Derivatives and Their Need in Foreign Exchange Management
Corporates face different types of risks related to foreign exposure in their domestic and international operations. These risks can be related to international trade transactions, international financial transactions, etc. Apart from exchange rate-related risks, there can be risks related to interest rate volatility on foreign assets and liabilities.
Forex derivatives are the major tools that can be used for hedging the above risks. Hedging can be defined as a technique for reducing the risk of loss arising out of the exchange rate volatility (or volatility of other underlying variables like interest rate) by purchasing or selling of equal quantities of the same or very similar currency exposures.
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It is done with an expectation that the future change in price in one market will be offset by an opposite change in the other market. For example, import payable results in a transaction exposure to foreign currency whose value can be affected by the exchange rate volatility. This is an exposure to a foreign currency in the spot market. The importer is said to be short on the currency on a payable date. A short position implies that any increase in the value of foreign currency will increase cost in the home currency.
This exposure for the purchase of foreign currency can be hedged with an exposure in the futures market. By purchasing currency futures now, a possible loss due to a higher exchange rate on the future date in the spot market can be nullified by selling currency futures at profit on the same date in the futures market. In other words, an increase in the value of foreign currency will increase costs due to a short position.
However, an increase in the value of foreign currency will lead to a profit in the long position taken in the currency futures market offsetting loss in the spot position. This is an example of how the hedging of exposure (in the spot market) can be done by taking an opposite exposure in another market (i.e., futures market). In the above example, future payable requires buying foreign currency at a future date, while the squaring off of the currency futures (purchased now) would involve selling currency futures on the same date, thereby offsetting any loss/gain. This is how hedging is done using a derivative product.
A derivative instrument is defined in IAS 39 as follows:
- “A derivative is a financial instrument
- Whose value changes in response to the change in an underlying variable such as an interest rate, commodity or security price, or index;
- That requires no initial investment, or one that is smaller than would be required for a contract with similar response to changes in market factors; and
- That is settled on a future date”
From the above definition of a derivative instrument, the following points can be concluded: - Currency futures is a derivative financial instrument whose value depends on the underlying variable, i.e., the exchange rate.
- The value of a currency futures changes in accordance with the changes in the exchange rate in the spot market.
- Investment in currency futures requires no initial investment except for minimal margin deposit (in the case of exchange-traded derivatives).
- It is settled in the future on the maturity date of the contract.
Note that the value of a derivative instrument changes in accordance with changes in the underlying variable. Both these values move in the same direction, which enables hedging by taking opposite positions in spot and futures markets.
Similar to currency futures, there are several other derivative products, viz., forward rate agreements, currency options, interest rate swaps, currency swaps, etc. All these derivative products can be used for hedging different kinds of risks encountered by banks and corporates.
- Whose value changes in response to the change in an underlying variable such as an interest rate, commodity or security price, or index;
- Various risks that can be hedged through derivative instruments are:
- Exchange rate risks
- Interest rate risks
- Price risks
- Credit risks
- Forex risks related to assets and liabilities denominated in foreign currencies can also pertain to interest rate uncertainties on different currencies. Hence, the underlying variable in currency derivatives can be:
- Exchange rates between currencies or
- Interest rates (on assets/liabilities)
Table 10.1 explains the purpose of different types of derivative products and costs associated with them:
| Derivative Product | For Hedging | Upfront Costs |
|---|---|---|
| Forward contracts | Exchange rate volatility | None |
| Forward rate agreements | Interest rate volatility | None |
| Currency futures | Exchange rate volatility | None |
| Currency options | Exchange rate volatility | Option premium |
| Interest rate swaps | Interest rate risks, asset-liability mismatches | None |
| Currency swaps | Interest rate risks, asset-liability mismatches | None |
| Complex derivatives | For any of the above tailored to meet the needs of corporates/banks | Depends |
Derivatives can also have other underlying variables like commodities, equities, bonds, etc. Derivative financial instruments are basically contracts that are settled on a future date based on the future value of the underlying. These contracts can be different depending on how the risks are managed.
Depending on the nature of the contract, derivatives can be any of the following types:
- Forward rate agreements
- Currency futures
- Currency options
- Interest rate and currency swaps
- Complex derivatives like interest rate options, swaptions, etc.
