How does a FX Forward transaction work?

| 27-11-2017 | treasuryXL |

 

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FX Forward Contract

A Foreign Exchange Swap (also known as a FX Forward) is a two-legged transaction where one currency is sold or bought against another currency at a determined date, and then simultaneously bought or sold back against the other currency at a future date. Normally this means the first transaction would take place at the prevailing spot rate and settle on the spot date, whilst the forward transaction would prevail at an agreed forward rate and settle on the agreed forward date. The difference between the Spot price (or first price) and the Forward price (or second price) represents the FX Forward and is expressed as Swap points.

 

Read more about the types of Forward Contracts


What are Swap points?

Swap points represent the cost of borrowing one currency, whilst simultaneously lending another currency for a time period equal to the swap period. Swap points are therefore the cost of carry netted out between two currencies and used to adjust the existing Spot price to express the Forward price.

Worked example

Currency 1 ABC
Currency 2 XYZ
Period 6 months
Days in period 183
Interest rate 6 months ABC 4%
Interest rate 6 months XYZ  7%
Spot ABC/XYZ 2.1025

For ABC 1,000,000.00 there are XYZ 2,102,500.00

ABC 1,000,000.00 * (1+4/100*183/360)     = ABC 1,020,000.00
XYZ 2,102,500.00 * (1+7/100*183/360)      = XYZ 2,177,313.96

XYZ 2,177,313.96/ABC 1,020,333.33 = 2.1339

Swap points = +/+ 314 pips

What does this mean?

The Forward price of 2.1339 is higher than the Spot price of 2.1025 and means that the currency ABC trades at a forward premium to currency XYZ. Therefore, the Swap points of 314 pips are added to the current Spot price. A bank that is quoting would only quote the Swap points. A two-way quote would look something like 304/324. At 304 the bank would sell and buy ABC – spot against 6 months – against buying and selling XYZ. At 324 they would do the complete reverse.

So is the Forward price the same as a future?

No, the Forward price is not an attempt to determine the future value of currency ABC expressed in the price of currency XYZ. It is a price that is derived by notionally hedging the notional values of both currencies against their respective interest rates that are applicable at that moment in time. The Forward price is an example of interest rate parity – a state of non-arbitrage or equilibrium where traders are indifferent to either as there is no monetary advantage in either. Forwards are traded ‘Over the Counter’ and not via an exchange. Regardless of what the future value of spot ABC/XYZ is, once the trade has been executed there can only ever be opportunity loss or profit in the bookkeeping.

Variations

FX Forwards can also be forward starting – a client might wish to create/hedge an exposure starting in 4 months’ time and with a tenor of 6 months. This would be seen as a 6 month starting in 4 months’ time – or a 4m*10m. Such a Forward would be calculated from the present spot to both 4 months and 10 months, with the present Spot rate adjusted for the Forward price for 4 months to reflect the new starting price.

Alternatively, instead of swapping a position, a client might just wish to hedge their exposure/obligation in the future by trading ‘Outright’. If they were to buy ABC forward they would enter into a FX Swap (sell ABC at spot and buy forward) and then immediately buy ABC at spot, offsetting the spot leg of the FX Swap.

What moves the price?

Changes in the underlying interest rates of both currencies will affect the calculation. Also as the interest rate differential of the two currencies is expressed as a price of the existing spot rate, changes in the spot rate will also cause changes in the outcome of the calculation – though generally smaller than those caused by changes in interest rates.

Why trade FX Forwards?

FX Forwards allow a company to hedge future exposure/obligations. Once the contract has been struck that value is confirmed and is not subject to ‘mark-to-market’ variation orders as happens with an off-balance-sheet instrument. An exposure in one currency can be transformed into another currency via use of a FX Forward. An expected inflow or outflow that is delayed can be rolled forward by using a FX Forward.

