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Chapter 6 Financial Derivatives for Currency Risk Management Introduction to Financial Derivatives Financial derivatives are financial instruments whose values are derived from an underlying asset such as a stock or a currency. Derivatives are mainly used to hedge against interest rate and foreign exchange risk. They are also used to speculate. Currency forwards, currency futures and options, currency swaps are main derivatives in the derivatives market. Currency Futures The violent fluctuations of commodity prices led to the creation of futures market. The collapse of the Bretton Woods pegged exchange rate system is the main reason for the first currency futures contract. Currency futures contract was created to cover the foreign exchange risk. A futures contract is an agreement between two parties to buy and sell a currency at a certain future time for a certain price. A futures contract remedies the problem inherent in a forward contract. The major problem with a forward contract is the default risk. A forward contract is a pure credit instrument. Whichever way the price of the spot rate of exchange moves, one party has an incentive to default. For example, if the forward rate is $1.35/€, the spot rate on the future delivery day is $1.40/€, then the party who sells the euro has the incentive to default. If the future spot rate goes down, the party who buys the euro may default. A futures contract is similar to a forward contract, but there are a lot of differences between the two. Forward versus CME Futures Contracts Forwards Exchange-traded futures 1. Location Interbank Exchange floor 2. Maturity Negotiated: typically 1,3,6,12 months or up to 10years The third Monday of March, June, September, December 3. Amount Negotiated: usually more than $5 million Standardized contract amount: such as €125,000 on euros 4. Fees Bid-ask spread Commissions charged per “round turn”, $30 per contract 5. Counterparty Bank Exchange clearinghouse 6. Collateral Negotiated: depending on customer’s credit risk Initial margin and maintenance margin, marked to market daily 7. Settlement Nearly all Less than 5% settled by physical delivery 8. Trading hours 24 hours During exchange hours Features of Currency Futures Futures contracts are standardized contract in terms of the currencies traded, contract size, and maturity of the contract. For example, (CME) JPY futures contract contract size: ¥12,500,000 expiration date: third Wed. of March, June, September, and December last trading day: the second business day proceeding the expiration day (usually Monday) Futures contracts are traded on an organized exchange. A Client who wants trade must open an account in commission house. All orders are executed through the commission house. Commission house is a “registered agent” of the client. Futures contracts are settled through exchange’s clearing house. The clearing house records trade, manages day-to-day settlement, and guarantees the delivery. Futures contracts are marked to market on a daily basis. Clearing house issues margin call if the position of a client’s account deteriorates. An initial margin and a maintenance margin are required to purchase a futures contract. An initial margin is the money a client must deposit when a futures contract is purchased. Maintenance margin is the minimum amount of the money that must be maintained in a margin account. A client must deposit extra money if a margin call is issued by the clearing house. Daily marking to market means profits and losses are paid every day and is equivalent to closing out a contract each day at the end of trading, paying off losses or receiving gains, and writing a new contract. Example of Marking to Market A client takes long position in a Swiss franc futures contract on Monday morning. Contract size: SFr125,000 Price of the contract: $0.85/SFr Initial margin: $2,000 Maintenance margin: $1,500 (Margin call will be issued if funds in margin account are less than $1,500) Cost of the contract: 0.85 x 125,000 = $106,250 Monday closing exchange rate: $0.88/SFr The client gains since the price is up. (0.88 – 0.85) x 125,000 = $3,750 The client’s margin account balance: $2,000 + $3,750 = $5,750 The old contract is closed out. The client has a new contract now($0.88/SFr). Tuesday closing exchange rate: $0.84/SFr The client loses since the price is down. (0.84 – 0.88) x 125,000 = -$5,000 The client’s margin account balance: $5,750 - $5,000 = $750 A margin call is issued. Extra deposit: $750 The price of the contract is $84/SFr now. If the contract expires now, the client loses $1,250 in his margin account. However, he gains from the new contract. His dollar payment is: 0.84 x 125,000 = $105,000 Compared to his previous cost of the contract, $106,250, he saves $1,250. If the holder of the futures contract loses in his margin account, he