Spot and Forward Rates, Currency Swaps, Futures and Options
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1 Spot and Forward Rates, Currency Swaps, Futures and Options Spot Rate (SR): Most transactions are completed in 2 days, enough time to debit and credit the necessary accounts both at home and abroadExample: 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 banksExample: 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 trading40% spot10% forward50% 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 fluctuationsOnly 4 dates per year are available: the 3rd Wednesday in March, June, September and DecemberOnly 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 SingaporeAmounts are usually smaller than in the forward marketThe forward and futures market are connected through arbitrage.Transactions costs are higher than in the forward marketThe market is increasing in size and importance.
4 Foreign Exchange Options: Began in 1982—limited to the Euro, British £, Canadian $, Japanese Yen and Swiss FranksCall Option: Contract giving purchaser the right but not the obligation to buyPut Option: Contract giving purchaser the right but not the obligation to sellEuropean Option: A standard amount of currency on a stated dateAmerican Option: A standard amount of currency at any time before a stated date
5 Foreign Exchange Options (continued) Buyer of the option can either exercise it or notSeller must fulfill the contract if the buyer so desiresTherefore: the buyer of the option usually pays a 1-5% premium
6 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 motionHowever, most people are risk averse—especially “bidness” peopleTypes 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 rateDeposit in bank and earn interest for 3 monthsCost = difference in interest paid and receivedBorrow £100,000 at current spot ratExchange for $’s at the current spot rateMajor Disadvantage: In both cases £100,000 is tied up for 3 months
8 Alternative to the Previous Hedge: Importer: Buy £100,000 forward for delivery in 3 months at today’s forward rateIf £’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 occurredIt is also possible to do the same transactions with options!
9 Speculation: Creating an intentional “open position” Spot Market:If a foreign rate is expected to risebuy that currency in the spot marketDeposit in a bank for 3 months to earn interestSell at a profitIf the domestic rate is expected to fallBorrow foreign currencyDeposit in bank for 3 months to earn interestBuy 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 rateBuy forwardIn 3 months, sell at a profitExample: FR = $2.02/£ and the expected spot rate is $1.98/ £Sell at $2.02 in 3 months and buy at $1.98Option Market:Speculator could buy an option to sell £’s at $2.02/ £If the spot rate falls to $1.98, exercise the option
11 Definitional StuffLong Position:A speculator buys a foreign currency in the spot, forward or futures market, orBuys an option to buyShort Position:A speculator borrows (spot), orSells forward
12 Interest ArbitrageUncovered: Interest rates vary among countries. So, it might be advantageous to invest in another country to earn that county’s interestScenario: 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 earnedIf the £ depreciates 2%, 0% return is earnedConsequently, covered interest arbitrage is the norm!
13 Covered Interest Arbitrage Spot purchase of foreign currencyForward sale of same currencyUs of foreign currency to buy T-Bills in foreign countryExample: T-Bills [6% in N.Y.] [8% in London]U.S. investor buys £’s in spot marketSells £’s in forward market at 1% discountBuys British T-Bills at 8%T-Bill is redeemed in £’s£’s are sold at 1% discountInvestor earns 7% [1% more than in U.S.]As the process continuesThe 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)