Foreign Currency Swap or Foreign Exchange Swap

Each entity has a different access and different needs in the international financial markets. Companies receive more favorable credit ratings in their country of domicile than in the country in which they need to raise capital. Investors are likely to demand a lower return from a domestic company, which they are more familiar with than from a foreign company. In some cases a company may be unable to raise capital in a certain currency. Currency swaps are also used to lower the risk of currency exposure or to change returns on investment into another, more favorable currency. Therefore, currency swaps are used to exchange assets or capital in one currency for another for the purpose of financial management.

A currency swap transaction involves an exchange of a major currency against the U.S. dollar. In order to swap two other non- U.S. currencies, a dealer may need to arrange two separate swaps. Although, any currency can be used in swaps, many counter-parties are unable to exchange their currencies due to a lack of demand. Since currency swaps involve die exchange of two or more types of currencies, the actual exchange of principals takes place at the commencement and the termination of the swaps. On certain occasions, the exchange occurs only at the inception of the swap depending on the nature of the swap. The exchange of principals is necessary because of the fluctuation of currencies. Also, counter parties may need to utilize the respective exchanged currencies. Principals and interest payments are exchanged based on the spot rate agreed at the inception of the swaps.… Read the rest

Pricing of Futures Contracts Using Interest Rate Parity in Forex Trading

According to the interest rate parity theory, the currency margin is dependent mainly on the prevailing interest rate (for investment for the given time period) in the two currencies. The forward rate can be calculated by the following formula:

F/S = (1+Rh)/ (1+Rf)

Where, F and S are future and spot currency rate. Rh and Rf are simple interest rate in the home and foreign currency respectively.

Alternatively, if we consider continuously compounded interest rate then forward rate can be calculated by using the following formula:

F = S*e (rh- rf)*t

Where, rh and rf are the continuously compounded interest rate for the home currency and foreign currency respectively, T is the time to maturity and e = 2.71828 (exponential).

If the following relationship between the futures rate and the spot rate does not hold, then there will be an arbitrage opportunity in the market. This will force the futures rate to change so that the relationship holds true.

Let us assume that risk free interest rate for one year deposit in India is 7% and in USA it is 3%. You as smart trader/ investor will raise money from USA and deploy it in India and try to capture the arbitrage of 4%. You could continue to do so and make this transaction as a non ending money making machine. Life is not that simple! And such arbitrages do not exist for very long.

We will carry out the above transaction through an example to explain the concept of interest rate parity and derivation of future prices which ensure that arbitrage does not exist.… Read the rest

Hedging with Foreign Currency Futures

Exchange rates are quite volatile and unpredictable, it is possible that anticipated profit in foreign investment may be eliminated, rather even may incur loss. Thus, in order to hedge this foreign currency risk, the traders’ often use the currency futures. For example, a long hedge (i.e., buying currency futures contracts) will protect against a rise in a foreign currency value whereas a short hedge (i.e., selling currency futures contracts) will protect against a decline in a foreign currency’s value.

It is noted that corporate profits are exposed to exchange rate risk in many situation. For example, if a trader is exporting or importing any particular product from other countries then he is exposed to foreign exchange risk. Similarly, if the firm is borrowing or lending or investing for short or long period from foreign countries, in all these situations, the firm’s profit will be affected by change in foreign exchange rates. In all these situations, the firm can take long or short position in futures currency market as per requirement.

The general rule for determining whether a long or short futures position will hedge a potential foreign exchange loss is:

  • Loss from appreciating in Indian rupee= Short hedge
  • Loss from depreciating in Indian rupee= Long hedge
Short Hedge

A short hedge involves taking a short position in the futures market. In a currency market, short hedge is taken by someone who already owns the base currency or is expecting a future receipt of the base currency.… Read the rest

Translation Exposure in Terms of Foreign Exchange Risk

Consolidation of financial statements, which involve foreign currency denominated assets and liabilities automatically, gives rise to translation exposure, sometimes termed as accounting exposure. Consolidation of foreign subsidiaries account into group financial statements denominated in home currency requires the application of a rate or rates of exchange to foreign subsidiaries accounts, in order that they may be translated into the parent currency. Both balance sheets and income statements must be consolidated and they both give rise to translation exposure. Translating foreign currency profit and loss accounts at either the average exchange rate during the accounting year or at the exchange rate at the end of the accounting year (both methods are currently permissible as per British accounting procedures) will mean that expected consolidated profit will vary as the average or that the expected closing rate changes. So the whole amount of profit earned in the foreign currency is exposed to translation risk in the sense that the home currency’s consolidated profit may vary as exchange rates vary.

Balance sheet exposure is somewhat more complex. Some items in a foreign subsidiary’s balance sheet may be translated at their historical exchange rates (the rate prevailing at the date of acquisition or any subsequent revaluation). Thus their home currency translated value cannot alter as exchange rates alter; such assets and liabilities are not exposed in the accounting sense. Other items may be translated at the closing exchange rate – the rate prevailing at the balance sheet date at the end of the accounting period.… Read the rest

Understanding the Financial Swaps Market

Exchange rate instability and the collapse of the Bretton Woods System and particularly the control over the movement of the capital internationally, paved the way for the origin of the financial swaps market. To day swaps are at the center of the global financial revolution. The growth is such that sometimes it looks like unbelievable but it is true. Though its growth will continue or not is doubtful. Already the shaking has started. In the “plain vanilla” dollar sector, the profits for brokers and market makers, after costs and allocation of risk capital, are measured in fewer than five basis points. This is before the regulators catch up and force disclosure and capital haircuts. At these spreads, the more highly paid must move on to currency swaps, tax-driven deals, tailored structures and schlock swaps.

The fact which is certain is that, although the excitement may diminish, swaps will stay. Already, swaps have had a major macro economic impact forging the linkage between the euro and the domestic markets, flattening the cash yield curves, and reducing central bank monopoly influence on markets. We are all swappers now and remember the saying “beware of honey offered on a sharp knife” when you are offered sweet deals. The problem in following the chaotic process of this very important market is quite simply that “he who knows does not speak, he who speaks does not know.”

The concept of the SWAPS

The aim of a swap contract is to bind the two counter-parties to exchange two different payment streams over time, the payment being tied, or at least in part, to subsequent-and uncertain-market price developments.… Read the rest

Factors That Affect Currency Values

To date, there is no exchange rate model that can predict future currency prices with 100% accuracy. In rapidly growing global foreign exchange markets, currency movements become harder to predict as more participants enter the market on a daily basis, bringing with them all their research opinions, emotions, and expectations about where currencies should be headed. Currency movements in the short term can be influenced by publicly available information like the release of the country’s gross domestic product data, the consumer price index, or employment data. The following publicly available information can have immediate impact on currency movements:

  • Local economic data releases and the anticipation of those releases.
  • Economic data releases in foreign countries, especially of major trading partners, and the anticipation of those releases.
  • Central banks, such as the U.S. Federal Reserve or the European Central Bank, raising or lowering interest rates.
  • Central banks making public their thoughts on monetary policy.
  • Expectation of central banks making public their views on local interest rates or monetary policy.
  • Political developments, both globally and in individual countries.
  • Natural disasters and perceptions about how they will impact economies.
  • Changes in commodity prices, particularly oil and gold.

This list is not exhaustive, but these factors would be among the more important catalysts for currency movements.

But there is also information that is not immediately publicly available, such as individual traders in-house strategic analyses on currencies or buy and sell orders that come from customers, which can affect the decision process of market participants. The activities of market participants such as central banks, commercial banks, hedge funds, individual investors, and multinational corporations will be influenced by a mixture of all these factors.… Read the rest