The Derivatives - Currency Futures

Similar to forward contracts but are exchange traded rather than OTC and is marked to market on a daily basis.

The price of currency futures change continuously in response to market conditions and expectations about future price movements. The largest exchange for currency futures is Chicago Mercantile Exchange where major contracts are for $ against Yen, Euro, and GBP. The futures are traded for four delivery days each year in - March, June, Sept and Dec. The contracts are referred to by delivery day e.g Dec Yen Futures

The standardization of the contract means the amount of contracts are rounded to a whole number which causes some inaccuracies in hedging (see below). The market price for each contract fluctuates, with each minimum price movement refereed to a 'tick'. Each contract has a fixed tick value. e.g Suppose value of tick was $10. If the contract goes up by 16 ticks there will be a gain $160 for a long position in the contract or
loss of $160 for someone in a short position.

Hedging with Futures Contract

To hedge with futures contract, the question needs to be asked are:

a) To buy or sell the contract?

(Seen in with a Importer)

If you need to buy a currency (e.g SF) on future date with $ then
- Buy the appropriate futures contract (SF) now
- On the date you buy the currency (SF), you close out by selling the same number of future contracts.

(Seen in with a Exporter)
If you need to sell a currency (e.g SF) on future date for $ then
- Sell the appropriate futures contract (SF) now
- On the date you sell the currency (SF), you close out by buying the same number of future contracts.

 

Note - Special case: $ futures do not exist on the exchange, so we need to restate the requirements:

(Seen in with a Importer)
If you need to buy $ on future date with domestic currency (SF) then
- Sell the appropriate futures contract (SF) now
- You close out by buying the same number of future contracts.

(Seen in with a Exporter)
If you need to sell $ on future date for for domestic currency (SF) then
- Buy the appropriate futures contract (SF) now
- You close out by selling the same number of future contracts.


b) How many contracts ?

 

 Futures can be bought and sold as a whole number of contracts. Normally the problem of contract comes if the receipt or payment is in $ (see Special case above). The method used in convert the other currency using today's futures rate.

 

 c) Which settlement month ?

 

To hedge currency receipts or payments a future contract must have a settlement date AFTER the date that is actual currency is received or needed. So one needs to select a contract which matures AFTER actual cash is needed or received.

Inefficiencies in Hedging

 

 Basis Risk : Its is difference between the future price and spot price. The basis will move towards 0 on settlement date.The risk is that futures price might move by a different amount from the price of the underlying currency.

Rounding problem: Amounts are rounded to a whole number of contracts.

Advantage or Disadvantage of Futures against Forwards

 

Advantage 

- Lower transaction cost.

- Exact date of reciept or payment of currency does not need to be known (equivalent to option forward)

- Does not take bank credit lines.

Disadvantage

- Cannot be tailored to users exact requirement

- Hedge inefficiencies due to contract size and basis risk

- Limited number if currencies on exchange.

Speculations with Futures

 

 If 3 December £ future contract is $1.68/£ (contract size is £62,500) and you know that in Dec the spot rate, and therefore the Dec futures price, will be $1.73/£ (i.e £ appreciates and $ depreciates), you can enter the contract to sell £ on the expiry of contract.

                        1) buy the £187,500 (3 contracts) @ $1.68/£ 
                          
  i.e. On expiry 2) sell £187,500 @ $1.73/£  as per the spot rate
                          

The profit is $0.05/£, hence the overall profit is $9,375 in total.

The Derivatives - Currency Forwards

What is Forward market for currency ?

The forward market allows importers or exporters to fix, at the time of the contract, a price for the purchase or sale of a fixed amount of foreign currency for delivery and payment at a specified future time.

This allows to eliminate the future exchange rate fluctuations.

The forward contracts are executed in the terms on a future date (1, 3, 6, 9 and 12 months.)

How do we calculate forward rates ?

The forward exchange rate is calculated by adjusting the spot exchange rate (the rate in the market at the present moment.) by the ratio of interest rates of the same maturity for the 2 currencies.

e.g If S Rs55/$ and the Annualized Deposit rate in India = 12%, Euro Dollar deposit rate = 8%

then the 90 day forward of Rs/$ i.e. F₉₀ Rs/$ =  Rs55 * (1.03/1.02) = Rs 55.54/$

Note - The above equation complies to the Interest Rate Parity (IRP) principle i.e. Interest rate differentials must equal the difference between forward and spot rates.

Also we can derive the forward rates from the Purchasing Power Parity (PPP) principle i.e. The relative costs of living in two countries will not be affected by differences in their inflation rates. Instead, the different inflation rates in local currencies will be offset by changes in the exchange rate between the two currencies.

Dealers Bid Offer Rate.

