1. Chapter 8 Foreign Currency Derivatives and Swaps

2. © 2012 Pearson Education, Inc. All rights reserved.8-2 Foreign Currency Derivatives and Swaps: Learning Objectives Explain how foreign currency futures are quoted, valued, and used for speculation purposes Illustrate how foreign currency futures differ from forward contracts Analyze how foreign currency options are quoted, valued, and used for speculation purposes Explain how foreign currency options are valued Define interest rate risk, and examine how can it be managed

3. © 2012 Pearson Education, Inc. All rights reserved.8-3 Foreign Currency Derivatives and Swaps: Learning Objectives Explain interest rate swaps and how they can be used to manage interest rate risk Analyze how interest rate swaps and cross currency swaps can be used to manage both foreign exchange risk and interest rate risk simultaneously

4. © 2012 Pearson Education, Inc. All rights reserved.8-4 Foreign Currency Derivatives and Swaps Financial management in the 21st century needs to consider the use of financial derivatives These derivatives, so named because their values are derived from the underlying asset, are a powerful tool used for two distinct management objectives: –Speculation – the financial manager takes a position in the expectation of profit –Hedging – the financial manager uses the instruments to reduce the risks of the corporation’s cash flow

5. © 2012 Pearson Education, Inc. All rights reserved.8-5 Foreign Currency Derivatives and Swaps The financial manager must first understand the basics of the structure and pricing of these tools The derivatives that will be discussed will be –Foreign Currency Futures –Foreign Currency Options –Interest Rate Swaps –Cross Currency Interest Rate Swaps A word of caution – financial derivatives are powerful tools in the hands of careful and competent financial managers. They can also be very destructive devices when used recklessly.

6. © 2012 Pearson Education, Inc. All rights reserved.8-6 Foreign Currency Futures A foreign currency futures contract is an alternative to a forward contract –It calls for future delivery of a standard amount of currency at a fixed time and price –These contracts are traded on exchanges with the largest being the International Monetary Market located in the Chicago Mercantile Exchange

7. © 2012 Pearson Education, Inc. All rights reserved.8-7 Foreign Currency Futures Contract Specifications –Size of contract – called the notional principal, trading in each currency must be done in an even multiple –Method of stating exchange rates – “American terms” are used; quotes are in US dollar cost per unit of foreign currency, also known as direct quotes –Maturity date – contracts mature on the 3rd Wednesday of January, March, April, June, July, September, October or December

8. © 2012 Pearson Education, Inc. All rights reserved.8-8 Foreign Currency Futures Contract Specifications –Last trading day – contracts may be traded through the second business day prior to maturity date –Collateral & maintenance margins – the purchaser or trader must deposit an initial margin or collateral; this requirement is similar to a performance bond At the end of each trading day, the account is marked to market and the balance in the account is either credited if value of contracts is greater or debited if value of contracts is less than account balance

9. © 2012 Pearson Education, Inc. All rights reserved.8-9 Foreign Currency Futures Contract Specifications –Settlement – only 5% of futures contracts are settled by physical delivery, most often buyers and sellers offset their position prior to delivery date The complete buy/sell or sell/buy is termed a round turn –Commissions – customers pay a commission to their broker to execute a round turn and only a single price is quoted –Use of a clearing house as a counterparty – All contracts are agreements between the client and the exchange clearing house. Consequently clients need not worry about the performance of a specific counterparty since the clearing house is guaranteed by all members of the exchange

10. © 2012 Pearson Education, Inc. All rights reserved.8-10 Using Foreign Currency Futures Any investor wishing to speculate on the movement of a currency can pursue one of the following strategies –Short position – selling a futures contract based on view that currency will fall in value –Long position – purchase a futures contract based on view that currency will rise in value –Example: Amber McClain believes that Mexican peso will fall in value against the US dollar, she looks at quotes in the WSJ for Mexican peso futures

