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Forex definition Forex based risk Forex Risk Management Process Forex Risk Management Framework Importance of managing forex risk Different forex markets Forex based instruments Forex fundamentals Delivery and settlement date How does a forex based platform work

FOREX DEFINITION
The market where currencies are bought and sold. Includes all currencies in the world. Most liquid market in the world. Movement of currency pairs are called pips. Pips definition: Smallest increment a currency pair can move. Trades around $4 trillion a day (BIS). Currencies are priced in pairs (ZAR/USD): First currency is called the base Second currency is called counter. Example: If you buy ZAR/USD then you have bought ZAR and sold USD.

FOREX DEFINITION
Objective of currency trading: Buy the currency that increases in value relative to the one sold If you bought a currency and the price appreciates in value then you must sell the currency back in order to lock the profit. FOR EXAMPLE: Expectations are that the ZAR will rise relative to the USD, thus you will buy one or more ZAR/USD currency pair lots. EUR/USD is trading at 1.3653 when you buy it. EUR/USD is trading at 1.3873 when you sell it. Hence profit is .0220 or 220 pips. Thus if the account is a 100 000 account: Profit is $2220 (x $10) Thus if the account is a mini account: Profit is $220 (x $1)

FOREX BASED RISK

A potential gain or loss that occurs as a result of an exchange rate change. For example, if an individual owns a share in Sasol, he will lose if the value of the Rand drops. A better concept of exchange risk is unexpected exchange rate changes. Different types of risk include:
Credit risk (Default risk/Political instability) Market risk (Unexpected movements in market price affecting B/S) Operational risk (System failure or human error) Foreign exchange risk (Broad category of market risk)

FX RISK MANAGEMENT PROCESS

Firms dealing in multiple currencies face a risk (an unexpected gain/loss), quantified in terms of exposures Exposure is defined as a contracted, projected or contingent cash flow whose magnitude is not certain at the moment and depends on the value of the foreign exchange rates The process of identifying risks faced by the firm and implementing the process of protection from these risks by financial or operational hedging is defined as forex risk management

Once a firm recognizes its exposure, it has to deploy resources in managing it Forecasts: based on valid assumptions, identifying trends Risk Estimation: a measure of the Value at Risk and its probability Benchmarking: set limits for handling forex exposure Hedging: an appropriate hedging strategy Stop loss: rescue arrangements Reporting and review: periodically done; analyses whether benchmarks set are valid and effective, whether overall strategy is working or needs change

FX RISK MANAGEMENT FRAMEWORK

 The subsequent liberalization of South African economy has resulted in substantial inflow of foreign capital into South Africa. With the globalization of trade and integration of domestic and world economy, forex risk management has become a necessity in South Africa Research in the area of efficiency of foreign exchange markets implies that successive changes in exchange rates cannot be predicted by analyzing the historical sequence of exchange rates or by employing resources to predict exchange rate changes

IMPORTANCE OF MANAGING FOREX RISK

DIFFERENT FOREX MARKETS

DIFFERENT FOREX MARKETS

SPOT MARKET
Definition: A commodities or securities market in which goods are sold for cash and delivered immediately. Contracts bought and sold on these markets are immediately effective. Spot FX transaction A spot FX transaction is an exchange of one currency against another at an agreed rate. Settlement takes place two days after the trade date. (T + 2) 37% of $4 Trillion traded in spot market.

SPOT MARKET
Spot Quotations An offer or selling rate is one at which market maker sells base currency against the other. Direct quotation Quotes using a country's home currency as the quoted currency. Eg. $1=R8.15 Used by most countries. Indirect quotations Quotes using a countries home currency as the base currency. Eg. R1=$0.12

SPOT MARKET
Cross Rates A cross rate is where neither of the currencies is the US Dollar. Examples: EUR/JPY EUR/GBP GBP/JPY Cross rates can be calculated using both rates against the USD.

SPOT MARKET
Market Maker vs. Market Taker
There are always two counterparties to a deal: One who asks for price Market taker or Price taker Other who quotes price Market Maker

DIFFERENT FOREX MARKETS

FORWARD MARKET
Definition: The forward FX Market is where counterparties buy and sell currencies for delivery at some future date. For example a forward transaction dealt today could have value date of 1 month later. Advantage: It can be tailored to the specific needs of the firm and an exact hedge can be obtained. Disadvantage: Contract are not marketable and cannot be sold to another party when they are no longer required and are binding.

