forward and future

forward and future - Forward and Futures FX Rates FBE 436...

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Unformatted text preview: Forward and Futures FX Rates FBE 436 Professor Aris Protopapadakis 1 How Would You Hedge? We talked about hedging in general terms, and more specifically when we discussed FX exposure What are the available financial market instruments? How would you use them? 3 Key Concepts and Skills Why are Forward/Futures markets important? What is the Forward rate? Market features? What is the forward premium/discount? What is a Futures contract and how is it different from a Forward contract? How “margin calls” work Reasons for hedging; examples 4 1 Forward Market In the spot market, currency is delivered usually in 2 business days In the forward market, currency is traded for delivery further out in the future Typically 1, 2, 3, 6, and 12 months You may negotiate an “odd” maturity for a forward contract with the bank, but the bid/ask spread is somewhat higher 5 Forward Market (cnt.) Usually max. maturity is 3 years As maturity increases companies are more likely to use the Swap market Trading volume in the forward market is smaller than trading volume in the spot market But trading volume is still huge! 6 Locking Future Settlement Rate A forward contract fixes the FX rate for a given amount of foreign currency for future delivery In principle there are no payments before the contract matures • Credit & faith However, you may be asked to deposit up to 5% of the contract value depending on how risky the foreign currency is 7 2 Settlement At the settlement date, the client delivers or receives the agreed-upon amount of foreign currency, at the agreed price Sometimes the contract is settled by its value, i.e., the difference between forward and spot (or spot and forward --NDF) In this case, no physical exchange of foreign currency takes place NDFs are used for currencies that are hard to settle 8 ¥/$ Spot & Forward Yen Forward & Spot 1986-current 180 Avg Spot 170 Avg 3m F Spot & Forward Yen/$ 160 150 140 130 120 110 100 90 1/ 31 /1 1/ 98 30 6 /1 1/ 987 29 /1 1/ 98 31 8 /1 1/ 989 31 /1 1/ 99 31 0 /1 1/ 991 31 /1 1/ 99 29 2 /1 1/ 993 31 /1 1/ 99 31 4 /1 1/ 995 31 /1 1/ 99 31 6 /1 1/ 997 30 /1 1/ 99 29 8 /1 1/ 999 31 /2 1/ 00 31 0 /2 1/ 001 31 /2 1/ 00 31 2 /2 1/ 00 30 3 /2 00 4 80 9 The Forward Rate in Perspective Forward and spot rates are tied together by CIPR 1 it fcN N , 360 Ft , N St 1 i$ N t,N 360 The Forward rate does not have an “independent life” 10 3 Premium/Discount Forward rates will differ from spot rates If a currency is worth more forward than spot: There is a forward premium on that currency If a currency is worth less forward than spot: There is a forward discount on that currency • These statements are always bilateral 11 Examples The examples below are based on recent data Note that a variety of maturities are used Note also that the US$ is selling at a forward premium against some currencies, but at a discount against others 12 American Terms – $/€ The FX rate is quoted in American terms as $/€ = 1.4515 The 6-month forward rate is $/€ = 1.4628 Premium or discount? => 13 4 European Terms - MXP/$ Spot MXP/$ = 10.90 1-month MXP/$ forward rate = 10.97 Premium or discount? 15 ¥/$ Spot is 116.89 ¥/$ 3-month forward is 115.47 ¥/$ Premium or discount? 17 Definition of Premium/Discount As before, the exchange rate is always domestic currency/foreign currency = dc/fc • “Domestic” currency will generally be the $ For example, $ is the dc for $/¥, and ¥ is the fc The forward premium on the foreign currency is: Because $/fc quote is the price of the foreign currency price F S S and annualized F Year 1 S N A negative premium is a discount 19 5 Example: $/£ S = 1.8257 $/£ F (90) = 1.8106 $/£ What is the FP on the £? 20 Futures Contracts Futures contracts are very similar to forward contracts The differences are contractual and institutional Provided that the Futures contract has not been closed out by its maturity, there is an obligation to deliver/acquire the specified currency In practice less than 5% are “exercised” compared to ~ 90% for Forward contracts 24 Forward-Futures Comparison Forwards Futures 1. Trade in a decentralized market 1. 2. Not negotiable 3. To be delivered at set intervals from contract date Generally no margin Settling up occurs only at maturity 5 – 10 M$/trade 4. 5. 6. 2. Trade in organized and regulated exchanges There is a continuous market, fully negotiable 3. To be delivered at set dates 4. 5. Margin is required Gains/losses are paid every day 6. Very roughly 100 T$/contract, fully standardized 25 6 The Futures Market International Money Market (IMM) of the Chicago Mercantile Exchange is the most important Tokyo International Financial Futures Exchange (TIFFE) Singapore International Monetary Exchange (SIMEX) etc. Prices can potentially vary by exchange 26 Maturities Standardized expiration days IMM: March, June, September, and December IMM: maturity on the 3rd Wednesday of the maturity month. If holiday, the following business day (but never spills into the following month!) Trading stops 2 days before maturity Therefore, two days before maturity the futures price equals the spot price A 2-day forward rate is also equal to the spot rate 27 Current Contract Sizes (CME) 12.5 million ¥ 125,000 € 100,000 C$ 62,500 £ 125,000 SFR 100,000 A$ 500,000 MXP 28 7 How Does the Margin Work? Margin is a security deposit, 3% - 5% of the face value of the contract (varies) Face Value (FV ): Quoted price*Amount Price = 1.45$/€; FV = 1.45*125,000 = $181,250 There is an initial margin and a maintenance margin 29 How Does the Margin Work? (cnt.) Initial margin say, 5% $181,250*5% = $9,062.50 $9,062.50 The maintenance margin is $7,250 $7,250 Money is added to or subtracted from the margin account according to current gains/losses If