ACCA P4 Advanced Financial Management - 2010 - Study text

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Chapter 13: Interest rate risk. Hedging with FRAs and swaps

Currency swaps

 The nature of currency swaps

 Reasons for using currency swaps

 FX swaps

5 Currency swaps

5.1 The nature of currency swaps

Interest rate swaps are swaps in the same currency, usually between a fixed rate and

a floating rate of interest, with interest calculated on a notional amount of principal.

Currency swaps are similar, but with some significant differences:

 The swap is between two different currencies. One party pays interest on an

amount of principal in one currency. The other party pays interest on an

equivalent amount of principal in a different currency.

 The interest rates that are swapped need not be a fixed rate in exchange for a

floating rate. A currency swap can be between a fixed rate in one currency and a

(different) fixed rate in the other currency.

 There is an actual exchange of principal. There must be an exchange of principal

at the end of the swap, at a rate of exchange that is fixed at the beginning of the

swap. (There might also be an actual exchange of principal at the beginning of

the swap, but this is not usual.)

Example

A UK company has taken an opportunity to borrow US$180 million in the bond

markets, by issuing a seven-year bond. However, it wants to have its interest

liabilities in sterling, not dollars. It might therefore arrange a seven-year currency

swap in which the agreed exchange rate is £1 = US$1.80.

 For the seven years of the swap, the UK company will receive fixed rate interest

in US dollars from the swap counterparty. The interest received on each interest

payment date will be interest for the period at the agreed swap rate for US

dollars, on $180 million.

 The UK company will pay interest in the swap on £100 million, also at a fixed

rate agreed in the swap.

 The interest received in US dollars can be used to meet the dollar interest

liabilities on the bonds. This leaves the company with net interest obligations in

sterling.

 At the end of the swap, there is an exchange of principal. The UK company will

receive US$180 million from the swap counterparty and in exchange must pay

£100 million. It will use the US$180 million to redeem the dollar bonds.

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The effects of the currency swap may be summarised as follows:

Interest Principal payments (end of the swap)

Bonds Pay dollars Pay dollars ($180 million)

Currency swap

Receive dollars

Receive dollars ($180 million)

Pay sterling

Pay

sterling

Net effect Pay sterling

Pay sterling

The effect of the currency swap has therefore been to borrow in one currency, but

swap the interest and loan principal repayment liabilities into a different currency.

Currency swaps are therefore used to hedge long-term currency risk.

5.2 Reasons for using currency swaps

As the previous example shows, currency swaps can be used to swap interest

payment and principal repayments from one currency into another, and so are a

method of hedging long-term currency risk exposures.

Companies can use currency swaps to borrow at a favourable interest rate in the

international loans or bonds markets, and swap their liabilities into a currency of

their preference. This could enable them to borrow more cheaply than borrowing

directly in the currency of their preference.

If the currency swap involves an exchange of interest at a fixed rate in one currency

for a floating rate in the other currency, the swap can also be used to hedge interest

rate risk.

However, currency swaps are far less common than interest rate swaps. Interest rate

swaps are used extensively in the financial markets, particularly by banks and other

financial institutions.

5.3 FX swaps

An FX swap is similar to a currency swap, but with one important difference.

 In a currency swap, the two swap counterparties exchange a series of interest

payments in the two currencies over the life of the swap.

 In an FX swap, there is no exchange of interest payments. There is an exchange

of principal at the start of the swap and a re-exchange at the end of the swap, but

there are no cash flows during the term of the swap.

The reason for having FX swaps is that a company might find it difficult to raise

debt in a particular currency. For example, a company might want to issue bonds in

a currency for which the bond market is illiquid and not popular with investors. The

company might want to issue bonds to obtain a liability in the currency for the

purpose of hedging its currency exposures.

Chapter 13: Interest rate risk. Hedging with FRAs and swaps

To create its liability in the currency, the company might:

 Issue bonds in another currency, such as US dollars

 Arrange an FX swap for the immediate exchange of the dollars for the other

currency. The company would then have a liability to repay the currency at the

end of the term of the swap.

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Paper P4

Advanced Financial Management

CHAPTER

Futures and hedging

with futures

Contents

1 Financial futures

2 The role of the futures exchange

3 Open positions and closing positions

4 Ticks and tick values

5 Basis and basis risk

6 Hedging risk exposures with futures

7 Currency futures

8 Short-term interest rate futures (STIRs)

9 Hedging with bond futures and stock index

futures

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Financial futures

 The nature of futures contracts

 Commodity futures and financial futures

 Futures exchanges

 Settlement dates

 Futures prices

1 Financial futures

1.1 The nature of futures contracts

A future is forward contract for the purchase or sale of a standard quantity of an

item, for settlement or delivery at a specified future date. It is therefore a contract to

buy or sell a quantity of an item at a future settlement date, at a price agreed ‘now’.

Futures contracts have some special features.

 They are standardised contracts. Every futures contract for the purchase/sale of

a particular item is identical to every other futures contract for the same item,

with the only exception that their settlement dates/delivery dates may differ.

 They are traded on an exchange, rather than negotiated ‘over-the-counter’.

1.2 Commodity futures and financial futures

Commodity futures are futures contracts for the sale and purchase of standard

quantities of standard commodities, such as wheat, oil, copper, gold, rubber, soya

beans, coffee, cotton, sugar, and so on.

Financial futures are futures contracts for the sale and purchase of a financial item,

such as a quantity of currency, a notional portfolio of shares, a quantity of notional

government bonds, a notional three-month deposit, and so on. There are currency

futures, short-term interest rate futures, bond futures and stock index futures.

