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Benefits of studying International Finance Country Risk
Benefits of studying International Finance Knowledge of international finance helps two important ways: 1. Helps financial manager decide how international events will affect a firm and steps to be taken to exploit positive development and insulate firm against harmful development. 2. Helps manager to anticipate events and to make profitable decisions before the event occurs. Events that affect the firm and manager must anticipate are; changes in exchange rates, interest rates, inflation rates, and asset values. Growing importance of International Finance • Importance of International finance springs from increasing importance of international flow of goods and capital. • Reason for growing importance of international trade due to two reasons. A liberalization of trade and investment has occurred via reductions in tariffs, quotas, currency controls, and other impediments to the international flow of goods and capital. Much of liberalization has come from the development of free- trade areas: EU, NAFTA, ASEAN etc. An unprecedented shrinkage of “economic space” has occurred via rapid improvements in communication and transportation technologies and cost reduction as a result. Eg. Cost of telephone calls, cost of international Importance of International finance springs from increasing importance of international flow of goods and capital. • Reason for growing importance of international trade due to two reasons. A liberalization of trade and investment has occurred via reductions in tariffs, quotas, currency controls, and other impediments to the international flow of goods and capital. Much of liberalization has come from the development of free-trade areas: EU, NAFTA, ASEAN etc. An unprecedented shrinkage of “economic space” has occurred via rapid improvements in communication and transportation technologies and cost reduction as a result. Eg. Cost of telephone calls, cost of international travel Rewards of International Trade Increased prosperity by allowing nations to specialize in producing goods and services at which they are efficient, Comparative Advantage There are more to successful international trade than comparative advantage which is based on productive efficiencies. That is due to competitive advantage based on dynamic factors, rather than static production possibilities. Eg. Hong Kong’s growth with limited resources, French success in wine and cheese, German in beer and finely engineered automobiles, British in cookies, Italian success in fashion, U.S. in entertainment, in part due to presence of consumers in the respective countries whose sophisticated tastes have forced firms to produce first- class products, and after becoming successful at home, they were able to succeed abroad. Risk of International Trade Rewards accompany risks. Most obvious risk of international trade arises from uncertainty about exchange rates. Unexpected changes of exchange rates have important impacts on sales, prices, and profits of exporters and importers. Country risk. This includes the risk as a result of war, revolution, or other political or social events a firm may not be paid for its exports. This applies to foreign investments and to credit granted in trade. Some times foreign buyers may be willing but unable to pay because their government unexpectedly imposes exchange restrictions. Moreover, uncertainty due to imposition or change of import tariffs or quotas, subsidies to local producers, and non-traiff barriers. Practices have evolved to cope with risk. E.g. special types of foreign exchange contracts designed hedge or cover some of the risks from unexpected changes in exchange rates. Export credit insurance schemes established to help country risk and letters of credit developed to reduce other risks of trade. In nutshell, more rapid growth of international trade versus domestic trade and the expanded international focus of investment offer adequate reason why it is important to study international finance. Exchange risk has risen greatly because exchange rates have become increasingly volatile. This has been resulted for example, from tension in Middle East or some other politically sensitive parts in the world, and at times by news on economic conditions of major country. This volatility is measured by using coefficient of variation in the exchange rates. Some attribute the increased volatility to flexible exchange rate system adopted in 1973. In addition to the growth of international trade, investment flow, and riskiness of international trade and investment due to country risk and increased volatility of exchange rates, increased importance of MNCs has