Foreign currency derivatives

and swaps
CHAPTER 8
A derivative is a contract between two or more
parties whose value is based on an agreed-upon
underlying financial asset, index, or security.
Common underlying instruments include: bonds,
commodities, currencies, interest rates, market
indexes, and stocks.

Futures contracts, forward

contracts, options, swaps, and warrants WHAT ARE
FINANCIAL
DERIVATIVES?
Financial derivatives are so named because their
values are derived from underlying assets.

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 • These instruments can be used for two
very distinct objectives:
• Speculation – use of derivative
instruments to take a position in the
PURPOSES OF expectation of a profit
FINANCIAL • Hedging – use of derivative
instruments to reduce the risks
DERIVATIVES associated with the everyday
management of corporate cash flow
 firms to achieve payoffs that they would not be able to achieve without derivatives, or could achieve only
Permit at greater cost

Hedge risks that otherwise would not be possible to hedge

Make underlying markets more efficient

Reduce volatility of stock returns

Minimize earnings volatility

Reduce tax liabilities

Motivate management (agency theory effect)

BENEFITS OF DERIVATIVES
 A foreign currency futures contract is an
alternative to a forward contract that calls
for future delivery of a standard amount of
foreign exchange at a fixed time, place, and Foreign
price (i.e., exchange rate).
Currency
Futures
It is similar to futures contracts that exist for
commodities such as cattle, lumber, interest-
bearing deposits, gold, etc.

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 • Contract specifications are established by the
exchange on which futures are traded.
• Major features that are standardized are:
• Contract size
• Method of stating exchange rates
Foreign
• Maturity date
Currency • Last trading day
Futures • Collateral and maintenance margins
• Settlement
• Commissions
• Use of a clearinghouse as a counterparty
Mexican Peso (CME)-MXN 500,000; $ per 10MXN
 • Foreign currency futures contracts differ from
forward contracts in a number of important ways:
• Futures are standardized in terms of size while
forwards can be customized
• Futures have fixed maturities while forwards can
have any maturity (both typically have maturities
Foreign of one year or less)
• Trading on futures occurs on organized
Currency exchanges while forwards are traded between
Futures individuals and banks
• Futures have an initial margin that is marked to
market on a daily basis while only a bank
relationship is needed for a forward
• Futures are rarely delivered upon (settled) while
forwards are normally delivered upon (settled)
 • A foreign currency option is a contract
giving the option purchaser (the buyer)
the right, but not the obligation, to buy
or sell a given amount of foreign
Foreign exchange at a fixed price per unit for a
specified time period (until the maturity
Currency date).
Options • Two basic types of options, puts and
calls:
• A call is an option to buy foreign currency
• A put is an option to sell foreign currency
 • The buyer of an option is the holder; the
seller is referred to as the writer or
grantor.
• Options have three different price
Foreign elements:
• The exercise or strike price – the exchange
Currency rate at which the foreign currency can be
purchased (call) or sold (put)
Options • The premium – the cost, price, or value of
the option itself
• The underlying or actual spot exchange rate
in the market
An American option gives
the buyer the right to
exercise the option at any
time between the date of
writing and the expiration or
maturity date. Foreign
Currency
A European option can be Options
exercised only on its
expiration date, not before.
An option whose exercise price is the
same as the spot price of the underlying
currency is said to be at-the-money
(ATM).

An option that would be profitable, Foreign

excluding the cost of the premium, if
exercised immediately is said to be in-
Currency
the-money (ITM). Options
An option that would not be profitable,
excluding the cost of the premium, if
exercised immediately is referred to as
out-of-the money (OTM).
In the past three decades, the use of
foreign currency options as a hedging
tool and for speculative purposes has
become a major foreign exchange
activity.
Options on the over-the-counter
(OTC) market can be tailored to the Foreign
specific needs of the firm but can Currency
expose the firm to counterparty risk.
Options
Options on organized exchanges are
standardized, but counterparty risk is
substantially reduced.
Swiss Franc Option Quotations (U.S. cents/SF)
Buyer of an option only exercises his/her
rights if the option is profitable.

In the case of a call option, as the spot price

of the underlying currency moves up, the Buyer of a
holder has the possibility of unlimited
profit. Call Option

