FX and FX Forward Bonggun Shin April 2012
General information Global foreign exchange market turnover was 20% higher in April 2010 than in April 2007, with average daily turnover of $4.0 trillion compared with $3.3 trillion. Spot turnover rose to $1.5 trillion in April 2010 from $1.0 trillion in April 2007. Foreign exchange market activity became more global, with cross-border transactions representing 65% of trading activity in April 2010, while local transactions accounted for 35% In 2011, Mongolia exported USD4.7bn to the world and imported USD6.5bn from the world. A small fluctuation (up or down 10%) can have a significant impact These trading volumes are expected to grow rapidly as Mongolia reaches its next phase of development. According to Bank of International Settlement (BIS), the FX trading volumes tend to double every 5-6 years in Emerging Markets but given the growth potential of Mongolia, it would be prudent to assume more rapid growth in FX value and volumes. 2
Global Foreign Exchange Market Turnover and Growth 5 100 Right, Total USD bn Left, % Growth 4 75 3 50 2 25 1 0 0 -25 1998 2001 2004 2007 2010 Source: Bank of International Settlement, 2010 3
Global Foreign Exchange Market Turnover by Instrument Source: Bank of International Settlement, 2010 4
Global Foreign Exchange Market Turnover by maturity Source: Bank of International Settlement, 2010 5
Mongolian MNT Foreign Exchange Market Historic Movement Historic 5 Day Difference, MNT (2007-2012) 250 200 150 100 50 0 -85 -19 1 22 105 Lower tail Upper tail 2.5% -28 -2.6% 2.5% 24 1.9% 5.0% -20 -1.9% 5.0% 19 1.5% 10.0% -12 -1.2% 10.0% 13 1.1% Source: SCB, Reuters 6
Survey of Asian NDFs daily transaction volume (USD mio) 4Q 2011 1Q 2012 KRW 3,330 3,000 CNY 3,830 4,000 INR 1,140 1,530 PHP 570 620 IDR 620 650 TWD 1,230 1,650 MYR 950 920 Source: SCB 7
FX Spot and Forward – Basics • An FX Spot transaction is an exchange of currencies at the prevailing market exchange rate. Physical delivery typically occurs two business days later. An FX Forward is an agreement between two parties to exchange a fixed amount of two particular currencies at a particular date/time in the future. Benefit : A tool to manage the risk inherent in currency markets by predetermining the rate and date on which companies will purchase or sell a given amount of foreign exchange. Risk : A company that uses an FX Forward to hedge future cash flows may be worse off compared to not hedging if the currency moves in the wrong direction. Example – Forward (USD/JPY) JPY 83.23 mio @ 12 months JPY 83.22 mio @ 12 months SCB Client Supplier USD 1.00 mio Goods today Forward enables client to lock in USD/JPY rate of 83.23 12 months from now 8 8
FX Forward – Pricing The FX Forward Rate is calculated according to the following formula: 1 r Counter FX Forward Spot Rate * where : r interest rate 1 r Base Example: - A company needs to buy USD 1,000,000 in 1 year - Assuming there was no market for forwards, how do we calculate the forward rate? On Day zero: - The client would borrow JPY 83,700,000 in the market for 1 year (@ 0.47%) - The client would sell JPY vs USD in the spot market and receive the equivalent USD amount (USD 1,000,000) - The client would lend USD 1,000,000 in the market for 1 year (@ 1.03%) In 1 Year: - The client would pay the JPY amount on the JPY Loan and receive the USD Amount on the USD Deposit i.e. Buy USD and Sell JPY - Implied Forward Rate = 83.70*(1+0.47%*365/360)/(1+1.03%*365/360) = 83.23 Forward Rate is a function of the Interest rate differentials between the counter currency and the base currency Counter currency interest rate > Base currency interest rate => Forward is at premium relative to spot Counter currency interest rate < Base currency interest rate => Forward is at discount relative to spot 9
FX Forward – Flows No Hedge: The client faces FX risk USD Payable JPY Receivables SUPPLIER CLIENT BUYER USD 1,000,000 JPY 83,230,000 With Hedge: The client is able to predetermine the future Exchange Rate USD Payable JPY Receivables SUPPLIER CLIENT BUYER USD 1,000,000 JPY 83,230,000 @ USD JPY 83.23 10
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