UNIT-II

FOREIGN EXCHANGE RISK

Introduction

The foreign exchange market also known as the currency of foreign exchange or FX market,
the foreign exchange market is not limited by any geographical boundaries, it does not have
any regular market timings, operates 24 hours , 7 days a week 365 days a year. Presently the
FX market is one of the largest and liquid financial markets in the world, and includes trading
between large banks, central banks, currency speculators, corporations, Governments,
financial institutions, exporters and importers.
The FX market is not a physical place, it is an electronically linked network of banks, foreign
exchange brokers and dealers etc, major FX trading centres are located in London, Tokyo,
New York.
Meaning
 It is a financial market “the exchange of one currency for another or the conversion of
one currency into another currency”.
 Foreign exchange is the art and science of international monetary exchange --Withers.
Reasons for exchange of currencies
 International trade
 Foreign investment
 Lending and borrowing
Features of Foreign exchange market
 Foreign exchange market operates around the clock
 To regulate foreign exchange market, Foreign Exchange Management Act 1999
(FEMA) replaced with Foreign Exchange Regulation Act 1973 (FERA)
 Affected by demand and supply
 Affected inflation rate
 Affected by rate of interest
 Spot and forward rates are different
 Affected by the fiscal policy of the Government
 Affected the political conditions of the country
 Trading between banks known as interbank market
 Banks provide foreign exchange services for a fee, fee fixed based on bid/ask %
Spread
 Trading channeled through networks of telephone, telex, satellite, now mostly
electronic Form namely OTC.
Functions of Foreign exchange market
 Transfer of funds from one nation and currency to another (T.T, M.T, Draft, Bill of
Exchange, Letter of credit, etc. The bill of exchange is the most important and
effective method of transferring purchasing power between two parties located in
different countries.
 Minimize foreign exchange risk (Hedging function)
Participants in Foreign exchange Market
 Traders: Traders use spot and forward markets to eliminate the risk of loss of value
of export or import orders

A.L.I.E.T 1 GLOBAL FINANCIAL MANAGEMENT

  Hedgers: For minimize the risk many MNC’s engage in forward contract to protect
the home currency values of foreign currency denominated assets and liabilities on
their balance sheet
 Speculators: Risk takers, buying and selling currencies in the forward market to gain
profit from the exchange rate fluctuations
 Arbitragers: These participants are risk free profit participants by seeking advantage
of price differences (exchange rate)
 Large international Banks
 Commercial companies
 Central banks
 Investment management firms
 Retail Foreign exchange brokers
 Investors

Exchange rate

 Exchange rate is the price of the currency of a country can be exchanged for the
number of units of currency of another currency --- Haines
 Exchange rate is that rate at which one unit of currency of a country can be exchanged
for the number of units of currency of another country
 Simple way price for which one currency is exchanged for another currency

Types of exchange rates

 Fixed exchange rate: Fixed exchange rate is the official rate set by the monetary
authorities of the governance for one or more currencies. a currency is pegged to a
foreign currency with fixed parity, the rates are maintained constant or they may
fluctuate within a narrow range. In these system central banks plays a crucial role and
regularly buy and sell of foreign currency to maintain the exchange rate.

Merits

- Provide stability in international trade

- Reduce risk for commercial transactions
- Exporter would know how much he is going to receive

Demerit

- This system is speculation

 Flexible exchange rate: One country currency value is determined through demand
and supply of the particular currency in foreign exchange market.

Merit

-Possibility to reduce speculation

 Managed float exchange rate/ Dirty float: Exchange rates fluctuated from day to
day but central banks attempt to influence their countries exchange rates through
buying and selling currencies.

A.L.I.E.T 2 GLOBAL FINANCIAL MANAGEMENT

Factors influencing exchange rates/ Determinants of exchange rtes
 Demand and supply of currency
 National economic performance
 Central bank policy
 Interest rates
 Trade balances ( exports and imports)
 Political factors
 Market sentiments ( expectations and rumors)
 Unforeseen events (terrorism and natural disasters)

INTERNATIONAL RISKS
Meaning of Risk

International business risk may be defined as the possibility of loss caused by some
unfavourable or undesirable event in international business operations; the degree of risk
differs from one company to another company and from one country to another country.

Classification of risk

I. Currency Risk
II. Interest rate Risk
III. Political Risk
IV. Country Risk

CURRENCY RISK /FOREIGN EXCHANGE RISK/ EXCHANGE RATE RISK

(International Financial Management by Madhu Vij, Page No: 240- 240) (International
Financial Management by V.A.Avadhani Page No: 197-215) (International Financial
Management by Vyuptakesh Sharan, Page No: 182-197)

 Foreign exchange risk is the possibility of gain or loss to a firm that occurs due to
unanticipated changes in exchange rate.
 Currency risk is a form of risk that arises from the change in price one currency
against another currency
 The risk that a business operations or an investment value will be affected by changes
in exchange rates.
 Foreign exchange risk that the value of an asset or liability will change because of a
change in exchange rates.

