FX Risk Mng All Slides

8/13/2019 FX Risk Mng All Slides

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Master in International Business

FOREIGN EXCHANGERISK MANAGEMENT

Lecturer tefan N M Ungureanu, PhD


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Course Outline

1. The foreign exchange market

2. International parity conditions

3. Foreign currency derivatives

4. Measuring and managing transaction exposure tocurrency risk

MAI FX Risk Management tefan N M Ungureanu, PhD


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Exchange rates and intl. business

Any time a transaction has crossed borders, it hasbeen subject to the influence of changes inexchange rates

Basic problem posed by exchange rates on cross-

border transactions: money across borders has nofixed value

Our course purposes:

to understand, categorize and define the types ofexchange rate risks that firms face across borders

to address how managers can plan for, manage, andhedge these risks

MPI FX Risk Management tefan N M Ungureanu, PhD


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Foreign exchange reported losses

Company Country Loss (in millions) PeriodAbbot Lab. USA USD 41.3 1993

Bank Negara Malaysia USD 2,100 1993

Citizen Japan JPY 15 Q2, 2002

Penoles Mexico USD 15.8 2000

ReadersDigest USA USD 2.2 Q1-Q3, 1994

PepsiCo USA USD 53 1998

Toyota Japan JPY 1,200 Q1-Q4, 2004

Gazprom Russia USD 4,500 2009, Q1



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Exchange rate fluctuations



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USD/EUR, January 1999 October 2011



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RON/EUR, July 2005 October 2011



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Source: McKinsey Global InstituteGlobal capital markets: Entering a new era, October 2009



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Before a manager can start to grapple with the

effective or potential consequences of exchange

rates changes on the business, it is necessary to

understand some of the underlying forces in the

foreign exchange market



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Topic 1 Foreign Exchange Market (FOREX)


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Topic 1 Outline

1. Currency terminology

2. FOREX organization and structure

3. The spot market

4. The forward market



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1. Currency terminology

Exchange rate / foreign currency exchange rate

Exchange rate regime/system

Exchange rate regimes

Free float Managed float

Fixed-rate regime

Devaluation versus depreciation Revaluation versus appreciation

Hard versus soft currencies



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Free Float

The value of a free floating exchange rate isexclusively established by demand and supply inthe foreign exchange market, with no outsideinterventions

Over time, the exchange rate will fluctuaterandomlyas market participants assess and reactto new information

Central bank (monetary authority) does notintervene in the process of currency valuedetermination



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Managed Float

Assumes central bank intervention, whichmanipulates the exchange rate given itsobjectives:

smoothing out exchange rate fluctuations

leaning against the wind

unofficial pegging of exchange rate

Central bank support of the rate is not automatic

Central bank reserves fluctuate quite heavily, buttypically around a certain level



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Fixed-Rate System

Currencies maintained within a band (% of changearound a central value -parity)

Central banks actively buy or sell their currenciesin the foreign exchange market whenever the

exchange rate deviated from par value In order to intervene on the FOREX, central bank

maintains reserves, which absorb the burden ofexchange rate adjustment high volatility ofreserves

Currency devaluation and revaluation is common



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2. Organization of FOREX

The first global 24-hour market in the world and by farthe largest OTC market 2 tiers:

Wholesale tierliquid inter-bank market

60 to 70% of transactions

about 700 banks worldwide stand ready to make a marketin foreign exchange

there are FX brokerswho match buy and sell orders but donot carry inventory and FX specialists(dealers)

most inter-bank dealing is by phone & computer networks there are corresponding banking relationships that

facilitate the functioning of the market

Retail tierclient market



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FOREX Participants

Bank and non-bank FX dealers market makers

Individuals and firms conducting commercial andinvestment transactions

Speculators and arbitragers

Central banks and treasuries

FX brokers



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Markets by delivery date

Spot (rate: St)

immediate(t) payment and delivery of currencies

settlement day : 1 or 2 working days

Forward (rate: Ft,T)

payment and delivery at some future date (T)

common maturities: 30, 90, 180, 270, and 360 days,and up to ten years

FX swap transactions involve both a spot and a forward transaction, for

instance, buy spot and sell forward, or sell spot andbuy forward, with the same counterparty



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Motives for FX transactions

Arbitrage is the simultaneous, or nearly simultaneous,purchase of securities in one market for sale in anothermarket with the expectation of a risk-free profit

Speculation entails more than the assumption of a

risky position it implies financial transactionsundertaken when an individuals expectations differfrom the markets expectation

Hedging is the avoidance of foreign exchange risk byentering into a transaction that lays off the risk to awilling counter party



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Foreign exchange market turnover

Global net turnover (2010) = US$ 3,210 billion per business day

Turnover = total US dollar value of all spot, outright forward, andforeign exchange swap transactions concluded (not settled) during themonth of April



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Currency distribution of FOREX



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FOREX turnover by geographicaldistribution, 2010



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3. Spot Exchange Markets

1. Definition of exchange rates

2. Quoting conventions

3. Bid and ask rates

4. Cross exchange rates



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Definition of Exchange Rates

Exchange rate

amount of currency that one has to pay in order tobuy one unit of another currency

amount of currency that one receives when sellingone unit of another currency

Which money is being bought or sold? dependson home currency



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Quoting conventions

Professional dealers and brokers quote currenciesin either of two ways:

direct basis HC/FCsuch as Canadian dollars perUS dollar or Romanian leu per US dollar when thisquote involves the USD as HC :American terms

indirect basis FC/HCsuch as US dollar per BritishPound (GBP) when this quote involves the USD asHC : European terms

Most currencies are quoted on a direct basis, theexception being some currencies from the formerCommonwealth - the most important ones are theBritish poundand the Euro



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Quoting conventions

Every exchange transaction involves two currencies

1.5625 CHF/USD

A trader always buys or sells a fixed amount of thebasecurrency

How to interpret changes in exchange rates: numerator increases the base currency is

strengthening the base currency appreciates and theterms currency depreciates

numerator decreasesthe base currency is weakeningthe base currency depreciates and the terms currencyappreciates

base/quoted currencyterms/counter currency

numerator denominator



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Measuring a change in spot rates

Example: 1.5625 CHF/USD to 1.2800 CHF/USD % change in the value of the USD in terms of the CHF is:

% change in the value of the CHF in terms of the USD is:

18.08%

1.5625

1.5625-1.2800

rateBeginning

rateBeginning-rateEnding

22.09%1.2800

1.2800-1.5625

rateEnding

rateEnding-rateBeginning

USD depreciatedby 18.08% against the CHF

CHF appreciatedby 22.09% against the USD



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Spot bid and ask quotations

Market makers will quote the rate at which they arewilling to buy the base currency (Bid) (in terms of theother currency) and the rate at which they are readyto sell the basecurrency (Ask)

1.5130 - 1.5145 CHF/USD

Often the quotation will be shortened to 30/45. Thesenumbers are points a point is the fourth place tothe right of the decimal point (0.0001)

The difference between the bid and the ask price isthe spread SPREAD = S

ask,t

Sbid,t

> 0

Market maker sells USDMarket maker buys USD

Client sells USD Client buys USD


Inverting exchange rates in the


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Inverting exchange rates in thepresence of spreads

Rule: the inverse of a bid quote is an ask quote, and vice

versa

ask,t

bid,tS(USD/CAD)

1S(CAD/USD)

bid,t

ask,tS(USD/CAD)

1S(CAD/USD)

Example: 1.3727 1.3730 CAD/USD

0.7283 - 0.7285 USD/CAD



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Cross exchange rates

Cross exchange rate = exchange rate between 2currency pairs where neither currency is the USD

