1. The Foreign Exchange Market (Part II)

2. © 2002 by Stefano Mazzotta 1 Learning Outcomes 1.Foreign currency forwards 2.Foreign currency futures

3. 1. Forward Currency Contracts

4. © 2002 by Stefano Mazzotta 3 Definition A forward currency contract is an agreement to buy or sell a specified amount of one currency against another one at a certain time in the future for a certain price (the delivery price). The parties of the contract are usually two banks or a bank and a non-financial institution. It is an OTC agreement.

5. © 2002 by Stefano Mazzotta 4 Terminology The party that has agreed to buy a currency at a future date is said to take a long position; the counterpart, i.e. the future seller is said to take a short position. The future buyer is also said to buy the currency forward; the future seller is said to sell it forward. The reference currency must be specified though, since buying currency A forward against currency B is equivalent to selling B forward against A

6. © 2002 by Stefano Mazzotta 5 Characteristics of the forward contract The forward contract entails the obligations and rights object of the contract for both parties of the contract. The exchange rate – the price to be paid at a future date for one currency in term of the other - is fixed at the time the contract is initiated. The initial value of the contract is zero, it changes during the life of the contract.

7. © 2002 by Stefano Mazzotta 6 Why using forwards? To reduce risk: – To lock in the price of a currency that is needed in the future. –To eliminate the uncertainty of future exchange rate fluctuations. To increase risk –To speculate on one’s belief or private information

8. © 2002 by Stefano Mazzotta 7 Example EXCHANGE RATES Tuesday, February 6, 1990 The New York foreign exchange selling rates below apply to trading among banks in amounts of $1 million and more, as quoted at 3 p.m. Eastern time by Bankers Trust Co. Retail transactions provide fewer units of foreign currency per dollar. Currency U.S. $ equiv. per U.S. $ CountryTues. Mon. Tues. Mon. Switzerland (Franc).6766.67841.47801.4740 30-Day Forward.6759.67781.47961.4754 90-Day Forward.6743.67651.48301.4783 180-Day Forward.6724.67481.48731.4820 Source: The Wall Street Journal

9. © 2002 by Stefano Mazzotta 8 Example: The question A U.S. aeronautics equipment company buys some parts from Quebec with the payment of C$ 10,000,000 which is scheduled in 180 days. It is possible that in the coming months the U.S. dollar will depreciate against the Canadian dollar. What will happen with the cost of the parts from Quebec for the American firm?

10. © 2002 by Stefano Mazzotta 9 Example: The exchange risk $/CAD Payment cost 0.6724 $6,724,000 -> $ depreciates<- $ appreciates

11. © 2002 by Stefano Mazzotta 10 Example: The solution (I) The cost of all imports from Quebec will increase. What can the U.S. firm do? Hedge its risk exposure with respect to appreciating Canadian dollar. How to do it? Contact a bank. Buy (long) C$ 10,000,000 at 0.6724 USD/CAD in the forward market using a 180-day forward contract.

12. © 2002 by Stefano Mazzotta 11 Example: The solution (II) If the contract is initiated, on its 180th day, the bank will have to pay C$ 10,000,000 to the firm. The firm will pay the bank the following: In the end, the U.S. firm will pay to its Quebec parties $6,724,000 equivalent of CAD in 180 days and the firm knows about it now. No exchange rate trouble!

13. © 2002 by Stefano Mazzotta 12 Example: The resulting risk is flat i.e. there is no uncertainty $/CAD Payment cost 0.6724 $6,724,000

14. © 2002 by Stefano Mazzotta 13 Example: In words The U.S. firm has to hedge a future purchase of a foreign currency in the spot market with a long position in the forward currency market. The bank has to find a customer who needs to hedge a sale of the same currency at the same future date in the spot market with a short position in the forward currency market.

15. © 2002 by Stefano Mazzotta 14 Example: What if? What if 180 days later and entering the forward the C$ depreciates against $. What does the forward do to the U.S. firm? Does the firm lose money? How much? C$ 10,000,000 times the difference between the forward rate and spot rate on the 180th day.

16. © 2002 by Stefano Mazzotta 15 Example: The final picture Forward contract gain Forward contract loss $/CAD Payment cost 0.6724 $6,724,000

17. © 2002 by Stefano Mazzotta 16 Forward quotations Outright price: –The actual price, such as the 180-day USD/CAD price of 0.6724. It is used for commercial customers. The swap rate: –The difference between forward and spot rates. It is used by professionals. –Forward is at premium if forward rate > spot rate. –Forward is at discount if forward rate < spot rate.

18. © 2002 by Stefano Mazzotta 17 Examples The spot SF/$ is 1.5625. The 90-day forward quote is 1.5450. The forward is quoted at 175 point discount. The spot SF/$ is 1.5625. The 90-day forward quote is 1.5800. The forward is quoted at 175 point premium.

19. © 2002 by Stefano Mazzotta 18 Example

20. © 2002 by Stefano Mazzotta 19 Forward spreads Bid-ask spreads for forwards are wider than for spot quotes. Why? More uncertainty about distant spot rates than those in the near future. Therefore, spreads usually increase with the maturity of the contract. But they also decrease with the liquidity.

21. 2. Foreign Currency Futures

22. © 2002 by Stefano Mazzotta 21 Definition A futures contract is an agreement to buy or sell a commodity at a date in the future. Everything about a futures contract is standardized except its price. All of the terms under which the commodity, service or financial instrument is to be transferred are established before active trading begins, there is no ambiguity. The price for a futures contract is what’s determined in the trading pit or on the electronic trading system

23. © 2002 by Stefano Mazzotta 22 Characteristics of the futures contract (I) A specific-sized contract: –Standardized contracts per currency. A standard quotation method: –The “American” method. A trading location: –Trading occurs only on the exchange floor. Trading hours: –Usual trade is among brokers on the floor; currently many exchanges move to 24-hour electronic trading.

24. © 2002 by Stefano Mazzotta 23 A standard maturity day: –The third Wednesday of January, March, April, June, July, September, October and December. A specified last trading day: –At IMM contracts may be traded through the second business day prior to the Wed. on which they mature. Daily marking-to-market: –Changes in the contract value are paid in cash daily. Collateral: –The purchaser of a contract must deposit a collateral or initial margin. Characteristics of the futures contract (II)

25. © 2002 by Stefano Mazzotta 24 Web resources http://www.cme.com/products/currency/index. cfmhttp://www.cme.com/products/currency/index. cfm http://www.cme.com/education/courses/intera ctive_features/education_courses_interactivef eatures_webinstantlessons.cfmhttp://www.cme.com/education/courses/intera ctive_features/education_courses_interactivef eatures_webinstantlessons.cfm Web Instant Lessons Sggested: Futures Contract Futures ExchangeContractsFutures ExchangeContracts PitTradingPitTrading PitWho's WhoPitWho's Who Risk ManagementHedgers & SpeculatorsRisk ManagementHedgers & Speculators Facts & Stats GLOBEX \GLOBEX Futures Intelligence Quiz check this out tooFutures Intelligence Quiz