2. Currency Futures & Options Markets

3. FuturesFred Thompson2 Objectives: to Understand The nature of currency futures and options contracts and how they are used to manage currency risk & to speculate on future currency movements The difference between forward & futures contracts The difference between futures & options contracts The factors that determine the value of an option

4. Currency Futures

5. FuturesFred Thompson4 Currency Futures Traded on centralized exchanges (illustrated in Figure 1 later) Highly standardized contracts –Size [A&C$100K, £62.5k, €125k, ¥12.5m] & maturity [delivery date] Clearinghouse as counter-party High leverage instrument –Daily settlement –Margin requirements

6. FuturesFred Thompson5 Currency Futures Performance Bond or Initial Margin: The customer must put up funds to guarantee the fulfillment of the contract - cash, letter of credit, Treasuries. Maintenance Performance Bond or Margin: The minimum amount the performance bond can fall to before being fully replenished. Mark-to-the-market: A daily settlement procedure that marks profits or losses incurred on the futures to the customer’s margin account.

7. FuturesFred Thompson6 Sample Performance Bond Requirements From the CME, 15 March 2000

8. FuturesFred Thompson7 Long and Short Exposures A person that is, for example, long the pound, has pound denominated assets that exceed in value their pound denominated liabilities. A person that is short the pound, has pound denominated liabilities that exceed in value their pound denominated assets.

9. FuturesFred Thompson8 Hedging With a Currency Future To hedge a foreign exchange exposure, the customer assumes a position in the opposite direction of the exposure. For example, if the customer is long the pound, they would short the futures market. A customer that is long in the futures market is betting on an increase in the value of the currency, whereas with a short position they are betting on a decrease in the value of the currency.

10. How an Order is Executed (Figure from the CME)

11. FuturesFred Thompson10 Example 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 exposure, as the dollar value of the profits will rise and fall with changes in the exchange value between the P and the dollar.

12. FuturesFred Thompson11 Example, continued The firm is long the peso, so to hedge its exposure it will go short [sell P] in the futures market. The face amount of each peso future contract is P500,000, so the firm will go short 8 contracts. If the peso depreciates, the dollar value of its Mexican division’s profits falls, but the futures account generates profits, at least partially offsetting the loss. The opposite holds for an appreciation of the peso.

13. Change spot value Change in futures price Gain Loss Underlying Long Position Futures Position

14. FuturesFred Thompson13 Example, continued The previous diagram can be used to illustrate the effect of a change in the value of the peso. An increase in the value of the peso increases the dollar value of the underlying long position and decreases the value of the futures position. A decrease in the value of the peso decreases the value of the underlying position and increases the value of the futures position.

15. FuturesFred Thompson14 Example, continued On the 25th, the spot rate opens at 0.10660 ($/P) while the price on a P future opens at 0.10310. The market closes at 0.10635 and 0.10258 respectively. The loss on the underlying position is: (0.10635-0.10660)  P4 mil. = -$1,000 The gain on the futures position is: (0.10310-0.10258)  8  P500,000=$2,080

16. Change spot value Change in futures price Gain Loss Underlying Long Position P4 million Futures Position P500,000 x 8 -0.00025 -0.00052 $1,000 $2,080 Gain and Loss on Underlying and Futures Position Day 1

17. FuturesFred Thompson16 Example, continued On the 28th, the spot rate moves to 0.10670 ($/P) and the price on a P future to 0.10285. The gain on the underlying position is: (0.10670-0.10635)  P4 mil. = $1,400 The loss on the futures position is: (0.10258-0.10285)  8  P500,000=-$1,080

18. Change spot value Change in futures price Gain Loss Underlying Long Position P4 million Futures Position P500,000 x 8 $1,080 $1,400 0.00035 0.00032 Gain and Loss on Underlying and Futures Position Day 2

19. FuturesFred Thompson18 Example, continued On the 29th, the spot rate moves to 0.10680 ($/P) and the price on a P future to 0.10290. The gain on the underlying position is: (0.10680-0.10670)  P4 mil. = $400 The loss on the futures position is: (0.10285-0.10290)  8  P500,000=-$200

