MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECONOMIC HOCHIMINH CITY
---- K ---
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
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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 playfield. 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. 1
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
1
http://www.pinnacle-exchange.com/forex-faq.html
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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
(http://www.exfin.com/historical-forex-aud)
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 t0 to be settled after the change in
exchange rate at time t1.
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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