boost the importance of international finance. International finance is synonymous with exchange rates: a large part of the study of international finance involves exchange rates. A variety of exchange rate exist Bank notes-only a small proportion of overall foreign exchange markets. Bank draft, checks issued by banks or by corporations Buying and selling prices can differ by a large percentage, usually more than 5 or 6 percent. Difference is called spread. Spot foreign exchange market: involved with the exchange of currencies held in different currency denominated bank accounts. Spot exchange rate, determined in the spot market, is number of units of one currency per unit of another currency in the form of bank deposits. Inter-bank Spot Market Inter-bank foreign exchange is the largest financial market with a turnover of almost one trillion dollars. The foreign exchange market is an informal arrangement of the larger commercial banks and a number of foreign exchange brokers. They are linked together by telephone, telex, and a satellite communications network called Society for Worldwide International Financial Telecommunication (SWIFT). Computer based communications system based in Brussels, Belgium links banks and brokers in every financial centres and keep them in almost constant contact 24 hours a day. Geographical Distribution of Average Daily Foreign Exchange Turnover April 1992 Country Net Turnover, Billion US$ Percentage Share United Kingdom 300 27 United State 192 17 Japan 126 11 Singapore 76 7 Switzerland 68 6 Hong Kong 61 5 Germany 57 5 France 36 3 Australia 30 3 Other 185 16 Total 1131 100 Efficiency of the spot foreign exchange market is reflected in the extremely narrow spread between buying and selling prices: can be smaller than a tenth of a percent, %, of the value of currency exchanged, that is one fiftieth or less of the spread faced on bank notes. Most markets including in the US there are two levels on which foreign exchange markets operates • A direct inter-bank level: banks trade directly with each other and all participating banks are market-makers. Banks quote buying and selling price to each other, known as an open bid double auction as there is no central location of the market and trading is continuous. Direct market characterized as a decentralized, continuous, open-bid, double-auction market. • An indirect level via brokers: so-called limited-orders are placed with brokers by banks. E.g. A commercial bank place an order with a broker to purchase £10 million at $1.5550/£. The brokers puts order on book and attempts to match the purchase order with sell order for pounds from other banks. Market-making banks take positions on their own behalves and for customers, brokers deal only for other, showing callers their best rates: inside spread, charging a commission to both buying and selling banks. Indirect broker-based market can be characterized as a quasi-centralized, continuous, limit-book, single-auction market. Settlement between banks Bank that purchased foreign currency have to pay the bank that sold the foreign currency. The payment generally takes place via a clearing house; an institution at which banks keep funds that can be moved from one bank’s account to another’s to settle interbank transactions. When foreign exchange is trading against dollar, the clearing house is called CHIPS: Clearing House Interbank Payments System, located in New York. Bank settlement via CHIPS CHIPS is a computerized mechanism through which banks hold US $ to pay each other when buying or selling foreign exchange. System is owned by large New York clearing banks, over 150 members and handled over 150,000 transactions a day, worth hundreds of billion of $. Retail versus Interbank Spot rates Exchange rates between interbanks determined in the market. Exchange rates faced by the banks’ clients are based on these interbank rates. Clients are charged slightly more than the going interbank selling rate: ask rate, pay slightly less than the interbank buying rate: bid rate. Foreign exchange rates can be given two ways. Number of US$ per foreign currency unit: U.S. $ equivalent Number of units of foreign currency per U.S. $: European terms Exchange Rates -Thursday, November 9, 2006 1 Sri Lanka Rupee = 0.009339 US Dollar - U.S. $. Equivalent 1 US Dollar (USD) = 107.080 Sri Lanka Rupee (LKR) - European terms Direct vs indirect exchange and cross exchange rates Compute the exchange rate between the Euro and the British pound Directly Indirectly, from the exchange rate between Euro and dollar and pound and dollar. If no costs of transacting in foreign exchange, no bid-ask spread. Suppose people want to exchange Euro for pounds or pounds for Euro Exchange can be made directly