Professional Documents
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Last Week:
Introduction
Forward fundamentals
Part I: Forwards
Forwards: Fundamentals
Definition
contract calling for delivery of a given asset
at a given future date, at a price agreed-upon today
no money changes hands today (caveat)
speculators
try to profit from price movements
traders-arbitrageurs
Regrets, anyone?
Interpretation
Speculator / Investor
US regulatory terminology: Non-Commercial
Profit/Loss from a
Long NAKED Forward Position
Profit
Ft,T
Price of Underlying
at Expiration (ST)
Cash-settled forward
a.k.a NDF (Non-Deliverable Forward)
No delivery, only cash settlement between Long & Short
Long gets { ST - Ft,T } from Short (who gets {Ft,T - ST })
Profit/Loss from a
Short NAKED Forward Position
Profit
Ft,T
Price of Underlying
at Expiration (ST)
Cash-settled forward
No delivery (cash settlement only, between Long & Short)
Short gets {Ft,T - ST} while Long gets { ST - Ft,T }
Interpretation
US regulatory terminology: Commercial
Payoff from a
HEDGED Forward Position
Hedging with commodity-settled contract
Examples: Long vs. Short hedge
Cash-Inflow
Payoff independent from ST, i.e.,
price of Underlying at Expiration
ST
Ft,T
Net Cash-Inflow
ST
Ft,T
Profit from short
NDF position
An option contract
OBLIGATION to
buy or sell at a
obligation) to buy or
certain price
X = Strike price;
ST = Price of underlying asset at maturity
Payoff
X
ST
Payoff
ST
Payoff
X
ST
ST
Foreign exchange
Outright currency forwards and FX swaps
1.6275 - 1.6299 $ / 1
33 -
46
1.6308 - 1.6345 $ / 1
Forwards 8
Forward quotes (OTC)
outright forward vs. swap rate (forward premium)
spot
1.6275 - 1.6299 $ / 1
swap rate
outright forward
33 -
46
1.6308 - 1.6345 $ / 1
1.6275 - 1.6299 $ / 1
swap rate
outright forward
45 -
33
1.6230 - 1.6266 $ / 1
Forwards 9
Swap rate & B-A spread
observation
subtract swap if discount, add if premium
why? (size of B-A spread)
explanations
risk?
liquidity (market depth)?
others?
10
Forwards 10
Annualizing the forward premium/discount
Example:
spot
3-month outright forward
$ 1.6275 / 1
$ 1.6230 / 1
Swap rate
f-s = -0.0045 $ / 1
or
discount of 45 points
Percentage premium/discount
(f-s)/s = -0.0045/1.6275 or
-0.28%
or
-1.11%
Forwards 11
Regulation?
Risks
volatility of underlying asset price
default
why?
Solution
Till 2010:
11
Forwards: Pricing
Relationship to current spot
forward-spot parity for domestic assets
forward-spot parity for currencies (covered) IRP
compounding & asset type
Forward Price
Formal definitions
delivery price
price at which the underlying asset will be delivered
agreed upon at time forward is entered into
forward price
delivery price that would make the contract have 0 value
changes during life of contract (but, who cares)
12
S0
- S0(1+r)
- S0
+ asset
+ D = S0 d
total
+ asset
+ F0,T
- asset
0
- S0(1+r) + S0 d + F0,T
13
vs.
vs.
commodity:
r + u
(storage cost born at rate u)
F0 vs. [S0+U](1 + r) (PV of storage cost known to be U)
solution
theory (no-arbitrage bands) vs. practice (triple witching)
Generalizations
Multi-period:
F0 = S0 (1 + r d)T
Commodities:
14
F = S (1 + r + u - d)
suppose S = $600/ounce, r =5%, d = 1% and u=0%
> Equilibrium F = 600 x (1 + 0.05 - 0.01) = 624
15
S0 / ed
(1) borrow
- ( S0 / ed ) er
- S0 / ed
+ (fraction of asset)
+ asset
total
+ F0
- asset
- [ S0 er / ed ] + F0
hence: 0 = - [ S0 er / / ed ] + F
and thus
F0 = S0 e(r-d)
F0 = S0(1 + r d)
continuous
F0 = S0 e(r-d)
Does it matter?
Size of difference vs. reasonable character of reinvestment hyp.
Domestic assets vs. currencies
16
S0
- S0 (1+r)
- S0
+ 1 FX
receive interest
+ 1 FX
+ r* FX
+ F0 (1+r*)
- (1+r*) FX
total
- S0(1+r) + F0 (1+r*)
and thus
F0 = S0(1+r)/(1+r*)
1+i T
360
*
1+i T
360
or
i - i* T
ft,T - st
360
=
st
*
1+i T
360
17
should sell at a premium
against the pound
approximately equal to
the interest rate differential between the two countries
*
T
i - iDKr
6.5% - 3.5% 90
f t,T - st
360
360 = 0.7435%
=
=
st
*
T
90
1 + iDKr
1 + 3.5%
360
360
18
Currencies:
One hypothesis:
In reality:
Spot
Price
Time
t0
19
F0 = S0(1 + r - d) or S0(1 + r + u - y)
F0 = S0 e(r-d) or S0 e(r+u-y)
F0 E[ST] (1 + r - k)
continuous time:
F0 E[ST] e(r-k)
20
Backwardation:
(normal) Backwardation:
21
ft,T = E st+T | IM
t
is efficiency consistent with a risk premium?
