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Forwards, Futures and Money Market Hedging

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Forwards, Futures and Money Market Hedging 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: uOpen uForward uMoney market uFutures uOptions l Ongoing transactions exposure Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 7 Giddy Forwards, Futures and Money-Market Hedging/2 Tools for Hedging l Petrobras has to pay for equipment from Japan, in Japanese yen, in 3 months uBorrow and pay now? uUse a forward contract/FX swap? uPay later at spot? Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 8 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 Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 9 Giddy Forwards, Futures and Money-Market Hedging/3 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. Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 10 A Typical Forward Contract l We agree today to pay a certain price for a currency in the future Soles SAN-SAN- BackusBackus TANDERTANDER Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 11 Giddy Forwards, Futures and Money-Market Hedging/4 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 Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 12 How Does the Bank Hedge a Forward Contract? Hedging approaches: uOpen uForward uSpot plus swap uRollover uMoney market Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 13 Giddy Forwards, Futures and Money-Market Hedging/5 Foreign Exchange Quotations Spot Forward points Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 14 How Banks Hedge SHORT LONG Today T+2 T+90 Methods: - Spot + swap - Spot + rollover swap - Money market - Outright forward Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 15 Giddy Forwards, Futures and Money-Market Hedging/6 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 Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 16 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. Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 17 Giddy Forwards, Futures and Money-Market Hedging/7 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 Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 18 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 FORWARD 13 125 PREMUIM, 12 PERCENT 11 PER 10 ANNUM 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 Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 19 Giddy Forwards, Futures and Money-Market Hedging/8 Linkages Between Interest Rates InterestInterest raterate differentialdifferential ExpectedExpected ForwardForward %% changechange inin premiumpremium exchangeexchange raterate Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 20 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 Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 21 Giddy Forwards, Futures and Money-Market Hedging/9 Corporate Hedging Decisions: Frutas Amazonas Exporting bananas to Spain, get paid in Spanish pesetas. Funding is in U.S. dollars. Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 22 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 $1=126 pesetas. This could be the cheapest l Switch funding to pesetas, despite the slightly higher cost l Borrow in dollars, but hedge the exchange risk in the forward market. Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 23 Giddy Forwards, Futures and Money-Market Hedging/10 Frutas Amazonas Eurodollar 3-month 5 9/16% loan rate Europeseta 3- 7 15/16% month loan rate Spot exchange Pta128.210 per rate today USD Forward exchange Pta129.005 per rate today USD Forward discount, -2.5 % per annum Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 24 Frutas Amazonas Type of Hedge Cost of Hedging Forward 2.5% Money Market Hedge 2.375% (Borrow to match assets) Do nothing 2/128 x 4 = 6.25% gain (or 2.5% loss?) Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 25 Giddy Forwards, Futures and Money-Market Hedging/11 Bid and Offer Quotations in the Long-Dated Forward Market EXCHANGE RATE, DOLLARS PER POUND STERLING .05% 1.9 1.85 1.8 .63% 1.75 1.25% 1.7 1.44% 1.65 1.62% 3.96% 1.6 1.55 6.34% 1.5 OFFER 1.45 1.4 BID 1.35 1.3 SPOT 2 YR 3 YR 4 YR 5 YR 7 YEAR 10 YEAR MATURITY OF FORWARD CONTRACT Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 26 Forwards, Money Market Hedging and Futures l Forward contracts: OTC contracts for future delivery, often settled in cash l Forwards can be used in 1. Hedging 2. Positioning 3. Arbitrage l Interest rate parity means that a forward hedge is, normally, the same as a money market hedge. l Futures are free of default risk. Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 27 Giddy Forwards, Futures and Money-Market Hedging/12 FUTURES PRICES, US$ PER MARK DAILY DM Marking-to- FUTURES PRICE 0.65 MOVEMENTS Market of a 0.645 Futures FUTURES 0.64 Contract SPOT 0.635 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 Perfect market: 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 Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 29 Giddy Forwards, Futures and Money-Market Hedging/13 Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 30.
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