Financial derivatives effective instrument to hedge exchange rate risk in Vietinbank BRVT branch Luận văn thạc sĩ

MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECONOMIC HOCHIMINH CITY
j



LUC THAO PHUONG HA


FINANCIAL DERIVATIVES
INSTRUMENT TO HEDGE
EXCHANGE RATE RISK IN
VIETINBANK BRVT BRANCH


In Banking and Finacial
Ology code: 60.31.12



MASTER’S THESIS

Supervisor : Dr.TRAN HUY HOANG





Ho Chi Minh City – 2010

Financial Derivatives


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DECLARATION
I assure that this thesis is my research. This thesis has not already been submitted for
any degree and is not being currently submitted for any other degree. The extracts and
data from the other studies have been cited clearly. I bear full responsibilities for
whatever un-honest of this thesis.

Luc Thao Phuong Ha
August, 2010

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ACKNOWLEDGMENTS


It is a good opportunity to participate to the master’s course of Banking in English,
which is conducted by the University of Economic Hochiminh City, Faculty of
Banking Course. I have achieved a lot of knowledge, methodology, techniques and
new ideas from this course. This thesis is a part of my accumulative knowledge that I
have gathered from the teachers, classmates and the colleagues.
First of all, I would like to express my grateful and indebtedness to my supervisor,
Associate Professor Ph.D Tran Huy Hoang who provided me the precious
methodology. He helped me a lot in construction of the thesis structure, and gave me
the new ideas in analysis. This thesis could not be done without his contribution.
I also would like to extend my sincere thanks to all the teachers, who have improved
my knowledge of development economics and other social economics understanding.
I am grateful for the help from the board of director of Vietinbank Baria Vungtau
branch, Mr Tu Nhu Phong, Mr Nguyen Huu Son, Ms Thu Ha, and all my colleagues,
who have facilitated me in this research.
I highly appreciate the helps from Mr Kien Quoc, Mr Manh Ha, Mr Thanh Hai and all
classmates of class of Banking, course 16, who have made a good condition for my
study. I would like to give my thanks to all of them.
Finally, I express my love to all members of my family, who have encouraged me in
the progress of my studying and completing this thesis.

Luc Thao Phuong Ha.

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Abstract


Based on the theory of foreign exchange (forex) market and foreign exchange risk
management, this thesis focuses on the involved banking products used to manage
risks in trading forex operation. They are financial derivatives.
Financial derivatives are rare in Vietnam although they are widely used in international
market. An overview of Vietnam forex market from 2007 to now demonstrated to give
the reasons why it is necessary to manage foreign exchange risk and what can be done
to mitigate risks? Finally, suggestions for applying financial derivative instruments in
Vietnam Bank for Industry and Trade (Vietinbank), Baria Vungtau Branch as a new
banking transaction are discussed to enhance its position in local province.

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TABLE OF CONTENT Page

INTRODUCTION 1
1. The rational of the study 1
2. Statement of the research problem 2
3. Research questions and objective 3
3.1 Research questions 3
3.2 Research objectives 3
4. Research methodology 4
5. Signification of the study 4
6. Structure of the study 5

CHAPTER ONE: FINANCIAL DERIVATIVES IN FOREIGN EXCHANGE
TRADING IN COMMERCIAL BANKS
1.1 Foreign exchange trading in commercial banks 6
1.1.1 What is a commercial bank? 6
1.1.2 Banking transactions – foreign exchange trading 7
1.1.3 Risks in foreign exchange trading 8
1.1.4 The necessity of managing foreign exchange risk 14
1.2 Financial derivatives in foreign exchange trading in commercial banks 14
1.2.1 What are financial derivatives? 14
1.2.2 Types of financial derivatives in exchange trading 15
1.2.3 Functions of financial derivatives 19
1.3 Conditions to apply and develop financial derivatives of foreign currency 22
1.3.1 Commercial banks’ internal conditions 22

1.3.2 Commercial banks’ external conditions 23
Conclusion 24

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CHAPTER TWO: RESEARCH METHODOLOGY
2.1 Introduction 25
2.2 Research design 26
2.3 Data collection 27
2.3.1 Sample 27
2.3.2 Data collection 27
2.3.3 Hypothesis 31
2.3.4 Scope of the research and data analysis 33
2.4 Conclusion 34

CHAPTER THREE: CURRENT SITUATION IN FOREIGN EXCHANGE
TRADING IN VIETINBANK BARIA VUNGTAU BRANCH
3.1 Background of Vietnam’s forex market 35
3.1.1 Characteristics of Vietnam’s forex market 35
3.1.2 Forex trading in BRVT province and Vietinbank BRVT branch 39
3.2 Analysis results 41
3.2.1 Unexpected movement of foreign currency impact on
businesses’ activites 42
3.2.2 Business’ demand for using derivatives 47
3.3 Vietinbank Baria Vungtau branch and perceptions about
application of derivatives 51
3.3.1 Forward and option contract 52
3.3.2 Combining financial derivatives with credit policy 53
3.3.3 Reasons why derivatives are not popular used in BRVT province 54
Conclusion 57

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CHAPTER FOUR : CONCLUSION AND RECOMMENDATION
4.1 Conditions for developing foreign exchange derivatives 59
4.2 Recommendation 62
4.3 Limitation of study and suggestion for further ones 64
4.4 Conclusion 65
LIST OF REFERENCES 66
APPENDIXES 68

ABBREVIATION

AUD: Australian dollars
BRVT: Baria Vungtau
CBI : Central Bank Intervantion
CPI: Customer purchase Index
EUR: Europe dollar
Forex market = FX: Foreign exchange market
GBP: Greatain Bristish Pound
GDP: Gross domestic product
IMF: International Monetary Fund
JPY: Japnanese yen
OTC: Over the Counter
SBV: The state bank of Vietnam
SOCB: The state-owned commercial banks
USD: United States dollar
VND: Vietnam dong

Vietinbank: Vietnam Bank for Industry and Trade
WB: World Bank
WTO: World Trade Oragnization

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LIST OF CHART
Chart 1.1: AUD/USD rate’s movement 10 years 9
Chart 2.1: Outline of Research methodology 25
Chart 2.2: Outline of Hypothesis and variables 32
Chart 3.1: Density inward of foreign currencies 35
Chart 3.2: The movement of VND/USD period 1999 – 2009 37
Chart 3.3: Import – Export turover in BRVT province 39
Chart 3.4: Volume of USD trading in Vietinbank BRVT branch 40
Chart 3.5: USD transferred to Vietinbank from exporters, remittance
and demand for USD from importers 51
Chart 3.6: Derivatives trading in Vietinbank BRVT branch and
Other banks in BRVT province 52



LIST OF TABLE
Table 3.1: Summary of the kind of investigated companies 41
Table 3.2: Descriotive statistic about impact of forex on companies’ activities 43
Table 3.3: Correlation and coefficient of Q7, Q8, Q9 and Q18 44
Table 3.4: Correlation and coefficient of Q10, Q11, Q12, Q13, Q14 and Q18 45
Table 3.5: Correlation and coefficient of Q15, Q16, Q17 and Q18 46
Table 3.6: Frequency analysis of Q19, Q21, Q22 47

Table 3.7: Frequency analysis of Q23, Q24, Q25, Q26, Q27 48
Table 3.8: Frequency analysis of Q28, Q29 and Q29B 50
Financial derivatives

