FOREIGN EXCHANGE, TREASURY AND RISK MANAGEMENT: Lecture notes: foreign exchange-Introduction 1.

The foreign exchange market is the largest market in the world 2. Though the worlds currency markets are thought of as the exclusive domain of the largest banks and multinational corporations, nothing could be further from the truth 3. major currencies are traded like commodities, it is distinguished both from the commodity and equity markets by having no fixed base. 4. in other words, the foreign exchange market through communications and information systems consisting of telephones, the internet or other means of instant communication, like, Reuters and Bloomberg 5. the FX market is not located in a building, nor is it limited by fixed trading hours, but is truly a 24 hour global trading system. 6. FX market knows no barriers and trading activity generally moves with the sun from one centre to the next- so that round the clock some a fx market is active somewhere in the world. 7. due to this decentralization, the actual size of the fx market can only be guessed at- estimated at 10 to the power 23 dollars a day!( IBS data) 8. FX market is an OTC market where buyers and sellers conduct business. 9. Many of the traders in the markets have started with the simplest of markets the FX markets, with its credo of buy low and sell high 10. thus the fx market is a global network of buyers and sellers of currencies with a fx transaction being a contract to exchange one currency for another currency at an agreed rate on an agreed date. 11. What began as a way of facilitating trade across country borders has grown into one of the most liquid, hectic and volatile markets in the world- where banks and many hedge funds are the major players and have the potential of generating huge profits or losses. 12. The fx market includes the cash market and the derivatives market. Our focus will be on the cash market, which is commonly referred to as the SPOT market.

13. A FX rate or a currency rate is simply the price of one countrys money in terms of anothers. 14. FX rates are affected by many factors, in the end, currency prices are a result of supply and demand forces 15. the worlds currency markets can be viewed as a huge melting pot:In a large and ever changing mix of current events, supply and demand factors are constantly shifting and the price of one currency in relation to the other shifts accordingly. 16. No other market encompasses as much of what is going on in the world at any given time as Fx market! 17 . Approximately 80% of fx transactions has a dollar leg. The US$ plays such a large role in the markets due to: a) it is used as an investment currency throughout the world b) it is a reserve currency held by many central banks c) it is transaction currency in many international commodity markets d) monetary bodies use it as an intervention currency for operations in their own currencies. 18. The most widely traded currency pairs are: a) USD/JPY b) EUR/USD c) GBP/USD d) USD/CHF 19. in general the EUR/USD is the most traded currency pair and has a 30% market share. It is followed by the USD/JPY with a 20% market share and GBP/USD with 11% share. 20. Most national currencies are represented in the fx market. USD/INR has an approximate market share of just over 1%, but it is growing ( 0.02% in 1995) 21. Most currencies operate under floating exchange rate mechanisms against one another. Rates can rise or fall depending largely on economic,political and military situations in a given country. 22. Basic information and definitions of FX and the FX market are as below: * Foreign exchange market is a global network of buyers and sellers of currencies. * FX is the exchange of one currency for another * FX rate is the price of one currency expressed in terms of another currency

*FX transaction is a contract to exchange one currency for another currency at an agreed rate on an agreed date * Spot rate is the ratio at which one currency is exchanged for another for settlement in TWO business days ( value date).

