.95%

A converted fixed rate to B converted floating to

floating LIBOR+.05% as fixed at 10.95% as against
against LIBOR+0.30% 11.20%

Comparative advantage shared equally

Interest Rate Swaps: with
Bank intermediation

LIBOR LIBOR
10% LIBOR+1%
A Bank B

9.90% 10%

A converted fixed rate to floating LIBOR+0.10% as against LIBOR+0.30%

B converted floating to fixed at 11.00% as against

11.20%
Bank earned 0.10%
Currency Swap
• Two counterparties agree to exchange interest
and principal in one currency for interest and
principal of another currency
• Exchange generally done at ruling spot rate the
time of entering into the contract
• May involve
1. Initial exchange of principal in two currency
2. Exchange of interest +repayment instalments or bullet
payment
3. Debt service obligation alone i.e 2 alone
• Interest rates for two currencies may differ and
may be fixed or floating
Currency Swaps

• Exchange of principal+ fixed rate interest payment of a

loan in one currency for payment on an equivalent loan in
another currency+ fixed rate interest thereon
• Principals exchanged at the beginning and end
• Principals chosen to be equivalent using exchange rate at
beginning

• A- 8.00%(Dollar) 11.6%(Sterling)
• B- 10.00% (Dollar) 12.00%(Sterling)
• A borrows in 8%dollar & pay 11%Sterling to bank-bank
pays dollar8% to A
• B borrows 12% sterling pays 9.4% Dollar to Bank – Bank
pays12% sterling to B
Currency Swap

• Motivated by comparative advantage

• A can borrow at $5% or AUD 12.6%
• B can borrow at $7% or AUD 13%

AUD 11.9% AUD 13%

$ 5%
A Bank B
$ 5%
$ 6.3% AUD 13%
 Comparative advantage: How
arise?
• Acceptability of the borrower in the market
• Too many recent flotation (scarcity value)( world
bank-IBM-1981-Swiss market)
• Special facilities available to borrower
– HDFC could cheap dollar debt under the guarantee of
United State Agency for International Development
(USAID) as per law housing finance co. of developing
country entitled
– HDFC raised floating dollar loan and swapped them for
Indian rupee with Indian banks in the process counter
parties have secured floating rate dollar at a rate they
would not have been able to raise
Currency Swap Quotation
EURO USD YEN
Bid Ask Bid Ask Bid Ask
1-year 2.19 2.21 1 1.42 0 0
.39 .06 .09
2-year 2.54 2.58 2 2.09 0 0
.06 .13 .16
3-year 2.90 2.94 2 2.66 0 0
.63 .24 .27
4-year 3.22 3.25 3 3.12 0 0
.09 .39 .42
Currency Swap Quotation
• USD quote-actual/360 against 3M
LIBOR
• Pound& Yen quoted –semi-annual
actual/365 against 6m LIBOR
• Euro/Swiss frank quoted –annual
basis against 6M Euribor/LIBOR
• : exception one year rate quoted
against three month bench mark
• Fixed rate quoted against each
currency
Currency Swap market

• Mostly OTC
• London Financial Future Exchange
(LIFFE)& CBoT introduced future
contract on 2,5,10 year swap rate
• Not found enough tkers
Cancellation of swap
• Example:
• $:Yen swap done when spot rate was JPY100
• Amount swapped JPY 125m payable in 3 yrs from now; interest 8%
on $ & 6%yen payable annually
• Cash flow remaining to be exchanged;
• Yr 1 : $80,000 Y7,500000
• YR2 : $80,000 Y7,500000
• YR3 :$1,080,000 Y7132,500,000
• Current spot exchange rate= Y110
• Three year swap rate 7% for $ & 8% for Y
• PV of USD =1026,243(disc. Rate ruling swap rate)
• PV of Y= 118,557,258 converted to $=1077793
• If Y paying party defaults risk to other party= $51,550
• This is the amount payable by Y payer to $ payer for unwinding or
cancellation swap at today’s rates
Swap market in India
• Interest rate derivative started in 1999-00
• Swap /FRA popular
• Commonly used floating rate bench mark
• MIBOR
• MITOR
MIFOR
• Currency swap with one currency leg
being Indian rupee introduced-January
2000
Cross currency and Fx interest
rate swap in India
• Banks in India act as intermediaries :
international market and corporate
customers
• Banks works on a full hedge basis
• Charge a spread over quote given by
correspondent abroad
USD:INR swaps
• Bench mark rate MIOCS
• Activity growing but market not still a very
• Liquid
• Outflow under the swap
– Interest on notional principal in $ calculated at spot exchange
rate at LIBOR+ principal in$ at the end
• Inflow
• Int. in RS at X% payable half-yearly on notional principal +
principal at the end
• Hedge strategy:
• Borrow rupee to buy dollar-invest $ at LIBOR-Pay $ interest
–service Rs borrowing with Rs receipt-
MIFOR Swap Market

