CHAPTER 11 Forwards, Futures, and Swaps

Forward versus Spot Contracts

Basic Characteristics
A spot contract is a price that is established today for immediate delivery.
Immediate delivery depends on the nature of the underlying contract.

A forward contract is a price that is established today for future delivery.

Can be specified for almost any future date because forward contracts are custom contracts between two parties. These types of contracts date back to the Roman Empire.

(Table 11 1 illustrates foreign exchange quotes for spot and forward delivery)
CHAPTER 11 Forwards, Futures and Swaps 11 - 2

Forex Forward Contracts

Basic Characteristics
Table 11-1 Foreign Exchange Quotes
Foreign Exchange Rates (Canadian dollars per foreign currency) US ($)
Spot 1 month 3 month 6 month 1 year 3 year 5 year 10 year 1.107 1.1063 1.1044 1.1017 1.0971 1.0697 1.0622 1.0312

GB ()
2.040 2.0393 2.0383 2.0368 2.0340 n/a n/a n/a

JAP ()
0.009721 0.009754 0.009821 0.009920 0.010116 n/a n/a n/a

Euro ()
1.3991 1.4007 1.4039 1.4082 1.4159 n/a n/a n/a

Reflects the importance of the US as a Canadian trading partner. (Remember, forward contracts occur between corporations and their Canadian banks.) Reflects the time value of moneyforward rates the price TODAY for future deliveryso the further away, the lower the present value.
11 - 3

Source: Data f rom Bank of Montreal (BMO) Nesbitt Burns, Globe and Mail , June 10, 2006.

CHAPTER 11 Forwards, Futures and Swaps

Forex Forward Contracts

Basic Characteristics
Forex forward contracts are bank instruments:
There is no organized exchange (they are an OTC instrument) Requires that the customer have a banking relationship.
Involves credit risk for the bank when investors suffer losses. Banks will only sell forward contracts for legitimate business purposes. Will only sell up to a companys approved credit limit. Consequently, forward contracts are used for hedging purposes by firms wishing to mitigate exposure to specific risks.

As customized instruments Forwards can be tailored to any specific date in the future and for any amount of money. Contracts must be fulfilled.
CHAPTER 11 Forwards, Futures and Swaps 11 - 4

Using Forward Contracts

Like all derivative securities, forward contracts can be used (theoretically) to:
Hedge mitigate or eliminate risk. Speculate make an educated guess about the future value of something in hopes of profiting from it.

Canadian banks however, will only provide forward contracts for legitimate business purposes (hedging), so speculative purposes arent not supported.
CHAPTER 11 Forwards, Futures and Swaps 11 - 5

Using Forward Contracts

Hedging vs. Speculating

Hedging using a forward contract requires that the investor have an opposite exposure to the contract.
This is a covered position.

Speculation on a forward contract requires that the investor NOT own the underlying asset.
This is a naked position a position that leaves the investor exposed to changes in the value of the underlying asset.
CHAPTER 11 Forwards, Futures and Swaps 11 - 6

Using Forward Contracts

Example of Long Position in the U.S. Dollar

This Canadian firm expects to receive $1million US in accounts receivable one year from now
Initial Conditions
Canadian dollar is at par with U.S. Both spot and 1-year forward rates are both at 1.0 (this implies 1a ratio of 1:1)

Exposure
The firm is long US$ because it owns them in the future. If the value of the US$ falls relative to the Canadian $, the firm will collect fewer Canadian $ once the conversion is made
CHAPTER 11 Forwards, Futures and Swaps 11 - 7

Forward Contracts
Long Position in U.S. Dollars
11 - 1 FIGURE
The payoff is linear.
profit

45 degree angle. Passes through the forward rate F. If spot exchange rate in the future exceeds the forward rate by $0.01, then the speculator earns $0.01 profit for every Canadian dollar sold forward for U.S. dollars.