CASE STUDY 1- EMBA DEC 11

WHAT A DIFFERENCE A FEW PERCENTAGE POINT MOVES ON THE EXCHANGE RATE MAKE! Until Autumn 1992 Sterling was a member of the European exchange rate mechanism(ERM), which meant the extent it could move in value vis--vis the other currencies in the ERM was severely limited. Then came Black Wednesday when the pound fell out of the ERM, the government gave up its efforts to keep up the high level of sterling and the pound fell by 20%. George Soros was one of the speculators who recognized economic gravity when he saw it, and bet the equivalent of $10 billion against sterling by buying other currencies. After the fall the money held in other currencies could be converted back into sterling to make $1billion of profit in a matter of days! When sterling was highly valued against other currencies exporters found life very difficult because, to the foreign buyer, British goods appeared expensive- every unit of their currency bought a few pounds. However, in the four years following Black Wednesday UK exporters had a terrific boost and helped pull the economy out of recession as overseas customers bought more goods. Other European companies , on the other hand, complained bitterly. The French government was prompted by its hard-pressed importers to ask for compensation from the European Commission for the competitive devaluations by its neighbours. Then things turned around. Between 1996 and 2001 the pound rose against most currencies. Looked at from the German importers viewpoint UK goods relative to domestic goods rose in price by something to the order of 30-40%. UK firms lined up to speak of the enormous impact the high pound was having on profits. Corus cut thousands of jobs in response to sterlings rise and started loosing money at an alarming rate. It also passed on the pain by telling 700 of its UK suppliers to cut prices. James Dyson, the vacuum cleaner entrepreneur, announced that he was planning to build a factory in East Asia rather than Britain because of the strength of the pound. The Japanese car makers Toyota, Honda and Nissan, which had established plants in Britain, complained bitterly about the high level of the pound. Their factories were set up to export cars. They were hurt by having to reduce prices and also by their commitment to buy 70% components from UK suppliers ( continental European suppliers benefited from a 30-40% price advantage because of the high pound).

Then things turned around again European companies had an increasingly hard time trying to export, particularly into the US and UK markets, because between 2002 and 2010 the Euro rose by 50%, making European goods 50% more expensive in the eyes of US and UK customers. Worse, US exporters could compete against their European rivals more effectively when selling to countries in Asia and elsewhere because of the rise of the Euro. Heineken , exporting beer to the USA, to maintain profits should have raised its export prices by 50% but found that competition meant it could only raise them 2-3% a year. Operating profit from its USA unit alone fell by an estimated two-thirds.Similar difficulties were experienced by a whole range of European exporters,from German car makers to Scotch whisky distillers. Also complaining were the UK companies that buy goods and services and borrow money abroad, because their margins were being squeezed. Next and JB Sports source most of their goods from overseas markets manufacturers; the low pound against the dollar as well as the euro meant that they had to pay more in pound terms for the same items. The householder Taylor Wimpey suffered because most of their debt was in dollars, which now needed more pounds for each unit of dollar interest. Branston Pickle ( Premier Foods) prices rose in part because the falling pound pushed up the cost of many of its (imported) raw materials. Those benefiting from the weak pound included pharmaceutical companies, which make a large share of their revenues overseas but report their results in pounds. And , of course, exporters , from engineers to English hoteliers, received a boost when their products or services became more competitive in the eyes of the overseas buyer. IMPACT OF CURRENCY RATE CHANGES ON A FIRM: 1. 2. 3. 4. 5. Income received from abroad. Amount actually paid for imports at some future date Valuation of foreign assets and liabilities long term viability of foreign operations The acceptability , or otherwise

BRIEF HISTORY OF FOREIGN EXCHANGE: 1. Where do we begin? 2. Rather than start with the barter system and discuss when coins were first introduced , let us start with when the original method for exchange and payment of international debits and credits was to use gold.

3. to do this, countries agreed not to restrict the movement of gold across their borders and to allow their gold coins to be melted down and recast by other countries. 4. During this period , rate fluctuations and associated risks were minor and small. 5. The gold standard lasted till World War I. 6. To finance the war , many countries started to print money- large amountsfar in excess of their gold reserves- leading to the demise of their gold standard. 7. Efforts to return to the gold standard failed after the war because most currencies were either over or undervalued and were not easily matched to a gold standard. 8. In addition, worldwide inflation at this time caused disparities amongst currencies , which led to currency devaluations and further inequalities among currencies. 9. Needless to say , this was a very difficult time to exchange currencies. 10. At the end of WWII, in an effort to avoid the problems encountered just after WWI, the Americans proposed a system of FIXED exchange rates and the creation of the IMF at the Bretton Woods conference in 1944. The new system had three goals: a) To create a system with stable exchange rates b) To eliminate exchange controls c) To allow convertibility of all currencies 11. To do this the Americans guaranteed that it would buy and sell gold at US$35 per ounce, thereby establishing the US$ as a parity reference for all currencies and for gold. In other words, the US$ replaced gold as the dominant reserve currency of the international monetary system. 12. As a result , in addition to reserves of gold, countries held reserves of dollars, which earned interest and could be easily converted to gold. 13. Thus , the dollar became the major currency for settlement of international transactions.