or indirectly via dollar If no foreign exchange transaction costs, banks quote a direct exchange rate between Euro and pound, exactly equal to implicit indirect exchange rate via dollar. No transaction costs, find all possible exchange rates via dollar With transaction costs, direct exchange rates not always equal to implicit indirect exchange rates via dollar. Zero foreign exchange transaction costs Spot exchange rate between $ and £ : S($/£), the number of US$ per British £ in the spot exchange market S(i/J): number of units of currency i per unit of currency j in the spot exchange market. Banks offering Euro for pounds at S(£/€) pound per Euro must offer at least as large number of pounds as would be obtained via indirect route. S(£/€) S(£/$) . S($/€) Alternatively, from Euro to pound, S(€/£) S(€/$) . S($/£) Exchange rate S(€/£) is a cross rate: exchange rate directly between currencies when neither of two currencies is US $. S i j S i $.S $ j Since , S $ j 1 S $ j cross rate can be computed as S i $ S i j S j $ Calculating cross rate is based on triangular arbitrage. If one started with $1, he could not end up with more than $1 or there would be an arbitrage profit. Nonzero foreign exchange transaction costs • Cost of transacting, * 1. bid-ask spread, and 2. lump- sum fee or commission on each transaction. • S($/ask£) : price that must be paid to the bank to buy one pound with dollar, bank selling rate of pounds. • S($/bid£) : number of dollars received from the bank for sale of pounds for $, bank’s bid rate (buying rate) on pounds. 1 • If no transaction costs, S $ £ S £ $ • With transaction costs, S $ ask£ S £ 1 $ and bid 1 S $ bid £ S £ ask$ 1 1 • Generally, S i askj and S i bidj S j bidi S j aski Forward Foreign Exchange Forward exchange rate: rate that is contracted today for the exchange of currencies at a specified date in the future. Foreign exchange net turnover by Market Segment- April 1992 Market Segment Turnover, Billion US. $ Percentage share Spot market 393.7 47 Forward 384.4 46 Outright 58.5 7 Swaps 324.3 39 Futures 9.5 1 Options 37.7 5 Total turnover 832.0 100 Forward Exchange Premium and Discounts When required to pay more for forward delivery than for spot delivery of a foreign currency, the foreign currency is said to be at a forward premium. When a foreign currency costs less for forward delivery, it is said to be at a forward discount. Forward exchange rate: Fn($/£), n-year forward exchange rate of dollars to pounds. Generally, Fn(i/j), n-year forward exchange rate of currency i to currency j. Premium / Discount (£ vs. $) , Fn $ £ S $ £ when value is nS $ £ positive, the pound is at forward premium vis-à-vis dollar. If negative, discount. When forward rate and spot rate are equal, say forward currency is flat. Eg: suppose , , and . Compute the forward premium or discount for the 90-day and 180-day forward pound. 1.465 1.4780 • Percentage premium/discount (£ vs. $) 100 1.286 (1 / 2) 1.4780 or , 1.465 1.4780 365 100 1.286 pound is at a forward 1.4780 180 discount 1.286 percent per annum. • Premium / Discount ($ vs. £) Fn £ $ S £ $ nS £ $ • Suppose , F1 4 £ $ £0.6791 / $ F1 2 £ $ £0.6810 / $ and , S £ $ £0.6766 / $ • Compute the forward premium or discount for the 90-day and 180-day forward dollar. 0.6810 0.6766 • Percentage premium/discount ($ vs. £) 100 1.301 (1 / 2) 0.6766 or , 0.6810 0.6766 365 100 1.301dollar is at a forward 0.6766 180 premium of 1.301 percent per annum. • More generally, n-year premium/ discount of currency i versus currency j is, Premium/discount (i vs. j) Fn j i S j i nS j i Example: consider the following exchange rates and calculate premium or discount on forward foreign exchange vis-à-vis U.S. $ for different forward periods Exchange Rates Thursday, February 17, 1984 Country U.S. $ equivalent Currency per U.S.$ Britain (Pound) …. 1.4780 .6766 30-day forward …. 1.4761 .6775 90-day forward …. 1.4725 .6791 180-day forward … 1.4685 .6810 The New York foreign exchange selling rates below apply to trading among banks in amounts of $1million and more, as quoted at 3 p.m. Eastern time by Bankers Trust Co., Telerate and other sources. Retail transactions provide fewer units of foreign currency per dollar. Currency Premium or Forward Period Discount 30 Days 90 Days 180 Days Pound Sterling £ discount -1.54 -1.49 -1.29 U.S. $ premium +1.60 +1.48 +1.30 Forward Rates vs. Expected future spot rates Assume speculators are risk-neutral, i.e., they do not care about risk, and if transaction costs in exchanging currencies are ignored, forward exchange rates equal the market’s expected future spot rates. That is, Fn i j Sn i j This follows because if market in general expected dollar to be trading at €1.30/$ in 1-year’s time and the forward