F = 1.0

C$ 1.0 per US $

loss

CHAPTER 11 Forwards, Futures and Swaps

11 - 8

Using Forward Contracts

A Short Position in the U.S. Dollar to Hedge

In order to remove this exposure, the firm needs to take on a short US$ position of an equal amount

If the value of the US dollar falls, the firm loses money on the receivable but makes the exact same amount in profits from selling US $ forward (a short position)
CHAPTER 11 Forwards, Futures and Swaps 11 - 9

Forward Contracts
Short Position in U.S. Dollars
11 2 FIGURE
The payoff from a naked sale of U.S. forward.
profit

F = 1.0
C$ 1.0 per US $

If U.S. $1 million is sold forward for C$1.0 million, and the Canadian dollar depreciates to C$1.20 then the forward contract loses money. The profit (loss) of the short position is identically opposite of the long position.

loss

CHAPTER 11 Forwards, Futures and Swaps

11 - 10

Forward Contracts
Long and Short Forward Positions in U.S. Dollars
11 - 3 FIGURE

profit Long Exposure

The firm is long in the Offsetting underlying long and asset, so a short short forward exposures contract the insulate gives this net firm for position. foreign exchange Long US $ risk during exposure is the life of the what contract. Canadian exporters face.

F = 1.0
loss

C$ 1.0 per US $ Short Exposure

CHAPTER 11 Forwards, Futures and Swaps

11 - 11

Pricing Forward Contracts

Interest Rate Parity Condition

The general condition is that investors can create a forward position in a storable commodity by buying it spot and holding it for future delivery. The only difference between the spot price (S) (S and forward (F) should be the costs of carry (F (interest costs on financing the purchase and costs of storing for future delivery).
CHAPTER 11 Forwards, Futures and Swaps 11 - 12

Pricing Forward Contracts

Commodity Pricing Model The Commodity Pricing Model is equation 11 5 and shows that the cost of carry links the Forward and Spot prices:

[11-5]

F ! (1  c) v S

Where:
c = the cost of carry, as percentage of S, over the period in question. = storage costs + financing costs S = spot price F = forward price
CHAPTER 11 Forwards, Futures and Swaps 11 - 13

Futures Contracts
The Mechanics of Futures Contracts

Futures contracts are a standardized exchange-traded exchangecontract in which the seller agrees to deliver a commodity to the buyer at some point in the future. Organized futures exchanges with standardized futures contracts:
Reduce credit risk through:
Clearing corporation being the counterparty in all transactions margin requirements (both initial and maintenance margins) and daily mark-to-market daily resettlement. mark-to-

Allow the contract features and volumes to be reported Allow the futures positions to be liquid (executing offsetting transaction to cancel the futures position) increasing the flexibility in their use.

CHAPTER 11 Forwards, Futures and Swaps

11 - 14

Futures Contracts
Futures Contracts Markets The term of the contract is set by individual exchanges but are generally standardized for simplification
Delivery months are March, June, September, December The exchange sets how much of the asset is traded in each contract. (ie. The notional amount)

For financial futures, most exchanges follow the lead of the major markets in Chicago:
Chicago Board of Trade (CBOT) Chicago Mercantile Exchange (CME)

Commodity futures trading in Canada is concentrated on the Winnipeg Commodity Exchange (WCE) Financial futures trading is concentrated since 2000 on the Montreal Exchange (ME) in Canada.
CHAPTER 11 Forwards, Futures and Swaps 11 - 15

Futures Contracts and Markets

Where things trade
Table 11- 2 Futures Contracts and Markets
Underyling Asset
Commodities Wheat/oats/soybeans Cattle/pigs/lumber Crude oil/heating oil/natural gas Cotton/orange juice Gold/silver/copper Lead/nickel/tin Canola/western barley/wheat Financial Futures Treasury notes and bonds/DJIA S&P index/Nikkei225 / C$ / / BAs/Canada bonds/TSX/S&P 60 index German bonds/European equities Other Weather derivatives

