Giddy Forwards, Futures and Money-Market Hedging/1

Forwards, Futures
and Money Market Hedging

Prof. Ian Giddy

New York University

Hedging Transactions Exposure

l Types of exposure
l One-shot exposure
l Hedging approaches:
u Open
u Forward
u Money market
u Futures
u Options

l Ongoing transactions exposure

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Tools for Hedging

l Petrobras has to pay for equipment from

Japan, in Japanese yen, in 3 months
u Borrow and pay now?
u Use a forward contract/FX swap?
u Pay later at spot?

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Forward Contracts, Futures

and Money Market Hedging
l Money market hedging: match currency
of assets and liabilities
l Forwards: OTC agreement to exchange
currencies at certain exchange rate in
the future
l FX swap: simultaneous spot sale and
forward purchase of a currency
l Futures: Exchange-traded contracts for
notional future delivery, minimizing
default risk via marking-to-market
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Forward Contracts

l Agreement to exchange currencies at

certain exchange rate in the future
l 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.
l On the settlement date, one party in
effect owes the other party a net
amount.
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A Typical Forward Contract

l We agree today to pay a certain price

for a currency in the future

Soles

SAN-
SAN-
Backus
Backus TANDER
TANDER

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Customization, Performance Risk

and Liquidity

l Customization implies bilateral

contracts, which carry performance risk

l Liquidity implies standardization and

freedom from counterparty risk, through
exchange-traded contracts

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How Does the Bank Hedge a Forward

Contract?
Hedging approaches:
u Open
u Forward
u Spot plus swap
u Rollover
u Money market

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Foreign Exchange Quotations

Spot Forward points

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How Banks Hedge

SHORT LONG

Today

T+2

T+90
Methods:
- Spot + swap
- Spot + rollover swap
- Money market
- Outright forward
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The FX Swap Hedge

3-month Swap

3-month Forward Contract

l Dealers typically hedge a forward foreign-

exchange commitment with a spot plus “FX
Swap”: spot sale plus forward purchase of a
foreign currency
l The FX swap rate is determined by the
interest differential
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The Roll-Over Swap Hedge

3-month Swap 3-month Swap

6-month Forward Contract

l Dealers often hedge a long-term foreign-

exchange commitment with shorter-term
contracts, which are “rolled over” as they
come due
l Corporations themselves do this too.
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The FX Swap Hedge

Borrow USD
Invest in DEM

3-month Forward Contract

l 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
l The FX swap rate is determined by the
interest differential
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The Forward Rate Tracks the Spot Rate

SPOT
(LEFT SCALE)
EXCHANGE
RATE, YEN
PER US$

140 24
23
22
FORWARD 21
135 (LEFT SCALE) 20
19
18
17
130 16
15
14
13
FORWARD
125 12
PREMUIM,
PERCENT
11
PER ANNUM
10
9
120 8
7
FORWARD PREMIUM 6
(RIGHT SCALE) 5
115 4
3
2
1
110 0
MONTHLY DATA, 1987-1989

FORWARD PREMIUM = [(SPOT-FORWARD)/SPOT]*(12/3)*100

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Linkages Between Interest Rates

Interest
Interest rate
rate
differential
differential

Expected
Expected
Forward
Forward
%
% change
change in
in
premium
premium
exchange
exchange rate
rate

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Cost of Hedging

Type of Hedge Cost of Hedging

Forward Forward premium

Money Market Hedge Interest rate

(Borrow to match differential
assets)
Do nothing Expected rate of
change of
exchange rate
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Corporate Hedging Decisions:

Frutas Amazonas
Exporting bananas to Spain, get paid in
Spanish pesetas. Funding is in U.S.
dollars.

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Corporate Hedging Decisions:

Frutas Amazonas
l Continue funding in U.S. dollars. The
peseta might get stronger in the next
three months, from $1=128 pesetas to
$1=126 pesetas. This could be the
cheapest
l Switch funding to pesetas, despite the
slightly higher cost
l Borrow in dollars, but hedge the
exchange risk in the forward market.

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Frutas Amazonas

Eurodollar 3-month 5 9/16%

loan rate
Europeseta 3- 7 15/16%
month loan rate
Spot exchange Pta128.210 per
rate today USD
Forward exchange Pta129.005 per
rate today USD
Forward discount, -2.5
% per annum

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Frutas Amazonas

Type of Hedge Cost of Hedging

Forward 2.5%

Money Market Hedge 2.375%

(Borrow to match
assets)
Do nothing 2/128 x 4
= 6.25% gain
(or 2.5% loss?)
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Bid and Offer Quotations

in the Long-Dated Forward Market
EXCHANGE
RATE,
DOLLARS
PER POUND
STERLING

.05%
1.9

1.85

1.8
.63%
1.75
1.25%
1.7 1.44%
1.65 1.62%
1.6
3.96%
1.55
6.34%
1.5
OFFER
1.45

1.4
BID
1.35

1.3
SPOT 2 YR 3 YR 4 YR 5 YR 7 YEAR 10 YEAR

MATURITY OF FORWARD CONTRACT

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Forwards, Money Market Hedging

and Futures
l Forward contracts: OTC contracts for
future delivery, often settled in cash
l Forwards can be used in
1. Hedging
2. Positioning
3. Arbitrage
l Interest rate parity means that a forward
hedge is, normally, the same as a
money market hedge.
l Futures are free of default risk.
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FUTURES PRICES,
DAILY DM
Marking-to- US$ PER MARK
0.65
FUTURES PRICE
MOVEMENTS
Market of a 0.645

Futures 0.64
FUTURES

Contract 0.635
SPOT

0.63

0.625
-25 -20 -15 -10 -5 -1
DAYS BEFORE SETTLEMENT DATE

LONG POSITION

DAILY GAINS AND LOSSES

SHORT POSITION

Forwards vs Futures vs Options

l Good credit: Forward usually best

l Sometimes, Money Market Hedge better
u Perfectmarket: same (covered int. arb.)
u Imperfect market: MMH may be better

l Credit problem: Futures

u But:
limited and standardized
u Requires margin and daily settlement

l Uncertain future cash flows:

u Liquid instrument (futures/forwards to assure
flexibility
u Options sometimes advisable

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