INTRODUCTION
1. The rationale of the study
In the recent years, the foreign exchange market in Vietnam has been formed and
developed. This is actually necessary for Vietnam in the process of integrating into
the international economy. Vietnamese businesses as well as commercial banks
have recently improved their operating abilities to run the business in the global
field. The operation of the foreign exchange market plays an important role in
promoting the international foreign trade and economic cooperation among
countries. Foreign exchange transaction not only has been now considered as one of
important banking services of commercial banks, but also marked a new step
forward of banking – modernizing movement. Transactions conducted in the
foreign exchange market determine the rate at which currencies are exchanged. The
major transactions in foreign exchange market are spot, forward, swap, future
contract and currency option. The basic of those transactions is the exchange rate.
Exchange rate affects the relative price of domestic and foreign goods, hence
exchange rate volatility strongly affects the foreign trade activities between
countries.
The year 2008 was coming with the pessimistic image of the global economy. It
started with the American sub-prime crisis, the international fluctuating price of oil
– up and down rapidly, the high inflation and the global economic slowdown…
therefore, the forex market around the world has been operating on unexpected
movement. Since the event that Vietnam became the official member of WTO, we
are directly impacted by these turmoil tendencies, influencing deeply in our
country’s emerging economy. The more Vietnam integrates into global economy,
the riskier in currency exchange rate the businesses have to exposure. In order to
support local import-export enterprises, commercial banks have to develop many

kinds of derivatives in foreign currency transaction for hedging exchange rate risk.
Vietnam commercial banking system has recently increased its’ abilities to meet the
international banking standards. As one of members of Vietnam banking system,
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2. Statement of the research problem
Foreign exchange risk management is crucial for businesses frequently trading in
the international market. There are many kinds of financial instruments used to risk
management, in which financial derivatives have been most popularly used in
hedging. Financial derivatives include four main types: forward, future, swap and
option. They have been widely used for hundreds of years in international market
such as stock market, commodity market, foreign exchange market … Speculators
use them to implement their arbitrage transactions to gain profit in financial market.
However, the most important effect of financial derivatives is hedging risks –
fluctuant changing in prices of goods. In the foreign exchange market, this effect is
more important to prevent investors from the rate’s volatility.
Firstly, this thesis analyzes risks derived from forex market, and the importance of
forex risks management. Then it aims to explain why derivatives have not implied
widely in Vietnam yet, and how to encourage this kind of financial instruments as
new banking services in Vietnam banks – especially in Vietinbank BariaVungtau
branch. The current Vietnamese foreign exchange market will be generally
demonstrated, giving its changes affected by outside factors and its influences on
local import-export businesses. Then some conditions for development of derivative
instruments for hedging foreign exchange rate in Vietnam are analyzed in detail,

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3. Research questions and objectives
3.1: Research questions:
The aim of this thesis is to learn about the foreign exchange risk in general and the
importance of currency exposure management in BariaVungtau enterprises by using
currency derivatives. The research question is formulated as follow: How can
financial derivatives’ instruments be developed as crucial banking transactions
in Vietinbank BariaVungtau in order to enhance the bank’s competitiveness?
To answer for this question, this thesis will analyze following aspects:
(1) The importance of hedging risks in international trading of import – export
enterprises as well as banking transactions in terms of foreign exchange.
(2) Reasons of financial derivatives not been popular used in BariaVungtau’s
enterprises as well as in Vietinbank BariaVungtau branch
(3) Perception of foreign currency exposure management in Vietinbank and
what financial derivatives – products and services – the bank can provide customers
(4) How to use financial derivatives instruments as a managerial method to
strengthen Vietinbank Baria Vungtau Branch’s competitiveness and protect the
bank from foreign exchange risk.
3.2: Research objectives
To learn about risks faced in international trading in terms of currency – the large
and rapid fluctuant movement in exchange rate in Vietnam.
To study the demand of import – export enterprises in BariaVungtau province
whether foreign exchange hedging risk is important?

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To launch some kinds of financial derivatives in term of foreign exchange to meet
market’s demand as well as increase Vietinbank BRVT branch’s ability as the best
commercial bank in BRVT province.

4. Research methodology
The scope of this thesis is to study about import-export enterprises in BariaVungtau
province, but not to cover Vietsovpetro Joint-venture because this enterprise’s
output (mainly from crude oil export) has large proportion in total foreign trade
turn-over in BariaVungtau province. In this thesis, observing method is employed to
expose volatility of foreign exchange rate which causes risk in international trade.
From data of forex transactions traded in 2006 to the first quarter of 2010 in
Vietnam and global forex market, the trend of exchange rate in Vietnam toward the
international movement will reflect the severely impact on import – export
operations in local province. The threat of foreign exchange risk will be evaluated
by questionnaire sent to enterprises in BRVT province in order to find out what can
be done to mitigate the foreign currency risk; whether it is necessary to apply the
financial derivatives instrument for hedging risk and how Vietinbank BRVT can do
to introduce new financial banking instruments to their customers.