Exchange
Chicago Board of Trade (CBOT) Chicago Mercantile Exch. (CME) New York Merchantile Exchange NY Cotton Exchange The Commodity Exchange (Comex) London Metal Exchange (LME) Winnipeg Commodity Exchange CBOT CME Montreal Exchange Euronext/Liffe CME

CHAPTER 11 Forwards, Futures and Swaps

11 - 16

Futures Contracts
Types of Futures

Commodity futures include:

Traditional agricultural products such as corn, wheat, hogs, etc. Energy products Base metals

Financial futures
S&P index / BAs/Canada bonds/S&P TSX 60 index

Other
Weather derivatives Futures contracts on real estate Futures contracts on the consumer price index (CPI)

CHAPTER 11 Forwards, Futures and Swaps

11 - 17

Futures Contracts
Futures Exchanges

There is significant competition across exchanges, however, some are separated by different time zones. Competition is a source of innovation:
New types of contracts are developed As interest declines or needs change, some die out.

Interest in futures has grown dramatically as companies learn to hedge their risk exposures through these instruments.
CHAPTER 11 Forwards, Futures and Swaps 11 - 18

Futures Contracts
Marked to Market Process

To limit their exposure to counter-party credit counterrisk, all profits and losses on a futures contract are credited to investors accounts every day by the exchange to calculate their equity position.
If the equity increases, these profits can be withdrawn. When the equity position drops below the maintenance margin (usually 50-75% of the initial 50margin) the investor will receive a margin call and be forced to contribute more money to increase the equity position.
CHAPTER 11 Forwards, Futures and Swaps 11 - 19

Trading/Hedging with Futures Contracts

Example of a Bond Portfolio Manager

A fixed-income portfolio manager holds a fixeddiversified portfolio of bonds that are predominantly Government of Canada. The manager believes interest rates will rise, causing the each bond price to fall. The manager can: ( too high transaction cost: bidbidask spread + transac fee)
1. Sell bonds and hold cash till the threat of rising interest rates pass, or until the change in rates has occurred, and then repurchase the bonds 2. Sell long term bonds and replace with shorter term bonds (reducing the portfolio duration and thereby limiting the losses if interest rates rise duration hedging) 3. OR.
CHAPTER 11 Forwards, Futures and Swaps 11 - 20

Trading/Hedging with Futures Contracts

Example of a Bond Portfolio Manager

3. Hold the portfolio and use a short hedge (short position in a futures contract in government bonds) the losses in the portfolio will be offset by gains on the short hedge.

This third alternative is often the best one, because buying and selling bonds will incur transactions costs and upset the structure of the portfolio. If the hedge cannot be perfectly constructed the portfolio will be exposed to basis risk because losses on the long portfolio may not be exactly offset by the short future position.
CHAPTER 11 Forwards, Futures and Swaps 11 - 21

Basis Risk
Is the residual risk resulting from an incomplete hedge. As futures contracts are standardized, it is possible that a particular risk exposure may not be completely hedgeable. Consider trying to hedge an $85,690 US payable using futures contracts in increments of $10,000
This is one of the advantages of forwards.
CHAPTER 11 Forwards, Futures and Swaps 11 - 22

Futures Contracts and Markets

Summary of Forward and Future Contracts

Forward and Future Contracts serve the same purpose. Forward contracts offer more flexibility because they are customized OTC contracts. Forward contracts, however, face additional risks:
Not actively traded (created by a bank for customers) Possess credit risk

CHAPTER 11 Forwards, Futures and Swaps

11 - 23

Swaps
Defined

An agreement between counterparties, to exchange cash flows in the future.

No formal exchange to guarantee performance, so the arrangement involves a dealer or OTC market and there is credit risk They have evolved into a bank instrument, with banks or swap dealers serving as intermediaries. An exchange of interest payments on a principal amount in which borrowers switch loan rates. Often this involves one counterparty trading fixed loan payments (the swap rate) for variable rate loan payments (usually LIBOR or CDOR (BA rates in Canada)

An interest rate swap is:

A plain vanilla interest rate swap is denominated in one currency.

