Ch23 WOW

Foreign exchange forward market

An informal network of banks and brokers that lets customers enter forward contracts to buy or sell currency in the future at a currently agreed rate; flexible terms but exposes participants to counterparty risk.

Currency futures

Standardized exchange-traded contracts to buy or sell a specified amount of foreign currency at a future date; subject to daily marking-to-market and clearinghouse guarantees, eliminating counterparty risk.

Counterparty risk

The risk that a trading partner cannot make good on its obligations under a contract if prices move against it. Important in forward markets, largely eliminated in futures markets by clearinghouse guarantees.

Direct exchange rate quote

Number of domestic-currency units required to purchase one unit of the foreign currency (e.g., $1.35 per pound).

Indirect exchange rate quote

Number of foreign-currency units required to purchase one unit of the domestic currency (e.g., 111 yen per dollar).

Spot exchange rate

The exchange rate for immediate delivery of currency.

Interest rate parity (IRP)

The no-arbitrage relationship linking spot and forward exchange rates to the risk-free interest rates in two countries; if violated, traders can earn risk-free profits with zero net investment.

Covered interest arbitrage

Another name for interest rate parity; the strategy of borrowing in one currency, lending in another, and using a futures contract to lock in the future exchange rate, eliminating FX risk.

Why might a dollar sell at a forward discount

When the U.S. interest rate is higher than the foreign rate, parity requires more dollars per unit of foreign currency in the forward market — offsetting the higher U.S. interest rate.

Hedge ratio (general definition)

The number of hedging vehicles (e.g., futures contracts) needed to offset the risk of an unprotected position; the ratio of the position's sensitivity to the underlying source of risk to the contract's sensitivity to the same risk.

Why an exporter is exposed to FX risk

Foreign-currency revenues translate into fewer domestic dollars when the foreign currency depreciates, and competitive pressures may prevent the firm from raising foreign prices to offset the move.

Cross-hedging

Hedging an exposure with a futures contract written on a different (but related) asset; eliminates a large portion of risk but is not perfect because the two assets aren't perfectly correlated.

How to estimate hedge sensitivity from historical data

Regress historical profits (or asset values) on the underlying risk factor (e.g., the exchange rate); the regression slope gives the sensitivity that determines the hedge ratio.

Why naive hedging of FX revenues can fail

Selling forward only the expected foreign-currency revenue ignores that the amount of revenue itself depends on the exchange rate (through prices and competitive position).

Stock-index futures

Futures contracts whose payoff is tied to the value of a stock index at maturity; settled in cash rather than by physical delivery of the underlying stocks.

Cash settlement

Settlement method where the long position receives a cash amount equal to the underlying index value times a multiplier minus the futures price, avoiding the cost of physical delivery.

Multiplier (stock-index futures)

The dollar value scaling factor that converts each index point into a dollar amount per contract (e.g., $50 per index point for E-mini S&P 500).

Synthetic stock position

A combination of T-bills plus long index futures contracts that produces the same payoff as actually holding the underlying stock index.

Why use index futures instead of actual stocks

Much lower transaction costs; quick and cheap to establish, adjust, or unwind positions; useful for market timing without disturbing the underlying portfolio.

Market timer

An investor who tries to profit from broad market moves by shifting between stocks and safer assets; index futures are an attractive low-cost way to implement timing strategies.

Index arbitrage

Strategy that exploits divergences between the actual futures price and its theoretical parity value by simultaneously trading the futures and the underlying stock index.

Program trading

Coordinated electronic submission of buy or sell orders for entire portfolios of stocks at once; enables index arbitrage and other strategies that require quasi-simultaneous trading of many stocks.

How to hedge a stock portfolio with index futures

Short enough index futures contracts so that the dollar gain on the futures position exactly offsets the expected dollar loss on the portfolio for a given market move; the size depends on the portfolio's beta.

Beta (in hedging)

The sensitivity of a portfolio's return to broad market returns; determines how much exposure must be hedged with index futures to neutralize market risk.

Market-neutral bet

A strategy where a stock is purchased to capture its alpha (firm-specific return) while index futures hedge the market exposure, leaving the position with a net beta of zero.

