Currency

5
Forwards and Futures

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INTRODUCTION Learning Objectives

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Globalization of business is the theme of almost all firms in the After going through this chapter,

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world. As economies grow and become more and more open by readers should be familiar with
relaxation of regulations concerning international trade, firms are foreign exchange rates, markets,
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expanding businesses from local markets in domestic currencies
to global markets in multiple currencies. International markets
and transactions
how forward contracts on
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currencies work
present several different challenges in finance in terms of the
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hedging foreign currency exposures

additional understanding required, due to the added dimension of importers and exporters through
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of choosing the currency of trade and for finance. As the world forward contracts
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economy becomes more and more integrated, a finance manager speculation and arbitrage with
is required to make additional decisions with respect to strategic forward contracts
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non-deliverable forward contracts;

issues such as the currency of borrowing, impact of globaliza-
their evolution, need, and relevance
tion on capital structure, and tactical issues (such as the currency currency futures
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of invoicing). These new dimensions have added complexities to hedging with currency futures for
trade. The dynamics of derivatives markets, too, has witnessed importers and exporters
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major changes ever since the onset of globalization. speculation and arbitrage with
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currency futures
Apart from the selection of currency for finance and trade,
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another important dimension that fig-

When multi-currency ures prominently on the agenda of
options are available, the finance managers is the exposure to
evaluation of all finance
avenues is not as simple
additional risk arising from deals in
as it is with a single currencies other than the domestic cur-
currency. rency. Apart from broadening the con-
ceptual scope of understanding the
interest rate structures followed in various countries and finan-
cial assets denominated in foreign currency, the finance manager
has the onerous task of gathering, assimilating, and analysing
the vast information that is generated all over the world. In this
way, an international firm, referred to as a multinational corpo-
ration (MNC), becomes different from a purely domestic firm
dealing in a single currency.

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 Currency Forwards and Futures 117

One may argue that the concepts of corporate finance must remain the same irrespective
of the currency being evaluated. All the three major decisions in finance—the investment
decision, the financing decision, and the dividend decision—should be independent of the
currency being considered. The argument is valid, but the presence of multiple currencies
makes each of these decisions more complicated, as the number of options available increases
significantly. Numerically, it is simple multiplication involving exchange rates to convert one
currency into another, but the decision-making framework changes drastically with regard
to international business, as managerial inputs are significantly larger, more complex, and
different.

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FOREIGN EXCHANGE PRELIMINARIES

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From the perspective of risk, dealing in foreign currencies adds a new type of risk, called

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exchange rate risk. To understand exchange rate risk, it is essential to understand the basic
structure of foreign exchange markets, their terminologies, and their practices. This section

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is aimed at providing the necessary background for all of this.

FOREIGN EXCHANGE RISK

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An additional dimension for transactions denominated in currencies other than the domestic
one is exposure to the risk of conversion of currency. Since foreign exchange rates change in
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the same way as stock prices change in the stock markets, all transactions denominated in a
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foreign currency face exchange rate risk. The MNCs deal in and possess assets and liabilities
denominated in various currencies. They need to bring down all these transactions, assets,
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and liabilities to a common single currency—the domestic currency of the country where
the MNC’s headquarter is located.
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Basically, all firms that have transactions, assets, or liabilities denominated in foreign
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currency face the risk of changes in the position of assets or liabilities and/or cash flows.
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The amount of foreign currency outstanding either as payables or receivables is referred to

as currency exposure. If the rate of exchange moves in an unfavourable direction, the
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impact on the balance sheet or the income statement is termed exchange rate risk. For
example, if an export firm has sold goods worth US $1000 on credit of 60 days, the trans-
action would be completed only after 60 days, upon receipt of the payment of US $1000.
If from the date of invoicing to the date of realization, the US dollar depreciates, the
exporter realizes a lesser sum in Indian rupees than what he/she envisaged at the time of
invoicing. However, an appreciation in the US dollar would be favourable
MNCs and firms dealing to the exporter, as he/she will realize more than expected. Similarly, an
in foreign currencies
face the additional risk importer needing to pay an outstanding in some foreign currency is worried
of exchange rates, and about its appreciation during the intervening period between creation of
need to understand liability and its actual liquidation. In contradiction to an exporter, an
the nuances of foreign importer would welcome depreciation of the foreign currency to which he/
exchange markets. she is exposed.

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 118 Derivatives and Risk Management

FOREIGN EXCHANGE MARKETS

Foreign exchange markets mainly consist of banks, called authorized dealers in India, These
markets are of the over-the-counter (OTC) type, where individuals and cor-
Despite foreign exchange porate traders come with their requirements for either buying or selling
markets being OTC, specific currencies. There is no organized exchange where foreign exchange
prices behave much in can be traded, in the manner of the various stock exchanges where custom-
the same way as stocks.
ers can place their orders for buying and/or selling stocks in the physical or
Information gathering and
negotiation skills become electronic market. Despite the fact that foreign exchange markets are OTC
predominant. in nature, the price behaviour of currencies is akin to that of stocks. This
implies that different rates of exchange would prevail in the market for dif-

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ferent currencies. The OTC nature of foreign currency markets places an additional burden

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on corporate finance managers exploring various avenues and possibilities to determine the

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most cost-effective solutions to their problems. These analyses not only are time consuming

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but also require deep understanding and good negotiation skills.
Further, foreign exchange markets are operative round the clock. There is no specific

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time for opening or closing. Foreign exchange rates fluctuate all the time. Banks and foreign
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exchange dealers quote foreign exchange rates depending upon the demand and supply posi-
tion they are facing. Normally, banking hours govern trading in foreign exchange.
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FOREIGN EXCHANGE RATES

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Trading in foreign currency, unlike trading in shares and other financial assets, is not done in
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any organized exchange. For exchange-traded assets, a single price in the public domain is
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available. The buyer and seller both pay brokerage. With a brokerage of 1% on a share priced
at `200, a buyer would pay `202, and the seller would receive `198, with `4 being the total
transaction cost for buyer and seller and the income for the brokers. There are many foreign
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exchange rates, briefly described in the following paragraphs.

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Bid Rate vs Ask Rate

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Foreign exchange markets are OTC markets, with various banks quoting rates in bid and ask
pairs—one for buying and the other for selling foreign currency. Bid and ask rates are defined
as follows:
Bid rate: The rate at which a bank buys foreign currency.
Ask rate: The rate at which a bank sells foreign currency.
To make a profit in foreign exchange transactions, banks must buy currencies at a lower
rate and sell them at a higher rate. Therefore, the ask rate is always higher than the bid rate.
While quoting rates, the convention is to specify the bid rate first. The dif-
Foreign exchange rates ference between the ask rate and the bid rate is the profit for the bank from
are always two-way a round transaction involving the buying and selling of one unit of foreign
quotes, one for buying
currency; this difference is known as the spread. Percentage spread is defined
foreign currency—the bid
rate, and other for sell- as follows:
ing—the ask rate. Ask rate  Bid rate
% Spread   100 (5.1)
Mid rate

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 Currency Forwards and Futures 119

Spot Rate vs Forward Rate

Transactions in foreign exchange may be carried out for settlement either now or at a
later date. Spot transactions in foreign exchange require settlement of contracts within
two business days. Transactions in foreign exchange involve at least two countries, which
hinders the immediate settlement of contracts. Therefore, a provision of two business days
is made to facilitate movement of currencies (by debits and credits) for settlement of spot
transactions.
Forward contracts in foreign exchange, like any other forward contract, fix the exchange rate
today for settlement at some future date. Settlement refers to the actual exchange of currencies.
Since various economic and political factors impact exchange rates on a continuous basis,
spot rates change with time, as do stock prices. The exchange rate, therefore, is dependent

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upon the time of delivery of the currencies. This makes for different spot and forward rates.

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What is valid today cannot be valid tomorrow. Except by coincidence, the spot and forward

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rate would not be identical. Essentially, the exchange rates are dependent upon the timing of
the settlement of the transaction.

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Some people may believe that the forward rate would always be higher than the spot rate

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at any point of time. However, it is not true. Forward rates, though dependent upon the spot
rate, can be lower than, equal to, or higher than the spot rate. We shall address this issue in
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the section on pricing of forward contracts in foreign exchange in this chapter.
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FORWARD PREMIUM/DISCOUNT
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There are two ways of quoting exchange rates, direct and indirect. Under the direct rate
convention, the value of foreign currency is stated in terms of number of units of domestic
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currency per unit of foreign currency, e.g., `47 per US dollar in India. The system of direct
rate prevails across the world, except for a few countries. Under the direct rate convention,
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a forward rate that is higher than the spot rate means that the foreign currency will be more
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expensive in the future than it is today, when it is said to be at premium. Similarly, a forward
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rate that is lower than the spot rate implies that the foreign currency will be cheaper in the
future than it is today, when it is said to be at a discount.
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How expensive or cheap the foreign currency will be, is stated conventionally on an annual
basis. Forward rates are available for varying contract periods ranging from
Foreign currency at one to six months and sometimes up to 12 months. As the foreign exchange
a premium/ discount
means that the forward
market is an OTC market, one can get foreign exchange rates for any forward
rate is higher/ lower than period on demand, but it is more common to find forward rates available at
the spot rate. monthly intervals. The annual premium or discount on the foreign currency
can be computed by using the forward rate, as follows:
Annualized forward premium/discount (%)
Forward ratemid  Spot ratemid 12
   100
Spot ratemid Forward period (in months)
Here mid refers to the average of the bid and ask rates. Since foreign exchange rates are
quoted in pairs of bid and ask rates, the premium or discount is calculated using the average
of the two, called the mid rate.

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 120 Derivatives and Risk Management

EXAMPLE 5.1 Calculating forward premium/discount

Consider the following rates of foreign exchange for euro:
Spot (rupees per euro) 57.90 58.10
1-m forward (rupees per euro) 57.50 57.80

(a) Find whether the euro is at a premium or discount.

(b) Calculate the annualized premium or discount for euro.
(c) What interpretation do you give to the figure arrived at in (b)?
(d) What do you think would be the average (mid) rate for 3-m, 6-m, and 12-m forward contracts, assuming bid–ask spreads of
`0.50, `0.80, and `1.00, respectively?
Solution

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(a) Since 1-m forward rates are lower than the spot rates, the foreign currency, i.e., the euro, is at a discount to rupee.

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(b) The amount of discount is:
Annualized Forward Premium/Discount (%)

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Forward ratemid  Spot ratemid 12 57.65  58.00

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   100   12  100  7.24%
Spot ratemid Forward period (in months) 58.00

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(c) A discount of 7.24% means that the euro is likely to depreciate by 7.24% in a year with respect to the rupee.
(d) Assuming that the premium/discount calculated using the 1-m forward rate is a fair representative of forward rates for the
whole year, the likely forward rates for 3, 6, and 12 months are as follows:
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3-m forward rate (mid)  58.00  (1  0.0724/4)  `56.95/euro
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6-m forward rate (mid)  58.00  (1  0.0724/2)  `55.90/euro

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12-m forward rate (mid)  58.00  (1  0.0724)  `53.80/euro

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Assuming even distribution of spread from the mid-rates, the forward bid and ask rates are:
3-m forward rate (rupees per euro) : 56.70 57.20
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6-m forward rate (rupees per euro) : 55.50 56.30

12-m forward rate (rupees per euro) : 53.30 54.30
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Since forward rates are available for different maturities, one faces a dilemma as to which
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of the forward periods is most appropriate for calculating the annualized premium/discount.
Purely on consideration that trading thins down as the forward period extends in time, it is
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most appropriate to estimate the annualized premium or discount on the foreign currency on
the basis of the nearest forward contract, i.e., the 1-m forward rate rather than the forward
rate for any other forward contract period. This approach is based on the presumption that
contracts with near maturity are traded the most. Greater liquidity implies truer representa-
tion of fair prices.
Another important feature of forward rates is that the spread in forward rates is larger
than the spread in spot rates. Since forward transactions have a greater risk, dealers
demand a greater spread. Given the increased risk, banks would expect a greater reward,
which is derived from the spread (the difference between the ask and bid rates). By the
same logic, the spread increases as the maturity of the forward contract extends, i.e., the
spread in a 6-m forward contract is likely to be higher than the spreads in 3-m and 1-m
forward rates.

