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Master in International Business

FOREIGN EXCHANGE
RISK MANAGEMENT
Lecturer tefan N M Ungureanu, PhD
Course Outline

1. The foreign exchange market
2. International parity conditions
3. Foreign currency derivatives
4. Measuring and managing transaction exposure to
currency risk
MAI FX Risk Management tefan N M Ungureanu, PhD
Exchange rates and intl. business
Any time a transaction has crossed borders, it has
been subject to the influence of changes in
exchange rates
Basic problem posed by exchange rates on cross-
border transactions: money across borders has no
fixed value
Our course purposes:
to understand, categorize and define the types of
exchange rate risks that firms face across borders
to address how managers can plan for, manage, and
hedge these risks
MPI FX Risk Management tefan N M Ungureanu, PhD
Foreign exchange reported losses
Company Country Loss (in millions) Period
Abbot Lab. USA USD 41.3 1993
Bank Negara Malaysia USD 2,100 1993
Citizen Japan JPY 15 Q2, 2002
Penoles Mexico USD 15.8 2000
Readers Digest USA USD 2.2 Q1-Q3, 1994
PepsiCo USA USD 53 1998
Toyota Japan JPY 1,200 Q1-Q4, 2004
Gazprom Russia USD 4,500 2009, Q1
MPI FX Risk Management tefan N M Ungureanu, PhD
Exchange rate fluctuations
MPI FX Risk Management tefan N M Ungureanu, PhD
Exchange rate fluctuations
USD/EUR, January 1999 October 2011
MPI FX Risk Management tefan N M Ungureanu, PhD
Exchange rate fluctuations
RON/EUR, July 2005 October 2011
MPI FX Risk Management tefan N M Ungureanu, PhD
Exchange rate fluctuations
Source: McKinsey Global Institute Global capital markets: Entering a new era, October 2009
MPI FX Risk Management tefan N M Ungureanu, PhD

Before a manager can start to grapple with the
effective or potential consequences of exchange
rates changes on the business, it is necessary to
understand some of the underlying forces in the
foreign exchange market
MPI FX Risk Management tefan N M Ungureanu, PhD
FOREIGN EXCHANGE
RISK MANAGEMENT
Topic 1 Foreign Exchange Market (FOREX)
Topic 1 Outline

1. Currency terminology
2. FOREX organization and structure
3. The spot market
4. The forward market
MPI FX Risk Management tefan N M Ungureanu, PhD
1. Currency terminology
Exchange rate / foreign currency exchange rate
Exchange rate regime/system
Exchange rate regimes
Free float
Managed float
Fixed-rate regime
Devaluation versus depreciation
Revaluation versus appreciation
Hard versus soft currencies
MPI FX Risk Management tefan N M Ungureanu, PhD
Free Float
The value of a free floating exchange rate is
exclusively established by demand and supply in
the foreign exchange market, with no outside
interventions
Over time, the exchange rate will fluctuate
randomly as market participants assess and react
to new information
Central bank (monetary authority) does not
intervene in the process of currency value
determination

MPI FX Risk Management tefan N M Ungureanu, PhD
Managed Float
Assumes central bank intervention, which
manipulates the exchange rate given its
objectives:
smoothing out exchange rate fluctuations
leaning against the wind
unofficial pegging of exchange rate
Central bank support of the rate is not automatic
Central bank reserves fluctuate quite heavily, but
typically around a certain level
MPI FX Risk Management tefan N M Ungureanu, PhD
Fixed-Rate System
Currencies maintained within a band (% of change
around a central value - parity)
Central banks actively buy or sell their currencies
in the foreign exchange market whenever the
exchange rate deviated from par value
In order to intervene on the FOREX, central bank
maintains reserves, which absorb the burden of
exchange rate adjustment high volatility of
reserves
Currency devaluation and revaluation is common
MPI FX Risk Management tefan N M Ungureanu, PhD
2. Organization of FOREX
The first global 24-hour market in the world and by far
the largest OTC market 2 tiers:
Wholesale tier liquid inter-bank market
60 to 70% of transactions
about 700 banks worldwide stand ready to make a market
in foreign exchange
there are FX brokers who match buy and sell orders but do
not carry inventory and FX specialists (dealers)
most inter-bank dealing is by phone & computer networks
there are corresponding banking relationships that
facilitate the functioning of the market
Retail tier client market

MPI FX Risk Management tefan N M Ungureanu, PhD
The worlds leading financial centers
0 4 8 12 16 20 24
Singapore
GMT
Sidney
Tokyo
Frankfurt
London
New York
MPI FX Risk Management tefan N M Ungureanu, PhD
FOREX Participants
Bank and non-bank FX dealers market makers

Individuals and firms conducting commercial and
investment transactions

Speculators and arbitragers

Central banks and treasuries

FX brokers
MPI FX Risk Management tefan N M Ungureanu, PhD
Markets by delivery date
Spot (rate: S
t
)
immediate (t) payment and delivery of currencies
settlement day : 1 or 2 working days
Forward (rate: F
t,T
)
payment and delivery at some future date (T)
common maturities: 30, 90, 180, 270, and 360 days,
and up to ten years
FX swap transactions
involve both a spot and a forward transaction, for
instance, buy spot and sell forward, or sell spot and
buy forward, with the same counterparty
MPI FX Risk Management tefan N M Ungureanu, PhD
Motives for FX transactions
Arbitrage is the simultaneous, or nearly simultaneous,
purchase of securities in one market for sale in another
market with the expectation of a risk-free profit
Speculation entails more than the assumption of a
risky position it implies financial transactions
undertaken when an individuals expectations differ
from the markets expectation
Hedging is the avoidance of foreign exchange risk by
entering into a transaction that lays off the risk to a
willing counter party

MPI FX Risk Management tefan N M Ungureanu, PhD
Foreign exchange market turnover
Global net turnover (2010) = US$ 3,210 billion per business day
Turnover = total US dollar value of all spot, outright forward, and
foreign exchange swap transactions concluded (not settled) during the
month of April
MPI FX Risk Management tefan N M Ungureanu, PhD
Currency distribution of FOREX
MPI FX Risk Management tefan N M Ungureanu, PhD
FOREX turnover by geographical
distribution, 2010
MPI FX Risk Management tefan N M Ungureanu, PhD
3. Spot Exchange Markets

1. Definition of exchange rates
2. Quoting conventions
3. Bid and ask rates
4. Cross exchange rates
MPI FX Risk Management tefan N M Ungureanu, PhD
Definition of Exchange Rates

Exchange rate
amount of currency that one has to pay in order to
buy one unit of another currency
amount of currency that one receives when selling
one unit of another currency

Which money is being bought or sold? depends
on home currency
MPI FX Risk Management tefan N M Ungureanu, PhD
Quoting conventions
Professional dealers and brokers quote currencies
in either of two ways:
direct basis HC/FC such as Canadian dollars per
US dollar or Romanian leu per US dollar when this
quote involves the USD as HC : American terms
indirect basis FC/HC such as US dollar per British
Pound (GBP) when this quote involves the USD as
HC : European terms
Most currencies are quoted on a direct basis, the
exception being some currencies from the former
Commonwealth - the most important ones are the
British pound and the Euro
MPI FX Risk Management tefan N M Ungureanu, PhD
Quoting conventions
Every exchange transaction involves two currencies
1.5625 CHF/USD




A trader always buys or sells a fixed amount of the
base currency
How to interpret changes in exchange rates:
numerator increases the base currency is
strengthening the base currency appreciates and the
terms currency depreciates
numerator decreases the base currency is weakening
the base currency depreciates and the terms currency
appreciates
base/quoted currency terms/counter currency
numerator denominator
MPI FX Risk Management tefan N M Ungureanu, PhD
Measuring a change in spot rates
Example: 1.5625 CHF/USD to 1.2800 CHF/USD
% change in the value of the USD in terms of the CHF is:




% change in the value of the CHF in terms of the USD is:


18.08%
1.5625
1.5625 - 1.2800
rate Beginning
rate Beginning - rate Ending
= =
22.09%
1.2800
1.2800 - 1.5625
rate Ending
rate Ending - rate Beginning
+ = =
USD depreciated by 18.08% against the CHF
CHF appreciated by 22.09% against the USD
MPI FX Risk Management tefan N M Ungureanu, PhD
Spot bid and ask quotations
Market makers will quote the rate at which they are
willing to buy the base currency (Bid) (in terms of the
other currency) and the rate at which they are ready
to sell the base currency (Ask)
1.5130 - 1.5145 CHF/USD



Often the quotation will be shortened to 30/45. These
numbers are points a point is the fourth place to
the right of the decimal point (0.0001)
The difference between the bid and the ask price is
the spread SPREAD = S
ask,t
S
bid,t
> 0
Market maker sells USD Market maker buys USD
Client sells USD Client buys USD
MPI FX Risk Management tefan N M Ungureanu, PhD
Inverting exchange rates in the
presence of spreads
Rule: the inverse of a bid quote is an ask quote, and vice
versa


ask,t
bid,t
S(USD/CAD)
1
S(CAD/USD) =
bid,t
ask,t
S(USD/CAD)
1
S(CAD/USD) =
Example: 1.3727 1.3730 CAD/USD

