The Forward Market and Hedging

I. Introduction Usually, when we discuss the forward market, we are talking about foreign currencies, although there are many other types of forward markets. For example, when one buys Japanese yen forward, one is fixing the exchange rate at which one will buy yen in the future, say in three months time. This rate is often called the 90 day forward rate on yen. If one wanted to buy yen today, then one would buy at the spot yen rate. It may seem that the forward market is very much the same as the futures market. But, there are still some important differences. First, there are no standardized contracts in the forward market, which means that the amount transacted can be anything. Second, there is no organized exchange as there is in the futures market. Instead, transactions are handled over the counter between contracting parties. Third, unlike the futures market, the forward market does not have daily settlement. Profit or loss is determined at the expiration of the forward contract. Finally, the futures market has a clearinghouse, which accepts the risk of non-payment by participants. The forward market does not have such a clearinghouse, and each party must accept the risk of non-payment by the other contracting party. Beyond this, there are differences in commissions and margins which must be paid. To understand the forward market better, it might be useful to consider an example. An important concept which we must remember at all times is that a forward contract cannot be liquidated before it expires. One must wait until expiration of the forward contract in order to collect one's profits or pay one's losses. Thus, one must be always considering the present value of these profits or losses before expiration of the agreement. Suppose that you buy a forward contract today at $100. The agreement will expire in 90 days and the risk free interest rate is 10%. After 20 days, suppose that the same type of forward contract is selling for $104 with 70 days left before expiration. You could now sell the underlying product forward 70 days, and this would guarantee that you have $4 profit 70 days later. What is the present value of your certain $4 profit to be received 70 days later. To find this one would simply discount this amount at the risk free rate of interest of 10% over the remaining 70

days -- which gives $3.93 of present value profit. In our example, we bought forward at $100 and sold forward at $104, but we never said what the product was that we were transacting forward. This is not really necessary, since the principle is the same whether we are transacting forward in currencies or commodities, or anything else. The key here is to understand that one's profit (or loss) is not realized until expiration, although the profit (or loss) can be determined before expiration. If the forward (or futures) price is less than the current spot rate, then a state of backwardation is said to exist. Conversely, if the forward price is above the current spot price, then a contango is said to exist. The forward rate (price) is sometimes thought to be a good measure of the expected spot rate (price), but this is not necessarily true. The forward rate may be biased upward or downward from the investor's expected spot rate. If the forward rate is not biased, we say that it is unbiased. This means that on average the forward rate correctly predicts the future spot rate. II. Hedging Currency Risks The forward market can be used to hedge currency exchange risks. For example, suppose that EVA, an international airline in Taiwan, decides to purchase three 74740 jets from Boeing. The total cost will be $180 million USD, and payment will be made in 270 days. EVA is worried that the NT$ may depreciate during this time. The current spot rate is $27.5 NT/1US$, and at this rate, the cost would be $4.95 billion NT. If the NT$ depreciates 1.82%, the cost to EVA would rise to $5.04 billion NT, for an exchange loss of about $90 million NT. EVA could hedge this risk by purchasing $180 million USD 270 days forward. Suppose that the forward rate is $27.8 NT/1US$, which means that the cost of the jets to EVA would be roughly $5 billion NT. By doing this EVA eliminates the risk that the NT$ will greatly depreciate. This hedging policy merely fixes the rate which EVA must use, 270 days later, to convert its NT$ to US$. There is no guarantee that this forward rate will be the same as the spot rate 270 days later. The actual spot rate may be either higher or lower. EVA could hedge the same transaction using a variety of other means (if they are available), such as currency futures, currency options, or even through a money market hedge. For a money market hedge, EVA would borrow $4.774 billion NT for 270 days

and immediately sell these NT dollars on the spot market to get $173.62 million USD. Suppose the riskless US interest rate in 5%. Then EVA would invest the $173.62 million USD in US money market instruments for 270 days. At the end of this time, it would have $180 million USD which it would use to pay Boeing for the jets. Note that EVA eliminated its exchange risks since the $180 million USD is guaranteed (riskless). Furthermore, when EVA pays off its NT$ loan, it does not need to worry about exchanging NT$ for US$ -- that is, the NT$ loan carries no exchange risk. If the interest rate on the 270 day NT$ loan is 8%, then EVA pays $5.054 billion for the Boeing jets. It would appear that the forward market is a cheaper way to hedge the risks, given these interest rates. III. Interest Rate Parity and Covered Interest Arbitrage An important concept showing the relation between interest rate, the spot exchange rate, and the forward exchange rate is that of interest rate parity. The word parity refers to a balance which should exist between these variables. Interest parity is a type of equilibrium condition. If parity doesn't hold, then it should be possible for an investor to profit from the imbalance. The imbalance can be arbitraged away by investors. This type of arbitrage is often called covered interest arbitrage. Therefore, to really understand covered interest arbitrage, one must clearly understand interest rate parity. Suppose that you have $100 USD and you have a choice of investing this money in the US or in Taiwan. In equilibrium, it should not matter whether you invest in Taiwan or in the US. The rate of return on your investment should be the same, as long as everyone can freely invest where they want and the tax treatment on such investment is the same in Taiwan and the US. Now suppose that RT is the risk free return in Taiwan, RUS is the risk free return in the US, e is the spot rate on the US dollar ( NT$/US$), and f is the forward rate on the US dollar (NT$/US$). Interest rate parity refers to a balance between these variables. We can write this parity condition as (1 + RUS) = (1+RT)e/f. Now suppose that (1+RUS) is greater than (1+RT)e/f. Interest parity does not hold, so it must be possible to make a profit. How can this be done? If you were a Taiwanese investor, then you would borrow NT$ at interest rate RT and sell these NT$ for US$ on the spot market at rate e. The US dollars you receive would today be invested in the US at interest rate RUS. You would also sell US dollars

forward today for NT$ at forward rate f. At the end of your investment period, you would be able to pay back your NT$ loan with interest and still make a profit. Note that borrowing NT dollars puts pressure on RT to rise, and selling NT$ for US$ on the spot market causes e to rise. Finally, selling the US$ forward will cause f to fall and investing these US dollars in the US will cause RUS to fall. Therefore, there is string pressure to bring all the variables back into balance. This transaction is an example of covered interest arbitrage. Interest rate parity shows clearly how that changes in short term interest rates can affect exchange rates. If RUS rises sharply, then there will be pressure on both e and RT to rise, and f to fall. We have seen before that short term interest rates are important to the economy because they can influence the exchange rate. We now see that international interest rate differentials can affect both the spot and the forward exchange rates. It is because of this that investors must carefully watch changes in monetary policies of different countries, especially the US. Changes in monetary policy can affect short term interest rates and thus the spot and forward exchange rates.

Discussion Questions: #1. What is a forward contract to sell Euros? #2. Why do we consider the present value of profits and losses in the forward market? #3. Suppose that today you buy yen 90 days forward at 97. After 30 days you find that you can sell yen 60 days forward at 100. If the riskless yield to maturity is 6%, then what is the present value of your profit. #4. When is there backwardation in the forward market? #5. Explain the basic idea of a money market hedge. #6. How do we use the forward market to hedge exchange risks? #7. What is interest rate parity? #8. Explain the concept of covered interest arbitrage