• An agreement to buy or sell a currency in the future (delivery beyond 2 business days) at a pre-determined exchange rate-forward rate
• Forward rate can be in premium or discount of the spot rate, reflecting the interest differential of the two currencies and the supply and demand in the money market
• Delivery can be on an agreed date (fixed date forward contract) or on any day before the final delivery date (optional forward contract)

A customer needs USD at a future date and has entered a long position on USD/HKD forward contract.

• Tenor: 6 Months
• Forward rate: USD/HKD 7.7590
• Spot rate: USD/HKD 7.7990
• Notional amount: USD100,000

At expiry date, the customer will buy USD100,000 at 7.7590. Using forward contracts, customers can lock-in an FX rate to cover their future FX exposures.

Non-deliverable forwards (NDF) are used when there are limitations for the delivery of the underlying currency, and this usually happens to countries which are having currency control policies.

Example

A customer has entered a short position on USD/CNY NDF contract to hedge against payments to a supplier in CNY.

• Tenor: 6 Months
• NDF rate: USD/CNY 7.0750
• Notinal Amount: USD100,000

In the above example, the total return at maturity is calculated as follows:

• An interest rate cap is designed to provide insurance against the borrowing rate rising above the specified cap level by paying a premium
• An interest rate floor guarantees a lower bound for the rate of interest received on an investment by paying a premium

Hedging interest rate exposure with an interest rate cap

Company A has a USD6 million 5-year USD floating-rate loan with interest rate at 3-month LIBOR + 2.50%. To hedge against the interest rate exposure, the company can enter a 5-year interest rate cap so that the interest rate of the loan will not rise above 8.00%. Terms are as follows:

• Tenor: 5 years, reset at every quarter, i.e. there are 20 reset dates
• Cap rate: 5.50%
• Notional amount: USD6,000,000
• Reference aount: 2-month LIBOR fixings
• Premium: USD20,000

Suppose that on a particular reset date the 3-month LIBOR fixed at 6.20%. The floating-rate loan would require USD130,500 of interest to be paid 3 months later. ((6.20% + 2.50%) x 6,000,000 x 0.25 years = USD130,500)

With a cap rate of 5.50%, the interest payment would be USD82,500. (5.50% x 6,000,000 x 0.25 years = USD82,500) That means the cap will provide a payoff of USD10,500 ((6.20% - 5.50%) x 6,000,000 x 0.25 years = USD10,500) 3 months after the reset date to compensate the interest paid by Company A for the floating-rate loan. The net interest payment for the loan in this particular reset date is USD120,000 (USD130,500 for the loan minus the USD 10,500 payoff of the interest rate cap), which is equivalent to an interest rate of 8.00%.

On the other hand, suppose on another particular reset date the 3-month LIBOR fixed at 4.95%, the payoff from the cap will be 0 as the fixing rate is lower than the cap rate. Thus, the interest rate cap provides insurance against the borrowing rate to rise above a certain level by paying USD as premium.

• A contractual agreement for an agreed period of time that one party agrees to pay interest at a pre-determined fixed rate on a notional principal, while the other party agrees to pay interest at a floating rate on the same notional principal
• Allows the buyers and sellers to transform the interest rate structure of a loan or investment, from fixed rate to floating rate or vice versa

Hedging an interest rate exposure with an IRS

Company A has a 2-year loan with interest rate at 3-month HIBOR + 1.50%. To hedge against the interest rate exposure, the company can enter a 2-year pay-fixed-receive-floating IRS so that its real interest rate of the loan will be a fixed rate loan. Terms are as follows:

• Tenor: 2 years, fixing at every quarter
• Fixed leg: Company A pays 3.50% p.a. every quarter
• Floating leg: Company A recieves 3-month HIBOR every quarter

The loan can be artificially transformed into a 2-year 5.0% fixed rate loan.

On the other hand, a company can also artificially transform a fixed rate loan into floating rate by entering a pay-floating-receive-fixed IRS.

Advantages of hedging with IRS

• A pay-floating-receive-fixed IRS can reduce a fixed-rate borrower's interest payments if interest rate declines
• A pay-fixed-receive-floating IRS gives a floating-rate borrower protection of any rise in interest rate
• IRS allows investors to lock-in profits without unloading their fixed income securities

Low credit risk: IRS transaction involves no exchange of principal, and the interest payments are further reduced by settling the net difference at each fixing date

Buyer of the option has the right but not the obligation to buy or sell a specified amount of one currency against another at a predefined exchange rate.

Advantages of currency options

• The right but not the obligation to exercise the option means that the holder can take advantage of favourable market movement
• Maximum loss of an option holder at expiry date is the option premium, while the potential profit can be unlimited
• Strike, maturity date and notional amount can be tailor-made to fit clients' risk appetite as well as their return objective

Example

A customer buys a European call option on EUR/USD, terms as follows:

• Tenor: 2 Weeks
• Strike: EUR/USD1.4850
• Spot Rate: EUR/USD1.4725
• Notional amount: USD100,000
• Premium: 0.5175%

In the above example, total return at maturity is calculated as follows: