Derivatives as a Risk Management Tool Risk Management An effective manager should be aware of the various financial instruments available in the market for managing financial risks. There are many tools for the same and a judicious mix of various tools helps in efficient risk management. Since the early 1970s, the world has witnessed dramatic increases in the volatility of interest rates, exchange rates and commodity prices. This is fuelled by increasing internationalization of trade and integration of the world economy, largely due to technological innovations. The risks arising out of this internationalization are significant. They have the capacity to make or break not only businesses but also the economies of nations. However, financial institutions are now equipped with tools and techniques that can be used to measure and manage such financial risks. The most powerful instruments among them are derivatives. Derivatives are financial instruments that are used as risk management tools. They help in transferring risk from the risk averse to the risk taker. Risk in case of Foreign exchange transactions Foreign exchange rate is the value of a foreign currency relative to domestic currency. The exchange of currencies is done in the foreign exchange market, which is one of the biggest financial markets. The participants of the market are banks, corporations, exporters, importers etc. A foreign exchange contract typically states the currency pair, the amount of the contract, the agreed rate of exchange etc. There are mainly two methods employed by governments to determine the value of domestic currency vis-à-vis other currencies: fixed and floating exchange rate. Fixed exchange rate regime: Fixed exchange rate, also known as a pegged exchange rate, is when a currency's value is maintained at a fixed ratio to the value of another currency or to a basket of currencies or to any other measure of value e.g. gold. In order to maintain a fixed exchange rate, a government participates in the open currency market. When the value of currency rises beyond the permissible limits, the government sells the currency in the open market, thereby increasing its supply and reducing value. Floating exchange rate regime: Unlike the fixed rate, a floating exchange rate is determined by a market mechanism through supply and demand for the currency. A floating rate is often termed "self-correcting", as any fluctuation in the value caused by differences in supply and demand will automatically be corrected by the market. For example, if demand for a currency is low, its value will decrease, thus making imported goods more expensive and exports relatively cheaper. The countries buying these export goods will demand the domestic currency in order to make payments, and the demand for domestic currency will increase. This will again lead to appreciation in the value of the currency. Therefore, floating exchange rate is self correcting, requiring no government intervention. However, usually in cases of extreme appreciation or depreciation of the currency, the country’s Central Bank intervenes to stabilize the currency. Thus, the exchange rate regimes of floating currencies are more technically called a managed float. There are various factors affecting the exchange rate of a currency. They can be classified as fundamental factors, technical factors, political factors and speculative factors. As we cannot avoid any risk in case of continuous changes in rates, what we can do is hedge by entering into derivatives. Tools for risk diversification: Derivatives : Currency Futures Derivatives are financial contracts whose value is determined from one or more underlying variables, which can be a stock, a bond, an index, an interest rate, an exchange rate etc. The most commonly used derivative contracts are forwards and futures contracts and options. There are other types of derivative contracts such as swaps, swapoptions, etc. Currency derivatives can be described as contracts between the sellers and buyers whose values are derived from the underlying which in this case is the Exchange Rate. Currency derivatives are mostly designed for hedging purposes, although they are also used as instruments for speculation. Currency markets provide various choices to market participants through the spot market or derivatives market. Before explaining the meaning and various types of derivatives contracts, let us present three different choices of a market participant. The market participant may enter into a spot transaction and exchange the currency at current time. The market participant wants to exchange the currency at a future date. Here the market participant may either: • Enter into a futures/forward contract, whereby he agrees to exchange the