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Chapter 8. Foreign Currency Derivatives and Swaps. Foreign Currency Derivatives and Swaps: Learning Objectives. Explain how foreign currency futures are quoted, valued, and used for speculation purposes Illustrate how foreign currency futures differ from forward contracts

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chapter 8

Chapter 8

Foreign Currency Derivatives and Swaps

foreign currency derivatives and swaps learning objectives
Foreign Currency Derivatives and Swaps: Learning Objectives

Explain how foreign currency futures are quoted, valued, and used for speculation purposes

Illustrate how foreign currency futures differ from forward contracts

Analyze how foreign currency options are quoted, valued, and used for speculation purposes

Explain how foreign currency options are valued

Define interest rate risk, and examine how can it be managed

foreign currency derivatives and swaps learning objectives3
Foreign Currency Derivatives and Swaps: Learning Objectives

Explain interest rate swaps and how they can be used to manage interest rate risk

Analyze how interest rate swaps and cross currency swaps can be used to manage both foreign exchange risk and interest rate risk simultaneously

foreign currency derivatives and swaps
Foreign Currency Derivatives and Swaps

Financial management in the 21st century needs to consider the use of financial derivatives

These derivatives, so named because their values are derived from the underlying asset, are a powerful tool used for two distinct management objectives:

Speculation – the financial manager takes a position in the expectation of profit

Hedging – the financial manager uses the instruments to reduce the risks of the corporation’s cash flow

foreign currency derivatives and swaps5
Foreign Currency Derivatives and Swaps

The financial manager must first understand the basics of the structure and pricing of these tools

The derivatives that will be discussed will be

Foreign Currency Futures

Foreign Currency Options

Interest Rate Swaps

Cross Currency Interest Rate Swaps

A word of caution – financial derivatives are powerful tools in the hands of careful and competent financial managers. They can also be very destructive devices when used recklessly.

foreign currency futures
Foreign Currency Futures

A foreign currency futures contract is an alternative to a forward contract

It calls for future delivery of a standard amount of currency at a fixed time and price

These contracts are traded on exchanges with the largest being the International Monetary Market located in the Chicago Mercantile Exchange

foreign currency futures7
Foreign Currency Futures

Contract Specifications

Size of contract – called the notional principal, trading in each currency must be done in an even multiple

Method of stating exchange rates – “American terms” are used; quotes are in US dollar cost per unit of foreign currency, also known as direct quotes

Maturity date – contracts mature on the 3rd Wednesday of January, March, April, June, July, September, October or December

foreign currency futures8
Foreign Currency Futures

Contract Specifications

Last trading day – contracts may be traded through the second business day prior to maturity date

Collateral & maintenance margins – the purchaser or trader must deposit an initial margin or collateral; this requirement is similar to a performance bond

At the end of each trading day, the account is marked to market and the balance in the account is either credited if value of contracts is greater or debited if value of contracts is less than account balance

foreign currency futures9
Foreign Currency Futures

Contract Specifications

Settlement – only 5% of futures contracts are settled by physical delivery, most often buyers and sellers offset their position prior to delivery date

The complete buy/sell or sell/buy is termed a round turn

Commissions – customers pay a commission to their broker to execute a round turn and only a single price is quoted

Use of a clearing house as a counterparty – All contracts are agreements between the client and the exchange clearing house. Consequently clients need not worry about the performance of a specific counterparty since the clearing house is guaranteed by all members of the exchange

using foreign currency futures
Using Foreign Currency Futures

Any investor wishing to speculate on the movement of a currency can pursue one of the following strategies

Short position – selling a futures contract based on view that currency will fall in value

Long position – purchase a futures contract based on view that currency will rise in value

Example: Amber McClain believes that Mexican peso will fall in value against the US dollar, she looks at quotes in the WSJ for Mexican peso futures

using foreign currency futures12
Using Foreign Currency Futures

Example (cont.): Amber believes that the value of the peso will fall, so she sells a March futures contract

By taking a short position on the Mexican peso, Amber locks-in the right to sell 500,000 Mexican pesos at maturity at a set price above their current spot price

