Chapter 4 Currency Derivatives

Forward Contract “An agreement between a commercial bank and a client about an exchange of two currencies to be made at a future point in time at a specified exchange rate” Forward rate: “ Rate at which a bank is willing to exchange one currency for another at some specified date in future”

Long Position: It implies that the holder of contract has agreed to buy the currency Short Position: It implies that the holder of contract has agreed to sell the currency

Forwards have no secondary market It means holder can not get out of the commitment He can not sell the contract What he can do? He can enter into another contract of the same maturity date So that he can offset the contract But the contract can not be cancelled

Example A firm enters into the contract to buy INR 100000 @ forward rate of PKR 1.50 On maturity date if the spot increases to 1.70 He will buy INR @ PKR 1.50 1.50 * 100000 He will pay = PKR 150000 Otherwise @ spot PKR 1.70 He had to pay 170000 170000-150000 Profit = 20000

Calculation of Points INR / PKR: 1.50/1.60 3-months: 30/20 (High / Low = Subtract) i.e. 1.60 - .20 1.40 3-months: 20/30 (Low/High = Add) + .30 1.90

Forward-Forward Swap It’s a contract between two forward dates Eg: combined with One month forward sale Three month forward purchase

Example Suppose 6-month swap points may be favorable GBP/USD spot: 1.7580/90 1-month 20/10 2-month 30/20 3-month 40/30 6-month 40/30 12-month 30/20 EXPECTATIONS After 6-months GBP rates may fluctuate in future (6-months) 6-month swap points may be favorable

Q. How can he profit from this forecast Buy 12 months forward sterling 5 million --- six month later when GBP value has changed Sell 6 months forward sterling After 6 months Suppose rates are: GBP/USD spot: 1.7585/95 6 months: 40/60

Calculation Suppose rates are: FIRST: He can buy 12-month forward GBP 5 m @ 1.7570 Suppose rates are: GBP/USD spot: 1.7580/90 12-months: 30/20 After selecting Ask price of 1.7590 Subtract 20 points from last digits (H/L=Subtract) i.e. 1.7590 - 20 1.7570

Calculation Suppose rates are: Second He can sell 6-month forward GBP 5 m @ 1.7625 Suppose rates are: GBP/USD spot: 1.7585/95 6-months: 40/60 After selecting Bid price of 1.7585 Add 40 points in last digits (L/H = Add) i.e. 1.7585 + 40 1.7625

Calculation Gain: 0.0055 * 5m = $ 27500 He sold 6-month forward GBP 5 m @ 1.7625 He bought 12-month forward GBP 5 m @ 1.7570 Gain $ 0.0055/GBP Gain: 0.0055 * 5m = $ 27500

Risk After 6 months If the GBP Depreciates than….. Suppose GBP/USD Spot: 1.7000/05 6-month: 40/60 He will sell @ 1.7040 i.e. 1.7000 1.7570 + 40 1.7040 1.7040 loss - 0.0530 Therefore a loss of: 0.0530 * 5m = ????

Example On day 1 do two swaps Buy GBP 5 m spot Sell 5 m GBP 6-months forward and Sell GBP 5 m spot Buy 5 m GBP 12-months forward Suppose both are done @ a spot rate of 1.7580

Calculation Suppose both are done @ a spot rate of 1.7580 First: Sell 6-months forward If the points are 40/30 GBP/USD spot: 1.7580 - 40 1.7540 Second: Buy 12-months forward If the points are 30/20 - 20 1.7560

On day 1 The planned cash flows are: Sell GBP @ Spot 5m BUY forward 12-months + GBP 5000000 - USD 8780000 (5m @ 1.7560) Buy GBP @ Spot 5m SELL forward 6-months - GBP 5000000 + USD 8770000 (5m @ 1.7540)

Calculation 6-months later GBP has fluctuated Suppose GBP/USD Spot: 1.7005 6-months: 80/160 --- (L/H:Add) Now Buy GBP 5m spot @ 1.7005 Sell GBP 5m 6-months forward @ 1.7085

After 6-months The planned cash flows are: SPOT BUY + GBP 5000000 - USD 8502500 (5m @ 1.7005) SELL Forward 6-months - GBP 5000000 + USD 8542500 (5m @ 1.7085)

Matching cash flows + USD 8770000 - USD 8780000 - USD 8502500 267500 Total Gain: - USD 8780000 (5m @ 1.7560) + USD 8542500 (5m @ 1.7085) 237500 30000

Discount or Premium Forward Discount: Percentage by which the forward rate is less than the spot rate Forward Premium Percentage by which the forward rate is more than the spot rate

Testing Question You expect that the USD will fluctuate in future (in 3-months) Suppose the rates are: USD / INR Spot: 42.92 / 42.93 1-month 50/40 2-month 60/50 3-month 70/60 6-month 75/65 9-month 90/80

You can do two swaps Buy USD 2 hundred thousand spot Sell USD 2 hundred thousand 3-months forward and Sell USD 2 hundred thousand spot Buy USD 2 hundred thousand 9-months forward Suppose both swaps are done @ a spot rate of 42.93

After 3-months USD has fluctuated Suppose USD / INR Spot: 43.90 6-months: 85/95 Now Buy USD 2 hundred thousand spot Sell USD 2 hundred thousand 6-months forward Calculate the profit/loss at the end of the day