MANAGING FOREIGN ECHANGE RISK

FACTORS THAT AFFECT EXCHANGE RATES

• Interest rate differential net of expected inflation

• Trading activity in other currencies

• International capital and trade flows

• International institutional investors sentiments

• Financial and political stability

• Monetary policy and the central bank

• Domestic debt levels

• Economic fundamentals

THEORIES OF EXCHANGE RATE DETERMINATION

• Purchasing Power Parityi = eif - ih =(ef - eh ) / eh

Exchange rates are in equilibrium when the real prices of goods are the

same in both countries. Any increase in price (inflation) in one country,

will be balanced out by the exchange rate change

THEORIES OF EXCHANGE RATE DETERMINATION

• Balance of Payments Approach– Trade and capital transactions impacts a

country’s foreign reserve can influence currency’s strength e.g. flexibility for central banks to intervene

THEORIES OF EXCHANGE RATE DETERMINATION

• Monetary approache = money supply

(ef – eh )/ eh = (msf - msh) / msh

Exchange rates are determined by a balance of supply and demand of

currencies

THEORIES OF EXCHANGE RATE DETERMINATION

• Asset approachr = e

rf - rh =(ef - eh ) / eh

Exchange rates are in determined by returns in different countries

FOREIGN EXCHANGE RISK

• Transaction Risk– Risk impacting operational transaction

• Translation Risk– Risk impacting financial reports

• Economic Risk– Risk impacting company’s investment value

MANAGING FOREX RISK

• Operational Hedging

• Instrumental Hedging

• Asset & Liability Hedging

ATTITUDE TOWARDS HEDGING

• Hedging is equal to insuring

SPOT TRANSACTIONS

• Spot Rate• Direct vs Indirect quotation• Selling – Buying• Cross Rate• Currency Arbitrage

FORWARD TRANSACTIONS

• Forward contracts• Forward pricing• Flexible forward• Non-deliverable forward• Closing Out a Forward Contract

FORWARD CONTRACTS

• Forward Rate : outright quotation and swap rate (% or points)

• Forward Premium – Forward Discount (% or points)

• Selling Forward– Buying Forward• Selling a forward contract vs Buying a

forward contract• Credit line needed

FORWARD PRICING

• Difference between interest rates of the respective currencies

• Difference between loan and deposit rate

• Or• Closing position via buying forward

FLEXIBLE FORWARD

• Provide flexibility in terms of several delivery dates

• For customers who cannot specify their delivery date

• Priced higher that straight forward contract

NONDELIVERABLE FORWARDS

• Does not require delivery of currency• Settlement in form of cash transactions

of the difference• Often used for hedging in emerging

market where delivery is difficult• Usually transacted between companies

CLOSING OUT A FORWARD CONTRACT

• Undertake delivery according to the terms of the forward contract

• Close out the forward by buying or selling an offsetting contract at prevailing market rates, with a resultant gain or loss

• Extend or roll the contract forward to another date at current rates

SWAPS

• Foreign exchange swaps• Currency swaps• Closing out a swap

FOREIGN EXCHANGE SWAPS

• Spot and forward transaction at the same time

• Tenor up to one year• Used for short-term investing or

borrowing in non-domestic currencies

CURRENCY SWAPS

• Transacted between counter parties with longer periods

• Combination of loan and investment with different currencies as well as different maturities

• Types of currency swaps :– Classic Currency swaps : - exchange currency

– Currency Basis swaps : - exchange currency w/ respective floating interest rates

– Common Currency swap : - exchange currency as well as fixed to floating interest vice versa FinalCrossCurrencySwap.pdf

CLOSING OUT A SWAP

• Advance settlement can be settled out via – Payments of fund breaking cost (the net

present value of future payments)

– Offsetting with another swap

– Swap extension

CURRENCY FUTURES

• Exchange traded forward contracts• Predetermined contract size, delivery

date and trading procedures set by exchange market where they trade

• No credit facility needed, but margin requirements ( in form of performance bond )

• No delivery needed

CLOSING OUT FUTURES CONTRACT

• Take delivery of the currency per the terms of the contract

• Buying or selling an offsetting contract at prevailing market rates, with a resultant gain or loss

• Extend or roll the contract forward to another delivery date

FOREIGN EXCHANGE OPTION• Option Premium

• Strike Rate

• Option duration

• American Option vs European Option

• Call option vs Put option

• Purchase of Option hedging

• Sell of Option speculating

• Over the counter vs Exchange traded

• Option position :– In the money

– At the money

– Out of the money

DETERMINANTS OF FOREX OPTION PRICES

• Current exchange rate• Exercise or strike rate• Risk free foreign interest rate• Risk free domestic interest rate• Volatility of the exchange rate• Put or Call option• Time until expiration of the option• American or European style

EXOTIC OPTIONS

• Foreign Exchange Collars• Average Rate Option• Barrier Option• Compound Option

FOREX COLLARS

Range Forward, Cylinder Option, Tunnel Option, zero cost collar

• Combines the purchase of a call option with a sale of put option with the same expiry date on the same currency pair

• European style• Zero cost collar :

– premium payment for call option = premium received from put option

FOREX COLLARS

CALL OptionStrike rate Rp. 9.500

PUT OptionStrike rate Rp. 8.500

REF. RATE = Rp. 11.000

REF. RATE = Rp. 8.000

Buy at Rp. 9.500

Option not exercised

Pay Rp. 500 morethan market rate

AVERAGE RATE OPTION

• Asian Option• Spot rate are calculated as an average

over a period• Transactions possible during the expiry

period at several predetermined dates• Strike rate can be fixed or floating

BARRIER OPTION

• Includes strike rate and barrier rate• Knock in Option (Call):

– Option can only be exercised if spot rate reaches the barrier rate

– The farther from market spot rate the cheaper the option

• Knock out Option (Put):– Option becomes non-exercisable if spot rate

reaches the barrier rate– The closer to market spot rate the cheaper the

option• Does not provide full protection• The key is in determining the barrier rate

KNOCK IN OPTION

BARRIER RATERp. 9.500

CALL OptionStrike rate Rp. 8.500

REF. RATE = Rp. 10.500

Option not exercisable

Option exercisable Knocked in

KNOCK OUT OPTION

BARRIER RATERp. 8.500

PUT OptionStrike rate Rp. 9.500

REF. RATE = Rp. 8.499Option knocked out

Option exercisable

COMPOUND OPTION

• Option on options• European style• Give the option buyer the right to buy or

sell an option contract at the compound option’s expiry date at a predetermined option premium

• Cheaper than straight option but might be more expensive hedging instrument

CLOSING OUT AN OPTION

• Deliver per terms of option contract or allow the option to expire at discretion of option holder

• Sell a purchased option at current market value

• Buy back a sold option at current market value

OPERATIONAL HEDGING

• Currency Netting– Net off cash in – out of same currency

– Hedge only the net balance

• Proxy Hedging– Hedging using different currency w/ hi corr.

• Foreign Currency Debt• Changes to purchasing/processing• Transfer exchange rate risk

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