The purchaser makes a profit as the franc

appreciates vs. the dollar – this is because
the purchaser has the right to purchase the
franc at a pre-specified, and in this case,
lower price than the current spot price.
Profit and Loss for the Buyer of a Call Option
 • Writer of a call:
• What the holder, or buyer of an option
loses, the writer gains
• The maximum profit that the writer of the
call option can make is limited to the
premium
Option • If the writer wrote the option naked, that is
Market without owning the currency, the writer
would now have to buy the currency at the
Speculation spot and take the loss delivering at the
strike price
• The amount of such a loss is unlimited and
increases as the underlying currency rises
• Even if the writer already owns the
currency, the writer will experience an
opportunity loss
Profit and Loss for the Writer of a Call Option
 • Buyer of a Put:
• The basic terms of this example are similar to
those just illustrated with the call
• The buyer of a put option, however, wants to be
able to sell the underlying currency at the
exercise price when the market price of that
Option currency drops (not rises as in the case of the call
option)
Market • If the spot price drops to $0.575/SF, the buyer of
the put will deliver francs to the writer and
Speculation receive $0.585/SF
• At any exchange rate above the strike price of
58.5, the buyer of the put would not exercise the
option, and would lose only the $0.05/SF
premium
• The buyer of a put (like the buyer of the call) can
never lose more than the premium paid up front
Profit and Loss for the Buyer of a Put Option
 • Seller (writer) of a put:
• If the spot price of francs drops
below 58.5 cents per franc, the
option will be exercised
Option • Below a price of 58.5 cents per franc,
Market the writer will lose more than the
premium received from writing the
Speculation option (falling below break-even)
• If the spot price is above $0.585/SF,
the option will not be exercised and
the option writer will pocket the
entire premium
Profit and Loss for the Writer of a Put Option
 • Price of currency options has six
elements
• Present spot rate
• Time to maturity
Option Pricing • Forward rate for matching maturity
and Valuation • U.S. dollar interest rate
• Foreign currency interest rate
• Volatility (standard deviation of daily
spot price movements)
 • The total value (premium) of an option is equal
to the intrinsic value plus time value.
• Intrinsic value is the financial gain if the option
is exercised immediately.
• For a call option, intrinsic value is zero
when the strike price is above the market
price
• When the spot price rises above the strike
Option Pricing price, the intrinsic value become positive
and Valuation • Put options behave in the opposite manner
• On the date of maturity, an option will have
a value equal to its intrinsic value (zero time
remaining means zero time value)
• The time value of an option exists because the
price of the underlying currency, the spot rate,
can potentially move further and further into
the money between the present time and the
option’s expiration date.
Option Intrinsic Value, Time Value, and Total Value
 • If currency options are to be used effectively,
either for the purposes of speculation or risk
management, the individual trader needs to
know how option values – premiums – react
to their various components.
• Forward rate sensitivity:
Currency • Standard foreign currency options are priced
around the forward rate because the current
Option Pricing spot rate and both the domestic and foreign
interest rates are included in the option
Sensitivity premium
• The option-pricing formula calculates a
subjective probability distribution centered on
the forward rate
• This approach does not mean that the market
expects the forward rate to be equal to the
future spot rate, it is simply a result of the
arbitrage-pricing structure of options
Summary of Option Premium Components
All firms – domestic or
multinational, small or large,
leveraged or unleveraged – are
sensitive to interest rate
movements in one way or
another. Interest Rate
Risk
The single largest interest rate
risk of nonfinancial firms is debt
service; multicurrency
dimension of interest rate risk
for the MNE is of serious
concern.
International Interest Rate Calculations
The second most prevalent source of
interest rate risk for the MNE lies in
its holdings of interest-sensitive
securities.

Unlike debt, which is recorded on the

right-hand side of the firm’s balance Interest Rate
sheet, the marketable securities
portfolio of the firm appears on the Risk
left-hand side.
Marketable securities represent
potential earnings for the firm.
Prior to describing the management of the
most common interest rate pricing risks, it is
important to distinguish between credit risk
and repricing risk.

Credit risk (roll-over risk): possibility that a

borrower’s credit worthiness, at the time of
Interest Rate
renewing credit, is reclassified by the lender
(resulting in changes to fees, interest rates,
Risk
credit line commitments, denial of credit).

Repricing risk: the risk of changes in interest

rates charged (earned) at the time a
financial contract’s rate is reset. This is
unrelated to changes in creditworthiness of
the specific borrower.
 Unlike foreign currency futures, interest
rate futures are relatively widely used by
financial managers and treasurers of
nonfinancial companies.

Their popularity stems from the relatively

high liquidity of the interest rate futures
Interest Rate markets, their simplicity in use, and the
rather standardized interest-rate exposures
Futures most firms possess.

The two most widely used futures contracts

are the Eurodollar futures traded on the
Chicago Mercantile Exchange (CME) and the
US Treasury Bond Futures of the Chicago
Board of Trade (CBOT).
Eurodollar Futures Prices
 • Common interest rate futures strategies:
• Paying interest on a future date (sell
futures contract/short position)
• If rates go up, the futures price falls
and the short earns a profit (offsets
higher interest expense)
• If rates go down, the futures price
Interest Rate rises and the short earns a loss
Futures • Earning interest on future date (buy
futures contract/long position)
• If rates go up, the futures price falls
and the long earns a loss
• If rates go down, futures price rises
and the long earns a profit
Interest Rate Futures Strategies for Common Exposures
A forward rate agreement (FRA) is an interbank-traded
contract to buy or sell interest rate payments on a notional
principal.

These contracts are settled in cash.

Forward Rate
The buyer of an FRA obtains the right to lock in an interest
rate for a desired term that begins at a future date.
Agreements

The contract specifies that the seller of the FRA will pay the
buyer the increased interest expense on a nominal sum
(the notional principal) of money if interest rates rise
above the agreed rate, but the buyer will pay the seller the
differential interest expense if interest rates fall below the
agreed rate.
 • