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Chapter 6

Chapter 6. Financial Derivatives for Currency Risk Management. Introduction to Financial Derivatives. Financial derivatives are financial instruments whose values are derived from an underlying asset such as a stock or a currency.

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Chapter 6

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  1. Chapter 6 Financial Derivatives for Currency Risk Management

  2. Introduction to Financial Derivatives • Financial derivatives are financial instruments whose values are derived from an underlying asset such as a stock or a currency. • Derivatives are mainly used to hedge against interest rate and foreign exchange risk. They are also used to speculate. • Currency forwards, currency futures and options, currency swaps are main derivatives in the derivatives market.

  3. Currency Futures • The violent fluctuations of commodity prices led to the creation of futures market. • The collapse of the Bretton Woods pegged exchange rate system is the main reason for the first currency futures contract. • Currency futures contract was created to cover the foreign exchange risk.

  4. A futures contract is an agreement between two parties to buy and sell a currency at a certain future time for a certain price. • A futures contract remedies the problem inherent in a forward contract. • The major problem with a forward contract is the default risk. A forward contract is a pure credit instrument. Whichever way the price of the spot rate of exchange moves, one party has an incentive to default.

  5. For example, if the forward rate is $1.35/€, the spot rate on the future delivery day is $1.40/€, then the party who sells the euro has the incentive to default. If the future spot rate goes down, the party who buys the euro may default. • A futures contract is similar to a forward contract, but there are a lot of differences between the two.

  6. Forward versus CME Futures Contracts

  7. Features of Currency Futures • Futures contracts are standardized contract in terms of the currencies traded, contract size, and maturity of the contract. For example, (CME) JPY futures contract contract size: ￥12,500,000 expiration date: third Wed. of March, June, September, and December

  8. last trading day: the second business day proceeding the expiration day (usually Monday) • Futures contracts are traded on an organized exchange. A Client who wants trade must open an account in commission house. All orders are executed through the commission house. Commission house is a “registered agent” of the client.

  9. Futures contracts are settled through exchange’s clearing house. The clearing house records trade, manages day-to-day settlement, and guarantees the delivery. • Futures contracts are marked to market on a daily basis. Clearing house issues margin call if the position of a client’s account deteriorates. • An initial margin and a maintenance margin are required to purchase a futures contract.

  10. An initial margin is the money a client must deposit when a futures contract is purchased. • Maintenance margin is the minimum amount of the money that must be maintained in a margin account. • A client must deposit extra money if a margin call is issued by the clearing house. • Daily marking to market means profits and losses are paid every day and is equivalent to closing out a contract each day at the end of trading, paying off losses or receiving gains, and writing a new contract.

  11. Example of Marking to Market • A client takes long position in a Swiss franc futures contract on Monday morning. Contract size: SFr125,000 Price of the contract: $0.85/SFr Initial margin: $2,000 Maintenance margin: $1,500 (Margin call will be issued if funds in margin account are less than $1,500) Cost of the contract: 0.85 x 125,000 = $106,250

  12. Monday closing exchange rate: $0.88/SFr The client gains since the price is up. (0.88 – 0.85) x 125,000 = $3,750 The client’s margin account balance: $2,000 + $3,750 = $5,750 The old contract is closed out. The client has a new contract now($0.88/SFr).

  13. Tuesday closing exchange rate: $0.84/SFr The client loses since the price is down. (0.84 – 0.88) x 125,000 = -$5,000 The client’s margin account balance: $5,750 - $5,000 = $750 A margin call is issued. Extra deposit: $750 • The price of the contract is $84/SFr now. If the contract expires now, the client loses $1,250 in his margin account. However, he gains from the new contract. His dollar payment is:

  14. 0.84 x 125,000 = $105,000 Compared to his previous cost of the contract, $106,250, he saves $1,250. • If the holder of the futures contract loses in his margin account, he gains from the spot exchange market; and vice versa. • Marking to market ensures that the clearing house’s exposure to currency risk is at most one day.