14. This system worked well till the oil price shock of 1973. In this year , due to massive American balance of payment deficits , the confidence in the dollar fell and the system of fixed exchange rates collapsed. 15. As fixed exchange rates were not practical , countries let their exchange rates float against other currencies. This was seen as a short term arrangements till a return to the fixed system. 16. An IMF conference in 1976 formally adopted flexible exchange rates as a gentlemans agreement . 17. Member states are required to abstain from rate manipulation and from creating unfair advantages over other member nations. 18. FX market is not a free market as some countries like India have rules regarding repatriation of funds and some currencies are fixed or semi-fixed to other countries. CNY is fixed to the US$ so are a majority of all the GCC currencies. SAR is an example. 19. Since currencies have been allowed to float, their values have fluctuated dramatically. 20. Continuous adjustments in currencies values have brought volatility to the FX market. 21. As a result, any company or institution doing business which involves currencies other than its own is faced with exposure to changes in the values of these other currencies.

FOREIGN EXCHANGE EXPOSURE: 1. FX exposure is the risk of financial impact due to changes in foreign exchange rates and in general , there are three types of FX exposures: a) TRANSACTION risk: Impact on a companys P&L a/c and cash flows b) TRANSLATION risk: Translation of foreign assets and liabilities into the companys home currency for accounting purposes c) Economic Risk: Relate to a companys exposure to foreign markets and suppliers. This includes risks to competitiveness, strategic or operational exposure .

2. There are basically FIVE FX products: i. Spot FX- about 2/3 of market volumes ii. Forward FX iii. FX Futures iv. FX Swaps v. FX Options BASIC USES: The basic uses are the following: 1. Settlement and funding in order to convert cash from one currency into another for commercial transactions ( imports or export payables or receivables) or to convert capital flows ( dividends, inter-company loans and investments) 2. To hedge/manage FX exposures caused by the passage of time and exchange rate fluctuations 3. For arbitrage to take advantage of short-term discrepancies between different currencies or market places. 4. For investment to take advantage of changing exchange rates and interest rates and to optimize all components of a global investment strategy. 5. To speculate to take advantage of anticipated exchange rate movements Various client groups such as governments, central banks, corporations, investors, funds and institutions will use the spot market as a part of their FX management programs.

CHARACTERISITCS: 1. It is active 24 hours a day 2. it is not centralized as in the case of the stock markets 3. Deals are done in an OTC style, with individual buyers and sellers dealing verbally, or acting through brokers: over the telephone or internet via various fx trading platforms

4. This means that rates change from dealer to dealer rather than being controlled by a central market. 5. Investors do not call around to get the best price on a specific stock because the price is quoted on the stock exchange, but they do call around to different dealers to get the best exchange rate on a specific currency. They may also refer to various widely available bank/broker screens like Bloomberg or Reuters for indicative pricing only. 6. FX currency futures are traded in a few regulated markets , IMM in Chicago and SIMEX and LIFFE in London. 7. Some countries have daily fixings . RBI polls select banks during a 5 minute period between 1030am and 1230pm every working day. 8. Although there is no central market place there are major dealing centers in three regions of the world where much of FX transactions take place. There are also many smaller centers in different parts of the world. 9. Europe is catered to centers in London, Frankfurt, Paris and Zurich. Americas by NYC and LA and most of Asia by Tokyo, Singapore and Hong Kong. About 84% of daily volumes are executed in these centers. MAJOR PARTICIPANTS AND THEIR ROLES: Market maker is a player willing and ready to buy and sell currencies. As per market practice a market maker (dealer , trader) will generally quote a two-way price to another market maker. Reciprocity is standard practice. Market makers constantly make prices to one another and are primarily banks. Price takers are those market participants seeking to either buy or sell currencies and are usually corporations , fund managers or speculators. For price-takers there is no reciprocity in as much as they will not quote a price to other market players or market participants. Major participants in the market play a number of roles depending on their need for foreign exchange and the purpose of their activities. International money centre banks: market makers and deal with other market participants Regional banks deal with money centre market makers for their own needs and that of their clients