Using the quotes from the table, Amber sells one March contract for 500,000 pesos at the settle price: $.10958/Ps

Value at maturity (Short position) = -Notional principal  (Spot – Forward)

using foreign currency futures13
Using Foreign Currency Futures

To calculate the value of Amber’s position we use the following formula

Using the settle price from the table and assuming a spot rate of $.09500/Ps at maturity, Amber’s profit is

Value at maturity (Short position) = -Notional principal  (Spot – Forward)

Value = -Ps 500,000  ($0.09500/ Ps - $.10958/ Ps) = $7,290

using foreign currency futures14
Using Foreign Currency Futures

If Amber believed that the Mexican peso would rise in value, she would take a long position on the peso

Using the settle price from the table and assuming a spot rate of $.11000/Ps at maturity, Amber’s profit is

Value at maturity (Long position) = Notional principal  (Spot – Forward)

Value = Ps 500,000  ($0.11000/ Ps - $.10958/ Ps) = $210

currency options
Currency Options

A foreign currency option is a contract giving the purchaser of the option the right to buy or sell a given amount of currency at a fixed price per unit for a specified time period

The most important part of clause is the “right, but not the obligation” to take an action

Two basic types of options, calls and puts

Call – buyer has right to purchase currency

Put – buyer has right to sell currency

The buyer of the option is the holder and the seller of the option is termed the writer

foreign currency options
Foreign Currency Options

Every option has three different price elements

The strike or exercise price is the exchange rate at which the foreign currency can be purchased or sold

The premium, the cost, price or value of the option itself paid at time option is purchased

The underlying or actual spot rate in the market

There are two types of option maturities

American options may be exercised at any time during the life of the option

European options may not be exercised until the specified maturity date

foreign currency options18
Foreign Currency Options

Options may also be classified as per their payouts

At-the-money (ATM) options have an exercise price equal to the spot rate of the underlying currency

In-the-money (ITM) options may be profitable, excluding premium costs , if exercised immediately

Out-of-the-money (OTM) options would not be profitable, excluding the premium costs, if exercised

foreign currency options markets
Foreign Currency Options Markets

The increased use of currency options has lead the creation of several markets where financial managers can access these derivative instruments

Over-the-Counter (OTC) Market – OTC options are most frequently written by banks for US dollars against British pounds, Swiss francs, Japanese yen, Canadian dollars and the euro

Main advantage is that they are tailored to purchaser

Counterparty risk exists

Mostly used by individuals and banks

foreign currency options markets20
Foreign Currency Options Markets

Organized Exchanges – similar to the futures market, currency options are traded on an organized exchange floor

The Chicago Mercantile and the Philadelphia Stock Exchange serve options markets

Clearinghouse services are provided by the Options Clearinghouse Corporation (OCC)

foreign currency options markets22
Foreign Currency Options Markets

The spot rate means that 58.51 cents, or $0.5851 was the price of one Swiss franc

The strike price means the price per franc that must be paid for the option. The August call option of 58 ½ means $0.5850/Sfr

The premium, or cost, of the August 58 ½ option was 0.50 per franc, or $0.0050/Sfr

For a call option on 62,500 Swiss francs, the total cost would be Sfr62,500 x $0.0050/Sfr = $312.50

foreign currency speculation
Foreign Currency Speculation

Speculating in the spot market

Hans Schmidt is a currency speculator. He is willing to risk his money based on his view of currencies and he may do so in the spot, forward or options market

Assume Hans has $100,000 and he believes that the six month spot for Swiss francs will be $0.6000/Sfr.

