International Finance

1. International Finance Lecture 6

2. World Financial Markets and Institutions • International Banking and Money Market • International Bond Market • International Equity Markets • Futures and Options on Foreign Exchange • Currency and Interest Rate Swaps • International Portfolio Investment

3. Futures Contracts • A futures contract specifies that a certain currency will be __________ 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. • Standardizing Features: • __________ Size • __________ Month • Daily __________ • ________ requirements (initial, maintenance margins)

4. Currency Futures Markets • The Chicago Mercantile Exchange (CME) is by far the largest. • Others include: • The Philadelphia Board of Trade (PBOT) • The MidAmerica Commodities Exchange • The Tokyo Financial Exchange • The London International Financial Futures Exchange (LIFFE)

5. After Hours Trading • __________ -hours trading on CME GLOBEX runs from 2:30 p.m. to 4:00 p.m dinner break and then back at it from 6:00 p.m. to 6:00 a.m. CST. • Singapore Exchange (SGX) offers contracts. • There are other markets, but none are close to CME and SGX trading volume.

6. Daily Resettlement: An Example • Suppose you want to speculate on a rise in the $/¥ exchange rate (specifically you think that the dollar will appreciate). Currently __________. The 3-month forward price is __________.

7. Daily Resettlement • Currently $1 = ¥140 and it appears that the dollar is strengthening. • If you enter into a 3-month futures contract to sell ¥ at the rate of $1 = ¥150 you will make money if the yen depreciates. The contract size is ¥12,500,000 • You do not have to have ¥ now, either way you have committed yourself to sell ¥12,500,000 and receive in exchange ¥12,500,000 * 1/150 [$/ ¥] = $ _________ • Your initial margin is 4% of the contract value:

8. Daily Resettlement • On Thursday the futures rate closes at $1 = ¥149, then your position’s value drops. Here’s why. • Your have a short position in ¥. The mark-to-market profit/loss for short position is_______. • That is, you have lost $ ________overnight • The $559.28 comes out of your $3,333.33 margin account, leaving $2,774.05

9. Reading a Futures Quote Highest and lowest prices over the lifetime of the contract. Daily Change Closing price Lowest price that day Highest price that day Opening price Number of open contracts Expiry month

10. Currency Futures Trading: Example • $CAN futures contract expiring on June 14 trades on CME at US$0.7761 on January 9. On the last trading day of the contract in June the spot rate is US$0.7570. The contract size is CAN$100,000. • What is the profit/loss for a trader who took a long position in the contract on January 9? • What is the profit/loss for a trader who took a short position in the contract on January 9?

11. Currency Futures Trading: Example

12. Eurodollar Interest Rate Futures • Widely used futures contract for hedging short-term U.S. dollar interest rate risk. • The underlying asset is a $1,000,000 90-day Eurodollar deposit—the contract is __________. • Traded on the CME and the Singapore International Monetary Exchange. • Eurodollar futures prices are stated as an index number of three-month LIBOR calculated as F = 100 – LIBOR. • For example, if the closing price F is 98.23, the implied yield is 5.77 percent = __________ • Hedging/speculation just like with forwards, except standardized amounts and daily resettlement

13. Example • The size of a yen futures contract at CME is 12.5 million yen. The initial margin is $2,025 per contract and the maintenance margin is $1,500. You decide to buy ten contracts with maturity on June 17, at the current futures price of $0.01056. Today is April 1 and the spot rate is $0.01041. Indicate cash flows on your position if the following prices are subsequently observed.

14. Example solved

15. Example • It is 1 April now and current 3-month LIBOR is 6.25%. Eurodollar futures contracts are traded on CME with size of $1 million at 93.280 with June delivery. The initial margin is $540 and the maintenance margin is $400. You are a corporate treasurer and you know your company will have to pay $10 million in cash for goods that will be delivered on June 17. You will sell the goods for profit, but you will not receive payment until September 17. Thus, you know you will have to borrow $10 million for 3 months in June. • What is the forward rate implicit in the Eurodollar futures price? • How to lock in 3-month borrowing rate for June 17 using Eurodollar futures? • On June 17, the Eurodollar futures is quoted at 91%, and the current Eurodollar rate is 9%. You close your position at that time. What are your cash flows?

