INTERNATIONAL FINANCE LESSON 4

 Futures contracts  Swaps futures and options  Forward exchange rates  Covered interest rate parity... Forward Contracts A forward contract is an agreement where the terms of a fut

Risk Management and Derivatives

Antu Panini Murshid

Today’s Agenda

 What are derivatives?

 Futures contracts

 Swaps futures and options

 Forward exchange rates

 Covered interest rate parity

What are Derivatives?

 Unlike other assets derivatives are not a

claim on a commodity or real asset

 A derivative is an instrument whose value

depends on the value of other underlying assets

 Pork bellies, oil, other financial instruments

 An increasing amount of trading takes place in

markets where actual commodities and instruments of borrowing and lending are not traded

Derivatives Risk Sharing or the

“11-letter 4-letter-word”

 Why use derivatives

 To hedge risks

 To speculate by taking a view on the

future direction of the market

 To lock in the rate of return or interest

costs on borrowed funds (decide on terms today)

 To change the nature of an investment

without incurring transaction costs

Forward Contracts

 A forward contract is an agreement

where the terms of a future trade are decided upon today

 This contrasts with a spot contract

where the agreement is to buy or sell the asset immediately

 Wheat farmer plants crop in January

and receives payment after harvest in July

 Farmer expects to sell wheat to a

miller for $10,000

 But price of wheat may fluctuate

 Price of wheat ↑ farmer gains and miller loses

 Price of wheat ↓ farmer loses and miller gains

Example

 Both parties face uncertain prices To

minimize these uncertainties they may agree the terms of their trade now

 By engaging in a forward transaction

the farmer reduces the risk of a loss and the miller reduces the risk of a

price fluctuation

Example

 The spot rate is the rate at which one

currency can be exchanged for another

currency at the present time

 The forward rate is the rate at which one

currency can be exchanged for another at some future delivery date (beyond the spot delivery date), where the terms of the

transaction are agreed upon today

Spot and Forward Exchange

Rates

 Forward exchange rates are used to

hedge against exchange rate risk

 Exchange rate risk is the effect of

unanticipated exchange rate

movements on profits

Exchange Rate Risk

 US firm sells Japanese radios at $100 each

 Firm will take delivery of radios in 30 days at

an agreed price of ¥9000 each

 Spot rate e=0.0105 → ¥9000 = $94.50

 Exchange rate risk: e=0.012→¥9000 = $108

 Forward rate F=0.0107→¥9000 = $96.30

Problems With Forward

Contracts

 Forward contracts contain terms

specific to the particular buyer and seller in the exchange This leads to illiquidity

 Forward contracts are subject to

default risk

 Futures are standardized contracts between

two parties to buy or sell an asset at a future date

 Standardized contracts do not provide an

exact match (amount or due date)

 E.g on the CME you can buy a contract of 12.5

million ¥ for delivery at a few specific dates

 Standardized contracts have low transactions

costs and increase liquidity

More on Futures

 Futures convey symmetric rights to

buyers and sellers of futures

 The buyer (long position) has the right

and obligation to receive the underlying

instrument at the specified date and price

 The seller (short position) has the right

and obligation to deliver the underlying

instrument at the specified date and price

Futures Trading

 The buyer and seller of futures trade with

each other anonymously

 Traditionally these trades were carried out

using the open outcry system where traders physically meet on the floor of the exchange

 This is being replaced by electronic trading

where computers match buyers and sellers

Settling Accounts

 Although the buyer (seller) of a futures

contract has the right to receive (deliver) the underlying instrument, rarely are these

assets actually exchanged

 Instead the “difference” is settled in cash by

the exchange on a daily basis in accordance

to the current spot price

 This daily settlements of accounts is called

marking to market

Futures Pricing

 The futures price is not specified in the

contract, rather on any given day, it is

determined by the market

 The futures price reflects the market’s

expectations regarding the spot price of the underlying asset on the date of delivery

 Clearly it must be the case then that the

futures price and spot price converge as the time to delivery approaches

Example: Reducing Interest

Rate Risk

 A bank makes 1-yr loan at 6% fixed interest

6-month time deposits earn variable int 4%

If interest rate ↑ then a loss is incurred

 Bank sells T-bill future (in March settle price

for a September delivery $1million T-bill is 95.16)

 If interest rate ↑ spot price<futures price

(loss covered)

 Agreements in which two parties trade

payment streams to guarantee that the

inflows of payments will more closely match outflows

 Swaps originated as instruments to hedge

against interest risk, however, they are also used in the foreign exchange market to

hedge against foreign exchange risk

Interest Rate Swaps

(Source: Burton and Lombra The Financial System and the Economy)

Deposits cost 6% fixed

Loans earn 12% variable Deposits cost 9% variable

Sells at 110€

Buys at $100 = 91€ Profit = 19€ 

Dollar

appreciates

e=.90

Sells at $110 Buys at 100€ = $90 Profit = $20 

Sells at 110€

Buys at $100 = 111€ Profit = -1€ 

Firms swap

payment

streams

Sells at $110 Pays $100 for Ger firm

Profit = $10

Sells at 110€

Pays 100€ for US firm

Profit = 10€

 Give the buyer the right, but not the

obligation, to buy or sell an asset in the future at a predetermined price (strike price)

 One party in the transaction has rights

but no obligations and the other party has obligations but no rights

Put and Call Options

 A put option gives the buyer the right

to sell but not the obligation to sell an asset in the future at the strike price

 A call option gives the buyer the right

to buy but not the obligation to buy an asset in the future at the strike price

 Interest rates denominated in different

currencies are the same once you

“cover” yourself against possible

currency changes

 Covered interest parity condition

implies that (1+i)=(1+if)F/e

Covered Interest Rate Parity

 In January 1992 the rate on 3-month

securities in the US was 4.19%

 Rate on DM-denominated 3-month

securities was 9.52%

 The premium can be attributed to covered

interest parity condition

Options Facing the Investor

 The investor is faced with two

strategies

 He could simply invest in US securities

an in three months he would earn 1.048% interest So on a one dollar investment

he would earn $1.0148

 Alternatively he could convert his dollars

to DM invest in Germany and reconvert his DM to dollars

Strategy Two Explained

 1 Convert $→DM at the spot rate e=0.6225

 2 Invest 1.606 DM (=1/e) in

DM-denominated security

 3 In 3 months interest earned would be

2.38% (=i f /4), so he has 1.644 DMs

 4 Instead of selling at the spot rate in

3-months he could sell 1.644 DMs (=1+i f /4)1/e

forward at the forward rate F=0.6114 leaving him with $1.01048 (=1+ i f /4)F/e

Strategy Two Explained

 Note the return on investments,

whether the investor invests abroad or

at home is the same ($1.0148), i.e

covered interest rate parity condition]

Forward Premiums (or

 Finally note that (1+i f )(1+fp)≈1+i f +fp, hence

you can think of fp as the forward premium

Forward Exchange Rate and

Expectations

 Note that the uncovered interest rate parity

condition is

 (1+i)=(1+i f )e t+1 /e t

 Recall that i≈i f +%(e) is just an approximation

 To see this note that (1+i)=(1+i f )[(e t+1 - e t )/e t +1]

 Hence (1+i)=(1+i f )[%(e) +1] ⇒ i≈i f +%(e)

 Compare UCIP to CIPC: (1+i)=(1+i f )F t /e t

 Hence F t is just your expectation of the future

exchange rate (note that we are assuming that investors are risk neutral)