FINC3240 International Finance Chapter 5 Currency Derivatives 1.

FINC3240FINC3240International FinanceInternational Finance

Chapter 5Chapter 5

Currency DerivativesCurrency Derivatives

11

Chapter OverviewChapter Overview

A. Currency ForwardsA. Currency Forwards

B. Currency FuturesB. Currency Futures

C. Currency OptionsC. Currency Options

D.D. Currency SwapsCurrency Swaps

22

3

DerivativesDerivatives

A derivative contract involves no actual transfer A derivative contract involves no actual transfer of ownership of the underlying assets at the time of ownership of the underlying assets at the time the contract is initiated. A derivative represents the contract is initiated. A derivative represents an agreement to transfer ownership of underlying an agreement to transfer ownership of underlying assets at a specific place, price, and time assets at a specific place, price, and time specified in the contract. Its value (or price) specified in the contract. Its value (or price) derives from the value of the underlying assets.derives from the value of the underlying assets.

The underlying assets: stocks, bonds, interest The underlying assets: stocks, bonds, interest rates, foreign exchanges, index, commodities, rates, foreign exchanges, index, commodities, some derivatives, etc.some derivatives, etc.

33

Currency ForwardsCurrency Forwards

Definition: an agreement between two Definition: an agreement between two parties to exchange a specified amount parties to exchange a specified amount of a currency at a specified exchange of a currency at a specified exchange rate (forward rate) on a specified date in rate (forward rate) on a specified date in the future.the future.

1.1. Terms are unique to each individual forward Terms are unique to each individual forward contract. That is, each contract is customized.contract. That is, each contract is customized.

2.2. There is a risk that one party might default on There is a risk that one party might default on its’ obligation.its’ obligation.

44

Forward ContractForward Contract

Forward bid-ask spreadForward bid-ask spread

Forward premium or discountForward premium or discount

P represents the forward premium (discount), or the P represents the forward premium (discount), or the percentage by which the forward rate exceeds (less) the percentage by which the forward rate exceeds (less) the spot rate.spot rate.

55

Forward Premium/Discount (1)Forward Premium/Discount (1)

If the euro’s spot rate is $1.03, and its If the euro’s spot rate is $1.03, and its one-year forward rate has a forward one-year forward rate has a forward premium of 2 percent, then the one-year premium of 2 percent, then the one-year forward rate is:forward rate is:

So, euro will appreciates !So, euro will appreciates !

66

Forward Premium/Discount (2)Forward Premium/Discount (2)

If the euro’s one-year forward rate is If the euro’s one-year forward rate is quoted at $1.00 and the euro’s spot rate quoted at $1.00 and the euro’s spot rate is quoted at $1.03, the euro’s forward is quoted at $1.03, the euro’s forward premium/discount is :premium/discount is :

77

Exhibit 5.1 Computation of Forward Rate Exhibit 5.1 Computation of Forward Rate Premiums or DiscountsPremiums or Discounts

88

Forwards ApplicationForwards Application

Why would MNC use Forward Why would MNC use Forward contracts and therefore forward rate contracts and therefore forward rate if they expect currency exchange in if they expect currency exchange in the future? Why not wait till then and the future? Why not wait till then and exchange the currency with the spot exchange the currency with the spot rate of that date?rate of that date?

To lock in the priceTo lock in the price

99

Forwards Application (1)Forwards Application (1)

Buying foreign currency forwardBuying foreign currency forward

Turz, Inc. on page 123Turz, Inc. on page 123

1010

Forwards Application (2)Forwards Application (2)

Selling foreign currency forwardSelling foreign currency forward

Scanlon, Inc. on page 124Scanlon, Inc. on page 124

1111

How to cancel a forward How to cancel a forward contractcontract

Negotiate to cancelNegotiate to cancel

Offset by creating another forward contract Offset by creating another forward contract Green Bay, Inc on page 126Green Bay, Inc on page 126

1212

Forward Application (3)Forward Application (3)

The current spot exchange rate is $1.95/£ and the three-The current spot exchange rate is $1.95/£ and the three-month forward rate is $1.90/£. Based on your analysis of the month forward rate is $1.90/£. Based on your analysis of the exchange rate, you are pretty confident that the spot exchange rate, you are pretty confident that the spot exchange rate will be $1.92/£ in three months. Suppose you exchange rate will be $1.92/£ in three months. Suppose you have $1,000. What actions do you need to take to speculate in have $1,000. What actions do you need to take to speculate in the forward market? What is the expected dollar profit from the forward market? What is the expected dollar profit from speculation?speculation?

