Part-10

FOREX
Introduction
 Foreign exchange or FOREX is not
traded on organized exchanges.
 Thus the market is purely OTC
 It is a network of dealers which is
primarily dominated by commercial
banks.
 In India all dealers have to obtain prior
approval from the RBI.
 Such dealers are called Authorized
Dealers or ADs.
FOREX Quotes
 The exchange rate for a currency
is the amount of that currency that
can be exchanged per unit of
another currency.
 In other words it is the price of one
currency in terms of another
currency.
Two Quoting Conventions
 Think of an asset such as a share.
 We usually quote the price as Rs 100
per share.
 We can also quote it as .10 shares for
Rs 10.
 However we always quote as units of
currency per unit of the asset and not as
units of the asset per unit of the currency.
Conventions (Cont…)
 The difference in the case of
FOREX is that we are quoting the
price of one currency (which is also
an asset), in terms of the price of
another currency.
 Thus we can quote in terms of
Rupees per Dollar or equivalently
in terms of Dollars per Rupee.
Direct Quotes
 If the price of the foreign currency
is quoted as the number of units of
the Domestic currency per unit of
the Foreign currency, it is called a
Direct Quote.
 For example Rs 43.75 per dollar is an
illustration of a direct quote.
Currency Symbols
 Before we proceed let us list the
internationally accepted symbols of
various currencies.
 Australian Dollar – AUD
 Canadian Dollar – CAD
 Indian Rupee – INR
 Japanese Yen – JPY
 Pound Sterling – GBP
 Singapore Dollar – SGD
 Swiss Franc – CHF
 US Dollar - USD
Direct Quotes (Cont…)
 Consider a quote of INR 43.75 per
USD.
 If the rate increases to INR 44.25 per
USD
 It implies that every dollar is worth more
in terms of Rupees
 And we would say that the dollar has
appreciated or the rupee has
depreciated.
Direct Quotes (Cont…)
 However if the rate were to decline to
INR 43.20 per USD
 Then each dollar would be worth less in
terms of rupees and we would say that
 The dollar has depreciated or that the
rupee has appreciated.
Direct Quotes (Cont…)
 Thus in the case of direct quotes:
 An increase in the quoted value
signals an appreciating foreign
currency and a depreciating domestic
currency
 A decrease in the quoted value signals
a depreciating foreign currency and an
appreciating domestic currency
Indirect Quotes
 We can also quote an exchange
rate as the number of units of
foreign currency per unit of the
domestic currency.
 For instance if we have a quote of
USD 2.25 per INR 100, it would be
an indirect quote in India.
Indirect Quotes (Cont…)
 If the rate were to increase to USD
2.40 per INR 100, it would imply that
 The dollar has depreciated or the rupee
has appreciated.
 Thus an increase in the value connotes
a depreciating foreign currency and an
appreciating home currency.
Indirect Quotes (Cont…)
 If the rate were to decline to USD
2.10 per INR 100, it would imply an
appreciating dollar and a
depreciating rupee.
 Thus a decline in the rate connotes an
appreciating foreign currency and a
depreciating home currency.
Confusion
 It appears that an increase in the
rate connotes an appreciating
foreign currency if rates are
quoted directly and a depreciating
foreign currency if they are quoted
indirectly.
 How do we avoid errors?
Numerator/Denominator
 Always think in terms of numerator and
denominator currencies.
 In a direct quote in India like INR 43.75
per USD, the rupee is the numerator
currency and the dollar is the
denominator currency.
 If the rate increases it means that the
numerator currency has depreciated.
 Else if it decreases it means that the
numerator currency has appreciated.
Numerator/Denominator
(Cont…)
 In the case of an indirect quote like USD
2.25 per INR 100, the dollar is the
numerator currency and the rupee is the
denominator currency.
 Once again an increase in the rate would
mean that the numerator currency
which is the dollar has depreciated.
Numerator/Denominator
(Cont…)
 On the other hand, a decline in the
value would mean that the
numerator currency has
appreciated.
Direct or Indirect
 Until 1993 banks in India were
using the indirect quotation
system.
 Subsequently they have switched
to the direct method.
 We will use the direct method for
most of our illustrations.
Purchase & Sale
 Whenever we say buying or selling
rates we always mean it from the
dealer’s perspective.
 When rates are quoted there will
be two rates, one for buying and
the other for selling.
Purchase & Sale (Cont…)
 Consider the Direct Quoting
system.
 43.25/43.70 INR/USD
 For the dealer purchase involves
conversion of foreign exchange
into rupees.
Illustration-1
 BHEL has exported turbines to
Libya and has received a check for
10 MM USD.
 When it presents it to its bank
asking for the equivalent amount
in rupees to be credited to its
account, it constitutes a purchase
transaction.
Illustration-2
 An NRI from Dubai has remitted
10000 USD to his relative in Kochi.
 When the bank converts it to the
rupee equivalent and credits the
relative’s account it constitutes a
purchase.
Purchase/Sales (Cont…)
 Conversion of domestic currency
into foreign currency by a bank will
be termed as a sale of foreign
exchange.
Illustration-3
 Tata Steel has imported iron ore
from Australia and needs to pay the
party in Sydney.
 It therefore requests SBI to prepare
a check for 50 MM AUD and debit
its current account.
 This constitutes a sale for the bank.
Bid and Ask
 For a given currency, the price at which
the dealer is willing to buy the currency
will obviously be lower than the price at
which he is willing to sell it.
 So in the direct quotation system the
bid will be lower than the ask.
 For instance, a quote for USD may read:
43.2400-43.3100.
Bid and Ask (Cont…)
 However in the indirect system, the bid
will be greater than the ask.
For instance a quote for USD may read:
2.2200-2.1500
 This means that when the AD is buying
dollars he will give 100 rupees for every
2.22 dollars purchased.
 However when he is selling USD he will
charge 100 rupees for every 2.15 dollars
sold.
Arbitrage
 Arbitrage in the FOREX market can
arise on various counts.
 We have situations conforming to
what are called:
 One point arbitrage
 Two point arbitrage
 Triangular or three point arbitrage
 Covered interest arbitrage
One Point Arbitrage
 ICICI bank is quoting: 43.2400-43.3100
 SBI is quoting: 43.3500-43.4200
 Consider the following strategy:
 Borrow 433,100 rupees
 By 10000 USD from ICICI.
 Sell 10000 USD to SBI
 Receive 433,500 from SBI
 There is an arbitrage profit of INR 400.
One Point Arbitrage
(Cont…)
 Now consider the following quotes:
 ICICI: 43.2400-43.3100
 SBI: 43.3000-43.3700
 Clearly arbitrage is not possible.
 Or:
 ICICI: 43.2400-43.3100
 SBI: 43.1800-43.2500
 Once again no arbitrage
One Point Arbitrage
(Cont…)
 So to rule out arbitrage the quotes
of two banks must overlap by at
least one point.
 What is a point, for most currencies
it is 1/10000 of the domestic
currency.
 For instance a point in India is
0.0001 rupees.
Two Point Arbitrage
 ICICI is quoting:
 27.2500-27.3500 INR/SGD
 DBS Singapore is quoting:
 3.7000-3.7250 SGD/100 INR
 This is an arbitrage opportunity
Two Point Arbitrage
(Cont…)
 Consider the following strategy:
 Borrow 10000 SGD and sell it to ICICI.
 You will get 272500 INR.
 Sell this to DBS in Singapore in return for:
3.7000 x 2725 = 10082.50
 There is an arbitrage profit of 82.50 SGD.
Why Arbitrage?
 Consider ICICI’s quote of:
27.2500-27.3500
 When ICICI is quoting 27.2500 for
buying 1 SGD it is effectively saying
that it is willing to sell 1 INR for
1/27.2500 = 0.036697 Ξ 3.6697
SGD/100INR
Why? (Cont…)
 Similarly a quote of 27.3500 for
selling SGD amount to a quote of:
1/27.3500 = 3.6563 SGD/100INR
for buying rupees.
 Thus 27.2500-27.3500 INR/SGD
corresponds to 3.6563-3.6697
SGD/100INR.
Why? (Cont…)
 This does not overlap with 3.7000-
3.7250 which is what DBS is
quoting in Singapore.
 Hence the potential for arbitrage.
 Thus two-point arbitrage is nothing
but the logic of one point arbitrage
extended to two markets.
Triangular or Three-Point
Arbitrage
 To do triangular arbitrage we need
three currencies.
 Assume that Bank Mitsubishi is
offering the following rates:
 75.2150-75.2750 JPY/AUD
 150.2025-150.2925 JPY/USD
 Citibank NYC is offering:
 0.5220-0.5280 USD/AUD
Arbitrage Strategy
 Borrow 752750 yen in Tokyo and buy
10000 AUD.
 Sell it in NYC for 5220 USD.
 Sell the USD in Tokyo in return for
5220 x 150.2025 = 784057.05 JPY
 Clearly there is an arbitrage profit of:
784057.05 – 752750 = 31307.05 JPY
Arbitrage (Cont…)
 Hence the condition required to
preclude arbitrage is that:
 (JPY/AUD)ask ≥ (USD/AUD)bid x (JPY/USD)bid
 Similarly it can be shown that:
 (JPY/AUD)bid ≤ (USD/AUD)ask x (JPY/USD)ask
 The LHS in the above expressions is the
natural rate for a currency.
 The RHS represents the synthetic rate for
the currency.
Arbitrage (Cont…)
 Thus the no arbitrage conditions
may be stated as:
 The natural ask should be greater
than or equal to the synthetic ask.
 The natural bid should be less than
or equal to the synthetic bid.
Forward Rates
 Forward trading is very common in
foreign currency markets.
 Although futures trading is very
active in certain countries,
particularly in the US, the volume
of trading in the forward market is
much higher than in the futures
market.
Forward Rates (Cont…)
 The forward market is an OTC
market.
 The majority of the participants are
commercial banks.
Forward Rates (Cont…)
 In the case of direct quotes, if the
forward rate is greater than the spot
rate then the foreign currency is said to
be trading at a forward premium.
 However if the forward rate is less than
the spot rate, then the foreign currency
is said to be trading at a forward
discount.
Forward Rates (Cont…)
 If the forward rate is equal to the
spot rate, then the currency is said
to be trading flat.
Illustration-1
 Spot: 43.2500-43.2800 INR/USD
 1 M Forward: 43.2650-43.3050
 Obviously the US dollar is at a
forward premium.
Illustration-2:
 Spot: 43.2500-43.2800
 1 M Forward: 43.2250-43.2600
 Obviously the US dollar is at a
forward discount.
Illustration-3
 Spot: 43.2500-43.2800
 1 M Forward: 43.2500-43.2800
 The dollar is trading flat
Forward Rates (Cont…)
 In the above cases the full forward rate
has been specified for both buying and
selling.
 These are called Outright Forward
Rates.
 However sometimes only the difference
between the spot rate and the forward
rate called the Forward Margin or the
Swap Points will be given.
Forward Rates (Cont…)
 Consider the following data:
 Spot: 43.2500-43.2800
 Forward: 45/75
 Obviously the forward figure
represents the swap points.
 However we do not know whether the
dollar is at a premium or at a
discount.
Forward Rates (Cont…)
 Thus should the swap points be
added to the spot rates or should
they be subtracted.
 The point to remember is that the
spot market has the maximum
liquidity.
 The further we go in time, the less
will be the liquidity and the higher
will be the spread.
Forward Rates (Cont…)
 Hence when the swap points are specified
as a/b where a < b, then adding the points
will widen the spread.
 Thus a specification of a/b where a < b
indicates that the foreign currency is at a
forward premium and that the points should
therefore be added to the spot rates.
Forward Rates (Cont…)
 In this case the rates would be:
 Spot: 43.2500-43.2800
 1 M Forward: 43.2545-43.2875
 However what if the swap points
had been specified as 75/45.
 In this case subtracting the swap
points from the spot rates will
widen the spread.
Forward Rates (Cont…)
 Thus a quote of 75/45 indicates
that the foreign currency is at a
forward discount.
 The corresponding forward rates
are:
 43.2425-43.2755
Indirect Quotes
 In the case of indirect quotes the
logic will have to be reversed.
 In such cases the bid will be higher
than the ask.