rate for 1 year were €1.28/$, speculators would buy dollar forward for €1.28 and expected to make €0.02 (€1.30 - €1.28) on each dollar when $ are sold at €1.30 each. This would drive up forward price of dollar until it was no longer lower than the expected future spot rate. Forward buying of $ continue until Fn (€/$) Sn (€/$) * Forward selling of $ continue until Fn(€/$) Sn (€/$) * No forward buying or selling takes place if Fn(€/$) Sn (€/$) * Outrights and Swaps • Outright forward contract: an agreement to exchange currencies at an agreed price at a future date • Swap has two components. Usually a spot transaction and forward transaction in the reverse direction, but could involve two forward transactions or borrowing one currency and lending another. • Swap-in Euro: an agreement to buy € spot and sell € forward • Swap-out Euro: an agreement to sell € spot and buy € forward • Forward-forward swap: e.g. contract to buy € for 1-month forward and sell € for 2-month forward • Rollover: swap involving purchase and sale are separated by only 1 day Definition of Swap A swap is an agreement to buy and sell foreign exchange at pre-specified exchange rates where the buying and selling are separated in time, or borrowing one currency and lending another. • Swaps – very valuable to those investing and borrowing in foreign currencies. E.g. one who invests in a foreign treasury bill can use a spot-forward swap to avoid foreign exchange risk. Sell forward foreign currency maturity value of the bill and at the same time, buy foreign currency spot to pay for the bill. (swap in) • One who borrows in foreign currency can buy forward foreign currency needed for repayment of the loan and at the same time borrow foreign funds on the spot market. • Growing popularity of swaps show value of swaps to international investors and borrowers • Swaps not very useful to importers and exporters, as payments in international trade are often delayed • Swaps popular with banks as it is difficult to avoid risk when making a market for many future dates and currencies • Some dates and currencies, a bank will be long in foreign exchange, agreed to purchase more foreign currencies than agreed to sell. • For other dates and currencies, a bank will be short in foreign exchange, agreed to sell more than it has agreed to buy. • Swaps help Bank to economically reduce risk; if Bank A is long on spot £ and short on 30-day forward pounds, will find another Bank B in the opposite situation. A will sell £ spot and buy £ forward – a swap out sterling – to Bank B. Both banks balance spot-versus-forward position, economizing on number of transaction required to achieve the balance. Forward quotations Swap points and outright forwards Even forward contract is outright, the convention in the interbank market to quote all forward rates in terms of spot rate and number of swap points. E.g. 180-day forward Canadian rate would conventionally be quoted as Spot 180-Day Swap 1.1401-17 24-28 Canadian dollars (Can$) per U.S.$: Spot buying rate (bid) Can$1.1401 and selling rate (ask) Can$1.1417 per U.S.$. Swap points, 24-28 must be added or subtracted from spot bid and ask rates. Need to add or subtract depends on whether two numbers in the swap points are ascending or descending. E.g. when swap points are ascending, they are added to spot rates, so that implied bid on U.S.$ for 180 days forward: Can$1.1401/$+Can$0.0024/$=Can$1.1425/$ Implied ask on U.S.$ for 180 days forward: Can$1.1417/$+Can$0.0028/$=Can$1.1445/$ If numbers are reversed, i.e., descending, the point are subtracted e.g. Spot 180-Day Swap 1.1401-17 28-24 Implied bid on U.S.$ for 180 days forward: Can$1.1401/$-Can$0.0028/$=Can$1.1373/$ Implied ask on U.S.$ for 180 days forward: Can$1.1417/$-Can$0.0024/$=Can$1.1393/$ 16 basis points in the spot spread, but implied forward spread is 20, larger. Bid – Ask spreads and Forward Maturity Wider spreads of implied outright rates with increasing forward maturities observed in the market Having larger spreads on longer maturity contracts not due to that they are riskier to the banks, but due to increasing thinness of the forward market. Bids and Asks on Sterling Pounds U.S. $/£ Type of exchange Bank Buys Sterling Bank Sells Sterling Spread (Bids) (Asks) (Points) Spot 1.4780 1.4785 5 30-day forward 1.4761 1.4768 7 90-day forward 1.4725 1.4735 10 180-day forward 1.4685 1.4700 15 Maturity Dates and Value Dates • Contracts traded on interbank forward market are mostly even dates, 1 month, 6 month and so on • Value date of an even-dated contract, a 1-month forward is the same day in the next month as the value date for a currently agreed spot transaction • E.g. forward contract is written on May 18, a day for spot transactions are