Solution: you should buy £ forward now and sell £ at spot after 3 Solution: you should buy £ forward now and sell £ at spot after 3 month. Your expected profit will be:month. Your expected profit will be:

1,000/1.90= £ 526.3158; 526.3158x1.92=$1010.52631,000/1.90= £ 526.3158; 526.3158x1.92=$1010.5263

Profit = $10.5263Profit = $10.5263

1313

Forward Application (4)Forward Application (4)

1414

An international pension fund manager plans to sell equities denominated in Swiss Francs (CHF) and purchase an equivalent amount of equities denominated in Chinese Yuan(CNY). He will realize net proceeds of 3 million CHF at the end of 30 days and wants to eliminate the risk that the CNY will appreciate relative to the CHF during this 30-day period. The following exhibit shows current exchange rates between the CNY, CHF, and the U.S. dollar (USD). Describe the currency transaction that manager should undertake to eliminate currency risk over the 30-day period.

USD/CNY USD/CNY USD/CHF USD/CHFMaturity Bid Ask Bid Ask

Spot 6.2681 6.2789 1.5282 1.5343

30-day 6.2538 6.2641 1.5226 1.5285

90-day 6.2104 6.2200 1.5058 1.5115

SolutionSolution The manager will receive CHF and pay CNY after 30 days.The manager will receive CHF and pay CNY after 30 days. If CNY appreciates against CHF, he needs to pay more CHF.If CNY appreciates against CHF, he needs to pay more CHF. He should sell 30-day forward CHF against CNY (sell 30-day He should sell 30-day forward CHF against CNY (sell 30-day

forward CHF against USD and buy 30-day forward CNY forward CHF against USD and buy 30-day forward CNY against USD).against USD).

1.1. 30 day forward CHF are sold for USD @ CHF1.5285 = $1 30 day forward CHF are sold for USD @ CHF1.5285 = $1

2.2. 30 day forward CNY are purchased for USD @ CNY6.2538 = $1 30 day forward CNY are purchased for USD @ CNY6.2538 = $1

(Dollars are simultaneously sold to purchase CNY)(Dollars are simultaneously sold to purchase CNY)

--For every 1.5285 CHF held, 6.2538 CNY are received; thus the cross --For every 1.5285 CHF held, 6.2538 CNY are received; thus the cross currency rate CNY/CHF iscurrency rate CNY/CHF is

1515

244411.02538.6

5285.1

CNY

CHF

In-class discussionIn-class discussion

Soho Herbal, LTD., located in central England, is an old-line producer of herbal Soho Herbal, LTD., located in central England, is an old-line producer of herbal teas, seasonings, and medicines. Its products are marketed all over the United teas, seasonings, and medicines. Its products are marketed all over the United Kingdom and in many parts of continental Europe as well. Soho generally Kingdom and in many parts of continental Europe as well. Soho generally invoices in British pound sterling when it sells to foreign customers in order to invoices in British pound sterling when it sells to foreign customers in order to guard against adverse exchange rate changes. Nevertheless, it has just guard against adverse exchange rate changes. Nevertheless, it has just received an order from a large wholesaler in central France for £320,000 of its received an order from a large wholesaler in central France for £320,000 of its products, conditional upon delivery being made in three months’ time and the products, conditional upon delivery being made in three months’ time and the order invoiced in euros. Soho’s controller, Elton Peters, is concerned with order invoiced in euros. Soho’s controller, Elton Peters, is concerned with whether the pound will appreciate versus the euro over the next three months, whether the pound will appreciate versus the euro over the next three months, thus eliminating all or most of the profit when the euro receivable is paid. He thus eliminating all or most of the profit when the euro receivable is paid. He thinks this is an unlikely possibility, but he decides to contact the firm’s banker thinks this is an unlikely possibility, but he decides to contact the firm’s banker for suggestions about hedging the exchange rate exposure.for suggestions about hedging the exchange rate exposure.

Mr. Peters learns from the banker that the current spot exchange rate €/£ is Mr. Peters learns from the banker that the current spot exchange rate €/£ is €1.4537. Mr. Peters also learns that the three-month forward rates for the €1.4537. Mr. Peters also learns that the three-month forward rates for the pound and the euro versus the U.S. dollar are $1.8990/£1 and $1.3154/€1, pound and the euro versus the U.S. dollar are $1.8990/£1 and $1.3154/€1, respectively. The banker offers to set up a forward hedge for selling the euro respectively. The banker offers to set up a forward hedge for selling the euro receivable for pound sterling based on the €/£ forward cross-exchange rate receivable for pound sterling based on the €/£ forward cross-exchange rate implicit in the forward rates against the dollar. What would you do if you were implicit in the forward rates against the dollar. What would you do if you were Mr. Peters? Mr. Peters?

1616

17

Currency FuturesCurrency FuturesA standardized “forward contract” traded on A standardized “forward contract” traded on an organized and regulated futures exchange.an organized and regulated futures exchange.