0.7283 - 0.7285 USD/CAD
MPI FX Risk Management tefan N M Ungureanu, PhD
Cross exchange rates
Cross exchange rate = exchange rate between 2
currency pairs where neither currency is the USD
( ) USD/GBP
t
S (EUR/USD)
t
S (EUR/GBP)
t
S =
Example: S(EUR/USD) = 1.2823
S(USD/GBP) = 1.4128

Cross exchange rate EUR/GBP is:
S(EUR/GBP) = 1.2823 x 1.4128 = 1.8116
MPI FX Risk Management tefan N M Ungureanu, PhD
3. Forward Markets

1. Forward market quotations

2. Forward premium or discount

3. Interest rate parity

4. Long and short forward positions



MPI FX Risk Management tefan N M Ungureanu, PhD
Forward market quotations
Buying and selling currencies for delivery on a
stipulated future date, at a rate agreed upon now

Practice: forward price = spot

Premium versus discount
When base currency is more expensive in the future
than it is now in terms of the other currency, the
former is said to be at a premium (assuming direct
quotes)

When base currency is less expensive, it is said to
stand at a discount (assuming direct quotes)
MPI FX Risk Management tefan N M Ungureanu, PhD
Forward market quotations

Outright rate
Spot 1.5130 - 1.5145 CHF/USD
3-month forward 1.5053 - 1.5078


Swap points
Spot 1.5130 - 1.5145 CHF/USD
3-month forward 77 - 67
MPI FX Risk Management tefan N M Ungureanu, PhD
Forward market quotations
Recovering the outright forward price from the
swap points rule :
1. If the points are decreasing, subtract from the spot
price
2. If the points are increasing, add to the spot price


Spread on
spot
15
Spread on
forward points
10
Spread on
outright forward
25
+ =
MPI FX Risk Management tefan N M Ungureanu, PhD
Forward market quotations
Suppose you read the following quotations:
Spot 1.4815 29 CAD/USD
3-month forward 40 38
Spot 0.6556 70 CHF/USD
6-month forward 51 64

The 3-month CAD/USD outright forward rate is:
F(CAD/USD) = 1.4775 - 1.4791

The 6-month CHF/USD outright forward rate is:
F(CHF/USD) = 0.6607 0.6634

MPI FX Risk Management tefan N M Ungureanu, PhD
Forward quotations in percentage terms


100
n
360
S
S - F
scount Premium/Di =
F - forward price
S - spot price
n - number of days in the contract

Discount on base currency is different from the
premium on terms currency
MPI FX Risk Management tefan N M Ungureanu, PhD
Forward quotations in percentage terms -
example
Suppose the following:
Spot rate 1.5437 CHF/USD
3-month forward rate 1.5398 CHF/USD

The discount on the USD is:



The premium on CHF is:

-1.01%p.a. = 100
90
360

1.5437
1.5437 - 1.5398
. a . p 1.013% = 100
90
360

1.5398
1.5398 - 1.5437
+
MPI FX Risk Management tefan N M Ungureanu, PhD
Interest rate parity
Interest rate parity (IRP) is an arbitrage condition that
establishes a relationship between spot and forward
exchange rates, and risk-equivalent domestic and
foreign nominal interest rates


Forward premium/discount ~ Interest differential
between currencies


The currency with the higher interest rate is at a
discount, the one with the lower interest rate is at a
premium

) i + (1
) i + (1
S
F
FC
HC
HC/FC
HC/FC
=
FC HC
i - i
S
S F
~

MPI FX Risk Management tefan N M Ungureanu, PhD


Interest rate parity
MPI FX Risk Management tefan N M Ungureanu, PhD
Interest Rate Parity example

90-day CHF interest rate 4%
90-day USD interest rate 8%
Spot rate (CHF/USD) 1.4800
90-day forward rate 1.4655

Is 1.4655 the correct forward price?

Note that because we do not use bid and ask rates, buying
and selling, as well as borrowing and lending, are done at
the same rates
MPI FX Risk Management tefan N M Ungureanu, PhD
Interest Rate Parity example
Start End
S=CHF1.4800/$

CHF1,480,000

$1,000,000

$1,020,000

CHF1,494,000
x 1.02

x 1.01
i
$
= 8.00% p.a.
(2.00% per 90 days)
I
CHF
= 4.00% p.a.
(1.00% per 90 days)
Dollar money market
Swiss franc money market

90 days
F
90
=CHF1.4655/$
MPI FX Risk Management tefan N M Ungureanu, PhD
IRP and Covered Interest Arbitrage
If IRP failed to hold, an arbitrage would exist
Example: Consider the following set of foreign
and domestic interest rates and spot and forward
exchange rates
Spot exchange rate S($/) = 1.25
360-day forward rate F
360
($/) = 1.20
US interest rate i
$
= 7.10% p.a.
UK interest rate i

= 11.56% p.a.

MPI FX Risk Management tefan N M Ungureanu, PhD
IRP and Covered Interest Arbitrage
According to IRP only one 360-day forward rate,
F
360
($/), can exist this is




Why?
If F
360
($/) = $1.20/, an arbitrageur could
engage in covered interest arbitrage (CIA)
and make money with one of the following
strategies:

$/ 1.20
0.1156 1
0.0710 1
1.25
360
F =
+
+
=
MPI FX Risk Management tefan N M Ungureanu, PhD
Arbitrage Strategy 1
If F
360
($/) > $1.20/
1. Borrow $1,000 at t = 0 at i
$
= 7.10%.
2. Exchange $1,000 for 800 at the prevailing spot
rate, (note that 800 = $1,000$1.25/)
3. Invest 800 at 11.56% (i

) for one year to achieve


892.48
4. Translate 892.48 back into dollars if F
360
($/) >
$1.20/, 892.48 will be more than enough to
repay your dollar obligation of $1,071
MPI FX Risk Management tefan N M Ungureanu, PhD
Arbitrage Strategy 2
If F
360
($/) < $1.20/
1. Borrow 800 at t = 0 at i

= 11.56% .
2. Exchange 800 for $1,000 at the prevailing spot
rate,
3. Invest $1,000 at 7.1% for one year to achieve
$1,071.
4. Translate $1,071 back into pounds if F
360
($/) <
1.20/, $1,071 will be more than enough to repay
your obligation of 892.48
MPI FX Risk Management tefan N M Ungureanu, PhD
Graphical Analysis of IRP
Zone of potential CIA
(sell FC forward)
Zone of potential CIA
(buy FC forward)
Interest Rate Differential: (i
HC
-i
FC
)/(1+i
FC
)
Forward
Premium (%)
Forward
Discount (%)
- 2
- 4
2
4
1 3 - 1 - 3
IRP line
Zone where CIA
is not feasible due
to transaction
costs
MPI FX Risk Management tefan N M Ungureanu, PhD
Long and short forward positions
Buy a currency = taking a long position
S
t+1
> F
t,t+1
buyer gains
S
t+1
< F
t,t+1
buyer looses


Sell a currency = taking a short position
S
t+1
> F
t,t+1
seller looses
S
t+1
< F
t,t+1
seller gains


Example: F
180 days
= 105 /$

MPI FX Risk Management tefan N M Ungureanu, PhD
Payoff profiles for forward contracts
loss
0
S
180
(/$)
F
180
(/$) = 105
120
If, in 180 days, S
180
(/$) = 120, the long will
make a profit by selling $ at S
180
(/$) = 120
and receiving $ at F
180
(/$) = 105.
15
profit
long position
MPI FX Risk Management tefan N M Ungureanu, PhD
Payoff profiles for forward contracts
If, in 180 days, S
180
(/$) = 120, the short
will lose by having to buy $ at S
180
(/$) =
120 and delivering $ at F
180
(/$) = 105.
loss
0
F
180
(/$) = 105
profit
120
15
S
180
(/$)
short position
MPI FX Risk Management tefan N M Ungureanu, PhD
Payoff profiles for forward contracts
0
S
180
(/$)
F
180
(/$) = 105
short position
long position
Since this is a zero-sum game,
the long position payoff is the
opposite of the short.
loss
profit
MPI FX Risk Management tefan N M Ungureanu, PhD
FOREIGN EXCHANGE
RISK MANAGEMENT
Topic 2 International Parity Conditions
Topic 2 Outline
1. The Parity Framework
2. Law of One Price and Purchasing Power Parity
3. Interest Rate Parity
4. Fisher Effects
5. Forward Rate Unbiased Property
6. Empirical evidence on parity conditions and
managerial implications

MPI FX Risk Management tefan N M Ungureanu, PhD
1. The Parity Framework
The framework is founded upon:
assumptions of rational economic behavior
the ability to transact freely at no cost in the markets
for goods and credit as well as the market for foreign
exchange
Simple models that describe relationships
between:
the spot exchange rate
the forward exchange rate
the interest rates
the inflation rates
MPI FX Risk Management tefan N M Ungureanu, PhD
Relevance and usefulness
Empirical evidence supporting each individual
parity condition is mixed
How much do they hold in the real world?
depends on the extent to which trade barriers
restrain the activities of traders from enforcing the
law of one price through arbitrage
Collectively, they constitute a useful way of
ordering ones thinking about the economic forces
governing exchange rate movements
international financial benchmarks or break-
even values
MPI FX Risk Management tefan N M Ungureanu, PhD
2. Law of one price (LOP)
Identical goods will sell for the same price in two
markets, taking into account the exchange rate

P
t
[US, wheat] = Spot
t
[$/] x P
t
[UK, wheat]

