FOS by chenshu

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									Currency Futures &
 Options Markets
   Objectives: to Understand
• How currency futures and options contracts
  are used to manage currency risk & to
  speculate on future currency movements
• The nature of currency futures and options
  contracts and
• The difference between futures & options
  contracts
• The factors that determine the value of an
  option

   Futures             Fred Thompson           2
Currency Risk
               Definition

• Currency Risk = Variability in the value
  of an exposure caused by uncertainty
  about exchange rate changes.




   Futures            Fred Thompson          4
             Currency Risk
• Degree of risk is a function of 2
  variables
  – Volatility of exchange rates
  – Amount of exposure
• Degree of Risk
  – Low = rate fixed, low exposure
  – High = rate volatile, high exposure


   Futures              Fred Thompson     5
What Happens if the Yen falls?



                    QuickTime™ an d a
           TIFF (Uncompressed) decompressor
              are need ed to see this p icture .




 Futures                 Fred Thompson             6
   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.




   Futures              Fred Thompson              7
         What is an exposure?
• Liabilities > assets = net exposure
  (short)
• If you are borrowing Yen to buy $
  denominated assets? Are you short or
  long?
• Who is long?
• Who is long on $? Who is short?

   Futures          Fred Thompson        8
                Hedging
• To hedge a foreign exchange exposure, one
  takes an equal and opposite position from
  that of the exposure.
• For example, if folks are long the pound, they
  would have to take an offsetting short
  position to hedge their exposure.
• One who is long in a market is betting on an
  increase in the value of the thing, whereas
  with a short position they are betting on a fall
  in its value.
  Futures               Fred Thompson                9
  You Can Hedge with Financial
          Derivatives!
• Contracts that derive their value from
  some underlying asset
  – Forwards
  – Futures
  – Options
  – Swaps



   Futures           Fred Thompson         10
             For example
• Vanilla bond -- coupon and principal
  – First stage decomposition
  – Second stage decomposition
  – Options
• What assets underlie currency
  derivatives?


   Futures           Fred Thompson       11
Currency Futures
             Currency Futures
• Traded on centralized exchanges (illustrated
  in Figure 1 later)
• Highly standardized contracts
  – Size [A&C$100K, £62.5k, €125k, ¥12.5m] &
    maturity [delivery date]
• Clearinghouse as counter-party
• High leverage instrument
  – Daily settlement
  – Margin requirements

   Futures                Fred Thompson          13
          Currency Futures
• Performance Bond or Initial Margin: The
  customer must put up funds to guarantee the
  fulfillment of the contract - cash, letter of
  credit, Treasuries.
• Maintenance Performance Bond or Margin:
  The minimum amount the performance bond
  can fall to before being fully replenished.
• Mark-to-the-market: A daily settlement
  procedure that marks profits or losses
  incurred on the futures to the customer’s
  margin account.
    Futures                Fred Thompson          14
Sample Performance Bond Requirements
            From the CME, 15 March 2000


   Currency Futures    Initial Maintenance
   Australian Dollar   $1,317    $975
   British Pound       $1,620    $1,200
   Canadian Dollar     $642      $475
   Deutsche Mark       $1,249    $925
   Euro                $2,430    $1,800




  Futures                Fred Thompson       15
How an Order is Executed (Figure from the CME)
                    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 (P) 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 P and the dollar.

    Futures               Fred Thompson               17
              Example, continued
• The firm is long the peso, so to hedge its
  exposure it will go short [sell P] in the futures
  market.
• The face amount of each peso future contract
  is P500,000, so the firm will go short 8
  contracts.
• If the peso depreciates, the dollar value of its
  Mexican division’s profits falls, but the futures
  account generates profits, at least partially
  offsetting the loss. The opposite holds for an
  appreciation of the peso.
    Futures               Fred Thompson               18
Gain   Underlying Long Position




         Change spot value
        Change in futures price




         Futures Position
Loss
         Example, continued
• The previous diagram can be used to
  illustrate 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.
     Futures                Fred Thompson             20
             Example, continued
• On the 25th, the spot rate opens at 0.10660
  ($/P) while the price on a P future opens at
  0.10310.
• The market closes at 0.10635 and 0.10258
  respectively.
• The loss on the underlying position is:
•     (0.10635-0.10660)P4 mil. = -$1,000
• The gain on the futures position is:
•     (0.10310-0.10258)8P500,000=$2,080
   Futures              Fred Thompson            21
Gain and Loss on Underlying and Futures Position
                    Day 1                 Underlying Long Position
                                         Gain
                                                         P4 million

                                           $2,080




                              -0.00025              Change spot value

                   -0.00052
                                                    Change in futures price
                                           $1,000