 Thus if the swap points are
specified as a/b where a < b, then
subtracting the points will widen
the spread.
Indirect Quotes (Cont…)
 Thus while a/b where a < b does
indicate a forward premium, the points
must be subtracted in order to arrive at
the outright forward rates.
 Similarly a/b where a > b indicates a
forward discount.
 However the points will have to be
added in order to arrive at the outright
forward rates.
Merchant Rates &
Exchange Margins
 Whenever a dealer buys or sells to a
client he will have to interact with the
Inter-bank market either prior to the
deal or subsequent to it.
 Consider a purchase transaction.
 In this case after acquiring the foreign
currency from the client, the dealer will
have to sell it in the inter-bank market.
Merchant…(Cont…)
 Had it been a sale transaction, the
dealer would have had to acquire the
currency in the inter-bank market prior
to selling it to the client.
 Clearly there has to be a relation
between the rates in the inter-bank
market and the rates quoted by the
dealer to the client, which are called
merchant rates.
Merchant…(Cont…)
 Let us take a purchase transaction.
 After the purchase the dealer will
have to dispose off the currency in
the inter-bank market.
 The relevant rate is therefore the
bid in the inter-bank market.
 Thus the Base Rate for purchase
transactions is the inter-bank bid.
Merchant…(Cont…)
 If the dealer has to make a profit on the
deal, the bid price quoted by the dealer
has to be lower than the bid in the
inter-bank market.
 Similarly in a sale transaction the
dealer has to acquire the currency at
the ask rate in the inter-bank market
before selling it to the client.
Merchant…(Cont…)
 The relevant base rate in this case is the ask
rate in the inter-bank market.
 In order for the dealer to make a profit the
ask rate quoted by him must be higher than
the inter-bank ask rate.
 The profit margins applied by the dealer is
known as the exchange margin.
Merchant…(Cont…)
 As should be obvious, in a purchase
transaction the exchange margin will
be subtracted from the base rate before
a buying rate is quoted to the client.
 In a sale transaction the exchange
margin will be added to the base rate
before a selling rate is quoted to the
client.
Illustration-1
 The inter-bank rates on a given day
for the US dollar are:
 44.2000-44.2500
 An exporter has just received a draft
for USD 10000 which he then
presents to the bank.
 The bank as a matter of policy levies
an exchange margin of 0.05%.
Illustration-1 (Cont…)
 Given the fact that the dealer is
buying his base rate is the bid of
44.2000.
 The rate quoted to the client will
therefore be:
44.2000(1 – 0.0005) = 44.1779
Illustration-2
 The inter-bank rates on a given
day are as follows:
 Spot: 44.2000-44.2500
 1 M Forward: 125/75
 A client comes to the bank seeking
to make an outward remittance of
10000 USD after one month.
Illustration-2 (Cont…)
 The first step is to calculate the
outright one-month forward rates.
 These are:
44.1875-44.2425
 Since the AD is selling the relevant
rate is the ask which is 44.2425.
 Assume that the exchange margin
is 0.08%.
Illustration-2 (Cont…)
 The rate that will be charged to the
client will therefore be:
44.2425(1 + 0.0008) = 44.2779
Inter-bank Swap Deals
 Banks regularly enter into deals with
each other where they either buy spot
and sell forward or vice-versa or else
buy forward for one maturity and sell
forward for another maturity.
 These are called Swap transactions and
Forward to Forward Swap transactions
respectively.
Swap Deals (Cont…)
 Since banks routinely enter into such
deals with each other they ignore the
bid-ask spread implicit in the inter-bank
spot quote and focus solely on the
premium or discount applicable for a
forward trade with the required
maturity.
 The following examples will illustrate
this.
Swap Deals…(Cont…)
 The rates in the inter-bank market are
as follows.
 Spot: 44.2000-44.2500
 Forward: 125/75
 ICICI Bank is selling spot to HDFC and
buying 1M forward.
 The number of concern here is the
discount applicable for a one month
forward sale which is 75 points.
Swap Rates…(Cont…)
 The spot rate chosen for the transaction
may be any rate between the current
quotes of 44.2000 and 44.2500.
 Assume that a rate of 44.2200 is chosen.
 ICICI will therefore sell spot at this rate.