for value on May 20, the value date for a 1- month forward is June 20, value date for a 2- month forward is July 20 and so on • If the future date is not a business day, the value date is moved to the next business day Currency Futures and Options Market Futures and options on futures are derivative assets: their values derived from underlying asset values. Futures from underlying currency, and options on currency futures from underlying futurescontracts. • Currency futures are standardized contracts that trade like conventional commodity futures on the floor of a futures exchange. • Orders to buy or sell a fixed amount of foreign currency are received by brokers or exchange members. Orders are communicated to the floor of the futures exchange. At the exchange, long positions are matched with short positions. • Long positions: orders to buy a currency • Short positions: orders to sell • The exchange or clearing corporation guarantees two-sided contract, contract to buy and contract to sell. • Willingness to buy and sell moves future prices up and down to maintain a balance between number of buy and sell orders. Market clearing price is reached in the future exchange. • Currency futures started trading in the International Money Market (IMM) of the Chicago Mercantile Exchange in 1972. After that many market opened up including, COMEX commodities exchange in New York, Chicago Board of Trade, and London International Finance Futures Exchange (LIFFE) • A market to be made in currency future contracts, it is necessary to have only a few value dates. At the Chicago IMM, there are four value dates of contracts: third Wednesday in the month of March, June, September, and December. • If contracts are held to maturity, delivery of foreign currency occurs 2 business days after contract matures to allow normal 2- day delivery of spot currency. • Contracts are traded in specific sizes - £62,500, Can$ 100,000, and so on. • Selected currencies that are traded with their contract sizes are given below Currency Lifetime Open Interest Open High Low Settle Change High Low JAPAN YEN (CME) – 12.5 million yen; $ per yen (.00) Mar .9645 .9680 .9580 .9593 -.0052 .9930 .8700 93,575 June .9672 .9708 .9616 .9628 -.0053 .9945 .8540 8,404 Sept .9675 .9695 .9670 .9672 -.0056 .9895 .8942 838 BRITISH POUND (CME) – 62500 pds.; $ per pound Mar 1.4746 1.4796 1.4720 1.4764 +.0022 1.5550 1.3950 40,094 June 1.4700 1.4738 1.4670 1.4714 +.0024 1.5300 1.4350 2,540 Sept 1.4640 1.4670 1.4630 1.4676 +.0026 1.4950 1.4570 437 CANADIAN DOLLAR (CME) – 100,000 dlrs.; $ per Can $ Mar .7408 .7484 .7480 .7474 + .0072 .7860 .7394 37,947 June .7419 .7485 .7419 .7468 + .0072 .7805 .7365 2,829 Sept .7435 .7460 .7435 .7465 + .0072 .7740 .7330 669 Dec .7430 .7455 .7430 .7463 +.0072 .7670 .7290 577 Futures prices are quoted in U.S. dollar equivalent terms. Prices per unit of foreign currency, prices of contracts shown above the respective quotations are the contract sizes x exchange rates. Above table shows IMM of Chicago Mercantile Exchange, futures price of foreign currencies quoted as U.S. dollar per unit of foreign currencies. Forward rates on the other hand except for British pounds are quoted in European terms. In the case of Japanese yen, the first two digits of the dollar price of yen are omitted. E.g.. Contract maturing March has a settle price of $0.009593 per Japanese yen . To convert these per-unit prices into futures contract prices, it is necessary to multiply the price in the table by contract amount. E.g. Japanese yen contract is for ¥12.5 million. With settle price per yen for March delivery of $0.009593, the price of one Japanese yen March contract is $0.009593 / ¥ ¥12,500,000 $119,912.5 0 As with forward exchange contract, if risk neutrality is assumed, per-unit price of future equals the market’s expected future spot rate of the foreign currency. Otherwise, if expected spot rate were above, speculators would buy futures, pushing the futures price up to the expected futures spot level. If expected spot rate were below the futures price, speculators would sell futures until futures price forced back to the expected future spot rate. Thus, changes in the market’s expected future spot rate drive futures contract prices up and down. Both buyers and sellers of currency futures post a margin and pay a transaction fee. Margin is posted in a margin account at a brokerage house, which then posts a margin at the clearing corporation of the exchange. Clearing corporation then matches each buy order with a sell order. All buy and sell orders are guaranteed by clearing corporation. Margin must be supplemented by contract holders and brokerage houses if the amount in a margin account falls below a certain level: maintenance