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 Currency Forwards and Futures 121

ARBITRAGE AND FOREIGN EXCHANGE RATES

Having discussed the various rates, the question of whether different dealers in foreign
exchange would quote the same rates for a currency remains. Basically, the main question
is: what is the process involved in determining and quoting rates?
The process of determination of rates is analogous to the process behind stock market
quotations. Without concern for the fair value of a financial asset like stocks
Arbitrage is a process or bonds, we all appreciate the fact that an asset cannot have two prices.
that makes prices
Having two prices provides an opportunity to investors to make immediate
converge in different mar-
kets. It is not concerned profits without investing or assuming risk. The costs of shares of Reliance
with whether the prices Industries Ltd in various stock exchanges across India at any given point of

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are fair or not. time necessarily have to be identical. In case the prices are not the same, the

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situation gives rise to arbitrage opportunities; traders may earn profits by

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buying the stock in a market where the price is low and simultaneously selling the stock in

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a market where the price is high, pocketing the difference between the two prices. This profit
is earned without making any investment and without taking any risk.

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The process of arbitrage would make the prices converge and helps to eliminate such
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profit opportunities very quickly. The visibility of an arbitrage opportunity is extremely high
in cases where trading in financial assets takes place on exchanges that display prices all the
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time. The same process of arbitrage makes foreign exchange rates converge across different
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traders and banks.

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However, arbitrage opportunities in the foreign exchange markets are not as visible as
with stocks and bonds. The primary reasons for this difference are: first, foreign exchange
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markets are OTC markets where the rates are not displayed for viewing, and, therefore, fewer
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investors are aware of the rates and the existence of discrepancies, if any. Second, foreign
exchange quotations are two-way quotes, with one price for buying and the other for selling.
Identification of arbitrage opportunities is relatively difficult in foreign exchange markets,
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compared to products that are exchange-traded. Apart from these reasons, foreign exchange
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markets may place restrictions on trading and prohibit taking of speculative positions, unlike
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stock markets, where such restrictions are almost non-existent.

Let us consider a simple example where two banks, Bank A and Bank B, (assuming both
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are American banks and follow the convention of direct rates) have offered the following
rates:

Amount of US dollars per euro Bid Ask

Bank A 1.3160 1.3260
Bank B 1.3280 1.3380
For arbitrage-free foreign
exchange rates, the bid The rates of Bank A mean that it would buy euro at $1.3160 and sell euro at
price of one trader must $1.3260. This means that customers can sell one euro and get $1.3160 (the
be less than the ask price bid rate) and if they wish to buy one euro, they will have to pay $1.3260 (the
of another, with both the ask rate). Similarly, at Bank B customers can sell one euro to get $1.3280 and
quotes expressed in a
pay $1.3380 to get one euro. A customer sells the foreign currency at the bid
similar fashion.
rate and buys foreign currency at the ask rate.

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 122 Derivatives and Risk Management

To derive profit, one needs to ‘sell high and buy low’. In the foreign exchange markets,
if the ask rate of one bank is higher than the bid rate of another, it would offer an arbitrage
opportunity, such that the difference between the ask of one and the bid of the other can
be earned as profit. The condition for arbitrage is exhibited in Fig. 5.1, and can be simply
expressed as,
For arbitrage: Bid2  Ask1
With the given rates, traders would buy euros from Bank A at the ask rate of $1.3260 and
sell the same amount of euros to Bank B to receive the bid rate of $1.3280, making a profit
of $0.0020 per euro without making any investment or carrying any risk.

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US $/ 1.3160 1.3260 1.3280 1.3380

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Bid1 Ask1 Bid 2 Ask 2

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Trader buys euro
Trader sells euro
$0.0020/euro
Profit by trader
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Fig. 5.1 Condition for arbitrage

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Obviously, the rates that offer arbitrage cannot exist for long in the market. Arbitrage
opportunities have to vanish very quickly. Bank A would face a great demand for euro, indi-
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cating that it can increase the ask rate. Continuing with the same rate would also result in the
fast depletion of its stock of euro. Similarly, Bank B would face a situation where everybody
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would be selling euro at $1.3280. This indicates that it can revise its quote downwards, and
also prevents unnecessary build-up of euro. Arbitrageurs would signal an upward revision of
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ask rate of Bank A and a downward revision of bid rate of Bank B. The inventory of foreign
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currency at hand would tell the bank which rate to revise as well as its direction.
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If the quotes of Bank A and Bank B overlap (the ask of one is greater than the bid of
another), the arbitrage opportunity would vanish. For example, the banks could revise the
rates in the following way:

Amount of US dollars per euro Bid Ask

Bank A 1.3160 1.3275
Bank B 1.3270 1.3380

The condition for no arbitrage to exist is depicted in Fig. 5.2, where the rates of the two
banks overlap. This may also be stated as
For no arbitrage: Bid2  Ask1
In competitive and well-informed markets, such arbitrage opportunities do not exist at all,
and if they do, then they vanish as quickly as they are spotted.

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 Currency Forwards and Futures 123

US $/ 1.3160 1.3270 1.3275 1.3380

Bid1 Bid2 Ask1 Ask2

Trader sells euro

Trader buys euro
$0.0005/euro
Loss by trader

Fig. 5.2 Condition for no arbitrage

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CURRENCY FORWARDS

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FOREIGN EXCHANGE TRANSACTIONS
Having understood the various rates quoted in foreign exchange markets, we now turn to an
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understanding of the nature of transactions. For better understanding of the applications of
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hedging, speculation, and arbitrage, a brief background of various transactions in the foreign
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currency markets is discussed in this section.

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Spot and Forward Transaction

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Transactions in foreign exchange can either be spot or forward, depending upon the time of
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settlement. For all buy or sell currency transactions, the actual exchange of cash (debit or
credit to the respective accounts) in the two currencies takes place later, and is referred to as
settlement. If a transaction is to be settled immediately, it is termed a spot transaction, and
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the rates applicable for such a transaction are known as spot rates. In foreign exchange trade,
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spot transactions are to be settled within two business days of the transaction to allow for
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clearance and confirmation on the communication network.

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Transactions in foreign currency can also be made for settlement at a later date. Such
transactions, where the rate is fixed now but the delivery of currencies is delayed, are known
as forward contracts. For example a 1-m forward contract for buying dollars executed by an
Indian importer at `45.00 per dollar implies that physical exchange of dollars and rupees
would take place one month after the date of transaction, but the rate of `45 per dollar has
been fixed today. It further provides for two business days for settlement. It does not matter
what exchange rate prevails one month later, on the day of settlement.
Forward contracts are Banks usually quote rates for delivery in months, and standard contracts
settled at a later date,
but at rates negotiated
for one, two, three, six, and nine months are generally available. However,
in advance. These rates banks can also quote rates for forward periods that are not exact multiples of
are usually available in a month. Traders can book contracts for any number of days forward. Such
advance for time periods contracts are called broken date or odd date contracts.
comprising months as Spot and forward rates, as quoted by the State Bank of India (SBI), are shown
units.
in Table 5.1. Note that the forward rates are quoted in unbroken months.

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 124 Derivatives and Risk Management

Table 5.1 Spot and forward foreign exchange rates

As on 16 September 2005 as quoted by the SBI
Import Export
Currency
6-m 3-m 1-m Spot Spot 1-m 3-m 6-m
44.13 44.06 44.02 43.97 US dollar 43.83 43.83 43.85 43.92
54.57 54.22 54.01 53.87 Euro 53.69 53.63 53.73 53.98
79.71 76.56 79.65 79.61 Pound Sterling 79.34 79.28 79.27 79.32
35.41 35.07 34.85 34.72 Swiss franc 34.61 34.56 34.66 34.90
7.32 7.27 7.24 7.22 Danish kroner 7.20 7.19 7.21 7.24
33.68 33.74 33.83 33.81 Australian dollar 33.69 33.80 33.76 33.72

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37.46 37.31 37.21 37.14 Canadian dollar 37.01 36.95 37.00 37.12

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` per unit of foreign currency

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Source: Business Line, 17 September 2005.

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Swap Transaction
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A swap transaction is a combination of spot and forward transactions. The spot and forward
legs of the swap are opposite and equal in value. On a given day, for example, a bank may buy
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$10,000 spot from another bank and simultaneously enter into a 1-m forward contract to sell
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$10,000 to the same bank. The rates for buying spot and selling forward would be different, but
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are known on that day itself. This called a swap transaction. With both buying and selling rates
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known, the bank is not exposed to any risk of fluctuation in exchange rates. Buying foreign
currency today and selling later, or selling today and buying later, is a composite contract in
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the swap deal. However, the same position is obtainable with two independent but opposite and
equal contracts—one spot and the other forward. An independent forward contract is called
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outright forward contract. Two independent contracts—one spot and the other outright for-
ward—are more expensive than a single swap contract.
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Composite swap contracts are of great utility to banks, as they enable avoidance of risk
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and the problem of finding an exact matching counterparty. A swap can do this by having
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offsetting positions in a single contract. Banks usually do trading on behalf of customers who
are exporters and importers. The transactions of a bank with its customers are normally on
an outright basis, while with other banks, the deals are on a swap basis.
Assume a bank buys a 1-m forward contract of $10,000 at `46 per dollar on an outright
basis from an exporter. The contract means that after one month, the exporter would deliver
$10,000 to the bank and receive `4,60,000 from it. After paying `4,60,000 to the exporter,
the bank would end up with $10,000. While the rupee amount payable by the bank is known
today, it does not know what amount of local currency $10,000 would fetch
A swap is a composite
later. Depending upon the rate prevailing at that point of time, the bank may
contract consisting of two realize an amount more than, equal to, or less than the `4,60,000 it paid.
legs, with the second leg Thus by buying dollars from an exporter, the risk of exchange rate fluctua-
being opposite and equal tions passed from the exporter to the bank. The bank must find a buyer (an
to the first leg, but settled importer-customer) who needs exactly the same amount at exactly the same
only after the first leg is
settled.
time. Though a transaction like this is theoretically possible, in practice it is
a difficult proposition to fulfil.

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 Currency Forwards and Futures 125

Most inter-bank deals are

Bankers would not accept such a position since it is not a bank’s business
swap deals, which help to assume risk on behalf of its customers, and, hence, the bank in this posi-
eliminate the exchange tion would in turn book a contract with another bank to sell $10,000 1-m
rate risk. forward. Such a step would mean that the bank, after receiving dollars from
its customer, would sell them to another bank at a rate known today. While
buying dollars forward, the second bank would sell an equal amount of dollars on spot basis
to the first bank. The dollars so received can be sold in the market at the prevailing spot price.
By doing so, the timings of the cash flows in foreign currency are matched with spot buying
and selling and forward buying and selling. Further, all the exchange rate risk is eliminated.
Figure 5.3 depicts the flow of foreign currency (dollars) for Bank A under a swap deal.
Note that cash flows on a spot basis as well as a forward basis in the foreign currency

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are matched with all the rates known today, eliminating any uncertainty about the foreign
exchange rates.

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Customer Buys $ forward Bank A ed Sells $ forward Bank B
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exporter
Buys $ spot
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Sells $ spot Swap deal

Note: Description relate to Bank A.
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Fig. 5.3 A swap transaction for bank A

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Outright Forward vs Swap

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We described a swap transaction as either of the following:

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Buy foreign currency spot and sell forward

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Sell foreign currency spot and buy forward

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A swap is a composite deal that has two equal legs, one the spot and the other the forward,
which is equal and opposite to the spot1. The exposure to foreign currency is nullified at the
end of the swap period. As both legs are equal and opposite, the net flow of foreign exchange
is zero. A swap contract merely changes the timings of the inflow of cash and the outflow of
foreign currency. Since the rate for the forward leg is predetermined, the risk of changes in
the foreign currency rates is eliminated. As the deal is composite, the foreign exchange rates
in the spot and the forward transactions are linked with each other.
Swap deals are quoted in a different fashion. Two rates are required for a swap deal: one
for the spot leg and another for the forward leg. While spot rates are readily available, the
rates for the forward leg are quoted in terms of swap points, instead of explicit rates. The spot
rates, together with the swap points, are used to arrive at the rate applicable for the forward
leg. This system can best be explained with an example. Assume a dealer wants to buy euro
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It is not necessary to have the first leg as a spot under the swap. One can buy (sell) a 1-m forward contract and sell (buy)
a 2-m forward contract of equal amount. Such a swap is called a forward–forward swap.

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 126 Derivatives and Risk Management

Forward rates under

now and sell euro one month later. This is a swap transaction, where the spot
swap are arrived at by leg is a buy and the forward leg is a sell for the dealer. Further, assume that
adding or subtracting a bank quotes the following rates:
the swap points. When
the swap points are low/ Spot (rupees per euro) 58.5800 – 58.6000
high, they are added to Swap points2 1-m 500/700
the spot rate, and when
they are high/low, they The dealer can achieve the same outcome as that of a swap by entering into
are subtracted from the two independent contracts; buy euros spot and sell the same quantity 1-m
spot rate. forward. The rates for the 1-m forward deal on an outright basis are derived
from the swap points using the following rules:
When the swap points are low/high The foreign currency is at a premium, and the rate

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for the forward deal is arrived at by adding the swap points to the spot rates.

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When the swap points are high/low The foreign currency is at a discount, and the rate

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for the forward deal is arrived at by subtracting the swap points from the spot rates.

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Using this rule, the rate for the outright forward contract in our example is derived as follows:
Spot (rupees per euro)
Swap points 1-m ed
58.5800 – 58.6000
500/700
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1-m forward rate 58.6300 − 58.6700
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(Swap points being low/high are added to the spot rates)

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The dealer can buy euro spot at 58.6000 (the ask rate for a spot deal) and sell euro 1-m
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forward on an outright basis at 58.6300 (the bid rate for the forward deal).
Instead of booking two independent contracts, the dealer can book a composite swap con-
-C

tract. Here, the spot transaction would be executed at the same rate (the ask rate at which the
dealer buys and the bank sells euro) of `58.6000 per euro. However, the rate for the forward
w

leg would differ and is calculated as follows:

ie

The rate for the spot leg becomes the reference rate to/from which the relevant swap
ev

points are either added or subtracted.

If the swap points are low/high, they would be added to the spot rate and if they are
Pr

high/low, they would be subtracted from the spot rate.

If the forward leg is ‘buy’ for the bank, the bid points are relevant, and if it is ‘sell’,
then the ask points are relevant.
Here, the reference rate is `58.6000 and the forward leg is ‘sell’ for the dealer and ‘buy’
for the bank; therefore, the bid points become relevant. Further, since the swap points are
low/high, they would be added to the reference rate for the forward leg. The
A swap deal is always forward rate would therefore be 58.6000  0.0500  `58.6500, yielding a
cheaper than two profit of `0.05 per euro for the dealer. Note that the profit for the dealer was
equivalent independent
lower at `0.03 per euro if he had booked two independent contracts for spot
contracts.
buy and 1-m outright forward sell.
2In inter-bank quotations, rates are quoted up to four decimal places. The first two decimal places are called basis points,

abbreviated as ‘bp’ and the last two decimal places are referred to as points-in-points abbreviated as ‘PIPs’. Swap points
are quoted in PIPs.

Derivatives_ch05.indd 126 28/02/14 11:55 AM

 Currency Forwards and Futures 127

A composite swap contract is always cheaper than the combination of two independent
contracts consisting of a spot deal followed by an outright forward contract.

Option Forwards
Parties to forward contracts are committed to settling their individual obligations on the due
date. A forward contract is a firm contract that has to be settled on a specific date. While
banks are in a better position to meet these commitments exactly on the specific date, it is
a rather difficult proposition for merchants dealing in exports and imports. For example, an
exporter expecting a payment in one month’s time from his customer may decide to sell the
foreign currency 1-m forward to his bank. Though the commitment has been made to sell the

l
foreign currency to the bank, the exporter may not realize his payment as expected. In such a

ia
case, the exporter would default, as he is not ready with the foreign currency to be delivered

er
to the bank on the scheduled date. A similar instance may happen with an importer who may

at
not be in a position to buy foreign currency on the date fixed in a forward contract booked
by him. These circumstances certainly do not imply that the merchants defaulted on their

M
contracted commitments intentionally. Prevailing business circumstances might be a reason
ed
for not honouring commitments on the dates decided.
Some flexibility in the timing of maturity of forward contracts is desired by merchants, as
ht
they can predict their cash flows only in an approximate basis due to the
Option forward contracts
ig

nature of their businesses. When the exact timing of the cash inflow/outflow
are not fixed-date
yr

contracts, but instead is uncertain, a forward contract can be booked for delivery within a given
provide flexibility to time period, called the option period, rather than on a specific date. For exam-
op

deliver foreign exchange ple, an exporter expecting payment anytime between two to three months
over a period, called the
-C

would like the kind of flexibility where he can deliver the foreign exchange
option period.
any time between two and three months of booking a forward contract. Such
a contract is called an option forward contract, and is depicted in Fig. 5.4.
w

Under the option forward contract, a merchant who has booked a forward contract at t  0,
ie

has an option period for delivery between two dates: the earliest date and the last date, rather
ev

than one fixed date.

The rates offered by banks in option forward contracts are based on the principle of least
Pr

risk and maximum gain. These rates would depend upon (a) whether the bank is buying
or selling the foreign currency forward, and (b) whether the currency is at a premium or
discount. For example, if the bank is dealing with an exporter who wants to tender foreign
currency anytime between two and three months forward, and the currency is at a premium,
the bank would use the 2-m forward rate rather than the 3-m alternative for quoting rates to
the customer. Since the foreign currency is at a premium, it is advantageous for the bank to

Time of contract Earliest delivery Latest delivery

Option period

Fig. 5.4 Option forward contract

Derivatives_ch05.indd 127 28/02/14 11:55 AM

 128 Derivatives and Risk Management

buy it earlier, as it becomes more expensive at a later date. The advantage to the bank can be
maximized if the bank adopts the following strategy for quoting the option forward rates:
Foreign currency state Buy Sell
Premium Earliest Latest
Discount Latest Earliest

Though rates based on this strategy would be expensive for the customer, the customer
must be prepared to pay an extra price for having the flexibility of timing when buying or
selling, and, therefore, must not feel too aggrieved.

l
HEDGING THROUGH FORWARD CONTRACTS

ia
er
A forward contract in foreign exchange can be used to remove uncertainty over exchange
rates in the future by buying and selling forward at rates fixed now.

at
Exporters who expect to realize sales in a given foreign currency face the risk of a fall in

M
the price of that foreign currency. They need protection against any reduction in the value of
the asset, the account receivable. If the foreign currency appreciates, the exporters welcome
ed
this rise, because it will increase the value of the asset. As it is an unfavourable movement,
ht
deprecation of foreign currency is a cause for concern here. This concern may be mitigated
by selling the anticipated receipts in foreign currency by entering into a forward contract with
ig

a bank, whereby the exporter promises to deliver the foreign currency in exchange for the
yr

domestic currency at a rate fixed now.

op

Similarly, importers who have to make a definite payment in foreign currency at a future
date are apprehensive about any increase in the price of that foreign currency. They con-
-C

sider that any increase in the value of the payable must be confined to an
A currency forward is acceptable level. In order to eliminate the risks changes in exchange rates,
an agreement to give or
w

take delivery of foreign

an exporter can freeze the exchange rate prevailing now, by entering into a
ie

currency in exchange forward contract to sell foreign currency, whereas an importer would obtain
the requisite foreign currency later in exchange for domestic currency at an
ev

for domestic currency at

a future date, at an ex- exchange rate known and accepted today.
Pr

change rate determined Two examples demonstrating how hedging for receivables and payables
today.
can be done are presented here.

Hedging Receivables (by Exporter) with Forward Contract

Exporters need to guard against the effects of appreciation of their local currencies, as they
realize lesser amounts of the domestic currency against foreign currency payments to be
received by them in the future. Assume an exporter, EXPressive Ltd, has sold merchandise
worth £1,00,000 to a customer in England. EXPressive expects to receive the
Exporters can sell foreign
currency forward at a money three months from now. The spot price of the pound is `79.34. The
price determined today, exporter is expecting the pound to depreciate over the next three months to
eliminating any risk of fall `79.00. What can EXPressive do to protect itself from the risk posed by the
in the value of the asset decreasing value of the pound?
due to a decline in the A 3-m forward contract from a bank for buying pounds is available at
exchange rate.
`79.27. If the firm thinks that in three months’ time the rupee would not

Derivatives_ch05.indd 128 28/02/14 11:55 AM

 Currency Forwards and Futures 129

depreciate as much as the forward rate indicates, then it can sell receivable 3-m forward. A
forward contract for selling £100,000 may be booked with the bank.
At maturity of the forward contract three months later, settlement will be done as follows:
EXPressive will deliver to the bank: £1,00,000
The bank will pay to EXPressive: `79,27,000
By booking the forward contract, EXPressive has mitigated any anticipated loss and has
assured itself of a firm level of cash flow in local currency. If the forward contract was
not booked, EXPressive would have to sell its pounds at the spot price prevailing three
months later. If the rate falls to `79.00 as anticipated, EXPressive would have realized only
`79,00,000. Through the forward sale of pounds, EXPressive ensured it would not lose prof-

l
its to the extent of `27,000. On the other hand, if the pound appreciates to `79.50, the local

ia
currency collection would be more `79,50,000. Here, the spot market would give `23,000

er
more than what could be realized from a forward contract. Note that a forward contract fixes

at
cash flow in the domestic currency. Forward contracts are used to protect future cash flows,

M
not to maximize the value of those cash flows.
Actions and decisions for hedging receivables in foreign currency are shown in Fig. 5.5.
ed
ht
Asset in foreign currency is created at t = 0 maturing
ig

at time t = T
yr
op

Compare the expected spot rate at T, ST with the

-C

forward rate, F
If ST < F Sell Forward
w
ie

At t = T deliver foreign currency and receive local

currency at fixed rate, F
ev
Pr

Fig. 5.5 Hedging receivables with currency forward

Hedging Payable (by Importers) with Forward Contract

While exporters do not face any risk from appreciating foreign currency, importers do. In
fact, exporters welcome appreciation of foreign currency, as their receivables appreciate in
value, and importers welcome depreciation of foreign currency, as their pay-
An importer books a ables fall in value.
forward contract to
Let us consider how importers can hedge payables against any rise in
buy foreign currency
at a price determined the price of the foreign currency required. Assume an importer, IMPressive
today, eliminating risk Ltd, has purchased a machine from a supplier in Germany for €10,000,
associated with a rise in with the payment due in six months. The spot price of the euro is `53.84.
the value of the liability The importer is expecting the euro to appreciate to a level of `55.00 in six
due to an increase in the
months’ time, and is worried about the rising value of the euro. What can the
exchange rate.
importer do to safeguard its interests?

Derivatives_ch05.indd 129 28/02/14 11:55 AM

 130 Derivatives and Risk Management

Forward contracts on
The importer is expecting a cash outflow of `5,50,000 based on its fore-
currency are OTC, cast for the exchange rate six months later. A forward contract for the euro is
settled with delivery, available at `54.57. To safeguard its position, IMPressive may buy €10,000
independent of underly- from the bank six months forward. At the time of maturity of the forward
ing contracts, and have contract, coinciding with the payment in euro after six months,
counterparty risk.
The bank will provide IMPressive with: €10,000
IMPressive will pay to the bank: `5,45,700
By booking a forward contract to buy the foreign currency at a predetermined price,
IMPressive has ensured that it pays exactly `54.57 per euro. Whether or not the importer
benefits economically from such a deal will be known only at the expiry of the forward

l
ia
contract, i.e., from the spot rate at the time of settlement of the forward contract. If the euro
appreciates to a level higher than `54.57, then IMPressive benefits from the forward contract.

er
On the other hand, if the price of the euro remains below `54.57 IMPressive would have been

at
better off without a forward contract.

M
Actions and decisions for hedging payables in foreign currency are shown in Fig. 5.6.

ed
ht
Liability in foreign currency is created at t = 0 maturing
at time t = T
ig
yr
op

Compare the expected spot rate at T, ST with the

forward rate, F
-C

If ST > F Buy Forward

w

At t = T deliver local currency and receive foreign

ie

currency at fixed rate, F

ev

Fig. 5.6 Hedging payable with currency forward

Pr

The following points need to be reinforced about forward contracts as hedge tools for
exporters and importers:
A forward contract is a derivative product, which derives its price from the spot price
of the foreign exchange that is the underlying asset. All forward prices mentioned in
Table 5.1 were derived from the spot price of the concerned currency. If the spot price
changes, the forward price will also change.
The contracts were OTC, as they were tailor-made to the requirements of customers in
terms of quantity of the underlying asset and time of delivery. If required, banks could
quote prices for any forward period depending upon the requirements of their customers.
A forward contract is settled with delivery on the due date, when both the bank and the
customer honour their commitments to each other for delivery of foreign currency and
local currency.

