1. Concepts of Derivatives: Forward Commitments and Swap Contracts A brief overview by Hasan Tareq Khan Assistant Director, DBI-2

2. Risk has two components Exposure (size, amount of risk) Uncertainty (probability of adverse consequences)

3. What is a foreign exchange contract? Two Parties A bilateral agreement Two cash Flows to buy or sell Two Currencies one currency against another Two way quote at an agreed price Two value dates at a specified value date

4. What is a foreign exchange rate? The price of one currency expressed in terms of another currency Examples: USD/JPY107.40 EUR/USD1.2585 Consists of two currencies Commodity (Base) currency: currency being priced; fixed number, e.g. 1.000 Terms (Counter) currency: the “other” currency; variable number, e.g. 107.40

5. Who are parties to a foreign exchange contract? Calling party (price taker) Quoting party (market maker)

6. What is implied in an FX rate?

7. ARBITRAGE It refers to the purchasing of foreign currency where its price is low and selling it where the price is high. This is also called currency arbitrage. Arbitrage may be due to interest rate differences in two financial centers, which is known as interest arbitrage.

8. SWAP Purchasing a foreign currency on the spot for selling forward or selling a foreign currency on the spot for purchasing forward.

9. HEDGING Foreign exchange risks can be avoided or covered by Hedging. This usually involves an agreement today to buy or sale a certain amount of foreign currency at some future date at a rate agreed upon today.

10. SPECULATION It is opposite of hedging. While a hedger seeks to avoid or cover a foreign exchange risk for fear of loss, the speculator accepts or even seeks a foreign exchange risk in the hope of making a profit. Speculation usually occurs in the forward exchange market.

11. Value date The date on which the exchange of currencies is to take place is the “value date” of the transaction. In theory, the essential principle of valeur compensee (compensated value) requires the currencies to change hands at the same point of time. In practice, this is not possible because of time differences in the two centers. Hence, the use of value dates,i.e. currencies must be paid and received on the same day. The value date of foreign exchange transaction will have to be a working day in both the centers where the money transfers are to take place.

12. DERIVATIVE Derivative is “something derived”(from a specified source)-WEBSTER In finance, derivatives are contracts whose value (the “something”) is derived from some underlying asset such as commodity, an interest rate, a stock, or a bond. A derivative, therefore, exists on the basis of another products. It is a special product created out of a core product.

13. Basic kinds of derivative products: Forwards and futures (exchange traded forwards) Swap Options

14. USE Hedging, speculating or selling risk- management or transaction services Provide banks with opportunities to strengthen customer relationship Emphasizes that bankers must recognize the potential benefits of selling risk- management services.

15. SPOT A spot foreign exchange deal is one made for settlement in two working day’s time. Thus under normal circumstances a spot deal done on Monday is settled on Wednesday. Settlement of both sides of a spot foreign exchange deal should be made on the same working day. The principle is that the two sides of the deal should be completed on the same day is referred to as the principle of valeur compensee or compensated value.

16. Example:

17. How banks quote spot rates to customers Ascertain the going exchange rate in the wholesale market, load a margin and make a customer quote. The underlying theory is that the currency sold to (bought from) a customer is simultaneously bought (sold) in the wholesale market, the margin representing transaction costs (overheads, brokerage etc.) and profit for the bank.

18. The margin that the bank charges to a customer is negotiable and is determined by the following factors,- Size of the transaction Customer relationship Customer awareness

19. Forward A forward exchange contract is an agreement between a bank and another party to exchange one currency for another at some future date. The rate at which the exchange is to be made, the delivery date and the amounts involved are fixed at the time of agreement.

20. Forward Contract Transaction in which Buyer and Seller agree upon –The delivery of a specified quantity & quality of an asset –At a specified future date –At a specified price

21. FORWARDS Definition: An FX Transaction in which two parties agree TODAY to exchange currencies on a SPECIFIC FUTURE date & at a SPECIFIC RATE. The Future date is known as the forward date. It is a Combination of Spot Rate and Interest Rates. FORWARD PRICE = BUY: Spot + (Spot x Higher Interest Rate/100 x FwdTenor/360) - ((1 x Lower Interest Rate/100) x FwdTenor/360) x Spot SELL: Spot + (Spot x ((1 + Higher Interest Rate/100 x FwdTenor/360) / (1 + Lower Interest Rate/100 x FwdTenor/360) - 1)) If BASE Currency Interest Rate is High then the Forward is at Discount; If BASE Currency Interest Rate is Low then the Forward is at Premium. Can be used for both Hedging and Trading Purposes.

