Chapter 8 Currency Derivatives Foreign Currency Derivatives and

Chapter 8 Currency Derivatives

Foreign Currency Derivatives and Swaps • Financial management of the MNE in the 21 st 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 1 -2 8 -2 © 2013 Pearson Education

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) 1 -3 8 -3 © 2013 Pearson Education

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 foreign currency futures is the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange. 1 -4 8 -4 © 2013 Pearson Education

Foreign Currency Futures • Contract specifications are established by the exchange on which futures 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 • Exhibit 8. 1 is an excellent description of futures contracts for the Mexican peso 1 -5 8 -5 © 2013 Pearson Education

Exhibit 8. 1 Mexican Peso (CME)MXN 500, 000; $ per 10 MXN 1 -6 8 -6 © 2013 Pearson Education

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) 1 -7 8 -7 © 2013 Pearson Education

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 1 -8 8 -8 © 2013 Pearson Education

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 1 -9 8 -9 © 2013 Pearson Education

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. 1 -10 8 -10 © 2013 Pearson Education

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). 1 -11 8 -11 © 2013 Pearson Education

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. 1 -12 8 -12 © 2013 Pearson Education

Exhibit 8. 2 Swiss Franc Option Quotations (U. S. cents/SF) 1 -13 8 -13 © 2013 Pearson Education

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. 1 -14 8 -14 © 2013 Pearson Education

Exhibit 8. 3 Profit and Loss for the Buyer of a Call Option 1 -15 8 -15 © 2013 Pearson Education

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 1 -16 8 -16 © 2013 Pearson Education

Exhibit 8. 4 Profit and Loss for the Writer of a Call Option 1 -17 8 -17 © 2013 Pearson Education

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 1 -18 8 -18 © 2013 Pearson Education

Exhibit 8. 5 Profit and Loss for the Buyer of a Put Option 1 -19 8 -19 © 2013 Pearson Education

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 1 -20 8 -20 © 2013 Pearson Education

Exhibit 8. 6 Profit and Loss for the Writer of a Put Option 1 -21 8 -21 © 2013 Pearson Education

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) 1 -22 8 -22 © 2013 Pearson Education

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 1 -23 8 -23 © 2013 Pearson Education

Exhibit 8. 7 Option Intrinsic Value, Time Value, and Total Value 1 -24 8 -24 © 2013 Pearson Education

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 1 -25 8 -25 © 2013 Pearson Education

Exhibit 8. 8 Summary of Option Premium Components 1 -26 8 -26 © 2013 Pearson Education

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. 1 -27 8 -27 © 2013 Pearson Education

Exhibit 8. 9 International Interest Rate Calculations 1 -28 8 -28 © 2013 Pearson Education

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. 1 -29 8 -29 © 2013 Pearson Education

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. 1 -30 8 -30 © 2013 Pearson Education

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 1 -31 8 -31 © 2013 Pearson Education

Exhibit 8. 10 Eurodollar Futures Prices 1 -32 8 -32 © 2013 Pearson Education

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 1 -33 8 -33 © 2013 Pearson Education

Exhibit 8. 11 Interest Rate Futures Strategies for Common Exposures 1 -34 8 -34 © 2013 Pearson Education

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. 1 -35 8 -35 © 2013 Pearson Education

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 1 -36 8 -36 © 2013 Pearson Education

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. 1 -37 8 -37 © 2013 Pearson Education

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. 1 -38 8 -38 © 2013 Pearson Education

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 1 -39 8 -39 © 2013 Pearson Education

Exhibit 8. 12 Interest Rate Swap Strategies 1 -40 8 -40 © 2013 Pearson Education

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. 1 -41 8 -41 © 2013 Pearson Education

Exhibit 8. 13 Interest Rate and Currency Swap Quotes 1 -42 8 -42 © 2013 Pearson Education