Giddy
Forwards, Futures and Money-Market Hedging/1
Forwards, Futures
and Money Market Hedging
Prof. Ian Giddy
New York University
Hedging Transactions Exposure
Types of exposure
l One-shot exposure
l Hedging approaches:
l
u Open
u Forward
u Money
market
u Futures
u Options
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
u Borrow
and pay now?
u Use a forward contract/FX swap?
u Pay later at spot?
Copyright ©1997 Ian H. Giddy
Forwards, Futures and Money-Market Hedging 8
Forward Contracts, Futures
and Money Market Hedging
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
l
Copyright ©1997 Ian H. Giddy
Forwards, Futures and Money-Market Hedging 9
Giddy
Forwards, Futures and Money-Market Hedging/3
Forward Contracts
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.
l
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
Backus
Backus
Copyright ©1997 Ian H. Giddy
SANSANTANDER
TANDER
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:
u Open
u Forward
u Spot
plus swap
u Rollover
u Money 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
l
Dealers typically hedge a forward foreignexchange commitment with a spot plus “FX
Swap”: spot sale plus forward purchase of a
foreign currency
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
l
Dealers often hedge a long-term foreignexchange commitment with shorter-term
contracts, which are “rolled over” as they
come due
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
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
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
135
FORWARD
(LEFT SCALE)
130
125
120
115
FORWARD PREMIUM
(RIGHT SCALE)
110
24
23
22
21
20
19
18
17
16
15
14
13
FORWARD
12
PREMUIM,
PERCENT
11
PER ANNUM
10
9
8
7
6
5
4
3
2
1
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
Interest
Interest rate
rate
differential
differential
Forward
Forward
premium
premium
Copyright ©1997 Ian H. Giddy
Expected
Expected
%
% change
change in
in
exchange
exchange rate
rate
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
Continue funding in U.S. dollars. The
peseta might get stronger in the next
three months, from $1=128 pesetas to
$1=126 pesetas. This could be the
cheapest
l Switch funding to pesetas, despite the
slightly higher cost
l Borrow in dollars, but hedge the
exchange risk in the forward market.
l
Copyright ©1997 Ian H. Giddy
Forwards, Futures and Money-Market Hedging 23
Giddy
Forwards, Futures and Money-Market Hedging/10
Frutas Amazonas
Eurodollar 3-month
loan rate
Europeseta 3month loan rate
Spot exchange
rate today
Forward exchange
rate today
Forward discount,
% per annum
Copyright ©1997 Ian H. Giddy
5 9/16%
7 15/16%
Pta128.210 per
USD
Pta129.005 per
USD
-2.5
Forwards, Futures and Money-Market Hedging 24
Frutas Amazonas
Type of Hedge
Cost of Hedging
Forward
2.5%
Money Market Hedge 2.375%
(Borrow to match
assets)
Do nothing
2/128 x 4
= 6.25% gain
(or 2.5% loss?)
Copyright ©1997 Ian H. Giddy
Forwards, Futures and Money-Market Hedging 25
Giddy
Forwards, Futures and Money-Market Hedging/11
Bid and Offer Quotations
in the Long-Dated Forward Market
EXCHANGE
RATE,
DOLLARS
PER POUND
STERLING
.05%
1.9
1.85
1.8
.63%
1.75
1.25%
1.44%
1.7
1.62%
1.65
3.96%
1.6
1.55
6.34%
1.5
OFFER
1.45
1.4
BID
1.35
1.3
SPOT
2 YR
3 YR
4 YR
5 YR
7 YEAR
10 YEAR
MATURITY OF FORWARD CONTRACT
Copyright ©1997 Ian H. Giddy
Forwards, Futures and Money-Market Hedging 26
Forwards, Money Market Hedging
and Futures
Forward contracts: OTC contracts for
future delivery, often settled in cash
l Forwards can be used in
l
1. Hedging
2. Positioning
3. Arbitrage
Interest rate parity means that a forward
hedge is, normally, the same as a
money market hedge.
l Futures are free of default risk.
l
Copyright ©1997 Ian H. Giddy
Forwards, Futures and Money-Market Hedging 27
Giddy
Forwards, Futures and Money-Market Hedging/12
Marking-toMarket of a
Futures
Contract
FUTURES PRICES,
US$ PER MARK
DAILY DM
FUTURES PRICE
MOVEMENTS
0.65
0.645
FUTURES
0.64
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
l
Good credit: Forward usually best
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