Financial Management in IB Currency Derivatives 1 Currency

Financial Management in IB Currency Derivatives 1

Currency Derivatives FX Markets Division FX Markets Spot Markets FX Forwards FX Swaps Forward Markets Currency Futures Currency-Swaps Currency Options Outright Transactions 2

Currency Derivatives – FX Forwards A forward contract is an agreement • between a corporation and a commercial bank • to exchange a specified amount of a currency • at a specified exchange rate (called the forward rate) • on a specified date in the future. 3

Currency Derivatives – FX Forwards If the forward rate exceeds the existing spot rate, it contains a premium. If it is less than the existing spot rate, it contains a discount. The premium (or discount) reflects the difference between the home interest rate and the foreign interest rate, so as to prevent covered interest arbitrage. 4

Currency Derivatives - FX Forwards Covered Interest Arbitrage Covered interest arbitrage tends to force a relationship between the interest rates of two countries and their forward exchange rate. 2 Strategies of Covered Interest Arbitrage: Borrowing Euros and lending US Dollars Borrowing US Dollars and lending Euros In response to the imbalance in demand supply resulting from such arbitrage activity, the rates will adjust very quickly. 5

Currency Derivatives - FX Forwards Borrowing Euros and lending US Dollars Costs in Euros: K. (1+i. EUR) Revenues in Euros: K. St. (1+i. USD). 1/FRt+n Equilibrium: 6

Currency Derivatives – FX Forwards Borrowing US Dollars and lending Euros Costs in US Dollars: K. (1+i. USD) Revenues in US Dollars: K. 1/St. (1+i. EUR). FRt+n Equilibrium: 7

Currency Derivatives – FX Forwards Covered Interest Rate Parity Condition 8

Currency Derivatives – FX Forwards Non Deliverable Forward Contracts Non-deliverable forward contracts (NDFs) are forward contracts whereby the currencies are not actually exchanged. Instead, a net payment is made by one party to the other based on the contracted rate and the market exchange rate on the day of settlement. 9

Currency Derivatives: Currency Futures • Currency Futures are contracts specifying a standard volume of a particular currency to be exchanged on a specific settlement date. • The contracts can be traded by firms or individuals on the trading floor of an exchange or on automated trading systems. • Currency Futures are standardized. • Normally, the price of a currency future is similar to the forward rate for a given currency and settlement date, but different from the spot rate. 10

Currency Derivatives: Currency Futures • Holders of futures contracts can close out their position by selling an identical futures contract. Similarly, sellers of futures contracts can close out their position by purchasing a currency futures contract with a similar settlement date. • The gain or loss to the firm is dependent on the difference between the purchase price and the sale price. • Most currency futures contracts are closed out before their settlement date. • The contracts are guaranteed by the exchange clearinghouse, and margin requirements are imposed to cover fluctuations in value. • At the end of each business day gains and losses are calculated for all open positions. 11

Currency Derivatives: Currency Futures • Corporations that have open positions in foreign currencies can use futures contracts to offset such positions. • Speculators also use them to capitalize on their expectation of a currency’s future movement. • Brokers who fulfill orders to buy or sell futures contracts earn a transaction fee in the form of a bid/ask spread. 12

Currency Derivatives: Currency Futures Example • Euro / US Dollar Futures - LIFFE Unit of trading: EUR 20, 000 Quotation: In US dollars per EUR 100 (USD 0. 01 represents USD 200 per contract) Minimum price movement (tick size and value): USD 0. 01 (USD 2) Last trading day: 13. 00 Amsterdam time on the third Friday of the delivery month, provided this is a business day. If it is not, the previous business day will be the last day of trading. Settlement: Cash settlement, based on the value of the €/$ rate set by Euro. FX at 13. 00 Amsterdam time. 13

Currency Derivatives: Currency Swaps Swap • A swap is a negotiated agreement between two parties to exchange cash flows at specified intervals (payment dates) during the agreed-upon life of the contract (maturity or tenor). Entering a swap typically does not require the payment of a fee. • An interest rate swap is an agreement to exchange interest rate cash flows, calculated on a notional principal amount, at specified intervals (payment dates) during the life of the agreement. • A cross-currency swap is an interest rate swap in which the cash flows are in different currencies. 14