5. Signification of the study
The goal of this thesis is to develop financial derivatives in foreign exchange
transaction in Vietinbank BariaVungtau branch. While financial derivatives are
popularly being used in the world, it is new and strange for Vietnam businesses and
banks. In order to enhance Vietinbank’s competitive ability, provide sufficient
banking services to its customers, Vietinbank should study and launch new products
that give the bank competitive advantage against its competitors in the global play-
field. BariaVungtau province has a large of import-export turn-over, therefore there
are previously problems of foreign exchange rate which rarely remains stable over
long period of time. However, financial derivative instrument is not popularly used

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for both of hedging risks and financial investment. Operating from 1988,
Vietinbank Baria Vungtau plays an important position in international payment
serving local enterprises, so it would be a good chance for the bank to learn and
develop new banking transactions to serve its customers as well as attract more
potential ones in local area.

6. Structure of the study
This essay includes three major parts. The first section will introduce theoretical
background of foreign exchange risk and foreign exchange exposure management
by using financial derivatives. The second section gives a view of Vietnam foreign
exchange, especially the period of time between 2007-2009 – the period of the rate
of USD and VND continuously unexpected up and down and the adverse effect to
import-export companies as well as banking sector in BariaVungtau province. The
third section studies more details of necessary conditions for developing financial
derivatives as banking services as well as applying financial derivatives
instruments.













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CHAPTER ONE: FINANCIAL DERIVATIVES IN FOREIGN EXCHANGE
TRADING IN COMMERCIAL BANKS

1.1 Foreign exchange trading in commercial banks
1.1.1 What is a commercial bank?
Banks are financial institutions that accept deposits and make loans. Included under
term banks are firms such as commercial banks, savings and loan associations,
mutual savings banks, and credit unions. A commercial bank known as business
banking is a type of financial intermediary and a type of bank. It is a bank that
provides checking accounts, savings accounts, and money market accounts and that
accepts time deposits. It also provides credit line to kinds of individuals and
enterprises in economy. With the role of financial intermediary institutions, the
commercial bank mobilizes fund from people who have surplus to others who have
lack of fund. It is also called traditional banking services.
Nowadays, traditional banking services are no longer banks’ essential ones, larger
proportion of banks’ income is from modern banking services, such as: debit –
credit cards, money transfer, properties- safe keeping, bank guarantee, international
payment, foreign exchange transaction, etc. In the world, banking system has long
development history, along with the fast movement of technologies, banking
transactions have been diversified to meet customers’ need; and gradually become
important players in international payment system of the global economy, especially
in current economic globalization.
In order to take a position in the global field, commercial banks have to modernize
their technology system to carry out modern banking transaction to meet their
customers’ needs which are more and more demand on quality and complexity.
Especially, in foreign trade payment, international currency exchange transaction,
commercial banks play an important role between customers in different countries.

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1.1.2 Banking transactions – foreign exchange trading.
Foreign exchange rate.

Most countries in the world have their own currencies; for example the United
States has dollar (USD), the European Monetary Union – the euro (EUR), the Great
Kingdom – the pound (GBP), India – the rupee, … Trade between countries
involves the mutual exchange of different currencies. Foreign Exchange is the
simultaneous buying of one currency and selling of another (transfer of purchasing
power). The price of one currency in terms of another is called the exchange rate.
The world's currencies are on a floating exchange rate and are always traded in
pairs, for example VND/USD or USD/EUR.
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The trading of currency and bank deposits denominated in particular currencies
takes place in the foreign exchange market – the financial market where exchange
rates are determined. The Foreign Exchange market, also referred to as the
"FOREX" market, is the largest financial market in the world, with a daily average
turnover of approximately $1.5 trillion. The foreign exchange market is
geographically dispersed, extending from Australia to Asia, from Europe to
America. The market is relatively thin when trading begins in the Far East and is far
more liquid when the last hours of trading in Europe coincide with trading in the
United States due to differences in the time zones.
Evolution of the international financial system – foreign exchange rate.