Swaps
Comparative Advantage

The benefits of swapping are not only based on hedging there can be cost savings as well.
Based on the comparative advantage of one party in fixed vs. floating rate debt markets or from one countrys debt market to anothers. Any firm offered a good deal in floating rate funds but doesnt need them should borrow them anyway and use a swap to exchange it for what is needed and lock in the financing advantage.

Swap Dealers
Swap Rate

A swap dealer is a financial intermediary who helps to reduce search costs for firms looking to swap rates, as well as diversifying counter-party risk counter They enter into numerous swaps with parties looking for both exposures to reduce the risk of default.

To account for these services, such intermediaries take a bit of the total savings for themselves.
There is a bid-ask spread on swap rates so dealers can offset bidlosses and earn profits.

Instead of the parties negotiating the swap rate (more later), it is set by the supply and demand of funds in the swap market.

Swaps
The interest rate benchmark is the Swap Rate Yield Curve which identifies the relationship between swap rate for different maturities
swap rate = fixed reference rate (gov bond, same maturity) + swap spread This yield curve plots just above the corresponding gov bond yield curve with the spread being determined by the perceived counter-party risk counter Like LIBOR, the Swap Rate is NOT risk-free riskCHAPTER 11 Forwards, Futures and Swaps 11 - 27

CAD vs USD Swap Curves

Swap rate is the rate that is paid in exchange for receiving CDOR/LIBOR or prepared to receive in exchange for paying CDOR/LIBOR
the 2 year swap rate tells the company that it needs to pay 2.31% to receive 3-month CDOR 3with the rate resetting every 3 months for 2 years
Canada
BA/CDOR 1mo BA/CDOR 3mo BA/CDOR SWAP RATE 2 year 3 year 4 year 5 year 8 year 9 year 10 year 2.31 2.67 2.99 3.24 3.77 3.90 4.03 2 year 3 year 4 year 5 year 8 year 9 year 10 year 1.34 1.93 2.44 2.87 3.72 3.90 4.04 Rate% 1.20 1.30

U.S.
LIBOR 1mo LIBOR 3mo LIBOR Rate% 0.27 0.31

Swap rates provided by CIBC World Markets

Interest Rate Swaps

The dollar amount of the interest payments exchanged is based on a predetermined dollar amount called the notional principal amount. amount.
This amount, multiplied by the appropriate net interest rate, determines the size of payments between the counterparties

The Bank for International Settlements reports that interest rate swaps are the largest component of the global OTC derivative market. The notional amount outstanding as of June 2009 in OTC interest rate swaps was $342 trillion, up from $310 trillion in Dec 2007. The gross market value was $13.9 trillion in June 2009, up from $6.2 trillion in Dec 2007.

Interpreting a Swap Position

There are two ways that a swap position can be interpreted:
1. as a package of forward/futures contracts, and 2. as a package of cash flows from buying and selling market instruments

1. Package of Forward Contracts

Investor to pay a swap rate of 10% and in turn receive 6 mo LIBOR If the principal amount is $50 million, then Investor A has agreed to buy 6 month LIBOR for $2.5 million (10%/2 x $50 million) This is effectively a 6 month forward contract where the investor agrees to pay $2.5 million to receive 6 month LIBOR (every 6 months for the term of the swap) There is therefore an implicit forward contract corresponding to each exchange date

Interpreting a Swap Position

2. Package of Cash Market Instruments
Buy $50 million par of a 5 year floating-rate note (FRN) that pays 6 floatingmonth LIBOR every 6 months Finance the purchase by borrowing $50 million for five years on terms requiring 10% annual interest rate paid every six months The net cash inflows versus outflows (fixed rate interest payment minus the cash inflow of LIBOR (all multiplied by the notional amount) is identical to the position of a fixed-rate payer/floating-rate receiver fixedpayer/floating0
6 months 1 year 1.5 years 2 years etc Time

