AJA4604.06 Currency Forwards, Futures, Options and Swaps

1. AJA4604.06Currency Forwards, Futures, Options and Swaps • A forward contract calls for the future delivery of units (a tailor-made units) of some goods or financial assets at a price established at the initiation of the contract. It is an obligation. • A futures contract is a promise (an obligation) to buy or sell standardized units of goods or financial assets at a predetermined price in the future. • Examples: commodity futures, stock index futures, currency futures, interest rate futures...

2. A currency forward or futures contract entails an obligation to trade the underlying currency at a pre-specified rate of exchange on a specified future delivery date. (Give examples of common fwd contracts) • The specified rate is called the forward rate or the futures rate. • A trader is said to hold a long position(short position) if the contract calls for the purchase(sale) of the underlying currency. • Currency forward and futures are derivative securities written on the underlying currencies and their prices depend on the underlying currencies' spot exchange rates.

3. Why Use Derivatives? • They offer investors and MNC enhanced ability to manage their foreign exchange exposure. • These contracts can also be employed for speculative purposes and for the future price discovery. • They are used by investment houses, asset-liability managers at banks, bank trust officers, endowment fund managers, pension fund managers, corporate treasurers, mortgage officers, oil corporations, farmers, ranchers, etc…

4. To change the nature of a liability. • To change the nature of an investment without incurring costs of selling one portfolio and acquiring another. • To hedge currency positions by MNCs and to capitalize on expectations of exchange rate movements by speculators.

5. Definition of Some Terms • Swap Transaction Swap transaction involves a spot transactionalong with a corresponding forward contract that will reverse the spot transaction. • A non-deliverable forward contract (NDF) does not result in an actual exchange of the underlying currencies. Instead, one party makes a net payment to the other based on a market exchange rate on settlement day.

6. The first listed currency futures contract began trading on the International Money Market (IMM) division of the Chicago Mercantile Exchange on May 16, 1972, about the time that floating exchange rate system emerged. • Before 1972, only commodity futures contracts were traded on organized exchanges. Today, financial futures represent the majority of all the futures trading. • Currency futures appeal more to individual traders, speculators, and small firmswho are unable to transact in the forward market. (See World's Major Futures and Options Exchanges)

7. Market Makers • While market making is not specific to futures, the way it is implemented is unique to the futures markets. • Making a market involves taking both sides of a trade and profiting off of the spread(diff between bid/ask prices) • In most futures exchanges, market makers, also called floor traders or speculators, are those trading for their own account as opposed to filling orders for customers. • Therefore, it is the market maker who supplies much of the capital that ensures a liquid futures market.

8. Currency Futures Contracts: Special Features. • Contract sizes and delivery are standardized • Qualified public speculation is encouraged. • Currency futures trading entails posting of a small security deposit. • Majority of futures contracts are settled by reversing trades (actual delivery  1- 5%).

9. Trading (traditionally) occurs in areas called PITS. Traders offer to buy or sell through a system of openoutcry or by sophisticated hand signals. • Electronic trading platforms replacing PITS while some contracts trade on both platforms side-by-side. • Standard maturity dates: IMM contracts mature on 3rd Wednesday of Jan, March, April, June, July, Sept, Oct,and Dec. • Not all of these maturities, however, are available for all currencies at any given time.

10. Trading and Transaction Costs Include • Floor trading and clearing fees. • Commissions (instead of bid/ask spreads) • Delivery costs: a trader who holds a futures position until delivery, is exposed to delivery costs. • Contracts can be traded by firms or individuals through brokers on the trading floor (Chicago Mercantile Exchange, LIFFE), automated trading systems (e.g. GLOBEX), or over-the-counter market. • Brokers who fulfill orders to buy or sell futures contracts typically charge commission.

