Version 1/9/2001

FINANCIAL ENGINEERING: DERIVATIVES AND RISK MANAGEMENT (J. Wiley, 2001)

K. Cuthbertson and D. Nitzsche

LECTURE Forward and Futures Markets in Foreign Currency

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Topics

Forward Market in Foreign Currency Covered Interest Parity

Creating a Synthetic Forward Contract

Foreign Currency Futures

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Forward Market in Foreign Currency

K.Cuthbertson, D.Nitzsche

Forward Market
Contract made today for delivery in the future Forward rate is price agreed, today eg. One -year Forward rate = 1.5 $ / Agree to purchase 100 s forward In 1-year, receive 100 and pay-out $150

K.Cuthbertson, D.Nitzsche

Forward Rates (Quotes)

Yen / $ Spot 131.05131.15 spot spread

Yen / $ 0.10 0.02 0.12

1m forwd 0.01-0.03 spread on discount discount 1m forwd 131.06rate 131.18 1m forwd spread

Rule of thumb. Here discount / premium should be added so that: forward spread > spot spread

Premium (discount) % = ( premium / spot rate ) x ( 365 / m )x 100

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Covered Interest Parity

K.Cuthbertson, D.Nitzsche

Covered Interest Parity

CIP determines the forward rate F and CIP holds when: Interest differential (in favour of the UK) = forward discount on sterling (or, forward premium on the $)

( rUK - rUS) / ( 1 + rUS ) = ( F - S ) / S

K.Cuthbertson, D.Nitzsche

An Example of CIP

The following set of prices are consistent with CIP rUK = 0.11 (11 %) rUS = 0.10 (10 %)

S = 0.666666 / $
Then F must equal: F = 0.67272726 / $

(I.e. 1.5 $ / )

ie. 1.486486 $ /

K.Cuthbertson, D.Nitzsche

Covered Interest Parity (CIP)

CHECK: CIP equation holds

Interest differential in favour of UK

( rUK - rUS) / ( 1 + rUS ) = (0.11 -0. 10) / 1.10 = 0.0091 (= 0.91%) Forward premium on the dollar (discount on ) = ( F - S ) / S = 0.91%

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CIP return to investment in US or UK are equal 1) Invest in UK TVuk = = 100 (1. 11) = 111 A ( 1 + rUK ) = $150 = $165

2) Invest in US 100 to $ ( 100 / 0.6666) At end year $( 100 / 0.6666 )(1.10) Forward Contract negotiated today
Certain TV (in s) from investing in USA:

TVus = [( 100 / 0.666 ) . (1.10) ] 0.6727 = 111

= [ (A / S ) (1 + rUS) ]. F Hence : TVuk = 111= TVUS = 111

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Covered Interest Parity (Algebra/Derivation)

Equate riskless returns ( in ) (1) TVuk = A ( 1 + rUK ) (2) TVus = [ ( A / S ) ( 1 + rUS ) ]. F F = S ( 1 + rUK ) / ( 1 + rUS ) or F / S = ( 1 + rUK ) / ( 1 + rUS ) Subtract 1 from each side: ( F -S ) / S = ( rUK - rUS ) / ( 1 + rUS ) Forward premium on dollar (discount on sterling) = interest differential in favour of UK eg. If rUK - rUS = minus1%pa then F will be below S, that is you get less per $ in the forward market, than in the spot market. - does this make sense for CIP ?
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Bank Calculates Forward Quote

CIP implies, banks quote for F (/$) is calculated as

F(quote)

= S

[( 1 + rUK ) / ( 1 + rUS ) ]

If rUK and rUS are relatively constant then F and S will move together (positive correln) hence: For Hedging with Futures If you are long spot $-assets and fear a fall in the $ then go short (ie.sell) futures on USD

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Creating a Synthetic Forward Contract

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Creating a Synthetic FX-Forward Contract

Suppose the actual quoted forward rate is: F = 1.5 ($/) Consider the cash flows in an actual forward contract Then reproduce these cash flows using other assets, that is the money markets in each country and the spot exchange rate. This is the synthetic forward contract Since the two sets of cash flows are identical then the actual forward contract must have a value or price equal to the synthetic forward contract. Otherwise riskless arbitrage (buy low, sell high) is possible.