currency in the future at a price decided now, or, • Buy a currency option contract, wherein he commits for a future exchange of currency, with an agreement that the contract will be valid only if the price is favorable to the participant. Forward Contracts Forward contracts are agreements to exchange currencies at an agreed rate on a specified future date. The actual settlement date is more than two working days after the deal date. The agreed rate is called forward rate and the difference between the spot rate and the forward rate is called as forward margin. Forward contracts are bilateral contracts (privately negotiated), traded outside a regulated stock exchange and suffer from counter-party risks and liquidity risks. Counter Party risk means that one party in the contract may default on fulfilling its obligations thereby causing loss to the other party. Futures Contracts Futures contracts are also agreements to buy or sell an asset for a certain price at a future time. Unlike forward contracts, which are traded in the over-the-counter market with no standard contract size or standard delivery arrangements, futures contracts are exchange traded and are more standardized. They are standardized in terms of contract sizes, trading parameters, settlement procedures and are traded on a regulated exchange. The contract size is fixed and is referred to as lot size. Since futures contracts are traded through exchanges, the settlement of the contract is guaranteed by the exchange or a clearing corporation and hence there is no counter party risk. Exchanges guarantee the execution by holding an amount as security from both the parties. This amount is called as Margin money. Futures contracts provide the flexibility of closing out the contract prior to the maturity by squaring off the transaction in the market. Strategies using Currency Futures Futures contracts act as hedging tools and help in protecting the risks associated with uncertainties in exchange rates. Anyone who is anticipating a future cash outflow (payment of money) in a foreign currency, can lock-in the exchange rate for the future date by entering into a futures contract. For example, let us take the example of an oil-importing firm – Mahesh & Co. The company is expected to make future payments of USD 1,00,000 after 2 months in USD for payment against machinery imports. Suppose the current 2-month futures rate is Rs. 45, then Mahesh & Co. has two alternatives: OPTION A: Mahesh & Co. does nothing and decides to pay the money by converting the INR to USD. If the spot rate after two months is Rs. 47, the Mahesh & Co. will have to pay INR 47,00,000 to buy USD 100000. Alternatively, if the spot price is Rs. 43.0000, Mahesh & Co. will have to pay only INR 43,00,000 to buy USD 100000. The point is that Mahesh & Co. is not sure of its future liability and is subject to risk of exchange rate fluctuations. OPTION B: Mahesh & Co. can alternatively enter into a futures contract to buy 1,00,000 USD at Rs. 45 and lock in the future cash outflow in terms of INR. In this case, whatever may be the prevailing spot market price after two months the company’s liability is locked in at INR 45,00,000. In other words, the company is protected against adverse movement in the exchange rates. This is known as hedging and currency futures contracts are generally used by hedgers to reduce any known risks relating to the exchange rate. In a currency futures contract, the party taking a long (buy) position agrees to buy the base currency at the future rate by paying the terms currency. The party with a short (sell) position agrees to sell the base currency and receive the terms currency at the pre-specified exchange rate. When the base currency appreciates and the spot rate at maturity date (S) becomes more than the strike rate in the futures contract (K), the ‘long’ party who is going to buy the base currency at the strike rate makes a profit. The party with the ‘long’ position can buy the USD at a lower rate and sell in the market where the exchange rate is higher thereby making a profit. The party with a ‘short’ position loses since it has to sell the base currency at a price lower than the prevailing spot rate. When the base currency depreciates and falls below the strike rate (K), the ‘long’ party loses and a ‘short’ position gains. Short Hedge Exporter MAHESH & CO. is expecting a payment of USD 1,000,000 after 3 months. Suppose, the spot exchange rate is INR 47.0000 : 1 USD. If the spot exchange rate after 3-months remains unchanged, then MAHESH & CO. will get INR 47,000,000 by converting the USD received from the export contract. If the exchange rate rises to INR 48.0000 : 1 USD, then MAHESH & CO. will get INR 48,000,000 after 3 months. However, if the exchange rate