Example: $4.50 = $1.50 x 3.00
bushel bushel
Enforced by arbitrage across markets buying where
the product is cheap and selling where the product is
dear
LOP can prevail over the long run due to the forces of
supply and demand
MPI FX Risk Management tefan N M Ungureanu, PhD
Purchasing Power Parity (PPP)
PPP establishes a formal link between a countrys price
level or inflation rates (relative to another country)
and the prevailing exchange rate between the two
countries
Absolute PPP based on price levels in 2 countries:

P
t
[US] = Spot
t
[USD/GBP] x P
t
[UK]

the exchange rate will adjust to eliminate
discrepancies in price levels OR
price levels will adjust to eliminate discrepancies in
exchange rates
MPI FX Risk Management tefan N M Ungureanu, PhD
Purchasing Power Parity (PPP)
Relative PPP based on price indexes in 2 countries:





The spot exchange rate adjusts perfectly to inflation
differentials: if goods prices rise in HC relative to FC,
then HCs currency must depreciate to maintain a
similar real price for the goods in the two countries
The change in the exchange rate is roughly equal to
the difference in inflation rates (inflation differential)
rate inflation - ;
+ 1
+ 1
=
S
S
FC
HC
0
HC/FC
1
HC/FC
FC HC
FC
HC
0
0 1
PPP
PPP
1
1
1
S
S S
S ~
+
+
=

=
MPI FX Risk Management tefan N M Ungureanu, PhD
Purchasing Power Parity - example
Example:
Switzerland inflation rate 4% p.a.
US inflation rate 2% p.a.
Spot rate
0
1.50 CHF/USD


(The USD will appreciate and CHF depreciate accordingly)


PPP predicts a 2% appreciation of USD against CHF and a
2% depreciation of CHF against USD
CHF/USD 1.5295
1.02
1.04
1.50 S
1
PPP
= =
2% - 4% 1.96%
1.02
1.04
S
PPP
~ + = = A 1
MPI FX Risk Management tefan N M Ungureanu, PhD
Purchasing Power Parity Line
Given an S
actual
:
AS
HC-FC
= t
HC
- t
HC


we are on the PPP line
and PPP holds
AS
HC-FC
= t
HC
- t
HC


we are not on the PPP
line and PPP does not
hold

-7
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
6
7
-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7
0
0 1
actual
HC/FC
S
S S
S

=
FC HC

MPI FX Risk Management tefan N M Ungureanu, PhD
Real exchange rate
Assume t
FC
> t
HC
and t
HC
is constant FC is expected
to depreciate against HC, according to PPP
this does not necessarily mean that the real value of HC
purchases of goods and services across borders has
become cheaper
if the increase in P
FC
has exactly offset the decline in
value of the FC, then PPP would remain the same
there has been a nominal depreciation of FC, but not a
real depreciation
What matters for PPP across any two countries is the
change in the nominal value of a currency after
adjustment for changes in the relative inflation rates
between the two countries
MPI FX Risk Management tefan N M Ungureanu, PhD
Real exchange rate
These deviations from PPP are measured using the real
exchange rate and changes in real exchange rate
Real exchange rate



Interpreting q values:
q=1 PPP holds (benchmark value)
q>1 FC appreciates in real terms against HC
HC depreciates in real terms against FC
q<1 FC depreciates in real terms against HC
HC appreciates in real terms against FC

t) Spot(PPP,
t) l, Spot(Actua
q = t) Spot(Real,
t
=
MPI FX Risk Management tefan N M Ungureanu, PhD
Real exchange rate example



Case 1
S
actual
=1.50 CHF/USD
S
PPP
=1.50 CHF/USD

CHF and USD are
at their values
Case 2
S
actual
=1.55 CHF/USD
S
PPP
=1.50 CHF/USD



USD overvalued
CHF undervalued

Case 3
S
actual
=1.45 CHF/USD
S
PPP
=1.50 CHF/USD



USD undervalued
CHF overvalued
1
1.50
1.50
q = =
1.033
1.50
1.55
q = =
0.967
1.50
1.45
q = =
MPI FX Risk Management tefan N M Ungureanu, PhD
Changes in real exchange rate




Example:
S
0
=1USD/EUR; t
$
=5% p.a.; t

=10% p.a.

PPP actual
PPP
PPP actual
S S
S
S S
q ~

=
0
0
1
actual
S
S S
0
0
1
PPP
S
S S
USD/EUR 0.9545
1.10
1.05
1 S
1
PPP
= =
4.55% 1
1.10
1.05
S
PPP
= =
PPP predicts a 4.55% depreciation of EUR against USD
MPI FX Risk Management tefan N M Ungureanu, PhD
Changes in real exchange rate
Example (contd)
3 possible cases regarding S
1
actual
:
S
1
actual

(USD/EUR)

AS
actual
(%) AS
PPP
(%) Aq(%) Interpretation
0.9545 -4.55 -4.55 0 No change in q
0.9600 -4.00 -4.55 +0.55 EUR appreciated in
real terms by 0.55%
against USD
0.9500 -5.00 -4.55 -0.45% EUR depreciated in
real terms by 0.45%
against USD
Nominal depreciation of EUR
MPI FX Risk Management tefan N M Ungureanu, PhD
Interest rate parity (IRP) states that the forward
premium or discount for the quoted currency reflects
the difference in interest rates for banking deposits in
the two currencies



The currency with the higher interest rate is at a
discount, the one with the lower interest rate is at a
premium
If IRP did not hold, then it would be possible for an
arbitrageur to make money exploiting the arbitrage
opportunity covered interest arbitrage
3. Interest rate parity
) i + (1
S
F
= ) i + (1
FC
HC/FC
HC/FC
HC
MPI FX Risk Management tefan N M Ungureanu, PhD
4. The Fisher Effects
Fisher parities describe how information regarding
expected inflation and expected exchange rates are
captured in interest rates
Fisher closed equation that links nominal interest
rate and inflation expectations for a single economy





Fisher closed represents another example of arbitrage
between real assets and financial assets within a
single economy
) (1 r) (1 i (1 + + = + )
r i + =
(approximation)
MPI FX Risk Management tefan N M Ungureanu, PhD
The International Fisher Effect (Fisher
Open or UIP)
Interest rates across countries must be set with an eye
toward expected exchange rate changes
The derivation of IFE is another straightforward
application of arbitrage an interest arbitrage but
uncovered



the expected spot exchange rate between two currencies
should change by an equal amount but in opposite direction
to the difference in interest rates between the two countries



i - i
S
S - ) E(S
ely approximat or
i + 1
i + 1
=
S
E(S
FC HC
0
0 1
FC
HC
0
1
~
)


% expected exchange = % interest differential
rate change
MPI FX Risk Management tefan N M Ungureanu, PhD
IFE and Exchange Rate Predictions
IFE predictions
HC interest rates > FC interest rates HC is expected
to depreciate E(S
1
) > S
0
logic: investors must be
paid a higher interest rate to compensate them for a
unit of account that is expected to depreciate in value
HC interest rates < FC interest rates HC is expected
to appreciate E(S
1
) < S
0
logic: investors willingly
accept a lower interest rate when they hold a unit of
account that is expected to appreciate in value
Computation of the markets implied future spot
rate:






t
FC
HC
1 + t
S
i + 1
i + 1
= ) E(S
MPI FX Risk Management tefan N M Ungureanu, PhD
IFE and Real Interest Rate Parity
Suppose Fisher closed is valid in HC and FC
HC HC HC
r i + =
FC FC FC
r i + =
) ( ) r (r i i
FC HC FC HC FC HC
+ =
FC HC FC HC
i i =
(IFE)
S
S ) E(S
i i
0
0 1
FC HC

=
0 r r assume
FC HC
=
holds PPP assume
IFE implicitly assumes that real interest rates are equal across
countries
MPI FX Risk Management tefan N M Ungureanu, PhD
5. The Forward Rate Unbiased Property
Follows directly from IRP and IFE:







% Forward premium = % Expected Exchange Rate Change
t
t 1 + t
t
t 1 + t t,
S
S ) E(S
=
S
S F
-
-
Forward rate is an unbiased predictor of the future spot
rate forward rates and interest differentials neither
systematically over- and underestimate the future spot rate
F
t,t+1
S
t
=
1+i
HC
1+i
FC
=
E(S
t+1
)
S
t
F
t,t+1
= E(S
t+1
)
MPI FX Risk Management tefan N M Ungureanu, PhD
Combining the parity relations
S
0
= 1.3250 CHF/USD
F
0,360
= 1.3509 CHF/USD
t
CHF
= 4% pa; t
USD
= 2% pa t
CHF
- t
USD
= 2%
i
CHF
= 5% pa; i
USD
= 3% pa i
CHF
i
USD
= 2%
Forward premium on USD


