Michael Melvin and Stefan Norrbin International Money & Finance Chapter 4: Forward-Looking Market Instruments Michael Melvin and Stefan Norrbin

Outline of This Chapter Fluctuations in exchange rate increase uncertainties and discourage trade. Market finds methods to hedge against risk of exchange rate movements. In this chapter, we will study some of these hedging methods. Forward rates Swaps Futures Options

Example: Exchange Rate Risk Assume that you are a retailer in the U.S. and order 2 BMWs from Germany valued at $100,000. You plan to sell these cars at $60,000 each for a profit of $20,000. Germany wants payment in Euros. In the contract, you will have to pay for these imported cars 90 days from now. Assume that the current exchange rate is S$/€ = 1.0 (read: spot exchange rate of the dollar price of one euro) Thus, your liability is the 90-day note to pay €100,000. How much will it cost you to pay €100,000 in 3 months?

Example: Exchange Rate Risk (Cont.) Your liability is the 90-day note to pay €100,000. 90 days from now: Scenario I: what if the exchange rate increases to S$/€ = 1.5 It costs you $150,000 to pay for the cars. Now you lose money, because you’ve already sold two cars for $120,000. You paid more that you earned from the cars, your loss = $30,000. Scenario 2: what if the exchange rate falls to S$/€ = 0.5 It costs you only $50,000 to pay for these cars. You make more profit than you anticipate. Your profit is $70,000.

What would you do? Buy euro now and invest it in Europe for three months and then pay BMW. We will discuss this in Chapter 6. Wait three months and buy euro when you need to pay BMW? The exchange rate could go up or down (like in scenarios 1 and 2). If I offer you a certain fixed price of euro today and you do not have to buy euro until you need it in three months, will you take it? In this case, you hedge the exchange rate risk!

Avoid Exchange Rate Risk by Using Forward Rates One way to protect yourself from exchange rate fluctuations is to use the forward rates. The forward market – buying and selling currencies to be delivered at a future date. In this case, you lock in to a fixed rate now that will be used 90 days from now. You know with certainty how many dollars the BMWs will cost in 90 days. Moreover, you do not need to buy the euro until you need it. Forward rate = fixed rate at some agreed upon future date Banks are willing to sell the forward contracts at the fixed future price, because they can normally perfectly diversify their risks. Therefore, banks do not need a premium to take on foreign exchange risk. Banks make money on the spread – the difference between forward buy price and forward sell price.

Notations in this chapter St = spot exchange rate today (at time t) St+1 = actual spot exchange rate tomorrow (at time t+1) Set+1 = expected future spot rate at time t+1 Ft = forward rate Note that the forward rate should be equal to the expected future spot rate (if banks can perfectly diversify). Ft = Set+1 Ex. A 3-month forward rate of a euro should be equal to what we expect the euro to be worth three months from now. Note that St+1 is not necessarily equal to Set+1 (if they are equal, you are a great forecaster).

Some definitions If the forward rate of a currency exceeds the current spot rate, that currency is said to be selling at a forward premium Ft – St > 0 → Forward premium If the forward rate is less than the current spot rate, this currency is selling at a forward discount. Ft – St < 0 → Forward discount Ft – St = 0 → Forward flat

Example 1 Let us assume that the following rates exist today: F360 = 2.20 (the forward rate quoted today. This is the dollar price of a pound that the bank locks in today, but is effective one year from today.) S$/£,t = 2.00 (the current spot rate of a pound) Calculate the forward premium/discount in percent: 10% forward premium on the British pound. Thus, banks are expecting the British pound to gain in value. Reversely, for the dollar, banks are expecting it to lose value and selling dollar at a forward discount.

Example 2 F90 = 1.90 (the rate that banks expect in 3 months) Forward 3-month discount on the British pound. Note that we quote the percentage of forward premia/discounts in the annualized form. That is why we multiply it by 4 for 3-month rate. The reason is to make it easier to compare with the borrowing and lending interest rates, which are quoted per annum. To annualize the 3-month percent to the annual percent

Forward Rates (Financial Time, March 12, 2012) This table shows spot and forward rates of U.S. dollar for March 12, 2012. The highlighted columns are 1-month, 3-month, and 1-year forward exchange rates. For example, the 3-month forward rate on the U.S. dollar would cost 6.8342 Swedish Kronor. The %PA is the forward premium/discount in percent. Since %PA = -1.4, this is a forward discount on SKr.