USD/GBPtS(EUR/USD)tS(EUR/GBP)tS

Example: S(EUR/USD) = 1.2823

S(USD/GBP) = 1.4128

Cross exchange rate EUR/GBP is:

S(EUR/GBP) = 1.2823 x 1.4128 = 1.8116



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3. Forward Markets

1. Forward market quotations

2. Forward premium or discount

3. Interest rate parity

4. Long and short forward positions



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Forward market quotations

Buying and selling currencies for delivery on astipulated future date, at a rate agreed upon now

Practice: forward price spot

Premium versus discount When base currency is more expensive in the future

than it is now in terms of the other currency, theformer is said to be at a premium (assuming direct

quotes)

When base currency is less expensive, it is said tostand at a discount(assuming direct quotes)



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Outright rate

Spot 1.5130 - 1.5145 CHF/USD

3-month forward 1.5053 - 1.5078

Swap points

Spot 1.5130 - 1.5145 CHF/USD

3-month forward 77 - 67



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Recovering the outright forward price from theswap points rule :

1. If the points are decreasing, subtract from the spotprice

2. If the points are increasing, add to the spot price

Spread on

spot

15

Spread on

forward points

10

Spread on

outright forward

25

+ =



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Suppose you read the following quotations: Spot 1.4815 29 CAD/USD

3-month forward 40 38

Spot 0.6556 70 CHF/USD

6-month forward 51 64

The 3-month CAD/USD outright forward rate is: F(CAD/USD) = 1.4775 - 1.4791

The 6-month CHF/USD outright forward rate is: F(CHF/USD) = 0.6607 0.6634



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Forward quotations in percentage terms

100n

360

S

S-FscountPremium/Di

F - forward price

S - spot price n - number of days in the contract

Discount on base currency is different from thepremium on terms currency


Forward quotations in percentage terms


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Forward quotations in percentage terms -example

Suppose the following:

Spot rate 1.5437 CHF/USD

3-month forward rate 1.5398 CHF/USD

The discount on the USDis:

Thepremium on CHFis:

-1.01%p.a.=10090

360

1.5437

1.5437-1.5398

.a.p1.013%=10090

360

1.5398

1.5398-1.5437



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Interest rate parity

Interest rate parity(IRP) is an arbitrage condition that

establishes a relationship between spot and forwardexchange rates, and risk-equivalent domestic andforeign nominal interest rates

Forward premium/discount Interest differential

between currencies

The currency with the higher interest rate is at adiscount, the one with the lower interest rate is at apremium

)i+(1

)i+(1

S

F

FC

HC

HC/FC

HC/FC

FCHC i-iS

SF



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Interest rate parity



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Interest Rate Parity example

90-day CHF interest rate 4%

90-day USD interest rate 8%

Spot rate (CHF/USD) 1.4800

90-day forward rate 1.4655

Is 1.4655 the correct forward price?

Note that because we do not use bid and ask rates, buyingand selling, as well as borrowing and lending, are done atthe same rates



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Interest Rate Parity example

Start End

S=CHF1.4800/$

CHF1,480,000

$1,000,000 $1,020,000

CHF1,494,000

x 1.02

x 1.01

i$= 8.00% p.a.

(2.00% per 90 days)

ICHF= 4.00% p.a.(1.00% per 90 days)

Dollar money market

Swiss franc money market

90 daysF90 =CHF1.4655/$



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IRP and Covered Interest Arbitrage

If IRP failed to hold, an arbitragewould exist Example: Consider the following set of foreign

and domestic interest rates and spot and forwardexchange rates

Spot exchange rate S($/) = 1.25

360-day forward rate F360($/) = 1.20

US interest rate i$ = 7.10% p.a.

UK interest rate i= 11.56% p.a.



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IRP and Covered Interest Arbitrage

According to IRP only one 360-day forward rate,F360($/), can exist this is

Why?

If F360($/) $1.20/, an arbitrageur could

engage in covered interest arbitrage (CIA)and make money with one of the followingstrategies:

$/1.200.115610.071011.25

360F



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Arbitrage Strategy 1

If F360($/) > $1.20/1. Borrow $1,000 at t= 0 at i$= 7.10%.

2. Exchange $1,000 for 800 at the prevailing spotrate, (note that 800 = $1,000$1.25/)

3. Invest 800 at 11.56% (i) for one year to achieve892.48

4. Translate 892.48 back into dollars if F360($/) >$1.20/, 892.48 will be more than enough torepay your dollar obligation of $1,071



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Arbitrage Strategy 2

IfF

360($/) < $1.20/

1. Borrow 800 at t= 0 at i= 11.56% .

2. Exchange 800 for $1,000 at the prevailing spotrate,

3. Invest $1,000 at 7.1% for one year to achieve$1,071.

4. Translate $1,071 back into pounds if F360($/) Ft,t+1buyer gains

St+1< Ft,t+1buyer looses

Sell a currency = taking a short position

St+1> Ft,t+1seller looses

St+1< Ft,t+1seller gains

Example: F180 days= 105 /$


P ff fil f f d


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Payoff profiles for forward contracts

loss

0S180(/$)

F180(/$) = 105

120

If, in 180 days, S180(/$) = 120, the long willmake a profit by selling $ at S180(/$) = 120and receiving $ at F180(/$) = 105.

15

profitlong position


P ff fil f f d t t


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If, in 180 days, S180

(/$) = 120, the shortwill loseby having to buy $ at S180(/$) =120 and delivering $ at F180(/$) = 105.

loss

0

F180(/$) = 105

profit

120

15

S180(/$)

short position


P ff fil f f d t t


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0S180(/$)

F180(/$) = 105

short position

long position

Since this is a zero-sum game,

the long position payoff is theopposite of the short.

loss

profit



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Topic 2 International Parity Conditions

T i 2 O tli


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Topic 2 Outline

1. The Parity Framework

2. Law of One Price and Purchasing Power Parity

3. Interest Rate Parity

4. Fisher Effects

5. Forward Rate Unbiased Property

6. Empirical evidence on parity conditions andmanagerial implications


1 Th P it F k


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1. The Parity Framework

The framework is founded upon:

assumptions of rational economic behavior

the ability to transact freely at no cost in the marketsfor goods and credit as well as the market for foreignexchange

Simple models that describe relationshipsbetween:

the spot exchange rate

the forward exchange rate

the interest rates

the inflation rates


R l d f l


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Relevance and usefulness

Empirical evidence supporting each individual

parity condition is mixed How much do they hold in the real world?

depends on the extent to which trade barriers

restrain the activities of traders from enforcing thelaw of one price through arbitrage

Collectively, they constitute a useful way ofordering ones thinking about the economic forces

governing exchange rate movements international financial benchmarks or break-even values



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P rchasing Po er Parit (PPP)


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Purchasing Power Parity (PPP)

PPP establishes a formal link between a countrys price

level or inflation rates (relative to another country)and the prevailing exchange rate between the twocountries

Absolute PPPbased on price levels in 2 countries:

Pt[US] = Spott[USD/GBP] x Pt[UK]

the exchange rate will adjust to eliminate

discrepancies in price levels OR price levels will adjust to eliminate discrepancies in

exchange rates




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Relative PPPbased on price indexes in 2 countries:

The spot exchange rate adjusts perfectly to inflationdifferentials: if goods prices rise in HC relative to FC,

then HCs currency must depreciate to maintain asimilar real price for the goods in the two countries

The change in the exchange rate is roughly equal tothe difference in inflation rates(inflation differential)

rateinflation-;+1

+1=S

S

FC

HC

0

HC/FC

1HC/FC

FCHCFC

HC

0

01

PPP

PPP 11

1

S

SS

S


Purchasing Power Parity example


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Purchasing Power Parity - example

Example:

Switzerland inflation rate 4% p.a.

