Chapter Instruments in forex market

Forex derivatives:Economic entities in India currently have a menu of OTC products, such as forwards, swaps and options, for hedging their currency risk and the markets for the same are fairly deep and liquid, as reflected in the volumes and bid-offer spreads. The origin of the forex market development in India could be traced back to1978 when banks were permitted to undertake intra-day trades. However, the market witnessed major activities only in the 1990s with the floating of the currency in March1993, following the recommendations of the Report of the High Level Committee on Balance of Payments.In respect of forex derivatives involving rupee, residents have access to foreign exchange forward contracts, foreign currency-rupee swap instruments and currency options both cross currency as well as foreign currency-rupee. In the case of derivatives involving only foreign currency, a range of products such as IRS, FRAs, option are allowed. While these products can be used for a variety of purposes, the fundamental requirement is the existence of an underlying exposure to foreign exchange risk whether on current or capital account. While initially the forward contracts could not be rebooked once cancelled, greater flexibility has now been given for booking cancellation and rebooking of forward contracts.In the case of exporters and importers, they are also allowed to book forward contracts based on past performance and the delivery condition has also been gradually liberalized. In order to simplify procedural requirements for Small and Medium Enterprises (SME) sector, RBI has recently granted flexibility for hedging, both underlying as well as anticipated, and economic exposures without going through the rigours of complex documentation formalities. In order to ensure that SMEs understand the risks of these products, only banks with whom they have credit relationship are allowed to offer such facilities. These facilities should also have some relationship with the turnover of the entity.Similarly, individuals have been permitted to hedge up to USD100,000 on self declaration basis.Rupee Forwards:An important segment of the forex derivatives market in India is the Rupee forward contracts market. This has been growing rapidly with increasing participation from corporate, exporters, importers, banks and FIIs. Till February 1992, forward contracts were permitted only against trade related exposures and these contracts could not be cancelled except where the underlying transactions failed to materialize. In March1992, in order to provide operational freedom to corporate entities, unrestricted booking and cancellation of forward contracts for all genuine exposures, whether trade related or not, were permitted. Although due to the Asian crisis, freedom to re-book cancelled contracts was suspended, which has been since relaxed for the exporters but the restriction still remains for the importers.Currency Futures:In the context of growing integration of the Indian economy with the rest of the world, as also the continued development of financial markets, there is a need to allow other hedging instruments to manage exchange risk like currency futures. The Committee on Fuller Capital Account Convertibility had recommended that currency futures may be introduced subject to risks being contained through proper trading mechanism, structure of contracts and regulatory environment. Accordingly, Reserve Bank of India in the Annual Policy Statement for the Year 2007-08 proposed to set up a Working Group on Currency Futures to study the international experience and suggest a suitable framework to implement the proposal, in line with the current legal and regulatory framework. Given that India is not yet fully convertible on capital account, various options are available to deal with the issue of reconciling the regulatory framework in the cash and OTC forward market with the currency futures segment. The international experience in this regard is mostly from OECD (The Organisation for Economic Co-operation and Development) countries except for one single exception of South Africa which has recently introduced domestic currency futures.A currency future or foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a future exchange rate. A futures contract is similar to a forward contract, with some exceptions.Futures contracts are traded on exchange markets, whereas forward contracts typically trade on over-the-counter markets (OTC). Also, futures contracts are settled daily on marked-to-market (M2M) basis, whereas forwards are settled only at expiration.Most contracts have physical delivery, so for those held till the last trading day, actual payments are made in respective currencies. However, most contracts are closed out before that. Investors can close out the contract at any time prior to the contract's delivery date. Investors enter into currency futures contract for hedging and speculation purpose.Rupee Interest rate derivatives:Rupee derivatives in India were introduced in July 1999 when RBI permitted banks/FIs/PDs to undertake Interest rate swaps and Forward rate agreements. These institutions were allowed to offer these products to corporates for hedging interest rate risk as well as deal in these instruments for their own balance sheet hedging and trading purposes. Since then, many initiatives have been undertaken to deepen and broaden the market.The rupee interest rate