RU/SAMS/IFM/ANS

Lesson 12: Forward Quotations and Contracts

Learning objective: To expose you to the mechanics of the functioning of the intermediary and derivative instruments such as forward quotations, option forwards, swaps; short date contracts are effectively used in the foreign exchange market to gain leverage. FORWARD QUOTATIONS Outright Forwards Quotations for outright forward transactions are given in the same manner as spot quotations. Thus a quote that like: USD/SEK 3-Month Forward: 9.1570/9.1595 means, as in the case of a similar spot quote, that the bank will give SEK 9.1570 to buy a USD and require SEK9.1595 to sell a dollar, delivery 3 months from the corresponding spot value date. Calculate of inverse rates and the notion of two-point arbitrage also carries over from the corresponding spot rates. Given the above USD/SEK 3-month forward quotation, SEK/USD 3-month forward = (1/4.4595)/(1/1.4570) = 0.2242/0.2244 Similarly, calculations of synthetic cross rates and relation between synthetic and direct quotes to prevent three-point arbitrage are also same as in case of spot rates. Given USDIINR I-month forward: 47.6955/47.6965 USD/CHF I-month forward: 1.4550/1.4555 The synthetic CHF/INR I-month forward quote is: CHF/INR I-month forward = (47.6955/1.4555)/(47.6865/1.4550) = 32.7691/32.7811 We will see below that in the interbank market, forward quotes are given not in this manner but as a pair of "swap points", to be added to or subtracted from the spot quotation. Option Forwards A standard forward contract calls for delivery on a specific day, the settlement date for the contract. In inter-bank market, banks offer what are known as optional forward contracts or option forwards. Here the contract is entered into at some time to, with the rate and quantities being fixed at this time, but the buyer has the option to take or make delivery on any day between t1 and t2 with t2> t1 > to. Margin Requirement When a forward contract is between two banks, nothing more than a telephonic

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RU/SAMS/IFM/ANS agreement on the price and amount is involved. However, when a bank enters into a forward deal with a non-bank corporation, it will want to protect itself against the possibility that the firm may default on its commitment. (Remember that the bank will have squared its position by entering into an opposite forward contract with another party. If the firm defaults, the bank must fulfill its commitment to that party possibly by buying the relevant currency in the spot market, and the rates may have moved against the bank in the meanwhile. This is known as "reverse exchange rate risk".) If the firm has a credit line with the bank, the amount of the credit line will be usually reduced by the amount involved in the forward contract. The forward desk must obtain the approval of the bank's credit department before entering into a forward contract with a party that is not the bank's usual client. Sometimes the bank may decline a customer's request for a forward contract if it cannot satisfactorily verity the customer's credit status. Sometimes, the bank may ask the firm for collateral in the form of a deposit equal to a certain percentage of the value of the contract. The deposit earns interest so there is no explicit cash cost. It is only a performance bond. Swaps in Foreign Exchange Markets: Swap Margins and Quotations Recall that a swap transaction between currencies A and B consists of a spot purchase (sale) of A coupled with a forward sale (purchase) of A both against B. The amount of one of the currencies is identical in the spot and forward. Since usually there will be a forward discount or premium on a vis--vis B, the rate applicable to the forward leg of the swap will differ from that applicable to the spot leg. The difference between the two is the swap margin, which corresponds to the forward premium or discount. It is stated as a pair of swaps points to be added to or subtracted from the spot rate to arrive at the implied outright forward rate. We will clarify this in detail shortly. While banks quote and do outright forward deals with their non-bank customers, in the inter-bank market forwards are done in the form of swaps. Thus, suppose a bank buys pounds one month forward against dollars from a customer, it has created a long position in pounds (short in dollars) one-month forward. If it wants to square this in the inter-bank market it will do it as follows: A swap in which it buys pounds spot and sells one month forward, thus creating an offsetting short pound position one month forward Coupled with a spot sale of pounds to offset the long pound position in spot created in the above swap. The reason for this is that it is very difficult to find counter parties with matching opposite needs to cover the original position by an opposite outright forward, whereas swap position can be easily offset by dealing in the Euro deposit markets. As mentioned above, in the interbank market outright forward quotes for a given maturity are derived from the spot quote and a pair of swap margins applicable to that maturity. Forward - Forward Swaps The swaps we have looked at so far are spot-forward swaps it is possible to do a

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RU/SAMS/IFM/ANS swap between two forward dates. For instance, purchase (sale) of currency a 3-months forward and simultaneous sale (purchase) of currency a 6-months forward, both against currency B. Such a transaction is called a forward-forward Swap. It can be looked upon as a combination of two spot forward swaps: 1. 2. Sell a spot and buy 3-months forward against B. Buy A spot and sell 6-months forward against B

In such a deal, both the spot-forward swaps will be "done off' an identical spot so that the spot transactions cancel out. The customer (and the bank) has created what is known as a swap position-matched inflow and outflow in a currency but with mismatched timing, with an inflow of three months hence and a matching outflow six months hence. The gain / loss from such a transaction depends only on the relative sizes of the three-month and six-month swap margins. Pricing of Short - Date and Broken Date Contracts: Short - Date Contracts We have seen above that the normal value date for a spot transaction is two business days ahead. It is possible to deal for shorter maturities, that is, value same day-"cash"--or value next day-"tom" or tomorrow-in currencies whose time zones permit the transaction to be processed. For instance, it is possible to do a /$ deal for delivery same day, because the five-to-six hour delay between New York and London allows instructions to be transmitted to, and processed in New York. A $/ deal for same day value would not be possible because by the time New York opens for business, Tokyo is closed. Short date transactions are those in which value date is before the spot value date.13 in this section we will explain the pricing of such deals. In the foreign exchange markets, one-day swaps are quoted between today and tomorrow (overnight or GIN), tomorrow and the next day (tom/next or TIN), and spot date and the next day (spot/next or SIN). Note that the TIN swap is between tomorrow and the spot date. These swap rates are governed by the relevant interest rate differentials for one-day borrowings. These swaps are used for rolling over maturing positions. Broken Dates We have seen that banks normally quote forward rates for certain standard maturities, viz. 1,2,3,6,9, and 12 months. However, they offer deals with any maturity, for instance, 47 days or 73 days etc. that is not in whole months. Such deals are called broken date or odd date deals. Rates for such deals are calculated by interpolating between two standard dates. Thus suppose today is September 7, the spot date is September 9 and we have: GBP/USD Spot: 1.7075/80 2 months: 45/35 3 months: 120/110

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We want the bid rate for GBP for November 19. This is 2 months and 10 days from the spot date. The premium over the third month is (120 - 45) = 75 points, and there are 30 days between November 9 and December 9. This is distributed pro-rata to get 10 days' points as (10/30) X 75 = 25, which are added to the two month points to give a total premium of 70 points and an outright bid rate of (1.7075 - 0.0070) = 1. 7005.

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