Spot and Forward Rates, Currency Swaps, Futures and Options

How may be used a currency futures or forward?

 Spot and Forward Rates, Currency Swaps, Futures and Options
Spot and Forward Rates:
1. Spot Rate (SR): Most transactions are completed in 2 days,
enough time to debit and credit the necessary accounts both at
home and abroad
• Example: R = $/£ = $2 per £
2. Forward Rate (FR): Best thought of as a “contract” to buy or sell
a specified amount of currency at a future date at a price agreed
upon today (usually a 10% margin requirement).
• Calculate Forward Premium or Discount:
• FD or FP = [(FR – SR)/SR] X 4 X 100
(the 4 annualizes the FD or FP due to the usual 3 month period
[1/4 of a year] of the contract)
Currency Swaps: Combined transactions are treated as one which
saves transactions costs
•Sell currency (in the spot market) and simultaneously repurchase
the same currency in the forward market: mostly used by banks
•Example: Suppose Regions Bank receives 5 million Euros that
it will need in 3 months. However, they would prefer to hold
dollars for the next 3 months (until they need the Euros).
•They execute a currency swap: They sell the Euros in the spot
market and simultaneously repurchase Euros in the forward
market.
•Spot Transactions and Swaps are the most common transactions in
interbank trading
•40% spot
•10% forward
•50% swaps
Foreign Exchange Futures: Began in 1972 and they are becoming
more popular
1. Contract size is fixed
2. Daily limit is set on rate fluctuations
3. Only 4 dates per year are available: the 3rd Wednesday in
March, June, September and December
4. Major currencies: Yen, Canadian $, British £, Swiss Franc,
Australian $, Mexican Peso, Euro and U.S. $
5. Only traded in a few exchanges: Chicago, New York, London,
Frankfurt, and Singapore
6. Amounts are usually smaller than in the forward market
7. The forward and futures market are connected through
arbitrage.
8. Transactions costs are higher than in the forward market
Specifications of Popular Foreign Exchange Futures:
Foreign Exchange Risks, Hedging and Speculation:

If a future payment is to be made or received [called an open

position], risk is involved.
•Reason: Both the spot and forward rate are constantly in motion

However, most people are risk averse—especially “bidness” people

Types of Exposure:
1. Transaction Exposure (future payment/receipt)
2. Accounting Exposure (valuation of inventories and assets abroad
translated into native currency)
3. Economic Exposure (future profitability valued in domestic
currency
Hedging: Covering an open position (avoiding exchange rate risk)
Example: A U.S. exporter expects to receive £100,000 in 3
months [possible hedges]

1. Borrow £100,000 at current spot rate

• Deposit in bank and earn interest for 3 months
• Cost = difference in interest paid and received
2. Borrow £100,000 at current spot rate
• Exchange for $’s at the current spot rate
• Deposit in bank and earn interest for 3 months
• Cost = difference in interest paid and received

Major Disadvantage: In both cases £100,000 is tied up for 3

months
Alternative to the Previous Hedge:
Importer: Buy £100,000 forward for delivery in 3 months at today’s
forward rate
•If £’s at the 3 month forward rate are selling at a 4% premium per
year, the importer will pay (assuming $/£ = 2) $202,000 in 3 months
for £100,000 (or 1% of 200,000)

Exporter: Sell £100,000 forward for delivery in 3 months at today’s

3 month forward rate (because they have already sold the currency
they expect to receive in 3 months, they have locked in the rate.)
•Notice: None of the Exporters funds have been tied up and no
borrowing has occurred
It is also possible to do the same transactions with options!
Speculation: Creating an intentional “open position”

Spot Market:
If a foreign rate is expected to rise
•buy that currency in the spot market
•Deposit in a bank for 3 months to earn interest
•Sell at a profit

If the domestic rate is expected to fall

Borrow foreign currency
Deposit in bank for 3 months to earn interest (domestic)
Buy at a profit
 Speculation: Creating an intentional “open position”
Forward Market:
1. If the spot rate is expected to be higher in 3 months than the
current forward rate
2. Buy forward
3. In 3 months, sell at a profit
 Example: FR = $2.02/£ and the expected spot rate is $1.98/ £
 Sell at $2.02 in 3 months and buy at $1.98

