Classnote 15, Forex, Forwards/Futures
Class 14: Spot vs. Forward transactions/contracts/prices. Hedging. Futures.
Class 15: Short selling. Currency risk exposure. Hedging simple transaction risks with
Forwards or Options or the Money Market (borrowing & lending). Forward Prices, Currency
Class 16: loose ends (15), review, Q&A.
Friday, mid-term on classes 10-16
• Different currencies have different interest rates.
• Generally high inflation currencies have higher interest rates.
1 • So here, the different interest rates refer to different currencies.
‘Short selling’ (‘shorting’, ‘going short’) Dell stock.
Dell is currently trading at $100. Mr. A has no Dell stock. He borrows 1 share of Dell from
Mr. Vanguard, (paying a small commission of $0.20, but let’s ignore that – it’s small) and
agreeing to return the stock to Mr. Vanguard in 2 weeks’ time. Mr.A immediately sells the
borrowed stock to Mrs. Z for $100. Show the profit/loss to Mr. A’s short selling strategy if
the Dell stock price in two weeks’ time turns out to be: i) $60=gain $40 ii) $90
iii) $100=0 iv) $110 v) $140=lose $40.
Use someone’s notes to copy graph.
This is a short forward?
You can think of this as a forward contract because, if you think prices will go down, you
can go buy a stock so that you’re covered.
When you sell short, you’re liability is the share, because you owe it to that person.
2 Sell high, buy low?!
Sell them high in the hope of buying them back in a couple weeks time at low. People do
this wil liquid shares.
Should short sales be banned?!
It drives stock price down (if enough people do it). In the 2008 crash, they banned short
selling for a while. However, banning will risk stocks being over-valued and people won’t
What is the beta of a short stock position? Negative.
3 You do short positions when you want to bet it will go down.
4 Exchange Rates: (we’ll use old numbers here because Parity (1USD=1CAD) is no fun
If there are 0.9248 USD$ to the CAD$, how many CAD$ to the USD$?
1.0812 cad/usd you get this by 1/0.0248. 1/(x/y) = y/x
If there are 0.9248 US$ to the CAN$, and 1.7781 CAN$ to the GB Pound, then how many
US$ to the GB Pound? 1.6444 which we got by multiplying the other two numbers.
If 1US$ buys 7.7502 HK$ and there are 90.07 Japenese Yen to the US$, how many HK$ to
If there are 0.0114 CHF to the Yen, and 1€ is worth 132.674 Yen, then how many € to the
1/132.674 y/e x I 0.0114 ch/yen = 3/chf = 0.66
5 A /C = A /B x B /C
6 Take any two and see if you can take the third one.
Currencies: Forward Contracts vs. Futures Contracts
Biggest market in the world is the forward market for foreign exchange.
Forward contracts: Not traded on an exchange
But MASSIVELY traded ‘Over-the-counter’ (‘one-to-one’, by phone) between
financial institutions and other large firms $4 trillion per day.
Counterparty Risk matters.
Futures contracts: Exchange traded…
Closing out (netting out, offsetting)
8 9 Foreign Exchange Exposure
In the nation of HomeLand, the national currency is the Zed
In the Intermediate Kingdom, the national currency is the Kareen.
Today’s spot exchange rate is 4 Zeds/ Kareen.
What does it mean to say that “the Zed currency weakens against the Kareen”?
Zed currency would depreciate so i.e., 5/to K…because now it takes more weak Zeds to
buy a K.
What does it mean to say that “the Zed currency strengthens against the Kareen”? so i.e.,
Graph the value of 100 Kareens (in Zeds) as the exchange rate moves from 4Z/K = 400; to
3Z/K=300; to 5Z/K = 500.
Graph the value of 100 Zeds (in Kareens) as the exchange rate moves from 4Z/K=25; to
3Z/K=33.3; to 5Z/K=20.
Make sure you copy someone’s graph.
10 Currency Hedging
Firm M is based in HomeLand, where the national currency is the Zed and the 1 year fixed
interest rate (for borrowing and lending) is 10%p.a. home interest rate
Firm M has placed an irrevocable order to purchase, in one year’s time, a machine from a
firm in the Intermediate Kingdom, where the national currency is the Kareen and the 1 year
fixed interest rate (for borrowing and lending) is 5%p.a.
The agreed price for the machine is 100 Kareens, payable next year.
• Thus the K is a liability, so to hedge, you buy 100K forward.
• So when you sell the Z for K, that K is an asset that…?
Today’s spot exchange rate is 4 Zeds/ Kareen.
Today’s ‘1 year forward’ exchange rate is 4.19 Z/K
100 K will be a liability, because we owe it to someone.
11 If the foreign currency gets strong, it is bad news for us, because it will cost us more in our
What exchange rate risk does M face?
• We have to know the PV of the K price that we pay in a year, which is 380.95
• Call on the K is the same thing as buying a put on the Z in this case.
• So with currencies, you can interchange put and call and mean the same thing.
Show the unhedged cost (in Zeds)of buying the machine for 100 Kareen in 1 year’s time
(as a function of the Z/K spot rate in 1 year’s time). E.g. @ 3 Z/K, @ 3.5 Z/K, @ 4 Z/K, @
4.5 Z/K, @ 5 Z/K.
How can Firm M hedge this exposure in the Forward FX market? Show M’s overall
(hedged) cost (in 1 year). What is the Present Value of this hedged cost?
- We need K’s because we have a K liability.
- The new thing we’re learning here is that the underlying asset itself is a currency.
4 Spot Z/K (In 1 year).
Without using the forward market, how else could M hedge this exposure?
1. With Currency OptionContracts?
2. In the Money Markets (borrowing and/or lending in