Before World War 1, the world economy operated under the gold standard, meaning

that the currency of most countries was convertible directly into gold. As long as
countries aided by the rules under the gold standard and kept their currencies
backed by and convertible into gold, exchange rates remained fixed. However,
adherence to the gold standard meant that a country had no control over its
monetary policy, because its money supply was determined by gold flows between
countries. Furthermore, monetary policy throughout the world was greatly
influenced by the production of gold and gold discoveries. World War 1 caused


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massive trade disruptions, countries could no longer convert their currencies into
gold and the gold standard collapsed.
After World War II, a new international monetary system – known as Bretton
Woods system - was developed to promote world trade. Under the Bretton Woods
system, each national currency was kept its exchange rate fixed at a certain level –
fixed exchange rate regime. Because the United States emerged from the World
War II as the world’s largest economy power, the Bretton Woods system of fixed
exchange rates was based on the convertibility of USD into gold. Thus an important
feature of the Bretton Woods system was the establishment of the US as the reserve
currency country, event after the breakup of the Bretton Woods system, the USD
has kept its position as the reserve currency in which most international financial
transactions are conducted. However, because there were several weaknesses of the
Bretton Woods system involving with deficit international reserves, the system
collapsed in 1971. After that, America and its trading partners had agreed to allow
exchange rates to float.

Although exchange rates are currently allowed to change daily in response to
market forces, central banks have not willing to give up their option of intervening
in the foreign exchange market. Nowadays, the current international financial
system is a hybrid of a fixed and a flexible exchange rate system. Rates fluctuate in
response to market forces but are not determined solely by them. With the purpose
of stabilizing national social and economic index, such as GDP, CPI, inflation,
customer’s confidence, …, central banks often use their political power to adjust
unexpected changes from forex market.

1.1.3 Risks in foreign exchange trading
Under system of fixed exchange rate regime, involved parties did not face exchange
rate risk. However, the managed – floating exchange rate causes uncertainty of
national currency in future. Volatility in the foreign exchange rate is the one of the
major sources of macroeconomic uncertainty that affects the enterprises and

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national economy. Foreign exchange rate volatility influences the value of the
company since the future cash flows of the company will change with the
fluctuations in the foreign exchange rates. The deepening of globalization process
has led to an increase in foreign exchange transactions in international financial
markets. This has determined a higher volatility of exchange rates, and, implicitly,
an increased foreign exchange risk.
Nowadays, the value and volume of international trade continues increasing year by
year. In order to effect international payment fluently, banks have been playing as
an important role for import and export enterprises to enter into global market.
Forex trading is one of the most important banking transactions. It not only services
import-export firms who can efficiently operate their businesses, but also do
businesses themselves to get profit. Therefore, banks always ehance their

capabilities to deeply supply more and more kinds of forex transactions. However,
along with advantages of forex trading, forex market also holds many types of
potential risks.
Chart No.1.1 : AUD/USD rate’s movement 10 years
(
There are also many definitions of foreign exchange risks. The risk that the
exchange rate on a foreign currency will move against the position held by an

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investor such that the value of the investment is reduced. For example, if an investor
residing in the United States purchases a bond denominated in Japanese yen,
deterioration in the rate at which the yen exchanges for dollars will reduce the
investor's rate of return, since he or she must exchange the yen for dollars.
Foreign exchange risk is commonly defined as the additional variability
experienced by a multinational corporation in its worldwide consolidated earning
that results from unexpected currency fluctuations. It is generally understood that
this considerable earnings variability can be eliminated – partially or fully – at a
cost, the cost of Foreign exchange risk management” (Jacques, 1981, p81-82)
Eitman and Stonehill (1986) and Shapiro (1991) define the three types of foreign
exchange exposure as:
Transaction exposure. Transaction exposure occurs when an enterprise trades,
borrows, or lends in a foreign currency, or sells fixed assets of its subsidiaries in a
foreign country. During the time between the commitment of the transaction and the
payment’s receipt, the involved exchange rate that maybe change will make the
enterprise carry unexpected exposure with actual cash flows. In other word,
transaction exposure is defined as the impact of the unexpected change in the
exchange rate on the cash flow arising from all the contractual relationships entered
prior to the change in exchange rate at time t

