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INTRODUCTION TO CORPORATE FINANCE Laurence Booth • W. Sean Cleary Prepared by Ken Hartviksen CHAPTER 11 Forwards, Futures, and Swaps Lecture Agenda • • • • • • Learning Objectives Important Terms Forward Contracts Futures Contracts Swaps Summary and Conclusions – Concept Review Questions CHAPTER 11 – Forwards, Futures and Swaps 11 - 3 Learning Objectives 1. 2. 3. 4. 5. The payoff associated with long and short positions in forward contracts How to price simple forward contracts and how interest rate parity is a variation of the forward pricing relationship The nature of futures contracts, and why they can be viewed as the public market version of forward contracts The mechanics of a basic interest rate swap and a basic currency swap The evolution of swap markets and how swaps can be used to lower borrowing costs and to hedge interest rate or foreign currency exposures CHAPTER 11 – Forwards, Futures and Swaps 11 - 4 Important Chapter Terms • • • • • • • • • • Basis risk Clearing corporation Commodity Comparative advantage Convenience yield Cost of carry Counterparties Covering Credit risk Currency swap • • • • • • • • Daily resettlement Forward interest rate Forward contract Forward rate agreement Futures contract Hedging Initial margin Interest rate swap CHAPTER 11 – Forwards, Futures and Swaps 11 - 5 Important Chapter Terms… • London Inter-Bank Offered Rate (LIBOR) • Long • Maintenance margin • Margin • Margin call • Naked position • Net payments • Notional amount • Offsetting • Open interest • Plain vanilla interest rate swap • Settlement price • Short • Speculate • Spot contract • Storage costs • Swap • Total return swap • Underlying assets CHAPTER 11 – Forwards, Futures and Swaps 11 - 6 Derivative Securities Defined • • Derivative securities have price behaviours that are derived from some other underlying asset. There are two basic types of derivative securities: 1. Forwards, futures, and swaps (linear payoff derivative contracts) 2. Options (non-linear payoff derivative contracts) CHAPTER 11 – Forwards, Futures and Swaps 11 - 7 Derivative Securities Relevance to Corporate Finance • • Derivative securities offer corporations the tools to manage pre-defined risks and/or capitalize on comparative advantage. Risks that can be mitigated through derivatives include: – – – Foreign exchange risk Credit risk Interest rate risk NOTE: because it costs the firm money to engage in derivative positions, the costs of these practices can be thought of as ‘insurance premiums’ the firm is willing to pay to reduce it’s overall exposure. (ie. To hedge) CHAPTER 11 – Forwards, Futures and Swaps 11 - 8 Forward versus Spot Contracts Basic Characteristics • A spot contract is a price that is established today for immediate delivery. – Immediate delivery depends on the nature of the underlying contract. • A forward contract is a price that is established today for future delivery. – Can be specified for almost any future date because forward contracts are custom contracts between two parties. (Table 11 – 1 illustrates foreign exchange quotes for spot and forward delivery) CHAPTER 11 – Forwards, Futures and Swaps 11 - 9 Forward Contracts Basic Characteristics Table 11-1 Foreign Exchange Quotes Foreign Exchange Rates (Canadian dollars per foreign currency) US ($) GB (£) JAP (¥) Euro (€) Spot 1.107 2.040 0.009721 1.3991 1 month 1.1063 2.0393 0.009754 1.4007 3 month 1.1044 2.0383 0.009821 1.4039 6 month 1.1017 2.0368 0.009920 1.4082 1 year 1.0971 2.0340 0.010116 1.4159 3 year 1.0697 n/a n/a n/a 5 year 1.0622 n/a n/a n/a 10 year 1.0312 n/a n/a n/a Source: Data from Bank of Montreal (BMO) Nesbitt Burns, Globe and Mail , June 10, 2006. CHAPTER 11 – Forwards, Futures and Swaps Reflects the importance of the US as a Canadian trading partner. (Remember, forward contracts occur between corporations and their Canadian banks.) Reflects the time value of money…forward rates the price TODAY for future delivery…so the further away, the lower the present value. 