FOREIGN CURRENCY DERIVATIVES (CHAPTER 8)

Forwards, Futures and Options

Derivatives
Defined

A derivative is an instrument whose value depends on the price of another asset.

Thus, the value of a derivative is derived from price of another asset. Ex: Futures Contracts

Derivatives: Futures Contracts

Contract Agricultural Corn Wheat Orange Juice Metals & Petroleum Gold Silver Unleaded gasoline Financial British Pound Japanese Yen Australian Dollar Contract Size 5,000 bushels 5,000 bushels 15,000 lbs. 100 troy oz. 5,000 troy oz. 42,000 gal. 62,500 12.5 million A$100,000

Basic Derivatives

Forward Contracts Futures Contracts Options Swaps

Derivative Markets
Exchange-traded futures and options
standardized products trading floor or computerized trading

Over-the-Counter forwards, options, & swaps

often non-standard (customized) products

Use of Derivatiwve
Relevance to Corporate Finance

Hedging: Hedgers use derivatives to reduce the risk that they from potential future movements in the price of an asset related to their business operations. Speculating: Speculators used derivatives to anticipate and attempt to profit by trading on expectations about future direction in the price of an asset. Arbitrage: Arbitrageurs take offsetting positions in the same asset to lock in a profits To change the nature of an asset or liability. To change the nature of an investment without incurring the costs of selling one portfolio and buying another.

Foreign Currency Forwards

Derivatives

Forward versus Spot Contracts

Basic Characteristics
A spot contract: A price is established today for pay immediate payment and delivery.
A forward contract: A future price is established today for future payment and delivery.

Forward Contracts
A forward contract gives the owner the right and obligation to buy an asset on a specified future date at a future price agreed today. The seller of the forward contract has the right and obligation to sell the asset on a specified future date at a future price agreed today. At the end of the forward contract, at delivery, ownership of the good is transferred and payment is made from the purchaser to the seller.

Forward Contracts
Generally, no money changes hands on the origination date of the forward contract. But, collateral may be demanded.

Delivery options may exist concerning

the quality of the asset the quantity of the asset the delivery date the delivery location.

Risk: Counterparty may default.

Forward Contracts
Basic Characteristics
Table 11-1 Foreign Exchange Quotes
Foreign Exchange Rates (Canadian dollars per foreign currency) US ($)
Spot 1 month 3 month 6 month 1 year 3 year 5 year 10 year 1.107 1.1063 1.1044 1.1017 1.0971 1.0697 1.0622 1.0312

GB ()
2.040 2.0393 2.0383 2.0368 2.0340 n/a n/a n/a

JAP ()
0.009721 0.009754 0.009821 0.009920 0.010116 n/a n/a n/a

Euro ()
1.3991 1.4007 1.4039 1.4082 1.4159 n/a n/a n/a

Reflects the time value of money and expected exchange rate changes. Forward rates the price TODAY for future delivery, so the further away, the lower the present value.

Source: Data from Bank of Montreal (BMO) Nesbitt Burns, Globe and Mail , June 10, 2006.

Using Forward Contracts / Hedging

Hedging using a forward contract requires that the investor have an opposite exposure to the contract.
This is a covered position.

Using Forward Contracts / Speculating

Speculation on a forward contract requires that the investor NOT own the underlying asset.
This is a naked position a position that leaves the investor exposed to changes in the value of the underlying asset.

Using Forward Contracts / Long and Short

Long : Buying expecting a price increase in an asset.

It is based on a bullish outlook (expected increase) for the asset.

Short : Selling expecting a price decrease in an asset.

It is based on a bearish outlook (expected decrease) for the underlying asset.

Foreign Exchange Forwards (FX Forward)

Definition: An agreement to exchange one currency for another, where
The exchange rate is fixed on the day of the contract,
but delivery and payment place on a specified future date.

Features of Foreign Currency Forwards

Available daily in major currencies in 30-, 90-, and 180-day maturities Forwards are entered into over the counter Deliverable forwards: face amount of currency is exchanged on settlement date Non-deliverable forwards: only the gain or loss is exchanged

Features of Foreign Currency Forwards

Contract terms specify:
forward exchange rate term amount value date (the day the forward contract expires)

locations for payment and delivery.

The date on which the currency is actually exchanged, the settlement date, is generally two days after the value date of the contract.

Foreign Currency Forwards / USES

(1) Hedge foreign currency risk (2) Arbitrage FX rate discrepancies within and between markets (3) Speculate on future market movements (4) Profit by acting as market maker

Hedging with Foreign Currency Forwards

Hedge payments and receipts denominated in foreign currencies. Example:
A Croatian firm exports to Germany and expects receiving a payment in Euro (EUR) wants to mitigate the risk of a depreciation of the EUR (appreciation of the HRK) at the time that the payment arrives.

