Forward-looking Market Instruments

In Chapter 1, we considered the problem of a U.S. importer buying Swiss watches. Since the exporter requires payment in Swiss francs, the transaction requires an exchange of U.S. dollars for francs. In the discussion in Chapter 1 it was assumed that the payment was done immediately, thus the chapter discussed the spot market—exchanging dollars for francs today at the current spot exchange rate. In the real world payments are not immediate. Instead the purchaser is usually granted 30, 60 or 90 days to pay for the purchase. Thus, the transaction requires the purchaser and the seller to try to predict the future foreign currency value. This chapter deals with instruments that help cover the risk of a foreign currency value becoming too high when the importer has a foreign currency liability, or too low when the exporter has a foreign currency receivable.

Suppose we return to the example of the U.S. watch importer. Earlier, the importer purchased francs in the spot market to settle a contract payable now. Yet much international trade is contracted in advance of delivery and payment. It would not be unusual for the importer to place an order for Swiss watches for delivery at a future date. For instance, suppose the order calls for delivery of the goods and payment of the invoice in three months. Specifically, let’s say that the order is for CHF100,000.

What options does the importer have with respect to payment? One option is to wait three months and then buy the francs. A disadvantage of this strategy is that the exchange rate could change over the next three months in a way that makes the deal unprofitable. Looking at Figure 4.1 ,

86 International Money and Finance

Country Closing mid-point 3-month One-year

forward Argentina (Peso)

spot rate

Australia (Australian $)

Brazil (Real)

Canada (Canadian $)

India (Rupee)

Indonesia (Rupiah)

Japan (Yen)

Sweden (Krona)

Switzerland (Franc)

U.K. (Pound)

1.4613 1.4452 Figure 4.1 Selected currency trading exchange rates. Source: Table is based on data

Euro (Euro)

from Financial Times, “Currency Markets: Dollar Spot Forward Against the Dollar and Dollar Against Other Currencies” on April 26, 2011. See: http://markets.ft.com/RESEARCH/ markets.

Then it would take $133,333 to purchase CHF100,000, and the watch purchase would not be as profitable for the importer. Of course, if the dollar were to appreciate against the franc, then the profits would be larger. As a result of this uncertainty regarding the dollar/franc exchange rate in the future, the importer may not want to choose the strategy of waiting three months to buy francs.

An alternative is to buy the francs now and hold or invest them for three months. This alternative has the advantage that the importer knows exactly how many dollars are needed now to buy CHF100,000. But the importer is faced with a new problem of coming up with cash now and investing the francs for three months. Another alternative that ensures a certain dollar price of francs is using the forward exchange market. As will

be shown in Chapter 6, there is a close relationship between the forward market and the former alternative of buying francs now and investing them for three months. For now, we will focus on the operation of the forward market.

Forward-looking Market Instruments 87

of the available quotes. Note in the figure that the three-month or 90-day forward rate on the Swiss franc is CHF0.8793 5 $1. To buy francs for delivery in 90 days would cost $1.1373 per franc. Note that Figure 4.1 also shows one-year forwards. Often one-month and six-month forward rates are also quoted, as these are commonly traded maturities.

The advantage of the forward market is that we have established a set exchange rate between the dollar and the franc and do not have to buy the francs until they are needed in 90 days. This may be preferred to the option of buying francs now and investing them for three months, because it is neither necessary to part with any funds now nor to have knowledge of investment opportunities in francs. (However, the selling bank may require that the importer hold “compensating balances” until the 90-day period is up—that is, leave funds in an account at the bank, allowing the bank to use the money until the forward date.) With a forward rate of $1.1373 5 CHF1, CHF100,000 will sell for $113,730. The importer now knows with certainty how many dollars the watches will cost in 90 days. In addition, note that the importer only pays a small amount above the spot exchange rate for this forward contract. Instead of paying $113,701 for 100,000 Swiss Franc in the spot market, the importer can pay an additional $29 for a contract that delivers the CHF100,000 in

90 days. If the forward exchange price of a currency exceeds the current spot price, that currency is said to be selling at a forward premium. A currency is selling at a forward discount when the forward rate is less than the current spot rate. The forward rates in Figure 4.1 indicate that the British pound is selling at a discount against the dollar, but the Japanese yen is selling at a premium. The implications of a currency selling at a discount or premium will be explored in coming chapters. In the event that the spot and forward rates are equal, the currency is said to be flat.

SWAPS Commercial banks rarely use forward exchange contracts for interbank

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transactions into one, thus cutting transactions costs in half. The firm avoids any foreign exchange risk by matching the liability created by borrowing foreign currencies with the asset created by lending domestic currency, both to be repaid at the known future exchange rate. This is known as hedging the foreign exchange risk.

For example, suppose Citibank wants pounds now, and wants to hold the pounds for three months. Instead of borrowing the pounds, Citibank could enter into a swap agreement wherein they trade dollars for pounds now and pounds for dollars in three months. The terms of the arrangement are obviously closely related to conditions in the forward market, since the swap rates will be determined by the discounts or premiums in the forward exchange market.