Forecast change in the spot rate


2% 2% 4%
S
S F
0
0 0,360
= ~

) appreciate to expected (USD 2% 2% 4%


S
S S
0
0 360
+ = ~

MPI FX Risk Management tefan N M Ungureanu, PhD


International parity relations in equilibrium
Forecast change in spot
exchange rate
+2%
(USD strengthens)
Forecast premium on
foreign currency
+2%
Difference in nominal
interest rates
+2%
(higher in Switzerland)
Forecast difference in
rates of inflation
+2%
(higher in Switzerland)
Interest rate parity
(2)
Forward rate
unbiased property
(5)
International Fisher
Effect
(4)
Fisher closed
(3)
Purchasing Power
Parity
(1)
MPI FX Risk Management tefan N M Ungureanu, PhD
6. Empirical evidence on parity conditions
Parity conditions play an important role in the
formation of strategies toward international financial
markets formulated by people in private enterprise
When parities hold, a source of risk and a source of
opportunity disappear a decision point is removed
If all parity conditions were valid at each and every
moment in time no important financial managerial
decisions to make
If parity conditions are not valid at each and every
moment in time two categories of financial
decisions:
Profit maximizing
Risk managing
MPI FX Risk Management tefan N M Ungureanu, PhD
Empirical evidence on parity conditions
Managers can identify deviations that are small and growing
larger, or already large and likely to persist active
profit-maximizing strategies will follow
Assumptions that managers can move quickly enough to
capture a parity deviation and that the risks involved are
not excessive
Managers believe that parity conditions hold on average,
but are not able to detect whether a deviation is likely to
be transitory or persistent strategies that aim at
reducing the firms exposure to the deviation risk
Understanding the magnitude and duration of deviations
from parity conditions forms the foundation for many of
international financial managers decisions
MPI FX Risk Management tefan N M Ungureanu, PhD
Empirical evidence on LOP and PPP
LOP is fragrantly and systematically violated
Tests on PPP show that it is strongly violated on the
short-run, but describes a long-run phenomenon
PPP does not hold precisely in the real world for a
variety of reasons :
transportation costs
existence of non-tradables
differences in consumption preferences
PPP-determined exchange rates still provide a valuable
benchmark for:
currency forecasting
determining over- and under-valuation of currencies
management of foreign exchange risk
MPI FX Risk Management tefan N M Ungureanu, PhD
A test of PPP - Big Mac Index

One test of the Law of
One Price is the Big Mac
index, which has been
published annually in
The Economist since
1986.

It was devised as a
light-hearted guide to
whether currencies are
at their correct level,
based on PPP.
MPI FX Risk Management tefan N M Ungureanu, PhD
Big Mac Index
US Big Mac price
(CAD/USD) S
price Mac Big Canadian
actual
price Mac Big US
price Mac Big Canadian
100
2.90
2.90 2.33

MPI FX Risk Management tefan N M Ungureanu, PhD


Pitfalls of the Big Mac test
The Big Mac Index shows the extent to which
international price discrimination is possible for a
particular product
The Big Mac is a non-tradable and nondurable product
It is a differentiated product with an implied warranty
associated with the reputation of the McDonalds Corp.
Big Macs are generally produced locally, with local labor
and on local land, usually with locally produced
materials
In many countries, Big Macs do not have close
substitutes

McDonalds sets the profit-maximizing price in a
country, ignoring the prospect of Big Mac arbitrage

MPI FX Risk Management tefan N M Ungureanu, PhD
Empirical evidence on IRP
Various empirical studies indicate that IRP holds in
free, deregulated markets (within a transaction cost
band)
Deviations may occur due to capital controls, taxes (on
repatriated capital), market incompleteness
Quite large deviations in closed less-developed
countries, since smaller currencies can be borrowed
and lent only domestically
Bankers often use the IRP model to quote forward
rates
MPI FX Risk Management tefan N M Ungureanu, PhD
Empirical evidence on IRP
Covered Interest Arbitrage opportunities
MPI FX Risk Management tefan N M Ungureanu, PhD
Empirical evidence on IFE
1973-1993 little relationship between the
current interest differential on Euro-$ and Euro-
DEM deposits and the future realized $/DEM
exchange rate changes
1973-1993 small average deviation from the IFE
for the pairs $/DEM and other eight major
currencies
Long-run tendency for the interest differential to
offset exchange rate changes
MPI FX Risk Management tefan N M Ungureanu, PhD
Empirical evidence on Forward rate
unbiased property
Empirical tests generally show that the forward
rate is not a good predictor of the level of the
future spot rate
However, there is strong evidence that the forward
rate does a better job of predicting at least the
direction of changes to future spot rate rather
than do about two-thirds of the better known
foreign exchange forecasting services

MPI FX Risk Management tefan N M Ungureanu, PhD
FOREIGN EXCHANGE
RISK MANAGEMENT
Topic 3 Foreign currency derivatives
Topic 3 Outline


1. Foreign Currency Futures
2. Foreign Currency Options
3. Currency Swaps

MPI FX Risk Management tefan N M Ungureanu, PhD
1. Foreign currency futures

1. What is a currency futures contract?
2. The market for currency futures contracts
3. Quoting currency futures contracts
4. Forward contracts versus futures contracts
5. Hedging with futures contracts

MPI FX Risk Management tefan N M Ungureanu, PhD
What is a futures contract? (I)
A futures contract represents a pure bet on the
direction of price (exchange rate) movement of the
underlying currency

ATTN!! The futures price is not a monetary amount
you pay to anyone, but the variable about which
you are betting

Your actual gain or loss depends on the position
taken on the market - long or short
MPI FX Risk Management tefan N M Ungureanu, PhD
What is a futures contract? (II)
If you buy a futures contract (go long) and
the futures price goes up you make money
the futures price goes down you lose money

If you sell a futures contract (go short) and
the futures price goes down you make money
the futures price goes up you lose money

Open interest the number of futures contracts outstanding
for which delivery is obligated
MPI FX Risk Management tefan N M Ungureanu, PhD
What is a futures contract? (III)
A futures contract is a binding agreement to pay
up your bet on a daily basis, for every day the
market is open and your bet is still in effect

You stop an FX futures bet prior to the end of
trading on the last trade day you are not
obligated to buy or deliver anything

After last trade dates you will be legally
obligated to acquire (if long) or to deliver (if
short) the underlying asset on whose price you
are betting, if contract is still in force
MPI FX Risk Management tefan N M Ungureanu, PhD
What is a futures contract? (IV)
The size of the bet you take by opening a futures
contract is governed by the face amount of the
contract
Futures long at price P
0
at the end of the day
there will be a positive or negative cash flow to
your futures account:
(P
1
P
0
) x Face value of contract
Next business day: cash flow to your account is
(P
2
P
1
) x Face value of the contract
MPI FX Risk Management tefan N M Ungureanu, PhD
What is a futures contract? (V)
Example:
62,500 futures contract opened at a negotiated
price of $1.4500/
the settlement prices at the end of Day 1 and Day 2
are

Opening price 1.4500 $/
Settlement price, end Day 1 1.4460 $/
Settlement price, end Day 2 1.4510 $/


MPI FX Risk Management tefan N M Ungureanu, PhD
What is a futures contract? (VI)
The respective cash flows for long and short
positions in a single contract opened at $1.4500/
are

Long Short
($1.4460/ - $1.4500/) x 62,500 = -$250 + $250
($1.4510/ - $1.4460/) x 62,500 = + $312.50 - $312.50
MPI FX Risk Management tefan N M Ungureanu, PhD
The market for futures contracts
How it emerged? the possibility of default for
forward contracts raised potentially serious
problem for counterparties overcoming the
risk:
1. Making forward contracts only with people of high
character, reputation, and credit quality
2. FUTURES CONTRACTS

May 1972 International Monetary Market
(IMM) of CME introduces trading in FX futures
July 1986 Philadelphia Board of Trade
introduces currency futures trading
MPI FX Risk Management tefan N M Ungureanu, PhD
Currency futures on CME

Expiry cycle: March, June, September, December

Delivery date 3rd Wednesday of delivery month

Last trading day is the second business day
preceding the delivery day

CME hours 7:20 a.m. to 2:00 p.m. CST.

MPI FX Risk Management tefan N M Ungureanu, PhD
Quoting Futures Contracts
Source: Financial Times, December 16, 2008
MPI FX Risk Management tefan N M Ungureanu, PhD
Forward versus Futures Contracts
Forward contracts Futures contracts
1. Customized transactions in terms of
size and delivery dates
1. Standardized contracts in terms of
size and delivery dates
2. Private contracts between two
parties
2. Standardized contracts between a
customer and a clearinghouse
3. Difficult to reverse a contract 3. Contract may be freely traded on
the market
4. Profit or loss on a position is
realized only on the delivery date
4. All contracts are marked to market,
so profits and losses are realized
immediately
5. Margins are set once, on the day of
the initial transactions
5. Margins must be maintained to
reflect price movements
MPI FX Risk Management tefan N M Ungureanu, PhD
Marking-to-market
Process of updating a margin account on a daily
basis to reflect the market value of the
underlying position
Margins are set by the exchange, subject to
periodic revision
Determined by looking at the risk of a given contract
Two types of margin:
Initial margin posted when the client first enters a
contract may be formed of cash or interest-bearing
securities
Maintenance margin minimum level of the margin
only in cash
MPI FX Risk Management tefan N M Ungureanu, PhD
Marking-to-market - example
June 15: purchase a CHF125,000 September CHF futures
contract traded on CME; price = $0.70/CHF.
Entering the transaction futures trading account with a
securities or brokerage firm post initial margin
assume is $7,000 (8%); maintenance margin = 83% of initial
margin (=$5,810)
June 16: Sept. CHF future ends the day at $0.696 new
value of contract: $87,000 you incur a $500 loss the
remaining value of your margin account = $6,500
June 17: Sept. CHF future falls to $0.692 new value of
contract = $86,500 you incur a $500 loss remaining
value of margin account = $6,000
MPI FX Risk Management tefan N M Ungureanu, PhD
Marking-to-market - example
June 18: Sept. CHF futures falls to $0.689 new value of
contract = $86,125 you incur a $375 loss balance of
margin account = $5,625
Because now the balance is lower than the maintenance
margin, the broker will issue a margin call for $1,375
(variation margin) to restore the initial margin of $7,000
Consider now a happier case: CHF appreciates to $0.71/$
the broker will credit your margin account for $1,250
(equal to the $0.01 gain on CHF125,000), bringing the
total to $8,250 these excess margin funds could be
withdrawn and put to some other use
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging FX risk using forwards versus futures
Assume a bank raised all its liabilities in dollars while
investing half of its assets in GBP-denominated loans and
the other half in USD-denominated assets