Currency Derivatives: Currency Swaps Cross Currency Swap • Upon initiation of a cross-currency swap, the counterparties make an initial exchange of notional principals in the two currencies. • During the life of the swap, each party pays interest (in the currency of the principal received) to the other. • At the maturity of the swap, the parties make a final exchange of the initial principal amounts, reversing the initial exchange at the same spot rate. • A cross-currency swap is sometimes confused with a traditional FX swap, which is simply a spot currency transaction that will be reversed at a predetermined date with an offsetting forward transaction. 15

Currency Derivatives: Currency Options Option purchaser (buyer, holder) § has a RIGHT, NOT the OBLIGATION to buy/sell § given amount of underlying currency § at fixed price = strike/exercise price § on specified expiration day/time period § pays option premium = price of the option (contract) 16

Currency Derivatives: Currency Options Option seller (writer, grantor) § has the OBLIGATION to sell/buy § given amount of underlying currency § at fixed price = strike/exercise price § on specified expiration day/time period § if the option buyer exercises his right § receives option premium 17

Currency Derivatives: Currency Options Basic types of options CALL => buying underlying currency § Holder has a RIGHT, NOT the OBLIGATION to buy § Writer has the OBLIGATION to sell PUT => selling underlying currency § Holder has a RIGHT, NOT the OBLIGATION to sell § Writer has the OBLIGATION to buy 18

Currency Derivatives: Currency Options The option HOLDER can Use his option § Buy in case of a call option § Sell in case of a put option Sell his option § Close long position with short one § The same exercise price, expiration day, amount. Do not use the option right at all § Cost – option premium to the writer/grantor 19

Currency Derivatives: Currency Options The option WRITER has to Sell underlying currency in case of a call option § If the holder of the call option exercises his right Buy underlying currency in case of a put option § If the holder of the put option exercises his right 20

Currency Derivatives: Currency Options Option styles AMERICAN OPTION § Holder can exercise (use) it on any day since its purchase till the expiration (maturity) day EUROPEAN OPTION § Buyer has the right to use the option ONLY on the expiration day, NOT BEFORE 21

Currency Derivatives: Currency Options are traded on ORGANIZED EXCHANGES § CBOE Chicago Board Options Exchange § LIFFE London International Financial Futures Exchange On the OVER-THE-COUNTER (OTC) MARKET § Options are written by banks, are NOT standardized 22

Currency Derivatives: Currency Options Basic option positions Long call § Right to buy underlying currency Long put § Right to sell underlying currency Short call § Obligation to sell underlying currency Short put § Obligation to buy underlying currency 23

Currency Derivatives: Currency Options I. Open Position (Speculative example) a) Buying Call Option on EUR against USD Option premium: 3. 00% Underlying currency: 100, 000 € Strike price: EUR/USD 1. 20 Spot rate: EUR/USD 1. 20 Maturity: 3 months 24

Currency Derivatives: Currency Options Profit /Loss Risk Profile: Long Call 0 1. 10 1. 20 1. 30 long call EUR/USD 25

Currency Derivatives: Currency Options Profit /Loss Long & Short Call 0 1. 10 1. 20 EUR/USD 1. 30 long call short call 26

Currency Derivatives: Currency Options I. Open Position (Speculative example) b) Buying Put Option on EUR against USD Option premium: 3. 00% Underlying currency: 100, 000 € Strike price: EUR/USD 1. 20 Spot rate: EUR/USD 1. 20 Maturity: 3 months 27

Currency Derivatives: Currency Options Profit /Loss Risk Profile: Long Put 0 1. 10 1. 20 1. 30 long put EUR/USD 28

Currency Derivatives: Currency Options Profit /Loss Long & Short Put 0 1. 10 1. 20 EUR/USD 1. 30 long put short put 29

Currency Derivatives: Currency Options Pricing and evaluation of the options Total Value (premium) of the option consists of 2 components: § Intrinsic Value – a gain if the option is traded immediately § Time Value - which takes into consideration a further possible change of the market Formula: Total Value = Intrinsic value + Time Value 30

Currency Derivatives: Currency Options Components of Option Pricing § Strike price § Present spot rate § Forward rate for matching maturity § USD interest rate § EUR interest rate § Volatility § Time to maturity 31

Currency Derivatives: Currency Options 32

Currency Derivatives: Currency Options 33