70-398 INTERNATIONAL FINANCE

SPRING 2023

Ch.3 Forward Markets and Transaction Exchange Risk

Prof. Serkan Akguc

Transaction Exchange Risk

• Transaction exchange risk – possibility of taking a loss in foreign exchange

transactions

• Who incurs transaction exchange risk?

• Corporations
• Institutional investors
• Individuals

• How to avoid?
• Hedging – protect against losses; get rid of uncertainty
Example
Fancy Foods (FF), a U.S. company imports meat pies from British firm.
FF has to pay £1,000,000 in 90 days in return for supplies. The spot rate is
$1.50/£ and FF expects the £ to appreciate by 2% [(1.50*1.02) = $1.53/£ ]

They can: 1) wait and buy £’s on the market or 2) hedge

conditional mean

1) No hedge: Realized $ cost= S(t+90, $/£)*(£1,000,000)

= ($1.53/ £)*(£1,000,000)=$1,530,000 → if expectations are true

2) Hedge: purchase a forward contract and lock in rate.

➔ No uncertainty.

Forward is the market’s best guess as to what the spot will be in 90 days so if the
market is right, you’re only out the bid/ask spread. If the market is wrong, hedging
could be good or bad! If £ appreciates (takes more $’s to buy a £), hedging would
have been better, if it depreciates (takes fewer $’s to buy a £), then hedging would
have been worse (you have to fulfil forward contract obligation).
 Describing Uncertain Future Exchange Rates

• Assessing exchange rate uncertainty using historical prices

• Percentage change: s(t) = [S(t) – S(t-1)]/S(t-1)
• Appreciation if (+)
• Depreciation if (-)
• Mean and standard deviation
• Normal distribution for major currencies
• Skewed distribution for emerging markets

Note: % change is for the “base” currency

Dollar/Pound Monthly Exchange Rate: 1975–2014

Mean = -0.04%
St.dev. = 2.95%

Empirical Exercise

Update this figure to January 2023?

DUE: Tuesday, 1/17/2023

 Peso/Dollar Monthly Exchange Rate: 1994–2014

Mean = 0.79%
St.dev. = 4.76%

How do you interpret right-skewed distribution? Long tail?

Empirical Exercise

Can you update this figure to January 2023?

DUE: Tuesday, 1/17/2023

Right skewed ➔ probability of peso depreciating against dollar is higher

Long tail ➔ large depreciations have occurred
 Describing Uncertain Future Exchange Rates

• The probability distribution of future exchange rates

• Depends on all of the information available at time t
➔ so we say it is “conditional”

Define Conditional mean

• Conditional mean/expectation at time t of the future spot exchange
rate S(t+90): S(t) * (1+μ)
What’s the probability that
• $1.50/£ * (1+0.02) = $1.53/£ exchange rate will be within
this interval?

• Conditional volatility: S(t) * σ suppose st.dev. of rate of appreciation

over the next 90 days is 4%
• $1.50/£ * 0.04 = $0.06/£
• Range (within 1 σ) is: $1.47/£ - $1.59/£
 Probability Distribution of S(t+90)

Within 1 σ

Probability of 68.26%

Within 2 σ

Probability of 95.45%

The range of future exchange rates that encompasses all but 4.55% of the future possible values
of dollar-pound exchange rates is $1.41/£ to $1.65/£ ➔ 1.53 -/+ (2*0.06)
Describing Uncertain Future Exchange Rates

• Assessing the likelihood of particular future exchange rate ranges –

how likely is it that the £ will appreciate in 90 days to $1.60/ £?

• $0.07/£ greater than conditional mean of $1.53/ £

z = 0.07/0.06 = 1.167 (~1.17) standard deviations away, or 12.1% for normal
distribution. (0.5-0.379 = 0.121)

See also Intel/Sony example

in problem set
Hedging Transaction Exchange Risk

• Forward contracts and hedging

• A forward contract between a bank and a customer calls for delivery, at
a fixed future date, of a specified amount of one currency against
payment in another currency (usually a large sum)

• Forward value or settlement date

• Most active dates are 30, 60, 90, 180 days [See Bloomberg Quotes]
• Highly customizable (contracts typically offered by banks for clients)
• Exchange takes place on the forward value date

• Eliminates risk/uncertainty
– Because the total amount you would owe the bank is determined today, it does
not depend in any way on the actual value of the future exchange rate.
The Forward Foreign Exchange Market

• Forward bid/ask spreads

• Larger than in spot market (why do you think so?)
• Spreads higher for greater maturities (again, why?)

