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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.