derivatives presently permissible are Forward Rate Agreements (FRA), Interest Rate Swaps (IRS) and Interest Rate Futures (IRF). The permitted benchmarks for FRA/IRS are any domestic money or debt market rupee interest rate; or, rupee interest rate implied in the forward foreign exchange rates, as permitted in respect of MIFOR swaps. While both banks and PDs are allowed as market makers in the swap market, all business entities (including banks and PDs) are permitted to hedge their underlying exposures using these instruments. PDs have been also permitted to hold trading position in IRF, subject to internal guidelines in this regard. The interest rate swap market has grown rapidly with participation from banks and corporates. The market is liquid and bid-offer spreads are narrow.Foreign currency rupee swaps (FC-RE):Another spin-off of the liberalization and financial reform was the development of a fledgling market in FC-RE swaps. A fledgling market in FC-RE swaps started with foreign banks and some financial institutions offering these products to corporates. Initially, the market was very small and two way quotes were quite wide, but the market started developing as more market players as well as business houses started understanding these products and using them to manage their exposures. Corporates started using FC-RE swaps mainly for the following purposes: Hedging their currency exposures (ECBs, forex trade, etc.) To reduce borrowing costs using the comparative advantage of borrowing in local markets (Alternative to ECBs Borrow in INR and take the swap route to take exposure to the FC currency)The market witnessed expanding volumes in the initial years with volumes up to US$ 800 million being experienced at the peak. Corporates were actively exploring the swap market in its various variants (such as principal only and coupon only swaps), and using the route not only to create but also to extinguish forex exposures. RBI tried to regulate the spot impact by passing the following regulations: The authorized dealers offering swaps to corporates should try and match demand between the corporates. The open position on the swap book and the access to the interbank spot market because of swap transaction was restricted to US$ 10 million The contract if cancelled is not allowed to be re-booked or re-entered for the same underlying.Currency SwapsCurrency swaps involve an exchange of cash flows in two different currencies. It is generally used to raise funds in a market where the corporate has a comparative advantage and to achieve a portfolio in a different currency of his choice, at a cost lower than if he accessed the market of the second currency directly. However, since these types of swaps involve an exchange of two currencies, an exchange rate, generally the prevailing spot rate is used to calculate the amount of cash flows, apart from interest rates relevant to these two currencies. By its special nature, these instruments are used for hedging risk arising out of interest rates and exchange rates. Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. A foreign currency swap is an "exchange of borrowings", where the principal and interest payments in one currency are exchanged for principal and interest payments in another currency. Mostly corporates with long-term foreign liability enters into currency swaps to get cheaper debt and to hedge against exchange rate fluctuations.The best example of swap transaction is paying fixed rupee interest and receiving floating foreign currency interest.Definition: A currency swap is a contract which commits two counter parties to an exchange, over an agreed period, two streams of payments in different currencies, each calculated using a different interest rate, and an exchange, at the end of the period, of the corresponding principal amounts, at an exchange rate agreed at the start of the contract.We can now see from the above that currency swaps differ from interest rate swaps in that currency swaps involve:An exchange of payments in two currencies.Not only exchange of interest, but also an exchange of principal amounts.Unlike interest rate swaps, currency swaps are not off balance sheet instruments since they involve exchange of principal at the end of the period.The idea of entering into the currency swap is that, Bank US is probably expecting an amount of GBP 10 million at the end of the period, while Bank UK is expecting an amount of USD 14 million, which they agreed to exchange at the end of the period at a mutually agreed exchange rate.The interest payments at various intervals are calculated either at a fixed interest rate or a floating rate index as agreed between the parties.Currency swaps can also use two fixed interest rates for the two different currencies different from the interest rate swaps.The agreed exchange rate need not be related to the market.The principal amounts can be exchanged even at the start of the swapSwap Market in India:In India, the Reserve Bank of India has permitted banks to arrange currency swaps with one currency leg being Indian Rupee. However, the USD/INR forward foreign exchange markets are illiquid beyond one year. Since currency swaps involve the forward foreign exchange markets also, there are limitations to entering the Indian Rupee currency swaps beyond twelve months. Moreover, banks are also not allowed to take risk /run open swap books i.e., they have to locate counter parties with matching requirements; e.g. one