Foreign Foreign Exchange (FX) Exchange (FX)

DerivativesDerivativesInformation Session on Usage of Information Session on Usage of FX Derivatives in Credit Union FX Derivatives in Credit Union

Operations Operations

– – Picuz Solutions Sept/09Picuz Solutions Sept/09

Today’s AgendaToday’s Agenda

Define Foreign Exchange (FX) Define Foreign Exchange (FX) DerivativesDerivatives

Usage of FX SwapsUsage of FX Swaps Pricing/Math on FX SwapsPricing/Math on FX Swaps Risk FactorsRisk Factors Accounting ConsiderationsAccounting Considerations Risk Management / Policy AdjustmentsRisk Management / Policy Adjustments Clearance from RegulationsClearance from Regulations

FX DerivativeFX Derivative

4 major types of FX derivatives for 4 major types of FX derivatives for financial institutionsfinancial institutions FX SwapsFX Swaps FX Futures ContractsFX Futures Contracts FX Currency SwapFX Currency Swap Outright Forward Purchases or SalesOutright Forward Purchases or Sales

Credit Unions’ exposure should be Credit Unions’ exposure should be limited to FX swaps and Outright limited to FX swaps and Outright Forwards related to member businessForwards related to member business

FX SwapsFX Swaps

Definition – an agreement to sell US$ Definition – an agreement to sell US$ today against an offsetting purchase today against an offsetting purchase of US$ at a future dateof US$ at a future date

US$ principals are equalUS$ principals are equal The FX rate today versus a FX rate in The FX rate today versus a FX rate in

the future is established todaythe future is established today Short terms to long terms (1 day to 5 Short terms to long terms (1 day to 5

yrs)yrs) Most activity inside 3 months for Most activity inside 3 months for

credit unionscredit unions

Why are FX Swaps Used?Why are FX Swaps Used? Used to transfer liquidity (cash) from one Used to transfer liquidity (cash) from one

currency to another without engaging in currency to another without engaging in currency riskcurrency risk

Example – credit union has US$ deposits and Example – credit union has US$ deposits and no US$ loans – forced to invest in US$ no US$ loans – forced to invest in US$ investmentsinvestments

With FX swaps CU converts US$ into C$ and With FX swaps CU converts US$ into C$ and lends funds out at higher rate than US$ lends funds out at higher rate than US$ investment level or pays down C1 borrowingsinvestment level or pays down C1 borrowings

FX swaps can boost income or reduce FX swaps can boost income or reduce borrowing costs!borrowing costs!

How to do an FX swap?How to do an FX swap?

Cash in US$ investments into C/ACash in US$ investments into C/A Sell US$ value cash (today, spot is Sell US$ value cash (today, spot is

actually next business day) at 1.1000actually next business day) at 1.1000 Agree to Buy US$ value 1 month from Agree to Buy US$ value 1 month from

today at a future rate 1.1015today at a future rate 1.1015 On the future date US$ back into C/A On the future date US$ back into C/A

and need to pay back C$and need to pay back C$ Do a new FX swap (rollover) on that Do a new FX swap (rollover) on that

datedate

Pricing an FX swapPricing an FX swap

Selling and buying at two different Selling and buying at two different rates creates a loss/gain – Why do rates creates a loss/gain – Why do FX swap?FX swap?

The gain or loss on FX swap is The gain or loss on FX swap is related to the interest rate related to the interest rate differential between Cdn and US 1 differential between Cdn and US 1 month yieldsmonth yields

Think interest rate costs not FX Think interest rate costs not FX gains or losses when doing FX swapgains or losses when doing FX swap

Math of FX SwapMath of FX Swap Cash in US$1 mil deposits yielding 0.20% Cash in US$1 mil deposits yielding 0.20%

give up $167 on 30 days of interestgive up $167 on 30 days of interest Sell US$1 mil at 1.10 for $1.1 mil C$Sell US$1 mil at 1.10 for $1.1 mil C$ Invest $1.1 mil at 0.45% and earn $406Invest $1.1 mil at 0.45% and earn $406 Give up $US167 at 1.10 = $184 vs $406Give up $US167 at 1.10 = $184 vs $406 Cost of buying US$ back will be higher Cost of buying US$ back will be higher

than spot rate to claw back the $222 gainthan spot rate to claw back the $222 gain If FX swap rates are 1.10 and 1.1002 most If FX swap rates are 1.10 and 1.1002 most

gains will be lostgains will be lost

Beating the FX Swap Beating the FX Swap MarketMarket

Beating the FX marketBeating the FX market Find higher C$ yield than money market Find higher C$ yield than money market

