COMM 328 Study Guide - Final Guide: Foreign Exchange Risk, Currency Swap, Cash Flow

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8 May 2016
Department
Course
Comm 328 Final Exam Review
Chapter 9
Classic Swap Transaction
Counterparties A and B both require $100MM for 5 years
Counterparties A (BBB rating) and B (AAA rating) have the following
borrowing options:
Counterparty Fixed Rate Floating Rate
A 8.5% 6-month LIBOR + 0.5%
B 7.0% 6-month LIBOR
Counterparty A wants to borrow at a fixed rate while counterparty B wants
to borrow at a floating rate
Currency swap – an exchange of debt-service obligations denominated in one
currency for the service on an agreed-upon principal amount of debt denominated
in another currency
i.e. Air Canada would ilke to borrow euros, and Lufthansa wants to borrow Canadian
dollars. Air Canada can borrow Canadian dollars at 9% and euros at 7%, whereas
Lufthansa can borrow Canadian dollars at 8.7% and euros at 6%. Suppose Air
Canada wants to borrow 7.5MM euros, Lufthansa wants to borrow C$10MM, and the
current euro/dollar exchange rate is 0.75.
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Chapter 8
Derivative Securities – a security whose value depends on or is derived from the
value of another security
Economic Motivation:
1. Income opportunities/speculation
2. Risk management
3. Financial engineering
Background: In 1972, the CME opened its International Monetary Market division
IMM provides an outlet for hedging currency risk with currency futures
Currency futures: an agreement to buy/sell a standard quantity of an available
currency at a fixed exchange rate at a set delivery date
Contract sizes are standardized by amount of foreign currency
E-micro contracts – 1/10 the size of a standard contract
Transaction costs: payment of commission to a trader and a round trip costs
as little as $15
Leverage is high – initial margin is relatively low (less than 2% of contract
value)
Maximum price movements
oContracts set to a daily price limit restricting maximum daily price
movements
oIf limit is reached, add’l margin requirements are imposed
Futures Contracts Forward Contracts
Trading Location Prices determined in
centralized exchanges,
mainly open outcry
Decentralized interbank market
with telecommunication linkages
Trading hours Most trading during
exchange hours; some
Open somewhere around the
world 24 hours a day
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movements to automated
24-hour systems
Regulation IMM is regulated by the
CFTC
Self-regulating
Contract with Futures Exhcnage Commercial Bank
Contract size (N) Standardized in terms of
currency amount i.e. 62,500
Any size, but typically in excess
of $1MM
Delivery date Specific delivery dates;
typically third Wednesday
of March, June, September,
or December
Banks offer forward contracts for
delivery on any date
Frequency of
delivery
Delivery of underlying
foreign currency is feasible,
but almost never occurs.
Position closed out with an
offsetting trade.
Actual delivery of foreign
currency normally takes place
Quotes American terms ($/FC) European terms (FC/$)
Transaction costs Commissions for buy and
sell orders
Bid-ask spread
Market value at
origination date
Zero Zero
Cash Flows Occurs daily because of
marking to market
No cash flows until forward
contract matures
Credit risk Clearing House becomes the
opposite side to each
futures contract, thereby
reducing credit risk
substantially
Credit risk is borne by each party
to a forward contract. Credit
limits must therefore be set for
each customer.
To establish a futures position, an initial margin must be deposited in a
collateral account
Each day:
oThe investor who takes a long position receives any increase in the
futures price from the previous day, or pays any decrease in the
futures price from the previous day
oThe investor who takes a short position pays or receives the opposite
of the long
oPayments are added to or deducted from margin accounts
oThe existing contract reflecting the previous day’s price is cancelled
oThe investor receives a new contract with the prevailing price
oIf the balance in the account falls below the maintenance margin, the
broker/exchange issues a margin call. New money must be added to
the account to bring the balance back to the initial margin.
When the dust settles, future and forward contracts provide the same
random payoff over their lives. The difference is that forward contracts
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