0
to be settled after the change in
exchange rate at time t
1
.
Economic exposure. Economic exposure measures the change in the present value
of the firm resulting from any change in the future cash flows of the company
caused by an unexpected change in the exchange rates. Future cash flows can be
divided into cash flows resulting from contractual commitments and cash flows
from anticipated future transactions. In a way, economic exposure includes
transaction exposure in itself. Transaction exposure is the part of economic
exposure comprising future cash flows resulting from contractual commitments and
denominated in foreign currency. However, transaction exposure arises from
company contractual commitments and the amounts to be paid or received are

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known. Economic exposure whose amounts are uncertain and based on estimates
can be defined as the future effect of foreign exchange changes on liquidity,
operations, financial structure and profit.
Translation exposure. Translation exposure arises from converting financial
statements expressed in foreign currency into the home currency. It is also defines
the unexpected change in exchange rates on the balance sheet of the subsidiary as
translated for consolidation purposes into the parent company’s currency.
Translation risk recognizes only items already on an accounting balance sheet and
income statements from the currency of the operating units offshore to that of the
parent potentially changes its equity.
In general there are also another definitions of risks: market risk, operating risk and
settlement risk.

Market risk. Market risk is also referred to as replacement risk. Market risk means
“What will it cost to replace the trade with counterparty at the currently prevailing
rate in the market?”. On a spot FX transaction the risk is less than with forwards,
since there is only two days until settlement. Usually, in any market, the greater the
maturity of the transaction is, the higher the degree of risk.
In order to recognize market risk, a market to market process is employed to
evaluate outstanding deals on financial institutions’ books. A current market price is
used to calculate the profit or loss of each deal on the books. In this way,
institutions can better understand their actual exposure to counterparties. It is
important to note that institutions usually are most interested in deals that they are
making money on, as opposed to deals in which they are losing money.
Operating risk. The exposure to the multi-period future cash flows arising due to
an unexpected change in exchange rate is referred to as an economic or operating
exposure. In this scenario the present value of the future cash flows is affected as a
result of an unexpected change in the exchange rate. The transaction exposure is the
effect of unexpected change in the nominal exchange rate on the cash flow
associated with the monetary assets and liabilities and is usually short term. The

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operating exposure, however, is related to the impact of the unexpected change in
the exchange rate on future cash flows associated with the real assets and liabilities.
Therefore, it is long term in nature.
Settlement risk. This arises as a result of the timing differences in the payments
due on a FX trade. On the settlement day of the FX deal between AYZ Bank and
XYZ bank, XYZ bank are due to pay AYZ bank 15 million DEM while receiving
10 million USD. The problem for XYZ bank is that they must make the payment to
AYZ bank’s correspondent in Frankfurt several hours before they receive the 10
million USD in New York. The dangers of this gap in time were clearly

demonstrated by the Bank Herstatt case. The closure of the private German bank in
June 1974 took place late in the afternoon, after payments of DEM had been
received by Herstatt, but before the corresponding USD payments in New York
were due to be made. Settlement risk is therefore often referred to as “Herstatt risk”.
Banks manage settlement risk by establishing a settlement limit, which restricts the
total USD volume of deals that are to settle on any given day. While this would not
stop a bank from being exposed to a Herstatt disaster, it at least puts a cap on
potential losses.
When a spot FX trade is done, the full value of the deal is applied against the
settlement limit for the value date of the trade. Credit is usually replenished at the
close of business of the settlement or maturity date.
Political risk. This is a kind of risk deriving from the intervention of national
central bank or state bank, it is also called central bank interventions (CBIs).
The foreign exchange market is the market where the price of a currency is
determined by supply and demand forces for the independently floating currencies.
While government intervention has been limited to extreme cases involving events
triggering a shot down of the market, CBI in the foreign exchange market to
maintain an exchange rate within a desirable range, whether such attempts prove
successful or not. For example, the central bank can weaken its domestic currency
by selling its currency to buy other ones or vice versus. Moreover, it is proved that

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intervention by individual central banks may not avoid from being futile if there is
not monetary coordinated policy in realigning currency value.

