Forwards and Futures

A forward contract represents the obligation to buy (sell) a security or commodity at a prespecified price, known as the forward price, at some future date. Forward contracts are inherent in many business contracts and have been in existence for hundreds of years. Exhibit 7.1 illustrates the exchange that takes place at the maturity date, or settlement date, of the forward contract. At maturity, the person or firm with the long position pays the forward price to the person with the short position, who in turn delivers the asset underlying the forward contract. Futures contracts are a special type of forward contract that trade on organized exchanges known as futures markets.

Exhibits 7.2 and 7.3 introduce foreign exchange forwards and futures. The "Currency Trading" listing in The Wall Street Journal (see Exhibit 7.2) shows 1-, 3-, and 6-month forward currency rates for exchanging dollars for British pounds, Canadian dollars, French francs, German marks, Japanese yen, and Swiss francs. The rates are

2An investment bank will often serve as an over-the-counter market maker in the derivative it creates, standing ready to buy the derivative at a bid price and sell it at an ask price.

3The valuation of options, one of the most popular derivatives, is covered in depth in Chapter 8, which also touches briefly on forward prices for some complex assets such as bonds, commodities, and foreign exchange.

Exhibit 7.1 The Exchange of an Asset for Cash in a Forward Contract at Maturity

Long position in forward contract

Cash (forward price)

Underlying asset

Short position in forward contract

Exhibit 7.2 Currency Trading

CURRENCY TRADING

Tuesday, October 24. 2000

EXCHANGE RATES

The New York foreign exchange mid-range rates hefow apply to trading among banks in amounts ot $ 1 million and more, as quoted at 4 p.m. Eastern time by Reuters and other sources.- Retail transactions provide fewer units of foreign currency per dollar. Rates for the 1 i Euro currency countries are derived from the latest dolfar-euro rale using the exchange ratios set 1/1/99.

U.S. S EQÜIU. CURRENCY PER U.S. $

COUNTRY

Tue

Mon

Tue

Mon

ArgeoUna (Peso)

1-0002

1,0002

.0938

.9998

Australia (Dollar)

.5258

,5263

1.9020

1.9002

Austria (Schilling)

.06081

■ .06072

16.445

16.469

Bahrain (Dinars

2.6525

2.6525

.3770

.3770

Seigium (Franc)

.0207

.0207

48.2102

48.2705

BrfflH (Rial)

.5238

.5280

1,9090

1.8940

Britain (Pound)

1.4501

1.4515

,6896

.8889

1-month forward

1.4509

1.4523

,6892

.8886

3-months forward

1.4526

1.4540

. ,6864

.6878

6-months forward

f.4545

' 1.4557

6875

.6870

Canada (Dollar)

.6607

.6623

1,5135

1.5100

1-montti forward

.6612

.6627

,1,5125

1.5089

,'i mil s forward

6622

.6637

1.5102

1.5066

6-months forward

-6635

.6640

1.5072

1 5039

Chile (Peso)

.001745

.001744

573,15

573.25

China (Renminbi)

.1208

.1208

8.2784

8.2784

Colombia (Peso)

-0004033

,0004645

2158.56

2153.00

Czech. Rep. (Koruna)

Commercial rate

.02396

•C2401

■41-739

41 655

Denmark (Krone)

.1124

,1123

8.8931

8.9075

Ecuador (US Dcllar)-e...

1.0000

1 CODO

1.0000

1-oooa

Finland (Markka)

.1*7

„1405

7.1057

7.1159

France (Franc)

.1276

.12/4

7.8393

7.8506

1 -month forward,

. .1277

.1276

■ 7.8279

7.8388

3-moMhs forward

.1281

.1279

7 8076

7.8191

6-nwntiis toward

■ .1285

.1283

7.7815

7 7938

Germany (Mark)

4278

.4272

2.3374

2.3408

1-month toward

.4284

.4279

2.3340

2.3372

3-months toward

.4206

.4289

2.3279

2.3314

6-months Inrward

.4310

.4303

2.3202

2.3238

Greece (Drachma)

