International Finance FINA 5331 Lecture 9: Financial crisis and the forward market Aaron Smallwood Ph.D.

Review: Terminology Long vs short: –A trader is long in a currency when they are owed that currency in the future. A trader is short in a currency when they owe that currency in the future. Hedging –The act of reversing a natural short or long position, such that no net position is taken. Speculation –The act of intentionally creating a short or long position in an attempt to profit on currency movements. This exposes the trader to risk. Arbitrage –The act of simultaneously buying and selling an asset, such that no net position remains.

Simple Hedging Strategies Activity to Hedge Strategy Payable in domestic currencyNothing, no FX risk. Payable in foreign currencyAccelerate payment if foreign currency expected to appreciate. Delay payment if foreign currency expected to depreciate. Receivable in domestic currencyNo FX risk. Receivable in foreign currencyAccelerate payment if foreign currency expected to depreciate. Delay payment if foreign currency expected to appreciate.

A Little More Sophisticated Hedging Strategies Activity to Hedge Strategy Payable in domestic currencyNothing, no FX risk. Payable in foreign currencyBorrow at the domestic interest rate i and convert the proceeds to foreign currency. Lend at the foreign interest rate i *. When payable comes due, sell foreign asset and make payable. Use domestic currency reserved for payable to pay off loan. Receivable in domestic currencyNo FX risk. Receivable in foreign currencyBorrow amount of receivable at the foreign interest rate i * and convert the proceeds to domestic currency. When receivable is paid, use foreign currency to pay off loan.

Hedging FX Risk Hedging will reduce or eliminate risk. But it will also eliminate profitable FX movements. Example – If you have a payable due in foreign currency in 90 days, a domestic depreciation will increase your domestic currency costs. But if the domestic currency appreciates over the 90 day period, your costs fall!

Hedging FX Risk Q - So why hedge? If hedging eliminates potential FX gains, why do it? A - Are you in business to sell goods and services or are you a FX market speculator? By not hedging FX risk, you are playing a risky game in a business that might not be your expertise. Stick to what you know best. Leave the FX speculation to the dealers and traders.

Forward contracts Forward contracts: Allow traders to buy/sell foreign currency for delivery in the future, for a price that is known TODAY. We will consider here both outright forward contracts and non-deliverable forward contracts (NDFs). Example: On July 5, the 3 month forward contract for Swiss Franc: $ On September 30, 2013, one could purchase or sell SF at that price.

Forward contracts Let’s consider aspects of deliverable forward contracts: 1. A forward contract is a derivative asset, based off of a spot contract. The forward market is known as an “over the counter” (OTC) market, as compared to futures markets, where trade typically occurs on a centralized exchange. 2. The terms of a forward contract are negotiated between a bank/dealer and their client. At least in theory, except where capital controls may be present, a forward contract can be written for any currency. 3. Based on 2, a forward contract can be written for delivery at any point in the future. 4. Again, based on 2, a forward contract can be written in any “lot size.”

Forward rates When the forward rate exceeds the spot rate, the foreign currency (currency in the denominator) is trading at a “forward premium.” –Example: S($/SF)= $1.0377…F($/SF) 3m =$1.0385, SF is selling at premium. …When the forward rate is less than the spot, the foreign currency is said to be selling at a “forward discount.” –Example: S($/£)=$1.4890… …F($/£) 3m =$1.4882, the pound is selling at a discount.

Forward rates Like spot rates, banks will buy forward foreign currency at one price (the bid price) and sell it forward at another price (the ask price). When the spot quotation is provided, the dealer will simply quote basis points for the associated forward rates. –For the basis points, the trader will understand that if the first quote exceeds the second, the basis points are subtracted from the spot quotations. –If the first number in the quote is less than the second, the basis points are added. A basis point is defined as

Example Suppose we call our dealer and ask for forward quotes relative to the spot rate for Canadian $. Our dealer supplies the following information: Spot: $ –1 month forward “12-10” –3 month forward “14-8” –6 month forward “16-2” –One month forward rates: $ $ –Three month forward rates: $ $ –Six month forward rates: $ $

Percentage forward premia/discount In some sense, the premium or discount provides information related to how the value of a currency changes over time. We can express these values in percentage terms. We will typically apply annualization. The calculation: Where “days” is the number of days until the contract matures.

Example Suppose the three month forward rate on yen today is $ The current spot rate $ Suppose a contract written for yen matures 92 days from now. The yen is trading at a premium: The yen is selling at 0.198% premium.

Premia/Discount Cont. If F t >S t, in some sense, this might signal that we expect foreign currency to appreciate in value. If F t <S t, this might indicate that we expect the foreign currency to depreciate in value.