11. © 2012 Pearson Education, Inc. All rights reserved.8-11 Exhibit 8.1 Mexican Peso (CME)-- MXN 500,000; $ per 10MXN

12. © 2012 Pearson Education, Inc. All rights reserved.8-12 Value at maturity (Short position) = -Notional principal  (Spot – Forward) Using Foreign Currency Futures Example (cont.): Amber believes that the value of the peso will fall, so she sells a March futures contract By taking a short position on the Mexican peso, Amber locks-in the right to sell 500,000 Mexican pesos at maturity at a set price above their current spot price Using the quotes from the table, Amber sells one March contract for 500,000 pesos at the settle price: $.10958/Ps

13. © 2012 Pearson Education, Inc. All rights reserved.8-13 Value at maturity (Short position) = -Notional principal  (Spot – Forward) Value = -P s 500,000  ($0.09500/ P s - $.10958/ P s ) = $7,290 Using Foreign Currency Futures To calculate the value of Amber’s position we use the following formula Using the settle price from the table and assuming a spot rate of $.09500/Ps at maturity, Amber’s profit is

14. © 2012 Pearson Education, Inc. All rights reserved.8-14 Value at maturity (Long position) = Notional principal  (Spot – Forward) Value = P s 500,000  ($0.11000/ P s - $.10958/ P s ) = $210 Using Foreign Currency Futures If Amber believed that the Mexican peso would rise in value, she would take a long position on the peso Using the settle price from the table and assuming a spot rate of $.11000/Ps at maturity, Amber’s profit is

15. © 2012 Pearson Education, Inc. All rights reserved.8-15 Currency Futures and Forwards Compared

16. © 2012 Pearson Education, Inc. All rights reserved.8-16 Currency Options A foreign currency option is a contract giving the purchaser of the option the right to buy or sell a given amount of currency at a fixed price per unit for a specified time period –The most important part of clause is the “right, but not the obligation” to take an action –Two basic types of options, calls and puts Call – buyer has right to purchase currency Put – buyer has right to sell currency –The buyer of the option is the holder and the seller of the option is termed the writer

17. © 2012 Pearson Education, Inc. All rights reserved.8-17 Foreign Currency Options Every option has three different price elements –The strike or exercise price is the exchange rate at which the foreign currency can be purchased or sold –The premium, the cost, price or value of the option itself paid at time option is purchased –The underlying or actual spot rate in the market There are two types of option maturities –American options may be exercised at any time during the life of the option –European options may not be exercised until the specified maturity date

18. © 2012 Pearson Education, Inc. All rights reserved.8-18 Foreign Currency Options Options may also be classified as per their payouts –At-the-money (ATM) options have an exercise price equal to the spot rate of the underlying currency –In-the-money (ITM) options may be profitable, excluding premium costs, if exercised immediately –Out-of-the-money (OTM) options would not be profitable, excluding the premium costs, if exercised

19. © 2012 Pearson Education, Inc. All rights reserved.8-19 Foreign Currency Options Markets The increased use of currency options has lead the creation of several markets where financial managers can access these derivative instruments –Over-the-Counter (OTC) Market – OTC options are most frequently written by banks for US dollars against British pounds, Swiss francs, Japanese yen, Canadian dollars and the euro Main advantage is that they are tailored to purchaser Counterparty risk exists Mostly used by individuals and banks

20. © 2012 Pearson Education, Inc. All rights reserved.8-20 Foreign Currency Options Markets –Organized Exchanges – similar to the futures market, currency options are traded on an organized exchange floor The Chicago Mercantile and the Philadelphia Stock Exchange serve options markets Clearinghouse services are provided by the Options Clearinghouse Corporation (OCC)

21. © 2012 Pearson Education, Inc. All rights reserved.8-21 Exhibit 8.2 Swiss Franc Option Quotations (U.S. Cents/SF)

