Hedging & Arbitraging with Forward

Contracts

Dr. Trilochan Tripathy

Prof. of Finance, XLRI Jamshedpur
 Coverage
• Recaps……
• Understanding FX market and Transactions
• What is Risk and Risk Classification
• Hedging and Hedging Instruments
• What is a forward contract?
• How do Forward Contracts Work?
• Users of the Forward Contracts
• Arbitrage with Forward
• Hedging with Forward
• Hedging with NDF
• Cancellation of Forward
• Limitations of Forward
 Risk
• Risk can be defined as any event or possibility of an
event which can impair corporate earnings or cash
flow over short/medium/long term horizon.
• Sources of Risk: Prices, Market, Productivity,
Competition, technology, liquidity …….
 Risk Classification

• Credit/Counterparty Risk
Functional • Market Risk
Perspective • Operational Risk

• Risk Avoidance
Managerial • Risk Transfer
Perspective • Risk Managed
(actively/Passive)
 Hedging
Hedging is a risk management strategy
employed to offset losses in investments by
taking an opposite position in a related asset.
 Derivatives Tools
• Forward
– A forward contract is a customized contract between two parties to
buy or sell an asset at a specified price on a forward date.
• Futures
– A forward contract is a exchange traded contract between two parties
to buy or sell an asset at a specified price on a future date.
• Options
– An option is a contract that gives the buyer the right, but not the
obligation, to buy or sell the underlying asset by a specified date
(expiration date) at a specified price.
• SWAPS
– a swap is a derivative contract in which one party exchanges or swaps
the values or cash flows of one asset for another.
 What is a forward contract?
• A forward contract is a contractual
agreement between two parties [i.e. buyer (
long) and seller (short)] to trade a specific
quantity (size of the contract/quantity)of an
asset or derivatives (underlying asset) for a
pre-specified price (Contract Price) set at the
start of the contract at a specific date in the
future (Maturity/expiry date).
 Forward Contract

0 t T

Contract initiation After initiation and before Contract expiration

day= ‘0’
‘o’ day expiration day= ‘n-k’ day day= ‘n’ day
 How do Forward Contracts Work?

• Forwards are not traded on centralized exchanges.

• They are rather customized, over the counter contracts
(OTC) that are created between two parties.
• On the date of expiry, the contract must be settled.
• One party will deliver the underlying asset, while the
other party will pay the agreed-upon price and take
possession of the asset.
• Forwards can also be cash-settled at the date of
expiration rather than delivering the physical
underlying asset.
 Users of the Forward Contracts

• Hedgers: Forward contracts are mainly used

to hedge (lock in a price for a future date) against
potential losses.
• For example, in the oil industry, entering into a
forward contract to sell a specific number of
barrels of oil can be used to protect against
potential downward swings in oil prices.
• Forwards are also commonly used to hedge
against changes in currency exchange rates when
making large international purchases.
 Users of the Forward Contracts

• Speculator: If a speculator believes that the

future spot price of an asset will be higher
than the forward price today, they may enter
into a long forward position.
• Arbitrageurs: If a arbitrageurs see that the mis
pricing in the forward rate, they may enter
into a forward position to exploit the market.
 Arbitrage with Forward
Suppose that the 2 year interest rates in Australia and
the United states are 5% and 7% respectively and the
spot exchange rate between AUD and USD is
0.6200US$/AUD. Suppose two year forward rate is
available at 0.6300 USD/AUD. Is there any arbitrage
opportunity?

1
2
 Solution
▪ Fs= S0*e(rus- raus)*T = 0.6200*e(7%-5%)*2 =0.6400 USD
▪ Fs>Ft
• Action on Day 0
▪ Borrow 1000AUD@ 5% interest rate per annum for 2 years
▪ Convert 1000 AUD to USD= 1000AUD*0.6200USD/AUD=620 USD
▪ Get into a long forward contract of AUD worth of 1000*e5%*2=1105.171
AUD
▪ Where pay 1105.171*0.6300=696.26 at maturity
▪ Invest 620 USD @ 7% interest for 2 years
• Action on the Day of settlement
▪ Received USD from bank which is USD 713.17
▪ Pay the 696.26 USD to bank and receive 1105.171
▪ Pay 1105.171 to the Australian bank and close theAUD loan
▪ Net profit is USD 713.17-696.26=USD 16.9
1
3
 Arbitrage with Forward
Suppose that the 2 year interest rates in Australia and
the United states are 5% and 7% respectively and the
spot exchange rate between AUD and USD is
0.6200US$/AUD. Suppose two year forward rate is
available at 0.6600 USD/AUD. Is there any arbitrage
opportunity?

