Chapter 11 Forwards, Futures and Swaps

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INTRODUCTION TO FORWARDS, FUTURES AND SWAPS
Prepared by Ken Hartviksen
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Forwards, Futures, and Swaps
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Lecture Agenda

• Learning Objectives
• Important Terms
• Forward Contracts
• Futures Contracts
• Swaps
• Summary and Conclusions
• Concept Review Questions

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Learning Objectives

• The payoff associated with long and short
  positions in forward contracts
• How to price simple forward contracts and how
  interest rate parity is a variation of the
  forward pricing relationship
• The nature of futures contracts, and why they can
  be viewed as the public market version of forward
  contracts
• The mechanics of a basic interest rate swap and a
  basic currency swap
• The evolution of swap markets and how swaps can
  be used to lower borrowing costs and to hedge
  interest rate or foreign currency exposures

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Important Chapter Terms

• Basis risk
• Clearing corporation
• Commodity
• Comparative advantage
• Convenience yield
• Cost of carry
• Counterparties
• Covering
• Credit risk
• Currency swap

• Daily resettlement
• Forward interest rate
• Forward contract
• Forward rate agreement
• Futures contract
• Hedging
• Initial margin
• Interest rate swap

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Important Chapter Terms

• London Inter-Bank Offered Rate (LIBOR)
• Long
• Maintenance margin
• Margin
• Margin call
• Naked position
• Net payments
• Notional amount
• Offsetting
• Open interest

• Plain vanilla interest rate swap
• Settlement price
• Short
• Speculate
• Spot contract
• Storage costs
• Swap
• Total return swap
• Underlying assets

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Derivative Securities

• Forwards, Futures and Swaps

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Derivative SecuritiesDefined

• Derivative securities have price behaviours that
  are derived from some other underlying asset.
• There are two basic types of derivative
  securities
• Forwards, futures, and swaps (linear payoff
  derivative contracts)
• Options (non-linear payoff derivative contracts)

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Derivative SecuritiesRelevance to Corporate
Finance

• Derivative securities offer corporations the
  tools to manage pre-defined risks and/or
  capitalize on comparative advantage.
• Risks that can be mitigated through derivatives
  include
• Foreign exchange risk
• Credit risk
• Interest rate risk
• NOTE because it costs the firm money to engage
  in derivative positions, the costs of these
  practices can be thought of as insurance
  premiums the firm is willing to pay to reduce
  its overall exposure. (ie. To hedge)

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Forward Contracts

• Forwards, Futures and Swaps

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Forward versus Spot ContractsBasic
Characteristics

• A spot contract is a price that is established
  today for immediate delivery.
• Immediate delivery depends on the nature of the
  underlying contract.
• A forward contract is a price that is established
  today for future delivery.
• Can be specified for almost any future date
  because forward contracts are custom contracts
  between two parties.
• (Table 11 1 illustrates foreign exchange quotes
  for spot and forward delivery)

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Forward ContractsBasic Characteristics
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Forward ContractsBasic Characteristics

• Are bank instruments
• There is no organized exchange (they are an OTC
  instrument)
• Requires that the customer have a banking
  relationship.
• Involves credit risk for the bank when investors
  suffer losses.
• Banks will only sell forward contracts for
  legitimate business purposes.
• Will only sell up to a companys approved credit
  limit.
• Consequently, forward contracts are used for
  hedging purposes by firms wishing to mitigate
  exposure to specific risks.
• As customized instruments Forwards can be
  tailored to any specific date in the future and
  for any amount of money.
• Contracts must be fulfilled.

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Using Forward Contracts

• Like all derivative securities, forward contracts
  can be used theoretically to
• Hedge mitigate or eliminate risk.
• Speculate make an educated guess about the
  future value of something in hopes of profiting
  from it.
• Canadian banks, performing their transmission of
  Monetary Policy role, will only provide forward
  contracts for legitimate business purposes
  (hedging purposes) so speculative purposes
  arent not supported.

