Foreign Exchange Contracts: Swaps and Options
10.1:
Primer to Foreign currency swaps, and options
Besides spot, forward and futures
contracts, companies also regularly enter into currency swaps, and option
contracts to mitigate foreign exchange risk. In the following sections, very
briefly details about foreign currency
swaps and options have been
discussed as these would be discussed in greater detail in subsequent modules.
10.2 Foreign Currency Swaps:
Very briefly, currency swap works like
this: An Indian company, XYZ Co. took an ECB
(External Commercial Borrowing) loan
of USD 250mn for 6 years at a fixed interest rate of 5.5%. After two years, remaining time to maturity is 4
years. XYZ Co. wants to shift this USD obligation and wants to pay the interest
and principal in INR. The Indian company fears that INR to depreciate – hence
increasing its INR expenditure to service the foreign currency denominated
interest as well as principal. It approaches different banks for swapping its
USD obligations. BBK bank agrees to be the counterparty for this swap at an
8.5% per annum. Once both parties agree, the following swap payment happens
between XYZ Co. and BBK Bank.
•
In
the beginning of the contract, XYZ Co. gives 250mn USD to BBK Bank. BBK Bank
pays INR 11750 mn (equivalent of 250mn USD at a rate of INR 47/USD) to
XYZ CO.
•
For
the next 4 years, BBK bank pays USD 13.75mn (5.5% of USD 200mn) to XYZ Co. In
return, XYZ Co. pays INR 998.75mn (8.5% of INR 11750mn) to BBK Bank.
•
After
the 4th year, BBK bank pays USD 250mn to XYZ
Co. XYZ Co. returns INR 11750mn to BBK Bank.
The
following figure, Figure 10.1
indicates the three steps in swap contract graphically.
Figure: 10.1
Currency Swap
Step 1: At swap origination
Hence due to the swap agreement, the
USD interest and principal repayment exposure of the Indian company is shifted
to the BBK bank. In other words, swap helped the Indian company to shift its
USD obligation to INR obligation. Of course, one may ponder, why BBK bank would
like to take such exposure. In fact BBK bank may not be taking the exposure at
all as BBK bank may be exactly taking an opposite swap contract with some other
counterparty. In the first swap agreement with Indian Bank, BBK bank was paying
USD and was receiving INR. BBK bank can mitigate this risk by entering into a
swap contract with another counterparty where it receives USD and pays INR.
Of course, all swap contracts are not
structured in a manner as given in Figure
10.1. As swaps are OTC contracts, swaps can be structured in different
formats. The swap contract can be used to only pay the interest payment only.
In such types of swap, step 1 and step 3 are redundant. The swap contract can
be used to cover the principal repayment and not the periodic interest payment.
At times, the principal is swapped in two different currencies. The company may
pay USD in step 1(receive INR) and receive Euro in step
10.3: Foreign
Currency Options: Brief Introduction to Call and Put Option
Companies buy and sell call and put
options to hedge their foreign times exchange exposure as well as at times
indulge in speculative activities. Options on foreign currency are offered by
banks as OTC product or can be bought and sold in exchanges. Before we proceed
to understand foreign currency options in greater details, let us understand
the 4 building blocks of options, namely long
call, short call, long put and short
put. However, if a reader has not been exposed to these concepts earlier,
then it is advisable to read a
derivative text book on options to get a deeper understanding of options before
proceeding with the remaining part of this session.
In a call option, the option buyer (long call position holder) has the
right to buy the underlying currency at the maturity at the exercise price. For
example, an importer wanting to hedge the USD risk, enters into long call
option for 20,000 USD at INR 44.45/USD with contract maturing after 15 days
from today. The counterparty to the importer takes a short call option. On T+15
day, the spot rate is INR 43.80/USD. Whether the importer will exercise his
option to buy USD from the counterparty or not? In this case, the option will not be exercised as the
importer is better off buying the USD from spot market than from the short call
position holder. The importer will exercise call option, when the spot price is
higher than INR 44.45/USD—when INR depreciates.
In a put option, the option buyer (long put position holder) has the
right to sell the underlying currency at the maturity at the exercise price.
