CHAPTER 3

FORWARD MARKET AND TRANSACTION EXCHANGE RISK

3.1 TRANSACTION EXCHANGE RISK

 The possibility of taking a loss in such a transaction.

 Also known as foreign exchange risk or FX risk, is the risk that the value of a
financial transaction will fluctuate due to movements in currency exchange rates
between the time a deal is agreed upon and the time it's settled.

3.2 DESCRIBING UNCERTAIN FUTURE EXCHANGE RATES

A. Assessing Exchange Rate Uncertainty Using Historical Data

 Historical data provide insight not only to what was happened in the past
but might happened in the future.
B. The Probability Distribution of Future Exchange Rates
 A valuable tool for understanding the potential movements of currencies.
 A probability distribution describes the likelihood of different outcomes for
a random event.
 In this case, the event is the future exchange rate between two currencies.

Conditional Means and Volatilities

 Because the probability distribution of the future exchange rate depends on

all the information available at time t, we say that it is a conditional
probability distribution (see the appendix to this chapter). Consequently,
the mean, which is the expected value of this distribution, is also referred to
as the conditional mean, or the conditional expectation, of the future
exchange rate.
 Because the conditional expectation of the future exchange rate plays an
important role in what is to follow, we use the following symbolic notation
to represent it:
Conditional expectation at time t of the future spot exchange rate at time
t+90 = Et 3S1t+9024

Assessing the Likelihood of Particular Future Exchange Rate Ranges

  Given a probability distribution of future exchange rates, we can also
determine the probability that the exchange rate in the future will be greater
or less than a particular future spot rate.

3.3 HEDGING TRANSACTION EXCHANGE RISK

A. Forward Contracts and Hedging

 Forward contracts are agreements between two parties to exchange a specific
amount of currency at a predetermined exchange rate on a future date.
 Forward rate: The exchange rate specified in the contract, is fixed at the time the
parties enter into the contract.
B. The Costs and Benefits of a Forward Hedge
 The appropriate way to think about the cost of a forward hedge: important
to ascertain when the cost is computed.
 If you do not hedge, you will bear the foreign exchange risk, and the actual
exchange rate at which you will transact in the future is very likely not
going to be the expected future spot rate.
 If you are buying foreign currency with domestic currency because your
underlying transaction gives you a foreign currency liability, you will be
glad to have hedged ex post if the future spot rate (domestic currency per
foreign currency) is above the forward rate. You will have regrets ex post if
the future spot rate is below the forward rate.

C. Point-Counterpoint (“Refining” a Hedging Strategy)

 Refining a hedging strategy involves fine-tuning your approach to mitigate risk
even more effectively.

Hedging Versus Speculating

 Two opposing strategies in the financial world, though both involve calculated
risks.
  Breakdown of key differences:
 Goal
o Hedging: Minimize risk from price fluctuations in an underlying asset
you already own or owe. It's about protection.
o Speculation: Aim to profit from price movements of an asset by taking
calculated bets on its future value. It's about potential gain.
 Risk Tolerance
o Hedging: Generally considered more conservative. Hedgers prioritize
reducing risk, even if it means sacrificing some potential profit.
o Speculation: More aggressive. Speculators are comfortable with higher
risks in the hope of greater returns.
 Strategies
o Hedging: Uses offsetting positions to reduce risk. For example, an
airline might buy options contracts to lock in fuel costs, protecting
themselves from price hikes.
o Speculation: Focuses on profiting from price movements. A speculator
might buy a stock they believe will increase in value, or short a stock
they think will decline.
 Benefits
o Hedging: Provides peace of mind and predictability in volatile markets.
o Speculation: Offers the potential for high profits, but also carries the
risk of significant losses.
 Here's an analogy:
o Hedging: Like taking an umbrella before a storm cloud appears, you
prepare for potential downside.
o Speculation: Like going surfing, you hope to catch a big wave (profit),
but there's a chance you might get wiped out (loss).
 In conclusion, hedging and speculation serve different purposes. Hedging
is a risk management tool, while speculation is a profit-seeking strategy.
Choosing the right approach depends on your financial goals and risk
tolerance.