Central banks to handle FX transactions for their governments and stabilize the markets through interventions Investment banks can be market makers Corporations are usually price takers and enter into transactions for a specific purpose , such as to convert trade or capital flows or to hedge currency positions Brokers are middlemen in the transaction and do not take positions on their own behalf. They provide market makers with bid or offers left by other market makers and they are bound by confidentiality not to reveal the name of one client to another until the deal is done. Investors are usually managers of large investment funds and are the major force in moving exchange rates today. Regulatory agencies, while not actually participants, impact the market from time to time. This sector includes governmental and international bodies. Much of the market is self-regulated with guidelines for conduct established by BIS and IMF. National governments impose controls , like the FEMA in India. SPOT FOREIGN EXCHANGE: FX rates are a means of expressing the value and worth of one economy as expressed by its currency as compared to that of another. Normal market usage is to quote the exchange rate for spot value, that is, delivery , two working days from the deal date. ( except CAD). Two business days are required normally in order to get the trade information between the counterparties agreed and to process the funds through the LOCAL clearing systems. The two payments are made on the same date , irrespective of time differences between the dealing centres. Fig:

Spot and Reciprocal Rates: Spot exchange can be expressed in either currency. Thus the price has two parts , the base currency and the quoted currency. e.g. 1 US $ = Rs 49.00 . When the exchange rate is known , the reciprocal rate is easily calculated i.e Rs 1 = 1/49.00= 0.0202 US cents Market convention is to quote the US $ as the base currency with the following exceptions: EUR/USD , GBP/USD and some currencies of the erstwhile british empire like the Maltese pound. SPOT TRANSACTIONS: Bid-Offer spreads: EUR/USD 1.3598-1.3601 USD/JPY 76.90-76.92 GBP/USD 1.5605-1.5608 USD/INR 49.1050-49.1075 Generally , most currency is quoted upto 4 decimal places but there are exceptions like the JPY. Note that the spreads favours the dealer who buys currency at one price and sells it at a slightly higher price. Thus is it is crucial that the price-taker understands the convention that the market maker is using in making a price to him. Reading FX Rates: Market Maker Sell INR Buy INR Market Maker Sell US$ Buy US$

Buy US$ 49.1050 Buy INR Sell US$ Price Taker Big Figures:

Sell US$ 49.1075 Sell INR Buy US$

Buy EUR 1.3598 Buy US$ Sell EUR

Sell EUR 1.3601 Sell US$ Buy EUR

Price Taker

Spread: Tighter spread to attract price takers CROSS RATES: Rate of exchange between two currencies that do not involve the base currency. e.g GBP/INR , SGD/INR PRICE DETERMINANTS: Exchange rates or prices in the FX market are driven by the laws of supply and demand. The supply and demand for specific currencies change given the amount trade and investment being done in that currency. If there is high demand for the currency , its value increases and if there is low demand its value decreases. The FX rate will also be determined by economic, political , monetary and social factors of the country involved as also by outside developments. FX rates can change quickly and significantly, reflecting the volatility in the market and rates can be moved by rumors and anticipated factors. Typically, currency rates can fluctuate from day to day due to small imbalances in supply and demand and to economic and political factors that affect the sentiment of market makers and investors. Economic factors include both the Fiscal ( budgetary and spending policies) and Monetary policies ( how the central bank manages the supply of money and thereby its cost). This is reflected in the level of interest rates. Economic conditions include:

Government budget deficits or surpluses: The market usually reacts negatively to

a widening of government budget deficits and positively to narrowing budget deficits

Balance of trade levels and trends: The trade flow among countries illustrates
the demand for goods and services , which in turn indicates demand for a currencys to conduct trade. Surpluses and deficits in the trade of goods and services reflect the competitiveness of a nations economy. For example, trade deficits may have a negative impact on a currency.

