Ch. 5 Currency Derivatives. Foreign Exchange Rate Risk. Financial Derivatives. Topics Forwards Futures Options
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1 Ch. 5 Currency Derivatives Topics Forwards Futures Options Foreign Exchange Rate Risk Foreign Exchange Rate Risk: Uncertainty about the rate at which a foreign currency can be exchanged for the investor s local currency in the future. Managing Foreign Exchange Rate Risk: involves using hedge instruments such as Currency forward contracts Currency futures Currency options Financial Derivatives Derivatives: Financial instruments whose payoffs and values are derived from/depend upon underlying assets. Forwards Futures Options Raison d'être for derivatives Hedging: To reduce one s risk exposure Speculating: To increase one s risk exposure 1
2 Forward Market The forward market facilitates the trading of forward contracts on currencies. Forward contract: 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. When MNCs anticipate future need or future receipt of a foreign currency, they can set up forward contracts to lock in the exchange rate. Forward contracts are often valued at $1 million or more, and are not normally used by consumers or small firms. Forward Market Long and short positions The party agreeing to buy is said to take a long position. The party agreeing to sell is said to take a short position. A forward contract is an obligation for each of the contracting parties. No money exchanges hands until maturity. Forward Market Non-deliverable forward contract (NDF): Forward contract whereby there is no actual exchange of currencies. Instead, a net payment is made by one party to the other based on the contracted rate and the market rate on the day of settlement. Although NDFs do not involve actual delivery, they can effectively hedge expected foreign currency cash flows. 2
3 Forward Market Contracting Issues in the Forward Market Default risk Liquidity risk Mitigated by financial intermediaries using customized forward contracts. Foreign Exchange Forwards The forward exchange rate is a function of the spot exchange rate, the spot domestic interest rate, and the spot foreign interest rate. Interest rate parity: The ratio between the risk free interest rates in two different countries is equal to the ratio between the forward and spot exchange rates. 1 + r foreign 1 + r $ = f S foreign / $ foreign / $ Forward Market As with the case of spot rates, there is a bid/ask spread on forward rates. Forward rates may also contain a premium or discount. If the forward rate exceeds the existing spot rate, it contains a premium. If the forward rate is less than the existing spot rate, it contains a discount. The forward premium/discount reflects the difference between the home interest rate and the foreign interest rate, so as to prevent arbitrage. 3
4 Forward Market Annualized forward premium/discount = forward rate spot rate 360 spot rate n n: number of days to maturity Currency Futures Market Currency futures contracts specify a standard volume of a particular currency to be exchanged on a specific settlement date, typically the third Wednesdays in March, June, September, and December. They are used by MNCs to hedge their currency positions, and by speculators who hope to capitalize on their expectations of exchange rate movements. The contracts can be traded by firms or individuals through brokers on the trading floor of an exchange (e.g. Chicago Mercantile Exchange), on automated trading systems, or over-the-counter. Currency futures contracts are similar to forward contracts in that they allow a customer to lock in the exchange rate at which a specific currency is purchased or sold for a specific date in the future. Currency Futures Contracts Traded on the Chicago Mercantile Exchange 4
5 Currency Futures Market Short hedge: Selling a futures contract Short hedges are used when you will be making delivery at a future date and you wish to minimize the risk of a drop in price. Long hedge: Buying a futures contract Long hedges are used when you will be making purchase at a future date and you wish to minimize the risk of a rise in price. How Firms Use Currency Futures Purchasing Futures to Hedge Payables - The purchase of futures contracts locks in the price at which a firm can purchase a currency. Selling Futures to Hedge Receivables - The sale of futures contracts locks in the price at which a firm can sell a currency. Closing Out a Futures Position Sellers (buyers) of currency futures can close out their positions by buying (selling) identical futures contracts prior to settlement. Most currency futures contracts are closed out before the settlement date. Brokers who fulfill orders to buy or sell futures contracts earn a transaction or brokerage fee in the form of the bid/ask spread. Currency Futures Market Currency futures contracts have no credit risk since they are guaranteed by the exchange clearinghouse. To minimize its risk in such a guarantee, the exchange imposes margin requirements to cover fluctuations in the value of the contracts. Speculators often sell currency futures when they expect the underlying currency to depreciate, and vice versa. 5
