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Currency Futures & Options Markets. Objectives: to Understand. How currency futures and options contracts are used to manage currency risk & to speculate on future currency movements The nature of currency futures and options contracts and The difference between futures & options contracts

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objectives to understand
Objectives: to Understand
  • How currency futures and options contracts are used to manage currency risk & to speculate on future currency movements
  • The nature of currency futures and options contracts and
  • The difference between futures & options contracts
  • The factors that determine the value of an option

Fred Thompson

definition
Definition
  • Currency Risk = Variability in the value of an exposure caused by uncertainty about exchange rate changes.

Fred Thompson

currency risk5
Currency Risk
  • Degree of risk is a function of 2 variables
    • Volatility of exchange rates
    • Amount of exposure
  • Degree of Risk
    • Low = rate fixed, low exposure
    • High = rate volatile, high exposure

Fred Thompson

long and short exposures
Long and Short Exposures
  • A person that is, for example, long the pound, has pound denominated assets that exceed in value their pound denominated liabilities.
  • A person that is short the pound, has pound denominated liabilities that exceed in value their pound denominated assets.

Fred Thompson

what is an exposure
What is an exposure?
  • Liabilities > assets = net exposure (short)
  • If you are borrowing Yen to buy $ denominated assets? Are you short or long?
  • Who is long?
  • Who is long on $? Who is short?

Fred Thompson

hedging
Hedging
  • To hedge a foreign exchange exposure, one takes an equal and opposite position from that of the exposure.
  • For example, if folks are long the pound, they would have to take an offsetting short position to hedge their exposure.
  • One who is long in a market is betting on an increase in the value of the thing, whereas with a short position they are betting on a fall in its value.

Fred Thompson

you can hedge with financial derivatives
You Can Hedge with Financial Derivatives!
  • Contracts that derive their value from some underlying asset
    • Forwards
    • Futures
    • Options
    • Swaps

Fred Thompson

for example
For example
  • Vanilla bond -- coupon and principal
    • First stage decomposition
    • Second stage decomposition
    • Options
  • What assets underlie currency derivatives?

Fred Thompson

currency futures13
Currency Futures
  • Traded on centralized exchanges (illustrated in Figure 1 later)
  • Highly standardized contracts
    • Size [A&C$100K, £62.5k, €125k, ¥12.5m] & maturity [delivery date]
  • Clearinghouse as counter-party
  • High leverage instrument
    • Daily settlement
    • Margin requirements

Fred Thompson

currency futures14
Currency Futures
  • Performance Bond or Initial Margin: The customer must put up funds to guarantee the fulfillment of the contract - cash, letter of credit, Treasuries.
  • Maintenance Performance Bond or Margin: The minimum amount the performance bond can fall to before being fully replenished.
  • Mark-to-the-market: A daily settlement procedure that marks profits or losses incurred on the futures to the customer’s margin account.

Fred Thompson

example
Example

A US manufacturing company has a division that operates in Mexico. At the end of June the parent company anticipates that the foreign division will have profits of 4 million Mexican pesos (P) to repatriate.

The parent company has a foreign exchange exposure, as the dollar value of the profits will rise and fall with changes in the exchange value between the P and the dollar.

Fred Thompson

example continued
Example, continued
  • The firm is long the peso, so to hedge its exposure it will go short [sell P] in the futures market.
  • The face amount of each peso future contract is P500,000, so the firm will go short 8 contracts.
  • If the peso depreciates, the dollar value of its Mexican division’s profits falls, but the futures account generates profits, at least partially offsetting the loss. The opposite holds for an appreciation of the peso.

Fred Thompson

slide19

Gain

Underlying Long Position

Change spot value

Change in futures price

Futures Position

Loss

example continued20
Example, continued
  • The previous diagram can be used to illustrate the effect of a change in the value of the peso.
  • An increase in the value of the peso increases the dollar value of the underlying long position and decreases the value of the futures position.
  • A decrease in the value of the peso decreases the value of the underlying position and increases the value of the futures position.

Fred Thompson

example continued21
Example, continued
  • On the 25th, the spot rate opens at 0.10660 ($/P) while the price on a P future opens at 0.10310.
  • The market closes at 0.10635 and 0.10258 respectively.
  • The loss on the underlying position is:
  • (0.10635-0.10660)P4 mil. = -$1,000
  • The gain on the futures position is:
  • (0.10310-0.10258)8P500,000=$2,080

Fred Thompson

slide22

Gain and Loss on Underlying and Futures Position

Day 1

Underlying Long Position

P4 million

Gain

$2,080

Change spot value

-0.00025

Change in futures price

-0.00052

$1,000

Futures Position

P500,000 x 8

Loss

example continued23
Example, continued
  • On the 28th, the spot rate moves to 0.10670 ($/P) and the price on a P future to 0.10285.
  • The gain on the underlying position is:
  • (0.10670-0.10635)P4 mil. = $1,400
  • The loss on the futures position is:
  • (0.10258-0.10285)8P500,000=-$1,080

Fred Thompson

slide24

Gain and Loss on Underlying and Futures Position

Day 2

Underlying Long Position

P4 million

Gain

$1,400

0.00032

Change spot value

0.00035

Change in futures price

$1,080

Futures Position

P500,000 x 8

Loss

example continued25
Example, continued
  • On the 29th, the spot rate moves to 0.10680 ($/P) and the price on a P future to 0.10290.
  • The gain on the underlying position is:
  • (0.10680-0.10670)P4 mil. = $400
  • The loss on the futures position is:
  • (0.10285-0.10290)8P500,000=-$200

Fred Thompson

slide26

Gain and Loss on Underlying and Futures Position

Day 3

Underlying Long Position

P4 million

Gain

$400

0.0001

Change spot value

0.00005

Change in futures price

$200

Futures Position

P500,000 x 8

Loss

example continued27
Example, continued
  • For the three days considered, the underlying position gained $800 in value and the futures contracts yielded $800.
  • The hedge was not perfect as the daily losses on the futures were less than the gains on the underlying position (day 2 and 3), and the daily gains on the futures exceeded the losses on the underlying position (day 1).
  • In this example, the imperfect hedge yielded additional gains.

Fred Thompson

example continued28
Example, continued
  • Suppose you wanted to close the futures position (without making delivery of the currency).
  • The position is simply reversed. That is, you would go long 8 P futures, reversing your current position and closing out your account. [offsetting trade]

Fred Thompson

additional information
Additional Information

For additional information on currency futures, visit the following sites:

  • The Chicago Mercantile exchange
  • The Futures Industry Institute

Fred Thompson

currency options31
Currency Options
  • A currency option is a contract that gives the owner the right, but not the obligation, to buy or sell a currency at a specified price at or during a given time.
  • Call Option: An option that gives the owner the right to buy a currency.
  • Put Option: An option that gives the owner the right to sell a currency.
  • How are currency options simultaneously both put & call options?

Fred Thompson

currency options32
Currency Options
  • American Option: An option that can be exercised any time before or on the expiration date.
  • European Option: An option that can only be exercised on the expiration date.

Fred Thompson

currency options33
Currency Options
  • Exercise or Strike Price: The price (spot exchange rate) at which the option may be exercised.
  • Option Premium: The amount that must be paid to purchase the option contract.
  • Break-Even: The point at which exercising the option exactly matches the premium paid.

Fred Thompson

currency options34
Currency Options
  • If the spot rate has not yet reached the exercise price [S<X], the option cannot be exercised and is said to be “out of the money.”
  • If the spot rate equals the exercise price [S=X], the option is said to be “at the money.”
  • If the spot rate has surpassed the exercise price [S>X], the option is said to be “in the money.”

Fred Thompson

call option
Call Option
  • The holder of a call option expects the underlying currency to appreciate in value.
  • Consider 4 call options on the euro, with a strike price of 152 ($/€) and a premium of 0.94 (both cents per €).
  • The face amount of a euro option is €62,500.
  • The total premium is:

$0.0094·4·€62,500=$2,350.

Fred Thompson

slide36

Call Option: Hypothetical Pay-Off

Profit

Payoff Profile

$1,400

152

152.5

0

Spot Rate

148.15

152.94

153.5

-$1,100

Break-Even

-$2,350

Out-of-

the-money

Loss

At

In-the-money

put option
Put Option
  • The holder of a put option expects the underlying currency to depreciate in value.
  • Consider 8 put options on the euro with a strike of 150 ($/€) and a premium of 1.95 (both cents per €).
  • The face amount of a euro option is €62,500.
  • The total premium is:

$0.0195·8·€62,500=$9,750.

Fred Thompson

slide38

Put Option: Hypothetical payoff

at a spot rate of 148.15

Profit

Payoff Profile

Break-Even

148.05

150

0

Spot Rate

148.15

-$500

-$9,750

Loss

In-the-money

At

Out-of-the-money

option pricing valuation
Option Pricing & Valuation
  • Value of a call option at maturity
    • S-X, where S-X>0 [otherwise value is zero], = Intrinsic value
  • Value of a call option prior to maturity
    • Intrinsic value + Time value

Time Value is a function of:

Time to expiration, volatility, domestic & foreign interest rate differentials

Fred Thompson

slide40

Comparing Futures and Options

The value of a futures contract at maturity (date t+n) to purchase one unit of foreign currency will be:

Value

0

St+n

Zt,t+n

The value of the futures contract is zero at maturity if the spot rate at maturity is equal to the current futures rate.

slide41

Consider now the value of an option to purchase one unit of foreign currency at that same price (i.e. a ‘call option’ with a strike price X equal to Zt,t+n):

Value

0

St+n

X

The value of the call option begins increasing when the exchange rate becomes larger than the exercise price - when the option becomes ‘in the money.’

slide42

But we’re missing something. While a futures contract has an expected return of zero, the value of the option looks like it is always positive…

Value

0

St+n

X

slide43

Hence, anyone taking the opposite side of the transaction (‘writing’ the option) will demand a premium (C) that makes the expected value zero once again:

Value

0

St+n

X

C

Regardless of the outcome, the option’s value is reduced everywhere by the certain payment of its premium.

slide44

The value of an option to sell one unit of foreign currency (a ‘put’ option) at a strike price equal to a corresponding futures contract price will have similar properties:

Value

0

St+n

X

slide46

Foreign Currency Swaps

A currency swap is an exchange of debt-service obligations denominated in one currency for the service on an agreed upon principal amount of debt denominated in another currency.

A currency swap is often the low-cost way of obtaining a liability in a currency in which a firm has difficulty borrowing.

A pair of firms simply borrow in currencies they have relative advantage borrowing in, and then trade the obligations of their respective loans, thereby effectively borrowing in their desired currency.

slide47

Dell computers would like to borrow in Swiss Francs to hedge its ongoing cash flows from that country…

Dell

SFr

slide49

But both firms are relatively unknown to the respective credit markets, and thus anticipate unfavorable borrowing terms.

Dell

Nestle

$

SFr

slide50

But an investment bank comes along and suggests that each borrow in the credit markets that are comfortable with them...

Dell

Nestle

I-Bank

$

SFr

slide51

…and then the investment bank will give them sufficient cash flows each period to cover the obligations of these loans...

Dell

Nestle

$

Sfr

I-Bank

$

SFr

slide52

…in return for making the payments in the foreign currency that exactly match the other firm’s obligations.

Dell

Nestle

Sfr

$

$

Sfr

I-Bank

$

SFr

slide53

In other words, the swap effectively ‘completes the market’. Giving each firm access to the foreign debt market at reasonable terms.

Dell

Nestle

Sfr

$

$

Sfr

I-Bank

$

SFr

slide54

The All-In Cost of a Swap

Clearly, the relative magnitudes of the respective payments determine each firm’s ultimate cost of borrowing.

This cost is called the ‘all-in cost’. It is the effective interest rate the firm ends up paying on the money that it raised.

It is the discount rate that equates the NPV of future interest and principal payments to the net proceeds received by the issuer.

IRR

slide55

Swaps vs. Forwards

Notice that on a one-year loan, a currency swap is no different than a one-year forward contract.

In fact, a currency swap can really be thought of as a firm taking a domestic currency loan and purchasing a series of forward contracts to convert the payments into known foreign currency obligations.

The implied forward rates need not equal the actual forward rates, but taken as a whole, should resemble an average forward rate over the term of the loan.

slide56

Comparative Borrowing Advantage

Swaps only exist because there are market imperfections. If firms can access foreign and domestic debt markets at equal cost, clearly swaps are redundant.

One important reason that currency swaps are so useful is that firms engaged in a swap need not each have an absolute borrowing advantage in the currency in which they borrow vis-a-vis the counterparty.

In fact, it is quite likely that Nestle has better access to both the U.S. and Swiss debt markets than Dell. Comparative Advantage

slide57

Key Points

1. A firm wishing to hedge foreign currency exposure has five main financial hedging tools which facilitate doing so: forward contracts, money market hedges, futures contracts, foreign currency options, and currency swaps.

2. Forward contracts have the benefit of being tailor-made, with quantities and timing matched to the needs of the firm. Forward contracts are typically quite costly over longer horizons, as the market becomes highly illiquid.

3. Money market hedges are equally flexible, but depend on a firm having equal access to domestic and foreign credit markets.

slide58

Key Points

4. Futures contracts, traded on highly liquid exchanges, have the benefit that they can be sold on the market before the maturity date. As a result, futures contracts are particularly useful for hedging exposures whose maturity is uncertain.

5. On the other hand, futures contracts are standardized in terms of timing and quantities, and therefore they rarely offer a perfect hedge.

6. Options contracts allow a firm to hedge against movements in one direction while retaining exposure in the other.

7. Options are particularly useful in hedging exposures that are highly uncertain with respect to timing and magnitude.

slide59

Key Points

8. Currency swaps offer firms the ability to borrow against long-term foreign currency exposures when access to foreign debt markets is costly.

9. Currency swaps converts a domestic liability into a foreign one via what are effectively a bundle of long-dated forward contracts between two firms.

10. The effective cost of a currency swap is its ‘all-in cost’ - the effective rate of interest that the firm ends up paying on the constructed foreign liability.

11. Currency swaps require only that firms have differential relative - rather than absolute - advantage in accessing debt markets.