1.3 Futures exchanges

Futures are traded on futures exchanges. Each futures exchange has its own

particular futures contracts. Only in a few cases do two futures exchanges compete

for business by offering trading in similar futures contracts.

The major futures exchanges include the Chicago Board of Trade (CBOT) and

Chicago Mercantile Exchange (CME), Eurex and LIFFE.

Chapter 14: Futures and hedging with futures

1.4 Settlement dates

Futures are traded on a futures exchange for just four settlement dates each year.

These are usually in March, June, September and December. Futures are therefore

referred to by their settlement date, such as March Eurodollar futures or September

S&P500 futures.

The actual settlement date for contracts in each month is specified by the futures

exchange. In examination questions it is normally assumed (for simplicity) that

contract settlement dates are at the end of the month.

1.5 Futures prices

The price for futures is the price at which buyers and sellers agree to make a

transaction with each other.

Dealing in futures contracts continues throughout the trading day on the futures

exchange, and the prices at which futures are bought and sold vary with each

transaction. However, the exchange authorities receive information about the prices

of transactions that have been made, and up-to-the minute price information is

published to the market. Buyers and sellers of futures are therefore aware of what

current market prices are.

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The role of the futures exchange

 Counterparty to all trades

 Margin

2 The role of the futures exchange

The futures exchange regulates the market that it provides. It establishes rules of

conduct and provides the systems in which trading can take place. In addition, the

exchange provides security to the market by virtually eliminating credit risk for its

participants.

2.1 Counterparty to all trades

An important feature of trading on a futures exchange is that when a buyer and

seller agree a transaction in futures and report the transaction to the exchange, the

exchange takes on the role of counterparty to the buyer and the seller in the

transaction. This means for example that if X makes a transaction to sell 20

December currency futures to Y:

 the futures exchange will become the buyer of 20 December futures from X and

 the exchange will also become the seller of 20 December futures to Y.

Both X and Y have a contract with the exchange, and not a contract with each other.

X is therefore not relying on the good credit standing of Y to honour the contract,

and Y is not relying on the good credit standing of X. They both rely on the credit

standing of the exchange itself. Since the credit status of the exchange is high, the

credit risk is minimised.

The exchange protects itself against credit risk from participants in the exchange, by

means of a system of margin payments. Margin payments are explained below.

(Note: Strictly speaking, the exchange itself is not the counterparty to every

transaction. The exchange is represented by a clearing house, that acts as

counterparty to every transaction. For the LIFFE futures exchange in London, for

example, the clearing house is the London Clearing House or LCH).

2.2 Margin

After someone has bought or sold futures at an agreed price, the market price of the

futures will move up or down. The buyer or seller of the futures will make a gain or a

loss on the futures position, depending on whether the market price has moved

favourably or adversely. If the price moves adversely by a large amount, a person

might have a large loss on his futures position. A problem for the futures exchange is

how to prevent someone with a large loss from refusing to settle the contract and pay

for the loss. This problem is overcome by a requirement for every position in futures to

be covered by a cash deposit with the exchange. This cash deposit is called a margin.

Chapter 14: Futures and hedging with futures

 When two parties agree to the sale/purchase of a quantity of futures, both

parties are required to pay a cash deposit, called an initial margin, to cover the

risk of short-term losses on their position.

 If a position goes into loss because the market price moves adversely, the exchange

will call for an additional cash payment of variation margin to cover the loss.

In this way, all loss positions have been covered by cash payments, and there is no

credit risk for the exchange from non-payment of losses by the buyers or sellers of

futures contracts.

Example

A company arranges to buy futures on coffee at a contract price of $2,000 per tonne.

Having bought the futures, it must pay a deposit or initial margin to the futures

exchange. The seller of the coffee futures must also pay initial margin.

If the ‘spot’ price of coffee then falls, and the price of coffee futures falls too, the

company will be making a loss on its futures position. To cover these losses, the

exchange will ask the company to pay an additional variation margin.

Margin protects the futures exchange against bad debt risk from buyers or sellers of

futures who makes losses on their position.

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Open positions and closing positions

 Open positions: long and short positions

 Settlement

 Closing positions

3 Open positions and closing positions

3.1 Open positions: long and short positions

When a person has bought futures without previously having sold any, he

establishes a long position in the futures. A long position in futures therefore

represents an undertaking to buy a quantity of futures at a future date. For example,

if a company buys 10 March US dollar-euro currency futures, it is ‘long’ 10 March

futures.

It is possible to sell futures without having any (in other words, without having a

long position). A position in which a person has sold futures, without previously

buying them, has a short position. For example, someone can sell 100 September

S&P500 Index futures, without already ‘owning’ 100 futures or even without

owning an equivalent quantity of shares in companies in the S&P500 Index.

Short and long positions are both open positions in futures, and at any time, the

total amount of long positions is always equal to the total of short positions. This is

because the number of futures contracts sold and the number purchased must be

equal.

3.2 Settlement

Someone with an open position in futures can keep the position open until the

futures contract reaches its settlement date. At settlement, the holder of a long

position will require the futures exchange to settle the contract for the purchase of

the underlying items in the futures contract. Similarly, at settlement the holder of a

short position will be required to make the sale of the underlying item to the futures

exchange.

Some futures contracts are cash-settled, and some are settled by physical delivery.

For example, short-term interest futures are always cash settled, whereas bond

futures are settled by the actual delivery of a quantity of bonds from the seller to the

buyer.

3.3 Closing positions

Open positions are not usually kept open until settlement, and so only a few futures

contracts are actually settled at their settlement date. Instead, positions are usually

closed before settlement.

ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing

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