See a few slides ahead for discussion on liquidity

Hedging Transaction Exchange Risk

Example – Fancy Foods (American company) owes Plain Pies £1m in 90 days
Fancy Foods can buy £1,000,000 at $1.53/£ forward, which gives them an asset to
match the liability (also £1,000,000) and then they have only a $ liability ($1,530,000)
but no exchange rate risk

Fancy Foods Partial Balance Sheet

Assets Liabilities
£1,000,000 due from the bank in 90 days £1,000,000 payable to Plain Pies in 90 days
$1,530,000 payable to the bank in 90 days

These asset and liability accounts demonstrate that using forward contracts can turn the
underlying British pound asset or liability that arises in the course of a U.S. firm’s normal
business transactions into a dollar asset or liability that has no foreign exchange risk
associated with it.
Hedging Transaction Exchange Risk

Example – Nancy Foods scheduled to receive £1m from Quirky Pies in 90 days.
The sale of pies gives Nancy Foods foreign currency asset.

Nancy Foods can sell £1,000,000 at $1.53/£ forward

Nancy Foods Partial Balance Sheet

Assets Liabilities
£1,000,000 receivable from Quirky Pies in 90 days £1,000,000 payable to the bank in 90 days
$1,530,000 receivable from the bank in 90 days
Gains and Losses Associated with Hedged Versus
Unhedged Strategies
Exchange rate = Domestic Currency / Foreign Currency
If money will be received, then
hedged position is preferable

If money will be paid, then

unhedged position is preferable

If money will be received, then

unhedged position is preferable

If money will be paid, then

hedged position is preferable
Hedging Transaction Exchange Risk
Costs and Benefits of a Forward Hedge

What is the appropriate way to view the cost of a forward hedge?

• Ex ante (before)
• Ex post (after)
• To hedge or not to hedge?

Cost of 1 foreign currency unit

Hedging Transaction Exchange Risk

• Hedging import payments

– Example: Hedge a €4M payment due in 90 days
Spot: $1.10/€; 90-day forward: $1.08/€
Hedged you will pay €4 M * $1.08/€ = $4,320,000
If dollar strengthens, however, you could lose money relative to
remaining unhedged (e.g. assume S(t+90, $/€) = $1.05/€)

• Hedging export receipts

– Example: Hedge a ¥500M receivable to arrive in 30 days
Spot: ¥176/£; 30-day forward: ¥180/£
Hedged you will receive ¥500M/(¥180/£) = £2,777,778
If the yen strengthens, you could lose money relative to remaining
unhedged (e.g. S(t+90, ¥ /£) = ¥ 175/£)
The Forward Foreign Exchange Market
There are two main reasons why forward markets are less liquid than spot
markets.
1. banks are exposed to counterparty default risk for a much longer time
interval in a forward contract than in a spot contract.
– impose limits on the total magnitude of the contracts (the “positions”) traders can
enter into with their counterparty banks in the interbank market.
– The limits vary with the creditworthiness and reputation of the other trading bank. In
retail transactions, the dealer bank also often requires the non-bank counterparty
either to maintain a minimum deposit balance with the dealer bank, to accept a
reduction in its normal credit line, or to provide some other form of collateral.

2. increased counterparty default risk reduces the number of forward

transactions banks are willing to do, banks find it more difficult to
manage open positions in forward contracts. Because it may take longer
to find a counterparty with whom to trade at reasonable prices, forward
contracts are more susceptible to foreign exchange risk. The increased
inventory risk reduces liquidity even more.
Risks in Forward Contracts – Source of Low
Liquidity
Suppose Canada Drink, a Canadian company, exports drinks to the United States and
receives regular payments in U.S. dollars.
Suppose Canada Drink enters into a 30-day forward contract with Bank of America to
sell USD1,000,000 in exchange for Canadian dollars.
➔ Canada Drink is selling its dollar revenues forward for Canadian dollars. Assume
that the forward rate is $0.90/CAD.
What risk does this transaction creates for Bank of America?
(Assume BoA is unhedged)
Bank of America is short Canadian dollars in the forward market—that is, it owes
Canadian dollars for future delivery.
➢ If, for example, spot rate in 30 days moves up to $1.00/CAD, then Bank of
America owes $1,111,111 for CAD 1,111,111 (not $1,000,000)
Canada Drink is long Canadian dollars and short U.S. dollars, but Canada Drink expects
to receive U.S. dollar revenues from its drink sales, which hedges this position
Risks in Forward Contracts

Panel A Original Positions

Bank of America

Assets Liabilities

$1,000,000 due from Canada Drink in 30 days CAD 1,111,111 payable to Canada Drink in 30 days

Forward
Canada Drink contract
Assets Liabilities
@ $0.90/C$
$1,000,000 export revenues in 30 days
(i.e. Accounts Receivable) $1,000,000 payable to Bank of America in 30 days

