1776_2719_Risk Management in Forex Markets_2nd Seminar_presentation
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Transcript of 1776_2719_Risk Management in Forex Markets_2nd Seminar_presentation
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7/29/2019 1776_2719_Risk Management in Forex Markets_2nd Seminar_presentation
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Risk Management in Forex Markets
- Basic and Emerging concerns
BySitarama Murthy@ Prmia,
Hyderabad
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Market Players
Commercial Banks
Central Banks
Corporates
Individuals
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Market
Global
24 hours (Never sleeps)
Through telex, telephone, fax, computernetworks
Simultaneous trading in all currencies
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Features
Risks similar to any commodity
Profits from exchange rates
Exchange exposure/funds position
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Role of Central Bank
Management of money Supply /inflation
Management of exchange rates
Ensuring orderly markets
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Quotes in Forex markets Spot, Cash, tom, forward
(- = $1.2000 -Price in terms of local currency (USA)
$ = (- 0.8333 -Reverse in home country (Europe)
(- = $1.2000 -Cross rate in a third country (England)
Bid/Offer rates. (- = 1.2000/05$ = 40.6500/25
(Unless indicated, quotes are good for standard market lots)
Bid/offer in money markets. (5 1/8 -1/4.)
-Period/amount are given in advance
Positions squared by money market or forex deals.
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Forward Markets
Forward rates mechanism Forward quotes: 10/5 or 5/10
Linkage between forex and money
Forward rates are influenced by interestrates
Eg: $/INR quote in forwards:
Buy $ spot & sell the same 1 month fwd:
Invest the $s for a month and earn lesserthan in INR
Sells fwd $s at premium (give lesser
dollars)
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Forward markets (Cont..)
Forward exchange rate differentials
Premiums/discounts
Swaps
The gain or loss in swaps is determined by the forward
differentials and not exchange rates. If interest rates arestable swaps do not involve any rate movement risks.
Fwd exchange rate differential / = FR-SR X 12 x 100
interest rate differential SR no of month
Cash flows/mismatchesA deal results in inflow in one currency but out flow in another.The mismatches can be squared through money market deals.They are also squared thro forex swap deals.
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Factors Effecting Rates,
Short Term
Time scale in forex
Supply/demand position
Movement of funds
Entry of a large Banks / Corporates
Political crises, wars, oil price
Central Bank intervention
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Factors Effecting Rates,
Long Term Economic fundamentals/data
Balance of payments
Govt.s economic policies
Interest rate changes
Capital movements
Technical/psychological factors
Purchase power parity
Interest rate parity
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Risks
Exchange risk Credit risk
Liquidity risk
Settlement risk
Operational risk
Compliance Risk
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Identifying, Measuring, Monitoring &
Managing Risks
Use of Derivatives in Risk Management
IDerivatives are contracts whose values are to be derived from
the assets covered by them
Exchange Rate Risk : Forwards, Options, Futures, Rangeforwards (Floors,Collars, Caps)
Interest Rate risk : FRAs, Options, Futures, IRS
Liquidity/CurrencyRisks : Currency Swaps/ swaptions,
Concept of value at risk in foreign exchange
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Identifying, Measuring, Monitoring &
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II
Forward/Future Rate Agreement
Cash settled forward contracts on notional
amounts
A mechanism to cover against adverseinterest rate movements
Available in all major currencies Flexibility of amount and period
Fine spreads available on quotes
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Identifying, Measuring, Monitoring &
Managing Risks
IIIOptions
A stipulated privilege to receive/deliver a security commodity /currency, at a given price, with in /on a specified date.
Confers a right with no obligation whereby the buyer can demanda purchase or sale by the writer of a specified amount of currency
/ number of bonds / shares, commodities
Call option gives a right to purchase and a put option, to sell
Premium paid on spot basis (2 days).
Terminology: strike price, maturity date, premium,
American / European options
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Identifying, Measuring, Monitoring &
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Options (contd.)
Price dependent on:
i. Difference between the strikeand the market price
ii. Interest rate differential
iii. Term of the optioniv. Volatility of the currency
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IVEngineered Options / FRAs
Cap: Insurance against rise in currency price or
short term interests on liabilities
Floor: For protection of income on an assetagainst fall in interest rates or currency prices.
Collar: -A range product, where simultaneously acap is bought and a floor is sold on a liability andvice-versa on an asset/currency
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Identifying, Measuring, Monitoring &
Managing Risks
V
FRA in credit portfolio A bank has $100 Mio mortgage loans @ a fixed rate of 7% when LIBOR
is 5% by loading 2%
Rates expected to go up and earnings have to be protected.
An FRA bought at LIBOR (floating) +1%, for 5 years at a fixed rate of6.5%
Current receipts on FRA at 6% and payments at 6.5%.
