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FINANCIAL ENGINEERING:

DERIVATIVES AND RISK MANAGEMENT(J. Wiley, 2001)

K. Cuthbertson and D. Nitzsche

LECTURE

Forward and Futures Markets

in Foreign Currency

K.Cuthbertson, D.Nitzsche

Forward Market in Foreign CurrencyCovered Interest ParityCreating a Synthetic Forward Contract Foreign Currency Futures

K.Cuthbertson, D.Nitzsche

Forward Market in Foreign Currency

K.Cuthbertson, D.Nitzsche

Forward Market

- Contract made today for delivery in the future
- Forward rate is “price” agreed, today
- eg. One -year Forward rate = 1.5 $ / £
- Agree to purchase £100 ‘s forward
- In 1-year, receive £100
- and pay-out $150

K.Cuthbertson, D.Nitzsche

Forward Rates (Quotes)

Rule of thumb. Here discount / premium should be added so that: forward spread > spot spread

Premium (discount) % = ( premium / spot rate ) x ( 365 / m )x 100

K.Cuthbertson, D.Nitzsche

Covered Interest Parity

K.Cuthbertson, D.Nitzsche

Covered Interest Parity

- CIP determines the forward rate F and CIP holds when:
- Interest differential (in favour of the UK)
- = forward discount on sterling
- (or, forward premium on the $)
- ( rUK - rUS) / ( 1 + rUS) = ( F - S ) / S

K.Cuthbertson, D.Nitzsche

An Example of CIP

- The following set of “prices” are consistent with CIP
- rUK = 0.11 (11 %) rUS = 0.10 (10 %)
- S = 0.666666 £ / $ (I.e. 1.5 $ / £ )
- Then F must equal:
- F = 0.67272726 £/ $ ie. 1.486486 $ / £

K.Cuthbertson, D.Nitzsche

Covered Interest Parity (CIP)

- CHECK: CIP equation holds
- Interest differential in favour of UK
- ( rUK - rUS) / ( 1 + rUS) = (0.11 -0. 10) / 1.10
- = 0.0091 (= 0.91%)
- Forward premium on the dollar (discount on £)
- = ( F - S ) / S = 0.91%

K.Cuthbertson, D.Nitzsche

CIP return to investment in US or UK are equal

- 1) Invest in UK TVuk = £100 (1. 11) = £111
- = £A ( 1 + rUK )
- 2) Invest in US
- £100 to $ ( 100 / 0.6666) = $150 At end year $( 100 / 0.6666 )(1.10) = $165
- Forward Contract negotiated today
- Certain TV (in £s) from investing in USA:
- TVus = £ [( 100 / 0.666 ) . (1.10) ] 0.6727 = £111
- = £ [ (A / S ) (1 + rUS) ]. F
- Hence : TVuk = £111= TVUS = £111

K.Cuthbertson, D.Nitzsche

Covered Interest Parity (Algebra/Derivation)

Equate riskless returns ( in £ )

- (1) TVuk = £A ( 1 + rUK )
- (2) TVus = £ [ ( A / S ) ( 1 + rUS ) ]. F
F = S ( 1 + rUK ) / ( 1 + rUS )

or F / S = ( 1 + rUK ) / ( 1 + rUS )

Subtract “1” from each side:

( F -S ) / S = ( rUK - rUS ) / ( 1 + rUS )

Forward premium on dollar (discount on sterling)

= interest differential in favour of UK

eg. If rUK - rUS = minus1%pa then F will be below S, that is you get less £ per $ in the forward market, than in the spot market. - does this make sense for CIP ?

K.Cuthbertson, D.Nitzsche

Bank Calculates Forward Quote

- CIP implies, banks quote for F (£/$) is calculated as
F(quote) = S [( 1 + rUK ) / ( 1 + rUS ) ]

If rUK and rUS are relatively constant then

F and S will move together (positive correln)

hence:

For Hedging with Futures

If you are long spot $-assets and fear a fall in the $ then go short (ie.sell) futures on USD

K.Cuthbertson, D.Nitzsche

Creating a Synthetic Forward Contract

K.Cuthbertson, D.Nitzsche

Creating a Synthetic FX-Forward Contract

- Suppose the actual quoted forward rate is: F = 1.5 ($/£)
- Consider the cash flows in an actual forward contract
- Then reproduce these cash flows using “other assets”, that is the money markets in each country and the spot exchange rate. This is the synthetic forward contract
- Since the two sets of cash flows are identical then the actual forward contract must have a “value” or “price” equal to the synthetic forward contract. Otherwise riskless arbitrage (buy low, sell high) is possible.

K.Cuthbertson, D.Nitzsche

Actual FX-Forward Contract: Cash Flows

- Will receive $150 and pay out £100 at t=1
- No “own funds” are used. No cash exchanges hands today ( time t=0)

Receive $150

Data: F = 1.5 ($/£)

1

0

Pay out £100

K.Cuthbertson, D.Nitzsche

Using two money markets and the spot FX rateSuppose: ruk = 11%, rus =10%, S = 1.513636 ($/£)Create cash flows equivalent to actual Forward ContractBegin by “creating” the cash outflow of £100 at t=1

Synthetic Forward Contract: Cash Flows

Receive $150

Borrow £90.09 at r(UK) = 11%

1

0

Switch £90.09 in spot market and lend $136.36

in the US at r(US) =10%.