11. The Clearing House • The Clearing House guarantees contract performance to all market participants by acting as a counterparty. • All traders have an obligation to the Clearing House but not to each other. • The Clearing House matches its long and short positions perfectly. (It is perfectly hedged or its net position in all futures contracts is zero). • The Clearing House charges a small fee for its role. • The existence of a Clearing House presents a reduced default risk in the futures market.

12. Margin Requirement • Currency futures traders represent a source of credit risk to the Clearing House. • To cover the risk, a trader is required to post a margin in the form of a cash deposit, a bank letter of credit, or a liquid asset such as T-Bills. This is the initial margin or collateral.

13. Daily Settlement • All changes in value are paid in cash daily. The amount to be paid is called margin variation. • Daily settlement or marking-to-the-market, is a futures market requirement whereby traders realize gains (or incur losses) daily. • This reduces the default risk on futures relative to forward contracts, since the value of a futures contract is set to zero everyday.

14. Reversing Trades. • Nearly all currency futures contracts are settled by reversing trades so that delivery rarely occurs. • A reversing trade makes a trader's net futures position equal to zero. • [For example, a long trader in BP futures can enter into a reversing trade (go short for same maturity) instead of taking delivery of the BP, while a short trader can assume a reversing trade (go long for same maturity) instead of delivery of BP.]

15. Market Regulation. • The market is regulated by Commodity Futures Trading Commission(CFTC). • In addition, the National Futures Association(NFA) was established as an independent, self-regulating, non-profit organization that regulates the futures market. • The NFA began operating in 1982. • Update derivatives regulation in general.

16. Uses of Futures Contracts (i) Price Discovery: • A currency futures (or forward) price may serve as an indicator of that currency's future value. • Forward and futures prices are readily available, inexpensive to obtain and alternative estimators of future spot prices are not, on average, more accurate.

17. (ii) Speculation. • A speculator is one who accepts the risk that a hedger does not want because he/she thinks the potential return outweighs the risk. • In like manner, an insurance company accepts the risk of a house fire, auto accident or medical malpractice because it ensures that the premium charged will adequately compensate for the attendant risk. • If forex markets are efficient, speculation in the currency futures and options markets should not consistently generate abnormally large profits.

18. An Example: Assume that it is now Sept. 2009. The current spot rate for pound(£) is $/£ =1.8300, and futures price for Dec. 2009 delivery = 1.8238. If a position trader thinks that the pound will not depreciate to the extent implied by the futures price, he/she will buy the futures contract and subsequently reverse his/her position before maturity. To gain, a speculator must be able to reverse at a new futures price, for December 2009 delivery, (e.g., at $1.8275) as shown below:

19. 1.8300 1.8275 1.8238 |---------------------------|--------------------------| 0 t Sept Dec Then his/her profits will be: (1.8275 - 1.8238)* 62500 £/contract = $231.25 (less transaction costs). Note: Credit risk (failure to fulfill the contract) is borne by the exchange in the futures market but each party bears a credit risk in a forward contract.

20. (iii) Arbitrage Between Forward & Futures: Arbitragers help to keep futures prices in line with bank forward rates by buying "low" and selling "high" when an arbitrage situation momentarily exists. (iv) Hedging Exchange Rate Exposure: • If a market participant faces an economic risk and uses a derivative market to reduce this risk, he/she is a hedger. • Currency futures contracts provide efficient means of risk transfer. • They serve as insurance contracts, allowing participants to reduce the disutility associated with price and revenue variability attributable to unexpected changes in exchange rates.

21. Currency Options • The buyer or holder or owner of an options contract on a foreign currency has the right, but not the obligation to purchase or sell standardized units of the underlying currency at a specified rate of exchange on or before a specified expiration date. • The seller of the options contract is called the writer or grantor. • The specified exchange rate is the option's exercise price or strike price.

22. The specified expiration date is the option’s maturity. • A Call Optiongrants the holder the right to buy • A Put Option grants the holder the right to sell. • Whether the buyer exercises the option is contingent on the exchange rate in effect at, or before, the expiration date. • Thus options are often called contingent claims.