Net margin on loans = Loan rate funding cost+ FRA receipts- FRApayments, i.e. (7-5+6-6.5) = 1.5%
If LIBOR goes up by 1%, to 6%: Receipts 7% and payment
6.5% on FRA. Funding cost 6%. Net margin= (7-6+7-6.5) =1.5%
If LIBOR goes up by 2%, to 7%: Receipts 8% and payments6.5% on FRA. Funding cost 7%. Net margin = (7-7+8-6.5) =1.5%
If LIBOR comes down by 1%, to 4%: Receipts 5% and payments6.5 % on FRA. Funding cost 4%. Net margin = (7-4+5-6.5)=
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Identifying, Measuring, Monitoring &
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VI
FRAs vs. Options in forex
A Swiss importer has to pay 1 Million USD in a year.
Current market rate is 1 $ =1.3000 CHF. The importer
wants to protect against $ going up.
An FRA is available at 1.7000 CHF. Option premium for
the same rate is CHF 80,000.
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FRAs vs. Options in forexComparison of No hedge, FRA and Option scenarios
Mkt. rate Liability in case of Gain over FRA/$
in one year No hedge FRA Option No he. Opt.
1.3000 1.3000 1.7000 1.3800* 0.40 0.32
1.5000 1.5000 1.7000 1.5800* 0.20 0.12
1.7000 1.7000 1.7000 1.7800 0 -0.08
1.9000 1.9000 1.7000 1.7800 -0.20 -0.08
2.1000 2.1000 1.7000 1.7800 -0.40 -0.08
* Option is not exercised and market is accessed.
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Identifying, Measuring, Monitoring &
Managing Risks
VII
Interest Rate Swaps Helps create the right mix of short term and long
term assets and liabilities, while controlling theinterest rates attached to them
No exchange of principal but only interestdifference on a notional amount
Interest rate risk can be shifted, by converting afloating rate to fixed rate or vice-versa
Interest payments made in the same currency
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Identifying, Measuring, Monitoring &
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Illustrations of IRS
Bringing together two divergent minds A company A has issued fixed rate bonds and expects rates to
come down or be stable. It opts for floating rate liability.
Another company B anticipates the LIBOR to go up and
is interested in switching over from floating to fixed rate.
CP--- (Com)--FRy- (Bank)--FRy-- (Com)-- FR Bonds
Libor+x
( B)--Libor+x ( )--Libor+x( A) at y
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Bank as the Swap provider
A US motor company has a 10 year floating rate borrowing and
believes rates will go up. It seeks a fixed rate payment option.
(US Motor)---- 6 month libor+0.50 %-----------( Bank)
( Comp )------ USD Fixed Rate payments--- ( Bank )
I
I
V
6 m Libor+0.50% borrowing
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VIIICurrency Swaps
Currency swaps help hedge currency risk and companies canfreely change the currencies in which they pay and receive
Liabilities and assets can be restructured
Balance sheet transaction risks can be hedged
Surplus in one currency can be used to take care of funding in
another currency Interest payments are made in two currencies
Currencies and principal are exchanged at a pre-fixed rate at thebeginning and end, of the contract period.
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Illustration of a currency swapA US company has need for Euros in Germany and a German company wants
USD for it US operations.
US ---Euros-------- German
company ------USD------- companyI I
V V
Subsidiary in Subsidiary in
Germany USA
I I
V VUses (= and pays Uses $ and
local interest pays $ interest
At the end of the contract period the companies return the principalamounts at a pre-agreed rate.
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IX
Swaptions
An arrangement/right to call on thecounter party to enter into a swap ata pre-agreed rate and for an agreedperiod
An asset swap can improve yield onbonds and avoid its selling.
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Swaptions - An illustration
A USD 1 Bio loan floated by Air-India at Libor +0.50%
Currently $ = (- 0.7000
An engineered product:
Air-India projects enough Euro income in 2 years.
Loan converted into a Libor + 5/8 % payment, with an option
to convert the loan in to euro loan at a rate of $= (- 0.8000 .
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Identifying, Measuring, Monitoring &
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X
Futures
An agreement to buy or sell a standardquantity of an asset at a future date at aprice agreed through an open cry on theFutures exchange.
Quantity, quality, date of delivery, units ofprice, minimum change in price, locationfor settlement are standardized
American and European style.
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Futures An Example
If an Indian exporter has to receive US $ 100
million one year hence, he can buy 20 futures
contracts of $ 5 mio at 41.
If the $ rate goes up (Rupee weakens) to say
$=INR44, he will lose. If it goes down to $=INR 38
he would gain. As he builds in to his calculations
a rate of 41, in both the cases he would retain his
estimated margins.
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Policy interventions in risk mitigation
Multi currency budgeting
Cash and funds flow projections
Multi currency pricing and invoicing
Asset- liability management in a multicurrency environment
Dynamics of a multi currency balance sheet
Appetite for risk
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Managing risks in foreignexchange markets iscomplex!
But it will be exciting and
rewarding.
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Thank You
Sitarama Murthy
Prmia, Hyderabad