6 Currency Futures Market Currency Options Markets Currency options provide the right to purchase or sell currencies at specified prices. Options Exchanges exchanges in Amsterdam, Montreal, and Philadelphia first allowed trading in standardized foreign currency options CME and CBOT merged to form CME group. Exchanges are regulated by the SEC in the U.S. Over-the-counter market - Where currency options are offered by commercial banks and brokerage firms. Unlike the currency options traded on an exchange, the over-thecounter market offers currency options that are tailored to the specific needs of the firm. Currency Options Market Currency options are classified as either calls or puts. Currency call option: Grants the holder the right to buy a specific currency at a specific price (called the exercise or strike price) within a specific period of time. Currency put option: Grants the holder the right to sell a specific currency at a specific price (called the exercise or strike price) within a specific period of time. The buyer of the option pays a premium. In both forward/futures contracts, the buyer and the seller have the obligation, not the option, to settle the contract at the future date. 6
7 Currency Options Market Factors Affecting Currency Call Option Premiums C = f (S X, T, σ) The premium on a call option (C) is affected by three factors: Spot price relative to the strike price (S X): The higher the spot rate relative to the strike price, the higher the option price will be. Length of time before expiration (T): The longer the time to expiration, the higher the option price will be. Potential variability of currency (σ): The greater the variability of the currency, the higher the probability that the spot rate can rise above the strike price. Currency Call Options A call option is in the money if spot rate > strike price at the money if spot rate = strike price out of the money if spot rate < strike price Option owners can sell or exercise their options. They can also choose to let their options expire. At most, they will lose the premiums they paid for their options. Firms may purchase currency call options to hedge future payables to hedge potential expenses when bidding on projects to hedge potential costs when attempting to acquire other firms Currency Call Options Speculators who expect a foreign currency to appreciate can purchase call options on that currency. Profit = selling price buying (strike) price option premium They may also sell (write) call options on a currency that they expect to depreciate. Profit = option premium buying price + selling (strike) price Break-even point from speculation Break even if the revenue from selling the currency equals the payments made for the currency plus the option premium. Some institutions may have a division that uses currency options to speculate on future exchange rate movements Most MNCs use currency derivatives for hedging and not speculation. 7
8 Currency Call Option Payoff: Buyer Call option value to buyer, given a $ X exercise price. Payoff/Profit S-X S-X-C -C X Price S Currency Call Options The purchaser of a call option will break even when selling price = buying (strike) price + option premium The seller (writer) of a call option will break even when buying price = selling (strike) price + option premium Currency Call Option Payoff: Seller Call option payoff to seller, given a $ X exercise price. Payoff/Profit C Price X S C-(S-X) -(S-X) 8
9 Currency Put Options Grants the right to sell a currency at a specified strike price or exercise price within a specified period of time. If the spot rate falls below the strike price, the owner of a put can exercise the right to sell currency at the strike price. The buyer of the options pays a premium. Currency Put Options A put option is in the money if spot rate < strike price at the money if spot rate = strike price out of the money if spot rate > strike price Put option premiums will be higher when: (strike price spot rate) is larger. the time to expiration date is longer. the variability of the currency is greater. Corporations with open foreign currency positions may use currency put options to cover their positions. For example, firms may purchase put options to hedge future receivables. Currency Put Options Speculators who expect a foreign currency to depreciate can purchase put options on that currency. Profit = selling (strike) price buying price option premium They may also sell (write) put options on a currency that they expect to appreciate. Profit = option premium + selling price buying (strike) price 9
10 Currency Put Option Payoff: Buyer Put option value to buyer, given a $ X exercise price. Payoff/Profit X-S X-S-P -P S X Price Currency Put Option Payoff: Seller Put option value to seller, given a $ X exercise price. Payoff/Profit P P-(X-S) -(X-S) S Price X Currency Options Straddle: Purchasing both a put option and a call option at the same exercise price. Strategy for profiting from high volatility: By purchasing both options, the speculator may gain if the currency moves substantially in either direction, or if it moves in one direction followed by the other. 10
11 Currency Options - Straddle Option value X Price Straddle European Currency Options European-style currency options are similar to Americanstyle options except that they can only be exercised on the expiration date. For firms that purchase options to hedge future cash flows, this loss in terms of flexibility is probably not an issue. Hence, if their premiums are lower, European-style currency options may be preferred. Efficiency of Currency Derivatives If foreign exchange markets are efficient, speculation in the currency futures and options markets should not consistently generate abnormally large profits. A speculative strategy requires the speculator to incur risk. On the other hand, corporations use the futures and options markets to reduce their exposure to fluctuating exchange rates. 11
12 Currency Derivatives & MNC s Value Currency Futures Currency Options Value = t=1 [ ( ) ( )] m E CF n j, t E ER j, t j= 1 t ( 1 + k ) E (CF j,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ER j,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent 12
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