gains from the spot exchange market; and vice versa. Marking to market ensures that the clearing house’s exposure to currency risk is at most one day. Futures Information Mexican Peso Futures US$/Peso (CME) Hedging or Speculating with a Currency Futures Contract An example of hedging The Texas Instrument has 100 million Danish kroner obligation due in September. Contract size: USD50,000 (Euronext standard) Futures price: DKr1.25/$ Maturity: September The company can sell dollar for kroner. So it takes a short position in the dollar futures. (100m/1.25)/(50,000) = 16 contracts No matter what the future exchange rate is, the company’s dollar payment is fixed at: 100m/1.25 = $80 million An example of speculation Mr. Speculator believes Mexican peso will appreciate against the dollar, he takes a long position in CME’s peso futures contract. Suppose he purchases 100 contracts at the price of $0.10615/Mex$. If the spot rate at the expiration date is $0.11146/Mex$ (5% up), his profit is: (0.11146 – 0.10615) x 500,000 x 100 = $265,500 If the peso is down by 5%, his loss is $265,500. Forward and futures share a common characteristic; what is gained on one side of the contract price is lost on the other. Drawbacks of futures contract The currency exposure cannot exactly match exchange’s contract size. Clients can only partly hedge their exposure. There is a mismatch between maturity of the contract and maturity of the cash flow. Frequent margin calls bring inconvenient for businesses. Currency Options An currency option provides investors, hedgers, or speculators with an instrument that have a one-sided payoff on a currency transaction. An option is a contract that gives its owner the right but not the obligation to buy or sell a given amount of an underlying asset at a fixed price (called “exercise price or strike price”) sometime in the future. An option holder is the buyer of the contract and has the choice to execute or abandon the contract. An option writer is the seller of the contract and has the obligation once the holder exercises the option. The option holder pays the writer an option premium (option price) for the right. A currency call option is the right to buy the underlying currency at a strike price and on a specified date. The underlying currency is the currency to be granted by an option contract. The currency to be exchanged for the underlying currency is called counter currency. For example, a euro option in CME or PSE is the right to buy or sell euro. Euro is the underlying currency and U.S. dollar is the counter currency. A currency put option is the right to sell the underlying currency at a strike price and on a specified date. If the right can be exercised at any time during the life of the option it is called an American option. If the right can be exercised only at the option’s expiration date, it is called a European option. Option quotes contract size, maturity, last trading day are all different at different exchanges. Options on CME are American options; while options on PSE are European options. CME GBP Option Quotes (contract GBP 62,500, quoted in cents per pound) Strike Price Calls-Settle Oct Nov Dec Puts-Settle Oct Nov Dec 1430 1440 1450 1460 1.86 0.98 0.36 0.16 2.66 2.04 1.50 1.06 3.28 2.72 2.16 1.72 0.04 0.16 0.54 1.34 0.84 1.22 1.68 2.24 1.48 1.90 2.34 2.90 1470 0.04 0.76 1.40 2.22 2.94 ··· 1480 0.08 0.52 1.10 3.18 ··· 4.24 Source: Wall Street Journal, 6 October 2000 Currency Option Markets Exchange-traded options are standardized contracts in terms of the currencies traded, contract size and maturity. Only brokers who own a “seat” on an exchange can directly purchase option contracts. OTC options are tailored to fit the needs of the clients. The underlying currency, strike price and maturity are specified by the clients. The writer quotes the option premium. The Intrinsic Value of an Option An option will be exercised only when it has value. Call option intrinsic value when exercised = Max[(Std/f – Ktd/f),0] When (Std/f – Ktd/f) > 0, the option has intrinsic value; When (Std/f – Ktd/f) ≤0, the option has no intrinsic value or zero intrinsic value. Put option intrinsic value when exercised = Max[(Ktd/f - Std/f),0] When (Ktd/f - Std/f) > 0, the option has intrinsic value; When (Ktd/f - Std/f) ≤0, the option has no intrinsic value or zero intrinsic value. An option with intrinsic value is in-themoney. An option with zero intrinsic value is out-of-the-money. If the future spot rate is the same as the strike price, the option is at-the-money. For a call option, if the spot rate closes above the strike price, it is in-the-money. If the spot rate is below the strike price, it is out-of-the-money. For a put option, if the spot rate closes above the strike price, it is out-of-themoney. If the spot rate is below the strike price, it is in-the-money. For both call and put, if the spot rate closes