22. © 2012 Pearson Education, Inc. All rights reserved.8-22 Foreign Currency Options Markets –The spot rate means that 58.51 cents, or $0.5851 was the price of one Swiss franc –The strike price means the price per franc that must be paid for the option. The August call option of 58 ½ means $0.5850/Sfr –The premium, or cost, of the August 58 ½ option was 0.50 per franc, or $0.0050/Sfr For a call option on 62,500 Swiss francs, the total cost would be Sfr62,500 x $0.0050/Sfr = $312.50

23. © 2012 Pearson Education, Inc. All rights reserved.8-23 Foreign Currency Speculation Speculating in the spot market –Hans Schmidt is a currency speculator. He is willing to risk his money based on his view of currencies and he may do so in the spot, forward or options market –Assume Hans has $100,000 and he believes that the six month spot for Swiss francs will be $0.6000/Sfr. Speculation in the spot market requires that view is currency appreciation

24. © 2012 Pearson Education, Inc. All rights reserved.8-24 Foreign Currency Speculation Speculating in the spot market –Hans should take the following steps –Use the $100,000 to purchase Sfr170,910.96 today at a spot rate of $0.5851/Sfr –Hold the francs indefinitely, because Hans is in the spot market he is not committed to the six month target –When target exchange rate is reached, sell the Sfr170,910.96 at new spot rate of $0.6000/Sfr, receiving Sfr170,910.96 x $0.6000/Sfr = $102,546.57 –This results in a profit of $2,546.57 or 2.5% ignoring cost of interest income and opportunity costs

25. © 2012 Pearson Education, Inc. All rights reserved.8-25 Foreign Currency Speculation Speculating in the forward market –If Hans were to speculate in the forward market, his viewpoint would be that the future spot rate will differ from the forward rate –Today, Hans should purchase Sfr173,611.11 forward six months at the forward quote of $0.5760/Sfr. This step requires no cash outlay –In six months, fulfill the contract receiving Sfr173,611.11 at $0.5760/Sfr at a cost of $100,000 –Simultaneously sell the Sfr173,611.11 in the spot market at Hans’ expected spot rate of $0.6000/Sfr, receiving Sfr173,611.11 x $0.6000/Sfr = $104,166.67 –This results in a profit of $4,166.67 with no investment required

26. © 2012 Pearson Education, Inc. All rights reserved.8-26 Foreign Currency Speculation Speculating in the options market –If Hans were to speculate in the options market, his viewpoint would determine what type of option to buy or sell –As a buyer of a call option, Hans purchases the August call on francs at a strike price of 58 ½ ($0.5850/Sfr) and a premium of 0.50 or $0.0050/Sfr –At spot rates below the strike price, Hans would not exercise his option because he could purchase francs cheaper on the spot market than via his call option

27. © 2012 Pearson Education, Inc. All rights reserved.8-27 Foreign Currency Speculation Speculating in the options market –Hans’ only loss would be limited to the cost of the option, or the premium ($0.0050/Sfr) –At all spot rates above the strike of 58 ½ Hans would exercise the option, paying only the strike price for each Swiss franc If the franc were at 59 ½, Hans would exercise his options buying Swiss francs at 58 ½ instead of 59 ½

28. © 2012 Pearson Education, Inc. All rights reserved.8-28 Foreign Currency Speculation Speculating in the options market –Hans could then sell his Swiss francs on the spot market at 59 ½ for a profit Profit = Spot rate – (Strike price + Premium) = $0.595/Sfr – ($0.585/Sfr + $0.005/Sfr) = $.005/Sfr

29. © 2012 Pearson Education, Inc. All rights reserved.8-29 Foreign Currency Speculation Speculating in the options market –Hans could also wait to see if the Swiss franc appreciates more, this is the value to the holder of a call option – limited loss, unlimited upside –Hans’ break-even price can also be calculated by combining the premium cost of $0.005/Sfr with the cost of exercising the option, $0.585/Sfr This matched the proceeds from exercising the option at a price of $0.590/Sfr