US inflation rate 2% p.a.

Spot rate0 1.50 CHF/USD

(The USD will appreciate and CHF depreciate accordingly)

PPP predicts a 2% appreciation of USD against CHF and a2% depreciation of CHF against USD

CHF/USD1.52951.02

1.041.50S

1

PPP

2%-4%1.96%1.021.04SPPP 1


Purchasing Power Parity Line


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Purchasing Power Parity Line

Given an Sactual: SHC-FC= HC- HC

we are on the PPP line

and PPP holds SHC-FCHC- HC

we are not on the PPP

line and PPP does nothold

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

7

-7 - 6 - 5 - 4 -3 - 2 - 1 0 1 2 3 4 5 6 7

0

01

actual

HC/FC S

SSS

FCHC


Real exchange rate


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Real exchange rate

Assume FC> HCand HCis constant FC is expected

to depreciate against HC, according to PPP this does not necessarily mean that the realvalue of HC

purchases of goods and services across borders hasbecome cheaper

if the increase in PFC has exactly offset the decline invalue of the FC, then PPP would remain the same

there has been a nominaldepreciation of FC, but not arealdepreciation

What matters for PPP across any two countries is thechange in the nominal value of a currency afteradjustment for changes in the relative inflation ratesbetween the two countries



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Real exchange rate example


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Real exchange rate example

Case 1

Sactual=1.50 CHF/USD

SPPP=1.50 CHF/USD

CHF and USD areat their values

Case 2Sactual=1.55 CHF/USD

SPPP=1.50 CHF/USD

USD overvalued

CHF undervalued

Case 3

Sactual=1.45 CHF/USD

SPPP=1.50 CHF/USD

USD undervalued

CHF overvalued

11.50

1.50q

1.0331.50

1.55q

0.9671.50

1.45q


Changes in real exchange rate


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Example: S0=1USD/EUR; $=5% p.a.; =10% p.a.

PPPactualPPP

PPPactual SSS

SSq

0

0

1

actual

S

SS

0

0

1

PPP

S

SS

USD/EUR0.95451.10

1.051S1PPP

4.55%11.10

1.05SPPP

PPP predicts a 4.55% depreciation of EUR against USD




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Example (contd)

3 possible cases regarding S1actual:

S1actual(USD/EUR)

Sactual(%) SPPP(%) q(%) Interpretation

0.9545 -4.55 -4.55 0 No change in q

0.9600 -4.00 -4.55 +0.55 EUR appreciated inreal terms by 0.55%against USD

0.9500 -5.00 -4.55 -0.45% EUR depreciated in

real terms by 0.45%against USD

Nominal depreciation of EUR


3 Interest rate parity


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Interest rate parity (IRP) states that the forward

premium or discount for the quoted currency reflectsthe difference in interest rates for banking deposits inthe two currencies

The currency with the higher interest rate is at adiscount, the one with the lower interest rate is at a

premium If IRP did not hold, then it would be possible for an

arbitrageur to make money exploiting the arbitrageopportunity covered interest arbitrage

3. Interest rate parity

)i+(1S

F

=)i+(1 FCHC/FC

HC/FC

HC


4 The Fisher Effects


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4. The Fisher Effects

Fisher parities describe how information regarding

expected inflation and expected exchange rates arecaptured in interest rates

Fisher closed equation that links nominal interestrate and inflation expectations for a single economy

Fisher closed represents another example of arbitrage between real assets and financial assets within asingle economy

)(1r)(1i(1 )

ri (approximation)


The International Fisher Effect (Fisher


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Open or UIP)

Interest rates across countries must be set with an eye

toward expected exchange rate changes The derivation of IFE is another straightforward

application of arbitrage an interest arbitrage butuncovered

the expected spot exchange rate between two currencies

should change by an equal amount but in opposite directionto the difference in interest rates between the two countries

i-iS

S-)E(Selyapproximator

i+1

i+1=

S

E(SFCHC

0

01

FC

HC

0

1 )

% expected exchange = % interest differentialrate change


IFE and Exchange Rate Predictions


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IFE and Exchange Rate Predictions

IFE predictions

HC interest rates > FC interest rates HC is expectedto depreciate E(S1) > S0 logic: investors must bepaid a higher interest rate to compensate them for aunit of account that is expected to depreciate in value

HC interest rates < FC interest rates HC is expectedto appreciate E(S1) < S0 logic: investors willinglyaccept a lower interest rate when they hold a unit ofaccount that is expected to appreciate in value

Computation of the markets implied future spotrate:

t

FC

HC1+t S

i+1

i+1=)E(S


IFE and Real Interest Rate Parity


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IFE and Real Interest Rate Parity

Suppose Fisher closed is valid in HC and FC

HCHCHC ri FCFCFC ri

)()r(rii FCHCFCHCFCHC

FCHCFCHC ii

(IFE)S

S)E(Sii0

01FCHC

0rrassume FCHC

holdsPPPassume

IFE implicitly assumes that real interest rates are equal across

countriesMPI FX Risk Management tefan N M Ungureanu, PhD

5 The Forward Rate Unbiased Property


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5. The Forward Rate Unbiased Property

Follows directly from IRP and IFE:

% Forward premium = % Expected Exchange Rate Change

t

t1+t

t

t1+tt,

S

S)E(S=

S

SF --

Forward rate is an unbiased predictor of the future spotrate forward rates and interest differentials neithersystematically over- and underestimate the future spot rate

Ft,t+1

St=1+ iHC

1+ iFC=E(St+1)

St Ft,t+1= E(St+1)


Combining the parity relations


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Combining the parity relations

S0= 1.3250 CHF/USD

F0,360= 1.3509 CHF/USD

CHF= 4% pa; USD= 2% pa CHF- USD = 2%

iCHF= 5% pa; iUSD= 3% pa iCHFiUSD= 2%

Forward premium on USD

Forecast change in the spot rate

2%2%4%S

SF

0

00,360

)appreciatetoexpected(USD2%2%4%S

SS

0

0360


International parity relations in equilibrium


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International parity relations in equilibrium

Forecast change in spotexchange rate

+2%

(USD strengthens)

Forecast premium onforeign currency

+2%

Difference in nominalinterest rates

+2%

(higher in Switzerland)

Forecast difference inrates of inflation

+2%

(higher in Switzerland)

Interest rate parity(2)

Forward rateunbiased property

(5)

International FisherEffect

(4)

Fisher closed(3)

Purchasing PowerParity

(1)


6 Empirical evidence on parity conditions


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6. Empirical evidence on parity conditions

Parity conditions play an important role in theformation of strategies toward international financialmarkets formulated by people in private enterprise

When parities hold, a source of risk and a source ofopportunity disappear a decision point is removed

If all parity conditions were valid at each and everymoment in time no important financial managerialdecisions to make

If parity conditions are not valid at each and every

moment in time two categories of financialdecisions:

Profit maximizing

Risk managing


Empirical evidence on parity conditions


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Empirical evidence on parity conditions

Managers can identify deviations that are small and growing

larger, or already large and likely to persist activeprofit-maximizingstrategies will follow

Assumptions that managers can move quickly enough tocapture a parity deviation and that the risks involved are

not excessive Managers believe that parity conditions hold on average,

but are not able to detect whether a deviation is likely tobe transitory or persistent strategies that aim at

reducing the firm

s exposure to the deviation risk Understanding the magnitude and duration of deviationsfrom parity conditions forms the foundation for many ofinternational financial managersdecisions


Empirical evidence on LOP and PPP


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Empirical evidence on LOP and PPP

LOP is fragrantly and systematically violated

Tests on PPP show that it is strongly violated on theshort-run, but describes a long-run phenomenon

PPP does not hold precisely in the real world for avariety of reasons :

transportation costs

existence of non-tradables

differences in consumption preferences

PPP-determined exchange rates still provide a valuablebenchmark for:

currency forecasting

determining over- and under-valuation of currencies

management of foreign exchange risk


A test of PPP - Big Mac Index


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A test of PPP Big Mac Index

One test of the Law ofOne Price is the Big Macindex, which has beenpublished annually in

The Economist since1986.