level. IMM required a minimum margin on British pound is currently $2000 per contract and its maintenance level is $1500. Margin adjustment is done on daily basis called making to market Example: suppose on day 1, a British £ June contract is bought at the opening price of $1.4700/£, means one contract for £62,500 has a market price of $1.4700 / £ £62,500 $91,875. Settle price, price at the end of the day used for . calculating settlement with the exchange, is $1.4714/£, the market’s expected future spot price for June at the end of day 1. At this price, June pound contract to buy £62,500 is worth $1.4714 / £ £62,500 $91,962.50 Purchase of £ futures contract has earned the contract buyer $91,962.50 $91,875 $87.50 . Assume this is left in the purchaser’s margin account and added to $2000 originally placed in the account. Suppose on day 2 the June £ futures rate falls to $1.4640/£. The contract is now worth $1.4640 / £ £62,500 $91,500 Compared to the previous settle contract price of $91,962.50, now there is a loss of $91,500 $91,962.50 $462.50 . When this is adjusted in the margin account, the total will be $1,625, and margin remains above the maintenance level of $1500 so nothing needs to be done. Suppose on day 3, settle price on June £ falls to $1.4600. Contract is now worth $1.4600 / £ £62,500 $91,250 and the loss is $91,250 $91,500 $250 This brings margin account to $1,625 $250 $1,375 , below the maintenance level $1,500. Now the contract buyer is asked to bring the margin account up to $2,000, requiring at least $625 be deposit in the buyer’s account. If on day 4 the June futures rate settles at $1.4750, the contract is worth: $1.4750 / £ £62,500 $92,187.50 . The gain over the previous settlement of $92,187.50 $91,250 $937.50 . The margin account becomes $2,937.50 and the contract owner can either withdraw $937.50 or use it for margin on another future contract. Assuming that it has been withdrawn, this example can be summarized as: Day Opening or Contract Price Margin Margin Margin Settle Price Adjustment Contribution (+) Account Withdrawal (-) 1 Opening $1.4700/£ $91,875.00 0 +$2,000.00 $2,000.00 1 Settle $1.4714/£ $91,962.50 +$87.50 0 $2087.50 2 Settle $1.4640/£ $91,500.00 -$462.50 0 $1,625.00 3 Settle $1.4600/£ $91,250.00 -$250.00 +$625.00 $2,000.00 4 Settle $1.4750/£ $91,187.50 +$937.50 -$937.50 $2,000.00 As with risk neutrality futures price equals market’s expected future spot exchange rate, futures can be considered as daily bets on the value of expected future spot exchange rate, where bets are settled each day. When buyer’s margin account is adjusted up, seller’s account is adjusted down by the same amount. Futures contract versus Forward contracts There is a daily settlement of bets on futures. Therefore, a futures contract is equivalent to entering a forward contract each day and settling each forward contract before opening another one, where forwards and futures are for the same future delivery date. Forward market no formal and universal arrangement for settling up as expected future spot rate and consequent forward contract value move up and down. No formal and universal margin requirement In case of inter-bank transactions and transactions with large corporate clients, banks require no margin, make no adjustment for day-to-day movements in exchange rates, and simply wait to settle up at the originally contracted rate. Procedure for maintaining the margin on a forward contract depends on the bank’s relationship with the customer. Margin may be called on customers without credit line (facilities), requiring supplementary funds to be deposited in the margin account if a large, unfavourable movement in the exchange rate occurs. In deciding whether to call for supplementing of margin accounts, usually banks consider possibility of their customers honouring forward contracts. • When banks calling margin, they are very flexible about what they will accept as margin, stocks, bonds and other instruments. • With forward contracts, no opportunity cost of margin requirements, but an opportunity cost with future contracts, specially when contract prices have fallen, and substantial cash payments consequently been made into margin account. • Unlike the case of forward contract, when buyer of a futures contract wants to take delivery of foreign currency, it is bought at going spot exchange rate at the time of delivery. • E.g. suppose a future contract buyer needs British £ in August and buys a September pound futures contract. August, when pounds are needed, the contract is sold back to the exchange, and £ are bought on the spot exchange market at whatever exchange rate exists on the day in August when the pounds are wanted. • Most of the foreign exchange risk