FIN 40500: International Finance

Forwards, Futures and Options

Derivative Securities vs. Stocks/Bonds

Currently, there are approximately 300 million derivative contracts outstanding with a market value of around $50 Trillion!!!Derivative securities can be used for hedging or for speculation

Stocks and Bonds represent claims to specific future cash flows

Derivative securities on the other hand represent contracts that designate future transactions

Porsche expects $12.5M in US sales over the next month that that it would like to repatriate back to Germany

Porsche is worried that the dollar might depreciate over the next month

Mercedes need to acquire $12.5M to meet its payroll for its Tuscaloosa, Alabama plant

Mercedes is worried that the dollar might appreciate over the next month

Both Porsche and Mercedes could avoid their potential currency risk by entering into a forward contract.

Deutsche Bank

Deutsche Bank negotiates a price of $1.25 per Euro

Forward contracts are individualized contracts to buy/sell a currency at a pre-specified date and for a pre-specified price.

Porsche approaches Deutsche Bank with an offer to buy Euro 30 days forward

Mercedes approaches Deutsche Bank with an offer to sell Euro 30 days forward

In 30 days, Porsche will buy 10 Million Euro from Mercedes for $12.5M

1.255

1.26

1.265

1.27

1.275

1.28

1.285

1.29

1.295

0 4 8 12 15 18 23 27

On Settlement day, Porsche delivers its $12.5M and acquires 10M Euro. Had it instead bought Euro in the spot market, It would’ve needed $12.9M to buy 10M Euro – Porsche “gains” $400,000

Note that Mercedes has an equal “loss” of $400,000

Days

EU

R/U

SD

e = 1.29

F = 1.25

Futures56%

Forward11%

Spot33%

EUR/USD 1.2762

1 month 1.2786

3 months 1.2836

6 months 1.2905

12 months 1.3026

Forward contracts are available on all the major currencies

The published prices are not actual contract prices but the average of contracts made at major banks.

In 1972, the Chicago Mercantile Exchange began trading currency Futures. By 2004, the number of currency futures outstanding stood at 48M with a value of approximately $5T!!

Futures are standardized (size and maturity), exchange traded commodities

Jan Mar June Dec.Sept.

Currency futures trade in a March, June, September, December expiration cycle – Delivery is made on the 3rd Wednesday of the month and the contracts are traded up to two days prior to delivery.

Currencies Agriculture Metals & Energy

Financial

British Pound Lumber Copper Treasuries

Euro Milk Gold LIBOR

Japanese Yen Cocoa Silver Municipal Index

Canadian Dollar Coffee Platinum S&P 500

Mexican Peso Sugar Oil DJIA

Cotton Natural Gas Nikkei

Wheat Eurodollar

Cattle

Soybeans

Futures are available for a wide range of commodities and assets

Currency Contract Size

Australian Dollar AUD 100,000

Brazilian Real BRR 100,000

British Pound GBP 62,500

Canadian Dollar CAD 100,000

Czech Koruna CZK 4,000,000

Euro EUR 125,000

Hungarian Forint HUF 30,000,000

Japanese Yen JPY 12,500,000

Mexican Peso MXN 500,000

New Zealand Dollar NZD 100,000

Norwegian Krone NKR 2,000,000

Polish Zlotny PLZ 500,000

Russian Ruble RUB 2,500,000

South African Rand ZAR 500,000

Swiss Franc CHF 125,000

There are also cross rate futures traded (EUR/GBP, EUR/JPY, and EUR/CHF) in contract sizes of EUR 125,000

Strike Open High Low Settle Pt Chge

Volume Interest

Mar06 1.2700 1.2804 1.2698 1.2756 +170 3500 8993

Jun06 1.2850 1.2987 1.2800 1.2799 -150 3 34

Sept06 ------ ------ ------ ----- UNCH ----- -----

EUR 125,000

Settlement Date Change From Prior Day (in Pips)

Opening, High, Low, and Closing Price

Contracts Outstanding (000s)

Total Contracts bought/sold that day (000s)

Futures are standardized (size and maturity), exchange traded commodities (Chicago Mercantile Exchange)

Chicago Mercantile Exchange

The CME simultaneously buys 80 contracts from Mercedes and sells 80 contracts to Porsche

Porsche goes long on 80 Euro contracts

Mercedes goes short on 80 Euro contracts

From the previous example, if Porsche is buying 10M Euro, it would need to purchase 80 Euro futures contracts (125,000 x 80 = 10M )

May 1 June 21

Futures contracts are marked to market daily. That is, profits and losses are kept track of on a daily basis.