Derivatives_ch05.indd 130 28/02/14 11:55 AM

 Currency Forwards and Futures 131

The obligations undertaken within a forward contract are independent of the underly-
ing contract. Whether or not the exporter actually receives money from its customer or
whether the importer actually made the required payment to its supplier is immaterial.
Irrespective of this situation, the commitment made to the bank under the forward con-
tract must be honoured. The underlying receivable or payable and the forward contract
thereon are independent of each other.
There is no front-end payment involved at the time of booking a forward contract. There
are no interim cash flows either. Only at maturity is the actual exchange of currencies
done.
Default by customers is possible (we do not expect a bank to fail in its commitment),
and thus, counterparty risk is present to that extent.

l
ia
One common misconception about hedging is that it improves profitability/cash flow and

er
can compensate for the losses anticipated. It needs to be clarified that a forward hedge cannot

at
provide the desired price. In fact, the spot price, S0, of an asset is market determined, and no
one can alter it.

M
Forward contracts ensure a price for the hedger irrespective of the future spot price of
ed
the currency, S1. The forward price, F1, is also market-determined and also cannot be
changed.
ht
An exporter, while booking a forward contract, realizes the forward price
A forward contract is
ig

a firm-price contract,
F1 that is fixed in advance for his receivables, irrespective of the price pre-
vailing at the time of realization. When he/she is unhedged, the amount real-
yr

providing protection from

any downsides in return ized will depend upon the spot price S1 prevailing at the time of receiving
op

for forgoing potential from the foreign currency, as shown in Fig. 5.7. The case would be similar as of
any upsides.
-C

an importer buying a forward contract for foreign currency.

w

EXAMPLE 5.2 Hedging payables with forward contracts

ie

Ultra Films Ltd (UFL) has imported raw materials worth US $2 million for which the payment is due after three months. The fol-
ev

lowing rates are quoted by a bank:

Spot (rupees per US dollar) 47.00 47.45
Pr

3-m forward 47.50 48.00

The firm is expecting appreciation of the US dollar by more than 5% in three months’ time.

(a) Should UFL hedge its payable?

(b) What rate would be paid by UFL if it decides to hedge?
(c) What would be the gain or loss if the actual spot rates after three months turn out to be (a) `46.50–`47.00, and (b)
`49.30–`49.85?
Solution

(a) The forward rates indicate an appreciation of the dollar of about 1% in three months’ time, while the firm expects a 5%
appreciation. It should go for hedging in order to save about 4% by buying US dollars forward.
(b) The forward ask rate is `48.00, at which rate UFL can buy US $2 million.
(c) If the spot rates at the end of three months were `46.50–`47.00, UFL would have fulfilled its requirement at `47.00. As
compared to the forward, the firm loses `1 per US dollar. Hence, the loss is `2 million.
If the spot rates at the end of three months were `49.30–`49.85, UFL could fulfil its requirement at `49.85. As compared to
the forward, the firm gained `1.85 per US dollar. Hence, the gain would be `1.85  2 million  `3.70 million.

Derivatives_ch05.indd 131 28/02/14 11:55 AM

 132 Derivatives and Risk Management

Unhedged

Amount realized/paid
Forward hedge
position

Forward price, F1

Spot price, S1

l
ia
Fig. 5.7 Payoff of a forward hedge

er
at
M
An important feature of the forward contract is that it provides an assured rate of exchange,
protecting against downside risk. However, while the rate of exchange is assured, one also
ed
forgoes the potential upside gain that one could get if the exchange rates were to move in a
ht
favourable direction.
ig

Further, it should be noted that by hedging through a forward contract, the risk was com-
pletely eliminated for the exporter and the importer, though it did not vanish from the envi-
yr

ronment. It merely got transferred from the customers to the bank. Banks cover the risk in
op

many other ways, including a swap transaction with another bank, as described earlier.
-C

Cost of Forward Hedge

Through a forward contract the exporter and the importer have assured themselves of fixed
w

prices, thus removing uncertainties. This price guarantee cannot come free of cost. We need
ie

to know what cost is borne by hedgers while booking a forward contract.

ev

Traditionally, the cost of a forward hedge is measured in terms of premium or discount

Pr

over the spot price. When a foreign currency futures is more expensive in than the spot,
i.e., F1  S0, it is said to be at a premium and when it is cheaper than the spot, i.e., F1 
S0, it is at a discount. The cost of a forward hedge is measured as a percentage premium or
discount over the current spot price, as shown here:
Cost of hedging  premium or discount ()  (F1  S0)/S0 (5.2)
In fact, the efficacy of the forward hedge can be measured only after the forward contract
period is over. The real cost or benefit of the forward hedge must be measured not when it was
set up but when it ended. The cost of the forward at the time of setup only reflects what premium
or discount is available. The real measure of effectiveness of a forward hedge
The cost of a forward
comes from the spot price, S1, at the end of the period of hedge, which tells
hedge is judged by the
premium/discount of the the story about whether the hedger actually benefited from the forward hedge
forward rates over the or not. The real cost of hedging is as follows:
spot rates.
Real cost of forward hedge  (F1  S1)/S0 (5.3)

Derivatives_ch05.indd 132 28/02/14 11:55 AM

 Currency Forwards and Futures 133

SPECULATION WITH FORWARD CONTRACTS

While hedging, exporters and importers cover their risks on assets/liabilities owned. The
exporter holds a foreign currency receivable and the importer holds a fixed
Forward contracts can
also be used for specula- amount of domestic currency for a foreign currency denominated payable.
tion in the currency ex- Hence, they book forward contracts with the purpose of hedging their receiv-
change rate markets by able and payable, respectively, and have all intentions of honouring their
holding a view contrary to commitments.
the market and taking a
In contrast to the actions of EXPressive and IMPressive, consider a finan-
position.
cial firm, BETTERS Ltd, which does not need to buy or sell foreign currency.
BETTERS researches foreign exchange movements and forecast rates, and

l
whenever it finds forward rates attractive, bets on them with the sole objective of making a

ia
profit.

er
As per Table 5.1, the spot price of the US dollar is `43.83 and a 6-m forward price is
`43.92 at an annualized premium of a mere 0.41%. BETTERS feels that the US dollar is

at
undervalued and should command a better premium than that indicated by the forward rate.

M
Therefore, BETTERS buys a US dollars 6-m forward at `43.92. It keeps a continuous watch
ed
on exchange rate movements, specifically of the US dollar. It is convinced that in six months’
time, the US dollar will command a higher price. It can do either of the following:
ht
Whenever the forward price of the US dollar crosses `43.92, it can neutralize its posi-
ig

tion by booking a sell contract such that the maturity of the new sell contract coincides
yr

with the maturity of the original buy contract. Suppose that three months later, a 3-m
op

forward contract is available at `44.00. BETTERS can book a 3-m forward contract to
sell dollars at `44.00 and earn a profit of `0.08 for each dollar. Note that the delivery
-C

dates of both the first and the second contracts coincide, although it is not at all neces-
sary to match maturity dates to take a speculative position.
w

Alternatively, BETTERS can wait till the contract matures, when it will be required to
take delivery of the dollars by paying at the equivalent rate of `43.92, the contracted
ie

rate. Rather than taking delivery, BETTERS sells the dollars at spot price, booking
ev

either a profit or a loss depending upon the spot price prevailing then.
Pr

The actions of BETTERS Ltd are termed speculative, since the firm held a view con-
trary to the one indicated by forward rates, and was prepared to assume a position on its
own regarding the future movement of the prices of US dollars. In fact, BETTERS was not
attempting to cover any risk, as it did not have the foreign currency, nor needed it in future;
instead, it was taking a risk by opening the first forward contract in the hope of neutralizing
the exposure subsequently. In case the likely movement was not in its favour, it would lose
some value.

ARBITRAGE WITH FORWARD CONTRACT

As defined earlier, the process of arbitrage requires setting up of a riskless position, in con-
trast to speculative actions, which set up an initial position and wait for an opportune time
to square up the initial position. It is not possible to find an opportunity to make arbitrage
profit from the same source, as the rates offered by the same bank will be such that they

Derivatives_ch05.indd 133 28/02/14 11:55 AM

 134 Derivatives and Risk Management

Different banks may

result in profit for the bank, and, hence, loss for the customer. However, it
quote differing exchange is possible to find another bank that offers rates such that a smart and aware
rates for the same investor can buy from one source at a cheaper rate and sell to the other at a
currency, which may higher rate simultaneously.
also provide arbitrage In Table 5.1, we note that the State Bank of India (SBI) offers the follow-
opportunities.
ing rates for the Swiss franc (CHF):
Exchange rates of SBI (` per CHF)
Import Export
Currency
6-m 3-m 1-m Spot Spot 1-m 3-m 6-m
35.41 35.07 34.85 34.72 CHF 34.61 34.56 34.66 34.90

l
ia
Hypothetically, let us assume that Citibank offers the following exchange rates at the same

er
time for the Swiss franc:

at
Exchange rates of Citibank (` per CHF)
Import Export

M
Currency
6-m 3-m 1-m Spot Spot 1-m 3-m 6-m
34.41 34.07 33.85 33.72 edCHF 33.61 33.56 33.66 33.90
ht
An arbitrageur spots an opportunity to make a profit from the rates available from the
banks. The arbitrageur can sell Swiss francs 6-m forward at `34.90 to the SBI, and simulta-
ig

neously buy Swiss francs 6-m forward from Citibank at `34.41.

yr

Note that by buying from one and selling to the other, the arbitrageur has assured himself
op

of a profit of `0.49 for each Swiss franc transacted, without involving any capital or entering
into a promise to perform that cannot be fulfilled. His position stands nullified, as he buys
-C

the Swiss francs from Citibank and simultaneously sells the same amount to the SBI, with
identical maturities.
w

Execution of arbitrage in the foreign currency markets through forwards is an extremely

ie

unlikely situation. This is because the bid–ask spreads of different banks are not in the public
domain. The rates are obtained on demand only.
ev
Pr

DETERMINING FORWARD RATES

Determination of forward rates that do not permit arbitrage is linked to the spot rates and the
interest rates prevailing for two currencies. Arbitrage in two different markets is dependent
upon the rates prevailing in the two markets. Arbitrage in the spot and the forward market
for the same underlying asset is governed by borrowing and investing. We borrow in one
currency and invest in another, depending upon the interest rates, spot rates, and the forward
rates. Because of the bid–ask spread and the borrowing–lending spread, there is a range of
forward rates that are feasible without any arbitrage opportunities.
No arbitrage condition places between (a) the lower bound for the ask rate and (b) the
upper bound for the bid rate. Within these bounds, any forward rates could be quoted. In
Example 5.3, it can be noticed from the upper and lower bounds that many different sets of
rates are possible with no arbitrage condition satisfied. Different banks can offer different
rates because of the vast range of feasible forward rates that are available. Transaction costs
would prohibit arbitrage.

Derivatives_ch05.indd 134 28/02/14 11:55 AM

 Currency Forwards and Futures 135

EXAMPLE 5.3 Bounds to forward rates

The following spot and interest rates prevail in the market:
Spot rate (rupees per euro) 60.00 61.00
Interest rate rupee: 8.00% 8.50%
euro: 5.00% 5.50%

Find out (a) the lower bound to the 6-m forward ask rate
(b) the upper bound to the 6-m forward bid rate
Solution

(a) To find the lower bound to the ask rate, we do as follows:

(i) Borrow foreign currency (euros) at the borrowing rate

l
ia
(ii) Convert spot into local currency (rupees) at the bid rate

er
(iii) Invest the local currency at the lending rate for the period of the forward
(iv) Sell the matured amount at the forward ask rate to reconvert into foreign currency

at
For no arbitrage, the matured amount through the forward must be less than the borrowing.
€

M
Borrow €1.00 at 5.50% for six months: Amount to repay  1.0275
Convert to rupees at the spot bid rate and get  `60.00
Invest for six months at 8% and get `1.04  60
Sell at the forward ask rate Fa to get ed  `62.40
 62.40/Fa
ht
For no arbitrage, we must have: 62.40/Fa 1.0275 or, Fa `60.7299
ig

(b) To find the upper bound on the bid rate, we do as follows:

yr

(i) Borrow local currency (rupees) at the borrowing rate

(ii) Convert spot into local currency (euros) at the ask rate
op

(iii) Invest the foreign currency at the lending rate for the period of the forward
(iv) Sell the matured amount at the forward bid rate to reconvert to local currency
-C

For no arbitrage, the matured amount through the forward must be less than the borrowing
Borrow `1.00 at 8.50% for six months: Amount to repay  `1.0425
w

Convert to euro at the spot ask rate and get €1/61.00  0.0164
Invest for six months at 5% and get €1.025  1/61  0.0168
ie

Sell at the forward bid rate Fb to get Fb  0.0168

ev

For no arbitrage, we must have: Fb × 0.0168 1.0425 or, Fb `62.0415

Pr

NON-DELIVERABLE FORWARDS

NON-DELIVERABLE FORWARD CONTRACTS

There exists a product, typical to the foreign exchange markets, which is neither a for-
ward contract nor a future contact. This product is known as the non-deliverable forward
(NDF) contract. An NDF contract, as the name suggests, is a forward contract where the
delivery of the underlying asset, mostly a currency or a commodity, is not required. The
need for such a contract arises from the impossibility of delivery of the underlying asset.
It is most prevalent in the foreign exchange markets in respect of currencies that are not
freely convertible. The governments of some nations exercise capital control in order to
prevent volatility in the exchange rates of their currencies, or for any other political or
economic reason.

