Forex Risk Management

through Derivatives-
Futures and Options

By

Ankit Kapoor – 234

Gaurav Palkar – 256
Sneha Saraf – 304
Ashutosh Saxena -
307
 Foreign exchange risk:
meaning
• Value of a currency changes
frequently
• Affects firms engaged in
international transactions
• Assets, liabilities and cash flows are
affected through changes in
exchange rates
• Possibility of unfavorable changes -
Risk
 Types of risk/ exposure
• Accounting/ translation exposure: financial
statements

• Economic exposure to foreign exchange risk:

- Transaction exposure
- change in value of monetary assets &
liabilities

- Operating exposure
- change in value of real assets
 Translation exposure
• Occurs on consolidation of financial
statements of different units of MNCs
• When the value of currency of a
subsidiary changes, its translated value
in the domestic currency of the parent
company changes
• This change represents translation
exposure
• It is only an accounting exposure
 Transaction exposure
• Impact of exchange rate fluctuations
on present cash flows
• From transactions already entered
into
– Export and import
– Borrowing and lending in foreign
currency
– Intra firm fund flow in an international
company
 Real operating exposure
• Changes in
exchange rates
alter future
operating revenues
and cost streams
of a company
• Changes in future
cash flows from
changes in
exchange rates
 Foreign exchange risk:
techniques of management
• Translation risk: accounting risk
– Current/Noncurrent Method
• Current accounts use current exchange rate for
conversion
• Income statement accounts use average exchange
rate for the period
– Monetary/Nonmonetary Method
• Monetary accounts use current rate and pertains to
– Cash
– accounts receivable\payable
– long term debt
• Nonmonetary accounts use historical rates which pertains
to
– inventory
– Fixed assets
– Long term investments
 Foreign exchange risk:
techniques of management
• Transaction risk (short term):
– Hedging using currency forwards or futures
– Risk shifting
• Firm will invoice exports in strong currency, import in weak
currency
– Currency risk sharing
• Parties would share the currency risk beyond a neutral zone
of exchange rate changes
• Real operating risk (long term):
– Take advantage of the MNC’s ability to respond to
differences in real foreign exchange rates
• Market selection: Shift marketing efforts toward countries
with higher demand or “overvalued” currencies
• Product sourcing: Shift production to countries with low real
costs
• What is Foreign Exchange Market?
• Futures
– What are Futures?
– Features
– Forex Futures v/s Traditional Futures
– Forward Contracts v/s Future Contracts
– Margin, Settlement and Regulation of Futures
• Use of Forex – Hedging, Speculation and
Arbitrage
FOREIGN EXCHANGE MARKET
 What is Foreign Exchange Market
?

• It’s the Market in which currencies are traded

• It is the domain of Government Central banks and

Commercial and Investment banks, not to mention
hedge funds and massive international corporations

• The forex offers trading 24-hours a day five days a week

• The daily dollar volume of currencies traded in the

currency market exceeds $5 trillion, making it the
largest and most liquid market in the world
Participants in Foreign Market

• Primary Price Makers or Professional Dealers

eg. Commercial Banks and Investment dealers

• Secondary Price Makers eg. Tourists Hotels

• Foreign Currency Brokers who are middle men

between two market-makers

• Price Takers are those who take the prices

quoted by the primary price makers eg.
Individuals and Corporates
 Structure of the Forex Market

FX MARKET

Retail Market Wholesale Market

Traveller's Currency Institutions

Banks
Cheque Notes
Futures Contract
 Asset Investment Class

• Commodities

• Fixed Income

• Equities
Futures Contract
• Foreign Exchange
 Futures Contract

A FUTURES CONTRACT FIXES THE PRICE

NOW

FOR A TRANSACTION THAT WILL TAKE PLACE IN

FUTURE
 Futures Contract

A futures contract is a binding agreement

between two parties

 to buy or sell a fixed amount of a financial

instrument
 for “delivery” on a fixed date in the future at a
fixed price
 Futures - Main Features
• Traded in Specific Exchanges (IMM, LIFFE etc.)
• Specific periods (Mar, Jun, Sept, Dec)
• Standardized amounts for each contract
• “Open Cry” trading in the Exchanges
• Guaranteed by the “Clearing House”
• Initial and variable Margins
• Provides Opportunities to Trade, Speculate, &
Hedge
• Exchange provides Liquidity
 Currency Futures Exchanges