Example: If an Indian firm imports goods and pays in foreign currency (say in dollars), its
outflow is in dollars, thus it is exposed to foreign exchange risk. If the value of the foreign
currency rises (i.e., the dollar appreciates), the Indian firm has to pay more domestic currency
to get the required amount of foreign currency.

Sources of Exchange Risks /Currency Risks (Types of foreign exchange risk)

TRANSACTION EXPOSURE (International Financial Management by Madhu Vij, Page

No: 241- 241, 297-302) (International Financial Management by V.A.Avadhani Page No:
197-215) (International Financial Management by Vyuptakesh Sharan, Page No: 182-197)

A.L.I.E.T 3 GLOBAL FINANCIAL MANAGEMENT

Transaction Exposure: This exposure refers to the extent to which the future value of firm’s
domestic cash flow is affected by exchange rate fluctuations. It arises from the possibility of
incurring foreign exchange gain or losses on transactions already entered into and
denominated in a foreign currency, these risk faced by companies involved in international
trade.

Transaction exposure emerges mainly on account of exports and import of commodities on

open account, borrowing and lending in a foreign currency and intra-firm flows in an
international company. The degree of transaction exposure depends on the extent to which a
firm’s transactions are in foreign currency. For example, the transaction exposure will be
more if the firm has more transactions in foreign currency.

Example: Indian company buy a equipment from USA Rs. 1,00,000 at that time dollar equal
to Rs.60, the payment due is 30 days, at the time of payment dollar value is Rs.64 then Indian
company will pay higher that is risk to the Indian company.

Transaction exposure can arise following activities

 Purchasing or selling of foreign goods and services on credit

 Borrowing or lending in another currency
 Foreign exchange contracts

Management of Transaction Exposure

Management of transaction exposure I usually accomplished by either

 Natural Hedging Strategies

 Contractual Hedging
- Future contracts
- Forward contract
- Options

TRANSLATION EXPOSURE/ ACCOUNTING EXPOSURE (International Financial

Management by Madhu Vij, Page No: 242- 242, 318-320)

Web link Reference: https://www.freshbooks.com/hub/accounting/accounting-foreign-

currency-translation

Web link PPT: https://www.slideshare.net/gaurpiyush90/foreign-currency-transilition

It is the degree to which a firm’s foreign currency denominated financial statements are
affected by exchange rate changes. If your business entity operates in other countries, you
will be using different currencies in your business operations. However, when it comes to
accounting, your financial statements have to be recorded in a home currency, then; all
financial statements of a foreign subsidiary have to be translated into the home currency for
the purpose of finalizing the accounts for a given period of time.

If a firm has subsidiaries in many countries, the fluctuations in exchange rate will make the
assets valuation different in different periods. The changes in asset valuation due to

A.L.I.E.T 4 GLOBAL FINANCIAL MANAGEMENT

fluctuations in exchange rate will affect the group’s asset, capital structure ratios, profitability
ratios, solvency ratios, etc.

Example:

Current exchange rate $1 = Rs.47.10

Assets Liabilities
Rs. 15,300,000 Rs. 15,300,000
$ 3,24,841 $ 3,24,841
In the next period, the exchange rate fluctuates to $1 = 47.50
Rs. 15,300,000 Rs. 15,300,000
$ 3,22,105 $ 3,22,105
Decrease in Book value of the assets is $ 2736

Measuring Foreign Currency Translation exposure

The three steps in the foreign currency translation process are as follows:

 Determine the functional currency of the Foreign Entity: Businesses must

determine a functional currency for reporting. The functional currency is the one
which the company uses for the majority of its transactions. You can choose the
currency of the country where your main headquarters are located or where your
major operations are.
 Re-measure the Financial Statements of the Foreign Entity into the Functional
Currency: You need to ensure that all your financial statements use the reporting
currency. The translation of financial statements into domestic currency begins with
translating the income statement. According to the FASB ASC Topic 830, Foreign
Currency Matters, all income transactions must be translated at the rate that existed
when the transaction occurred. The GAAP regulations require the items in the balance
sheet be converted in accordance with the rate of exchange as on the date of balance
sheet while the income statement items are converted according to the weighted
average rate of exchange.
 Record Gains and Losses on the Translation of Currencies: The gains and losses
arising from foreign currency transactions that are recorded and translated at one rate
and then result in transactions at a later date and different rate are recorded in the
equity section of the balance sheet.