It was devised as alight-hearted guide towhether currencies areat their correctlevel,based on PPP.


Big Mac Index


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Big Mac Index

US Big Mac price

(CAD/USD)S

priceMacBigCanadian

actual

priceMacBigUS

priceMacBigCanadian

100

2.90

2.902.33


Pitfalls of the Big Mac test


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Pitfalls of the Big Mac test

The Big Mac Index shows the extent to whichinternational price discrimination is possible for aparticular product The Big Mac is a non-tradable and nondurable product

It is a differentiated product with an implied warrantyassociated with the reputation of the McDonalds Corp.

Big Macs are generally produced locally, with local laborand on local land, usually with locally producedmaterials

In many countries, Big Macs do not have close

substitutes

McDonalds sets the profit-maximizing price in acountry, ignoring the prospect of Big Mac arbitrage


Empirical evidence on IRP


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Various empirical studies indicate that IRP holds in

free, deregulated markets (within a transaction costband)

Deviations may occur due to capital controls, taxes (on

repatriated capital), market incompleteness Quite large deviations in closed less-developed

countries, since smaller currencies can be borrowedand lent only domestically

Bankers often use the IRP model to quote forwardrates




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Covered Interest Arbitrage opportunities


Empirical evidence on IFE


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Empirical evidence on IFE

1973-1993 little relationship between thecurrent interest differential on Euro-$ and Euro-DEM deposits and the future realized $/DEMexchange rate changes

1973-1993 small average deviation from the IFEfor the pairs $/DEM and other eight majorcurrencies

Long-run tendency for the interest differential tooffset exchange rate changes


Empirical evidence on Forward ratebi d t


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unbiased property

Empirical tests generally show that the forwardrate is not a good predictor of the level of thefuture spot rate

However, there is strong evidence that the forward

rate does a better job of predicting at least thedirection of changes to future spot rate ratherthan do about two-thirds of the better knownforeign exchange forecasting services



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Topic 3 Foreign currency derivatives

Topic 3 Outline


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p

1. Foreign Currency Futures

2. Foreign Currency Options3. Currency Swaps


1. Foreign currency futures


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g y

1. What is a currency futures contract?

2. The market for currency futures contracts

3. Quoting currency futures contracts

4. Forward contracts versus futures contracts

5. Hedging with futures contracts


What is a futures contract? (I)


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( )

A futures contract represents a pure bet on thedirection of price (exchange rate) movement of theunderlying currency

ATTN!!The futures price is not a monetary amountyou pay to anyone, but the variable about whichyou are betting

Your actual gain or loss depends on the positiontaken on the market - long or short


What is a futures contract? (II)


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( )

If you buya futures contract (golong) and the futures price goes up you make money

the futures price goes down you lose money

If you sella futures contract (go short) and the futures price goes down you make money

the futures price goes up you lose money

Open interest the number of futures contracts outstandingfor which delivery is obligated


What is a futures contract? (III)


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A futures contract is a binding agreement to payup your bet on a daily basis, for every day themarket is open and your bet is still in effect

You stop an FX futures bet prior to the end oftrading on the last trade day you are notobligated to buy or deliver anything

After last trade dates you will be legallyobligated to acquire (if long) or to deliver (ifshort) the underlying asset on whose price youare betting, if contract is still in force


What is a futures contract? (IV)


90/189

The size of the bet you take by opening a futurescontract is governed by the face amount of thecontract

Futures long at price P0

at the end of the daythere will be a positive or negative cash flow toyour futures account:

(P1P0) x Face value of contract

Next business day: cash flow to your account is

(P2P1) x Face value of the contract


What is a futures contract? (V)


91/189

Example: 62,500 futures contract opened at a negotiatedprice of $1.4500/

the settlement pricesat the end of Day 1 and Day 2

are

Opening price 1.4500 $/

Settlement price, end Day 1 1.4460 $/

Settlement price, end Day 2 1.4510 $/


What is a futures contract? (VI)


92/189

The respective cash flows for long and shortpositions in a single contract opened at $1.4500/are

Long Short

($1.4460/ - $1.4500/) x 62,500 = -$250 + $250

($1.4510/ - $1.4460/) x 62,500 = + $312.50 - $312.50


The market for futures contracts


93/189

How it emerged? the possibility of default for

forward contracts raised potentially seriousproblem for counterparties overcoming therisk:

1. Making forward contracts only with people of highcharacter, reputation, and credit quality

2. FUTURES CONTRACTS

May 1972 International Monetary Market(IMM) of CME introduces trading in FX futures

July 1986 Philadelphia Board of Tradeintroduces currency futures trading


Currency futures on CME


94/189

Expiry cycle: March, June, September, December

Delivery date 3rd Wednesday of delivery month

Last trading day is the second business daypreceding the delivery day

CME hours 7:20 a.m. to 2:00 p.m. CST.


Quoting Futures Contracts


95/189

Quoting Futures Contracts

Source: Financial Times, December 16, 2008


Forward versus Futures Contracts


96/189

Forward contracts Futures contracts

1. Customized transactions in terms ofsize and delivery dates

1. Standardized contracts in terms ofsize and delivery dates

2. Private contracts between two

parties

2. Standardized contracts between a

customer and a clearinghouse

3. Difficult to reverse a contract 3. Contract may be freely traded onthe market

4. Profit or loss on a position isrealized only on the delivery date

4. All contracts are marked to market,so profits and losses are realizedimmediately

5. Margins are set once, on the day ofthe initial transactions

5. Margins must be maintained toreflect price movements


Marking-to-market


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Process of updating a margin account on a dailybasis to reflect the market value of theunderlying position

Margins are set by the exchange, subject to

periodic revision Determined by looking at the risk of a given contract

Two types of margin:

Initial margin posted when the client first enters acontract may be formed of cash or interest-bearingsecurities

Maintenance margin minimum level of the marginonly in cash


Marking-to-market - example


98/189

June 15: purchase a CHF125,000 September CHF futures

contract traded on CME; price = $0.70/CHF. Entering the transaction futures trading account with a

securities or brokerage firm post initial margin assume is $7,000 (8%); maintenance margin = 83% of initial

margin (=$5,810) June 16: Sept. CHF future ends the day at $0.696 new

value of contract: $87,000 you incur a $500 loss theremaining value of your margin account = $6,500

June 17: Sept. CHF future falls to $0.692 new value ofcontract = $86,500 you incur a $500 loss remainingvalue of margin account = $6,000


Marking-to-market - example


99/189

June 18: Sept. CHF futures falls to $0.689 new value of

contract = $86,125 you incur a $375 lossbalance ofmargin account = $5,625

Because now the balance is lower than the maintenancemargin, the broker will issue a margin call for $1,375

(variation margin) to restore the initial margin of $7,000

Consider now a happier case: CHF appreciates to $0.71/$ the broker will credit your margin account for $1,250(equal to the $0.01 gain on CHF125,000), bringing the

total to $8,250 these excess margin funds could bewithdrawn and put to some other use


Hedging FX risk using forwards versus futures


100/189

g g g

Assume a bank raised all its liabilities in dollars whileinvesting half of its assets in GBP-denominated loans andthe other half in USD-denominated assets

Assets and liabilities are of a 1 year maturity and duration;interest rate on UK loan: 15% p.a.