30. © 2012 Pearson Education, Inc. All rights reserved.8-30 Exhibit 8.3 Profit and Loss for the Buyer of a Call Option

31. © 2012 Pearson Education, Inc. All rights reserved.8-31 Foreign Currency Speculation Speculating in the options market –Hans could also write a call, if the future spot rate is below 58 ½, then the holder of the option would not exercise it and Hans would keep the premium –If Hans went uncovered and the option was exercised against him, he would have to purchase Swiss francs on the spot market at a higher rate than he is obligated to sell them at –Here the writer of a call option has limited profit and unlimited losses if uncovered

32. © 2012 Pearson Education, Inc. All rights reserved.8-32 Profit = Premium – (Spot rate - Strike price) = $0.005/Sfr – ($0.595/Sfr + $0.585/Sfr ) = - $0.005/Sfr Foreign Currency Speculation Speculating in the options market –Hans’ payout on writing a call option would be

33. © 2012 Pearson Education, Inc. All rights reserved.8-33 Exhibit 8.4 Profit and Loss for the Writer of a Call Option

34. © 2012 Pearson Education, Inc. All rights reserved.8-34 Foreign Currency Speculation Speculating in the options market –Hans could also buy a put, the only difference from buying a call is that Hans now has the right to sell currency at the strike price –If the franc drops to $0.575/Sfr Hans will deliver to the writer of the put and receive $0.585/Sfr –The francs can be purchased on the spot market at $0.575/Sfr –With the cost of the option being $0.005/Sfr, Hans realizes a net gain of $0.005/Sfr –As with a call option - limited loss, unlimited gain

35. © 2012 Pearson Education, Inc. All rights reserved.8-35 Profit = Strike price – (Spot rate + Premium) = $0.585/Sfr – ($0.575/Sfr + $0.005/Sfr) = $0.005/Sfr Foreign Currency Speculation Speculating in the options market –Hans’ payout on buying a put option would be

36. © 2012 Pearson Education, Inc. All rights reserved.8-36 Exhibit 8.5 Profit and Loss for the Buyer of a Put Option

37. © 2012 Pearson Education, Inc. All rights reserved.8-37 Foreign Currency Speculation Speculating in the options market –And of course, Hans could write a put, thereby obliging him to purchase francs at the strike price –If the franc drops below 58 ½ Hans will lose more than the premium received –If the spot rate does not fall below 58 ½ then the option will not be exercised and Hans will keep the premium from the option –As with a call option - unlimited loss, limited gain

38. © 2012 Pearson Education, Inc. All rights reserved.8-38 Profit = Premium – (Strike price - Spot rate) = $0.005/Sfr – ($0.585/Sfr + $0.575/Sfr) = - $0.005/Sfr Foreign Currency Speculation Speculating in the options market –Hans’ payout on writing a put option would be

39. © 2012 Pearson Education, Inc. All rights reserved.8-39 Exhibit 8.6 Profit and Loss for the Writer of a Put Option

40. © 2012 Pearson Education, Inc. All rights reserved.8-40 Option Pricing and Valuation The pricing of any option combines six elements –Present spot rate, $1.70/£ –Time to maturity, 90 days –Forward rate for matching maturity (90 days), $1.70/£ –US dollar interest rate, 8.00% p.a. –British pound interest rate, 8.00% p.a. –Volatility, the standard deviation of daily spot rate movement, 10.00% p.a.