Assets and liabilities are of a 1 year maturity and duration;
interest rate on UK loan: 15% p.a.
Assets Liabilities
U.S. loans ($) $100 million U.S. CDs $200 million
U.K. loans () 100 million
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging FX risk using forwards
0 1
Make loan (100 million)
Sell principal (100
million) plus interest (15
million) forward at the
forward exchange rate at
time 0
Deliver principal and
interest (115 million) on
loan to forward contract
buyer and receive $s at the
time 0 forward exchange
rate
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging FX risk using futures
Suppose the bank wished to hedge this loan position on
Sept. 25, 2001 only 2 contracts available on that day for
GBP in the futures market: a December 2001 maturity one
and a March 2002 maturity
The bank could use futures only by rolling over the hedge
into a new futures contract on maturity
How many futures should the bank sell?
The amount that produces a sufficient profit on the GBP
futures contract to just offset any exchange rate losses
on the GBP loan portfolio should the GBP fall in value
relative to USD
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging FX risk using futures
Two cases to consider:

1. The futures USD/GBP price is expected to change in
exactly the same fashion as the spot USD/GBP price
over the course of the year NO BASIS RISK

2. Futures and spot prices, while expected to change in
the same direction, are not perfectly correlated
THERE IS BASIS RISK
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging FX risk using futures Case 1
Sept. 25, 2001: S
t
= 1.4713 USD/GBP; f
t
for Dec. 2001 =
1.4640 USD/GBP
Forecasts for 1 years time spot and futures: S
t+1
= 1.4213
USD/GBP; f
t+1
= 1.4140 USD/GBP
Over the year: AS
t
= -5 cents; Af
t
= -5 cents
Number of futures contract to be sold:


Loss on GBP loan: 115 million (-5 cents) = $5.75 mill.
Gain on futures contract:
115 million (5 cents) = $5.75 mill.

contracts 1,840
62,500
00 115,000,0
contract futures of Size
position long of Size
N
f
= = =
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging FX risk using futures Case 2
Sept. 25, 2001: S
t
= 1.4713 USD/GBP; f
t
for Dec. 2001 =
1.4640 USD/GBP
Forecasts for 1 years time spot and futures: S
t+1
= 1.4213
USD/GBP; f
t+1
= 1.4340 USD/GBP
Over the year: AS
t
= -5 cents; Af
t
= -3 cents BASIS RISK
Suppose the bank manager ignored the basis risk and sold
1,840 futures contracts
Loss on GBP loan: 115 million (-5 cents) = $5.75 mill.
Gain on futures: (1,840 62,500) 3 cents = $3.45 mill.
Net loss = $5.75 - $3.45 = $2.3 mill.

MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging FX risk using futures Case 2
The bank manager should take into account the lower
sensitivity of futures prices relative to spot rates changes
by selling more than 1,840 futures contracts to fully hedge
the GBP loan risk
Hedge ratio: how many futures should be sold to hedge the
long position in the GBP when the spot and futures prices
are imperfectly correlated


Since spot rates are 66% more sensitive than futures
prices, for every 1 in the long asset position, 1.66
futures contracts should be sold

1.66
$0.03
$0.05
f
S
h
t
t
= = =
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging FX risk using futures Case 2
Suppose now the bank manager does not ignore the basis
risk
Number of futures contracts sold:


Computing losses and gains:
Loss on GBP loan: 115 million (-5 cents) = $5.75 mill.
Gain on futures: (3,054 62,500) 3 cents = $5.73 mill.
Net loss = $5.75 - $5.73 = -$0.02 mill. (due to rounding)
contracts 3,054 1.66
62,500
00 115,000,0
h
contract futures of Size
position long of Size
N
f
= = =
MPI FX Risk Management tefan N M Ungureanu, PhD
Deciding on futures versus forwards
Depends on the purpose and scale of the
transaction
Hedgers if similar prices, will prefer interbank
forward contracts (if access to the market exists)
Speculators
Short-term speculator exchange-traded futures
contracts
Larger-scale speculators interbank market, but
more likely the trade is in spot contracts
MPI FX Risk Management tefan N M Ungureanu, PhD
2. Foreign currency options

1. What is an option?
2. The market for currency options
3. Quoting prices for currency options
4. Introduction to FX option pricing and valuation

MPI FX Risk Management tefan N M Ungureanu, PhD
What is an option? (I)
Unique type of financial contract with a throwaway
feature they give you the right, but not the
obligation, to do something
No daily cash flows on the long side of an option
Limited potential loss on a long position
Call versus put options
American versus European options
MPI FX Risk Management tefan N M Ungureanu, PhD
What is an option? (II)

A call on spot a contract between a buyer
and a writer/seller whereby the buyer pays a
price (the premium) to the writer in order to
acquire the right, but not the obligation, to
purchase a given amount (size) of one currency
from the writer at purchase price (exercise
price, strike price) stated in terms of a second
currency

MPI FX Risk Management tefan N M Ungureanu, PhD
What is an option? (III)

Example: CME December 2001 call option on GBP31,250;
exercise price = $1.50/GBP; premium = $322

American option: you can buy GBP31,250 at any time
before the Saturday prior to the third Wednesday in
December 2001

European option: you can buy GBP31,250 only on the
Saturday prior to the third Wednesday in December 2001
MPI FX Risk Management tefan N M Ungureanu, PhD
What is an option (IV)
A put on spot a contract between a buyer and
a writer/seller whereby the buyer pays a price
(the premium) to the writer in order to acquire
the right, but not the obligation, to sell a given
amount (size) of one currency to the writer at
selling price (exercise price, strike price) stated
in terms of a second currency
MPI FX Risk Management tefan N M Ungureanu, PhD
What is an option? (V)

Example: CME June 2001 put option on JPY1,000,000;
exercise price = JPY150/$; premium = $320

American option: you can sell JPY1,000,000 at any time
before the Saturday prior to the third Wednesday in
June 2001

European option: you can sell JPY1,000,000 only on the
Saturday prior to the third Wednesday in June 2001

MPI FX Risk Management tefan N M Ungureanu, PhD
Currency Options Markets
Philadelphia Stock Exchange
Hong Kong Financial Exchange
20-hour trading day.
OTC volume is much bigger than exchange
volume.
Trading is in seven major currencies plus the euro
against the U.S. dollar.

MPI FX Risk Management tefan N M Ungureanu, PhD
Currency Options Contracts - example (PSE)
Contract type: European-style call option on PSE

Underlying asset: GBP

Expiration date: Third Wednesday in December

Exercise price: $1.45/ spot rate

Contract size: 31,250

MPI FX Risk Management tefan N M Ungureanu, PhD
Currency options quotes - PSE
PHILADEPHIA Sterling Options 31,250 (cents per pound)

Strike
price
CALLS PUTS
Mar Apr May Mar Apr May
1.620 2.01 2.63 3.11 0.63 1.32 1.77
1.630 1.38 2.10 2.56 0.97 1.75 2.21
1.640 0.94 1.67 2.13 1.44 2.22 2.69
Previous days vol., Calls-Puts 422. Prev. days open int., Calls 1553 Puts 19,754
MPI FX Risk Management tefan N M Ungureanu, PhD
Writing FX options
The writer of a FX option is in a different position
form the buyer of the option

The writer is a source of credit risk once the
premium has been paid the clearing house
requires margin to be posted

Writing options is a form of risk-exposure of
importance at least equal to that of buying
options
MPI FX Risk Management tefan N M Ungureanu, PhD
Moneyness
In the money (ITM)
A call/put option on spot is in the money if the current
spot rate is higher/lower than the option exercise price
Out of the money (OTM)
A call/put option on spot is out of the money if the
current spot rate is lower/higher than the option
exercise price
At the money (ATM)
A call/put option on spot is at the money if the current
spot rate is equal to the option exercise price
MPI FX Risk Management tefan N M Ungureanu, PhD
Payoff profiles for options
Buyer of an option limited loss, unlimited
profit
Writer of an option unlimited loss, limited
profit
Example:
1. Call option on CHF; strike price = 58.5 US
cents/CHF; premium = 0.5 US cents/CHF
2. Put option on CHF; strike price = 58.5 US
cents/CHF; premium = 0.5 US cents/CHF

MPI FX Risk Management tefan N M Ungureanu, PhD
Payoff profile for buyer of a call option
-1
-0.5
0
0.5
1
57 57.5 58 58.5 59 59.5 60
Spot price of underlying currency (US cents/CHF)
P
r
o
f
i
t