desiring to swap a dollar liabilities into rupee liabilities and the other wishing to exchange rupee debt servicing obligation for dollar obligations. However, some aggressive banks do provide quotes for currency swaps for three to five years out for reasonable size transactions. Corporates who have huge rupee liabilities and want have foreign currency loans in their books, both as a diversification as well as a cost reduction exercise could achieve their objective by swapping their rupee loans into foreign currency loans through the dollar/rupee swap route. However, the company is assuming currency risk in the process and unless carefully managed, might end up increasing the cost of the loan instead of reducing it. In India, it is more the norm for corporates to swap their foreign currency loans into rupee liabilities rather than the other way round.Example:A corporate has a loan of USD 10 million outstanding with remaining maturity of 2 years, interest on which is payable every six months linked to 6-month Libor + 150 basis points. This dollar loan can be effectively converted into a fixed rate rupee loan through a currency swap. If the corporate wants to enter into a currency swap to convert his loan interest payments and principal into INR, he can find a banker with whom he can exchange the USD interest payments for INR interest payments and a notional amount of principal at the end of the swap period. The banker quotes a rate of say 10.75% for a USD/INR swap. The total cost for the corporate would now work out to 12.25%. If the spot rate on the date of transaction is 44.65, the rupee liability gets fixed at Rs. 446.50 mio. At the end of the swap, the bank delivers USD 10 million to the corporate for an exchange of INR 446.50 mio, which is used by the corporate to repay his USD loan. The corporate is able to switch from foreign currency.INTEREST RATE CAPS:An Interest Rate Cap is a series of borrowers options which sets a maximum interest rate on a medium term floating rate borrowing. The buyer of a cap can choose the strike price, but the cost of the premium will vary according to the strike price chosen. The cap holder has the right to exercise an option on each fixing date or rollover date of the loan, and this covers the interest period up to the next fixing date. If on any fixing date, the reference market rate of interest is above the caps strike price, exercise and cash settlement are triggered automatically.Like borrowers options, caps are cash settled. The cap writer pays a compensating amount to the cap holder when the interest rate is above the pre-agreed strike level on the expiry date for any of the options in the series.FORWARD RATE AGREEMENTS: FRA is a financial contract between two parties to exchange interest payments for a Notional Principal Amount on a future settlement date, for a specified period from start date to maturity date. Accordingly, on settlement date, cash payments based on contract (fixed) and the settlement rate, made by the parties to one another. The settlement rate is the agreed benchmark/reference rate prevailing on the settlement date. The buyer of an FRA is fixing the rate of interest payable on a notional loan. The seller of an FRA is fixing the rate of interest receivable on a notional deposit.Interest Rate Swaps: Interest rate swaps are used to hedge interest rate risks as well as to take on interest rate risks. If a treasurer is of the view that interest rates will be falling in the future, he may convert his fixed interest liability into floating interest liability; and also his floating rate assets into fixed rate assets. If he expects the interest rates to go up in the future, he may do vice versa. Since there are no movements of principal, these are off balance sheet instruments and the capital requirements on these instruments are minimal. A contract which involves two counter parties to exchange over an agreed period, two streams of interest payments, each based on a different kind of interest rate, for a particular notional amount. Mechanism of an Interest Rate Swap:Take the case of an interest rate swap, in which Counter Party A and Counter Party B agree to exchange over a period of say, five years, two streams of semi-annual payments. The payments made by A are calculated at a fixed rate of 6% (Fixed rate) per annum while the payments to be made by B are to be calculated using periodic fixings of 6-month Libor (floating). The swap is for a notional principal amount of USD 10 million. The above swap is called the "plain vanilla" or the "coupon swap". Interest rates are normally fixed at the beginning of the contract period, but settled at the end of the period.Typical Characteristics of the Interest Rate Swaps:1. The principal amount is only notional.2. Opposing payments through the swap are normally netted.3. The frequency of payment reflects the tenor of the floating rate indexWith a view to deepening the money market and also to enable banks; primary dealers and all-India financial institutions to hedge interest rate risks, the Reserve Bank of India has allowed scheduled commercial banks, primary dealers and all-India financial institutions to make markets in Interest Rate swaps from July 1999. However, the market which has taken off seriously so far is the one based on Overnight Index Swaps (OIS). Benchmarks of tenor beyond overnight have not become popular due to the absence of a vibrant interbank term money market. The NSE