Dealers quote 2 prices, rate to buy (bid) and rate to sell (offer) the base currency (often seen in indirect quote)

e.g. Bid - S Rs54/$ - Dealer buying $ will give Rs54 per $

e.g. Offer - S Rs50/$ - Dealer selling $ will accept Rs50 per $

Premium or discount in the spot rates will be subtracted or added respectively to calculate the Forward rates.

Hedging with Forward Contracts

A US importer knows on 1April he will need to pay Swiss supplier SF26,500 in one months time.


The importer can arrange a forward exchange contract with his bank on 1st April whereby the bank agrees to sell SF 26,500 to the importer @ SF2.6400/$.

Thus the importer knows that his cost of the transaction will be ~ $10,037.00

If spot rate in months time goes below 2.6400, i.e. the SF appreciates and the $ weakens, the importer has successfully protected himself as he has avoided paying more $ to obtain the SF as per the agreement of his forward contract.

If spot rate in months time goes above 2.6400, i.e. the $ appreciates and the SF weakens, the importer has lost his upside potential as he has pay more $ to obtain the SF as per the agreement of his forward contract than he would have to pay if he obtained the SF at the spot rate on end of the month.

Thus the forward contract with a fixed exchange rate removes upside potential and downward risk.

Speculation in Forward Contracts
 
Since Forward contracts enable you to lock into a future price and so speculate on the future spot rate for profit.

e.g Lets assume you have $100 with you. If current 3month forward contract is $0.009/Y and you know that spot rate in 3 months will be $0.008/Y (i.e Y appreciates and $ depreciates), you can enter the contract to sell Y on the expiry of contract.

i.e. On expiry, 1) buy the Y @$0.008
                           i.e. with $100 you will get Y12,500 and

                      2) sell Y @0.009 as per the fwd contract.
                          Hence you receive $112.5 selling Y. The overall profit is $12.5 with no cash outlay

Options and Forward Contracts

In this case the customer has the option to call for the performance of the contract at any date from the contract being made up to the future specified date.

The call must take place at some time, it cannot be avoided altogether

These are usually used when the customer is unsure of the exact date on which he will want to buy or sell the currency.

The Budget and its jargon

1) Government Revenues & Spending...
Government's budget is largely about revenues and expenditure. These are divided under two heads: revenue and capital. Spending is also split into plan and non-plan

• Revenue receipt/expenditure: All receipts, such as taxes, and expenditure, like salaries, subsidies and interest payments that in general do not entail sale or creation of assets, fall under the revenue account.
• Capital receipt/expenditure: Capital account shows all receipts from liquidating (e.g., selling shares in a public sector company) assets and spending to create assets (e.g., lending to receive interest).
• Revenue/captial budget: The government has to prepare a Revenue Budget (detailing revenue receipts & revenue expenditure) and a Capital Budget (capital receipts and capital expenditure). 

A. Revenues  

• Gross tax revenue: The total tax received by the government from which it has to pay the states their share as mandated by the relevant finance commission. The balance is available to the Union government.

• Non-tax revenue: The main receipts under this head are interest on loans given by the government, and dividends and profits received from PSUs. The government also earns from various services, including public services, it provides. Of this, only the Railways is a separate department, though all its receipts and expenditure are routed through the Consolidated Fund of India. 

• Capital receipts: These include recoveries of loans and advances.

• Miscellaneous capital receipts: These are primarily receipts from PSU disinvestment.

 
B. Expenditure
Before we understand government spending, it is important to know the concept of plan and non-plan spending and the Central Plan
 

• Gross budgetary support: The Five-Year Plans are split into five annual plans. The funding of the Plan is split almost evenly between government support (from the budget) and internal and extra-budgetary resources of state-owned enterprises. The government's support to the Plan, which includes state plans, is called Gross Budgetary Support.

• Plan expenditure: This is essentially the budget support to the annual plans. This is typically considered developmental spending (on health, education, infrastructure and social goals). Like all budget heads, it is also split into revenue and capital components.

• Non-plan expenditure: This is in the nature of consumption expenditure, broadly corresponding to revenue expenditure: interest payments, subsidies, salaries, defence & pensions. Its 'capital' component is small, the largest chunk being defence.

 

2) ...And The Shortfall
When government's expenditure exceeds its receipts, it has to borrow to meet the shortfall. This deficit has material implication for the economy as bridging it increases public debt and eats up revenues through higher interest payments.

