1、Chapter 8Foreign Currency Derivatives and Swaps 2013 Pearson Education,Inc.All rights reserved.8-2 Foreign Currency Derivatives and Swaps Financial management of the MNE in the 21st century involves financial derivatives.These derivatives,so named because their values are derived from underlying ass
2、ets,are a powerful tool used in business today.These instruments can be used for two very distinct management objectives:Speculation use of derivative instruments to take a position in the expectation of a profit Hedging use of derivative instruments to reduce the risks associated with the everyday
3、management of corporate cash flow 2013 Pearson Education,Inc.All rights reserved.8-3 Foreign Currency Derivatives Derivatives are used by firms to achieve one of more of the following individual benefits:Permit firms to achieve payoffs that they would not be able to achieve without derivatives,or co
4、uld achieve only at greater cost Hedge risks that otherwise would not be possible to hedge Make underlying markets more efficient Reduce volatility of stock returns Minimize earnings volatility Reduce tax liabilities Motivate management(agency theory effect)2013 Pearson Education,Inc.All rights rese
5、rved.8-4 Foreign Currency Futures A foreign currency futures contract is an alternative to a forward contract that calls for future delivery of a standard amount of foreign exchange at a fixed time,place and price.It is similar to futures contracts that exist for commodities such as cattle,lumber,in
6、terest-bearing deposits,gold,etc.In the U.S.,the most important market for foreign currency futures is the International Monetary Market(IMM),a division of the Chicago Mercantile Exchange.2013 Pearson Education,Inc.All rights reserved.8-5 Foreign Currency Futures Contract specifications are establis
7、hed by the exchange on which futures are traded.Major features that are standardized are:Contract size Method of stating exchange rates Maturity date Last trading day Collateral and maintenance margins Settlement Commissions Use of a clearinghouse as a counterparty Exhibit 8.1 is an excellent descri
8、ption of futures contracts for the Mexican peso 2013 Pearson Education,Inc.All rights reserved.8-6 Exhibit 8.1 Mexican Peso(CME)-MXN 500,000;$per 10MXN 2013 Pearson Education,Inc.All rights reserved.8-7 Foreign Currency FuturesForeign currency futures contracts differ from forward contracts in a num
9、ber of important ways:Futures are standardized in terms of size while forwards can be customized Futures have fixed maturities while forwards can have any maturity(both typically have maturities of one year or less)Trading on futures occurs on organized exchanges while forwards are traded between in
10、dividuals and banks Futures have an initial margin that is market to market on a daily basis while only a bank relationship is needed for a forward Futures are rarely delivered upon(settled)while forwards are normally delivered upon(settled)2013 Pearson Education,Inc.All rights reserved.8-8 Foreign
11、Currency Options A foreign currency option is a contract giving the option purchaser(the buyer)the right,but not the obligation,to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period(until the maturity date).There are two basic types of options,puts a
12、nd calls.A call is an option to buy foreign currency A put is an option to sell foreign currency 2013 Pearson Education,Inc.All rights reserved.8-9 Foreign Currency Options The buyer of an option is termed the holder,while the seller of the option is referred to as the writer or grantor.Every option
13、 has three different price elements:The exercise or strike price the exchange rate at which the foreign currency can be purchased(call)or sold(put)The premium the cost,price,or value of the option itself The underlying or actual spot exchange rate in the market 2013 Pearson Education,Inc.All rights
14、reserved.8-10 Foreign Currency Options An American option gives the buyer the right to exercise the option at any time between the date of writing and the expiration or maturity date.A European option can be exercised only on its expiration date,not before.The premium,or option price,is the cost of
15、the option.2013 Pearson Education,Inc.All rights reserved.8-11 Foreign Currency Options An option whose exercise price is the same as the spot price of the underlying currency is said to be at-the-money(ATM).An option that would be profitable,excluding the cost of the premium,if exercised immediatel
16、y is said to be in-the-money(ITM).An option that would not be profitable,again excluding the cost of the premium,if exercised immediately is referred to as out-of-the money(OTM).2013 Pearson Education,Inc.All rights reserved.8-12 Foreign Currency Options In the past three decades,the use of foreign
17、currency options as a hedging tool and for speculative purposes has blossomed into a major foreign exchange activity.Options on the over-the-counter(OTC)market can be tailored to the specific needs of the firm but can expose the firm to counterparty risk.Options on organized exchanges are standardiz