Inflation levels and trends:Typically, a currency will lose value if there is a high

level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency.

Economic growth and health:Reports such as GDP, employment levels, retail

sales, inflation figures among others detail the levels of a countrys economic growth and health. Generally the more robust and healthy a countrys economy, the better its currency will perform and the more demand for it there will be.

Political Factors: Internal , regional and international political conditions and events can have a profound effect on the currency markets. For instance , political upheaval and instability can have a negative effect on a nations economy. The rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country or region may spur positive or negative interest in a neighboring country and in the process affect its currency. Market Psychology: Perhaps the most difficult to define but it does influence the FX market in a variety of ways.

Flight to quality: Unsettling international events can lead to a flight to quality,

with investors seeking a safe haven. There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts Long-term trends: Very often, currency markets move in long pronounced trends. Unlike physical commodities which have a specific growing season , business cycles make a difference to the value of a currency. Cycle analysis looks at longer term price trends that may arise from economic or political trends.

buy the rumor and sell the fact . This market truism can apply to many

currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and when the anticipated event

comes to pass, react in exactly the opposite direction. This may also be referred to the market being over-bought or over-sold.

While economic numbers can certainly reflect economic policy, some reports and numbers take on a talismanic effect.

The number itself becomes important to market psychology and may have an immediate impact on short term market moves. What to watch can change over time. In recent times, money supply, employment data, trade balance figures and inflation numbers have taken turns at the spotlight. RISK CONSIDERATIONS Credit Risk: Market/Price Risk: Country Risk ASKING FOR A QUOTE Market maker Corporate Dealer- Corporate- Corporate Treasurer. Back office manages settlements and documentation.

In todays business world , unpredictable movements in exchange rates , interest rates and commodity prices can not only affect a companys performance but may even determine whether a firm survives. Over the past couple of decades, companies have been increasingly challenged by financial price risks. It is no longer enough to be the company with the most advanced production technology, the cheapest labour supply , or the best marketing team. Price volatility can put even the best run company out of business and changes in exchange rates can create strong new competitors.

Similarly , fluctuations in commodity prices can drive input prices to the point that substitute products ( or products made from different inputs) become more affordable to end users. Changes in interest rates can put pressure on the companys costs, as higher interest rates may hurt sales and thus the company can find itself in financial distress as sales plummet and borrowing costs skyrocket. Hence , it is not surprising that the financial markets have responded to increasing price volatility with a range of financial instruments and strategies that can be used to manage the resulting exposures to financial price risk. We shall consider such financial instruments such as FX forwards, FX swaps, Currency Swaps and NDFs. FOREIGN EXCHANGE FORWARD CONTRACTS Forward contracts are a common hedging product and are used by importers, exporters, investors and borrowers. They are valuable to those with existing assets or liabilities in foreign currencies and those wanting to lock in a specific FX rate in the future. Forwards may be used to hedge payables and receivables, corporations will also hedge other assets and liabilities in the companys balance sheet. The value dates of forward contracts are often constructed to match up with the expected dates of receipts for a foreign payment, or payment of a foreign currency obligation. A forward contract can be tailored to meet a clients specific needs in terms of delivery dates and amount. In addition to transacting with clients banks often trade in the forex forwards amongst themselves as well. In essence , forwards provide certainty in the uncertain world of currency movements , locking in a specific rate and as the forward markets are quite liquid the bid/offer spreads are relatively low for the major currencies. Definitions A Forward Contract is a transaction executed today in which one currency is bought or sold against another for delivery on a specified date that is not the spot date, for example , three months from now. In addition, forward points are relative interest rate differentials expressed as units of currency , or fractions of spot value of that currency.