Swap Market Only banks are allowed to do this type of transaction. 2 types of swap: Foreign exchange swap – allows you to use the funds you have in one currency to fund obligations denominated in a different currency, without incurring foreign exchange risk. This swap is a spot and forward transaction combined, and is frequently used for interbank trading. Currency swap – an agreement in which two parties repay each other’s loans denominated in different currencies.

Foreign Exchange Swap A Foreign Exchange Swap is an agreement to exchange currencies on an agreed date and to inversely exchange the currencies on a future date. Example: Your company, a U.S. firm, has money sitting in a bank account in Europe (€500,000), invested at short-term rates. You have a funding need at the U.S. headquarter for 3 months. In this case, you would agree to sell the euro to the bank and get dollar at the spot rate. At the same time, you would agree to buy back the euro and send back the dollar in three-month time at a forward rate.

Example: Foreign Exchange Swap You want to borrow some $ with your €500,000. Suppose that the current spot rate S$/€ = 0.90 and the 3- month forward rate is 0.8955. The swap transaction becomes: The two transactions happen as one single step at the bank. Thus, saving transactions costs.

Currency Swap A currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated. Example: Suppose the exchange rate is $1.25 per euro at the time of a swap contract.

Example: Currency Swap Firms will exchange the principals. Firms exchange their interest payments on their principal amount annually. At the end of the swap, the firms exchange back the original principal amounts. Firm A sends €40 million to Firm B. And, firm B pays $50 million to Firm A.

Benefits of a swap Lower transaction costs of cross-currency cash management. Reduce foreign exchange risk for financing transactions. Allow firm to acquire financing for which it has a comparative advantage. Ex. a well-known U.S. firm that wants to expand its operations into Europe where it is less well known. It tends to get more favorable loan terms in the U.S. than in the Europe. By using a currency swap, the firm ends with the euros it needs to fund its expansion.

Futures Futures – an agreement to buy or sell a standard quantity of a specific foreign currency at a specified future date and at a price agreed on an exchange. You can lock into a specific price today for future delivery of the currency. The currency is sold in relatively small, fixed amounts at pre-determined dates. Since the futures contracts are well-defined in terms of size and delivery dates, they are more likely to be traded after the original purchase. Thus, a person that buy the contract may not be the same person who deriver the currency when the contract matures. Unlike the forward contract, the person who buys the contract always make delivery of the currency in the future.

Forward vs. Futures Futures Market Forward Market Contract type Standardized - Fixed amount - Fixed maturity - Small amount Customized - Flexible amount - Flexible delivery date - Large amount Cash backing the contract A fraction of the contract is held as a deposit. The contract holders are held liable for daily cash settlements. Normally, not due until the contract expires Participants Smaller firms Speculators Large firms Banks (mostly in swaps)

How currency futures work? Chicago Mercantile Exchange (CME) is the largest currency futures market. The futures market differs from the forward market in that only a few currencies are traded. The contracts involve a specific amount of currency to be delivered at specific maturity dates. Contracts mature on the third Wednesday of March, June, September, and December.

How to read the table: Example: Swiss Franc The contract is written for a fixed amount of 125,000 SFr. Numbers are in dollars per Swiss Franc Month – month that the contract matures (June) Open – the price that contract had at the beginning of the trading day Latest – the settlement price or the closing price on that day. High/ Low – the highest (lowest) trading price on that day. Change – a change in the price from previous trading day. Est. vol – the estimated number of contracts actually exchanged during that day. Open Int – the number of contracts outstanding (open interest).

Example of Swiss Franc Purchase For a 125,000 Swiss Franc future for June that we purchase on May 7th. May 7th: 125,000 x 0.8282 = $103,525 (using the settle price at the end of the day). To buy the 125,000 SFr, you need to pay $103,525 when the contract matures in June. The amount that will cost you in June is already fixed on May 7th. Since you are not going to pay the money for awhile, the bank typically wants a small portion of the cost as security (margin), depending on how reliable you are as a trader. Let say, the bank need 10% to secure the deal. You will have to put $10,352.50 in a saving account with the bank.

