Lecture International finance: An analytical approach (3/e): Chapter 9 - Imad A. Moosa

Chapter 9

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


Unwinding a forward contract
(cont.)

JPY

C

(c) Entering an offsetting
        position with E

AUD
A

AUD

E
JPY

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

9-11


How futures contracts solve these
problems
• Standardised contract dimension
• Default risk is controlled by the clearing corporation
and some regulations
• They are liquid

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

9-12

The role of the clearing corporation
in futures trading

USD
A
AUD

Clearing 
corporation
(exchange)

USD
B
AUD

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

9-13


A comparison of forward and
futures markets
•
•
•
•

Market size
Market structure
Contract size
Traded currencies

(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

9-14


A comparison of forward and
futures markets (cont.)
•
•
•
•

Cross rates
Exchange rate fluctuations
Maturity dates
Maturity lengths

(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

9-15


A comparison of forward and
futures markets (cont.)
•
•
•
•
•

Credit risk
Cash flows
Hours of trading
Eligible dealers
Major users

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

9-16


Futures exchanges
• The Philadelphia Stock Exchange
• The Chicago Mercantile Exchange
• The Sydney Futures 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

9-17


Definition of swaps
• Currency and interest rate swaps involve the
exchange of interest and foreign currency cash
flows. They differ from swaps in the forward FX
market (FX swaps)

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

9-18


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
1

A

KS1

B

KS0
2

A

B

KS 2
KS0

3

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