Lionel Pavey

 

 

Lionel Pavey

Cash Management and Treasury Specialist

 

 

How does a FX spot transaction work?

| 14-11-2017 | treasuryXL |

Every day we enter into transactions in our own domestic market. Goods are priced in our own currency and we settle purchases in our own currency. Here in the Netherlands that means everything is priced and settled in Euro’s. It is a clear and concise system – of course we might argue about the price of goods, but that is another matter. Now consider what happens when we sell our goods to a counterparty domiciled in a different country – we shall assume from the United States. We would prefer to invoice in EUR as this is our domestic currency, whilst our counterparty would prefer to settle in USD. This makes sense as in both instances neither of us would be exposed to fluctuations in the exchange rate between the EUR and USD.

There are 3 basic choices to trade with a foreign based counterparty:

  • Price in our currency, but run the risk that they will not trade with us
  • Price in their currency, win the trade but do nothing about the risk
  • Price in their currency, but adjust our price for the perceived FX risk and sell their currency for our currency as soon as the deal is closed

As we are keen to expand our export markets we agree to charging the buyer in USD, but what price should we charge in USD? By accepting payment in USD we are now assuming a foreign exchange risk as the value of the USD could fall in relationship to the EUR before we have sold the USD for EUR. If the fall was large it could take away all our profit from the original transaction, possibly even leading to a loss on the order.

We must therefore enter into a transaction to sell USD and to receive EUR to book our profit and to neutralize the FX risk. This leads us into the world of Foreign Exchange (FX) trading.

In FX trading quotations are always shown for a pair of currencies such as EUR/USD – but what does this mean?

  • The first currency – EUR – is called the base currency
  • The second currency – USD – is called the quoted currency
  • The spot rate is shown as 1.1595
  • This means that every unit of the base currency is equal to 1.1595 units of the quoted currency

If our order was for EUR 100.000,00 then the USD equivalent would be USD 115.950,00

In this example it is the USD price that fluctuates as it is the quoted currency, but this does not mean that fluctuations are only caused by changes in the value of USD. The value can also fluctuate because of changes in the value of EUR – even though this is the base currency.

Most major currency pairs are quoted to 4 decimal places – with the 3rd and 4th places being called “pips”. Pips are the expression traders use to describe their profit or their market spread.

If we traded EUR 1 million into USD, we would have an equivalent of USD 1.159.500,00

The value of 1 “pip” would be USD 100,00

When we approach a bank for a quotation in spot EUR/USD, the bank quotes a 2-way price such as 1.1592/97

The lower price – 1.1592 – represents the bank’s bid price. This is the price at which the bank buys EUR and sells USD.

The higher price – 1.1597 – represents the bank’s offer price. This is the price that at which the bank sells EUR and buys USD.

If the bank quoted this price into the market and one clients hit the bid at 1.1592 and another took the offer at 1.1597, both in EUR 1 million, then the bank would book a profit of USD 500,00 – or a profit of 5 pips on EUR 1 million.

FX is one of the largest markets in the world – daily turnover exceeds USD 5 trillion per day. That means 5 followed by 12 zeros – every working day.

With such a large daily turnover, prices are constantly changing. The market consists of price makers (who make the prices), price takers (who take the prices), intermediaries like brokers who assist the market by transmitting the prices and placing orders, and clients who place orders at specific levels. Prices are only valid for a few seconds before they change either because the market has traded on the quoted price or a new order replaces the existing price.

When you trade on the quoted price then you have entered into a binding contract with the counterparty. Settlement is normally 2 working days after the trade date. If you sell USD then you must ensure your counterparty receives the agreed USD amount on their account in 2 working days, and you receive the agreed EUR amount on your account in 2 working days.

Trade settlement is very important and means that you must have a complete operational procedure in placing to effect settlement, establish positions, agree counterparties, have trading limits etc.

Traditionally spot FX trades were done with banks. Now trades can also be transacted via electronic exchanges, electronic brokers etc. It is always important to know who your counterparty is – it could be that your internal operational control prohibits you from trading with specific counterparties.

