0:05 We are still much on FX risk management
0:10 and remember we said to manage FX risk
0:14 usually you can be using internal method
0:17 or external method we've been looking at
0:20 external method for some time now things
0:22 like forward
0:24 money market edge futures
0:31 options the last video actually focused
0:33 on options
0:36 and now we're looking at swaps. So this
0:40 is done done.
0:42 Now we finish
0:46 FX risk management with swaps which is
0:48 quite short. So now I'm going to be
0:51 looking at swaps. How do we use swaps to
0:56 manage our FX risk exposure?
0:57 First of all you need to know there are
1:00 two types of this. Please take note and
1:03 they are totally different. The first
1:06 type is a forex swap
1:09 and the other one is a currency swap
1:12 and this differs based on the objective
1:15 that is what the company is trying to
1:18 mitigate the situation of the company.
1:21 Why would a company wants to use forex
1:26 exposure I mean forex swaps?
1:30 Usually this is necessary or comes handy
1:33 when the company is struggling to borrow
1:36 in foreign currency.
1:38 So this one is just for a company to
1:42 have I'll say for access to
1:44 to
1:46 borrowing borrowing foreign currency borrowing.
1:52 Yeah. Usually that the company will not
1:57 be able to get so let's say not
2:03 maybe because of credit rating or
2:05 because of restrictions or whatever it
2:08 is that is when a company most likely
2:13 will decide to use forex swap. However,
2:16 if the objective of the company is to
2:19 look for cheap foreign loan, you see
2:22 different thing. The access is there,
2:25 but definitely
2:27 it will be more expensive as a foreign
2:30 country company. Think about it. If you
2:32 are a company based in the UK and you
2:34 want to borrow money in Australia, your
2:36 rate will be different from an
2:38 Australian company that resides in
2:39 Australia that is trying to borrow
2:42 within Australia because there is a
2:46 inter jurisdiction and because of that
2:48 locationational international difference
2:51 then there's an additional risk that
2:53 will be attached to that borrower and
2:55 because of that your borrowing rate will
2:58 be different and in that case a currency
3:02 swap will help you in that space. So
3:05 this one is used to
3:08 swap interest rates.
3:09 I'm going to explain how this program
3:14 work. This is just a way to swap
3:17 interest rate in
3:19 in
3:29 Yeah. And what do you get? Most likely
3:33 what you're looking for is a cheaper boring
3:34 boring
3:49 This one is about cost
3:51 interest rates.
3:54 So that is the cost of loan.
3:57 Yeah. So I'm going to use example to
3:59 just drive this home quickly. This is
4:02 very easy. What we're saying here is
4:05 that you need two parties.
4:09 A needs the currency of B
4:11 and they go into swap agreement. They
4:14 fix rate
4:17 the swap money principle.
4:20 A gives B is currency. PP gives a
4:24 currency on day one
4:27 and expiring the swap back. That's all
4:30 we're saying.
4:32 B returns the money, A returns the
4:41 That's what we're saying. But it's
4:44 different for currency swap because for
4:46 currency swap
4:50 A will help B to take loan in his own
4:54 currency. So A will gives B
5:00 loan itself the loan amount.
5:04 Yeah. A will be paying the bank interest.
5:07 interest. Yeah.
5:08 Yeah.
5:14 However, B will have to refund A of that interest
5:16 interest
5:20 and the same thing A will be doing for
5:24 B. B will do for A. So B will also help
5:27 A to borrow money in his own currency.
5:31 B will be servicing the interest in his
5:35 country. However, A will have to refund
5:39 that money back to
5:43 B. So they are each other. So you can
5:48 see in currency both principle
5:50 and interest
5:53 are relevant.
5:56 But here our focus is just on principle swap
5:58 swap
6:00 just to make you see the difference
6:04 easily. Okay, take one second to digest
6:07 that. Now, let's look at the question
6:10 for both of them just to help you so
6:13 that you can have a better grasp of what
6:14 we're talking about. Look at this
6:17 question is on forex swap. I'm going to
6:20 be using this question to explain what
6:24 we've been talking about forex swap. You
6:28 have man that wants to go to Pakistan to
6:32 build a school. Usman is a UK company.
