risk management and financial engineering

TOPIC 4:CURRENCYRISK MANAGEMENTANDCURRENCY HEDGINGTECHNIQUES4.1. Leading and Lagging4.2. Currency Futures And Forwards 4.3. Money Market Hedge4.4. Currency Swaps4.5. Parallel Loan AndBack-To-Back Loan4.6. Equity Index SwapsTopic 44 CURRENCY RISK MANAGEMENT ANDTECHNIQUES................ 340-361 HEDGINGCURRENCY4.1 LEADING AND LAGGING (343)4.2 CURRENCY FUTURES AND FORWARDS (343)4.3 MONEY MARKET HEDGE (343)4.4 CURRENCY SWAPS.......................................344 - 3584.4.1 Cash Flows on the Swap with No Initial Exchange.....348 - 3504.4.2 Different Types of Currency Swap (351)4.4.3 Liquidity Considerations......................................................351 - 3524.4.4 Currency Swap Quotations.................................................352 - 3534.4.5 Hedging with a Fixed/Floating Currency Swap............353 - 3554.4.6 Comparison of Currency Swaps andForward Foreign Exchange.................................................355 - 3564.4.7 When to use Currency Swaps (357)Availability (357)4.4.84.4.9 Practical Considerations (358)4.5 PARALLEL LOAN AND BACK-TO-BACK LOAN.........359 - 3604.6 EQUITY INDEX SWAPS (361)Figure 4.1 Currency Swap (345)Figure 4.2 Principal and Interest Obligations (347)Figure 4.3 Cash Flows on a Currency Swap (348)Figure 4.4 Cocktail Swap or Tri-partite Swap (352)Figure 4.5 Currency Swap Cash Flows (354)Figure 4.6 Currency Swap Cash Flows (355)Figure 4.7 Outright Forward FX Deal Cash Flow (356)Figure 4.8 Parallel Loan (359)Figure 4.9 Back-to-back Loan (360)Topic 4: Currency Risk Management and Currency Hedging Techniques CURRENCY RISK MANAGEMENT AND TOPIC 4:CURRENCY HEDGING TECHNIQUES4.1 LEADING AND LAGGINGRefer to the class illustration by Professor Malick Sy(Topic 4 powerpoint slides from Slide 4-3 to Slide 4-15)4.2 CURRENCY FUTURES AND FORWARDS(Refer to the class illustration by Professor Malick Sy)(Topic 4 powerpoint slides from Slide 4-18 to Slide 4-20)4.3 MONEY MARKET HEDGERefer to the class illustration by Professor Malick Sy(Topic 4 powerpoint slides from Slide 4-21 to Slide 4-32)TOPIC 4.4:CURRENCY SWAPS4.4.1. Cash Flows on the Swap with NoInitial Exchange4.4.2. Different Types of CurrencySwap4.4.3. Liquidity Considerations4.4.4. Currency Swap Quotations4.4.5. Hedging with a Fixed/FloatingCurrency Swap4.4.6. Comparison of Currency Swapsand Forward Foreign ExchangeDefinitionA currency swap is an agreement between two or more parties to exchange interest obligations/receipts, for an agreed period, between two different currencies, and at the end of the period to re-exchange the corresponding principal amounts, at an exchange rate agreed at the beginning of the transaction.Definition discussedCurrency swaps differ from interest rate swaps in that they involve an exchange of interest in two currencies, and also involve an exchange of principal amounts. They therefore impinge on the balance sheets of each counterparty. As a result, currency swaps are used almost exclusively to hedge a risk rather than to trade a speculative position.Like an interest rate swap, a currency swap is a legal obligation, and at the outset each party has to agree what its role will be, and on what interest basis it will pay and receive.There are three types of currency swap:) Fixed/fixed) Fixed/floating) Floating/floatingThe interest rates are determined in advance, either as a fixed rate, e.g., 10 per cent per annum, or a specified floating rate such as 6 month dollar LIBOR. At maturity the two counterparties will exchange the principal amounts. The exchange rate used is set at the beginning of the transaction.The sterling principal repaid to Dragon Bank by Bank Georgia would be used to repay the sterling borrowing, and the sterling interest received during the swap will be used to service the debt repayments on the loan. The borrowings which are taken out to fund the initial exchange are separate from the swap itself. Where a swap has initial as well as final exchange, the credit risk is substantially reduced.True derivatives?A currency swap is not a true derivative as it will always involve a final exchange of principal. Market convention however deems that it should be treated as one.Currency Swap Terminology:CIRSCurrency Interest Rate SwapPayerThe party wishing to pay the agreed currency.ReceiverThe party wishing to receive the agreed currency.Swap rate, guaranteed rateThe swap interest rate agreed between the parties at the outset of the transaction.Rollovers/resetsThe frequency of the LIBOR settlements, e.g., a two-year swap DM swap against 6 month $ LIBOR. Dates when the swap rates are net cash-settled. Settlement is in arrears.4.4.2 Different Types of Currency Swapcurrency swap would keep the fixed interest rates traditional) Aconstant and simply swap into a different currency (fixed US$ vs fixed yen).) A cross currency swap will swap fixed for floating as well as crossing the currency (fixed US$ vs floating sterling). These are also known as cross currency coupon swaps.) A cross-currency basis swap, will swap two different floating rates in two different currencies (floating sterling vs floating French francs). These are also known as cross-currency basis swaps.Occasionally the terms asset and liability swaps are used. These terms merely denote whether the interest flows at the start come from an asset or a liability.Considerations4.4.3 LiquidityThere is less liquidity in currency swaps than in interest rate swaps, and because of this, it is sometimes necessary to go through a third intervening swap, usually a fixed/floating US dollar swap, to end up at the interest and currency basis required by both parties. These multi-legged swaps are sometimes known as cocktail swaps, or