Section 7.3 The Forward Market and 7.3 The Forward Market Section 4.5 Parity l Example of a : In May, a crude oil producer gets together with a refiner to agree on a price for crude oil. This price is for crude that will be delivered in six months, November. l The producer wishes to reduce his risk (that the price crude might fall in six months). The refiner wishes to reduce risk also, his worry is that crude prices might rise. This act of setting a price l Oct. 7, 2002 William Pugh today for a transaction in the future, is called hedging.

The Forward Market The Forward Market l Companies wishing to currency l A company that owes Yen, (for goods purchased exposure, usually do so with a currency dealer from Japan) is short (has liabilities in ) Yen. (often a money-center bank). Such a company decides to purchase Yen from l A company expecting to be paid in Swiss francs bank, at a set price today for delivery in 3 in 3 months is long (has assets in ) SFr. Such a months. company decides to sell these SFr to the bank, at l This company has engaged in a long hedge, that a set price today for delivery in 3 months. is, it has acquired (future) assets in Yen, to offset l This company has engaged in a short hedge, that its (future) liabilities in Yen. is, it has created a liability in SFr, to offset its l The two situations (SFr, Yen) are examples of a assets in SFr. forward hedge.

The Forward Market Participants in the Forward Market: l A. Definition of a Forward Contract: an legally l binding agreement between a bank (dealer) and a 1) Hedgers: start with either assets or liabilities customer (hedger) to deliver a specified amount in a foreign currency and use the exchange of currency against another currency at a markets to reduce currency exposure. specified future date and at a specified (fixed) l 2) Arbitrageurs: Start with no currency . exposure, they simultaneously buy in a cheap l Purpose of a Forward contract: Main purpose is market, sell in a dear market, leaving them still for Hedging - the act of reducing exchange rate with no net currency exposure. risk l The forward (and futures) market was supposedly invented for hedging (not gambling).

1 Participants in the Forward Market: Hedging using the Forward market l 3) Speculators: (gamblers) start with no l You import €1,000,000 worth of BMW parts. exposure, and take on currency exposure based BMW gives you 60days of “trade credit” on expectations of a currency rise or fall. (accounts payable for you; accounts receivable l Speculators usually do not have access to for them). forward markets, as forward markets are l You now have a liability in euros, thus you have dominated by commercial banks arranging currency risk - the euro may rise against the $. international trade financing. l Arrange with Nation’s Bank to buy € 1,000,000 l Thus speculators use only the futures and options for delivery in 60 days on the forward market. markets. Futures market “invented” by an angry “Lock in” at the 60-day rate. Milton Friedman? l You have just hedged your forex exposure.

The Forward Market The Forward Market l Calculating the Forward Premium or Discount: l Do everything in American terms simple annualization l Suppose the spot Mex$ is $.10 and the 30 day l Premium = f - e0 x 360 x 100% forward is $.099 l e0 n Prem = $.099 -$.10 x 360 x 100% l where f = the exchange rate currently available $.10 30 for some specific future. l = -.01 x 12 x 100% = -12% l l e0 = the spot rate of exchange This is called a forward discount. l n = the number of days in the forward contract l Uses the 360-day accounting year

The Forward Market The Forward Market l Forward Contract Maturities: Normal Contract l Banks profit from the bid-ask spread, as they do Terms are for 30-day, 90-day, 180-day, and in the spot market. 360-day. This is only because these are the l Spreads widen with longer maturities because typical lengths of trade credit offered by forward contract involve less more risk and less corporations. trading volume ( liquidity and competition). l Banks also offer longer-term contracts and odd l Client default risk becomes more of a problem maturities (e.g. 107 days). with forward contracts. l Banks offer a wide range of currencies (more than printed in the WSJ)

2 Alternative to the Forward Market Section 4.5 Interest Rate Parity l A company that owes Yen, (for goods purchased l from Japan) is short (has liabilities in ) Yen, can The forward rate is determined by a relationship either go long on the forward market or purchase called Interest Rate Parity (IRP). Yen today on the spot market. This second l IRP is nothing more than comparing the different strategy is called a money-market hedge. present value relations of the two currencies you l A company that is owed SFr. is long SFr. can go wish to trade with. short (sell the Sfr. on the forward market or l Present Value allows us to compare cash flows borrow SFr., (convert the Sfr. Loan into that occur at two different times. dollars today) then using the eventual payment from the Swiss customer to pay off the loan. This technique is also called a money-market hedge.

