International Finance and Accounting Handbook

are foreign currency version of caps, floors, and swaptions, which are defined in an
analogous manner.

7.12 FOREIGN EXCHANGE AND INTEREST RATE RISK AND HEDGING INSTRUMENTS.
Foreign exchange and interest rate risks are an ever-present and important problem
facing both individuals and companies. We have discussed various methods by which
these risks can be hedged by using derivatives. These derivatives may be used to fix
future borrowing or lending rates (using futures, forwards/FRAs or swaps) or to in-
sure against adverse movements (using IRO’s or caps/floors).
As mentioned earlier, many of the deals in the interest rate derivatives market are
done “over the counter,” that is, between banks and counterparties such as other firms
and institutional investors, rather than on organized exchanges. This has led to the de-
velopment of customized deals between the counterparties. These contracts take ac-
count of the particular circumstances of the hedging firm. Detailed description of
these customized or “exotic” derivatives is beyond the scope of this chapter. How-
ever, the following list provides a brief definition of a selection of these hedging in-
struments. This gives some idea of the range of products available.

7.13 SUMMARY 7 • 17

Diff swap

American/Bermudan
swaption

Asian option

Barrier option

Pay-as-you-go option

Pays the difference between the interest rate in one currency and the

interest rate in another, on a principal amount denominated in one

currency.

An American swaption is an option on a swap exercisable at any time

up to the maturity of the option. A Bermudan swaption is exercisable

on specified dates before maturity.

An option on the average interest rate over a specified period.

An option that is valid only if the interest rate stays above or below

a particular level or within a specified range, e.g., knockout and

knockin options.

An option where an additional premium is required at a series of

points of time to maintain a valid option on the interest rate.

The diff swap has been used by U.S. firms that have views about rates in one for-
eign currency, (e.g., euros) compared to U.S. dollar rates. Asian options have been
particularly popular in Japan and Europe, where many loan contracts depend on the
average of interest or foreign exchange rates, over a specified period. Barrier options
such as knockout options, and “pay-as-you-go” options have been popular with cor-
porations that wish to reduce the cost of caps or floors and are prepared to take the
risks of certain events occurring. These products show both the innovative ability and
the complexity of the derivatives industry’s solutions to the problem of interest rate
and foreign exchange risk.

7.13 SUMMARY. Foreign exchange and interest rate risk are among the most im-
portant risks facing most economic agents, whether they are corporations, institu-
tional investors, or households. In recent times, the volatility of these rates has in-
creased substantially and, as a result, agents have a greater need to hedge against
these risks. A number of hedge instruments have been developed to manage these
risks effectively. Broadly speaking, there are forward and futures contracts, which