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Chapter 4

Chapter 4. Currency Derivatives. Forward Contract. “An agreement between a commercial bank and a client about an exchange of two currencies to be made at a future point in time at a specified exchange rate” Forward rate:

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Chapter 4

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  1. Chapter 4 Currency Derivatives

  2. Forward Contract “An agreement between a commercial bank and a client about an exchange of two currencies to be made at a future point in time at a specified exchange rate” Forward rate: “ Rate at which a bank is willing to exchange one currency for another at some specified date in future”

  3. Long Position: It implies that the holder of contract has agreed to buy the currency • Short Position: It implies that the holder of contract has agreed to sell the currency

  4. Forwards have no secondary market • It means holder can not get out of the commitment • He can not sell the contract What he can do? • He can enter into another contract of the same maturity date • So that he can offset the contract • But the contract can not be cancelled

  5. Example • A firm enters into the contract to buy INR 100000 @ forward rate of PKR 1.50 • On maturity date if the spot increases to 1.70 • He will buy INR @ PKR 1.50 1.50 * 100000 He will pay = PKR 150000 Otherwise @ spot PKR 1.70 He had to pay 170000 170000-150000 Profit = 20000

  6. Calculation of Points • INR/PKR: 1.50/1.60 3-months: 30/20 (High / Low = Subtract) i.e. 1.60 - .20 1.40 • INR/PKR: 1.50/1.60 3-months: 20/30 (Low/High = Add) i.e. 1.60 + .30 1.90

  7. Forward-Forward Swap • It’s a contract between two forward dates Eg: • combined with Three month forward purchase One month forward sale

  8. Example Suppose GBP/USD spot: 1.7580/90 1-month 20/10 2-month 30/20 3-month 40/30 6-month 40/30 12-month 30/20 • EXPECTATIONS After 6-months • GBP rates may fluctuate in future (6-months) • 6-month swap points may be favorable

  9. Q. How can he profit from this forecast • Buy 12 months forward sterling 5 million • --- six month later when GBP value has changed • Sell 6 months forward sterling After 6 months Suppose rates are: GBP/USD spot: 1.7585/95 6 months: 40/60

  10. Calculation FIRST: He can buy 12-month forward GBP 5 m @ 1.7570 Suppose rates are: GBP/USD spot: 1.7580/90 12-months: 30/20 • After selecting Ask price of 1.7590 • Subtract 20 points from last digits (H/L=Subtract) i.e. 1.7590 - 20 1.7570

  11. Calculation Second He can sell 6-month forward GBP 5 m @ 1.7625 Suppose rates are: GBP/USD spot: 1.7585/95 6-months: 40/60 • After selecting Bid price of 1.7585 • Add 40 points in last digits (L/H = Add) i.e. 1.7585 + 40 1.7625

  12. Calculation • He sold 6-month forward GBP 5 m @ 1.7625 • He bought 12-month forward GBP 5 m @ 1.7570 Gain $ 0.0055/GBP Gain: 0.0055 * 5m = $ 27500

  13. Risk After 6 months • If the GBP Depreciates than….. Suppose GBP/USD Spot: 1.7000/05 6-month: 40/60 • He will sell @ 1.7040 i.e. 1.7000 1.7570 +401.7040 1.7040 loss - 0.0530 Therefore a loss of: 0.0530 * 5m = ????

  14. Example On day 1 do two swaps • Buy GBP 5 m spot • Sell 5 m GBP 6-months forward and • Sell GBP 5 m spot • Buy 5 m GBP 12-months forward Suppose both are done @ a spot rate of 1.7580

  15. Calculation • Suppose both are done @ a spot rate of 1.7580 First: Sell 6-months forward If the points are 40/30 GBP/USD spot: 1.7580 - 40 1.7540 Second: Buy 12-months forward If the points are 30/20 GBP/USD spot: 1.7580 - 20 1.7560

  16. Buy GBP @ Spot 5m SELL forward 6-months - GBP 5000000 + USD 8770000 (5m @ 1.7540) Sell GBP @ Spot 5m BUY forward 12-months + GBP 5000000 - USD 8780000 (5m @ 1.7560) On day 1The planned cash flows are:

  17. Calculation 6-months later GBP has fluctuated Suppose GBP/USD Spot: 1.7005 6-months: 80/160 --- (L/H:Add) Now • Buy GBP 5m spot @ 1.7005 • Sell GBP 5m 6-months forward @ 1.7085

  18. SPOT BUY + GBP 5000000 - USD 8502500 (5m @ 1.7005) SELL Forward 6-months - GBP 5000000 + USD 8542500 (5m @ 1.7085) After 6-monthsThe planned cash flows are:

  19. + USD 8770000 (5m @ 1.7540) - USD 8502500 (5m @ 1.7005) 267500 Total Gain: - USD 8780000 (5m @ 1.7560) + USD 8542500 (5m @ 1.7085) 237500 30000 Matching cash flows

  20. Discount or Premium • Forward Discount: Percentage by which the forward rate is less than the spot rate • Forward Premium Percentage by which the forward rate is more than the spot rate

  21. Testing Question • You expect that the USD will fluctuate in future (in 3-months) Suppose the rates are: USD / INR Spot: 42.92 / 42.93 1-month 50/40 2-month 60/50 3-month 70/60 6-month 75/65 9-month 90/80

  22. You can do two swaps • Buy USD 2 hundred thousand spot • Sell USD 2 hundred thousand 3-months forward and • Sell USD 2 hundred thousand spot • Buy USD 2 hundred thousand 9-months forward Suppose both swaps are done @ a spot rate of 42.93

  23. After 3-months USD has fluctuated Suppose USD / INR Spot: 43.90 6-months: 85/95 Now • Buy USD 2 hundred thousand spot • Sell USD 2 hundred thousand 6-months forward • Calculate the profit/loss at the end of the day

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