Currency Futures Introduction and Example

FuturesDaniels and VanHoose2 Currency Futures A derivative instrument. Traded on centralized exchanges (illustrated in Figure 1 later). Highly standardized contracts. Clearinghouse as counter-party. High leverage instrument.

FuturesDaniels and VanHoose3 Currency Futures Initial Margin: The customer must put up funds to guarantee the fulfillment of the contract - cash, letter of credit, Treasuries. Maintenance Margin: The minimum amount the margin account can fall to. Mark-to-the-market: A daily settlement procedure that marks profits or losses incurred on the futures to the customer’s margin account.

FuturesDaniels and VanHoose4 Sample Bond Performance Requirements From the CME, 15 March 2000

FuturesDaniels and VanHoose5 Long and Short Exposures A person that is, for example, long the pound, has pound denominated assets that exceed in value their pound denominated liabilities. A person that is short the pound, has pound denominated liabilities that exceed in value their pound denominated assets.

FuturesDaniels and VanHoose6 Hedging With a Currency Future To hedge a foreign exchange exposure, the customer assumes a position in the opposite direction of the exposure. For example, if the customer is long the pound, they would short the futures market. A customer that is long in the futures market is betting on an increase in the value of the currency, whereas with a short position they are betting on a decrease in the value of the currency.

How an Order is Executed (Figure from the CME)

FuturesDaniels and VanHoose8 Example A US manufacturing company has a division that operates in Mexico. At the end of June the parent company anticipates that the foreign division will have profits of 4 million Mexican pesos (MP) to repatriate. The parent company has a foreign exchange exposure, as the dollar value of the profits will rise and fall with changes in the exchange value between the MP and the dollar.

FuturesDaniels and VanHoose9 Example, continued The firm is long the peso, so to hedge the exposure they will go short in the futures market. The face amount of each peso future contract is MP500,000, so the firm will go short 8 contracts. If the peso depreciates, the dollar value of the division’s profits falls, but the future account generates profits, at least partially offsetting the loss. The opposite holds for an appreciation of the peso.

Change spot value Change in futures price Gain Loss Underlying Long Position Futures Position

FuturesDaniels and VanHoose11 Example, continued The previous diagram illustrates the effect of a change in the value of the peso. An increase in the value of the peso increases the dollar value of the underlying long position and decreases the value of the futures position. A decrease in the value of the peso decreases the value of the underlying position and increases the value of the futures position.

FuturesDaniels and VanHoose12 Example, continued On the 25th, the spot rate opens at ($/MP) while the price on a MP future opens at The market closes at and respectively. The loss on the underlying position is: ( )  MP4 mil. = -$1,000 The gain on the futures position is: ( )  8  MP500,000=$2,080

Change spot value Change in futures price Gain Loss Underlying Long Position MP4 million Futures Position MP500,000 x $1,000 $2,080 Gain and Loss on Underlying and Futures Position Day 1

FuturesDaniels and VanHoose14 Example, continued On the 28th, the spot rate moves to ($/MP) and the price on a MP future to The gain on the underlying position is: ( )  MP4 mil. = $1,400 The loss on the futures position is: ( )  8  MP500,000=-$1,080

Change spot value Change in futures price Gain Loss Underlying Long Position MP4 million Futures Position MP500,000 x 8 $1,080 $1, Gain and Loss on Underlying and Futures Position Day 2

FuturesDaniels and VanHoose16 Example, continued On the 29th, the spot rate moves to ($/MP) and the price on a MP future to The gain on the underlying position is: ( )  MP4 mil. = $400 The loss on the futures position is: ( )  8  MP500,000=-$200

Change spot value Change in futures price Gain Loss Underlying Long Position MP4 million Futures Position MP500,000 x 8 $200 $ Gain and Loss on Underlying and Futures Position Day 3

FuturesDaniels and VanHoose18 Example, continued For the three days considered, the underlying position gained $800 in value and the futures contracts yielded $800. The hedge was not perfect as the daily losses on the futures were less than the gains on the underlying position (day 2 and 3), and the daily gains on the futures exceeded the losses on the underlying position (day 1). In this example, the imperfect hedge yielded additional gains.

FuturesDaniels and VanHoose19 Example, continued Suppose you wanted to close the futures position (without making delivery of the currency). The position is simply reversed. That is, you would go long 8 MP futures, reversing your current position and closing out your account.

FuturesDaniels and VanHoose20 Additional Information For additional information on currency futures, visit the following sites: The Chicago Mercantile exchange at The Futures Industry Institute at

Currency Options

FuturesDaniels and VanHoose22 Currency Options A currency option is a contract that gives the owner the right, but not the obligation, to buy or sell a currency at a specified price at or during a given time. Call Option: An option that gives the owner the right to buy a currency. Put Option: An option that gives the owner the right to sell a currency.

FuturesDaniels and VanHoose23 Currency Options American Option: An option that can be exercised any time before or on the expiration date. European Option: An option that can only be exercised on the expiration date.

FuturesDaniels and VanHoose24 Currency Options Exercise or Strike Price: The price (spot exchange rate) at which the option may be exercised. Option Premium: The amount that must be paid to purchase the option contract. Break-Even: The point at which exercising the option exactly matches the premium paid.

FuturesDaniels and VanHoose25 Currency Options If the spot rate has not yet reached the exercise price, the option cannot be exercised and is said to be “out of the money.” If the spot rate equals the exercise prices, the option is said to be “at the money.” If the spot rate has surpassed the exercise price, the option is said to be “in of the money.”

FuturesDaniels and VanHoose26 Call Option The holder of a call option expects the underlying currency to appreciate in value. Consider 4 call options on the euro, with a strike of 92 ($/€) and a premium of 0.94 (both cents per unit). The face amount of a euro option is €62,500. The total premium is: $0.0094·4·€62,500=$2,350.

Profit Loss Payoff Profile Spot Rate -$2,350 -$1,100 0 $1,400 Out-of- the-money AtIn-the-money Call Option: Hypothetical Pay-Off 92.5 Break-Even

FuturesDaniels and VanHoose28 Put Option The holder of a put option expects the underlying currency to depreciate in value. Consider 8 put options on the euro with a strike of 90 ($/€) and a premium of 1.95 (both cents per unit). The face amount of a euro option is €62,500. The total premium is: $0.0195·8·€62,500=$9,750.

Profit Loss Payoff Profile Spot Rate -$9,750 -$500 0 In-the-moneyAtOut-of-the-money Put Option: Hypothetical payoff at a spot rate of Break-Even

Currency Swaps

FuturesDaniels and VanHoose31 Introduction A currency swap is an agreement between two parties to exchange a given amount of one currency for another, or a stream of payments or receipts in one currency for a stream of payments or receipts in another currency. Currency swaps, in contrast to interest rate swaps, typically involve an exchange of principle. A cross-currency swap involves the additional exchange of a floating interest rate for a fixed rate.

FuturesDaniels and VanHoose32 Purpose A currency swap allows a firm to lock in the domestic currency value of a debt issue or future receipt. It can allow a firm access to more favorable loan conditions.

FuturesDaniels and VanHoose33 Difference with Forward A forward contract could be used to accomplish the same thing as a swap. As opposed to forwards, swaps usually involve the immediate matching of two counter parties with opposite needs, or a double coincidence of wants. Long-dated forwards, therefore, tend to be much more costly to the firm.

FuturesDaniels and VanHoose34 Example Consider the following example: A US firm wants to borrow euros to finance a project in Europe. The firm is not well know in the foreign markets. Higher information costs translate into higher financing costs. Hence, the firm finds it cheaper to borrow dollars in the domestic market.

FuturesDaniels and VanHoose35 Example At the same time, a European firm is in need of dollar financing. An intermediary (or swap dealer) can arrange a swap between the two firms. Each firm borrows in their own home market— presenting the respective home market with a well- know identity versus and unknown identity— thereby reducing the cost of funds to each firm.

FuturesDaniels and VanHoose36 Solution The US firm issues dollar-denominated debt in the US market, while the European firm issues euro- denominated debt in the European market. Using the proceeds from the debt issues, the two firms swap the dollar principal for an equivalent euro principal.

FuturesDaniels and VanHoose37 Solution The US firm makes periodic euro payments to the dealer in exchange for an agreed amount of dollars. The dollars are used to pay interest to US bondholders. The European firm makes periodic dollar payments to the dealer in exchange for an agreed amount of euros. The euros are used to pay interest to the European bondholders.

FuturesDaniels and VanHoose38 Solution – The US Firm At the end of the maturity period, the US firm pays euro-denominated principal to the dealer in exchange for the dollar equivalent. The dollar funds received from the dealer are used to repay the principal to the bondholders. The initial inflow and subsequent outflows of the firm replicate euro denominated debt, but at a lower cost.

FuturesDaniels and VanHoose39 Illustration – US Firm Note that the swap has two branches: One between the US firm and the dealer and another between the European firm and the dealer. The swap, from the perspective of the US firm is illustrated in the next slide.

Dealer Firm Bondholders $ principal € equivalent Dealer Firm Dealer Bondholders $ interest € payment $ payment € payment $ payment $ interest € principal $ equivalent $ principal