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Using Forward ContractsSpeculating

• Speculation on a forward contract requires that
  the investor NOT own the underlying asset.
• This is a naked position a position that
  leaves the investor exposed to changes in the
  value of the underlying asset.

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Using Forward ContractsHedging

• Hedging using a forward contract requires that
  the investor have an opposite exposure to the
  contract.
• This is a covered position.

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Using Forward ContractsLong and Short

• Long investing is owning an asset in the hopes it
  will increase in value and the investor gains by
  its capital appreciation.
• It is based on a bullish outlook (forecast
  increase) for the underlying asset.
• Short investors owe something.
• It is based on a bearish outlook (forecast price
  declines) for the underlying asset.

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Using Forward ContractsExample of a Naked Long
Position in the U.S. Dollar

• A U.S. company can speculate on the exchange rate
  between the Canadian and U.S. dollars
• (Companies often do this to offset (mitigate)
  exchange rate risk it is exposed to as a normal
  course of its operations for example, it expects
  to receive 1million Canadian in accounts
  receivable one year from now ).
• Initial Conditions
• Canadian dollar is at par with U.S.
• Both spot and 1-year forward rates are both at
  1.0 (this implies a ratio of 11)
• Action
• Canadian buys US 1.0 million forward
• Obligates the investor to pay C1million and
  receive U.S.1million in one year.
• Exposure
• Exposed to changes in the underlying asset US
  vis a vis the Canadian dollar
• Long U.S. dollars
• Short Canadian dollars
• Payoffs
• U.S. rises against Canadian investor gains
  (gains offset losses in dollars received from
  accounts receivable)
• Canadian dollar rises against U.S. investor
  looses (losses are offset by appreciated Canadian
  dollars in accounts receivable)
• (Payoffs from this position are illustrated in
  Figure 11-1)

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Forward ContractsLong Position in U.S. Dollars
The payoff is linear. 45 degree angle. Passes
through the forward rate F. If spot exchange rate
in the future exceeds the forward rate by 0.01,
then the speculator earns 0.01 profit for every
Canadian dollar sold forward for U.S. dollars.
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Forward ContractsProfit from a Long Forward
Contract

• The profit (loss) from the long position is U.S.
  dollars is equal to the difference between the
  future spot price (ST) and the forward price
  (rate) F times the number of contracts entered
  into (n)

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Using Forward ContractsA Naked Short Position in
the U.S. Dollar

• A naked short position in the U.S. dollar is the
  opposite of the firms long position in U.S.
  dollars.
• The company needs to sell U.S. dollars forward
  for Canadian dollars.
• (Payoffs from this position are illustrated in
  Figure 11-2)

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Forward ContractsShort Position in U.S. Dollars
The payoff from a naked sale of U.S. forward. If
U.S. 1 million is sold forward for C1.0
million, and the Canadian dollar depreciates to
C1.20 then the forward contract loses money. The
profit (loss) of the short position is
identically opposite of the long position.
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Forward ContractsHedging

• Hedging is reducing the risk of adverse price
  movement by taking an offsetting position in a
  derivative to eliminate exposure to an underlying
  price.

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Forward ContractsLong and Short Forward
Positions in U.S. Dollars

• As mentioned previously, Canadian banks will not
  negotiate forward contracts for speculative
  purposes.
• So inherently, companies take covered positions
  (not naked ones) where they already have a given
  exposure, and they wish to hedge (mitigate the
  risk in that exposure)
• Figure 11 3 illustrates a the combined position
  of a firm with a long US exposure of US
  1million that buys a forward contract to sell
  U.S. dollars forward for Canadian dollars.
• The combined position is simply the sumso the
  payoffs are offsetting and the firm is insulated
  for foreign exchange risk.

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Forward ContractsLong and Short Forward
Positions in U.S. Dollars
Offsetting long and short exposures insulate the
firm for foreign exchange risk during the life of
the contract.
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Interest Rate Parity Revisited

• Forwards, Futures and Swaps

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Forward ContractsExposures of the Bank Making
the Market for Forward Contracts

• Forward foreign exchange market is a bank market.
• The bank sells forward contracts to its customers
  to allow them to manage their foreign exchange
  exposure.
• The banks are not buying and selling foreign
  exchange for speculative purposes.
• If the bank finds, however, that its has sold too
  many US forward contracts so that it has now
  become exposed, it can
• Enter the inter-bank market to offset its
  exposure by trading with other banks, or
• Synthetically create forward foreign exchange
  contracts using the Interest rate parity (IRP)
  condition.

