1. Chapter 6 Currency Futures and Swaps

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 2 Objectives To describe futures contracts and show how they circumvent the problems of forward contracts. To compare forward and futures markets. To describe swaps and introduce some terminology.

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 3 Definition Currency futures contracts represent an obligation of the seller to deliver a certain amount of a specified currency in the future at an exchange rate determined now.

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 4 Problems of Forward Contracts Non-standard contract dimensions Default risk Lack of liquidity

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 5 Using a Forward Contract C A Forward contract JPYGoods B AUD JPY

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 6 Tendency to Default on a Forward Contract A tends to default A B USD 1 million Forward rate = 1.80 AUD 1.8 million C Spot rate = 1.90 USD 1 million AUD 1.9 million

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 7 Tendency to Default on a Forward Contract (cont.) B tends to default USD 1 million Forward rate = 1.80 AUD 1.8 million Spot rate = 1.70 USD 1 million AUD 1.7 million A B C

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 8 Tendency to Default on a Forward Contract (cont.) Neither tends to default A B USD 1 million Forward rate = 1.80 AUD 1.8 million C Spot rate = 1.80 USD 1 million AUD 1.8 million USD 1 million AUD 1.8 million

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 9 Unwinding a Forward Contract C A Compensation JPY Compensation D AUD (a) Assigning the obligation to another counterparty (D)

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 10 Unwinding a Forward Contract (cont.) C A (b) Cancelling the forward contract Cancellation fee

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 11 Unwinding a Forward Contract (cont.) C A (c) Entering an offsetting position with E E AUD JPY

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 12 How Futures Contracts Solve These Problems Standardised contract dimension Default risk is controlled by the clearing corporation and some regulations They are liquid

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 13 The Role of the Clearing Corporation in Futures Trading A B USD AUD Clearing corporation (exchange)

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 14 A Comparison of Forward and Futures Markets Market size Market structure Contract size Traded currencies

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 15 A Comparison of Forward and Futures Markets (cont.) Cross rates Exchange rate fluctuations Maturity dates Maturity lengths

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 16 A Comparison of Forward and Futures Markets (cont.) Credit risk Cash flows Hours of trading Eligible dealers Major users

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 17 Futures Exchanges The Philadelphia Stock Exchange The Chicago Mercantile Exchange The Sydney Futures Exchange

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 18 Definition of Swaps Currency and interest rate swaps involve the exchange of interest and foreign currency cash flows. They differ from swaps in the forward FX market (FX swaps).

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 19 Currency Swaps A currency swap is a transaction in which two counterparties exchange specific amounts of two different currencies at the outset and repay over time according to a predetermined rule.

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 20 Some Features of Currency Swaps They emerged in the 1980s with the World Bank playing a major role. They have evolved as a successor to parallel loans.

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 21 Stages of Currency Swaps The counterparties exchange the principal amounts. On specific dates, they exchange interest payments. On maturity, the principal amounts are re- exchanged.

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 22 Currency Swaps with Notional Principals A notional principal is not exchanged. Only compensatory payments are made by one counterparty to the other.

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 23 A Swap without Exchanging Principals A B1 A B2 A B3 A Bn

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 24 Interest Rate Swaps A fixed-for-floating swap involves the exchange of cash flows by applying fixed and floating interest rates to a notional principal in a specific currency.

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 25 Fixed-for-Floating Interest Rate Swap A B ik (floating) ik (fixed)

26. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 26 Other Kinds of Interest Rate Swaps A basis swap involves two floating interest rates. A zero-coupon swap involves a zero fixed rate.

27. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 27 Cross-Currency Interest Rate Swaps Involve the exchange of payments in different currencies, one of which is calculated on the basis of a fixed interest rate and the other on the basis of a floating rate.

28. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 28 Cross-Currency Interest Rate Swaps A B Fixed JPY Floating AUD (a) Dealing with one counterparty C A B (b) Dealing with two counterparties Fixed JPY Floating AUD Fixed AUD

29. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 29 Swap Terminology Money market and term swaps Spot-start, delayed-start and forward swaps Option on swap, swaption and swap buyout Amortising swap