Solve???

1
4
 Hedgers: FX insights
▪ What is hedging?
▪ What are the basic instruments through which one
can hedge?
▪ Whether importer and exporter have control over
these factors?
▪ How do the firms eliminate the FX exposure to
protect the top and bottom lines?
▪ Which is the most dominant hedging instruments
usually used by the Indian exporter and importer?
▪ Why have the OTC (forward) market in FX more
dominant than the exchange traded markets?
15
 Hedging and its instrument types?
▪ Hedging is a risk management strategy employed to
offset losses in investment/receivables and payables.
▪ Basic hedge instruments are forward, futures, options,
swaps.
▪ Long Hedge and Short Hedge
▪ Applied to Stock, Gold, FX, Interest rate…..
▪ Here we only deal with FX instruments

16
 FX Volatility impacts
▪ How does FX rate fluctuation impact the exporters and
importers?
Nature of Appreciation Depreciation
exposure
Exporters Receivable: asset Increased cash flow Decreased cash flow in
denominated in FX in domestic currency domestic currency than
to be realised later than expected expected

Importers Payable: Liabilities Decreased cash flow Increased cash flow in

denominated in FX in domestic currency domestic currency than
to be liquidated than expected expected
later

17
 Outcome of hedged and unhedged position

Positions Appreciation Depreciation

Exporters- Unhedged Desirable Not desirable
Receivable:
Hedged Not desirable Desirable

Importers- Unhedged Not desirable Desirable

Payable:
Hedged Desirable Not desirable

18
 Pay off hedged and Unhedged Position
Position Appreciation Depreciation
Exporters- Unhedged Pay off ST-S0=Gain ST-S0=Loss
Receivable:
Hedged F F-ST=Gain
Pay off (Short)

Importers- Unhedged Pay off ST-S0=Loss ST-S0=Gain

Payable:

Hedged F-ST=Gain F
Pay off (Long)

19
 Hedging Receivables with Fx. Forward
Rajesh Exports an Indian MNC has invoiced to a French customer jewellery
worth of € 20,000 and expects receivable in 3 months. The current spot
exchange rate is INR 82 / €. Due to extreme volatile situation in Greece, Euro
likely to weaken against all currencies. Forward contract is available at INR
80/ €.
a. Evaluate the exporter position if he has hedged with the 3 M forward and
at the date of maturity if the spot rate appears to INR 75/ € and (ii) INR
85/ €.
b. Compare his unhedged realization of the Rajesh Exports in the aforesaid
scenarios.
Hedged realisation Unhedged realisation
Scenario I € 20,000 * INR 80/ € = INR € 20,000 * INR 75/ € = INR
16,00000 15,00000
Scenario II € 20,000 * INR 80/ € = INR € 20,000 * INR 85/ € = INR
16,00000 17,00000

20
 Hedging receivables with FX Forward
Profit
Forward price

+ 10
+ INR 100000
+5

0 Spot price
65 75 80 85 90 (INR/Euro)
-5
- INR 100000

- 10

Loss
Pay off Short Position
 Hedging receivables with FX Forward
Exchange Sate Hedged value realisation Unhedged realisation
at Expiry

75 € 20,000 * INR 80/ € = INR 16,00,000 € 20,000 * INR 75/ € = INR 15,00,000

80 € 20,000 * INR 80/ € = INR 16,00,000 € 20,000 * INR 80/ € = INR 16,0000

85 € 20,000 * INR 80/ € = INR 16,00,000 € 20,000 * INR 85/ € = INR 17,00,000
 Hedging Payable with Fx. Forward
Grover Vineyards an Indian wine producer has imported raw
materials from a US exporter USD 1,00,000 for which payment is
due in 3 months. Due to wide arrays of domestic uncertainties in
India, importer was worried about the appreciation of USD
against INR. However, a 3 M forward contract is now available
in premium at INR 70/USD against current INR spot rate 68
INR/USD. The importer expects that USD to move further.
a. Evaluate the importer position if he has hedged with the 3
M forward and at the date of maturity if the spot rate appears
to INR 65/ $ and (ii) INR 75/ $.
b. Compare his unhedged realization of the Grover Vineyards in
the aforesaid scenarios.

