Lecture International finance: An analytical approach (3/e): Chapter 9 - Imad A. Moosa

Chapter 9 - Currency futures and swaps. In this chapter, the learning objectives are: To describe futures contracts and show how they circumvent the problems of forward contracts, to compare forward and futures markets, to describe swaps and introduce some terminology,...

Chapter 9

Currency Futures and

Swaps

Objectives

• To describe futures contracts and show how they

circumvent the problems of forward contracts

• To compare forward and futures markets

• To describe swaps and introduce some terminology

• Currency futures contracts represent an obligation of the seller to deliver a certain amount of a specified currency in the future at an exchange rate

determined now

Problems of Forward Contracts

• Non-standard contract dimensions

• Default risk

• Lack of liquidity

Using a forward contract

C

A Forward contract

JPY  Goods 

B AUD 

JPY 

Tendency to default on a forward

million AUD 1.9  million

(cont.)

Tendency to default on a forward

C

(cont.)

Tendency to default on a forward contract (cont.)

Spot rate =  1.80 USD 1 

million

AUD 1.8 millionUSD 1 

million

AUD 1.8 million

Unwinding a forward contract

Unwinding a forward contract

Unwinding a forward contract

JPY

JPY

How futures contracts solve these problems

• Standardised contract dimension

• Default risk is controlled by the clearing corporation and some regulations

• They are liquid

The role of the clearing corporation

in futures trading

AUD AUD

Clearing  corporation (exchange)

A comparison of forward and

A comparison of forward and

futures markets (cont.)

A comparison of forward and

futures markets (cont.)

Futures exchanges

• The Philadelphia Stock Exchange

• The Chicago Mercantile Exchange

• The Sydney Futures Exchange

Definition of swaps

• Currency and interest rate swaps involve the

exchange of interest and foreign currency cash

flows They differ from swaps in the forward FX

market (FX swaps)

Currency swaps

• A currency swap is a transaction in which two

counterparties exchange specific amounts of two

different currencies at the outset and repay over time according to a predetermined rule

Some features of currency swaps

• They emerged in the 1980s with the World Bank

playing a major role

• They have evolved as a successor to parallel loans

Stages of currency swaps

• The counterparties exchange the principal amounts

• On specific dates, they exchange interest payments

• On maturity, the principal amounts are re-exchanged

Currency swaps with notional

principals

• A notional principal is not exchanged Only

compensatory payments are made by one

counterparty to the other

A swap without exchanging

Interest rate swaps

• A fixed-for-floating swap involves the exchange of

cash flows by applying fixed and floating interest

rates to a notional principal in a specific currency

Fixed-for-floating interest rate

Other kinds of interest rate swaps

• A basis swap involves two floating interest rates

• A zero-coupon swap involves a zero fixed rate

Cross-currency interest rate swaps

• Involve the exchange of payments in different

currencies, one of which is calculated on the basis of

a fixed interest rate and the other on the basis of a floating rate

Cross-currency interest rate swaps

Fixed JPY Floating AUD

(a) Dealing with one counterparty

 (b) Dealing with two counterparties

Fixed JPY Floating AUD

Fixed AUD Fixed AUD

Swap terminology

• A money market swap has a maturity of three years

or less This is unlike a term swap, which has a

maturity of more than three years

(cont.)

Swap terminology (cont.)

• A spot-start swap starts (that is, it becomes

operational) two days after the contract has been

agreed upon verbally

• A swap that starts after more than two days but

within one year is a delayed-start swap

• If the starting date is more than one year after the

start of the verbal agreement, it is a forward swap

(cont.)

Swap terminology (cont.)

• An option on a swap is a contract allowing the holder

to exercise, or otherwise, the right to engage in a

specified swap

• A swaption allows one party to the contract (the

holder of the swaption) to alter the swap

(cont.)

Swap terminology (cont.)

• If a counterparty wishes to terminate the swap

without holding a swaption, then he or she would

indulge in a swap buyout (that is, the swap is closed and settled at current prices)

(cont.)

Swap Terminology (cont.)

• Normally, the notional principal on which a swap is based is constant throughout the life of the swap

• In the case of an amortising swap, the principal

declines with time

• Another alteration is when the principal takes an

irregular pattern