Alpha

A stock's expected return in excess of what its market exposure (beta) would justify; a market-neutral position isolates alpha by hedging away market risk.

Why selling and rebuying a portfolio is costly

Trading costs and tax consequences (realization of capital gains) make in-and-out moves expensive; using index futures to hedge avoids disturbing the underlying portfolio.

Modified duration

A measure of a bond's price sensitivity to a small change in yield; multiplying modified duration by a yield change gives the percentage price change (with opposite sign).

Price value of a basis point (PVBP)

The dollar change in the value of a bond or portfolio for a one-basis-point change in yield; used to size interest-rate hedges.

Treasury bond futures

Futures contract that nominally calls for delivery of long-term Treasury bonds; widely used to hedge interest-rate risk on bond portfolios.

How to hedge a bond portfolio against rising rates

Take a short position in interest-rate futures sized so the futures' PVBP times the number of contracts equals the portfolio's PVBP; gains on the short futures offset bond losses when rates rise.

Why bond managers may prefer futures over selling bonds

Selling and rebuying bonds incurs trading costs and may trigger capital gains taxes; futures offer a fast, cheap, reversible hedge.

Why interest-rate hedges typically aren't perfect

Most hedges are cross-hedges: the hedge instrument (e.g., T-bond futures) reflects different yields than the bonds being hedged (e.g., corporate bonds), and yield spreads change unpredictably.

Swap

A multi-period extension of a forward contract; an agreement to exchange streams of cash flows on multiple future dates.

Interest rate swap

An agreement to exchange a stream of fixed-rate interest payments for a stream of floating-rate payments on a given notional principal.

Foreign exchange (currency) swap

An agreement to exchange a stream of payments in one currency for a stream of payments in another currency over multiple future dates.

Notional principal

The reference amount used to scale interest payments in a swap. Not exchanged in interest rate swaps (it cancels), but IS exchanged at maturity in currency swaps.

Why use an interest rate swap

To quickly, cheaply, and anonymously restructure a balance sheet — for example, converting fixed-rate debt into synthetic floating-rate debt without selling the underlying bonds.

Synthetic floating-rate portfolio

Created by holding a fixed-rate bond and entering a swap to pay fixed and receive floating; net income then behaves like a floating-rate asset.

Synthetic fixed-rate debt

Created by issuing floating-rate debt and entering a swap to receive floating and pay fixed; net obligation then behaves like fixed-rate debt.

Pay-fixed-receive-floating swap

A swap where you pay a fixed rate and receive a floating rate; useful when you want to convert fixed-rate debt or income into a synthetic floating-rate position.

Pay-floating-receive-fixed swap

A swap where you pay a floating rate and receive a fixed rate; useful when you want to convert floating-rate debt or income into a synthetic fixed-rate position.

Swap dealer

A financial intermediary (typically a bank) that takes the opposite side of swaps and matches counterparties wanting opposite positions; earns a bid-ask spread.

How does a swap dealer make money

By charging a small bid-ask spread on the fixed rate (e.g., paying 6.95% to one party while receiving 7.05% from another); the dealer's net interest-rate exposure is zero.

Why is a swap's NPV zero at inception

Like a forward contract, a swap is simply an agreement to exchange cash on terms both parties accept today; neither side starts with a positive value.

LIBOR

The London Interbank Offer Rate; historically the most common short-term reference rate for swaps, now being phased out.

SOFR

The Secured Overnight Financing Rate; the U.S. benchmark short-term rate replacing LIBOR in dollar-denominated interest rate swaps.

Eurodollar futures

Exchange-traded contract that functions as a one-period interest rate swap on the 3-month LIBOR rate; one of the most heavily traded futures contracts.

Eurodollar futures quoting convention

The quoted 'futures price' equals 100 minus the contract interest rate, so traders effectively negotiate over the interest rate itself.

Why dealers use long-dated Eurodollar futures

To hedge the interest-rate exposure of their long-term swap books.

