Forward exchange contract

By entering into a forward exchange contract with a bank, the company agrees now to buy or
sell an amount of foreign currency at the current forward exchange rate in a fixed future date.
Pros:
 Hedge the uncertainty of future spot exchange rate different from the current forward
exchange rate.
 Eliminate the downside risk of adverse movements of the future spot exchange rate.
 Cheaper than the money market hedge.
Cons:
 Eliminate/ not benefit upside potential of favourable movements of the future spot
exchange rate.
E.g:
The current spot rate for US dollars against UK sterling is $1.4525 - $1.4535 = £1 and the one-
month forward rate is quoted as $1.4550 - $1.4565 = £1.
A UK exporter expects to receive $400,000 in one month.
If a forward exchange contract is used, the company will receive $400,000 x $1.4565 =
$582,600. Using $1.4565, as the UK exporter, when receiving payments in dollars, to spend
them, they have to sell to the bank and the bank buys high ie. At $1.4565/ £1.

Forward rate agreement

By entering into a forward rate agreement, the company agrees now to pay or receive interest
on specified quantity of money at “current forward” (target) interest rate at a fixed future date.

If the future interest rate higher than the target interest rate, the bank will compensate the
company with the difference.
If the future interest rate lower than the target interest rate, the company will compensate the
bank with the difference.
The bank in the FRA could be different from the bank in the loan contract.

Pros:
Hedge the uncertainty of future interest rate different from the target interest rate.
Protect the company from the future interest higher than the target interest → eliminate the
downside of the adverse movement (any unxpected increase) in future interest rate.
Cons:
Not benefit if the future interest rate is lower than the target interest rate.

E.g:
A Co needs to borrow £30m for 8 months, starting in 3 months’ time.
A 3-11 FRA at 2.75 – 2.60 is available.

The agreement starts in 3 months’ time and ends in 11 months’ time.

Annual interest rates for borrowing and lending: 2.75% - 2.60%. The borrowing rate is always
the highest.
Show the interest payable if the market rate is 4%, 2%.

Market rate is at 4% Market rate is at 2%

Interest payable £30m x 4% x 8/12 = £0.8m £30m x 2% x 8/12 = £0.4m
Compensation payable £30m x (2.75%-2%) x 8/12 =
£0.15m
Compensation receivable £30m x (4%-2.75%) x 8/12 =
£0.25m
Locked-in interest payable at £0.55m £0.55m
2.75% in FRA

Currency futures
Futures are like a forward contract in that:
- The company agrees now to buy or sell a certain amount of foreign currency at the
current forward exchange rate at a fixed future date.
- It is a binding contract.

The futures contract differ from a forward contract in that:

- It can be traded on futures exchanges.
- It is separated from the transaction itself, allowing the contracts to be easily traded.
- It is settled on quarterly basis or three-monthly basis.
- It has a duration of 3 months.
- Its maturity dates is the end of March, June, September and December. The company
can buy or sell September futures or December futures and so on.
- It is a standardised contract for standardised amounts. For example: a sterling futures
contract with a standard size of £50,000. Only whole number multiples of this amount
can be bought or sold.
- The price is the exchange rate for the currencies specified in the contract.

For sterling futures contracts:

- If the sterling is to be sold on a future date, the company will buy sterling futures
contracts on the same date to offset the transaction and sell those futures contracts
now. (SS)
- If the sterling is to be bought on a future date, the company will sell sterling futures
contracts on the same date to offset the transaction and buy those futures contracts
now. (BB)

- When a currency futures contract is bought or sold, the buyer or seller is required to
deposit a sum of money with the exchange (initial margin).
- If losses are incurred as exchange rates and hence the prices of currency futures
contracts changes, the buyer or seller will be required to deposit additional funds
(variation margin) with the exchange.
 - Profits are credited to the margin account daily as the contract is marked to market.

Most currency futures contracts are closed out before their settlement dates by the company
undertaking the opposite transaction to the initial futures transaction. If the company initially
buys the currency futures contracts, it closes out them by selling them.

If a company expects a $ receipt in 3 months’ time, it will lose out if the $ depreciates to £.
- Using a futures contract, the company bets that the $ will depreciate.
- If it does, the win on the bet cancels out the loss on the transaction.
- If the $ strengthens, the gain on the transaction covers the loss on the bet.
In the end, futures ensure a no win/no loss position.

Feb: a US exporter expects to receive £50,000 in June.

Current spot rate now: $1.65 = £1
The quote for June Sterling futures: $1.65
Standard size of futures contract: £62,500.