.002465

.002460

405.74

406.48

Hong Kong (Dollar)

.1262

.1282

7.7989

7.7986

Hungary (Forint)

.0031B6

.003161

313.88

314.42

India (Rupee)

.02155

,02156

46410

46.390

Indonesia (fiupiab)

.0001125

.0001118

8917.50

8947.50

Ireland (Punt)

1.0625

1,0600

.9412

.9426

Israël (Shekel)

.2404

.2415

4.1600

4,1400

Italy (Lira)

.0004322

0004315

2314.04

2317.36

Italy (Lira)

. .0004322

.0004315

2314.04

2317.36

Japan (Yen)

. 009267

.009233 C09286

107.91

108.31

1-montii ferard

. .009319

107,31

107.89

3-months torward

, .000414

,009379

106,22

106.82

6-marrttis forward

■ .000557

.009520

104,64

105.04

Jordan (Dinar) ,...,

1.4035

1.4065

.7100

.7110

Kuwait (Dinar)

3.2446

3.2446

.3082

,3032

Lebanon (Pound)

.0006605

•0006605

1514.00

■ 1514.13

Malaysia (Rintgii)-b.

.2632

.2832

3,8000

3.8006'

Malta (Lira)

2.1556

2.1538

,4839

4643

Mexico (Peso)

Floating rate

.1042

1043

0,5970

9.5890

Netherland (Guilder)

.3797

.3792

2,6337

2.6374

New Zealand (Dollar)

.4030

,4007

2 4814

2.4956

Norway (Krone)

.1051

,1051

9-5155

9.5153

Pakistan (Rupee)

.01750

01750

57,150

57150

Peru (new Sol)

.2849

.2847

3.5103

3.5128

Philippines (Peso)

.02030

.02043

49.250

48.950

Poland (Zloty)-d..

.2145

.2125

46625

4.7050

Portugal (Escuds)

.004174

.004168

239,60

2.39.94

Russia (Ruble)'S

.03584

.03577

27.902

27.953

Saudi Arabia (Riff)

2666

.2666

3.7512

3,7513

Singapore (Dollar)

.5711

.57«)

1.7510

1.7543

SM Rap. (Kemna)

.01929

.01929

51.852

51.85s

South Africa (Rant)..-..

,1316

.1317

7.6000

7.5925

South Korea (Won)

.0008799

.0008768

1136.50

1140.50

Spain (Peseta) :

.005029

.005022

198-85.

199.13

Sweden (Krona)

.0089

.0985

101110

10.1495

Switzerland (Franc)

.5569

.5559

1,7957

1.7990

1-montb forward

.5585

.5575

1.7904

1.7936

3-months forward

.5614

.5603

1,7812

1.7846

6-montbs forward

.5655

,5645

1,7682

1.7716

Taiwan (Donar)

■ .03125

.03120

32000

32.050

Thailand (Bald)

,02298

.02276

43.525

43.945

Turkey (Lira)

.00000146

.00000146

684580.00

68461000

United Arab (Dlrham)

.2723

.2723

3.6730

36729

Uruguay (New Peso)

financial

.08046

.08074

12 425

12,385

Venezuela (Bolivar)

.001441

.001444 ■

693,75

692.75

SDR

1.2801

1.2791

.7812

.7816

Euro

,8368

.8356

1.1950

1.1967

Special Drawing Rights (SDR) are based on exchange rates for the U.S., German, British, French, and Japanese curren cies, Source: Internationai Monetary Fund. a-Russian Central Bank rate. b-Güvernment rate, d-Floating rate; trading band suspended on d/l !/90. r-Adopted ÍJ.5. «aliar as of 9/11/00. foreign Exchange rates are available from Readers' Reference Service (413) 592-3600

Source: Reprinted by permission of The Wall Street Journal, © 2000 by Dow Jones & Company. All Rights Reserved.