16. Example solved • Implicit rate = __________ = __________ Note that forward rate 6.72% > spot 6.25%, term structure __________ sloping • You will have to borrow $10 million for 3 months as you know. Borrow = __________ instruments. Borrow in the future and lock in the % rate = __________. You __________ Eurodollar contracts. • Interest rates ____________________ Your profit from the short position in the futures contracts is ______________________________. Your borrowing cost is _______________________ Your total borrowing CF = _______ _______ = $168,000. For 3 months borrowing you pay ________ __________ = 1.68% Convert this into per annum: __________________

17. Options Contracts • An option gives the holder __________, but not the obligation, to buy or sell a given quantity of an asset in the future, at prices agreed upon today. • Call vs. Put options. Call/Put options gives the holder the right, to buy/sell a given quantity of some asset at some time in the future, at prices agreed upon today. • European vs. American options. • European options can only be exercised __________ expiration date. American options can be exercised at any time up to and including the expiration date. • Since this option to exercise early generally has value, American options are usually __________ than European options, other things equal.

18. Options Contracts • In-the-money options • Profitable to exercised __________ • At the money options • Profit = 0 if exercised __________ • Out of the money options • __________ if exercised under the option’s terms • Intrinsic Value • In the money: The difference between the exercise price of the option and the spot price of the __________ asset. • Out of the money: __________

19. Currency Options Markets • Currency • 20-hour trading day. • __________ is much bigger than exchange volume. • Trading is in six major currencies against the U.S. dollar. • View standard specifications from PHLX • Options on currency futures • Options on a currency futures contract. Exercise of a currency futures option results in a long futures position for the ________of a call or the __________of a put. • Exercise of a currency futures option results in a short futures position for the __________ of a call or the __________ of a put.

20. Basic Relationships at Expiry • At expiry, an American call option is worth the same as a European option with the same characteristics. • If the call is in-the-money, it is worth __________ • If the call is out-of-the-money, it is __________. • CaT = CeT= Max[ST - E, 0] • At expiry, an American put option is worth the same as a European option with the same characteristics. • If the put is in-the-money, it is worth _______ • If the put is out-of-the-money, it is _______. • PaT = PeT= Max[E - ST, 0]

21. Basic Option Profit Profiles Call. Long position (_____). If the call is in-the-money, it is worth ST – E. If the call is out-of-the-money, it is worthless and the buyer of the call loses his entire investment of c0. Call. Short position (_____). If the call is in-the-money, the writer loses ST – E. If the call is out-of-the-money, the writer keeps the option premium. Put. Long position (______). If the put is in-the-money, it is worth E–ST. If the put is out-of-the-money, it is worthless and the buyer of the put loses his entire investment of p0. Put. Short position (______). If the put is in-the-money, it is worth E–ST. If the put is out-of-the-money, it is worthless and the seller of the put keeps the option premium of p0.

22. American Option Pricing • With an American option, you can do everything that you can do with a European option—this option to exercise early has value. • CaT>CeT = Max[ST - E, 0] • PaT>PeT = Max[E - ST, 0]

23. Market Value, Time Value and Intrinsic Value for an American Call The black line shows the _________ at maturity (not profit) of a call option. Note that even an out-of-the-money option has value—__________________.

24. Example • Calculate the payoff at expiration for a call option on the euro in which the underlying is $0.90 at expiration, the option is on EUR 62,500, and the exercise price is • $0.75 • $0.95

25. Example • Calculate the payoff at expiration for a put option on the euro in which the underlying is $0.90 at expiration, the option is on EUR 62,500, and the exercise price is • $0.75 • $0.95

26. Example • Calculate the payoff at expiration for a call option on a currency futures contract in which the underlying is at $1.13676 at expiration, the futures contract is for CAN$1,000,000 and the exercise price is: • $1.13000 • $1.14000

27. Example • Calculate the payoff at expiration for a put option on a currency futures contract in which the underlying is at $1.13676 at expiration, the futures contract is for CAN$1,000,000 and the exercise price is: • $1.13000 • $1.14000

28. Pricing currency options • Bounds on option prices are imposed by arbitrage conditions (ignore in this course) • Exact pricing formulas (theoretical) • Lattice models, for example binomial model (ignore for now) • Pricing based on continuous time modeling and stochastic calculus (mathematics used in modeling heat transfers, flight dynamics, and semiconductors). No derivations here. More _________ than binomial. • Idea: model evolution of the underlying asset’s price in ____________ time (i.e. not week-by-week) and calculate expected value of the option payoff.

29. Currency Option Pricing r = the interest rate (foreign or domestic), T – time to expiration, years S – current exchange rate, E – exercise exchange rate, DC/FC

30. Example • Consider a 4-month European call option on GBP in the US. The current exchange rate is $1.6000, the exercise price is $1.6000, the riskless rate in the US is 8% and in the UK is 11%. The volatility is 20%. What is the call price?