18、ed,but counterparty risk is substantially reduced.Exhibit 8.2 shows a published quote for the Swiss Franc.2013 Pearson Education,Inc.All rights reserved.8-13 Exhibit 8.2 Swiss Franc Option Quotations(U.S.cents/SF)2013 Pearson Education,Inc.All rights reserved.8-14 Buyer of a Call Option Buyer of an
19、option only exercises his/her rights if the option is profitable.In the case of a call option,as the spot price of the underlying currency moves up,the holder has the possibility of unlimited profit.Exhibit 8.3 shows a static profit and loss diagram for the purchase of a Swiss Franc Call Option.Noti
20、ce how the purchaser makes a profit as the franc appreciates vs.the dollar this is because the purchaser has the right to purchase the franc at a pre-specified,and in this case,lower price than the current spot price.2013 Pearson Education,Inc.All rights reserved.8-15 Exhibit 8.3 Profit and Loss for
21、 the Buyer of a Call Option 2013 Pearson Education,Inc.All rights reserved.8-16 Option Market Speculation Writer of a call:(see Exhibit 8.4)What the holder,or buyer of an option loses,the writer gains The maximum profit that the writer of the call option can make is limited to the premium If the wri
22、ter wrote the option naked,that is without owning the currency,the writer would now have to buy the currency at the spot and take the loss delivering at the strike price The amount of such a loss is unlimited and increases as the underlying currency rises Even if the writer already owns the currency
23、,the writer will experience an opportunity loss 2013 Pearson Education,Inc.All rights reserved.8-17 Exhibit 8.4 Profit and Loss for the Writer of a Call Option 2013 Pearson Education,Inc.All rights reserved.8-18 Option Market SpeculationBuyer of a Put:(see Exhibit 8.5)The basic terms of this example
24、 are similar to those just illustrated with the call The buyer of a put option,however,wants to be able to sell the underlying currency at the exercise price when the market price of that currency drops(not rises as in the case of the call option)If the spot price drops to$0.575/SF,the buyer of the
25、put will deliver francs to the writer and receive$0.585/SF At any exchange rate above the strike price of 58.5,the buyer of the put would not exercise the option,and would lose only the$0.05/SF premium The buyer of a put(like the buyer of the call)can never lose more than the premium paid up front 2
26、013 Pearson Education,Inc.All rights reserved.8-19 Exhibit 8.5 Profit and Loss for the Buyer of a Put Option 2013 Pearson Education,Inc.All rights reserved.8-20 Option Market Speculation Seller(writer)of a put:(see Exhibit 8.6)In this case,if the spot price of francs drops below 58.5 cents per franc
27、,the option will be exercised Below a price of 58.5 cents per franc,the writer will lose more than the premium received from writing the option(falling below break-even)If the spot price is above$0.585/SF,the option will not be exercised and the option writer will pocket the entire premium 2013 Pear
28、son Education,Inc.All rights reserved.8-21 Exhibit 8.6 Profit and Loss for the Writer of a Put Option 2013 Pearson Education,Inc.All rights reserved.8-22 Option Pricing and Valuation The pricing of any currency option combines six elements:Present spot rate Time to maturity Forward rate for matching
29、 maturity U.S.dollar interest rate Foreign currency interest rate Volatility(standard deviation of daily spot price movements)2013 Pearson Education,Inc.All rights reserved.8-23 Option Pricing and ValuationThe total value(premium)of an option is equal to the intrinsic value plus time value.Intrinsic
30、 value is the financial gain if the option is exercised immediately.For a call option,intrinsic value is zero when the strike price is above the market price When the spot price rises above the strike price,the intrinsic value become positive Put options behave in the opposite manner On the date of
31、maturity,an option will have a value equal to its intrinsic value(zero time remaining means zero time value)The time value of an option exists because the price of the underlying currency,the spot rate,can potentially move further and further into the money between the present time and the options e
32、xpiration date.See Exhibit 8.7 for a diagram of the intrinsic value and time value of an option 2013 Pearson Education,Inc.All rights reserved.8-24 Exhibit 8.7 Option Intrinsic Value,Time Value,and Total Value 2013 Pearson Education,Inc.All rights reserved.8-25 Currency Option Pricing SensitivityIf
33、currency options are to be used effectively,either for the purposes of speculation or risk management,the individual trader needs to know how option values premiums react to their various components.Summarized in Exhibit 8.8.Forward rate sensitivity:Standard foreign currency options are priced aroun