is still removed here, because if £ has unexpectedly increase in value from the time of buying future contract, there will be a gain in the margin account. The amount in the margin account or amount paid to maintain it depends on the entire path of the futures price from initial purchase, and on interest rate earned in the account or interest forgone on cash contribution to the account. The risk as a result of variability of interest rate called marking-to-market risk, and this makes futures riskier than forward contracts. Problem with using futures contracts to reduce foreign exchange risk: contract size unlikely to match to a firm’s needs. E.g. if a firm needs £50,000, the closest is to buy one £62,500 contract. But forward contract with banks can be taken for any desired amount. Flexibility in values of forward contracts and in margin maintenance, absence of marking-to-market risk, makes forward contract preferable to futures especially for importers, exporters, borrowers and lenders who wish to precisely hedge foreign exchange risk and exposure. Currency futures are more likely to preferred by speculators because gains on futures contract can be taken as cash and transaction costs are small. With forward contracts, necessary to buy an off-setting contract for same maturity to lock in a profit and wait for maturity before settling the contract and taking gain. Open interest indicates the extent to which futures are used to speculate rather than to hedge. It refers to number of outstanding two-sided contracts at any given time. Currency Option Forward and currency futures contracts must be honoured by both parties. No option allowing a party to settle only if it is to that party’s advantage. Unlike forward and futures contracts, currency options give buyer the opportunity, but not the obligation, to buy or sell at a pre-agreed price – strike price or exercise price – in the future. Allows buyer who purchases options, the option or right either to trade at the rate or price stated in the contract, if it is to the advantage of the option’s buyer or if not, to let the option expire, if that would be better. Thus, options have a throwaway feature. Exchange- Traded Options Futures Options Vs Spot Options At IMM in Chicago currency options are options on currency futures. Give buyers the right but not the obligation to buy or sell currency futures contracts at a pre-agreed price. Value of Options on futures prices of underlying futures expected future spot value of the currency. Therefore, indirectly, value of options on futures derives from the expected future spot value of the currency. Currency options also traded on Philadelphia Exchange, but spot currency. Give buyer the right to buy or sell the currency at a pre-agreed price. Therefore, options on spot currency derive value directly from expected future spot value of the currency, not indirectly via the price of futures. All currency options derive their value from movements in the underlying currency. Lets focus on direct linkage involving spot option contract, but also applies to futures options, as they approach maturity become more like spot options. Characteristics of Spot currency options Options traded on the same currencies as in futures Size of contracts – half of those of currency futures, help expand those who can afford to trade in option, while allowing options to use in conjunction with futures. European Options: exercise only on the maturity date of the option (European Style) American Options: majority of options are American options. Offer buyers more flexibility, can be exercised on any date up to and including the maturity date of the option. Expiry months for options – March, June, September, and December plus one or two near-term months. Call option – gives buyer the right to buy foreign currency at the strike price or exchange rate on the option Put option – gives buyer the right to sell foreign currency at the strike price Illustration: OPTIONS PHILADELPHIA EXCHANGE Calls Puts Vol. Last Vol. Last German Mark 62,500 German Marks – European Style 56 Jun … … 25 0.53 57 Mar … … 25 0.09 57 ½ Mar … … 765 0.13 58 Mar … … 600 0.26 58 ½ Mar 100 0.37 … … 59 Mar 556 0.31 … … 59 ½ Mar 110 0.19 … … 60 ½ Mar 60 0.05 … … Note going spot price of the German Mark is 58.60 U.S. cents, the exchange rate is $0.5860/DM. on the spot market. From the table we see the European style options on 62,500 marks, strike price ranges from 56 U.S. cents per mark to 60 ½ cents per mark. Meaning of “58 Mar” option for which 600 contracts and last trading price of put option of 0.26 U.S cents per mark. This European put option gives buyers the right to sell the mark at 58 U.S. cents. The price of the option, 0.26 U.S. cents per