account hits the maintenance margin, you have to maintenance add money to bring it up to the initial margin initial Here is a daily history of the price of this futures contract: 30 Date Rate Value Gain/Loss Margin Acct 0 1.450 181,250 --- 9,063 1 1.460 182,500 2 1.442 180,250 3 1.435 179,375 4 1.430 178,750 5 1.444 180,500 31 8 Date Rate Value Gain/Loss Margin Acct 0 1.450 181,250 --- 9,063 1 1.460 182,500 1,250 10,313 2 1.442 180,250 -2,250 8,063 3 1.435 179,375 -875 Add 1,875 7,188 M. Call 9,063 4 1.430 178,750 -625 8,438 5 1.444 180,500 1,750 32 10,188 Currency Hedging: Forwards or Futures A US investor buys Japanese zero coupon bonds that expire in 9 months => She will need to convert 1B ¥ into $ in 9 months If she does nothing, the prevailing spot FX rate in 9 months will determine the $ return on her investment 33 Market Rates & Expectations Assume that the spot rate is 0.00869 $/¥ The 9-month forward rate is 0.00900 $/¥ Even if she expects the spot rate to equal 0.00900 in 9 months if she doesn’t hedge there is uncertainty! hedge 34 9 Uncertainty At her expected future spot rate 0.00900: Revenue is: 1B ¥*0.00900 = $ 9,000,000 If the spot rate turns out to be 0.00760 Revenue is: 1 B ¥*0.00760 = $ 7,600,000 • “Loss” of $1,400,00 If the spot rate turns out to be 0.01040 Revenue is: 1 B ¥*0.01040 = $10,400,000 • “Gain” of $1,400,000 This is “FX risk” once again 35 Investor Choice If the investor is risk neutral, she cares only about expected return, not risk Indifferent between hedging & not hedging If the investor is risk-averse she will prefer to hedge In this example the expected cost of hedging is zero 38 The Downside If you have $8M you may be willing to risk a loss of $1.4M for the chance of a similar gain You are still a millionaire! However, large losses may throw people or companies into financial distress, bankruptcy, or even loss of future earning capacity 39 10 Auto Importer An auto importer believed Korean cars were cheap during the Asian currency crisis when the FX rate was 1,680 Won/$ He ordered 1,000 Kia’s for a price of 16,800,000 Won each, for delivery and payment three months later => $10,000 each Didn’t know about the forward market! 40 Auto Importer (cnt.) Cars like that sold for $15,000 in the US, giving a nice $5,000 profit for each car => $5,000*1,000 = $ 5M total But by 3 months the Asian crisis was over and the Won was back to 890 Won/$ The cost/car now became 16,800,000/890 = $18,876 41 Auto Importer (concl.) He still had to pay the same Wons but he had to spend more $s to buy the same Wons! The loss was $18,876-$15,000 = $3,876 per car => $3,876*1,000 = $3,876,000 With only a net wealth of $1M in stocks, the importer went bankrupt! 42 11 Hedging Pays There are (at least) three obvious hedging strategies He could have secured the position in the forward or futures market He could have engineered a synthetic forward He could have pre-paid Secured the position using current spot rate Very similar to a synthetic forward 43 Long Term Hedging Many hedging needs are long term More than one year Yet neither futures nor forwards have maturities more than 1 year Trading volume is overwhelmingly in the shortest maturity True for most derivatives What gives? 44 Long Term Hedging Long term hedging needs can be met quite well by rolling over short term hedges. This works if Transactions costs are very small The future short term interest rates implied by the term structure are good forecasts Short term contracts are liquid Their price is highly correlated “underlying” with the • In this case the spot rate This help in accounting reports of gains and losses 45 12 Understanding Futures The following example should clarify how futures work: Current: Spot price of widgets = 2.00 March Futures price of widgets = 3.00 46 Understanding Futures (cnt.) Scenario #1: Spot in March = 4.00 Buyer of Widgets: He buys the contract @ 3.00. As the spot price rises (from 2.00 to 4.00) the future price rises as well, and he receives the gains in his margin account • This compensates him for the fact that he will buy the widgets @ 4.00 in March Seller of Widgets: She sells the contract @ 3.00 & receives the proceeds. As the future prices rises, she pays the losses into her margin account • This offsets the fact that she’ll sell the widgets @ 4.00 in March 47 Understanding Futures (concl.) Scenario #2: Spot in March = 2.00 Buyer of Widgets: He buys the contract @ 3.00. As the spot price doesn’t change, the future price falls to 2.00. He pays the losses into his margin account • This offsets the fact that he will buy the widgets @ 2.00 in March Seller of Widgets: She sells the contract @ 3.00 & receives the proceeds. As the future prices fall, she receives payments into her margin account • This compensates her for the fact that she’ll sell the widgets @ 2.00 in March 48 13 Speculation The 1-year forward SFR/$ rate is 1.2379 The speculator believes that the spot rate in one year will be 1.2600 For her, forward SFR seems to be overvalued She could speculate and sell SFR futures Doesn’t have to have the money now It is a risky play 50 Other FX Contracts FX Options • Traded in Exchanges Will not cover Very similar to stock options Currency Swaps Exchanging debt in one currency for debt in another Chapter 13 52 Takeaways A forward contract delivers currency a known number of days in the future, at a price agreed upon now Forward and Spot are traded in the same market A currency can be at a premium or discount forward A Futures contract has a very similar function to a Forward contract but the institutional details differ Futures contract are for much smaller amounts but they are subject to margin calls Risk averse entities will want to hedge their foreign currency risk Forwards and futures can be used to hedge or speculate! 53 14 The End 54 15 ...
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