1. P4 Advanced Investment Appraisal

2. 2 Section F: Treasury and Advanced Risk Management Techniques F2. The use of financial derivatives to hedge against forex risk F3. The use of financial derivatives to hedge against interest rate risk Designed to give you the knowledge and application of:

3. 3  Evaluate, for a given hedging requirement, which of the following is the most appropriate strategy, given the nature of the underlying position and the risk exposure: i.the use of the forward exchange market and the creation of a money market hedge ii.synthetic foreign exchange agreements (SAFEs) iii.exchange-traded currency futures contracts iv.currency swaps v.FOREX swaps vi.currency options  Advise on the use of bilateral and multilateral netting and matching as tools for minimising FOREX transaction costs and the management of market barriers to the free movement of capital and other remittances. [3 F2: The use of financial derivatives to hedge against forex risk Learning Outcomes

4. 4 Hedging strategy given underlying position and risk exposure Forward exchange contract Agreement made today to exchange a specified instrument: (commodity, currency or other underlying asset):  for specified quantity  at a predetermined future date  at a price agreed upon today (called forward rate) Exposed to counterparty risk Not traded Each contract is unique and custom-designed On date of expiry, contract has to be settled by delivery It hedges the risks relating to currency exposure risk or commodity prices Features of forward contract

5. 5 Denotes the number of units of foreign currency required to buy one unit of domestic currency Denotes the number of units of domestic currency required to buy one unit of foreign currency Currency quotations Rule: Buy low, sell highRule: Buy high, sell low Direct quote Indirect quote Example  Direct quote: $1 = £0.504 means one dollar can be exchanged for £0.504. This quote is a direct quote for a party in the UK.  Indirect quote: The quote £1 = $1.9841 is an indirect quote for a party in the UK. Currency quotations

6. 6 Terms in Foreign exchange contract Rate for buying foreign currency in exchange for domestic currency Rate for selling foreign currency in exchange for domestic currency Difference between bid & offer price Bid price (buying rate) Offer price (selling rate) Bid offer spread Spot price Price of the underlying asset for immediate delivery Terms in Foreign exchange contract

7. 7 Forward rate Forward at par Forward rate = Spotrate Forward at discount Forward rate < Spotrate Forward at premium Forward rate > Spotrate Range forwards  Agreement to buy or sell a currency on a specified future date at an exchange rate that lies within an agreed range of values  Values agreed by parties while structuring range forward contract  Used for hedging currency exposures for both payables and receivables Forward rate Continued …

8. 8 If spot price moves above agreed upper limit If spot price moves below agreed lower limit Currency will be traded at agreed upper value Currency will be traded at agreed lower value Participating forward contracts  Agreement that allows company to cap its downside currency risk through a worst case exchange rate.  Allows company to participate in favourable movements in exchange rates.  Participation in profits due to exchange rate fluctuations is based on the percentage of difference between: future spot rate and worst case exchange rate Foreign exchange delivered on due date Client could request cancellation of forward contract Client could request extension of forward contract Execution of forward contracts Continued …

9. 9 Forward exchange market and money market hedge Forward market hedge Company enters into a binding contract with a bank to buy / sell:  a certain quantity of foreign exchange  at predetermined exchange rate  at an agreed future date Company can sell expected net inflow of foreign currency and buy expected net outflow of foreign currency Forward market hedge Covered hedge funds for forward contract are in hand or expected to be received in the near future Uncovered hedge funds needed for forward exchange contract are not currently available. They need to be purchased on the spot market at some future date

10. 10 Money market hedge Process of:  borrowing in money market of a country,  converting funds borrowed at spot rate of currency of the country in which payment is due, and  investing in second country. Total receipts (principal plus interest) after liquidating foreign currency investment are used to make business payment Difference between money market hedge and forward market hedge Money market hedge: currency is required immediately Forward market hedge: currency is required at end of contract period Refer to Example (page 481-482) Money market hedge