Option Market:
1. Speculator could buy an option to sell £’s at $2.02/ £
2. If the spot rate falls to $1.98, exercise the option
 Definitional Stuff

Long Position:
1. A speculator buys a foreign currency in the spot, forward or
futures market, or
2. Buys an option to buy

Short Position:
1. A speculator borrows (spot), or
2. Sells forward
 Interest Arbitrage

Uncovered: Interest rates vary among countries. So, it might be

advantageous to invest in another country to earn that county’s
interest

Scenario: 3 month T-Bill [6% in N.Y.] [8% in London]

1. U.S. investor exchanges $’s for £’s at current spot rate and
buys British T-Bill.
2. At maturity, T-Bill is redeemed and U.S. investor uses the
proceeds in £’s to buy $’s.

• If there is 0 change in spot rate, 2% return is earned

• If the £ depreciates 2%, 0% return is earned
Consequently, covered interest arbitrage is the norm!
 Covered Interest Arbitrage
1. Spot purchase of foreign currency
2. Forward sale of same currency
3. Use of foreign currency to buy T-Bills in foreign country
Example: T-Bills [6% in N.Y.] [8% in London]
1. U.S. investor buys £’s in spot market
2. Sells £’s in forward market at 1% discount (£ depreciate)
3. Buys British T-Bills at 8%
4. T-Bill is redeemed in £’s
5. £’s are sold at 1% discount
6. Investor earns 7% [1% more than in U.S.]
As the process continues
1. The price of British T-Bills and the interest they bear 
2. As £’s are sold forward the discount increases and parity is
approached [Thus, we have CIAP (covered interest arbitrage
parity)
 Carry Trade
• A carry trade is a strategy in which the trader invests in a high
yielding instrument financed by borrowing in a low yielding
instrument.
Carry Trade
 Carry Trade
Carry trade for USD $1 million:
•borrow USD $1 million for three months at 0.35%
•purchase Indian Rupee [100*USD 1m/1.6920 = INR 59.102 m]
•invests the funds at the INR rate of 7.75%
•3 months later. receive INR 60.246 m (59.102 * =1+0.0775/4)
•repay USD 1.000875 m (1 + 0.0035/4)
•buy USD: USD 1.019134 m (60.246 * 1.6916)
•excess return will be $18,259
•7.3036% per annum
 Carry Trade
In the carry trade, there are three important sources of risk.

• High interest rates paid on emerging market currencies could

be due to hidden catastrophic events that had not yet occurred.

• Risk related to contagious crises in emerging markets.

• Exposure of the trade to a financial crisis in the developed

markets.
 Carry Trade
In the carry trade, there are three important sources of risk.

• High interest rates paid on emerging market currencies could

be due to hidden catastrophic events that had not yet occurred.

• Risk related to contagious crises in emerging markets.

• Exposure of the trade to a financial crisis in the developed

markets.
 Carry Trade
The uncovered carry trade we described above has several
specific steps:
• Borrow the present value of one unit of “foreign" currency,
• Change it into home currency,
• Invest at the home currency interest rate
• Obtain the future value of the investment later, at maturity or
whenever the trade is closed out,
• Change the proceeds back into the foreign currency, and
• Repay the loan.
 Carry Trade
The cash effects, step by step are:
 Carry Trade
Putting it all together we have the profit from the uncovered carry
trade:

Any winnings for the investor in the trade described above mean
losses for a counterparty.
 Carry Trade
Consider the implications of the idea that uncovered carry
trades make no profit.
Uncovered interest rate parity holds when:

Then uncovered carry trades make no profit means that the

spot exchange rate has adjusted to a level where traders have
no incentive to do a carry trade.
 Stock Index Futures

Stock index futures are quoted in terms of the underlying or

spot or cash index value in index points.