Interest rate differentials Market participants adopt the interest rate differential between two currencies and the current market spot rate as the basis of their calculations. The forward price is often referred to as forward points, forward pips or swap points. For example , assume the spot rate between US Dollars and Pound Sterling are the same but the interest rates in sterling are 4%p.a for a three month deposit , while in $ it is 2%.Investors would sell spot $ to buy Sterling and invest it in a higher deposit rate, They would simultaneously sell sterling forward and buy $ forward for delivery at the end of the investment period. This way , an investor would end up with more $ than if the investment had been kept in $. Periods Forward markets are regularly traded in the market for periods of 1,2,3,6 and 12 months from the spot value date value date. A broken period or odd date forward deal is a contract with maturity other than a normal market quote of complete months. An example would be to ask for the forward pips for 24 days. Premium or Discount Forward prices are determined by two main factors , the current spot price between the two currencies and the interest rate prevailing in each of the two currencies. The forward price is calculated as the spot rate plus or minus the forward pips. As all exchange rates have a fixed and variable component , if the interest rate in the variable currency are more than that of the fixed currency , the variable currency is trading at a discount relative to the fixed currency and forward points are to be added to the spot rate to arrive at a forward rate. The converse situation arises if the variable currency is at a premium to the fixed currency. There are two simple rules of the thumb to determine if a currency is at a premium or at a discount and what to do with the forward points. Exchange rates are quoted as units of that currency which equal 1 $. ( except for Euro, Sterling, AUD and NZD). If the forward points are ascending ( 20/25) bid is lower than the offer , the currency is at a discount to the dollar and hence the forward points are added to

the spot rate. ( The major exception is sterling and the euro where they are at a premium to the dollar). If the bid is numerically higher than the offer, that is the points are descending ( 25/20) that is the forward points decline from left to right, the currency is at a premium to the dollar and the forward points are deducted from the spot rate . ( the major exception is the quotation for the Euro and Sterling against the dollar, where if the forward points decline from the left to the right, the points are deducted , but the dollar is at a premium to the euro and sterling). Calculations Forward rates are not determined by where the market expects the currency to be in the future but rather by the interest rate differential. Also , the forward exchange rate is fixed at the time of the transaction, but no accounts are debited or credited until the maturity date. Example of calculation of forward points: Say you want to buy 3 month forward dollars against INR . Steps are as follows: 1. Buy US$ against INR spot 2. Place the $ in a deposit for 3 months, say 2% ( 2/3% spread) 3. Borrow INR for 3 months at market rate, say 12%.( 11/12% spread) 4. What is 1 $ equal to forward INR. Forward Cross Rates These are worked out in the same manner as spot rates. First , work out the forward rate from the spot rate and the forward points. Then , decide, what currency is being bought and which sold. Finally , decide if the rates should be divided or multiplied by one another, as appropriate.

USD/JPY Spot: 3-month pips 115.90/95 53.9-53.6

USD/CHF 1.4409/14 27-26

CHF/JPY 80.41/80.47 23-22

CHF/JPY three-month forward can be worked out as:

3 months

USD/JPY 115.90 115.95 -53.90 -53.60 115.361 115.414

USD/CHF 1.4409 1.4414 -.0027 -.0026 1.4382 1.4388

CHF/JPY 80.41 80.47 ? ? 80.18 80.25

Answer

-23 - 22.