  15. Futures InformationMexican Peso Futures US$/Peso (CME)

  16. Hedging or Speculating with a Currency Futures Contract • An example of hedging The Texas Instrument has 100 million Danish kroner obligation due in September. Contract size: USD50,000 (Euronext standard) Futures price: DKr1.25/$ Maturity: September

  17. The company can sell dollar for kroner. So it takes a short position in the dollar futures. (100m/1.25)/(50,000) = 16 contracts • No matter what the future exchange rate is, the company’s dollar payment is fixed at: 100m/1.25 = $80 million • An example of speculation Mr. Speculator believes Mexican peso will appreciate against the dollar, he takes a long position in CME’s peso futures contract.

  18. Suppose he purchases 100 contracts at the price of $0.10615/Mex$. If the spot rate at the expiration date is $0.11146/Mex$ (5% up), his profit is: (0.11146 – 0.10615) x 500,000 x 100 = $265,500 If the peso is down by 5%, his loss is $265,500. • Forward and futures share a common characteristic; what is gained on one side of the contract price is lost on the other.

  19. Drawbacks of futures contract The currency exposure cannot exactly match exchange’s contract size. Clients can only partly hedge their exposure. There is a mismatch between maturity of the contract and maturity of the cash flow. Frequent margin calls bring inconvenient for businesses.

  20. Currency Options • An currency option provides investors, hedgers, or speculators with an instrument that have a one-sided payoff on a currency transaction. • An option is a contract that gives its owner the right but not the obligation to buy or sell a given amount of an underlying asset at a fixed price (called “exercise price or strike price”) sometime in the future.

  21. An option holder is the buyer of the contract and has the choice to execute or abandon the contract. • An option writer is the seller of the contract and has the obligation once the holder exercises the option. • The option holder pays the writer an option premium (option price) for the right. • A currency call option is the right to buy the underlying currency at a strike price and on a specified date.

  22. The underlying currency is the currency to be granted by an option contract. The currency to be exchanged for the underlying currency is called counter currency. • For example, a euro option in CME or PSE is the right to buy or sell euro. Euro is the underlying currency and U.S. dollar is the counter currency. • A currency put option is the right to sell the underlying currency at a strike price and on a specified date.

  23. If the right can be exercised at any time during the life of the option it is called an American option. • If the right can be exercised only at the option’s expiration date, it is called a European option. • Option quotes contract size, maturity, last trading day are all different at different exchanges. Options on CME are American options; while options on PSE are European options.

  24. CME GBP Option Quotes (contract GBP 62,500, quoted in cents per pound) Calls-Settle Puts-Settle Strike Price Oct Nov Dec Oct Nov Dec 1430 1.86 2.66 3.28 0.04 0.84 1.48 1440 0.98 2.04 2.72 0.16 1.22 1.90 1450 0.36 1.50 2.16 0.54 1.68 2.34 1460 0.16 1.06 1.72 1.34 2.24 2.90 1470 0.04 0.76 1.40 2.22 2.94 ··· 1480 0.08 0.52 1.10 3.18 ··· 4.24 Source: Wall Street Journal, 6 October 2000

  25. Currency Option Markets • Exchange-traded options are standardized contracts in terms of the currencies traded, contract size and maturity. • Only brokers who own a “seat” on an exchange can directly purchase option contracts. • OTC options are tailored to fit the needs of the clients. The underlying currency, strike price and maturity are specified by the clients. The writer quotes the option premium.

  26. The Intrinsic Value of an Option • An option will be exercised only when it has value. • Call option intrinsic value when exercised = Max[(Std/f – Ktd/f),0] When (Std/f – Ktd/f) > 0, the option has intrinsic value; When (Std/f – Ktd/f) ≤0, the option has no intrinsic value or zero intrinsic value.

  27. Put option intrinsic value when exercised = Max[(Ktd/f -Std/f),0] When (Ktd/f -Std/f) > 0, the option has intrinsic value; When (Ktd/f -Std/f) ≤0, the option has no intrinsic value or zero intrinsic value. • An option with intrinsic value is in-the-money. An option with zero intrinsic value is out-of-the-money. If the future spot rate is the same as the strike price, the option is at-the-money.