23. The options buyer can call(put) the foreign exchange from (to)the options writer or grantor. The writer or grantor has contracted to sell(buy)the underlying currency at the exercise price to(from) the call(put) options buyer or holder. • The premium is the cost/price charged by the writer/grantor/seller. • European Option may be exercised only at expiration. • American Option may be exercised at anytime on or before expiration date.

24. Buying and Writing Calls (Puts?) • A call option grants the owner the right (but not the obligation) to buy an asset at a pre-specified exercise(or strike) price within a specified period of time. • Since a call represents an option to buy, the purchase of a call is undertaken / appropriate if the price of the underlying asset is expected to go up. • The buyer of a call is said to be long in a call and the writer is said to be short in a call. • The buyer of a call pays a premium which represents the maximum loss he/she can sustain.

25. A Practical Example: • A major retailer advertized a sale on Plasma TV for $1200. • You visit the store to purchase the TV but it is out-of- stock. The manager gives you a rain check that entitles you to buy the TV for the advertized price of $1200 within the next 90 days. • You have now received a call option that gives you the right, but no obligation, to buy the TV in the future at the set price of $1200 within the expiration date of 90 days. • Suppose that a month later you observe that the TV is now in stock and priced at $1500. You exercise the right (the rain check) and buy the TV for $1200. You saved $300. • Suppose, on the other hand, a month later you observe that the TV is now in stock but priced at $1000. Your rain check is worthless since you, or anyone else, can buy the TV at the reduced price. You let your option expire worthless. You have no obligation to exercise it.

26. * Hedging With Currency Options: • Firms with open positions in the foreign exchange may employ currency options to hedge the positions against adverse exchange rate movements. • Options can be used to immunize a contingent international trade or contractual agreement against exchange rate risk. * Price Discovery • The underlying exchange rates can be inferred from currency options prices, so that appropriate options valuation can be used to make inferences about subsequent exchange rate movements (implied exchange rates can be derived from observed options prices).

27. Contingency Graphs for Currency Options • In-the-money (profitable if exercised now) • Out-of-the-money (not profitable if exercised now) • At-the-money (exercise price = spot price). • Options contract sizes are half the size of the IMM futures contracts (See text / handout)

28. For Buyer of £ Call Option For Seller of £ Call Option Strike price = $1.50 Premium = $ .02 Strike price = $1.50 Premium = $ .02 Net Profit per Unit Net Profit per Unit +$.04 +$.04 Future Spot Rate +$.02 +$.02 0 0 $1.46 $1.50 $1.54 $1.46 $1.50 $1.54 –$.02 Future Spot Rate –$.02 –$.04 –$.04 Contingency Graphs for Currency Options

29. For Buyer of £ Put Option For Seller of £ Put Option Strike price = $1.50 Premium = $ .03 Strike price = $1.50 Premium = $ .03 Net Profit per Unit Net Profit per Unit +$.04 +$.04 Future Spot Rate +$.02 +$.02 0 0 $1.46 $1.50 $1.54 $1.46 $1.50 $1.54 –$.02 –$.02 Future Spot Rate –$.04 –$.04 Contingency Graphs for Currency Options

30. Futures versus Options • Suppose a U.S. firm naively entered into a futures contract with December expiration to sell SF to be received from a contingent international trade agreement. (i.e., hopes to receive SF in the future, sells SF futures contract that locks in the price to sell SF.) • If the firm lost the bid and the dollar depreciated (i.e., $/SF increases), then the firm would lose money on its short position. • Since no SF are forthcoming, the firm effectively holds a naked futures position. • Its potential losses are unlimited. • Instead, employing a SF put option ensures a limited downside loss for the firm.

