Forward Contracts, FX Swaps, and Currency Options

Forwards Vs. Futures

This section addresses the simplest hedging scenario: a 100% hedge ratio for a single foreign currency exposure. Both futures and forward contracts can be utilized to achieve full currency hedges, but institutional investors typically prefer forward contracts for the following reasons:

1. Futures contracts are standardized and may not align with a portfolio’s requirements.
2. Futures contracts might not always be available for the required currency pair, especially for less frequently traded pairs.
3. Futures contracts entail an upfront margin, and investing in spot exchange rates also has cash flow implications during the period. Investors must provide additional variation margins when spot exchange rates move against their positions. Consequently, the investor’s capital becomes tied up and requires careful monitoring throughout the portfolio’s lifespan, increasing portfolio management expenses.
   In contrast, forward markets are over the counter (“OTC”), providing greater flexibility and customization. Managers can design custom hedges instead of relying on prepackaged products, tailoring them to meet the specific needs of the portfolio.

The table below offers a summary of the above points.

Using Hedge Ratios

Hedge ratios are valuable tools for portfolio managers to measure and understand the effectiveness of hedges in a portfolio. A hedge ratio equal to the desired hedge ratio indicates a properly hedged portfolio. If the hedge remains unchanged over time, it is known as a static hedge. In this approach, the investor buys or sells the appropriate number of contracts and leaves them unchanged. On the other hand, a dynamic hedge involves a hedge ratio that may drift away from the desired ratio over time. Portfolio managers must periodically adjust the forward currency contracts’ size, number, and maturities to maintain a dynamic hedge.

It’s important to appreciate that stricter hedging comes with increased transaction costs. Managers with lower risk aversion tend to lean towards static hedges, accepting less frequent adjustments. Conversely, more risk-averse managers are willing to incur higher costs to maintain tighter control over the portfolio.

Example: Hedging

Let’s take the example of a portfolio manager based in Switzerland who manages a portfolio denominated in EUR. Initially, the manager needs to hedge EUR 10,000,000 worth of asset exposure. After one month, the asset’s value has increased to EUR 11,000,000. The manager follows a monthly hedge-rebalancing cycle to adjust the hedge position accordingly.

Scenario 1:

• To hedge this asset, the manager would sell EUR 10,000,000 against the CHF in the forward market with a one-month forward contract.
• At contract expiration, the investor can roll the hedge forward for the next month by using an FX swap.
• For the near leg of the FX swap, the manager would, a few days before the initial contract expiration date, buy EUR 10,000,000 at spot to settle the expiring initial forward contract.
• For the far leg of the swap, the investor will sell EUR 11,000,000 for one month.
• This is called a mismatched FX swap because spot and forward transactions are not of equal size.
• The EUR amounts net zero because of initial short contact and spot market purchase
• A CHF cashflow will be generated from any differences in CHF/EUR exchange rate.

Scenario 2:

• To hedge this asset, the manager would sell EUR 10,000,000 against CHF in the forward market with a three-month forward contract.
• Due to monthly rebalancing, the manager would have to sell an additional EUR 10,000,000 for two months.
• As there is no cash flow at the time the second forward contract is entered, all realized gains/losses and cash flows are deferred until the end of the three-month contract.

Question

Which of the following is least likely a reason why many institutional investors prefer forwards to futures?

1. Futures contracts are standardized.
2. Futures are not always available for all currency pairs.
3. Future contracts lower up-front margin.

Solution

The correct answer is C:

The first two choices, A and B are why many institutional managers choose forwards over futures due to the flexibility they provide.

Option C is the least likely because futures contracts increase up-front margin requirements. The marking-to-market process they undergo can be seen as an additional cost, which institutional managers usually try to mitigate.

Derivatives and Risk Management: Learning Module 3: Currency Management: An Introduction; Los 3(f) Describe how forward contracts and FX (foreign exchange) swaps are used to adjust hedge ratios