Note : S = 1.513636$/£ and no “own funds” are used

£100

K.Cuthbertson, D.Nitzsche

Synthetic FX-Forward Contract

- Borrowed £100/(1+ruk) =£90.09 at t=0
- ( Pay out£100at t=1)
- Convert to USD [100/(1+ruk) ] S = $136.36 at t=0
- Lend in USA and receive [100/(1+ruk) ] S (1+rus)
- = $150at t=1
- Synthetic Forward Rate SF:
- Rate of exchange ( t=1) = (Receipt of USD) / (Pay out £’s)
- = $150 / £100
- SF = [100/(1+ruk) ] S (1+rus) / 100
- = S (1+rus) / /(1+ruk)
- The actual forward rate must equal the synthetic forward rate

K.Cuthbertson, D.Nitzsche

Bank Calculates Outright Forward Quote

F(quote) = S [ ( 1 + rus ) / ( 1 + ruk ) ]

Covered interest parity (CIP)

Also Note:

If rus and ruk are relatively constant then

F and S will move together (positive correln)

Hedging

Long spot $’s then go short (ie.sell) futures on $

K.Cuthbertson, D.Nitzsche

Bank Quotes “Forward Points”

Forward Points = F - S

= S [ rus - rUK ) / ( 1 + ruk ) ]

- The forward points are calculated from S, and the two money market interest rates
Eg. If “forward points” = 10 and S=1.5 then

Outright forward rate F = S +Forward Points

F = 1.5000 + 10 points = 1.5010

K.Cuthbertson, D.Nitzsche

Risk Free Arbitrage Profits ( F and SF are different)

- Actual Forward Contract with F = 1.4 ($/£)Pay out $140 and receive £100 at t=1
- Synthetic Forward(Money Market)
- Data: ruk = 11%, rus =10%, S = 1.513636 ($/£) so SF=1.5 ($/£)
- Receive $150 and pay out £100
- Strategy:
- Sell $140 forward, receive £100 at t=1 (actual forward contract)
- Borrow £90.09 in UK money market at t=0 (owe £100 at t=1)
- Convert £90.09 into $136.36 in spot market at t=0
- Lend $136 in US money market receive $150 at t=1(synthetic)
- Riskless Profit = $150 - $140 = $10

K.Cuthbertson, D.Nitzsche

Speculation in Forward Market

- Bank will try and match hedgers in F-mkt to
- balance its currency book
- Open Position
- Suppose bank has forward contract. at F0 = 1.50 $ / £, to
- pay out £100,000 and receive $150,000
- One year later : ST = 1.52 $ / £
- Buy £100,000 spot and pay $152,000
- But only receive $150,000 from the f.c.
- Loss (or profit) = ST - F0

K.Cuthbertson, D.Nitzsche

Foreign Currency Futures

K.Cuthbertson, D.Nitzsche

Futures: Contract Specification

- Table 4.1 : Contract Specifications IMM Currency Futures(CME)
- Size Tick Size [Value] Initial Margin
- Margin Maintenance Margin
- 1 Pound Sterling £62,500 0.02¢ per £[$12.50] $2,000
- 2 Swiss Franc SF125,000 0.01¢ per SFr $2,000
- 3 Japanese Yen Y12,500,000 0.01¢ per 100JY[$12.5] $1,500
- 4 Canadian Dollar CD100,000 0.001 ($/CD)[$100] $900
- 5 Euro 125,000 0.01¢ per Euro [$12.50] varies

K.Cuthbertson, D.Nitzsche

Futures: Hedging

S0 = spot rate = 0.6700($/SFr) F0 = futures price (Oct. delivery) = 0.6738($/SFr)Contract Size, z = SFr 125,000Tick size, (value) = 0.0001($/SFr) ($12.50)US ImporterTVS0 = SFr 500,000 Vulnerable to an appreciation of SFr and hence takes a long position in SFr futuresNf = 500,000/125,000 = 4 contracts

K.Cuthbertson, D.Nitzsche

Futures: Hedging

Net $-cost = Cost in spot market - Gain on futures = TVS0 S1 - Nf z (F1 – F0) = TVS0 (S1 - F1 + F0) = TVS0 (b1 + F0) = $ 360,000 - $ 23,300 = $ 336,700 Notes: Nfz = TVS0Hedge “locks in” the futures price at t=0 that is F0, as long as the final basis b1 = S1 - F1 is “small”.Importer pays out $336,700 to receive SFr 500,000 which implies an effective rate of exchange at t=1 of :[4.14] Net Cost/TVS0= b1 + F0 = 0.6734 ($/SFr)~close to the initial futures price of F0 = 0.6738($/SFr) the difference being the final basis b1 = -4 ticks.

K.Cuthbertson, D.Nitzsche

K.Cuthbertson, D.Nitzsche

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