Speculation in the spot market requires that view is currency appreciation

foreign currency speculation24
Foreign Currency Speculation

Speculating in the spot market

Hans should take the following steps

Use the $100,000 to purchase Sfr170,910.96 today at a spot rate of $0.5851/Sfr

Hold the francs indefinitely, because Hans is in the spot market he is not committed to the six month target

When target exchange rate is reached, sell the Sfr170,910.96 at new spot rate of $0.6000/Sfr, receiving Sfr170,910.96 x $0.6000/Sfr = $102,546.57

This results in a profit of $2,546.57 or 2.5% ignoring cost of interest income and opportunity costs

foreign currency speculation25
Foreign Currency Speculation

Speculating in the forward market

If Hans were to speculate in the forward market, his viewpoint would be that the future spot rate will differ from the forward rate

Today, Hans should purchase Sfr173,611.11 forward six months at the forward quote of $0.5760/Sfr. This step requires no cash outlay

In six months, fulfill the contract receiving Sfr173,611.11 at $0.5760/Sfr at a cost of $100,000

Simultaneously sell the Sfr173,611.11 in the spot market at Hans’ expected spot rate of $0.6000/Sfr, receiving Sfr173,611.11 x $0.6000/Sfr = $104,166.67

This results in a profit of $4,166.67 with no investment required

foreign currency speculation26
Foreign Currency Speculation

Speculating in the options market

If Hans were to speculate in the options market, his viewpoint would determine what type of option to buy or sell

As a buyer of a call option, Hans purchases the August call on francs at a strike price of 58 ½ ($0.5850/Sfr) and a premium of 0.50 or $0.0050/Sfr

At spot rates below the strike price, Hans would not exercise his option because he could purchase francs cheaper on the spot market than via his call option

foreign currency speculation27
Foreign Currency Speculation

Speculating in the options market

Hans’ only loss would be limited to the cost of the option, or the premium ($0.0050/Sfr)

At all spot rates above the strike of 58 ½ Hans would exercise the option, paying only the strike price for each Swiss franc

If the franc were at 59 ½, Hans would exercise his options buying Swiss francs at 58 ½ instead of 59 ½

foreign currency speculation28
Foreign Currency Speculation

Speculating in the options market

Hans could then sell his Swiss francs on the spot market at 59 ½ for a profit

Profit = Spot rate – (Strike price + Premium)

= $0.595/Sfr – ($0.585/Sfr + $0.005/Sfr)

= $.005/Sfr

foreign currency speculation29
Foreign Currency Speculation

Speculating in the options market

Hans could also wait to see if the Swiss franc appreciates more, this is the value to the holder of a call option – limited loss, unlimited upside

Hans’ break-even price can also be calculated by combining the premium cost of $0.005/Sfr with the cost of exercising the option, $0.585/Sfr

This matched the proceeds from exercising the option at a price of $0.590/Sfr

foreign currency speculation31
Foreign Currency Speculation

Speculating in the options market

Hans could also write a call, if the future spot rate is below 58 ½, then the holder of the option would not exercise it and Hans would keep the premium

If Hans went uncovered and the option was exercised against him, he would have to purchase Swiss francs on the spot market at a higher rate than he is obligated to sell them at

Here the writer of a call option has limited profit and unlimited losses if uncovered

foreign currency speculation32
Foreign Currency Speculation

Speculating in the options market

Hans’ payout on writing a call option would be

Profit = Premium – (Spot rate - Strike price)

= $0.005/Sfr – ($0.595/Sfr + $0.585/Sfr)

= - $0.005/Sfr

foreign currency speculation34
Foreign Currency Speculation

Speculating in the options market

Hans could also buy a put, the only difference from buying a call is that Hans now has the right to sell currency at the strike price

If the franc drops to $0.575/Sfr Hans will deliver to the writer of the put and receive $0.585/Sfr

The francs can be purchased on the spot market at $0.575/Sfr

With the cost of the option being $0.005/Sfr, Hans realizes a net gain of $0.005/Sfr

As with a call option - limited loss, unlimited gain

foreign currency speculation35
Foreign Currency Speculation

Speculating in the options market

Hans’ payout on buying a put option would be

Profit = Strike price – (Spot rate + Premium)

= $0.585/Sfr – ($0.575/Sfr + $0.005/Sfr)

= $0.005/Sfr

foreign currency speculation37
Foreign Currency Speculation

Speculating in the options market

And of course, Hans could write a put, thereby obliging him to purchase francs at the strike price

