SWAPS

for
Risk Management

November 4, 2021
 On Managing Currency Risk thus spake...
 There is no sphere of human thought in which it is
easier for a man to show superficial cleverness and the
appearance of superior wisdom than in discussing
questions of currency and exchange.

Sir Winston Churchill

 Structure
Structureof
ofWorld
WorldFinancial
FinancialMarkets
Markets

CC rr oo ss ss -- bb oo rr dd ee rr FF inin aa nn cc iaia ll FF lolo ww ss

(( FF oo rr ee xx ))

TT rr aa dd ee FF lol o ww ss CC aa pp itit aa ll FF lolo ww ss OO tt hh ee rr ss

CC oo mm mm oo dd itit ieie ss SS ee rr vv icic ee ss

CC aa pp iitt aa ll DD ee bb tt AA idid ss //GG rr aa nn ttss RR e mm it t aa n c e ss
 Forex Quotes
RIC BID ASK NAME HIGH LOW TmAct

INR= 48.89 48.91 SBI 48.91 48.88 11:44

EUR= 0.9774 0.9779 BHF BANK 0.9068 0.9070 11:52

JPY= 121.24 121.99 BOT 122.79 121.05 11:50

GBP= 1.5047 1.5052 Barclays 1.4951 1.5085 11:51
CHF= 1.5026 1.5031 UBS 1.4977 1.5155 11:51

All forex quotes are for US $

Direct quote : 1$ = INR 48.89 ($ is base Ccy)
Indirect quote : 1euro = $ 0.9774 ($ is quoted Ccy)
 Forex
Forex flows
flows –– The
The Indian
Indian context
context

Trade a/c
Export receipts
Current A/c Imports

Invisibles Remittances
Remittances

•Capital flows •Capital flows

Capital A/c •Debt
•Debt
•Others
•Others
Reserves

Forex Reserves = Forex, Gold & SDRs

State Bank Staff College
Hyderabad
 Managing Currency Risk
Increased Uncertainty, Increased Risk

IDR=, Bid [Hi/Lo/Cl Bar] Daily

26Dec96 - 30Jan99
Pr
IDR= , Bid, Hi/Lo/Cl Bar / USD
26Apr99 8620 8425 8570 16000

14000

12000

10000

8000
USD/IDR DAILY CHART
6000

4000

Jan97 Mar May Jul Sep Nov Jan98 Mar May Jul Sep Nov Jan99

11/04/21 8
 Managing Currency Risk
Increased Uncertainty, Increased Risk

JPY=, Bid [Hi/Lo/Cl Bar] Daily

04Sep97 - 10May99
Pr
JPY= , Bid, Hi/Lo/Cl Bar / USD
26Apr99 119.34 118.70 118.84 145

140

135

130

125

120

USD/JPY DAILY CHART 115

110

Oct97 Nov Dec Jan98 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan99 Feb Mar Apr May

11/04/21 9
 Economic
Economic // Financial
Financial Risks
Risks

Exchange Fluctuation in exchange rate may reduce quantum of inflows -

Risk Transaction risk

Adverse change may result in depreciation of foreign currency

assets - Translation risk

Interest  Borrowing is preferred to raising equity. Fixed interest loans

Risk are limited. Rise in floating rates may impact cash flows
over time.
 Fall in interest rates affect flows from investments or
deployed temporary surpluses

11/04/21 10
Forex Forex deals may be commercial or speculative.
markets - Dynamics of currency speculation
Speculation
 Currency price is a function of demand and supply gap
 Leads/lags between trade and required forex affect gap
 Also shifts in sentiments due to disasters, coups, regulations
Speculating on Trends
 Sail with the wind and reap a harvest
 Go long in the currency in demand and sell it when the
prices appreciate due to enhanced demand.

Weak domestic currency

If
your currency is fundamentally weak, buy forex now because you may
have to pay more if you delay.