Reduce C1 loan = savings 0.30% (0.75% - 0.45%)Reduce C1 loan = savings 0.30% (0.75% - 0.45%) Lend funds to members at Prime = bigger savingsLend funds to members at Prime = bigger savings

Calculate the potential gain to CUCalculate the potential gain to CU US$ 1 mil * 0.20% * 30 / 360 = -C$184US$ 1 mil * 0.20% * 30 / 360 = -C$184 C$ 1.1 mil * 3.00% * 30 / 365 = C$ 2,712C$ 1.1 mil * 3.00% * 30 / 365 = C$ 2,712 Less forward pts .0002 * $ 1 mil = -C$200Less forward pts .0002 * $ 1 mil = -C$200 Pick up from FX swap strategy = $2,339 Pick up from FX swap strategy = $2,339 Annual gains $27,939 per million!!!Annual gains $27,939 per million!!!

FX Swap FactorsFX Swap Factors

If US rates > Cdn Rates forward If US rates > Cdn Rates forward yields at a discount to spot (ex. 1.10 yields at a discount to spot (ex. 1.10 & 1.0998)& 1.0998) Sell and Buy results in a FX gainSell and Buy results in a FX gain

If US rates < Cdn Rates forward If US rates < Cdn Rates forward yields at a premium to spot (ex 1.10 yields at a premium to spot (ex 1.10 and 1.1002)and 1.1002)

Gains or Losses on FX swap not FX Gains or Losses on FX swap not FX losses but interest costs losses but interest costs

Risk FactorsRisk Factors

US$ deposit expenses will build up if US$ deposit expenses will build up if not offset with US$ spot purchasesnot offset with US$ spot purchases

Default RiskDefault Risk If counterpart fails = result = open If counterpart fails = result = open

currency position currency position Mitigate risk by dealing with highly-Mitigate risk by dealing with highly-

rated counterpartsrated counterparts Consider only doing short term swaps 1 Consider only doing short term swaps 1

to 3 monthsto 3 months

Risk Factors Risk Factors

US$ depos redeem before FX swap purchaseUS$ depos redeem before FX swap purchase Members draw down US$ deposits and put C/A Members draw down US$ deposits and put C/A

into overdraftinto overdraft Enter into Buy and Sell US$ Contract Enter into Buy and Sell US$ Contract

Buy US$ for cash to cover overdraftBuy US$ for cash to cover overdraft Sell US$ forward to match date of previous purchaseSell US$ forward to match date of previous purchase Sell C$ investments to buy US$ todaySell C$ investments to buy US$ today

Potential Risk to income from the change in Potential Risk to income from the change in forward points on the outstanding buy and sell forward points on the outstanding buy and sell

Mitigate risk by keeping terms to less than 3 Mitigate risk by keeping terms to less than 3 monthsmonths

Internal IssuesInternal Issues Set Up Off balance Sheet accounts for Set Up Off balance Sheet accounts for

US$ and counter C$ balancesUS$ and counter C$ balances US$ forward purchases and forward salesUS$ forward purchases and forward sales

FX Translation effects to understandFX Translation effects to understand Month end spot rate 1.10 Month end spot rate 1.10 Sell FX at 1.08 on first of next month 1.0802Sell FX at 1.08 on first of next month 1.0802 Close current month end at 1.07Close current month end at 1.07 Gain .03 on deposits, Loss of .02 FX Sale (1.10 Gain .03 on deposits, Loss of .02 FX Sale (1.10

vs 1.08)vs 1.08) Outstanding FX Buy at 1.0802 vs 1.07 (loss Outstanding FX Buy at 1.0802 vs 1.07 (loss

of .0102)of .0102)

Calculation of FX Calculation of FX PositionPosition

Old FX position calculationOld FX position calculation Sum (Investments, Current Account) less Sum (Investments, Current Account) less

deposit terms and accounts = Net FX positiondeposit terms and accounts = Net FX position New FX position calculationNew FX position calculation

Old FX position add US$ forward Purchases Old FX position add US$ forward Purchases and Salesand Sales

Remember US$ deposit interest will exist Remember US$ deposit interest will exist without US$ investment income using FX without US$ investment income using FX swaps – requiring the occasional US$ swaps – requiring the occasional US$ purchasepurchase

Example US$ Deposit Example US$ Deposit RedemptionRedemption

CU manager has $1 mil US$ deposits and CU manager has $1 mil US$ deposits and enters into Sell/Buy FX swapenters into Sell/Buy FX swap On B/S = $1 mil US$ deposit (negative flow)On B/S = $1 mil US$ deposit (negative flow) Off B/S = $1 mil Purchase (positive flow)Off B/S = $1 mil Purchase (positive flow)