USA IMM - International Monetary Market

UK LIFFE- London International Financial Futures Exchange

Singapore SIMEX- Singapore Mercantile Exchange

Australia SFE - Sydney Futures Exchange

** There are many other Exchanges

 Currency Futures Exchanges

e.g LIFFE
Contract Amounts: GBP 25,000
DEM 125,000
CHF 125,000
JPY 12.5

Contract Periods March, June,

September,

December

Delivery Third Wednesday

 Margin

• A margin is cash or marketable securities such as

Treasury bills or in some cases bank letters of
credit deposited by an investor with his or her
broker (Initial Margin-2.5 to 10% of the value of
contract paid by both Buyer and Seller)

• The balance in the margin account is adjusted to

reflect daily settlement (Maintenance Margin based
on Mark to Market price)

• Margins minimize the possibility of a loss through a

default on a contract

• Minimum margin varies if price volatility increases

 Settlement

• Settlement is a act of consummating the

contract

• Settlement can be done by two ways

– Physical Delivery
– Cash Settlement
 Convergence of Futures to Spot

Futures
Spot Price
Price
Spot Price Futures
Price

Time Time

(a) (b)
The futures price, normally, converges towards the settlement price on the
delivery date.
 Regulation of Futures
• Regulation is designed to protect the public
interest

• Regulators try to prevent questionable

trading practices by either individuals on the
floor of the exchange or outside groups
 Use of Futures Contract

• Hedging

• Speculation

• Arbitrage
 Using Futures for Hedging
• Covering against adverse movement of
Currency
• An exporter is expecting to receive payment
from his US client $1,00,000 after 3 months.
• Current Spot Rate of USD is Rs.45 in July
• At current exchange rate if exporter sells
$1,00,000 then he will receive Rs 45,00,000
• If after 3 months USD falls to Rs 43 then the
exporter will receive only Rs 43,00,000
 Currency Futures
Situation To cover DEM requirement for September
(DEM 1,250,000)
Present Spot 1.5050 (in July)
View DEM is likely to strengthen
Aim To lock into present exchange rate
Action Buy Sept DEM Futures Contract

Date Spot Futures Action

Today 1.5050 0.6645 Buy 10

Sept Contracts
Sept 1.4500 0.6895 Sell 10
 Currency Futures

Result:
10 x 125,000 x 0.6645 = USD
830,625
10 x 125,000 x 0.6895 = USD
861,875
--------------------
Profit = USD
31,250

Increased cost of purchasing DEM in

 Using Futures for Speculation

• It means buying or selling foreign

currency contracts with the sole aim of
earning money through correct
anticipation of movement of exchange
rate.

• High Risk
 Using Futures for Arbitrage

• Arbitrage is done to utilize the

opportunities provided by the market
due to differentials in Bid and Ask
rates in the same markets or in
different markets like Spot and
Futures.
 Using Futures for Arbitrage

Forward Rate Mispricing

If futures price < 0.65625 e.g. $0.64

Actions to take today

1. Buy a futures price at $0.64 per Deutsche Mark.

2. Borrow the spot rate in the German market
@4%.
+ 1 DM
3. Convert the Deutsche Marks into Dollars at spot
rate.
- 1 DM/ $ 0.65
4. Invest dollars in the U.S. market @ 5%. -$0.65
 Using Futures for Arbitrage
Actions at expiration of futures contract

1. Collect on Dollar investment. +$ 0.6825

2. Convert dollars at futures price.

- $ 0.6825 /+1.0664 DM

3. Repay DM borrowing with interest. (1.04 DM)

Profit = 1.0664-1.04 = 0.0264 DM
 Observations
• Forex futures operate similarly to traditional
stock and commodity futures

