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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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Presentation Transcript
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”

slide3
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

slide13
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

slide22
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

slide23
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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