11 - 10 Forward Contracts Basic Characteristics • Are bank instruments: – There is no organized exchange (they are an OTC instrument) – Requires that the customer have a banking relationship. • Involves credit risk for the bank when investors suffer losses. • Banks will only sell forward contracts for legitimate business purposes. • Will only sell up to a company’s approved credit limit. • Consequently, forward contracts are used for hedging purposes by firms wishing to mitigate exposure to specific risks. – As customized instruments Forwards can be tailored to any specific date in the future and for any amount of money. – Contracts must be fulfilled. CHAPTER 11 – Forwards, Futures and Swaps 11 - 11 Using Forward Contracts • Like all derivative securities, forward contracts can be used theoretically to: – Hedge – mitigate or eliminate risk. – Speculate – make an educated guess about the future value of something in hopes of profiting from it. • Canadian banks, performing their transmission of Monetary Policy role, will only provide forward contracts for legitimate business purposes (hedging purposes) …so speculative purposes aren’t not supported. CHAPTER 11 – Forwards, Futures and Swaps 11 - 12 Using Forward Contracts Speculating • Speculation on a forward contract requires that the investor NOT own the underlying asset. – This is a ‘naked’ position – a position that leaves the investor exposed to changes in the value of the underlying asset. CHAPTER 11 – Forwards, Futures and Swaps 11 - 13 Using Forward Contracts Hedging • Hedging using a forward contract requires that the investor have an opposite exposure to the contract. – This is a ‘covered’ position. CHAPTER 11 – Forwards, Futures and Swaps 11 - 14 Using Forward Contracts Long and Short • Long investing is owning an asset in the hopes it will increase in value and the investor gains by its capital appreciation. – It is based on a bullish outlook (forecast increase) for the underlying asset. • Short investors owe something. – It is based on a bearish outlook (forecast price declines) for the underlying asset. CHAPTER 11 – Forwards, Futures and Swaps 11 - 15 Using Forward Contracts Example of a Naked Long Position in the U.S. Dollar • A U.S. company can speculate on the exchange rate between the Canadian and U.S. dollars: (Companies often do this to offset (mitigate) exchange rate risk it is exposed to as a normal course of its operations …for example, it expects to receive $1million Canadian in accounts receivable one year from now ). Initial Conditions – Canadian dollar is at par with U.S. – Both spot and 1-year forward rates are both at 1.0 (this implies a ratio of 1:1) Action – Canadian buys US $ 1.0 million forward • Obligates the investor to pay C$1million and receive U.S.$1million in one year. Exposure – Exposed to changes in the underlying asset US$ vis a vis the Canadian dollar • • Long U.S. dollars Short Canadian dollars Payoffs – U.S.$ rises against Canadian $ – investor gains (gains offset losses in dollars received from accounts receivable) – Canadian dollar rises against U.S.$ – investor looses (losses are offset by appreciated Canadian dollars in accounts receivable) (Payoffs from this position are illustrated in Figure 11-1) CHAPTER 11 – Forwards, Futures and Swaps 11 - 16 Forward Contracts Long Position in U.S. Dollars 11 - 1 FIGURE The payoff is linear. profit 45 degree angle. Passes through the forward rate F. F = 1.0 C$ 1.0 per US $ loss CHAPTER 11 – Forwards, Futures and Swaps If spot exchange rate in the future exceeds the forward rate by $0.01, then the speculator earns $0.01 profit for every Canadian dollar sold forward for U.S. dollars. 11 - 17 Forward Contracts Profit from a Long Forward Contract – The profit (loss) from the long position is U.S. dollars is equal to the difference between the future spot price (ST) and the forward price (rate) F times the number of contracts entered into (n): [11-1] Profit (loss) from long position [ ST - F] n CHAPTER 11 – Forwards, Futures and Swaps 11 - 18 Using Forward Contracts A Naked Short Position in the U.S. Dollar • A naked short position in the U.S. dollar is the opposite of the firm’s long position in U.S. dollars. • The company needs to sell U.S. dollars forward for Canadian dollars. (Payoffs from this position are illustrated in Figure 11-2) CHAPTER 11 – Forwards, Futures and Swaps 11 - 19 Forward Contracts Short Position in U.S. Dollars 11 – 2 FIGURE The payoff from a naked sale of U.S. forward. profit F = 1.0 C$ 1.0 per US $ loss [11-2] Profit (loss) from short position [ F ST ] n CHAPTER 11 – Forwards, Futures and Swaps If U.S. $1 million is sold forward for C$1.0 million, and the Canadian dollar depreciates to C$1.20 then the forward contract loses money. The profit (loss) of the short position is identically opposite of the long position. 