• Inter-bank term-money market not

very liquid
• The forward market not liquid
beyond one year
• Interest rate parity with forward
margin prevails always
• Forward margin function of demand
supply
MIFOR Swap
• Pay MIFOR receive fixed
• Hedge :
– A. borrow 3 yr money
– B. Buy USD spot
– C. Deposit in one year LIBOR
– D. sell $ forward one year
– E . Roll over transaction twice repeating B,C& D
– F. At the end use rupee out of dollar to
repay borrowing at A
Principal only swap
• In effect hedge (or create) exchange risk on the
principal amount alone leaving interest payment
in original currency
• USD 100 5-year bullet payment loan
• INR/USD spot=50
• Initial exchange
– Bank pays Rs 5000
– Client pays USD100
• On loan maturity
– Bank pays USD100
– Clint pays Rs 5000
Principal only swap
• How to hedge?
• Conceptual frame work
• Invest a part of USD100 for 5yrs ZCB of
FV=USD100- Cost say (X)
• Remaining amount USD (100-X) convert into
rupee= (100-X)* 50= Y (say)
• Borrow Rs (5000-Y)
• Repayment obligation on borrowing on maturity
=Z(say)
• On maturity return USD from proceeds of ZCB
• Repay borrowing obligation Z out of Rs 5000
Diff=(Z-5000) may be recovered by pricing the
swap
 Using MIFOR SWAP
• MIFOR SWAP used to hedge long term USD/INR Currency
SWAP even in the absence of long term forward exchange
market

• SWAP-3 yr- Pay USD LIBOR every year &USD principal at end
• Receive INR fixed rate every year & INR principal at end
• HEDGE
• Steps :
• A. Buy USD forward 1yr
• B. Use MIFOR SWAP –receive one year floating & pay fixed
rate
• C. Rollover (A) twice
• Premium on USD & LIBOR payment will be received at “B”:
• Fixed rate payment under “B” will be based on quoting INR
fixed rate to counter party
Coupon only swap
• USD:INR coupon only swap
• Considered by companies with rupee debts : to
reduce cost of funds
• Both short & medium term in vogue
• Exchange of interest payment in one currency (INR)
for interest payment in another currency (USD)
• Example:
– Maturity –one year
– Banks pays 11%p.a on notional INR
– Bank receives 12 m LIBOR+ 7% in USD on notional
converted swap exchange rate( spot rate at the
start)
Credit Risk in SWAP
• Chance that one party in financial
difficulties/default
• Financial institution has credit risk
exposure from swap only when value of
swap to it is positive
• Potential loss from swap default much less
than potential loan default with same
principal
• Potential losses from currency swap is
greater than IRS
Futures

• Simultaneous right and obligation to

buy and sell
• Standard quantity of specific
financial instrument
/commodity/currency
• At a specific future date
• At price agreed between the parties
when contract entered into
• Exchange traded forward
Futures
• Future rarely provide perfect hedge
• Some significant advantage over OTC
product
• Price transparency
• Ease of unwinding position
• Absence of counter party risk: margin
system
• Marked to market daily
• To reflect the price change
• Liquidity in the exchange
• Cash flow by way of margin through
process of M to M
Currency future: hedging
tool
• Importer has to pay UDS 160000 in April 20
• Feb worried that USD may appreciate against £
• Wants to cover the exchange risk in future market
• LIFFE selling £ : USD future size £25000
• Maturity second week of June
• Current spot rate USD1.50per £
• Forward rate delivery April , 20 USD1.48
• June contract being traded at USD 1.45
• Sells 4 June contract: at USD1.45
• On April, 20 : spot rate in cash market:1.40; Future:1.36
• Purchase of USD 160000 cost £114 285.71
• Loss of £6177.61compared to ruling rate when hedging
done
• Buy back four future contract at current price (1.36)
• Profit USD 9000 equivalent £6428.57 at current spot rate
compensate for loss
Characteristics of Futures
market
• There is no credit risk and transactions are
transparent unlike OTC contracts
• Liquidity is high
• Settlement is easy
• Contracts is standardized and hence exact
hedge not possible as there could be
– Amount mismatch
– Product mismatch
– Mismatch between spot & futures price (known
as basis risk)
Interest Future
• Most popular contract ; 3M Euro Dollar contract
• Future contract on 3M LIBOR expected rule on
maturity
• On Chicago Mercantile Exchange such contract
have maturity up to 10 years
• Under $1M – 3M future contract:
– Seller undertakes to find a bank for the buyer to accept
buyer’s $1M -3M at interest now agreed
– Buyer undertakes to place the deposit
• Price quotes as (100- the rate on maturity)
• Contract pricing based on 90/360 interest
convention
• 0.01% change in in the price leads to change in
Options
• Fundamentally different from forwards,
futures and swaps and provide greater
flexibility in risk management than any
other derivative contract.
• Holder or the buyer of option has a right to
buy or sell an underlying without
concomitant obligation to do so i.e. only
seller has the obligation.
Some terms
• Strike price – the price at which the right
to buy or sell is exercised / agreed
• Expiry Date – The date on which option
contract expires or becomes invalid
• Call Option – the right to buy an
underlying
• Put Option – the right to sell an underlying
• American Option – right can be exercised
at any time during the life of an option
• European Option – right can be exercised
only at the end of the option contract
 Option Premium
• Option premium is the price for the option
• Premium is payable upfront which is the
gain realized by the option writer
• Option buyer has unlimited profit potential
but loss is limited to the premium paid
• Option writer has no right but face
unlimited obligation
• Option writer covers his option contracts
with customers on back to back basis
either in the domestic market or in
overseas market
Pay off Profile of call option

