Currency risk

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Foreign Exchange Forward

  • Foreign Exchange Forward
    A foreign exchange forward is a binding agreement between two parties to buy or sell a specific currency amount at a fixed exchange rate on specified date. The parties determine the exchange rate when entering into the transaction.
  • Qualities
    • Future exchange rate is known in advance.
    • Possibility to accurately plan income/expenses and, consequently, profit.
    • No additional expenses: taxes, premiums, commissions.
  • For whom is it useful?

    Exporters
    EXAMPLE. A company exports into Great Britain, gets income in GBP, but as the business is in Estonia, it needs EUR: for paying salaries, rent for premises, etc.
    As the GBP rate drops, the company’s income decreases along with its profit.

    Importers

    EXAMPLE. A company imports from the USA and/or Asian countries, pays for goods in USD, but generates income in EUR (sells goods and/or services in Estonia).
    As the USD rate rises, the company is to pay more for acquired raw materials/goods, their cost increases, whereas the profit decreases.

    Company with a loan in a currency different from its income currency

    EXAMPLE. A company generates income in EUR and RUB (sells goods in Estonia and exports to Russia), has a loan in USD.
    As the USD rate rises, the loan servicing becomes more expensive, the company’s expenses increase, whereas the profit drops.


  • How is a FX forward rate calculated?

    FX forward rate is not determined by expectations for the future FX rates but by the factors like current currency rate, transaction period and interest rates of particular currencies for transaction period. Let it be illustrated with FX forward rate formula: 

    F = S x (1+(P1 x T/B1))/ (1+(P2 x T/B2))

    F – FX Forward rate

    S – spot foreign exchange rate in the market (different currency pairs have different market standards for settlements in wholesale currency markets but usually its either T+2 or T+1)
    P1 – foreign currency interest rate for a certain period
    P2 - base currency interest rate for a certain period
    B1 - foreign currency day basis (360 or 365)
    B2 - base currency day basis (360 or 365)
    T – forward period (time to settlement date)


  • How to make a forward?

    Before being able to do FX forward transactions:

    • The Customer needs to sign a Master Agreement on Derivatives;
    • The Bank needs to perform a Customer assessment and grant to the Customer a limit for FX derivatives;
    • According to the MIFID requirements the Bank needs to assess the appropriateness of the product for the Customer;
    • The Customer must acquire an LEI code.

Currency Swap

  • Currency Swap
    A currency swap (also called as FX swap) is an agreement between two parties to buy or sell a specific currency amount at a fixed exchange rate on specified date near term and sell it back or repurchase it at the agreed exchange rate on specific date in a more distant future. The parties determine both exchange rates when entering into the transaction. In other words, a currency swap consists of two transactions, the first of which is usually a spot foreign exchange transaction (transaction settlement date according to the market standards either T+2 or T+1) and the second is a foreign exchange forward. In essence, a currency swap could be seen also as borrowing one currency against another for certain time period. Whereas, in case of standard borrowing, an interest payment is made then in case of currency swap the interest rate is included in the swap rate.
  • Qualities
    • The exchange rates for both the initial and following transaction in swap are known in advance.
    • Calculating profit/loss is possible.
    • No additional expenses: taxes, premiums, commissions.
  • For whom is it useful?
    Companies that need a certain currency for a short period
    EXAMPLE. A company needs USD in order to pay for goods, but it expects income in USD (the company exports to the CIS countries, imports from Asian countries). The company can make a currency swap for the period until the expected income in USD will arrive in order to effect a payment now. By doing the currency swap company avoids opening itself to the currency risk. Namely, as an alternative the company could just buy USD to its account via standard currency conversion and initiate the needed payment and later on, as the sales income arrives, sell USD via currency conversion, but this would mean that in the meantime it has been open to the risk of currency rate fluctuations and might suffer loss due to the currency rate changes.

    Companies that have a forward – in order to advance or postpone the transaction

    EXAMPLE. A company calculated that it will need to purchase SEK at the beginning of March (3 March) and made a forward SEK purchase transaction. However, it turned out that the payment is due on 15 February – for this purpose it needs a currency swap, the first settlement date of which would be 15 February and the second date would be 3 March. In case of postponing a transaction, the first settlement date would be 3 March and the second date would be later.