11 - 20 Forward Contracts Hedging • Hedging is reducing the risk of adverse price movement by taking an offsetting position in a derivative to eliminate exposure to an underlying price. CHAPTER 11 – Forwards, Futures and Swaps 11 - 21 Forward Contracts Long and Short Forward Positions in U.S. Dollars • As mentioned previously, Canadian banks will not negotiate forward contracts for speculative purposes. • So inherently, companies take ‘covered’ positions (not naked ones) where they already have a given exposure, and they wish to hedge (mitigate the risk in that exposure) • Figure 11 – 3 illustrates a the combined position of a firm with a long US$ exposure of US $1million that buys a forward contract to sell U.S. dollars forward for Canadian dollars. • The combined position is simply the sum…so the payoffs are offsetting and the firm is insulated for foreign exchange risk. CHAPTER 11 – Forwards, Futures and Swaps 11 - 22 Forward Contracts Long and Short Forward Positions in U.S. Dollars 11 - 3 FIGURE profit Long Exposure C$ 1.0 per US $ F = 1.0 Short Exposure loss CHAPTER 11 – Forwards, Futures and Swaps The firm is long in the Offsetting underlying long and asset, short so a short forward exposures contract insulate the gives this net firm for position. foreign exchange Long US $ risk duringis exposure the whatlife of the contract. Canadian exporters face. 11 - 23 Forward Contracts Exposures of the Bank Making the Market for Forward Contracts • • • • Forward foreign exchange market is a bank market. The bank sells forward contracts to its customers to allow them to manage their foreign exchange exposure. The banks are not buying and selling foreign exchange for speculative purposes. If the bank finds, however, that its has sold too many US $ forward contracts so that it has now become exposed, it can: – – Enter the inter-bank market to offset its exposure by trading with other banks, or Synthetically create forward foreign exchange contracts using the Interest rate parity (IRP) condition. CHAPTER 11 – Forwards, Futures and Swaps 11 - 24 Forward Contracts Interest Rate Parity (IRP) Revisited • Equation 11 – 3 shows that the ratio of the forward to the spot rate must equal the ratio of one plus the interest rate in both markets. CHAPTER 11 – Forwards, Futures and Swaps 11 - 25 Interest Rate Parity (IRP) IRP Condition • Equation 11 – 3 shows that the ratio of the forward to the spot rate must equal the ratio of one plus the interest rate in both markets. [11-3] • F (1 k domestic ) S (1 k foreign ) This equation can be rearranged to solve for the forward rate (F ): CHAPTER 11 – Forwards, Futures and Swaps 11 - 26 Interest Rate Parity (IRP) Using Forward Contracts • The forward rate is the ratio of one plus the interest rate in both markets times the spot rate. [11-4] • • (1 k domestic ) F S (1 k foreign ) The current spot rate S is observable The two inflation rates can be estimated using each country’s statistical reports. CHAPTER 11 – Forwards, Futures and Swaps 11 - 27 Pricing Forward Contracts Interest Rate Parity Condition – IRP is a special case for pricing forward contracts. – The general condition is that investors can create a forward position in a storable commodity by buying it spot and holding it for future delivery. CHAPTER 11 – Forwards, Futures and Swaps 11 - 28 Pricing Forward Contracts The General Condition – Storable Commodity Pricing Model – – – The general condition is that investors can create a forward position in a storable commodity by buying it spot and holding it for future delivery. The only difference between the spot price (S) and forward (F) should be the costs of carry (interest costs on financing the purchase and storage costs). Important terms: • • • • Commodity – something traded based solely on price, because it is undifferentiated and can be traded without requiring physical examination. Storage costs – the price charged for holding a commodity for future delivery Convenience yield – the benefit or premium derived from holding the asset rather than holding a derivative. Cost of carry – the total cost of buying a commodity spot and then carrying it or effecting physical delivery when the forward contract expires (this includes both storage costs and financing costs) CHAPTER 11 – Forwards, Futures and Swaps 11 - 29 Pricing Forward Contracts Commodity Pricing Model – The Commodity Pricing Model is equation 11 – 5 and shows that the cost of carry links the Forward and Spot prices: [11-5] F (1 c) S Where: c = the cost of carry, as percentage of S, over the period in question. S = spot price F = forward price CHAPTER 11 – Forwards, Futures and Swaps 11 - 30 Futures Contracts The Mechanics of Futures Contracts • Futures contracts are a standardized exchange-traded contract