2. n www.stern.nyu.edu

3. n www.stern.nyu.edu/~igiddy/ifmx.htm

4. www.giddy.org

5. INTERNATIONAL FINANCIAL MANAGEMENT

6. Topics 1 Exchange Rate Systems and Forecasting 2 Hedging Tools 3 Foreign Exchange Exposure 4 FX Risk Management 5 International Taxation 6 International Investment Decisions (Hangzhou Hanel Case)

7. Topics (continued) 7 Swap Financing Techniques (Yin & Yang Negotiation) 8 Global Bond & Equity Financing 9 Integrated Financing Decisions Final Exam

8. Forwards, Futures and Money Market Hedging Prof. Ian Giddy New York University

9. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 9 Hedging Transactions Exposure l Types of exposure l One-shot exposure l Hedging approaches:  Open  Forward  Money market  Futures  Options l Ongoing transactions exposure

10. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 10 Tools for Hedging l Petrobras has to pay for equipment from Japan, in Japanese yen, in 3 months  Borrow and pay now?  Use a forward contract/FX swap?  Pay later at spot?

11. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 11 Forward Contracts, Futures and Money Market Hedging l Money market hedging: match currency of assets and liabilities l Forwards: OTC agreement to exchange currencies at certain exchange rate in the future l FX swap: simultaneous spot sale and forward purchase of a currency l Futures: Exchange-traded contracts for notional future delivery, minimizing default risk via marking-to-market

12. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 12 Forward Contracts l Agreement to exchange currencies at certain exchange rate in the future l Default risk in forward contracts arises because such a contract is a commitment for future performance, and one or other party may be unwilling or unable to honor that commitment. l On the settlement date, one party in effect owes the other party a net amount.

13. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 13 A Typical Forward Contract l We agree today to pay a certain price for a currency in the future Backus SAN- TANDER SAN- TANDER Soles

14. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 14 Customization, Performance Risk and Liquidity l Customization implies bilateral contracts, which carry performance risk l Liquidity implies standardization and freedom from counterparty risk, through exchange-traded contracts

15. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 15 How Does the Bank Hedge a Forward Contract? Hedging approaches:  Open  Forward  Spot plus swap  Rollover  Money market

16. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 16 Foreign Exchange Quotations SpotForward points

17. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 17 How Banks Hedge SHORT LONG Today T+2 T+90 Methods: - Spot + swap - Spot + rollover swap - Money market - Outright forward

18. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 18 The FX Swap Hedge 3-month Forward Contract 3-month Swap l Dealers typically hedge a forward foreign- exchange commitment with a spot plus “FX Swap”: spot sale plus forward purchase of a foreign currency l The FX swap rate is determined by the interest differential

19. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 19 The Roll-Over Swap Hedge 6-month Forward Contract 3-month Swap l Dealers often hedge a long-term foreign- exchange commitment with shorter-term contracts, which are “rolled over” as they come due l Corporations themselves do this too.

20. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 20 The FX Swap Hedge 3-month Forward Contract Borrow USD Invest in DEM l Dealers also hedge a forward commitment in the money market: borrow the currency you will be receiving, and invest in the currency you will be paying l The FX swap rate is determined by the interest differential

21. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 21 The Forward Rate Tracks the Spot Rate

22. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 22 Linkages Between Interest Rates Interest rate differential Interest rate differential Forward premium Forward premium Expected % change in exchange rate Expected % change in exchange rate

23. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 23 Cost of Hedging

24. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 24 Frutas Amazonas

25. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 25 Bid and Offer Quotations in the Long-Dated Forward Market

26. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 26 Forwards, Money Market Hedging and Futures l Forward contracts: OTC contracts for future delivery, often settled in cash l Forwards can be used in 1. Hedging 2. Positioning 3. Arbitrage l Interest rate parity means that a forward hedge is, normally, the same as a money market hedge. l Futures are free of default risk.

27. Marking-to- Market of a Futures Contract

28. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 28 Forwards vs Futures vs Options l Good credit: Forward usually best l Sometimes, Money Market Hedge better  Perfect market: same (covered int. arb.)  Imperfect market: MMH may be better l Credit problem: Futures  But: limited and standardized  Requires margin and daily settlement l Uncertain future cash flows:  Liquid instrument (futures/forwards to assure flexibility  Options sometimes advisable

29. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 29

30. Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 30 www.giddy.org Ian Giddy NYU Stern School of Business Tel 212-998-0332; 917-930-0291 Fax 212-995-4233; 630-604-7413 ian.giddy@nyu.edu http://www.giddy.org