Controlling Currency Exposure

Currency Swaps

Currency swaps allow investors to hedge against or profit from fluctuations in foreign currency prices. These swaps involve the exchange of different currencies associated with specific interest rates. Additionally, the notional principal amounts in a currency swap can be traded either at the beginning or at the termination of the swap contract.

Start With the Big Picture

Candidates preparing for the CFA exam should initially focus on understanding the exposure a swap provides. Determining whether the swap position would enhance or lower the portfolio’s gains is essential. This understanding of the directional exposure is a significant milestone, enabling candidates to assess the potential impact of market movements on the portfolio based on the swap position. The next step involves refining the analysis by applying relevant periodic conventions and time value of money techniques. While these adjustments are essential, they should be built upon the foundation of comprehending the positive or negative position taken in the swap.

Currency Forwards and Futures

Currency forwards and futures serve as tools for managing currency risk. They involve buying or selling a specific amount of foreign currency at a predetermined future time and price to hedge against unfavorable exchange rate movements. Futures contracts are standardized and commonly used by dealers and investors to manage portfolio currency risk. On the other hand, corporations often utilize customized forward contracts in the over-the-counter (OTC) market to manage cash flow risk in foreign currencies. OTC contracts offer high customizability and are tailored to meet the specific requirements of individual deals.

Question

Bank of the Port contacts Farmers National Bank to inquire about a quote for an exchange transaction. They want to sell $1,020,000,350 in exchange for purchasing Japanese Yen in three months at -120. This scenario most likely describes which of the following agreements?

1. Currency future.
2. Currency swap.
3. Currency forward.

Solution

The correct answer is C.

This scenario represents a currency-forward contract. The fact that one bank contacts another to request a quote indicates a direct agreement between two counterparties without involving intermediaries. The agreement involves the future purchase and sale of currency at a specific date, distinguishing it from a swap. Additionally, since the agreement is unregulated and conducted over-the-counter (OTC), it falls under the category of a forward contract.

If Bank of the Port were to access their preferred futures exchange brokerage platform to search for prices of standardized contracts, it would be described as a currency future.

A is incorrect. Currency futures are standardized contracts traded on exchanges, and they involve the obligation to buy or sell a specific amount of currency at a predetermined future date and price. They do not allow customization of the terms, making them less suitable for this scenario where the Bank of the Port wants a specific exchange rate.

B is incorrect. Currency swaps involve the exchange of principal and interest payments in one currency for the same in another. They are often used to manage long-term currency risk or to obtain a specific currency for an extended period. The scenario describes a one-time transaction, not a series of payments over time.

Derivatives and Risk Management: Learning Module 2: Swaps, Forwards, and Futures Strategies; Los 2(b) Demonstrate how currency swaps, forwards, and futures can be used to modify a portfolio's risk and return