1. MANAGING FOREIGN ECHANGE RISK

2. FACTORS THAT AFFECT EXCHANGE RATES Interest rate differential net of expected inflation Trading activity in other currencies International capital and trade flows International institutional investors sentiments Financial and political stability Monetary policy and the central bank Domestic debt levels Economic fundamentals

3. THEORIES OF EXCHANGE RATE DETERMINATION Purchasing Power Parity  i =  e i f - i h = (e f - e h ) / e h  Exchange rates are in equilibrium when the real prices of goods are the same in both countries. Any increase in price (inflation) in one country, will be balanced out by the exchange rate change

4. THEORIES OF EXCHANGE RATE DETERMINATION Balance of Payments Approach –Trade and capital transactions impacts a country’s foreign reserve  can influence currency’s strength e.g. flexibility for central banks to intervene

5. THEORIES OF EXCHANGE RATE DETERMINATION Monetary approach  e =  money supply ( e f – e h )/ e h = ( ms f - ms h ) / ms h  Exchange rates are determined by a balance of supply and demand of currencies

6. THEORIES OF EXCHANGE RATE DETERMINATION Asset approach  r =  e r f - r h = (e f - e h ) / e h  Exchange rates are in determined by returns in different countries

7. FOREIGN EXCHANGE RISK Transaction Risk –Risk impacting operational transaction Translation Risk –Risk impacting financial reports Economic Risk –Risk impacting company’s investment value

8. MANAGING FOREX RISK Operational Hedging Instrumental Hedging Asset & Liability Hedging

9. ATTITUDE TOWARDS HEDGING Hedging is equal to insuring

10. SPOT TRANSACTIONS Spot Rate Direct vs Indirect quotation Selling – Buying Cross Rate Currency Arbitrage

11. FORWARD TRANSACTIONS Forward contracts Forward pricing Flexible forward Non-deliverable forward Closing Out a Forward Contract

12. FORWARD CONTRACTS Forward Rate : outright quotation and swap rate (% or points) Forward Premium – Forward Discount (% or points) Selling Forward– Buying Forward Selling a forward contract vs Buying a forward contract Credit line needed

13. FORWARD PRICING Difference between interest rates of the respective currencies Difference between loan and deposit rate Or Closing position via buying forward

14. FLEXIBLE FORWARD Provide flexibility in terms of several delivery dates For customers who cannot specify their delivery date Priced higher that straight forward contract

15. NONDELIVERABLE FORWARDS Does not require delivery of currency Settlement in form of cash transactions of the difference Often used for hedging in emerging market where delivery is difficult Usually transacted between companies

16. CLOSING OUT A FORWARD CONTRACT Undertake delivery according to the terms of the forward contract Close out the forward by buying or selling an offsetting contract at prevailing market rates, with a resultant gain or loss Extend or roll the contract forward to another date at current rates

17. SWAPS Foreign exchange swaps Currency swaps Closing out a swap

18. FOREIGN EXCHANGE SWAPS Spot and forward transaction at the same time Tenor up to one year Used for short-term investing or borrowing in non-domestic currencies

19. CURRENCY SWAPS Transacted between counter parties with longer periods Combination of loan and investment with different currencies as well as different maturities Types of currency swaps : –Classic Currency swaps : - exchange currency –Currency Basis swaps : - exchange currency w/ respective floating interest rates –Common Currency swap : - exchange currency as well as fixed to floating interest vice versa FinalCrossCurrencySwap.pdf FinalCrossCurrencySwap.pdf

20. CLOSING OUT A SWAP Advance settlement can be settled out via –Payments of fund breaking cost (the net present value of future payments) –Offsetting with another swap –Swap extension

21. CURRENCY FUTURES Exchange traded forward contracts Predetermined contract size, delivery date and trading procedures set by exchange market where they trade No credit facility needed, but margin requirements ( in form of performance bond ) No delivery needed

22. CLOSING OUT FUTURES CONTRACT Take delivery of the currency per the terms of the contract Buying or selling an offsetting contract at prevailing market rates, with a resultant gain or loss Extend or roll the contract forward to another delivery date

23. FOREIGN EXCHANGE OPTION Option Premium Strike Rate Option duration American Option vs European Option Call option vs Put option Purchase of Option  hedging Sell of Option  speculating Over the counter vs Exchange traded Option position : –In the money –At the money –Out of the money

24. DETERMINANTS OF FOREX OPTION PRICES Current exchange rate Exercise or strike rate Risk free foreign interest rate Risk free domestic interest rate Volatility of the exchange rate Put or Call option Time until expiration of the option American or European style

25. EXOTIC OPTIONS Foreign Exchange Collars Average Rate Option Barrier Option Compound Option

26. FOREX COLLARS  Range Forward, Cylinder Option, Tunnel Option, zero cost collar Combines the purchase of a call option with a sale of put option with the same expiry date on the same currency pair European style Zero cost collar : –premium payment for call option = premium received from put option

27. FOREX COLLARS CALL Option Strike rate Rp. 9.500 PUT Option Strike rate Rp. 8.500 REF. RATE = Rp. 11.000 REF. RATE = Rp. 8.000 Buy at Rp. 9.500 Option not exercised Pay Rp. 500 more than market rate

28. AVERAGE RATE OPTION Asian Option Spot rate are calculated as an average over a period Transactions possible during the expiry period at several predetermined dates Strike rate can be fixed or floating

29. BARRIER OPTION Includes strike rate and barrier rate Knock in Option (Call): –Option can only be exercised if spot rate reaches the barrier rate –The farther from market spot rate the cheaper the option Knock out Option (Put): –Option becomes non-exercisable if spot rate reaches the barrier rate –The closer to market spot rate the cheaper the option Does not provide full protection The key is in determining the barrier rate

30. KNOCK IN OPTION BARRIER RATE Rp. 9.500 CALL Option Strike rate Rp. 8.500 REF. RATE = Rp. 10.500 Option not exercisable Option exercisable  Knocked in

31. KNOCK OUT OPTION BARRIER RATE Rp. 8.500 PUT Option Strike rate Rp. 9.500 REF. RATE = Rp. 8.499 Option knocked out Option exercisable

32. COMPOUND OPTION Option on options European style Give the option buyer the right to buy or sell an option contract at the compound option’s expiry date at a predetermined option premium Cheaper than straight option but might be more expensive hedging instrument

33. CLOSING OUT AN OPTION Deliver per terms of option contract or allow the option to expire at discretion of option holder Sell a purchased option at current market value Buy back a sold option at current market value

34. OPERATIONAL HEDGING Currency Netting –Net off cash in – out of same currency –Hedge only the net balance Proxy Hedging –Hedging using different currency w/ hi corr. Foreign Currency Debt Changes to purchasing/processing Transfer exchange rate risk Eliminate Currency difference