Foreign Currency Derivatives

6.
Foreign currency derivatives

Foreign currency futures
Currency options
Interest rate and foreign currency swaps
Using these derivatives to hedge foreign exchange
risk
152
Universidade do Minho
Escola de Economia e Gestão
Departamento de Gestão
Currency futures contracts

specify a standard volume of a particular
currency to be exchanged on a specific
settlement date
typically the third Wednesdays in March, June,
September, and December
http://www.cmegroup.com/trading/fx/g10/euro-
fx_quotes_globex.html
used by MNCs to hedge their currency
positions, and by speculators to capitalize
on their expectations of exchange rate
movements
153
1
A buyer of a currency futures contract locks in

the exchange rate to be paid for a foreign
currency at a future point in time
A seller of a currency futures contract locks in
the exchange rate at which a foreign currency
can be exchanged for the home currency
Contract specifications (size, quotes in US
dollar per unit of foreign currency, maturity
date, collateral & maintenance margins,…
Comparison with forward contracts
154
Currency futures contracts have no credit

risk since they are guaranteed by the
exchange clearinghouse
To minimize its risk in such a guarantee,
the exchange imposes margin
requirements to cover fluctuations in the
value of the contracts
155
2
Normally, the price of a currency futures

contract is similar to the forward rate for a given
currency and settlement date
but differs from the spot rate when the interest
rates on the two currencies differ
These relationships are enforced by the potential
arbitrage activities that would occur otherwise
At expiration, the futures price converges to the
spot price
What would happen if the Futures price is higher
than the spot rate? ____________________
156
Currency futures may be purchased by

MNCs to hedge foreign currency payables,
or sold to hedge receivables.
Hedging receivables
April 4 June 17
1. Expect to receive 2. Receive C$500,000
C$500,000. as expected
Contract to sell
C$500,000 on 3. Sell the C$ at the
June 17 locked-in rate
157
3
Hedging payables
April 4 June 17
1. Have to pay
C$500,000. 2. Buy the C$ at the
Contract to buy locked-in rate
C$500,000 on
June 17 3. Pay C$500,000
158
Holders of futures contracts can close out

their positions by selling similar futures
contracts. Sellers may also close out their
positions by purchasing similar contracts
January 10 February 15 March 19
1. Contract to 2. Contract to 3. Incurs $3000
buy sell loss from
A$100,000 A$100,000 offsetting
at $.53/A$ at $.50/A$ positions in
($53,000) on ($50,000) on futures
March 19. March 19. contracts.
159
4
Hedging problems
Basis risk
Cross-hedge risk
Most currency futures contracts are closed

out before their settlement dates
Brokers who fulfill orders to buy or sell
futures contracts earn a transaction or
brokerage fee in the form of the bid/ask
spread
Currency options
A currency option is another type of

contract that can be purchased or sold by
speculators and firms
http://www.nasdaq.com/asp/currency-
options.asp
standard options that are traded on an
exchange are guaranteed, but require
margin maintenance
no credit guarantees for OTC options, so
some form of collateral may be required
Currency options: calls or puts
161
5
Currency options
A currency call option grants the holder

the right to buy a specific currency at a
specific price (called the exercise or strike
price) within a specific period of time
A call option is
in the money - if spot rate > strike price,
at the money - if spot rate = strike price,
out of the money - if spot rate < strike
price.
162
Currency options
Option owners can sell or exercise their

options. They can also choose to let their
options expire
At most, they will lose the premiums they paid
for their options
Call option premiums will be higher when:
(spot price – strike price) is larger
the time to expiration date is longer
the variability of the currency is greater
163
6
Currency options
Firms with open positions in foreign

currencies may use currency call options to
cover those positions
purchase currency call options
to hedge future payables
to hedge potential expenses when bidding on
projects
to hedge potential costs when attempting to
acquire other firms
164
Currency options
A currency put option grants the holder

the right to sell a specific currency at a
specific price (the strike price) within a
specific period of time
A put option is
in the money - if spot rate < strike price,
at the money - if spot rate = strike price,
out of the money - if spot rate > strike
price.
165
7
Currency options
Put option premiums will be higher when:

(strike price – spot rate) is larger
the time to expiration date is longer
the variability of the currency is greater
Corporations with open foreign currency
positions may use currency put options to
cover their positions
firms may purchase put options to hedge
future receivables
166
Currency options
A British pound call option

Strike price = $1.50 Premium = $.02
Net Profit Net Profit
per Unit per Unit
+$.04 +$.04
Future
+$.02 +$.02 Spot
Rate
0 0
$1.46 $1.50 $1.54 $1.46 $1.50 $1.54
- $.02 Future - $.02
Spot
- $.04 Rate - $.04
167
8
Currency options
A British pound Put Option

