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Emerging Market currencies hurt by risk aversion !
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FOREX 101!
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Currency future
A currency future, also FX future or foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the last trading date. Typically, one of the currencies is the US dollar. The price of a future is then in terms of US dollars per unit of other currency. This can be different from the standard way of quoting in the spot foreign exchange markets. The trade unit of each contract is then a certain amount of other currency, for instance EUR 125,000. Most contracts have physical delivery, so for those held at the end of the last trading day, actual payments are made in each currency. However, most contracts are closed out before that.
nvestors use these futures contracts to hedge against foreign exchange risk. They can also be used to speculate and, by incurring a risk, attempt to profit from rising or falling exchange rates. Investors can close out the contract at any time prior to the contract's delivery date.
Currency futures were first created at the Chicago Mercantile Exchange (CME) in 1972, less than one year after the system of fixed exchange rates was abandoned along with the gold standard. Some commodity traders at the CME did not have access to the inter-bank exchange markets in the early seventies, when they believed that significant changes were about to take place in the currency market. They established the International Monetary Market (IMM) and launched trading in seven currency futures on May 16, 1972. Today, the IMM is a division of CME. In the second quarter of 2005, an average of 332,000 contracts with a notional value of USD 43 billion were traded every day. Most of these are traded electronically nowadays [1].
Other futures exchanges that trade currency futures are Euronext.liffe [2] and Tokyo Financial Exchange [3]
The IMM dates are the third Wednesday in March, June, September and December.
Example
Peter buys 10 September CME Euro FX Futures, at 1.2713 USD/EUR. At the end of the day, the futures close at 1.2784 USD/EUR. The change in price is 0.0071 USD/EUR. As each contract is over EUR 125,000, and he has 10 contracts, his profit is USD 8,875. As with any future, this is paid to him immediately.
More generally, each change of 0.0001 USD/EUR (the minimum Commodity tick size), is a profit or loss of USD 12.5 per contract.
Forex swap
Forex swap is an over the counter short term interest rate derivative instrument. A Forex swap consists of a spot foreign exchange transaction entered into at exactly the same time and for the same quantity as a forward foreign exchange transaction. The forward portion is the reverse of the spot transaction, where the spot purchase is offset by a forward selling. In this reason, surplus funds in one currency are for a while swapped into another currency for better use of liquidity. Protects against adverse movements in the forex rate, but favourable moves are renounced.
It should not be confused with a currency swap, which is a much rarer, long term transaction, governed by a slightly different set of rules.
In emerging money markets, Forex swaps are usually the first derivative instrument to be traded, ahead of Forward rate agreements.
Currency swap A currency swap is a foreign exchange agreement between two parties to exchange a given amount of one currency for another and, after a specified period of time, to give back the original amounts swapped.
Currency swaps can be negotiated for a variety of maturities up to at least 10 years. Unlike a back-to-back loan, a currency swap is not considered to be a loan by United States accounting laws and thus it is not reflected on a company's balance sheet. A swap is considered to be a foreign exchange transaction (short leg) plus an obligation to close the swap (far leg) being a forward contract.
Currency swaps are often combined with interest rate swaps. For example, one company would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a floating-rate debt denominated in Euro. This is especially common in Europe where companies "shop" for the cheapest debt regardless of its denomination and then seek to exchange it for the debt in desired currency.
Foreign exchange option
In finance, a foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.
For example a USD/GBP FX option might be specified by a contract allowing the purchaser to exchange £1,000,000 into $2,000,000 on December 31st. In this case the pre-agreed exchange rate, or strike price, is 2USD/GBP or 0.5GBP/USD and the notional is £1,000,000. This type of contract may be called either a dollar call or a sterling put depending on the market convention. If the dollar is stronger than 0.5GBP/USD come December 31st (say at 0.55GBP/USD) then the option will be exercised, making a profit of (2 - 1/0.55)*1,000,000 = $181,818 or £100,000.
Valuing FX options: The Garman-Kohlhagen model
As in the Black-Scholes model for stock options and the Black model for certain interest rate options, the value of a european option on an FX rate is typically calculated by assuming that the rate follows a log-normal process.
Examples
Suppose a United Kingdom manufacturing firm is expecting to be paid $100,000 for a piece of engineering equipment to be delivered in 90 days. If the exchange rate goes down over the next 90 days the UK firm will lose money, but if the rate goes up then the UK firm will make a profit. The UK firm can purchase an option (the right to sell part or all of their expected income for pounds sterling at a given rate near today's rate) to mitigate their risk of exchange rate fluctuation over the 90 days. Conversely another party may wish to have the reverse option for a similar reason. A market maker will buy and sell these options with the aim of making a profit while not incurring too much risk.
In 1983 Garman and Kohlhagen extended the Black-Scholes model to cope with the presence of two interest rates (one for each currency). Suppose that rd is the risk-free interest rate to expiry of the domestic currency and rf is the foreign currency risk-free interest rate (where domestic currency is the currency in which we obtain the value of the option; the formula also requires that FX rates - both strike and current spot be quoted in terms of "units of domestic currency per unit of foreign currency"). Then the domestic currency value of a call option into the foreign currency is
The value of a put option has value
where :
S is the current spot rate
K is the strike rate
N is the cumulative normal distribution function
rd is domestic risk free rate
rf is foreign risk free rate
and σ is the volatility of the FX rate.
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