Spot and Forward Rates, Currency Swaps, Futures and Options

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# Spot and Forward Rates, Currency Swaps, Futures and Options - PowerPoint PPT Presentation

Spot and Forward Rates, Currency Swaps, Futures and Options. Spot and Forward Rates: Spot Rate (SR): Most transactions are completed in 2 days, enough time to debit and credit the necessary accounts both at home and abroad Example: R = \$/ £ = \$2 per £.

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## Spot and Forward Rates, Currency Swaps, Futures and Options

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Spot and Forward Rates, Currency Swaps, Futures and Options

• Spot and Forward Rates:
• Spot Rate (SR): Most transactions are completed in 2 days, enough time to debit and credit the necessary accounts both at home and abroad
• Example: R = \$/£ = \$2 per £
• Forward Rate (FR): Best thought of as a “contract” to buy or sell a specified amount of currency at a future date at a price agreed upon today (usually a 10% margin requirement).
• Calculate Forward Premium or Discount:
• FD or FP = [(FR – SR)/SR] X 4 X 100
• (the 4 annualizes the FD or FP due to the usual 3 month period [1/4 of a year] of the contract)

Currency Swaps: Combined transactions are treated as one which saves transactions costs

• Sell currency (in the spot market) and simultaneously repurchase the same currency in the forward market: mostly used by banks
• Example: Suppose Regions Bank receives 5 million Euros that it will need in 3 months. However, they would prefer to hold dollars for the next 3 months (until they need the Euros).
• They execute a currency swap: They sell the Euros in the spot market and simultaneously repurchase Euros in the forward market.
• Spot Transactions and Swaps are the most common transactions in interbank trading
• 40% spot
• 10% forward
• 50% swaps

Foreign Exchange Futures: Began in 1972 and they are becoming more popular

• Contract size is fixed (approximately \$100,000)
• Daily limit is set on rate fluctuations
• Only 4 dates per year are available: the 3rd Wednesday in March, June, September and December
• Only a few currencies are traded: Yen, Mark, Canadian \$, British £, Swiss Franc, Australian \$, Mexican Peso, Euro and U.S. \$
• Only traded in a few locations: Chicago, New York, London, Frankfurt, and Singapore
• Amounts are usually smaller than in the forward market
• The forward and futures market are connected through arbitrage.
• Transactions costs are higher than in the forward market
• The market is increasing in size and importance.

Foreign Exchange Options: Began in 1982—limited to the Euro, British £, Canadian \$, Japanese Yen and Swiss Franks

• Call Option: Contract giving purchaser the right but not the obligation to buy
• Put Option: Contract giving purchaser the right but not the obligation to sell

European Option: A standard amount of currency on a stated date

American Option: A standard amount of currency at any time before a stated date

Foreign Exchange Options (continued)

• Buyer of the option can either exercise it or not
• Seller must fulfill the contract if the buyer so desires
• Therefore: the buyer of the option usually pays a 1-5% premium

Foreign Exchange Risks, Hedging and Speculation:

• If a future payment is to be made or received [called an open position], risk is involved.
• Reason: Both the spot and forward rate are constantly in motion

However, most people are risk averse—especially “bidness” people

• Types of Exposure:
• Transaction Exposure (future payment/receipt)
• Accounting Exposure (valuation of inventories and assets abroad translated into native currency)
• Economic Exposure (future profitability valued in domestic currency

Example: A U.S. exporter expects to receive £100,000 in 3 months [possible hedges]

• Borrow £100,000 at current spot rate
• Deposit in bank and earn interest for 3 months
• Cost = difference in interest paid and received
• Borrow £100,000 at current spot rat
• Exchange for \$’s at the current spot rate
• Deposit in bank and earn interest for 3 months
• Cost = difference in interest paid and received

Major Disadvantage: In both cases £100,000 is tied up for 3 months

Alternative to the Previous Hedge:

• Importer: Buy £100,000 forward for delivery in 3 months at today’s forward rate
• If £’s at the 3 month forward rate are selling at a 4% premium per year, the importer will pay (assuming \$/£ = 2) \$202,000 in 3 months for £100,000 (or 1% of 200,000)
• Exporter: Sell £100,000 forward for delivery in 3 months at today’s 3 month forward rate (because they have already sold the currency they expect to receive in 3 months, they have locked in the rate.)
• Notice: None of the Exporters funds have been tied up and no borrowing has occurred

It is also possible to do the same transactions with options!

Speculation: Creating an intentional “open position”

• Spot Market:
• If a foreign rate is expected to rise
• buy that currency in the spot market
• Deposit in a bank for 3 months to earn interest
• Sell at a profit
• If the domestic rate is expected to fall
• Borrow foreign currency
• Deposit in bank for 3 months to earn interest
• Buy domestic currency at a profit

Speculation: Creating an intentional “open position”

Forward Market:

• If the spot rate is expected to be higher in 3 months than the current forward rate
• In 3 months, sell at a profit
• Example: FR = \$2.02/£ and the expected spot rate is \$1.98/ £
• Sell at \$2.02 in 3 months and buy at \$1.98
• Option Market:
• Speculator could buy an option to sell £’s at \$2.02/ £
• If the spot rate falls to \$1.98, exercise the option

Definitional Stuff

• Long Position:
• A speculator buys a foreign currency in the spot, forward or futures market, or
• Short Position:
• A speculator borrows (spot), or
• Sells forward

Interest Arbitrage

Uncovered: Interest rates vary among countries. So, it might be advantageous to invest in another country to earn that county’s interest

• Scenario: 3 month T-Bill [6% in N.Y.] [8% in London]
• U.S. investor exchanges \$’s for £’s at current spot rate and buys British T-Bill.
• At maturity, T-Bill is redeemed and U.S. investor uses the proceeds in £’s to buy \$’s.
• If there is 0 change in spot rate, 2% return is earned
• If the £ depreciates 2%, 0% return is earned
• Consequently, covered interest arbitrage is the norm!

Covered Interest Arbitrage

• Spot purchase of foreign currency
• Forward sale of same currency
• Us of foreign currency to buy T-Bills in foreign country
• Example: T-Bills [6% in N.Y.] [8% in London]
• U.S. investor buys £’s in spot market
• Sells £’s in forward market at 1% discount
• Buys British T-Bills at 8%
• T-Bill is redeemed in £’s
• £’s are sold at 1% discount
• Investor earns 7% [1% more than in U.S.]
• As the process continues
• The price of British T-Bills and the interest they bear 
• As £’s are sold forward the discount increases and parity is approached [Thus, we have CIAP (covered interest arbitrage parity)