23
 Hedged realisation Unhedged realisation
Scenario I $ 1,00,000 * INR 70/ $ = $ 1,00,000 * INR 65/ $ = INR
INR 70,00000 65,00000
Scenario II $ 1,00,000 * INR 70/ $ = $ 1,00,000 * INR 75/ $ = INR
INR 70,00000 75,00,000
 Hedging payables with FX Forward
Profit Forward price
Pay off long position

+ 10

+5 + INR 500000

0 Spot price
60 65 70 75 80 (INR/USD)
- INR 500000
-5

- 10

Loss
Payables

25
Hedging receivables and paybles with FX
Forward
Profit Pay off Long position
Forward price

+ 10

+5

0 Spot price
65 75 80 85 90 (INR/Euro)
-5

- 10

Loss
Pay off Short Position
 Forward Contract Payoff

• Long (short) in forward benefits when, the

underlying asset price has risen (fallen) on the date
of maturity.
• The payoff of a forward contract is given by:
– Forward contract long position payoff: ST – K
– Forward contract short position payoff: K – ST
• Where:
• K is the agreed-upon delivery price.
• ST is the spot price of the underlying asset at maturity.
Can you try the following Problem?
• An investor sells 20 million yen forward to a buyer at a
forward price of $0.0090 per yen. At expiration, the
spot price is $0.0083 per yen.
• What is the long position payoff?
• What is the short position payoff?
• Solution.

• (a) At the expiration date, the long position’s payoff is

(0.0083 – 0.009) * 20,000000=-$14,000
• (b) The short position’s payoff is $14000 that is a profit
of $14,000
 Cancellation of FX Forward
▪ What if the said receivable does not mature on due date?
• Exporter must have to honour the contract
• Since it doesn’t have required amount of EURO, it can comply the
forward contract requirement by two ways:
Way I Action Realisation
Scenario I Buy € 20,000 @ INR 75/ € from the spot market Pay INR15,00,000
Pay € 20,000 to the bank and receive INR 16,00,000 Receive INR 16,00,000
Net gain= 1,00,000
Scenario II Buy € 20,000 @ INR 85/ € from the spot market Pay INR17,00,000
Pay € 20,000 to the bank and receive INR 16,00,000 Receive INR 16,00,000
Net Loss= -1,00,000
Buy EURO from spot and settle the contract

Way 2 Action Realisation

Scenario I Under 3 M contract sell € 20,000 Under 1 M Receive 1600000
contract Buy € 20,000 @INR 82/€ Pay INR 1640000
Net Loss=- INR 40000
If exporter learns that receivable would not mature as scheduled, he can buy a near month
forward contract. For example 1 month Forward is available at INR 82 INR/EURO.

29
 Forward Premium
• Suppose on June 10, 2023, $1.6099/GBP is traded in
the spot market. On the same day the 3 Month
Forward price is $1.6004/GBP indicating that $ is
being sold at forward discount. Compute annualized
forward premium and discount %.

• Annualised forward premium or Discount

= [(F-S)/Spot]*n
= [(1.6004-1.6099)/1.6099]*4
= -0.0236=-2.36%

https://www.wsj.com/articles/companies-weigh-currency-hedging-strategies-amid-
coronavirus-market-turmoil-11584055544
 Cost of Forward Hedge & Forward Settlement

▪ Does hedgers bears the cost of forward hedge?

• Yes, though not directly but indirectly
• Cost of forward hedge is measured by premium or
discount
• Real Cost of Forward hedge= [ F-St]/S0

▪ What are the different methods of forward

settlement?

Settlement Settlement
by delivery by Cash

31
 Forward Delivery and Settlements

Forward Settlements

Cash Settlement Delivery Settlement

A deliverable forward contract

A Cash settled forward contract stipulates that the long will pay the
stipulates that the long and short agreed-upon price to the short,
to pay the net cash value of the who in turn will deliver the
position on the delivery date. underlying asset to the long, a
process called delivery
 Forward Delivery and Settlements
Suppose two parties agree to a forward contract to deliver a zero-
coupon bond at a price of Rs. 995 per Rs.1000 par. At the contract's
expiration, suppose the underlying zero-coupon bond is selling at a
price of Rs. 998 (Rs.992). Do the settlements?
Scenario 1
– Delivery settlement: Upon expiry the long should pay Rs.995 to seller and in turn
long receives a zero coupon bond delivery worth of Rs. 998 from the seller.
– Cash Settlement: Short simply pays Rs. 3.00 to the long and settle the contract.
• Scenario 2
– Delivery settlement: Upon expiry the long should pay Rs.995 to seller and in turn
long receives a zero coupon bond delivery worth of Rs. 993 from the seller.
– Cash Settlement: Short simply receives Rs. 3.00 from the long and settle the
contract.
 Case Discussion
• What is SV’s business and how is the state of
its business in 2002?
 Case Discussion
• What is the central dilemma the Jacques
Dupuis , President of VS facing with?
 Case Discussion
• What is the state of the tour and hospitality
Industry in Canada in 2021-2002?
 Case Discussion
• What are the major challenges in this
business?
 Case Discussion
• What is the central dilemma the Jacques
Dupuis , President of VS facing with?