Methods to Manage Translation Exposure

 Current- Non current Rate Method

 All current assets and current liabilities of foreign affiliates are translated into
the parent currency at current exchange rates.
 All non-current assets, non-current liabilities, and owner’s equity are
translated at historical exchange rates.
 Most income statement items are related to current assets or current liabilities
and are translated at the average exchange rate over the reporting period.

A.L.I.E.T 5 GLOBAL FINANCIAL MANAGEMENT

  Depreciation is related to non-current assets and translated at the historical
exchange rate.
 Monetary/Nonmonetary Method
 All monetary balance sheet accounts (Cash, marketable securities, accounts
receivables, etc.) of a foreign subsidiary are translated at the current exchange
rate.
 All other (non-monetary) balance sheet accounts (owners ‘equity, land) are
translated at the historical exchange rate in effect when the account was first
recorded.
 Temporal Rate Method
 Monetary assets (Cash, accounts receivables) and monetary liabilities (in
general all liabilities are monetary) are translated at current exchange rates.
 Non monetary assets (Inventory and fixed assets) non monetary liabilities and
owners’ equity are translated at historical rates.
 Most income statements items related to current items are translated at average
exchange rates.
 Deprecation and cost of goods sold are related to real assets (Non monetary)
and are translated at historical exchange rates.
 Current rate method
 All assets and liabilities except common equity are translated at the current
exchange rate.
 Common equity is translated at historical exchange rates.
 Income statements items are translated at a current exchange rate
 Any imbalance between the book value of assets and liabilities is recorded as a
separate equity account called the cumulative translation adjustment (CTA)

Which translation method is best?

Globally US MNCs accepted current/ non-current method of foreign currency translation

from 1930 to 1975. After 1976, US MNCs adopted FASB 8 (Financial Accounting Standard
Board) which was based on temporal method.

ECONOMIC EXPOSURE/ OPERATING EXPOSURE/ COMPETITIVE EXPOSURE/

STRATEGIC EXPOSURE

It is a type of foreign exchange exposure caused by the effects of unexpected currency

fluctuations on a company’s future cash flow.

Example: XYZ is a business importing goods from Japan to sell in the USA, if the Japanese
Yen were increase against US dollar, it would make it more expensive for company XYZ to
purchase goods and sell into US markets, and it may affect the sales of XYZ Company and
reduce cash flows, returns.

Management of Economic Exposure

 Diversification of operations : Diversify the production location, target markets

 Diversifying Financing: Diversify in cheaper currency market
 Currency Swaps
 Risk sharing Agreements

A.L.I.E.T 6 GLOBAL FINANCIAL MANAGEMENT

MANAGEMENT OF EXPOSURES

INTERNAL TECHNIQUES/ NATURAL HEDGES (International Financial Management by

V.A.Avadhani Page No: 216-228)

I. Natural hedges / Internal techniques: Do not involve contractual relationship with any
party outside the firm
 Netting: Netting is a technique of optimizing cash flow movements with the joint
efforts of subsidies. The process involves the reduction of administration and
transaction costs that result from currency conversion.
 Leads (Early) and lags (Delay): The alteration of normal payment or receipts in a
foreign exchange transaction because of an expected change in exchange rates, an
expected increase in exchange rates is likely to speed up payments, while an expected
decrease in exchange rates will probably slow them down.
 Cross hedging: Cross hedging is when you hedge a position by investing in two
positively correlated securities or securities that have similar price movements. The
investor takes opposing positions in each investment in an attempt to reduce the risk
of holding just one of the securities. The effectiveness of cross hedging depends upon
how two assets are strongly correlated.
Example: Use Japanese Yen contract to cross hedge Korean won (assuming that the
yen and won are strongly correlated).
 Currency diversification: A portfolio diversification strategy/ investment strategy
that involve securities denominated in several currencies. In a simple way securities
are purchased in various foreign currency denominations.
Example: One may buy stock that trade in US dollars, British pound, Japanese yen
and Euros.
 Risk sharing: It is risk management method in which the cost of the consequences of
a risk is distributed among parties or enterprises.

A.L.I.E.T 7 GLOBAL FINANCIAL MANAGEMENT

  Parallel loans/ back to back loans: A type of foreign exchange loan agreement that
was a precursor to currency swaps, a parallel loan involves “two parent companies
taking loans from their respective national financial institutions and then lending the
resulting funds to the other company’s subsidiary.

