Chapter 4
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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

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Chapter 4

Chapter 4

Currency

Derivatives


Forward contract

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:

“ Rate at which a bank is willing to exchange one currency for another at some specified date in future”


Chapter 4

  • 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


Forwards have no secondary market

Forwards have no secondary market

  • 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


Example

Example

  • 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

    He had to pay 170000

    170000-150000

    Profit = 20000


Calculation of points

Calculation of Points

  • 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

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

    i.e. 1.60

    + .30

    1.90


Forward forward swap

Forward-Forward Swap

  • It’s a contract between two forward dates

    Eg:

  • combined with

Three month

forward purchase

One month

forward sale


Example1

Example

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


Q how can he profit from this forecast

Q. How can he profit from this forecast

  • 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


Calculation

Calculation

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


Calculation1

Calculation

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

  • Add 40 points in last digits (L/H = Add)

    i.e. 1.7585

    + 40

    1.7625


Calculation2

Calculation

  • 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


Chapter 4

Risk

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 = ????


Example2

Example

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


Calculation3

Calculation

  • 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

    Second: Buy 12-months forward

    If the points are 30/20

    GBP/USD spot: 1.7580

    - 20

    1.7560


On day 1 the planned cash flows are

Buy GBP @ Spot 5m

SELL forward

6-months

- GBP 5000000 + USD 8770000

(5m @ 1.7540)

Sell GBP @ Spot 5m

BUY forward

12-months

+ GBP 5000000

- USD 8780000

(5m @ 1.7560)

On day 1The planned cash flows are:


Calculation4

Calculation

6-months later GBP has fluctuated

Suppose

GBP/USD Spot: 1.7005

6-months: 80/160 --- (L/H:Add)

Now

  • Buy GBP 5m spot @ 1.7005

  • Sell GBP 5m 6-months forward @ 1.7085


After 6 months the planned cash flows are

SPOT BUY

+ 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:


Matching cash flows

+ USD 8770000

(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


Discount or premium

Discount or Premium

  • Forward Discount:

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

  • Forward Premium

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


Testing question

Testing Question

  • 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


Chapter 4

You can do two swaps

  • 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


Chapter 4

After 3-months USD has fluctuated

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


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