41. © 2012 Pearson Education, Inc. All rights reserved.8-41 Option Pricing and Valuation The intrinsic value is the financial gain if the option is exercised immediately (at-the-money) –This value will reach zero when the option is out-of-the- money –When the spot rate rises above the strike price, the option will be in-the-money –At maturity date, the option will have a value equal to its intrinsic value

42. © 2012 Pearson Education, Inc. All rights reserved.8-42 Option Pricing and Valuation When the spot rate is $1.74/£, the option is ITM and has an intrinsic value of $1.74 - $1.70/£, or 4 cents per pound When the spot rate is $1.70/£, the option is ATM and its intrinsic value is $1.70 - $1.70/£, or zero cents per pound When the spot rate is is $1.66/£, the option is OTM and has no intrinsic value, only a fool would exercise this option

43. © 2012 Pearson Education, Inc. All rights reserved.8-43 Exhibit 8.7 Option Intrinsic Value, Time Value & Total Value

44. © 2012 Pearson Education, Inc. All rights reserved.8-44 Option Pricing and Valuation The time value of the option exists because the price of the underlying currency can potentially move further into the money between today and maturity –In the exhibit, time value is shown as the area between total value and intrinsic value

45. © 2012 Pearson Education, Inc. All rights reserved.8-45 Interest Rate Risk All firms, domestic or multinational, are sensitive to interest rate movements The single largest interest rate risk of a non-financial firm is debt service (for an MNE, differing currencies have differing interest rates thus making this risk a larger concern – see exhibit) The second most prevalent source of interest rate risk is its holding of interest sensitive securities Ever increasing competition has forced financial managers to better manage both sides of the balance sheet

46. © 2012 Pearson Education, Inc. All rights reserved.8-46 Exhibit 8.8 Summary of Option Premium Components

47. © 2012 Pearson Education, Inc. All rights reserved.8-47 Exhibit 8.9 International Interest Rate Calculations

48. © 2012 Pearson Education, Inc. All rights reserved.8-48 Credit and Repricing Risk Credit Risk or roll-over risk is the possibility that a borrower’s creditworthiness at the time of renewing a credit, is reclassified by the lender –This can result in higher borrowing rates, fees, or even denial Repricing risk is the risk of changes in interest rates charged (earned) at the time a financial contract’s rate is being reset

49. © 2012 Pearson Education, Inc. All rights reserved.8-49 Credit and Repricing Risk Strategy #1 assures itself of funding at a known rate for the three years; what is sacrificed is the ability to enjoy a lower interest rate should rates fall over the time period Strategy #2 offers what #1 didn’t, flexibility (repricing risk). It too assures funding for the three years but offers repricing risk when LIBOR changes Strategy #3 offers more flexibility and more risk; in the second year the firm faces repricing and credit risk, thus the funds are not guaranteed for the three years and neither is the price

50. © 2012 Pearson Education, Inc. All rights reserved.8-50 Interest Rate Futures Interest Rate futures are widely used; their popularity stems from high liquidity of interest rate futures markets, simplicity in use, and the rather standardized interest rate exposures firms posses Traded on an exchange; two most common are the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) The yield is calculated from the settlement price –Example: March ’03 contract with settlement price of 94.76 gives an annual yield of 5.24% (100 – 94.76)

51. © 2012 Pearson Education, Inc. All rights reserved.8-51 Exhibit 8.10 Eurodollar Futures Prices

52. © 2012 Pearson Education, Inc. All rights reserved.8-52 Exhibit 8.11 Interest Rate Futures Strategies for Common Exposures

53. © 2012 Pearson Education, Inc. All rights reserved.8-53 Interest Rate Swaps Swaps are contractual agreements to exchange or swap a series of cash flows If the agreement is for one party to swap its fixed interest payment for a floating rate payment, its is termed an interest rate swap If the agreement is to swap currencies of debt service it is termed a currency swap A single swap may combine elements of both interest rate and currency swap The swap itself is not a source of capital but an alteration of the cash flows associated with payment

54. © 2012 Pearson Education, Inc. All rights reserved.8-54 Interest Rate Swaps If firm thought that rates would rise it would enter into a swap agreement to pay fixed and receive floating in order to protect it from rising debt- service payments If firm thought that rates would fall it would enter into a swap agreement to pay floating and receive fixed in order to take advantage of lower debt- service payments The cash flows of an interest rate swap are interest rates applied to a set amount of capital, no principal is swapped only the coupon payments

55. © 2012 Pearson Education, Inc. All rights reserved.8-55 Exhibit 8.12 Interest Rate Swap Strategies

56. © 2012 Pearson Education, Inc. All rights reserved.8-56 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 allows firms to swap across currencies. These swap rates are based on the government security yields in each of the individual currency markets, plus a credit spread applicable to investment grade borrowers in the respective markets. 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.