CAD 1,111,111 due from Bank of America in 30 days

 Risks in Forward Contracts
Bank of America Risk Management – 2 ways
1 day later the C$ appreciates.
BofA does not want to take the
risk and goes long C$ to cover
the position. Assume 29-day
forward rate now is $0.92.
Panel B Bank of America Risk Management - Case 1
lost $22,222 in one day
Bank of America but now fully covered
Assets Liabilities
$1,000,000 due from Canada CAD 1,111,111 payable to Canada Drink in 29
Drink in 29 days days
CAD 1,111,111 due from Interbank
counterparty in 29 days $ 1,022,222 payable to Interbank counterparty in 29 days

Panel C: Bank of America Risk Management - Case 2

Hedging from the beginning Bank of America

Banks generally immediately
hedge their positions with
corporate customers
Assets
$1,000,000 due from Canada
Drink in 30 days
CAD 1,111,111 due from Interbank
counterparty in 30 days
Liabilities
CAD 1,111,111 payable to Canada Drink in 30
days
$ 1,000,000 payable to Interbank counterparty in 30 days

As long as forward contracts are traded actively enough for this transaction to occur at fair prices, the
bank does not have to worry much about the currency risk in the forward contract
 Risks in Forward Contracts – Default Risk
• Canada Drink may not honor the forward contract if it goes bankrupt between now
and 30 days from now.

• If Canada Drink does not deliver the U.S. dollars, Bank of America does not need to
deliver the Canadian dollars to Canada Beer, but Bank of America was counting on
having U.S. dollars in its portfolio, not the additional Canadian dollars.

• In fact, if Bank of America indeed hedged the original transaction, it will receive
Canadian dollars from its bank counterparty and must wire U.S. dollars to that bank.
Hence, if Bank of America does not want to build up an inventory of Canadian
dollars, it will have to sell Canadian dollars for U.S. dollars in the spot market if
Canada Drink defaults.

• This spot transaction will occur about 28 days from now, so that it settles 2 business
days later, at the same date the forward contract with the bank counterparty does.
In other words, currency risk reappears because the future Canadian versus U.S.
dollar exchange rate may be disadvantageous for Bank of America.
 The Forward Foreign Exchange Market

• Net settlement
• Settling a contract by paying or receiving a net settlement that depends
on the value of the contract
• Can be used in a case where the situation changes from original scenario
• Often used in forex futures market (Ch. 20)

See example on next slide!

 Net settlement - Example

• Suppose you think you will owe a Mexican company MXN20,000,000 in 30 days, and
you would like to pay with dollars.

• You could enter into a forward contract to purchase MXN20,000,000 with dollars at
a forward rate of, say, MXN10/USD. On the settlement day of the forward contract,
you could expect to receive MXN20,000,000 from the bank and expect to pay $2
million for it

• Suppose that 1 business day before the forward value date, the spot exchange rate
is MXN 12/USD, and you learn that you no longer need to purchase MXN20,000,000
because the underlying transaction has been cancelled.

Bank allows for net settlement of

USD2,000,000 – USD1,666,667 = USD333,333 (loss for your company)
 Net settlement to get around capital controls
NDF – non-deliverable forward contracts

• In many emerging markets, there are capital controls in place, making it

more difficult to trade foreign exchange for non-residents.

• Foreign exchange dealers have responded by developing offshore markets

in forward contracts that do not require physical delivery of currency but
are cash settled, mostly in U.S. dollars.

• These non-deliverable forward contracts (NDFs) have become an important

market segment for currencies such as the Korean won, the Chinese yuan,
the Indian rupee, the Brazilian real, and the Russia ruble.
SEE BIS REPORT and Credit Suisse Reading on NDF (posted on Canvas)
The Forward Foreign Exchange Market

• Market organization
• Outright forward contracts - only 12% of all transactions

• SWAP
– Simultaneous purchase and sale of a certain amount of foreign
currency for two different dates in the future
– About 52% of forex transactions are swaps (more on interest rate
SWAPS later in the semester. Right now, we will focus on forex swaps
only)
• https://stats.bis.org/statx/srs/table/d11.1
The Foreign Exchange Swap Market

Most of the trading of forward contracts happens in the swap market

A swap simultaneously combines two foreign exchange transactions with
different value dates but in opposite directions

Many portfolio managers want to invest in the bond and equity markets of
foreign countries without being exposed to changes in the values of those
countries’ currencies.
• To buy a foreign equity, these people must first buy the foreign currency in
the spot market.
• To hedge the currency risk, they sell that currency forward.

Hence, it is natural to combine the spot and forward transaction in one trade
The Foreign Exchange Swap Market

Banks also actively use swaps to manage the maturity structure of their
currency exposure. If they think they have too much exposure at one
particular maturity, they can conveniently switch their position to another
maturity, using a single swap transaction without changing their overall
exposure to that currency.