Derivatives_ch05.indd 135 28/02/14 11:55 AM

 136 Derivatives and Risk Management

EVOLUTION AND GROWTH OF NDF

The NDFs evolved in the 70s, when the Australian currency was subjected to capital restric-
tions. The NDFs began trading, obviating the requirement of delivery and
The NDFs are forward yet providing an effective means of hedging. They came into existence
contracts normally en-
tered off-shore and cash- because of the increased volatility in interest rates, which made hedging
settled for currencies that difficult with the on-shore banking system through deliverable forward mar-
have capital control. kets. Transactions for hedging were conducted in the NDF market, and,
hence, they are also called the hedge markets. In the case of Australia, the
development of the NDF market was on-shore, with settlement in the local currency, the
Australian dollar.

l
Today, the NDF market primarily consists of six Asian currencies, namely, the Chinese ren-

ia
minbi (RMB), the Indian rupee, the Korean won, the Indonesian rupiah, the Philippine peso, and

er
the Taiwanese dollar, all of which are subject to governmental capital control in varying degrees.

at
One of the popular measures to exercise such control is to ban forward trading in the currency
markets. Due to regulations and legal and practical constraints in the free conversion and move-

M
ment of a currency, an NDF in any currency is normally traded off-shore, i.e., outside the bounds
ed
of the home country of that currency. For example, if the Indian rupee is subject to non-delivery
outside India, an NDF contract could be traded outside India, say at Dubai or Singapore.
ht
The banking system in a nation may prohibit booking of forward contracts in the absence
ig

of exposure in the underlying currency. Such controls make hedging feasible, but other spec-
yr

ulative and arbitrage activities are denied, restricting the depth of the forward markets.
The NDFs provide alternative hedging avenues for non-residents who can-
op

NDFs provide much

not participate in the on-shore deliverable market. Further, an on-shore deliv-
needed liquidity and
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depth to non-convertible erable market may be illiquid too. Capital controls are aimed at restricting
currencies. The rates short-term capital flows that are not trade related. The growth in NDFs in the
in NDF are considered 1990s is believed to be related to the Asian currency crisis that led to further
w

better, as they are market tightening of the currency controls. The participation by foreign nationals in
ie

determined and free from

the on-shore forward markets is regarded as speculative enough to destabi-
controls and regulations.
ev

lize the currency’s value by making the exchange rate extremely volatile.3
Pr

FEATURES OF NDFS
Unlike the Australian dollar, today’s NDF markets are off-shore. The NDFs are generally
quoted and settled in US dollars, though cross rates can be used for NDFs in other currencies
too. Since delivery is not possible due to restrictions on convertibility of the currency dealt
in, the settlement of a forward contract in the currency has to be on the basis of the differ-
ence between the contracted price and the spot price. Further, settlement has to be done in a
currency that is freely acceptable. Most NDFs are cash-settled in US dollars. Such contracts
have a notional principal amount.
NDFs are foreign exchange derivative products traded OTC. On maturity, the parties to an
NDF contract settle the transaction not by delivering the underlying pair of currencies but by
3
Higgins P, and Humpage, O.M. (2005), Non-Deliverable Forwards: Can We Tell Where Renminbi Is Headed, Federal
Reserve Bank of Cleveland, September.

Derivatives_ch05.indd 136 28/02/14 11:55 AM

 Currency Forwards and Futures 137

making a net payment equal to the difference between the agreed foreign exchange rate and
the spot fixing rate4. The NDF enables hedging by foreign participants who are not allowed
access to on-shore markets for these currencies.

HOW NDF WORKS

An NDF works in the same manner as a deliverable forward contract from the perspective of
hedging. However, the mechanism is somewhat different. The settlement of an NDF is done
in foreign currency in cash, with the difference between the forward price and the settlement
price over a notional principal, as per Eq. 5.4, which follows:
Settlement amount  (1  forward rate/settlement rate)  notional principal (5.4)

l
ia
As an example, consider an exporter in Thailand who has supplied goods to India worth

er
`4,80,000 and has agreed to accept payment in Indian rupees after six months. However, the
Indian rupee is expected to depreciate from the current spot rate of `48 per dollar. Assume

at
that a 6-m NDF is quoted at US $0.02 per rupee (equivalent to `50 per dollar). The Thai

M
exporter decides to hedge by selling a 6-m NDF at 0.02. By doing so, the Thai exporter locks
in his receivable in US dollars at US $9600 (`4,80,000  US $0.02 per rupee), based on
ed
the NDF rate of US $0.02 per rupee. The position of the Thai exporter for depreciation and
ht
appreciation of Indian rupee is demonstrated in the following paragraphs.
ig

If the rupee depreciates excessively to spot at US $ 0.0192 per rupee:

yr

Settlement amount receivable under the NDF

op

 (0.02 − 0.0192)  4,80,000  US $384

Realized US dollars from the receivable
-C

 4,80,000  0.0192  US $9216

Total realization  US $9600
w

If the rupee appreciates to spot at US $ 0.0217 per rupee:

ie

Settlement amount payable under the NDF

ev

 (0.02 − 0.0217)  4,80,000  −US $816

Realized US dollars from the receivable
Pr

 4,80,000  0.0217  US $10,416

Total realization  US $9600

NDF AND INTEREST RATE PARITY

We know that when the capital markets are freely accessible, the forward markets and the
spot markets are linked with interest rate parity (IRP) as follows:
(1  rh)n
Fn  S 0 (5.5)
(1  rf)n
where Fn is the forward rate for n periods, S0 is the spot rate, and rh and rf are the interest
rates in the home and foreign countries, respectively.
4Guonon Ma, Corrinne Ho, and Robert McCaulay (2004), ‘Markets for Non Deliverable Forwards in Asian Currencies’,
Bank for International Settlement Quarterly Review June.

Derivatives_ch05.indd 137 28/02/14 11:55 AM

 138 Derivatives and Risk Management

However, when capital account controls exist, lending and borrowing on-shore is restricted
for foreigners, distorting the IRP. This gives rise to the off-shore market. The rate of NDF,
therefore, would imply an interest rate differential that is not the same as the differential
reflected in the deliverable forward markets on-shore. Since NDF is not subject to capital
controls, the validity of the IRP tends to be greater.
Assuming a 12-m NDF contract in Indian rupees is quoted at `42.60 per dollar as against
the spot rate of `42.00, with a 6% interest rate in US dollars, the implied interest rate for the
Indian rupee would be 7.51%:
42.60
(1 + rNDF)  1.06   1.0751 or rNDF  7.51%
42.00
This may be compared with the interest rate prevailing (one measure could be T-bills

l
ia
yields) that becomes the benchmark for an on-shore forward market. The differential between

er
the off-shore and the on-shore rates as implied in the NDF rate and the forward rate may be
taken as the measure of effectiveness of capital controls. The larger the differential, the more

at
effective is the capital control.

M
An active NDF market and a lower differential between the off-shore and the on-shore

ed
interest rates would be an indicator or precursor of the likely exchange rate markets scenario
if the capital flow controls were to vanish. The NDF would be regarded as a truer reflector of
ht
free market conditions than the conditions prevailing in the on-shore markets for currencies
ig

where controls exist on capital flows.

Where local residents operating in on-shore markets also have access to off-shore mar-
yr

kets, the differential between the off-shore and the on-shore forward rates (or the differential
op

between the yields) would give rise to arbitrage opportunities. This would make off-shore
and on-shore yields and forward rates stay in close proximity with each other, with a nominal
-C

differential that probably will not exceed the transaction costs in the two markets.
The differential is likely to be greater where interventions by governments in foreign
w

exchange markets are frequent and large. In situations of fixed exchange rates and restrictions
ie

on local residents that prevent access to off-shore markets, the NDF may suggest the likely
ev

revaluation/devaluation of a given currency.

Pr

ARE NDFs DESIRABLE

The NDF markets are often viewed with suspicion, as they circumvent the local exchange
control rules and provide easy alternatives to those who cannot access the on-shore deliv-
erable forward markets. However, they must be viewed from a different perspective. The
on-shore deliverable markets in regulated environments provide hedging applications but
they inhibit speculative and arbitrage activities. In contrast, those who need to hedge through
NDF would be few, but an off-shore NDF market would present opportunities for speculators.
Both stand-alone markets would lack depth and only when combined can present a truer and
competitive picture regarding the status of a currency.
Further, it is believed that an NDF market5 (a) facilitates smoother transition of an econ-
omy from a controlled regime to full convertibility, as they serve as an intermediate bridge

5Debelle,
G., J. Gyntelberg, and M. Plumb (2006), ‘Forward Currency Markets in Asia; Lesson from Australian Experience’,
BIS Quarterly Review, September.

Derivatives_ch05.indd 138 28/02/14 11:55 AM

 Currency Forwards and Futures 139

for the interim period, and (b) provide skills and expertise developed in the NDF markets to
be adapted to the deliverable forward market as and when capital controls are lifted or full
convertibility of the currency is achieved.

CURRENCY FUTURES

Currency futures serve the same purpose as currency forward contracts, i.e., by providing
importers/exporters with a way to cover exchange rate risks with respect to their receivables/
payables.
Though forward markets have been in existence for long, currency futures markets are

l
ia
relatively a new development. Internationally, futures contracts on foreign currencies devel-
oped in the early 70s, when the International Monetary Market at the Chicago Mercantile

er
Exchange (CME) commenced trading on currency futures. Forward and futures markets have

at
co-existed in foreign currencies.

M
The cost of hedging through futures, being exchange-traded, is expected to be much
smaller than that of forward contracts. However, forward contracts offer a perfect hedge, as
ed
the exchange rate realized or paid is known with certainty at the time of booking the con-
tracts. The limitations of futures that make a hedge imperfect, i.e., mismatches of quality,
ht
quantity, and timing of the hedge, do not occur in forward contracts, which are OTC products
ig

matching the specific needs of exporters and importers.

yr

In India, there were no futures exchanges until 2008. The National Stock Exchange (NSE)
op

introduced futures contracts on the US dollar on 28 August 2008, and the Multi-commodity
Exchange-Stock Exchange (MCX-SX) did so on 7 October 2008. The features of the futures
-C

contract on US dollar available in India are as follows.

w
ie

Derivatives in Practice Different Forex Markets

ev

One country, two systems, three currencies

Pr

HSBC points out that trading in the Chinese currency, RMB, is hardly simple. There are multiple markets—all of which trade
differently—and only a few that foreigners can truly position in, To start with, although the RMB, which is traded both on-shore
in China and off-shore (primarily in Hong Kong), is the same currency, it is traded at different rates. This is by design: as regula-
tion has explicitly kept on-shore and off-shore separated, the respective supply and demand conditions lead to separate market
clearing exchange rates.
Hence came about the emergence of a new currency code, CNH, to represent the exchange rate of RMB that trades off-shore
in Hong Kong. However, it does not end here. There is the traditional off-shore RMB market, the dollar-settled NDF, which itself
trades independently of either on-shore CNY or off-shore CNH, as well as a trade-settlement exchange rate (sometimes called
CNT) to which off-shore corporates have access, just adding to the complexity.
The CNH is effectively a separate currency altogether, a perfect proxy neither for the domestic RMB (on-shore CNY)
nor for the NDF (forward) curve market. The latter is otherwise known as the off-shore dollar-settled NDF market, which is
the traditional domain of off-shore participants. And to add to all of that, in July 2010, the RMB itself became officially
deliverable in Hong Kong—leading to its own rate, sometimes known as CNT. However, this is only available to off-shore corporate
entities.
A diagram from HSBC highlights the different markets for RMB (Fig. I) and Fig. II shows how the three main markets (CNY,
CNH, and NDF) have diverged in the recent past.
(Cont d )

Derivatives_ch05.indd 139 28/02/14 11:55 AM

 140 Derivatives and Risk Management

(Contd )

Mainland China
On-shore “supply”
Capital controls Central bank
swaps
Offshore
RMB Trade jurisdictions NDF market
Settlement
On-shore supply

QFll, FDI
Offshore
On-shore CNY Hong Kong Demand
Market
Resident purchases
CNH CNH
Central bank swaps
Supply
market

l
On-shore demand RMB Trade Settlement

ia
er
Key: Flow

at
Source of
Jurisdiction Market Fixing Regulatory restrictions
Supply/Demand

M
Fig. I The different markets for RMB
Source: HSBC

ed
ht
The three markets, similar, but not identical
ig

6.85
yr

6.75
op

6.65

6.55
-C

6.45
1-Jul-10 1-Aug-10 1-Sep-10 1-Oct-10 1-Nov-10
w

USD-CNY USD-CNH 1m NDF

ie

Fig. II The three markets (CNY, CNH, NDF); similar but not identical
Source: Bloomberg, Reuters, HSBC
ev
Pr

What about arbitrage? That is the whole point: there is no arbitrage. However, the off-shore RMB market was created explic-
itly to allow the RMB to start developing internationalization characteristics, while at the same time keeping domestic markets
sequestered from global markets. By deliberately separating on-shore from off-shore liquidity, the CNY and CNH are designed
not to be arbitraged and, hence, will naturally have distinct market equilibriums.
Source: http://ftalphaville.ft.com/ posted by Izabella Kaminska on 12 December 2010.