 Since it is buying 1M forward and the
dollar is at a discount, the applicable rate
will be 44.2200 - .0075 = 44.2125.
Option Forwards
 Sometimes while entering into a
forward contract the client may not
know the exact date on which he would
need to buy or sell.
 For instance an importer is expecting a
shipment which is likely to arrive
between one to two months from now.
 However he is not sure of the precise
date.
Option Forwards (Cont…)
 The importer can in such cases negotiate a
forward contract with the option to take
delivery of the foreign currency at any time
between one to two months from now.
 The question is how should the bank quote a
rate.
 Should it assume that the transaction will
take place one month later or should it
assume that it will take place two months
later.
Option Forwards (Cont…)
 The AD will always assume that the
transaction will take place at the worst
possible time from his point of view.
 What is the worst possible situation?
 It would depend on:
 Is the AD buying or selling
 Is the currency at a premium or at a
discount
Illustration-1
 Indian Rayon is importing
machinery and requires dollars
between two and three months
from now.
 It wants a forward contract with an
option to buy at any time between
two and three months from now.
Illustration-1 (Cont…)
 The inter-bank rates are:
 Spot: 45.4500-45.8525
 1M Forward: 45/85
 2M Forward: 70/110
 3M Forward: 110/155
Illustration-1 (Cont…)
 The relevant rate in this case is the
selling rate since the dealer is
selling.
 If the contract is completed after 2
months the applicable premium is
110 points.
 However if it is completed after
three months the applicable
premium will be 155 points.
Illustration-1 (Cont…)
 Since a premium is being charged,
the dealer will levy the higher of
the two amounts.
 So the applicable rate for the
option forward will be:
45.8525 + 0.0155 = 45.8680
Rule
 In a sale transaction where a
premium is applicable, charge the
premium for the latest date of
delivery.
Illustration-2
 Assume that the spot rate is the
same as earlier but that the dollar
is trading at a discount.
 Spot: 45.4500-45.8525
 1M: 75/35
 2M: 115/75
 3M: 140/95
Illustration-2 (Cont…)
 If the transaction is completed after two
months the applicable discount will be 75
points.
 Whereas if it is completed after three
months, the applicable discount will be 95
points.
 Since the dealer is giving a discount he
will give the lower of the two values.
 So the applicable rate will be:
45.8525 – 0.0075 = 45.8450
Rule
 For a sale transaction where the
foreign currency is trading at a
discount, the rule is allow the
discount applicable for the earliest
date of delivery.
Illustration-3
 A party has exported a consignment
and will be paid in dollars at a point in
time between one and two months
from today.
 The rates in the inter-bank market
are:
 Spot: 45.3500-45.7320
 1M: 35/80
 2M: 65/115
Illustration-3 (Cont…)
 The relevant base rate here is the bid
of 45.3500.
 If the transaction occurs after one
month the applicable premium will
be 35 points.
 However if it occurs after two months
the applicable premium will be 65
points.
Illustration-3 (Cont…)
 Since the AD is buying, he will give
the lower of the two premia.
 So the applicable rate in this case
will be:
45.3500 + 0.0035 = 45.3535
Rule
 So the rule for a purchase transaction
where the currency is quoting at a
premium is:
 Offer the premium for the earliest
delivery date.
 If the currency had been quoting at a
discount, the rule would have been:
 Offer the discount for the latest date of
delivery.
Covered Interest Arbitrage
 The strategies that result in the no-
arbitrage condition for foreign
exchange forward contracts are
called Covered Interest Arbitrage
strategies.
Cash and Carry
 Consider the following information:
 Spot rate: 25.2025 INR/SGD
 3M Forward rate: 25.5075 INR/SGD
 Interest rate for 3M loan in India:
7.5% p.a.
 Interest rate for 3M loan in Singapore:
4.5% p.a.
Cash and Carry (Cont…)
 Borrow 252025 INR and buy 10000 SGD.
 Invest it in Singapore at 4.5%.
 Future value = 10000(1.01125) = 10112.50
SGD
 At the outset go short in a forward contract to
sell this amount after 3 months.