• Whether to hedge the transaction risk that

arises by the contract for the hotel
accommodation denominated in USD and
requiring payment in 6 months.
 Case Discussion
• What are the alternatives available before the
President Dupuis?
– Do nothing
– Go ahead with forward hedge for 6 months
– Go ahead with money market hedge for 6 months
 Case Discussion
• What criteria needs to be considered to meet
VS obligation on October 1, 2002?

– What if CAD increases?

– What if CAD decreases?
– What if VS is unable to sale allof its hotel rooms?
 Case Discussion
• Analysis ( Alternative 1: Do Nothing)

– How will value of USD payable change under different

exchange rate scenarios?
US$ 60,000,000@ 0.6298 USD/CAD$= CAD$95,268,336
@ 0.6000 USD/CAD$= CAD 1,00,000,000
@ 0.6250 USD/CAD$ =CAD$ 96,000,000
@ 0.6500 USD/CAD$= CAD$ 92,307,692
@ 0.6750 USD/CAD$= CAD$ 88,888,888
 Case Discussion
• Analysis ( Alternative 2: Forward Hedge)

– How will value of USD payable change under different

exchange rate scenarios? The cost associate with forward
hedge will be:
US$ 60,000,000@ 0.6271 USD/CAD$= CAD$95,678,520
@ 0.6000 USD/CAD$= CAD$95,678,520
@ 0.6250 USD/CAD$ = CAD$95,678,520
@ 0.6500 USD/CAD$= CAD$95,678,520
@ 0.6750 USD/CAD$= CAD$95,678,520
 Case Discussion
• Analysis ( Alternative 2: Money Market Hedge)

– How will value of USD payable change under different

exchange rate scenarios? The cost associate with money
market hedge will be:
– Strategy to follow
• Step I: Borrow X amount of CAD @ 2.70% p.a. rate
• Step II: Covert CAD $ into US$ and invest @1.65%
p.a. rate
 Case Discussion
• Step I:
Determine number of US $ we need today to
have $60 million after 6 months:
• US$ 60,000,000/(1+1.65%/2)=US $ 59,509,050
• Step II: Determine number of CAD we should
Borrow?
• US $ 59,509,050/0.6298USD/CAD$= CAD$ 94,488,806
• Step III: Determine number of CAD we have to
pay to close CAD $ bank loan?
• CAD$ 94,488,806* (1+2.70%/2)= CAD$95,764,405.
 Hedging with NDF
Suppose an Australian exporter expecting to receive US $10,000 in 3 months
time. The spot price is 1.28A$/US$, where 3 M forward suggesting
depreciation of $ which is quoted at A$ 1.22./US $. Demonstrate the
settlement , if the exporter decides to hedge through NDF via onshore and off-
shore with the then spot rate 1.25A$ /US$ prevailing at the end of the forward
period(settlement rate).
Solution:
• No delivery settlement and only cash settlement is possible under hedging with NDF
• Settlement amount (in foreign currency) = [1- Forward rate/Settlement rate)*
notional principal
• Exporter’s receivable amount:
• Under off-shore forward: (1-(1.22/1.25))* US$10000= US$ 240
• Under onshore forward: [((1-1.22)/1.25)* US$10000]* A$ 1.25/US$= A$300

45
 NDF& Interest Rate parity
Fn= S0*[(1+rd)n/(1+rf)n]
Where Fn is forward rate, S0 is spot rate, rd and rf are risk free interest rates in
home country and foreign country.

Problem: Assume that a 12 month NDF rupee dollar contract is quoted at INR
66/US$ as against the spot rate of INR65/US$ with 5% $ interest rate in US.
Using Interest rate parity theory find out the what is the implied rupee interest
rate in India?
Solution:

46
 Limitations of Forward
▪ Fairness of Forward price
▪ Price information in Public Domain
▪ Cash Settlement and ease of Entry and exit
▪ Eliminating Counter party risk

21