If the franc drops below 58 ½ Hans will lose more than the premium received

If the spot rate does not fall below 58 ½ then the option will not be exercised and Hans will keep the premium from the option

As with a call option - unlimited loss, limited gain

foreign currency speculation38
Foreign Currency Speculation

Speculating in the options market

Hans’ payout on writing a put option would be

Profit = Premium – (Strike price - Spot rate)

= $0.005/Sfr – ($0.585/Sfr + $0.575/Sfr)

= - $0.005/Sfr

option pricing and valuation
Option Pricing and Valuation

The pricing of any option combines six elements

Present spot rate, $1.70/£

Time to maturity, 90 days

Forward rate for matching maturity (90 days), $1.70/£

US dollar interest rate, 8.00% p.a.

British pound interest rate, 8.00% p.a.

Volatility, the standard deviation of daily spot rate movement, 10.00% p.a.

option pricing and valuation41
Option Pricing and Valuation

The intrinsic value is the financial gain if the option is exercised immediately (at-the-money)

This value will reach zero when the option is out-of-the-money

When the spot rate rises above the strike price, the option will be in-the-money

At maturity date, the option will have a value equal to its intrinsic value

option pricing and valuation42
Option Pricing and Valuation

When the spot rate is $1.74/£, the option is ITM and has an intrinsic value of $1.74 - $1.70/£, or 4 cents per pound

When the spot rate is $1.70/£, the option is ATM and its intrinsic value is $1.70 - $1.70/£, or zero cents per pound

When the spot rate is is $1.66/£, the option is OTM and has no intrinsic value, only a fool would exercise this option

option pricing and valuation44
Option Pricing and Valuation

The time value of the option exists because the price of the underlying currency can potentially move further into the money between today and maturity

In the exhibit, time value is shown as the area between total value and intrinsic value

interest rate risk
Interest Rate Risk

All firms, domestic or multinational, are sensitive to interest rate movements

The single largest interest rate risk of a non-financial firm is debt service (for an MNE, differing currencies have differing interest rates thus making this risk a larger concern – see exhibit)

The second most prevalent source of interest rate risk is its holding of interest sensitive securities

Ever increasing competition has forced financial managers to better manage both sides of the balance sheet

credit and repricing risk
Credit and Repricing Risk

Credit Risk or roll-over risk is the possibility that a borrower’s creditworthiness at the time of renewing a credit, is reclassified by the lender

This can result in higher borrowing rates, fees, or even denial

Repricing risk is the risk of changes in interest rates charged (earned) at the time a financial contract’s rate is being reset

credit and repricing risk49
Credit and Repricing Risk

Strategy #1 assures itself of funding at a known rate for the three years; what is sacrificed is the ability to enjoy a lower interest rate should rates fall over the time period

Strategy #2 offers what #1 didn’t, flexibility (repricing risk). It too assures funding for the three years but offers repricing risk when LIBOR changes

Strategy #3 offers more flexibility and more risk; in the second year the firm faces repricing and credit risk, thus the funds are not guaranteed for the three years and neither is the price

interest rate futures
Interest Rate Futures

Interest Rate futures are widely used; their popularity stems from high liquidity of interest rate futures markets, simplicity in use, and the rather standardized interest rate exposures firms posses

Traded on an exchange; two most common are the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT)

The yield is calculated from the settlement price

Example: March ’03 contract with settlement price of 94.76 gives an annual yield of 5.24% (100 – 94.76)

interest rate swaps
Interest Rate Swaps

Swaps are contractual agreements to exchange or swap a series of cash flows

If the agreement is for one party to swap its fixed interest payment for a floating rate payment, its is termed an interest rate swap

If the agreement is to swap currencies of debt service it is termed a currency swap

A single swap may combine elements of both interest rate and currency swap

The swap itself is not a source of capital but an alteration of the cash flows associated with payment

interest rate swaps54
Interest Rate Swaps

If firm thought that rates would rise it would enter into a swap agreement to pay fixed and receive floating in order to protect it from rising debt-service payments

If firm thought that rates would fall it would enter into a swap agreement to pay floating and receive fixed in order to take advantage of lower debt-service payments

The cash flows of an interest rate swap are interest rates applied to a set amount of capital, no principal is swapped only the coupon payments

currency swaps
Currency Swaps

Since all swap rates are derived from the yield curve in each major currency, the fixed-to floating-rate interest rate swap existing in each currency allows firms to swap across currencies.