II. Contractual Hedging / External techniques

 Forward market hedge: Contract to buy or sell asset at a given price on a specified
Date in The future. Investors use this device to avoid major losses if the price of the
asset changes dramatically before it is exchanged.
 Future contracts: A currency future is a future contract to exchange one currency for
another at a specified date in future at a specified price (exchange rate) that is fixed on
purchase date.
 Hedge with Options: The word option means the holder has the right but not the
obligation to buy / sell underlying assets. Options are contracts through which a seller
gives a buyer the right but not the obligation to buy or sell a specified number of
underlying assets at a predetermined price within a specified time period.

MANAGEMENT OF RISK IN FOREIGN EXCHANGE MARKETS

FOREX DERIVATIVES/CURRENCY DERIVATIVES
Concept of Derivatives
Derivatives are financial contracts that derive their value from the value of the underlying
asset. The underlying asset can be equity, bonds, currencies, commodities or other assets.
Examples: Let’s look at a simple example to understand the complex world of derivatives.

 Do you remember your mother complaining that the cost of milk has gone up from Rs
59/litre to Rs 61/litre?
 The next day, the cost of curd went up from Rs 58/400 grams to Rs 60/400 grams!
 Then came cheese, which would now cost Rs 150/200 grams instead of Rs 145 /200
grams!
Curd and cheese have no value of their own. They derive their value from the value of the
underlying asset i.e. ‘milk’. So, derivatives are financial contracts, which have no value of
their own but they derive their value from the price of the underlying asset. An increase in the
price of the underlying asset will lead to an increase in the price of its derivative. So,
expensive milk equals expensive curd.
Definition of derivative

A.L.I.E.T 8 GLOBAL FINANCIAL MANAGEMENT

  A derivative is financial instrument whose value derived from the value of underlying
assets.
Underlying assets
 Interest rates
 Currency/ Foreign exchange rates
 Agricultural commodities
 Bonds
 Crude oil
 Precious metals
 Share/Stocks
Objectives of derivatives/Benefits
 Reduce risk(sharing of risk from one party to another)
 Lower transaction cost
 Portfolio management
 Provide price discovery process
Participants in derivates market/traders
 Hedgers
 Speculators
 Arbitrager

Types of derivatives or derivative contracts

 Futures
 Forwards
 Options
 Swaps

Concept of Foreign Exchange Derivatives / Currency Derivatives

Currency derivatives are contracts to buy or sell currencies at a future date. The major types
of currency derivatives are forward contracts, futures contracts, options and swaps. Despite
having an average daily turnover of Rs 44,859 crores, currency derivatives in India are
largely unknown to small retail investors. The currency derivatives trading segment in India
is dominated by importers, exporters, central banks, banks and corporations. While currency
derivatives in India are primarily used for hedging, retail investors can create wealth in the
currency derivatives segment by speculating and arbitraging.

Classification of Currency Derivatives

CURRENCY FUTURE CONTRACTS / FOREX FUTURE CONTRACTS
(International Financial Management by Dr.Pradip Kumar Sinha, Page No: 92-93)
Reference:https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/
currency-futures/
 Future Contract meaning: A standardized contract where both parties agree to
buy/sell a particular asset of specific quantity at a predetermined price in the future
date.

A.L.I.E.T 9 GLOBAL FINANCIAL MANAGEMENT

  Currency Future: Currency futures contracts also referred to as foreign
exchange futures or FX futures for short, are a type of standardized futures contract to
exchange a currency for another at a fixed exchange rate on a specific date in the
future.
 Currency futures, also called forex futures or foreign exchange futures, are contracts
to buy or sell a specified amount of a particular currency at a set price and date in the
future.
(Note: Currency futures were introduced at the Chicago Mercantile Exchange (now the CME
Group) in 1972 soon after the fixed exchange rate system and the gold standard were
discarded. Speculators are the most active participants in the futures market but close their
positions before expiry. So, in reality, they do not physically deliver the currencies, rather
they make or lose money based on the price changes of the futures contract)
How firms use currency futures
 Purchasing futures to hedge payables: The purchase of futures contracts locks in
the price at which a firm can purchase a currency.
 Selling futures to hedge receivables: The sale of futures contracts locks in the
price at which a firm can sell a currency.
How do Currency Futures work?

