FX Risk Management FRAM PDF

Foreign Exchange Risk Management Thota Nagaraju Dept of Econ & Fin...

Foreign Exchange Risk Management Thota Nagaraju Dept of Econ & Fin BITS-Pilani Hyd Campus FRAM: Foreign Exchange Risk Management Note: This PPT is a self explanatory in nature, therefore you do not need any reference material. Though, this presentation is coming from various resources but majority of the part is coming from “International Financial Management by Cheol Eun, and Bruce G. Resnick, 6th edition, McGraw-Hill. Chapter 5 and 6) Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 1 Why Risk Management? Risk management is the identification, assessment and prioritization of risks followed by coordinated and economical application of resources to minimize the impact of such risks. The purpose of risk management is to:- ▪ Identify all possible risks ▪ Reduce or allocate these risks ▪ Provide a rational basis for better decision making in regards to all risks ▪ Plan for the future ▪ Risk management is important so that potential risks are identified and mitigated and problems are effectively tackled if and when they are encountered. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 2 Steps in Risk Management Framework Risk Management Risk Identification Risk Measurement Objectives and Strategy Cash Flow Analysis Scenario Analysis Strategy Design & Testing Translational Risk Regression Analysis Policy Development Strategic Risk Value at Risk Benchmarking and Risk Management Strategy Execution Analysis Process Program Review Instrument Design & Financial Planning Quantitative Selection Accounting Compliance Performance Analysis Capital Market Information Market Strategies Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management Second Sem 2022-23 Importance of the Forex Markets Foreign Exchange Market:-The foreign exchange market provides the physical and institutional structure through which the money of one country is exchanged for that of another country, the rate of exchange between currencies is determined, and foreign exchange transactions are physically completed. FX Market Participants:- international banks, bank customers, nonbank dealers (eg: insurance firms, venture capitalists, currency exchanges, some microloan organizations, and pawn shops), FX brokers, and central banks. Trading Hours: The market for foreign exchange is the largest financial market in the world by virtually any standard. It is open somewhere in the world 365 days a year, 24 hours a day. Market Size:- Trading in foreign exchange markets averaged $7.5 trillion per day in April 2022. This is equivalent to over $937 in transactions for every person on earth. The US dollar remained the dominant vehicle currency, being on one side of 88% of all trades in April 2022. The euro, yen and Australian dollar all lost market share. In contrast, many emerging market currencies increased their share. In April 2022, sales desks in five countries – the United Kingdom, the United States, Singapore, Hong Kong and Japan – intermediated 78% of foreign exchange trading, up from 75% in April 2013 and it continue to be at 78% from 2016. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 4 Importance of the Forex Markets (Why?). ~ $7.5 trn daily Multiple price market turnover sources Liquid Transparent Slippage is the difference between Low the expected price of Scalable Transaction a trade and the price at which the trade is Costs executed Large market size Tight bid-offer in means low competitive slippage market Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 5 Foreign Exchange - Spot Market The Spot Market:- The spot market involves almost the immediate purchase or sale of foreign exchange. Spot foreign exchange quotations can be given in variety of ways i.e, direct/indirect American/European, base/variable quotations. Direct and Indirect quotes:- A direct quote is the home currency price of one unit of foreign currency. An indirect quote is foreign currency price of one unit of domestic currency. A forex quotation becomes direct/indirect quotations depending on who is using this quote. For example, INR 82.76/USD is a direct quotation for resident Indian while it is indirect quotation for American. Similarly, USD 0.012/ INR is a direct quotation for American person while it is an indirect quotation for Indian. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 6 Foreign Exchange - Spot Market American/European quotes:- Foreign currency price per one USD, also known as “European Terms” b) USD price per unit of foreign currency also known as “American Terms”. For example, INR 82.76 /USD is in “European Terms” while USD 0.012/INR is in “American Terms”. Base/Variable quotes:- Each forex quotation has a “base” currency and a “variable/quote/term” currency. Any exchange rate quotation shows how many units of variable/quote/term currency for unit of base currency. For example a forex exchange dealer is quoting USD/INR as 82.76. In his case, USD is the base currency while INR 82.76 variable/quote/term currency. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 7 Foreign Exchange - Spot Market notations Most currencies in the interbank market are quoted in either American or European terms. In general, S(j/k) will refer to the price of one unit of currency k in terms of currency j and “s” denotes the spot rate. S($/₹) = 0.012, which indicates that $0.012 per rupee. S(₹/$)= 82.76, which indicates that ₹ 82.76 per dollar. It should be intuitive that the American and European term quotes are reciprocals of one another. That is, 1 1 S($/₹) = ₹ ➔ 0.012=( ) and 82.76 𝑆( ) $ 1 1 S(₹/$)= ➔ 82.76 =( ) $ 𝑆( ) 0.012 ₹ Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 8 Cross-Exchange Rate Quotations A cross-exchange rate is an exchange rate between a currency pair where neither currency is the U.S. dollar. The cross-exchange rate can be calculated from the U.S. dollar exchange rates for the two currencies, using either European or American term quotations. For example, the €/£ cross-rate can be calculated from American term quotations as follows: Lets assume that S($/£) = 1.9077, S($/€) = 1.3112, S(€/$) = 0.7627 and S(£/$)= 0.5242 S($/£) 1.9077 Then S(€/£)= ➔ 1.3112 = 1.4549 S($/€) That is, if £1.00 cost $1.9077 and €1.00 cost $1.3112, the cost of £1.00 in euros is €1.4549. In European terms, the calculation is S(€/$) 0.7627 S(€/£)= ➔ = 1.4549 S(£/$) 0.5242 S($/€) 1.3112 Analogously, S(£/€)= ➔ ➔ 0.6873 and S($/£) 1.9077 S(£/$) 0.5242 S(£/€)= ➔ ➔ 0.6873 S(€/$) 0.7627 Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 9 Alternative Expressions for the Cross-Exchange Rate For some purposes, it is easier to think of cross-exchange rates calculated as the product of an American term and a European term exchange rate rather than as the quotient of two American term or two European term exchange rates. For example, 1 S(€/$) for can be rewritten as: S($/€) S(€/£) = S($/£) X S(€/$) ➔ 1.9077 X.7627 = 1.4549 In general terms, S(j/k) = S($/k) X S(j/$) and taking reciprocals of both sides of the above equation yields S(k/j) = S(k/$) X S($/j) Note the $ signs cancel one another out in both the above equations. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 10 Triangular Arbitrage Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange rate between the two is not in alignment with the cross-exchange rate. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 11 Forex Quotes: Pips and the Big Figure The last two digits of an exchange rate are the points or pips. The rest of the rate is called big figure. Exchange rates are usually quoted to five figures. The first three digits of the quote are the big figures. CAD=Canadian Dollar Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 12 The Forward Market for Forex The forward market involves contracting today for the future purchase or sale of foreign exchange. or An Agreement to exchange one currency for another on a future date at an exchange rate agreed on today. The forward price may be the same as the spot price, but usually it is higher (at a premium) or lower (at a discount) than the spot price. Forward exchange rates are quoted on most major currencies for a variety of maturities. Bank quotes for maturities of 1, 3, 6, 9, and 12 months are readily available. It is common to express the premium or discount of a forward rate as an annualized percentage deviation from the spot rate. Forward exchange rate > Spot exchange rate = Premium Forward exchange rate < Spot exchange rate = Discount So the premium or discount is known as the forward-spot differential. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 13  International Parity Conditions Interest Rate Parity (IRP) Purchasing Power Parity (PPP) 14 Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 Interest Rate Parity (IRP) Law of One Price “a good must sell for the same price in all locations”. This law is derived from the assumption of the inevitable elimination of all arbitrage. Arbitrage is the process of buying and selling in more than one market to make a riskless profit. Interest rate parity (IRP) is an no arbitrage condition that must hold when international financial markets are in equilibrium. If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity. Since we don’t typically observe persistent arbitrage conditions, we can safely assume that IRP holds. Assumptions of IRPT 1) No Transaction Costs 2) No Capital Controls 3) Unlimited borrowing is allowed Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 15 Interest Rate Parity Defined Consider alternative one-year investments for $1: 1. Invest in the U.S. at 𝑖$. Future value = $1 × (1 + 𝑖$ ) 2. Alternatively you can invest in U.K. exchange $1 for a pound amount that is £ (1/$) at the prevailing spot rate(S). 3. Invest the amount at the U.K. interest rate 𝑖£ with maturity value £ (1/$)(1 + 𝑖£) 4. Sell the maturity value of the U.K. investment forward in the exchange for a predetermined dollar amount that is $[(1/S)(1 + 𝑖£)F, where F denotes the forward exchange rate. This is known as “covered interest rate parity. i.e. 𝐹 interest rate differential between the two markets The effective dollar interest rate from the U.K. investment alternatives is given by (1 +i£) -1 is zero. 𝑆 or No arbitrage equilibrium then would dictate that the future dollar proceeds An investment in a foreign money market instrument that is completely hedged against from investing in the two equivalent investments must be the same, implying that exchange rate risk should yield exactly the same return as an otherwise identical domestic money 𝐹 1+𝑖$ market investment. 