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Chapter 5: Use of Currency Derivatives

18 Mins 26 Apr 2023 0 COMMENT

In Jan 2023, Argentina's local artist Sergio Guillermo Diaz started painting on currency notes. In an interview with Reuters, He told that Once I paint on it, I could sell it for much more than what the bill is worth. As the annual inflation soared nearly 100% last year, the largest currency note of Argentina, the 1000 peso bill, is worth around 5.6 USD.

 

Source: Reuters

Don’t get worried; currencies have other use too. Currency and its derivatives have some other better use as well.

Have you ever thought about how global businesses manage their currency risk? Let’s go through a real-world problem.

Suppose Amish runs an export house in India where he exports goods to many countries, including the USA and European countries. He receives payment in USD and Euros as per the payment terms, but he is always worried about what would be his actual cash flow as he needs to convert the USD/Euro to INR as per the prevailing rate when the payment arrives in his account. He can control the cash flow in foreign currency but can’t control the cash flow in INR due to fluctuating conversion rates. It means his profit margin will also fluctuate and could positively and negatively impact his margins. And Amish is not alone. Many firms, including big corporates, face these issues. So, how do they manage?

Currency derivatives are considered one of the best options to manage the risk involved in foreign currency exchange exposure. The three primary players in these markets are:

 

Directional trader: Directional traders or speculators try to take long and short positions in the Futures as per the appreciation or depreciation of the currency. Leveraging also helps as they can take significant positions with a small investment and maximize returns on investments.

Hedgers: These players have real exposure to foreign currency and want to hedge their currency conversion price risk with the help of currency derivatives.

Arbitrage: These players take advantage of the difference in exchange rates of the same currency in different markets or segments and try to profit from those transactions.

Directional trading

These directional traders take positions according to expected currency movement in the future. For example, if traders expect the USD to appreciate against INR, they will prefer to buy USDINR Future. Similarly, they will choose to go short if they expect a fall in USD against INR. Not only Futures, but traders can also take positions in Options as per their view in the market.

Hedging

In simple words, hedging means minimizing expected losses. Hedging is a mechanism by which the participants in the physical / cash markets can cover their price risk. The cost of carry determines the relationship between the Futures and cash prices. The two prices, therefore, move in tandem. This enables the participants in the physical/cash markets to cover their price risk by taking the opposite position in the Futures market. Cost of Carry or CoC is an investor's cost for holding a specific Futures contract until it expires. The longer the expiry period, the higher the cost of carry. On expiry, the cost of carry becomes zero and the Futures price converges with the spot price.

Let's understand hedging with an example:

Example: Mr. X is an exporter who is supposed to receive 2000 US Dollars in two months for exported goods. The current USDINR spot rate is Rs. 80 and his expected receivable as per the current USDINR rate is Rs. 160000. (2000 * 80).

He wants to lock his receivable at the current spot price from any possible risk of appreciation in the Indian Rupee. Accordingly, today he sold two lots of USDINR Futures (1 lot = 1000 USD), which expire after two months, at today's USDINR Futures rate of Rs. 80.10 (2000 * 80.10 = 160200).

Suppose after two months at the time of expiry, the USDINR spot falls to Rs. 78 and subsequently USDINR Futures also converse to the spot price of Rs. 78. Mr. X receives 2000 USD, the same he converts to INR and receives Rs. 156000 (2000 * 78), Rs. 4000 less than expected receivable (160000 - 156000). But at the same time, he will repurchase two lots of USDINR Futures contracts at 78, which he earlier sold for hedging and book a profit of Rs. 4200 [(2000 * (80.1 - 78)]and recover losses caused by appreciation in INR.

So this way, exporters can hedge their futures receivables and minimize expected risk through currency derivatives.

