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Chapter 9 - Currency futures and swaps. In this chapter, the learning objectives are: To describe futures contracts and show how they circumvent the problems of forward contracts, to compare forward and futures markets, to describe swaps and introduce some terminology,...
Chapter Currency Futures and Swaps Objectives • To describe futures contracts and show how they circumvent the problems of forward contracts • To compare forward and futures markets • To describe swaps and introduce some terminology Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-2 Definition • Currency futures contracts represent an obligation of the seller to deliver a certain amount of a specified currency in the future at an exchange rate determined now Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-3 Problems of Forward Contracts • Non-standard contract dimensions • Default risk • Lack of liquidity Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-4 Using a forward contract JPY C Forward contract A AUD JPY Goods B Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-5 Tendency to default on a forward contract USD 1 million A tends to default A USD 1 million Spot rate = 1.90 Forward rate = 1.80 B AUD 1.8 million AUD 1.9 million C (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-6 Tendency to default on a forward contract (cont.) USD 1 million B tends to default A Forward rate = 1.80 B AUD 1.8 million AUD 1.7 million Spot rate = 1.70 USD 1 million C (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-7 Tendency to default on a forward contract (cont.) USD 1 million Neither tends to default Forward rate = 1.80 A B AUD 1.8 million USD 1 million Spot rate = 1.80 AUD 1.8 AUD 1.8 million million Spot rate = USD 1 1.80 million C Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-8 Unwinding a forward contract (a) Assigning the obligation to another counterparty (D) JPY D Compensation C AUD A Compensation (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-9 Unwinding a forward contract (cont.) (b) Cancelling the forward contract C Cancellation fee A (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-10 Currency swaps • A currency swap is a transaction in which two counterparties exchange specific amounts of two different currencies at the outset and repay over time according to a predetermined rule Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-19 Some features of currency swaps • They emerged in the 1980s with the World Bank playing a major role • They have evolved as a successor to parallel loans Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-20 Stages of currency swaps • The counterparties exchange the principal amounts • On specific dates, they exchange interest payments • On maturity, the principal amounts are re-exchanged Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-21 Currency swaps with notional principals • A notional principal is not exchanged Only compensatory payments are made by one counterparty to the other Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-22 A swap without exchanging principals KS0 A KS1 B KS0 A B KS KS0 A B KS3 KS0 n A KS n B Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-23 Interest rate swaps • A fixed-for-floating swap involves the exchange of cash flows by applying fixed and floating interest rates to a notional principal in a specific currency Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-24 Fixed-for-floating interest rate swap ik (floating) B A ik (fixed) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-25 Other kinds of interest rate swaps • A basis swap involves two floating interest rates • A zero-coupon swap involves a zero fixed rate Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-26 Cross-currency interest rate swaps • Involve the exchange of payments in different currencies, one of which is calculated on the basis of a fixed interest rate and the other on the basis of a floating rate Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-27 Cross-currency interest rate swaps Fixed JPY B A Floating AUD (a) Dealing with one counterparty Fixed JPY Floating AUD B A C Fixed AUD Fixed AUD (b) Dealing with two counterparties Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-28 Swap terminology • A money market swap has a maturity of three years or less This is unlike a term swap, which has a maturity of more than three years (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-29 Swap terminology (cont.) • A spot-start swap starts (that is, it becomes operational) two days after the contract has been agreed upon verbally • A swap that starts after more than two days but within one year is a delayed-start swap • If the starting date is more than one year after the start of the verbal agreement, it is a forward swap (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-30 Swap terminology (cont.) • An option on a swap is a contract allowing the holder to exercise, or otherwise, the right to engage in a specified swap • A swaption allows one party to the contract (the holder of the swaption) to alter the swap (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-31 Swap terminology (cont.) • If a counterparty wishes to terminate the swap without holding a swaption, then he or she would indulge in a swap buyout (that is, the swap is closed and settled at current prices) (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-32 Swap Terminology (cont.) • Normally, the notional principal on which a swap is based is constant throughout the life of the swap • In the case of an amortising swap, the principal declines with time • Another alteration is when the principal takes an irregular pattern Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9-33 ... future at an exchange rate determined now Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9- 3 Problems... McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9- 16 Futures exchanges • The Philadelphia Stock Exchange •... Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 9- 23 Interest rate swaps • A fixed-for-floating swap