FUTURE & OPTIONS ON FOREIGN EXCHANGE CURRENCY & SWAP

INTRODUCTION

A derivative is a financial instrument whose value is derived from the underlying asset, which in this case is foreign exchange. The pace of financial innovation has been very swift and it has resulted in the emergence of newer and flexible financial instruments that are used actively to manage risk.

There exists a number of instruments that can be used manage and hedge risk and exposure.

OPTIONS

• An option is a financial contract that gives the holder the right but not the obligation to buy or sell the underlying asset at a prestated price, on or up to a specified date. In a currency option the underlying asset is the foreign exchange.

• The buyer of option has the right but no obligation to enter into a contract with the seller.

• In a currency option , there are two currencies involved e.g. an option to buy US dollars (USD) for Japanese Yen (JPY) is a USD call and a JPY put option.

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• The price at which the option buyer purchases the right to buy or sell the currency is called as the strike price or exercise price.

• The buyer can exercise the option on the specified date. Such an option is called as an European option.

• In case the buyer has the right to exercise the option on any business day from initiation to maturity, then such an option contract is the American option.

• While entering into the contract the buyer has to pay a fee to the option writer is called option premium.

TYPES OF OPTIONS

CALL OPTION

PUT OPTION

CALL OPTION

• In this option buyer has the right , but not the obligation to purchase a currency against the other at a specified price. This option can be an European call option or an American call option.

PUT OPTION

• A put option gives the holder the right, but no obligation to sell the underlying currency at a pre specified rate on or up to a pre-specified rate. The same situation can be reversed for a put option.

USES OF CURRENCY OPTIONS

• The currency options help an exporter or an importer in providing cover to their trade exposure that arises due to uncertain foreign exchange cash flows.

• They provide cover against contingent currency exposures, such as a tender to contract in foreign currency.

• Currency options are also used to provide cover against currency fluctuations that have an effect on the value of balance sheet assets and liabilities.

FUTURES

• The birth of futures contract coincides with the death of the fixed exchange rate system. In 1972 the International Monetary Market(IMM),a division of the Chicago Mercantile Exchange , was formed to offer futures contract in foreign currencies: British pound, Canadian dollar, west German mark, Japanese yen, Mexican peso, and Swiss franc. In 1973 Western economics allowed currency exchange rate to float free.

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• Futures are standardized contracts having a fixed size, value and expiration date. It is a transferable obligation between two parties to exchange currencies at a specified rate during a specified delivery month in multiples of standard amounts.

Essential Features Of Currency Futures

• They are purchased and traded on a regulated exchange.

• A key features of the futures contract is the standardization.

• The futures trading process is characterized by the presence of a clearing house.

• The members trading in futures have to post an initial margin with the clearing house.

FUTURE TRADING PROCESS

• Trading in futures takes place at an exchange with members of the exchange alone trading through the system of open cry. The process starts with member posting an initial margin. This margin amount is usually between 5-15% of the value of the contracts in my deal.

• Once a deal is reached between two parties, it is replaced by two deals , with the clearing house interposing between the two parties.

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• If the price of the underlying commodity or financial instrument rises the contract holder can make a profit and the same is credited to the account.

• If the price falls , a loss will be incurred and the required amount will be debited from the contract holders account. These are known as variation margins.

• In case the amount falls beyond a particular amount, known as maintenance margin.

• The trader receives a margin call and is required to make up the amount.

SWAP Globalisation of the financial markets has

resulted into the emergence of another type of financial instrument namely, swaps. They allow a borrower to exchange his liability with another type of liability.

There are various types of swaps

1.INTEREST RATE SWAP

2.CURRENCY SWAPS

INTEREST RATE SWAP

• An interest rate swap is a cotractual agreement between two parties under which each agrees to make periodic payment to the other for an agreed period of time based upon a national amount of principal.

• The principal amount is national because there is no need to exchange actual amounts of principal when there is no foreign exchange component to be take account of.

• However ,a national amount of principal is required in order to compute the actual cash amounts that will be periodically exchanged.

CURRENCY SWAP• A currency swap involves an exchange of two payments

denominated in two different currencies.• Let us assume that there are two firms X and Y. Firm X ,a US

firm, has gone for a 10 year fixed rate loan of $20 million at an interest rate of 10% while firm Y, German firm,has gone for a EUR25 million at 9.6 % for a 10 year period at fixed interest liability. Under a currency swap the two firms agree to exchange the repayment liability of each other’s loan. Thus firm A will receive a payment of $2 million in the each year and $22 million in the last year from firm B. At the same time, firm B will receive a payment of EUR 2.4 million each year and EUR27.4 in the last year from firm A. Thus both the firms have managed to exchange the currency denomination of their loan liability.

ADVANTAGES OF SWAP

• They provide greater options to the firm to manage their assets and liabilities.

• Swap often have the positive impact of lowering the total cost of funding.

• Swap allow success to markets which otherwise may not be available to firm.