34、d the forward rate because the current spot rate and both the domestic and foreign interest rates are included in the option premium calculation The option-pricing formula calculates a subjective probability distribution centered on the forward rate This approach does not mean that the market expect
35、s the forward rate to be equal to the future spot rate,it is simply a result of the arbitrage-pricing structure of options 2013 Pearson Education,Inc.All rights reserved.8-26 Exhibit 8.8 Summary of Option Premium Components 2013 Pearson Education,Inc.All rights reserved.8-27 Interest Rate Risk All f
36、irms domestic or multinational,small or large,leveraged or unleveraged are sensitive to interest rate movements in one way or another.The single largest interest rate risk of the nonfinancial firm(our focus in this discussion)is debt service;the multicurrency dimension of interest rate risk for the
37、MNE is of serious concern.Exhibit 8.9,shows that even the interest rate calculations vary on occasion across currencies and countries.2013 Pearson Education,Inc.All rights reserved.8-28 Exhibit 8.9 International Interest Rate Calculations 2013 Pearson Education,Inc.All rights reserved.8-29 Interest
38、Rate Risk The second most prevalent source of interest rate risk for the MNE lies in its holdings of interest-sensitive securities.Unlike debt,which is recorded on the right-hand side of the firms balance sheet,the marketable securities portfolio of the firm appears on the left-hand side.Marketable
39、securities represent potential earnings for the firm.2013 Pearson Education,Inc.All rights reserved.8-30 Interest Rate Risk Prior to describing the management of the most common interest rate pricing risks,it is important to distinguish between credit risk and repricing risk.Credit risk,sometimes te
40、rmed roll-over risk,is the possibility that a borrowers credit worthiness,at the time of renewing a credit,is reclassified by the lender(resulting in changes to fees,interest rates,credit line commitments or even denial of credit).Repricing risk is the risk of changes in interest rates charged(earne
41、d)at the time a financial contracts rate is reset.2013 Pearson Education,Inc.All rights reserved.8-31 Interest Rate Futures Unlike foreign currency futures,interest rate futures are relatively widely used by financial managers and treasurers of nonfinancial companies.Their popularity stems from the
42、relatively high liquidity of the interest rate futures markets,their simplicity in use,and the rather standardized interest-rate exposures most firms possess.The two most widely used futures contracts are the Eurodollar futures traded on the Chicago Mercantile Exchange(CME)and the US Treasury Bond F
43、utures of the Chicago Board of Trade(CBOT).For an example,see Exhibit 8.10 2013 Pearson Education,Inc.All rights reserved.8-32 Exhibit 8.10 Eurodollar Futures Prices 2013 Pearson Education,Inc.All rights reserved.8-33 Interest Rate Futures Common interest rate futures strategies:Paying interest on a
44、 future date(sell a futures contract/short position)If rates go up,the futures price falls and the short earns a profit(offsets loss on interest expense)If rates go down,the futures price rises and the short earns a loss Earning interest on a future date(buy a futures contract/long position)If rates
45、 go up,the futures price falls and the short earns a loss If rates go down,the futures price rises and the long earns a profit Exhibit 8.11 provides an overview of these two basic interest rate exposures 2013 Pearson Education,Inc.All rights reserved.8-34 Exhibit 8.11 Interest Rate Futures Strategie
46、s for Common Exposures 2013 Pearson Education,Inc.All rights reserved.8-35 Forward Rate AgreementsA forward rate agreement(FRA)is an interbank-traded contract to buy or sell interest rate payments on a notional principal.These contracts are settled in cash.The buyer of an FRA obtains the right to lo
47、ck in an interest rate for a desired term that begins at a future date.The contract specifies that the seller of the FRA will pay the buyer the increased interest expense on a nominal sum(the notional principal)of money if interest rates rise above the agreed rate,but the buyer will pay the seller t
48、he differential interest expense if interest rates fall below the agreed rate.2013 Pearson Education,Inc.All rights reserved.8-36 Interest Rate Swaps Swaps are contractual agreements to exchange or swap a series of cash flows.These cash flows are most commonly the interest payments associated with d
49、ebt service,such as the floating-rate loan described earlier.If the agreement is for one party to swap its fixed interest rate payments for the floating interest rate payments of another,it is termed an interest rate swap If the agreement is to swap currencies of debt service obligation,it is termed
50、 a currency swap A single swap may combine elements of both interest rate and currency swaps 2013 Pearson Education,Inc.All rights reserved.8-37 Interest Rate Swaps The swap itself is not a source of capital,but rather an alteration of the cash flows associated with payment.What is often termed the