T1
Pay fixed coupon of $2.5 MM Receive 6 month LIBOR from FRN

T2
Pay fixed coupon of $2.5 MM Receive 6 month LIBOR from FRN

T3

T4

Pay fixed coupon Pay fixed coupon of $2.5 MM of $2.5 MM Receive 6 month Receive 6 month LIBOR from FRN LIBOR from FRN

Schedule of Payments Exchange

Assume:
Term of the Swap: 5 years 5 year US gov bond rate is 5.50% at the time the swap is entered into swap spread: 50 bps reference rate: 3-month LIBOR 3notional amount: $50 million frequency of payments: quarterly (every 3 months)

Therefore:

Swap Rate = 5.50%+ 50 bps = 6.00%

This means that the fixed-rate payer agrees to pay a 6% annual rate fixedfor the next 5 years with payments made quarterly and receive (from the fixed rate-receiver) 3-month LIBOR also made quarterly on rate3$50MM notional amount

Schedule of Payments Exchange

Payments by Fixed Rate Payer Assuming a Notional principal amount: $50,000,000 Swap Rate 6% 6% 6% 6% 6% Annual Dollar Amount $3,000,000 $3,000,000 $3,000,000 $3,000,000 $3,000,000 Quarterly $750,000 $750,000 $750,000 $750,000 $750,000

Payments by Fixed Rate Receiver Assuming a Notional principal amount: $50,000,000 If LIBOR is 2% 3% 4% 5% 6% Annual Dollar Amount $1,000,000 $1,500,000 $2,000,000 $2,500,000 $3,000,000 Quarterly $250,000 $375,000 $500,000 $625,000 $750,000

Net Payments
In swap arrangements, counterparties are often unequal partners to the contract.
One counterparty may be AAA ratedthe other BBB for example

The net credit risk is borne by the higher rated counterparty (generally the swap dealer).
AAAs counter party (rated BBB) has a higher probability of default

Strategies to control credit risk include:

Set-off rights in the swap agreement allowing the other party to stop Setmaking payments if the other party defaults Net payments instead of exchanging total interest amounts, only the difference between the two streams are exchanged and structuring the payments into sub-periods (every six months) sub-

Net Payments
Assuming the standard Canadian market convention of a 365 day count, the formula to calculate the periodic settlement in a rate swap would be:
Net Payment = (Swap rate - BA rate) x (notional amount) x (# of days/365) For example:
Fixed swap rate = 4.50% BA rate = 5.00% Notional Amount = $50 million Quarterly resets

Net Payment = (4.50%- 5.00%)x ($50 million) x (91/365) = -$62,328.76 (4.50% This negative amount implies a SAVINGS for the firm which bought the swap

Swapping to Reduce Fixed Funding Costs

A firm has 3 years remaining on a $50 MM fixed rate bond of 7.00% but can swap the fixed rate coupon for a floating obligation at a rate of (3-month BA's plus 315 bps) (3 Assume 3 month BA rates are at 2.10% By refinancing in this way, the firms interest cost (for the next three months) is equal to (3.15% + 2.10% = 5.25%) versus the fixed 7.00%

Breakeven BA rate = Existing debt coupon rate BA Spread

= 7% - 3.15% = 3.85%
If BA rates are below this level (3.85%), the firms (net) funding costs would be reduced.

Swapping to Reduce Fixed Funding Costs

Plain vanilla interest rate swap (contd)
Break Even BA Rate is 3.85%

When rates begin to rise, the benefit to the client would decline, reaching breakeven at a BA rate of 3.85% If BA rates rise beyond 3.85%, the result would be an increase in the clients overall interest rate
Floating rate index (3 month BA s + 315 bps) The Company Fixed Rate Obligation (loan or corporate bond) Bond Investors or Lender Fixed Swap Rate 7% in example Swap Desk

Swaps without Dealers

In the absence of a swap dealer (less developed capital markets), firms can negotiate their own swap agreement.
For this to be useful to both firms, one must have a comparative advantage over the other in borrowing either fixed or floating debt.