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Forward ContractsInterest Rate Parity (IRP)
Revisited

• Equation 11 3 shows that the ratio of the
  forward to the spot rate must equal the ratio of
  one plus the interest rate in both markets.

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Interest Rate Parity (IRP)IRP Condition

• Equation 11 3 shows that the ratio of the
  forward to the spot rate must equal the ratio of
  one plus the interest rate in both markets.
• This equation can be rearranged to solve for the
  forward rate (F )

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Interest Rate Parity (IRP)Using Forward Contracts

• The forward rate is the ratio of one plus the
  interest rate in both markets times the spot
  rate.
• The current spot rate S is observable
• The two inflation rates can be estimated using
  each countrys statistical reports.

11-4
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Pricing Forward Contracts

• Forwards, Futures and Swaps

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Pricing Forward ContractsInterest Rate Parity
Condition

• IRP is a special case for pricing forward
  contracts.
• The general condition is that investors can
  create a forward position in a storable commodity
  by buying it spot and holding it for future
  delivery.

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Pricing Forward ContractsThe General Condition
Storable Commodity Pricing Model

• The general condition is that investors can
  create a forward position in a storable commodity
  by buying it spot and holding it for future
  delivery.
• The only difference between the spot price (S)
  and forward (F) should be the costs of carry
  (interest costs on financing the purchase and
  storage costs).
• Important terms
• Commodity something traded based solely on
  price, because it is undifferentiated and can be
  traded without requiring physical examination.
• Storage costs the price charged for holding a
  commodity for future delivery
• Convenience yield the benefit or premium
  derived from holding the asset rather than
  holding a derivative.
• Cost of carry the total cost of buying a
  commodity spot and then carrying it or effecting
  physical delivery when the forward contract
  expires (this includes both storage costs and
  financing costs)

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Pricing Forward ContractsCommodity Pricing Model

• The Commodity Pricing Model is equation 11 5
  and shows that the cost of carry links the
  Forward and Spot prices
• Where
• c the cost of carry, as percentage of S, over
  the period in question.
• S spot price
• F forward price

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Futures Contracts and Markets

• Forwards, Futures and Swaps

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Futures ContractsThe Mechanics of Futures
Contracts

• Futures contracts are a standardized
  exchange-traded contract in which the seller
  agrees to deliver a commodity to the buyer at
  some point in the future.
• Organized futures exchanges with standardized
  futures contracts
• Reduce credit risk through
• Clearing corporation being the counterparty in
  all transactions
• margin requirements (both initial and maintenance
  margins) and
• daily mark-to-market daily resettlement.
• Allow the contract features and volumes to be
  reported
• Allow the futures positions to be liquid
  (executing offsetting transaction to cancel the
  futures position) increasing the flexibility in
  their use.

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Futures ContractsFutures Contracts Markets

• The term of the contract is set by individual
  exchanges.
• Delivery months are
• March
• June
• September
• December
• Standardized underlying asset so that even if
  delivery rarely takes place, people know what
  they are getting.
• The exchange sets how much of the asset is traded
  in each contract. (ie. The notional amount)
• For financial futures, most exchanges follow the
  lead of the major markets in Chicago
• Chicago Board of Trade (CBOT)
• Chicago Mercantile Exchange (CME)
• Commodity futures trading in Canada is
  concentrated on the Winnipeg Commodity Exchange
  (WCE)
• Financial futures trading is concentrated since
  2000 on the Montreal Exchange (ME) in Canada.

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Futures ContractsFutures Exchanges

• Formal exchanges develop the market in futures
  contracts.
• There is significant competition across
  exchanges, however, some are separated by
  different time zones.
• Competition is a source of innovation
• New types of contracts are developed
• As interest declines or needs change, some die
  out.
• Interest in Financial futures has grown
  dramatically as companies learn to hedge their
  risk exposures through these instruments.