For example, an exporter wanting to hedge the USD risk, enters into long put
option for 18950 USD at INR 44.45/USD with contract maturing after 15 days from
today. The counterparty to the exporter takes a short put option. On T+15 day, the spot rate is INR 43.80/USD.
Whether the exporter will exercise his option to sell USD to the counterparty
or not? In this case, the option will be
exercised as the exporter can sell USD at INR44.45 per USD due to the
option contract. Without the option, the exporter would have sold USD at INR
43.80/USD. The exporter will exercise his put option, when the spot price is
lesser than INR 44.45/USD—when INR appreciates.
Depending upon whether options can be
exercised only on maturity date or on or before maturity date, options are
categorized as European and American respectively. An option is in-the-money (ITM) if
it is profitable to exercise. For a call option, if the spot exchange rate is
higher than the strike exchange rate, then it is an ITM option. For an ITM put
option, the spot exchange rate is lesser than the strike exchange rate.
An option is out-of-money (OTM) when it is not profitable to exercise these
options. For a call option, when the spot exchange rate is lesser than the
strike exchange rate, it is an OTM option. For a put option, when the spot
exchange rate is higher than the strike exchange rate, it is an OTM option.
An
at-the-money (ATM) option is when
the exercise price is at par with the spot price.
10.4: Currency Options in India:
Foreign currency options are available
both in OTC market as well as traded in Indian exchanges. OTC options are
offered by banks with banks taking one taking one side in each option contract.
Though little dated, details given in Box 10.4 explain the call and option
concepts as well as highlight the popularity of currency options offered by
Indian Banks.
Box 10.4 Rupee options a hit among corporates
The rupee options market has seen
increased activity with leveraged options finding favour with corporates in
recent times. Daily volumes have increased by nearly 50 % to reach a turnover
of about $50 million to $100 million, compared to a daily turnover of $25
million to $50 million a month or two back, dealers said. The reason for the
popularity of these instruments over
forwards is that options do not
confer an obligation on the buyer to perform a contract, dealers said. An option is a contract, which gives the
buyer a right but not an obligation to fulfill the contract on a due date; a
premium is required to be paid to the `writer' or seller of the option for this
contract.
If an exporter books a forward contract, he
is bound to fulfil it at the due date, while they are not tied down to an
exchange rate in an option. In a forward contract, merchants cannot take advantage of a subsequent movement of
exchange rates in their favour.
According to
traders, earlier a secular movement in the rupee was observed but now there is
inter-day volatility. So corporates are getting edgy about the direction of the
rupee. Even with the rupee appreciating uni- directionally to 45.04/05 levels
from the 45.75 levels seen in mid-October, volatility has increased, as the
rupee moves into the 10-15 paise band in a day.
According to dealers, the view on the
rupee has changed, as now the expectation is of a 44.00 level against the
anticipation of a 47.50 level nearly two months ago. With the dollar weakening
across all major currencies, the rupee is expected to appreciate, but this has
failed to assuage sentiments given the high volatility in the dollar-rupee
exchange market.
"Rupee
options are increasing in popularity, as the view on the domestic currency is
changing," said
Mr Abhishek Chaudhary, forex options trader, ICICI Bank. He said ICICI Bank was
an active player in the rupee options market and volumes transacted by the bank
had doubled recently. Over the last couple of months, nearly a 300-per
cent jump in business had been recorded with about $1.5 billion worth of deals
being transacted.
Not only have the plain vanilla
options, active up to one year, gained popularity, options having a time period
of over a year have also seen a demand. "Deals have been struck for
five-year options too, with two to three years instruments also being traded in
large amounts," Mr Chaudhary said.
Plain vanilla options are the put or call
options, which can be exercised by corporates. A put option is a right to sell
- so purchase of a USD put will give a corporate the right but not the
obligation to sell dollars at a particular date, at a pre-determined rate,
known as the strike price. An exporter, who would want to sell dollars if the
market moves against him but does not want to sell dollars if the market
exchange rate is in his favour, would normally buy a USD put.
A call option, on
the other hand, is a right to buy - so a USD call option would give the buyer a
right but not an obligation to buy dollars at a strike price, at a particular
exercise date.