Pricing Stock Index Futures:

 Stock Index Futures

CME provides an estimate of the fair value:

CME provides an estimate of the fair value:

 Stock Index Futures

Contract specs:
 Stock Index Futures

Equity Index Sector futures add leverage and hedge

opportunities:
BLOOMBERG
SECTOR FUTURES
OUTRIGHT
S&P SELECT SECTOR

E-mini Communication Services Select Sector futures XASA

E-mini Consumer Discretionary Select Sector futures IXYA

E-mini Consumer Staples Select Sector futures IXRA

E-mini Energy Select Sector futures IXPA

E-mini Financial Select Sector futures IXAA

E-mini Health Care Select Sector futures IXCA

E-mini Industrial Select Sector futures IXIA

E-mini Materials Select Sector futures IXDA

E-mini Real Estate Select Sector futures XARA

E-mini Technology Select Sector futures IXTA

E-mini Utilities Select Sector futures IXSA

 Stock Index Futures

How to take spread positions?

Equalize the monetary value:

Example:

Financial / Tech
0.627 = 250*413.95 / 100*1650.20
 Stock Index Futures

Ratio need 2 Tech and 3 Financial.

 Uses of Index futures

CAPM suggests that the total risk associated with any

particular stock may be categorized into systematic risks and
unsystematic risks.

To measure unsystematic relation: β.

 Uses of Index futures
Use Beta to hedge:

Example:
 Uses of Index futures
Use Beta to hedge:
 Uses of Index futures
To change portfolio beta:

Effective hedge or leverage, will rely on index low tracking

error, and unchanging betas.
 Uses of Index futures
Cash Equitization:

Mutual funds typically offer investors the opportunity to add

or withdraw funds on a daily basis.

Equity managers are often called upon to deploy additions

or fund withdrawals on short notice.

They could attempt to buy or sell stocks in proportions

represented by the benchmark.

Or, they can utilize stock index futures.

 Uses of Index futures
Long - Short strategies:

One of the most common of long/short strategies is known

simply as “130/30.”

Buy stocks that outperform.

Sell stocks that underperform.
 Uses of Index futures
Sector Rotation:

Bull market  buy leverage high beta sector

Bear market  sell leverage high beta sector
 Uses of Index futures
Spread trading:
XAIZ3 DEC 2023 Industrial
Bids Offers

Time Size Price Price Size

10:30 5 1036 1040 4

10:31 3 1034 1045 4
10:10 5 1032 1050 4
10:40 2 1025

XAFZ3 DEC 2023 Financial

Bids Offers
Size Price Price Size Time
5 415 420 5 10:20
5 415 422 5 10:30
5 414 424 5 10:31
430 2 10:40
 SOFR and EURODOLLAR Futures
• The Eurodollar, itself, is a dollar denominated deposit that is held in a
bank outside of the U.S.
• Eurodollar futures are based on a $1 million face-value, three-month
maturity Eurodollar Time Deposit.
• It is settled in cash on the second London bank business day just
prior to the third Wednesday of the contract month based on the
British Banker’s Association Fixing for three-month Eurodollar
Interbank Time Deposits.
• These contracts mature during the months of March, June,September,
or December.
• These contracts are quoted in terms of the ‘‘IMM Index.’’1 The IMM
Index is equal to 100 less the yield on the security.
• The value of a basis point may be computed as $25 = $1,000,000 x
(90 days/360 days) x 0.01%.
 SOFR and EURODOLLAR Futures
• Evidence that the process had been manipulated by some of the
traders at some of the banks in the LIBOR survey.

• Retirement of LIBOR as reference rate.

• Searching for replacement.

