Currency Forwards

FINC 456

Currency Forward Markets: Why do we care?

Currency forwards are some of the most widely used and most liquid risk management products available.
Trade 24 hours a day, nearly 365 days a year somewhere in the OTC market The most liquid currencies tend to be the large European countries, but recently banks have aggressively begun selling forwards on much more exotic currencies, at least for short (1 year and less) maturities.

The concept is relatively simpleif the company is receiving or paying a certain amount of currency in the future, the company can lock in the value today.

Simple Currency Hedging Situations: Importers

Suppose your computer company has contracted to buy 100,000 memory chips from Japan in 6 months, at 500 yen per chip.
At an exchange rate of 120 yen/dollar, thats $416,667. If the exchange rate goes to 150/dollar its $333,333.
Is this a depreciation of the yen or an appreciation?

If the exchange rate goes to 100 yen/dollar, thats $500,000.

So your companys risk is to movements in the yen, specifically when the yen/dollar rate decreases
So what to do?

Simple Currency Hedging Situations: Exporters

Suppose that you are selling your computers in Europe, all 25,000 of them at 1000 and expect to receive the euros in a year.
At an exchange rate of 1.25 ($/euro), thats $31,250,000. If the rate goes to 1.40, you receive $35 million.
Is this a depreciation or an appreciation of the euro?

If the rate goes to 1, you receive $25,000,000.

So your risk is to movements in the Euro rate, specifically to decreases in the rate
So what do you do?

Hedging exchange rate risk

If you are receiving the foreign currency, you are at risk from a devaluation (or depreciation).
Thats because each unit of the currency will be worth less in dollar terms. To hedge this risk, you sell the currency forward and lock in todays rate.

If you are spending the foreign currency in the future, you are at risk from a re-valuation (or appreciation).
Thats because each foreign currency unit will require more dollars to buy. To hedge this risk, you buy the currency forward

Currency forwards: the market

Currency forwards are quoted in forward points, or the amount that youd add or subtract to the spot rate to get the forward rate for that period.
The number of decimals is just considered known, that is, 2 for the yen, 5 for most other liquid currencies The actual forward rate is know as the outright.

Currency forwards are essentially interest rate products (as well see in a few slides) and as such are available wherever and to whatever maturity liquid deposit markets exist in that currency.

Digression: LIBOR and deposit markets

LIBOR, or the London Inter-Bank Offer Rate, is the interest rate of choice for real world currency forward applications. LIBOR fixings are quoted daily at 11:00 a.m. London time for terms of up to 1 year. The most liquid LIBORs are the 3 and 6 month fixings LIBOR is quoted in many currencies:
For example GBP; USD; EUR; JPY; CHF; CAD, etc.

LIBOR rates are annually compounded on an ACT/360 basis

Pricing Currency Forwards

If we think about currencies as any other commodity, it is not so strange to think of a currency growing at its interest rate. And if thats the case, the relevant formula is: Note that q, the growth rate, has been replaced by rf, the foreign interest rate
This formula presumes, requires, has to have,spot rates quoted as the spot price in dollars of one unit of foreign currency $ That is, S

F0 = S 0 e

( rd r f )T

Foreign

Another way of thinking about currency forwards

Suppose that the yen is trading at 105 and the 1 year forward is 200 points. I have two investments available for my $1000:
I can invest my dollars here for 2% I can buy yen today, invest the yen at .5%, and then sell a forward contract to deliver the yen for dollars in a year.

In a year, my dollars are worth $1020.20 (cont. comp). I buy 105,000 yen, and in a year, these are worth 105,526.31 yen, which I sell at 103, giving me $1024.53.
If the forward rate is 100 do I have more or fewer dollars?

Arbitrage in Euros

Suppose that I sell Euros forward at 1.20 for 2 years, and the spot rate today is 1.25, and US rates are 2%.
This means I must deliver the Euros in 2 years and receive 1.25 dollars. For instance if I sell 100,000 euros forward, Ill receive for sure $120,000 in 2 years.

How many Euros do I need to buy today in order to have 100,000 of them in 2 years if euro rates are 3%?
How about 94,176 eurosor $117,721? If I just invested the dollars Id have $122,524 in two years
Is the forward cheap or expensive?

Arbitrage in Euros, cont

Can I make some money here? How about if I buy the Euros forward at 1.05
But what is my risk hereIll have Euros in 2 years and I really dont want them!

So, maybe I can pay them back to someone

Why dont I borrow Euros today (Ill need to pay back 100,000 of them, so borrow 94,176). Ill sell them at the spot rate, and get $117,721. And invest that amount at 2% hereto get $122,525.

In 2 years, I earn $2,525 for sureso I keep buying forwards!

The Money Market Hedge

If I sell Euros forward, Ill receive dollars for Euros in the future.
Do this to hedge depreciation or appreciation risk?

I could also receive dollars and pay Euros by:

Borrowing Euros Selling the borrowed Euros in the spot market to get dollars Lending out the dollars

The difference in interest rates essentially locks in a forward rate!

When I get my Euros in the future, I use them to pay back the loan

So what do forward markets tell us about interest rates?

If the forward implies a depreciation, of the currency, interest rates in that country are higher than in the US.
Whats the intuition here?

If the forward implies an appreciation of the currency, interest rates in that country are lower than in the US.
Whats a good example here?

Currency Forward Markets: The real world

Often, especially in emerging markets, there are impediments to one side of the arbitrage
For instance, before the Mexican devaluation, it was difficult/impossible to borrow pesos and difficult to sell in the spot market The continuing restrictions in Argentina are another perfect example

Banks or companies with significant operations in country have advantages, since they can use the currency, and observe deposit flows Occasionally, non-delivery forwards are offered to circumvent these restrictions
These are cash-settled, and either hedged using futures, correlated markets, or by selling products to investors

Currency Markets: The real world formula

If we are not in the continuously compounded world, the money-market deposit version of the forward pricing formula is:
1 + rUS t basis F0 = S 0 1+ r t f basis

( (

) )

And remember, with the bid/ask spread, the second rule of financeyou as the consumer always lose money to the bank.