The US exporter uses futures to hedge its currency risk by selling Sterling futures.
In June, the company receives £500,000.
The spot rate in June moved to: $1.70 = £1 → $ depreciates to £
The futures rate in June: $1.70.

Number of contracts = £500,000/£62,500 = 8

Exporter needs to sell futures (sell £s).
- In Feb: the hedge is set up by:
Selling (8 contracts x £62,500) = £500,000 for June delivery at $1.65.
- In June: the futures position is closed
Buying (8 contracts x £62,500) = £500,000 for June delivery at $1.70.
Summary of futures position:
Sell £ for $1.65
Buy £ for ($1.70)
($0.05)
Loss on futures position = $0.05 x (8 contracts x £62,500) = $25,000.

The £500,000 received by the US exporter is then sold in June at the prevailing spot rate.
£500,000 x $1.70 = $850,000
As the sterling appreciates while the dollar depreciates in the spot rate over the period, this
increases the value of sterling.
Value of £500,000 in Feb at $1.65 is $820,000. Value of £500,000 in June at $1.70 is $850,000.
So the increase in value is $25,000.

Loss on futures position = $25,000

Increase in value of sterling = $25,000
The futures hedge removes both risk: downside risk and upside potential.

A US company has to pay £720,000 in 30 days.

It wants to hedge against the £ strengthening against $.
Now:
- Current spot: $0.9215 - $0.9221 = £1
- Futures rate: $0.9245 = £1
The standard size of a 3-month £ futures contract is £125,000.
In 30 days’ time:
- Future Spot: $0.9345 - $0.9351
- Closing futures rate: $0.9367 = £1

Exporter needs to buy futures (buy £s).

Number of contracts = £720,000/£125,000 = 5.76 or 6

Tick size = minimum price movement x contract size = 0.0001 x 125,000 = $12.50

Outcomes in futures market

Opening futures price (buy futures): $0.9245

Closing futures price (sell futures): $0.9367
Difference in futures prices = ($0.9367-$0.9245)/0.0001 = 122 ticks
Movement in ticks: 122 ticks
Future profit/loss:
= Movement in ticks x tick size x number of contracts = 122 x $12.50 x 6 = $9,150

Net outcome
Spot market payment = 720,000 x $0.9351 = $673,272
Futures market profit = $9,150
Net outcome = $673,272 - $9,150 = $664,122

Decrease in value = 720,000 x (0.9345-0.9215) = 9360

Net loss = 9360-9150 = 210

Pros:
Theoretically eliminate both risk: upside potential of favourable movements and downside risk
of adverse movements in future spot exchange rate.
Any gains in currency futures market are offset by exchange rate losses in cash market and vice
versa.
Cheaper than other hedging methods such as forwards.

Cons:
Not benefit if the future forward exchange rate is lower than the agreed current forward
exchange rate.

Interest rate futures

The company agrees now to receive or pay a fixed interest rate on a certain amount of money
(loans or investments) on a fixed future date.
It is separated from the loan contract.

If the company is to pay interests on a borrowing on a future date, the company will buy
futures contracts on the same date to offset the transaction and sell those futures contracts
now. (BS)
If the company is to receive interests on a deposit on a future date, the company will sell
futures contracts on the same date to offset the transaction and buy those futures contracts
now. (DB)
The only cash flow arising is the net interest paid or received ie. The profit or loss on the future
contracts.

Interest rates rise:

- Borrowing more expensive → loss from paying higher interest.
- Futures price fall → profit (sell at higher price than buy)
- Net position: interest cost fixed.
Interest rates fall:
- Borrowing cheaper → gain from paying less interest.
- Futures price fall → loss (sell at lower price than buy).
- Net position: interest cost fixed.

Pros:
Theoretically eliminate both risk: upward potential for favourable movements and downside
risk for adverse movements in future interest rate compared with agreed interest rate.
Any gains in interest futures market are offset by the losses in the interest rate changes in cash
markets.

Cons:
Imperfect hedge exists as the gains or losses of futures contracts do not offset perfectly the
losses or gains from changes of foreign exchange rate or interest rate. Due to the following
reasons:
1) Basis risk is the risk that Market forces make the price of a futures contract different
from the spot price on a given date.
However, on the maturity date of the futures contracts, the basis is zero as there is no
difference between its price and spot price. This leads to the losses or gains from the
standardised futures contracts could not offset perfectly the hedging company’s foreign
exchange or interest rate risk.
 2) The commodity being hedged (either currency or interest) must be rounded to a whole
number multiply of the standardised size of the futures contract, leading to
inaccuracies. This leads to the losses or gains from the standardised futures contracts
could not offset perfectly the hedging company’s foreign exchange or interest rate risk.