falls to INR 46.0000 : 1 USD, then MAHESH & CO. will get INR 46,000,000 thereby losing INR 1,000,000. Thus, MAHESH & CO. is exposed to an exchange rate risk, which it can hedge by taking an exposure in the futures market. By taking a short position in the futures market, MAHESH & CO. can lock-in the exchange rate after 3months at INR 48.0000 per USD (suppose the 3 month futures price is Rs. 48). Since a USD-INR futures contract size is of 1000 USD, MAHESH & CO. has to take a short position in 1000 contracts. Whatever may be the exchange rate after 3-months, MAHESH & CO. will be sure of getting INR 48,000,000. A loss in the spot market will be compensated by the profit in the futures contract and vice versa. This can be explained as under: If USD strengthens and the exchange rate becomes INR 49.0000 : 1 USD Spot Market: MAHESH & CO. will get INR 49,000,000 by selling 1 million USD in the spot market. Futures Market: MAHESH & CO. will lose INR (48 – 49)* 1000 = INR 1000 per contract. The total loss in 1000 contracts will be INR 1,000,000. Net Receipts in INR: 49 million – 1 million = 48 million If USD weakens and the exchange rate becomes INR 47.0000 : 1 USD Spot Market: MAHESH & CO. will get INR 47,000,000 by selling 1 million USD in the spot market. Futures Market: MAHESH & CO. will gain INR (48 – 47)* 1000 = INR 1000 per contract. The total gain in 1000 contracts will be INR 1,000,000. Net Receipts in INR: 47 million + 1 million = 48 million An exporting firm can thus hedge itself from currency risk, by taking a short position in the futures market. Irrespective, of the movement in the exchange rate, the exporter is certain of the cash flow. Long Hedge An Importer, IMP, has ordered certain computer hardware from abroad and has to make a payment of USD 1,000,000 after 3 months. The spot exchange rate as well as the 3months future rate is INR 48.0000 : 1 USD. If the spot exchange rate after 3-months remains unchanged then IMP will have to pay INR 48,000,000 to buy USD to pay for the import contract. If the exchange rate rises to INR 49.0000 : 1 USD, then IMP will have to pay more - INR 49,000,000 after 3 months to acquire USD. However, if the exchange rate falls to INR 47.0000 : 1 USD, then IMP will have to pay INR 47,000,000 (INR 1,000,000 less). IMP wants to remain immune to the volatile currency markets and wants to lock-in the future payment in terms of INR. IMP is exposed to currency risk, which it can hedge by taking a long position in the futures market. By taking long position in 1000 future contracts, IMP can lock-in the exchange rate after 3-months at INR 48.0000 per USD. Whatever may be the exchange rate after 3-months, IMP will be sure of getting the 1 million USD by paying a net amount of INR 48,000,000. A loss in the spot market will be compensated by the profit in the futures contract and vice versa. This can be explained as under: If USD strengthens and the exchange rate becomes INR 49.0000 : 1 USD Spot Market: IMP has to pay more i.e. INR 49,000,000 for buying 1 million USD in the spot market. Futures Market: IMP will gain INR (49 – 48)* 1000 = INR 1000 per contract. The total profit in 1000 contracts will be INR 1,000,000. Net Payment in INR: – 49 million + 1 million = 48 million If USD weakens and the exchange rate becomes INR 47.0000 : 1 USD Spot Market: IMP will have to pay less i.e. INR 47,000,000 for acquiring 1 million USD in the spot market. Futures Market: The importer will lose INR (48–47)* 1000 = INR 1000 per contract. The total loss in 1000 contracts will be INR 1,000,000. Net Payment in INR: - 47 million - 1 million = 48 million An importer can thus hedge itself from currency risk, by taking a long position in the futures market. The importer becomes immune from exchange rate movement. Derivatives in India: The phenomenal growth of financial derivatives across the world is attributed to the fulfillment of needs of hedgers, speculators and arbitrageurs by these products. In India, finally these contracts can be used by various entities at the NSE. The Reserve Bank of India has currently permitted futures only on the USD-INR, GBP-INR, EUR-INR, JPY-INR. Trading Hours: The trading on currency futures is available from 9 a.m. to 5 p.m. from Monday to Friday. Size of the contract: The minimum contract size of the currency futures contract at the time of introduction is USD/EUR/GBP/ 1000 against INR and in case of JPY-INR it is JPY-1,00,000. Tenor of the contract The maximum maturity of the contract would be 12 months. Available contracts All monthly maturities from 1 to 12 months would be made available. Settlement mechanism The contract would be settled in cash in Indian Rupee. Settlement price The settlement price would be the Reserve Bank Reference Rate on the date of expiry.