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Currency Futures

Currency Futures

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Currency Futures

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  1. Currency Futures Introduction and Example

  2. Currency Futures • A derivative instrument. • Traded on centralized exchanges (illustrated in Figure 1 later). • Highly standardized contracts. • Clearinghouse as counter-party. • High leverage instrument. Daniels and VanHoose

  3. Currency Futures • Initial Margin: The customer must put up funds to guarantee the fulfillment of the contract - cash, letter of credit, Treasuries. • Maintenance Margin: The minimum amount the margin account can fall to. • Mark-to-the-market: A daily settlement procedure that marks profits or losses incurred on the futures to the customer’s margin account. Daniels and VanHoose

  4. Sample Bond Performance RequirementsFrom the CME, 15 March 2000 Daniels and VanHoose

  5. 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. Daniels and VanHoose

  6. Hedging With a Currency Future • To hedge a foreign exchange exposure, the customer assumes a position in the opposite direction of the exposure. • For example, if the customer is long the pound, they would short the futures market. • A customer that is long in the futures market is betting on an increase in the value of the currency, whereas with a short position they are betting on a decrease in the value of the currency. Daniels and VanHoose

  7. How an Order is Executed (Figure from the CME)

  8. 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 (MP) 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 MP and the dollar. Daniels and VanHoose

  9. Example, continued • The firm is long the peso, so to hedge the exposure they will go short in the futures market. • The face amount of each peso future contract is MP500,000, so the firm will go short 8 contracts. • If the peso depreciates, the dollar value of the division’s profits falls, but the future account generates profits, at least partially offsetting the loss. The opposite holds for an appreciation of the peso. Daniels and VanHoose

  10. Gain Underlying Long Position Change spot value Change in futures price Futures Position Loss

  11. Example, continued • The previous diagram illustrates 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. Daniels and VanHoose

  12. Example, continued • On the 25th, the spot rate opens at 0.10660 ($/MP) while the price on a MP 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)MP4 mil. = -$1,000 • The gain on the futures position is: • (0.10310-0.10258)8MP500,000=$2,080 Daniels and VanHoose

  13. Gain and Loss on Underlying and Futures Position Day 1 Underlying Long Position MP4 million Gain $2,080 Change spot value -0.00025 Change in futures price -0.00052 $1,000 Futures Position MP500,000 x 8 Loss

  14. Example, continued • On the 28th, the spot rate moves to 0.10670 ($/MP) and the price on a MP future to 0.10285. • The gain on the underlying position is: • (0.10670-0.10635)MP4 mil. = $1,400 • The loss on the futures position is: • (0.10258-0.10285)8MP500,000=-$1,080 Daniels and VanHoose

  15. Gain and Loss on Underlying and Futures Position Day 2 Underlying Long Position MP4 million Gain $1,400 0.00032 Change spot value 0.00035 Change in futures price $1,080 Futures Position MP500,000 x 8 Loss

  16. Example, continued • On the 29th, the spot rate moves to 0.10680 ($/MP) and the price on a MP future to 0.10290. • The gain on the underlying position is: • (0.10680-0.10670)MP4 mil. = $400 • The loss on the futures position is: • (0.10285-0.10290)8MP500,000=-$200 Daniels and VanHoose

  17. Gain and Loss on Underlying and Futures Position Day 3 Underlying Long Position MP4 million Gain $400 0.0001 Change spot value 0.00005 Change in futures price $200 Futures Position MP500,000 x 8 Loss

  18. 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. Daniels and VanHoose

  19. 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 MP futures, reversing your current position and closing out your account. Daniels and VanHoose

  20. Additional Information For additional information on currency futures, visit the following sites: • The Chicago Mercantile exchange at www.cme.com. • The Futures Industry Institute at www.fiafii.orb. Daniels and VanHoose