                                                    Futures Position
                                                     P500,000 x 8
                                         Loss
             Example, continued
• On the 28th, the spot rate moves to
  0.10670 ($/P) and the price on a P
  future to 0.10285.
• The gain on the underlying position is:
•     (0.10670-0.10635)P4 mil. = $1,400
• The loss on the futures position is:
•     (0.10258-0.10285)8P500,000=-$1,080

   Futures            Fred Thompson          23
Gain and Loss on Underlying and Futures Position
                    Day 2                 Underlying Long Position
                                  Gain
                                                    P4 million

                             $1,400




                                         0.00032 Change spot value
                                              0.00035
                                              Change in futures price


                             $1,080



                                              Futures Position
                                               P500,000 x 8
                                  Loss
             Example, continued
• On the 29th, the spot rate moves to
  0.10680 ($/P) and the price on a P
  future to 0.10290.
• The gain on the underlying position is:
•     (0.10680-0.10670)P4 mil. = $400
• The loss on the futures position is:
•     (0.10285-0.10290)8P500,000=-$200

   Futures            Fred Thompson         25
Gain and Loss on Underlying and Futures Position
                    Day 3                 Underlying Long Position
                                 Gain
                                                          P4 million

                              $400




                                            0.0001   Change spot value
                                                 0.00005
                                                 Change in futures price


                              $200



                                                     Futures Position
                                                      P500,000 x 8
                                     Loss
              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.

    Futures             Fred Thompson              27
             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 P futures, reversing
  your current position and closing out
  your account. [offsetting trade]

   Futures            Fred Thompson           28
         Additional Information
For additional information on currency
  futures, visit the following sites:
• The Chicago Mercantile exchange
• The Futures Industry Institute




   Futures           Fred Thompson       29
Currency Options
              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.
• How are currency options simultaneously
  both put & call options?
    Futures              Fred Thompson              31
             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.



   Futures           Fred Thompson         32
             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.


   Futures             Fred Thompson             33
             Currency Options
• If the spot rate has not yet reached the
  exercise price [S<X], the option cannot be
  exercised and is said to be “out of the
  money.”
• If the spot rate equals the exercise price
  [S=X], the option is said to be “at the money.”
• If the spot rate has surpassed the exercise
  price [S>X], the option is said to be “in the
  money.”

   Futures               Fred Thompson              34
              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 price of 152 ($/€) and a premium of
  0.94 (both cents per €).
• The face amount of a euro option is €62,500.
• The total premium is:
           $0.0094·4·€62,500=$2,350.

   Futures             Fred Thompson             35
               Call Option: Hypothetical Pay-Off
    Profit
                                                   Payoff Profile

$1,400

                      152   152.5
     0                                                   Spot Rate
             148.15                 152.94       153.5
-$1,100                             Break-Even



-$2,350

           Out-of-
      Loss
           the-money At      In-the-money
               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 150 ($/€) and a premium of 1.95
  (both cents per €).
• The face amount of a euro option is €62,500.
• The total premium is:
           $0.0195·8·€62,500=$9,750.

   Futures             Fred Thompson             37
                      Put Option: Hypothetical payoff
     Profit                at a spot rate of 148.15

              Payoff Profile

                 Break-Even
                   148.05      150
      0                                                 Spot Rate
  -$500                 148.15



-$9,750

     Loss     In-the-money At Out-of-the-money
   Option Pricing & Valuation
• Value of a call option at maturity
  – S-X, where S-X>0 [otherwise value is
    zero], = Intrinsic value
• Value of a call option prior to maturity
  – Intrinsic value + Time value
       Time Value is a function of:
 Time to expiration, volatility, domestic &
     foreign interest rate differentials
   Futures              Fred Thompson         39
    Comparing Futures and Options
The value of a futures contract at maturity (date t+n) to purchase one
unit of foreign currency will be:

Value




    0                                                                    St+n
                                         Zt,t+n


                                 The value of the futures contract
                                 is zero at maturity if the spot rate
                                 at maturity is equal to the current
                                 futures rate.
Consider now the value of an option to purchase one unit of
foreign currency at that same price (i.e. a ‘call option’ with a
strike price X equal to Zt,t+n):


Value



   0                                                               St+n
                                      X


                               The value of the call option
                               begins increasing when the
                               exchange rate becomes larger
                               than the exercise price - when the
                               option becomes ‘in the money.’
But we’re missing something. While a futures contract has an
expected return of zero, the value of the option looks like it is
always positive…



Value



   0                                                                St+n
                                      X
Hence, anyone taking the opposite side of the transaction
(‘writing’ the option) will demand a premium (C) that makes the
expected value zero once again:



Value



   0                                                              St+n
                     C              X


                                  Regardless of the outcome,
                                  the option’s value is reduced
                                  everywhere by the certain
                                  payment of its premium.
The value of an option to sell one unit of foreign currency (a
‘put’ option) at a strike price equal to a corresponding futures
contract price will have similar properties:



Value



   0                                                               St+n
                                     X
Swaps
        Foreign Currency Swaps
A currency swap is an exchange of debt-service
obligations denominated in one currency for the
service on an agreed upon principal amount of debt
denominated in another currency.
A currency swap is often the low-cost way of
obtaining a liability in a currency in which a firm has
difficulty borrowing.
A pair of firms simply borrow in currencies they have
relative advantage borrowing in, and then trade the
obligations of their respective loans, thereby
effectively borrowing in their desired currency.
Dell computers would like to borrow in Swiss Francs
to hedge its ongoing cash flows from that country…




         Dell




                                             SFr
Nestle would like to borrow in Dollars to hedge its
sales to the U.S...




          Dell                               Nestle




           $                                   SFr
But both firms are relatively unknown to the respective
credit markets, and thus anticipate unfavorable
borrowing terms.




          Dell                              Nestle




           $                                  SFr
But an investment bank comes along and suggests
that each borrow in the credit markets that are
comfortable with them...




         Dell                           Nestle




          $             I-Bank           SFr
…and then the investment bank will give them
sufficient cash flows each period to cover the
obligations of these loans...




         Dell                                 Nestle




                $                       Sfr

           $              I-Bank               SFr
…in return for making the payments in the foreign
currency that exactly match the other firm’s
obligations.




         Dell                                 Nestle

                     Sfr            $

                $                       Sfr

          $                I-Bank              SFr
In other words, the swap effectively ‘completes the
market’. Giving each firm access to the foreign debt
market at reasonable terms.




         Dell                                 Nestle

                     Sfr            $
                $                       Sfr


           $               I-Bank              SFr
        The All-In Cost of a Swap
Clearly, the relative magnitudes of the respective
payments determine each firm’s ultimate cost of
borrowing.
This cost is called the ‘all-in cost’. It is the effective
interest rate the firm ends up paying on the money
that it raised.
It is the discount rate that equates the NPV of future
interest and principal payments to the net proceeds
received by the issuer.
                              IRR
           Swaps vs. Forwards

Notice that on a one-year loan, a currency swap is
no different than a one-year forward contract.
In fact, a currency swap can really be thought of as
a firm taking a domestic currency loan and
purchasing a series of forward contracts to convert
the payments into known foreign currency
obligations.
The implied forward rates need not equal the actual
forward rates, but taken as a whole, should
resemble an average forward rate over the term of
the loan.
Comparative Borrowing Advantage
Swaps only exist because there are market
imperfections. If firms can access foreign and
domestic debt markets at equal cost, clearly swaps
are redundant.
One important reason that currency swaps are so
useful is that firms engaged in a swap need not
each have an absolute borrowing advantage in the
currency in which they borrow vis-a-vis the
counterparty.
In fact, it is quite likely that Nestle has better
access to both the U.S. and Swiss debt markets
than Dell. Comparative Advantage
                      Key Points

1. A firm wishing to hedge foreign currency exposure has five
main financial hedging tools which facilitate doing so: forward
contracts, money market hedges, futures contracts, foreign
currency options, and currency swaps.
2. Forward contracts have the benefit of being tailor-made,
with quantities and timing matched to the needs of the firm.
Forward contracts are typically quite costly over longer
horizons, as the market becomes highly illiquid.
3. Money market hedges are equally flexible, but depend on a
firm having equal access to domestic and foreign credit
markets.
                      Key Points

4. Futures contracts, traded on highly liquid exchanges, have
the benefit that they can be sold on the market before the
maturity date. As a result, futures contracts are particularly
useful for hedging exposures whose maturity is uncertain.
5. On the other hand, futures contracts are standardized in
terms of timing and quantities, and therefore they rarely offer a
perfect hedge.
6. Options contracts allow a firm to hedge against movements
in one direction while retaining exposure in the other.
7. Options are particularly useful in hedging exposures that are
highly uncertain with respect to timing and magnitude.
                      Key Points
8. Currency swaps offer firms the ability to borrow against
long-term foreign currency exposures when access to foreign
debt markets is costly.
9. Currency swaps converts a domestic liability into a
foreign one via what are effectively a bundle of long-dated
forward contracts between two firms.
10. The effective cost of a currency swap is its ‘all-in cost’ -
the effective rate of interest that the firm ends up paying on
the constructed foreign liability.
11. Currency swaps require only that firms have differential
relative - rather than absolute - advantage in accessing debt
markets.

								
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