Learning Outcomes By the end of the lecture the students should be able to: Explain the main features of forwards contracts. Apply and evaluate forward contracts as a hedging tool. Explain and apply money market techniques to hedge currency risk.

Derivatives Derivatives is a term which applies to a broad range of investment instruments whose price depends on, or is derived from, the price of an underlying asset (such as currency) Common derivatives are: Forwards Options Swaps Futures

Derivatives Derivatives can be used either of the following: Risk management (i.e. to “hedge” by providing offsetting compensation in case of an undesired event, “insurance”) Often a prudent aspect of operations and financial management for firms Speculation (i.e. making a financial "bet"). Offers managers and investors a seductive opportunity to increase profit, but not without incurring additional risk that is often undisclosed to stakeholders

Financial Derivatives Embryonic derivatives market Dramatic financial collapses due to exchange rate movements Rolls Royce - £ Cost, $ Revenue Laker Airlines - £ Revenue, $ Costs No derivatives available to manage currency risks.

Financial Derivatives More complex instruments Tighter accounting regulation But still large derivative losses Societe Generale £3.7bn loss from trading in futures derivatives. Caisse D’Epargne £500m loss from derivative trading M&B £274m loss from derivative hedge, when underlying position did not materialise.

Hedging Tools Currency Interest Rate Internal techniques Money market Forward Forward Contracts FRA Futures Futures Options Options Currency SWAP SWAP

Forward Exchange Contract: Definition A Forward Exchange Contract is: An immediate firm and binding contract between a bank and a customer For the purchase or sale of A specified quantity Of a stated currency For delivery at specified future date

Forward Contracts - Advantages Removes downside risk Simple to understand and to operate No monitoring required once in place Separate management of foreign exchange risk from commercial decisions Tailor made Cheap technique – since highly liquid market in UK Broad range of currencies quoted

Forward Contracts - Disadvantages Illiquid and unmarketable instrument Difficult to unwind Loss of upside potential Potential losses if hedged position does not materialise Example: JLR bids on a contract worth €10m. to be paid in 3 months. However, JLR will only know in 2 months if the bid has been accepted If it hasn’t been accepted, and they entered into a forward contract to hedge their potential risk, they are now still obligated to the forward contract

Money Market Hedge – Synthetic Forward Definition: A series of money market transactions, set up to hedge exchange rate risk An alternative to using derivatives, a money market hedge involved borrowing and lending money

Money Market Hedge – Strategy for Foreign Payment Borrow sterling today Convert to foreign currency at spot Deposit foreign currency with foreign bank When payment is due Withdraw foreign deposit to make foreign payment Repay UK loan and interest

Money Market Hedge – Strategy for Foreign Receipt Borrow foreign currency today Convert immediately today at spot rate Place on deposit in home country When foreign currency received Repay foreign currency loan and interest Take cash from home currency deposit

Money Market Hedge - Payment A British company must pay its German supplier €350,000 in 3 months. Current market rates are; Spot rate 1.6276 €/£ Current interest rates UK 6% Germany 4% Calculate the cost of the payment in three months if the firm enters into a money market hedge.

Solution Borrow (£) Invest(€) 350,000

Solution Borrow (£) Invest(€) 346,535 4% 350,000

Solution Borrow (£) Invest(€) 212,911 346,535 Spot 1.6276 4% 350,000

Solution Borrow (£) Invest(€) 212,911 346,535 Spot 1.6276 6% 4% 216,105 350,000

Solution Borrow (£) Invest(€) 212,911 346,535 Spot 1.6276 6% 4% 216,105 350,000 Effective Rate 1.6196€/£

Student Activity You will receive 350,000€ receipt in six months time. Using the following rates, calculate the effective exchange rate if the company has entered into a money market hedge Spot rate 1.6276 €/£ Current interest rates UK 6% Germany 4%

Solution Day 1 The company will receive €350,000. It, therefore, needs to borrow an amount (in €) today such that, with interest, it will have to repay in 6 months a total of €350,000. If German interest rate is 4% pa, this is equal to 2% for 6 months Therefore, the company should borrow €350,000/1.02 = €346,534 The company then converts the money it has borrowed into sterling at the spot rate: €346,534 @ €1.6276 = £210,824 This is then invested in the UK for 6 months at 6% a year

Solution In 6 months time The company receives payment from its German customer = €350,000 It uses this money to repay the loan + interest on the € debt = €350,000 It also receives the money + interest that it invested in the UK. Recall that it lent £210,824 in the UK for a period of 6 months at 6% per annum Thus, it receives £210,824 x 1.03 = £217,149 The firm has managed to guarantee translating €350,000 into £217,149 in 6 months i.e. It locked in an exchange rate of 350,000/217,149 = €1.6118/£

Solution Invests (£) Borrows(€) 210,824 343,137 Spot 1.6276 6% 4% 217,149 350,000 Effective Rate 1.6118€/£

Money Market Hedge - Advantages Protects against downside risk Very flexible – tailor made No monitoring required

Disadvantages Unlikely to obtain better rate than forward rate. Covered Interest Arbitrage would imply that it was not possible to obtain better rate than the forward rate. Difficult to unwind. Loss of upside potential.

