Home CAIIB Bank Financial Management Basics of forex derivatives

Basics of forex derivatives

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Forex Risk Management in Banks

Positions in Foreign Currency

          Long or Overbought Position

          Short or Oversold Position

Covering of Position Risk 

         The position is covered by fixing suitable limits:

          Day-light limit

          Overnight limit

          Stop loss limit

          Gap limit

          Counter party limit

          Country limit

          Dealer limit

          Deal size limit

Derivative Instruments

Definition : ¨Derivative instruments are  management tools derived from underlying exposures such as currency, commodities, shares, bonds or any other indices used to reduce or neutralize the exposure on the underlying contracts.

Derivative Market : ¨Derivatives could be over the counter (OTC) i.e. made to order or exchange traded facilities which are  standardized in terms of quantity, quality, start and ending dates.

Participant : ¨Users and market makers

Purpose : ¨It enables transfer of various financial risks to entities who are better suited to manage them. ¨

Hedging Instruments

Forward Contracts

Option Contracts



Merchant Forward Contract

DEFINITION ◦A Forward Contract is an agreement between Bank and Customer where Bank agrees to buy/sell foreign exchange at a future date at a rate fixed on the date of contract. ◦It is obligatory on the part of the customer to fulfill the contract.

FEMA Regulations

Genuine trade transactions.

Permitted Currencies under FEMA.

Contracted Exposure and Probable Exposure based on past performance.

Declaration of an exposure.

Limits for booking of contracts.

Maturity of contract.

Resident individual can book contract up to  USD 1 Mio subject to conditions.

Contracts for NRIs

Types of Forward Contract

Fixed date basis.

Option forward period basis.

Delivery Under Forward Contract

Export-On receipt of shipping documents for purchase/negotiation and payment of rupees to the customer.

In case of collection documents, date of payment of rupees to the customer on realization of bills.

Import-While making payment/crystallization for Import bills.

Known holiday – preceding working day.

Suddenly declared holiday – next working day.

Early Delivery/Cancellation/Rebooking under Contract

Early delivery : Delivery before due date. Bank shall recover/pay swap difference and interest on outlay/inflow of funds. Cancellation : Request to be obtained on or before maturity of contract subject to recovery/pay the exchange difference. Extension : Extension of contract is by way of cancellation/rebooking subject to recovery of charges and other guidelines.

Automatic Cancellation

The overdue contracts will be automatically cancelled on the 3rd working day after the maturity date.

However contract may be cancelled after maturity date but before 3rd working day with the specific request from the customer.

Option Contracts

An Option confers on the buyer the eligibility to buy or sell a sum of foreign currency at a predetermined rate on a future date without investing him with an obligation to do so. }On the due date the buyer of the option may elect to buy/sell or he may choose to let it go unused.

Features of Option Contracts

Parties : Option Buyer §Option Seller

Call and Put Options :

Call – Buyer has right to purchase the currency. §Put – Buyer has right to sell the currency.

Premium : Consideration for the seller to offer the right to the buyer

Strike Price : Exchange rate

Maturity  : Date on which contract expires

Execution :When the Buyer can exercise his right.

At the money : Strike price is equal to the current spot rate.

In the money : Strike price is favorable in relation to current spot price.

Out of money : Strike price is unfavorable in relation to current spot price

Types of Option

American Option ◦The Option Buyer can exercise his right on any day during the currency of the contract.

European Option ◦The Option Buyer can exercise his rights only on its maturity date.

Currency Future Contracts

Future Contract conveys the right to purchase or sell a specified quantity of a foreign currency at a fixed exchange rate on a specified future date.

Currency Future Contracts are traded in recognized stock exchanges.

Difference between Forward & Future Contracts


Available in Foreign currency / Rupee pairs

Traded OTC Contracts

In case of Non-utilization stands cancelled Automatically on 3rd  working day

No Margin Payment


Available against Rupee pairs

traded Exchange  Contracts

Standardized amount and delivery dates as per rules of Exchange

Non Deliverable and Net Settled

To cover counter party risk mandatory margins  are kept by the exchange which are daily adjusted as per price movements i.e. RBI Reference Rates etc.

Interest Rate Swap

¨Interest Rate Swap ¨An Interest rate swap is an arrangement whereby one party exchange one set of interest payment streams for another without exchange principal.

¨Most common arrangement is an exchange of fixed interest rate payment for another rate over a time period. The interest rates are calculated on notional value of principals.

¨Interest rate swaps enable one to restructure debt without refinancing and change the composition of an income flow from an asset. ¨

Coupon swap : (Fixed/floating ) ¨Index or basis swap : (Floating/floating )

Currency Swap

Straight Currency swap : ¨The contracting parties exchange predetermined streams of payment denominated in one currency in return  for receipt of payments denominated in another currency during an agreed period of time. ¨The counterparties exchange principal amounts of different currencies at the prevailing spot rate and pay each other interest cost.

Cross Currency Interest rate swap : ¨It is a combination of an interest rate swap and currency swap. ¨One party exchange a fixed interest cash flow in one currency with another party floating rate interest in a different currency.

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