Foreign_Currency_Derivatives.ppt

8/22/2019 Foreign_Currency_Derivatives.ppt

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FOREIGN CURRENCY DERIVATIVES

(CHAPTER 8)

Forwards, Futures and Options


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DerivativesDefined

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

Thus, the value of a derivative is derived from price ofanother asset.

Ex: Futures Contracts


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Derivatives: Futures Contracts

Contract Contract Size

Agricultural

Corn 5,000 bushels

Wheat 5,000 bushels

Orange Ju ice 15,000 lbs.Metals & Petroleum

Gold 100 troy oz.

Silver 5,000 troy oz.

Unleaded gasol ine 42,000 gal.

FinancialBr iti sh Pound 62,500

Japanese Yen 12.5 million

Austral ian Dollar A$100,000


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Basic Derivatives

Forward Contracts Futures Contracts

Options

Swaps

.


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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


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Use of DerivatiwveRelevance to Corporate Finance

Hedging: Hedgers use derivatives to reduce the risk thatthey from potential future movements in the price of an assetrelated to their business operations.

Speculating: Speculators used derivatives to anticipate and

attempt to profit by trading on expectations about futuredirection in the price of an asset.

Arbitrage: Arbitrageurs take offsetting positions in the sameasset to lock in a profits

To change the nature of an asset or liability.

To change the nature of an investment without incurring thecosts of selling one portfolio and buying another.


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Foreign Currency Forwards

Derivatives


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Forward versus Spot ContractsBasic Characteristics

A spot contract: A price is established today for payimmediate payment and delivery.

A forward contract: A future price is established today forfuture payment and delivery.


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A forward contract gives the owner the right andobligation to buy an asset on a specified future date at afuture price agreed today.

The seller of the forward contract has the right andobligation to sell the asset on a specified future date at afuture price agreed today.

At the end of the forward contract, at delivery, ownershipof the good is transferred and payment is made from thepurchaser to the seller.

Forward Contracts


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Forward Contracts

Generally, no money changes hands on theorigination date of the forward contract. But, collateralmay 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.


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Forward ContractsBasic Characteristics

Foreign Exchange Rates (Canadian dollars per foreign currency)

US ($) GB () JAP () Euro ()

Spot 1.107 2.040 0.009721 1.3991

1 month 1.1063 2.0393 0.009754 1.4007

3 month 1.1044 2.0383 0.009821 1.4039

6 month 1.1017 2.0368 0.009920 1.4082

1 year 1.0971 2.0340 0.010116 1.4159

3 year 1.0697 n/a n/a n/a

5 year 1.0622 n/a n/a n/a

10 year 1.0312 n/a n/a n/a

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

Table 11-1 Foreign Exchange QuotesReflects the timevalue of moneyand expectedexchange ratechanges. Forwardrates the priceTODAY for futuredelivery, so thefurther away, thelower the presentvalue.


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Using Forward Contracts / Hedging

Hedgingusing a forward contract requires that theinvestor have an opposite exposure to the contract.

This is a covered position.


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Using Forward Contracts / Speculating

Speculation on a forward contract requires that theinvestor NOT own the underlying asset.

This is a naked position a position that leaves theinvestor exposed to changes in the value of theunderlying asset.


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Using Forward Contracts / Long and Short

Long: Buying expecting a price increase in anasset.

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

Short: Selling expecting a price decrease in anasset.

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


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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 specifiedfuture date.


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Features of Foreign Currency Forwards

Available daily in major currencies in 30-, 90-, and

180-day maturities

Forwards are entered intoover the counter Deliverable forwards: face amount of currency is

exchanged on settlement date

Non-deliverable forwards: only the gain or loss is

exchanged


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Contract terms specify:

forward exchange rate

term

amount valuedate (the day the forward contract expires)

locations for payment and delivery.

The date on which the currency is actually

exchanged, the settlementdate, is generally two

days after the value dateof the contract.