CU manager pays out $600k in US$ CU manager pays out $600k in US$ depositsdeposits Manager Buys and Sells $US600k FX SwapManager Buys and Sells $US600k FX Swap On B/S = $400k US$ deposit (negative flow)On B/S = $400k US$ deposit (negative flow) Off B/S = $1 mil Buy and $600k sell = $400k Off B/S = $1 mil Buy and $600k sell = $400k

(positive flow)(positive flow)

Policy AmendmentsPolicy Amendments Allow FX swap transactions under Allow FX swap transactions under

Market Risk policyMarket Risk policy Set maximum term from spot and Set maximum term from spot and

maximum US$ dollar valuemaximum US$ dollar value Review annually for appropriatenessReview annually for appropriateness Prepare Board reporting packagePrepare Board reporting package

FX Outright ForwardsFX Outright Forwards

Second type of FX derivative used by Second type of FX derivative used by credit unionscredit unions

Related to Corporate client businessRelated to Corporate client business Importer or Exporter wish to hedge their Importer or Exporter wish to hedge their

exposure to US$ from their businessexposure to US$ from their business Buy or Sell US$ forward outright at a Buy or Sell US$ forward outright at a

rate set todayrate set today Can provide Corporate Client with a Can provide Corporate Client with a

option dated delivery (any time during a option dated delivery (any time during a specific month at a specific rate)specific month at a specific rate)

Risks to Income from Risks to Income from Outright ForwardsOutright Forwards

Counterparty riskCounterparty risk Client defaults = big risk to incomeClient defaults = big risk to income Mitigate by shorter terms or collateral Mitigate by shorter terms or collateral

(deposits)(deposits) Re-pricing riskRe-pricing risk

Client doesn’t need FX when it maturesClient doesn’t need FX when it matures Client wants to roll over contract and use Client wants to roll over contract and use

same ratessame rates Client is borrowing money from credit union if Client is borrowing money from credit union if

same rate is used – must build interest costs same rate is used – must build interest costs into new forward rateinto new forward rate

Policy Amendments for Policy Amendments for Outright Forward ActivityOutright Forward Activity

Great way of earning additional income Great way of earning additional income on commercial creditson commercial credits

Require Assistance call us or Central Require Assistance call us or Central OneOne

Should match buys and sells with Should match buys and sells with Central One or bank as close as possibleCentral One or bank as close as possible

Should have maximum terms for Should have maximum terms for transactions and fully matched for risk transactions and fully matched for risk management reflected in market risk management reflected in market risk policypolicy

Policy AmendmentsPolicy Amendments

Forward Outrights require market Forward Outrights require market risk policy amendmentsrisk policy amendments

Maximum terms, limits on levels of Maximum terms, limits on levels of mismatch by time period, credit mismatch by time period, credit reviews and individual risk limits per reviews and individual risk limits per client are importantclient are important

Simple Excel solution should work Simple Excel solution should work for reporting and managing riskfor reporting and managing risk

FX Derivatives ReportingFX Derivatives Reporting

Sum On-B/S Assets and LiabilitiesSum On-B/S Assets and Liabilities Sum Off-B/S FX Swap US$ Forward Sum Off-B/S FX Swap US$ Forward

Purchases and SalesPurchases and Sales Sum of FX Outright Forward Sum of FX Outright Forward

Purchases and SalesPurchases and Sales Provide a gap report to board with US$ Provide a gap report to board with US$

buys and sells outstanding by month buys and sells outstanding by month with weighted average ratewith weighted average rate

FX Derivatives and the FX Derivatives and the RegulationsRegulations

Regulations prohibit the use of FX Regulations prohibit the use of FX derivatives (very prescriptive…)derivatives (very prescriptive…)

Request in writing an exception from Request in writing an exception from Regulator on usage of FX derivativesRegulator on usage of FX derivatives

State the purpose of the usage of FX State the purpose of the usage of FX derivatives (FX swaps for liquidity derivatives (FX swaps for liquidity management and FX outrights for customer management and FX outrights for customer business)business)

State the adjustments made to market policy State the adjustments made to market policy to measure and report for this exposureto measure and report for this exposure

Receive response from Regulator Receive response from Regulator

ConclusionsConclusions Improved profitability levelsImproved profitability levels Swaps are safe and efficiently pricedSwaps are safe and efficiently priced Easy to account for and measure for risk Easy to account for and measure for risk

managementmanagement Keep FX swap terms to 30 days and Keep FX swap terms to 30 days and

starting and maturing near start of the starting and maturing near start of the month will reduce any issuesmonth will reduce any issues

Member business is profitable too, but be Member business is profitable too, but be prepared for additional credit risk prepared for additional credit risk (collateral conditions, term and volume (collateral conditions, term and volume limits are required)limits are required)