3) Floating interest rates on size-matched assets and liabilities are determined on

differerent basis. One could be linked to LIBOR while the other is not. So, the two
floating rates don’t move perfectly in line with each other and create unexpected gains
and losses of interest. This leads to the losses or gains from standardised futures
contracts could not offset perfectly these gains or losses of interest.

4) As futures contracts are standardised contracts which are settled on a fixed maturity
date, they do not cover the hedging company’s exact exchange rate risk or interest rate
risk.

Currency options
It gives the company the option/ right (not obligation) to undertake a forward exchange
contract.
It is more expensive than forward exchange contract.
The option/right to sell (put option) or buy (call option) foreign currency at agreed rate on a
fixed future date.
If the exchange rates are expected to be higher than target rate in FEC, the company will use
FEC as it’s cheaper way to hedge adverse movements.
If the exchange rates are unpredictable, the company will use currency options.
When the exchange rates are actually higher than agreed exchange rates, the company will
exercise the options to hedge against adverse movements.
When the exchange rates are actually lower than agreed exchange rates, the company will let
the options lapse and do not exercise it.
2 types:
Over-the-counter from banks: tailored to individual clients esp. SMEs’ needs.
Exchange-traded: standardised like currency futures, traded on futures exchange, for larger
companies.

Pros:
Eliminate only downside risk of adverse movements.
Not eliminate upward potential of favourable movements.

Cons:
Even if the company will never use options, when it buys options, it still has to pay a premium
to option sellers as options are more flexible than forwards.
Interest rate options
It gives the company the option/ right (not obligation) to undertake a forward rate agreement.
It is more expensive than forward rate agreements.
The option/ right to pay (put-sell option) or receive (call-buy option) interests at agreed rate
on a fixed future date.
If the interest rates are expected to be higher than target interest rates in FRA, the company
will use FRAs as it’s cheaper way to hedge adverse movements.
If the interest rates are unpredictable, the company will use interest rate options although they
are more expensive than FRAs.
When the interest rates actually higher than agreed interest rates, the company will exercise
the options to hedge against adverse movements.
When the interest rates actually lower than agreed interest rates, the company will let the
option lapse and do not exercise it.
2 types:
Over-the-counter from banks are tailored to individual clients and SMEs needs.
Exchange-traded are standardised like futures contracts, traded on futures exchange, for larger
companies.

Pros:
Eliminate only downside risk of adverse movements in interest rates.
Not eleminate upside potential of favourable movements in interest rates.

Cons:
Even if the company does not exercise the options, when it buys options, it has to pay a
premium for the option sellers as options are more flexible than forwards.

Interest rate cap:

interest rate option used to set a maximum interest rate. If the actual interest rate is lower than
the maximum, the option (to borrow/put option-borrower buys this) is allowed to lapse. It is
useful for borrowers as they don’t have to pay that much interests.

Interest rate floor:

interest rate option used to set a minimum interest rate. If the actual interest rate is higher
than the minimum interest rate, the option (to lend/ call option-lender buys this) is allowed to
lapse. It is useful for lenders as they don’t have to receive that little interests.

Interest rate collar:

interest rate options used to set both a maximum and a minimum range for the interest paid or
received.
A borrower buys a cap (to fix maximum interest rate) and sell a floor (making premium as
selling to lenders). when interest rates fall, cap generates no gains but floor sold generates
premium.
A lender buys a floor (to fix minimum interest received) and sell a cap (making premium as
selling to borrowers). When interest rates rise, floor generates no gains but cap sold generates
premium.

Currency swap:
One party has debts in one currency while the other has debts in another currency.
They agree to pay each other’s debts but don’t exchange principal.
If the counterparty defaults on interest payments, the original party still has to pay interests to
the lenders.
Pros:
- Cheaper way to obtain the desired currency than being exposed to foreign exchange
risk.
- Cheaper way to achieve the desired exchange rate structure (from one currency to
another and vice versa).
- Absorb excess liquidity of one currency not needed immediately (find a useful use for
idle currency)

Interest rate swap:

One party has floating interest rate debts while the other has fixed interest rate debts.
They agree to pay each other’s debts but don’t exchange principal.
If the counterparty defaults on interest payments, the original party still has to pay interests to
the lenders.

Pros:
- Cheaper way to achieve the desired interest rate structure (from fixed to floating and
vice versa) than repaying floating/ fixed debts early and incurring early repayment
penalties and taking out new fixed/ floating debts.
- Flexible as arranged in any size.
- Low transaction costs.