ETM3-Chapter 9: Financial Risk Management Using Derivatives Foreign Exchange (FX) Risk Management FX Quotes and Rates
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1 ETM3: Chapter 9 Part 3 Module ETM3-Chapter 9: Financial Risk Management Using Derivatives Foreign Exchange (FX) Risk Management FX Quotes and Rates Essentials of Treasury Management, 3rd Ed. (ETM3) is published by the AFP, which holds the copyright and all rights to the related materials. As a prep course for the CTP exam, significant portions of these lectures are based on materials from the Essentials text The Treasury Academy - All Rights Reserved 1
2 How Companies Really Use Derivatives Forward contracts are typically settled with delivery of the underlying asset Futures and options contracts typically involve using the gains or losses on a financial contract to offset the real operating losses or gains Most futures and options contracts are closed out prior to delivery 2012 The Treasury Academy - All Rights Reserved 2
3 Hedging Example Assume a small oil refinery is worried about the future price of oil Current oil price is $90/bbl The refinery would be hurt by rising prices They could buy a futures contract that would allow purchase of $90/bbl in 30 days A call options contract is also available would allow them to buy $90/bbl in 30 days The option premium is $1/bbl 2012 The Treasury Academy - All Rights Reserved 3
4 The Results in 30 Days Futures Contract If Oil = $95 Futures contract has profit of $5/bbl Company buys oil at spot rate of $95 Net price = $90 If Oil = $85 Futures contract has loss of $5/bbl Company buys oil at spot rate of $85 Net price = $90 Options Contract Company pays $1/bbl premium to buy option If Oil = $95 Option value = $5 Company buys oil at spot rate of $95 Net price = $91 If Oil = $85 Option is out of money Company buys oil at spot rate of $85 Net price = $ The Treasury Academy - All Rights Reserved 4
5 Foreign Exchange (FX) Risk Management in Treasury Challenges in International/Global Treasury Management Foreign Exchange (FX) Risk Cash Flow Complexity Tax Issues Foreign Exchange (FX) Rates FX rates are quoted in several ways, depending on the currencies and the markets involved An FX rate is expressed as the equivalent unit of one currency per unit of another currency at a given moment in time 2012 The Treasury Academy - All Rights Reserved 5
6 Sample Foreign Currency Quotation Formats Currency USD Equivalent Unit of Currency per one USD GBP-British pound GBP/USD USD/GBP CAD-Canadian dollar CAD/USD USD/CAD EUR-Euro EUR/USD USD/EUR JPY-Japanese yen JPY/USD USD/JPY Quotes in table are from March 2010 Most common formats are in Bold/Italic Source: ETM3 - AFP 2012 The Treasury Academy - All Rights Reserved 6
7 Foreign Exchange (FX) Rates Example: The quoted rate for the USD equivalent is EUR/USD How many euros would $2 million buy? $2,000,000 = EUR1,494, Example: The quoted rate for the USD equivalent is GBP/USD How many pounds would $2 million buy? $2,000,000 = GBP1,334, The Treasury Academy - All Rights Reserved 7
8 Foreign Exchange (FX) Rates Example: The quoted rate for the Japanese yen USD/JPY How many yen would $2 million purchase? $2,000,000 x = JPY185,120,000 Example: The quoted rate for the Can. dollar is USD/CAD CAD2,000,000 would be equivalent to how many USD? CAD2,000,000 = USD1,948, The Treasury Academy - All Rights Reserved 8
9 Foreign Exchange (FX) Rates: Bid-Offer Spreads and Dealer Profit Bid rate: Dealer buys currency Offer rate: Dealer sells currency Bid/offer spread or bid/ask spread: Difference between rates (dealer s profit) Dealer bid-offer quote; e.g., USD/JPY Scenario Company Delivers Dealer Buys Dealer Sells Company Receives Company wants to buy JPY USD USD at bid rate (JPY90.57) JPY JPY Company wants to sell JPY for USD JPY JPY USD at offer rate (JPY90.63) USD Source: ETM3 - AFP 2012 The Treasury Academy - All Rights Reserved 9
10 Foreign Exchange (FX) Markets Spot Market (spot rate) Forward Market (forward rate) Par Discount Premium Interest Rate Parity 2012 The Treasury Academy - All Rights Reserved 10
11 Session Wrap-up Module What did we learn in this session? What topics do we need to learn more about? 2012 The Treasury Academy - All Rights Reserved 11
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