(
U
S

c
e
n
t
s
/
C
H
F
)
Strike price
At-the-money
Out-of-the-money
In-the-money
Limited loss
Unlimited profit
Break-even
price
MPI FX Risk Management tefan N M Ungureanu, PhD
Payoff profile for writer of a call option
-1
-0.5
0
0.5
1
57 57.5 58 58.5 59 59.5 60
Spot price of underlying currency (US cents/CHF)
P
r
o
f
i
t

(
U
S

c
e
n
t
s
/
C
H
F
)
Strike price
At-the-money
Out-of-the-money
In-the-money
Limited profit
Unlimited
loss
Break-even
price
MPI FX Risk Management tefan N M Ungureanu, PhD
Payoff profile for buyer of a put option
-1
-0.5
0
0.5
1
57 57.5 58 58.5 59 59.5 60
Spot price of underlying currency (US cents/CHF)
P
r
o
f
i
t

(
U
S

c
e
n
t
s
/
C
H
F
)
Strike price
At-the-money In-the-money Out-of-the-money
Unlimited profit
up to 58 cents
Limited loss
Break-even
price
MPI FX Risk Management tefan N M Ungureanu, PhD
Payoff profile for writer of a put option
-1
-0,5
0
0,5
1
57 57,5 58 58,5 59 59,5 60
Spot price of underlying currency (US cents/CHF)
P
r
o
f
i
t

(
U
S

c
e
n
t
s
/
C
H
F
)
Strike price
At-the-money In-the-money Out-of-the-money
Unlimited
loss up to
58 cents
Limited profit
Break-even
price
MPI FX Risk Management tefan N M Ungureanu, PhD
Basic Option Pricing Relationships at Expiry
At expiry, an American call option is worth the
same as a European option with the same
characteristics.

C
aT
= C
eT
= Max[S
T
- X, 0]

Call in-the-money S
T
X

Call out-of-the-money worthless

MPI FX Risk Management tefan N M Ungureanu, PhD
At expiry, an American put option is worth the
same as a European option with the same
characteristics

P
aT
= P
eT
= Max[X - S
T
, 0]

Put in-the-money X S
T


Put out-of-the-money worthless

Basic Option Pricing Relationships at Expiry
MPI FX Risk Management tefan N M Ungureanu, PhD
Option Pricing and Valuation
The price (premium) of an option has two components:
Intrinsic value the amount the option is in the money
Time value the option premium minus the intrinsic
value


Option
Premium
=
Intrinsic
Value
+
Time
Value
MPI FX Risk Management tefan N M Ungureanu, PhD
Option Pricing and Valuation
Example:
$1.25 call on GBP is priced at $0.030 when the
spot price is $1.27

Intrinsic value = Spot price - Strike price
= $1.27 - $1.25 = $0.02

Time value = Premium - Intrinsic value
= $0.03 - $0.02 = $0.01

MPI FX Risk Management tefan N M Ungureanu, PhD
Total Value of a Call Option
0
1
2
3
4
5
6
7
8
1,64 1,65 1,66 1,67 1,68 1,69 1,7 1,71 1,72 1,73 1,74 1,75 1,76
Spot rate ($/)
O
p
t
i
o
n

p
r
e
m
i
u
m

(
U
S

c
e
n
t
s
/

)
Total value
Time value
Intrinsic value
MPI FX Risk Management Alexandra Horobet, PhD
FX options price determinants
Premium rises if :
For a Call For a Put
1. Spot rate
2. Exercise price
3. Interest rate in HC
4. Interest rate in FC
5. Volatility
6. Time to maturity
MPI FX Risk Management tefan N M Ungureanu, PhD
3. Currency Swaps

1. The short-term swap
2. Back-to-back and parallel loans
3. The modern currency swap
4. Absolute and comparative advantage in swaps
5. Valuation of swaps

MPI FX Risk Management tefan N M Ungureanu, PhD
Some useful definitions
In a swap, two counterparties agree to a
contractual arrangement wherein they agree to
exchange cash flows related to debt obligations at
periodic intervals
Two types of swaps:
Single currency interest rate swap interest rate
swap fixed for floating swap
Cross-Currency interest rate swap currency swap
fixed for fixed swap
The market for currency swaps evolved first, but
today the market for interest rate swaps is larger
MPI FX Risk Management tefan N M Ungureanu, PhD
The Short-term Currency Swap

Bank of England (BoE) wants to borrow USD from
the Bundesbank (Buba)
Buba asks, as security, an equivalent amount of GBP
(to be deposited by the BoE with the Buba)
Barring default, on the expiration day the USD and the
GBP would each be returned, with interest, to the
respective owners
MPI FX Risk Management tefan N M Ungureanu, PhD
The Short-term Currency Swap An Example
Example
S = 2.50 $/, r
$
= 3%, r

= 5%
Time t:
BoE receives $100m from the Buba for six months
BoE deposits 100m/2.5 = 40m into an escrow
account with the Buba
Time T:
Buba returns 40m x 1.05 = 42m
BoE returns $100m x 1.03 = $103m
MPI FX Risk Management tefan N M Ungureanu, PhD
Back-to-back Loans
UK institutional investor (UKII) wants to invest in
US, but an investment dollar premium makes
foreign investments expensive to UK investors
UKII wants to avoid the spot market at t and T
UKII sets up a deal with a foreign firm (USCo) that
wants to invest in the UK
USCo lends $ to UKII
UKII lends to USCo (or its UK subsidiary)
Right of offset between these two loan contracts
if (say) UKII cannot pay back, USCo can withhold
its payments and sue for the net loss (if any)

MPI FX Risk Management tefan N M Ungureanu, PhD
Back-to-back Loans
USD










Flow of initial principals under a back-to-back loan
USD capital
market
UKII
USCos
subsidiary
USCo

GBP
MPI FX Risk Management tefan N M Ungureanu, PhD
Parallel Loans (I)
USCo faces capital export controls she cannot
export USD to its UK subsidiary

UKCo wants to lend to its US subsidiary, but there
is a dollar premium

Both can avoid the spot market by granting loans to
each other (or to each others subsidiary), with a
right of offset in the two loan contracts
MPI FX Risk Management tefan N M Ungureanu, PhD
Parallel Loans (II)












The initial flows of principal under a parallel loan
UKCos
subsidiary
UKCo
USCos
subsidiary
USCo
USD

GBP
MPI FX Risk Management tefan N M Ungureanu, PhD
The Modern Currency Swap
Two parties agree to
exchange, at time t, two initially equivalent principals
denominated in different currencies may be
skipped
return these principals to each other at T
pay the normal interest, periodically, to each other on
the amounts borrowed

One single contract, with a right of offset
MPI FX Risk Management tefan N M Ungureanu, PhD
The Swap Bank
A swap bank a financial institution that
facilitates swaps between counterparties

The swap bank can serve as either a broker or a
dealer.
Broker it matches counterparties but does not
assume any of the risks of the swap
Dealer it stands ready to accept either side of a
currency swap, and then later lay off their risk, or
match it with a counterparty
MPI FX Risk Management tefan N M Ungureanu, PhD
Absolute advantage in borrowing
A US MNC needs to borrow CHF 1.6m for the next 4 years
A Swiss MNC needs to borrow $1m for the same period
Spot rate: 0.625$/CHF
Borrowing opportunities:
US dollar CHF
US MNC 6.00% p.a. 5.00% p.a.
Swiss MNC 7.50% p.a. 3.50% p.a.
Absolute advantage 1.50% 1.50%
MPI FX Risk Management tefan N M Ungureanu, PhD
Absolute advantage in borrowing

US MNC
Swap
Bank
$6%
$6%
CHF 4%
CHF 3.5%
$6.5%
Swiss
MNC
CHF 3.5%
US
Bank
Swiss
Bank
MPI FX Risk Management tefan N M Ungureanu, PhD
Absolute advantage in borrowing

US MNC
Swap
Bank
$6%
$6%
CHF4%
CHF3.5%
$6.5%
Swiss
MNC
CHF3.5%
US
Bank
Swiss
Bank
US MNCs net position is to borrow at CHF4%
US MNC saves CHF1%
MPI FX Risk Management tefan N M Ungureanu, PhD
Absolute advantage in borrowing

US MNC
Swap
Bank
$6%
$6%
CHF4%
CHF3.5%
$6.5%
Swiss
MNC
CHF3.5%
US
Bank
Swiss
Bank
Swiss MNCs net position is to borrow at $6.5%
Swiss MNC saves $1%
MPI FX Risk Management tefan N M Ungureanu, PhD
Absolute advantage in borrowing

US MNC
Swap
Bank
$6%
$6%
CHF4%
CHF3.5%
$6.5%
Swiss
MNC
CHF3.5%
US
Bank
Swiss
Bank
The swap bank
makes money too:
+0.5% on CHF
+0.5% on $
The swap bank faces
exchange rate risk, but
maybe they can lay it
off in another swap.
MPI FX Risk Management tefan N M Ungureanu, PhD
Comparative advantage in
borrowing
Consider two firms A and B:
Firm A U.S.based multinational
Firm B U.K.based multinational

Both firms wish to finance a project in each others
country of the same size borrowing
opportunities
$
Company A 8.0% 11.6%
Company B 10.0% 12.0%