Derivative products can also differ in terms of the market mechanism. They can be traded in either a market like exchange-traded derivatives including futures and options or OTC products like forward contracts and forward rate agreements.
Table shows the market mechanism of various derivatives:
| Derivative Product | Market Mechanism |
|---|---|
| Forward contracts | Over-the-Counter (OTC) |
| Forward rate agreements | OTC |
| Currency futures | Exchange traded |
| Currency options | Exchange traded (OTC also applicable) |
| Interest rate swaps | OTC |
| Currency swaps | OTC |
| Complex derivatives | OTC |
Apart from hedging, derivatives, especially exchange-traded derivatives, serve several other functions in financial markets. Some of these functions are:
- Hedging risks
- Speculating on prices of underlying
- Price discovery
You have already studied the meaning of hedging. Speculation refers to trading for making short-term profits by speculating on price movements of the underlying asset but using derivatives instead of the underlying asset, as derivatives do not require initial investments. Price discovery is an economic function associated with asset markets. As several market participants with different risks and respective views on asset price movements participate in the derivative trading, it leads the underlying asset price to move towards its intrinsic value over a period of time.
For example, if the rupee is overvalued now and everybody expects rupee to depreciate in the future, the resulting transactions will automatically bring down the value of the rupee in the spot market. However, if there is no market through which market participants can express their views on the future price, the rupee will remain overvalued in the spot market leading to inefficient asset allocation.
Exchange Traded Vs OTC Products
The derivative products like futures and options are exchange-traded as against the OTC nature of forward contracts. The very concept of price or return of a derivative instrument arises because the derivatives are generally exchange-traded. This means these products are standardised and listed in derivative exchanges and can be traded in secondary markets like equity products. Since trading in secondary markets is possible, there is no physical settlement in general for these exchange-traded derivative products (though possible).
The primary return from the derivative product depends on the price of the derivative product between the dates of purchase and sale. The price of the derivative product, in turn, is determined by the price of underlying asset on which the derivative instrument is created. The exchange-traded nature of the derivative products implies that there need not necessarily be an underlying risk exposure. The derivative products can, thus, be traded for purely speculative purposes.
This is in contrast to outright forward contracts that are primarily used for hedging an existing risk exposure. Though most of the futures and option products are exchange-traded, there are also OTC derivative products – these are basically tailor-made contracts between two counterparties as per their own requirements. These OTC derivatives cannot be listed in exchanges and hence no secondary trading is possible.
This implies that the OTC derivative products generally have an underlying exposure in the assets concerned, and hence, the primary purpose of these products is to hedge the risks involved. OTC derivatives are resorted to when the standard exchange-traded products are not amenable for hedging the exposure. Forward contracts can be termed the OTC derivative products with the foreign exchange as the underlying asset and the exchange rate volatility being the risk hedged.
However, with the advent of exchange-traded derivatives, it is also possible to hedge exchange rate risks with currency futures. Forward rates are quoted in terms of points in foreign exchange markets and referred to as pips. These points show the variation between the forward exchange rate quote and the spot exchange rate quote. It is important to note that the base currency is traded at forward premium when the forward rate is more than the spot rate. On the other hand, the base currency is traded at discount when the spot rate is higher than the forward rate.
Trading Mechanism
Majority of the transactions pertaining to bank-to-bank derivatives take place in the interbank broker market, which makes this market one of the most crucial segments of the Foreign Exchange (FX) derivatives market. Interbank brokerage firms participate in the FX derivatives market to deal on behalf of the bank. These brokerage firms work through their teams that integrate them with the international derivatives market. The categorisation of brokers can be done on the basis of currency blocks such as G10 majors or Asia EM.
They can also be classified on the basis of option types such as vanillas and exotics. Let us discuss the interbank trading mechanism through an illustrative example. The trader at bank A wants to enter into a particular vanilla contract and make request for the price quotation from its broker working at one of the interbank brokerages. This is termed the ‘interest of trader A’ on which the broker starts to search for a suitable deal for that specific vanilla. It should be noted that a broker may work simultaneously for various traders having multiple interests.