31. Settlement Months • Like the IMM futures contracts common settlements months are March, June, September and December. • First currency option traded in Philadelphia in 1983. • Market has grown to be a popular instrument for traders to handle risk and for speculators to make a profit. • Organized Exchanges: for standardized options. • Customized options offered by brokerage firms and commercial banks are traded in the over-the-counter market.

32. Factors Affecting Options Prices • Level of current spot price relative to strike price • Length of time before expiration date • Supply and demand for specific options • Potential variability of the underlying currency • Level of domestic and foreign interest rates. Rising interest rates increase call values and decrease put values.

33. Hedging Effectiveness - Empirical Evidence: • Options perform the hedging less effectively than futures (Chang & Shanker, 1986). • Options as risk-limiting instruments. • Futures as hedging instruments. The risks of trading futures contracts are symmetric; The risks of trading options contracts are not. • The buyer of a futures contract will lose as much when the spot price falls below the contract price as will be gained when the spot price rises above the contract price by the same magnitude. • In contrast, the most the options buyer can lose is the premium, while the gain is limited only by movement in the spot price of the underlying instrument.

34. Which To Use: Forward, Futures, Options This depends on the individual circumstances and the comparison of the respective costs: (see handout) • Forwards are accommodative as to amounts and delivery dates which are flexible, convenient but requires credit worthiness. • Futures are particularly useful for hedging large amounts, financial or commercial, and for speculators and investors. • Options are especially appropriate for companies involved in tender on foreign projects, having an undetermined eventual payments or receipts denominated in foreign currencies.

35. The Swaps Market • A financial swap is a contractual agreement in which two parties, called counterparties, agree to an exchange of financial obligations. • Each party employs its comparative (relative) advantage to secure a financial obligation in a currency or a type of interest payment that it does not desire and exchanges the obligation with the other party for mutual advantage. • The swap market is standardized partly by the International Swaps and Derivatives Association (ISDA)

36. Swaps are often motivated by a desire to exploit comparative advantages in the market place. • Swaps also rest on the principle of offsetting risks. • They are often used to hedge interest rate risk, exchange rate risk, commodity price risk, and equity return risk. • A hedge is a position taken for the purpose of reducing the risk associated with another position having an opposite risk. • The result is that the two risks are offsetting.

37. Swaps Facilitators: • One of the earliest problems with swaps is the difficulty of finding a potential counter-party with matching needs. • This problem is solved by: • Brokers: Financial institutions first became involved in swaps by taking on the role of swap brokers. A broker locates parties with matched needs and negotiates with each on behalf of the other. Preserves anonymity. Assumes no risk/does not take a position in the swap. Acts only as an agent. • Dealers: Swap dealers working for commercial banks, investment banks, and merchant banks, offer themselves as counter-parties. This is called "positioning" the swap or "booking" the swap. Dealers earn pay-receive (bid/ask) spreads for their services.

38. The underlying assets, called notionals, may or may not be exchanged. • The swap commences on its effective date (value date) • The swap terminates on its termination date (also known as maturity date) • The period between the effective date and the termination date is called the swap's tenor. • The swap dealer is also called a market maker or a swap bank. The swap bank can serve as either a broker or a dealer. As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap. As a dealer, swap bank stands ready to accept either side of a swap, and later lays off its risk, or matches it with a counterparty.

39. Interest Rate Swaps • An interest rate swap is a contractually agreed exchange between two counter-parties of their respective interest rate obligations. • Interest rate swaps are commonly used as a means of transforming fixed rate to floating rate debts and vice versa. • The swaps involve no exchange of notional principals but restructures the interest rate flows of existing assets and liabilities. • The notional amount is the theoretical principal underlying the swap.

40. Rationale • Different risk premia apply to different types of debt, depending on the credit worthiness of the borrower and the capital market accessed. • The interest rate swap exploits the comparative advantages of borrowing that one party may enjoy over another, creating actual interest rate savings for both parties out of the differential in borrowing costs between them.