  21. Currency Options

  22. 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. Daniels and VanHoose

  23. 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. Daniels and VanHoose

  24. 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. Daniels and VanHoose

  25. Currency Options • If the spot rate has not yet reached the exercise price, the option cannot be exercised and is said to be “out of the money.” • If the spot rate equals the exercise prices, the option is said to be “at the money.” • If the spot rate has surpassed the exercise price, the option is said to be “in of the money.” Daniels and VanHoose

  26. 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 of 92 ($/€) and a premium of 0.94 (both cents per unit). • The face amount of a euro option is €62,500. • The total premium is: $0.0094·4·€62,500=$2,350. Daniels and VanHoose

  27. Call Option: Hypothetical Pay-Off Profit Payoff Profile $1,400 Break-Even 92 92.5 92.94 0 Spot Rate 88.15 93.5 -$1,100 -$2,350 Out-of- the-money Loss At In-the-money

  28. 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 90 ($/€) and a premium of 1.95 (both cents per unit). • The face amount of a euro option is €62,500. • The total premium is: $0.0195·8·€62,500=$9,750. Daniels and VanHoose

  29. Put Option: Hypothetical payoff at a spot rate of 88.15 Profit Payoff Profile Break-Even 88.05 90 0 Spot Rate 88.15 -$500 -$9,750 Loss In-the-money At Out-of-the-money

  30. Currency Swaps

  31. Introduction • A currency swap is an agreement between two parties to exchange a given amount of one currency for another, or a stream of payments or receipts in one currency for a stream of payments or receipts in another currency. • Currency swaps, in contrast to interest rate swaps, typically involve an exchange of principle. • A cross-currency swap involves the additional exchange of a floating interest rate for a fixed rate. Daniels and VanHoose

  32. Purpose • A currency swap allows a firm to lock in the domestic currency value of a debt issue or future receipt. • It can allow a firm access to more favorable loan conditions. Daniels and VanHoose

  33. Difference with Forward • A forward contract could be used to accomplish the same thing as a swap. • As opposed to forwards, swaps usually involve the immediate matching of two counter parties with opposite needs, or a double coincidence of wants. • Long-dated forwards, therefore, tend to be much more costly to the firm. Daniels and VanHoose

  34. Example Consider the following example: A US firm wants to borrow euros to finance a project in Europe. The firm is not well know in the foreign markets. Higher information costs translate into higher financing costs. Hence, the firm finds it cheaper to borrow dollars in the domestic market. Daniels and VanHoose

  35. Example • At the same time, a European firm is in need of dollar financing. • An intermediary (or swap dealer) can arrange a swap between the two firms. • Each firm borrows in their own home market—presenting the respective home market with a well-know identity versus and unknown identity—thereby reducing the cost of funds to each firm. Daniels and VanHoose

  36. Solution • The US firm issues dollar-denominated debt in the US market, while the European firm issues euro-denominated debt in the European market. • Using the proceeds from the debt issues, the two firms swap the dollar principal for an equivalent euro principal. Daniels and VanHoose

  37. Solution • The US firm makes periodic euro payments to the dealer in exchange for an agreed amount of dollars. The dollars are used to pay interest to US bondholders. • The European firm makes periodic dollar payments to the dealer in exchange for an agreed amount of euros. The euros are used to pay interest to the European bondholders. Daniels and VanHoose

  38. Solution – The US Firm • At the end of the maturity period, the US firm pays euro-denominated principal to the dealer in exchange for the dollar equivalent. • The dollar funds received from the dealer are used to repay the principal to the bondholders. • The initial inflow and subsequent outflows of the firm replicate euro denominated debt, but at a lower cost. Daniels and VanHoose

  39. Illustration – US Firm • Note that the swap has two branches: One between the US firm and the dealer and another between the European firm and the dealer. • The swap, from the perspective of the US firm is illustrated in the next slide. Daniels and VanHoose

  40. Dealer Dealer Dealer Dealer $ principal € principal € payment € payment € equivalent $ payment $ equivalent $ payment Firm Firm Firm Firm $ principal $ principal $ interest $ interest Bondholders Bondholders Bondholders Bondholders