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The Foreign Exchange Market (Part II)

The Foreign Exchange Market (Part II). Learning Outcomes. Foreign currency forwards Foreign currency futures. 1. Forward Currency Contracts. Definition.

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The Foreign Exchange Market (Part II)

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  1. The Foreign Exchange Market(Part II)

  2. Learning Outcomes • Foreign currency forwards • Foreign currency futures © 2002 by Stefano Mazzotta

  3. 1. Forward Currency Contracts

  4. Definition • A forward currency contract is an agreement to buy or sell a specified amount of one currency against another one at a certain time in the future for a certain price (the delivery price). • The parties of the contract are usually two banks or a bank and a non-financial institution. It is an OTC agreement. © 2002 by Stefano Mazzotta

  5. Terminology • The party that has agreed to buy a currency at a future date is said to take a long position; the counterpart, i.e. the future seller is said to take a short position. • The future buyer is also said to buy the currency forward; the future seller is said to sell it forward. • The reference currency must be specified though, since buying currency A forward against currency B is equivalent to selling B forward against A © 2002 by Stefano Mazzotta

  6. Characteristics of the forward contract • The forward contract entails the obligations and rights object of the contract for both parties of the contract. • The exchange rate – the price to be paid at a future date for one currency in term of the other - is fixed at the time the contract is initiated. • The initial value of the contract is zero, it changes during the life of the contract. © 2002 by Stefano Mazzotta

  7. Why using forwards? • To reduce risk: • To lock in the price of a currency that is needed in the future. • To eliminate the uncertainty of future exchange rate fluctuations. • To increase risk • To speculate on one’s belief or private information © 2002 by Stefano Mazzotta

  8. Example EXCHANGE RATES Tuesday, February 6, 1990 The New York foreign exchange selling rates below apply to trading among banks in amounts of $1 million and more, as quoted at 3 p.m. Eastern time by Bankers Trust Co. Retail transactions provide fewer units of foreign currency per dollar. Currency U.S. $ equiv. per U.S. $ Country Tues. Mon. Tues. Mon. Switzerland (Franc) .6766 .6784 1.4780 1.4740 30-Day Forward .6759 .6778 1.4796 1.4754 90-Day Forward .6743 .6765 1.4830 1.4783 180-Day Forward .6724 .6748 1.4873 1.4820 Source: The Wall Street Journal © 2002 by Stefano Mazzotta

  9. Example: The question • A U.S. aeronautics equipment company buys some parts from Quebec with the payment of C$ 10,000,000 which is scheduled in 180 days. • It is possible that in the coming months the U.S. dollar will depreciate against the Canadian dollar. • What will happen with the cost of the parts from Quebec for the American firm? © 2002 by Stefano Mazzotta

  10. Example: The exchange risk Payment cost $6,724,000 0.6724 $/CAD <- $ appreciates -> $ depreciates © 2002 by Stefano Mazzotta

  11. Example: The solution (I) • The cost of all imports from Quebec will increase. What can the U.S. firm do? • Hedge its risk exposure with respect to appreciating Canadian dollar. • How to do it? Contact a bank. • Buy (long) C$ 10,000,000 at 0.6724 USD/CAD in the forward market using a 180-day forward contract. © 2002 by Stefano Mazzotta

  12. Example: The solution (II) • If the contract is initiated, on its 180th day, the bank will have to pay C$ 10,000,000 to the firm. • The firm will pay the bank the following: • In the end, the U.S. firm will pay to its Quebec parties $6,724,000 equivalent of CAD in 180 days and the firm knows about it now. No exchange rate trouble! © 2002 by Stefano Mazzotta

  13. Example: The resulting risk is flat i.e. there is no uncertainty Payment cost $6,724,000 0.6724 $/CAD © 2002 by Stefano Mazzotta

  14. Example: In words • The U.S. firm has to hedge a future purchase of a foreign currency in the spot market with a long position in the forward currency market. • The bank has to find a customer who needs to hedge a sale of the same currency at the same future date in the spot market with a short position in the forward currency market. © 2002 by Stefano Mazzotta

  15. Example: What if? • What if 180 days later and entering the forward the C$ depreciates against $. What does the forward do to the U.S. firm? Does the firm lose money? How much? • C$ 10,000,000 times the difference between the forward rate and spot rate on the 180th day. © 2002 by Stefano Mazzotta

  16. Example: The final picture Payment cost Forward contract gain $6,724,000 Forward contract loss $/CAD 0.6724 © 2002 by Stefano Mazzotta

  17. Forward quotations • Outright price: • The actual price, such as the 180-day USD/CAD price of 0.6724. It is used for commercial customers. • The swap rate: • The difference between forward and spot rates. It is used by professionals. • Forward is at premium if forward rate > spot rate. • Forward is at discount if forward rate < spot rate. © 2002 by Stefano Mazzotta

  18. Examples • The spot SF/$ is 1.5625. • The 90-day forward quote is 1.5450. • The forward is quoted at 175 point discount. • The spot SF/$ is 1.5625. • The 90-day forward quote is 1.5800. • The forward is quoted at 175 point premium. © 2002 by Stefano Mazzotta

  19. Example © 2002 by Stefano Mazzotta

  20. Forward spreads • Bid-ask spreads for forwards are wider than for spot quotes. Why? • More uncertainty about distant spot rates than those in the near future. • Therefore, spreads usually increase with the maturity of the contract. • But they also decrease with the liquidity. © 2002 by Stefano Mazzotta

  21. 2. Foreign Currency Futures

  22. Definition • A futures contract is an agreement to buy or sell a commodity at a date in the future. • Everything about a futures contract is standardized except its price. • All of the terms under which the commodity, service or financial instrument is to be transferred are established before active trading begins, there is no ambiguity. • The price for a futures contract is what’s determined in the trading pit or on the electronic trading system © 2002 by Stefano Mazzotta

  23. Characteristics of the futures contract (I) • A specific-sized contract: • Standardized contracts per currency. • A standard quotation method: • The “American” method. • A trading location: • Trading occurs only on the exchange floor. • Trading hours: • Usual trade is among brokers on the floor; currently many exchanges move to 24-hour electronic trading. © 2002 by Stefano Mazzotta

  24. Characteristics of the futures contract (II) • A standard maturity day: • The third Wednesday of January, March, April, June, July, September, October and December. • A specified last trading day: • At IMM contracts may be traded through the second business day prior to the Wed. on which they mature. • Daily marking-to-market: • Changes in the contract value are paid in cash daily. • Collateral: • The purchaser of a contract must deposit a collateral or initial margin. © 2002 by Stefano Mazzotta

  25. Web resources • http://www.cme.com/products/currency/index.cfm • http://www.cme.com/education/courses/interactive_features/education_courses_interactivefeatures_webinstantlessons.cfm • Web Instant Lessons Sggested: • Futures Contract • Futures ExchangeContracts • PitTrading • PitWho's Who • Risk ManagementHedgers & Speculators • Facts & Stats • GLOBEX \ • Futures Intelligence Quiz check this out too © 2002 by Stefano Mazzotta

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