Currency futures are standardized contracts that trade on centralized exchanges. These
futures are either cash settled or physically delivered. Cash-settled futures are settled daily on
a mark-to-market basis. As the daily price changes, the differences are settled in cash until
the expiration date. For futures settled by physical delivery, at the expiration date, the
currencies must be exchanged for the amount indicated by the size of the contract. Foreign
exchange futures contracts have several components outlined below:

 Underlying Asset: This is the specified currency exchange rate

 Expiration Date: For cash-settled futures, this is the last time it is settled. For
physically delivered futures this is the date the currencies are exchanged
 Size: Contracts sizes are standardized. For example, a euro currency contract is
standardized to 125,000 euros
 Margin Requirement: To enter into a futures contract, an initial margin is required.
A maintenance margin will also be established and if the initial margin falls below
this point, a margin call will happen meaning the trader or investor must deposit
money to bring it above the maintenance margin. A typical initial margin can be
around 4% and a maintenance margin around 2%.

Currency Futures-Worked Example

Let us now look at an example that involves currency futures. Say you purchase 8 future Euro
contracts (€125,000 per contract) at 0.89 US$/€. At the end of the day, the settlement price
has moved to 0.91 US$/€. How much have you lost or profited?
The price has increased meaning you have profited. The calculation to determine how much
you have profited is as follows:
(0.91 US$/€ – 0.89 US$/€) x €125,000 x 8 = 20,000 US$

A.L.I.E.T 10 GLOBAL FINANCIAL MANAGEMENT

CURRENCY FORWARD CONTRACTS
Reference:https://corporatefinanceinstitute.com/resources/knowledge/finance/currency-
forward/

 Forward Contract Meaning: A customized contract between two parties to buy/sell

an asset at specified price on a future date.
 A currency forward is a customized, written contract between parties that sets a fixed
foreign currency exchange rate for a transaction that will occur on a specified future
date. The future date for which the currency exchange rate is fixed is usually the date
on which the two parties plan to conclude a buy/sell transaction of goods.
Uses of currency forward
 Currency forward contracts are primarily utilized to hedge against currency exchange
rate risk. It protects the buyer or seller against unfavorable currency exchange rate
occurrences.
Practical Example
Currency forward contracts are most frequently used in relation to a sale of goods between a
buyer in one country and a seller in another country. The contract fixes the amount of money
that will be paid by the buyer and received by the seller. Thus, both parties can proceed with
a firm knowledge of the cost/price of the transaction.
When a transaction that may be affected by fluctuations in currency exchange rates is to take
place at a future date, fixing the exchange rate enables both parties to budget and plan their
other business actions without worrying that the future transaction will leave them in a
different financial condition than they had expected.
For example, assume that Company A in the United States wants to contract for a future
purchase of machine parts from Company B, which is located in France. Therefore, changes
in the exchange rate between the US dollar and the euro may affect the actual price of the
purchase – either up or down.
The exporter in France and the importer in the US agree upon an exchange rate of 1.30 US
dollars for 1 euro that will govern the transaction that is to take place six months from the
date the currency forward contract is made between them. At the time of the agreement, the
current exchange rate is 1.28 US dollars per 1 euro.
If, in the interim and by the time of the actual transaction date, the market exchange rate is
1.33 US dollars per 1 euro, then the buyer will have benefited by locking in the rate of 1.3.
On the other hand, if the prevailing currency exchange rate at that time is 1.22 US dollars for
1 euro, then the seller will benefit from the currency forward contract. However, both parties
have benefited from locking down the purchase price so that the buyer knows his cost in his
own currency, and the seller knows exactly how much they will receive in their currency.

CURRENCY OPTION CONTRACTS / FOREX OPTION CONTRACTS (International

Financial Management by Dr.Pradip Kumar Sinha, Page No: 94-97)
Reference: https://www.wallstreetmojo.com/currency-options/

Option Meaning: The word option means the holder has the right but not the obligation to
buy / sell Particular underlying asset on a future date at a predetermined price. There are two
types of options: ‘Call’ option and ‘Put’ option.

A.L.I.E.T 11 GLOBAL FINANCIAL MANAGEMENT

Currency Option: Currency options are contracts that give the buyer the right, but not the
obligation, to buy or sell a certain currency on a future date at a pre-decided price. There are
two types of currency options: ‘Call’ option and ‘Put’ option.

Types of Currency Options

1. Currency Call option: Option gives the buyer the right but not obligation to buy a
given quantity of underlying assets (Currency) at a particular date by paying
premium.
Factors affecting currency call option
 Level of existing spot price relative to stock price: The higher the spot rate
relative to the strike price, the higher the option price will be. This is due to the
higher probability of buying the currency at a substantially lower rate than what
you could see it for.
 Length of time before the expiration date: It is generally expected that the spot
rate has a greater chance of rising above the strike price if it has a longer period
of time to do so.
 Potential variability of currency: The greater the variability of the currency, the
higher the probability that the spot rate can rise above the strike price. Thus less
volatile currencies have lower call option prices. Example: the Canadian dollar is
more stable than most other currencies.
How firms use currency call options?
 Using call options to hedge payables: MNC’s can purchase call options on a
currency to hedge future payables.
 Using call options to project bidding: US based MNC’s that bid for foreign
projects may purchase call options to lock in the dollar cost of the potential
expenses.
 Using call options to hedge target bidding: firms can also use call options to
hedge a possible acquisitions.