How do we benefit or lose from this futures contract? May 7th: 125,000 x 0.8282 = $103,525 What would happens if the exchange rate changes? On May 14th, if $/SFr = 0.9000 (SFr appreciates): May 14th: 125,000 x 0.9000 = $112,500 We have made $8,975 in a week, if we sell. However, we can also lose. On May 21st, if $/SFr = 0.8000 (SFr depreciates): May 21st: 125,000 x 0.8000 = $100,000 Now you are losing money on your position -$3,525. You should have sold your position last week to realize the gain that you had then. The bank may ask you to deposit more money (margin call), if you continue to hold the position as you are losing money.

Options Options – are contracts that give a buyer the option, or right, to buy or sell the underlying financial instrument at a specified price within a specific period. A specified price is called exercise price or strike price. The seller of the option is obligated to buy or sell the financial instrument to the buyer if the owner of the option exercises the right to buy or sell. The owner (or buyer) of an option does not have to exercise the option. She can let the option expire without using it. The owner of an option will have to pay a premium for the right to buy or sell the currency at a fixed price.

Options: some definitions American options – can be exercised at any time up to the expiration date of the contract. European options – can be exercised only on the expiration date. Foreign currency option – is a contract that provides the right to buy or sell a given amount of currency at a fixed exchange rate on or before the maturity date. A call option – a contract that gives the owner the right to buy. A put option – a contract that gives the owner the right to sell. Strike price – price you have the option to buying or selling.

Example: Options Suppose you need to deliver pound (£) in the future at a price $1.50 per pound. If £ appreciates, you will lose money. Thus, you want to hedge against the exchange rate risk. You could buy £ in the forward market, but this means that you are obligated to buy £. What if the price of £ is low in the future? To retain some flexibility, you can buy an option. In this case, it is an option to buy British pound (call option). Options are rights, rather than obligations, to buy or sell. So, your payoff depends on whether you exercise the options or not.

How do the call options work? For the call option: If S > K, you are “in-the- money” and you can make a profit. Your payoff is the difference between the current price and the strike price, less the cost of the option. If S < K → the option would not be exercised. Your payoff will be zero and you lose only the premium paid for the option. S = current price or the spot exchange rate K = the strike price (the price you lock in to buy currency in the future). The payoff from a call option is: Not Exercise Choose to Exercise Call Option S - K

How do the put options work? For the put option: If S > K, the option will not be exercised. You can make more by selling in the spot market. Thus, the payoff is zero. You only lose the option premium. If S < K, a fall in the spot price makes the put option more profitable. Your profit is the difference between the strike price and the current price of currency. You are “in-the-money.” S = current price or the spot exchange rate K = the strike price (the price you lock in to sell currency in the future). The payoff from a put option is: Not Exercise Choose to Exercise Put Option K - S

The option prices for 125,000 Swiss Franc contract Contracts were quoted on Feb. 28, 2011. On that day the spot Swiss franc values was $1.0764. 2 types of contracts: call and put options. 2 maturities: March and June. Each strike price has a cost in terms of cents per SFr for a call or put option. Ex: at a 1045 strike price, the price of a call option for June is 4.40 cents per Swiss franc. This contract will give you a right to buy Swiss Franc in June at $1.045 per SFr.

Suppose that you need 1 million Swiss Franc in June. You need 8 contracts of 125,000 SFr. Suppose that you choose 1090 as a strike price (giving you the right to buy/sell SFr at $1.090). You will buy the call options – cost 1.92 cents per SFr. The cost of buying 8 contracts of the call options: 1.92/100 x 125,000 x 8 = $19,200 In June: If the SFr appreciates to $1.20 – you exercise the option and buy SFr at $1.09. If the SFr depreciates to $1.00 – you throw the options away and buy SFr in the spot market (lose $19,200).

Summary Many international transactions involve future delivery of goods and payments, subjecting traders to uncertainty about future exchange rate fluctuations at the time of delivery. Therefore, there exists several forward-looking market instruments to reduce traders’ currency risk. The forward exchange market is composed of commercial banks buying and selling foreign currencies to be delivered at a future date. The forward exchange swap is a combination of spot and forward transactions of the same amount of the currency delivered in two different dates. The two steps are executed in one single step. Foreign currency futures are standardized contracts traded on established exchanges for delivery of currencies at a specified future date. Foreign currency options are contracts that give the buyer the right to buy (call option) or sell (put option) currencies at a specified price within a specific period of time. The strike price is the price at which the owner of the contract has the right to transact.