FORWARD MARKET
One month, Two months, Three months, six months and one year forward dates are called Fixed Periods. Any value date falling between the fixed dates is called Broken Date or Odd Date. Forward Premium/Discount The difference between the forward and spot price is called Forward Premium/Discount Currency with higher forward rate than its spot rate is said to be traded at premium in forward Currency with lower forward rate than its spot rate is said to be traded at discount in forward

FORWARD MARKET
Forward Points Forward rates are quoted in forward points. For most currencies one point equals 0.0001 because currencies are quoted to four decimal places One exception is USD/JPY where one point equals .01. Forward rate is calculated by adding or deducting the forward points to or from the spot rate Addition or deduction is determined by the order by which forward points are quoted

FORWARD MARKET
BMW-SA goes to the local market and buys forward cover on ZAR to repay Euros (buys Euro forward) they know how many Euros they need to repay. From the Standard Bank site, forward rates (percentages converted to ZAR cents) can be obtained: SPOT is currently ZAR8.2850
Forward points over 3 months = 1403 cents Forward points over 6 months = 2715 cents Forward points over 9 months = 3925 cents Forward points over 12 months = 5224 cents Can request for longer periods

FORWARD MARKET
12 months means that forward rate is 5224 cents above the current SPOT
12 months 5224 plus 8.2850 = 8.8074

In percentage terms: 0.5224/8.2850 => 6,2% (Expensive!!) Total rate: 1,75% plus 6,2% = 7,95% BMW-SA can grant loans at 7,95% except if they want to receive a margin as well.

FORWARD MARKET
FX Forwards & Interest Rates For example, a Pakistani Air line has to buy USD 100 Million after six months. It has two options: Buy USD 100 Million spot and invest for six months Buy USD 100 Million for delivery six months forward The two options above should produce same result otherwise there would be arbitrage opportunities. INSTRUMENT: Forward Contract

FORWARD MARKET
EXAMPLE:
If SASOL wants to buy crude oil in US dollars six months time, it can enter into a forward contract to pay ZAR and buy USD and lock in a fixed exchange rate for ZAR/USD to be paid after 6 months regardless of the actual ZAR/USD rate at the time. In this example the downside is an appreciation of Dollar which is hedged by a fixed forward contract.

FORWARD MARKET
RISK MANAGEMENT THROUGH FORWARDS:

Forward contracts are typically negotiated with a commercial bank. The forward market facilitates the trading of forward contracts. The depreciation of the receivable currency is hedged against by selling a currency forward If the risk is that of a currency appreciation (if the firm has to buy that currency in future say for import), it can hedge by buying the currency forward Commercial banks profit from the difference between the bid price and the ask price and are exposed to exchange rate risk if their purchases do not match their sales of a foreign currency

DIFFERENT FOREX MARKETS

DERIVATIVES MARKET
1971-Bretton Woods system of administering fixed Forex was abolished and a regime of fluctuating exchange rates was introduced Corporates struggled to cope with uncertainty in: Profits Cash Flows Future Costs It was then that financial derivatives emerged as a means of managing risks

DERIVATIVES MARKET
Definition: The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. The market can be divided into two, that for exchange-traded derivatives and that for over-the-counter derivatives. The legal nature of these products is very different as well as the way they are traded, though many market participants are active in both. The main role of derivatives is that they reallocate risk among financial market participants, help to make financial markets more complete.

Most commonly used derivatives

DERIVATIVES MARKET
Forex derivatives can be used to: Speculate on future exchange rate movements Hedge anticipated cash inflows or outflows in a given foreign currency Institutional investors have increased their international investments, which has increased their exposure to exchange rate risk

DERIVATIVES MARKET
WHY USE DERIVATIVES IN FOREX? An effective solution to the problem of risk caused by uncertainty and volatility in underlying asset. Risk management tools that help an organization to effectively transfer risk. Instruments which have no independent value, their value depends upon the underlying asset. Speculate on future exchange rate movements Hedge anticipated cash inflows or outflows in a given foreign currency Institutional investors have increased their international investments, which has increased their exposure to exchange rate risk

DERIVATIVES MARKET
Different derivatives:

Forwards Futures Options Swaps

DERIVATIVES MARKET
FUTURES
Definition: A futures contract is similar to the forward contract but is more liquid because it is traded in an organized exchange i.e. the futures market

Advantage: There is a central market for futures which eliminates the problem of double coincidence, lower risk, speculative gains and flexible, . Disadvantage: Tailor ability of the futures contract is limited i.e. only standard denominations of money can be bought instead of the exact amounts that are bought in forward contracts.

