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Chapter 8
Currency
Derivatives
Foreign Currency Derivatives and
Swaps
• Financial management of the MNE in the 21st
century involves financial derivatives.
• These derivatives, so named because their values
are derived from underlying assets, are a powerful
tool used in business today.
• These instruments can be used for two very distinct
management objectives:
– Speculation – use of derivative instruments to take a
position in the expectation of a profit
– Hedging – use of derivative instruments to reduce the risks
associated with the everyday management of corporate
cash flow
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Foreign Currency Derivatives
• Derivatives are used by firms to achieve one of
more of the following individual benefits:
– Permit firms to achieve payoffs that they would not be able
to achieve without derivatives, or could achieve only at
greater cost
– Hedge risks that otherwise would not be possible to hedge
– Make underlying markets more efficient
– Reduce volatility of stock returns
– Minimize earnings volatility
– Reduce tax liabilities
– Motivate management (agency theory effect)
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Foreign Currency Futures
• A foreign currency futures contract is an alternative
to a forward contract that calls for future delivery of
a standard amount of foreign exchange at a fixed
time, place and price.
• It is similar to futures contracts that exist for
commodities such as cattle, lumber, interestbearing deposits, gold, etc.
• In the U.S., the most important market for foreign
currency futures is the International Monetary
Market (IMM), a division of the Chicago Mercantile
Exchange.
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Foreign Currency Futures
• Contract specifications are established by the
exchange on which futures are traded.
• Major features that are standardized are:
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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
• Exhibit 8.1 is an excellent description of futures
contracts for the Mexican peso
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Exhibit 8.1 Mexican Peso (CME)MXN 500,000; $ per 10MXN
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Foreign Currency Futures
• Foreign currency futures contracts differ from forward
contracts in a number of important ways:
– Futures are standardized in terms of size while forwards
can be customized
– 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
forwards are traded between individuals and banks
– Futures have an initial margin that is market to market on
a daily basis 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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Foreign Currency Options
• A foreign currency option is a contract
giving the option purchaser (the buyer) the
right, but not the obligation, to buy or sell a
given amount of foreign exchange at a fixed
price per unit for a specified time period
(until the maturity date).
• There are two basic types of options, puts
and calls.
– A call is an option to buy foreign currency
– A put is an option to sell foreign currency
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Foreign Currency Options
• The buyer of an option is termed the
holder, while the seller of the option is
referred to as the writer or grantor.
• Every option has three different price
elements:
– The exercise or strike price – the exchange rate
at which the foreign currency can be purchased
(call) or sold (put)
– The premium – the cost, price, or value of the
option itself
– The underlying or actual spot exchange rate in
the market
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Foreign Currency Options
• An American option gives the buyer the
right to exercise the option at any time
between the date of writing and the
expiration or maturity date.
• A European option can be exercised only on
its expiration date, not before.
• The premium, or option price, is the cost of
the option.
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Foreign Currency Options
• An option whose exercise price is the same as the
spot price of the underlying currency is said to be
at-the-money (ATM).
• An option that would be profitable, excluding the
cost of the premium, if exercised immediately is
said to be in-the-money (ITM).
• An option that would not be profitable, again
excluding the cost of the premium, if exercised
immediately is referred to as out-of-the money
(OTM).
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Foreign Currency Options
• In the past three decades, the use of foreign
currency options as a hedging tool and for
speculative purposes has blossomed into a major
foreign exchange activity.
• Options on the over-the-counter (OTC) market can
be tailored to the specific needs of the firm but can
expose the firm to counterparty risk.
• Options on organized exchanges are standardized,
but counterparty risk is substantially reduced.
• Exhibit 8.2 shows a published quote for the Swiss
Franc.
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Exhibit 8.2 Swiss Franc Option
Quotations (U.S. cents/SF)
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Buyer of a Call Option
• Buyer of an option only exercises his/her rights if
the option is profitable.
• In the case of a call option, as the spot price of the
underlying currency moves up, the holder has the
possibility of unlimited profit.
• Exhibit 8.3 shows a static profit and loss diagram
for the purchase of a Swiss Franc Call Option.
Notice how the purchaser makes a profit as the
franc appreciates vs. the dollar – this is because
the purchaser has the right to purchase the franc
at a pre-specified, and in this case, lower price
than the current spot price.
