Currency Futures and Swaps International Finance ‐ 04 Outline 1. The Market for Currency Futures 2. Markets for Currency Swaps Forward Contract is not Perfect There are two key imperfections in forward contracts: 1. Default risk: a. the customer fails to deliver ‐ the bank withholds the payment , b. the customer fails to buy ‐ the bank sells at spot ⟹ in both cases the net opportunity loss is , Ways of reducing default risk: • the right to offset –bank withdraws at the client’s default without breaching contract • credit lines (when dealing with banks) & credit agreements • restricted applications & shorter lives w/ option to rollover Forward Contract is not Perfect • margin in the form of interest‐baring deposit or of securities – form of collateral • the initial margin is posted ⟶ if market value of forward contract < 0 bank ask for additional margin ⟶ if customer fails to provide it, the bank seizes the margin and closes out • periodic reconstructing ‐ market value is computed every day – the party w/ negative value buys back the contract and new contract is signed ‐ if the loser fails to settle the value, the bank seizes the initial margin and closes out the contract 2. Illiquidity ‐ the lack of the secondary market prevents to easily sell forward contracts before maturity Futures contracts: alternative to forward contracts • Futures are forward transactions with standard contract sizes and maturity dates • Futures are standardized and are usually traded on an exchange created for this purpose (Chicago Mercantile/International Money Market is the largest one) • The average contract length is roughly 3 months. Futures contracts: currencies, sizes • USD/GBP – 65,500 GBP at IMM • USD/EUR – 125,000 EUR at IMM • EUR/USD – 50,000 USD at Stockholm, EUREX • USD/CHF – 125,000 CHF at IMM • USD/AUD, USD/NZD – 100,000 AUD‐NZD at IMM‐NZFE • USD/JPY – 12,500,000 JPY at IMM • USD/CAD – 100,000 at IMM Features of Future Contract A currency future contract's characteristics: • the initial value is zero • it stipulates delivery of a known number of FC units on a known future date T • the HC payment for the FC is known amount , & paid later Definition: buying a contract (purchase transaction) customer will get FC and pay it with HC Terminology: going long in FC / going long forex Features of Future Contract 1. Marking to market: measuring and recording a fair market value of asset (whose value changes over time) • we have daily cash flows , , with final payment , = ST • if , , < 0 buyer pays the seller • if , , > 0 seller pays the buyer • the payments are done through a clearing house • futures are similar to periodic reconstructing as in case of forward contract • but in forward contract changes are discounted, in futures not • in case of default, the loss is a one‐day marked‐to‐market outflow: all previous losses have already been settled Features of Future Contract Example: Implication of marking to the market At investor A buys EUR 1m at , = USD/EUR 0.960 At , = USD/EUR 0.890 At , = USD/EUR 0.889 and the investor A defaults Futures at investor A pays 1m (0.960 0.890) = USD 70000 as amarked‐to‐market cash flow. Because of default at , A does not pay 1m (0.890 0.889) = USD 1000 Forward the loss for the seller is 1m ( ) = 1m (0.960 0.889) = USD 71000 Features of Future Contract 2. Margin requirements • a buyer and seller should put up initial security that almost for sure covers a one‐day loss • initial margin • maintenance margin ‐ the minimal level of the margin; if reached margin call ‐ request to " the margin • failure to make a margin payment your position is liquidated • if you bought, the contract will be sold • if you were short, the contract will be bought • the loss or gain is subtracted from your margin Margin requirements also decrease the loss in case of default Features of Future Contract 3. Organized markets • forward contracts initiated over‐the‐counter and held until maturity • futures are traded on organized exchanges w/ specific terms of contracts, w/ an active secondary market 4. Standardized contracts • a future is standardized in size and expiration date • a forward contract is unique in size and expiry date Features of Future Contract 5. Clearing corporation • futures are not initiated between agents A and B, • but either party has a contract w/ a futures clearing corporation or clearing house • sale from A to B: A sells to clearing house clearing house sells to B • while in forward contracts , A sell to B directly Hedging with Future Contract Problems: • contract size is fixed it is unlikely to match the position to be hedged • the expiration dates of futures rarely match those of currency inflows/outflows which should be hedged • the choice of underlying assets in futures is limited – the currency one wished to hedge may not have a future contract the need for imperfect hedge: • cross‐hedge ‐ the currencies do not match • delta‐hedge ‐ the maturities do not match • cross‐and‐delta hedge ‐ currencies and maturities mismatch Generic Problem for Hedging w/ Futures We want to minimize the variance of the hedged cash flow 1. There is 1 unit of FC e ("exposure") to be received at time and will be converted into HC w/ spot rate . 