  • How is a currency swap rate calculated?
    A currency swap has two rates – the rate for the first part of the transaction and the rate for the second part of the transaction. The first part rate is usually the spot foreign exchange rate at the time of the transaction. The second part rate is calculated in the same way as a foreign exchange forward rate.
  • How to make a currency swap?

    Before being able to do FX swap transactions:

    • The Customer needs to sign a Master Agreement on Derivatives;
    • The Bank needs to perform a Customer assessment and grant to the Customer a limit for FX derivatives;
    • According to the MIFID requirements the Bank needs to assess the appropriateness of the product for the Customer;
    • The Customer must acquire an LEI code.

Currency Option

  • Currency Option
    A currency option is a right to buy or sell certain amount of currency at specific rate on agreed date in the future. Whereas bought option is purely a right but not an obligation for the option buyer then for the option seller it is an obligation.
  • Qualities
    • Possibility to choose an exchange rate.
    • Buyer has an option whether or not to perform the transaction on the settlement date.
    • The option buyer is to pay a premium.
    • In order to avoid additional costs, a combination of options can be made, where there is no premium.
  • For whom is it useful?
    Companies participating in tender procedures
    EXAMPLE. A company takes part in a tender procedure for a contract work. Materials would be bought from Asian countries, they would be paid for in USD. As margins usually are not big in tender procedures, the USD rate fluctuation can determine whether a contract will be profitable. Thus, hedge against fluctuation guarantees profit. In case a bid is not successful, the company has a possibility to sell the option if the option has value or let the option expire if it does not have any value left.

    Companies for which it is important to assess the worst case scenario – having an option, the worst case is known in advance


    Companies expecting to earn from foreign exchange rate fluctuations

    EXAMPLE. A company thinks that SEK exchange rate will increase, but a possibility of decrease cannot be excluded either. Then, in case of buying an option which gives a right to buy SEK, the Customer benefits if SEK exchange rate increases. If SEK rate decreases, the Customer’s loss is limited to the paid premium.

  • How is the option price calculated?

    Various models can be used for calculation of the option price. One of the most popular is Black-Scholes model. For FX options, however, Garman-Kohlhagen valuation model is mostly used. More information on this and other models is available for example at: http://en.wikipedia.org/.

    Currency option price or premium is affected by the following factors:

    • spot foreign exchange rate in the market;
    • strike price (FX rate at which one party has a right or an obligation to buy or sell FX;
    • foreign currency interest rate for a relevant period;
    • base currency (EUR) interest rate for a relevant period;
    • interest rate difference;
    • option term (time to settlement date);
    • foreign exchange rate volatility (this indicator reflects the foreign exchange rate fluctuation amplitude in a relevant period in percent; however, its calculation is somewhat more complicated).

     The price of the option increases as:

    •  the difference between the transaction rate and the spot foreign exchange rate in the market, which is favourable for the option buyer, increases;
    • volatility increases;
    • transaction period increases.

  • How to make a currency option transaction?

    Before being able to do FX option transactions:

    • The Customer needs to sign a Master Agreement on Derivatives;
    • The Bank needs to perform a Customer assessment and grant to the Customer a limit for FX derivatives (only if Customer is selling option / in case of option purchases limit is not needed);
    • According to the MIFID requirements the Bank needs to assess the appropriateness of the product for the Customer;
    • The Customer must acquire an LEI code.

Market and credit risk factors

  • Foreign Exchange Forward

    Foreign Exchange Forward

    When entering into a foreign exchange forward, one must understand that when the transaction settlement date comes, the transaction will have to be performed irrespective of the foreign exchange rate in the market at the time. It may happen that the rate in the market will be more favourable than the pre-agreed forward rate, however, in spite of that, one will have to settle the forward at the rate agreed when the transaction was made, in this way losing potential profit, which would have been earned if no forward had been made.
  • Currency Swap

    Currency Swap

    When entering into a currency swap, one must understand that when the transaction settlement dates come, one will have to settle according to foreign exchange rates agreed at the time of entry into the transaction. A currency swap does not create an additional currency risk, thus, in this respect, it is essentially different from foreign exchange forwards. The rate of the second part of a currency swap cannot change during the effective term of the transaction, irrespective of changes in interest rates of both the currencies and the effect of this on calculation of the above.
  • Currency Option