mark means: for the contract of 62,500 German marks the option buyer must pay . By paying $162.50, the option buyer acquires the right to sell 62,500 marks for 58 U.S. cents ($0.58) each at the expiry date of the option, the Friday before the third Wednesday of March. Since option is European style and valid only for the expiry date. Option will not be exercised if spot rate of mark on the expiry date is above $0.58, because better to sell marks spot. If spot rate is below $0.58, the option has value, as it gives holder the right to receive $0.58 per mark, more than its market value. Option writer: person selling the put option, who receive $162.50 from the sale of the option. Actually, instead of exercising the option, buyer is likely to accept the difference between exercise price and the going spot rate from the option writer. Consider the following table, “58 Mar” option. It does not say “European style”, the options are American options. They can be exercised on any date prior to maturity. We notice there 6038 call options, and 31 put options at strike price of 58 ½ U.S. cents per mark, an exchange rate of $0.5850/DM. Calls Puts Vol. Last Vol. Last German Mark 62,500 German Marks – cents per unit. 56 Mar 40 2.75 … … 56 Apr 5 2.36 1030 0.18 56 Jun … … 150 0.49 56 ½ Apr … … 46 0.22 57 Mar 31 1.76 … … 57 Jun 5 1.95 1209 0.78 57 ½ Mar 100 1.07 160 0.13 57 ½ Apr … … 360 0.48 58 Mar 207 0.85 32 0.26 58 Apr … … 1027 0.71 58 Jun 18 1.57 27 1.15 58 ½ Mar 6038 0.60 31 0.39 58 ½ Apr … … 360 0.89 59 Mar 406 0.36 28 0.66 59 Apr 913 0.71 … … 59 ½ Mar 296 0.20 … … 59 ½ Apr 32 0.51 … … 60 Mar 130 0.11 … … 60 Apr 546 0.40 … … 60 Jun 2 0.78 … … 60 ½ Apr … … 5 2.24 61 Apr 1350 0.18 … … 61 Jun 5900 0.39 … … Call option costs 0.60 U.S. cents or $0.0060 per mark. Call option contract costs . Buyer acquires right to buy DM62,500 for $0.5850 per mark up to the expiry date in March for $375. If mark is above $0.5850 on the spot market, option will be exercised on or before expiry or its value will be collected from the option writer or another buyer. If the spot value is below $0.5850, not exercise the option and thrown away, loss is $375. Can be thought of as an insurance premium for which unfavourable events do not occur, and insurance simply expires. In the Money: Call option that gives buyer the right to buy currency at a strike exchange rate below the spot exchange rate. Put option that gives buyer the right to sell currency when strike exchange rate is higher than the spot exchange rate. Out of the Money: Call option with a strike price above the spot exchange rate. Put option with a strike price below the spot exchange rate. Intrinsic Value: is extent to which an option is in the money. Intrinsic value is how many cents per currency would be gained by exercising the option immediately. Call options have intrinsic value when the strike price is below the spot rate, and put options have intrinsic value when the strike price exceeds the spot rate. Option Premium: amount paid for the option on each unit of foreign currency. Option premium consists of two parts: intrinsic value and time value. Time value: possibility of having a higher intrinsic value in future than at the moment. At the money: strike price exactly equals the spot rate. Option premium is only option time value. Determinants of the Market Values of Currency Options: Factors influencing the price of an option: Intrinsic value Volatility of the spot or futures exchange rate Length of period to expiration American or European option type Interest rate on currency of purchase Forward premium/discount or interest differential Forwards, Futures, and Options compared Forward Contracts Currency Futures Currency Options Delivery discretion None None Buyer’s discretion. Seller must honour if buyer exercises. Maturity date Any date Third Wednesday of March, Friday before third Wednesday of March, June, September, or June, September, or December on Maximum length Several years December regular options. Last Friday of month 12 months on end-of-month (EOM) options. Contracted amount Any value £62,500, Can$ 100,000 etc. 9 months Can sell via exchange £31,250, Can$ 50,000 etc. Secondary market Must offset with bank Formal fixed sum per contract, Can sell via exchange e.g. $2,000. Daily marking No margin for buyer who pays for Margin requirement Informal; often line of to market. contract. Seller posts 130% of credit or 5-10% on Outright premium plus lump sum varying with account Futures clearing corporation intrinsic value. Contract variety Swap or outright Primarily speculators. Outright Options clearing corporation. Guarantor None Hedgers and speculators Major users Primarily hedgers
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