publishes MIBOR (Mumbai Interbank Offered Rate) rates for three other tenors viz., 14-day, 1month and 3 month. The other longer tenor benchmark that is available is the yield based on forex forward premiums. This is called MIFOR (Mumbai Interbank Forward Offered Rate). Reuters published 1m,3m,6m 1yr MIFORs are the market standard for this benchmark.Interest rate swaps can be used to hedge interest rate risk:Floating rate loans expose the debtor to the risk of increasing interest rates. To avoid this risk, he may like to go for a fixed rate loan, but due to the market conditions and his credit rating, his fixed rate loans are available only at a very high cost. In that case, he can go for a floating rate liability and then swap the floating rate liability into a fixed rate liability. He can do the swap with another counter party whose requirements are the exact opposite of his or, as is more often the case, can do the swap with a bank.Interest Rate Swaps in India:With a view to deepening the money market and also to enable banks; primary dealers and all-India financial institutions to hedge interest rate risks, the Reserve Bank of India has allowed scheduled commercial banks, primary dealers and all-India financial institutions to make markets in Interest Rate swaps from July 1999. However, the market which has taken off seriously so far, is the one based on Overnight Index Swaps (OIS). Benchmarks of tenor beyond overnight have not become popular due to the absence of a vibrant inter bank term money market. The NSE publishes MIBOR (Mumbai Interbank Offered Rate) rates for three other tenors viz., 14-day, 1month and 3 month. The other longer tenor benchmark that is available is the yield based on forex forward premiums. This is called MIFOR (Mumbai Interbank Forward Offered Rate). Reuters published 1m,3m,6m 1yr MIFORs are the market standard for this benchmark.Futures is a contract between two anonymous persons to buy or sell a particular commodity or financial instrument at a specific price and at a particular date in the future ,despite the vagaries in the base price of that commodity or financial instrument. It is similar to a forward contract which is an Over the counter product, while futures is traded in exchanges. We can also call it as exchange traded forward contracts.Rupee FuturesIn Rupee futures the underlying is the Indian Rupee whose base rate fluctuates as any other currency based on demand, supply and various other factors. Currently, Rupee futures are traded in NSE, MCX-SX and USE stock exchanges in India. Also, the Dubai Commodity exchange offers facility to trade in Rupee futures.August 06, 2008 RBI allowed USD/INR currency futures trading in India. Currency pairs in rupee futures contracts are USD/INR, EUR/INR, GBP/INR, and JPY/INR and the Underlying for the same is Exchange rate of Indian Rupee v/s the US Dollar, Euro, Britain Pound and Japanese Yen.Individuals, Corporate, NBFC and Banks can trade in the currency futures segment. FIIs & NRIs are currently not allowed to trade in this segment.The market is very much liquid so any trader/hedger can enter the market and exit the market conveniently. However, only the near month contracts are more liquid. For example, the first three month contracts are very much liquid for USD/INR and EUR/INR pairs while only the first two month contracts are liquid for GBP/INR & JPY/INR pairs.The flexibility to exit the futures contract is a boon to the trader, only if he decides to square off the position. Open positions can be squared off any time during the Exchange's working hours and during the life of the contract. Squaring off can be done by entering an opposite trade position in the underlying contract before its maturity.ie) if one has bought 10 lot EUR/INR FEB 2011 contract then to close the position he has to sell 10 lots EUR/INR FEB 2011 contract.In Indian Rupee futures, the profit is calculated with the difference in the value of currency pair [e.g. USD/INR, EUR/INR etc], at which the trader enters and exits his position. Every one paisa gain is equivalent to Rs.10/lot. If a traders view goes right and gets a gain of 20 paisa in his position, he gains Rs.200/lot. However, this is without the brokerage charges, service charge and education cess, which a trader should pay to the broker. Normally a broking firm charges 1 to 3 paisa per transaction [either buy or sell]. Saying that, the normal brokerage commission makes up to 2 to 6 paisa for completing one position [i.e. buy and sell or sell and buy]. A trader should consider these charges also before deriving profit for his position.Currency OptionsUnlike futures or forwards, which confer obligations on both parties, an option contract confers a right on one party and an obligation on the other. The seller of the option grants the buyer of the option the right to purchase from, or sell to, the seller a designated instrument (currency) at specified price within a specified period of time. If the option buyer exercises that right, the option seller is obligated.Investors can hedge against foreign currency risk by purchasing a currency option put or call. For example, assume that an investor believes that the USD/INR rate is going to increase from 45.00 to 46.00, implies that it will become more expensive for an Indian investor to buy U.S dollars.In this case, the investor would buy a call option on USD/INR so that he or she could stand to gain from an increase in the exchange rate. The