22. FORWARDS Dissection

23. HEDGING FX EXPOSURE BY SINGLE FORWARD DEAL Company XYZ Opened USD 250,000 LC, payable after 90 days. Current USD-BDT Spot Rate is 66.25. The Customer feels that the USD-BDT Spot rate may go as high 68.00 which will cause loss in overall business. The Customer wants to hedge its Forex risk. Assumptions = 90 Days USD Interest Rate = 3.50% = 90 Days BDT Interest Rate = 9.00% Break-Even Forward Selling Rate = => Spot + (Spot x ((1 + Higher Interest Rate/100 x FwdTenor/360) / (1 + Lower Interest Rate/100 x FwdTenor/360) - 1)) => 66.25+(66.25 x ((1+9/100 x 90/360) / (1+3.5/100 x 90/360)-1)) = 67.1530

24. Forward Contracts: Payoff Profiles profit S(T) The long profits if the spot price at delivery, S(T), exceeds the original forward price, F(0,T). The short profits if the price at delivery, S(T), is below the original forward price, F(0,T). Long forward Short forward F(0,T)

25. Premium and discount: Forward rates are quoted in terms of premiums and discounts on the spot rates. Swap points=Forward rate-spot rate Forward rate>Spot rate=Premium Forward rate<spot rate=Discount »(Ref. Commodity currency)

26. Example of Forward Suppose Spot rate $1=Tk 40, Cost to a bank for borrowing taka for 90 days is 9%per annum. Bank can invest in US$ for 90 days at 6% per annum. –Interest rate differential=3% –Swap points=40*(3/100)*(90/360)=0.3 –So the spot rate must be adjusted by 0.3 But it is to be added or subtracted? –Bank borrows @9%;but can earn only @6%; so if $1=Tk 40 for immediate delivery, it should be more expensive to settle for future delivery in order to compensate for 3% loss. Forward rate =Tk 40+0.30=40.30

27. FORMS OF FORWARD Outright forward :An outright is a forward purchase or sale of a currency at a foreign exchange rate which expresses the actual price of one currency for a specific value date. SWAP:Combination of spot and forward.

28. Simple Currency SWAP An Overview

29. Definition Currency Swap can be defined as the exchange of one currency for another with an obligation to reverse the exchange at a future date.  Price of both the exchange and the reversal are fixed at the onset of the deal.  SWAP is similar to Repo/Reverse repo transaction, i.e. Sell and Buy back or Buy and Sell back of one currency for another.

30. FOREIGN EXCHANGE SWAP Definition The simultaneous purchase and sale of a currency for two different dates One of which is the spot delivery date (or before) and the other occurring after this date. Funds are exchanged on each date. Deal is Done in the form of BUY/SELL or SELL/BUY Key Purpose Cash Flow Management Money Market Arbitrage

31. Mechanism & Pricing Calculation A Swap transaction involves:  today’s spot price,  a fixed tenor  interest rate of base currency  interest rate of variable currency  near leg of the deal (SPOT)  far leg of the deal (FWD) Spot leg of the deal is priced at current market rate To calculate the price of far leg of the deal the future value of both the currencies are calculated and divided.

32. Example Let us look at a Swap of USD/BDT 1.0 million for 7-days, and assume that the Spot Usd/Bdt price is 63.20. Counterparty 1 (CPT1) will Buy/Sell and opposite will be true for Counterparty 2 (CPT2) who will Sell/Buy. CPT1 will receive $1.0mln  Place $1.0mln for 7-Days and earn interest of (say) 2.5% => 1,000,000*7*2.5/36000 = $486.11 CPT2 will receive BDT63.2mln  Place BDT63.20mln for 7-days and earn interest of (say) 6.0% => 63,200,000*7*6.0/36000 = BDT73,333.33 Swap price (break even) = BDT (63,200,000+73,333.33) USD (1,000,000+486.11) BDT 63,273,333.33 USD 1,000,486.11 = = 63.2426