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Exhibit 8.3 Profit and Loss for the
Buyer of a Call Option
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Option Market Speculation
• Writer of a call: (see Exhibit 8.4)
– What the holder, or buyer of an option loses, the
writer gains
– The maximum profit that the writer of the call
option can make is limited to the premium
– If the writer wrote the option naked, that is
without owning the currency, the writer would
now have to buy the currency at the spot and
take the loss delivering at the strike price
– The amount of such a loss is unlimited and
increases as the underlying currency rises
– Even if the writer already owns the currency, the
writer will experience an opportunity loss
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Exhibit 8.4 Profit and Loss for the
Writer of a Call Option
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Option Market Speculation
• Buyer of a Put: (see Exhibit 8.5)
– The basic terms of this example are similar to those just illustrated
with the call
– The buyer of a put option, however, wants to be able to sell the
underlying currency at the exercise price when the market price of
that currency drops (not rises as in the case of the call option)
– If the spot price drops to $0.575/SF, the buyer of the put will
deliver francs to the writer and receive $0.585/SF
– At any exchange rate above the strike price of 58.5, the buyer of
the put would not exercise the option, and would lose only the
$0.05/SF premium
– The buyer of a put (like the buyer of the call) can never lose more
than the premium paid up front
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Exhibit 8.5 Profit and Loss for the
Buyer of a Put Option
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Option Market Speculation
• Seller (writer) of a put: (see Exhibit 8.6)
– In this case, if the spot price of francs drops
below 58.5 cents per franc, the option will be
exercised
– Below a price of 58.5 cents per franc, the writer
will lose more than the premium received from
writing the option (falling below break-even)
– If the spot price is above $0.585/SF, the option
will not be exercised and the option writer will
pocket the entire premium
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Exhibit 8.6 Profit and Loss for the
Writer of a Put Option
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Option Pricing and Valuation
• The pricing of any currency option combines
six elements:
– Present spot rate
– Time to maturity
– Forward rate for matching maturity
– U.S. dollar interest rate
– Foreign currency interest rate
– Volatility (standard deviation of daily spot price
movements)
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Option Pricing and Valuation
• The total value (premium) of an option is equal to the intrinsic value
plus time value.
• Intrinsic value is the financial gain if the option is exercised
immediately.
– For a call option, intrinsic value is zero when the strike price is
above the market price
– When the spot price rises above the strike price, the intrinsic
value become positive
– Put options behave in the opposite manner
– On the date of maturity, an option will have a value equal to its
intrinsic value (zero time remaining means zero time value)
• The time value of an option exists because the price of the
underlying currency, the spot rate, can potentially move further and
further into the money between the present time and the option’s
expiration date.
• See Exhibit 8.7 for a diagram of the intrinsic value and time value of
an option
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Exhibit 8.7 Option Intrinsic Value,
Time Value, and Total Value
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Currency Option Pricing
Sensitivity
• If currency options are to be used effectively, either for the
purposes of speculation or risk management, the individual
trader needs to know how option values – premiums – react
to their various components. Summarized in Exhibit 8.8.
• Forward rate sensitivity:
– Standard foreign currency options are priced around the forward
rate because the current spot rate and both the domestic and
foreign interest rates are included in the option premium
calculation
– The option-pricing formula calculates a subjective probability
distribution centered on the forward rate
– This approach does not mean that the market expects the
forward rate to be equal to the future spot rate, it is simply a
result of the arbitrage-pricing structure of options
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Exhibit 8.8 Summary of Option
Premium Components
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Interest Rate Risk
• All firms – domestic or multinational, small or
large, leveraged or unleveraged – are sensitive to
interest rate movements in one way or another.
• The single largest interest rate risk of the
nonfinancial firm (our focus in this discussion) is
debt service; the multicurrency dimension of
interest rate risk for the MNE is of serious concern.
• Exhibit 8.9, shows that even the interest rate
calculations vary on occasion across currencies and
countries.
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Exhibit 8.9 International Interest
Rate Calculations
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Interest Rate Risk
• The second most prevalent source of interest
rate risk for the MNE lies in its holdings of
interest-sensitive securities.
• Unlike debt, which is recorded on the righthand side of the firm’s balance sheet, the
marketable securities portfolio of the firm
appears on the left-hand side.
• Marketable securities represent potential
earnings for the firm.
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Interest Rate Risk
• Prior to describing the management of the most
common interest rate pricing risks, it is important to
distinguish between credit risk and repricing risk.
• Credit risk, sometimes termed roll-over risk, is the
possibility that a borrower’s credit worthiness, at the
time of renewing a credit, is reclassified by the lender
(resulting in changes to fees, interest rates, credit line
commitments or even denial of credit).
