Hedging with Foreign Currency Futures and Swaps (9.5 & 9.6)

By:

Jeffrey B. Miracle

GSM 686

10.28.03

Introduction of Topics

• Currency Swaps

• Futures

• Hedging with Foreign Currency Futures

• In-Class Problem (winner gets a trinket!)

Swap

A Swap is an agreement in which two parties repay each other’s

loans. In its simplest form currency swaps involve exchanging

repayment of two fixed interest-rate loans denominated by

different currencies.

Swap Example:

Miracle Inc. of the USA, wishes to obtain financing in Swiss Francs to hedge against exposure generated by exports to Switzerland. Likewise Thompson Technologies, a Swiss firm is interested in obtaining a dollar liability to hedge its sales in the USA.

Each Company takes out a 10 yr fixed-rate loan for $100 million in it’s local currency. Miracle Inc. has a 10% interest rate while Thompson Tech.obtains a Sf loan of 9.6 The exchange rate is $.80/SFr, the payments look as follows:

Swap Example cont…Year Miracle.Inc:

USAThompson Tech: Switzerland

0 $ 100 Mil SFr 125 Mil

1 ($10 Mil) (SFr 12 Mil)

2 ($10 Mil) (SFr 12 Mil)

3 ($10 Mil) (SFr 12 Mil)

….. ……. ……..

10 ($110 Mil) (SFr 137 Mil)

Swap Example cont…

Year Miracle.Inc: USA

Thompson Tech: Switzerland

0 $100 Mil SFr 125 Mil

1 (SFr 12 Mil) ($10 Mil)

2 (SFr 12 Mil) ($10 Mil)

3 (SFr 12 Mil) ($10 Mil)

….. ……. ……..

10 (SFr 137 Mil) ($110 Mil)

Swap Example cont…..

As you can see, both Miracle Inc. and Thompson Technologies have achieved liabilities in their desired currencies without having to access overseas capital markets.

All-in cost of a currency swap

(Swap Principal - Swap Fee)/So=Payment 1/(1+i)+Payment 2/(1+i)^2+ Payment 3/ (1+i)^3…Payment n/ (1+n)^n

Or in the example of Miracle Inc.

($100 mil - $1 mil)/($.80Fr)= (Sfr 12mil)/(1+i)+ (Sfr 12 mil)/(1+i)^2 + (Sfr 12 mil)/(1+i)^3+ (Sfr 137 Mil)/(1+i)^10

Miracle’s all-in cost is calculated to be 9.76 percent

This formula calculates the discount rate, i, that equates swap payments with net swap proceeds:

The Market for Foreign Exchange Swaps

Segmentation of Markets: Capital Markets continue to price the obligations of firms differently, therefore demand different interest rates from the same firm. Differences in a firms cost of debt across markets are frequent and can be significant

Time: Few banks are interested in taking the opposite side of a series of long-dated forward contracts, so bid-ask prices tend to represent a significant portion of the total price. Swaps match parties interested in converting long dated obligations into each other’s currency, enjoy a liquidity that makes their transactions cost low

Credit Rating: Lastly swaps have become popular is because they do not require that a firm be matched according to their credit rating.

Futures Contracts

Futures contracts are contracts which specify delivery of fixed quantities of foreign currencies on a set delivery date in the future, these contracts are traded on an organized exchange.

These contracts are standardized by size and delivery date to making trading easier.

Futures Contractsvs.

Forward Contracts

1) Forwards, Banks/ Futures, Exchange

2) Size of Contract

3) Date of Maturity

4) The Settlement

Principals of Hedging with Foreign Currency Futures

When hedging with a foreign currency there are three important dates that you must consider.

t--------------t+n-------------------T

Inception liquidation Maturity

Futures Hedging Simplified

One of the most frequent ways a futures hedge is used is to establish a futures position that offsets an existing position one-for-one.

For example hedging $1 million with 8 $125,000 contracts.

The firm will buy/sell futures at date t for liquidation at date t+n.

Futures Held to Maturity

A futures contract held until maturity enables a perfect hedge to be created.

This is the same as a forward contract because futures contracts held to maturity are equivalent to forward contracts with the same maturity dates

After all both forwards and futures are priced according to covered interest parity.

Contracts Not Held to Maturity

Futures not held to maturity are not perfect because the remaining time to maturity on the futures price has not yet converged to the spot price.

Also, the relative interest rates at the time the position is liquidated are not known in advance and will most likely change over the interval though liquidation.

Gain or Loss on Hedged Position

Gain(Loss)= X[(St+n- bSt) - (Zt+n,T-Zt,T)]

b= [1+it,t+n]1/a^/ [1+ i*t,t+n]1/a^ (The interest rate ratio)

X= the amount of exposure

a^= annualized factor for the interval from t to t+n

(Z t+n,T-Z t,T) = is the change the price of a futures contract maturing time T, over the time period from ,t inception of the position, to t+n, liquidation of the position

(S t+n - bSt) = is the deviation of the future spot exchange rate (or forward rate) at inception of the position

In-Class Problem

In Closing

Futures contracts almost never completely eliminate risk

Futures are most likely to be used for hedging purposes when:

1) Transaction date is indefinite

2) Transaction amount is imprecise

3) Amount is too small for the forward market

Questions ?

Thank You!