Exhibit 7.3 Futures Prices for Currency

CURRENCY

■ Lifetime Open Open High Low Settle Change High Low interest Japan Yen (CMEj-12.5 million yen: $ per yen (.00) Dec .9325 9352 .93B .3350 + .0023 1.0434 9225 66.897 IMt .9488 .9495 .9460 : 9493 + .0023 1.0300 9380 228

Est ml 7,516; vol Mon 10,100; open int 67,229. -244. Deutschemark (CMEj-125.000 marks; $ per mark

Est vol 0: vol Hun t; open int 49!, +1. Canadian Dollar (CME)-100,000 dlrs.; $ per Can $ Dec .6635 .6636 .6612 .6616 - .0017 . 7025 Mr01 6640 .6642 .6630 .6634 - .0017 . 7040 June .6654 ,6654 .6650 . 6647 - .0017 6990 Sep! .6663 .6663 .6663 6660 - .0017 6906

Est vol 5,722: m! Mon 7,095; open int 82.431. -2,791 British Pound {CME)-62.5Q0 pds.: $ per pound Dec 1.4534 1,4576 14486 1.4514 - .0028 1.5500 1,3970 3 0 917 MrOI 1.4550 1.4570 1.4500 1.4534 - ,0028 1.6950 14030 96 Est vol 3.015; vol Mon 2,665: open int 31,016. +121. Swiss Franc (CME)-125,000 francs; $ per franc Dec .5666 .5630 . 558! .5595 + 0005 6687 . 5581 49140 Est vol 3,932; mi Mon 4,231: open int 49,187, +358.

6570

78.001

6586

2,467

6600

1,289

6630

463

5645

27t

Australian Dollar (CMEJ-100,000 dlrs.; $ per A.$

Dec .5259 .5307 . 5248 ,5261 + .0005 .8704 .5155 22,770 Mr01 5262 .5306 . 5259 ,5266 + ,0006 ,6390 . 6168 1,447

open int 24,223, -375

Mexican Peso (CME^-500,000 new Max. peso, 5 per MP

dec .10235 .10285 .10210 Mi01

.10333 - 00125 .10495 ,10340

- 00125 .10320 09120 3,545

.09705 - 00125 .10060 ,19070 254

June

Esl vol 2.475; vol Mon 1,924; open int 13,537, +311. Euro FX (CME)Eura 125,000; $ par Euro

Dec -8375 ,8417 8367 .8391 + .0015 1.0! MrOI ,8410 -8435 .8395 8422 + -0015 . 9999 .8395

Sept

.8470

Est vol 6,350: vol Mon 7.598; open int 77,152, +243.

Source: Reprinted by permission of The Wall Street Journal, © 2000 by Dow Jones & Company. All Rights Reserved Worldwide.

similar to those provided in the futures market (see Exhibit 7.3). For example, the Japanese yen had a foreign exchange rate on Tuesday, October 24, 2000, at 4 p.m. New York time, of 107.91 yen to the U.S. dollar. However, the 6-month forward rate was 104.64 yen to the dollar. This means that one could have agreed at 4 p.m. that day to have exchanged a single U.S. dollar for 104.64 yen 6 month hence. Exhibit 7.3 contains data on comparable exchange rate futures. The futures exchange rate with the closest maturity, the March 2001 contract traded on the Chicago Mercantile Exchange, specifies 100 yen is exchangeable for .9493 U.S. dollars, which translates into one U.S. dollar being exchanged for 105.34 yen. The discrepancy between the two, 104.64 vs. 105.34, can be mostly attributed to differences in both the quote times and the maturities of the forward contract and the futures contract.

Markets for Forwards and Futures. The first organized futures trading market, the Chicago Board of Trade, dates back to the U.S. Civil War. Although the Board's early trading records were lost in the Great Chicago Fire of 1871, the earliest futures contracts were probably limited to agricultural commodities that were grown in the Midwest.

Today, futures and forward markets are also well known for the trading of contracts on financial securities, such as Treasury bonds, stock indexes, short-term interest rate instruments, and currencies. Because of their sheer size and the relevance of their prices to the actions of investors, the three most important financial futures markets are those that trade:

Chapter 7 Pricing Derivatives 219

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