The Croatian Kuna is the currency of Croatia.

The currency code for Kuna is HRK, and the currency symbol is kn.

Hedging a Payment with an Foreign Currency Forward

Hedged Item Company must pay EUR 1,000,000 to a eurozone supplier in 3 months Spot rate HRK/EUR: 7.3000. Treasurer believes HRK will depreciate during next 3 months Exposure to FX risk: What will be exchange rate HRK/EUR in three months?? Hedging Instrument Buy 1,000,000 EUR forward at forward rate of 7.3750 FX risk: Company is protected against large adverse FX rate movements If FX rate is unfavorable in 3 months (ie, > 7.3750), Company pays just 7.3750

Hedging a Payment with an Foreign Currency Forward

Hedged Item Company must pay EUR 1,000,000 to a eurozone supplier in 3 months Spot rate HRK/EUR: 7.3000. Treasurer believes HRK will depreciate during next 3 months Hedging Instrument Buy 1,000,000 EUR forward at forward rate of 7.3750

Advantages of Hedge: Company knows its costs and can plan its finances accordingly Cost of the hedge is zero - No money is exchanged at inception of the forward FX agreement

Disadvantage of Hedge: Company is still exposed to FX risk if the HRK/EUR spot rate is less than 7.3750 in 3 months
Note: Effect of hedge is same as buying EUR today and holding in an interest-bearing account (Forward FX agreement is NOT a simple speculation)

Hedging a Payment with an Foreign Currency Forward

Unhedged Company If in 3 months, spot rate is 7.4500
Effect of Hedging Hedged Company has already bought EUR forward
Hedged Company will pay: 7.375 x 1,000,000 = HRK 7,375,000

Unhedged Company must pay: 7.45 x 1,000,000 = HRK 7,450,000 Money saved by hedging: 7,450,000 7,375,000 = HRK 75,000

Deriving the Forward Exchange Rate

The spot rate HRK/EUR is 7.3000 A bank today sells a 3-month HRK/EUR forward to a company for a forward exchange rate of 7.3371 Q: How did the bank compute the forward rate?

Deriving the Forward Exchange Rate

Three month interest rates are:
1% on the euro

3% on the kuna
A company with EUR 1 million and a need for HRK in three months should be indifferent ( because of arbitrage opportunities related to Internationa l Rate Parity), as to whether it: Invests the EUR 1 million for 3 months at 1% and converts the euros (plus interest) into HRK at the end of this time, OR Sells the EUR 1 million spot for HRK, and invests the HRK at 3% for 3 months

Deriving the Forward Exchange Rate

OPTION 1 OPTION 2 Sell EUR 1 million spot at 7.30 Buy HRK 7.3 million Invest HRK for 3 months at 3%

Invest EUR 1 million at 1% for 3 months (91 days)

Interest earned EUR 2,493.15 (1 million x 1% x 91/360)

Interest earned HRK 55,358.33 (7.3 million x 3% x 91/360)

Value after 3 months EUR 1,002,493

Value after 3 months HRK 7,355,358

Forward Exchange Rate: 7.3371

Profits and Losses from a Long Forward Contract

The profit (loss) from the long position is equal to the difference between the spot price at delivery (ST) and the forward price (rate) F times the number of contracts entered into (n):

Profit (loss) from long position [ ST - F] n

Profits and Losses from a Long Forward Contract

The long profits if the spot price at delivery, S, exceeds the original forward price, F.
If spot exchange rate in the future exceeds the forward rate, then the investor will make a profit, otherwise, a loss

profit

S <F

S >F

The payoff is linear with 45 degree angle and passes through the forward rate F.

loss

Profit (loss) from long position [ ST - F] n

Profits and Losses from a Short Forward Contract

The profit (loss) from the short position is equal to the difference between the forward price (rate) F and the spot price (ST) at delivery times the number of contracts entered into (n):
Profit (loss) from short position [ F ST ] n

Profits and Losses from a Short Forward Contract

The profit (loss) of the short position is identically opposite of the long position.

profit

The short profits if the spot price at delivery, S, is below the original forward price, F.

S<F
loss

F=S

S>F

Profit (loss) from short position [ F ST ] n

Profits and Losses for Forward Contracts

If S(T) > F, the long profits by S(T) - F per unit, and the short loses this amount. If S(T) < F, the short profits by F - S(T) per unit, and the long loses this amount.

Example: You sell 20 million forward at a forward price of $0.0090/ . At expiration, the spot price is $0.0083/ . Did you profit or did you lose? How much?