in which the seller agrees to deliver a commodity to the buyer at some point in the future. • Organized futures exchanges with standardized futures contracts: – Reduce credit risk through: • Clearing corporation being the counterparty in all transactions • margin requirements (both initial and maintenance margins) and • daily mark-to-market daily resettlement. – Allow the contract features and volumes to be reported – Allow the futures positions to be liquid (executing offsetting transaction to cancel the futures position) increasing the flexibility in their use. CHAPTER 11 – Forwards, Futures and Swaps 11 - 31 Futures Contracts Futures Contracts Markets • The term of the contract is set by individual exchanges. • Delivery months are – – – – • • • • Standardized underlying asset so that even if delivery rarely takes place, people know what they are getting. The exchange sets how much of the asset is traded in each contract. (ie. The notional amount) For financial futures, most exchanges follow the lead of the major markets in Chicago: – – • March June September December Chicago Board of Trade (CBOT) Chicago Mercantile Exchange (CME) Commodity futures trading in Canada is concentrated on the Winnipeg Commodity Exchange (WCE) Financial futures trading is concentrated since 2000 on the Montreal Exchange (ME) in Canada. CHAPTER 11 – Forwards, Futures and Swaps 11 - 32 Futures Contracts Futures Exchanges • • • Formal exchanges develop the market in futures contracts. There is significant competition across exchanges, however, some are separated by different time zones. Competition is a source of innovation: – New types of contracts are developed – As interest declines or needs change, some die out. • Interest in Financial futures has grown dramatically as companies learn to hedge their risk exposures through these instruments. CHAPTER 11 – Forwards, Futures and Swaps 11 - 33 Futures Contracts Types of Futures • Commodity futures include: – – – • Financial futures – • Traditional agricultural products such as corn, wheat, hogs, etc. Energy products Base metals S&P index / BAs/Canada bonds/S&P TSX 60 index Other – – – Weather derivatives Futures contracts on real estate Futures contracts on the consumer price index (CPI) (See Table 11 – 2 for a useful summary) CHAPTER 11 – Forwards, Futures and Swaps 11 - 34 Futures Contracts and Markets Basic Characteristics Table 11- 2 Futures Contracts and Markets Exchange Underyling Asset Commodities Wheat/oats/soybeans Cattle/pigs/lumber Crude oil/heating oil/natural gas Cotton/orange juice Gold/silver/copper Lead/nickel/tin Canola/western barley/wheat Financial Futures Treasury notes and bonds/DJIA S&P index/Nikkei225 / C$ / € / £ BAs/Canada bonds/TSX/S&P 60 index German bonds/European equities Chicago Board of Trade (CBOT) Chicago Mercantile Exch. (CME) New York Merchantile Exchange NY Cotton Exchange The Commodity Exchange (Comex) London Metal Exchange (LME) Winnipeg Commodity Exchange CBOT CME Montreal Exchange Euronext/Liffe Other Weather derivatives CHAPTER 11 – Forwards, Futures and Swaps CME 11 - 35 Futures Contracts Marked to Market Process The Marked to market process helps to limit exposure to credit risk for the exchange. – All futures contracts are marked to market each day. – All profits and losses on a futures contract are credited to investors’ accounts every day to calculate their equity position. • • If the equity position increases, these profits can be withdrawn. When the equity position drops below the maintenance margin (usually 75% of the initial margin) the investor will receive a margin call and be forced to contribute more money to increase the equity position. CHAPTER 11 – Forwards, Futures and Swaps 11 - 36 Trading/Hedging with Futures Contracts Example of a Bond Portfolio Manager • • • A fixed-income portfolio manager holds a diversified portfolio of bonds that are predominantly Canadas. The manager believes interest rates will rise, causing the each bond price to fall. The manager can: 1. Sell bonds and hold cash till the threat of rising interest rates pass, or until the change in rates has occurred, and then repurchase the bonds 2. Sell long term bonds and replace with shorter term bonds (reducing the portfolio duration and thereby limiting the losses if interest rates rise) 3. Hold the portfolio and use a short hedge (short position in a futures contract in government bonds) …the losses in the portfolio will be offset by gains on the short hedge. – – The third alternative is often the best one, because buying and selling