Assets LiabilitiesU.S. loans ($) $100 million U.S. CDs $200 million

U.K. loans () 100 million


Hedging FX risk using forwards


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0 1

Make loan (100 million)Sell principal (100million) plus interest (15million) forward at the

forward exchange rate attime 0

Deliver principal andinterest (115 million) onloan to forward contractbuyer and receive $s at thetime 0 forward exchange

rate


Hedging FX risk using futures


102/189

Suppose the bank wished to hedge this loan position onSept. 25, 2001 only 2 contracts available on that day forGBP in the futures market: a December 2001 maturity oneand a March 2002 maturity

The bank could use futures only by rolling over the hedgeinto a new futures contract on maturity

How many futures should the bank sell?

The amount that produces a sufficient profit on the GBPfutures contract to just offset any exchange rate losseson the GBP loan portfolio should the GBP fall in valuerelative to USD


Hedging FX risk using futures


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Two cases to consider:

1. The futures USD/GBP price is expected to change inexactly the same fashion as the spot USD/GBP priceover the course of the year NO BASIS RISK

2. Futures and spot prices, while expected to change in

the same direction, are not perfectly correlatedTHERE IS BASIS RISK


Hedging FX risk using futures Case 1


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Sept. 25, 2001: St = 1.4713 USD/GBP; ft for Dec. 2001 =1.4640 USD/GBP

Forecasts for 1 years time spot and futures: St+1 = 1.4213USD/GBP; ft+1= 1.4140 USD/GBP

Over the year:

St= -5 cents;

ft= -5 cents Number of futures contract to be sold:

Loss on GBP loan: 115 million (-5 cents) = $5.75 mill. Gain on futures contract:

115 million (5 cents) = $5.75 mill.

contracts1,84062,500

00115,000,0

contractfuturesofSize

positionlongofSizeNf




105/189

Sept. 25, 2001: St = 1.4713 USD/GBP; ft for Dec. 2001 =1.4640 USD/GBP

Forecasts for 1 years time spot and futures: St+1 = 1.4213USD/GBP; ft+1= 1.4340 USD/GBP

Over the year:

St= -5 cents;

ft= -3 cents BASIS RISK Suppose the bank manager ignored the basis risk and sold1,840 futures contracts

Loss on GBP loan: 115 million (-5 cents) = $5.75 mill.

Gain on futures: (1,840 62,500) 3 cents = $3.45 mill. Net loss = $5.75 - $3.45 = $2.3 mill.




106/189

The bank manager should take into account the lowersensitivity of futures prices relative to spot rates changesby selling more than 1,840 futures contracts to fully hedgethe GBP loan risk

Hedge ratio: how many futures should be sold to hedge the

long position in the GBP when the spot and futures pricesare imperfectly correlated

Since spot rates are 66% more sensitive than futuresprices, for every 1 in the long asset position, 1.66futures contracts should be sold

1.66$0.03

$0.05

f

Sh

t

t




107/189

Suppose now the bank manager does not ignore the basisrisk

Number of futures contracts sold:

Computing losses and gains:

Loss on GBP loan: 115 million (-5 cents) = $5.75 mill.

Gain on futures: (3,054 62,500) 3 cents = $5.73 mill. Net loss = $5.75 - $5.73 = -$0.02 mill. (due to rounding)

contracts3,0541.6662,500

00115,000,0

hcontractfuturesofSize

positionlongofSize

Nf


Deciding on futures versus forwards


108/189

Depends on the purpose and scale of thetransaction

Hedgers if similar prices, will prefer interbankforward contracts(if access to the market exists)

Speculators

Short-term speculator exchange-traded futurescontracts

Larger-scale speculators interbank market, butmore likely the trade is in spot contracts


2. Foreign currency options


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1. What is an option?

2. The market for currency options

3. Quoting prices for currency options

4. Introduction to FX option pricing and valuation


What is an option? (I)


110/189

Unique type of financial contract with a throwawayfeature they give you the right, but not theobligation, to do something

No daily cash flows on the long side of an option Limited potential loss on a long position

Call versusput options

American versusEuropean options


What is an option? (II)


111/189

A call on spot a contract between a buyerand a writer/seller whereby the buyer pays aprice (the premium) to the writer in order to

acquire the right, but not the obligation, topurchasea given amount (size) of one currencyfrom the writer at purchase price (exerciseprice, strike price) stated in terms of a second

currency


What is an option? (III)


112/189

Example: CME December 2001 call option on GBP31,250;exercise price = $1.50/GBP; premium = $322

American option: you can buy GBP31,250 at any timebefore the Saturday prior to the third Wednesday inDecember 2001

European option: you can buy GBP31,250 only on theSaturday prior to the third Wednesday in December 2001


What is an option (IV)


113/189

A put on spota contract between a buyeranda writer/seller whereby the buyer pays a price(thepremium) to the writer in order to acquire

the right, but not the obligation, to sell a givenamount (size) of one currency to the writer atselling price (exercise price, strike price) statedin terms of a second currency


What is an option? (V)


114/189

Example: CME June 2001 put option on JPY1,000,000;exercise price = JPY150/$; premium = $320

American option: you can sell JPY1,000,000 at any timebefore the Saturday prior to the third Wednesday inJune 2001

European option: you can sell JPY1,000,000 only on theSaturday prior to the third Wednesday in June 2001


Currency Options Markets


115/189

Philadelphia Stock Exchange

Hong Kong Financial Exchange

20-hour trading day.

OTC volume is much bigger than exchangevolume.

Trading is in seven major currencies plus the euroagainst the U.S. dollar.


Currency Options Contracts - example (PSE)


116/189

Contract type: European-style call option on PSE

Underlying asset: GBP

Expiration date: Third Wednesday in December

Exercise price: $1.45/ spot rate

Contract size: 31,250


Currency options quotes - PSE


117/189

PHILADEPHIA Sterling Options 31,250 (cents per pound)

Strikeprice

CALLS PUTS

Mar Apr May Mar Apr May

1.620 2.01 2.63 3.11 0.63 1.32 1.77

1.630 1.38 2.10 2.56 0.97 1.75 2.21

1.640 0.94 1.67 2.13 1.44 2.22 2.69

Previous days vol., Calls-Puts 422. Prev. day

s open int., Calls 1553 Puts 19,754


Writing FX options


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The writer of a FX option is in a different positionform the buyer of the option

The writer is a source of credit risk once the

premium has been paid the clearing houserequires margin to be posted

Writing options is a form of risk-exposure of

importance at least equal to that of buyingoptions


Moneyness


119/189

In the money (ITM) A call/put option on spot is in the money if the currentspot rate is higher/lower than the option exercise price

Out of the money (OTM)

A call/put option on spot is out of the money if thecurrent spot rate is lower/higher than the optionexercise price

At the money (ATM)

A call/put option on spot is at the money if the currentspot rate is equal to the option exercise price


Payoff profiles for options


120/189

Buyer of an option limited loss, unlimitedprofit

Writer of an option unlimited loss, limitedprofit

Example:

1. Call option on CHF; strike price = 58.5 UScents/CHF; premium = 0.5 US cents/CHF

2. Put option on CHF; strike price = 58.5 UScents/CHF; premium = 0.5 US cents/CHF


Payoff profile for buyer of a call option


121/189

-1

-0.5

0

0.5

1

57 57.5 58 58.5 59 59.5 60

Spot price of underlying currency (US cents/CHF)

Profit(UScents/CHF

Strike priceAt-the-moneyOut-of-the-money In-the-money

Limited loss

Unlimited profit

Break-even

price


Payoff profile for writer of a call option


122/189

-1

-0.5

0

0.5

1

57 57.5 58 58.5 59 59.5 60


Profit(USc

ents

/CHF)

Strike price

At-the-moneyOut-of-the-money In-the-money

Limited profit

Unlimited

loss

Break-even

price


Payoff profile for buyer of a put option


123/189

-1

-0.5

0

0.5

1

57 57.5 58 58.5 59 59.5 60


Profit(USc

ents/CHF

Strike price

At-the-moneyIn-the-money Out-of-the-money

Unlimited profit

up to 58 cents

Limited lossBreak-even

price


Payoff profile for writer of a put option


124/189

-1

-0,5

0

0,5

1

57 57,5 58 58,5 59 59,5 60


Profit(USc

en

ts/CHF)

Strike price

At-the-moneyIn-the-money Out-of-the-money

Unlimited

loss up to

58 cents

Limited profitBreak-even

price


Basic Option Pricing Relationships at Expiry


125/189

At expiry, an American call option is worth thesame as a European option with the samecharacteristics.

CaT= CeT= Max[ST- X, 0]

Call in-the-money STX

Call out-of-the-money worthless


Basic Option Pricing Relationships at Expiry


126/189

At expiry, an American put option is worth thesame as a European option with the samecharacteristics

PaT= PeT= Max[X - ST, 0]

Put in-the-money X ST

Put out-of-the-money worthless


Option Pricing and Valuation


127/189

The price (premium) of an option has two components:

Intrinsic value the amount the option is in the money

Time value the option premium minus the intrinsicvalue

OptionPremium

=IntrinsicValue

+Time

Value


Option Pricing and Valuation


128/189

Example:$1.25 call on GBP is priced at $0.030 when thespot price is $1.27

Intrinsic value= Spot price - Strike price

= $1.27 - $1.25 = $0.02

Time value = Premium - Intrinsic value= $0.03 - $0.02 = $0.01


Total Value of a Call Option


129/189

0

1

2

3

4

5

6

7

8

1,64 1,65 1,66 1,67 1,68 1,69 1,7 1,71 1,72 1,73 1,74 1,75 1,76

Spot rate ($/)

Optionpremium(U

Scents/)

Total value

Time value

Intrinsic value

MPIFX Risk Management Alexandra Horobet, PhD

FX options price determinants


130/189

Premium rises if :

For a Call For a Put

1. Spot rate

2. Exercise price

3. Interest rate in HC

4. Interest rate in FC

5. Volatility

6. Time to maturity


3. Currency Swaps


131/189

1. The short-term swap

2. Back-to-back and parallel loans

3. The modern currency swap

4. Absolute and comparative advantage in swaps

5. Valuation of swaps


Some useful definitions


132/189

In a swap, two counterparties agree to acontractual arrangement wherein they agree toexchange cash flows related to debt obligations atperiodic intervals

Two types of swaps:

Single currency interest rate swap interest rateswap fixed for floating swap

Cross-Currency interest rate swap currency swap fixed for fixed swap

The market for currency swaps evolved first, buttoday the market for interest rate swaps is larger


The Short-term Currency Swap


133/189

Bank of England (BoE) wants to borrow USD fromthe Bundesbank (Buba)

Buba asks, as security, an equivalent amount of GBP(to be deposited by the BoE with the Buba)

Barring default, on the expiration day the USD and theGBP would each be returned, with interest, to the

respective owners


The Short-term Currency Swap An Example


134/189

ExampleS = 2.50 $/, r$= 3%, r = 5%

Time t:

BoE receives $100m from the Buba for six months

BoE deposits 100m/2.5 = 40m into an escrowaccount with the Buba

Time T:

Buba returns 40m x 1.05 = 42m BoE returns $100m x 1.03 = $103m


Back-to-back Loans


135/189

UK institutional investor (UKII) wants to invest inUS, but an investment dollar premium makesforeign investments expensive to UK investors

UKII wants to avoid the spot market at t and T

UKII sets up a deal with a foreign firm (USCo) thatwants to invest in the UK

USCo lends $ to UKII

UKII lends to USCo (or its UK subsidiary)

Right of offset between these two loan contractsif (say) UKII cannot pay back, USCo can withholdits payments and sue for the net loss (if any)


Back-to-back Loans


136/189

USD

Flow of initial principals under a back-to-back loan

USD capital

market

UKIIUSCos

subsidiary

USCo

GBP


Parallel Loans (I)


137/189

USCo faces capital export controls

she cannotexport USD to its UK subsidiary

UKCo wants to lend to its US subsidiary, but there

is a dollar premium

Both can avoid the spot market by granting loans to

each other (or to each others subsidiary), with aright of offset in the two loan contracts


Parallel Loans (II)


138/189

The initial flows of principal under a parallel loan

UKCos

subsidiary

UKCo

USCos

subsidiary

USCoUSD

GBP


The Modern Currency Swap


139/189

Two parties agree to exchange, at time t, two initially equivalent principals

denominated in different currencies may beskipped

return these principals to each other at T

pay the normal interest, periodically, to each other onthe amounts borrowed

One single contract, with a right of offset


The Swap Bank


140/189

A swap bank a financial institution thatfacilitates swaps between counterparties

The swap bank can serve as either a broker or a

dealer. Broker it matches counterparties but does notassume any of the risks of the swap

Dealer it stands ready to accept either side of a

currency swap, and then later lay off their risk, ormatch it with a counterparty


Absolute advantage in borrowing


141/189

A US MNC needs to borrow CHF 1.6m for the next 4 years

A Swiss MNC needs to borrow $1m for the same period

Spot rate: 0.625$/CHF

Borrowing opportunities:

US dollar CHF

US MNC 6.00% p.a. 5.00% p.a.

Swiss MNC 7.50% p.a. 3.50% p.a.

Absolute advantage 1.50% 1.50%




142/189

US MNC

Swap

Bank

$6%

$6%

CHF 4% CHF 3.5%

$6.5%

SwissMNC

CHF 3.5%

US

Bank

Swiss

Bank




143/189

US MNC

Swap

Bank

$6%

$6%

CHF4% CHF3.5%

$6.5%

SwissMNC

CHF3.5%

US

Bank

Swiss

Bank

US MNCs net position is to borrow at CHF4%

US MNC saves CHF1%




144/189

US MNC

Swap

Bank

$6%

$6%

CHF4% CHF3.5%

$6.5%

SwissMNC

CHF3.5%

US

Bank

Swiss

Bank

Swiss MNCs net position is to borrow at $6.5%

Swiss MNC saves $1%




145/189

US MNC

Swap

Bank

$6%

$6%

CHF4% CHF3.5%

$6.5%

SwissMNC

CHF3.5%

US

Bank

Swiss

Bank

The swap bankmakes money too:

+0.5% on CHF

+0.5% on $

The swap bank facesexchange rate risk, butmaybe they can lay itoff in another swap.


