Forward Looking Market Instruments Forward,Swap,Futures,Option s

An Example U.S importer buying swiss watches. İmporter purchased francs in the spot market. The order calls for delivery and payment in 3 months. Order is 100,000 SF.

An Example What options does the importer have with respect to payment? 1.Wait 3 months then buy francs. Disadvantage: exchange rate could change in months. Current spot rate is $0.7332=SF1 100,000SF is $ no guarantee this spot rate will prevail in the future.

An example İf the $ were to depreciate against the franc more dollars to buy same amount of francs. Suppose future spot rate currently unkown is:$0.75=SF1 then $ should be given to purchase SF

Conclusion Due to uncertainty regarding the dollar/franc exchange rate in the future waiting three months to buy francs may not be desirable for the importer. Alternative is to buy the francs now and hold or invest them for 3 months. Thirdly using forward exchange market.

Conclusion Advantages: importer knows exactly how many dollars are needed now to buy SF Disadvantage: You need cash to invest now.

Forward Rates Definition: Forward exchange market is buying and selling currencies to be delivered at a future date. If the forward price of a currency exceeds the current spot price the currency is said to be selling at forward premium. When the forward rate is less than the current spot rate currency is selling at forward discount.

Example If the 3 months or 90 day forward rate on the franc is $0.7346=SF1.SF 100,000 will sell for $73,460. The importer knows now with certainty how many dollars the watches will cost in 90 days. The forward rates in fig 4.1 indicate that the british pound is selling at discount against dollar but the japanese yen is selling at premium. In the event that spot and forward rates are equal the currency is said to be flat.

Swaps Commercial Banks rarely use forward exchange contracts for interbank trading; instead swap agreements are arranged. Definitio: A foreign exchange swap is a trade involving two currencies.

Example Swap Suppose Citibank wants pounds now.They could borrow the pounds arranging to repay in 3 months. Then they could buy the pounds in the forward market to ensure a certain price to be paid when the pounds are needed in 3 months.

Swap : Example Alternatively Citibank could enter into a swap agreement wherein they trade dollars for pounds now and pounds for dollars in 3 months. Swap rates will be determined by discounts or premiums in the forward exchange market.

Swap : example Citibank wants pounds for 3 months and works a swap with Llyods. Citibank will trade dollars to Llyods and in return receive pounds. In three months the trade is reversed.Citibank will pay out pounds to Lloyds and receive dollars.(Swap could be for any period not only 3 months).

Basis Point Accounting Suppose the spot rate is $/£= $2.00 and the three month forward rate is $/ £= $2.10so there is a $0.10 premium on the pound. These premiums or discounts are actually quoted in basis points when serving as swap rates.

Basis Point Definition: A basis point is 1/100 percent or Thus the $0.10 premium converts into swap rate of 1,000 points. All the swap participants are interested in basis point not in the actual spot or forward rate.Just the difference btw them matters.

Swap Rates Swap rates are usefully converted into percent per annum terms to make them comparable to other borrowing or lending rates. The Swap rate of 1000 points for three months can be converted to annual terms by: finding the percentage return for the swap period and multiplying it by the reciprocal of the fraction of the year for which swap exists.

Swap Rate Calculation Premium (discount) / spot rate = 0.10/$2.00 = 0.05 The fraction of a year for which the swap exists is 3 months/12 months=1/4 Reciprocal of the fraction is 1/1/4 = 4. Thus the percent per annum premium(discount) or swap rate is: =0.20 This swap yields a return of %20 per annum.

Currency Swap We have been discussing foreign exchange swap, simultaneous exchange of two currencies at a specific date and rate agreed at the time of the contract adn a reverse exchange of the same two currencies. Currency Swap is a contract in which two counterparties exchange streams of interest payments in diff currencies for an agreed period of time and then exhange principal amounts in the respective currencies at an agreed exchange rate at maturity.

Currency Swap Why is it done?????? Allows firms to obtain long term foreign currency financing at a lower cost than they can by borrowing directly.

Currency Swap Example Suppose Canadian firm wants to receive Japanese Yen today with repayment in 5 yrs. If the Canadian firm is not well known to Japanese banks, the firm will pay higher interest rate than firms that actively participate in Japanese financial markets.

Currency Swap Ex The Canadian firm may approach a bank to arrange a currency swap that will reduce its borrowing costs.The bank will find a japanese firm desiring Canadian dollars. The Canadian firm is able to borrow Canadian dollars more cheaply than the Japanese firm and the Japanese firm is able to borrow Yen more cheaply than the Canadian firm. The intermediary bank will arrange for each firm to borrow its domestic currency and then swap the domestic currency for the desired foreign currency.