 Proceeds in INR = 10112.50 x 25.5075 =
257944.59
Cash and Carry (Cont…)
 Amount due in India =
252025(1.01875) = 256750.46
 Arbitrage profit = 257944.59 –
256750.46
= 1194.13 INR
Reverse Cash and Carry
 Consider the following information:
 Spot: 25.2025
 3M Forward: 25.3075
 3M rate in India = 7.5% p.a.
 3M rate in Singapore = 4.5% p.a.
Reverse Cash and Carry
 Borrow 10000 dollars in Singapore.
 Convert it into 252025 INR.
 Invest it in India.
 Future value = 252025(1.01875) =
256750.46
 Amount due in Singapore =
10000(1.01125) = 10112.50
Reverse Cash and Carry
 Go long in forward contract at the
outset to buy this amount.
 Cost = 25.3075 x (10112.50) =
255922.09
 Arbitrage profit = 256750.46 –
255922.09
= 828.37 INR
Symbolic No-Arbitrage
Condition
 Spot: S INR/FCR
 M Period Forward: F INR/FCR
 Indian M-period rate = id
 Foreign M-period rate = if
 No arbitrage requires that:
S(1+id) = F(1+if)
So: F = S x (1+id)
______
(1+if)
Interest Rate Parity
 This is called the interest rate
parity condition.
 It can be written:
F–S id - if
_______ = ________ ≈ id - if
S (1+if)
Reality Check
 What looks like an arbitrage opportunity
in practice may not be exploitable.
 One reason is the presence of
transactions cost.
 The issue is therefore can we make a
profit after taking such costs into
account.
 Secondly a country may not permit free
movement of currencies across borders.
Reality Check (Cont…)
 Thus a perceived opportunity may not be
exploitable in practice.
 In fact even a perception that exchange
controls may be imposed may preclude
arbitrageurs from trying to take advantage of
such opportunities.
 Take the case of the arbitrageur who buys
and invests 10000 dollars in Singapore.
Reality Check (Cont…)
 His arbitrage profit is realizable
subject to the condition that he is
able to repatriate the amount from
Singapore after 3 months.
 The other key factor is the tax
regulations in the two countries.
 The issue of relevance is the
possibility of a post-tax profit.
Arbitrage with Transactions
Costs
Let us introduce bid-ask spreads in the spot
and forward markets, as well as differential
rates for borrowing and lending
Spot: Sb/Sa
Forward: Fb/Fa
Domestic Rates: rdb /rdl
Foreign Rates: rfb /rfl
Cash and Carry
 The arbitrageur will buy Singapore
dollars at the spot ask rate, which is Sa.
 He will lend it in Singapore.
 The future value will be (1+rfl )
 He would have gone short in a forward
contract at Fb.
 He will get Fb(1+rfl ) when he delivers
under the forward contract.
Cash and Carry (Cont…)
 Amount due in India is Sa(1+rdb)
 Arbitrage will be ruled out if
Sa(1+rdb) ≥ Fb(1+rfl)
⇒Fb ≤ Sa(1+rdb)
_______
(1+rfl)
Reverse Cash and Carry
 Borrow a Singapore dollar and buy Sb rupees.
 Lend it in India.
 Future value = Sb(1+rdl )
 Go long in a forward contract at Fa.
 Equivalent amount in Singapore dollars at
maturity = Sb(1+rdl )
_________
Fa
 Amount due in Singapore = (1+rfb )
Reverse Cash and Carry
(Cont…)
 Arbitrage is ruled out if:
Sb(1+rdl )
_________ ≤ (1+rfb )
Fa
⇒ Fa ≥ Sb(1+rdl )
_______
(1+rfb )
Illustration
 Consider the following rates:
 Spot: 1.5015/1.5125 USD/GBP
 Forward: 1.5295/1.5410 USD/GBP
 US rates: 5.5%/5.3%
 UK rates: 4.5%/4.3%
Illustration (Cont…)
 First let us check whether cash and carry is feasible.
 Borrow 1.5125 USD and buy 1 pound.
 Invest it in the UK at 4.3%
 Go short in a forward contract at 1.5295.
 Final proceeds in dollars = 1.043x 1.5295
= 1.5952685
 Amount due in dollars = 1.5125 x 1.055
= 1.5956875
 Hence: NO ARBITRAGE
Illustration (Cont…)
 What about reverse cash and carry.
