5.1. PRACTICAL ASPECTS OF FORWARDS IN REAL-WORLD MARKETS 175
1.5×0.25 =usd375,000 with the bank, which remains with the bank until he
has paid for thegbp. The interest earned on the deposit is Mr. Freedman’s. This
way, the bank is covered against the combined contingency of thegbprising by
up to 25 percentandMr. Freedman defaulting on the contract.- Restricted useEven within an agreed credit line, “speculative” forward posi-
tions are frowned upon—unless a lot of margin is posted. Banks see forwards as
hedging devices for their customers, not as speculative instruments. - Short lives Maturities go up to 10 years, but in actual fact the life of most
forward contracts is short: most contracts have maturities less than one year,
and longer-term contracts are entered into only with customers that have excel-
lent credit ratings. To hedge long-term exposures one then needs to roll over
short-term forward contracts. For example, the corporation can engage in three
consecutive one-year contracts if a single three-year contract is not available.
Example 5.4
At time 0, an Indian company wants to buy forward usd1m for three years.
Suppose that the bank gives it a three-year forward contract atF 0 , 3 =inr/usd
40. Suppose the bank’s worst dreams become true: the spot rate goes down all
the time, say, to 38, 36, and 34 at times 1, 2, and 3, respectively. If, at time 3,
the company defaults, the bank is stuck withusd1m worthinr34m rather than
the contracted value, 40m. Thus, the bank has a loss of (F 0 , 3 −S 3 ) =inr6m.
Suppose instead that at t = 0, the bank gave a one-year contract at the rate
F 0 , 1 = 40.3. After one year, the customer paysinr40.3m for the currency, takes
delivery of theusd1m, and sells these (spot) atS 1 = 38. After verification of
the company’s current creditworthiness, the bank now gives it a new one-year
contract at, say,F 1 , 2 = 37.2. At time t = 2, the customer takes the second loss.
If it is still creditworthy, the customer will get a third one-year forward contract
at, say,F 2 , 3 = 35.9. If there is default at time 3, the bank’s loss on the third
contract is just 1.9m rather than the 6m it would have lost with the three-year
contract.
From the bank’s point of view, the main advantage of the alternative of rolling over
short-term contracts is that losses do not accumulate. The uncertainty, at time
0, about the spot rate one year out is far smaller than the uncertainty about the
rate three years out. Thus,ex antethe worst possible loss on a three-year contract
exceeds the worst possible loss on a one-year contract. In addition, the probability
of default increases with the time horizon—in the course of three years, a lot more
bad things can happen to a firm than in one year,ex ante—and also with the size of
the loss. For these three reasons, the bank’s expected losses from default are larger
the longer the maturity of the forward contract.
The example also demonstrates that rolling over is an imperfect substitute to a
single three-year forward contract. First, there are interim losses or gains, creating
a time-value risk. For instance, the hedger does not know at what interest rates