2. 宁波工程学院国商教研室蒋力编 Chapter 4 Forward-Looking Market Instrument

3. 4-2 宁波工程学院国商教研室蒋力编 Topics to be Covered Forward Rate Swaps Futures Options

4. 4-3 宁波工程学院国商教研室蒋力编 Example ： Suppose your firm has an account payable to a French firm of €2,000,000 due in 180 days. So, what’s your options available for managing this foreign currency liability?

5. 4-4 宁波工程学院国商教研室蒋力编 a.You could rely on the spot market, buy the euros at any time in the next 180 days. b.You could rely on the spot market, buy € at today's spot rate and invest for the next 180 days. c.You could buy € today but in the forward market. d.You could buy a futures contract for €. e.You could buy a call option contract for €.

6. 4-5 宁波工程学院国商教研室蒋力编 Forward Rates (cont.) Forward exchange market—where a currency may be bought or sold at a price (i.e., forward rate) agreed upon today but for delivery at a future date. Figure 4.1

7. 4-6 宁波工程学院国商教研室蒋力编 Forward Premium vs. Forward Discount P87 Forward Premium （远期溢价） —when the forward exchange price of a currency is greater than the spot rate. Forward Discount （远期折价） —when the forward exchange price of a currency is less than the spot rate. Flat Currency （平价） —when the forward rate and spot rate are equal.

8. 4-7 宁波工程学院国商教研室蒋力编 In the following examples, is the dollar selling at a premium or discount? Spot 90-day Forward (a) $/₤ = 1.77 $/₤ = 1.78 (b) $/¥ = 0.01 $/¥ = 0.0125 (c) €/$ = 0.80 €/$= 1.25 (d) $/SF = 0.90 $/SF = 1.15

9. 4-8 宁波工程学院国商教研室蒋力编 Example: Citibank wants pound now to invest a project in England for three month, after that it need to convert it’s profits in terms of pound to U.S dollar. So, what’s your suggestion to practice the plan in terms of money exchange?

10. 4-9 宁波工程学院国商教研室蒋力编 CITI BANK LLOYDS Need ₤ now, and repay 3-month later Exchange USD into GPD at spot rate Exchange GPD into USD at forward rate

11. 4-10 宁波工程学院国商教研室蒋力编 Foreign Exchange Swap Foreign Exchange Swap—an agreement to trade currencies at one date and then reverse the trade at a later date. A foreign exchange swap consists of two legs: a spot foreign exchange transaction, and a forward foreign exchange transaction.

12. 4-11 宁波工程学院国商教研室蒋力编 Calculate the swap rate CITI BANK Lloyds Exchange USD into GPD at spot rate $/₤=$2.00 Exchange GPD into USD at forward rate $/₤=$2.10 Annualized swap rate= [(2.10-2.00)/2.00]*4=0.2, which can be compared to the other opportunities.

13. 4-12 宁波工程学院国商教研室蒋力编 These agreements are frequently used by commercial banks for inter-bank trading. It is also common to trade forward-forward, where both transactions are for (different) forward dates. Need ₤ 3-month later, and repay 9-month later The most popular currencies are: –U.S. dollar –Japanese yen –Euro –British pound sterling 14-12

14. 4-13 宁波工程学院国商教研室蒋力编 A currency swap is often the low-cost way of obtaining a liability in a currency in which a firm has difficulty borrowing. A pair of firms simply borrow in currencies they have relative advantage borrowing in, and then trade the obligations of their respective loans, thereby effectively borrowing in their desired currency. Currency Swap P89

15. 4-14 宁波工程学院国商教研室蒋力编 interest rate swap A company facing $8%, £10%; B company facing £10%, $12%. Now A company need borrow £1m,and B company need borrow $2m, spot rate is $/£=2. If A and B just directly borrow the currency they needed respectively. They have to pay interest rate at £10% and $12%.

16. 4-15 宁波工程学院国商教研室蒋力编 Alternatively, they use currency swap. A borrows $2m to exchange £1m borrowed by B, and exchange back at the same rate later. A pays back $2.16m for £1m, i.e. £1.08m for £1m. A gets £8%; B pays back £1.1m for $2m, i.e.$2.2m for $2m, B gets $10%.

17. 4-16 宁波工程学院国商教研室蒋力编 The Swap Bank Bank may involve in charge A £9%, B $11%. It refers to swap bank A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. Example P89 14-16

18. 4-17 宁波工程学院国商教研室蒋力编 Foreign Exchange Futures Market Futures market is similar to the forward market where currencies may be bought and sold for future delivery.

