SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 39)

Forward, Futures, and Options Agreements (part A)

by

Charles Lamson

Never let the future disturb you. You will meet it,

if you have to, with the same weapons of 

reason which today arm you against the present.

---Marcus Aurelius

A Single Solution

It is 5:10 P.M. on Friday in late 2016. The CEO's meeting with his staff has run later than usual, and a sense of uneasiness pervades the room. Doz-All, a newly emerging conglomerate is involved in diversified financial and manufacturing areas. The mortgage banking division has committed to make $10 million in loans at 8 percent to be funded in 60 days; $25 million in bonds issued 10 years ago for start up money is maturing in three months, and the company plans to pay off the existing bondholders by issuing new bonds. The newly formed international division is converting $20 million to Japanese yen to invest in Japanese securities over the next few months. The stock adviser points out that although the corporation has a diversified portfolio, there is a general fear that the market may be heading down.

All of these situations expose the corporation to risks---the risk that the interest rates (and hence bond prices), stock prices, or foreign exchange rates will move in an unexpected direction causing the corporation to experience a loss. The senior vice president appears tired. She cannot help but perceive that the risks associated with everyday business seem to have escalated in recent years.

In the past three decades, financial prices, such as interest rates, stock prices, and exchange rates, have become more volatile. The greater volatility has created greater risks. The chief financial officer (CFO) is a young business school graduate whom senior management has come to rely on. He assures them that there are ways to deal with the increased risk, although doing so will cost money. In this case, however, his recommendations are the source of the tension felt in the room. To reduce Doz-All's risk exposure, the CFO is recommending that the corporation use the financial forward, futures, or options markets that have emerged in the past 40 years actually be used to reduce or manage the risks inherent in everyday business?

Risk-averse financial intermediaries and corporations use financial forward, futures, and options contracts in their everyday business for just this purpose---to reduce the risks associated with price fluctuations.

Forward Transactions

Financial forward transactions can be used to hedge the risks associated with price changes of any financial instruments. Although virtually all financial prices have become more volatile in recent decades, forward agreements are primarily and more widely used to deal with the risks created by price fluctuations in foreign exchange markets.

The exchange rate is the price of one currency in terms of another. Exchange rate risk is the risk that changes in the exchange rate will cause someone to experience unexpected losses. The more unpredictable and unstable exchange rates are the greater the exchange rate risk. Exchange rates have become much more volatile since the major industrialized countries adopted the flexible exchange rate system in 1973. Also, as international trade has increased and as financial markets have become more globalized, the demand for foreign financial instruments has soared. This has led to the increased trading of foreign currencies with more volatile prices and a dramatic increase in exchange rate risk for market participants. The participants have found ways to hedge this greater exchange rate risk through the development of foreign markets.

Large banks have many customers that operate on a global basis. These customers may know that they will receive and/or need foreign currencies on a future date. The foreign currencies are used by the bank's customers to purchase or to pay for goods, services, and financial instruments. For example, perhaps one U.S. company will be liquidating its holding of French stock in six months to pay off a maturing domestic bond issue while another U.S. company plans to increase its investment in Europe. The first company will be receiving euros; the latter company will need euros. Another customer may be an importer or an exporter, or a securities firm that sells domestic and foreign financial instruments globally. Large banks not only buy and sell foreign exchange at spot rates for present delivery, but they also buy and sell foreign exchange for future delivery at a forward rate. The forward rate for a foreign currency will gravitate toward the expected future spot exchange rate for that currency. The forward rate is affected by the same factors that affect spot rates. These factors, which affect the supply and demand for foreign exchange, include expected inflation and interest rate differentials between the two countries, the economic outlook in both countries, and domestic and foreign monetary and fiscal policies. The forward rate can be used as a market-based forecast of the future spot rate.

Limitations of Forward Agreements

As we have seen, forward transactions can reduce the risks of future price changes which reduce profit. But as with most things in life, appearances may not reveal the whole picture. The forward market in foreign currencies described previously, works well because large banks have developed the market. For other financial instruments such as stocks and bonds, forward markets are not as highly developed. In this case, there are two general problems with arranging forward agreements:

1. Finding partners may be difficult; the transactions costs may be high and outweigh the possible gain. Finding partners who want the exact amount of the financial instrument on the exact date can be difficult at best.
2. One party to the agreement may default, that is, not keep its part of the agreement. The party who is likely to default is the one who is worse off down the road by entering into the forward agreement earlier. Getting compliance may require legal action and may be costly, if not impossible.

Although volatile prices of financial instruments other than foreign exchange may lead to large losses that could be reduced with forward agreements, the forward markets are not highly developed. Consequently, the costs of finding a partner and then enforcing the forward contract may be prohibitively high. To minimize the costs and risks involved with arranging forward transactions, standardized agreements called futures contracts have been developed for many types of financial instruments including stocks, T-bills, notes, bonds, and foreign currencies.

Recap

Forward contracts are agreements to buy or sell something at a price determined today for delivery on a later date. Forward assignments between individual market participants are arranged by intermediaries. In financial markets, forward contracts in the most widely traded currencies have been established by large commercial banks. In addition, to buying and selling foreign currencies at spot prices, the banks also buy and sell the major currencies at forward rates. In this case, the bank is an actual partner in the transaction. When there are not exact offsetting transactions, the bank has some exposure to exchange rate risk. Foreign currency forward agreements can be used to hedge exchange rate risk or to speculate about future currency values. Foreign markets are not highly developed for financial instruments other than foreign currencies.

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 433-439*

END