Features of Foreign Currency Forwards


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Foreign Currency Forwards / USES

(1) Hedge foreign currency risk

(2) Arbitrage FX rate discrepancies within andbetween markets

(3) Speculate on future market movements

(4) Profit by acting as market maker


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Hedging with Foreign Currency Forwards

Hedge paymentsand receiptsdenominated in fore igncurrencies.

Example:

A Croatian firm exports to Germany and expects receiving apaymentin Euro (EUR) wants to mitigate the risk of adepreciat ion of the EUR (appreciat ion of the HRK)at the timethat the payment arrives.

The Croatian Kuna is the currency of Croatia.

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


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Hedging a Paymentwith an Foreign Currency Forward

Hedged Item

Company must pay EUR1,000,000 to a eurozonesupplier in 3 months

Spot rate HRK/EUR: 7.3000. Treasurer bel ieves HRK w il l

depreciate dur in g next 3

months

Exposure to FX risk:What w i l l be exch ange rate

HRK/EUR in thr ee

months??

Hedging Instrument Buy 1,000,000 EUR forward at

forward rate of 7.3750

FX risk: Company isprotected against largeadverse FX ratemovements

If FX rate is unfavorable in 3

mon ths (ie, > 7.3750),Company pays just7.3750


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Hedged Item Company must pay EUR

1,000,000 to a eurozone supplierin 3 months

Spot rate HRK/EUR: 7.3000.

Treasurer believes HRK willdepreciate during next 3 months

Advantages of Hedge:Company knows its costs and can

plan its finances accordingly

Cost of the hedge is zero --

No money is exchanged atinception of the forward FXagreement

Hedging Instrument Buy 1,000,000 EUR forward at

forward rate of 7.3750

Disadvantage of Hedge:Company is still exposed to FXrisk if the HRK/EUR spot rateis less than 7.3750 in 3 months

Note: Effect of hedge is same as

buy ing EUR today and holding in

an interest-bear ing accoun t

(Forw ard FX agreement is NOT a

simp le speculat ion)



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Unhedged Company

If in 3 months, spotrate is 7.4500

Unhedged Companymust pay:

7.45 x 1,000,000 =

HRK 7,450,000

Effect of Hedging

Hedged Company hasalready bought EURforward

Hedged Company will pay:

7.375 x 1,000,000 = HRK

7,375,000

Money saved by hedging :

7,450,0007,375,000 =

HRK 75,000



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Deriving the Forward Exchange Rate

The spot rate HRK/EUR is 7.3000

A bank today sells a 3-month HRK/EUR forward to acompany for a forward exchange rate of 7.3371

Q: How did the bank compute the forward rate?


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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 threemonths should be indi f ferent ( because of arbi trageoppo rtun it ies related to Internationa l Rate Parity),asto whether it:

Invests the EUR 1 million for 3 months at 1% andconverts the euros (plus interest) into HRK at the end ofthis time, OR

Sells the EUR 1 million spot for HRK, and invests the

HRK at 3% for 3 months


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Invest EUR 1 million at 1%

for 3 months (91 days)

Interest earned EUR

2,493.15

(1 million x 1% x 91/360)

Value after 3 months

EUR 1,002,493

Sell EUR 1 million spot at 7.30

Buy HRK 7.3 million

Invest HRK for 3 months at 3%

Interest earned HRK

55,358.33

(7.3 million x 3% x 91/360)

Value after 3 months

HRK 7,355,358

OPTION 1 OPTION 2

Forward Exchange Rate: 7.3371


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Profits and Losses froma Long Forward Contract

The profit (loss) from the long position is equal to thedifference between the spot price at delivery (ST) andthe forward price (rate) Ftimes the number of contracts

entered into (n):

nF]-[positionlongfrom(loss)Profit T

S


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F

profit

loss

S >FS


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Profits and Losses froma Short Forward Contract

The profit (loss) from the short position is equal to thedifference between the forward price (rate) Fand thespot price (ST) at delivery times the number of contracts

entered into (n):

n][positionshortfrom(loss)Profit T

SF


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Profits and Losses froma Short Forward Contract

F=S

profit

loss

S>FS


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Profits and Losses for Forward Contracts

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

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

Example: You sell 20 million forward at a forward price of $0.0090/ . Atexpiration, the spot price is $0.0083/ .

