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Figure 13-1. The Difference between Interest Rate Futures and Interest Rate Futures Options

Figure 13-1. The Difference between Interest Rate Futures and Interest Rate Futures Options

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Currency Futures

Hedging FX Risk

Example: Customer due € 20 million in two months,

current € = $0.50

1. Forward agreeing to sell € 20 million for $10

million, two months in future

2. Sell € 20 million of futures

© 2005 Pearson Education


Currency Swaps

In a currency swap two parties effectively trade assets and

liabilities denominated in different currencies.

The simplest currency swap is an agreement to sell a

currency now at a given price and then repurchase it at a

stated price on a specified future date. The difference

between the two prices is called the swap rate.


A German bank might swap € for $ with a Canadian bank by

agreeing to sell € 1 million at a price of € /$ = € 0.60 and to

repurchase € 1 million a year later at a price of € /$ = € 0.70.

This currency swap allows the German bank to borrow $ and

the Canadian bank to borrow €.

© 2005 Pearson Education



Often currency swaps are tied to debt issues. In particular,

two parties issue debt denominated in different currencies

and then agree to swap the proceeds of the debt issue and to

repay each other's debts -- effectively transforming each debt

into the other currency.


A Canadian company wants to borrow € 10 million. The

company, however, believes that it can get better terms if it

issues $-denominated bonds in Canada where it is well

known, and then swap the $ for € with a German company

that wants to borrow $ but for the same reasons finds it

easier to borrow € in Europe --- see next slide.

© 2005 Pearson Education


Currency Swap Contract



Can$ Coupon + Principal→






DM Coupon

© 2005 Pearson Education






+ Principal→




Using Currency Swaps to Manage

Exchange Rate Risk

First Bank




$188 m $-Denominated

$50 m


$12 m €-Denominated

$30 m

(€7.5 m @ $1.6/€)

(€18.75 m @ $1.6/€)

Net worth

$120 m

© 2005 Pearson Education



Considering the hypothetical balance sheet shown

in the previous slide, if the $ depreciates relative

to the €, € -denominated assets and liabilities will

be worth more $.

Because the bank has more € -denominated

liabilities than € -denominated assets, it will

suffer losses.

For example, if the $/€ exchange rate increases to

$1.7, then the bank will have a capital loss of $1.05 m, as

can be seen in the following slide:

© 2005 Pearson Education



First Bank




$188 m $-Denominated

$50 m


12.75 m €-Denominated

$31.8 m

(€7.5 m @ $1.7/€)

(€18.75 m @ $1.7/€)

Net worth



$200.75 Total


© 2005 Pearson Education



To reduce its exposure to the $/€ exchange rate risk,

the bank could swap $18 million of its € -denominated

liabilities for $-denominated liabilities.

This would leave the bank with $12 million in €

-denominated liabilities, which matches its $12

million of € -denominated assets.

With € -denominated assets = € -denominated

liabilities, a change in $/€ exchange rate does not

change the bank’s net worth.

© 2005 Pearson Education


Interest Rate Swaps

In an interest-rate swap, two unrelated parties take out

loans. Then they agree to make each other’s periodic

interest payments.

The two parties do not exchange their debts or lend each

other money, but simply agree to make each other’s

periodic interest payments as if they had swapped debts.

This kind of swap is illustrated by the hypothetical

example in the next slide.

© 2005 Pearson Education


Interest-Rate Swap Contract

© 2005 Pearson Education


Hedging with Interest Rate Swaps

Reduce interest-rate risk for both parties

1. Midwest converts $1m of fixed rate assets to rate-sensitive

assets, RSA ↑, lowers GAP

2. Friendly Finance RSA ↓, lowers GAP

Advantages of swaps

1. Reduce risk, no change in balance-sheet

2. Longer term than futures or options

Disadvantages of swaps

1. Lack of liquidity

2. Subject to default risk

Financial intermediaries help reduce disadvantages of swaps

© 2005 Pearson Education


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Figure 13-1. The Difference between Interest Rate Futures and Interest Rate Futures Options

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