Assignment Code: MFP-4/TMA/JULY/2022-23

Course Code: MFP-4

Assignment Name: Currency and Debt Markets

Year: 2022-23

Verification Status: Verified by Professor

Note: Attempt all the questions and submit to the coordinator of your study centre. Last date of submission for July 2022 session is 31st October, 2022 and for January 2023 session is 30th April, 2023.

1. Explain the structure of the currency market in India. Who are the participants in the currency market and what are the products traded in the Indian foreign currency market.

Ans) The currency market in India is a decentralized market where foreign exchange transactions take place between buyers and sellers from all over the world. The currency market in India is regulated by the Reserve Bank of India (RBI) and operates through a network of banks, financial institutions, and brokers.

Participants in the Currency Market in India

1. Banks: Commercial banks and foreign banks are the primary participants in the currency market. They deal with foreign currency transactions on behalf of their clients and manage their own foreign exchange positions.

2. Corporate Firms: Indian corporations that have exposure to foreign exchange risks due to their international business activities participate in the currency market to hedge their foreign exchange risks.

3. Individuals: Individuals who require foreign currency for travel, education, and other purposes participate in the currency market through authorized dealers.

4. Brokers: Brokers act as intermediaries between buyers and sellers in the currency market. They facilitate transactions by providing information on exchange rates, executing trades, and managing risk.

Products Traded in the Indian Foreign Currency Market

1. Spot Transactions: Spot transactions involve the immediate exchange of one currency for another at the prevailing exchange rate.

2. Forward Transactions: Forward transactions involve the exchange of currencies at a predetermined exchange rate and date in the future.

3. Currency Futures: Currency futures are standardized contracts that involve the exchange of one currency for another at a predetermined price and date in the future.

4. Options: Currency options are contracts that give the holder the right but not the obligation to buy or sell a currency at a predetermined price and date in the future.

Overall, the Indian currency market is a dynamic and rapidly growing market that provides opportunities for investors and traders to participate in foreign exchange transactions and manage their foreign exchange risks.

2. What are Currency Swaps? Explain how it can be used to reduce the cost of borrowings.

Ans) Currency swaps are financial contracts in which two parties agree to exchange a series of cash flows denominated in different currencies. The cash flows exchanged are typically interest payments and principal amounts associated with loans or bonds denominated in different currencies. Currency swaps can be used by companies to manage their foreign currency exposure, reduce their borrowing costs, and access capital in foreign markets.

Currency swaps can be used to reduce the cost of borrowings in several ways:

Accessing Lower Interest Rates: Companies can use currency swaps to access capital in foreign markets where interest rates may be lower than those available domestically. For example, a company in India may swap its rupee-denominated debt for US dollar-denominated debt with a US company to take advantage of lower interest rates in the US.

Eliminating Currency Risk: Companies can use currency swaps to eliminate currency risk associated with their foreign borrowings. For example, a company that has taken out a loan denominated in a foreign currency may be exposed to exchange rate fluctuations that could increase the cost of its borrowings. By using a currency swap, the company can exchange the foreign currency cash flows for domestic currency cash flows, effectively eliminating the currency risk.

Achieving Optimal Debt Structure: Companies can use currency swaps to achieve an optimal debt structure by matching their cash inflows with their cash outflows. For example, a company that generates revenue in US dollars but has expenses in Indian rupees can use a currency swap to exchange its US dollar cash flows for rupee cash flows to better match its cash inflows with its cash outflows.

Overall, currency swaps are a useful tool for companies to manage their foreign currency exposure and reduce the cost of their borrowings. However, they involve certain risks, including credit risk, interest rate risk, and liquidity risk, and should be used with caution. It is important for companies to carefully consider their objectives and consult with their financial advisors before entering into a currency swap.

3. Explain the following

(a) REPOs

Ans) REPOs (Repurchase agreements) are short-term borrowing and lending transactions in which one party (usually a bank or a financial institution) sells a security to another party (usually the central bank) with an agreement to repurchase it at a later date, typically the next day or within a few days, at a slightly higher price. The difference between the selling price and the repurchase price is the interest charged on the loan and is known as the repo rate. REPOs are commonly used by banks and other financial institutions to manage their liquidity needs. By borrowing funds through a repo, banks can obtain short-term financing and use the securities they hold as collateral. The central bank, on the other hand, uses REPOs to inject liquidity into the financial system or to influence interest rates.

In India, the RBI conducts REPO operations as a part of its monetary policy. Banks can participate in REPO auctions conducted by the RBI to borrow funds for short periods of time, typically one day, against government securities or other approved securities as collateral. The RBI can also use REPOs to inject liquidity into the banking system by buying government securities from banks. REPOs are considered to be low-risk transactions because they involve the exchange of collateral and are typically backed by high-quality securities. However, there is a risk of default if the party borrowing funds is unable to repurchase the securities at the agreed-upon price.