Comparative advantage inborrowing


146/189

Consider two firms A and B: Firm A U.S.based multinational Firm B U.K.based multinational

Both firms wish to finance a project in each otherscountry of the same size borrowingopportunities

$

Company A 8.0% 11.6%Company B 10.0% 12.0%




147/189

Ais the more credit-worthy of the two firms

Still,Ahas a comparative advantage in borrowingin dollars it borrows at 2% less than B

B has a comparative advantage in borrowing inpounds it borrows at only 0.4% less than A

If they borrow according to their comparative

advantage and then swap, there will be gains forboth parties




148/189

CompanyA

Swap

Bank

$8% 12%

$8%

11%12%

$9.4%

Company

B




149/189

$8% 12%

$8%

11%12%

$9.4%

As net position is to borrow at 11%

A saves 0.6%

Swap

Bank

CompanyA

Company

B




150/189

$8% 12%

$8%

11%12%

$9.4%

Bs net position is to borrow at $9.4%

B saves $0.6%

Swap

Bank

CompanyA

Company

B




151/189

$8% 12%

$8%

11%12%

$9.4%

The swap bankmakes money too:

At S0($/) =$1.60/, that is a

gain of $64,000 peryear for 5 years.

The swap bank faces exchange rate risk, but maybe they canlay it off in another swap.

1.4% of $16 million

financed with 1% of10 million per year

for 5 years.

Swap

Bank

CompanyA

Company

B


Swap rates


152/189

The interest payments for each currency are basedon the currencys swap (interest) rate yieldsat par for near-riskless bonds with the same

maturity as the swap

Why risk-free rates?

Right-of-offset clause

Probability of default is small


Costs


153/189

A commission of, say, USD500 on a USD1m swap, for eachpayment to be made

Equivalent up-front fee is asked

Example

7-year yields at par: 7.17% on USD and 9.9% on DEM

The swap dealer quotes:

USD 7.13% - 7.21%

DEM 9.85% - 9.95%

If you borrowDEM and lendUSD you pay 9.95%on the DEM, and you receive 7.13% on the USD


Valuation of currency swaps (I)


154/189

A company swaps a loan of GBP 50m into USD 100m for 7years swap rates: 10% on USD leg and 12% on GBP leg

Spot rate at the beginning of the swap: 2 USD/GBP

Two years after the inception of the swap, the swap rateshave changed: 8% on the USD leg and 14% on the GBP leg

Also, the spot rate has changed to 1.7 USD/GBP

Which is the value of this swap at the inception and aftertwo years?


Valuation of currency swaps (II)


155/189

The initial exchange of principals is a zero-valuetransaction, since the amounts are initially equivalent

The future interest payments have also equal presentvalues

At inception:

At the spot rate of 2 USD/GBP, the two legs are equivalentswap value =0

$100m1.1

100m

1.1

10mPV

7

7

1ttUSD

GBP50m1.12

50m

1.12

6mPV

7

7

1ttGBP


Valuation of currency swaps (III)


156/189

After two years:

Swap value = PV of inflows PV of outflows

For the company paying USD:

PV of swap in USD = GBP46.567m 1.7 USD/GBP

USD107.985m

= -USD28.821 NET LIABILITY

$107.985m1.08100m

1.0810mPV

5

5

1ttUSD

GBP46.567m1.14

50m

1.14

6mPV

5

5

1ttGBP



157/189


Topic 4 Managing and Measuring Exposureto FX Risk

Topic 4 Outline

1 FX Exposure taxonomy


158/189

1. FX Exposure taxonomy

2. Measuring transaction exposure (TREX)

3. Managing transaction exposure using financial

instruments

Forward contracts

Money market operations

Currency options


Risk and exposure to risk

Exchange risk uncertainty about the future spot rate


159/189

Exchange risk= uncertainty about the future spot rate

measured by2

(St)or (St) currency variability levels may change over time

Currency 1981-1993 1994-1998

British pound 0.0309 0.0148Canadian dollar 0.0100 0.0110Japanese yen 0.0279 0.0298

New Zealand dollar 0.0289 0.0190Swedish krona 0.0287 0.0195Swiss franc 0.0330 0.0246Singapore dollar 0.0111 0.0174

Standard Deviations of Exchange Rate MovementsBased on Monthly Data


Risk and exposure to risk

Exchange rate exposure: measures how sensitive the


160/189

Exchange rate exposure: measures how sensitive the

(home-currency) value of a firm, an asset/liability, orcash flow is to changes in the exchange rate

Example A portfolio contains (1) a CHF (=FC) T-bill maturing at

time t, with face value CHF100,000, and (2) a USD (=HC)T-bill with face value at time t of USD50,000

Vt= USD50,000 + CHF100,000 x St Exposure = CHF100,000

t

t

tt

tt

S

V

)E(SS

)E(VVExposure


Types of foreign exchange exposure

Transaction (contractual) exposure


161/189

Transaction (contractual) exposure

measures changes in the value of outstanding financialobligationsincurred prior to a change in exchange ratesbut not due to be settled until after the exchange rateschange

deals with changes in cash flows the result from existing

contractual obligations Vt= HC value of contractually fixed cash flows

Operating (economic, competitive, strategic) exposure measures the change in the market value of the firm

resulting from any change in future operating cash flowsof the firm caused by an unexpectedchange in exchangerates

Vt= market value of the firm


Types of exchange rate exposure

Accounting (translation) exposure


162/189

Accounting (translation) exposure

Occurs because of the need to translate FC financialstatements of foreign affiliates into a single currency toprepare worldwide consolidated financial statements

Vt= book value of the firm when consolidation occurs

Moment in time whenexchange rate changes

Accounting exposure

Transaction exposure

Operating exposure

Time


Which exposure matters most?A survey of corporate treasurers and CFOs


163/189

Jesswein, Kwok, Folks Adoption of Innovative Products in Currency RiskManagement: Effects of Management Orientations and ProductCharacteristics,Journal of Applied Corporate Finance, Fall 1995

Mean score of

level ofagreement

Managing transaction exposure is important 1.4

Managing operating exposure is important 1.8

Managing translation exposure is important 2.4

(1) strongly agreed(5) strongly disagreed


Do companies hedge FX risk?


164/189

GM is exposed to market risk from changes in foreigncurrency exchange rates, interest rates, and certaincommodity prices. In the normal course of business, GMenters into a variety of foreign exchange, interest rate, andcommodity forward contracts, swaps, and options, with the

objective of minimizing exposure arising from these risks. Arisk management control system is utilized to monitorforeign exchange, interest rate, commodity, and relatedhedge positions.

General Motors Annual Report, 2004


Do companies hedge FX risk?


165/189

In the normal course of business, we are exposed toforeign currency exchange rate, interest rate and equityprice risks that could impact our financial position resultsof operations. Our risk management strategy with respectto these three market risks includes the use of derivative

financial instruments. We use derivatives only to manageexisting underlying exposures of HP. Accordingly, we do notuse derivative contracts for speculative purposes.

