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International Finance FINA 5331 Lecture 9: Hedging currency risk Read: Chapter 7 (125-129) Aaron Smallwood Ph.D. Review: Forward contracts Let’s consider aspects of deliverable forward contracts:

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International Finance

FINA 5331

Lecture 9:

Hedging currency risk

Read: Chapter 7 (125-129)

Aaron Smallwood Ph.D.


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Review: Forward contracts

  • Let’s consider aspects of deliverable forward contracts:

    • 1. A forward contract is a derivative asset, based off of a spot contract. The forward market is known as an “over the counter” (OTC) market, as compared to futures markets, where trade typically occurs on a centralized exchange.

    • 2. The terms of a forward contract are negotiated between a bank/dealer and their client. At least in theory, except where capital controls may be present, a forward contract can be written for any currency.

    • 3. Based on 2, a forward contract can be written for delivery at any point in the future.

    • 4. Again, based on 2, a forward contract can be written in any “lot size.”


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Review: Forward rates

  • When the forward rate exceeds the spot rate, the foreign currency (currency in the denominator) is trading at a “forward premium.”

    • Example: S($/SF)= $0.9314…F($/SF)3m=$0.9322, SF is selling at premium.

  • …When the forward rate is less than the spot, the foreign currency is said to be selling at a “forward discount.”

    • Example: S($/£)=$1.5247… …F($/£)3m=1.5239, the pound is selling at a discount.


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Review: Forward rates

  • Like spot rates, banks will buy forward foreign currency at one price (the bid price) and sell it forward at another price (the ask price).

  • When the spot quotation is provided, the dealer will simply quote basis points for the associated forward rates.

    • For the basis points, the trader will understand that if the first quote exceeds the second, the basis points are subtracted from the spot quotations.

    • If the first number in the quote is less than the second, the basis points are added.

      • A basis point is defined as 0.0001.


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Example

  • Suppose we call our dealer and ask for forward quotes relative to the spot rate for euros. Our dealer supplies the following information:

  • Spot: $1.3355-60

    • 1 month forward “2-4”

    • 3 month forward “6-10”

    • 6 month forward “9-16”

    • One month forward rates: $1.3357-$1.3364

    • Three month forward rates: $1.3361 - $1.3370

    • Six month forward rates: $1.3364 - $1.3376.


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Percentage forward premia/discount

  • In some sense, the premium or discount provides information related to how the value of a currency changes over time. We can express these values in percentage terms. We will typically apply annualization. The calculation:

  • Where “days” is the number of days until the contract matures.


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Example

  • Suppose the three month forward rate on yen today is $0.010724. The current spot rate $0.010718. Suppose a contract written for yen matures 92 days from now. The yen is trading at a premium:

  • The yen is selling at 0.219% premium.


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Premia/Discount Cont.

  • If Ft>St, in some sense, this might signal that we expect foreign currency to appreciate in value.

  • If Ft<St, this might indicate that we expect the foreign currency to depreciate in value.


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Non-deliverable forward contracts

These are pure cash settlement contracts.

The buyer/seller never takes delivery of the underlying asset.

Non-deliverable forward contracts are available in yuan:

Nanyang Commercial bank.

Examples: If we are short RMB, we can sell USD and buy RMB.

If we are short $, we can sell RMB and buy $.


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Futures Contracts: Preliminaries

  • A futures contract is like a forward contract:

    • It specifies that a certain currency will be exchanged for another at a specified time in the future at prices specified today.

  • A futures contract is different from a forward contract:

    • Futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse.


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Futures Contracts: Preliminaries

  • Standardizing Features:

    • Contract Size

    • Delivery Month

    • Daily resettlement

  • Initial Margin (about 4% of contract value, cash or T-bills held in a street name at your brokers).

  • Some contracts can be settled with cash instead of the specified commodity. This makes it more attractive for speculators.


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Margin account

At the close of each day, if you buy a contract:

  • Money is added to your account if the settlement price has increased.

  • Money is subtracted if the settlement price has fallen.

    At the close of each day, if you sell a contract:

  • Money is added to your account if the settlement price has fallen.

  • Money is subtracted if the settlement price has increased.


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Example

Suppose we want to short the euro…

Sell one June euro contract. Suppose we acquired the euro contract at the final settlement price...$1.3351.

Suppose on December 17: S($/€)=$1.20.

WE WIN!!!! How.


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How?

Over the course of the contract, money will be added to our account:

($1.3351-$1.20)*125,000 = $16,887.50.

NOTE, if you were long in the euro, you would have to pay this amount.

To settle, we have to sell euros…What if we don’t have them?

We use a simple “reversing trade”

Buy euros for $1.20

Sell euros for $1.20

KEEP THE MONEY IN THE MARGIN


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Example

Suppose a trader needs £250,000 in September. They can buy 4 futures contracts.

Suppose they obtain the contracts at the opening price ($1.5226).

Suppose on September 15, S($/£)=$2.00…

They will buy pounds at $2.00…Cost $500,000.

However, money has been added to their margin account over the life of the contract


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How much?

(2.00-1.5226)*250,000=$119,350.

Total cost to the trader:

$500,000 - $119,350 = $380,650.

Note 1.5226*250000=$380,650.


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Hedging

Futures contracts are inconvenient from a hedging point of view.

  • What if you needed €200,000?

  • What if you needed euros in July?

  • The possibility of a margin call exists if the initial margin is depleted.

  • Nonetheless they have been used from a hedging perspective in some cases.


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Review

Speculation

  • If we short a currency:

    • We profit if the currency depreciates

    • We lose if the currency appreciates

  • If we are long in a currency:

    • We profit if the currency appreciates

    • We lose if the currency depreciates.


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Currency options

An options contract can be bought/sold not only over the counter, but also on a centralized exchange. In the case of an options contract, there are several centralized exchanges including the Philadelphia Stock Exchange.

Options contracts bought and sold on exchanges are only available in certain currencies. In particular, an options contract is available for Australian dollars, British pounds, Canadian dollars, euros, Japanese yen, and Swiss franc (all against the $) on the Philadelphia Stock Exchange.

Options contracts bought and sold on exchanges are only sold in fixed lots. In particular, on the Philadelphia Stock Exchange, currency options are available in the following denominations:

A$ 50,000 £31,250

C$ 50,000 €62,500

¥ 6,250,000 CHF 62,500


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Currency options…continued

Currency options sold on a centralized exchange have specific delivery dates. In particular, a currency option bought or sold on the Philadelphia Stock Exchange matures on the Friday before the third Wednesday of the expiration month. Contracts on the exchange have a trading cycle of March, June, September, and December with two additional near term monthly contracts. This implies that if it is November, then there will be options contracts available in the next two months (December and January).

Unlike a forward contract, the culmination of the contract need not result in delivery of currency. For example, if an options contract is purchased in Canadian $, the trader never has to take delivery of Canadian $ as a result of the contract if they don’t wish to. In other words, the trader has the right, but not the obligation to take delivery of currency in the future. The trader will only use the option if the movements in future exchange rates make it profitable or cost-efficient to do so.


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