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 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 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

5. 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

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 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

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
Major 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 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!

9. 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

11. 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 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!

13. 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)