call option gives buyer of the option the right (but not the obligation) to buy currency on the expiration date.Forex HedgeA transaction implemented by a forex trader to protect an existing or anticipated position from an unwanted move in exchange rates. By using a forex hedge properly, a trader who is long a foreign currency pair can be protected from downside risk, while the trader who is short a foreign currency pair can protect against upside risk.The primary method of hedging currency trades for the retail forex trader is through spot contracts and foreign currency options. Spot contracts are the run-of-the-mill trades made by retail forex traders. Because spot contracts have a very short-term delivery date (two days), they are not the most effective currency hedging vehicle. In fact, regular spot contracts are usually the reason why a hedge is needed.Foreign currency options are one of the most popular methods of currency hedging. As with options on other types of securities, foreign currency options give the purchaser the right, but not the obligation, to buy or sell the currency pair at a particular exchange rate at some time in the future. Regular options strategies can be employed, such as long straddles, long strangles, and bull or bear spreads, to limit the loss potential of a given trade.Not all retail forex brokers allow for hedging within their platforms. Be sure to research the broker you use before beginning to trade.Internal TechniquesNetting Netting implies offsetting exposures in one currency with exposure in the same or another currency, where exchange rates are expected to move high in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure. It is of two types-bilateral netting & multilateral netting. In bilateral netting, each pair of subsidiaries nets out their own positions with each other. Flows are reduced by the lower of each companys purchases from or sales to its netting partner.Matching The netting is typically used only for inter company flows arising out of groups receipts and payments. As such, it is applicable only to the operations of a multinational company rather than exporters or importers. In contrast, matching applies to both third parties as well inter-company cash flows. It can be used by the exporter/importer as well as the multinational company. It refers to the process in which a company matches its currency inflows with its currency outflows with respect to amount and timing. Receipts generated in a particular currency are used to make payments in that currency and hence, it reduces the need to hedge foreign exchange risk exposure. Hedging is required for unmatched portion of foreign currency cash flows. The aggressive company may decide to take forward cover on its currency payables and leave the currency receivables exposed to exchange risk; if forward rate looks cheaper than the expected spot rate. In matching operation, the basic requirement is a two-way cash flow in the same foreign currency. This kind of operation is referred to as natural matching. Parallel matching is another possibility. In parallel matching, gains in one foreign currency are expected to be offset by losses in another, if the movements in two currencies are parallel. In parallel matching, there is always the risk that if the exchange rates move in opposite direction to expectations, both sides of the parallel match leads to exchange losses or gains.Leading and LaggingIt refers to the adjustment of intercompany credit terms; leading means a prepayment of a trade obligation and lagging means a delayed payment. It is basically intercompany technique whereas netting and matching are purely defensive measures. Intercompany leading and lagging is a part of risk-minimizing strategy or an aggressive strategy that maximizes expected exchange gains. Leading and lagging requires a lot of discipline on the part of participating subsidiaries. Multinational companies which make extensive use of leading and lagging may either evaluate subsidiary performance in a pre-interest basis or include interest charges and credits to overcome evaluation problem.Another important complicating factor in leading & lagging is the existence of local minority interests. If there are powerful local shareholders in the losing subsidiary, there will be strong objections because of the added interest cost and lower profitability which results from the consequent local borrowing Government by implementing credit and exchange controls may restrict such operations.External hedging methods:External transactions or instruments undertaken or used with the specific intension of hedging risks arising out of internal business operations represent external hedging. Such products are called derivatives. Hence to manage risk derivatives are used because, they help the user to reduce or eliminate foreign exchange risk through various instruments.A derivative can be defined as, a transaction or a financial instrument which derives its value through some other asset or security. Foreign currency derivatives derive their values from the value of underlying currency. Derivatives can be used for, Hedging exchange rate risk, Speculation, Maximization of profits, Adjusting liquidity and hedging mismatched maturity risk (interest rate risk).The commonly used foreign currency derivatives are: Foreign currency forwards contracts, Foreign currency swaps, Foreign currency futures contracts, Foreign currency option contracts.