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Futures ContractsTypes of Futures

• Commodity futures include
• Traditional agricultural products such as corn,
  wheat, hogs, etc.
• Energy products
• Base metals
• Financial futures
• SP index / BAs/Canada bonds/SP TSX 60 index
• Other
• Weather derivatives
• Futures contracts on real estate
• Futures contracts on the consumer price index
  (CPI)
• (See Table 11 2 for a useful summary)

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Futures Contracts and MarketsBasic
Characteristics
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Futures ContractsMarked to Market Process

• The Marked to market process helps to limit
  exposure to credit risk for the exchange.
• All futures contracts are marked to market each
  day.
• All profits and losses on a futures contract are
  credited to investors accounts every day to
  calculate their equity position.
• If the equity position increases, these profits
  can be withdrawn.
• When the equity position drops below the
  maintenance margin (usually 75 of the initial
  margin) the investor will receive a margin call
  and be forced to contribute more money to
  increase the equity position.

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Trading/Hedging with Futures ContractsExample of
a Bond Portfolio Manager

• A fixed-income portfolio manager holds a
  diversified portfolio of bonds that are
  predominantly Canadas.
• The manager believes interest rates will rise,
  causing the each bond price to fall.
• The manager can
• Sell bonds and hold cash till the threat of
  rising interest rates pass, or until the change
  in rates has occurred, and then repurchase the
  bonds
• Sell long term bonds and replace with shorter
  term bonds (reducing the portfolio duration and
  thereby limiting the losses if interest rates
  rise)
• Hold the portfolio and use a short hedge (short
  position in a futures contract in government
  bonds) the losses in the portfolio will be
  offset by gains on the short hedge.
• The third alternative is often the best one,
  because buying and selling bonds will incur
  transactions costs and upset the structure of the
  portfolio.
• If the hedge cannot be perfectly constructed the
  portfolio will be exposed to basis risk because
  losses on the long portfolio may not be exactly
  offset by the short future position.

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Futures Contracts and MarketsSummary of Forward
and Future Contracts

• Forward and Future Contracts serve the same
  purpose.
• Forward contracts offer more flexibility because
  they are customized OTC contracts.
• Forward contracts, however, face additional
  risks
• Not actively traded (created by a bank for
  customers)
• Possess credit risk
• Differences are listed in Table 11 3 on the
  following slide.

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Forwards versus Futures
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Swaps and Swap Markets

• Forwards, Futures and Swaps

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SwapsDefined

• Is an agreement between two parties, called
  counterparties, to exchange cash flows in the
  future.
• No formal exchange to guarantee performance, so
  the arrangement involves a dealer or OTC market
  and there is credit risk.
• Have evolved into a bank instrument, with banks
  or swap dealers serving as intermediaries.

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SwapsInterest Rate Swaps

• An interest rate swap is
• An exchange of interest payments on a principal
  amount in which borrowers switch loan rates.
• Often this involves one counterparty trading
  fixed loan payments for variable rate loan
  payments.
• A plain vanilla interest rate swap is
• The fixed for floating interest rate swap
  denominated in one currency.
• Table 11 4 illustrates a plain vanilla interest
  rate swap between counterparties A and B and is
  structured to benefit both parties equally. This
  is rarely the case.

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SwapsExample of an Interest Rate Swap
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SwapsComparative Advantage

• Comparative advantage is
• A benefit that one firm has relative to another.
• Any firm offered a good deal in floating rate
  funds but doesnt need them should borrow them
  anyway and use a swap to exchange it for what is
  needed and lock in the financing advantage.