• Repricing risk is the risk of changes in interest rates
charged (earned) at the time a financial contract’s rate
is reset.
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Interest Rate Futures
• Unlike foreign currency futures, interest rate futures are
relatively widely used by financial managers and
treasurers of nonfinancial companies.
• Their popularity stems from the relatively high liquidity
of the interest rate futures markets, their simplicity in
use, and the rather standardized interest-rate exposures
most firms possess.
• The two most widely used futures contracts are the
Eurodollar futures traded on the Chicago Mercantile
Exchange (CME) and the US Treasury Bond Futures of
the Chicago Board of Trade (CBOT).
• For an example, see Exhibit 8.10
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Exhibit 8.10 Eurodollar Futures
Prices
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Interest Rate Futures
• Common interest rate futures strategies:
– Paying interest on a future date (sell a futures contract/short
position)
• If rates go up, the futures price falls and the short earns a profit
(offsets loss on interest expense)
• If rates go down, the futures price rises and the short earns a
loss
– Earning interest on a future date (buy a futures
contract/long position)
• If rates go up, the futures price falls and the short earns a loss
• If rates go down, the futures price rises and the long earns a
profit
• Exhibit 8.11 provides an overview of these two basic
interest rate exposures
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Exhibit 8.11 Interest Rate Futures
Strategies for Common Exposures
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Forward Rate Agreements
• A forward rate agreement (FRA) is an interbank-traded
contract to buy or sell interest rate payments on a notional
principal.
• These contracts are settled in cash.
• The buyer of an FRA obtains the right to lock in an interest
rate for a desired term that begins at a future date.
• The contract specifies that the seller of the FRA will pay the
buyer the increased interest expense on a nominal sum (the
notional principal) of money if interest rates rise above the
agreed rate, but the buyer will pay the seller the differential
interest expense if interest rates fall below the agreed rate.
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Interest Rate Swaps
• Swaps are contractual agreements to exchange or
swap a series of cash flows.
• These cash flows are most commonly the interest
payments associated with debt service, such as the
floating-rate loan described earlier.
– If the agreement is for one party to swap its fixed interest rate
payments for the floating interest rate payments of another, it
is termed an interest rate swap
– If the agreement is to swap currencies of debt service
obligation, it is termed a currency swap
– A single swap may combine elements of both interest rate and
currency swaps
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Interest Rate Swaps
• The swap itself is not a source of capital, but rather
an alteration of the cash flows associated with
payment.
• What is often termed the plain vanilla swap is an
agreement between two parties to exchange fixedrate for floating-rate financial obligations.
• This type of swap forms the largest single financial
derivative market in the world.
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Interest Rate Swaps
• The two parties may have various motivations for
entering into the agreement.
• A very common situation is as follows:
– A corporate borrower of good credit standing has existing
floating-rate debt service payments.
– The borrower may conclude that interest rates are about to
rise.
– In order to protect the firm against rising debt-service
payments, the company’s treasury may enter into a swap
agreement to pay fixed/receive floating.
– This means the firm will now make fixed interest rate
payments and receive from the swap counterparty floating
interest rate payments.
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Interest Rate Swaps
• Similarly, a firm with fixed-rate debt that
expects interest rates to fall can change
fixed-rate debt to floating-rate debt.
• In this case, the firm would enter into a pay
floating/receive fixed interest rate swap.
• Interest rate swaps are also known as
coupon swaps.
• Exhibit 8.12 presents a summary table of
the recommended interest rate swap
strategies
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Exhibit 8.12 Interest Rate Swap
Strategies
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Currency Swaps
• Since all swap rates are derived from the yield curve in each major
currency, the fixed- to floating-rate interest rate swap existing in
each currency allow firms to swap across currencies.
• The usual motivation for a currency swap is to replace cash flows
scheduled in an undesired currency with flows in a desired currency.
• The desired currency is probably the currency in which the firm’s
future operating revenues (inflows) will be generated.
• Firms often raise capital in currencies in which they do not possess
significant revenues or other natural cash flows (a significant reason
for this being cost).
• The utility of the currency swap market to an MNE is significant. An
MNE wishing to swap a 10-year fixed 6.04% U.S. dollar cash flow
stream could swap to 4.46% fixed in euro, 3.30% fixed in Swiss
francs, or 2.07% fixed in Japanese yen. It could swap from fixed
dollars not only to fixed rates, but also to floating LIBOR rates in the
various currencies as well. All are possible at the rates quoted in
Exhibit 8.13.
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Exhibit 8.13 Interest Rate and
Currency Swap Quotes
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