the same as the strike price, the option is at-the-money with zero intrinsic value. The Intrinsic Value of a Call and Put Option Callt$/Mex$ Putt$/Mex$ out-of-the -money out-of-the money in-themoney in-themoney St$/Mex$ $0.1045/Mex$ at-the-money St$/Mex$ $0.1045/Mex$ at-the-money Time Value of an Option An American option also has time value. This is because that at some time prior to expiry an out-of-the-money option will become an in-the-money option or in-the-money option further increases its value. Time value of an option = Option premium – intrinsic value Example: suppose the premium of a put option is 5 cents for selling euro at $1.40/€ and the spot rate of euro is $1.45/€. The option has no intrinsic value because the spot rate is higher than the strike price. The time value is: Premium – Intrinsic value = $0.05 Hedging with Options A Japanese firm expects a $156,250 cash inflow on June 20. If the firm uses a forward contract to hedge risk exposure, it cannot benefit from the dollar appreciation. One solution for the firm is to purchase a dollar put option. If the dollar depreciates, the firm exercises the option. If the dollar appreciates, the firm abandon the option and captures the full benefit of the dollar appreciation. The option contract allows the firm to gain onesided payoff while limiting its loss (premium). A Call Option Payoff Profile A speculator believes the Japanese yen will be strong next month and decides to buy a yen call option. The quotes on CME is “JPY June 1250 call” selling at “$0.000328/¥”. The contract specification: K$/¥ = 0.0125 (strike price) Contract size: ¥12,500,000 (CME standard) Expiration date: June 20 (third Wed) Current call price: $0.000328/¥ (premium) Profit and loss on a currency call option at expiration (JPY12,500,000/Contract) Exchange rate $0.0115/¥ Payments Premium cost -$4,100 Cost of exercise $0 Receipts ¥ sale Net profit or loss $0 -$4,100 $0.0125/¥ $0.012828/¥ $0.0130/¥ $0.0135/¥ -$4,100 $0 -$4,100 -$156,250 -$4,100 -$156,250 -$4,100 -$156,250 $0 $160,350 $162,500 $168,750 $0 $2,150 -$4,100 $8,400 Profit at expiration ($/¥) at-the-money break-even St$/¥ 0 $0.0115 $0.0125 $0.012828 $0.0130 - $0.000328/¥ out-of-the-money in-the-money $0.0135 A Put Option Payoff Profile A British pound put option quoted on PSE as “British pound Dec 1590 put” and is selling at $0.0175/₤. Contract specification: K$/₤ = 1.59 (strike price) Contract size = 31,250 (PSE standard) Expiration date: third Wed. in December Current put option price = $0.0174/₤(premium) Premium cost for 100 contracts: ($0.0174/₤)(₤31,250)(100) = $54,375 Profit and loss on a currency put option at expiration (GBP31,250/contract) Exchange rate $1.5600/₤ Payments Premium cost -$54,375 Spot ₤ -$4,875,000 purchase Receipts Exercising $4,968,750 contract Net profit or loss $39,375 $1.5700/₤ $1.5726/₤ $1.5900/₤ $1.0000/₤ -$54,375 -$4,906,250 -$54,375 -$4,914,375 -$54,375 $0 -$54,375 $0 $4,968,750 $4,968,750 $0 $0 $8,125 $0 -$54,375 -$54,375 Profit at expiration ($/₤) A break-even $39,375 at-the-money S t$/₤ 0 $1.5600/₤ $1.5726/₤ $1.5900/₤ $1.6000/₤ - $54,375 in-the-money out-of-the-money Currency Swaps A currency swap is a contractual agreement to exchange a principal amount of two currencies and, after a prearranged length of time, to give back the original principal. Interest payments in each currency also typically are swapped during the life of the agreement. A forward contract is a simple form of swap. A forward contract does not exchange the interest, but the swap does. Borrow currency in the foreign market Borrower Country BP VW U.K. 6% 8% Germany 7% 5% Both companies have disadvantages if they borrow from the foreign market. In the 1970s, U.K. taxed all cross-border currency transactions involving sterling pounds. Then the parallel loan was created to avoid the taxes. Under the parallel arrangement, BP made a sterling loan to VW in U.K. In return, VW lent the equivalent amount in euro to BP in Germany. Germany U. K € at 5% ₤ at 6% D. Bank VW € at 7% BPG BP ₤ at 8% VWUK HSBC Advantages of parallel loans Tax dodge (a way to avoid paying taxes) Lower borrowing costs Covering currency exposure Drawbacks of parallel loans Default risk An adverse balance sheet impact Search costs Currency swap remedies the default risk in parallel loans. It does not increase a firm’s debt/equity ratio. Commercial banks and investment banks serve as market dealers. The most common form of a currency swap is the currency coupon swap, a fixed-forfloating rate nonamortizing currency swap, traded primarily through international commercial banks. Nonamortizing loan means the entire principal is repaid at maturity and only interest is paid during the life of the loan. Amortizing loan means periodic payments spread the principal repayment throughout the life of the loan. LIBOR (London Inter Bank Offered Rate) is the rate at which banks lend