6:35 So which means Usman does not have rupes
6:38 but is lucky that the government of
6:43 Pakistan has agreed to swap
6:48 100 million for £5 million
6:50 because if you look at it the current
6:52 spot rate was the agree.
6:56 So first of all you need the swap rate
6:59 that has been agreed. This swap rate
7:03 will be used both at the beginning
7:07 and at the end such that the amount will
7:08 not be different. That's why they always
7:12 fix it. So in this question that rate
7:16 has been agreed to be 20 rupees for
7:23 So which means
7:26 we try to break it down. Let's say we
7:28 have Usman here
7:33 and uh
7:35 I'll just put government here but my
7:37 focus is on Usman which is the company
7:41 that is trying to use the edging method. Right
7:43 Right
7:52 what is going to happen? A one
7:54 Usman will have to borrow
7:56 in local currency because
7:58 because
8:02 he needs to 100 rupees in on day one and
8:06 20 rupees is one pound. So which means
8:08 the total amount that he will need to be
8:10 able to do his swap. He needs to swap
8:12 his in his own currency for what he
8:16 want. That will be equivalent to 5
8:19 million. Yeah, that is 100 million rupees.
8:22 rupees.
8:23 So if he's going to get 100 million
8:25 rupees from the government, he must be
8:27 able to give government 5 million
8:30 pounds. Government of Pakistan. But
8:31 remember, you don't use your money for
8:33 all these transactions because without
8:34 your money, you won't need all this edge
8:36 anyway. So you have to go and borrow
8:40 money. So he needs to borrow 5 million.
8:44 So he's going to borrow 5 million and
8:54 So which means it's going to leave 5
8:56 million and it's going to give it to
9:03 Likewise, government will have to let go
9:05 of so let's say we have two currency
9:12 column one for pounds and one for rupee.
9:16 Let's do the same thing here
9:20 for pounds and for rupee.
9:23 So same day government will also need to
9:26 let go of 100 million rupees and they
9:29 will give it to
9:33 Mr. Usman come who's trying to build a
9:36 school. So on day one you can see that
9:38 Usman already has the money that he
9:41 needs for his investment. And this
9:44 particularly is important because
9:47 remember that he doesn't have to buy
9:49 foreign currency at the expiry date
9:51 because he's doing this strategy because
9:54 he knows that he's going to get 100 200
9:56 million actually.
9:59 So from this he can actually pay back
10:02 the he can close the swap. Yeah. Without
10:04 necessary having to buy currency and
10:07 having more exposure.
10:09 So that is day one.
10:13 The swap already in existence.
10:16 No interest is paid. Next thing is you
10:19 wait to expire. So two years time two
10:21 things will happen.
10:23 Number one is that they need to close
10:25 the swap.
10:28 So which means they swap again.
10:32 Yeah. So what we are saying is
10:35 they reverse the initial swap. So which
10:39 means this time around
10:43 man will be the one that will receive
10:47 5 million pounds from the government and
10:50 he would have received his 200 million
10:53 from the sale of the school. Out of that
10:55 he will have to give the government 100
10:59 million rupee back. Government will also
11:02 pay him back this £5 million and they
11:04 receive their 100 million. You can see
11:07 this comes to zero for government. Our
11:10 focus is on this guy Usman. Remember it
11:12 doesn't end here for us man. There are
11:14 two things left.
11:16 The second one after the first one we
11:18 spoken about is the fact that he will
11:20 need to
11:29 Unfortunately for him on this date after
11:34 two years rupee has gone to 40 uh one
11:39 pound. So which means that 100
11:44 million rupee will now be worth just 2.5
11:49 million. You see that is lucky that you
11:52 actually edge. So
11:54 So
11:57 see more because he also borrowed
12:00 remember the 5 million was borrowed for
12:02 2 years and they gave us the interest
12:06 rates in the UK at 10%. So he's going to
12:10 pay interest at 10% for 2 years over the
12:14 amount of 5 million that he borrowed and
12:16 that means he's still going to pay an
12:19 extra one year.
12:21 So invariably you'll discover that he's
12:24 still better off. Rupee drops to zero
12:27 and his local currency say gives him
12:30 additional 1.5 million left.