• Forex futures market is only 1/100th the size of

Forex

• Used as a convenient tool for hedging,

speculation or arbitrage against price risk and as
a way of betting on price movements rather than
as a means of physical acquisition of the
underlying asset
 EXOTIC
EXOTIC OPTIONS
OPTIONS

STRATEGIES
STRATEGIES

PRICING
PRICING

O
OPPT
T II O
ONN B
BAAS
S II C
CSS
 WHAT IS AN
OPTION ?
An option is a contract that
confers on the buyer
the Right
But not the obligation

To buy or sell a specific asset

at
pre agreed price in the
future
 4 ESSENTIALS OF
OPTION
• GIVES OPTION BUYER THE “RIGHT”, BUT
NOT THE “OBLIGATION”
– TO BUY OR TO SELL AN AGREED AMOUNT OF
ONE CURRENCY IN EXCHANGE FOR OTHER
CURRENCY (NOTIONAL VALUE)
– ON OR BEFORE AN AGREED FUTURE DATE
(EXPIRY DATE)
– AT AN AGREED EXCHANGE RATE (STRIKE
PRICE)
– IN EXCHANGE FOR A FEE (OPTION PREMIUM)
 CALL & PUT OPTION

CALL OPTION
OPTION TO BUY AT AGREED PRICE

PUT OPTION
OPTION TO SELL AT AGREED PRICE
 FOREX OPTION : CALL =
PUT ?
CALL OPTION ON ONE CURRENCY IS PUT OPTION
ON OTHER CURRENCY ( FOR OPTION BUYER ) IN
THE CURRENCY PAIR

• BUY 1 MN USD AGAINST INR, AT 44.20

(USD CALL OPTION)

• SELL 1 MN USD AGAINST INR, AT 44.20

(USD PUT OPTION)
 BASIC OPTION
TERMINOLOGY

EXERCISE TYPE
EUROPEAN AMERICAN

BERMUDAN

EUROPEAN – EXERCISED ON EXPIRY DATE ONLY

AMERICAN – CAN BE EXERCISED ON ANY DAY
BERMUDAN – EXERCISED ON PRE-SPECIFIED
DAYS ONLY
 BASIC OPTION
TERMINOLOGY

STRIKE PRICE
IN THE OUT OF
MONEY MONEY
AT THE MONEY

IN THE MONEY – YOU ARE MAKING PROFIT. SO,

EXERCISE OPTION
AT THE MONEY – YOU ARE BREAKING EVEN.
STRIKE PRICE = SPOT PRICE
OUT OF MONEY – YOU WILL MAKE LOSS IF YOU
EXERCISE OPTION
 CALL OPTION
P&L

PREMIUM, C
0
SPOT
(S)
STRIKE (X)

PAY OFF = SPOT – STRIKE PRICE –

PREMIUM
OUT OF MONEY : S<X
AT THE MONEY : S=X
IN THE MONEY : S>X
OPTION VS FUTURE

FUTURE OPTION
Obligation to Right to buy/sell
buy/sell
PAYOFF PAYOFF

S0 PREMIUM
0 0
SPOT SPOT

Premium Pre- Upfront premium

loaded
 EXOTIC
EXOTIC OPTIONS
OPTIONS

STRATEGIES
STRATEGIES

P
PRR II C
C II N
NGG

OPTION
OPTION BASICS
BASICS
 FACTORS AFFECTING
PREMIUM

• TYPE OF OPTION
• DIFFERENCE BETWEEN STRIKE
PRICE & SPOT PRICE
• TIME PERIOD OF OPTION
• CURRENCY VOLATILITY
 TYPE OF OPTION

• COMMODITY / CURRENCY / EQUITY

• BUY / SELL – CALL / PUT
• EUROPEAN/BERMUDAN/AMERICAN
• VANILLA / EXOTIC
STRIKE Vs SPOT PRICE
• HIGHER THE DIFFERENCE, LESSER THE
PROBABILITY OF EXERCISE
• SPOT PRICE - INR 45
• EXAMPLE – CALL OPTION
STRIKE PRICE PROB PREMIUM
INR 45.5 95% INR 0.40
INR 46 60% INR 0.30
INR 47 10% INR 0.10
INR 48 0.1%INR 0.05
 TIME PERIOD OF
OPTION
• LONGER THE TIME, GREATER
THE CHANCES OF EXERCISE OF
OPTION, SO HIGHER THE PRICE

P
R
I
C
E
TIME TO EXPIRY
 VOLATILITY
.
STRIKE
PRICE
PRICE
SPOT

TIME

VOLATILE

STABLE
OPTION VALUE

OPTION
VALUE TIME
INTRINSI
C VALUE VALUE
TIME TILL
MATURITY
DIFFERENCE
BETWEEN
STRIKE AND
+ VOLATILITY

SPOT RATE INT RATE

DIFFERENTIA
L
PRICING MODELS
BINOMIAL MODEL

BLACK SCHOLES
OPTION
PRICE
GARMAN KOHLHAGEN

MONTE CARLO SIMULATION

BASIC PRICING PRINCIPLE

PRICE
PRICE =
= DISCOUNTED
DISCOUNTED EXPECTED
EXPECTED CASH
CASH FLOWS
FLOWS

PRESENT
PRESENT VALUE
VALUE INFLOWS/OUTFLOWS
INFLOWS/OUTFLOWS

PROBABILITY
PROBABILITY
 OPTION GREEKS
CHANGE IN
VOLATILITY CHANGE IN INT
RATE
CHANGE IN
SPOT CHANGE IN
TIME
DELTA VEG
THETA
A
GAMM RHO
A

CHANGE IN OPTION VALUE

 OPTION GREEKS
A set of measures derived from the Black Scholes
option pricing formula

• delta - a measure of an option’s sensitivity to

changes in the price of the underlying asset
• gamma - a measure of delta’s sensitivity to
changes in the price of the underlying asset
• vega - a measure of an option’s sensitivity to
changes in the volatility of the underlying asset
• theta - a measure of an option’s sensitivity to
time decay
• rho - a measure of an option’s sensitivity to
changes in the risk free interest rate
 EXOTIC
EXOTIC OPTIONS
OPTIONS

S
STTR
RAAT
TEEG
G II E
ESS

PRICING
PRICING

OPTIONS
OPTIONS BASICS
BASICS
 BASIC OPTION
STRATEGIES
BUTTERFLY STRADDLE / STRANGLE
SPREAD
RANGE
FORWARD VANILLA BULL/BEAR

OPTION STRATEGIES
 PLAIN VANILLA CALL
OPTION
SPOT: 46.85, SIX MONTHS FORWARD : 40 PAISE
BUY USD CALL/ INR PUT AT STRIKE 47.25
2.00

1.50
Gain/ (loss)

1.00

0.50

writer
0.00
buyer
45.00

45.75

46.50

47.25

48.00

48.75

49.50
-0.50

-1.00
 BULL SPREAD
PURPOSE: REDUCE PREMIUM
MARKET : SPOT: 46.20, CALL PREMIUM – 40 PAISE
STRATEGY: BUY USD CALL AT STRIKE 46.20, SELL USD
CALL AT STRIKE 46.80; PREMIUM – 10 PAISE
1.5

0.5

47.70
45.00

45.90

46.20

46.50

46.80
45.30

45.60

47.10

47.40
-0.5

-1

USD Call/INR Put USD Call/INR Put Net Payoff

 RANGE FORWARD
EXPECTATION: EXPLOIT RANGE BOUND MARKET
MARKET: SPOT: 46.83; FORWARD = 47.20
STRATEGY: BUY USD CALL AT STRIKE 47.60, SELL
USD PUT AT STRIKE 46.80. ZERO COST
RANGE FORWARD=FORWARD+ITM PUT-OTM CALL
2

1.5

0.5

0
46.40

46.80

47.20

47.60

48.00
46.00
45.60

48.40

48.80

49.20
-0.5

-1

-1.5

-2

Exposure Option Payoff Net payoff

 RANGE PLAY /
STRANGLE
EXPECTATION: EXPLOIT RANGE BOUND MARKET
MARKET: SPOT - 46.24, FORWARD - 46.40
STRATEGY: SELL USD PUT AT STRIKE 46.20
SELL USD CALL AT STRIKE 46.50
1