Strike price = $1.50 Premium = $.03
Net Profit Net Profit
per Unit per Unit
+$.04 +$.04
Future
+$.02 Spot +$.02
Rate
0 0
$1.46 $1.50 $1.54 $1.46 $1.50 $1.54
- $.02 - $.02 Future
Spot
- $.04 - $.04 Rate
168
Currency options
The pricing of any option combines six

elements
Present spot rate, $1.70/£
Time to maturity, 90 days
Forward rate for matching maturity (90 days),
$1.70/£
US dollar interest rate, 8.00% p.a.
British pound interest rate, 8.00% p.a.
Volatility, the standard deviation of daily spot
rate movement, 10.00% p.a.
169
9
Currency options
The intrinsic value is the financial gain if

the option is exercised immediately (at-the-
money)
This value will reach zero when the option is
out-of-the-money
When the spot rate rises above the strike
price, the option will be in-the-money
At maturity date, the option will have a value
equal to its intrinsic value
170
Currency options
When the spot rate is $1.74/£, the option is

ITM and has an intrinsic value of $1.74 -
$1.70/£, or 4 cents per pound
ATM and its intrinsic value is $1.70 - $1.70/£,
or zero cents per pound
OTM and has no intrinsic value, only a fool
would exercise this option
171
10
Currency options
The time value of the option exists

because the price of the underlying
currency can potentially move further into
the money between today and maturity
Option volatility is defined as the
standard deviation of the daily percentage
changes in the underlying exchange rate
It is the most important variable because of
the exchange rate’s perceived likelihood to
move either in or out of the range in which
the option would be exercised
172

Interest rate risk
All firms, domestic or multinational, are sensitive
to interest rate movements
The single largest interest rate risk of a non-
financial firm is debt service (for an MNE, differing
currencies have differing interest rates thus
making this risk a larger concern)
The second most prevalent source of interest rate
risk is its holding of interest sensitive securities
Ever increasing competition has forced financial
managers to better manage both sides of the
balance sheet
173
11
Credit and repricing Risk

Example: Consider a firm facing three debt
strategies
Strategy #1: Borrow $1 million for 3 years at a
fixed rate
Strategy #2: Borrow $1 million for 3 years at a
floating rate, LIBOR + 2% to be reset annually
Strategy #3: Borrow $1 million for 1 year at a
fixed rate, then renew the credit annually
Although the lowest cost of funds is always a
major criteria, it is not the only one
174
Example using Trident corporation’s loan

of US$10 million serviced with annual
payments and the principal paid at the end
of the third year
The loan is priced at US dollar LIBOR +
1.50%; LIBOR is reset every year
When the loan is drawn down initially (at time
0), an up-front fee of 1.50% is charged
Trident will not know the actual interest cost
until the loan has been completely repaid
175
12
176

If Trident had wished to manage the interest rate
risk associated with the loan, it would have a
number of alternatives
Refinancing – could go back to the lender and
refinance the entire agreement
Forward Rate Agreements (FRAs) – could lock
in the future interest rate payment in much the
same way that exchange rates are locked in with
forward contracts
Interest Rate Futures
Interest Rate Swaps – could swap the floating
rate note for a fixed rate note with a swap dealer
177
13
Interest Rate Swaps
Swaps are contractual agreements to
exchange or swap a series of cash flows
If the agreement is for one party to swap its fixed
interest payment for a floating rate payment, its is
termed an interest rate swap
If the agreement is to swap currencies of debt
service it is termed a currency swap
A single swap may combine elements of both
interest rate and currency swap
The swap itself is not a source of capital but an
alteration of the cash flows associated with
payment
178
If firm thought that rates would rise it would enter

into a swap agreement to pay fixed and receive
floating in order to protect it from rising debt-
service payments
If firm thought that rates would fall it would enter

into a swap agreement to pay floating and receive
fixed in order to take advantage of lower debt-
service payments
The cash flows of an interest rate swap are interest

rates applied to a set amount of capital, no
principal is swapped only the coupon payments
179
14
180

Comparative advantage
Companies of different credit quality are treated
differently by the capital markets
For example, Unilever (U.K.) and Xerox (U.S.)
are both in the market for $30 million of debt for
a 5-year period
Unilever is an AAA credit rating (the highest),
and therefore has access to both fixed and
floating interest rate debt at attractive rates
Unilever would prefer to borrow at floating rates,
since it already has fixed-rate funds and wishes
to increase the proportion of its debt portfolio
which is floating
181
15
Comparative advantage
Xerox has a BBB credit rating (the lowest major
category of investment grade debt ratings), and
would prefer to raise the debt at fixed rates of
interest
Although Xerox has access to both fixed-rate
and floating-rate finds, the fixed-rate debt is
considered expensive
The firms, through Citibank, could actually
borrow in their relatively ‘advantaged’ markets
and then swap their debt service payments
182
183
16
Trident’s CFO is concerned about the

floating rate loan
she thinks that rates will rise over the life of
the loan and wants to protect Trident from an
increased interest payment
she believes that an interest rate swap to pay
fixed/receive floating would be Trident’s best
alternative
She contacts the bank and receives a quote of
5.75% against LIBOR; this means that Trident
will receive LIBOR and pay out 5.75% for the
three years
184
The swap does not replace the original

loan, Trident must still make its payments
at the original rates; the swap only
supplements the loan payments
Trident’s 1.50% fixed rate above LIBOR
must still be paid along with the 5.75% as
per the swap agreement; however, Trident
now receives LIBOR thus offsetting the
floating rate risk in the original loan
Trident’s total payment will therefore be
7.25% (5.75% + 1.50%)
185
17
186