Interest Rate Parity Interest Rate Parity l Suppose the prevailing one-year interest rate in l Now suppose one peso is worth $0.10 on the the U.S. is 6%, then a dollar in year has a PV of spot market, what should the one-year forward $1.00/(1.06). This means that the typical lender exchange rate be? (or borrower) is indifferent to having $1.00 in l Ex: You owe a supplier Mex$ 1 million, due in one year or $.943 today. one year. You would like to set aside the funds l Suppose the Mexican one-year rate is 16%, then today for this forex payable. the typical lender and borrower in pesos, feels l 1) You could convert dollars to pesos now, and that ten pesos in one year is equivalent to hold the pesos in a Mexican bank - earning 16%. 8.6207 pesos today. One million peso discounted at 16% means that you need to first buy 862,067 pesos ($86,207).

Interest Rate Parity Interest Rate Parity l The previous is often called a money-market l Both forward and money market hedges are used hedge. frequently, because they usually provide the l 2) Another approach, the forward hedge, hold hedger with about the same benefits and costs: the $86,207 in a Eurodollar account in the same we should spend $86,207 either way. Mexican bank, where you would earn the dollar- l If the forward peso rate is too high, everyone will based 6% rate. At the same time, arrange to buy pesos using the spot market. If it too low, convert the dollars (plus interest) into peso at a everyone will buy pesos using the forward one-year forward rate. What should the forward market peso rate be?

3 Interest Rate Parity Interest Rate Parity l l 1) $86,207(1/e0)(1+.16) = Mex$1 million (mmkt) May be easier to see using FV (inverse of PV) M ex$862,070(1+.16) = Mex$1 million l Trade Date T =0 FV at T = 1 l 2) We are looking for a forward rate “f1” that will U.S $.10 $.10(1.06) cost the same in USD and give us the needed Mexico Mex$1.00 Mex$1.00(1.16) l pesos. $86,207(1+.06) (1/f1) = Mex$1 million The spot rate and the two interest rates establish l so $86,207(1/e0)(1+.16) = $86,207(1+.06) (1/f1) that these four expression are equivalent. l l (f1 /e0) = (1+.06) (1+.16) see equation 4.17 Thus, $.10(1.06) = Mex $1.00(1.16) l f1 = e0(1+.06) (1+.16) = $.09138/peso

Interest Rate Parity Interest Rate Parity l therefore the rate at which pesos and dollars contract at T = 0, for delivery in one year, is The IRP formula is thus

$.10(1.06) = Mex $1.00(1.16) f1 = e0 (1 + rh) l always use American terms in this course (1 + rf) l where r is the nominal rate in the home country, f1 = $.10(1.06)/Mex$1.00(1.16) h $.10/Mex$1.00 (1.06)/ (1.16) the foreign country’s rate is rf. l e0 (1.06)/ (1.16) = $0.09138 Nominal rate: the observed or contract rate. As opposed to the real or inflation-adjusted rate. l Here you must use decimal rather than percents.

Interest Rate Parity Interest Rate Parity l Consider a currency with a lower interest rate. l The forward rate (f) should differ from the spot l Suppose the spot rate on the Euro is $1.05 and rate (e0) by an amount approximately equal to the US interest rate is 6% and the Euro rate is the interest differential (rh - rf) between two 3%. What is the Euro’s six month forward rate? countries (The quick version) l You must apply only six month’s worth of l Suppose the Real sells for $.55 spot, the one interest: year interest rate in the US is 5% and Brazil’s l f = $1.05 (1 + .03) = $1.0655 is 20%. The Real will sell at forward (1 + .015) a premium discount one year out. l 5% - 20% @ -15%

4 Interest Rate Parity Interest Rate Parity l $.55 reduced by 15% is f = $.4675 l IRP is “enforced” by covered interest l a six month forward discount would be less : “Arbs” can make money when the because the effects of the interest difference forward rate does not equal the value predicted has been cut in half ( 7.5%) f = $.50875 by the IRP equation: l This is meant to be a “quick and dirty” l Hedgers enforce IRP too. method and is a good way to guess a forward l Ex: If the one year forward peso also sells for discount or premium at a glance. $0.10, then according to IRP, the forward peso is expensive. Hedgers expecting payments in peso will sell their exposure on the forward markets at ten cents.

IRP: Interest Rate Parity Interest Rate Parity predicts: l Hedgers with a liability in pesos one year out l 1.Currencies with higher interest rates will sell at will not buy pesos on the forward market, but forward discounts. Mexican Peso, Real buy them at spot for 10 cents and hold them in a l 2.Currencies with lower interest rates will sell at high yield peso account until the pesos are forward premiums. Yen, Swiss Franc, Euro. needed to satisfy the debts. (what about currency l Such effects are also seen on the currency futures risk?) market, also for gold and bond futures. l So hedgers are either buying pesos at spot or l Gold futures should sell at ….? selling them on the forward market. l Bond futures should sell at ….? l What should eventually happen?

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