Ways of expressing forward rates

In addition to the direct or indirect quotation, forward exchange rates can be expressed in one of three ways. First, the forward rate can be quoted as an outright rate — i.e. the actual forward rate of exchange.

Secondly, it can be quoted as forward exchange margins or points (also called swap rates). These latter are either discounts or premiums depending on the interest differentials between the home and foreign currency. If the foreign currency interest rate is higher than the home currency interest rate, the foreign currency will be at a forward discount to its spot rate. If, on the other hand, the foreign interest rate is below the home currency interest rate, the foreign currency will be at a forward premium to its spot value. The magnitude of the discount or premium is dependent upon the size of the differential in home and foreign interest rates and the time to maturity of the forward contract. Read more »

Posted: June 24th, 2008 under Currency Futures, Foreign Exchange Futures, Futures Market.
Comments: 5

The foreign exchange market is an interbank market, in that there is no designated market-place; instead transactions are conducted over the telecommunications system using telephones and computer screens. As a consequence, the foreign exchange (or FX) market is truly global, with all the major commercial banks around the world and the treasury departments of many companies participating. In addition, central banks enter the market in the execution of their monetary and exchange rate policies. There is also a system of brokers who act as intermediaries to supplement the direct contact between participants. As the trading day progresses, the centre of activity moves from one time zone to another, making it possible t trade internationally 24 hours a day.

The transactions in the FX market emanate from international trade, international investment, the hedging of exchange risks, the establishment of speculative positions or arbitraging between mispriced sections of what is a vast market. Read more »

Posted: June 24th, 2008 under Currency Futures, Foreign Exchange Futures, Future Exchange, Future Trading.
Comments: 4

The Black model should not be used for valuing American options on currency futures because it may be optimal to exercise the options early in the same way as it may be optimal to exercise options on the spot currency early. The binomial or the Barone-Adesi and Whaley models may be used for valuing those options.

The early exercise potential of American options on futures is different to that of options on the spot. Futures prices do not exhibit the discrete jumps that accompany spot market assets when the underlying spot asset makes discrete distributions. However, as the carry basis of the future converges to zero at delivery, the futures price converges to the spot price in an orderly manner. Read more »

Posted: June 22nd, 2008 under Currency Futures, Futures Options, Futures Prices, Swap Futures, investment.
Comments: 4

This section explains two of the many uses of options that rely upon the ability of the option buyer to abandon the option at no extra cost. The first is the purchase of options to insure against a fall in the value of a currency. The second is the hedging of the currency risk in a foreign currency tender.

Purchasing options as a form of insurance

If a US investment manager has strong expectations of a rise in the value of Sterling but wishes to insure against being totally wrong, slightly out-of-the money puts will provide the required insurance. Read more »

Posted: June 21st, 2008 under Commodities Futures, Equity Futures, Foreign Exchange Futures, Future Fund, Future Investing, Futures Options, Futures Prices, Futures Spreads, Futures Trading System, Managed Futures, Stock Futures, Stock Market Futures.
Comments: 5

Average rate currency options are based upon the average exchange rate of the underlying currency as distinct from the exchange rate on a single date — the expiry date.

The advantage of an average rate option is that the volatility of a moving average of a variable is less than the volatility of individual observations of that same variable. With daily observations, and with the volatility levels seen in the currency markets, the volatility of the moving average is in the order of 60% of that of the raw observations. Consequently, the price of an average rate option with a given exercise price will be less than an otherwise identical standard European currency option. Read more »

Posted: June 21st, 2008 under Equity Futures, Future Market Trends, Futures Market, Futures Options, Futures Spreads, S&P Futures, Stock Market Futures, Swap Futures, investment.
Comments: 5

Basket options are not new, for equity index options are a form of basket option. However, basket options relating to currencies are only available (at the time of writing) from the OTC market. The one exception is the ECU option traded on the Philadelphia Stock Exchange.

Currency basket options, like equity index options, are options on portfolios of specified currencies. As such they are appropriate for managing the currency risk inherent in the cash flows generated in a variety of currencies. An example would be the monthly remittance of income from a variety of foreign currency bond holdings. Read more »

Posted: June 19th, 2008 under Futures Market.
Comments: 4

However, this theory of the development of the swaps market assumes that the financial markets remain informationally inefficient and that the benefits of comparative advantage are not arbitraged away. There is no doubt that in the early days of the interest rate and currency swaps markets it was possible to locate such inefficiencies that resulted in generous benefits to both parties, but in the years since the market’s inception the benefits have to some extent been reduced by arbitrage, yet the market still grows dramatically.

Thus there must be some other reason, or reasons, for the existence of the swaps market as the comparative advantage theory assumes that some markets persistently underprice credit risk relative to other markets. Three alternative reasons for the market’s existence can be postulated. Read more »

Posted: June 14th, 2008 under Currency Futures, Foreign Exchange Futures, Future Exchange, Future Investing, Future Management, Future Trading, Interest Rate Futures, Managed Futures, Stock Futures, Stock Market Futures, Swap Futures.
Comments: 4

Currency swaps, which were developed before interest rate swaps, were derivations of the 1970s practice of establishing parallel loans between two parties whereby, for example, company A would lend its domestic currency to company B, in return for a loan of company B’s domestic currency. These parallel loans were often used to manage exchange risk or to circumvent exchange control regulations.

This system of mutual lending had two serious drawbacks. First, there was no automatic off-set of the cash flows between parties. Thus, if company A defaulted on its loan from B, company B would still have to honour its commitment to A. Secondly, although the two loans effectively cancelled each other out, they were still shown on the balance sheets of each company. Read more »

Posted: June 14th, 2008 under Commodities Futures, Crude Oil Futures, Equity Futures, Future Exchange, Future Fund, Future Investing, Future Management, Future Trading, Futures Contracts, Managed Futures, Swap Futures.
Comments: 3

The application of currency swaps

The parties enter into currency swaps in order to hedge the currency risk from their assets or liabilities. As the swap runs for many years without any change in the exchange rate used, the currency hedging is long term. It is this long-term hedging of currency risk that makes currency swaps complementary to, and not in competition with, the forward exchange market.

An example of the mechanics of a fixed for fixed currency swap is given on pp. 344-6, and below an example is given of how a fixed for floating currency swap can be used to hedge the currency risk in new borrowings. Read more »

Posted: June 7th, 2008 under Futures Market.
Comments: 6

The exact nature of market risk will depend upon the nature of the swap: it will be interest rate risk, currency risk, equity market risk or commodity risk, according to the type of swap being considered. Generally intermediaries or counterparties will be able to hedge market risk, but credit risk cannot be hedged. However, it may be reduced substantially by holding a diversified portfolio of credit risks.

Credit risk

The fact that, at least for interest rate swaps, the principals are not exchanged means that the exposure to default is limited to the difference between the present value of the fixed and the floating cash flows. Consider a pay fixed/receive floating swap, first, from the viewpoint of the pay fixed side. We noted earlier that if interest rates have fallen since the swap was initiated, the swap will have a negative value to the pay fixed side — i.e. the present value of the future fixed payments to be made is greater than the present value of the floating payments to be received. Read more »

Posted: June 7th, 2008 under Futures Market.
Comments: 6