1. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 1 Outline 6 6. Currency Futures and Options 6.1 Introduction 6.2 Currency Futures 6.2.1 Forward & Futures Contracts 6.2.2 Advantages / Disadvantages of Futures 6.2.3 How to Use Futures 6.3 Currency Options 6.3.1 Pricing Currency Options 6.4 How the Use of Currency Futures & Options Affects MC Value

2. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 2 6.1 Introduction Derivatives: –Financial contracts or assets that derive their value from other assets –FX derivatives values derived from the underlying value of a currency –Used to manage FX risk and to take speculative risks on currency changes –Future, option and forward contracts are derivatives

3. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 3 6.2 Currency Futures Futures: contracts with standard volumes and future delivery dates for a currency –A futures contract is a standardized forward contract Volume and delivery dates are standard Exchange rate is fixed for the day –Available for a limited number of currencies: A$, Brazil real, £, CAD$, euro, ¥, Mex. Peso, NZ$, ruble, So. African rand, Swiss franc Currency options availability depends upon demand –Number of contracts outstanding is “open interest”

4. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 4 6.2 Currency Futures Future (continued): –“Marked-to-market”: profit / loss on the future contract is settled at the the end of each trading day Helps to ensure credit of investor along with margin req. After settlement, new contract is issued at prevailing price. –High leverage; bought on margin, requirement averages 2% of the value of the contract –Maintenance margin is the minimum margin; If contract incurs losses, margin account falls below maint. margin, you must add $ to maint. margin level –Pay commissions for futures trading – very inexpensive –Circuit breakers exist to keep price movements within a bandwidth

5. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 5 6.2 Currency Futures Future (continued): –If prices drops below floor, trading is halted until maint. margin requirement is met to ensure payment of losses on the contract –High leverage and low transactions costs encourages participation in the currency future markets –Futures are traded on physical exchanges with traders interacting face-to-face –See cme.com/prices/daily_settlement.cfm for daily futures price data

6. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 6 6.2 Currency Futures Currency futures trading commissions at Chicago Mercantile Exchange: –Retail Trader Rates (cost per round-trip trade): Online $15.75 Broker-Assisted $46.50 –Large, Non-Member Rates: Online $10.00 Broker-Assisted $20.00

7. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 7 6.2 Currency Futures Future contract marked-to-market example: –Euro contract due in December 2003: Prior Day Settle Price (10/27/03): $1.1726 Current Settle Price (10/28/03): $1.1669 Point change: -57 or –57 x $0.0001 or $0.0057 -$0.0057 x euro 125,000 = -$712 $2,025 initial margin - $712 = $1,313 Maint. Margin for euro contract = $1,500 Must add $1,500 - $1,313 = $187 to account Daily loss is $712 + $15 commission = $727 on $2,025 investment (-35.9% in 1 day)

8. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 8 6.2 Currency Futures Future contract marked-to-market example: –Canadian $ contract due in December 2003: Prior Day Settle Price (10/27/03): $0.7606 Current Settle Price (10/28/03): $0.7617 Point change: +11 or +11 x $0.0001 or $0.0011 +$0.0011 x C$100,000 = +$110 $608 initial margin + $110 = $719 Maint. Margin for C$ = $450 Daily profit is: $110 - $15 commission or $95 on $608 investment (+15.6% in 1 day)

9. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 9 6.2 Currency Futures Large profits / losses were generated from small changes in the exchange rate price of the futures contract: daily ror’s: –35.9% daily loss on Euro contract –15.6% daily profit on C$ contract –Due to leverage: only invested $2,025 to buy 125,000 euros or $608 to buy C$100,000 –Leverage is generally less than 2% of contract value (margins required typically $1,000-$2,000 per contract)

10. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 10 6.2.1 Forward and Futures Contracts Futures contracts are standardized contracts: –March, June, September December delivery dates –Expire 2 business days before 3 rd Wednesday of delivery month –Currency volumes are standardized –Standardization encourages trading –Daily settlement reduces default risk Forward contracts are custom contracts with terms only known to both parties – difficult to trade –No daily settlement to prevent default

11. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 11 ForwardFutures Contract SizeCustomizedStandardized Delivery DateCustomizedStandardized Security DepositNone; bank balance required or letter of credit Small security deposit MarketplaceTelephoneCentral exchange floors RegulationSelf-regulatedCommodity Futures Trading Assoc., National Futures Assoc. Transactions CostsBank Bid-Ask SpreadBroker Fees

12. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 12 6.2.2 Advantages / Disadvantages of Futures Contracts Small sizes and ability to liquidate any day before maturity are advantages over forward Limited currencies, rigid delivery dates, rigid currency amounts Futures will only be useful for businesses with a regular stream of cash in foreign currency Futures are otherwise too rigid to conform to specific needs of a business

13. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 13 6.2.3 How to Use Currency Futures Speculation: –Expect a currency’s value to rise in the future, buy a futures contract to lock-in the price the currency is bought at a future date –On the settlement date, buy the currency at price specified by the contract –Sell at the (hopefully) higher spot rate for a profit

14. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 14 6.2.3 How to Use Currency Futures Speculation: Currency futures are sold by speculators who expect the spot rate of a currency to be less than the rate they would be obligated to sell currency

15. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 15 6.2.3 How to Use Currency Futures Speculation e.g.: April 4 Mexican pesos 500,000 futures contract with a June settlement date priced at $0.09 –On April 4 speculators expect peso to decline sell futures contracts –On June 17 (settlement date) the spot rate is $0.08: 1.4/4: Contract to sell 500k pesos: $0.09 x p500,000 = $45,000 2.6/17: Buy pesos spot: $0.08 x p500,000 = $40,000 3.Sell p500,000 for $0.09 ($45,000) to fulfill the futures contract 4.Gain on the futures position is $5,000

16. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 16 6.2.3 How to Use Currency Futures Hedging: Purchasing Futures to Hedge Payables: –Purchase of the futures contract locks in the price to buy a currency –US firm orders Canadian goods and on delivery will pay Canadian exporter C$500,000 Purchase 5 C$ futures contracts today to lock in the future price of buying $C at a future settlement date C$ currency exposure is hedged Hedging: Purchasing Futures to Hedge Receivables: –US firm sell futures contracts when it plans to receive Thai baht from exporting goods to Thailand –Selling a futures contract, the firm locks-in the selling price of the Thai baht at which it will be able to sell at the settlement date –The firm would do this if it expects the Thai baht to depreciate

17. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 17 6.3 Currency Options Option: –Right but not the obligation to sell or buy a financial instrument at a specified price and volume up to the expiration date –Currency Call Option: right to buy a specified amount of a currency at a specific price within a specific period of time –Currency Put Option: right to sell a currency –Standard volumes and future delivery dates Open Interest: number of contracts outstanding Currency options contracts available for limited number of currencies depending on demand

18. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 18 6.3 Currency Options Option: –The seller of the option must fulfill the contract if the buyer desires to do so –The option to not buy or sell has value, the buyer must pay a premium for this privilege –Currency option has two sides: call (right to buy foreign currency) can be converted to a put (right to sell domestic currency)

19. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 19 6.3.1 Pricing Currency Options Factors that Affect Currency Call Option Premiums: 1.Level of existing spot price relative to strike price Higher spot rate relative to strike price, the higher the option price 2. Length of time before the expiration date The longer the time to expiration, the higher the chance the spot rate > strike price 3. Potential variability of currency Higher the var. of spot rate, the higher the chance that the spot rate will be above the strike price – more volatile currencies have higher call option prices

20. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 20 6.3.1 Pricing Currency Options Profit From Buying a Call at Various Spot Rates at Termination Profit e + Limited Loss e strike 0 + _ e break-even

21. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 21 6.3.1 Pricing Currency Options Profit From Selling a Call at Various Spot Rates at Termination Profit e _ Profit = Call Prem. e strike 0 + _ e break-even

22. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 22 6.3.1 Pricing Currency Options Profit From Buying a Put at Various Spot Rates at Termination + Profit e Limited Loss e strike 0 + _ e break-even

23. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 23 6.3.1 Pricing Currency Options Profit From Selling a Put at Various Spot Rates at Termination Profit e Profit = Put Premium e strike 0 + _ e break-even _

24. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 24 6.3.1 Pricing Currency Options SEE EXHIBITS 7.5, 7.6, 7.7, and 7.8 on pp. 194-196

25. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 25 6.3.1 Pricing Currency Options Option Price: –Intrinsic value: difference between spot rate and exercise or strike price –Time value: premium above intrinsic value for chance that the option premium can grow or chance that an out-of-the-money option will be in the money (grows with greater time to expiration and volatility of spot rate)

26. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 26 6.3.1 Pricing Currency Options Option Pricing Models: –Will not discuss explicitly due to mathematical complexity: Black-Scholes options pricing and other models: P = f(dom. Interest rate, foreign interest rate, spot rate, standard deviation of spot rate, option’s time to expiration, probability of spot rate > exercise price)

27. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 27 6.4 How the Use of Currency Futures & Options Affects MC Value Currency futures & options can affect the value of a firm –Futures can prevent the possibility that the value of foreign currency receipts will  because of that currency against the $

28. 9/19/2015Multinational Corporate Finance Prof. R.A. Michelfelder 28 6.4 How the Use of Currency Futures & Options Affects MC Value Currency options: –Offer same protection against depreciation of currencies but allow more flexibility to capitalize on potential appreciation of the foreign currency, but they cost a premium, thereby reducing a MC’s cash flows