11. 11 Synthetic foreign exchange agreements (SAFEs) SAFEs  Forward contract in which profits or losses on notional principal amount are settled in cash at the end of the contract.  Due to cash settlement, the notional amount of currencies does not change hands  Used as a replacement for forward contracts in those currency markets where currencies are not freely convertible Futures contract  Commitment to buy commodity, security or currency at predetermined future date at a price agreed upon today  Used to hedge entire price change of a commodity, a foreign currency or a financial instrument Traded on organised exchange Standardised contract Margin requirements range from 5% to 10% of the face value of a contract Presence of clearing houses Features of futures contract

12. 12 Key terms in futures Spot price Price at which underlying asset trades in spot market Futures price Price at which futures contract trades in futures market Contract cycle Period over which futures contract trades. Eg: one-month, two- month or three-month expiry cycles. Expiry date Date specified in futures contract. At that date, the contract will cease to exist. Contract / lot size Amount of asset that has to be delivered under one contract. Cost of carry Relationship between futures prices and spot prices.

13. 13 Exchange-traded currency futures contracts Foreign currency futures contract Derivative contract which:  entails delivery of one or more foreign currencies  at predetermined future rate  at price agreed upon today Construction of futures hedge Identification of underlying transaction to be hedged Identification of currency risk in underlying transaction Construction of futures position resulting in profit if loss occurs in underlying position Refer to Example (page 485-486) Continued …

14. 14 ConceptAction Profit potential Loss potential Long straddle Buy put & buy call at same strike price and time to expiry UnlimitedLimited Short straddle Sell put & sell call at same strike price and time to expiry LimitedUnlimited Long strangle Buy put & buy call at different strike prices and same time to expiry UnlimitedLimited Short strangle Sell put & sell call at different strike prices and same time to expiry LimitedUnlimited Straddle Derivative position, which involves simultaneous purchase (or sale) of a call option & a put option at the same strike price and time to expiry Strangle Derivative position which involves the simultaneous purchase (or sale) of a call option and a put option with the same time to expiry but with different strike prices Continued …

15. 15 Currency swaps and FOREX swaps Swaps Bilateral OTC derivative contract resulting in exchange of a series of future cash flows over a period of time. Currency swaps Contract in which two counterparties:  exchange a specific amount of two different currencies  exchange interest payments in the two currencies over the term of swap and  re-exchange the principal at maturity FOREX swaps  similar to a currency swap  no exchange of interest payments  principal is exchanged at the start of the swap and re-exchanged at the end of the swap fixed interest obligations in one currency are exchanged for fixed interest obligations in another currency fixed rate obligations in one currency are swapped for floating rate obligations in another currency Types of currency swaps Fixed to fixed currency swap Fixed to floating currency swap Refer to Example (page 491)

16. 16 Currency options Gives the buyer the right but not the obligation  to buy or sell a specific amount of foreign currency  at a specific exchange rate (the strike price)  on or before a predetermined future date American option European option can be exercised on any business day up to & including expiry date can be exercised only on expiry date of the option Difference between strike price & spot rate of currency options Time to maturity Volatility in exchange rates Interest rates Factors determining currency options premium  the buyer has to pay a premium  can be a call or put option  limit the maximum loss to premium paid up-front

17. 17 Netting Process under which,  debit balances are netted off against credit balances,  so that only net amounts remain to be paid in actual currency flows. Objective: Offset the expected loss in one currency exposure by the likely gain in another Types of netting Bilateral netting  Netting between two parties  Lower balances are netted off against the higher balances  Remainder is paid or received  Does not require the intervention of a central treasury function Multilateral netting  Netting among more than two parties  Coordinated by clearing-house, central exchange or group’s treasury operations department  advantage over bilateral netting is that it reduces a higher credit exposure

18. 18 Recap  Evaluate, for a given hedging requirement, which of the following is the most appropriate strategy, given the nature of the underlying position and the risk exposure: i.the use of the forward exchange market and the creation of a money market hedge ii.synthetic foreign exchange agreements (SAFEs) iii.exchange-traded currency futures contracts iv.currency swaps v.FOREX swaps vi.currency options  Advise on the use of bilateral and multilateral netting and matching as tools for minimising FOREX transaction costs and the management of market barriers to the free movement of capital and other remittances. [3

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