1. 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.

2. 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

3. 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

4. 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.

5. 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.

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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. Money Market Hedge - Payment
A British company must pay its German supplier €350,000 in 3 months. Current market rates are; Spot rate €/£ 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.

14. Solution
Borrow (£) Invest(€) 350,000

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

16. Solution
Borrow (£) Invest(€) 212, ,535 Spot % 350,000

17. Solution
Borrow (£) Invest(€) 212, ,535 Spot % 4% 216, ,000

18. Solution
Borrow (£) Invest(€) 212, ,535 Spot % 4% 216, ,000 Effective Rate €/£

19. 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 €/£
Current interest rates UK 6%
Germany 4%

20. 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: € = £210,824
This is then invested in the UK for 6 months at 6% a year

21. 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/£

22. Solution
Invests (£) Borrows(€) 210, ,137 Spot % 4% 217, ,000 Effective Rate €/£

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

24. 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.

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

26. International Finance
An Introduction to Currency Futures

27. 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.

28. 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

29. 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

30. 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

31. Market Data

32. Market data CME €125,000 Currency Futures Contract Sett
$/€ Contract Dec
Mar
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

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

34. Trading in Futures - Example
You buy one Sterling September futures
contract at $
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

35. Solution
1. Sell at(Close out) Bought at Loss (Ticks) 36 Loss = 36 x $6.25 = $ Sell at(Close Out) Bought at Gain(Ticks) 64 Gain = 64 x $6.25 =$400

36. 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

37. Example 2 You sell one September Sterling futures
contract at $ 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

38. Solution
1. Sell at Buy at(Close out) Gain (Ticks) 100 Gain = 100 x $6.25 = $ Sell at Bought at(Close Out) Loss(Ticks) 99 Loss = 99 x $6.25 =$618.75

39. 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

40. 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.

41. 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

42. Directed Study Eun C – pages 203-205
Buckley Chapter 12,15
Eun Chapter 7
Eun C – pages
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