12:32 That is
12:35 what Forex swap is all about. It's
12:36 pretty straightforward. You just
12:39 swapping at the beginning at the end at
12:42 the same fixed rate. And remember in the
12:45 middle you I mean at the end of the
12:49 of the contract you need to
12:52 find out how much interest expense the
12:53 company will pay because you will always
12:57 have to borrow your first swap. That's
12:58 the major thing. It's not the time
13:00 you're going to have excess but if you
13:02 have excess as well you need to know
13:04 that that will be done at the spot
13:06 trade. Excess is just like unhedged
13:09 portion. That is what we always say that
13:11 you need to know be careful because you
13:14 might always have unedged
13:17 portion of your exposure
13:20 and if it's on edge then it will have to
13:23 be executed at the market spot. Whatever
13:26 the market spot rate is talking about
13:29 that will be your reality.
13:32 Let's look at another question for
13:35 currency swap.
13:37 So that is for forex swap. Let's look at
13:39 currency swap.
13:43 So you can take one minute to look at
13:45 this question. Very interesting one.
13:48 This is on currency swap. Remember what
13:50 I said. Currency swap is a way to look
13:56 for deep foreign loan.
13:58 And if you had read this scenario that I
14:00 have here, you'll discover that if one
14:04 is trying to go to Euro by himself to
14:09 borrow, he will have to borrow at 5.6.
14:12 But if Eurosport helps him to borrow,
14:14 he'll be able to get the same loan at
14:19 5.5. Same thing applicable to Eurosport.
14:22 If Eurosport decides to go and borrow by
14:24 himself in Australia, he will have to
14:26 pay at 7.2%. 2%.
14:29 However, if he's smart enough to use
14:32 currency swap, one can actually borrow
14:36 for him at 7%. Much cheaper. Now, let's
14:38 look at the dynamics. How does this work
14:41 for the two companies? How do they set
14:43 this up? Remember
14:49 initiation this is a swap
14:54 and at initation said both principle
14:56 will be swapped as well. It's not just
15:00 interest it's not just principle in this
15:01 currency swap both principal and
15:04 interest are swapped. And how does it
15:08 work? What will happen?
15:13 Let's break this into two sections.
15:30 Yeah. So, now we're talking of
15:32 initation. What is going to happen on
15:35 day one? That's what we're saying
15:38 a one
15:42 because one will have to help
15:46 zero spot zero spot will have to one.
15:51 But what we know is that what one needs
15:54 this guy needs
16:02 Erosport needs
16:11 He doesn't want to go to Australia to
16:15 get it because of the rate will be 7.2%.
16:16 This guy too doesn't want to go to
16:18 Europe to get it himself because if he
16:21 tries to do that, you will need to pay
16:24 at 5.6%.
16:25 Now they approached each other and they
16:30 agreed to do a foreign currency swap.
16:33 swap.
16:35 Okay. What does this mean for both of
16:40 them? On day one means that one
16:44 one co will have to borrow. So this guy borrows
16:50 on behalf of Eurosport. He doesn't have
16:51 to tell the bank that he's borrowing for
16:56 EOS. just get it himself. So he borrows that
16:58 that
17:01 the same thing will do trying to help
17:04 his brother
17:08 have to borrow what one needs
17:11 to form. Can see they've helped each
17:14 other to borrow.
17:17 Once they borrow it, they swap. So the
17:20 swap starts immediately on day one which means
17:22 means one
17:24 one gives
17:26 gives
17:28 euro spot
17:31 the money we borrow from him 40 million
17:34 and return
17:37 he will receive
17:40 24 million euro from
17:42 from
17:50 Similarly, you have the same thing going
17:54 on on the other side because
17:58 Euro sport. Yes.
18:00 Euro sport.
18:03 We have to hand over this money to one
18:08 gives 24 million euro
18:10 to one co.
18:13 Yeah, that's this and
18:16 and
18:29 the money that he has been praying for
18:36 Yeah, I'm talking about Euro sport here.
18:38 Confusible currency.
18:41 Okay, you can see that is the swap on
18:43 the one that's happened. This goes to
18:57 they have to be servicing the loan.
18:59 Yeah, you pay interest the loan you have
19:01 collected because the bank does not know
19:03 that when has collected loan for
19:05 anybody. So when we have to pay
19:08 interest. So which means let's said this
19:10 is for one year we have assigned the
19:17 yeah assume the interest is paid end of
19:20 the year. Yeah that's going to be the
19:22 case anyway
19:26 you simplify the scenario. Okay
19:28 remember what is to get the understanding.