 Borrow a pound and convert it into 1.5015
dollars.
 Invest it at 5.3%.
 Final proceeds = 1.053x1.5015 = 1.5810795
 Go long in a forward contract to acquire:
1.5810795
_________ = 1.0260087 pounds
1.5410
Illustration (Cont…)
 Amount to be paid back in UK =
1.045
 Hence: NO ARBITRAGE
Futures Markets
 The biggest futures exchange for foreign
exchange is the International Monetary
Market (IMM) at the Chicago Mercantile
Exchange (CME).
 Currencies traded include:
Australian Dollars; Canadian Dollars, Brazilian
Reals; Euro; Japanese Yen; Pound Sterling;
Mexican Peso; NZ Dollar; Swiss Francs
Russian Rubles; South African Rands
Illustration on Hedging using
Futures Contracts
 Eli Lilly is scheduled to receive 25 MM Swiss
Francs after 2 months.
 The worry is obviously that the dollar will
appreciate and that since the invoice is
denominated in Swiss Francs, the proceeds in
dollars may be less than anticipated.
 Since Swiss Francs have to be sold, the
company needs to go short in futures.
 Assume that it uses 3 month contracts.
Illustration (Cont…)
 On the IMM each Swiss Francs
futures contract is for 125,000 CHF.
 So for 25 MM CHF

25,000,000
_____________ = 200 contracts will be
125,000 required.
 The rates in the futures market are:

0.5150/0.5190
Illustration (Cont…)
 Obviously the applicable rate is the bid of
0.5150.
 Assume that the rates after two months
are as follows:
Spot: 0.4985-0.5025
1M Futures: 0.4985-0.5025
 If the company had not hedged, it would
have had to sell 25 MM CHF at 0.4985
which would have yielded 12,462,500USD
Illustration (Cont…)
 Since it has hedged it will receive:
25,000,000 x (0.5150 – 0.5025) =
312,500 as a profit from the
futures market.
 The proceeds from the cash
market = 12,462,500
 Total proceeds = 12,775,000
Illustration (Cont…)
 Effective rate: 12,775,000
__________ = 0.5110
25,000,000
Illustration-2
 An airline in the US has ordered parts from the US
worth 4MM pounds.
 The payment is due after one month.
 The worry is that the dollar will depreciate for if it
does, the payment in dollars will go up.
 Since pounds have to be acquired the firm needs to
go long in a futures contract.
 Assume that two month contracts are available.
Illustration-2 (Cont…)
 Current rates are:
Spot: 1.4025-1.4075
2M Forward: 1.4120-1.4190
 Assume that the rates after one
month are:
Spot: 1.4150-1.4220
1M Forward: 1.4250-1.4335
Illustration-2 (Cont…)
 If the company had not hedged it
would have paid
4,000,000 x 1.4220 = 5,688,000
 The effective cost if it hedges can be
calculated as follows.
 Buy spot at 5,688,000
 Profit from futures =
4,000,000(1.4250-1.4190) = 24000
Illustration-2 (Cont…)
 Total payment in dollars =
5688000 - 24000 = 5664000
 Effective exchange rate:

5664000
__________ = 1.4160
4000000
FOREX Options
 Foreign currency options are
traded on a number of exchanges.
 In the U.S. the Philadelphia exchange
is a major centre for such contracts.
 In addition to exchange traded
options, customized contracts are
traded by banks and other
financial institutions.
Hedging
 For a party who wants to hedge a
foreign currency exposure, options
provide an alternative to forward
contracts.
Illustration
 An Indian exporter is expecting to be paid
in pounds after a month.
 His worry is that the pound will depreciate
and that he may receive fewer rupees than
anticipated.
 He can hedge by buying put options on
Sterling.
 He can then be sure that the value of the
Sterling will never be below the exercise price.
Illustration (Cont…)
 Similarly, a party who is due to make a
payment in Sterling at a future date
will be afraid that the Sterling may
appreciate.
 One way for it to hedge is by buying
calls on Sterling.
 This way it can ensure that the currency
will not cost more than the exercise price.