11/04/21 11
 Dialectics
Dialectics of
of Forex
Forex Markets
Markets

Determinants of  Excessive demand pushes up and over-supply

Currency Price depresses currency value.
 Play of market forces correct temporary aberrations
 Central banks intervene to stabilize – a major factor.
Major Factors Fundamental Factors
Balance of Payments
Interest and inflation rates
Leading and lagging indicators
Economic growth
Fiscal deficit and money supply
Reporting delays and Market expectations
Institutional Factors
Technical Factors
11/04/21 12
 Global
Global Forex
Forex Markets-
Markets- Structure
Structure

Forex Products

OTC Market Exchange Market

Spot Future
Future
Cash - Same day Forward - Future
Swap - Exchange Futures - Future
Tom - Next day
Spot - 2nd bus. day Option - A right Option - A right

Derivatives
 Sources
Sources of
of Risks
Risks

Trade Exports
related Imports
 Price fluctuations
 Currency Rate fluctuations
 Interest rate fluctuations

Remittances  Currency Rate fluctuations

Capital Raising GDRs/ADRs/FCCBs

market Floating Bonds
 Currency Rate fluctuations
 Interest rate fluctuations

11/04/21 15
Derivatives
Derivatives Market
Market
 Size : US dollar 41 trillion
 Players
 Investment banks
 Banks
 Corporates
 Funds
 Investors
 Complex and challenging
 One man’s risk is another man’s profit opportunity

Uses of derivatives
To hedge risks on Forex and capital markets
To profit from opportunities created by risks

11/04/21 16
Derivatives
Derivatives Markets-
Markets- Structure
Structure

Derivative Products

OTC Market Exchange Market

Future
Future

Futures - Future
Forward - Future
Swap - Exchange Option - A right
Option - A right Derivatives
 Derivative
Derivative Instruments
Instruments

Definition An instrument based on an underlying commodity

Forex Interest
OTC Products Forwards Fwd Rate Agreements
Swaps (FRA)
Options Swaps
 Put Options
 Call  Caps, Floors &
Collars

Exchange  Futures  Futures

Traded
 Options  Options

11/04/21 18
 Forward
Forward Contracts
Contracts

Definition A contract to buy or sell a given amount of

currency for settlement at some future date, at a
rate of exchange agreed at the time of dealing. No
money changes hands until the settlement date.

 A mechanism by which exchange rate can be fixed

in advance in respect of future known foreign
currency flows. It is a hedge against the risk of
losing from adverse exchange rate movements.

11/04/21 19
 Forward
Forward Rates
Rates

Concepts  Covering any time gap between cash available and cash
payable has a price in terms of interest received or paid -
or in terms of interest foregone.
 Difference between spot and forward prices is a function
of interest differential between the pair of currencies
involved
 LIBOR interest rates on Euro-currencies serve as basis
for working out forward rates for them
 Money market dealers also quote two-way rates:
Offered Rate: The rate for lending money (offer of funds).
Bid Rate :The rate for taking deposit ( bid for funds).

11/04/21 20
 Forward
Forward FX
FX Contracts
Contracts

Example Indco imported goods from USA for sale in India. Invoice
Importer’s currency is USD. Payment is due after 90 days. Indco
Case intends to pay the supplier out of sale proceeds.

The risk : If the rupee weakens in the interregnum, Indco will

have to pay more rupees for each USD.

Solution To hedge, Indco can lock in import costs thus :

 Buy the required US $ to day in spot with INR borrowed
for 3 months. Place $ as deposit for 3 months. At
maturity, repay INR loan with sale proceeds and use US$
deposit proceeds to pay the supplier.
or
 Contract with a bank to buy $ at a rate fixed now (forward)

11/04/21 23
 Forward
Forward Exchange
Exchange Rates
Rates

Market rates Spot Exchange Rates

 USD/INR = 48.88 - 48.91

Interest Rates - 90 days

Bid Offer
(Borrow) (Lend)
US dollar 2.25 2.50
Indian Rupees 8.50 8.75

Forward Rate = Spot + Int. differential (margin)

11/04/21 25
 Forex
Forex Forward
Forward Rate
Rate

Direct hedge Indco wants to buy cars from USA for $ 2 mio. payable
against after 90 days. $/INR spot today is 48.91 while interest
forward risk rates for $ and INR are ruling at 2.25% & 8.75 % resp.
Indco may hedge against $ by borrowing INR necessary
to buy enough dollars in the spot that would become $ 2
mio. after 90 days if held in bank deposit.
 By discounting at 2.25%, we can obtain dollars needed
to day that will become $ 2 mio after 90 days
2,000,000
= $ 1,988,813
2.25 x90
1 +
100 x 360
INR needed to buy $1,969,231 @ 48.91 are Rs. 97,272,840

