FIN 40500: International
Finance
Forwards, Futures and Options
Derivative Securities vs. Stocks/Bonds
Derivative securities
Stocks and Bonds on the other hand
represent claims to represent contracts
specific future cash that designate future
flows transactions
Currently, there are approximately 300 million derivative
contracts outstanding with a market value of around $50 Trillion!!!
Derivative securities can be used for hedging or for speculation
Porsche expects $12.5M in Mercedes need to acquire
US sales over the next month $12.5M to meet its payroll for
that that it would like to its Tuscaloosa, Alabama plant
repatriate back to Germany
Porsche is worried that the Mercedes is worried that the
dollar might depreciate over dollar might appreciate over
the next month the next month
Both Porsche and Mercedes could avoid their potential
currency risk by entering into a forward contract.
Forward contracts are individualized contracts to buy/sell a currency at a
pre-specified date and for a pre-specified price.
Deutsche
Bank
Deutsche Bank
negotiates a
Porsche Mercedes
approaches price of $1.25 approaches
Deutsche per Euro Deutsche
Bank with an Bank with an
offer to buy offer to sell
In 30 days, Porsche will
Euro 30 days Euro 30 days
buy 10 Million Euro from
forward forward
Mercedes for $12.5M
On Settlement day, Porsche delivers its $12.5M and acquires 10M
Euro. Had it instead bought Euro in the spot market, It would’ve
needed $12.9M to buy 10M Euro – Porsche “gains” $400,000
1.295
1.29 e = 1.29
1.285
EUR/USD
1.28
F = 1.25
1.275
1.27
1.265
1.26
1.255
0 4 8 12
Days 15 18 23 27
Note that Mercedes has an equal “loss” of $400,000
Forward contracts are available on all
the major currencies
Spot
33%
EUR/USD 1.2762
Futures
56%
1 month 1.2786
Forward
3 months 1.2836 11%
6 months 1.2905
12 months 1.3026
The published prices are not
actual contract prices but the
average of contracts made at
major banks.
In 1972, the Chicago Mercantile Exchange began trading
currency Futures. By 2004, the number of currency
futures outstanding stood at 48M with a value of
approximately $5T!!
Futures are standardized (size and maturity), exchange traded
commodities
Currency futures trade in a March, June,
September, December expiration cycle –
Delivery is made on the 3rd Wednesday of the
month and the contracts are traded up to two
days prior to delivery.
Jan Mar June Sept. Dec.
Futures are available for a wide range of commodities and assets
Currencies Agriculture Metals & Financial
Energy
British Pound Lumber Copper Treasuries
Euro Milk Gold LIBOR
Japanese Yen Cocoa Silver Municipal Index
Canadian Dollar Coffee Platinum S&P 500
Mexican Peso Sugar Oil DJIA
Cotton Natural Gas Nikkei
Wheat Eurodollar
Cattle
Soybeans
Currency Contract Size
Australian Dollar AUD 100,000
Brazilian Real BRR 100,000
British Pound GBP 62,500
Canadian Dollar CAD 100,000
Czech Koruna CZK 4,000,000
Euro EUR 125,000
Hungarian Forint HUF 30,000,000
Japanese Yen JPY 12,500,000
Mexican Peso MXN 500,000
New Zealand Dollar NZD 100,000
Norwegian Krone NKR 2,000,000
Polish Zlotny PLZ 500,000
Russian Ruble RUB 2,500,000
South African Rand ZAR 500,000
Swiss Franc CHF 125,000
There are also cross rate futures traded (EUR/GBP, EUR/JPY, and
EUR/CHF) in contract sizes of EUR 125,000
Futures are standardized (size and maturity), exchange traded
commodities (Chicago Mercantile Exchange)
Opening, High, Low, Total Contracts bought/sold
and Closing Price that day (000s)
EUR 125,000
Strike Open High Low Settle Pt Volume Interest
Chge
Mar06 1.2700 1.2804 1.2698 1.2756 +170 3500 8993
Jun06 1.2850 1.2987 1.2800 1.2799 -150 3 34
Sept06 ------ ------ ------ ----- UNCH ----- -----
Contracts Outstanding
Settlement Date Change From Prior Day (in Pips)
(000s)
Chicago
Mercantile
Exchange
Mercedes
The CME simultaneously goes short
Porsche
goes long buys 80 contracts from on 80 Euro
on 80 Euro Mercedes and sells 80 contracts
contracts contracts to Porsche
From the previous example, if Porsche is buying 10M Euro, it would
need to purchase 80 Euro futures contracts (125,000 x 80 = 10M )
Futures contracts are marked to market daily. That is, profits and losses
are kept track of on a daily basis.