Other
Several risks need to be considered in interest rate and currency swaps. These risks
include basis risk due to the mismatch of the cash flow created, the counterparty or

credit exposure, and sovereign risk.
Basis risk stems from the mismatch of the cash flows in the interest rate or currency
swaps. The interest rate index used may not be perfectly correlated with the floating
rate interest rate in the swap. For example, the LIBOR index used in floating rate
notes may go up by 0.8 percent, while the cost of borrowing by a financial
institution pegged to an index of money market funds increases by 1 percent over
the same period. The swap cash flow for the financial institution receiving LIBOR
and paying based on money market index would be adversely affected as a result of
basis risk as the financial institution exposure to interest rate risk would not be
completely eliminated.
Counterparty risk is due to the failure of one of the parties to the swap to meet its
financial obligations; therefore, the financial institution has to pick up the offsetting
position of the party that failed to make a payment. The financial institution
assumes the counterparty risk by charging a fee directly or indirectly to both parties
in the swap; the swap dealer takes the offsetting position in both fixed for floating
and floating for fixed interest rate swaps.
Sovereign risk reflects the political fallout and its impact on the stability of the
sovereign nation in meeting its financial obligations in a swap transaction. The
sovereign country may impose exchange controls and block access by the
counterparty to foreign exchange, causing the counterparty to default in its financial
obligations.



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1.1.4. The necessity of managing foreign exchange risk
In practice, the risks deriving from foreign exchange trade can bring a big loss to
company’s value, especially in the period of crisis. Historical forex data shows that

the currency tendency is difficult to forecast, in a day of transaction the value of
exchange rate can continuously change down and up with a big amplitude. The key
to successful trading in forex market is understanding and managing risk.
Risk-management and gambling may look similar, but they are different. For
example, what would happen if the investor who wants to buy other currency did
not know anything about movement of foreign market? If such an investor merely
went out without studying the underlying economics of forex market and what the
potential for demand would be in the future, that would not be risk management but
gambling. On the other hand, if the investor went out and looked at forecasts about
the tendency of this currency, he is managing the risk he is taking with regard to
buying the rights to use the currency. He would still be obligated to pay for the right
to invest, but he is forecasting that there will be a lot of demand for this currency,
and he will make profit.
Understanding foreign exchange, trade and hedging is increasingly becoming an
integral element for all import and export businesses. Should importers and
exporters hedge their foreign currency exposures or subject themselves to the
vagaries of the international currency markets? The answer is of course yes. The
lessons from international financial crises have proved that understanding,
forecasting, and managing forex risk is one of the keys for enterprises’ success.

1.2 Financial derivatives in foreign exchange trading in commercial banks
1.2.1 What are financial derivatives?
A derivative can be defined as a financial instrument whose value depends on (or
derives from) the values of other, more basic, underlying variables. Financial
derivatives are instruments that allow financial risks to be traded directly because
each derivative is linked to a specific instrument or indicator commodity. The

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derivative is a contract which gives one party a claim on an underlying asst or cash
value of the asset, at some fixed date in the future. The other party is bound by the
contract to meet corresponding liability. A derivative is said to be a contingent
instrument because its value will depend on the future performance of the
underlying asset. The traded derivatives that are sold in well-established markets
give both parties more flexibility than the exchange of the underlying asset or
commodity.
In the financial and currency exchange markets, derivatives play a significant role in
transferring risk form those who happen to dislike risk (risk averse) to those who
will take it for a profit. They are considered as risk-management financial tools,
however, if not managed correctly they can be risky. Financial derivatives are so
effective in reducing risk because they enable financial institutions to hedge risks –
involving engaging in a financial transaction that offsets a long position by taking
an additional short position, or offsets a short position by taking an additional long
position.
Financial derivatives are designed to manage risks; but the pool of risk associated
with them must be well understood. These tools can quickly create a lot of wealth
for individuals, but just as quickly, if not managed properly, can cause loss.