In these situations, the difference in fixed vs floating spreads is the total amount of savings available to the two firms.
How those savings are divided depends entirely on the swap rate they negotiate (as in example 11-4 where the 10.9% swap rate was chosen 11by the firms so that each would save exactly the same amount)

In general, the more credit worthy firm captures a great percentage of the savings as they have more negotiating power (better rating).

Swaps without Dealers

Table 11 4 illustrates an OTC plain vanilla interest rate swap between counterparties A and B and is structured to benefit both parties equally. This is rarely the case. In this example, the total savings were 0.7% and the two parties agreed to split it equally
The swap rate was chosen to make this happen.

To determine the swap rate, consider the rates the parties would have had to borrow on their own at, remove the savings, and this is amount must be the sum of the three transactions (one initial and two others from the swap)
The 10.9% swap rate here was back-engineered in this fashion back-

Swaps without Dealers

Firms choose to split savings equally
Table 11- 4 An Interest Rate Swap

A
Quotes Floating Fixed Initial Floating Fixed Swap -10.8 B pays A fixed and A pays B floating +10.9 - LIBOR Net Saving - (LIBOR - 0.10) 0.35% - 10.9 + LIBOR - 11.65 0.35% LIBOR + 0.25 10.8 (AAA) LIBOR + 0.75 12.0

B
(BBB)

- (LIBOR + 0.75)

(note that payments are being made semi-annually) semiTable 11- 5 Interest Rate Swap Net Payments
Floating Pay Fixed Pay (%) (%)
-4.00 -4.50 -4.90 -5.50 -6.00 +5.45 +5.45 +5.45 +5.45 +5.45

Interest Rate Swaps

Period
1 2 3 4 5

LIBOR (%)
8.0 9.0 9.80 11.00 12.00

Net Pay (%)

+ 1.45 + 0.95 + 0.55 - 0.05 - 0.55

Currency Swaps
Currency swaps permit the firms to adjust their foreign exchange exposure.
This means that there is increased credit riskbut it presents opportunities.

The first swap was a currency swap between IBM and the World Bank.
This swap was motivated by comparative advantage It was a primary market transaction both IBM and the World Bank used it to raise new capital cheaply. Once swaps became standardized, it became possible to constantly change the nature of the institutions liability stream.

Currency swaps require exchange of all cash flows.

Not just net cash flows as in an interest rate swap

Currency Swaps
Cross currency swaps are done when a client has revenue for his products in a currency that does not match his liabilities (or borrowings) A cross currency swap can be used to hedged forex risk, allowing a firm to emulate a CAD issuance for the entire life of the term loan (a synthetic position) The re-exchange of the principal under the crossrecrosscurrency swap is done at the same exchange rate as established at the inception of the transaction because the interest rate differential is already taken into account in the fixed or floating rates payable on the swap

Currency Swaps
Telus borrowed in USD to take advantage of cheaper rates but now has regular USD liabilities (paying a fixed rate coupon in USD) and it must repay USD principal at the end of the term Company does not want this risk, but instead wants CAD Fixed

Currency Swaps
USD proceeds from bond issue i.e. USD 3.3 Billion sold to Swap Desk Client
CAD equivalent @ current spot F/X CAD Interest

Swap Desk

Client
USD Interest Residual CAD @ original F/X rate

Swap Desk

Client
Residual USD amount

Swap Desk

Step #1: The USD proceeds are sold to the bank at the current F/X spot rate and the CAD equivalent is paid by the bank to the client Step#2 : The USD interest on the term loan is paid by the bank to the client to satisfy the payment the client is required to make to the bond holders. In return a coupon in CAD is paid by the client to the bank Step #3: On the maturity of the term loan the notional amounts are re-exchanged at the rehistorical F/X rate this provides the client with the USD proceeds to retire the term loan in exchange for payment to the bank of the CAD equivalent