After raising the $10 million in floating rate
financing and swapping into fixed rate payments,
Trident decides it would prefer to make its debt-
service payments in Swiss francs
Trident signed a 3-year contract with a Swiss
buyer, thus providing a stream of cash flows in
Swiss francs
Trident would now enter into a three-year pay
Swiss francs and receive US dollars currency swap
Both interest rates are fixed
Trident will pay 2.01% (ask rate) fixed Sfr interest
and receive 5.56% (bid rate) fixed US dollars
187
18
The spot rate in effect on the date of the

agreement establishes what the notional
principal is in the target currency
In this case, Trident is swapping into francs, at
Sfr1.50/$
This is a notional amount of Sfr15,000,000.
Thus Trident is committing to payments of
Sfr301,500(2.01%×Sfr15,000,000=
Sfr301,500)
Unlike an interest rate swap, the notional
amounts are part of the swap agreement
189
19
190
As with the original loan agreement, a swap

can be entered or unwound if viewpoints
change or other developments occur
Assume that the three-year contract with
the Swiss buyer terminates after one year,
Trident no longer needs the currency swap
Unwinding a currency swap requires the
discounting of the remaining cash flows
under the swap agreement at current
interest rates then converting the target
currency back to the home currency
191
20
If Trident has two payments of Sfr301,500 and

Sfr15,301,500 remaining (interest plus principal in
year three) and the 2 year fixed rate for francs is
now 2.00%, the PV of Trident’s commitment in
francs is:
Sfr301,500 Sfr15,301,500
PV(Sfr) = + = Sfr15,002,912
(1.020)1 (1.020) 2
192

At the same time, the PV of the remaining cash
flows on the dollar-side of the swap is determined
using the current 2 year fixed dollar rate which is
now 5.50%
$556,000 $10,556,000
PV(US$) = + = $10,011,078
(1.055)1 (1.055) 2
193
21
Trident’s currency swap, if unwound now, would yield
a PV of net inflows of $10,011,078 and a PV of net
outflows of Sfr15,002,912. If the current spot rate is
Sfr1.4650/$ the net settlement of the swap is
Sfr15,002,912
Settlement = $10,011,078 − = ($229,818)
Sfr1.4650/$
Trident makes a cash payment to the swap dealer of
$229,818 to terminate the swap
Trident lost on the swap due to franc appreciation
194

Counterparty Risk is the potential exposure any
individual firm bears that the second party to any
financial contract will be unable to fulfill its
obligations
A firm entering into a swap agreement retains the
ultimate responsibility for its debt-service
In the event that a swap counterpart defaults, the
payments would cease and the losses associated
with the failed swap would be mitigated
The real exposure in a swap is not the total notional
principal but the mark-to-market value of the
differentials
195
22

Foreign Currency Derivatives

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Foreign Currency Derivatives

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6.

Foreign currency derivatives

Foreign currency futures

Currency futures contracts

A buyer of a currency futures contract locks in

Foreign currency futures

Currency futures contracts have no credit

Normally, the price of a currency futures

Foreign currency futures

Currency futures may be purchased by

Foreign currency futures

Holders of futures contracts can close out

Most currency futures contracts are closed

A currency option is another type of

A currency call option grants the holder

Option owners can sell or exercise their

Firms with open positions in foreign

A currency put option grants the holder

Put option premiums will be higher when:

A British pound call option

A British pound Put Option

The pricing of any option combines six

The intrinsic value is the financial gain if

When the spot rate is $1.74/£, the option is

The time value of the option exists

Interest rate and foreign currency swaps

Credit and repricing Risk

Interest rate and foreign currency swaps

Example using Trident corporation’s loan

Interest rate and foreign currency swaps

Interest rate and foreign currency swaps

If firm thought that rates would rise it would enter

If firm thought that rates would fall it would enter

The cash flows of an interest rate swap are interest

Interest rate and foreign currency swaps

Trident’s CFO is concerned about the

Interest rate and foreign currency swaps

The swap does not replace the original

Interest rate and foreign currency swaps

The spot rate in effect on the date of the

Interest rate and foreign currency swaps

As with the original loan agreement, a swap

If Trident has two payments of Sfr301,500 and

Interest rate and foreign currency swaps

Interest rate and foreign currency swaps

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