Did you profit or did you lose?

How much?


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Foreign Currency Futures


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A foreign currency futures contractis an alternative to aforward contract for future delivery of a standard amount offoreign exchange at a specified time, place and priceagreed today.

It is similar to futures contracts that exist for commoditiessuch as cattle, lumber, interest-bearing deposits, gold, etc.

In the US, the most important market for foreign currencyfutures is the International Monetary Market (IMM), adivision of the Chicago Mercantile Exchange.


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Contract specifications are established by the exchange on whichfutures 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 contracts differ from forward contracts in anumber of important ways:

Futures are standardized in terms of size while forwards can becustomized

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 forwardsare traded between individuals and banks

Futures have an initial margin that is market to market on a dailybasis 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

Underyling Asset Exchange

Commodities

Wheat/oats/soybeans Chicago Board of Trade (CBOT)

Cattle/pigs/lumber Chicago Mercantile Exch. (CME)

Crude oil/heating oil/natural gas New York Merchantile Exchange

Cotton/orange juice NY Cotton ExchangeGold/silver/copper The Commodity Exchange (Comex)

Lead/nickel/tin London Metal Exchange (LME)

Canola/western barley/wheat Winnipeg Commodity Exchange

Financial Futures

Treasury notes and bonds/DJIA CBOT

S&P index/Nikkei225 / C$ / / CMEBAs/Canada bonds/TSX/S&P 60 index Montreal Exchange

German bonds/European equities Euronext/Liffe

Other

Weather derivatives CME

Futures Contracts and Markets


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Futures Contracts and MarketsSummary of Forward and Future Contracts

Forward and Future Contracts serve the samepurpose.

Forward contracts offer more flexibility because theyare 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.


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Forwards versus Futures

Forwards Futures

Contracts Customized Standardized

Trading Dealer or OTC markets Exchanges

Default (credit risk) Important Unimportant - guaranteed by clearinghouse

Initial deposit Not required Initial margin and maintenance margin required

Settlement On maturity date Marked to market daily

Table 11- 3 Forwards versus Futures


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Exhibit 8.2 Currency Futures and Forwards Compared


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

SHORT AND LONG POSITIONSIN FOREIGN CURRENCY FUTURES


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Foreign Currency Options


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A foreign currency option is a contract giving the optionpurchaser (the buyer) the right, but not the obligation,to buy or sell a given amount of foreign exchange at afixed price per unit for a specified time period (until thematurity date).

There are two basic types of options,puts and calls. A callis an option to buy foreign currency

A pu tis an option to sell foreign currency


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The buyer of an option is termed the holder, while the sellerof the option is referred to as the writerorgrantor.

Every option has three dif ferent price elements:

The exercise or s tr ike pr ice the exchange rate at which theforeign currency can be purchased (call) or sold (put)

The premiumthe cost or price or value of the option

The cu rrent spot exchange ratein the market

F i C O ti A i d


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Foreign Currency Options: American andEuropean Op t ions

An Americanoption gives the buyer the right toexercise the option at any time between the date ofwriting and the expiration or maturity date

A Europeanoption can be exercised only on itsexpiration date, not before.



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

Foreign Currency OptionsQuotat ion s and Prices



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Foreign Currency OptionsQuotat ion s and Prices


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Foreign Currency Speculation

Speculation is an attempt to profit by trading onexpectations 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 atsome future date will differ from todays forward price for the samedate

Options markets extensive differences in risk patterns produceddepending on purchase or sale of put and/or call

F i C O ti


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Foreign Currency OptionsAt the money, In the money, Out of the money

An option whose exercise price is the same as the spotprice of the underlying currency is said to be at-the-money(ATM).

An option that would beprofitable, excluding the cost of thepremium, if exercised immediately is said to be in-the-money(ITM).

An option that would not beprofitable, excluding the cost of

the premium, if exercised immediately is referred to as out-of-the money(OTM)


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Foreign_Currency_Derivatives.ppt