5.-6. FRA and FX swaps

International Financial Services I

Karel Bruna

Main Business Problems(FRA and FX swaps)

• Strategy of management of single and multi-currency liquidity position in bank/MNC

• Main sources of risk involved in multi-currency cash flow

• FX swaps as the hedging instrument against FX

• FRA as the hedging instrument against interest rate risk

Main Characteristics of FRA

Maturity: 1Mx3M, 3Mx6M, 6Mx9M, 9Mx12M, odd dates

Price: bid/ask FRA rate

Currencies: those with existed interbank money markets

Amount: minimum defined by the market maker

Purpose of trading: management of single-currency liquidity

hedging of interest rate exposure

Forward Rate AgreementPricing and quotation, cash settlement

1 + IRD,LONG(tLONG/360) 360FRA rateBID = (---------------------------------- - 1) ------

1 + IRL,SHORT(tSHORT/360) tFRA

1 + IRL,LONG(tLONG/360) 360FRA rateASK = (--------------------------------- - 1) ------

1 + IRD,SHORT(tSHORT/360) tFRA

notional value(IR – FRA rate)(tFRA/360)cash settlement = ------------------------------------------------------

1 + IR(tFRA/360)

Forward Rate AgreementHedging against interest rate risk

• cash shortage situation - risk of future rise of interest rates in money market

company buys FRA contract at FRA rateASK

company obtains compensation payment in case SR > FRA rate

company pays compensation payment in case SR < FRA rate

• cash excess situation – risk of future decline of interest rates in money market

company sells FRA contract at FRA rateBID

company obtains compensation payment in case SR < FRA rate

company pays compensation payment in case SR > FRA rate

Main Characteristics of FX Swaps

Maturity: short dates, 1M, 2M, 3M, 6M, 9M, 12M, odd dates

Price: bid/ask forward (swap) points

Currency pairs: as in case of forward contracts

Amount: minimum defined by the market maker

Purpose of trading: management of multi-currency liquidity

hedging of FX exposure

Outright forwards vs. FX Swaps

outright forwards forward value date USD FRASK

CZK

FX swaps second leg value date USD SRMID+(-) swap pointsASK

CZKUSD

first leg value date CZK SRMID

Bank Client

Dealer 1 Dealer 2

FX Swaps

FX Swap Transactions 1st Leg Value Date 2nd Leg Value Date

Spot/forwardFixed Period spot

1, 2, 3, 6, and 12 months forward value date

Broken (Odd)Dates

spotany day between two fixed

forward value dates

Forward/forwardFixed Period

1, 2, 3 and 6 months forward value date

2, 3, 6, and 12 monthsforward value date

Broken (Odd)Dates

any day between two fixed forward value dates

any day between two fixed forward value dates

Short Dates

O/N Overnight today first business day after today

T/N Tomorrow-next

(Tom-next)

first business day after today

second business day after today (spot value date)

S/N Spot-next

spot first business day after spot

S/W Spot-1 week

spot 1 week after spot