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Concepts of Derivatives:
Forward Commitments and
Swap Contracts
A brief overview
by
Hasan Tareq Khan
Assistant Director, DBI-2
Risk has two components
• Exposure (size, amount of risk)
• Uncertainty (probability of
consequences)
adverse
What is a foreign exchange
contract?
Two Parties
A bilateral agreement
Two cash Flows
to buy or sell
Two Currencies
one currency against another
Two way quote
at an agreed price
Two value dates
at a specified value date
What is a foreign exchange
rate?
The price of one currency expressed in terms of
another currency
Examples:
USD/JPY
EUR/USD
107.40
1.2585
Consists of two currencies
Commodity (Base) currency: currency being priced;
fixed number, e.g. 1.000
Terms (Counter) currency: the “other” currency; variable
number, e.g. 107.40
Who are parties to a foreign
exchange contract?
Calling party (price taker)
Quoting party (market maker)
What is implied in an FX rate?
Suppose the rate
Bid
Offer
107.50
107.55
You Quote
You Call
Buy USD
107.50
107.55
Sell USD
107.55
107.50
Buy JPY (Sell USD)
107.55
107.50
Sell JPY (Buy USD)
107.50
107.55
Spot USD/JPY
Bid and Offer rates refer to the COMMODITY currency
ARBITRAGE
• It refers to the purchasing of foreign
currency where its price is low and selling
it where the price is high. This is also
called currency arbitrage. Arbitrage may be
due to interest rate differences in two
financial centers, which is known as
interest arbitrage.
SWAP
• Purchasing a foreign currency on the spot
for selling forward or selling a foreign
currency on the spot for purchasing
forward.
HEDGING
• Foreign exchange risks can be avoided or
covered by Hedging. This usually involves
an agreement today to buy or sale a certain
amount of foreign currency at some future
date at a rate agreed upon today.
SPECULATION
It is opposite of hedging. While a hedger seeks to
avoid or cover a foreign exchange risk for fear of
loss, the speculator accepts or even seeks a
foreign exchange risk in the hope of making a
profit. Speculation usually occurs in the forward
exchange market.
Value date
• The date on which the exchange of currencies is
to take place is the “value date”
of the
transaction. In theory, the essential principle of
valeur compensee (compensated value) requires
the currencies to change hands at the same point
of time. In practice, this is not possible because of
time differences in the two centers. Hence, the use
of value dates,i.e. currencies must be paid and
received on the same day. The value date of
foreign exchange transaction will have to be a
working day in both the centers where the money
transfers are to take place.
DERIVATIVE
Derivative is “something derived”(from a
specified source)-WEBSTER
In finance, derivatives are contracts whose value
(the “something”) is derived from some
underlying asset such as commodity, an
interest rate, a stock, or a bond. A derivative,
therefore, exists on the basis of another
products. It is a special product created out of
a core product.
Basic kinds of derivative
products:
• Forwards and futures (exchange traded
forwards)
• Swap
• Options
USE
• Hedging, speculating or selling riskmanagement or transaction services
• Provide banks with opportunities to
strengthen customer relationship
• Emphasizes that bankers must recognize
the potential benefits of selling riskmanagement services.
SPOT
• A spot foreign exchange deal is one made for
settlement in two working day’s time. Thus
under normal circumstances a spot deal done
on Monday is settled on Wednesday.
Settlement of both sides of a spot foreign
exchange deal should be made on the same
working day. The principle is that the two
sides of the deal should be completed on the
same day is referred to as the principle of
valeur compensee or compensated value.
Example:
Suppose the rate
Bid
Offer
107.50
107.55
You Quote
You Call
Buy USD
107.50
107.55
Sell USD
107.55
107.50
Buy JPY (Sell USD)
107.55
107.50
Sell JPY (Buy USD)
107.50
107.55
Spot USD/JPY
Bid and Offer rates refer to the COMMODITY currency
How banks quote spot rates to
customers
• Ascertain the going exchange rate in the
wholesale market, load a margin and make a
customer quote.
• The underlying theory is that the currency
sold to (bought from) a customer is
simultaneously bought (sold) in the wholesale
market, the margin representing transaction
costs (overheads, brokerage etc.) and profit
for the bank.
The margin that the bank charges to a
customer is negotiable and is determined by the
following factors,-
• Size of the transaction
• Customer relationship
• Customer awareness
Forward
A forward exchange contract is an
agreement between a bank and another
party to exchange one currency for
another at some future date. The rate at
which the exchange is to be made, the
delivery date and the amounts involved
are fixed at the time of agreement.
Forward Contract
• Transaction in which Buyer and
Seller agree upon
– The delivery of a specified quantity & quality
of an asset
– At a specified future date
– At a specified price
FORWARDS
Definition:
•
An FX Transaction in which two parties agree TODAY to exchange
currencies on a SPECIFIC FUTURE date & at a SPECIFIC RATE.
•
The Future date is known as the forward date.