 Currency Put option: Put gives the seller the right but not obligation to sell a given
quantity of the underlying asset (Currency) at a given price on or before a particular
date by paying premium.

Factors affecting currency put option

 Level of existing spot price relative to stock price: The lower the spot rate
relative to the strike price, the more valuable the put option.
 Length of time until the expiration date: The longer the time to expiration, the
greater the put option premium.
 Potential variability of currency: Greater the variability, the greater the put
option premium will be again reflecting a higher probability that the option will
be exercised.
Currency Option Terminology
Some of the more common option related terms are defined below:
 Exercise: The act performed by the option buyer of notifying the seller that they
intend to deliver on the option’s underlying forex contract.

A.L.I.E.T 12 GLOBAL FINANCIAL MANAGEMENT

  Expiration Date: The last date upon which the option can be exercised.
 Delivery Date: The date upon when the currencies will be exchanged if the option is
exercised.
 Call Option: Confers the right to buy a currency.
 Put Option: Confers the right to sell a currency.
 Premium: The upfront cost involved in purchasing an option.
 Strike Price: The rate at which the currencies will be exchanged if the option is
exercised.
Advantages
 It allows traders to take leverage trades as the premium cost of the option contract is
very minimal compared to the actual buying of the contract, which enables them to
take a large position by paying a nominal premium.
 It is a low-cost tool for hedging and can be used by Corporate to hedge against any
adverse currency movement.
Disadvantages
 Due to the high leveraged position, Currency Options are prone to manipulation by
speculators and cartels. Also, currency markets are controlled by the local government
of each country, which impacts the Value of Currency Options.
Example of a Currency Option
Let's say an investor is bullish on the euro and believes it will increase against the U.S. dollar.
The investor purchases a currency call option on the euro with a strike price of $115, since
currency prices are quoted as 100 times the exchange rate. When the investor purchases the
contract, the spot rate of the euro is equivalent to $110. Assume the euro's spot price at the
expiration date is $118. Consequently, the currency option is said to have expired in the
money. Therefore, the investor's profit is $300, or (100 * ($118 - $115)), less the premium
paid for the currency call option.
Difference between future and forwards
Characteristics Foreign currency Futures Foreign currency Forwards
Contract size Standardized Any size desired/ customized
Maturity Fixed maturity Any maturity up to a year
Location Organized exchange Individuals & banks
Pricing Open outcry Bid(buyer) or ask(seller) quotes
Daily market to market(usually 2-4
Margin/collateral No collateral
contract values)
Single commission for purchase &
Fees Bid/ask spread
sell
Trading hours Exchange hours 24 hours
Counter parties Through clearing houses Direct contact
liquidity Very liquid Liquid relatively large amount

CURRENCY SWAPS/SWAP CONTRACTS (International Financial Management by

V.A.Avadhani Page No: 229-242)
Reference: https://corporatefinanceinstitute.com/resources/knowledge/finance/currency-
swap-contract/