20. Change spot value Change in futures price Gain Loss Underlying Long Position P4 million Futures Position P500,000 x 8 $200 $400 0.00005 0.0001 Gain and Loss on Underlying and Futures Position Day 3

21. FuturesFred Thompson20 Example, continued For the three days considered, the underlying position gained $800 in value and the futures contracts yielded $800. The hedge was not perfect as the daily losses on the futures were less than the gains on the underlying position (day 2 and 3), and the daily gains on the futures exceeded the losses on the underlying position (day 1). In this example, the imperfect hedge yielded additional gains.

22. FuturesFred Thompson21 Example, continued Suppose you wanted to close the futures position (without making delivery of the currency). The position is simply reversed. That is, you would go long 8 P futures, reversing your current position and closing out your account. [offsetting trade]

23. FuturesFred Thompson22 Additional Information For additional information on currency futures, visit the following sites: The Chicago Mercantile exchange The Futures Industry Institute

24. Currency Options

25. FuturesFred Thompson24 Currency Options A currency option is a contract that gives the owner the right, but not the obligation, to buy or sell a currency at a specified price at or during a given time. Call Option: An option that gives the owner the right to buy a currency. Put Option: An option that gives the owner the right to sell a currency. How are currency options simultaneously both put & call options?

26. FuturesFred Thompson25 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.

27. FuturesFred Thompson26 Currency Options Exercise or Strike Price: The price (spot exchange rate) at which the option may be exercised. Option Premium: The amount that must be paid to purchase the option contract. Break-Even: The point at which exercising the option exactly matches the premium paid.

28. FuturesFred Thompson27 Currency 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.”

29. FuturesFred Thompson28 Call Option The holder of a call option expects the underlying currency to appreciate in value. Consider 4 call options on the euro, with a strike price of 92 ($/€) and a premium of 0.94 (both cents per €). The face amount of a euro option is €62,500. The total premium is: $0.0094·4·€62,500=$2,350.

30. Profit Loss 88.15 9292.94 93.5 Payoff Profile Spot Rate -$2,350 -$1,100 0 $1,400 Out-of- the-money AtIn-the-money Call Option: Hypothetical Pay-Off 92.5 Break-Even

31. FuturesFred Thompson30 Put Option The holder of a put option expects the underlying currency to depreciate in value. Consider 8 put options on the euro with a strike of 90 ($/€) and a premium of 1.95 (both cents per €). The face amount of a euro option is €62,500. The total premium is: $0.0195·8·€62,500=$9,750.

32. Profit Loss 88.05 90 Payoff Profile Spot Rate -$9,750 -$500 0 In-the-moneyAtOut-of-the-money Put Option: Hypothetical payoff at a spot rate of 88.15 88.15 Break-Even

33. FuturesFred Thompson32 Option Pricing & Valuation Value of a call option at maturity –S-X, where S-X>0 [otherwise value is zero], = Intrinsic value Value of a call option prior to maturity –Intrinsic value + Time value Time Value is a function of: Time to expiration, volatility, domestic & foreign interest rate differentials

34. Comparing Futures and Options The value of a futures contract at maturity (date t+n) to purchase one unit of foreign currency will be: Value 0S t+n The value of the futures contract is zero at maturity if the spot rate at maturity is equal to the current futures rate. Z t,t+n

35. Consider now the value of an option to purchase one unit of foreign currency at that same price (i.e. a ‘call option’ with a strike price X equal to Z t,t+n ): Value 0S t+n The value of the call option begins increasing when the exchange rate becomes larger than the exercise price - when the option becomes ‘in the money.’ X

36. But we’re missing something. While a futures contract has an expected return of zero, the value of the option looks like it is always positive… Value 0S t+n X

37. Hence, anyone taking the opposite side of the transaction (‘writing’ the option) will demand a price (C) that makes the expected value zero once again: Value 0S t+n Regardless of the outcome, the option’s value is reduced everywhere by the certain payment of its price. X C

38. The value of an option to sell one unit of foreign currency (a ‘put’ option) at a strike price equal to a corresponding futures contract price will have similar properties: Value 0S t+n X

39. Foreign Currency Swaps A currency swap is an exchange of debt-service obligations denominated in one currency for the service on an agreed upon principal amount of debt denominated in another currency. 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.