    Currency Option

    If the Customer buys an option, no limit is necessary – the Customer pays a premium on the transaction entry date and has no other obligations. It acquires the right to choose whether or not to perform the transaction. Standard settlement by paying a premium in the market is 2 business days after the entry into the transaction. If at the time of entry into the transaction the Customer does not have funds in its bank account and chooses to pay in more than 2 business days, the Customer needs a forward limit. If the Customer wishes to sell an option to the Bank, a limit is necessary, as the Customer gets an obligation to perform the transaction, meanwhile the Bank buys the right to choose whether or not to perform the transaction.

    Possible loss of a currency option buyer is limited to the paid premium, whereas potential loss of the option seller is unlimited. Having in mind that the Customer usually is an option buyer, its possibility to earn from the transaction is unlimited, whereas potential loss will not be more than the paid premium. In spite of that, the Customer must take into account that if on the option exercise date the rate in the market is more favourable and it is not necessary to exercise the option, it will face the situation where the option is unnecessary, but the premium is already paid and non-refundable. Thus, an option should be used as a method of hedging, but not as a speculation.
Follow the instructions of regulators

Get adviced

  • EMIR

    EMIR (European Market Infrastructure Regulation or Regulation No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories) stipulates settlement of derivative instruments via central counterparties and the obligation to inform the trade repositories thereof and the new procedures for the management of derivative instrument contracts.

    The regulative changes resulting from EMIR have an impact on all counterparties within and outside the financial sector (except private persons) who operate on the market of derivative instruments. This is part of the global effort to increase the transparency of the market and to decrease operational and counterparty credit risks on the markets of derivative instruments.

    EMIR contains three main additional requirements compared to the previous provisions:

    • Risk management standards must be perfected.
    • All transactions with derivative instruments must be reported to trade repositories.
    • Transactions with derivative instruments which meet the established criteria must be settled via central counterparties.

     

    Trade reporting

     
    All derivative trades must be reported to trade repositories from 12 February 2014. A trade repository is an entity that centrally collects details about derivative trades in a register to which financial regulators have access for supervision purposes.

    The reporting obligation covers both over-the-counter (OTC) and exchange-traded derivative instruments. It is important to note that forward currency contracts are also covered by the reporting obligation set forth in EMIR.

    The reporting obligation applies to all parties that are registered in an EU/EEA country (except private persons, central banks and some public bodies). Danske Bank also reports transactions on behalf of its Customers if so agreed between the bank and the Customer. Danske Bank reports the transactions of its Customers to DTCC GTR (the Depository Trust & Clearing Corporation – Global Trade Repository).

    If the Customer has requested the reporting service and consents to the terms and conditions of the service, the Customer authorises Danske Bank to report transactions with derivative instruments made with the bank to the trade repository on its behalf. In order to do this the Customer must acquire an LEI (Legal Entity Identifier) and inform Danske Bank about this.

  • LEI (Legal Entity Identifier) code

    As of 3 January 2018, legal entities who wish to perform transactions involving securities or derivatives (such as FX Forwards, FX Swaps or Interest Rate Swaps) will need to submit to the bank their LEI (Legal Entity Identifier). This code is used globally to identify legal entities. It is a combination of 20 numbers and letters.

    HOW CAN AN LEI BE OBTAINED?
    You can request an LEI from an authorized LEI issuer, who assesses certain information about the company to which the LEI will be issued before issuing the LEI.

    • Choose an LEI provider. See section below.
    • Register your details on the provider's website.
    • Pay the charge for registration. The charge appears on the website of each individual LEI provider.
    • The LEI provider approves your details.
    • Please provide Danske Bank with your new LEI by sending it by email marketsoperations@danskebank.ee.
    • Renew your LEI every year.

    LEI PROVIDERS
    In Estonia it is possible to obtain LEI from Nasdaq CSD (Nasdaqcsd.com)You will find a list of authorised LEI issuers here.

    FEE
    Requesting a LEI is subject to a fee (ca. €100) and it can take up to a couple of weeks. An annual fee may also be applied (ca. €80).

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