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

Giddy Forwards, Futures and Money-Market Hedging/1

Forwards, Futuresand Money Market Hedging

Prof. Ian GiddyNew York University

Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 7

Hedging Transactions Exposure

l Types of exposurel One-shot exposurel Hedging approaches:uOpen

uForward

uMoney market

uFutures

uOptions

l Ongoing transactions exposure



Tools for Hedging

l Petrobras has to pay for equipment fromJapan, in Japanese yen, in 3 monthsuBorrow and pay now?

uUse a forward contract/FX swap?

uPay later at spot?


Forward Contracts, Futuresand Money Market Hedging

l Money market hedging: match currencyof assets and liabilities

l Forwards: OTC agreement to exchangecurrencies at certain exchange rate inthe future

l FX swap: simultaneous spot sale andforward purchase of a currency

l Futures: Exchange-traded contracts fornotional future delivery, minimizingdefault risk via marking-to-market



Forward Contracts

l Agreement to exchange currencies atcertain exchange rate in the future

l Default risk in forward contracts arisesbecause such a contract is acommitment for future performance, andone or other party may be unwilling orunable to honor that commitment.

l On the settlement date, one party ineffect owes the other party a netamount.


A Typical Forward Contract

l We agree today to pay a certain pricefor a currency in the future

BackusBackus SAN-TANDER

SAN-TANDER

Soles



Customization, Performance Riskand Liquidity

l Customization implies bilateralcontracts, which carry performance risk

l Liquidity implies standardization andfreedom from counterparty risk, throughexchange-traded contracts


How Does the Bank Hedge a ForwardContract?

Hedging approaches:uOpen

uForward

uSpot plus swap

uRollover

uMoney market



Foreign Exchange Quotations

Spot Forward points


How Banks Hedge

SHORT LONG

Today

T+2

T+90

Methods:- Spot + swap- Spot + rollover swap- Money market- Outright forward



The FX Swap Hedge

3-month Forward Contract

3-month Swap

l Dealers typically hedge a forward foreign-exchange commitment with a spot plus “FXSwap”: spot sale plus forward purchase of aforeign currency

l The FX swap rate is determined by theinterest differential


The Roll-Over Swap Hedge


3-month Swap 3-month Swap

l Dealers often hedge a long-term foreign-exchange commitment with shorter-termcontracts, which are “rolled over” as theycome due

l Corporations themselves do this too.



The FX Swap Hedge


Borrow USDInvest in DEM

l Dealers also hedge a forward commitment inthe money market: borrow the currency youwill be receiving, and invest in the currencyyou will be paying

l The FX swap rate is determined by theinterest differential


110

115

120

125

130

135

140

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

EXCHANGERATE, YENPER US$

FORWARDPREMUIM,PERCENTPER ANNUM

FORWARD(LEFT SCALE)

SPOT (LEFT SCALE)

FORWARD PREMIUM(RIGHT SCALE)

MONTHLY DATA, 1987-1989

FORWARD PREMIUM = [(SPOT-FORWARD)/SPOT]*(12/3)*100

The Forward Rate Tracks the Spot Rate



Linkages Between Interest Rates

Interest ratedifferential


Forwardpremium

Forwardpremium

Expected% change in

exchange rate

Expected% change in

exchange rate


Cost of Hedging

Type of Hedge Cost of HedgingForward Forward premium

Money Market Hedge(Borrow to matchassets)


Do nothing Expected rate ofchange ofexchange rate



Corporate Hedging Decisions:Frutas Amazonas

Exporting bananas to Spain, get paid inSpanish pesetas. Funding is in U.S.dollars.


Corporate Hedging Decisions:Frutas Amazonas

l Continue funding in U.S. dollars. Thepeseta might get stronger in the nextthree months, from $1=128 pesetas to$1=126 pesetas. This could be thecheapest

l Switch funding to pesetas, despite theslightly higher cost

l Borrow in dollars, but hedge theexchange risk in the forward market.



Frutas Amazonas

Eurodollar 3-monthloan rate

5 9/16%

Europeseta 3-month loan rate

7 15/16%

Spot exchangerate today

Pta128.210 perUSD

Forward exchangerate today

Pta129.005 perUSD

Forward discount,% per annum

-2.5


Frutas Amazonas

Type of Hedge Cost of HedgingForward 2.5%

Money Market Hedge(Borrow to matchassets)

2.375%

Do nothing 2/128 x 4= 6.25% gain(or 2.5% loss?)



Bid and Offer Quotationsin the Long-Dated Forward Market

1.3

1.35

1.4

1.45

1.5

1.55

1.6

1.65

1.7

1.75

1.8

1.85

1.9

SPOT 2 YR 3 YR 4 YR 5 YR 7 YEAR 10 YEAR

.05%

.63%

1.25%1.44%

1.62%3.96%

6.34%

EXCHANGERATE,DOLLARSPER POUNDSTERLING

OFFER

BID

MATURITY OF FORWARD CONTRACT


Forwards, Money Market Hedgingand Futures

l Forward contracts: OTC contracts forfuture delivery, often settled in cash

l Forwards can be used in1. Hedging

2. Positioning

3. Arbitrage

l Interest rate parity means that a forwardhedge is, normally, the same as amoney market hedge.

l Futures are free of default risk.


Marking-to-Market of aFuturesContract

0.625

0.63

0.635

0.64

0.645

0.65

-25 -20 -15 -10 -5 -1

SHORT POSITION

LONG POSITION

DAILY GAINS AND LOSSES

DAILY DMFUTURES PRICEMOVEMENTS

FUTURES

SPOT

FUTURES PRICES,US$ PER MARK

DAYS BEFORE SETTLEMENT DATE


Forwards vs Futures vs Options

l Good credit: Forward usually best

l Sometimes, Money Market Hedge betteruPerfect market: same (covered int. arb.)u Imperfect market: MMH may be better

l Credit problem: FuturesuBut: limited and standardizeduRequires margin and daily settlement

l Uncertain future cash flows:uLiquid instrument (futures/forwards to assure

flexibilityuOptions sometimes advisable



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