Contract Specifications The contract on US dollar futures at MCX-SX is specified in

Table 5.2. Specifications are identical with the contract introduced by NSE.
Currency futures are Standard contracts with a size of US $1000 are available for the next 12 months,
derivatives based on providing hedging period of a maximum of one year. Each contract expires on
exchange rates that are the last working day of the month on which spot transaction would be settled.
exchange-traded and are For example, the January 2012 contract expired on 27 January 2012, which
a substitute for forward
was the last day of settlement for spot transactions (two business days prior to
contracts.
the last working day of the month).

Derivatives_ch05.indd 140 28/02/14 11:55 AM

 Currency Forwards and Futures 141

Table 5.2 Details of contract specification of dollar/rupee futures at MCX-SX

Unit of trading 1 (1 unit denotes US $1000)

Underlying The exchange rate is in units of Indian rupees for a unit of the US dollar

Tick size 25 paise or `0.0025

Last trading day Two working days prior to the last business day of the expiry month at 12 noon.
The last working day (excluding Saturdays) of the expiry month.
Final settlement day
The last working day will be the same as that for interbank settlements in Mumbai.
Quantity Freeze Above 10,000
Base price Theoretical price on the first day of the contract. On all other days, DSP of the contract

l
ia
Tenure up to six months Tenure greater than six months
Price operating range
3 % of base price 5% of base price

er
Minimum initial margin 1.75% on day 1, 1% thereafter

at
Extreme loss margin 1% of the MTM value of the open position

M
`400/- for a spread of 1 month, `500/- for a spread of 2 months, `800/- for a spread of
Calendar spreads
3 months, and `1000/- for a spread of 4 months or more
Settlement
ed
Daily settlement: T  1 Final settlement: T + 2
ht
Mode of settlement Cash settled in Indian rupees
ig

DSP Calculated on the basis of the last half an hour’s weighted average price.
yr

FSP The RBI reference rate

op

Source: www.mcx-sx.com, accessed on 25 September 2012.

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Trading One can start trading in currency futures by initiating a long/short position in
foreign currency through the members of the exchange dealing in currency futures. An
w

initial margin is payable as prescribed by the exchange (1.75% in case of MCX-SX), and
ie

is released when the position closes. The initial margin is a performance bond used by the
ev

exchange as a risk-containment measure in order to cover potential loss over a time period.
As such, no cash flow on account of the contract is involved while initiating a buy/sell
Pr

futures contract.
Daily marking to the market (MTM) is done with daily settlement prices (DSPs) worked
out on the basis of the average of the last 30 minutes’ trades. The final settlement is done
with the RBI reference rate on the last working day of the expiry month.
The price quotation is rupees per unit of foreign currency (per 100 units in the case of
Japanese yen), with a tick size of `0.0025 (25 paise). The minimum price change for a con-
tract would be `2.50 (`0.0025  1000).
Settlement Participants in futures contracts are expected to nullify their positions before
the last day of trading for the contract. However, if any position is outstanding, it is treated
as closed at the final settlement price (FSP), with any difference between the prices of the
opening and the closing contracts paid or received, as the case may be. All futures contracts
are cash-settled, and no delivery is asked for. As is true with any futures contract, settlement
by delivery is rarely chosen, even on underlying assets where allowed.

Derivatives_ch05.indd 141 28/02/14 11:55 AM

 142 Derivatives and Risk Management

In contrast with the currency futures at NSE or MCX-SX, CME deals in various curren-
cies with different lot sizes. Contract sizes are much larger than US $1000, and only four
quarterly contracts are available. At CME, different currencies are quoted in terms of the
number of US dollars per unit of any other currency, with
tick size of $0.01;
delivery standardized in March, June, September, and December; and
standard lots of Australian $10,000; Canadian $100,000; Sterling pounds 62,500; Yen
12,500,000; and CHF 125,000.
Figure 5.8 depicts trading information for US dollar futures in terms of Indian rupees on
the MCX-SX. It provides information for 12 monthly futures contracts. The product is speci-

l
ia
fied as USDINR with maturity date. Price information for best buy quantity and price as well
as best sell quantity and price is displayed. It also gives information about the last traded

er
price (LTP), volume, and open interest in terms of the number of contracts (each contract is

at
for US $1000), and the value of the contracts is in crores of rupees.

M
The differences between forward and futures contracts are many, and have already been
discussed in Chapter 2. Forward markets in foreign currency are available worldwide, with
ed
ht
ig
yr
op
-C
w
ie
ev
Pr

Fig. 5.8 Trading information of currency futures on MCX-SX

Source: www.mcx-sx.com, accessed on 25 September 2012.

Derivatives_ch05.indd 142 28/02/14 11:55 AM

 Currency Forwards and Futures 143

no specified time of operation. In contrast, futures markets operate for specified hours.
Delivery in forward markets is tailor-made, while futures have a specified maturity date.
Despite the emergence of futures market in currencies, the forward market continues to
dominate trading in foreign exchange, possibly because of the comfort level banks provide
to traders and users.

PRICING CURRENCY FUTURES AND FORWARDS

The pricing of foreign currency futures will depend upon the interest rates of the currencies
involved in the contract. The concepts of IRP and covered interest arbitrage are central to the
determination of forward rates of various currencies. Under conditions of free trade policies

l
ia
and free flow of capital across international borders, interest rates in the two currencies must

er
determine future exchange rates.
As a standard concept of economics, the price of any commodity is determined by the

at
factors that affect the demand and supply of the commodity. Foreign currency is no differ-

M
ent from any commodity. The demand for foreign currency emanates from importers, and
supply sources predominantly comprise exporters who enter transactions involving goods
ed
and services abroad in currencies other than the domestic one. Apart from the usual risks of
ht
trade, importers and exporters face the additional risk of currency exchange rate fluctuations.
Importers and exporters have a genuine need to hedge the foreign currency transactions they
ig

enter into.
yr

Besides hedgers (importers and exporters), who constitute the demand and supply com-
op

ponents of foreign exchange, there are speculators and arbitrageurs operating in the foreign
exchange markets, subject to the exchange control regulations in place in any economy. All
-C

over the world, speculators and arbitrageurs constitute a majority of transactions. In fact,
transactions that are being hedged actually form a miniscule 3–4% of the volumes in foreign
w

exchange markets. Irrespective of speculation or hedging, the pricing of forward contracts is

ie

based on conditions that satisfy a no-arbitrage condition.

To examine how arbitrage works in determining forward exchange rates, let us consider
ev

an example. Assume that a trader has `10 lakh today, available for one year. He/she has a
Pr

choice of either (a) investing in rupees, or (b) converting these rupees into US dollars at
today’s spot rate, investing the US dollars and reconverting the US dollars back into rupees
one year later. In an efficient market, the two strategies of investment must yield the same
reward. Further, the outcome of both the strategies must be certain. Therefore, we assume
that the investment must be made in risk-free securities in either market.
If the spot price is `50.00 per dollar and the risk-free interest rates for rupees and US dollars
are 5% and 3%, respectively, then the two strategies that can be followed are as follows:
Invest in domestic markets:
The price of a currency
forward contract depends
Invest `10,00,000 at 5% for a year and get `10,50,000 after a year.
upon the spot price and Here, 5% is the return from risk-free investments such as T-bills.
the differential between Invest in markets abroad:
interest rates in two dif- Convert rupees into US dollars at the current spot rate of US $1 
ferent currencies. `50.00 and get US $20,000.

Derivatives_ch05.indd 143 28/02/14 11:55 AM

 144 Derivatives and Risk Management

Invest for one year at 3% to yield US $20,600 at maturity after one year. Again, the
investment is in risk-free securities such as T-bills in the USA.
Obtain Indian rupees back by selling the dollars at the spot rate prevailing after a
year, S1.
Here, the final amount of Indian rupees that the investor would get is dependent upon the
exchange rate prevailing at the end of the investment window. Both the investment strategies
are depicted in Fig. 5.9.

Today One year later

l
At 5%
`10,00,000 `10,50,000

ia
er
Forward price
Spot F = S × (1 + rd)/(1 + rf)
Forward
`50/$

at
M
Today At 3% One year later
US $20,000 US $20,600

ed
ht
Fig. 5.9 Determination of forward exchange rate
ig
yr

For either strategy, the investor must be indifferent in terms of value in both the markets,
op

i.e., the Indian and the US financial markets. If this has to happen, the spot exchange rate
one year later, S1, must be such that US $20,600 is equal to `10,50,000. This implies a spot
-C

exchange rate of `50.97 per US dollar one year later.

In symbolic terms, if the spot rates today and one year later are S0 and S1, and domestic
w

and foreign interest rates are rd and rf, respectively, the relationship of the two spot rates is
ie

given by Eq. 5.6 as follows:

(1  rd)
ev

S1  S0  (5.6)
(1  rf)
Pr

In this argument, we ignored the aspect of risk. There are two sources of risk:
Rates of interest for making investment
Spot exchange rate one year later
To be at equal levels of risk in both the markets, we may assume investment at risk-free
rates in both rupee and dollar markets. However, the second source of risk remains as it is.
While converting the matured amount to rupees, the investor is not aware of the future spot
rate S1. If the investor knew today exactly what rate he would get after a year for the US dollars
invested today, the risk of exchange rate fluctuation too would have been covered. Cover for
risk relating to the future spot rate can be easily achieved using the forward markets. If the
investor sells US dollars forward, the risk is covered. The actions would now be as follows:
Step 1 Invest in domestic markets:
Invest `10,00,000 at 5% for a year and get `10,50,000 after a year; for one unit of
home currency we get (1  rd).

Derivatives_ch05.indd 144 28/02/14 11:55 AM

 Currency Forwards and Futures 145

Step 2 Invest abroad:

Convert rupees into US dollars at the spot rate of `50.00 per dollar and get US
$20,000.
Invest for one year at 3% to yield US $20,600 after one year at maturity; for one unit
of home currency, we get (1/S0)  (1  rf).
Book a forward contract for selling the maturity value at F1 to get back rupees; for
one unit of home currency, we get (F1/S0)  (1  rf).
For no arbitrage, the maturity value in step 1 and the sum under the third action under step 2
must be equal. This gives the following relationship between the forward rate and the spot rate:
(1  rd)
F1  S0  (5.7)
(1  rf)

l
ia
With continuous compounding, Eq. 5.7 gets modified to

er
F1  S0  e(rd  rf )t (5.8)

at
The relationship expressed by Eqs 5.7 and 5.8 is known as the IRP, which relates the for-

M
ward markets with the money markets and the spot markets. The price of a forward contract

ed
is governed by the interest rates for the two currencies in the transaction and the spot rates
prevailing.
ht
Therefore, forward/futures price F (direct)  S  (1  rd)/(1  rf)
ig

Reconciling IRP and Cost of Carry Models The price of a futures/forward contract
yr

arrived at through IRP and the no-arbitrage argument in fact is the same as the price calcu-
op

lated using the cost of carry model.