1.1. Futures contracts are guaranteed by the Futures contracts are guaranteed by the exchange’s clearinghouse that eliminates the exchange’s clearinghouse that eliminates the risk of contra-party default.risk of contra-party default.

2.2. Each contract is standardized on the quantity, Each contract is standardized on the quantity, quality, delivery place, delivery date, contract quality, delivery place, delivery date, contract expiration date expiration date (3(3rdrd Wed in Mar, Jun, Sep, Dec) Wed in Mar, Jun, Sep, Dec)

3.3. A deposit called “margin” is required to both A deposit called “margin” is required to both buyers and sellers. buyers and sellers. http://www.cmegroup.com/trading/fx/http://www.cmegroup.com/trading/fx/

1717

Exhibit 5.2 Currency Futures Contracts Traded Exhibit 5.2 Currency Futures Contracts Traded on the Chicago Mercantile Exchangeon the Chicago Mercantile Exchange

1818

19

Forwards vs. FuturesForwards vs. Futures

1.1. Futures contracts trade on an organized Futures contracts trade on an organized exchange.exchange.

2.2. Futures positions can be closed or transferred Futures positions can be closed or transferred easily.easily.

3.3. Futures contracts have standardized terms Futures contracts have standardized terms (quantity, expiration, etc.)(quantity, expiration, etc.)

4.4. Futures contracts are guaranteed by the Futures contracts are guaranteed by the clearinghouse associated with the exchange.clearinghouse associated with the exchange.

5.5. Futures are subject to daily settlement (Futures are subject to daily settlement (marked marked to the marketto the market).).

6.6. Margin is required to both the buyer and seller.Margin is required to both the buyer and seller.1919

ClearinghouseClearinghouse

Guarantees that all traders in the futures Guarantees that all traders in the futures markets will honor their obligations.markets will honor their obligations.

Act in a position of buyer to every seller Act in a position of buyer to every seller

and seller to every buyer. So no default and seller to every buyer. So no default risk as a counter-party to every trader.risk as a counter-party to every trader.

Goods GoodsBuyer Clearinghouse Seller

Funds Funds

2020

Margin and Daily SettlementMargin and Daily Settlement

Initial margin Initial margin $1,000 - $2,000/currency futures$1,000 - $2,000/currency futures

Maintenance marginMaintenance marginif the value of the futures contract keeps on decliningif the value of the futures contract keeps on declining

Marking to marketMarking to marketrealize any loss or profit in cash every day.realize any loss or profit in cash every day.

2121

Marking to MarketMarking to Market

2222

Euro Futures BuyerDay 1 morning, bought at $ 1.4551 euro amount 125,000

contract value ($) 181887.50initial margin ($) 2000.00

Day Close Contract Value ($) Profit/Loss ($) Maintenance Margin ($)1 1.4565 182062.50 175.00 2175.002 1.4570 182125.00 62.50 2237.503 1.4500 181250.00 -875.00 1362.504 1.4535 181687.50 437.50 1800.005 1.4480 181000.00 -687.50 1112.50

Euro Futures SellerDay 1 morning, sold at $ 1.4551 euro amount 125,000

contract value ($) 181887.50initial margin ($) 2000.00

Day Close Contract Value ($) Profit/Loss ($) Maintenance Margin ($)1 1.4565 182062.50 -175.00 1825.002 1.4570 182125.00 -62.50 1762.503 1.4500 181250.00 875.00 2637.504 1.4535 181687.50 -437.50 2200.005 1.4480 181000.00 687.50 2887.50

Closing a Position by DeliveryClosing a Position by Deliveryexample on Page 129example on Page 129

On Feb 10, a futures contract on 62,500 British On Feb 10, a futures contract on 62,500 British pounds with a march settlement date is priced at pounds with a march settlement date is priced at $1.50 per pound. If both buyer and seller of such $1.50 per pound. If both buyer and seller of such a futures hold their positions to settlement date a futures hold their positions to settlement date when the settlement price is $1.4900, then on when the settlement price is $1.4900, then on delivery date the buyer of this currency futures delivery date the buyer of this currency futures will receive BP62,500 and will pay $93,125 will receive BP62,500 and will pay $93,125 (62500x(62500x1.49001.4900). The seller of this contract ). The seller of this contract delivers BP62,500 and receive $93,125. delivers BP62,500 and receive $93,125.

2323

Closing a Position by Closing a Position by Reverse tradingReverse tradingexample: Tacoma Co. on page 132.example: Tacoma Co. on page 132.