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Actual FX-Forward Contract: Cash Flows

Receive $150

Data: F = 1.5 ($/)

Pay out 100

Will receive $150 and pay out 100 at t=1 No own funds are used. No cash exchanges hands today ( time t=0)

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Synthetic Forward Contract: Cash Flows

Using two money markets and the spot FX rate Suppose: ruk = 11%, rus =10%, S = 1.513636 ($/) Create cash flows equivalent to actual Forward Contract Begin by creating the cash outflow of 100 at t=1 Receive $150 Borrow 90.09 at r(UK) = 11%

Switch 90.09 in spot market and lend $136.36 in the US at r(US) =10%. Note : S = 1.513636$/ and no own funds are used
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Synthetic FX-Forward Contract

Borrowed 100/(1+ruk) =90.09 at t=0 ( Pay out 100 at t=1)

Convert to USD [100/(1+ruk) ] S = $136.36 at t=0 Lend in USA and receive [100/(1+ruk) ] S (1+rus) = $150 at t=1 Synthetic Forward Rate SF: Rate of exchange ( t=1) = (Receipt of USD) / (Pay out s) = $150 / 100 SF = [100/(1+ruk) ] S (1+rus) / 100 = S (1+rus) / /(1+ruk) The actual forward rate must equal the synthetic forward rate

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Bank Calculates Outright Forward Quote

F(quote)

= S

[ ( 1 + rus ) / ( 1 + ruk ) ]

Covered interest parity (CIP)

Also Note: If rus and ruk are relatively constant then F and S will move together (positive correln) Hedging Long spot $s then go short (ie.sell) futures on $

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Bank Quotes Forward Points Forward Points = F - S = S [ rus - rUK ) / ( 1 + ruk ) ]

The forward points are calculated from S, and the two money market interest rates Eg. If forward points = 10 and S=1.5 then Outright forward rate F = S +Forward Points F = 1.5000 + 10 points = 1.5010

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Risk Free Arbitrage Profits ( F and SF are different)

Actual Forward Contract with F = 1.4 ($/) Pay out $140 and receive 100 at t=1

Synthetic Forward(Money Market) Data: ruk = 11%, rus =10%, S = 1.513636 ($/) so SF=1.5 ($/)
Receive $150 and pay out 100 Strategy: Sell $140 forward, receive 100 at t=1 (actual forward contract) Borrow 90.09 in UK money market at t=0 (owe 100 at t=1) Convert 90.09 into $136.36 in spot market at t=0 Lend $136 in US money market receive $150 at t=1(synthetic) Riskless Profit = $150 - $140 = $10
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Speculation in Forward Market

Bank will try and match hedgers in F-mkt to balance its currency book Open Position Suppose bank has forward contract. at F0 = 1.50 $ / , to pay out 100,000 and receive $150,000 One year later : ST = 1.52 $ / Buy 100,000 spot and pay $152,000 But only receive $150,000 from the f.c. Loss (or profit) = ST - F0
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Foreign Currency Futures

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Futures: Contract Specification

Table 4.1 : Contract Specifications IMM Currency Futures(CME) Size Tick Size [Value] Initial Margin Margin Maintenance Margin 1 Pound Sterling 62,500 0.02 per [$12.50] $2,000 2 Swiss Franc SF125,000 3 Japanese Yen Y12,500,000 4 Canadian Dollar CD100,000 5 Euro 125,000 0.01 per SFr $2,000

0.01 per 100JY[$12.5] $1,500 0.001 ($/CD)[$100] $900

0.01 per Euro [$12.50] varies

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Futures: Hedging S0 = spot rate = 0.6700($/SFr) F0 = futures price (Oct. delivery) = 0.6738($/SFr) Contract Size, z = SFr 125,000 Tick size, (value) = 0.0001($/SFr) ($12.50)

US Importer TVS0 = SFr 500,000

Vulnerable to an appreciation of SFr and hence takes a long position in SFr futures Nf = 500,000/125,000 = 4 contracts
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Futures: Hedging
Net $-cost = Cost in spot market - Gain on futures = TVS0 S1 - Nf z (F1 F0) = TVS0 (S1 - F1 + F0) = TVS0 (b1 + F0) = $ 360,000 - $ 23,300 = $ 336,700 Notes: Nfz = TVS0 Hedge locks in the futures price at t=0 that is F0, as long as the final basis b1 = S1 - F1 is small. Importer pays out $336,700 to receive SFr 500,000 which implies an effective rate of exchange at t=1 of : [4.14] Net Cost/TVS0= b1 + F0 = 0.6734 ($/SFr)

~close to the initial futures price of F0 = 0.6738($/SFr) the difference being the final basis b1 = -4 ticks.
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Slides End Here

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