to each other. LIBOR is a bench-mark for variable-rates loans within the U.K. and internationally. Currency swaps can be structured as fixedfor-fixed, fixed-for-floating, or floatingfor-floating swaps of either nonamortizing or amortizing variety. Most currency swaps are designed for long term. Currency swaps are very useful for multinational corporations. JP Morgan currency coupon swaps quotes (₤/$) (semiannual interest payments) Maturity 2 3 4 5 years years years years Bid (in ₤) 5.25% 5.40% 5.75% 6.00% Ask (in ₤) 5.35% 5.50% 5.85% 6.10% All quotes against 6-month dollar LIBOR flat An Example of a Currency Swap AT&T has $100 million of 3-year debt at a floating rate of 6-month ($) LIBOR. The company needs fixed-rate sterling debt to fund its operations in U.K. JP Morgan agrees to pay AT&T’s floating rate dollar debt in exchange for a fixed-rate pound payment from the company. Suppose the spot exchange rate is S$/₤ = 1.60. At this spot rate, $100 million is equal in value to ₤62.5 million. Cash transactions proceed as follows: $100 million Initial exchange of principals AT&T JP Morgan ₤62.5 million Cash flows during the life of the swap ₤ 5.50% AT&T JP Morgan 6-m $ LIBOR ₤62.5 million Reexchange of principals AT&T JP Morgan 100 million Interest Rate Swap Interest rate swap is a variant of currency swap in which both sides of the swap are denominated in the same currency. The principal is called notional principal and needn’t be exchanged. The notional principal is used only to calculate the interest payments. The most common type of interest rate swap is the fixed-for-floating swap. Citigroup Interest Rate Swaps Quotes Coupon Swaps ($) Bank Pays Maturity Fixed Rate 2 years 2 yr TN + 19bps 3 years 3 yr TN + 24bps 4 years 4 yr TN + 28bps 5 years 5 yr TN + 33bps Bank Receives Fixed Rate 2 yr TN + 40bps 3 yr TN + 47bps 4 yr TN + 53bps 5 yr TN + 60bps Current TN Rate 7.05% 7.42% 7.85% 7.92% The schedule assumes nonamortizing debt and semiannual rates. All quotes are against 6-month dollar LIBOR flat. TN = U.S. Treasury note rate An example of an interest rate swap Exxon-Mobil and Citigroup reached a 5-year $50 million interest rate swap agreement. Initiation date: June 15, 2011 Exxon-Mobil pays 7.92% fixed rate Citigroup pays 6-month dollar LIBOR Interest payment on June 15 and December 15 during the next 5 years starts in 2011. The first payment date: December 15 Exxon-Mobil pay Citigroup fixed rate: ($50m)x[(0.0792 + 0.0060)/2] = $2,130,000 Citigroup pays Exxon-Mobil floating rate. The payment is determined by LIBOR at the beginning of the settlement period and made at the end of the settlement period. The payment on December 15 is based on LIBOR on the previous June 15. Suppose LIBOR on June 15 is 8.5%. Citigroup then pays: ($50m) x [(0.085/2)] = $2,125,000 Since Exxon-Mobil owes $2,130,000 to the bank and the bank owes $2,125,000, only the difference needs to be paid. So, Exxon-Mobil pays $5,000 to Citigroup. Other Types of Swaps Commodity swaps can be based either on two different commodities or on the same commodity. When the commodities are the same, this kind of swap typically takes the form of a floating-for-fixed swap. One party makes periodic payments at a fixed per-unit price for a given quantity of some commodity while the other party makes periodic payments at a floating rate pegged to the spot commodity price. The most common commodity swap is oil swap. Commodity swaps across two different commodities can be structured as fixed-forfixed, fixed-for-floating, or floating-forfloating swaps. In this case, commodities could be changed but the difference in spot prices is usually settled in cash. Equity swaps refer to the asset portfolio swaps. Mr. Bear has $100 million invested in a welldiversified portfolio of stocks that is highly correlated with the S&P 500 and wants to get into 10-year T-bonds for one year. Mr. Bull has a $100 million portfolio of 10-year Tbonds and wishes to get into stocks for one year. The two men could form a debt-for-equity swap in which Mr. Bear pays Mr. Bull the S&P 500 return on a $100 million notional principal and Mr. Bull pays Mr. Bear the returns from his $100 million portfolio of 10-year T-bonds. This swap could be engineered with a 1-year term. A number of combinations and variations of this debt-for-equity swap are possible. Swaptions is a derivative contract granting the right to enter into a swap. For example, an MNC wants to finance a project in three months. The company now has a five-year floating rate debt but it hopes to swap into fixed interest payments. If the company purchases a swaption which is a right to receive 3-month LIBOR floating rate and pay fixed rate (6%) for five years, the company will exercise the swaption when the fixed rate is higher than 6% at the market. If the fixed rate is lower than 6% three months later, the company simply let the swaption expire.