11/04/21 26
 Forex
Forex Forward
Forward Rate
Rate

 After 90 days
 $ in bank deposits will become

1,988,813 x26.25 x90

+ 1,988,813 = $ 2,000,000
100 x 360

• INR liability will be

97,272,840 x 8.75 x 90
+ 97,272,640 = INR 99,400,683.65
100 x 360
99,400,683.65
• Forward Rate of $ will be = = INR 49.700
2,000,000

Forward rate on simple formula basis came to INR 49.705

Difference is INR 00.005
Forward
Forward FX
FX Rates
Rates :: Formula
Formula

 The condensed general formula:

Outright Forward Rate =

1 + (Days/360 x CCY interest rate/100)

Spot Rate x —————————————————————-

1 + (Days/360 x Base cur. int. rate/100)

 The formula contains the spot rate and a term

which represents the net cost of carry.

11/04/21 28
Forward
Forward premiums
premiums &
& discounts
discounts

 Forward points can be obtained with a simple

formula
 Assuming that dollar and INR interest rates are 8.75%
and 2.25% for 90 days, forward points for USD/INR when
spot is at 48.91 will be :

SPOT x{(CCY int - $int) x days/360X100}

1 + ($ int x days/100x360)
= 0.79
The same result will come in the first method also.

11/04/21 29
 Forward
Forward Rates
Rates

INR 0.729 0.790 (INR 8.75/8.50% - $ 2.5/2.25%)

DEM - 0.0094 - 0.0092 (DEM 3% - $ 5%)
JPY - 1.4980 - 1.4912 (JPY 0.5% - $ 5%)

Concepts Premium Currency = Lower interest Ccy

Discount Currency = Higher interest Ccy

In $ / INR, INR is Discount Currency

In $ / DEM, DEM is Premium Currency

11/04/21 30
 Interest
Interest Rate
Rate Forwards
Forwards
Forward Rate Agreements (FRAs)
A contract to cash flows on a fixed future date, using fixed interest rates
agreed today

Example
XYZ company bought 3/6 FRA @ 5.74 to lock-in LIBOR for a 3-m deposit
for $ mio. to be made after 3 months when LIBOR for 3-m and 6-m are
5.31% and 5.60%. However, the deposit time LIBOR is 5.94%.

The FRA seller, to hedge his risk

1. Create an Asset
Place for 6 -m $ 1mio. @ 5.60 = 28,000
2. Borrows for 3m $ 1 mio. @ 5.31 % = 13,275
Borrows for 3m $ 1mio. @ 5.94 % = 14,850 = 28,175
Difference to be paid by the FRA buyer (discounted) = 493
Forward
Forward contracts
contracts

Advantages
 Provides a hedge for maturities up to 2 yrs.
 Standardized in form, so easy to arrange.

Disadvantages
 A definite commitment to exchange flows -
future cashflows must be reasonably certain
 Credit risk increases with the period

11/04/21 32
Futures
Futures Contracts
Contracts

A standard contract quoted on an official exchange to buy or

sell a standard amount of commodity (a currency, interest
or a product )at a fixed future date at a fixed price.
 Standard delivery on 3rd Wednesday of March, June,
September and December
 They are exchange traded with margin money deposit
 Concerned with the prices of instruments rather than the
underlying instruments.
 Settlement can be by way of buying/selling an offsetting
reverse transaction

11/04/21 33
Futures
Futures Contracts
Contracts

1. For hedging loans, deposits etc.

 Short term interest rate futures
 Forward Rate Agreements(FRA) - interest
related
2. For hedging exposures on bonds and stocks
 Bond futures
 Stock Market futures

3. For hedging currency futures

 Currency futures

4. Commodity futures
5. Options on futures

11/04/21 34
Futures
Futures contracts
contracts ....

 Out cry model of the pits of Chicago Board of

Trade (CBOT) used for trading
 Margin payments are made - initial and variation
margins on the basis of marked to market daily
 Price fluctuations are subject to day ceilings
 Interest Futures quoted as ‘100 -interest’
 All currencies are quoted in terms of so many
dollars

11/04/21 35
Futures
Futures contracts
contracts ...
...