Most major currencies can be traded against each other without restrictions such as exchange control. Therefore, currency pairings can be found everywhere such as USD/JPY and EUR/GBP and ZAR/CHF.

Spot FX transactions are not traded on listed exchanges; these trades occur “over the counter” with a clearly identifiable counterparty.

 

Lionel Pavey

 

 

Lionel Pavey

Cash Management and Treasury Specialist

 

FX-Risks Versus Technology

| 27-10-2017 | Treasurer Development | Minor Treasury @ Hogeschool Utrecht | Frans Boumans |

Today’s blog has been written by Daphne Piereij and Martijn Mullié, who are 2 students studying for the minor Treasury Management at the University of Applied Sciences in Utrecht. We welcome their contribution – it is good to see the youth engaging in Treasury matters! Here is their opinion on FX – risks versus technology.

“The one unchangeable certainty is that nothing is certain or unchangeable.” Those words were uttered by former US president John F Kennedy in a State of the Union address before Congress in 1962.

This still applies to the current state of the world. Especially within the financial markets and with FX Risks. Managing these risks have been completely revolutionized the past decades because of the new innovations in technology.

Traditionally traders manually update their volatility surfaces and bid-offer spreads, and that default pricing would have gone directly out to clients. More efficient is to use the electronic market data and automate much of that process, particularly in the most liquid currency pairs, creating a more transparent, data-driven practice.

According to McKinsey these are the trends in FX risk management with evolving technology and advanced analytics:

Big Data

Faster, cheaper computing power enables risk functions to use reams of structured and unstructured customer information to help them make better credit risk decisions.

In the future while this technology evolves and the quality of analytics of big data becomes better it will be easier to manage FX risks.

Machine Learning

This method improves the accuracy of risk models by identifying complex, nonlinear patterns in large data sets. Every bit of new information is used to increase the predictive power of the model.

Keeping in mind the words of former president John F. Kennedy the world will never be predictable and neither will the financial market. Because it’s not ran by machines but by humans, and humans are in general unpredictable. Which means this process has no end until the financial markets are managed by machines which are predictable.

Crowd Sourcing

The Internet enables the crowdsourcing of ideas, which many incumbent companies use to improve their effectiveness.

The internet can motivate people with challenges to work together to make algorithms for analytic functions so market data can be used more efficiently. It’s not always the most effective method to use the in-house developers to create algorithms. To make the most effective FX risk management algorithms is very hard and time consuming. Crowd Sourcing enables a whole different aspect to create algorithms, using more brains to create these immensely complicated methods to decrease FX risks.

Resources
https://www.mckinsey.com/business-functions/risk/our-insights/the-future-of-bank-risk-management
https://www.risk.net/risk-management/5276541/managing-fx-risk-how-to-prepare-for-the-unpredictable

Minor Treasury Management

More information about the minor Treasury Management at the University of Applied Sciences?
Please contact Frans Boumans.

 

Frans Boumans

Manager Minor Treasury Management @ University of Applied Sciences in Utrecht

 

 

Managing Treasury Risk – Foreign Exchange Risk (Part III)

| 7-2-2017 | Lionel Pavey |

 

There are lots of discussions concerning risk, but let us start by trying to define what we mean by risk. In my third article I will focus on foreign exchange risk. This risk has to be taken into consideration when a financial commitment is denominated in a currency other than the base currency of a company.
There are 4 types of foreign exchange risk.

Transaction Risk

Transaction risk occurs when future cash flows are denominated in other currencies. This refers to both payables and receivables.  Adverse changes in foreign exchange prices can lead to a fall in profit, or even a loss.

Translation Risk

Translation risk occurs when accounting translation for asset and liabilities in financial statements are reported. When consolidating from an operating currency into a reporting currency (overseas offices etc.) the value of assets, liabilities and profits are translated back to the reporting currency. Translation risk does not affect a company’s cash flows, but adverse changes can affect a company’s earnings and value.