57. © 2012 Pearson Education, Inc. All rights reserved.8-57 Exhibit 8.13 Interest Rate and Currency Swap Quotes

58. © 2012 Pearson Education, Inc. All rights reserved.8-58 Summary of Learning Objectives A foreign currency futures contract is an exchange-traded agreement calling for future delivery of a standard amount of foreign currency at a fixed time, place and price Foreign currency futures contracts are in reality standardized forward contracts. Unlike forward contracts, however, trading occurs on the floor of an organized exchange. They also require collateral and are normally settled through the purchase of an offsetting position

59. © 2012 Pearson Education, Inc. All rights reserved.8-59 Summary of Learning Objectives Futures differ from forward contracts by size of contract, maturity, location of trading, pricing, collateral/margin requirements, method of settlement, commissions, trading hours, counterparties and liquidity Financial managers typically prefer foreign currency forwards over futures out of simplicity of use and position maintenance. Financial speculators prefer futures over forwards because of the liquidity of the market

60. © 2012 Pearson Education, Inc. All rights reserved.8-60 Summary of Learning Objectives Foreign currency options are financial contracts that give the holder the right, but not the obligation, to buy or sell a specified amount of currency at a predetermined price on or before a specified maturity date The use of currency options as a speculative device for a buyer arise from the fact that an option gains in value as the underlying currency rises or falls. The amount of loss when the underlying currency moves opposite the desired direction is limited to the premium of the option The use of currency options as a speculative device for a seller arise from the option premium. If the option expires out-of-the-money, the writer has earned and retains the entire premium

61. © 2012 Pearson Education, Inc. All rights reserved.8-61 Summary of Learning Objectives Speculation is an attempt to profit by trading on expectations about prices in the future. –In the foreign exchange market, one speculates by taking position on a currency and then closing that position after the exchange rate has moved. –A profit results only if the rate moves in the direction that was expected Currency option valuation is a complex combination of the current spot rate, the specific strike price, the forward rate, currency volatility and time to maturity The total value of an option is the sum of its intrinsic and time value. –Intrinsic value depends on the relationship between the option’s strike price and the spot rate at any single point in time, whereas time value estimates how the intrinsic value may change prior to the option’s maturity

62. © 2012 Pearson Education, Inc. All rights reserved.8-62 Summary of Learning Objectives The single largest interest rate risk of the nonfinancial firm is debt-service. The debt structure of the MNE will possess differing maturities of debt, different interest rate structures (such as fixed versus floating rate), and different currencies of denomination. The increasing volatility of world interest rates, combined with the increasing use of short-term and variable rate debt by firms worldwide, has led many firms to actively manage their interest rate risks.

63. © 2012 Pearson Education, Inc. All rights reserved.8-63 Summary of Learning Objectives The primary sources of interest rate risk to a multinational nonfinancial firm are short-term borrowing and investing, as well as long-term sources of debt. The techniques and instruments used in interest rate risk management in many ways resemble those used in currency risk management: the old tried and true methods of lending and borrowing. The primary instruments and techniques used for interest rate risk management include forward rate agreements (FRAs), forward swaps, interest rate futures, and interest rate swaps.

64. © 2012 Pearson Education, Inc. All rights reserved.8-64 Summary of Learning Objectives The interest rate and currency swap markets allow firms that have limited access to specific currencies and interest rate structures to gain access at relatively low costs. This in turn allows these firms to manage their currency and interest rate risks more effectively. A cross currency interest rate swap allows a firm to alter both the currency of denomination of cash flows in debt service, but also to alter the fixed-to-floating or floating-to- fixed interest rate structure.