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Currency Forward, Currency Futures, Currency swaps , FRA , Hedging & Valuation of currency Derivatives
Dr. A.L.Saini
1.Derivatives came into being primarily as risk management products to manage either the current or potential exposure to cash markets. 2.A farmer is worried about the prices of soybean that he is expecting to harvest from his farm. 3. A Person may have bought equity stock ( a cash market exposure at present) and is worried about stock price going down. 4.A Company has borrowed on fixed rate/floating rate basis ( a cash market exposure at present), and is worried about interest rates going down/going up.
1. Leveraged Position
Currency Derivatives
Cash Market Derivative markets
1.Equity
2.Fixed Income Securities 3.Foreign Exchange 4.Commodities
Forward Contract-Meaning Forward Contract A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price.
Forward Contract
The salient features of forward contracts are: They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset.
FORWARD CONTRACTS
Case Study : On 1st April, Mr. X enters into a forward contract with Mr. Y and agrees to purchase 1000 shares of TCS Ltd. for a predetermined price of Rs. 10 ,three months forward. Here on the fixed future date, Mr. X will get the 1000 shares and will pay the price i.e. Rs. 10,000 and Mr. Y will deliver the shares and will receive the money.
Specified Price
Y
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Derivatives Currency
Case Study Forward contract A forward to buy $500 for 300 in 1 year
Forward Contract Case Study Entity X enters into a forward contract to purchase one million tonnes of copper. Copper is traded on the London Metals Exchange and is readily convertible to cash. The contract permits X to take physical delivery of the copper at the end of 12 months( to use to manufacture finished goods) or to pay or receive a net settlement in cash, based on the change in fair value of copper.
Forward Contract-currency Case study Entity A enters into a forward purchase agreement with Entity B to buy 100 units of a commodity at CU1.00 per unit. Entity A defaults on the forward when the prevailing market price of the commodity is CU0.75 per unit. Under the non-performance penalty provisions incorporated into the contract, Entity A has to pay Entity B a penalty of CU25, i.e. 100 x (CU1.00 CU0.75).
Derivative-Examples
Case Study An entity enters into a forward contract to purchase wheat. The contract meets the definition of a derivative, but does not meet the expected purchase, sale or usage requirements scope exception as the entity has a history of net cash settling similar contracts.
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Floating Rate Benchmark:6 month USD LIBOR Such a FRA is denoted as a 6x12 FRA, and the difference between the two numbers 12-6 represents the duration of the FRA which is 6 months.
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BUYER
EXCHANGE
Asset
SELLER
Customized
Any entity Exists
Standardized
Clearing house Assumed by clearing House.
Liquidity Margins
Very high Margins are received/paid on a daily basis All contracts are marked to market on a daily basis
Valuation
Not done
FUTURES CONTRACTS
Case Study No.: On 1st September, Mr. X enters into a futures contract to purchase 100 equity shares of TCS Ltd. at an agreed price of Rs. 100 in December. If on the maturity date (as determined by the rules of the exchange for the month of December) the price of the equity stock rises to Rs. 120 , Mr. X will receive Rs. 20 per share and otherwise if the price of the share falls to Rs. 90, Mr. X will pay Rs. 10 per share.
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Futures- Specifications
Key Terminologies Futures Spot Price : Price at which underlying asset trades in spot market Futures Prices : agreed upon price at the time of delivery for a specified future date. Contract Cycle : the period over which the contract trades. Expiry Date : date of the final settlement, the date at which the trading ceases for the futures contract. Contract Size : market lot or lot size or trading unit Net open position Initial Margin Mark to Market
Futures- Specifications
Pricing of Futures
Futures are priced according to the cost of carry model As per this model, the futures price should be equal to the spot price of the underlying asset compounded at relevant interest rate for a time period equal to the futures expiry period. Thus the factors which affect the value of futures are:
1. Underlying Asset Price: Futures price fluctuates as spot asset price changes 2. Interest Rate: If interest rates go up, cost of carry leading to higher futures price 3. Time period Futures which mature later will have greater value
Future Trading
Participants in Futures Trading Hedgers Those with underlying interest in specific delivery or ready delivery contracts, and use futures to insure against adverse price movements To minimize/control the risk (risk averseness) Offsetting in the physical market Speculators May not have an interest in ready contract, but see opportunity of price movement favorable to them Tendency to get maximum profits form the transactions Risk taking Arbitrageurs To take the risk profits and to gain from the price difference between the markets
Futures buyer and seller have obligations Futures must be settled physically or cash basis Futures trade price is contractual Futures mature at delivery Future sellers maximum potential loss is unlimited Future buyer's maximum potential loss is the contract value based on the purchase price. Futures do not trade with premiums