Example:
When a bank has a short Swiss franc position of CHF1,000,000 (i.e. sold
CHF1,000,000 forward for dollars) with a maturity of 180 days and would like
to shorten the maturity of these contracts to 90 days.
➔ simply enter into a swap to buy CHF1,000,000 at a 180-day value date and
sell CHF1,000,000 at a 90-day value date. → Can you see how this would
shorten the maturity?
The Foreign Exchange Swap Market

Foreign exchange swap types

• The purchase of foreign currency spot against the sale of foreign
currency forward
• The sale of foreign currency spot against the purchase of foreign
currency forward
• The purchase of foreign currency short-term forward against the sale
of foreign currency long-term forward
• The sale of foreign currency short-term forward against the purchase
of foreign currency long-term forward
 The Foreign Exchange Swap Market

How swap prices are quoted

– Spot: ¥/$ 104.30 (bid) – 40 (ask)
– 30-day swap points: 80 (bid)/85 (ask) – basis points

A rule for using swap points

– If first number in swap quote is smaller than the second, add the points
to the bid and ask prices to get the forward quotes
– if larger – subtract the points.

➔ Forward quote: ¥/$ 105.10 (bid) – 25 (ask)

Note that bid-ask spread is larger in forward market due to lower liquidity
than spot market
How swap prices are quoted – another example
– Spot: ¥/$ 104.30 (bid) – 35 (ask)
– 30-day swap points: 15/20 basis points
– Outright forward quote for 30 days

– ¥/$ 104.30 + ¥/$ 0.15 = ¥/$ 104.45 forward bid for dollars
– ¥/$ 104.35 + ¥/$ 0.20 = ¥/$ 104.55 forward ask for dollars

– 30-day swap points: 20/15 basis points

– Outright forward quote for 30 days

– ¥/$ 104.30 - ¥/$ 0.20 = ¥/$ 104.10 forward bid for dollars
– ¥/$ 104.35 + ¥/$ 0.15 = ¥/$ 104.20 forward ask for dollars
Cash Flows in a Swap – Example
Swapping out of Dollars and into Yen

Nomura, a Japanese investment bank, quotes the spot rates

¥104.30 / $ bid and ¥104.35 / $ ask
swap points of 20/15

Suppose that IBM wants to swap out of $10,000,000 and into yen for 30 days.
To do so, IBM sells dollars in the spot market in exchange for yen, but also
wants to buy dollars for yen 30 days from now using a forward transaction.
Both transactions can be combined in a swap. IBM swaps out of $10,000,000
and into an equivalent amount of yen for 30 days.
Cash Flows in a Spot-Forward Swap

Bid rate is used because

Nomura is buying $

Nomura is willing to
F(¥/$) = ¥104.20/$ → (¥104.35/ $ – ¥0.15/ $) accept ¥1,000,000 less
in return when it buys
$10,000,000 from IBM
IBM keeps ¥1,043,000,000 – ¥1,042,000,000 = ¥ 1,000,000 for 30 days? WHY ?
Cash Flows in a Swap - Example

Nomura is willing to accept ¥1,000,000 less in return when it buys $10,000,000 from
IBM for 30 days? WHY ?
➔ the interest rate differential between the two currencies.

In a swap, each party is giving up the use of one currency and gaining the use of a
different currency for the period of time of the swap.

The two parties could charge each other the going market rates of interest on the
respective currencies for this privilege. Instead of doing this, swaps are priced so that
the party that is borrowing the high-interest-rate currency pays the party that is
borrowing the low-interest-rate currency the difference in basis points.

Here, note that the yen must be the low-interest-rate currency relative to the dollar in
this example because IBM had the use of yen while Nomura had the use of dollars, and
IBM paid Nomura less yen in the future than the amount of yen Nomura paid IBM for its
use of the dollars.
 Forward Premiums and Discounts

• Forward premium - occurs when the price of the currency contract is higher
then the spot rate
• F$/€ > S$/€ (the price of a € is higher for Forward)

• Forward discount - occurs when the price of the currency contract is lower
than the spot rate
• F$/€ < S$/€ (the price of a € is lower for Forward)

𝑓𝑜𝑟𝑤𝑎𝑟𝑑 − 𝑠𝑝𝑜𝑡 360

𝐴𝑛𝑛𝑢𝑎𝑙𝑖𝑧𝑒𝑑 % = ×
𝑠𝑝𝑜𝑡 𝑁 𝑑𝑎𝑦𝑠

the formal linkage between the forward premium or discount and the interest differential
between the two currencies will be discussed later
 Forward Premiums and Discounts

• Forward premiums and swap points

• Because forward contracts typically trade as part of a swap, the swap

points indicate the premium or discount for the denominator currency

• 1st<2nd (swap points added) – currency in denominator is at a premium

• 1st>2nd (swap points subtracted) – currency in denominator is at a discount

Historical Means of Forward Premiums or Discounts
Euro was at a
Pound traded at a forward premium vs Dollar
discount relative to the Dollar

See Excel File for Updated Bank of England Data