1 + 𝑖$ = 𝑆 (1 + 𝑖£) alternatively, F=S 1+𝑖 £ Market equilibrium requires that the net cash flow on the maturity date be zero for this portfolio: 1 + 𝑖£ 𝐹 − 1 + 𝑖$ 𝑆 = 0 The IRP relationship is sometimes approximated as follows: 𝐹−𝑆 𝐹−𝑆 𝑖$ − 𝑖£ = 1 + 𝑖£ ≈ 𝑆 𝑆 Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 16 Interest Rate Parity Defined Contd……… When IRP holds, you will be indifferent between investing your money in the United States and investing in the U.K. with forward hedging. However, if IRP is violated, you will prefer one to another. You will be better off by investing in the United States (U.S.) if (1 + 𝑖$ ) is greater (less) than (F/S)(1 + 𝑖£). When you need to borrow, on the other hand, you will choose to borrow where the dollar interest is lower. When IRP doesn’t hold, the situation also gives rise to covered interest arbitrage opportunities. Reasons for Deviations from IRP 1) Transactions Costs 2) Capital Controls Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 17 Interest Rate Parity-Numerical Example. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 18 Interest Rate Parity-Numerical Example. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 19 How long will this arbitrage opportunity last? (AKA-Market adjustment mechanism) As soon as deviations from IRP are detected, informed traders will immediately carry out CIA transactions. As a result of these arbitrage activities, IRP will be restored quite quickly. To see this, let’s get back to our numerical example, which induced covered interest arbitrage activities. Since every trader will (1) borrow in the United States as much as possible, (2) lend in the U.K., (3) buy the pound spot, and, at the same time, (4) sell the pound forward, the following adjustments will occur to the initial market condition 1. The interest rate will rise in the United States (𝑖$ ↑). 2. The interest rate will fall in the U.K. (𝑖£↓). 3. The pound will appreciate in the spot market (S↑). 4. The pound will depreciate in the forward market (F↓). Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 20 Interest Rate Parity and Exchange Rate Determination Being no arbitrage equilibrium condition involving the (spot) exchange rate, IRP has an immediate implication for exchange rate determination. To see why, let us reformulate the IRP relationship in terms of the spot exchange rate: 1+𝑖$ S= 𝐹 1+𝑖 £ The above indicates that given the forward exchange rate, the spot exchange rate depends on relative interest rates. All else equal, an increase in the U.S. interest rate will lead to a higher foreign exchange value of the dollar. This is so because a higher U.S. interest rate will attract capital to the United States, increasing the demand for dollars. In contrast, a decrease in the U.S. interest rate will lower the foreign exchange value of the dollar. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 21 Purchasing Power Parity (PPP) The exchange rate between currencies of two countries should be equal to the ratio of the countries’ price levels. Let 𝑃$ be the dollar price of the standard commodity basket in the United States and 𝑃£ the pound price of the same basket in the United Kingdom. Formally, PPP states that the exchange rate between the dollar and the pound should be 𝑃 S= $ൗ𝑃 £ where S is the dollar price of one pound. PPP implies that if the standard commodity basket costs $225 in the United States and £150 in the U.K., then the exchange rate should be $1.50 per pound: $1.50/£ = $225/£150 If the price of the commodity basket is higher in the United States, say, $300, then PPP dictates that the exchange rate should be higher, that is, $2.00/£. To give an alternative interpretation to PPP, let us rewrite above equation, as follows: 𝑃$ = S X 𝑃£ The above equation states that the dollar price of the commodity basket in the United States, 𝑃$ , must be the same as the dollar price of the basket in the U.K., that is, 𝑃£ multiplied by S. In other words, PPP requires that the price of the standard commodity basket be the same across countries when measured in a common currency. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 22 Fisher Effect An increase (decrease) in the expected inflation rate in a country will cause a proportionate increase (decrease) in the interest rate in the country is known as “Fisher effect”. For a single economy, the nominal interest rate equals the real interest rate plus the expected rate of inflation. The Fisher effect represents arbitrage between real assets and nominal (or financial) assets within a single economy. At the end of one period, a $1 commodity holding can be liquidated for $1[1+E(𝜋)], where E(𝜋) is the expected rate of inflation. To be indifferent, an interest-bearing security will need an end-of-period value of $1(1+r)[1+E(𝜋)], or $1(1+i). So, (1+𝑖$ ) = (1+𝑟$ )[1+E(𝜋$ )] ➔ 𝑖$ = 𝑟$ +E(𝜋$ )+rE(𝜋$ ) Where “r” is the real inflation rate and E(𝜋) expected inflation. Where inflation and the real interest rate are low, the Fisher effect is usually approximated as: 𝑖$ = 𝑟$ +E(𝜋$ ) % nominal interest rate = % real interest rate + % expected inflation. The fisher effect holds as long as bond market is efficient. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 23 What Are Non-Deliverable Forwards (NDFs)? Development ◼ Foreign investors who wish to hedge foreign exchange risk in emerging markets often face government regulations that ban or restrict trading in the local currency forwards market. ◼ Non-Deliverable Forwards (NDFs) are forward contracts settled in a fully convertible currency e.g. USD and outside the direct jurisdiction of the authorities of the corresponding currencies Features of NDFs ◼ Provides an otherwise unavailable hedging and speculative foreign exchange instruments in markets with limited foreign access. ◼ Currently there are a few Asian currency markets that actively trade NDFs ◼ Taiwan Dollar (TWD), Korean Won (KRW), Chinese Renminbi (CNY), Indian Rupee (INR), Indonesian Rupiah (IDR), Philippine Peso (PHP) ◼ Asian currency NDFs have greater co-movements with each other than their spot counterparts Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 24 Why Trade FX ? FX is growing as an asset class ▪ Traditionally, investors used to look at equities and credit markets for generating returns ▪ With funds looking for investment opportunities surpassing available traditional asset classes, investors start exploring FX as an asset class ▪ Being the most liquid market, FX markets was able to absorb this investor demand easily ▪ Popular investment strategies in FX include carry, value, momentum and volatility trading ▪ There has been a growing demand from investors for FX linked investment products – with FX margin trading capturing the largest market share ▪ HNI and Family offices are getting more sophisticated in FX investing Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 25 FX Margin Trading.▪ FX Margin Trading refers to the practice of using borrowed funds from a broker to trade currencies ▪ Purchased assets forms the collateral for the loan from the broker ▪ Use of financial leverage can potentially magnify Return On Investment (ROI) ▪ Margin refers to the amount of funds that the investor must personally put up from his or her own resources as collateral to hold an open position. It is not a transaction cost, but a good faith deposit Risks and Benefits Opportunity Benefits Risks Leverage Magnifies ROI Amplifies Losses Use of Shares as Portfolio Collateral for Margin Forced Liquidation Diversification Loan Repaying Margin Interest Charges and Repayment Flexibility Debt Rate Risk Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 26 Introduction to Vanilla FX Options. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 27 Introduction to Vanilla FX Options. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 28 Put-Call Parity. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 29 FX Volatility Surface. ZAR=South African Rand equals Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 30 FX Volatility Smile. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 31 Type of FX Exposures. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 32 Corporate FX Risks - Solutions. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 33 Why Hedge FX Risk? There are several reasons why fund managers hedge FX Risk in portfolios Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 34.. Popular FX Hedging Strategies – Cashflow Hedging Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 35 Hedging Strategies for a client with a requirement to Buy EUR / Sell USD. Hedging With a Forward Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 36 Hedging Strategies for a client with a requirement to Buy EUR / Sell USD Hedging. With a Long Option Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 37 Hedging Strategies for a client with a requirement to Buy EUR / Sell USD. Hedging With a Naked Short Option Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 38 Hedging Strategies for a client with a requirement to Buy EUR / Sell USD Hedging. With a Participating Forward Participating Forwards could be suitable if you're a business not wanting to pay a premium, but would like to enjoy protection and a degree of participation without the prospect of triggering an unfavourable rate. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 39 Hedging Strategies for a client with a requirement to Buy EUR / Sell USD Hedging. With a Leveraged Forward Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 40 Hedging Strategies for a client with a requirement to Buy EUR / Sell USD. Hedging With a Choice Forward a.k.a. Range Forward Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 41 Hedging Strategies for a client with a requirement to Buy EUR / Sell USD. Hedging With a Risk Reversal Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 42 Hedging Strategies for a client with a requirement to Buy EUR / Sell USD. Hedging With a Seagull A seagull option is a three-legged option trading strategy that involves either two call options and a put option or two puts and a call. Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 43 Hedging Strategies for a client with a requirement to Buy EUR / Sell USD. Hedging With a Bull Spread Thota Nagaraju BITS-Pilani Hyderabad Campus FRAM-FX Risk Management First Sem 2024-25 44