•
It is a Combination of Spot Rate and Interest Rates.
•
FORWARD PRICE =
• BUY: Spot + (Spot x Higher Interest Rate/100 x FwdTenor/360) - ((1 x Lower Interest
Rate/100) x FwdTenor/360) x Spot
• SELL: Spot + (Spot x ((1 + Higher Interest Rate/100 x FwdTenor/360) / (1 + Lower
Interest Rate/100 x FwdTenor/360) - 1))
•
If BASE Currency Interest Rate is High then the Forward is at Discount;
If BASE Currency Interest Rate is Low then the Forward is at Premium.
•
Can be used for both Hedging and Trading Purposes.
FORWARDS Dissection
Client
Bank Sell
3 Month USD
Forward
Client Sell
3 Month
Forward
At Maturity Bank
Delivers the USD
to Client
At Maturity Client
Delivers the BDT
to Bank
BANK
FX DESK
Bank Deposit
USD for 3 Month
Bank Pay Bank
BDT Spot Borrow
BDT for
3 Month
Bank Buy
USD Spot
FX
Market
Money
Market
HEDGING FX EXPOSURE BY
SINGLE FORWARD DEAL
Company XYZ Opened USD 250,000 LC, payable after 90 days.
Current USD-BDT Spot Rate is 66.25. The Customer feels that the
USD-BDT Spot rate may go as high 68.00 which will cause loss in
overall business. The Customer wants to hedge its Forex risk.
• Assumptions
= 90 Days USD Interest Rate = 3.50%
= 90 Days BDT Interest Rate = 9.00%
• Break-Even Forward Selling Rate =
=> Spot + (Spot x ((1 + Higher Interest Rate/100 x FwdTenor/360) / (1 + Lower Interest
Rate/100 x FwdTenor/360) - 1))
=> 66.25+(66.25 x ((1+9/100 x 90/360) / (1+3.5/100 x 90/360)-1)) = 67.1530
Forward Contracts:
Payoff Profiles
profit
Long forward
F(0,T)
profit
S(T)
The long profits if the spot price at
delivery, S(T), exceeds the original
forward price, F(0,T).
Short forward
F(0,T)
S(T)
The short profits if the price at
delivery, S(T), is below the
original forward price, F(0,T).
Premium and discount:
• Forward rates are quoted in terms of
premiums and discounts on the spot
rates.
• Swap points=Forward rate-spot rate
• Forward rate>Spot rate=Premium
• Forward rate<spot rate=Discount
» (Ref. Commodity currency)
Example of Forward
• Suppose Spot rate $1=Tk 40, Cost to a bank for borrowing taka for
90 days is 9%per annum. Bank can invest in US$ for 90 days at 6%
per annum.
– Interest rate differential=3%
– Swap points=40*(3/100)*(90/360)=0.3
– So the spot rate must be adjusted by 0.3
• But it is to be added or subtracted?
– Bank borrows @9%;but can earn only @6%; so if $1=Tk 40 for
immediate delivery, it should be more expensive to settle for future
delivery in order to compensate for 3% loss.
• Forward rate =Tk 40+0.30=40.30
FORMS OF FORWARD
• Outright forward :An outright is a forward
purchase or sale of a currency at a foreign
exchange rate which expresses the actual
price of one currency for a specific value
date.
• SWAP:Combination of spot and forward.
Simple Currency SWAP
An Overview
Definition
Currency Swap can be defined as the exchange of one
currency for another with an obligation to reverse the
exchange at a future date.
 Price of both the exchange and the reversal are fixed at
the onset of the deal.
 SWAP is similar to Repo/Reverse repo transaction, i.e. Sell
and Buy back or Buy and Sell back of one currency for
another.
FOREIGN EXCHANGE SWAP
Definition
• The simultaneous purchase and sale of a currency for two
different dates
• One of which is the spot delivery date (or before) and the other
occurring after this date.
• Funds are exchanged on each date.
• Deal is Done in the form of BUY/SELL or SELL/BUY
Key Purpose
•
•
Cash Flow Management
Money Market Arbitrage
Mechanism & Pricing Calculation
A Swap transaction involves:
 today’s spot price,
 a fixed tenor
 interest rate of base currency
 interest rate of variable currency
 near leg of the deal (SPOT)
 far leg of the deal (FWD)
 Spot leg of the deal is priced at current market rate
 To calculate the price of far leg of the deal the future value
of both the currencies are calculated and divided.
Example
Let us look at a Swap of USD/BDT 1.0 million for 7-days, and
assume that the Spot Usd/Bdt price is 63.20. Counterparty 1 (CPT1)
will Buy/Sell and opposite will be true for Counterparty 2 (CPT2) who
will Sell/Buy.