Economic Risk

Economic risk occurs when changes in foreign exchange rates can leave a company at a disadvantage in comparison to competitors. This can affect competitive advantage and market share. Future cash flows from investments are also exposed to economic risk.

Contingent Risk

Contingent risk occurs when potential future work is expressed in a foreign currency. An example would be taking part in a tender for work in another country where the pricing is also in a foreign currency. If a company won a large foreign tender, which results in an immediate down payment being received, the value of that money would be subject to transaction risk. There is a timeframe between submitting a tender and knowing if the tender has been won, where a company has contingent exposure.

Identifying Foreign Exchange Risk

  1. What risk does a company face and how can it be measured
  2. What hedging or rate management policy should a company use
  3. What financial product, available in the market, should be best used
  4. Does the risk relate to operational cash flows or financial cash flows

Initially we need to ascertain what we think future FX rates will be. Methods that can be used include the Forward Rate Parity, the International Fisher Effect which also includes expected inflation, forecasts provider by banks and international forums, along with VaR. Model analysis can be provided, among others, via fundamental factors, technical analysis, and political analysis.

Different FX rates can then be used to simulate the effects on cash transactions when converted back into the base currency. This will provide different results that will allow a company to determine what level of risk it is prepared to accept. Finally a decision must be taken as to whether the company wishes to hedge its exposure or not. Before the advent of the Euro, both the Netherlands and Germany  were members of the Exchange Rate Mechanism (ERM). This meant there was agreed band within which the spot rate could move around an agreed central point – this was NLG 112.673 equal to DEM 100.00 with a bandwidth of +- 2.25%. For some companies, this tight band meant that they took the decision not to hedge any exposure between DEM and NLG.

Financial products that are commonly used to manage foreign exchange risk include Forward Exchange contracts, Futures, Caps, Floors, Collars, Options, Currency Swaps and Money Market hedging.

Lionel Pavey

 

 

Lionel Pavey

Cash Management and Treasury Specialist

 

 

More articles of this series:

Managing treasury risk: Risk management

Managing treasury risk: Interest rate risk 

Option Tales: Cheap Options Part III

| 31-05-2016 | Rob Söentken

banking

 

Today in Rob Söentken’s Option Tales: When buying options it is tempting to see if the premium expenses can be minimized. A number of solutions are possible, which will be discussed in four articles. In the previous article I talked about choosing the longer tenor and the compound option. Today I will discuss the average rate option (ARO) and the conditional premium option.

Average Rate Option (ARO)

An Average Rate Option (ARO) can be misleading because it is like a vanilla option except for the reference rate against which it is exercised. The reference rate for an ARO is an average based on spot rates for USD taken at predetermined intervals. For a vanilla option it is the single rate for spot at maturity. If the intention was to hedge the rate for USD in 1-year time, the average of USD rates during the year is really something different.

If we would be looking to hedge a 1-year tenor and the averaging would be at quarterly intervals, a rough and quick estimate of an ARO’s cost would be the average premium of separate vanilla options for respective tenors, in this case that would be 0.9% (see diagram 3). Which would be considerably less than a vanilla option costing 1.50%.average rate option ARO
But unlike a strip of options which can be exercised individually, an ARO can only be exercised in total. At maturity the averaging of the fixings is mostly done, and it could happen that while the last fixing is In The Money (ITM), the average of the fixings is not, making the ARO expire worthless. In this example it would be advantageous to have a strip of vanilla options because each option would be exercisable independently of the other. The ARO on the other hand is worthless because the average would still be above the strike. This inherent risk in using an ARO will make the premium of an ARO even a bit cheaper than a strip of vanilla options.

The bottom line remains that the premium of an ARO is lower than a vanilla option for the same tenor, because the embedded tenor of the ARO is really shorter. The effect is comparable to paragraph 2 ‘Choose shorter tenor’. Slightly worse even when considering the averaging effect.