Forward Premium in Swap The interest rates paid on the two currencies will reflect the forward premium in existence at the time the swap is executed. When swap agreements matures, the original principal amounts are traded back to the source firms. Both firms benefit by having access to foreign funds at a lower cost than they could obtain directly.

Swap Conclusion Swaps are an efficient way to meet the firms need for foreign currencies. They combine two separate transactions into one. In foreign exchange dealing banks do not always trade directly with one another but often use someone in the middle- a broker.

Broker’s Market If a bank wants to buy a particular currency several other banks could be contacted for quotes. OR the bank representative could input an order with an electronic broker where many banks participate and the best price at the current time among the participating banks is revealed.

Broker’s Market While trading in the broker’s market the names of the banks making bids and offers are not known until a deal is reached. Advantage: Allows banks of different sizes and market positions to trade on an equal footing. Brokers reward comission is less than 0.01 percent of the selling price split by the buyer and seller.

Electronic Brokers Market In the electronic brokers market computer programs take offers to buy and sell from different agents and match them. %54 of trading in USA goes through such networks copmpared to %66 in the U.K and %48 in Japan.

Futures The Futures market differs from the forward market in that only a few currencies are traded. trading occurs in standardized contracts In specific geographical location such as International Money Market (IMM) of the Chicago Mercantile Exchange (CME).

Futures Markets CME is the largest currency futures market. CME futures are traded on the British Pound, Canadian Dollar, Japanese Yen, Swiss Franc, Australian Dollar, Mexican peso and euro. Contracts involve a specific amount of currency to be delivered at a specific maturity date.They mature on the 3’rd wednsday of march, June, September and December.

Forward Market Contracts In the forward markets contracts are typically 30, 90 or 180 days long and are maturing every day of the year. Forward market contracts are written for any amount agreed upon by the parties involved. In the futures market contracts are written for fixed amounts: GBP 62,500, CAD 100,000,JPY 12,500,000,CHF125,000,MXP 500,000 and Eur 125,000.

Future Contract Ex Future markets provide a hedging facility for firms involved in int trade. As well as speculative opportunity for the ones forecasting accurately the future price of a currency. For instance if we believe that in September the pound will sell for $1.60 and the september futures contract is currently priced at $ we would sell a september contract.

Futures vs Forward Future contracts are for smaller amounts of currency therefore useful as hedging vehicle for relatively small firms. Forward contracts are within the realm of wholesale banking activity and are typically used only by large financial institutions, other large business firms that deal in very large amounts of forex.

OPTİONS Definition: A foreign currency option is a contract providing the right to buy and sell a given amount of currency at a fixed exchange rate on or before the maturity date.(American Options) European options may be exercised only at maturity.

Strike Price-Exercise Price A call option gives the right to buy currency and a put option gives the right to sell. The price at which currency can be bought or sold is the strike price or exercis price. The use of options for hedging is straight forward.

Options for Hedging Suppose U.S importer is buying equipment from Swiss manufacturer with a SF1 million payment in due in Dec. The importer can hedge against a franc appreciation by buying a call option ; purchasing francs over the next three months until the Dec maturity at a specified price.

Options for Hedging Assume the current spot exchange rate is $0.70 per franc.At this exchange rate SF1million would cost $700,000. If the franc appreciated at $0.75 over the next 3 months, then using the spot market in 3 months would change the value of the imports to $750,000. An increase in the price of imports of $50,000. The Call Option will provide insurance against such change.

Options Foreign currency options have been traded only since Dec 1982, when the Philadelphia Stock Exchange offered a market. The Philedelphia exchange offers contracts for AUD , GBP 31,250, JPY 6,250,000 and CHF 62,500. If the strike price is less than the current spot rate for a call or greater than the spot rate for a put an option is said to be “in the money”

Options Advantage of options over futures or forwards is greater flexibility. An option offers the right to buy or sell if desired in the future and is not an obligation. A futures or forward contract is an obligation to buy or sell at a set exchange rate.

Recent Practices The options contracts have grown since the early 1980’s and this has stimulated new products and techniques for managing forein exchange assets and liabilities. One recent development combines the features of a forward contract and an option contract.

Break Forward, FOX Forward contract with an option to break are used within terms break forward, participating forward or FOX forward with an option exit. In this case the forward exchange rate price includes an option premium for the right to break the forward contract.

Break-forward vs Straight Option An option requires an up-front premium payment. The break-forward hides the option premium in the forward rate so it may be treated as a simple forward contract for tax and accounting purposes whether the contract is broken or not.