bonds will incur transactions costs and upset the structure of the portfolio. If the hedge cannot be perfectly constructed the portfolio will be exposed to basis risk because losses on the long portfolio may not be exactly offset by the short future position. CHAPTER 11 – Forwards, Futures and Swaps 11 - 37 Futures Contracts and Markets Summary of Forward and Future Contracts • Forward and Future Contracts serve the same purpose. • Forward contracts offer more flexibility because they are customized OTC contracts. • Forward contracts, however, face additional risks: – Not actively traded (created by a bank for customers) – Possess credit risk Differences are listed in Table 11 – 3 on the following slide. CHAPTER 11 – Forwards, Futures and Swaps 11 - 38 Forwards versus Futures Table 11- 3 Forwards versus Futures Forwards Futures Contracts Customized Standardized Trading Dealer or OTC markets Exchanges Default (credit risk) Important Unimportant - guaranteed by clearinghouse Initial deposit Not required Initial margin and maintenance margin required Settlement On maturity date Marked to market daily CHAPTER 11 – Forwards, Futures and Swaps 11 - 39 Swaps Defined • Is an agreement between two parties, called counterparties, to exchange cash flows in the future. – No formal exchange to guarantee performance, so the arrangement involves a dealer or OTC market and there is credit risk. – Have evolved into a bank instrument, with banks or swap dealers serving as intermediaries. CHAPTER 11 – Forwards, Futures and Swaps 11 - 40 Swaps Interest Rate Swaps • An interest rate swap is: – An exchange of interest payments on a principal amount in which borrowers switch loan rates. – Often this involves one counterparty trading fixed loan payments for variable rate loan payments. • A plain vanilla interest rate swap is: – The fixed for floating interest rate swap denominated in one currency. • Table 11 – 4 illustrates a plain vanilla interest rate swap between counterparties A and B and is structured to benefit both parties equally. This is rarely the case. CHAPTER 11 – Forwards, Futures and Swaps 11 - 41 Swaps Example of an Interest Rate Swap Table 11- 4 An Interest Rate Swap Quotes A B (AAA) (BBB) Floating LIBOR + 0.25 LIBOR + 0.75 Fixed 10.8 12.0 Initial Floating Fixed Swap - (LIBOR + 0.75) -10.8 B pays A fixed and A pays B floating +10.9 - 10.9 - LIBOR + LIBOR Net - (LIBOR - 0.10) - 11.65 Saving 0.35% 0.35% CHAPTER 11 – Forwards, Futures and Swaps 11 - 42 Swaps Comparative Advantage • Comparative advantage is: – A benefit that one firm has relative to another. – Any firm offered a good deal in floating rate funds but doesn’t need them should borrow them anyway and use a swap to exchange it for what is needed and lock in the financing advantage. CHAPTER 11 – Forwards, Futures and Swaps 11 - 43 Swap Arrangements Challenge and Response • In swap arrangements, counterparties are often ‘unequal’ partners to the contract. – One counterparty may be AAA rated…the other BBB • There is credit risk and it is borne by the higher rated counterparty. – AAA may have to honour its own and the other interest obligations if BBB defaults. • Strategies to control credit risk include: – Set-off rights in the swap agreement allowing the other party to stop making payments if the other party defaults – Net payments – instead of exchanging total interest amounts, only the difference between the two streams are exchanged and structuring the payments into sub-periods (every six months) (Table 11 – 5 illustrates a Net Payments swap structure over time) CHAPTER 11 – Forwards, Futures and Swaps 11 - 44 Interest Rate Swaps Table 11- 5 Interest Rate Swap Net Payments Floating Pay Fixed Pay (%) (%) Period LIBOR (%) 1 8.0 -4.00 +5.45 + 1.45 2 9.0 -4.50 +5.45 + 0.95 3 9.80 -4.90 +5.45 + 0.55 4 11.00 -5.50 +5.45 - 0.05 5 12.00 -6.00 +5.45 - 0.55 CHAPTER 11 – Forwards, Futures and Swaps Net Pay (%) 11 - 45 The Evolution of Swap Markets Currency Swaps • Currency swaps require exchange of all cash flows. • Currency swaps permit the firms to adjust their foreign exchange exposure. – This means that there is increased credit risk…but it presents opportunities. • The first swap was a currency swap between IBM and the World Bank. – This swap was motivated by comparative advantage – It was a primary market transaction – both IBM and the World Bank used it to raise new capital cheaply. – Once swaps became standardized, it became possible to constantly change the nature of the institution’s liability stream. • Today currency swaps have