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Spot and Forward Rates, Currency Swaps, Futures and Options PowerPoint Presentation
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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 £.

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slide1

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)
slide2

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
slide3

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.
slide4

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

slide5

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
slide6

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
slide7

Hedging: Covering an open position (avoiding exchange rate risk)

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

slide8

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!

slide9

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
slide10

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
  • Buy forward
  • 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
slide11

Definitional Stuff

  • Long Position:
  • A speculator buys a foreign currency in the spot, forward or futures market, or
  • Buys an option to buy
  • Short Position:
  • A speculator borrows (spot), or
  • Sells forward
slide12

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!
slide13

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)