19:30 understanding.
19:33 So after one year
19:36 one will have to pay interest for sure.
19:38 So which means but you'll be paying that
19:41 interest at 7%.
19:44 Yeah. Likewise your spot will pay
19:47 interest on euro loan but 5.5%.
19:49 5.5%.
19:56 Mr. one
20:06 at 7%.
20:10 And that will be equivalent to just
20:32 We have to pay his own back to
20:36 the interest on the looney collected
20:45 That's equivalent to
20:47 just 1.32
20:54 Then the next thing again is swap the interest.
20:55 interest.
20:58 So this follow this followed by interest swap.
21:04 Remember initially swap the principle
21:11 What is going to happen?
21:14 You can already know because
21:18 it's a refund session which means that one
21:21 one
21:24 will have to refund your spot. So one pays
21:27 pays
21:34 just€1.32 million.
21:37 million.
21:41 So that's a refund for this
21:44 Yeah, use different color as a refund.
21:47 It's trying to refund him of this. Likewise,
21:49 Likewise,
21:52 your spot will have to refund one as
22:00 the same swap will happen here. And
22:15 that amount that he paid on his behalf
22:18 and that is 2.8 million Australian dollars
22:20 dollars
22:27 you have swapped. You will discover that
22:31 invariably what you are saying is that
22:33 this guy has been compensated for this.
22:37 He got a refund through this. Likewise,
22:39 this guy
22:42 has been compensated for this because he got
22:44 got
22:47 a refund.
22:49 So invariably what we're saying is that
22:52 the net interest
22:55 that these guys have paid is that this
22:58 guy has paid 1.32 million interest and
23:01 this guy has paid
23:03 2.8 million
23:06 Australian dollars. And imagine
23:09 if they had not done this, this guy
23:17 Yeah. But let me finish before I show
23:19 you that so that you don't confuse it.
23:23 Let's just finish. So interesting.
23:25 interesting.
23:27 We're done with the interest swap. But
23:29 they cannot close it because it's also
23:32 needing to still swap the principle to
23:36 close to fully close the contract.
23:43 So principal is swap both at the
23:47 beginning and at the end. Yeah.
23:50 So principal swap.
23:54 Yeah. To close,
23:55 not to initiate. Remember they do to
23:58 initiate and they also do to close. So
24:00 in that case it means that Euro sport
24:04 will have to give one the money that he
24:06 hand over handed over to him at the
24:09 beginning. So and one will do the same
24:12 thing. So one gives
24:14 gives
24:16 Euro spot
24:24 the principle which is 24 million.
24:38 the $40 million Australian dollars that
24:41 he borrowed for him.
24:45 And once that is done,
24:48 one can now cuz this money is coming to
24:52 one. So one will
25:03 Yeah. Likewise, your sport can repay the back
25:16 and the opening is closed. So, Europe
25:20 spot will repay the bank is 24 million
25:25 and one will repay the bank the 40
25:28 million Australian dollars
25:30 and that is it. That is currency as
25:33 well. And like I was saying, look at how
25:37 much they paid. Let's see without edge,
25:46 without edging? It means that that 24
25:48 million that he borrowed, he would have
25:58 And that would have been
26:01 equals to 1.344.
26:16 1.344 million.
26:18 That's what you would have paid instead
26:24 And the other guy would have paid at 7.2%
26:31 of 40 million Australian dollars which
26:33 would have been
26:37 2.88 88
26:46 savings easy we can see it that is
26:49 equals to 1.344
26:52 minus 1.32
27:01 and this guy the same as we're having
27:15 which means this guy was able to save
27:24 and this guy was able to save
27:28 $80,000 Australian dollars.
27:30 That's how much they are able to save by
27:34 edging. So that is it basic understanding
27:36 understanding
27:38 very good straightforward
27:43 and that actually marks the end of
27:46 FX risk management
27:49 the next series we'll start looking at
27:54 interest rate management and the same
27:55 strategy we're going to be using going
27:59 to be talking about forward future
28:01 future
28:05 options and swaps. But this time around