Suppose that Porsche goes long on 80 Euro contracts at
a price of $1.25 per Euro – The total cost of the contract
is $12.5M
Porsche is required to deposit an initial performance bond equal
to 2% of the contract value – this can be in the form of cash or a
Treasury bill.
2% of $12.5M = $250,000
May 1 June 21
Delivery Date
On May 1, Porsche deposited $250,000 worth of Treasury
Bills into its maintenance account.
On May 2, the closing price for June Euro futures is
$1.27. Porsche’s profit on its contract is $200,000. This is
deposited into Porsche’s maintenance account ($450,000
balance).
On May 3, the closing price for June Euro futures
is $1.24. Porsche’s one day loss on its contract is
$300,000. This is withdrawn from Porsche’s
maintenance account ($150,000 balance).
May 1 May 2 May 3 June 21
Delivery Date
When your maintenance account drops below 75% of its original
value, you must add to it!!
While the overwhelming majority (90%) of forward contracts end with
actual delivery of the currency, very few futures contracts (1%) result in
delivery.
Suppose that on June 3, Porsche wishes to end its futures
contract. Suppose that the current price of a June Euro future
is $1.28
Porsche goes short on 80 June Euro
futures at a price of $1.28. The two
contracts offset one another and
Porsche goes home with its profit of
$300,000
May 1 June 3 June 21
F = $1.25/Euro Delivery Date
Essentially, futures positions are making “bets”
on the price of the underlying commodity.
Profits from
Long Position
price increases
Short Position Profits from price
decreases
Treasury futures first began trading on the CME in 1976. The
underlying commodity is a $1M Treasury Bill with 90 days to maturity.
Remember, when interest rates rise, Treasury prices fall!
FV P 360
DY 100
FV n
Profits from Profits from
Long Position price decreasing
increases interest rates
Profits from Profits from
Short Position price increasing
decreases interest rates
T-Bill futures are listed using the IMM (International
Monetary Market) Index
IMM = 100 – Annualized Discount Yield
For example, if the Price of a $100, 90 Day Treasury were $98.
$100 $98 360
DY 100 8%
100 90
IMM = 100 – 8 = 92
Note that Every .01 increase in the IMM raises the value of a
long T-Bill position by $25 (per basis point).
Eurodollar futures were introduced in 1981 as an alternative to
Treasury futures.
The underlying commodity is a $1M, 3 month Eurodollar time
deposit. However, these deposits are not marketable.
Therefore, Eurodollar futures are settled on a cash basis
Eurodollar futures can be treated like a T-Bill Future
IMM = 100 – Annualized LIBOR
Every .01 increase in the IMM raises the value of the long
position by $25 (per basis point)
Eurodollar Futures vs. T-Bill Futures
T-Bill Futures Eurodollar
Contract Futures
Contracts
Volume (2001) 123 730,000
As the Eurodollar market grew, it became more liquid
relative to the T-Bill market
LIBOR is a “risky” rate. Therefore, it correlates better
with other risks
Suppose that you expect to receive $20M in June. You do not need
the $20M until September. The current 3 month LIBOR rate is 2.91%
(Annualized)
This $20M should be invested from June to September to earn interest,
but currently the interest rate from June to September is uncertain.
June Eurodollar futures are currently trading at 96.56
IMM = 96.56
$20M $20M
LIBOR = 2.91% received needed
May 1 June September
The June Eurodollar futures with a 96.56 price implies an annualized
rate of return equal to 3.44% from June to September
You can “lock in” the 3.44% interest rate by taking a long position in
Eurodollar futures. Suppose that you purchase 20 Eurodollar
contracts at the current price of 96.56.
3.44%
IMM = 96.56
$20M $20M
received needed
May 1 June September
Suppose that in June, the LIBOR rate is 3.10% Annualized.
You receive your $20M in June and deposit it in a
Eurodollar account at 3.1% (annual) interest. Your interest
earned well be $155,000 - $20M*(.031/4)
Your profit from the Future is (96.90-96.56)(100)($25)(20) = $17,000
Your total gain is $17,000 + $155,000 = $172,000
(3.44% Annualized return)
3.10%
You paid 96.56 per
contract in May (20
contracts) IMM = 96.90
May 1 June September
Unlike a future, an option gives the owner the right, but not the
obligation to buy or sell the underlying commodity.
Call Option
The owner (long position) on a call option has the right but not
the obligation to buy the underlying commodity at the
predetermined price
The seller (writer) of the call option has the obligation to sell the
underlying commodity if the option is exercised.
Put Option
The owner (long position) on a put option has the right but not
the obligation to sell the underlying commodity at the
predetermined price
The seller (writer) of the put option has the obligation to buy the
underlying commodity if the option is exercised.
The stated price that the underlying commodity is bought or sold at is
known as the strike price.
In December 1982, the Philadelphia Stock Exchange started
trading American and European options on foreign currency.
Can only be exercised at
maturity
Can be exercised at any time during the
life of the contract
Traded options have an expiration cycle March, June, September and
December with original maturities of 3,6,9,and 12 months.
Currency Contract Size
Australian Dollar AUD 50,000
British Pound GBP 62,500
Canadian Dollar CAD 50,000
Japanese Yen JPY 6,250,000
Swiss Franc CHF 62,500
Euro EUR 62,500
At expiration, an American option and a European option that has not
been exercised will have the same terminal value.
Call option Put option
C max S E ,0 P max E S ,0
Exercise price of the option
contract
Spot price of the underlying asset
Remember, as the owner of the option, you will not exercise if it is
unprofitable!!
Suppose that you purchase a call option on Euro at an exercise
price of 130 ($1.30 per Euro). The standard Euro contract is 62,500
Euro.
Expiration Value
V ($1.35 $1.30)(62,500) $3,125
Spot Exchange
Rate
$1.30 $1.35
Here, the option is “out of the money”
and will not be exercised.
Note that the writer of the call has the opposite payout (as with
futures, this is a zero sum game)
Expiration Value
Spot Exchange
$1.30 $1.35 Rate
V ($1.30 $1.35)(62,500) $3,125
Options have a premium attached to them. This is the price that the buyer
pays for the option contract. Suppose that the premium on this Euro call is
4.59 cents per Euro (the option will cost .0459*62,500 = $2,868.75)
Expiration
Value V ($1.35 $1.30)(62,500) 2,868.75 $256.25
$1.3459
Spot
Exchange
-$2,868.75 Rate
$1.30 $1.35
Suppose that you purchase a put option on Euro at a strike price of
$1.30. The premium on this option is 3.50 cents per Euro
(.035*62,500 = $2,187.50)
Expiration
Value V ($1.30 $1.25)(62,500) $2,187.50 $937.50
$1.2650
$1.30
Spot
$1.25 Exchange
-$2,187.50 Rate
The previous example dealt with “vanilla options”. There are many,
many more “exotic” options.
Bermuda Options: Can be exercised at various, predetermined dates
over the life of the contract
Asian Option: Also known as an average option – exercised at
maturity and the payoff is based on the average price of the underlying
commodity over the life of the contract.
Barrier options: The payoff is contingent on whether or not the
underlying commodity has reached a predetermined price
Compound Options: The underlying commodity is an option
Digital Option: Also known as a binary option – the payout is fixed
once the strike price has been reached.
You can also buy options on futures contracts.
Currency swaps are contracts to convert known income/payment
streams from one currency to another – think of them as a
portfolio of forwards with varying maturities/strikes
As with forward contracts, swaps are individualized and not
traded.
Suppose that IBM wishes to raise funds by issuing a 5 year Swiss
Franc denominated Eurobond with a face value of CHF 100,000
and fixed annual coupon payments of 6%. Up front, IBM receives
CHF 100,000. IBM plans on using the proceeds to finance
domestic operations
0 Yrs 1 Yrs 2 Yrs 3 Yrs 4 Yrs 5 Yrs
IBM owes IBM owes IBM owes IBM owes
CHF 6,000 CHF 6,000 CHF 6,000 CHF 6,000
IBM Collects CHF IBM owes CHF
100,000 106,000
IBM Wishes to hedge
its currency exposure
IBM enters into a swap
agreement with
0 Yrs 1 Yrs 2 Yrs 3 Yrs 4 Yrs 5 Yrs
IBM buys IBM buys IBM buys IBM buys
CHF 6,000 CHF 6,000 CHF 6,000 CHF 6,000
@ .845 @ .830 @ .800 @ .840
IBM Sells
CHF IBM buys CHF
100,000 106,000
@ .844 @ .836
This swap is very similar to buying/selling six separate futures
contracts and is priced in a similar fashion
The Bottom Line…
There is a virtually endless set of options
(pardon the pun) for hedging currency exposure.
However, your ability to effectively and efficiently
hedge depends on your understanding of the
specific exposure that you face!!