Suppose Citibank wants pounds for three months and works a swap with Lloyds. Citibank will trade dollars to Lloyds and in return will receive pounds. In three months the trade is reversed. Citibank will pay out pounds to Lloyds and receive dollars (of course, there is nothing special about the three-month period used here—swaps could

be for any period). Suppose the spot rate is $/d 5 $2.00 and the three-month forward rate is $/d 5 $2.10, so that there is a $0.10 premium on the pound. These premiums or discounts are actually quoted in basis points when serving as swap rates (a basis point is 1/100 percent, or 0.0001). Thus the $0.10 premium converts into a swap rate of 1,000 points, which is all the swap participants are interested in; they do not care about the actual spot or forward rate since only the difference between them matters for a swap.

Swap rates are usefully converted into percent per annum terms to make them comparable to other borrowing and lending rates (remember a swap is the same as borrowing one currency while lending another currency for the duration of the swap period). The swap rate of 1,000 points or 0.1000 was for a three-month period. To convert this into annual terms, we find the percentage return for the swap period and then multiply this by the reciprocal of the fraction of the year for which the swap exists. The percentage

Forward-looking Market Instruments 89

And the reciprocal of the fraction is

Thus, the percent per annum premium (discount) or swap rate is

Annualized percentage swap rate 5 0:05 3 4 5 20% This swap, then, yields a return of 20 percent per annum, which can

be compared to the other opportunities open to the bank. An alternative swap agreement is a currency swap. A currency swap is a contract in which two counterparties exchange streams of interest payments in different currencies for an agreed period of time and then exchange principal amounts in the respective currencies at an agreed exchange rate at maturity.

Currency swaps allow firms to obtain long-term foreign currency financing at lower cost than they can by borrowing directly. Suppose a Canadian firm wants to receive Japanese yen today with repayment in five years. If the Canadian firm is not well known to Japanese banks, the firm will pay a higher interest rate than firms that actively participate in Japanese financial markets. The Canadian firm may approach a bank to arrange a currency swap that will reduce its borrowing costs. The bank will find a Japanese firm desiring Canadian dollars. The Canadian firm is able to borrow Canadian dollars more cheaply than the Japanese firm, and the Japanese firm is able to borrow yen more cheaply than the Canadian firm. The intermediary bank will arrange for each firm to borrow its domestic currency and then swap the domestic currency for the desired foreign currency. The interest rates paid on the two currencies will reflect the forward premium in existence at the time the swap is executed. When the swap agreement matures, the original principal amounts are traded back to the source firms. Both firms benefit by having access to foreign funds at a lower cost than they could obtain directly.

FAQ: What Is a Credit Default Swap? It is difficult to keep up with all the terminology, but the financial crisis in

90 International Money and Finance

then receive a fee for taking on the risk of a default of the payments by the party that is making a payment.

For example, assume that a Japanese company has borrowed money and has agreed to pay a periodic amount to Bank of America. Bank of America may then purchase a CDS to cover the risk of the Japanese firm defaulting on their payments. Bank of America buys such a CDS from AIG. Note that the bank now has hedged the default risk of the Japanese firm, but still has a risk that the seller of the CDS, in this case AIG, defaults. This was not seen as an issue until the financial crisis showed that the sellers of CDSs were vulnerable. AIG adopts the risk that the Japanese firm will continue to make its payments. In exchange for adopting this risk a periodic payment will be made by Bank of America to AIG. Note that is essentially as if AIG, the seller of the CDS, has been “lending” money to the Japanese firm, and is receiving payments indirectly through Bank of America. The major difference between direct lending (as Bank of America did in this case) and the indirect lending through the CDS (that AIG did in the above case) is that AIG never had to fund the loan. This means that companies can leverage themselves much more, and “lend” large amounts of money. See Mengle (2007) for a detailed discussion of credit derivatives.

Table 4.1 presents data on the volume of activity in the foreign exchange market. In 2010 about 37 percent of the transactions reported by the banks surveyed were spot transactions. Swaps constitute 45 percent of the business, and forwards account for around 12 percent. Swaps have about four times the volume of outright forward purchases or sales of currency.

In foreign exchange dealing, banks do not always trade directly with one another but often use someone in the middle—a broker. If a bank wants to buy a particular currency, several other banks could be contacted for quotes, or the bank representative could input an order with an electronic broker where many banks participate and the best price at the current time among the participating banks is revealed. While trading in

Table 4.1 Foreign Exchange Market Turnover Average daily turnover (Billions of U.S. Dollars)

Forward-looking Market Instruments 91

the broker’s market is in progress, the names of the banks making bids and offers are not known until a deal is reached. This anonymity may be very important to the trading banks, because it allows banks of different sizes and market positions to trade on an equal footing.

In the electronic brokers market, computer programs take offers to buy and sell from different agents and match them. In addition to the electronic brokers, there are electronic dealing systems. Rather than talk- ing directly over the telephone dealer-to-dealer, computer networks allow for trades to be executed electronically. The use of electronic broker systems varies greatly across countries. Approximately 54 percent of trading in the United States goes through such networks, compared to 66 percent in the United Kingdom and 48 percent in Japan.

Forward-looking Market Instruments