2. The futures contract is available for a "related" currency h ("hedge") w/ expiration at 3. The size of the futures contract is 1 unit of FC h Generic Problem for Hedging w/ Futures 4. Contracts are infinitely divisible ‐ the fixed‐contract‐ size problem is ignored So, we want to minimize the variance of , , Where –the number of contract sold, – change in the prices btw t & , , Generic Problem for Hedging w/ Futures So slope coefficient from , , , , Where , Perfect Match There is a perfect match if • future contract expires at (that is, = ) • e = h • : on the last day of trading , the future price equal the spot rate 1 ‐ sell forward one for one Currency‐Mismatch Hedge or Cross‐Hedge • Future contract expires at (that is, = ) • e h • : on the last day of trading the future , price equal the spot rate In reality to run ∆ ´∆ ´, where ∆ denotes change of variable over time Currency‐Mismatch Hedge or Cross‐Hedge Since distribution of ∆S is still not constant, you might run the regressions with percentages " ", where ∆/ and use (by definition and ∆ ) ∆ / and is the cross rate • You assume that not but is constant / • Practitioners often guess 1 ⟹ • This rule is biased, but has zero sampling error Delta‐Hedge • Future contract does not expire at (that is, ) • e = h Since futures and forwards are almost indistinguishable 1 , 1 , ⟹ , , 1, 1, !!! ‐ interest rates are not know ahead of time now Delta‐Hedge The rule of thumb that there is no uncertainty abut interest rates and you assume some level of ratio 1 / 1 ⟹ , ⟹ a is like the forward‐looking regression coefficient of on The rule of thumb ‐ set the hedge ratio = the forecast ratio 1 / 1 • you can use the current n days rates or • forecast implicit on forward interest rates Cross‐and‐Delta Hedge The rule of thumb / • set the hedge ratio = x / • hedge ratio equals the current cross rate times the forecast ratio Adjusting for the Size of the Spot Exposure and the Future Contract So far we assume • exposure was 1 unit of currency j • the size of futures contract is 1 unit of FC i • if the exposure is a larger number, , the number of contracts one needs to sell obviously goes up proportionaly • if the size of the futures contract is rather than unity, the number of futures contracts goes down ⟹ the number of contracts to be sold in order to hedge units of currency j using a futures with size units of currency iis given by Pros and Cons of Futures Contracts Relative to Forwards Pros: • because of institutional arrangement in futures markets, the default risk is low even relatively small players can trade in the future markets • because of standardizations futures markets have low transaction costs small contracts can be arranged • because of the liquidity of the secondary market, futures positions can be closed out earlier Pros and Cons of Futures Contracts Relative to Forwards Cons: • because of standardization the hedge is almost sure imperfect: cheap future imperfect hedge vs expensive hedge in the forward market • future contracts exist only for a few high‐turnover exchange rates for most exchange rates the hedger has to choose btw forward contracts or money‐market hedges, or across‐hedge in the futures markets, which is less effective Fixed‐for‐Fixed Currency Swaps A fixed‐for‐fixed currency swap is a transaction where two parties • two parties at the time of contract initiation, exchange the to principals • these two principals are denominated in different currencies, but have roughly the same market value • two parties return the principals when the contracts expires • in addition, they periodically pay a normal interest to each other on the amount borrowed • swap interest rate ‐ yield at par for near‐riskless bonds with the same maturities as the swap Why Are Swap Rates almost Riskless? • The risks in case of default are limited by the right‐to‐ offset clause • if one counterparty defaults the right‐to‐offset provides the other party the right not to full its obligation under the contract • The probability of default is low because the customers are screened Why Are Swap Rates almost Riskless? • Many swaps have a credit trigger clause • if the customer's credit trigger clause is downgraded the financial institution can terminate the