1.2.2 Types of financial derivatives in exchange trading
Derivatives can be traded OTC or on exchanges. OTC derivatives are created by an
agreement between two individual counterparties. Most of these contracts are held
to maturity by the original counterparties, but some are altered during their life or
offset before termination. Financial derivatives include four basic types: forwards,
futures, options and swaps, and these can be combined with each other of traditional
securities and loan in order to create hybrid instruments or structured securities.
- Forwards. The forwards contract determines the buying or the selling of a given
quantity of a specific asset at a specified future date at a pre-determined price.

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Forwards is part of Over the Counter Derivatives and is trading and negotiated
privately.
Suppose that a company in Vietnam has a plan to import goods from USA. This
company signs a sale contract with his counterparty, in which amount of contract
will be paid after 3 months from goods delivery. If exchange rate VND/USD will
appreciate in the future, the import company has to disburse a higher VND in the
mature, and it may cost this company a substantial capital loss. In this case, the
company can purchase a forward that a specific amount of foreign currency will be
exchanged 3 months from today at a stated rate. By locking in the future rate, the
company has eliminated the risk it faces from the foreign exchange rate.
The advantage of forward contracts is that they can be as flexible as the parties
involved want them to be. This means that an counterparty may be able to hedge
completely the foreign exchange risk for the exact currency but with opposite
positions. However, forward contracts suffer from two problems that severely limit
their usefulness. The first is that it may be very hard for an institution to find
another party to make the contract with. The second problem is that they are subject
to default risk, because there is no outside organization guaranteeing the contract,
the counterparty may default on the forward contract if there are significant
difference between spot rate and forward contract’s one. The presence of default
risk in forward contract means that parties to these contracts must check each other
out to be sure that the counterparty is both financially sound and likely to be honest
and live up to its contractual obligations. Because this type of investigation is costly
and all the adverse selection and moral hazard problems, default risk is a major
barrier to the use of exchange risk forward contracts and makes it less usefulness to
financial institutions.
- Futures. They function like forwards but are standardized and traded publicly on
exchanges. A financial futures contract is similar to a forward contract, in that if
specifies that a financial instrument must be delivered by one party to another on a

stated future date. However, it differs from forward contract in several ways that

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overcome some of the liquidity and default problems of forward contract. Financial
futures contracts are traded on organized exchanges that are highly competitive and
have their own design contracts and rules in order to increase the amount of futures
trading on its exchange.
- Options. They are contracts that give the purchaser the option, or right – not
obligation, to buy or sell the underlying financial instrument at a specified price,
called the exercise price or strike price, within a specific period of time – expiration.
The seller (called the writer) of the option is obligated to buy or sell the financial
instrument to the purchaser of the owner of the option exercises the fight to sell or
buy. These option contract features are important enough to be emphasized: the
buyer of an option does not have to exercise the option, he can let the option expire
without using it. Hence the owner of an option is not obligated to take any action,
but rather has the right to exercise the contract if he so chooses. The seller of an
option, by contrast, has no choice in the matter, he must buy or sell the financial
instrument if the owner exercises the option. Because the right to buy or sell a
financial instrument at a specified price has value, the owner of an option is willing
to pay an amount for it called a premium.
- Swaps. They are agreements to exchange one stream of cash flows for another. For
instance an investor could switch financing a currency for financing in another. It
could also be used in the case of interest rates. One could swap a floating rate for a
fixed rate, and the other would be vice verse.
It is highly unlikely that two parties to interest rate or currency swaps would take an
offsetting position in exactly the same notional principal and over the same time
horizon. In practice, the market maker in the swap or the swap bank (the financial
institution) may not be able to find a party willing to take the offsetting position in

the swap. Therefore, financial institutions are likely to warehouse the swap and use
a forward rate agreement or futures contract to manage their exposure until a
suitable party is located that is willing to take the offsetting position but may not
wish to swap for exactly the same amount of notional principal and the same

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