Delivery Date

Suppose that Porsche goes long on 80 Euro contracts at a price of $1.25 per Euro – The total cost of the contract is $12.5M

Porsche is required to deposit an initial performance bond equal to 2% of the contract value – this can be in the form of cash or a Treasury bill.

2% of $12.5M = $250,000

May 1 June 21Delivery Date

On May 1, Porsche deposited $250,000 worth of Treasury Bills into its maintenance account.

May 2

On May 2, the closing price for June Euro futures is $1.27. Porsche’s profit on its contract is $200,000. This is deposited into Porsche’s maintenance account ($450,000 balance).

May 3

On May 3, the closing price for June Euro futures is $1.24. Porsche’s one day loss on its contract is $300,000. This is withdrawn from Porsche’s maintenance account ($150,000 balance).

When your maintenance account drops below 75% of its original value, you must add to it!!

May 1 June 21Delivery Date

June 3

While the overwhelming majority (90%) of forward contracts end with actual delivery of the currency, very few futures contracts (1%) result in delivery.

F = $1.25/Euro

Suppose that on June 3, Porsche wishes to end its futures contract. Suppose that the current price of a June Euro future is $1.28

Porsche goes short on 80 June Euro futures at a price of $1.28. The two contracts offset one another and Porsche goes home with its profit of $300,000

Long Position

Short Position

Profits from price increases

Profits from price decreases

Essentially, futures positions are making “bets” on the price of the underlying commodity.

Treasury futures first began trading on the CME in 1976. The underlying commodity is a $1M Treasury Bill with 90 days to maturity. Remember, when interest rates rise, Treasury prices fall!

Long Position

Short Position

Profits from price increases

Profits from price decreases

Profits from decreasing interest rates

Profits from increasing interest rates

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nFV

PFVDY

T-Bill futures are listed using the IMM (International Monetary Market) Index

IMM = 100 – Annualized Discount Yield

For example, if the Price of a $100, 90 Day Treasury were $98.

IMM = 100 – 8 = 92

Note that Every .01 increase in the IMM raises the value of a long T-Bill position by $25 (per basis point).

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360

100

98$100$

DY

The underlying commodity is a $1M, 3 month Eurodollar time deposit. However, these deposits are not marketable. Therefore, Eurodollar futures are settled on a cash basis

Eurodollar futures can be treated like a T-Bill Future

IMM = 100 – Annualized LIBOR

Every .01 increase in the IMM raises the value of the long position by $25 (per basis point)

Eurodollar futures were introduced in 1981 as an alternative to Treasury futures.

Eurodollar Futures vs. T-Bill Futures

T-Bill Futures Contract

Eurodollar Futures Contracts

Volume (2001) 123 730,000

As the Eurodollar market grew, it became more liquid relative to the T-Bill market

LIBOR is a “risky” rate. Therefore, it correlates better with other risks

May 1 SeptemberJune

LIBOR = 2.91%

Suppose that you expect to receive $20M in June. You do not need the $20M until September. The current 3 month LIBOR rate is 2.91% (Annualized)

$20M received

$20M needed

IMM = 96.56

June Eurodollar futures are currently trading at 96.56

This $20M should be invested from June to September to earn interest, but currently the interest rate from June to September is uncertain.

May 1 SeptemberJune

$20M received

$20M needed

IMM = 96.56

The June Eurodollar futures with a 96.56 price implies an annualized rate of return equal to 3.44% from June to September

3.44%

You can “lock in” the 3.44% interest rate by taking a long position in Eurodollar futures. Suppose that you purchase 20 Eurodollar contracts at the current price of 96.56.

May 1 SeptemberJune

IMM = 96.90

You paid 96.56 per contract in May (20 contracts)

Suppose that in June, the LIBOR rate is 3.10% Annualized.

3.10%

You receive your $20M in June and deposit it in a Eurodollar account at 3.1% (annual) interest. Your interest earned well be $155,000 - $20M*(.031/4)

Your profit from the Future is (96.90-96.56)(100)($25)(20) = $17,000

Your total gain is $17,000 + $155,000 = $172,000 (3.44% Annualized return)

Unlike a future, an option gives the owner the right, but not the obligation to buy or sell the underlying commodity.

Call Option

The owner (long position) on a call option has the right but not the obligation to buy the underlying commodity at the predetermined price

The seller (writer) of the call option has the obligation to sell the underlying commodity if the option is exercised.