MPI FX Risk Management tefan N M Ungureanu, PhD
A is the more credit-worthy of the two firms
Still, A has a comparative advantage in borrowing
in dollars it borrows at 2% less than B
B has a comparative advantage in borrowing in
pounds it borrows at only 0.4% less than A
If they borrow according to their comparative
advantage and then swap, there will be gains for
both parties

Comparative advantage in
borrowing
MPI FX Risk Management tefan N M Ungureanu, PhD
Comparative advantage in
borrowing
Company
A
Swap
Bank
$8%
12%
$8%
11%
12%
$9.4%
Company
B
MPI FX Risk Management tefan N M Ungureanu, PhD
Comparative advantage in
borrowing
$8%
12%
$8%
11%
12%
$9.4%
As net position is to borrow at 11%
A saves 0.6%
Swap
Bank
Company
A
Company
B
MPI FX Risk Management tefan N M Ungureanu, PhD
Comparative advantage in
borrowing
$8%
12%
$8%
11%
12%
$9.4%
Bs net position is to borrow at $9.4%
B saves $0.6%
Swap
Bank
Company
A
Company
B
MPI FX Risk Management tefan N M Ungureanu, PhD
Comparative advantage in
borrowing
$8%
12%
$8%
11%
12%
$9.4%
The swap bank
makes money too:
At S
0
($/) =
$1.60/, that is a
gain of $64,000 per
year for 5 years.
The swap bank faces exchange rate risk, but maybe they can
lay it off in another swap.
1.4% of $16 million
financed with 1% of
10 million per year
for 5 years.
Swap
Bank
Company
A
Company
B
MPI FX Risk Management tefan N M Ungureanu, PhD
Swap rates

The interest payments for each currency are based
on the currencys swap (interest) rate yields
at par for near-riskless bonds with the same
maturity as the swap

Why risk-free rates?
Right-of-offset clause
Probability of default is small

MPI FX Risk Management tefan N M Ungureanu, PhD
Costs
A commission of, say, USD500 on a USD1m swap, for each
payment to be made
Equivalent up-front fee is asked
Example
7-year yields at par: 7.17% on USD and 9.9% on DEM
The swap dealer quotes:
USD 7.13% - 7.21%
DEM 9.85% - 9.95%
If you borrow DEM and lend USD you pay 9.95%
on the DEM, and you receive 7.13% on the USD
MPI FX Risk Management tefan N M Ungureanu, PhD
Valuation of currency swaps (I)
A company swaps a loan of GBP 50m into USD 100m for 7
years swap rates: 10% on USD leg and 12% on GBP leg
Spot rate at the beginning of the swap: 2 USD/GBP
Two years after the inception of the swap, the swap rates
have changed: 8% on the USD leg and 14% on the GBP leg
Also, the spot rate has changed to 1.7 USD/GBP

Which is the value of this swap at the inception and after
two years?
MPI FX Risk Management tefan N M Ungureanu, PhD
Valuation of currency swaps (II)
The initial exchange of principals is a zero-value
transaction, since the amounts are initially equivalent
The future interest payments have also equal present
values
At inception:





At the spot rate of 2 USD/GBP, the two legs are equivalent
swap value =0
$100m
1.1
100m
1.1
10m
PV
7
7
1 t
t
USD
= + =

=
GBP50m
1.12
50m
1.12
6m
PV
7
7
1 t
t
GBP
= + =

=
MPI FX Risk Management tefan N M Ungureanu, PhD
Valuation of currency swaps (III)
After two years:





Swap value = PV of inflows PV of outflows
For the company paying USD:
PV of swap in USD = GBP46.567m 1.7 USD/GBP
USD107.985m
= -USD28.821 NET LIABILITY
$107.985m
1.08
100m
1.08
10m
PV
5
5
1 t
t
USD
= + =

=
GBP46.567m
1.14
50m
1.14
6m
PV
5
5
1 t
t
GBP
= + =

=
MPI FX Risk Management tefan N M Ungureanu, PhD
FOREIGN EXCHANGE
RISK MANAGEMENT
Topic 4 Managing and Measuring Exposure
to FX Risk
Topic 4 Outline
1. FX Exposure taxonomy

2. Measuring transaction exposure (TREX)

3. Managing transaction exposure using financial
instruments
Forward contracts
Money market operations
Currency options
MPI FX Risk Management tefan N M Ungureanu, PhD
Risk and exposure to risk
Exchange risk = uncertainty about the future spot rate
measured by o
2
(S
t
) or o(S
t
)
currency variability levels may change over time



Currency 1981-1993 1994-1998
British pound 0.0309 0.0148
Canadian dollar 0.0100 0.0110
Japanese yen 0.0279 0.0298
New Zealand dollar 0.0289 0.0190
Swedish krona 0.0287 0.0195
Swiss franc 0.0330 0.0246
Singapore dollar 0.0111 0.0174
Standard Deviations of Exchange Rate Movements
Based on Monthly Data
MPI FX Risk Management tefan N M Ungureanu, PhD
Risk and exposure to risk
Exchange rate exposure: measures how sensitive the
(home-currency) value of a firm, an asset/liability, or
cash flow is to changes in the exchange rate


Example
A portfolio contains (1) a CHF (=FC) T-bill maturing at
time t, with face value CHF100,000, and (2) a USD (=HC)
T-bill with face value at time t of USD50,000
V
t
= USD50,000 + CHF100,000 x S
t
Exposure = CHF100,000


t
t
t t
t t
S
V
) E(S S
) E(V V
Exposure =

=
MPI FX Risk Management tefan N M Ungureanu, PhD
Types of foreign exchange exposure
Transaction (contractual) exposure
measures changes in the value of outstanding financial
obligations incurred prior to a change in exchange rates
but not due to be settled until after the exchange rates
change
deals with changes in cash flows the result from existing
contractual obligations
V
t
= HC value of contractually fixed cash flows
Operating (economic, competitive, strategic) exposure
measures the change in the market value of the firm
resulting from any change in future operating cash flows
of the firm caused by an unexpected change in exchange
rates
V
t
= market value of the firm
MPI FX Risk Management tefan N M Ungureanu, PhD
Types of exchange rate exposure
Accounting (translation) exposure
Occurs because of the need to translate FC financial
statements of foreign affiliates into a single currency to
prepare worldwide consolidated financial statements
V
t
= book value of the firm when consolidation occurs


Moment in time when
exchange rate changes
Accounting exposure
Transaction exposure
Operating exposure
Time
MPI FX Risk Management tefan N M Ungureanu, PhD
Which exposure matters most?
Jesswein, Kwok, Folks Adoption of Innovative Products in Currency Risk
Management: Effects of Management Orientations and Product
Characteristics, Journal of Applied Corporate Finance, Fall 1995
Mean score of
level of
agreement
Managing transaction exposure is important 1.4
Managing operating exposure is important 1.8
Managing translation exposure is important 2.4
A survey of corporate treasurers and CFOs
(1) strongly agreed (5) strongly disagreed
MPI FX Risk Management tefan N M Ungureanu, PhD
Do companies hedge FX risk?

GM is exposed to market risk from changes in foreign
currency exchange rates, interest rates, and certain
commodity prices. In the normal course of business, GM
enters into a variety of foreign exchange, interest rate, and
commodity forward contracts, swaps, and options, with the
objective of minimizing exposure arising from these risks. A
risk management control system is utilized to monitor
foreign exchange, interest rate, commodity, and related
hedge positions.

General Motors Annual Report, 2004


MPI FX Risk Management tefan N M Ungureanu, PhD
Do companies hedge FX risk?

In the normal course of business, we are exposed to
foreign currency exchange rate, interest rate and equity
price risks that could impact our financial position results
of operations. Our risk management strategy with respect
to these three market risks includes the use of derivative
financial instruments. We use derivatives only to manage
existing underlying exposures of HP. Accordingly, we do not
use derivative contracts for speculative purposes.

Hewlett-Packard Annual Report, 2004
MPI FX Risk Management tefan N M Ungureanu, PhD
Measuring TREX
Sources of TREX:
Purchasing or selling on credit goods or services whose
prices are stated in foreign currencies
Borrowing or lending funds when repayment is due in
foreign currencies
Being a party to an existing foreign exchange forward
contract
Otherwise acquiring assets or incurring liabilities
denominated in foreign currencies
Attributes of TREX:
It is typically a short-term exposure
High certainty regarding the exposure timing and
amount
MPI FX Risk Management tefan N M Ungureanu, PhD
Measuring TREX from transactions at a
particular date
Inflows: FC accounts receivables
FC long-term sales contracts
FC deposits, bonds, notes
Forward purchase of FC
Outflows: FC accounts payable
FC long-term purchase contracts
FC loans, bonds, notes
Forward sales of FC

Net Exposure = Total inflows Total outflows
Only this amount is hedged
MPI FX Risk Management tefan N M Ungureanu, PhD
Measuring TREX from transactions at a
particular date
Example:
Spanish firm with USD commitments recorded on May 1:

1. A/Rs: USD 100,000 - June 1; USD 2,200,000 - July 1

2. Expiring deposits: USD 3,000,000 - June 1

3. A/Ps: USD 2,300,000 - June 1; USD 1,000,000 - July 1

4. Loan due: USD 2,300,000 - July 1

MPI FX Risk Management tefan N M Ungureanu, PhD
Measuring TREX from transactions at a
particular date
Transaction June 1 July 1
INFLOWS A/R 100,000 2,200,000
Deposit 3,000,000
OUTFLOWS A/P -2,300,000 -1,000,000
Loan -2,300,000
NET EXPOSURE 800,000 -1,100,000
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging using forward contracts
If you are going to owe foreign currency in the future,
agree to buy the foreign currency now by entering into
long position in a forward contract.