tripartite swaps. In Figure 4.4, the bank is trying td hedge a swap in French francs and dollars that it has just undertaken with client A. The only way it can protect itself is to use another French franc/sterling swap for the correct maturity from the interbank market, but this is matched only on the French franc side not on the dollar side. So an intervening fixed/floating dollar swap is installed with another swap bank in the interbank market.)Cross-currency coupon swaps - paying and receiving refer to the fixed rate, the floating rate is assumed to be 6 month dollar LIBOR.)Cross-currency basis swaps - both sides of the swap need to be identified.)Fixed vs fixed currency swaps - both sides of the swap must be specified.4.4.5. Hedging with a Fixed/Floating Currency SwapA UK communications company with mostly sterling revenues has borrowed fixed-rate dollars to finance the purchase of plant and machinery, from the USA. It expects the dollar to appreciate, owing to sustained interest rate rises. But an increase in the value of the dollar would increase the amount of sterling required to repay the original loan. The sterling equivalent cost of interest payments may also increase. A currency swap is being considered. The swap would fix the rate at maturity where the UK company could exchange sterling revenues for the dollars needed to repay the borrowings. This would hedge the exchange risk. The communications company also believe that sterling interest rates may fall, but not by very much. Consequently they could, through the swap, take a view on their own domestic interest rates as well as hedge their currency risk. They could swap from the fixed rate dollars needed to repay the dollar loan into floating-rate sterling. This would be described as a cross-currency coupon swap. It does however open the company up to an interest rate risk, an element of speculation. The simplest structure will not involve an initial exchange of principal and in any case the original borrowing was taken out years ago. The UK communications company will contact their swap bank and they will:4.4.7. When to Use Currency SwapsCurrency swaps can be used to hedge foreign exchange risk, and on occasions allow the client to take a view on the strength or weakness of his own domestic currency. However, as we have already seen, the over-riding rule of when to use swaps is that both counterparties (and the bank) should be in a better position after the swap. It follows, then, that there are circumstances when a currency swap should not be contemplated.These are:)when the existing currency of a foreign currency liability is expected to depreciate. This would reduce the amount of domestic currency required to repay the liability, which is a good thing.)when the existing currency of a foreign currency asset is expected to appreciate. This would increase the domestic currency value of the asset, also good.)when the currency into which the liability is to be swapped is expected to appreciate. This would increase the amount of domestic currency required to repay the liability, which is to be avoided.)the currency into which an asset is to be swapped is expected to depreciate. This would reduce the domestic currency value of the asset, also to be avoided.4.4.8. AvailabilityCurrency swaps are available in most major currencies and some cross-currencies, in minimum amounts of £5 million or US$5 million (or equivalent). Smaller amounts may be available on request, but there will be a price to pay included in the swap rate. Periods of up to 15 years are possible, but due to the heavy nature of the credit risk, the majority of deals are transacted for seven years and under.4.4.9. PracticalConsiderationsAny counterparty can deal in a currency swap, subject to credit considerations. Unfortunately, the credit risk on these deals includes, not only the possible interest rate movements, as in interest rate swaps; but also the potential movement between the two currency exchange rates for entire maturity. The risk to the counterparty bank is therefore very much higher. The credit department of the swap bank will need to assess their counterparty risk with the client. They will need to consider the maturity amount of any swaps the client may wish to execute, and may even specify a terminal maturity, say, nothing longer than seven years. Dealing lines and credit lines must be set up in advance.In addition to credit lines, the documentation is quite onerous for those dealing with swaps for the first time. The market has adopted the ISDA (International Swaps and Derivatives Association) document, which is a master agreement that must be set up in advance of the first deal. This is not a precondition as such, but the documentation is quite long, and company lawyers and solicitors may need to spend some time examining the main document. All swap deals are dealt 'subject to docs’: if the documentation cannot be agreed within a fairly short period, the swap will be cancelled.Within the swap itself, the rollover frequency can be monthly, quarterly, semi-annually or annual. It is not necessary for the fixed and floating payments to be paid on the same day, but the client must specify the frequency of all interest payments at the time of dealing. Each swap price will factor in the payment frequency, and the swap rates will be different to reflect this.There are a number of currency swap providers in the market, but not nearly as many as in the Interest Rate Swap Market. As a consequence, swap counterparties may be harder to find, and the product is certainly less liquid.4.6 EQUITY INDEX SWAP(Refer to the class illustration by Professor Malick Sy)(Topic 4 powerpoint slides from Slide 4-102 to Slide 4-118)。