Besides OTC contracts, currency options
for many currency pairs are available for trading through exchanges. Annexure
10.2 highlights US Dollar INR options contracts specifications trading at
United Stock exchanges of India. In Section
10.5, the contract specification is explained in detail. Size of each contract is for 1000 USD
i.e, a long call (put) option gives the buyer the right to buy (sell) 1000 USD.
The option premium is quoted in INR terms.
All options traded are European
style. The option premium tick size is in INR 0.0025. At a given point
of time, three monthly contracts and three
quarterly contracts are available. For example, in the month of August
2011, contract maturing on August 2011, September 2011, October 2011 as well as
December 2011, March 2012 and June 2012 contracts are available. Hence at a
given point of time, a trader can buy/sell options upto a maximum period of 9
months. Strike price indicates at a
given point of time, 12 ITM, 12 OTM and 1 ATM option will be available for
trading. Strike price interval indicates
the price the difference between consecutive two strike prices. Options strike price are in the multiple of INR 0.25. Exercise at expiry indicates that open
positions results in delivery of both currencies. For example, if a trader as
15 open long call options at an exercise price of INR 40.20, then on the
maturity date, the trader pays INR 603,000 and receives USD 15000 from the
short call position holder. Position
limit indicates the maximum open position a member can take depending on
the category of the trader. Initial
margin and extreme moss margin is calculated in a similar manner as that of
currency futures explained in Session 9.
Settlement of premium indicates that option premium is paid by the buyer in
cash on day T and paid out to seller on T+1 day.
Table
10.1 shows
a snapshot of options order book (USD/INR) at United Stock Exchange of India.
Table 10.1: Option Trading details at United
Stock Exchange of India http://www.useindia.com/markets_opt.php on
23rd August 2011 at 13:33:45
Column 0 of
Table 10.1 indicates the contract maturity date along with whether the option is a call (c) or put (p) option
along with exercise price ranging from INR 45.5 to INR in the multiple of INR
0.25. Columns 1 and 4 indicate the buy and sell quantity respectively. Columns
2 and 3 indicate the buy and sell
premium quoted by different traders. Column 5 represents the spread which
is calculated as the sell premium – buy premium. Column 6 indicates LTP (last traded price). The LTP of
0.245 indicates that both buyer and seller of (USDAUG11 C 45.5) option have
agreed on an option premium of INR 0.245. This means that a long call option
holder has paid INR 0.245 for having the right to buy 1 USD at an exercise
price of INR 45.5. As the contract size is for 1000 USD, the long call option
holder pays INR 245 as option premium.
Though exchange
traded plain vanilla options (long/short call/put) options are available to
Indian companies, many Indian companies have entered into exotic currency
option contracts in the OTC market. One such exotic option currency is a
zero-cost option contract. Many companies bought sold call options and used the
option premium to buy call options. This ensured that the companies need not
have to pay any upfront premium. Hence these combinations were known as zero-cost derivatives/cost reduction structures. However many companies
incurred massive losses when exchange rate
moved beyond certain levels. RBI had banned these contracts in November
2009. Details given in Box 10.5
shows the structure of a zero cost derivatives.
Box 10.5: Zero
Cost Options:
The buyer of a ‘put’ option has the
right but not the obligation to sell a specified amount of an underlying asset
at a set price within a specified time. Similarly, the buyer of a ‘call’ option
has the right but not the obligation to buy an asset in a similar manner. When
a company enters into a foreign exchange option transaction with a bank, the
structure is such that the bank sells a ‘call’ option to the company, which, in
turn, sells a ‘put’ option to the bank. This nullifies the cost of entering
into such a transaction. It is known as a zero-cost structure, for which no
premium income is earned.
RBI had in November 2009 banned this
product but allowed importers and exporters to write and sell ‘put’ options both
in foreign currency-rupee and cross-currencies and earn premium on them.
RBI, in its final guideline in December
2010, on over-the-counter foreign exchange derivatives said companies having a “minimum net worth of Rs. 200 crore and an
annual export and import turnover
exceeding Rs. 1,000 crore” and satisfying other risk management criteria, are allowed to use cost reduction
structures.
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