Derivative

s
Risks and
Rewards

Forward Contract
This is a contract with the Bank to buy / sell a specific currency, at a pre-determined exchange rate and on an agreed future date.
A Forward contract is binding on both the parties to the contract.

Key Benefit Protection from foreign exchange market volatility

Key Risk Potential loss due to unfavourable movement in currency market

Regulatory
Environment
A person resident in India may enter into a forward contract with an AD in India

to hedge an exposure to exchange risk in respect of a transaction for which sale

and/or purchase of foreign exchange is permitted under the FEMA Act, or rules
& regulations issued, subject to the following conditions:

There has to be a genuine underlying exposure i.e. Forward contracts are

permitted only for hedging and not for speculation.
A forward contract can be booked for the following:
an inward / outward remittance for export / import transactions
respectively
foreign currency loans / bonds - only after RBI approval, where
necessary, has been obtained

The currency of hedge and tenor will be the customers choice

Maturity of the hedge should not exceed the maturity of the underlying
transaction

FX
Options

Definition

A Currency Option is a Financial Contract which gives the

BUYER (Holder) the RIGHT, but not the Obligation, to
exchange a specified amount of currency versus another at a
specified rate on, or up to, a specified date.
The SELLER (or Writer) of the Currency Option contract has
the OBLIGATION to deliver the specified amount of currency
at the specified rate on the specified date.

Benefits over Forwards

Options offer Flexibility to not lock in rates.

Can tailor risk / reward to specific client requirements

Terminology
Notional

: The amount of Currency to be exchanged

Call Option

: Right to Buy

Put Option

: Right to Sell

Strike

: Pre Agreed Exchange Rate

Trade date

: Start date of the trade

Expiry Date

: Date on which the Buyer decides to use the option

Maturity date

: Date of settling the Currency Exchange

Case
Studies

Case - Exporter

Customer is an exporter :

Need To protect against potential USD depreciation against

the INR from current levels over the month.
Spot Rate :

46.75*

Notional :
( Jul 24th)

$ 1 mio receiveable 1 month from now

Strategy 1 Hedging by
using Forward Contract

The 1 month forward premia is 2 p. Hence, the forward rate will be 46.77 ( Spot
46.75 + premia 0.02)
1 month later ; possible scenarios
Scenario 1:US$ has depreciated, say to 46.50
The exporter receives 46.77 million instead of the market rate of 46.5 million.
He gains US$ 6K by entering into the forward contract

Scenario 2:US$ has appreciated, say to 47.30

The exporter receives 46.77 million instead of the market rate of 47.00
million.
He loses US$ 5K by entering into the forward contract

There is an option to cancel the contract before the maturity date. The prevailing premia for the
remaining tenor will need to be adjusted & the profit / loss will be credited/debited to the account

Strategy 2 Hedging using

Options
Customer buys 1 month Put @ 46.75 for $ 1.0 mio
Customer pays 0.65 % or USD 6.5k for this option

Scenario 1:US$ has depreciated, say to 46.30

The importer exercises the option sells at 46.75 million better
than the market rate
He gains US $ 10 k by entering into the forward contract. He
also paid a cost of $ 6.5K.
6.5K So net save is $ 3.5k

Scenario 1:US$ has appreciated, say to 47.30

Customer lets option expire worthless. He would have lost $
12k by locking into the forward contract; whereas in this case
he only loses the premium cost of $6.5k

Question: Can I reduce this premium cost?

Strategy 3 Zero cost

Option
To offset the cost in the earlier case, customer sells
(a)
(b)

sells a Call [ sells USD buys INR ] after 47.00;

sells a Put [ buys USD sells INR @ 46.50]

Customer sells Put @ 46.50 for $ 1.0 mio, He receives 0.20% or USD 2000
Customer sells Call @ 47.00 for 1 mio, He receives 0.45% or USD 4500
Customer receives 0.65 % or USD 6500 for this option
Scenario 1:US$ has appreciated, say to 46.90

None of the options get exercised

The exporter sells USD at a favourable market rate of 46.90
Scenario 2:US$ has appreciated, say to 47.30

Customer enjoys upside on USD-INR from 46.75 to 47.00 for $ 1 mio.

From 47.00 customer is out of money for $ 1 mio to the extent of ( spot
rate 47.0) x $ 1 mio.

Strategy 3 Zero cost

Option
Scenario 3:US$ has depreciated, say to 46.60

The customer exercises the Put option @ 46.75 and gains from
46.75 to 46.60 of $3.2k. The other 2 options do not get exercised.

Scenario 4:US$ has depreciated, say to 46.30

The bank exercises the Put option @ 46.50 and Customer

exercises put @ 46.75; customer gains till 46.50 and thereafter he
takes a loss of $4.4k on market movement beyond 46.5 till 46.30
for $ 1 mio

Risks

The foreign currency market is a very volatile market, and there is

potential for losses in case of adverse movement in currencies

With the FX market open 24 Hours a day, profit target and stop loss
levels could get breached

Booking forward contracts might lead to potential losses also in case

the actual market rate at time of maturity is worse off than the locked
in forward rate, or in case of early pick up

Collateral is taken for booking forward contracts. In cases of

adverse currency movements, which results in substantial margin
erosion the customer will be required to provide additional margin

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Thank You