Put Option

The owner (long position) on a put option has the right but not the obligation to sell the underlying commodity at the predetermined price

The seller (writer) of the put option has the obligation to buy the underlying commodity if the option is exercised.

The stated price that the underlying commodity is bought or sold at is known as the strike price.

In December 1982, the Philadelphia Stock Exchange started trading American and European options on foreign currency.

Can be exercised at any time during the life of the contract

Can only be exercised at maturity

Currency Contract Size

Australian Dollar AUD 50,000

British Pound GBP 62,500

Canadian Dollar CAD 50,000

Japanese Yen JPY 6,250,000

Swiss Franc CHF 62,500

Euro EUR 62,500

Traded options have an expiration cycle March, June, September and December with original maturities of 3,6,9,and 12 months.

At expiration, an American option and a European option that has not been exercised will have the same terminal value.

Call option

0,max ESC 0,max SEP

Put option

Spot price of the underlying asset

Exercise price of the option contract

Remember, as the owner of the option, you will not exercise if it is unprofitable!!

Suppose that you purchase a call option on Euro at an exercise price of 130 ($1.30 per Euro). The standard Euro contract is 62,500 Euro.

Expiration Value

Spot Exchange Rate

Here, the option is “out of the money” and will not be exercised.

$1.30 $1.35

125,3$)500,62)(30.1$35.1($ V

Note that the writer of the call has the opposite payout (as with futures, this is a zero sum game)

Expiration Value

Spot Exchange Rate$1.30 $1.35

125,3$)500,62)(35.1$30.1($ V

Options have a premium attached to them. This is the price that the buyer pays for the option contract. Suppose that the premium on this Euro call is 4.59 cents per Euro (the option will cost .0459*62,500 = $2,868.75)

Expiration Value

Spot Exchange Rate

$1.30 $1.35

25.256$75.868,2)500,62)(30.1$35.1($ V

-$2,868.75

$1.3459

Suppose that you purchase a put option on Euro at a strike price of $1.30. The premium on this option is 3.50 cents per Euro (.035*62,500 = $2,187.50)

Expiration Value

Spot Exchange Rate

$1.30

$1.25

50.937$50.187,2$)500,62)(25.1$30.1($ V

-$2,187.50

$1.2650

The previous example dealt with “vanilla options”. There are many, many more “exotic” options.

Bermuda Options: Can be exercised at various, predetermined dates over the life of the contract

Asian Option: Also known as an average option – exercised at maturity and the payoff is based on the average price of the underlying commodity over the life of the contract.

Barrier options: The payoff is contingent on whether or not the underlying commodity has reached a predetermined price

Compound Options: The underlying commodity is an option

Digital Option: Also known as a binary option – the payout is fixed once the strike price has been reached.

You can also buy options on futures contracts.

Currency swaps are contracts to convert known income/payment streams from one currency to another – think of them as a portfolio of forwards with varying maturities/strikes

As with forward contracts, swaps are individualized and not traded.

Suppose that IBM wishes to raise funds by issuing a 5 year Swiss Franc denominated Eurobond with a face value of CHF 100,000 and fixed annual coupon payments of 6%. Up front, IBM receives CHF 100,000. IBM plans on using the proceeds to finance domestic operations

0 Yrs 5 Yrs1 Yrs 2 Yrs 3 Yrs 4 Yrs

IBM Collects CHF 100,000

IBM owes CHF 106,000

IBM owesCHF 6,000

IBM owesCHF 6,000

IBM owesCHF 6,000

IBM owesCHF 6,000

IBM Wishes to hedge its currency exposure

0 Yrs0 Yrs 5 Yrs5 Yrs1 Yrs1 Yrs 2 Yrs2 Yrs 3 Yrs3 Yrs 4 Yrs4 Yrs

IBM Sells IBM Sells CHF CHF 100,000 100,000 @ .844@ .844

IBM buys CHF IBM buys CHF 106,000106,000@ .836@ .836

IBM buysCHF 6,000@ .845

IBM buysCHF 6,000@ .830

IBM buysCHF 6,000@ .800

IBM buysCHF 6,000@ .840

IBM enters into a swap agreement with

This swap is very similar to buying/selling six separate futures contracts and is priced in a similar fashion

The Bottom Line…

There is a virtually endless set of options (pardon the pun) for hedging currency exposure. However, your ability to effectively and efficiently hedge depends on your understanding of the specific exposure that you face!!