Buyer
Profit

Strike
Price

Spot Price
0 (Underlying)

Break even Point

Loss
Seller
Pay off Profile of put option

Buyer
Profit

Strike
Price

Spot Price
0 (Underlying)

Break even Point

Loss
Seller
Options : few variations
• Average Rate Option/Asian Option: average rate
over a set period used as strike price
• Knock Out : option lapses if underlying price falls
below a level or exceeds given level with
reference to strike price
• Knock In : option becomes operative if before
expiry underlying price goes above or below
given levels
• Contingent Option: a call on pound at (say)
USD1.50 but exercisable if pound LIBOR is (say)
more than 6.5%
• Binary Option: predetermined constant amount
paid if on expiry option is in the money
• Look back Option: gives right to buyer to sell/buy
at best price during the life of the option
Foreign currency option

• In India all currency options are OTC

and European style option
• Cross currency option was introduced
in January, 1994
• Foreign currency – Rupee option was
introduced in July, 2003
Foreign currency option- zero
cost structure
• Range forward
• Buy a call to hedge payable-sell a put
to reduce /zeroise cost
• Two strikes different : call-50/put -46
• Both out of money
• The min. exchange rate capped at
strike of the call
Foreign currency option- zero
cost structure
• Participating forward; USD 100000
• Buy call –SP=50.00,premium=60 paise-out
of money
• Sell put: in the money put – SP=50, pre.=
Rs1.20- sell ½ put to zeroise cost
• If on maturity rate=51, call exercised : if
on maturity rate=47 ; put exercised-buy $
50000 at Rs50/$ and remaining at Rs 47/-
average =48.50
Hedging : Options or
Forwards?
• Option carry a upfront fees
• No general definitive answer
• Few worth noting points:
– Option to be preferred for hedging contingent
exposures
– Forwards are not cost free- banks some times insist
on margin against counter party risk
– Opportunity cost inherent in forward: cannot take
advantage of favourable movement
– Option has up front cost but no opportunity cost
– For SP= forward rate –option more expensive
unless spot rate moves in favour by more than
price paid
Hedging : Options or
Forwards?
• A= option premium –European call
• F=Forward price /strike price
• X= spot rate at maturity
• X<= F : effective rates=F & X+A*
• X> F : effective rate = F & F+A**
• *Option cheaper only if F-X>A
• ** Option always costlier
• Forward to be preferred if adverse movement expected
• Option in case expected favourable movement
• Protection bought against potential unfavourable
movement
• In that case buy out of money option to limit upfront cost
Foreign Currency – Rupee
Options
• AD banks having a minimum CRAR of 9 per cent can
offer foreign currency – rupee options on a back-to-back
basis,

• Allowed to run option book

– adequate internal control, risk monitoring/ management
systems, mark to market mechanism
• Continuous profitability for at least three years
– Minimum CRAR of 9 per cent
– Net NPAs at reasonable levels (not more than 5 per cent of
net advances)
– Minimum Net worth not less than Rs. 200 crore
– a one time approval from the Reserve Bank
• AD banks can offer only plain vanilla European
options.
• Customers can purchase call or put options.
• Customers can also enter into packaged products
• Cost reduction structures (provided the structure
does not increase the underlying risk and does
not involve customers receiving premium)
• Writing of options by customers is not permitted.
• Zero cost option structures can be allowed.
• undertaking from customers interested :clearly
understood the nature of the product and its
inherent risks.
• Quote for option premium in Rupees or as a
percentage of the Rupee/foreign currency
notional.
• Settled on maturity either by delivery on spot
basis or by net cash settlement in Rupees on spot
basis as specified in the contract.
• In case of unwinding of a transaction prior to
maturity, the contract may be cash settled based
on the market value of an identical offsetting
option.
• Only one hedge transaction against
a particular exposure/ part for a
given time period.
Option contracts cannot be used to
hedge contingent or derived
exposures (except exposures out of
submission of tender bids in foreign
exchange)
RBI Draft Guidelines: Some
Changes
Option Trading Strategies
• Spread
• Taking position in two or more options of the
same type( two or more call or put)
• Bull spread
• Example:
• Buy a call at SP=100
• Sell the same call at SP=120
• Example :
• Buy a put at SP=100
• Sell same put at SP=120
Option Trading Strategies

• Bear spread
• Buy a put SP=100
• Sell the same put SP= 90
• Alternative:
• Buy a call SP= 100
• Sell the same call SP= 90