 Contract sizes :
 3m Euro $- 1 mio Treasury bills $ 1mio
 Long gilts GBP 50,000
 Price quotations - 1/32 for $ or 1/100th for DEM
 Margin requirements depend on underlyings
may range from 0.0625% (Euro $) to 2%
(Treasury)
a) initial margin b) variation margin(marked-to-market)
 Users
 Investment banks - for hedging and speculating
 Banks- for hedging, bridging gaps & speculation
 Institutions and Corp. - Hedging - limited role

11/04/21 36
Futures
Futures Contracts
Contracts

 Used for locking in returns or flows

 They are standardized forwards traded on official
exchanges
Advantages
 Exchange traded, so no credit risk
 Standard format - easy and cheap to use
 Large and liquid market for reversing contracts
 No need to use up credit limits with banks
Disadvantages
 Available only for certain amounts
 Lacks flexibility
 Prone to speculative movements

11/04/21 37
 OPTIONS
OPTIONS

Forex Interest
Option
Option Contracts
Contracts

Option Contracts
A contract with the seller, which gives the buyer the right,
but not the obligation, to buy or sell a specific amount of
the commodity, at a predetermined price on or before a
specified date in the future

Instruments used for hedging risks /speculative gain

 Interest Rate Options
 Currency Options
 Commodity options

11/04/21 39
Currency
Currency Option
Option Contracts
Contracts

Concepts in Options
Spot rate 1.90 GBP CALL 1.90 GBP PUT
1.85 Out-of-the-money in-the-money
1.90 at-the-money at-the-money
1.95 in-the-money out-of-the-money

An option is described as
in-the-money if it is profitable to exercise now,
at-the-money if exercising option does not result in +/ (-)
out-of- the money if it is unprofitable to exercise option

11/04/21 40
Interest
Interest Options
Options

 Caps - An insurance sold by the writer to the holder

(borrower) against future interest rises
 Floors - A guarantee given by the writer to the holder
(investor) for the agreed return
 Collars - A simultaneous purchase of CAP and COLLAR
to cut premium payments
 The holder has the right to claim from the Writer losses
arising out of actual interest rates being at variance with
the contracted rates
 Simultaneous of purchase of PUT and CALL is called
‘Range Forward’

11/04/21 41
Option
Option Contracts
Contracts

 The option buyer is known as ‘ Holder’

 The options seller is called ‘Writer’
 An option to buy is called ‘ CALL’
 An option to sell is called ‘ PUT’
 Price paid for the options is ‘Premium’
 The principle amount is ‘Notional Principle’
 Rate at which option can be exercised - ‘ Strike Price’
 The date on which option expires - ‘Expiry Date’
 ‘European Option’ can be exercised on expiry date
 ‘American Option’ can be exercised on any day before
the expiry date

11/04/21 42
Option
Option Contracts
Contracts -- features
features

 Option premium depends on strike price Vs spot price,

volatility of market, maturity period, interest rates, etc.
 Premium is payable up-front
 The buyer’s risk is limited to the premium, but potential
profit is unlimited
 The Writer’s profit is limited but his potential risk is
unlimited
 Option has time value and intrinsic value, the latter being
gain to be made from exercising option

11/04/21 43
 SWAPS
SWAPS

Forex Interest
 SWAPS
SWAPS

Definition SWAP
Swap is a legal agreement between two parties to
exchange specified cash flows at future dates
Eg.:
 Interest rate swap to exchange fixed to floating or
floating to floating in a single currency
 Currency swap to transform an obligation in one
currency into that in another currency
 Cross currency to exchange interest related payments
in different currencies

11/04/21 45
Forex
Forex SWAPS
SWAPS

 Swap is a pair of offsetting FX transactions for

different value dates, written at the same time and on
the same deal ticket.
 From cash flows standpoint, one party borrows one
currency and simultaneously lends a different
currency over the same period.
 The FX swap is therefore a pair of money market
operations concealed in FX clothing.
 Swaps are used by banks for mainly funding and
hedging.

11/04/21 46
 State Bank Staff College
Forex
Forex SWAPS
SWAPS Hyderabad

Forex Give owned currency in exchange for desired currency with an

agreement to re-exchange at a predetermined future date

Eg.: • Indco has dollars but can use them after 90 days. Has a rupee loan
costing 14% p.a.
• Exco needs dollars to close FCNRB loan while it will get dollars
after 90 days. Has spare rupees.

The needs of Indco and Exco are complementary. They can

swap cash flows to satisfy mutual needs.