If you are going to receive foreign currency in the
future, agree to sell the foreign currency now by
entering into short position in a forward contract.

Example: Swiss exporter, A/R $1 million, 3 months
maturity, S
0
= 1.5000 CHF/$, F
90
= 1.4960 CHF/$
MPI FX Risk Management tefan N M Ungureanu, PhD
1.49
1.492
1.494
1.496
1.498
1.5
1.502
1.504
1.506
1.508
1.51
1.490 1.492 1.494 1.496 1.498 1.500 1.502 1.504 1.506 1.508 1.510
Spot rate in 3 months
A
/
R

v
a
l
u
e

(
C
H
F
,

m
i
l
l
i
o
n
s
)
Hedging using forward contracts
Unhedged
Forward hedge
Gains from
forward hedge
Losses from
forward hedge
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging using forward contracts
Forward contracts eliminate FX risk certainty over
future revenues and payments in FC, when translated in
HC
Which is the cost of using forwards for hedging?
Real cost compare forward rate with the future spot


Expected cost = 0 (if forward rate is unbiased)
Possibility of bias in forward rate SELECTIVE
HEDGING:
Long FC hedge when FC is at a forward discount
Short FC hedge when FC is at a forward premium
1
1 0,1
S
S F
cost Real

=
It can be known only at contract
maturity
MPI FX Risk Management tefan N M Ungureanu, PhD
Money market hedge Sunrise
Sunrise Corp. (US) has sold umbrellas to a Spanish
company and billed it 1m euros, to be paid in 1 year
A/R of 1m euros, 1 year maturity
S
0
: 1.1933$/euro, F
12m
:1.1850$/euro, i
$
=3.5% p.a.,
i
euro
= 4% p.a.
Money market hedge:
Borrow euros now 1m/1.04 = 0.9615m euros
Sell 0.9615m euros against $ at 1.1933$/euro
1.1474m$
Invest 1.1474m$ at 3.5% 1.1876m$ in one year hence
In one year, use the 1m euro from the contract to pay
the loan
Total result (certain): 1.1876m$
MPI FX Risk Management tefan N M Ungureanu, PhD
Forward vs. money market hedge
When should you use them?
If IRP is holding the results of forward hedge and
money market hedge will be the same
If IRP is not holding proceeds from money market
hedge will not be the same as those from forward hedge
one hedging method will dominate the other

Be aware of the fact that there might be higher
transaction costs associated to hedging using money
market as compared to forward:
Bid-ask spread on the forward contract
Difference between borrowing and lending rates
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging using options
Options provide a flexible hedge against the
downside, while preserving the upside potential.
To hedge a foreign currency receivable/asset buy
puts on the currency
If the FC depreciates, your put option lets you sell the
currency for the exercise price.
Options provide a floor price on the domestic
currency value of foreign exchange:

Floor price = Exercise price of put Put premium

MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging an A/R using FX options
Boeing has an A/R of 10m GBP for 1 year
Boeing buys a put option on 10m GBP, X=$1.46/GBP,
Pr=$0.02/GBP ($200,000 for the option)
13.80
14.00
14.20
14.40
14.60
14.80
15.00
15.20
15.40
15.60
1.40 1.42 1.44 1.46 1.48 1.50 1.52 1.54
Spot rate in one year ($/GBP)
A
/
R

v
a
l
u
e

(
$
,

m
i
l
l
i
o
n
s
)
Unhedged
Hedging with a put
Floor price
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging using options
To hedge a foreign currency payable/liability buy
calls on the currency.
If the FC appreciates, your call option lets you buy
the currency at the exercise price of the call.
Options provide a ceiling price on the domestic
currency value of foreign exchange:

Ceiling price = Exercise price of call + Call premium

MPI FX Risk Management tefan N M Ungureanu, PhD
6.90
7.00
7.10
7.20
7.30
7.40
7.50
7.60
7.70
7.80
1.40 1.42 1.44 1.46 1.48 1.50 1.52 1.54
Spot rate in one year ($/GBP)
A
/
P

v
a
l
u
e

(
$
,

m
i
l
l
i
o
n
s
)
Hedging an A/P using FX options
Boeing has an A/P of 5m GBP for 1 year
Boeing buys a call option on 5m GBP, X=$1.46/GBP,
Pr=$0.025/GBP ($125,000 for the option)
Unhedged
Hedging with a call
Ceiling price
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging an A/R - Dayton Manufacturing
Dayton Manufacturing, US-based maker of gas
turbine equipment, sold in March a turbine generator
to Crown, a British firm, for 1,000,000. Payment
due three months later, in June.

The following information is available to the CFO of
Dayton:
Spot exchange rate: $1.7640/
3-month forward rate: $1.7540/
UK 3-month interest rates: 8.0% - 10.0%
US 3-month interest rates: 6.0% - 8%
MPI FX Risk Management tefan N M Ungureanu, PhD
Dayton Manufacturing
June put option; OTC market for 1,000,000: strike
price $1.7500 (nearly ATM); 1.5% premium paid at
current spot
June put option; OTC market for 1,000,000: strike
price $1.7100 (OTM); 1.0% premium paid at current
spot
Daytons foreign exchange advisory service forecasts
that the spot rate in 3 months will be $1.7600/
The minimum acceptable margin for the contract is at
a sale price of $1,700,000 the budget rate =
$1.7000/
MPI FX Risk Management tefan N M Ungureanu, PhD
Dayton Manufacturing
Four alternatives are available to Dayton:
1. Remain unhedged

2. Hedge in the forward market

3. Hedge in the money market

4. Hedge in the options market
MPI FX Risk Management tefan N M Ungureanu, PhD
Dayton Manufacturing
1. Unhedged position
Today Three months hence
Do nothing
Receive 1,000,000
Sell 1,000,000 spot and
receive $ at spot rate
existing then
MPI FX Risk Management tefan N M Ungureanu, PhD
Dayton Manufacturing
2. Forward Market Hedge
Three months hence
Sell 1,000,000 forward
@$1.7540/
Receive 1,000,000
Deliver 1,000,000 against
forward sale
Receive $1,754,000
Today
MPI FX Risk Management tefan N M Ungureanu, PhD
Dayton Manufacturing
3. Money market hedge
Today
Receive 1,000,000
Repay 975,610 loan plus
24,390 interest, for a total of
1,000,000
Receive 1,746,790 $

Three months hence
Borrow 975,610 @ 10% p.a.
Exchange 975,610 for $ @
$1.7640/
Receive $1,720,976 cash
Invest $1,720,976 @ 6% p.a.

MPI FX Risk Management tefan N M Ungureanu, PhD
Dayton Manufacturing
4. Options market hedge (ATM option illustrated)
Today Three months hence
Buy put option to sell @
$1.75/
Pay $26,460 for put option
Receive 1,000,000
Either deliver 1,000,000 against
put, receiving 1,750,000; or sell
1,000,000 spot if current spot rate
> $1.75/
MPI FX Risk Management tefan N M Ungureanu, PhD
Dayton Manufacturing
Put Option Strike Price ATM Option
$1.75/
OTM Option
$1.71/
Option cost $26,460 $17,640
Proceeds if exercised $1,750,000 $1,710,000
Minimum net proceeds $1,723,540 $1,692,360
Maximum net proceeds Unlimited Unlimited
MPI FX Risk Management tefan N M Ungureanu, PhD
1,68
1,7
1,72
1,74
1,76
1,78
1,8
1,82
1,84
1,68 1,69 1,7 1,71 1,72 1,73 1,74 1,75 1,76 1,77 1,78 1,79 1,8 1,81 1,82 1,83 1,84
Ending spot exchange rate ($/)
D
a
y
t
o
n
'
s

r
e
v
e
n
u
e
s

f
r
o
m

A
/
R

(
m
i
l
l
i
o
n
s

$
)
Dayton Manufacturing

Uncovered
Forward market hedge
Money market hedge
OTM put option hedge
ATM put option hedge
MPI FX Risk Management tefan N M Ungureanu, PhD
Factors influencing the hedging decision
The selection of the proper hedging instrument
depends on:
Firms willingness to take a directional view on the
movement of the FX rate
Firms risk tolerance
Hedging instruments availability
Frequency of exposures
Number of currencies for which exposures are detected
Degree of certainty associated to a particular exposure
MPI FX Risk Management tefan N M Ungureanu, PhD
What Risk Management Products do Firms Use?
Type of product Awareness Adoption
Forward contracts 100.0% 93.1%
Foreign currency swaps 98.8 52.6
Foreign currency futures 98.8 20.1
Exchange-traded currency options 96.4 17.3
Exchange-traded futures options 95.8 8.9
OTC currency options 93.5 48.8
Cylinder options 91.2 28.7
Synthetic forwards 88.0 22.0
Synthetic options 88.0 18.6
Participating forwards 83.6 15.8
Forward exchange agreements 81.7 14.8
Foreign currency warrants 77.7 4.2
Break forwards 65.2 4.9
Compound options 55.8 3.8
Look-back options 52.1 5.1
Average across products 84.4% 23.9%
MPI FX Risk Management tefan N M Ungureanu, PhD

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