1776_2719_Risk Management in Forex Markets_2nd Seminar_presentation

7/29/2019 1776_2719_Risk Management in Forex Markets_2nd Seminar_presentation

1/31

Risk Management in Forex Markets

- Basic and Emerging concerns

BySitarama Murthy@ Prmia,

Hyderabad


2/31

Market Players

Commercial Banks

Central Banks

Corporates

Individuals


3/31

Market

Global

24 hours (Never sleeps)

Through telex, telephone, fax, computernetworks

Simultaneous trading in all currencies


4/31

Features

Risks similar to any commodity

Profits from exchange rates

Exchange exposure/funds position


5/31

Role of Central Bank

Management of money Supply /inflation

Management of exchange rates

Ensuring orderly markets


6/31

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.


7/31

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)


8/31

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.


9/31

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


10/31

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


11/31

Risks

Exchange risk Credit risk

Liquidity risk

Settlement risk

Operational risk

Compliance Risk


12/31

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


13/31


Managing Risks

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


14/31


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


15/31


Managing Risks

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


16/31


Managing Risks

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


17/31


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)=


18/31


Managing Risks

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.


19/31


Managing Risks

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.


20/31


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


21/31


Managing Risks

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


22/31


Managing Risks

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


23/31


Managing Risks

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.


24/31


Managing Risks

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.


25/31


Managing Risks

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.


26/31


Managing Risks

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 .


27/31


Managing Risks

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.


28/31


Managing Risks

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.


29/31

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


30/31

Managing risks in foreignexchange markets iscomplex!

But it will be exciting and

rewarding.


31/31

Thank You

Sitarama Murthy

Prmia, Hyderabad

Date post:	03-Apr-2018
Category:	Documents
Upload:	rohit-jain
View:	216 times
Download:	0 times

1776_2719_Risk Management in Forex Markets_2nd Seminar_presentation

Documents