Conditional Premium Option

A Conditional Premium Option has the advantage over a vanilla option in that premium only has to be paid if the option is In-The-Money (ITM). But… if the option is ITM the premium will be a multiple of a vanilla option. The premium of such a Conditional Premium Option is calculated by dividing the premium of a vanilla optionconditional premium option (1.5%, see diagram 5) by the chance it will be exercised (Delta, in this case 25%), ie 1.5% : 25% = 6%. It could be a very disappointing to find that if this Conditional Premium option is only marginally ITM at maturity, because the premium of 6% still has to be paid.

A Conditional Premium Option is constructed by buying a vanilla option and selling a digital option with the same strike. The digital option will be for a payout of 6% and because it also has a chance on exercise of 25% it will generate 1.5% premium, offsetting the premium of the vanilla option.

Next week in the last Option Tales article; the Reverse Knock-Out Option (RKO).

Would you like to read more on Rob Söentken’s Option Tales?:

1. Options are for wimps

2. ATM or OTM

3. Cheap Options part I

4. Cheap Options part II

 

Rob Soentken

 

 

Rob Söentken

Ex-derivates trader

Option Tales: Cheap Options Part II

| 24-05-2016 | Rob Söentken |

bankingToday in Rob Söentken’s Option Tales: When buying options it is tempting to see if the premium expenses can be minimized. A number of solutions are possible, which will be discussed in four articles. In the previous article I talked about the first two solutions: Choose the strike further OTM and Choose shorter tenor. Today I will be discussing the next two solutions: Choose the longer tenor and the Compound option.

 

3- Choose longer tenor

Following the comparison between a 3-month and a 12-month option, it should be remembered that a 12-month option will have some remaining value after 3 months have passed, at least theoretically. If we assume ‘ceteris paribus’ (everything remained unchanged) the remaining option value of a 12-month option would be 1.1%. If we diagram1pt2bought the option for 1.5%, we could sell it after 3 months at 1.1% and buy the USD through an outright forward transaction. This approach shows that the net cost of option protection would be only 0.4% (1.5% – 1.1%). Which would be cheaper than the premium of a 3-month option with the same Delta. Also, because the option has a higher Delta than a 3-month option with the same strike (25% vs 10%, see diagram 2), it will follow the spot market much better. The bottom line of paragraph 3 is that a longer dated option can be bought with the intention to sell it again at some point, the net cost being less than buying a shorter dated option. While it serves as a hedge against price changes.

4- Compound option

A compound option is the right to buy an option against a certain premium. For example we could be considering todiagrampt2 buy the 1-year option in diagram 2 for 1.5%. Alternatively we could consider buying a right to buy this option for 0.4% in 3 months time. At that time the 1-year option will only have 9 months remaining, but the strike and 1.5% premium are fixed in the contract. On the expiry date of the compound option we can decide if we want to pay 1.5% for the underlying option. Alternatively, assuming nothing has changed, we could buy a 9 month option in the market for 1.1% (see diagram 2). In such a case we wouldn’t exercise the compound option.

An alternative to the compound option would be to buy the 3-month option for 0.2%. On expiry, assuming nothing has changed again, we could buy a 9 month option in the market for 1.1% (see diagram 2).

In my next two articles I will discuss the last two solutions for minimizing premium expenses when buying options:

  • Conditional Premium option
  • Reverse Knock Out

Would you like to read more in Rob Söentken’s Option Tales?
1. Options are for wimps
2. ATM or OTM
3. Cheap options part 1

 

Rob Soentken

 

 

Rob Söentken

Ex-derivatives trader

 

Option Tales: Cheap Options Part I

17-05-2016 | By Rob Soentken |

banking

 

Today in Rob Soentken’s Option Tales: When buying options it is tempting to see if the premium expenses can be minimized. A number of solutions are possible, which will be discussed in four articles. Today I’m discussing the first two solutions: Choose the strike further OTM and Choose shorter tenor.