CPT1 will receive $1.0mln
CPT2 will receive BDT63.2mln
 Place $1.0mln for 7-Days
and earn interest of (say) 2.5%
=> 1,000,000*7*2.5/36000 =
$486.11
 Place BDT63.20mln for 7-days
and earn interest of (say) 6.0%
=> 63,200,000*7*6.0/36000 =
BDT73,333.33
BDT (63,200,000+73,333.33)
Swap price (break even) =
=
USD (1,000,000+486.11)
BDT 63,273,333.33
USD 1,000,486.11
= 63.2426
Day One
Example
BDT 69,200,000
CPT 1
CPT 2
USD 1,000,000
Day Seven
CPT2 will receive $1,000,000.00 (note: USD is paid without
interest as the interest earned in USD is priced into the swap
calculation for BDT)
USD 1,000,000
CPT 1
CPT 2
BDT 69,242,600
ILLUSTRATION : FX SWAP - FC / BDT
• On Jan 01 CBC Sold USD 250,000 to its Import Client
for 3 Months against BDT, Value Date Mar 30 @ 66.00
• The Client will be allowed to take delivery of the
Forward on any day from the end of 2 months (Feb 28)
till the maturity date (Mar 30).
• CBC Purchased same amount of forward from Export
Client for the same tenor (Value Mar 30), but without
any early delivery option @ 65.00
– After 2 Months, the Import Client Claimed the Forward
Amount USD 250,000.00
ILLUSTRATION continues
CASH FLOW OF CBC
• CBC is Short USD 250,000.00 on Feb 28 since it has to Pay
the Import Client from its Nostro Account.
• CBC is Long USD 250,000.00 on Mar 30 since it will Receive USD
from the Export Client in its Nostro Account.
Feb 28
(USD 250,000)
Mar 30
+ USD 250,000
• CBC has to do a USD 250,000 BUY/SELL SWAP Value Date Feb
28 and Mar 30 to match the cash flow:
Feb 28
(USD 250,000)
+USD 250,000
Mar 30
+ USD 250,000
(USD 250,000)
ILLUSTRATION continues
Calculation:
(SpotRate x No. of Days) x (VariableCurrency Interest Rate - BaseCurrency
InterestRate)
--------------------------------------------------------------------------------------------------------((No. Of Days x BaseCurrencyInterestRate) + (360 x 100)
If Spot USD-BDT Rate
Base Currency Interest Rate
Variable Currency Interest Rate
Number of Days
Swap Points =
= 66.00
= 3.25%
= 6.70%
= 30
(66.00 x 30) x (6.70 - 3.25)
----------------------------------- = 0.189237
((30 x 3.25) + (360 x 100))
BUY/SELL Rate = 66.00 / 66.189237
Note: This is applicable when CBC prefers to use BDT in the SWAP.
Alternative is also possible in case CBC prefers to use other currency
i.e. GBP.
Regulatory Requirements
• Regulators generally limit banks to use fx
products for hedging purposes. BB has devised
the following regulations in GFET,1996.
• 1. ADs, on their own, are free to buy and sell
foreign currencies forward in accordance with the
internationally established practices however, in
all cases the ADs must ensure that the cover is
intended to neutralize the risks arising from
definite and genuine transactions.
• 2. Be it forward sale or purchase, ADs must cover
their own risk within the shortest possible time.
GFET(ch-6)
3. All forward contracts should be treated as firm and should be closed out on expiry. In
such cases the ADs should charge the difference between the contracted (booked) rate
and the TT clean spot buying or TT spot selling rate, as the case may be, ruling on the
date the contract is closed out. The forward contract should be closed without charging
any difference if the rate moves in favour of the customer on the date of the closure. In
other words, in case of a forward purchase by Authorized Dealer no difference will be
charged if the TT spot selling rate on the date of closure is at par or lower (i.e., inferior
from the point of view of tile customer) than the booked rate. Similarly, no difference
should be charged for closing out a forward sale contract if the TT clean spot buying
rate on the date of closure is at par or higher (i.e., costlier than the booked rate from
the point of view of the customer) than the booked rate. No forward contract should be
renewed at the old rate. All cases of renewal should be treated as new contracts and
the rates as applicable for purchase-sale of forward contracts on the date of renewal
should be applied.
GFET,1996 (ch-6)
4. The ADs may undertake swap transactions to
cover their risks arising from forward
transactions. However, they are advised to refrain
from taking speculative positions through swap
transactions.
5. All documents (copy of LC, contracts etc.)
relating to forward contracts and Swap
transactions must be, preserved for subsequent
inspection by the Bangladesh Bank.
CIRCULARS
•
•
•
•
FE Circular No-21;dated 26-10-2002
FE Circular No-02;dated 25-02-2004
FE Circular No-01;dated 04-01-2005
FE Circular No-03;dated 23-02-2005
»THANK YOU
SWAP CALCULATIONS
USING INTEREST RATE
BUY/SELL
SPOT RATE
NO.OF DAYS
Base ccy FC INTEREST RATE
Var ccy
LOCAL INTEREST RATE
SWAP POINTS=
PRICE:
70.0000
30
3.25
6.7
0.2007
70.2007