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Forwards, Futures
and Money Market Hedging
Prof. Ian Giddy
New York University
Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 7
Hedging Transactions Exposure
l Types of exposure
l One-shot exposure
l Hedging approaches:
uOpen
uForward
uMoney market
uFutures
uOptions
l Ongoing transactions exposure

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Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 8
Tools for Hedging
l Petrobras has to pay for equipment from
Japan, in Japanese yen, in 3 months
uBorrow and pay now?
uUse a forward contract/FX swap?
uPay later at spot?
Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 9
Forward Contracts, Futures
and Money Market Hedging
l Money market hedging: match currency
of assets and liabilities
l Forwards: OTC agreement to exchange
currencies at certain exchange rate in
the future
l FX swap: simultaneous spot sale and
forward purchase of a currency
l Futures: Exchange-traded contracts for
notional future delivery, minimizing
default risk via marking-to-market

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Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 10
Forward Contracts
l Agreement to exchange currencies at
certain exchange rate in the future
l Default risk in forward contracts arises
because such a contract is a
commitment for future performance, and
one or other party may be unwilling or
unable to honor that commitment.
l On the settlement date, one party in
effect owes the other party a net
amount.
Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 11
A Typical Forward Contract
l We agree today to pay a certain price
for a currency in the future
BackusBackus SAN-
TANDER
SAN-
TANDER
Soles

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Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 12
Customization, Performance Risk
and Liquidity
l Customization implies bilateral
contracts, which carry performance risk
l Liquidity implies standardization and
freedom from counterparty risk, through
exchange-traded contracts
Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 13
How Does the Bank Hedge a Forward
Contract?
Hedging approaches:
uOpen
uForward
uSpot plus swap
uRollover
uMoney market

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Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 14
Foreign Exchange Quotations
Spot Forward points
Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 15
How Banks Hedge
SHORT LONG
Today
T+2
T+90
Methods:
- Spot + swap
- Spot + rollover swap
- Money market
- Outright forward

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Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 16
The FX Swap Hedge
3-month Forward Contract
3-month Swap
l Dealers typically hedge a forward foreign-
exchange commitment with a spot plus “FX
Swap”: spot sale plus forward purchase of a
foreign currency
l The FX swap rate is determined by the
interest differential
Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 17
The Roll-Over Swap Hedge
6-month Forward Contract
3-month Swap 3-month Swap
l Dealers often hedge a long-term foreign-
exchange commitment with shorter-term
contracts, which are “rolled over” as they
come due
l Corporations themselves do this too.

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Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 18
The FX Swap Hedge
3-month Forward Contract
Borrow USD
Invest in DEM
l Dealers also hedge a forward commitment in
the money market: borrow the currency you
will be receiving, and invest in the currency
you will be paying
l The FX swap rate is determined by the
interest differential
Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 19
110
115
120
125
130
135
140
0
1
2
3
4
5
6
7
8
9
10
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12
13
14
15
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18
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22
23
24
EXCHANGE
RATE, YEN
PER US$
FORWARD
PREMUIM,
PERCENT
PER ANNUM
FORWARD
(LEFTSCALE)
SPOT
(LEFTSCALE)
FORWARDPREMIUM
(RIGHTSCALE)
MONTHLY DATA, 1987-1989
FORWARDPREMIUM=[(SPOT-FORWARD)/SPOT]*(12/3)*100
The Forward Rate Tracks the Spot Rate

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Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 20
Linkages Between Interest Rates
Interest rate
differential
Interest rate
differential
Forward
premium
Forward
premium
Expected
% change in
exchange rate
Expected
% change in
exchange rate
Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 21
Cost of Hedging
Type of Hedge Cost of Hedging
Forward Forward premium
Money Market Hedge
(Borrow to match
assets)
Interest rate
differential
Do nothing Expected rate of
change of
exchange rate

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Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 22
Corporate Hedging Decisions:
Frutas Amazonas
Exporting bananas to Spain, get paid in
Spanish pesetas. Funding is in U.S.
dollars.
Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 23
Corporate Hedging Decisions:
Frutas Amazonas
l Continue funding in U.S. dollars. The
peseta might get stronger in the next
three months, from $1=128 pesetas to
$1=126 pesetas. This could be the
cheapest
l Switch funding to pesetas, despite the
slightly higher cost
l Borrow in dollars, but hedge the
exchange risk in the forward market.

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Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 24
Frutas Amazonas
Eurodollar 3-month
loan rate
5 9/16%
Europeseta 3-
month loan rate
7 15/16%
Spot exchange
rate today
Pta128.210 per
USD
Forward exchange
rate today
Pta129.005 per
USD
Forward discount,
% per annum
-2.5
Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 25
Frutas Amazonas
Type of Hedge Cost of Hedging
Forward 2.5%
Money Market Hedge
(Borrow to match
assets)
2.375%
Do nothing 2/128 x 4
= 6.25% gain
(or 2.5% loss?)

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Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 26
Bid and Offer Quotations
in the Long-Dated Forward Market
1.3
1.35
1.4
1.45
1.5
1.55
1.6
1.65
1.7
1.75
1.8
1.85
1.9
SPOT 2YR 3YR 4YR 5YR 7YEAR 10 YEAR
.05%
.63%
1.25%
1.44%
1.62%
3.96%
6.34%
EXCHANGE
RATE,
DOLLARS
PERPOUND
STERLING
OFFER
BID
MATURITYOFFORWARDCONTRACT
Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 27
Forwards, Money Market Hedging
and Futures
l Forward contracts: OTC contracts for
future delivery, often settled in cash
l Forwards can be used in
1. Hedging
2. Positioning
3. Arbitrage
l Interest rate parity means that a forward
hedge is, normally, the same as a
money market hedge.
l Futures are free of default risk.

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Marking-to-
Market of a
Futures
Contract
0.625
0.63
0.635
0.64
0.645
0.65
-25 -20 -15 -10 -5 -1
SHORT POSITION
LONG POSITION
DAILYGAINS ANDLOSSES
DAILYDM
FUTURES PRICE
MOVEMENTS
FUTURES
SPOT
FUTURES PRICES,
US$PERMARK
DAYSBEFORESETTLEMENTDATE
Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 29
Forwards vs Futures vs Options
l Good credit: Forward usually best
l Sometimes, Money Market Hedge better
u Perfect market: same (covered int. arb.)
u Imperfect market: MMH may be better
l Credit problem: Futures
u But: limited and standardized
u Requires margin and daily settlement
l Uncertain future cash flows:
u Liquid instrument (futures/forwards to assure
flexibility
u Options sometimes advisable

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Copyright ©1997 Ian H. Giddy Forwards, Futures and Money-Market Hedging 30