Swap pricing principle

A swap can be interpreted as simultaneously issuing one bond and buying another; the fair fixed swap rate equals the coupon on a par-value fixed-rate bond of matching maturity.

Currency swap pricing

Equivalent to issuing a par-value bond in one currency and buying a par-value bond in another at the current spot exchange rate.

Why notional principal isn't exchanged in interest rate swaps

Both parties owe the same principal in the same currency, so it cancels out; only the net interest payments are exchanged.

Why principal IS exchanged in currency swaps

Principals are in different currencies and don't cancel; the final exchange of principal at maturity is meaningful and exposes parties to FX movements.

Why a fixed-income manager might prefer swaps over selling bonds

Selling bonds incurs trading costs and may trigger capital gains taxes; swaps allow rapid, anonymous, low-cost restructuring without disturbing the underlying portfolio.

Why a bank might use an interest rate swap

A bank paying floating rates to depositors but lending at fixed rates can swap to receive floating and pay fixed, matching its assets and liabilities and removing interest-rate risk.

Why a corporation might use a currency swap

To raise debt where it gets the best credit terms (often its home market) but convert the obligation into a currency that matches its operating cash flows.

Credit risk in swaps vs. notional principal

Credit risk is far smaller than notional principal because if a counterparty defaults, both sides' obligations disappear; the loss is only the net present value of the remaining payment difference.

Credit default swap (CDS)

A contract in which one party pays a periodic fee and the other agrees to compensate them if a specified credit event occurs at a reference firm; functions like insurance on credit risk.

CDS physical settlement

Upon a credit event, the swap seller pays par value and takes delivery of the defaulted bond from the swap buyer.

CDS cash settlement

Upon a credit event, the swap seller pays the buyer the difference between par value and market value of the defaulted bond.

How a CDS differs from an interest rate swap

A CDS doesn't involve periodic netting of two rates; payment is contingent on a discrete credit event, making it function more like an insurance policy than a true swap.

Why CDS can be used for speculation

Unlike conventional insurance, you can buy a CDS on a bond you don't actually own, allowing pure bets on a reference firm's credit deterioration.

Carrying costs (commodities)

Costs associated with holding a physical commodity over time, including storage, insurance, and an allowance for spoilage; in addition to financing/interest costs.

Convenience yield

The non-monetary benefit of physically holding a commodity in inventory — for example, protection against stockouts that could disrupt production or sales.

Net carrying cost

Carrying cost minus convenience yield; the relevant 'cost' for commodity futures pricing because the convenience benefit partially offsets storage costs.

Spot-futures parity for commodities

Holds when a commodity can be bought and stored; treats net carrying cost as a 'negative dividend' analog to the stock-futures parity relationship.

Why parity may not hold for some commodities

It assumes the commodity can and will be bought and stored; commodities that are non-storable (like electricity) or uneconomic to store across harvests (like agricultural goods) violate the assumption.

Non-storable commodity

A commodity that cannot be physically held in inventory, such as electricity; futures pricing must rely on expected-spot/discounted-cash-flow analysis instead of arbitrage.

Why agricultural commodities aren't stored across harvests

Prices typically fall after each harvest, so storing across harvest cycles incurs interest and storage costs without offsetting price gains; better to wait and buy after the next harvest.

Discounted cash flow (DCF) approach to commodity futures

When storage isn't feasible, the futures price is set so that the present value of the futures payment equals the present value of the expected spot price at maturity, discounted at a risk-adjusted rate.

Required return on a commodity

Estimated using a risk-return model such as the CAPM, with the commodity's beta substituted for a stock's beta; used as the discount rate in DCF-based futures pricing.

Consistency between DCF and parity

For a stock paying no dividends, the DCF approach reduces to the standard spot-futures parity relationship — confirming the two frameworks describe the same underlying logic.

Seasonal price pattern (agricultural commodities)

Typical pattern of steep price drops at each harvest followed by gradual rises until the next harvest; financial assets do not exhibit this pattern.

Why a higher commodity beta lowers the futures price

A higher beta raises the required rate of return, which lowers the present value of the expected spot payoff; to keep the parity relationship intact, the equilibrium futures price must fall.