• In U.S. surge SOFR (Secured Overnight Financing Rate)

• SOFR: Cost of borrowing cash overnight collateralized by Treasury

securities (REPO)
– Tri-party Treasury general collateral (“GC”) repo transactions cleared and
settled by Bank of New York Mellon (“BNYM”).
– Tri-party Treasury GC repo transactions made through the FICC(Fixed
Income Clearing Corporation) GCF repo market, FICC is counterparty.
SOFR and EURODOLLAR Futures
Contract Critical Dates
 SOFR and EURODOLLAR Futures

• Hence, as the “current” day progresses through the reference quarter,

the share of known versus unknown values determining its settlement
rate increases.
• Their volatility tends to decrease, as seen in the lines becoming flatter
toward their end.
• They respond less and less to changing market expectations about
future interest rates. During the decreasing interest rate environment
of 2019, expectations about Fed rate cuts affected all SOFR values in
the reference quarters of back month contracts, but only some of the
SOFR values in the reference quarter of the front month contract,
which therefore tended to stick to a higher level.
 STRIPs

• The combination of successive ED futures is known as a strip and the

corresponding interest rate as a strip rate.

• Example: Which strategy is preferable,

• to (1) buy a nine-month investment yielding 2.96%,
• or (2) enter into the 3-month investment, buy March futures, and buy
June futures? Our analysis suggests that the nine-month strip yields
slightly more than 2.97% relative to 2.96% on the nine-month
investment.
 STRIPs

• Example: Which strategy is preferable,

• to (1) buy a nine-month investment yielding 2.96%,
• or (2) enter into the 3-month investment, buy March futures, and buy
June futures?
 STRIPs

• Our analysis suggests that the nine-month strip yields slightly more
than 2.97% relative to 2.96% on the nine-month investment.
 STRIPs

• For ED strips, the first contract used in the strip covers an interest
period entirely in the future.

• For example, for a term rate starting on Sep 1, 2022, for the time
until Sep 21, 2022, the 3Week LIBOR is used.

• For SR3 strips, the first futures contract used in the strip covers with
its reference quarter an interest period that is partly in the past and
partly in the future.

• For a term rate starting on Sep 1, 2022, for the time until Sep 21,
2022, the price of the Jun 2022 SR3 contract can be used.
 STRIPs

• To calculate the yield for the period until the first full reference
quarter:
 STRIPs

• Now strip rates can be calculated from SOFR futures in the same
manner as from ED futures, i.e.:

• Using money market conventions, the strip rate S can then be

annualized by solving the following equation for Sann:
CONVERTING FLOATING RATE EXPOSURE TO
FIXED
• Consider a treasurer needs to invest USD 50 million, secured by US
Treasuries interest rate. He decided he'd like to effectively fix the
interest rate.
• Consider a treasurer needs to invest USD 50 million, secured by US
Treasuries interest rate. He decided he'd like to effectively fix the
interest rate.
• To determine the number of contracts to purchase:
– CME SOFR futures contract is defined so that the value of a 1 bp change in
price is USD 25.
– Calculate 1bp for the amount to invest: 0.01 × (91/360) × USD 50,000,000 =
USD 1,263.89. (1 bp in IMM index equals 0.01)
– Number of contracts = desired sensitivity/ contract sensitivity
– Number of contracts: 1,263.89 / USD 25 = 50.56
 CONVERTING FLOATING RATE EXPOSURE TO
FIXED
Check final result for fixed rate:

• Let's assume that on 18-Dec-19, the treasurer purchased 50 three-month SOFR futures
contracts, expiring in 18-Mar-20, with a purchase price of 98.41.

• SOFR rate 100 – P = 100 – 98.41 = 1.59%

• Assuming the daily rate were constant from 18-Dec-19 through 17-Mar-20. That rate is
1.5869%.

• The starting value of USD 50,000,000 million would have increased to USD
50,200,956.00.
 CONVERTING FLOATING RATE EXPOSURE TO
FIXED
• Suppose SOFR rate decreased toward the end of this period, such that, without any
hedging, the initial deposit of USD 50 million actually increased to only USD
50,187,105.05

• USD 13,850.95 less than implied rate.

• Suppose final settlement: SOFR futures price: 98.5175. Difference of 0.1075.

• Futures total cash flow (some interest may be earned) : 50 x 25 x 10.75 = 13,437.5

• Results in a combined value of USD 50,187.105.05 + USD 13,437.50 = USD

50,200,542.55. Less by USD 413.45 of the figure of USD 50,200,956.00 we calculated
earlier.