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# Chapter 4 - PowerPoint PPT Presentation

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:

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### Chapter 4

Currency

Derivatives

“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

• 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

• 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

170000-150000

Profit = 20000

• INR/PKR: 1.50/1.60

3-months: 30/20 (High / Low = Subtract)

i.e. 1.60

- .20

1.40

• INR/PKR: 1.50/1.60

i.e. 1.60

+ .30

1.90

• It’s a contract between two forward dates

Eg:

• combined with

Three month

forward purchase

One month

forward sale

Suppose

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

• 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

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

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

i.e. 1.7585

+ 40

1.7625

• 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

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

+401.7040

1.7040 loss - 0.0530

Therefore a loss of: 0.0530 * 5m = ????

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

• 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

If the points are 30/20

GBP/USD spot: 1.7580

- 20

1.7560

SELL forward

6-months

- GBP 5000000 + USD 8770000

(5m @ 1.7540)

Sell GBP @ Spot 5m

12-months

+ GBP 5000000

- USD 8780000

(5m @ 1.7560)

On day 1The planned cash flows are:

6-months later GBP has fluctuated

Suppose

GBP/USD Spot: 1.7005

Now

• Buy GBP 5m spot @ 1.7005

• Sell GBP 5m 6-months forward @ 1.7085

+ GBP 5000000

- USD 8502500

(5m @ 1.7005)

SELL Forward

6-months

- GBP 5000000

+ USD 8542500

(5m @ 1.7085)

After 6-monthsThe planned cash flows are:

(5m @ 1.7540)

- USD 8502500

(5m @ 1.7005)

267500

Total Gain:

- USD 8780000

(5m @ 1.7560)

+ USD 8542500

(5m @ 1.7085)

237500

30000

Matching cash flows

• Forward Discount:

Percentage by which the forward rate is less than the spot rate

Percentage by which the forward rate is more than the spot rate

• 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

• 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

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