Spot and Forward Rates, Currency Swaps, Futures and Options

1
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)

2

• 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

3

• 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.

4
Foreign Exchange Options Began in 1982limited
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
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Foreign Exchange Options (continued)

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

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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 averseespecially
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

7
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
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Alternative to the Previous Hedge

• Importer Buy 100,000 forward for delivery in 3
  months at todays 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 todays 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!
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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

10
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

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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

12
Interest Arbitrage
Uncovered Interest rates vary among countries.
So, it might be advantageous to invest in another
country to earn that countys 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!

13
Covered Interest Arbitrage

1. Spot purchase of foreign currency
2. Forward sale of same currency
3. 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)