0.5
45.00

45.60

45.90

46.20

46.50

46.80

47.10

47.40

47.70
45.30

-0.5

-1

-1.5

USDCall/INRPut USDPut/INRCall
 STRADDLE
SITUATION :MOVEMENT CERTAIN, BUT DIRECTION -??
MARKET :SPOT: 46.24, FORWARD - 46.40
STRATEGY: BUY USD PUT AT STRIKE 46.20
BUY USD CALL AT STRIKE 46.20
1.5

0.5
45.00

45.30

45.60

45.90

46.20

46.50

46.80

47.10

47.40

47.70
0

-0.5

-1

USDCall/INRPut USDPut/INRCall
 BUTTERFLY SPREAD
SITUATION: LOSS MINIMUM, PROFIT LIMITED
STRATEGY: BUY USD CALL AT STRIKE 46.20
BUY USD CALL AT STRIKE 46.80
SELL 2 USD CALL AT STRIKE 46.50
1.5

0.5

0
45.00

45.30

45.60

45.90

46.20

46.80

47.40
46.50

47.10

47.70
-0.5

-1

Net payoff
 EXOTIC
EXOTIC OPTIONS
OPTIONS

STRATEGIES
STRATEGIES

PRICING
PRICING

OPTIONS
OPTIONS BASICS
BASICS
 WHAT IS AN EXOTIC
OPTION
• AN OPTION WITH MODIFIED TERMS/
CONDITIONS/CHARACTERISTICS -
INTRODUCES MUTUALLY AGREED
WHIMSICAL CONDITIONS
• CLASSIFICATION
– PATH DEPENDENT - SHOUT/LADDER
– TIME DEPENDENT - CLIQUET
– LIMIT DEPENDENT - BARRIER
– MULTI-FACTOR - QUANTO
– PAYOFF-MODIFIED - DIGITAL
 SHOUT OPTION
• OPTION TO RESET STRIKE PRICE AT
ANY TIME WITH PROFIT AT THAT
POINT LOCKED IN.

PROFIT
LOCKED-IN

0 120

STRIK SHOUT AT –
E– 115
110
 LADDER OPTION
• OPTION WHERE PROFIT IS
AUTOMATICALLY LOCKED AS SPOT
PRICE CROSSES PRE-AGREED LEVELS.
NO NEED TO SHOUT.

STRIK AUTO LOCK-

E– IN POINTS
110
 CLIQUET OPTION
• A CLIQUET OPTION IS SETTLED AT
SPECIFIED INTERVALS AND STRIKE
IS RESET AT THE THEN SPOT LEVEL
• PURCHASED WHEN VOLATILITY IS
EXPECTED TO INCREASE IN LATER
PERIOD.
 BARRIER OPTIONS

• BARRIER OPTIONS GET ACTIVATED

OR DEACTIVATED WHEN SPOT RATE
CROSSES AN AGREED LEVEL.

• ONCE ACTIVATED, THEY BEHAVE

LIKE PLAIN VANILLA OPTIONS.
 QUANTOS OPTIONS
• A CROSS-CURRENCY DERIVATIVE IN WHICH
THE UNDERLYING ASSET IS DENOMINATED
IN A CURRENCY OTHER THAN THE
CURRENCY IN WHICH THE OPTION IS
SETTLED. QUANTOS ARE SETTLED AT A
FIXED RATE OF EXCHANGE, PROVIDING
INVESTORS WITH SHELTER FROM
EXCHANGE-RATE RISK
 DIGITAL / BINARY
OPTIONS
• FIXED PROFIT AFTER SPOT PRICE CROSSES STRIKE PRICE
IRRESPECTIVE LEVEL OF SPOT PRICE.

“4 to
PROFIT

1”
PAYOFF (JPY 4)
SPOT –
108
0 PREMIUM (JPY
1)
STRIKE –
110
THANK YOU