Exhibit 5.4Exhibit 5.4

2424

Participants in Futures MarketsParticipants in Futures Markets

Hedgers: hedging, risk managementHedgers: hedging, risk management

Speculators: make money by taking riskSpeculators: make money by taking risk

Brokers: receive commission feeBrokers: receive commission fee

Regulators: Futures Exchanges and Regulators: Futures Exchanges and Clearinghouses, the National Futures Clearinghouses, the National Futures AssociationAssociation

2525

Futures Application (1)Futures Application (1)

Spot: GBP/USD $1.4550Spot: GBP/USD $1.4550 1-year Futures $1.45501-year Futures $1.4550 1-year US interest rate=5%1-year US interest rate=5% 1-year UK interest rate=10%1-year UK interest rate=10%

Can you speculate on this information?Can you speculate on this information?

Yes. Purchase Pound at spot rate $1.4550 and invest in UK Yes. Purchase Pound at spot rate $1.4550 and invest in UK bonds or saving account; simultaneously sell Pound 1-year bonds or saving account; simultaneously sell Pound 1-year Futures (Forward) at $1.4550. Futures (Forward) at $1.4550.

What is the effect of this strategy on the exchange rate?What is the effect of this strategy on the exchange rate?

Upward pressure on the GBP spot rate and downward Upward pressure on the GBP spot rate and downward pressure on futures price.pressure on futures price.

2626

Futures Application (2)Futures Application (2)

A speculator expects the British pound to A speculator expects the British pound to appreciate in one year. He purchases a 1-year appreciate in one year. He purchases a 1-year futures contract that will lock in the price at which futures contract that will lock in the price at which he buys pounds at settlement date. On the he buys pounds at settlement date. On the settlement date, he purchases pounds at the rate settlement date, he purchases pounds at the rate specified by the futures contract and then sell specified by the futures contract and then sell these pounds at the spot rate at that time. He will these pounds at the spot rate at that time. He will profit if the spot rate after one year turns out to profit if the spot rate after one year turns out to be higher than the rate he paid in the futures be higher than the rate he paid in the futures contract. contract.

2727

Futures Application (3)Futures Application (3)

Expect the foreign currency to depreciate. Expect the foreign currency to depreciate. (Example on page 132)(Example on page 132)

On April 4, a futures contract on 500,000 Mexican On April 4, a futures contract on 500,000 Mexican pesos and a June settlement date is priced at pesos and a June settlement date is priced at $0.09. On April 4, speculators who expect the $0.09. On April 4, speculators who expect the peso will decline sell futures contracts on pesos. peso will decline sell futures contracts on pesos. On June 17 (settlement date), the spot rate of the On June 17 (settlement date), the spot rate of the peso is $0.08. The gain each contract on this peso is $0.08. The gain each contract on this strategy is $5,000.strategy is $5,000.

2828

000,5$000,5001

08.0$000,500

1

09.0$ p

pp

p

Futures Application (3)Futures Application (3)

Purchasing Futures to hedge payables (example Purchasing Futures to hedge payables (example on page 131)on page 131)

Teton Co. orders Canadian goods and will need to Teton Co. orders Canadian goods and will need to send C$500,000 to the Canadian exporter. Thus, send C$500,000 to the Canadian exporter. Thus, Teton purchase Canadian dollar futures contracts Teton purchase Canadian dollar futures contracts today, thereby locking in the price to be paid for today, thereby locking in the price to be paid for Canadian dollars at a future settlement date. By Canadian dollars at a future settlement date. By holding futures contracts, Teton does not have to holding futures contracts, Teton does not have to worry about changes in the spot rate of the worry about changes in the spot rate of the Canadian dollar over time.Canadian dollar over time.

2929

Futures Application (4)Futures Application (4)

Selling Futures to hedge receivables (example on Selling Futures to hedge receivables (example on page 131)page 131)

Karla Co. sells futures contracts when it plans to Karla Co. sells futures contracts when it plans to receive a foreign currency from exporting that it receive a foreign currency from exporting that it will not need. It locks in the price at which it will will not need. It locks in the price at which it will be able to sell this currency as of the settlement be able to sell this currency as of the settlement date. Such an action is appropriate if Karla date. Such an action is appropriate if Karla expects the foreign currency to depreciate expects the foreign currency to depreciate against Karla’s home currency.against Karla’s home currency.

3030

Homework 5Homework 5

Chapter 5 Q&A: 1,4,17,18.Chapter 5 Q&A: 1,4,17,18.

Extra: Suppose an investor bought the CAD Extra: Suppose an investor bought the CAD futures contract at $0.9077 Monday morning. The futures contract at $0.9077 Monday morning. The close price are 0.9090, 0.9100, 0.9120, 0.9085, close price are 0.9090, 0.9100, 0.9120, 0.9085, 0.9080 for the week. Draw an excel table of 0.9080 for the week. Draw an excel table of marking to market that looks like the one on slide marking to market that looks like the one on slide # 18. Let the initial margin be $1500.# 18. Let the initial margin be $1500.

3131