  28. For a call option, if the spot rate closes above the strike price, it is in-the-money. If the spot rate is below the strike price, it is out-of-the-money. • For a put option, if the spot rate closes above the strike price, it is out-of-the-money. If the spot rate is below the strike price, it is in-the-money. • For both call and put, if the spot rate closes the same as the strike price, the option is at-the-money with zero intrinsic value.

  29. Callt$/Mex$ out-of-the -money in-the- money St$/Mex$ $0.1045/Mex$ at-the-money Putt$/Mex$ out-of-the money in-the- money St$/Mex$ $0.1045/Mex$ at-the-money The Intrinsic Value of a Call and Put Option

  30. Time Value of an Option • An American option also has time value. This is because that at some time prior to expiry an out-of-the-money option will become an in-the-money option or in-the-money option further increases its value. • Time value of an option = Option premium – intrinsic value

  31. Example: suppose the premium of a put option is 5 cents for selling euro at $1.40/€ and the spot rate of euro is $1.45/€. • The option has no intrinsic value because the spot rate is higher than the strike price. • The time value is: Premium – Intrinsic value = $0.05

  32. Hedging with Options • A Japanese firm expects a $156,250 cash inflow on June 20. If the firm uses a forward contract to hedge risk exposure, it cannot benefit from the dollar appreciation. One solution for the firm is to purchase a dollar put option.

  33. If the dollar depreciates, the firm exercises the option. If the dollar appreciates, the firm abandon the option and captures the full benefit of the dollar appreciation. The option contract allows the firm to gain one-sided payoff while limiting its loss (premium).

  34. A Call Option Payoff Profile • A speculator believes the Japanese yen will be strong next month and decides to buy a yen call option. • The quotes on CME is “JPY June 1250 call” selling at “$0.000328/￥”. • The contract specification: K$/￥= 0.0125 (strike price) Contract size: ￥12,500,000 (CME standard) Expiration date: June 20 (third Wed) Current call price: $0.000328/￥ (premium)

  35. Profit and loss on a currency call option at expiration (JPY12,500,000/Contract) Exchange rate $0.0115/￥ $0.0125/￥ $0.012828/￥ $0.0130/￥ $0.0135/￥ Payments Premium cost -$4,100 -$4,100 -$4,100 -$4,100 -$4,100 Cost of exercise $0 $0 -$156,250 -$156,250 -$156,250 Receipts ￥ sale $0 $0 $160,350 $162,500 $168,750 Net profit -$4,100 -$4,100 $0 $2,150 $8,400 or loss

  36. Profit at expiration ($/￥) at-the-money break-even 0St$/￥ $0.0115 $0.0125 $0.012828 $0.0130 $0.0135 - $0.000328/￥ out-of-the-money in-the-money

  37. A Put Option Payoff Profile • A British pound put option quoted on PSE as “British pound Dec 1590 put” and is selling at $0.0175/₤. • Contract specification: K$/₤ = 1.59 (strike price) Contract size = 31,250 (PSE standard) Expiration date: third Wed. in December Current put option price = $0.0174/₤(premium) Premium cost for 100 contracts: ($0.0174/₤)(₤31,250)(100) = $54,375

  38. Profit and loss on a currency put option at expiration (GBP31,250/contract) Exchange rate $1.5600/₤ $1.5700/₤ $1.5726/₤ $1.5900/₤ $1.0000/₤ Payments Premium cost -$54,375 -$54,375 -$54,375 -$54,375 -$54,375 Spot ₤ -$4,875,000 -$4,906,250 -$4,914,375 $0 $0 purchase Receipts Exercising $4,968,750 $4,968,750 $4,968,750 $0 $0 contract Net profit $39,375 $8,125 $0 -$54,375 -$54,375 or loss

  39. Profit at expiration ($/₤) Abreak-even $39,375 at-the-money 0 St$/₤ $1.5600/₤ $1.5726/₤ $1.5900/₤ $1.6000/₤ - $54,375 in-the-money out-of-the-money

  40. Currency Swaps • A currency swap is a contractual agreement to exchange a principal amount of two currencies and, after a prearranged length of time, to give back the original principal. Interest payments in each currency also typically are swapped during the life of the agreement. • A forward contract is a simple form of swap. A forward contract does not exchange the interest, but the swap does.