A.L.I.E.T 13 GLOBAL FINANCIAL MANAGEMENT

Swaps: A swap is an agreement between two parties for an exchange of one financial
instrument for another between parties concerned, this exchange takes place at a pre
determined time, as specified in the contact(exchange means trading oriented through bank)
swaps can be used to hedge risk of various kinds which includes interest rate risk currency
risk.
Advantages of swaps
 Borrowing at Lower Cost: Swap facilitates borrowings at lower cost. It works on the
principle of the theory of comparative cost as propounded by Ricardo. One borrower
exchanges the comparative advantage possessed by him with the comparative
advantage possessed by the other borrower. The net result is that both the parties are
able to get funds at cheaper rates.
 Access to New Financial Markets: Swap is used to have access to new financial
markets for funds by exploring the comparative advantage possessed by the other
party in that market. Thus, the comparative advantage possessed by parties is fully
exploited through swap. Hence, funds can be obtained from the best possible source at
cheaper rates.
 Hedging of Risk: Swap cal also be used to hedge risk. For instance, a company has
issued fixed rate bonds. It strongly feels that the interest rate will decline in future due
to some changes in the economic scene. So, to get the benefit in future from the fall in
interest rate, it has to exchange the fixed rate obligation with floating rate obligation.
That is to say, the company has to enter into swap agreement with a counterparty,
whereby, it has to receive fixed rate interest and pay floating rate interest. The net
result is that the company will have to pay only floating rate of interest. The fixed rate
it has to pay is compensated by the fixed rate it receives from the counterparty. Thus,
risks due to fluctuations in interest rate can be overcome through swap agreements.
Similar, agreements can be entered into for currencies also.
 Tool to correct Asset-Liability Mismatch: Swap can be profitably used to manage
asset-liability mismatch. For example, a bank has acquired a fixed rate bearing asset
on the one hand and a floating rate of interest bearing liability on the other hand. In
case the interest rate goes up, the bank would be much affected because with the
increase in interest rate, the bank has to pay more interest. This is so because; the
interest payment is based on the floating rate. But, the interest receipt will not go up,
since, the receipt is based on the fixed rate. Now, the asset- liability mismatch
emerges. This can be conveniently managed by swap. If the bank feels that the
interest rate would go up, it has to simply swap the fixed rate with the floating rate of
interest. It means that the bank should find a counterparty who is willing to receive a
fixed rate interest in exchange for a floating rate. Now, the receipt of fixed rate of
interest by the bank is exactly matched with the payment of fixed rate interest to swap
counterparty. Similarly, the receipt of floating rate of interest from the swap
counterparty is exactly matched with the payment of floating interest rate on
liabilities. Thus, swap is used as a tool to correct any asset- liability mismatch in
interest rates in future.
Types/Classification of Swaps
 Currency swap: Currency Swaps refer to exchange of an agreed amount of a
currency for another currency at a specific future date this is equivalent to currency
forward contract in a sophisticated way.
Or
A currency swap is an agreement between two parties to exchange the cash flows of
one party’s loan for the other of a different currency denomination.
Example: A US firm has receivable in Euro from a Belgium buyer, so it is locking for
Euro denominated liability to hedge the receivables on the other hand, a Belgium firm

A.L.I.E.T 14 GLOBAL FINANCIAL MANAGEMENT

 export to USA and has US dollar denominated receivables it needs US dollar liability
to hedge receivables in US dollar
 Interest rate swaps: An interest rate swap is a contractual agreement between the
parties to exchange interest payments through intermediary (banks).
Example: Party A agrees to make payments to party B based on fixed interest rate,
and party B agrees to make payments to party A based on floating interest rate. (The
floating rate is reference rate i.e. LIBOR).
Types of Currency Swap Contracts
Similar to interest rate swaps, currency swaps can be classified based on the types of legs
involved in the contract. The most commonly encountered types of currency swaps include
the following:
 Fixed vs. Float: One leg of the currency swap represents a stream of fixed interest
rate payments while another leg is a stream of floating interest rate payments.
 Float vs. Float (Basis Swap): The float vs. float swap is commonly referred to as
basis swap. In a basis swap, both swaps’ legs both represent floating interest rate
payments.
 Fixed vs. Fixed: Both streams of currency swap contracts involve fixed interest rate
payments.
For example, when conducting a currency swap between USD to CAD, a party that decides
to pay a fixed interest rate on a CAD loan can exchange that for a fixed or floating interest
rate in USD. Another example would be concerning the floating rate. If a party wishes to
exchange a floating rate on a CAD loan, they would be able to trade it for a floating or fixed
rate in USD as well. The interest rate payments are calculated on a quarterly or semi-annually
basis.
How Do Currency Swap Contracts Work?
In order to understand the mechanism behind currency swap contracts, let’s consider the
following example. Company A is a US-based company that is planning to expand its
operations in Europe. Company A requires €850,000 to finance its European expansion.

On the other hand, Company B is a German company that operates in the United States.
Company B wants to acquire a company in the United States to diversify its business. The
acquisition deal requires US$1 million in financing.

Neither Company A nor Company B holds enough cash to finance their respective projects.
Thus, both companies will seek to obtain the necessary funds through debt financing.
Company A and Company B will prefer to borrow in their domestic currencies (that can be
borrowed at a lower interest rate) and then enter into the currency swap agreement with each
other.

The currency swap between Company A and Company B can be designed in the following
manner. Company A obtains a credit line of $1 million from Bank A with a fixed interest rate
of 3.5%. At the same time, Company B borrows €850,000 from Bank B with the floating
interest rate of 6-month LIBOR. The companies decide to create a swap agreement with each
other.

A.L.I.E.T 15 GLOBAL FINANCIAL MANAGEMENT

According to the agreement, Company A and Company B must exchange the principal
amounts ($1 million and €850,000) at the beginning of the transaction. In addition, the parties
must exchange the interest payments semi-annually.

