8-1 Lecture #12 Hedging foreign currency risk: Issues outside of China Aaron Smallwood, PhD. UT-Arlington

8-2 Examples outside of China  A US firm learns in June that it will receive €500,000 in September. The firm is very concerned with exchange rate risk. –What to do? (For reference, on June 9, $ price of the euro was ) Nothing Sell a forward contract Sell a futures contract Purchase a put option. Money market hedge as just considered

8-3 Options Contracts: Preliminaries  An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset (in our case a currency) in the future at prices agreed upon today.  Calls vs. Puts: –Call options give the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future at prices agreed upon today. –Put options give the holder the right, but not the obligation, to sell a given quantity of some asset at some time in the future at prices agreed upon today.

8-4 Options Contracts: Preliminaries  European versus American options: –European options can only be exercised on the expiration date while American options can be exercised at any time up to and including the expiration date. –American options are usually worth more than European options, other things equal.  Money –If immediate exercise is profitable, an option is “in the money.” –Out of the money options can still have value.

7-5 PHLX Currency Option Specifications CurrencyContract Size Australian dollarAUD 10,000 British poundGBP 10,000 Canadian dollarCAD 10,000 EuroEUR 10,000 Japanese yenJPY 1,000,000 Mexican pesoMXN 100,000 New Zealand dollarNZD 10,000 Norwegian kroneNOK 100,000 South African randZAR 100,000 Swedish kronaSEK 100,000 Swiss francCHF 10,000

8-6 Options  Call and put options, summary –Call gives the option to buy –Put gives the option to sell  The price at which an option would be exercised is known as the “strike price.” –If the future exchange rate exceeds the strike price: Call option is exercised (prefer to buy at the lower price). Put option is not exercised (prefer to sell at the higher price)  A premium must be paid no matter what. –Notice for the puts, premium increases with the strike price (better chance of being exercised)… Opposite is true for a call.

8-7 Possibilities  The premium must be paid no matter what.  Suppose we select an option with a strike price of 139. Premium is 3.70 cents per euro:  3 possibilities. –On Sept. 20, 2014, dollar price of the euro is less than $ –On Sept. 20, 2014, spot dollar price of the euro is between $ and $1.39 –On Sept. 20, 2014, spot dollar price of the euro is greater than $1.39

8-8 In the money  Scenario 1: Suppose S($/€)=$1.32: –Pay *500,000=$18,500 upfront –Sell euros at $1.39 with an option: $695,000 –Total Proceeds: $676,500 –Without an option: $500,000 *1.32=$660,000  Scenario 2: Suppose S($/€)=$1.37 –Pay *500,000=$18,500 upfront –Sell euros at $1.39 with option: $695,000 –Total Proceeds: $676,500 –Without an option: $685,000

8-9 Out of the money.  Anytime the future spot rate exceeds $1.39, the option expires worthless. We always pay the premium of $18,500 regardless.  Summary: –Exchange rate less than $1.3530: the option is exercised. Total benefit, ignoring lost interest (on principal of $18,500) is highest for the option. –Exchange rate between $ and $1.39. The option is exercised, but we would have been better off without one. –Exchange rate greater than $1.39. Options expires worthless. Better off without and option.

8-10 Put Option Profit Profiles $1.39 STST Benefit Loss – $ Long 1 put $ If the put is in- the-money, it is worth $ – future spot rate. The maximum gain is $ If the put is out- of-the-money, it is worthless, and the buyer of the put loses her entire investment of $ Out-of-the-moneyIn-the-money

8-11 Futures Contracts: Preliminaries  Standardizing features: –Contract size –Delivery month –Daily resettlement  Initial performance bond (about 2 percent of contract value, cash or T-bills)

8-12 Currency Futures Markets  The CME Group (formerly Chicago Mercantile Exchange) is by far the largest currency futures market.  CME hours are 7:20 a.m. to 2:00 p.m. CST Monday-Friday.  Extended-hours trading takes place Sunday through Thursday (local) on GLOBEX i.e. from 5:00 p.m. to 4:00 p.m. CST the next day.  The Singapore Exchange offers interchangeable contracts.  There are other markets, but none are close to CME and SIMEX trading volume.  Expiry cycle: March, June, September, December.  The delivery date is the third Wednesday of delivery month.  The last trading day is the second business day preceding the delivery day.

8-13 Futures Contract: EuroOpenHighLowSettleChangeOpen Sept ,783

8-14 Details  An initial deposit of usually 2% or more is required.  Recall, the contract is marked to market every day.  Futures contract are not very convenient for hedging purposes, but can be used nonetheless.  Suppose the future’s contract is purchased at the settlement price of $ –Two possibilities: In Sept $ price of the euro: $1.35 $1.40

8-15 Scenarios  First scenario: –Settlement price will converge to the spot rate at the moment the contract matures: –Because we are selling euros, and the dollar price of the euro drops, money is added to the trader’s account: ($ $1.35)*500,000= $4,200 Sell euros at $1.35: $675,000 TOTAL: $679,200 = 500,000 *

8-16 Second scenario  If future spot rate ends up being $1.40… –Over the life of the contract, ($1.40- $1.3584)*500,000 = $20,800 is subtracted. –Will require potentially costly funds to be deposited if the position remains open.  In September, sell euros for 1.40: –500,000*1.40 = $700,000 –TOTAL proceeds: 700,000 – 20,800 = $679,120.

8-17 Other Hedging Strategies  Hedging through invoice currency. –The firm can shift, share, or diversify: Shift exchange rate risk by invoicing foreign sales in home currency Share exchange rate risk by pro-rating the currency of the invoice between foreign and home currencies Diversify exchange rate risk by using a market basket index  Hedging via lead and lag. –If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency. –If a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow.

8-18 What Risk Management Products do Firms Use?  Most U.S. firms meet their exchange risk management needs with forward, swap, and options contracts.  The greater the degree of international involvement, the greater the firm’s use of foreign exchange risk management.