  41. Borrow currency in the foreign market Borrower Country BP VW U.K. 6% 8% Germany 7% 5% • Both companies have disadvantages if they borrow from the foreign market. • In the 1970s, U.K. taxed all cross-border currency transactions involving sterling pounds. Then the parallel loan was created to avoid the taxes.

  42. Under the parallel arrangement, BP made a sterling loan to VW in U.K. In return, VW lent the equivalent amount in euro to BP in Germany. Germany U. K € at 5% ₤ at 6% € at 7% ₤ at 8% D. Bank VW BP HSBC BPG VWUK

  43. Advantages of parallel loans Tax dodge (a way to avoid paying taxes) Lower borrowing costs Covering currency exposure • Drawbacks of parallel loans Default risk An adverse balance sheet impact Search costs • Currency swap remedies the default risk in parallel loans. It does not increase a firm’s debt/equity ratio. Commercial banks and investment banks serve as market dealers.

  44. The most common form of a currency swap is the currency coupon swap, a fixed-for-floating rate nonamortizing currency swap, traded primarily through international commercial banks. • Nonamortizing loan means the entire principal is repaid at maturity and only interest is paid during the life of the loan. • Amortizing loan means periodic payments spread the principal repayment throughout the life of the loan.

  45. LIBOR (London Inter Bank Offered Rate) is the rate at which banks lend to each other. LIBOR is a bench-mark for variable-rates loans within the U.K. and internationally. • Currency swaps can be structured as fixed-for-fixed, fixed-for-floating, or floating-for-floating swaps of either nonamortizing or amortizing variety. • Most currency swaps are designed for long term. Currency swaps are very useful for multinational corporations.

  46. JP Morgan currency coupon swaps quotes (₤/$)(semiannual interest payments) Maturity Bid (in ₤) Ask (in ₤) 2 years 5.25% 5.35% 3 years 5.40% 5.50% 4 years 5.75% 5.85% 5 years 6.00% 6.10% All quotes against 6-month dollar LIBOR flat

  47. An Example of a Currency Swap • AT&T has $100 million of 3-year debt at a floating rate of 6-month ($) LIBOR. The company needs fixed-rate sterling debt to fund its operations in U.K. • JP Morgan agrees to pay AT&T’s floating rate dollar debt in exchange for a fixed-rate pound payment from the company. • Suppose the spot exchange rate is S$/₤ = 1.60. At this spot rate, $100 million is equal in value to ₤62.5 million.

  48. Cash transactions proceed as follows: $100 million Initial exchange of principals ₤62.5 million Cash flows during ₤ 5.50% the life of the swap 6-m $ LIBOR ₤62.5 million Reexchange of principals 100 million AT&T JP Morgan AT&T JP Morgan AT&T JP Morgan

  49. Interest Rate Swap • Interest rate swap is a variant of currency swap in which both sides of the swap are denominated in the same currency. • The principal is called notional principal and needn’t be exchanged. The notional principal is used only to calculate the interest payments. • The most common type of interest rate swap is the fixed-for-floating swap.

  50. Citigroup Interest Rate Swaps Quotes Coupon Swaps ($) Bank Pays Bank Receives Current Maturity Fixed Rate Fixed Rate TN Rate 2 years 2 yr TN + 19bps 2 yr TN + 40bps 7.05% 3 years 3 yr TN + 24bps 3 yr TN + 47bps 7.42% 4 years 4 yr TN + 28bps 4 yr TN + 53bps 7.85% 5 years 5 yr TN + 33bps 5 yr TN + 60bps 7.92% The schedule assumes nonamortizing debt and semiannual rates. All quotes are against 6-month dollar LIBOR flat. TN = U.S. Treasury note rate

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