Assignment no: 1 Question:

1. Explain in detail the difference between Forward & Future.

Limitations of Forwards contracts: 1. Lack of centralized trading. Any two individuals can enter into a forwards contract 2. Lack of Liquidity 3. Counterparty risk - The case wherein either the buyer or seller does not honour his end of the contract. Futures Contract: A futures contract is an agreement to buy or sell an asset at a certain time in the future at a specific price. The Contractual terms of the futures contracts are very clear. The Futures market was designed to solve the shortcomings in the forwards contracts. Unlike forwards, futures are traded in organized exchanges. They also use a clearing house that provides the necessary protection to both the buyer and the seller. The price of the futures contract can change prior to delivery. Hence, both participants must settle daily price changes as per the contract values. An Example of a futures contract would be an agreement to 100 tonnes of Steel at Rs. 10000/- per tonne at some date say in December 2008. If no interim payments are made and if the price of Steel moves violently, a considerable credit risk could build up. To avoid this a margin system is used by the exchanges. As per the margin system, both parties must deposit a small sum with the exchange. This amount will be a small percentage of the total contract. This amount is called the initial margin. As the steel value changes, the contract value also changes. If the contract value changes, the margin must be topped up by an amount corresponding to the change in price of steel. The margin money is the property of the person who deposits it and would be returned to them if the contract gets cancelled/completed. Characteristics of Futures contract: 1. They are traded in organized exchanges 2. Credit risk is eliminated with the margin system. Both parties deposit a portion of the contract with the clearing house. 3. Both the buyer and seller are bound by the contract terms and are expected to honour their end of the contract.
The fundamental difference between futures and forwards is that futures are traded on exchanges and forwards trade OTC. The difference in trading venues gives rise to notable differences in the two instruments:

Futures are standardized instruments transacted through brokerage firms that hold a "seat" on the exchange that trades that particular contract. The terms of a futures contract - including delivery places and dates, volume, technical specifications, and trading and credit procedures - are standardized for each type of contract. Like an ordinary stock trade, two parties will work through their respective brokers, to transact a futures trade. An investor can only trade in the futures contracts that are supported by each exchange. In contrast, forwards are entirely customized and all the terms of the contract are privately negotiated between parties. They can be keyed to almost any conceivable underlying asset or measure. The settlement date, notional amount of the contract and settlement form (cash or physical) are entirely up to the parties to the contract. Forwards entail both market risk and credit risk. Those who engage in futures transactions assume exposure to default by the exchange's clearing house. For OTC derivatives, the exposure is to default by the counterparty who may fail to perform on a forward. The profit or loss on a forward contract is only realized at the time of settlement, so the credit exposure can keep increasing. With futures, credit risk mitigation measures, such as regular mark-to-market and margining, are automatically required. The exchanges employ a system whereby counterparties exchange daily payments of profits or losses on the days they occur. Through these margin payments, a futures contract's market value is effectively reset to zero at the end of each trading day. This all but eliminates credit risk. The daily cash flows associated with margining can skew futures prices, causing them to diverge from corresponding forward prices. Futures are settled at the settlement price fixed on the last trading date of the contract (i.e. at the end). Forwards are settled at the forward price agreed on at the trade date (i.e. at the start). Futures are generally subject to a single regulatory regime in one jurisdiction, while forwards - although usually transacted by regulated firms - are transacted across jurisdictional boundaries and are primarily governed by the contractual relations between the parties. In case of physical delivery, the forward contract specifies to whom the delivery should be made. The counterparty on a futures contract is chosen randomly by the exchange. In a forward there are no cash flows until delivery, whereas in futures there are margin requirements and periodic margin calls.

DIFFERENCE BETWEEN FORWARDS AND FUTURES: FORWARDS:

Standardized contract terms. Requires margin payment. Follows daily settlement. Traded on exchanges.

FUTURES:

Customized contract term. No margin payment. Settlement at the end of the period. OTC in nature.

2. Is it possible to hedge foreign exchange risk fully?

3. How is translation exposure covered in the money market? Explain in detail with an example.
EXPOSURE :: Definition

24. Foreign currency exposure is the extent to which the future cash flows of an enterprise, arising
from domestic and foreign currency denominated transactionsinvolving assets and liabilities, and generating revenues and expenses are susceptible to variations in foreign currency exchange rates. It involves the identification of existing and/or potential currency relationships which arise from the activities of an enterprise, including hedging and other risk management activities.