become a bank market through their links to the forward foreign exchange market. – The bank is capable of executing a secondary market transaction with itself as the counterparty because a currency swap can be though of as a series of forward transactions. CHAPTER 11 – Forwards, Futures and Swaps 11 - 46 The Evolution of Swap Markets Swap Rate • Standardization has helped to grow the swap market. • Interest rate swaps have also become a bank market through standardization. – Floating rates are fixed against LIBOR – Fixed rates are fixed against the government bond rate • The choice of rate depends on whether it is a five year, 10 year or other maturity contract. • This becomes the swap rate. • The swap rate is the rate of the fixed portion of a swap which is used for quoting swaps. Table 11 – 6 revisits the previous interest rate swap assuming a swap rate of 10.65% CHAPTER 11 – Forwards, Futures and Swaps 11 - 47 Percent Interest Rate Swap The Swap Rate Table 11- 6 Percent Interest Rate Swap Quotes A B (AAA) (BBB) Floating LIBOR + 0.25 LIBOR + 0.75 Fixed 10.8 12.0 Initial - (LIBOR + 0.75) Floating Fixed Swap -10.8 The Swap rate B pays A fixed and A pays B floating +10.65 - 10.65 - LIBOR + LIBOR Net - (LIBOR - 0.15) - 11.40 Saving 0.10% 0.60% CHAPTER 11 – Forwards, Futures and Swaps 11 - 48 Integration of the Swap and Forward Markets – Interest rate swaps are found around the world. – Table 11 – 7 gives swap rates for the euro, U.S. dollar and the pound sterling for June 7, 2006. – Swap rates follow the full spectrum of the yield curve from 1 year to 30 years. • • This allows swaps to manage interest rate exposure. It also links swaps to forward rate agreements (FRAs) – A FRA is an agreement that uses forward rates to manage a firm’s exposure to interest rate risk; agreements to borrow or lend at a specified future date at an interest rate that is fixed today. CHAPTER 11 – Forwards, Futures and Swaps 11 - 49 Interest Rate Swap Quotes Table 11-7 Interest Rate Swap Quotes Euro (€) Current US ($) Current UK (£) Current 1 year 3.41% 5.41% 4.95% 2 year 3.61% 5.38% 5.30% 3 year 3.73% 5.38% 5.08% 5 year 3.87% 5.43% 5.09% 7 year 4.00% 5.50% 5.07% 10 year 4.16% 5.57% 5.00% 12 year 4.24% 5.61% 4.96% 15 year 4.34% 5.66% 4.90% 20 year 4.44% 5.70% 4.80% 25 year 4.48% 5.71% 4.70% 30 year 4.49% 5.71% 4.62% Fixed Rate Source: Data from CLP Structured Finance, June 7, 2006. CHAPTER 11 – Forwards, Futures and Swaps 11 - 50 Swaps Evolution of Swap Markets – Integration of swap markets with the forward market has fueled expansion of the market – Firms wanting to change a floating rate liability into a fixed rate liability simply calls their bank and executes the interest rate swap as a secondary market transaction executed against a line of credit. – Creating swaps is a key component of the services provided by major banks for their corporate clients. CHAPTER 11 – Forwards, Futures and Swaps 11 - 51 Swaps Recent Developments • The focus of the text is on major vehicles used to manage interest and currency exposure: – – • Interest rate swaps Currency swaps Other swap opportunities exist and evolve including the total return swap especially between private sector counterparties: – The more specialized the swap: • • – • The less tradable it is The greater the counterparty risk Only standardized swaps are done with banks. An Example is the Total Return Swap. CHAPTER 11 – Forwards, Futures and Swaps 11 - 52 Recent Developments in Swaps Total Return Swap Total return swap is an exchange of an interest rate return for the total return on for the total return on an equity index plus or minus a spread. CHAPTER 11 – Forwards, Futures and Swaps 11 - 53 Summary and Conclusions In this chapter you have learned: – How to diagnose long and short positions in foreign currency and how these positions can be hedged by using forward foreign currency contracts. – How interest rate parity can be used to derive forward interest rates and how banks could create synthetic securities – Future contracts can be viewed as the public version of forward contracts. – How swap markets operate and can be used to hedge interest rate or foreign currency exposures. CHAPTER 11 – Forwards, Futures and Swaps 11 - 54 Internet Links • Bank of Canada Website: www.bankofcanada.ca • Financial Engineering News Website: www.fenews.com • Department of Finance Canada Website: www.fin.gc.ca CHAPTER 11 – Forwards, Futures and Swaps 11 - 55 Copyright Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein. CHAPTER 11 – Forwards, Futures and Swaps 11 - 56