 

1-Choose Out of The Money (OTM) Strike

Hedging the purchase of a certain amount of USD could be done by purchasing a USD call option with the strike set At The Money (ATM). In diagram 1 it shows that such an option would costs about 2.0%. The strike is 0% OTM, so ATM. A strike further OTM would cost less premium. For example, a strike set at 3% OTM would costs only 0.8%. The cost saving is 1.2%, but also the protection kicks-in only after USD has appreciated by 3%. Should we need to exercise the option to get our USD, it still means a combined hedging cost of 3.8%. Which is more than if we had bought the ATM option for 2% premium. Conclusion: Buying an OTM option reduces the up-front cost versus buying an ATM option. But ex-post hedging with an OTM option could result in total hedging cost which are higher than an ATM option.

2- Choose shorter tenor

Hedging the purchase of a certain amount of USD in 1-year time could be done by purchasing a USD call option with 25% chance of exercise. In diagram 2 it shows that such an option would have a strike 6.2% OTM and would cost 1.5%. Options with the same strike but with a shorter tenor would cost less up front. For example: choosing a 3-month time to expiry would make the option premium 0.2%. It must be noted that while the 3-month option has the same strike as the 12-month, its chance on exercise (Delta) is substantially less. By itself choosing a 3-month tenor is not ‘wrong’ when hedging a 12 months USD flow. It is just the on the expiry date of the option either the option is exercised, or the USD must be purchased from the market at the prevailing rate.

 

 

In my next two articles I will discuss the following solutions for minimizing premium expenses when buying options:

  • Choose longer tenor
  • Average rate option
  • Conditional Premium option
  • Reverse Knock Out

Want to read more in Rob Soentken’s Option Tales?

Option Tales – Options are for Wimps
Options Tales – ATM OR OTM?

 

Rob Soentken

 

 

Rob Soentken

Ex derivates trader

Option Tales: ATM or OTM?

banking10-05-2016 | By Rob Soentken |

 

When uncertainty is substantial and the decision was made to hedge with options, should the strike be put ‘At The Money’ (ATM) or ‘Out of The Money’ (OTM)? Diagram 1 shows the dilemma.

 

 

An ATM call option on USD with strike at 1.1400 costs about 2% while a 4% OTM option with the strike at 1.0944 costs only about 0.6%. The latter is substantially cheaper but the protection only kicks in once the USD has appreciated 4%.

option tales - 1

We know the premiums and the strikes, but each strike / premium combination has its merits. It would help if we would know the amount of Risk we are running. To speak in terms of insurance: We know the premium, but we do not know the potential loss. One thing we do know is the chance on that loss. This chance factor is called Delta. It is the chance of the USD appreciating below the strike of the option. The premium divided by the chance on the loss is the potential loss. It could be more, it could be less, but it is the estimated average loss. For example: The 1.14 strike costs 2% premium and has a 50% chance of being worth anything. Therefore the 2% is the premium on an insurance contract potentially worth 2% : 50% = 4%. Lets call this Risk.

Diagram 2 shows Premiums, Delta and Risk for various OTM strikes.option tales - 2 Risk appears fairly stabile across strikes, which makes sense because the premiums are calculated with one volatility on one underlying. The Risk on OTM is lower than that for ATM options. It appears that OTM premiums are relatively more expensive, they give protection against less potential loss.

Knowing the Risk to be around 3.5-4% on the USD to be purchased, it does not come as a surprise that in real life many option strikes are bought to protect for losses beyond this percentage amount. Hedgers are looking for protection beyond the expected potential loss on the underlying. These are OTM strikes in this case 3-4% OTM, with a Delta (chance of exercise) between 20-25%.

option tales - 3Diagram 3 shows Premiums, Delta and Risk for different tenors. ‘Time’ is the time to expiry of the options in fractions of years. Its shows that for longer tenors, the Risk is higher. But disproportionally. For the same chance on exercise a hedger could double the premium to buy a hedge for a 4x longer tenor.

Rob Soentken

 

 

Rob Soentken

Ex-derivatives trader