Directed Study Buckley Chapter 13 Eun pages 194 to 201 Stephens Chapter 3 Complete seminar question - Riley

International Finance An Introduction to Currency Futures

Learning Outcomes By the end of the lecture the students should be able to: Explain how currency futures may be used to hedge currency risk. Create an appropriate hedging strategy using futures. Critically appraise the use of currency futures.

Currency Futures Definition A legally binding obligation to Buy or sell A standard quantity of a foreign currency At a specified future time At a rate(price) agreed now

Forwards v Futures A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time Customized to customers need Negotiated directly by the buyer and seller Market not regulated A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price Standardized Quoted and traded on the Exchange Government regulated market

Important Features Openly traded on organised exchange Based on standard quantities of currency e.g. on Chicago Mercantile Exchange (CME) € 125,000 Euro Futures SFr 125,000 Swiss Franc Futures Yen 12.5m Japanese Yen £ 62,500 Sterling Futures   Standard delivery dates e.g. on CME  March, June, September, December Exchange rate is determined on market floor

Market Data

Market data CME €125,000 Currency Futures Contract Sett $/€ Contract Dec 1.4926 Mar 1.4916 If you buy one contract Means you are contracted to buy €125,000 and selling $ at a future date. If you sell one contract Means you are contracted to sell €125,000 and buying $ at a future date

Tick Size Tick Size Smallest movement allowed in contract price Currency Future Contract Size Tick Value of a Tick ($) € €125,000 $0.0001 per € $12.5 SFr SFr125,000 $0.0001 per SFr Yen Y12.5m $0.0001 per 100Y £ £62,500 $0.0001 per £ $6.25

Trading in Futures - Example You buy one Sterling September futures contract at $1.5636. Calculate the gain/loss on the contract if at the time of closing out the contract the futures price has moved to: $1.5600 $1.5700

Solution 1. Sell at(Close out)1.5600 Bought at 1.5636 Loss (Ticks) 36 Loss = 36 x $6.25 = $225 2. Sell at(Close Out)1.5700 Bought at 1.5636 Gain(Ticks) 64 Gain = 64 x $6.25 =$400

Summary If Purchase (Long) Futures contract If Sterling depreciates Loss in futures market If Sterling appreciates Gain in futures market Exporter with receipt in $ will make losses if sterling appreciates To hedge position, will purchase (go long) futures

Example 2 You sell one September Sterling futures contract at $1.5636. Calculate the gain or loss made on the contract if at the time of closing out the futures price has moved to: 1.5536 1.5735

Solution 1. Sell at 1.5636 Buy at(Close out) 1.5536 Gain (Ticks) 100 Gain = 100 x $6.25 = $625 2. Sell at 1.5636 Bought at(Close Out) 1.5735 Loss(Ticks) 99 Loss = 99 x $6.25 =$618.75

Summary If you Sell (Short) Future Contract If Sterling depreciates Will gain on futures contract If Sterling appreciates Will make loss in futures market An importer with a $ payment will make losses if sterling depreciates To hedge position will sell (short) futures

Other Features of Futures market Clearing house interposition Clearing house operates margining system Futures prices set by reference to forward rates otherwise arbitrage will take place Basis = Futures Price – Spot Price Basis risk – Risk that futures price and spot price do not move in line with one another.

Evaluation of Futures Advantages Disadvantages Liquid instrument, can be closed out at any time Credit risk removed by margining system Because customers deal with a clearing house, there is greatly reduced risk for buyers and sellers that a counterparty would fail to meet the terms of the contract  Disadvantages Standardised contracts Not available in many currencies Margining system has daily cash flow implications Basis risk may arise

Directed Study Eun C – pages 203-205 Buckley Chapter 12,15 Eun Chapter 7 Eun C – pages 203-205 Arnold, Glen. (2013) Corporate Financial Management. 5th ed. Pearson Giddy, I. H. (1994) Global Financial Markets, D.C. Heath and Company, Chapter 7 &8 Visit module web for access to other learning material Complete seminar question