19. 4-18 宁波工程学院国商教研室蒋力编 The futures market differs from the forward market in that: –Only a few currencies are traded –Trading occurs in standardized contracts Size [C$100K, £62.5k, €125k, ¥12.5m] p91 –Contracts mature on a specific dates The third Wed of March, June, Sept., Dec. –Trading occurs in a specific geographic locations the International Monetary Market of the Chicago Mercantile Exchange ， London International Financial Futures Exchange (LIFFE) Figure 4.2 p92 The story of speculation

20. 4-19 宁波工程学院国商教研室蒋力编 Example: Use futures to hedge the EX risk A US manufacturing company has a division that operates in Mexico. At the end of June the parent company anticipates that the foreign division will have profits of 4 million Mexican pesos (P) to repatriate. The parent company has a foreign exchange risk, as the dollar value of the profits will fall with the depreciation of the peso against dollar (or the appreciation of dollar against peso) The US company can use forward contracts to fix the profits in terms of dollar

21. 4-20 宁波工程学院国商教研室蒋力编 Example, continued The US company use forward to fix profits and avoid the risk caused by the peso depreciation, but at the same time, it might lose the opportunity earning more money by the peso appreciation against $ Here we introduce the future instrument The amount of each peso future contract is P500,000, so the firm will sell 8 contracts peso.

22. 4-21 宁波工程学院国商教研室蒋力编 Example, continued On the March 19th, the spot rate at 0.091240 ($/P) while the price on a P future at 0.089425. On the June 29 th, the spot market closes at 0.065815. If the US company did nothing to heddge the foreign exchange risk, the loss of profits in terms of $ is: (0.065815 - 0.091240)  P4 m. = -$101700 If the US company sell 8 contracts peso at the future price on the March 19th, then the US company can fix the profits in terms of $ at 0.089425  P4 m = $357700, avoiding the risk of peso's depreciation against $

23. 4-22 宁波工程学院国商教研室蒋力编 Example, continued On the March 19th, the spot rate at 0.091240 ($/P) while the price on a P forward at 0.089425. On the June 29 th, the spot market closes at 0.065815. If the US company did nothing to heddge the foreign exchange risk, the loss of profits in terms of $ is: (0.065815 - 0.091240)  P4 m. = -$101700 If the US company sell peso at the forward price on the March 19th, then the US company can fix the profits in terms of $ at 0.089425  P4 m = $357700, avoiding the risk of peso's depreciation against $

24. 4-23 宁波工程学院国商教研室蒋力编 Example, continued On the March 19th, the spot rate at 0.091240 ($/P) while the price on a P future at 0.089425. On the June 29 th, the spot market closes at 0.10670. If the US company did nothing to heddge the foreign exchange risk, the gain of profits in terms of $ is: (0.10670 - 0.091240)  P4 mil. = $61840 If the US company has already sold peso at the future price on the March 19th, while, don’t forget we can sell the future contracts at any time before maturity

25. 4-24 宁波工程学院国商教研室蒋力编 future price of Euro in terms of $ spot price of Euro in terms of $

26. 4-25 宁波工程学院国商教研室蒋力编 Foreign Currency Option Foreign Currency Option—a contract that provides the right to buy or sell a currency at a fixed exchange rate on or before the maturity date if desired and is not an obligation. Foreign currency options were first traded in December 1982 at the Philadelphia Stock Exchange. –Trading occurs in standardized contracts Size [C$50K, £31.25k, €62.5k, ¥6.2.5m] (half of the future contact)

27. 4-26 宁波工程学院国商教研室蒋力编 Call Option—an option to buy currency. ( 看张期权、买进期 权 ) Put Option—an option to sell currency. （看跌期权、卖出期 权） Strike or Exercise Price—the price of the currency stated in an option contract. Option Premium( 期权费 ): The amount that must be paid to purchase the option contract.

28. 4-27 宁波工程学院国商教研室蒋力编 Currency Options American Option: An option that can be exercised any time before or on the expiration date. European Option: An option that can only be exercised on the expiration date. Figure 4.3 p95

29. 4-28 宁波工程学院国商教研室蒋力编 Call Options If the spot rate has not yet reached the exercise price [S<X], the option cannot be exercised and is said to be “out of the money.” If the spot rate equals the exercise price [S=X], the option is said to be “at the money.” If the spot rate has surpassed the exercise price [S>X], the option is said to be “in the money.”

30. 4-29 宁波工程学院国商教研室蒋力编 Call Option Consider 4 call options on the euro, with a strike price of 92 ($/€) and a premium of 0.94 (both cents per €). The amount of a euro option contract is €62,500. The total option premium is: $0.0094*4*€62,500=$2,350.

31. 4-30 宁波工程学院国商教研室蒋力编 Profit Loss 88.15 9292.94 93.5 Payoff Profile Spot Rate -$2,350 -$1,100 0 $1,400 Out-of- the-money At In-the-money 92.5 Break-Even

32. 4-31 宁波工程学院国商教研室蒋力编 Put Option Consider 8 put options on the euro with a strike of 90 ($/€) and a premium of 1.95 (both cents per €). The amount of a euro option contract is €62,500. The total premium is: $0.0195*8*€62,500=$9,750.

33. 4-32 宁波工程学院国商教研室蒋力编 Profit Loss 88.05 90 Payoff Profile Spot Rate -$9,750 -$500 0 In-the-moneyAtOut-of-the-money 88.15 Break-Even