These swap rates are based on the government security yields in each of the individual currency markets, plus a credit spread applicable to investment grade borrowers in the respective markets.

The utility of the currency swap market to an MNE is significant. An MNE wishing to swap a 10-year fixed 6.04% U.S. dollar cash flow stream could swap to 4.46% fixed in euro, 3.30% fixed in Swiss francs, or 2.07% fixed in Japanese yen. It could swap from fixed dollars not only to fixed rates, but also to floating LIBOR rates in the various currencies as well. All are possible at the rates quoted in Exhibit 8.13.

summary of learning objectives
Summary of Learning Objectives

A foreign currency futures contract is an exchange-traded agreement calling for future delivery of a standard amount of foreign currency at a fixed time, place and price

Foreign currency futures contracts are in reality standardized forward contracts. Unlike forward contracts, however, trading occurs on the floor of an organized exchange. They also require collateral and are normally settled through the purchase of an offsetting position

summary of learning objectives59
Summary of Learning Objectives

Futures differ from forward contracts by size of contract, maturity, location of trading, pricing , collateral/margin requirements, method of settlement, commissions, trading hours, counterparties and liquidity

Financial managers typically prefer foreign currency forwards over futures out of simplicity of use and position maintenance. Financial speculators prefer futures over forwards because of the liquidity of the market

summary of learning objectives60
Summary of Learning Objectives

Foreign currency options are financial contracts that give the holder the right, but not the obligation, to buy or sell a specified amount of currency at a predetermined price on or before a specified maturity date

The use of currency options as a speculative device for a buyer arise from the fact that an option gains in value as the underlying currency rises or falls. The amount of loss when the underlying currency moves opposite the desired direction is limited to the premium of the option

The use of currency options as a speculative device for a seller arise from the option premium. If the option expires out-of-the-money, the writer has earned and retains the entire premium

summary of learning objectives61
Summary of Learning Objectives

Speculation is an attempt to profit by trading on expectations about prices in the future.

In the foreign exchange market, one speculates by taking position on a currency and then closing that position after the exchange rate has moved.

A profit results only if the rate moves in the direction that was expected

Currency option valuation is a complex combination of the current spot rate, the specific strike price, the forward rate, currency volatility and time to maturity

The total value of an option is the sum of its intrinsic and time value.

Intrinsic value depends on the relationship between the option’s strike price and the spot rate at any single point in time, whereas time value estimates how the intrinsic value may change prior to the option’s maturity

summary of learning objectives62
Summary of Learning Objectives

The single largest interest rate risk of the nonfinancial firm is debt-service. The debt structure of the MNE will possess differing maturities of debt, different interest rate structures (such as fixed versus floating rate), and different currencies of denomination.

The increasing volatility of world interest rates, combined with the increasing use of short-term and variable rate debt by firms worldwide, has led many firms to actively manage their interest rate risks.

summary of learning objectives63
Summary of Learning Objectives

The primary sources of interest rate risk to a multinational nonfinancial firm are short-term borrowing and investing, as well as long-term sources of debt.

The techniques and instruments used in interest rate risk management in many ways resemble those used in currency risk management: the old tried and true methods of lending and borrowing.

The primary instruments and techniques used for interest rate risk management include forward rate agreements (FRAs), forward swaps, interest rate futures, and interest rate swaps.

summary of learning objectives64
Summary of Learning Objectives

The interest rate and currency swap markets allow firms that have limited access to specific currencies and interest rate structures to gain access at relatively low costs. This in turn allows these firms to manage their currency and interest rate risks more effectively.

A cross currency interest rate swap allows a firm to alter both the currency of denomination of cash flows in debt service, but also to alter the fixed-to-floating or floating-to-fixed interest rate structure.