Short dated contracts Value date TODAY , TOM are also quoted. Swaps are cash/tom , cash/ spot and tom/next. Prices normally added on are deducted and prices normally deducted are added on. This is actually not as odd as it sounds. If prices are quoted normally for spot delivery and a value tomorrow quote means that the market maker will have to surrender that currency earlier than normal, and therefore has to be compensated. Long dated contracts With any forward transaction, the quotation is based on the relationship between the prevailing interest rates of the currencies concerned. However, when considering forwards beyond one year, it is necessacary to account for the annual interest compounding effect. Broken date contracts A broken date forward contract is a contract with a maturity other than the normal market quote of complete months and in order to price a broken dated contract , it is necessary to interpolate between the two standard date quotations on either side of the desired maturity. For example, to work out the forward pips for USD/JPY for one and a half months ( 45 days) assume the following rates: $/JPY spot 117.06/117.09 1 month fwd 21/18

2 mth fwd

44/41

Pips for the 45 day period is arrived as follows: Work out the number of days in the period between the one and two month forward quotes, because the delivery date falls within this period. The answer is 45 days Subtract the bid one-month forward pips from the bid two-month forward pips , which will then show what the two-month pips are worth more than the one-month forward pips Divide the difference in forward pips (23) by the number of days in the period between the two standard quotes ( 45) and multiply the answer ( 0.5111) by the difference in the number of days between the required date and the last day of the two month quote ( 15) . Hence the total of those days is 7.7 pips Subtract this answer ( 7.7) from the two month-forward pips , giving us the forward pips for the broken date of 36.3. FOREIGN EXCHANGE SWAP It is the simultaneous purchase and sale of one currency against another for two different value dates. Usually, one of the value dates is the spot date and the other is the date in the future. In a typical swap transaction , one currency amount is held constant for both dates of the transaction. Most FX swaps have maturity less than one year. In addition a forward/forward swap is where both the near date and end dates are forward dates. Combinations: In fact, a swap may be most easily understood as simply a combination of a spot and a forward or the combination of two forwards. It can be a combination of a spot purchase with a simultaneous forward sale or a sale with a simultaneous forward purchase. Like forward contracts, swaps are regularly quoted for periods of 1,2,3,6 and 12 months. Frequently , the date is customized to suit the clients interests. Uses: Primarily investors and borrowers for cash management purposes use them. They are valuable to those who have liquidity in one currency but need liquidity in another currency. A swap allows the two parties involved to use a currency for a period in exchange for another currency not needed at that time. For example, companies can access foreign currency to finance foreign currency denominated assets ,

such as those of a foreign subsidiary. Hence, foreign exchange swaps can help clients to diversify their investments, to fund intra-company loans, to fund a position rather than use the money markets, to potentially improve the yield wit no exchange risk in conjunction with a foreign currency investment and to minimize borrowing costs in certain cases by using a swap instead of a straight borrowing in a foreign currency. In such contracts the exposure is therefore one of interest rate risk rather than currency risk. Consequently , market makers will only charge or pay the interest rate differential. In the swap market this interest rate differential is expressed, again in points or pips Swaps are undertaken together with a money market operation to benefit from interest rate differentials. Such differentials are used by companies to benefit from borrowing in one jurisdiction where they have an advantage to that of another where they suffer . Example is SBI borrows in India to lend in the USA. Swaps are also used when the domestic money markets do not offer opportunities for investments. Swaps can be used to access broader and well developed markets overseas to make longer term investments. Example of Switzerland where HNI clients place short term swiss deposits and convert them into longer term US$ deposits. Swaps are used to hedge exposure by converting spot transactions into forwards. Risks: A swap becomes a forward once the near date is settled.

CURRENCY SWAPS: A swap is an agreement between two counterparties to exchange future cash flows. There are two fundamental types of swap : Cross currency, which involves the exchange of cash flows in one currency for those in another with an agreement to reverse that transaction at a future date and the

Interest rate( single currency) swap , which changes the basis on which the income streams or liabilities are received and paid on a specified principal amount. From a Foreign Exchange perspective, the cross-currency swap is much more relevant , as they allow companies to borrow in the most efficient market , usually one in which the company has not borrowed heavily in the past. Technique involved: An interest rate swap is exclusively concerned with the exchange of cash flows relating to the interest payments on the designated notional amount. However, there is no exchange of notional at the inception of the contract. The notional amount is the same for both sides of the currency and it is delineated in the same currency, that is, principal exchange is redundant. In the case of a Currency Swap , however principal exchange is not redundant. The exchange of principal on the notional amounts is done at market rates, often using the same rate for the transfer at inception as is employed at maturity. This

makes it an on-balance sheet transaction unlike the forward which is off-balance sheet and moves to the accounts only on maturity of the forward contract.