Hewlett-Packard Annual Report, 2004


Measuring TREX

Sources of TREX:


166/189

f

Purchasing or selling on credit goods or services whoseprices are stated in foreign currencies

Borrowing or lending funds when repayment is due inforeign currencies

Being a party to an existing foreign exchange forwardcontract

Otherwise acquiring assets or incurring liabilitiesdenominated in foreign currencies

Attributes of TREX:

It is typically a short-termexposure

High certainty regarding the exposure timing andamount


Measuring TREX from transactions at aparticular date

Inflows: FC accounts receivables


167/189

Inflows: FC accounts receivables

FC long-term sales contractsFC deposits, bonds, notes

Forward purchase of FC

Outflows: FC accounts payableFC long-term purchase contracts

FC loans, bonds, notes

Forward sales of FC

Net Exposure= Total inflows Total outflows

Only this amount is hedged



Example:


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Example:

Spanish firm with USD commitments recorded on May 1:

1. A/Rs:USD 100,000 - June 1; USD 2,200,000 - July 1

2. Expiring deposits: USD 3,000,000 - June 1

3. A/Ps: USD 2,300,000 - June 1; USD 1,000,000 - July 1

4. Loan due: USD 2,300,000 - July 1




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Transaction June 1 July 1

INFLOWS A/R 100,000 2,200,000

Deposit 3,000,000OUTFLOWS A/P -2,300,000 -1,000,000

Loan -2,300,000

NET EXPOSURE 800,000 -1,100,000


Hedging using forward contracts

If you are going to owe foreign currency in the future


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If you are going to oweforeign currency in the future,

agree to buythe foreign currency now by entering intolong position in a forward contract.

If you are going to receive foreign currency in the

future, agree to sell the foreign currency now byentering into short position in a forward contract.

Example: Swiss exporter, A/R $1 million, 3 monthsmaturity, S0= 1.5000 CHF/$, F90= 1.4960 CHF/$


1 51



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1.49

1.492

1.494

1.496

1.498

1.5

1.502

1.504

1.506

1.508

1.51

1.490 1.492 1.494 1.496 1.498 1.500 1.502 1.504 1.506 1.508 1.510

Spot rate in 3 months

A/Rvalue(C

HF,millions) Unhedged

Forward hedgeGains fromforward hedge

Losses from

forward hedge



Forward contracts eliminate FX risk certainty over


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Forward contracts eliminate FX risk certainty overfuture revenues and payments in FC, when translated inHC

Which is the cost of using forwards for hedging?

Realcost compare forward rate with the future spot

Expectedcost = 0 (if forward rate is unbiased)

Possibility of bias in forward rate SELECTIVE

HEDGING: Long FC hedge when FC is at a forward discount

Short FC hedge when FC is at a forward premium

1

10,1

S

SFcostReal

It can be known only at contract

maturity


Money market hedge Sunrise

Sunrise Corp. (US) has sold umbrellas to a Spanish


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p ( ) pcompany and billed it 1m euros, to be paid in 1 year

A/R of 1m euros, 1 year maturity S0: 1.1933$/euro, F12m:1.1850$/euro, i$=3.5% p.a.,

ieuro= 4% p.a.

Money market hedge: Borrow euros now 1m/1.04 = 0.9615m euros Sell 0.9615m euros against $ at 1.1933$/euro

1.1474m$

Invest 1.1474m$ at 3.5% 1.1876m$ in one year hence

In one year, use the 1m euro from the contract to paythe loan

Total result (certain): 1.1876m$


Forward vs. money market hedge

When should you use them?


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When should you use them?

If IRP is holding the results of forward hedge andmoney market hedge will be the same

If IRP is not holding proceeds from money markethedge will not be the same as those from forward hedgeone hedging method will dominate the other

Be aware of the fact that there might be highertransaction costs associated to hedging using money

market as compared to forward: Bid-ask spread on the forward contract

Difference between borrowing and lending rates


Hedging using options


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Options provide a flexible hedge against thedownside, while preserving the upside potential.

To hedge aforeign currency receivable/asset buyputs on the currency

If the FC depreciates, your put option lets you sell thecurrency for the exercise price.

Options provide a floor price on the domestic

currency value of foreign exchange:

Floor price = Exercise price of put Put premium


Hedging an A/R using FX options

Boeing has anA/R of 10m GBP for 1 year


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Boeing buys a put option on 10m GBP, X=$1.46/GBP,

Pr=$0.02/GBP ($200,000 for the option)

13.80

14.00

14.20

14.40

14.60

14.8015.00

15.20

15.40

15.60

1.40 1.42 1.44 1.46 1.48 1.50 1.52 1.54

Spot rate in one year ($/GBP)

A/Rv

alue($,

millions) Unhedged

Hedging with a put

Floor price


Hedging using options


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To hedge a foreign currency payable/liability buycalls on the currency.

If the FC appreciates, your call option lets you buythe currency at the exercise price of the call.

Options provide a ceiling price on the domesticcurrency value of foreign exchange:

Ceiling price = Exercise price of call + Call premium


Hedging an A/P using FX options

Boeing has anA/P of 5m GBP for 1 year


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6.90

7.00

7.10

7.20

7.30

7.40

7.50

7.60

7.70

7.80

1.40 1.42 1.44 1.46 1.48 1.50 1.52 1.54

Spot rate in one year ($/GBP)

A/Pvalu

e($,

millions)

Boeing buys a call option on 5m GBP, X=$1.46/GBP,Pr=$0.025/GBP ($125,000 for the option)

Unhedged

Hedging with a call

Ceiling price


Hedging an A/R - Dayton Manufacturing

Dayton Manufacturing, US-based maker of gasbi i ld i M h bi


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turbine equipment, sold in March a turbine generator

to Crown, a British firm, for 1,000,000. Paymentdue three months later, in June.

The following information is available to the CFO ofDayton:

Spot exchange rate: $1.7640/

3-month forward rate: $1.7540/

UK 3-month interest rates: 8.0% - 10.0% US 3-month interest rates: 6.0% - 8%


Dayton Manufacturing

June put option; OTC market for 1,000,000: strike


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p p ; , ,

price $1.7500 (nearly ATM); 1.5% premium paid atcurrent spot

June put option; OTC market for 1,000,000: strikeprice $1.7100 (OTM); 1.0% premium paid at current

spot Daytons foreign exchange advisory service forecasts

that the spot rate in 3 months will be $1.7600/

The minimum acceptable margin for the contract is at

a sale price of $1,700,000 the budget rate =$1.7000/



F lt ti il bl t D t


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Four alternatives are available to Dayton:

1. Remain unhedged

2. Hedge in the forward market

3. Hedge in the money market

4. Hedge in the options market



1. Unhedged position


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g p

Today Three months hence

Do nothingReceive 1,000,000

Sell 1,000,000 spot and

receive $ at spot rateexisting then



2. Forward Market Hedge


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g

Three months hence

Sell 1,000,000 forward@$1.7540/

Receive 1,000,000

Deliver 1,000,000 againstforward sale

Receive $1,754,000

Today




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3. Money market hedge

Today

Receive 1,000,000

Repay 975,610 loan plus24,390 interest, for a total of

1,000,000

Receive 1,746,790 $

Three months hence

Borrow 975,610 @ 10% p.a.

Exchange 975,610 for $ @$1.7640/

Receive $1,720,976 cash

Invest $1,720,976 @ 6% p.a.



4. Options market hedge (ATM option illustrated)


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p g ( p )

Today Three months hence

Buy put option to sell @$1.75/

Pay $26,460 for put option

Receive 1,000,000

Either deliver 1,000,000 againstput, receiving 1,750,000; or sell

1,000,000 spot if current spot rate> $1.75/




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Put Option Strike Price ATM Option

$1.75/

OTM Option

$1.71/

Option cost $26,460 $17,640

Proceeds if exercised $1,750,000 $1,710,000

Minimum net proceeds $1,723,540 $1,692,360

Maximum net proceeds Unlimited Unlimited


1,84$)



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1,68

1,7

1,72

1,74

1,76

1,78

1,8

1,82

1,84

1,68 1,69 1,7 1,71 1,72 1,73 1,74 1,75 1,76 1,77 1,78 1,79 1,8 1,81 1,82 1,83 1,84

Ending spot exchange rate ($/)

Dayton'srevenuesf

romA

/R(millio

ns

Uncove

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