(b) Forward Rate Agruments (FRAs)

Ans) Forward rate agreements (FRAs) are financial contracts that allow parties to lock in an interest rate for a future period. FRAs are used to manage interest rate risk and provide a hedge against adverse changes in interest rates. The two main types of FRA are a borrowing FRA and a lending FRA. A borrowing FRA is a contract in which one party agrees to pay a fixed interest rate on a notional amount of funds borrowed for a future period. The other party agrees to pay the prevailing floating interest rate for the same notional amount.

The FRA settles the difference between the fixed rate and the floating rate at the end of the period.  A lending FRA is the opposite of a borrowing FRA, where one party agrees to receive a fixed interest rate on a notional amount of funds lent for a future period. The other party agrees to pay the prevailing floating interest rate for the same notional amount. The FRA settles the difference between the fixed rate and the floating rate at the end of the period.

The Key Arguments Used in FRA Pricing

1. Interest Rate Expectations: The expected interest rates for the future period play a critical role in the pricing of FRAs. If the prevailing market interest rates for the future period are expected to be higher than the fixed rate agreed upon in the FRA, the buyer of the FRA (the party paying the fixed rate) will receive a pay out at the settlement date. Conversely, if the expected interest rates are lower, the seller of the FRA (the party receiving the fixed rate) will receive a pay-out.

2. Notional Amount: The notional amount is the amount on which the fixed and floating interest rates are based. The size of the notional amount affects the pay out at the settlement date. A larger notional amount will result in a larger pay out.

3. FRA Duration: The duration of the FRA, or the length of the period for which the interest rate is fixed, also affects the pay-out. A longer duration will result in a larger pay out.

4. Credit Risk: The creditworthiness of the parties involved in the FRA contract also affects the pricing. A higher credit risk will result in a higher fixed interest rate to compensate for the increased risk of default.

4. What is interest rate risk? Explain the interest rate sensitivity policy and discuss its broad parameters.

Ans) Interest rate risk refers to the risk of loss that arises from changes in interest rates. It is the risk that an investor will face a decline in the value of an investment due to fluctuations in interest rates. Interest rate risk is a significant concern for financial institutions, including banks and insurance companies, as well as for individual investors who hold fixed-income securities, such as bonds.

Interest rate sensitivity policy is a framework for managing interest rate risk. The policy sets out guidelines for how an institution will manage its exposure to interest rate risk, with the aim of minimizing the potential impact of interest rate fluctuations on the institution's financial position.

The broad parameters of an interest rate sensitivity policy may include:

1. Interest Rate Risk Measurement: The policy should establish a methodology for measuring the institution's exposure to interest rate risk. This may include stress testing, scenario analysis, and other quantitative techniques.

2. Risk Tolerance and Limits: The policy should define the institution's risk tolerance for interest rate risk and establish limits on the maximum acceptable level of risk exposure. The limits should be consistent with the institution's overall risk management framework.

3. Hedging Strategies: The policy should outline the institution's hedging strategies for managing interest rate risk. These may include using derivative instruments, such as interest rate swaps and options, to mitigate the impact of interest rate fluctuations.

4. Monitoring and Reporting: The policy should establish procedures for monitoring and reporting on the institution's exposure to interest rate risk. This should include regular reporting to senior management and the board of directors, as well as ongoing monitoring of key risk indicators.

5. Staff Training: The policy should require staff training on interest rate risk management. This will ensure that all staff members understand the policy and their role in managing interest rate risk.

Overall, an interest rate sensitivity policy is an important tool for managing interest rate risk. By establishing clear guidelines for measuring, managing, and reporting on interest rate risk exposure, institutions can minimize the potential impact of interest rate fluctuations on their financial position. The specific parameters of an interest rate sensitivity policy will vary depending on the nature and size of the institution and its risk management objectives.

5. What is Duration and Modified Duration? How are they calculated?

Ans) Duration is a measure of the sensitivity of the price of a fixed-income security to changes in interest rates. It represents the average time it takes for an investor to receive the present value of all the cash flows of the security, including both coupon payments and the principal repayment. Duration is expressed in years and is calculated as the weighted average of the time to each cash flow, with the weights being the present value of each cash flow.

Modified duration is a modified version of duration that takes into account the fact that the price-yield relationship of a bond is not linear. Modified duration is used to estimate the percentage change in the price of a bond for a given change in yield, and is calculated as follows:

Modified duration = Duration / (1 + Yield / Number of coupon payments per year)

The formula adjusts the duration calculation by dividing it by a factor that accounts for the non-linear relationship between price and yield. The higher the modified duration, the more sensitive the bond's price is to changes in interest rates.

To calculate duration and modified duration, the following steps are typically followed:

1. Calculate the present value of each cash flow of the security, using the current market yield as the discount rate.

2. Calculate the total present value of all the cash flows.

3. Calculate the weight of each cash flow as its present value divided by the total present value.

4. Multiply the time to each cash flow by its weight and sum the results to calculate the duration.

5. Calculate the modified duration using the formula above.

Duration and modified duration are important tools for bond investors and portfolio managers as they provide a measure of the sensitivity of a bond's price to changes in interest rates. By understanding the duration and modified duration of a bond or a portfolio of bonds, investors can better manage their interest rate risk and make informed investment decisions.