To Hedge or Not to Hedge?

  The decision to hedge or not to hedge depends on several factors and your
overall financial goals.

3.4 THE FORWARD FOREIGN EXCHANGE MARKET

A. Market Organization
 Forward contracts greatly facilitate corporate risk management, and bank
traders happily quote forward exchange rates for their corporate and
institutional customers.
 Simple forward contracts, called outright forward contracts, are a relatively
unimportant component of the foreign exchange market.
 Swap: forward contracts are much more often part of a package deal.
B. Forward Contract Maturities and Value Dates
 Forward value date, or forward settlement date: the parties agree to the
price today, but no monies change hands until the maturity of the contract.
 The most active maturities in the forward market tend to be the even
maturities of 30, 60, 90, and 180 days. Because the forward market is an
over-the-counter market
 However, it is possible for the corporate and institutional customers of
banks and traders at other banks to arrange odd-date forward contracts with
maturities of, say, 46 or 67 days.
C. Forward Market Bid-Ask Spreads
 Bid–ask spreads are quite narrow in the spot market.
 In the forward market, they tend to widen as the maturity of the forward
contract increases.
Liquidity in the Forward Market
 The bid–ask spreads are larger in the forward market than in the spot
market because the forward market is less liquid than the spot market.
 Liquid markets allow traders to buy and sell something without incurring
large transaction costs and without significantly influencing the market
price.
 The liquidity of the market depends on the number of people who are
actively trading in the market and on the sizes of the positions they are
willing to take.
  In very liquid markets, it is easy to find a buyer if you want to be a seller
and vice versa.
 Two main reasons why forward markets are less liquid than spot markets.
1) Banks are exposed to counterparty default risk for a much longer time
interval in a forward contract than in a spot contract.
2) Because increased counterparty default risk reduces the number of
forward transactions banks are willing to do, banks find it more
difficult to manage open positions in forward contracts.
D. Net Settlement
 Most outright forward contracts are settled by payment and delivery of the
amounts in the contract.
 Often used in the forex future market.
E. The Foreign Exchange Swap Market
 More of the trading of forward contracts happened in the swap market.

How Swap Prices Are Quoted

 Unlike stock prices or quotes you might see on a typical exchange, foreign
exchange (FX) swaps aren't directly quoted with a single price. The pricing
in the FX swap market is more nuanced and reflects several factors.

A Rule for Using Swap Points

 If the first number in the swap quote is smaller than the second, you add the
points to the spot bid and ask prices to get the outright forward quotes; if the
first number in the swap points is larger than the second, you subtract the
points.

Cash Flows in a Swap

 The net cash flow in each currency over the swap period depends on the
relative interest rates and the initial exchange rate.
 FX swaps can be structured for various purposes, including hedging
exposure, speculation on interest rates, or borrowing in a specific currency.
 Cash flow calculations can be more complex for swaps with features like
non-standard maturities or multiple exchange dates.
3.5 FORWARD PREMIUM AND DISCOUNTS

 If the forward price of the euro in terms of dollars (that is, USD>EUR) is higher
than the spot price of USD>EUR, the euro is said to be at a forward premium in
terms of the dollar.
 Conversely, if the forward price of the euro in terms of dollars (USD>EUR) is
less than the spot price of USD>EUR, the euro is said to be at a forward
discount in terms of the dollar.
A. Sizes of Forward Premiums or Discounts
 The size of forward premiums or discounts can vary depending on several
factors, but typically they range from a fraction of a percent to a few
percentage points.
B. Forward Premiums and Swap Points
 Because forward contracts are typically traded as part of a swap, the swap
points tell us whether the denominator currency is at a premium or a
discount.

3.6 CHANGES IN EXCHANGE RATE VOLATILITY (ADVANCED)

Volatility Clustering

 Percentage changes in exchange rates show a pattern.

 When volatility is high, it tends to remain high for a while; periods of low
volatility are likewise persistent.