DERIVATIVES MARKET
FUTURES
DIFFERENCE BETWEEN FUTURE AND FORWARD CONTRACTS: Futures are marked to market at the end of every trading day Forwards are private contracts and do not trade on organized exchanges Forwards are customized contracts satisfying the needs of the parties involved A single clearinghouse, is the counterparty to all futures contracts Forwards are usually not regulated

DERIVATIVES MARKET
FUTURES
PRICING OF A FUTURES CONTRACT: No arbitrage price of a Futures contract should be the same as that of a forward contract FP = S * (1+Rf)^T FP = Futures Price S = Spot price at inception Rf = Annual Risk free rate T = Futures contract term in years

DERIVATIVES MARKET
FUTURES
Cash & Carry Arbitrage Borrow money for the term of the contract at market interest rate Buy the underlying asset at the spot price Sell a futures contract at the current Futures price Deliver the asset and receive the futures contract price Repay the loan plus interest

DERIVATIVES MARKET
FUTURES
Cash & Carry Arbitrage Example: Gold price $300 1 year futures price $325 Interest rate 7% Futures price = $300 * 1.07 = $321 Strategy Buy spot Short futures contract

Currency Options
A currency option is a contract giving the right, not the obligation, to buy or sell a specific quantity of one foreign currency in exchange for another at a fixed price; called the Exercise Price or Strike Price. Call Options are used if the risk is an upward trend in price (of the currency), while Put Options are used if the risk is a downward trend. A currency put option provides the right to sell a particular currency at the exercise price within a specified period

Currency Options
Risk management: Currency options are: Used to hedge payables in a foreign currency The fixed nature of the exercise price reduces the uncertainty of exchange rate changes and limits the losses of open currency positions Options are particularly suited as a hedging tool for contingent cash flows, as is the case in bidding processes Put options are: Hedge receivables in a foreign currency

Currency Options
EXAMPLE Sasol: Needs to purchase crude oil in USD in 6months time. Risk: upward trend in dollar rate BUY A CALL OPTION Two scenarios: Scenario 1: If the exchange rate movement is favour of Sasol - dollar depreciates, (compared to todays spot rate) Then Sasol can buy them at the spot rate as they have become cheaper.

Currency Options
Conversely: Scenario 2: If the exchange rate moves against Sasol - dollar appreciates (compared to todays spot rate) Sasol can exercise the option to purchase it at the agreed strike price. In either case SASOL benefits by paying the lower price to purchase the dollar.

SWAPS
Foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate (barter or exchange). At maturity, principal amount is effectively re-swapped at predetermined exchange rate, GOAL: parties end up with their original currencies There are 2 types: I) INTEREST RATE SWAPS (SWAP only the interest related cash flows) ii) CURRENCY SWAPS (swapping both principal and interest between two parities with CF in different currency)

SWAPS
Risk Management through SWAPS Firms with limited appetite for exchange rate risk can move to a partially or completely hedged position through the mechanism of foreign currency swaps, and leave the underlying borrowing intact Swaps cover the exchange rate risk Swaps also allow firms to hedge the floating interest rate risk

SWAPS
EXAMPLE An export oriented company that has entered into a swap for a notional principal of $1 million at an exchange rate of R8 per dollar. The company pays US 6months LIBOR to the bank and receives 11.00% p.a. every 6 months on 1st January & 1st July for the next 5 years. The company will have earnings in USD and can use the earnings to pay interest for this kind of borrowing (in USD rather than in ZAR), thus hedging its exposures.

Fundamental Analysis
Focuses on what ought to happen in a market Factors involved in price analysis: 1. Supply and demand 2. Seasonal cycles 3. Weather 4. Government policy

Technical Analysis
Focuses on what actually happens in a market Charts are based on market action involving: 1. Price 2. Volume 3. History

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