Now, broker A will contact the other brokers concerning the interest of the transaction. The brokers will further contact the relevant traders of other banks in the market requesting a price for the interest. Thus, brokers play the main role not only in trading by an individual but also in interbank trading. On the basis of the size of a transaction, a commission is paid to the brokers. It is important to note that, for an individual a booking for various derivatives takes place through their bank that acts as a broker for them. The commission is charged by the bank for providing such kind of financial services.
International Market Innovation
International Cash Management
The term cash management refers to managing cash in terms of maintaining optimal transaction cash balances to cover scheduled cash outflows for the cash budgeting period and maintaining precautionary cash balances necessary for meeting unexpected cash requirements. It also involves investing excess cash for maximum return and borrowing for cash deficits at minimal cost for meeting temporary shortages.
The cash management discipline has a lot more significance in the international context for all kinds of companies: purely domestic companies, companies that have exports/imports and companies that have operations abroad. It becomes a specialised function in the case of MNCs that have subsidiaries in different countries.
Organisations with excess cash try to fulfil their basic objectives, which are:
- Procuring and controlling cash resources of the organisation quickly and efficiently
- Protecting or securing cash reserves from market risks and exposure and maintaining a healthy liquidity position.
- Utilising cash reserves of the organisation in the best possible manner
International Bond Markets
The various types of bond instruments actively issued and traded in the international bond market include the following:
Dim-sum Bonds
These bonds are issued in Hong Kong and are denominated in Chinese yuan and are subjected to Chinese regulations. It is a good option for foreign investors who want to have exposure of yuan-denominated assets. However, organisations based in China or Hong Kong and foreign companies are allowed to issue these bonds, but largely the organisation based in China or Hong Kong deals in these bonds.
Samurai Bonds
These bonds are issued in Tokyo by any non-Japanese company in yen-denomination and are subject to Japanese regulations. The issuers can raise funds to finance investment proposals available in Japan by issuing these bonds. These are also used for hedging foreign exchange rate risks.
Bull Dog Bonds
These bonds are traded in the UK. The investors interested to earn revenue in British pound or sterling can invest in these bonds. The non-British institutions are allowed to raise funds in the UK by issuing the bonds. These bonds can also be purchased by the U.S. investors, but in that case, they would be exposed to the risk if the value of the sterling gets changed.
Masala Bonds
RBI permitted 2 multilateral institutions of India, the International Financial Corporation (IFC) and the Asian Development Bank (ADB), in 2014 so that they can raise funds in the offshore capital market by issuing rupee-denominated bonds called masala bonds. Any Indian corporate, real estate investment trusts and infrastructure investment trusts are allowed to issue masala bonds.
In addition, banks, Non-banking Financial Companies (NBFCs), infrastructure or investment holding companies and companies in the service sector are also allowed to raise capital by issuing masala bonds. The minimum maturity period of the bond is 5 years.
Euro Bonds
A eurobond is a bond that is issued in a particular currency but sold to investors belonging to a country other than the country in whose currency the bond is denominated. For example, if a US MNC issues USD-denominated bonds to investors in Eurozone, then these are eurobonds. Eurobonds can be denominated in any of the currencies like GBP, Swiss francs and yen.
For example, if a Japanese manufacturer issues bonds denominated in yen to US and European investors, these are called Euroyen bonds. Similarly, if a UK manufacturer issues GBP-denominated bonds to international investors in New York, Paris, Tokyo, etc., these are called Eurosterling bonds. More than 80% of all new international bond offerings belong to the eurobond segment of the international bond market.
LIBOR Rate
LIBOR is used as a benchmark reference rate in the international financial market. It is the rate for all unsecured short-term money market instruments. It is quoted as an annualised interest rate as per market conventions. It is also used as reference rate in other loan products. For example, even a medium-term or long-term floating rate loan may be based on the reference rate of LIBOR prevailing in respective time periods. LIBOR is applicable only in interbank or wholesale market.
When corporates access money markets, a spread is added to the LIBOR called “credit spread” based on the credit rating applicable for the company. The interest spread is quoted in terms of basis points. A one percent interest rate corresponds to 100 basis points. Thus, a short-term corporate loan in US dollars can have an interest rate of 3-month USD LIBOR + 70 basis points. If the 3-month LIBOR applicable for the period is 2% p.a., then the lending rate applicable is 2.7% p.a.