41. The market allows a borrower to raise funds in a debt market where it enjoys the greater advantage over another borrower, even though it may not want to use those funds in that particular form. • The advantaged borrower then swaps out of that debt-type or market, into another form at funding levels better than it can obtain by direct access to the desired market or debt. Two types of Interest Rate Swaps: • Single Currency IRS: “Plain Vanilla” fixed-for-floating swaps frequently called “interest rate swaps”. • Cross-currency IRS: Often called “currency swap”… fixed for fixed rate debt service in multiple currencies.

42. Typical Uses of an IRS • Converting liabilities: Fixed rate to floating rate Floating rate to fixed rate • Converting investments: Fixed rate to floating rate Floating rate to fixed rate • Note that in an interest rate swap the principal is not exchanged. However, in a currency swap, the principal is exchanged at the beginning and end of the swap’s tenors.

43. Example I : 10 year debt financing swap. AA and BB face the following conditions in the market: Counter-partyBorrowing Costs FloatingFixed BB 6.50% 11.50% AA 6.0% 10.50% A dealer stands ready to enter into a swap as either a fixed-rate payer (floating rate receiver) or vice versa. The dealer will pay 10.70% fixed against 6.0% floating or receive 10.75% fixed against 6.0% floating. BB and AA borrow in their respective advantaged market and then swap their respective obligations.

44. Under these conditions, if swap is arranged by a dealer, the • effective funding costs for each party can be obtained as follows: • Party BBParty AA • Cost of market obligation: 6.50 % 10.50 % • Less rate offered by dealer: 6.0 % 10.70 % • Net Cost differential: 50 Bsp - 20 Bps • +Swap coupon paid to dealer 10.75 % 6.0 % • Final Cost of Financing 11.25 % 5.80 % • The swap dealer earns 5 Bps for his services. • This represents the difference between the swap coupon received from AA and the coupon paid to BB.

45. Currency Swaps: • Currency swaps enable borrowers to exchange debt service obligations denominated in one currency for similar obligations denominated in another currency. • By swapping future cash flow obligations, the two parties are able to alter their currency holdings without increasing their currency exposures. • In a currency swap, the principal is usually exchanged at the beginning and end of the contract

46. Example II: Consider two counter-parties, A and B. Floating($)Fixed(£) A's Objective: Desires 7-year floating on $. A: Prime 9% Cost of borrowing directly: Prime p.a. on $. B: Prime10.1% Relative advantage: 9% fixed on BP (£). Diff 0 1.1% Net Diff. 1.1% B’s Objective: Desires 7-year fixed rate on BP. Cost of borrowing directly: 10.1% fixed on BP. Relative advantage: Prime p.a. on $. A swap dealer proposes £-$ currency swaps. It offers to pay a fixed-rate of 9.45% on BP against Prime p.a., and is prepared to pay Prime p.a. against receiving fixed 9.55% on BP. The counterparties borrow in their respective advantaged markets and then enter into a swap agreement.

47. Effective Funding Costs: Party AParty B Borrow fixed-rate BP: 9% Borrow floating-rate USD: P Pay floating-rate on swap: P Pay fixed-rate on swap: 9.55% Rec. fixed-rate on swap: -9.45% Rec. floating-rate on swap: -P Final cost = P - 45Bps Final cost = 9.55% · Savings for A = 45 Bps · Savings for B = 55 Bps · Swap dealer earns = 10 Bps Total = 1.10% = Net Difference.

48. Example III Counterparties AAA and AA are faced with the following borrowing conditions in the marketplace. Fixed Floating AAA 5.8% 3.75% AA 6.65% 4.10% AAA desires a floating rate loan while AA desires fixed. A dealer stands ready to pay 6.20% fixed against a floating rate of 3.90% or receive a fixed rate of 6.40% against a floating rate of 4%. Assume that each party exploits its relative advantage and swaps with the other. What is the net cost of each party’s desired obligation and the dealer’s net spread?