Foreign Currency Derivatives Chapter 7 Foreign Currency Derivatives

Foreign Currency Derivatives Financial management of the MNE in the 21st century involves financial derivatives. These derivatives, so named because their values are derived from underlying assets, 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 management of corporate cash flow Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

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 could 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) Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

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, interest-bearing deposits, gold, etc. In the US, the most important market for foreign currency futures is the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Foreign Currency Futures Contract specifications are established 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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Foreign Currency Futures Foreign currency futures contracts differ from forward contracts in a number 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 individuals 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) Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Foreign 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 and calls. A call is an option to buy foreign currency A put is an option to sell foreign currency Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

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 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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

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 the option. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

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 the would be profitable, excluding the cost of the premium, if exercised immediately 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) Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Foreign Currency Options In the past three decades, the use of foreign 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 standardized, but counterparty risk is substantially reduced. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Foreign Currency Speculation Speculation is an attempt to profit by trading on expectations about prices in the future. Speculators can attempt to profit in the: Spot market – when the speculator believes the foreign currency will appreciate in value Forward market – when the speculator believes the spot price at some future date will differ from today’s forward price for the same date Options markets – extensive differences in risk patters produced depending on purchase or sale of put and/or call Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Option Market Speculation Buyer of a call: Assume purchase of August call option on Swiss francs with strike price of 58½ ($0.5850/SF), and a premium of $0.005/SF At all spot rates below the strike price of 58.5, the purchase of the option would choose not to exercise because it would be cheaper to purchase SF on the open market At all spot rates above the strike price, the option purchaser would exercise the option, purchase SF at the strike price and sell them into the market netting a profit (less the option premium) Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Option Market Speculation Writer of a call: 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 writer 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, the writer will experience an opportunity loss Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Option Market Speculation Buyer of a Put: The basic terms of this example 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 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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Option Market Speculation Seller (writer) of a put: In this case, if the spot price of francs drops below 58.5 cents per franc, the option will be exercised Below a price of 58.5 cents per franc, the writer will lose more than the premium received fro 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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Option Pricing and Valuation The pricing of any currency option combines six elements: Present spot rate Time to maturity Forward rate for matching maturity US dollar interest rate Foreign currency interest rate Volatility (standard deviation of daily spot price movements) Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Option Pricing and Valuation The total value (premium) of an option is equal to the intrinsic value plus time value. Intrinsic 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 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 option’s expiration date. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Currency Option Pricing Sensitivity If 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. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Currency Option Pricing Sensitivity Forward rate sensitivity: Standard foreign currency options are priced around 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 expects the forward rate to be equal to the future spot rate, it is simply a result of the arbitrage-pricing structure of options Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Currency Option Pricing Sensitivity Spot rate sensitivity (delta): The sensitivity of the option premium to a small change in the spot exchange rate is called the delta delta = Δ premium The higher the delta, the greater the probability of the option expiring in-the-money Δ spot rate Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Currency Option Pricing Sensitivity Time to maturity – value and deterioration (theta): Option values increase with the length of time to maturity theta = Δ premium A trader will normally find longer-maturity option better values, giving the trader the ability to alter an option position without suffering significant time value deterioration Δ time Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exhibit 7.11 Theta: Option Premium Time Value Deterioration Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Currency Option Pricing Sensitivity Sensitivity to volatility (lambda): Option volatility is defined as the standard deviation of daily percentage changes in the underlying exchange rate Volatility is important to option value because of an exchange rate’s perceived likelihood to move either into or out of the range in which the option will be exercised lambda = Δ premium Δ volatility Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Currency Option Pricing Sensitivity Volatility is viewed in three ways: Historic Forward-looking Implied Because volatilities are the only judgmental component that the option writer contributes, they play a critical role in the pricing of options. All currency pairs have historical series that contribute to the formation of the expectations of option writers. In the end, the truly talented option writers are those with the intuition and insight to price the future effectively. Traders who believe that volatilities will fall significantly in the near-term will sell (write) options now, hoping to buy them back for a profit immediately volatilities fall, causing option premiums to fall. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Currency Option Pricing Sensitivity Sensitivity to changing interest rate differentials (rho and phi): Currency option prices and values are focused on the forward rate The forward rate is in turn based on the theory of Interest Rate Parity Interest rate changes in either currency will alter the forward rate, which in turn will alter the option’s premium or value A trader who is purchasing a call option on foreign currency should do so before the domestic interest rate rises. This timing will allow the trader to purchase the option before its price increases. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Currency Option Pricing Sensitivity The expected change in the option premium from a small change in the domestic interest rate (home currency) is the term rho. rho = Δ premium The expected change in the option premium from a small change in the foreign interest rate (foreign currency) is termed phi. phi = Δ premium Δ US $ interest rate Δ foreign interest rate Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exhibit 7.13 Interest Differentials and Call Option Premiums Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Currency Option Pricing Sensitivity The sixth and final element that is important to option valuation is the selection of the actual strike price. A firm must make a choice as per the strike price it wishes to use in constructing an option (OTC market). Consideration must be given to the tradeoff between strike prices and premiums. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exhibit 7.14 Option Premiums for Alternative Strike Rates Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exhibit 7.15 Summary of Option Premium Components Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Mini-Case Questions: Rogue Trade, Nick Leeson What was Nick Leeson’s strategy to earn trading profits on derivatives? What went wrong that caused his strategy to fail? Why did Nick Leeson establish a bogus error account (88888) when a legitimate account (99002) already existed? Why did Barings and its auditors not discover that the error account was used by Leeson for unauthorized trading? Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Mini-Case Questions (cont’d): Rogue Trade, Nick Leeson Why did none of the regulatory authorities in Singapore, Japan, and the United Kingdom discover the true use of the error account? Why was Barings Bank willing to transfer large cash sums to Barings Futures Singapore? Why did the attempt by the Bank of England to organize a bailout for Barings fail? Suggest regulatory and management reforms that might prevent a future debacle of the type that bankrupted Barings. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

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