Of Knock-ins, Knock-outs & KIKOs
PRIMER FOREX DERIVATIVES
| Derivative: A security whose price is derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the price of underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. |
| Objective: Derivatives are generally used to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company on an American exchange (using American dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock-in a specified exchange rate for the future stock sale and currency conversion back into euros. |
| Types of Derivatives: Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are contracts; so, just about anything can be used as an underlying asset. There are derivatives based on weather data, like how much it will rain in a particular region. Derivatives can be broadly divided into two""swaps and options. |
| SWAPS |
| Principal-Only-Swaps (POS): These are typically used for hedging loan transactions. If a corporate borrows in yen and wants to swap the loan into US $ or Rupee, it could opt for a product like principal-only-swaps (POS). This helps you move the principal from one currency to another. |
| If a company has taken a loan when the dollar-yen rate was at 120, and it has done a POS at 120, then it would receive from the bank equivalent yen principal at 120, and it would pay equivalent US$ to the bank Additionally, the company will have to pay a premium, which is the interest rate differential. |
| Most companies, who have gone for external commercial borrowings (ECBs) denominated in yen, have opted for a POS. This locks in their liability by moving the loan from yen to dollar, which protects them against the dollar-yen exchange rate movements. |
| Interest Rate Swaps (IRS): In interest rate swaps, you are addressing only the interest rate part of the loan. If a company takes a view that the interest rates are going to be higher and if it has borrowed in floating rate, say linked to the LIBOR (London Inter Bank Rate), then it could do an interest rate swap""it pays a fixed rate and receives a floating rate from the bank. |
| This effectively converts a floating rate liability into a fixed rate liability. The benefit: if a company has done the swap and interest rates move higher, then it will receive the higher floating rate from the bank, and will have to pay only a pre-determined fixed rate. |
| Companies enter into interest rate swaps when they expect interest rates to move up or down. When they expect interest rates to move up, they would do a swap by which they will receive a floating rate from the bank, and pay a fixed rate. Similarly, when they expect interest rates to fall, they would do a swap by which they will receive a fixed rate from the bank, and have to pay a floating rate. |
| Currency Swap: It's a derivative instrument which takes care of both, principal-only-swap and interest rate swap, together. If a company has borrowed in US$ and wants to covert it into a rupee loan, it can do a currency swap, wherein it will receive from the bank the principal and interest in US$, and pay the bank a fixed rupee interest rate and also freeze its principal payment for the entire tenure of the loan. Effectively, the dollar loan becomes a rupee loan in Indian rupees. |
| Carry trade/ Hybrid Swap: In a carry-trade swap, a company can move from a higher interest-rate currency to a lower interest-rate currency, and rather than hedging the full currency risk through forward contract which would eliminate the carry, it can reduce the cost of hedging by buying options with a knock-out (an option which ceases to exist if a knock-out event happens and a particular level is hit "" like yen hitting a particular level against the dollar). |
| As long as the knock-out doesn't happen, the company doesn't have a risk. If the knock-out happens, then the company has to buy the Swiss franc / yen at the market rate prevailing on the date of maturity and settle the deal on maturity and hence will get exposed to the currency fluctuation between the US dollar and Swiss franc or between the US dollar and Japanese yen. |
| Banks use various permutations and combinations to structure products and create a pay-off (risk-reward equation) that a client is comfortable. |
| OPTIONS |
| Option is a contract which gives a buyer a right, but not an obligation, to buy an underlying/ currency/ stock/ commodities at a pre-determined rate, known as strike price, for settlement at a future day. The right to buy is called a call option. The right to sell is called a put option. There are different types of options. |
| Knock-out option: An option which ceases to exist if the knock-out event occurs. A knock out happens when a particular level is hit (like the Swiss franc touching the level of 1.10 against the dollar), when the option ceases to exist. |
| Knock-in option: An option which comes into existence if the knock-in event happens. It works exactly the reverse of a knock-out. In a knock-in, an option comes into existence if a certain level is hit. |
| KIKO (knock-in, knock-out): This is an option with both a knock-in and knock-out. The option kicks in, or comes alive, if the knock-in is seen. The option ceases to exist if anytime, pre or post, the knock-in event happening, the knock-out happens. |
| One-touch option: When a certain level (of any currency pair) is hit, a company buying an option gets a pre-determined pay-off (it could be $10,000, $20,000, or $30,000). This is how companies made money through derivative deals last year. |
| Double-touch option: There are two levels. If either of the two levels is hit, the company buying an option will get a pay off. All options require a buyer to pay a premium. Conversely, sellers of options would receive a premium. |
| STRUCTURES |
| Banks, foreign exchange consultants work out zero-cost option structures/ strategies for companies so that they don't have to pay any premium. To make a zero-cost structure, a company has to buy some option and sell some option so that the premium is zero (the premium paid for buying an option is set-off against the premium received for selling the option). |
| For instance, when the rupee-dollar parity is 40.10, an exporter buys a put option at the rate of 39.50, and sells a call option for 41.00 for delivery of exports at the end of June, July and August an export commitment of $1 million each month. By entering into this contract, the best rate the exporter can get is 41, and the worst rate it can get is 39.50. |
| If the rupee goes below 39.50, the exporter will be able to encash its receivables at the rate of 39.50. If the rupee is trading between 39.50 and 41, the exporter will be able to encash its receivables at the prevailing market rate. |
| However, if the rupee is ruling above 41, it will get its receivables at Rs 41 as he's locked in that level. This kind of structure is popular with software companies, who can realise their receivables in a range (between the best and worst), unlike in a forward contract where they get locked in at a particular rate. |
| Banks also offer, what they call, a 1:2 leveraged option, wherein a company buys some calls, makes some puts and use a combination of these to create zero-cost strategy for the company. Companies that have big positions in derivative trades have been selling KIKOs, or a series of KIKOs and buying one-touch options and double-touch options. These structures helped companies make money last year. |