31. Example • Consider a 2-month European put option on GBP in the US. The current exchange rate is $1.5800, the exercise price is $1.6000, the riskless rate in the US is 8% and in the UK is 11%. The volatility is 15%. What is the put price?

32. Put-call parity for currency options

33. Option Value Determinants Call Put 1. Exchange rate 2. Exercise price 3. Interest rate at home 4. Interest rate in other country 5. Variability in exchange rate 6. Expiration date The value of a call option C0 must fall within max (S0 – E, 0) <C0<S0. The precise position will depend on the above factors.

34. Empirical Tests • The European option pricing model works fairly well in pricing American currency options. • It works best for ______________ and _______________ options. • When options are in-the-money, the European option pricing model tends to _____________ American options.

35. World Financial Markets and Institutions • International Banking and Money Market • International Bond Market • International Equity Markets • Futures and Options on Foreign Exchange • Currency and Interest Rate Swaps • International Portfolio Investment

36. Preliminaries • In Corp Fi we learn how to package debt and/or equity financing (_____________). • Now assume that we have done so, i.e., the optimal capital structure is in place. For a MNC this is a _________________________ securities denominated in different currencies with some being ________________. • Question: How a non-financial corporation can manage this complex exposure?

37. Risk exposures • MNE’s are exposed to a variety of risks: • Interest rate • Currency • Business Cycle • Inflation • Commodity • Industry • We have so far focused only on currency risk. • Now extend to _____________________ • Both asset and liability sides of a MNC is exposed to it (think of ____________ and _____ that MNE’s hold on the _____________).

38. Risk exposures • Corporate floating-rate loans are the dominant financing instrument • Two types of risks with loans: • Credit risk: • Re-pricing risk: • Task is to measure the impact of the risks on the cost of debt and come up with suitable hedging strategy

39. Motivation for Swaps • A UK firm wants to convert ______________ into ________________ to offset its revenues from US sales • The UK firm’s alternatives include • A ___________ in US dollars • A ____________ that trades floating-rate £ debt for the fixed-rate $ debt of a U.S. company

40. Parallel Loan British Petroleum Citigroup Ford HSBC BPUS FordUK

41. Parallel loans provided accessto new capital markets • Parallel loan: Borrow in ________________ and then trade for the debt of a foreign counterparty • Provided access to new capital markets • Legally _________________ on cross-border currency transactions • Provided ___________________ for foreign subsidiaries • May lower the firm’s _________________

42. Problems with parallel loans • The foreign counterparty may have _______________ • Parallel loans ___________________ on the balance sheet • Search costs can be _______

43. The swap contract • Solution: Package the parallel loans into a single legal agreement called the ______________ • Reduced the default risk of parallel loans via the _______________ (if one party defaults, the other is automatically freed from its obligation) • Swaps _____________________ on the balance sheet • High swap volume led to ___________

44. Development of the swaps market • 1981 • ______________ engineers the first currency swap between the _____________ and _____ • Early 1980s • Customized, low-volume, high-margin deals • Late 1980s and 1990s • Commercial and investment banks begin to serve as swaps dealers • Swaps turn into a ___________, ____________, _____________ business • Volume and liquidity grow

45. Swap Market • In 2001 the notional principal of: Interest rate swaps was $58,897,000,000,000. Currency swaps was $3,942,000,000,000 • The most __________ currencies are: • US$, JPY, Euro, SFr, GBP • A ___________ is a generic term to describe a financial institution that facilitates swaps between counterparties. It can serve as either a broker or a dealer. • A broker ___________ counterparties but does not assume any of the risks of the swap. • A dealer ____________ to accept either side of a currency swap, and thus may assume exchange rate risk.

46. Size of the Swap Market

47. Swaps • A swap is an agreement to exchange cash flows at ___________________ according to certain specified rules (traded on OTC) • Notional Principal • Counterparties: _________ and ________________ (market makers)

48. Swaps • Interest Rate Swaps • Currency Swaps • Basket Swaps – swap a currency for a weighted basket of other currencies. The basket is chosen to _________________ of a MNC.

49. Interest rate swaps • Interest rate swap • Similar to a currency swap, but cash flows in a _____________ are exchanged • A _________________ is paid during the life of the swap • The __________________ is not usually swapped

50. An Example of a “Plain Vanilla” Interest Rate Swap • An agreement by Microsoft to _________ ___________ & pay a _______________ every 6 months for 3 years on a notional principal of $100 million • Next slide illustrates cash flows • Note that in practice Fixed Rates are on __________ or __________ basis whereas Floating Rates are on _________ basis.