Company A must pay Company B the floating rate interest payments denominated in Euros,
while Company B will pay Company A the fixed interest rate payments in US dollars. On the
maturity date, the companies will exchange back the principal amounts at the same rate ($1 =
€0.85).

How a Currency Swap is Priced

Pricing is expressed as a value based on LIBOR +/- spread, which is based on the credit risk
between the exchanging parties. LIBOR is considered a benchmark interest rate that major
global banks lend to each other in the interbank market for short-term borrowings. The spread
stems from the credit risk, which is a premium that is based on the likelihood that the party is
capable of paying back the debt that they had borrowed with interest.
NOTE:
 OTC: Over-the-counter (OTC) or off-exchange trading is done directly between two
parties, without the supervision of an exchange. It is contrasted with exchange
trading, which occurs via exchanges.
 Bid –ask spread: A bid-ask spread is the amount by which the ask price exceeds
the bid price for an asset in the market. The bid-ask spread is essentially the difference
between the highest price that a buyer is willing to pay for an asset and the lowest
price that a seller is willing to accept to sell it.
 Balance of trade: Difference in value of imports and exports of goods only i.e.
visible items only. If visible exports are more than the visible imports it is known as
surplus balance of trade or Favorable Balance of trade, if visible exports are less than
the visible imports it is known as adverse balance of trade or Deficit balance of trade.
 Contractionary fiscal policy: It means government policy makers cut spending or
increase taxes, the objective of this policy is control inflation.(simply Government
expenditure < Tax revenue).
 Cartels: A cartel is an organization created between a group of producers of a good
or service to regulate supply in order to manipulate prices.
 Devaluation of rupee: In modern monetary policy, devaluation is an official
lowering of the value of a country's currency within a fixed exchange rate system, by
which the monetary authority formally sets a new fixed rate with respect to a foreign
reference currency or currency basket.
 Option writer: The person who writes the option and is the seller is referred as
option writer
 Option holder: Who holds the option and is the buyer is called option holder
 Premium: Price paid for the option by the buyer to the seller
 Strike price: Pre decided price
 Expiration date: Date on which option expires
 Exercised date: Option is exercised
 Put-call ratio: Ratio of put to the calls traded in the market
 Currency forward contract: A forward contract is an agreement between a
corporations and a commercial bank to exchange a specified amount of a currency at a
specified exchange rate (forward rate) on a specified date in the future.
 Premium: If forward rate exceeds the existing spot rate called premium
 Discount: If forward rate is less than the existing spot rate called discount
 NSE started currency future trading on 29th August 2008
 NSE started currency option trading on 29th October 2010

A.L.I.E.T 16 GLOBAL FINANCIAL MANAGEMENT

  Anyone can trade currency futures and options by opening an account under a broker
or trading member
 Currency future contracts are available on four international currency dollar, pound,
euro and Yan.
 Currency future contracts are available for trade on all days of the week except
Saturday, Sunday and holidays declared by NSE in advance
 Currency trading time 9.00 A.M-5.00 P.M
 Exchange rate between different currencies example: Indian rupee and Chinese
Yuan: 1 CNY = 11.945 INR, US Dollar and Chinese Yuan: 1 USD= 6.36046 CNY,
Euro and US Dollar: 1 EUR=1.09307 USD
 Cods are there for every currency
Example: US $ code – USDINR
€ Code- EURINR
£ (Pound) Code – GBPINR

 Call and put option example:

Call option example

Call option
Current price = Rs.250 Right to buy 100 reliance
 shares at a price of Rs.300
Premium= (Rs 25 per Strike price
share) = Rs 2500 per share after 3 months
(25*100) Expiry date

Amount  to buy call
option=Rs
 2500 (100*25)
 Suppose after 3 months the market price is
Suppose after 3months Rs.200 then the option is not exercised.

market price is Rs.400

then the option is Net loss=premium amount = Rs 2500

exercised i.e. the shares
are bought.

Net gain=40000-30000-
2500= Rs. 7500

Put Option example

Current price=Rs250

A.L.I.E.T 17 GLOBAL FINANCIAL MANAGEMENT

 Right to sell 100 reliance
Amount to buy call
 Rs2500 shares at a price of ₨.300 per
option
 share after 3 months

Suppose after 3 months Suppose after a month market

market price is Rs 200 then price is Rs300 then the option
option is exercised i.e. the is not exercised
shares are sold
Net loss=premium amount
Net gain=30000-20000-2500 Rs=2500

= Rs7500

A.L.I.E.T 18 GLOBAL FINANCIAL MANAGEMENT