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- Foreign Exchange exposure results in foreign exchange risk due to the unanticipated variability in exchange rates.
- Foreign Exchange exposure is defined as "the sensitivity of changes in the real domestic currency value of assets and liabilities or operating incomes to unanticipated changes in exchange rates.
- Exposure can be measured in terms of (i) foreign currency assets and liabilities which have fixed foreign-currency values (ii) foreign currency assets and liabilities with foreign-currency values that change with an unexpected change in the exchange rate (iii) domestic currency assets and liabilities (iv) operating incomes.
- Foreign Exchange Risk is defined as "the variance of the domestic-currency value of an asset, liability, or operating income that is attributable to unanticipated changes in exchange rates".
- Exposure can be classified as Transaction Exposure, Translation Exposure and Operating Exposure.
- Transaction exposure is the exposure that arises from foreign currency denominated transactions, which an entity is committed to complete. It arises from contractual, foreign currency, future cash flows.
- Translation exposure is the exposure that arises from the need to convert values of assets and liabilities denominated in a foreign currency into domestic currency.
- Operating exposure is the extent to which the value of the firm stands exposed to exchange rate movements, the firm's value being measured by the present value of its expected cash flows. It is a result of economic consequences. Therefore, it is also called economic exposure.
- Futures contracts are legally binding agreements to buy or sell a predetermined quantity of a commodity of a specified quality at a predetermined future date and price.
- A long position means one agrees to buy and a short position means one agrees to sell.
- Futures are traded on organized exchanges with respective clearing houses. Exchanges usually have two types of members namely floor brokers and floor traders.
- A futures contract should specify the exact nature of the asset, price, contract size, delivery arrangements, delivery months, tick size, daily fluctuation limits and trading units.
- There are three types of margins in futures market: Initial margin, maintenance margin and variation margin.
- There are various types of orders in the futures market which can be divided into market orders, market-if-touched, time orders, limit orders, market-on-close orders, stop-loss orders, exchange for physical orders, discretionary orders, not held orders and spread orders.
- The settlement procedure can be by physical delivery, cash settlement, offsetting and exchange of futures for physicals.
- Basis means the difference between the cash price and the futures price of a commodity and the extent to which the cash price exceeds the future price at a point of time is called the cost of carry.
- Futures are of various types and depending on the underlying asset, can be divided into physical commodities, energy sources, foreign currency, interest earnings assets or an index.
- Currency futures are binding obligations to buy or sell a particular currency against another at a designated rate of exchange on a specified future date.
- Currency risk can be hedged with the help of currency futures, where both the exporter and importers can hedge their positions by buying or selling futures.
- Interest rate future can be both short-term as well as long-term. Their tremendous growth is attributed to the growth in the market for fixed income securities and increased fluctuation in interest into the contract.
- A call option gives the buyer of the option the right to purchase the underlying asset and a put option gives the buyer of the option the right to sell the underlying asset.
- An option can be in-the-money, out-of-the-money or at-the-money, depending on whether the strike price is below, above or equal to the stock price respectively.
- Options can be American or European. While American options can be exercised on any day till expiration date, European options can only be exercised on the expiration day.
- The factors influencing the option price are the current price of the underlying asset, the strike price of the option, the time left to maturity, the volatility of the underlying asset, the risk-free rate of interest in the economy and the dividends (if any) expected during the life of the option.
- Positions in options can be opened or closed with a purchase or sale.
- Margins are imposed on the option traders in accordance to the rules of the exchange to avoid defaults and losses.
- Other types of options are currency options, index options, future options, borrowers options, lenders options, over-the-counter options, etc.
- For non-dividend paying stocks, the calls should be exercised on expiration and the puts should be exercised immediately.
- For dividend paying stocks, if the dividend can be estimated with certain accuracy, the calls should be exercised immediately.
- The binomial pricing model is based on the construction of a binomial tree which represents the possible paths followed by the underlying asset price over the life of the option.
- Binomial trees can be of a single period (one-step binomial trees) or two-step binomial trees (more than one period).
- Black-Scholes option pricing model aims to establish a no-arbitrage portfolio to value the option when the stock prices are binomial, as both the stock price and option price are influenced by the same underlying sources of uncertainty in the stock price movements.
- The assumptions of Black-Scholes model: Short selling of securities is permitted, there are no taxes and transaction costs, there are no dividend payments during the life of the option, no arbitrage opportunities are there, security trading is continuous, the risk-free rate of return is constant and the terms of exercise are European (exercise on maturity).
- The main advantage of Black-Scholes is the ease to use and its reasonable accuracy in pricing the option.
- Financial swaps are agreements to exchange future cash flows with or without the exchange of cash flows at present.
- Broadly. financial swaps are classified as interest rate swaps and currency swaps.
- The swap markets have the following limitations: difficulty to identify a party with opposite requirements for the swap, difficulty in termination of the contract, existence on inherent default risks, underdeveloped secondary markets for swaps, limited application of the theory of comparative advantage in real life situations, no exchange control in over the counter transactions.
- Interest rate swap is an agreement between two or more parties to exchange interest payments over a specific period of time on agreed terms.
- The conventions followed in interest rate swaps are as follows: Actual/360, actual/actual, actual/365 and the payment convention for holidays is known as follows: modified following day, following business day and preceding business day.
- The main swap risks are interest rate risks, currency exchange risks, market risks, credit risks, mismatch risks, basis risks, spread risks, settlement risks and sovereign risks.