Foreign Currency Futures

Foreign Currency Futures

A foreign currency futures contract is an alternative to a forward contract for future delivery of a standard amount of foreign exchange at a specified time, place and price agreed today. It is similar to futures contracts that exist for commodities such as cattle, lumber, interest-bearing deposits, gold, etc. In the US, the most important market for foreign currency futures is the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange.

Foreign Currency Futures

Contract specifications are established by the exchange on which futures are traded. Major features that are standardized are: Contract size Method of stating exchange rates Maturity date Last trading day Collateral and maintenance margins Settlement Commissions Use of a clearinghouse as a counterparty

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Foreign Currency Futures

Foreign currency futures contracts differ from forward contracts in a number of important ways: Futures are standardized in terms of size while forwards can be customized Futures have fixed maturities while forwards can have any maturity (both typically have maturities of one year or less) Trading on futures occurs on organized exchanges while forwards are traded between individuals and banks Futures have an initial margin that is market to market on a daily basis while only a bank relationship is needed for a forward Futures are rarely delivered upon (settled) while forwards are normally delivered upon (settled)

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Futures Contracts and Markets

Futures Contracts and Markets
Underyling Asset
Commodities Wheat/oats/soybeans Cattle/pigs/lumber Crude oil/heating oil/natural gas Cotton/orange juice Gold/silver/copper Lead/nickel/tin Canola/western barley/wheat Financial Futures Treasury notes and bonds/DJIA S&P index/Nikkei225 / C$ / / BAs/Canada bonds/TSX/S&P 60 index German bonds/European equities Other Weather derivatives

Exchange
Chicago Board of Trade (CBOT) Chicago Mercantile Exch. (CME) New York Merchantile Exchange NY Cotton Exchange The Commodity Exchange (Comex) London Metal Exchange (LME) Winnipeg Commodity Exchange CBOT CME Montreal Exchange Euronext/Liffe CME

Futures Contracts and Markets

Summary of Forward and Future Contracts

Forward and Future Contracts serve the same purpose. Forward contracts offer more flexibility because they are customized OTC contracts. Forward contracts, however, face additional risks:
Not actively traded (created by a bank for customers) Possess credit risk
Differences are listed in Table 11 3 on the following slide.

Forwards versus Futures

Table 11- 3 Forwards versus Futures

Forwards
Contracts Trading Default (credit risk) Initial deposit Settlement Customized Dealer or OTC markets Important Not required On maturity date Standardized Exchanges

Futures

Unimportant - guaranteed by clearinghouse Initial margin and maintenance margin required Marked to market daily

Exhibit 8.2 Currency Futures and Forwards Compared

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SHORT AND LONG POSITIONS IN FOREIGN CURRENCY FUTURES

Exhibit 8.1 Mexican Peso Futures, US$/Peso (CME)

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SHORT AND LONG POSITIONS IN FOREIGN CURRENCY FUTURES

SHORT AND LONG POSITIONS IN FOREIGN CURRENCY FUTURES

Foreign Currency Options

Foreign Currency Options

A foreign currency option is a contract giving the option purchaser (the buyer) the right, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period (until the maturity date). There are two basic types of options, puts and calls.
A call is an option to buy foreign currency A put is an option to sell foreign currency

Foreign Currency Options

The buyer of an option is termed the holder, while the seller of the option is referred to as the writer or grantor. Every option has three different price elements:
The exercise or strike price the exchange rate at which the foreign currency can be purchased (call) or sold (put) The premium the cost or price or value of the option

The current spot exchange rate in the market

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Foreign Currency Options: American and European Options

An American option gives the buyer the right to exercise the option at any time between the date of writing and the expiration or maturity date
A European option can be exercised only on its expiration date, not before.

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Foreign Currency Options Quotations and Prices

Exhibit 8.3 Swiss Franc Option Quotations (U.S. cents/SF)

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Foreign Currency Options Quotations and Prices

Foreign Currency Speculation

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

Speculators can attempt to profit in the:

Spot market when the speculator believes the foreign currency will appreciate in value

Forward market when the speculator believes the spot price at some future date will differ from todays forward price for the same date
Options markets extensive differences in risk patterns produced depending on purchase or sale of put and/or call

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Foreign Currency Options

At the money, In the money, Out of the money
An option whose exercise price is the same as the spot price of the underlying currency is said to be at-the-money (ATM). An option that would be profitable, excluding the cost of the premium, if exercised immediately is said to be in-themoney (ITM).

An option that would not be profitable, excluding the cost of the premium, if exercised immediately is referred to as outof-the money (OTM)