2 Forward ContractThis is a contract with the Bank to buy / sell a specific currency, at a pre-determined exchange rate and on an agreed future date. A Forward contract is binding on both the parties to the contract.Key Benefit – Protection from foreign exchange market volatilityKey Risk – Potential loss due to unfavourable movement in currency market
3 Regulatory Environment A person resident in India may enter into a forward contract with an AD in India to hedge an exposure to exchange risk in respect of a transaction for which sale and/or purchase of foreign exchange is permitted under the FEMA Act, or rules & regulations issued, subject to the following conditions:There has to be a genuine underlying exposure i.e. Forward contracts are permitted only for hedging and not for speculation.A forward contract can be booked for the following:an inward / outward remittance for export / import transactions respectivelyforeign currency loans / bonds - only after RBI approval, where necessary, has been obtainedThe currency of hedge and tenor will be the customers choiceMaturity of the hedge should not exceed the maturity of the underlying transaction
5 DefinitionA Currency Option is a Financial Contract which gives the BUYER (Holder) the RIGHT, but not the Obligation, to exchange a specified amount of currency versus another at a specified rate on, or up to, a specified date.The SELLER (or Writer) of the Currency Option contract has the OBLIGATION to deliver the specified amount of currency at the specified rate on the specified date.Benefits over ForwardsOptions offer Flexibility to not lock in rates.Can tailor risk / reward to specific client requirements
6 Terminology Notional : The amount of Currency to be exchanged Call Option : Right to BuyPut Option : Right to SellStrike : Pre Agreed Exchange RateTrade date : Start date of the tradeExpiry Date : Date on which the Buyer decides to use the optionMaturity date : Date of settling the Currency Exchange
8 Case - Exporter Customer is an exporter : Need – To protect against potential USD depreciation against the INR from current levels over the month. Spot Rate : *Notional : $ 1 mio receiveable 1 month from now ( Jul 24th)
9 Strategy 1 – Hedging by using Forward Contract The 1 month forward premia is 2 p. Hence, the forward rate will be ( Spot – premia 0.02)1 month later ; possible scenariosScenario 1:US$ has depreciated, say to 46.50The exporter receives million instead of the market rate of million.He gains US$ 6K by entering into the forward contractScenario 2:US$ has appreciated, say to 47.30The exporter receives million instead of the market rate of million.He loses US$ 5K by entering into the forward contractThere is an option to cancel the contract before the maturity date. The prevailing premia for the remaining tenor will need to be adjusted & the profit / loss will be credited/debited to the account
10 Strategy 2 –Hedging using Options Customer buys 1 month for $ 1.0 mio Customer pays 0.65 % or USD 6.5k for this optionScenario 1:US$ has depreciated, say to 46.30The importer exercises the option sells at million better than the market rateHe gains US $ 10 k by entering into the forward contract. He also paid a cost of $ 6.5K. So net save is $ 3.5kScenario 1:US$ has appreciated, say to 47.30Customer lets option expire worthless. He would have lost $ 12k by locking into the forward contract; whereas in this case he only loses the premium cost of $6.5kQuestion: Can I reduce this premium cost?
11 Strategy 3 – Zero cost Option To offset the cost in the earlier case, customer sells(a) sells a Call [ sells USD buys INR ] after 47.00;(b) sells a Put [ buys USD sells 46.50]Customer sells for $ 1.0 mio, He receives 0.20% or USD 2000Customer sells for 1 mio, He receives 0.45% or USD 4500Customer receives 0.65 % or USD for this optionScenario 1:US$ has appreciated, say to 46.90None of the options get exercisedThe exporter sells USD at a favourable market rate of 46.90Scenario 2:US$ has appreciated, say to 47.30Customer enjoys upside on USD-INR from to for $ 1 mio.From customer is out of money for $ 1 mio to the extent of ( spot rate – 47.0) x $ 1 mio.
12 Strategy 3 – Zero cost Option Scenario 3:US$ has depreciated, say to 46.60The customer exercises the Put and gains from to of $3.2k. The other 2 options do not get exercised.Scenario 4:US$ has depreciated, say to 46.30The bank exercises the Put and Customer exercises ; customer gains till and thereafter he takes a loss of $4.4k on market movement beyond 46.5 till for $ 1 mio
13 RisksThe foreign currency market is a very volatile market, and there is potential for losses in case of adverse movement in currenciesWith the FX market open 24 Hours a day, profit target and stop loss levels could get breachedBooking forward contracts might lead to potential losses also in case the actual market rate at time of maturity is worse off than the locked in forward rate, or in case of early pick upCollateral is taken for booking forward contracts. In cases of adverse currency movements, which results in substantial margin erosion the customer will be required to provide additional margin
14 DisclaimerWe are pleased to present to you the proposed transaction or transactions described herein. Although the information contained herein is believed to be reliable, we make no representation as to the accuracy or completeness of any information contained herein or otherwise provided by us. The ultimate decision to proceed with any transaction rests solely with you. We are not acting as your advisor or agent. Therefore, prior to entering into any proposed the transaction you should determine, without reliance upon us or our affiliates, the economic risks and merits, as well as the legal, tax and accounting characterizations and consequences of the transaction, and independently determine that you are able to assume these risks.The terms set forth herein are intended for discussion purposes only and subject to the final expression of the terms of a transaction as set forth in a definitive agreement and/or confirmation. This proposal is neither an offer to sell nor the solicitation of an offer to enter into a transaction. Our firm and our affiliates may act as principal or agent in similar transactions or in transactions with respect to instruments underlying a proposed transaction. This document and its contents are proprietary information and products of our firm and may not be reproduced or otherwise disseminated in whole or in part without our written consent unless required to by judicial or administrative proceeding.