Types of Exposure Translation Exposure

25. Translation exposure is also referred to as accounting exposure or balance sheet exposure. The

restatement of foreign currency financial statements in terms of a reporting currency is termed translation. The exposure arises from the periodic need to report consolidated worldwide operations of a group in one reporting currency and to give some indication of the financial position of that group at those times in that currency.

26. Translation exposure is measured at the time of translating foreign financial statements for reporting

purposes and indicates or exposes the possibility that the foreign currency denominated financial statement elements can change and give rise to further translation gains or losses, depending on the movement that takes place in the currencies concerned after the reporting date. Such translation gains and losses may well reverse in future accounting periods but do not, in themselves, represent realized cash flows unless, and until, the assets and liabilities are settled or liquidated in whole or in part. This type of exposure does not, therefore, require management action unless there are particular covenants, e.g., regarding gearing profiles in a loan agreement, that may be breached by the translated domestic currency position, or if management believes that translation gains or losses will materially affect the value of the business. International Accounting Standards set out best practice.

27. . Transaction Exposure 28.

29. Multinational firms routinely transact in different currencies. The value of a multinational firms cash flows, denominated in the home currency, will depend on the value of the corresponding exchange rates. Transaction exposure refers to gains or losses that arise from the future settlement of transactions denominated in foreign currency. These transactions include purchasing or selling on credit goods or services whose prices are stated in foreign currency, borrowing or lending funds denominated in foreign currency, acquiring assets denominated in foreign currency, and being a party to an unexpired futures currency contract.
30. 31. Exchange rates are very volatile. Moreover, exchange rates are not only volatile, but they are also difficult to forecast. The uncertainty about the future value of exchange rates makes uncertain the home currency value of a multinational firms cash flows. Take, again, the case of Swiss Cruises, with headquarters in Switzerland. The owners of Swiss Cruises only care about CHF cash flows. Almost half of Swiss Cruises business is done in the U.S., through a subsidiary based in Miami. The usual practice is to quote U.S. packages in USD. For example, a standard 7-day Caribbean cruise package is sold for USD 649. In general, it takes an average of 20 days to settle these transactions.

If, during the 20-day settlement period, the USD appreciates (depreciates) against the CHF, Swiss Cruises CHF cash flows will increase (decrease). Thus, every cruise package sold in the U.S. involves an uncertain CHF denominated cash flow. This uncertainty about the future value of a foreign exchange denominated transaction is referred as transaction exposure. 32. 33. 34. 1.A 35. 36. Transaction exposure is very easy to identify and measure, especially in the short-run, when firms can forecast future cash flows with high accuracy. For a multinational firm, measurement of transaction exposure requires a consolidation of the contractually fixed future currency inflows and outflows for all subsidiaries, categorized by currency. Take the case of a U.S. multinational firm. If a subsidiary has positive cash flows in EUR and another subsidiary has negative cash flows in EUR, the net transaction exposure might be very low. Thus, firms evaluate transaction exposure on net basis. The net transaction exposure in each currency is converted to the domestic currency so the firm has a standardized measure for each currency. 37. 38. Example VIII.2: Swiss Cruises, a Swiss firm, has sold cruise packages to a U.S. wholesaler for USD 2.5 million. Swiss Cruises has bought fuel oil for USD 1.5 million. Both cash flows are going to occur in 30 days. Assume St = 1.45 CHF/USD. Thus, the net transaction exposure in USD is: 39. 40. (USD 2,500,000 - USD 1,500,000) x 1.45 CHF/USD = CHF 1,450,000 41. 42. Swiss Cruises also estimates the sensitivity of this net transaction exposure to changes in the CHF/USD exchange rate. For example, if the exchange rate changes by -/+10%, then transaction exposure changes by -/+CHF 145,000. 43. 44. Now, suppose that a U.S. multinational has a subsidiary with positive cash flows in EUR and another subsidiary has negative cash flows in GBP. The U.S. multinational knows that there is very high and positive correlation between these two currencies. The U.S. multinational will take this correlation into account when measuring the overall net transaction exposure. This measurement technique is called netting. 45. 46. Netting involves offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in opposite directions. Therefore, gains Measuring Transaction Exposure

(losses) in the first exposure compensate for the losses (gains) in the second exposure. Netting involves looking at transactions with a portfolio approach. The assumption behind exposure netting is that the net gain or loss is what really matters to a company or an international investor. Under this view, hedging decisions are not made transaction by transaction. Rather, hedging decisions are made based on the exposure of the portfolio.