22
1+i T
360
ft,T = st
*
1+i T
360
+ FP
ft,T = E st+T | IM
t
= UIRP
E st+T
1+i T
360
= st
1 + i* T
360
Usefulness
i - i* T
E st+T - st
360
=
st
*
1+i T
360
23
Strategies
IR diff is big borrow low, invest high & bet that the spot
FX rate doesnt move much (Case 1)
IR diff is very small bet on FX rate changes (Case 2)
Either way, light up a bunch of candles and pray!
Examples
47
Strategy
Borrow in the funding currency (low-yielding)
Invest in the target currency (high-yielding)
Light up a bunch of candles and pray!
24
49
Strategy
Borrow in the weak currency
Invest in the strong currency
Light up a bunch of candles and pray!
25
forward price
delivery price that would make the contract have 0 value
changes during life of contract (who should care?)
26
in reality
bid-asked spreads on the markets (or brokerage fees)
borrowing costs more than depositing
consequence
equalities vs. bounds
27
T
a
)
S t (1+ ia
360
b
F t ,T
T
( 1+ i*b
)
360
No-arbitrage condition 2
T
b
)
S t (1+ i b
360
a
F t ,T
T
(1+ i*a
)
360
28
1+i T
1+0.055 180
360 = (0.01 $ / 1)
360 = 0.010249 $ / 1
1+i* T
1+0.005 180
360
360
Now compare this with the 6-month forward rate quoted directly by Daiwa: 0.010256 $ /
1.
Clearly, you will want to buy low and sell high, i.e.:
sell to Daiwa 6-month outright forward at 97.50/1$.
The other sides of the transaction are:
borrow $ at 5.5%,
buy spot with the borrowed dollars at 100/1$,
and invest the at the rate of 0.5%.
29
cash-flows today
a.
b.
d.
e.
total
+ 1$
- 1$
+ 100
- 100
cash-flows in 6 months
(borrow 1$)
(exchange for )
(invest )
none (sell forward)
none
___________
0
For every dollar borrowed, the gains are 0.0007$, i.e., a 0.07% profit margin.
30
31
t+T
invest domestically:
$:
-1
invest abroad
$:
-1
FX: 1/St
FX: - 1/St
$: (1+ i
FX:
T
360
)
360
T
FX: - ( 1+ i*
)
St
360
Ft ,T
T
$:
( 1+ i*
)
St
360
St
1
( 1+ i*
$1
foreign:
$1
Risk
similar
T
360
)=
Ft ,T
St
( 1+ i*
T
360
32
t
(1) borrow
t+T
$1
$: (1+ i
$:
FX: 1/St
(2b) invest FX
FX: - 1/St
T
360
-1
FX:
1
St
FX: -
( 1+ i*
T
360
T
)
360
Ft ,T
T
$:
( 1+ i*
)
St
360
St
( 1+ i*
FX: 0; $: 0
t+T:
FX: 0; $: (1+ i
T
360
)+
Ft ,T
St
( 1+ i*
T
360
No-arbitrage condition
(1+ i
T
360
)=
Ft ,T
St
( 1+ i*
T
360
Ft ,T St (i i* ) 360
St
( 1+ i*
T
)
360
33
t
(1) borrow
t+T
$1
$: (1+ i
$: -1
FX :1/ S ta
FX : -1/ S ta
(2b) invest FX
FX :
T
)
a 360
1
T
( 1+ i*b
)
a
360
St
1
T
( 1+ i*b
)
a
360
St
b
F t ,T
T
$:
( 1+ i*b
)
a
360
St
FX : -
FX: 0; $: 0
FX: 0; $: (1+ ia
t+T:
T
360
)+
b
F t ,T
T
( 1+ i*b
)
a
360
St
No-arbitrage condition
T
b
F t ,T
T
(1+ i
)
( 1+ i*b
)
a 360
a
360
St
T
a
)
S t (1+ ia
360
b
F t ,T
T
( 1+ i*b
)
360
34
(1) borrow
t+T
FX 1
T
FX : (1+ i*a
)
360
$: S bt
FX : -1
$: S bt
(2b) invest $
T
$: S b
)
t ( 1+ i b
360
T
$: - S b
)
t ( 1+ i b
360
b
T
S
FX: t ( 1+ i b
)
a
360
F t ,T
FX: 0; $: 0
t+T:
b
T
T
S
) + t (1+ i b
)
$: 0; FX: (1+ i*a
360 F a
360
t ,T
No-arbitrage condition
b
T
T
S
(1+ i*a
) t (1+ i b
)
360 F a
360
t ,T
T
b
)
S t (1+ i b
360
a
F t ,T
T
(1+ i*a
)
360
35