• Public debt: The money borrowed by the government is eventually a burden on the people of India, and is, therefore, called public debt. It is split into two heads: internal debt (money borrowed within the country) and external debt (funds borrowed from non-Indian sources)

• Fiscal deficit: The money borrowed by the government is eventually a burden on the people of India, and is, therefore, called public debt. It is split into two heads: internal debt (money borrowed within the country) and external debt (funds borrowed from non-Indian sources). Usually the government spends more than what it earns through various sources. This shortfall, which is met with borrowed funds, is called fiscal deficit. Technically, it is the excess of government expenditure over 'non-borrowed receipts' — revenue receipts plus loan repayments received by the govt plus miscellaneous capital receipt

• Revenue Deficit: It is the excess of revenue expenditure over revenue receipts. All expenditure on revenue account should ideally be met from receipts on revenue account; the revenue deficit should be zero. In such a situation, the government borrowing will not be for consumption but for creation of assets.

• Effective revenue deficit: This is an even tighter number than the revenue deficit. It is revenue deficit less grants for creation of capital assets.

• Primary deficit: It is the fiscal deficit less interest payments made by the government on its earlier borrowings.

• Deficit and GDP: Apart from the numbers in rupees, the budget document also mentions deficit as a percentage of GDP. This is because in absolute terms, the fiscal deficit may be large, but if it is small compared to the size of the economy, then it's not such a bad thing, especially if it is being used to create production capacities.

 Source: Budget 2013: Decoding key concepts and jargon from FM's speech

Forwards and Options.

The following can be a way to look at derivative instruments and claim its understanding. In case you are a farmer who has to sell rice and is constantly worried about the price fluctuations, you can protect yourself from the falling prices by selling a forward contract which will ensure that you will get an assured price for the volume of rice sold. This is a way where the price risk is negotiated for your commodity.

While the forward allows the farmer to be protected against the losses in case the price of rice falls, he is however giving up the opportunity of making profit if the price of rice increases. Thus he needs an insurance against falling rice prices. The farmer buys a put option wherein if the price of rice falls below the agreed price (strike/exercise) then the seller of put option will pay the difference between the agreed price and fallen price. If the price of rice increases above the strike price then the farmer benefits from the price rise. Thus the farmer is protected from the losses of price fall and benefits from the price rise all by paying a premium fee for this kind of price insurance.

OCM – A tale of misplaced risk strategies:

Recently I picked up this book ‘Traders Guns and Money’ by Satyajit Das. The book highlighted some of the common misplaced notions of how risk management products instead of hedging risks can in fact double the losses if used in a detrimental fashion. The book begins with a very hilarious encounter about OCM, a noodle maker from Thailand which finds itself embroiled in the mysterious web of derivates, and deals that it undertook that would serve as a final nail in the coffin for the company.

I wanted to outline some of the deals in a chronological order so that it gave me a perspective on how some of these potent products can harm innocent customers, who get committed to these deals without knowing the mess they are getting into.  Following is a rendition from the book which i highly recommend to like minded folks who are curios about the way the derivative world works.

1)      OCM enters into a common currency SWAP that allows it to pay dealer dollar rate LIBOR as part of its interest and principal payments of the borrowing while the dealer pays the counterpart in Thai rupiah. This arrangement of a swap agreement allows for cheaper borrowing for the counterparty and the dealer.

2)      When the dollar yield curve was steep, the company entered into a ‘Arrears Reset SWAP’ in which the interest rate is reset on a 6 months basis, with payments to be made 2 days before the reset. As the dollar interest rates began to rise, the dealers advised to get out of the transaction and have the OCM make some profit.

3)      With some conviction that the rate would keep increasing, the dealers asked OCM to enter into a transaction that would allow them to fix the rates. This allowed OCM to make some more money.

4)      With confidence over the transactions, OCM were lured by the success of their financial genius by now entering into a ‘Double SWAP’. This was the transaction that led to their grave.  

The dollar rates at this time were steep i.e. the 5 yr rate was higher than the 6 month rate. OCM now entered into a contract to have the interest rate fixed for five years. This meant the cost of borrowing would be high but not necessarily higher than the rupiah rates.

To make the cost cheaper, OCM decided to place a bet, wherein if the rates increased then the fixed rate would convert into floating and if the rates went down the deal would double the size i.e. if they were to pay $300 now they pay $600. This meant, with the new swap, if the rates went up then their protection of fixed interest rate would be lost as it converted into floating rate and if it went down then the size of the transaction doubled. Mmmm...something fishy ? On top of that there was a exchange rate risk. If the dollar appreciated (rupiah weakens) then it would haven really cumbersome. However if the dollar weakened (rupiah appreciated) OCM would not incur exchange risk on the $600 but on the original $300 of the transaction as that was at a fixed exchange rate. This is probably their death knell move.

OCM had entered into these trades to lower the cost of borrowing by entering into fixed dollar rate. OCM achieved the lower cost by selling lots of its options (on dollar interest rates and rupiah/dollar exchange rate) to the dealer.