40. Dell SFr Dell computers would like to borrow in Swiss Francs to hedge its ongoing cash flows from that country…

41. DellNestle SFr$ Nestle would like to borrow in Dollars to hedge its sales to the U.S...

42. DellNestle SFr$ But both firms are relatively unknown to the respective credit markets, and thus anticipate unfavorable borrowing terms.

43. DellNestle I-Bank SFr$ But an investment bank comes along and suggests that each borrow in the credit markets that are comfortable with them...

44. DellNestle SFr$ …and then the investment bank will give them sufficient cash flows each period to cover the obligations of these loans... $ Sfr I-Bank

45. DellNestle SFr$ …in return for making the payments in the foreign currency that exactly match the other firm’s obligations. $ Sfr $ I-Bank

46. DellNestle SFr$ In other words, the swap effectively ‘completes the market’. Giving each firm access to the foreign debt market at reasonable terms. $ Sfr $

47. The All-In Cost of a Swap Clearly, the relative magnitudes of the respective payments determine each firm’s ultimate cost of borrowing. This cost is called the ‘all-in cost’. It is the effective interest rate the firm ends up paying on the money that it raised. It is the discount rate that equates the NPV of future interest and principal payments to the net proceeds received by the issuer. IRR

48. Swaps vs. Forwards Notice that on a one-year loan, a currency swap is no different than a one-year forward contract. In fact, a currency swap can really be thought of as a firm taking a domestic currency loan and purchasing a series of forward contracts to convert the payments into known foreign currency obligations. The implied forward rates need not equal the actual forward rates, but taken as a whole, should resemble an average forward rate over the term of the loan.

49. Comparative Borrowing Advantage Swaps only exist because there are market imperfections. If firms can access foreign and domestic debt markets at equal cost, clearly swaps are redundant. One important reason that currency swaps are so useful is that firms engaged in a swap need not each have an absolute borrowing advantage in the currency in which they borrow vis-a-vis the counterparty. In fact, it is quite likely that Nestle has better access to both the U.S. and Swiss debt markets than Dell. Comparative Advantage

50. Key Points 1. A firm wishing to hedge foreign currency exposure has five main financial hedging tools which facilitate doing so: forward contracts, money market hedges, futures contracts, foreign currency options, and currency swaps. 2. Forward contracts have the benefit of being tailor-made, with quantities and timing matched to the needs of the firm. Forward contracts are typically quite costly over longer horizons, as the market becomes highly illiquid. 3. Money market hedges are equally flexible, but depend on a firm having equal access to domestic and foreign credit markets.

51. Key Points 4.Futures contracts, traded on highly liquid exchanges, have the benefit that they can be sold on the market before the maturity date. As a result, futures contracts are particularly useful for hedging exposures whose maturity is uncertain. 5.On the other hand, futures contracts are standardized in terms of timing and quantities, and therefore they rarely offer a perfect hedge. 6.Options contracts allow a firm to hedge against movements in one direction while retaining exposure in the other. 7.Options are particularly useful in hedging exposures that are highly uncertain with respect to timing and magnitude.

52. Key Points 8.Currency swaps offer firms the ability to borrow against long-term foreign currency exposures when access to foreign debt markets is costly. 9.Currency swaps converts a domestic liability into a foreign one via what are effectively a bundle of long-dated forward contracts between two firms. 10.The effective cost of a currency swap is its ‘all-in cost’ - the effective rate of interest that the firm ends up paying on the constructed foreign liability. 11.Currency swaps require only that firms have differential relative - rather than absolute - advantage in accessing debt markets.