Under the cost of carry model, spot and futures prices are related by the cost of carry for
-C

the period of contract. In the case of a currency, this happens to be the risk-free rate of inter-
est. The future value of an asset is given by S0  erdt. However, the exchanged asset would
have earned risk-free interest in the foreign currency, which is like the value of benefits of
w

owning the asset. Therefore, the net cost of carry is the differential of interest rates between
ie
ev
Pr

EXAMPLE 5.4 Fair value of currency futures

At MCX-SX, currency futures in US dollar are traded. Today is 12 December and January futures would expire on 28 January.
Spot rate in the exchange market for dollar is `45.45. The yields in the T-bills markets of India and USA are 5.90% and 2.40%,
respectively.

(a) At what price January futures would be traded?

(b) What would be the price of February futures if its expiry is on 24 February?
Solution

(a) The fair value of futures is given by Eq. 5.8.

Here S0  45.45, rd  5.90%, rf  2.40%, and t  57 days (From 12 December to 28 January)
F1  S0  e (rd  rf)t  45.45  e (0.059  0.024)57/365  `45.6991
(b) For February futures, the time to expiry would be 57  27  84 days. The price of February futures would be:
F1  S0  e (rd  rf)t  45.45  e (0.059  0.024)84/365  `45.8176

Derivatives_ch05.indd 145 28/02/14 11:55 AM

 146 Derivatives and Risk Management

the two currencies. If rd is less than rf, it becomes a case of negative cost of carry, as the
dividends on the asset are higher than the cost of carrying in local currency.

HEDGING THROUGH CURRENCY FUTURES

Hedging currency exchange rate fluctuations with currency futures is no different than hedg-
ing price risks through commodity futures or currency forwards. We use the same principle of
taking a position in the futures market opposite to that of the physical market. Subsequently,
we enter into another futures contract that offsets the initial contract. In the case of commodi-
ties, we strive to nullify gain/loss in the physical market with loss/gain in the futures market
in order to achieve a target price as close as possible to the initial futures contract price, with

l
ia
as much certainty as possible.
One must remember that the target price should not be construed as a profitable price.

er
The target price in case of a forward contract is fixed, and is governed by the forward rates

at
available. One cannot desire an exchange rate that is out of line with market conditions. The

M
ultimate price realized in a hedge through futures is dependent upon the prices of futures
at the times of initiating the contract and cancelling the contracts, and on the ultimate price
prevailing in the spot market. ed
The following two examples illustrate the mechanics of hedging through futures for the
ht
importer and the exporter, they known as long hedge and short hedge, respectively.
ig
yr

Hedge for Importer—Long Hedge

op

A hedge that involves taking a long position on futures contract is known as a long hedge. It
-C

is appropriate when one has to purchase certain assets in the future and needs to lock-in the
price now. Consider the following situation:
In June 2008, an Indian importer buys a machine at US $50,000. Pay-
w

An importer is short on
foreign currency. To ment is due after six months in December 2008. The spot exchange rate
ie

hedge against appreciat- is `45.5625, while December futures are trading at `46.6500, indicat-
ev

ing foreign currency, he ing an appreciation of the dollar by about 2.4% over six months. The
goes long on a futures
importer feels that the dollar will appreciate much more. What should he
Pr

contract.
do? Assume that the size of the futures contract available is US $1000.
Hedging strategy As a hedging strategy, the importer buys a futures contract now, trading
at `46.6500, and sells the same close to the delivery date before December. The importer
knows the exact amount of dollars to be covered, and, therefore, he/she buys 50 contracts on
MCX-SX.
Exposure amount 50000
Number of contracts bought by importer    50
Value of one contract 1000
Having bought 50 futures, the importer would cancel his/her position in the futures by
selling the futures at a date close to the actual date of payment in December.
Let us examine two different exchange rates scenarios when the payment falls due in
December.

Derivatives_ch05.indd 146 28/02/14 11:55 AM

 Currency Forwards and Futures 147

When the US dollar appreciates to `47.5600 and a futures contract sells for `47.5700
The importer exits the futures contract at `47.5700 and buys foreign currency in the spot
market at the prevailing spot rate.
Figures in `
Buy $50,000 at spot rate;
Cost  50,000  47.5600  23,78,000
Sell 50 future contracts booked earlier at `47.5700;
Net gain on futures (47.5700  46.6500)  50,000  46,000
Net rupee amount paid  23,32,000
Effective exchange rate (23,32,000/50,000)  46.6400

l
As against the spot price of `47.5600, the importer ends up buying dollars at `46.6400.

ia
When the US dollar depreciates to `44.5625 and a futures contract sells for `44.5700

er
Figures in `

at
Buy $50,000 at the spot rate;

M
Cost  50,000  44.5625  22,28,125
Sell 50 future contracts at `44.5700;
ed
Net loss on futures (46.6500  44.5700)  50,000  1,04,000
ht
Net rupee amount paid  23,32,125
ig

Effective exchange rate (23,32,125/50,000)  46.6425

yr

As against the spot price of `44.5625, the importer ends up buying dollars at `46.6425.
op

It may be observed that irrespective of appreciation or depreciation of the US dollar, the

effective cost of buying dollars remains close to the opening futures price, i.e., `46.6500.
-C

The difference between the actual cost and the futures price is on account of the differential
between the spot price and the futures price when the hedge was lifted, referred to as basis
risk (discussed in Chapter 3).
w
ie

Hedging for Exporter—Short Hedge

ev

Exporters are long on the asset, and to cover risk through the future, they have to take an oppo-
Pr

site position in futures, i.e., go short on the futures. This strategy is appropriate
An exporter is long on
foreign currency. To when one has to sell a certain asset in the future and needs to lock-in the price.
hedge against depreciat- Assume that it is December now. A British exporter is expecting to receive
ing foreign currency, he US $5 million in six months’ time, in June. He is expecting the dollar to
goes short on a futures depreciate and the pound to appreciate, as is reflected in the following spot
contract.
and futures rates at CME:
Spot: $1.5530 per pound, and June futures: $1.5600 per pound
Hedging strategy The hedging strategy would involve selling the futures now and covering
later. The exporter is facing a loss on his receivable, and he/she is long on US dollars in the
physical market. Therefore, he must go short in the futures market, i.e., buy pounds and sell dol-
lars. A standard contract at CME is for £62,500. The number of contracts to be purchased  $5
million/1.5530/62,500  51.51. The actual number of contracts purchased  52 (rounded off).

Derivatives_ch05.indd 147 28/02/14 11:55 AM

 148 Derivatives and Risk Management

Say that in June, prior to the settlement date, the following rates are prevailing ($/£)
Spot: 1.6250, and June futures: 1.6275
The exporter squares up and sells the futures contract.
Gain on the futures market  (1.6275  1.5600)  52  62,500  $2,19,375
This is equivalent to £1,35,000 (using the spot price of $1.6250 per pound)
Loss on the receivable  (1/1.5530  1/1.6250)  5 million  £1,42,652
Net loss  £1,42,652  £1,35,000  £7652
If the exporter had not hedged, he/she would have received £30,72,196 (50,00,000/1.6275).
With hedging, he/she receives £1,35,000 extra from the futures contract, at a realization rate

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of $1.5590/£.

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SPECULATION WITH CURRENCY FUTURES

at
M
Like forwards in currencies and futures in stocks, indices, and commodities, foreign currency
futures too can be used for taking speculative positions on exchange rate movements. This
ed
is also referred to as open position trading. When speculation is made on the movement of
price of a futures contract that is not consistent with the opinion held by the speculator on
ht
the future spot exchange rates, one may take a position in futures and hope that the opinion
ig

held proves correct. Consider the following prices of US dollar:

yr
op

Spot Mar futures Jun futures Sep futures

US $/SGD
0.5070 0.5100 0.5150 0.5220
-C

These rates imply that the Singapore dollar (SG $) will appreciate against the US dollar.
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A speculator does not agree and believes that the Singapore dollar would depreciate or will
ie

not appreciate much. Therefore, he/she sells the September futures contract at 0.5220.
However, the Singapore dollar does appreciate to a small extent. The rates (US$/SGD) on
ev

1 September are as follows:

Pr

Spot: 0.5150 and futures

September: 0.5158
The speculator squares up his/her position by buying a September contract and gains
(0.5220  0.5158)  $0.0062 per Singapore dollar or $775 per contract (SG $1,25,000),
ignoring the transaction cost and marking-to-market. If the Singapore dollar had depreciated
instead, the gain of the speculator would have been even larger.

ARBITRAGE WITH CURRENCY FUTURES

Arbitrage with futures can be executed in case the futures trade at a value other than fair
value. If the futures are overpriced, then one can sell them and if they are underpriced, one
can buy them. An equivalent position can be created from borrowing/lending and the spot
market. The following steps ensure arbitrage:

Derivatives_ch05.indd 148 28/02/14 11:55 AM

 Currency Forwards and Futures 149

EXAMPLE 5.5 Arbitrage with currency futures

The following data from the financial markets is available
Spot exchange rate (rupees per dollar) 49.5000
180-day futures 50.4000
Rupee interest rate (T-bill yield) 10%
Dollar interest rate (T-bill yield) 5%
Based on the above data, find out the fair price of a futures contract. Is there any arbitrage opportunity? If yes, how can the
arbitrage be executed?
Solution
The fair price of the futures, using simple interest rates, is given by;

( 365 ) ( 365 )

l
days 180
1  Rupee interest rate 1  0.10

ia
Fair Price of Futures  Spot   49.50   `50.6912

er
(1  Dollar interest rate 365 )
days
(1  0.05 180
365 )

at
The actual futures trading, at `50.40 as against the fair price of `50.69, is underpriced. Therefore, we need to buy dollar
futures. Hence, we borrow dollars now and do as follows:

M
Cash flows
ed $ `
ht
Now
Borrow US dollar 1,000.00 —
ig

Convert to rupee using spot market 1,000.00 49,500.00

yr

Invest rupee at 10% for 180 days 49,500.00

Buy dollar in futures maturing after 180 days
op

Worth `51,941
Total 0.00 0.00
-C

At maturity
Receive invested rupee 51,941.00
Deliver rupee against futures 51,941.00
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Receive dollars against futures (51,941/50.40) 1,030.58

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Pay dollar borrowed at 5% 1,024.66

ev

Total 5.92 —
At the maturity of the futures contract, the arbitrageur can make a profit of $5.92 for every 1000 dollars borrowed.
Pr

When futures are overpriced

Now At maturity of futures

Borrow local currency for the period till the futures mature Deliver foreign currency against the futures sold
Convert to foreign currency using the spot market Receive local currency against the futures sold
Invest in foreign currency for the period of the futures Pay for the borrowed local currency
Sell futures equal to the matured foreign currency investment

Since the futures are overpriced, the amount of local currency received would exceed the
liability of the borrowing.

Derivatives_ch05.indd 149 28/02/14 11:55 AM

 150 Derivatives and Risk Management

When future is underpriced

Now At maturity of futures

Borrow foreign currency till the futures mature Deliver local currency against the futures sold
Convert to local currency using the spot market Receive foreign currency against the futures bought
Invest in local currency for the period of the futures Pay for the borrowed foreign currency
Buy futures equal to the matured local currency investment

Since the futures are underpriced, the amount of foreign currency received would exceed
the liability of the borrowing.