 Let us understand hedging with another example for an importer:

Suppose Mr. X is an importer going to pay 1000 US dollars for their order in two months and want to protect himself from an expected depreciation in the Indian Rupee (INR) from the current level of Rs 80 per Dollar. To minimize this risk, he bought one lot of USDINR Futures contracts today at Rs. 80.10. Suppose, as per expectation, USDINR appreciates in two months to Rs. 82, then he will pay Rs. 2000 more on his import bills, but this loss will be recovered by booking a profit of Rs. 1900 on selling your Futures position at Rs 82 per Dollar.

Arbitrage

Other players in the currency markets are Arbitrageurs who take a position in different currencies and take advantage of the currency conversion rate of different currencies, but these opportunities are rare in the market.

Another way of arbitrage is to trade in different currency markets and try to encash the price difference between the two markets. For example, if a currency is quoted for 100 units in one market and 100.5 in another, a trader can buy the currency at 100 and sell it in another market at 100.5.

But have you ever thought of borrowing in one country where interest rates are low and investing in another where interest rates are high? For this, we need to understand the concept of interest rate parity and how forward rates are impacted.

Let's understand this with an example of USDINR.

Forward premium and Interest rate parity

We know that there is a lot of difference in the interest rate of the US and Indian markets. The fed interest rate in the US market is 4.5% in Dec 2022. On the other hand, in India, the repo rate is 6.25%. It seems evident that if we can borrow from the US market and invest in the Indian market, we can earn 1.75% easily. This seems like a dream arbitrage opportunity. Let us understand this with an example. Suppose you borrow 1000 USD in the US market at an annual interest rate of 4.5%. Assuming the conversion rate of USD is 82 INR, you can convert the 1000 USD into 82000 INR and invest at 6.25% p.a. interest. After a year, this amount becomes = 82000 + (82000 * 0.0625) = INR 87,125. You can again convert this amount into USD at the same price and receive = 87125 / 82 = 1062.5 USD.

We need to pay the principal and interest back to the US lender and pay 1000 + (1000 * 0.045) = 1045 USD to the lender. Therefore, we can save 1062.5 – 1045 = 17.5 USD on this arbitrage transaction. This is equivalent to 1.75% of 1000 USD.

But this could be possible with dream assumptions like currency conversion rate will remain constant, money flow across the border is unrestricted, no transaction charges, etc. But in the real world, all these things are not possible. So there is no risk-free profit in this world.

Now, if there is no risk-free profit exist, then currency value should be adjusted in such a way that INR 87,125 received after a year should be equivalent to the amount that we need to pay in USD to the lender, i.e., 1045 USD

So the value of the USDINR pair after one year would be = 87125 / 1045 = 83.37

So in the currency market, the forward price of a 1-year contract would equal 83.37.

Forward price = Spot rate * (1+ N* ) / ( 1+ N* )

Where N is the no. of years.

Calculating the forward price in this way is known as interest rate parity.

We can verify the forward rate by the above equation.

Forward price = 82 * (1 + 0.0625) / (1 + 0.045) = 83.37. This is known as the forward premium, quoted above the spot rate of INR 82. A country's currency will depreciate, which has a higher interest rate. In this example, the rupee depreciated from INR 82 to INR 83.37 in a year.

Similarly, we can also calculate the approximate forward rate by the difference in the interest rate. 

F = Spot price * (1 + difference in the interest rate)

F = 82 * (1 + 0.0175) = 83.43

Now, you can see this type of arbitrage is difficult. Future currency prices also depend on the difference in interest rates of both countries.

Now, this brings us to the end of the currency module. So, now you are confident to trade in currency derivatives.

Summary

  • Three major players in the currency derivatives market are Directional traders, Hedgers, and Arbitrageurs.
  • Hedgers use currency derivatives to hedge their exposure to foreign currency. For example, exporters can take a short Future position and importers can take a long position to hedge their foreign currency exposure.
  • Arbitrageurs can gain from the price difference by trading currency in different markets or segments.
  • Future premium also depends on the difference in the interest rates of the two counties for the concerned currencies in a Future contract.

Congratulations! You are now through with the currency course. Revisit any of these chapters at any time to familiarize yourself with the basics and boost your understanding. Happy trading!

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