33. Example Day One CPT 1CPT 2 BDT 69,200,000 USD 1,000,000 Day Seven CPT2 will receive $1,000,000.00 (note: USD is paid without interest as the interest earned in USD is priced into the swap calculation for BDT) CPT 1CPT 2 USD 1,000,000 BDT 69,242,600

34. ILLUSTRATION : FX SWAP - FC / BDT On Jan 01 CBC Sold USD 250,000 to its Import Client for 3 Months against BDT, Value Date Mar 30 @ 66.00 The Client will be allowed to take delivery of the Forward on any day from the end of 2 months (Feb 28) till the maturity date (Mar 30). CBC Purchased same amount of forward from Export Client for the same tenor (Value Mar 30), but without any early delivery option @ 65.00 –After 2 Months, the Import Client Claimed the Forward Amount USD 250,000.00

35. ILLUSTRATION continues CASH FLOW OF CBC CBC is Short USD 250,000.00 on Feb 28 since it has to Pay the Import Client from its Nostro Account. CBC is Long USD 250,000.00 on Mar 30 since it will Receive USD from the Export Client in its Nostro Account. Feb 28Mar 30 (USD 250,000) + USD 250,000 CBC has to do a USD 250,000 BUY/SELL SWAP Value Date Feb 28 and Mar 30 to match the cash flow: Feb 28Mar 30 (USD 250,000) + USD 250,000 +USD 250,000 (USD 250,000)

36. ILLUSTRATION continues Calculation: (SpotRate x No. of Days) x (VariableCurrency Interest Rate - BaseCurrency InterestRate) --------------------------------------------------------------------------------------------------------- ((No. Of Days x BaseCurrencyInterestRate) + (360 x 100) If Spot USD-BDT Rate = 66.00 Base Currency Interest Rate = 3.25% Variable Currency Interest Rate= 6.70% Number of Days= 30 (66.00 x 30) x (6.70 - 3.25) Swap Points = ----------------------------------- = 0.189237 ((30 x 3.25) + (360 x 100)) BUY/SELL Rate = 66.00 / 66.189237 Note: This is applicable when CBC prefers to use BDT in the SWAP. Alternative is also possible in case CBC prefers to use other currency i.e. GBP.

37. Regulatory Requirements Regulators generally limit banks to use fx products for hedging purposes. BB has devised the following regulations in GFET,1996. 1. ADs, on their own, are free to buy and sell foreign currencies forward in accordance with the internationally established practices however, in all cases the ADs must ensure that the cover is intended to neutralize the risks arising from definite and genuine transactions. 2. Be it forward sale or purchase, ADs must cover their own risk within the shortest possible time.

38. GFET(ch-6) 3. All forward contracts should be treated as firm and should be closed out on expiry. In such cases the ADs should charge the difference between the contracted (booked) rate and the TT clean spot buying or TT spot selling rate, as the case may be, ruling on the date the contract is closed out. The forward contract should be closed without charging any difference if the rate moves in favour of the customer on the date of the closure. In other words, in case of a forward purchase by Authorized Dealer no difference will be charged if the TT spot selling rate on the date of closure is at par or lower (i.e., inferior from the point of view of tile customer) than the booked rate. Similarly, no difference should be charged for closing out a forward sale contract if the TT clean spot buying rate on the date of closure is at par or higher (i.e., costlier than the booked rate from the point of view of the customer) than the booked rate. No forward contract should be renewed at the old rate. All cases of renewal should be treated as new contracts and the rates as applicable for purchase ‑ sale of forward contracts on the date of renewal should be applied.

39. GFET,1996 (ch-6) 4. The ADs may undertake swap transactions to cover their risks arising from forward transactions. However, they are advised to refrain from taking speculative positions through swap transactions. 5. All documents (copy of LC, contracts etc.) relating to forward contracts and Swap transactions must be, preserved for subsequent inspection by the Bangladesh Bank.

40. CIRCULARS FE Circular No-21;dated 26-10-2002 FE Circular No-02;dated 25-02-2004 FE Circular No-01;dated 04-01-2005 FE Circular No-03;dated 23-02-2005

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