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Forwards, Futuresand Money Market Hedging
Prof. Ian Giddy
New York University
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 9
Hedging Transactions Exposure
Types of exposure One-shot exposure Hedging approaches:
OpenForwardMoney marketFuturesOptions
Ongoing transactions exposure
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 10
Tools for Hedging
Petrobras has to pay for equipment from Japan, in Japanese yen, in 3 monthsBorrow and pay now?Use a forward contract/FX swap?Pay later at spot?
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 11
Forward Contracts, Futuresand Money Market Hedging
Money market hedging: match currency of assets and liabilities
Forwards: OTC agreement to exchange currencies at certain exchange rate in the future
FX swap: simultaneous spot sale and forward purchase of a currency
Futures: Exchange-traded contracts for notional future delivery, minimizing default risk via marking-to-market
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 12
Forward Contracts
Agreement to exchange currencies at certain exchange rate in the future
Default risk in forward contracts arises because such a contract is a commitment for future performance, and one or other party may be unwilling or unable to honor that commitment.
On the settlement date, one party in effect owes the other party a net amount.
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 13
A Typical Forward Contract
We agree today to pay a certain price for a currency in the future
BackusBackus SAN-
TANDER
SAN-
TANDER
Soles
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 14
Customization, Performance Riskand Liquidity
Customization implies bilateral contracts, which carry performance risk
Liquidity implies standardization and freedom from counterparty risk, through exchange-traded contracts
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 15
How Does the Bank Hedge a Forward Contract?
Hedging approaches:OpenForwardSpot plus swapRolloverMoney market
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 16
Foreign Exchange Quotations
Spot Forward points
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 17
How Banks Hedge
SHORT LONG
Today
T+2
T+90
Methods:
- Spot + swap
- Spot + rollover swap
- Money market
- Outright forward
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 18
The FX Swap Hedge
3-month Forward Contract
3-month Swap
Dealers typically hedge a forward foreign-exchange commitment with a spot plus “FX Swap”: spot sale plus forward purchase of a foreign currency
The FX swap rate is determined by the interest differential
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 19
The Roll-Over Swap Hedge
6-month Forward Contract
3-month Swap 3-month Swap
Dealers often hedge a long-term foreign-exchange commitment with shorter-term contracts, which are “rolled over” as they come due
Corporations themselves do this too.
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 20
The FX Swap Hedge
3-month Forward Contract
Borrow USD
Invest in DEM
Dealers also hedge a forward commitment in the money market: borrow the currency you will be receiving, and invest in the currency you will be paying
The FX swap rate is determined by the interest differential
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 21
110
115
120
125
130
135
140
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
EXCHANGERATE, YENPER US$
FORWARDPREMUIM,PERCENTPER ANNUM
FORWARD(LEFT SCALE)
SPOT (LEFT SCALE)
FORWARD PREMIUM(RIGHT SCALE)
MONTHLY DATA, 1987-1989
FORWARD PREMIUM = [(SPOT-FORWARD)/SPOT]*(12/3)*100
The Forward Rate Tracks the Spot Rate
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 22
Linkages Between Interest Rates
Interest rate
differential
Interest rate
differential
Forward
premium
Forward
premium
Expected
% change in
exchange rate
Expected
% change in
exchange rate
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 23
Cost of Hedging
Type of Hedge Cost of HedgingForward Forward premium
Money Market Hedge(Borrow to matchassets)
Interest ratedifferential
Do nothing Expected rate ofchange ofexchange rate
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 24
Frutas Amazonas
Type of Hedge Cost of HedgingForward 2.5%
Money Market Hedge(Borrow to matchassets)
2.375%
Do nothing 2/128 x 4= 6.25% gain(or 2.5% loss?)
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 25
Bid and Offer Quotations in the Long-Dated Forward Market
1.3
1.35
1.4
1.45
1.5
1.55
1.6
1.65
1.7
1.75
1.8
1.85
1.9
SPOT 2 YR 3 YR 4 YR 5 YR 7 YEAR 10 YEAR
.05%
.63%
1.25%1.44%
1.62%3.96%
6.34%
EXCHANGERATE,DOLLARSPER POUNDSTERLING
OFFER
BID
MATURITY OF FORWARD CONTRACT
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 26
Forwards, Money Market Hedgingand Futures Forward contracts: OTC contracts for future
delivery, often settled in cash Forwards can be used in
1. Hedging
2. Positioning
3. Arbitrage Interest rate parity means that a forward
hedge is, normally, the same as a money market hedge.
Futures are free of default risk.
Marking-to-Market of aFutures Contract
0.625
0.63
0.635
0.64
0.645
0.65
-25 -20 -15 -10 -5 -1
SHORT POSITION
LONG POSITION
DAILY GAINS AND LOSSES
DAILY DMFUTURES PRICEMOVEMENTS
FUTURES
SPOT
FUTURES PRICES,US$ PER MARK
DAYS BEFORE SETTLEMENT DATE
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 28
Forwards vs Futures vs Options
Good credit: Forward usually best Sometimes, Money Market Hedge better
Perfect market: same (covered int. arb.) Imperfect market: MMH may be better
Credit problem: FuturesBut: limited and standardizedRequires margin and daily settlement
Uncertain future cash flows: Liquid instrument (futures/forwards to assure
flexibilityOptions sometimes advisable
Copyright ©1999 Ian H. Giddy Forwards, Futures and Money-Market Hedging 29