Chapter 2 Foreign Exchange
Unit 3
LEARNING OUTCOMES 学习效果:
At the end of this lecture, students should be able to
distinguish the futures contract from forward contract
understand the forward premium and discount
explain how to hedge by using the forward exchange contract
FOCUS AND DIFFICULTIES 知识重难点:
Focus: the difference between futures and forward, forward premium and discount, hedging
Difficulty: how to hedge using the forward contract
LECTURE VIDEO 授课视频:
LEARNING OUTLINE 学习大纲:
1. Forward and Futures Markets
Futures contract is an agreement to buy or sell an underlying asset at a predetermined future date and price.
Futures and Forward are similar types of agreements that lock in a future price in the present, but forwards are traded over-the-counter (OTC) and have customizable terms that are arrived at between the counterparties.
Futures contract is standardized, unlike forward contracts. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange.
Futures contract is traded on a publicly-traded exchange and in a specific geographic location, like, Chicago Mercantile Exchange(CME), Shanghai Futures Exchange(SHFE), etc.
Futures are available on many different types of assets. There are futures contracts on stock exchange indexes, commodities, and currencies.
Futures are derivative financial contracts of which underlying assets include physical commodities or other financial instruments.
Commodity futures include agricultural futures, metals futures, and energy futures.
Financial futures include foreign currency futures, interest rate futures, stock index futures, treasury futures.
Futures obligate the parties to transact an asset at a predetermined future date and price. Here, the buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.
Physical delivery − the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts.
Cash settlement − a cash payment is made based on the underlying reference rate, such as a short-term interest rate index such as 90 Day T-Bills, or the closing value of a stock market index. The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires. Cash settled futures are those that, as a practical matter, could not be settled by delivery of the referenced item—for example, it would be impossible to deliver an index.
2. The Forward Market
In the forward market, currencies are bought and sold for future delivery at forward rate. The forward market is an over-the-counter marketplace in which banks provide their consumers the forward contracts to earn profits.
Forward rate is the exchange rate used in the settlement of forward foreign exchange contract.
If the forward rate of a foreign currency is greater than the spot rate, the foreign currency is more expensive in the forward market than in the spot market, hence the foreign currency is said to be at a premium.
If the forward rate of a foreign currency is less than the spot rate, the foreign currency is at a discount.
Per annum percentage premium (discount) ==(forward rate-spot rate)/spot rate ×12/ no. of months forward.
3. Managing your Foreign Exchange Risk: Forward Foreign Exchange Contract
You are exposed to exchange rate risk if the value of your income or wealth or net worth will change when exchange rates in the future change unpredictably.
How can firms and individuals protect themselves from unexpected ex-rate movements? They can enter the forward market and engage in hedging.
Hedging refers to the process of avoiding or covering a foreign exchange risk.
Case 1: A U.S. importer hedge against the dollar depreciation.
Assume a US importer needs to pay £100,000 three months from now.
The US importer is exposed to ex-rate risk because the dollar payments in 3-month time can be affected by the future ex-rate movements.
If the dollar depreciates relative to pounds in 90 days later, the 100,000 pound payments will cost a larger amount of dollars in the spot market.
To hedge against this risk, the US importer can contract to purchase 100,000 forward pounds at $1.6/£ in 90 days. And, in 90 days, the imports will cost $160,000 for sure regardless of what happens to the future spot rate in 90 days.
Hedging in the forward market thus protect the U.S. importer against the possiblity that dollar will depreciate relative to pound.
However, even if the dollar appreciates, in a favorable direction, the U.S. importer will not be able to benefit since it is obliged to fulfill the delivery in the binding forward contract. The U.S. importer has been locked in the specified quantity of dollars payment and pound receipts in 90 days by the forward contract.
Case 2: A U.S. exporter hedges against a dollar appreciation.
A US exporter will receive £100,000 in three months from its exports to a British buyer.
The US exporter is exposed to ex-rate risk because the dollar receipts in 90 days can be influenced by the future spot rate.
If dollar appreciate relative to pound in 90 days, the 100,000 pound exporting revenues bring in fewer quantity of dollars in the spot market.
To cover against this risk, the US exporter can contract to sell 100,000 forward pounds at $1.59/£ in 90 days. Therefore, the US exporter was locked into the 159,000 dollars it would receive in 90 days.
As our examples indicate, importers and exporters participate in the forward market to reduce or eliminate the risk of exchange rate fluctuations. While, hedging is not limited to exporters and importers.
Hedging applies to anyone who is obliged to make or receive a foreign currency payment at a future time and want to hedge its foreign exchange risks.