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ia
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SOLVED PROBLEMS

at
SP 5.1: Forward premium/discount and forward rates

M
The following spot rates for the US dollar prevail in the foreign exchange markets:
Spot (rupee per dollar) 47.90 48.10
ed
(a) If the US dollar is at an annualized premium of 5%, find the forward bid rates and the ask rates for 3, 6, and 12 months.
(b) If the US dollar is at an annualized discount of 8%, find the forward bid rates and ask rates for 3, 6, and 12 months.
ht
ig

Assume that in each quarter, the bid–ask spread increases by 20 basis points (bps) for the forward period.
yr

Solution
The spot mid rate is `48.00. We can find the forward mid rates for 3, 6, and 12 months using the following equation:
op

(a) When the US dollar is at 5% premium

Annualized % Premium  Forward months
( )
-C

Forward Mid rate  Spot mid rate  1 +

100  12
(
3-m Forward Mid rate  48.00  1  0.05 
3
 48.60)
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12
( 6
)
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6-m Forward Mid rate  48.00  1  0.05   49.20

12
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12-m Forward Mid rate  48.00  1  0.05 ( 12

12
 50.40 )
Pr

With the bid–ask spread increasing at 20 bps for each quarter, the following would be the forward rates:
Bid Ask
3-m forward 48.40 48.80
6-m forward 48.90 49.50
12-m forward 50.00 50.80

(b) When the US dollar is at a discount of 8%

(
3-m Forward Mid rate  48.00  1  0.08 
12 )
3
 47.04

6-m Forward Mid rate  48.00  (1  0.08  )  46.08

6
12
12-m Forward Mid rate  48.00  (1  0.08  )  44.16
12
12
With the bid–ask spread increasing at 20 bps for each quarter, the following would be the forward rates:

Derivatives_ch05.indd 150 28/02/14 11:55 AM

 Currency Forwards and Futures 151

Bid Ask
3-m forward 46.84 47.24
6-m forward 45.78 46.38
12-m forward 43.76 44.56

SP 5.2: Hedging receivables with forwards

Multiplex Ltd has exported copper castings worth US $1 million for which payment is due after six months. The firm has projected
profits assuming the current spot rate of `45 per dollar. Though the US dollar has been steady for the last year; the firm anticipates
a decline in its value in the coming days. The following rates are quoted by the bank:
Spot (rupee/dollar) 45.00 45.35
6-m Forward 45.50 46.00

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(a) Should Multiplex Ltd hedge its receivable?
(b) What realization could be made in Indian rupees it if it decides to hedge?

er
Solution:

at
(a) Since the market is expecting a decline in the value of the US dollar, it would be better if Multiplex Ltd books a forward contract
for selling its receivable, especially when the firm has projected its profit at `45.00. Hedging receivable with forward contracts

M
may help reap high profits.
(b) The forward bid rate is `45.50, at which the firm can sell US $1 million, ensuring a rupee cash inflow of `455.00 lakh.
SP 5.3: Bounds to forward rates
ed
ht
In the inter-bank markets of New York, the prevailing spot rates and interest with respect to the euro are:
ig

Spot rate (dollar per euro) 1.1200 1.1250

yr

Interest rate dollar 5.00% 5.30%

euro 4.00% 4.20%
op

Find out (a) the lower bound to the 3-m forward ask rate
-C

(b) the upper bound to the 3-m forward bid rate

Solution
(a) To find the lower bound on the ask rate, we (a) borrow €1.00 at 4.20% for three months (to repay €1.0105 after three months)
w

(b) convert spot into US dollars at the bid rate to get $1.1200, (c) invest at 5% for three months to get $1.1340 after three months,
ie

and (d) the sell matured dollars forward to get euro to pay for the borrowing.
ev

The matured amount of US dollar is sold to get euros at the forward ask rate. For no arbitrage, the matured amount through
forwards must be less than €1.0105.
Pr

Alternatively, for no arbitrage, we must have 1.1340/Fa 1.0105 or Fa $1.1222

(b) To find out the upper bound on the bid rate we (a) borrow $1.00 at 5.30% for three months (to repay $1.01325 after three
months), (b) convert spot into euro at the ask rate to get €0.8889, (c) invest at 4% for three months to get €0.8978 after three
months, and (d) sell matured euro forward to get dollar to pay for the borrowing.
The matured amount of euro is sold to get euro at the forward bid rate. For no arbitrage, the matured amount through the forward
must be less than $1.01325.
Alternatively, for no arbitrage, we must have 0.8978  Fb 1.01325 or Fb $1.1286
SP 5.4: Settlement of NDF
In Singapore, foreign exchange NDFs are quoted in RMB for settlement in US dollar. An exporter based in Hong Kong has RMB
1 million receivable after three months. The RMB is likely to depreciate. The NDF is being offered at RMB 8.20 per dollar, which
the exporter books. What amount would the exporter pay/receive if on the settlement date, the fixing rate is RMB 8.30 per dollar?
Solution
The exporter sells RMB (buys US dollars) at an exchange rate of RMB 8.20 per dollar. Therefore, the notional principal is US
$10,00,000/8.20 = $1,21,991.20.

Derivatives_ch05.indd 151 28/02/14 11:55 AM

 152 Derivatives and Risk Management

On settlement, the fixing rate is 8.30. The exporter would receive from the bank what is necessary to cover the shortfall he would
have on RMB receivables when converted to US dollars at spot rate.
Settement amount  Notional principal  1  ( NDF rate
Fixing rate )
Settement amount  1,21,91.20  1  ( 8.20
8.30 )
 $1469.29

SP 5.5: Speculation with currency futures

Dollar futures with expiry in 60 days from now at MCX-SX are trading at `48.65. In the spot market, the rate is `47.75. Risk-free
rates in the USA are estimated to be 9% and 5%. If the estimates are assumed correct, what action would you take to earn profit?
Solution
The fair value of the futures is
F  S0  e(rd  rf)t  47.75  e(0.09  0.05)60/365  `48.0650

l
ia
The future is overpriced. Therefore, it must be sold.

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SP 5.6: Arbitrage with currency futures

at
The following data is available from the financial markets:

M
Spot exchange rate (rupee per dollar) 49.7500
90-day futures 51.4000
Rupee interest rate (T-bill yield)
Dollar interest rate (T-bill yield)
ed 12%
8%
ht
Based on these data, find out the fair price of the futures contract. Is there any arbitrage opportunity? If yes, how can the arbitrage
ig

be executed?
yr

Solution
op

The fair price of the futures using simple interest rates is given by

( 1  Rupee interest rate

365 )
days
( 1  0.12
365 )
90
-C

Fair price of futures  Spot   49.75   `50.2312

( 1  Dollar interest rate
365 )
days
( 1  0.08
365 )
90
w

The actual future trading at `51.40, as against the fair price of `50.23, is overpriced. Therefore, we need to sell dollar futures.
ie

Hence, we borrow rupees now and make arbitrage profit as demonstrated below.
ev

Cash flows
$ `
Pr

Now
Borrow rupees — 1,000.00
Convert to dollars using the spot market 20.1005 1,000.00
Invest the dollars at 8% for 90 days 20.1005 —
Sell the dollars in futures maturing after 90 days worth `51,941
Total 0.00 0.00
At maturity
Receive invested dollars 20.2970 —
Deliver dollars against futures 20.2970 —
Receive rupees against futures (20.1005 × 51.40) 1,053.55
Pay rupee borrowed at 12% 1,029.59
Total — 23.96

At the maturity of the futures contract, the arbitrageur can make a profit of `23.96 for every `1000 borrowed.

Derivatives_ch05.indd 152 28/02/14 11:55 AM

 Currency Forwards and Futures 153

SUMMARY
With increased globalization and liberalization of trade, an addi- They are popular instruments in currencies that have capital
tional dimension of risk is added to the menu of finance manag- flow controls. Forward contracts, being OTC, offer flexibility with
ers. Beside business risks, firms that trade internationally face respect to delivery of foreign exchange, by allowing a period
the risk of fluctuating exchange rates for exports and imports. rather than a specific date. Such contracts are called option for-
A risks related to foreign exchange is somewhat different, as it wards.
involves consideration of global factors that are not only hard to The rates offered in various locations by various banks are
comprehend, but are time consuming and too divergent. They different and yet competitive, and it is difficult to capture arbitrage
require more managerial time than would be needed to handle opportunities in foreign exchange markets, because these vary-
other kind of risks. ing rates are not in the public domain.
Foreign exchange markets are intricate and function quite dif- Hedging in foreign exchange rates can be done on the same
ferently in terms of rates. Foreign exchange rates for buying and principle of taking a position in forwards and/or futures opposite

l
selling are different, and are known as the bid rate and the ask to that of the physical markets. An exporter is long on foreign

ia
rate, respectively. Further, foreign exchange markets are OTC. currency, and, therefore, he/she sells a futures contract. It is a

er
Transactions in spot are settled within two business days, time short hedge. On the contrary, an importer, who needs foreign
given to allow for the logistics of exchange of one currency into currency, has to go long in the futures market to hedge. This also

at
another, which involves a chain of banks and nations. remains the position in case of hedging with forward contracts.

M
Forward contracts are more popular as hedging, speculative While speculation on a forward contract is possible, arbitrage is
instruments, and futures contracts. There also exist NDF con- a near impossibility, as forward rates are OTC. Arbitrage and
tracts, which are mostly handled off-shore and are cash-settled.
ed
speculation in futures do not suffer from such disadvantages.
ht
KEY TERMS
ig
yr

Ask rate The rate at which a bank sells foreign currency. Non-deliverable forward An off-shore forward contract in for-
Bid rate The rate at which a bank buys foreign currency. eign currency where no delivery is required, and the contract is
op

Currency futures A forward contract in foreign exchange that necessarily cash-settled on maturity.
is traded on an exchange. Option forward A contract that allows flexibility of settlement
-C

Forward premium or discount The annualized percentage date by specifying a period rather than a specific date.
variation of the forward rate with respect to the spot rate. A for- Spot transaction The transactions in foreign exchange that
ward rate higher than the spot rate means the foreign currency are settled in two business days.
w

is at a premium. Swap transaction A transaction consisting of two equal and

ie

Forward transaction A transaction that needs to be settled at opposite legs, to be completed at two different points of time.
a future date, at a rate specified now.
ev

Interest rate parity The condition that implies that the forward
rate is determined by the equality of returns in different currencies.
Pr

QUESTIONS
5.1 What are the typical features of foreign exchange markets 5.6 Explain hedging of payables and receivables with a forward
as compared to markets for other financial assets? contract.
5.2 Differentiate between (a) bid rate and ask rate, and (b) spot 5.7 What is an NDF? Explain its utility and operation.
rates and forward rates. 5.8 How are currency futures different from currency forwards?
5.3 What do you understand by premium or discount in foreign 5.9 How are currency futures and forwards priced?
exchange? How it is calculated? Show with an example. 5.10 Describe the hedging strategy for payables and receivables
5.4 What is a swap transaction and why is it popular in inter- using currency futures.
bank markets? 5.11 Explain with an example the operation of arbitrage when
5.5 What are option forwards and how are they beneficial? futures are not correctly priced.

Derivatives_ch05.indd 153 28/02/14 11:55 AM

 154 Derivatives and Risk Management

PROBLEMS
P 5.1 Triangular arbitrage from now. The spot price of the US dollar is `50.00 while a
Assume that a bank in India has offered exchange rates for the 3-m futures contract at the NSE is trading at `49.30, indicating
US dollar and the euro at `48.00 and `78.00 for a 2-m forward depreciation of the US dollar. Under what circumstances would
contract, respectively. An American bank has quoted a 2-m for- you like to hedge? What would be the hedging strategy?
ward rate of US $1.70 per euro. If you are allowed to book any P 5.6 Hedging a long position with futures and effective
contract, can you take advantage of the rates offered by the bank exchange rates
in India and the bank in America? Refer to P 5.5. Assume that the exporter hedges with the futures
P 5.2 Arbitrage in futures and forward market contract. One futures contract at NSE is for US $1000, and it is
A futures contract expiring on 28 October in US dollars at the cash-settled. Find out the exchange rate realized by the exporter
NSE is selling for `48.6800. Your bank has offered a forward when prior to maturity (a) the spot rate is `50.50 and the futures
contract for delivery on 28 October at `48.9000. How can you is selling for `50.42 and (b) the spot rate is `48.40 and the

l
futures is selling for `48.48.

ia
take advantage of the disparity in the futures and the forward
markets? How do you think the position would correct itself? P 5.7 Hedging a short position with futures and effective

er
P 5.3 Pricing futures contracts exchange rates

at
The risk-free continuously compounded interest rates in the USA Impex Ltd has to make a payment of US $25,000 after three
and Japan are estimated at 8% and 3% respectively for 3-m months. The spot exchange rate is `46, and it has been increas-

M
maturity. If the spot rate in Japan is Japanese yen 102 per dollar, ing in the recent past. The appreciation of the dollar is expected
what is the likely price for a 3-m futures contract? to continue, as reflected in the 3-m futures quotation of `47.50.
P 5.4 Fair price of futures and interest rates
The spot exchange rate in Germany is €1.25 per pound. A 6-m
ed
The management of Impex Ltd believes that the US dollar is
expected to go beyond `47.50 in three months’ time.
ht
futures contract in Sterling pounds is quoted at €1.27 per pound. (a) How can Impex Ltd hedge its foreign currency exposure?
ig

With returns of 6% in German government securities for maturi- (b) Assume that Impex Ltd takes position in futures and after 3
yr

ties of six months and assuming that the futures are correctly months, at the time of making payment, it unwinds position in
priced, what risk-free rate would you expect in England? futures. Find out the effective exchange rate paid by Impex
op

P 5.5 Hedging strategy for receivables with currency futures Ltd when (i) spot rate is `49.10 and futures price is `49.20,
As an exporter, you expect to receive US $20,000 three months and (ii) spot rate is `46.75 and futures price is `46.80.
-C
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ie
ev
Pr

Derivatives_ch05.indd 154 28/02/14 11:55 AM