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Swap ArrangementsChallenge and Response

• In swap arrangements, counterparties are often
  unequal partners to the contract.
• One counterparty may be AAA ratedthe other BBB
• There is credit risk and it is borne by the
  higher rated counterparty.
• AAA may have to honour its own and the other
  interest obligations if BBB defaults.
• Strategies to control credit risk include
• Set-off rights in the swap agreement allowing the
  other party to stop making payments if the other
  party defaults
• Net payments instead of exchanging total
  interest amounts, only the difference between the
  two streams are exchanged and structuring the
  payments into sub-periods (every six months)
• (Table 11 5 illustrates a Net Payments swap
  structure over time)

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Interest Rate Swaps
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The Evolution of Swap MarketsCurrency Swaps

• Currency swaps require exchange of all cash
  flows.
• Currency swaps permit the firms to adjust their
  foreign exchange exposure.
• This means that there is increased credit
  riskbut it presents opportunities.
• The first swap was a currency swap between IBM
  and the World Bank.
• This swap was motivated by comparative advantage
• It was a primary market transaction both IBM
  and the World Bank used it to raise new capital
  cheaply.
• Once swaps became standardized, it became
  possible to constantly change the nature of the
  institutions liability stream.
• Today currency swaps have become a bank market
  through their links to the forward foreign
  exchange market.
• The bank is capable of executing a secondary
  market transaction with itself as the
  counterparty because a currency swap can be
  though of as a series of forward transactions.

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The Evolution of Swap MarketsSwap Rate

• Standardization has helped to grow the swap
  market.
• Interest rate swaps have also become a bank
  market through standardization.
• Floating rates are fixed against LIBOR
• Fixed rates are fixed against the government bond
  rate
• The choice of rate depends on whether it is a
  five year, 10 year or other maturity contract.
• This becomes the swap rate.
• The swap rate is the rate of the fixed portion of
  a swap which is used for quoting swaps.
• Table 11 6 revisits the previous interest rate
  swap assuming a swap rate of 10.65

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Percent Interest Rate SwapThe Swap Rate
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Integration of the Swap and Forward Markets

• Interest rate swaps are found around the world.
• Table 11 7 gives swap rates for the euro, U.S.
  dollar and the pound sterling for June 7, 2006.
• Swap rates follow the full spectrum of the yield
  curve from 1 year to 30 years.
• This allows swaps to manage interest rate
  exposure.
• It also links swaps to forward rate agreements
  (FRAs)
• A FRA is an agreement that uses forward rates to
  manage a firms exposure to interest rate risk
  agreements to borrow or lend at a specified
  future date at an interest rate that is fixed
  today.

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Interest Rate Swap Quotes
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SwapsEvolution of Swap Markets

• Integration of swap markets with the forward
  market has fueled expansion of the market
• Firms wanting to change a floating rate liability
  into a fixed rate liability simply calls their
  bank and executes the interest rate swap as a
  secondary market transaction executed against a
  line of credit.
• Creating swaps is a key component of the services
  provided by major banks for their corporate
  clients.

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SwapsRecent Developments

• The focus of the text is on major vehicles used
  to manage interest and currency exposure
• Interest rate swaps
• Currency swaps
• Other swap opportunities exist and evolve
  including the total return swap especially
  between private sector counterparties
• The more specialized the swap
• The less tradable it is
• The greater the counterparty risk
• Only standardized swaps are done with banks.
• An Example is the Total Return Swap.

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Recent Developments in SwapsTotal Return Swap

• Total return swap is an exchange of an interest
  rate return for the total return on for the total
  return on an equity index plus or minus a spread.

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Summary and Conclusions

• In this chapter you have learned
• How to diagnose long and short positions in
  foreign currency and how these positions can be
  hedged by using forward foreign currency
  contracts.
• How interest rate parity can be used to derive
  forward interest rates and how banks could create
  synthetic securities
• Future contracts can be viewed as the public
  version of forward contracts.
• How swap markets operate and can be used to hedge
  interest rate or foreign currency exposures.

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Concept Review Questions

• Forwards, Futures, and Swaps

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Concept Review Question 1Credit Risk and Forward
Contracts

• Why do forward contracts involve credit risk for
  banks?

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Internet Links

• Bank of Canada Website www.bankofcanada.ca
• Financial Engineering News Website
  www.fenews.com
• Department of Finance Canada Website
  www.fin.gc.ca