We take up the classic case study of the FIRST currency swap transaction between IBM and the World Bank . In 1995, IBM issued a Swiss Franc denominated bond with fixed semi-annual coupon payments of 6% on Swiss Franc 100 million. Upfront IBM received 100 million CHF from the proceeds of the Eurobond issue. They issued in Switzerland because they have a competitive advantage as they had not issued there earlier and the Swiss investors were looking for a long term investment opportunity as the Swiss money markets were not well developed and do not have long tenors. IBM used the CHF raised from the bond issue into US$ by entering into a currency swap with the World Bank. IBM agreed to exchange the CHF 100 million at inception into US$, receive the CHF coupon dates on the same dates as the coupon payments to its investors: pay $ interest rate linked to LIBOR and re-exchange the US$ into CHF on maturity of the swap ( same as the tenor of the bond issued by IBM). This is the fundamental difference between a currency swap and a foreign exchange swap. During the life of the transaction, each currency bears an agreed rate of interest, which is usually paid or received at intervals.

No interest rate payable Under a foreign exchange swap, no interest is payable on either currency. Rather the price at which the currencies will be exchanged at maturity takes account of the interest rate differential between them. Thus , if GBP rates for one year are 5% and US$ rates are 2% , the theoretical forward rate between the two currencies is 3%- less than the spot rate prevailing. Under a one-year currency swap between the two the rate for re-exchange at the end of one year will be the same as that used at the start , but interest will be payable or receivable on each currency. In the simple case of a one-year swap, there is little difference between the two. Consider a 5 year traditional fx swap between US$ and CHF. The forward fx rate will represent the compounded interest rate differential between the two currencies and only two cash flows will occur, namely, the spot transaction and the forward leg in 5 years at a radically different exchange rate. Under a currency swap, an amount of CHF will be exchanged for US$ at the start ( determined by the spot rate prevailing) , the party receiving the francs would pay and agreed interest rate periodically as would be the party receiving US$. At the end of 5 years , the same amount of currency will be re-exchanged. The interest rate for each currency can be fixed or floating . A vast majority of currency swaps currently transacted are between US$ at 6mLIBOR and another currency at a fixed rate of interest, payable either annually or semi-annually between the two parties. Flexibility Currency swaps give companies extra flexibility to exploit their comparative advantage in their respective borrowing markets. Also currency markets allow companies to exploit advantages across a matrix of currencies and maturities.

Liquid and cost effective

One of the most common transactions in the currency swap market is that related to a capital market debt issue, which is then swapped into its entirety to another currency that the borrower requires. Take the case of a company that has taken a 20 year loan in another currency or issued a bond for 20 years , denominated in a foreign currency. The limitation of currency futures and currency forward market is that these products last only ONE year and therefore 20 odd contracts need to be booked. Besides , FX forwards have uneven cash flows in the quoted currency and at the time of roll-over , the spot rate then prevailing could be higher or lower than the maturing forward leg and therefore poses considerable accounting and funding problems. Exposure Due to the exchange and re-exchange of notional principal amounts the currency swap generates a larger credit exposure than an interest rate swap. Graphic Example 1. Initial exchange of principal: USD 10 m CHF 15 m Swap Counterparty

Borrower

CHF 15m

Bank Lender or Bond Holders

2. Intermediate Flows Borrower Pays US Libor Receive CHF interest rate

Swap Counterparty

Pays Interest in CHF

Bank Lender or Bond Holders

3. Final Principals: Borrower

Exchange

of CHF 15 m USD 10 m Swap Counterparty

CHF 15m

Bank Lender or Bond Holders