Transaction date Party Give Ccy Take Ccy Exchange Rate

Spot Indco Dollars Rupees Spot Rate

Reversal Indco Rupees Dollars Forward
 Currency Swaps – USD/INR Swap

 Customer with FX liability for long term undertakes a swap to hedge

FX risk by entering into an agreement with a bank wherein the
customer pays a fixed or floating interest rate on the Rupee and
receives FX interest on each interest payment date.

USD Libor

USD 10MM
Front Exchange CUSTOMER
State Bank of India
(USD 10Mio Liability)
INR 435 MM
INR Interest
(Fixed or Floating)
 Interest Rate Derivatives
Interest Rate Swaps

An interest rate swap is a transaction in which

two parties
 agree to make to each other periodic payments
calculated

 on the basis of specified interest rates and a

hypothetical (or notional) amount.
 Interest
Interest Rate
Rate Swaps
Swaps

Coupon SWAPS  Swapping Fixed rate to floating rate or vice versa

Fixed rate Loan

Lender Borrower
Fixed Interest

Floating
Fixed

Swap Party

Basis SWAPS Floating interest on one reference rate against

floating interest on another reference rate
6m LIBOR to 3m USCAP Index

11/04/21 51
 Interest Rate Derivatives - Rate Swaps
Interest Rate Derivatives
Application of Interest Rate Swaps
 To obtain fixed rate financing when it is impossible to access the
bond markets directly
 To achieve funding at rates below those available in the bond
market or from banks
 To restructure a debt profile

6 MO USD LIBOR
State Bank of India Corporate
USD 6.75

NPA : USD 50 MM
Tenor : 5 Years
 Interest
Interest Rate
Rate SWAP
SWAP Contracts
Contracts

Principle Ccy  Balsara raises a 5 year dollar loan but likes to a rupee
Swap liability for principle and interest. Construct a SWAP

Balsara Give $ & Receive rupee equi.(at spot)

SBI
Return Rs. & receive $ at original value
$Lender

11/04/21 53
 Interest
Interest Rate
Rate SWAP
SWAP Contracts
Contracts

Relative advantages of company A & B are

Eg A B Dif.
Fixed rate 4.50 5.70 1.20
Floating rate LIBOR+0.25 + 0.75 0.50
The net differential of 0.70 can be shared thus:
Company A Company B Bank
0.20 0.20 0.30

Calculations Fixed @4.50% Fixed @5.50%

A LIBOR+0.05
SBI LIBOR+0.75 B
Borrows Borrows LIBOR+
fixed Fixed : +1.00 0.75
12% LIBOR: -0.70
FxL Fl.L
Net :+0.30

11/04/21 54
SWAP
SWAP contracts
contracts

Advantages
 Can be tailor made
 Available for periods up to 10 yrs also.
 Banks use for funding exposures

Disadvantages
 Involves considerable credit risk on
counterparty
 A definite commitment, so requires certain
cashflows

11/04/21 55
 State Bank Staff College
Key
Key elements
elements of
of Hyderabad
RISK
RISK MANAGEMENT
MANAGEMENT
Objectives Philosophy
 Low risk - Low reward
 For best rate ?
 Cover all exposures
 Not feasible
 Risk averse & conservative
 For reasonable profit?  High risk – Low reward
 Over budgeted rate  Open exposures
 Cost centre?  High risk gamble
 Insure cash flows  Low risk–Reasonable reward
 Gross vs Net  Selective hedging
 What to cover  Prediction driven
 Choice of Currency  High risk – High reward
 Dollar vs non-dollar  Active trading – Cancel/rebook
 Profit centre approach
 Risk Management
Process

Identification Measurement Control Power

Delegation
Impacting
ImpactingP&L
P&L Define
Define Limits
Limitson
on
•Import/export
•Import/export •Time
•Timeperiod •Position
•Position Delegation
period Delegation
•Credits/loans
•Credits/loans •Net
•Netposition •Gaps
•Gaps •Policy
position •Policy
•Income/expenses •Gaps •Counter-party •Who
•Income/expenses
•Depreciation
•Gaps
•Mismatches
•Counter-party •Whocan?
can?
•Depreciation •Mismatches •How much?
•How much?
•Reporting
•Reporting
Impacting •Monitoring
ImpactingBB/ /SS •Monitoring
•FC
•FCloans
loans
•Interest
•Interestflows
flows
•Draw-down
•Draw-downdelaydelay
Thank
Thank
You
You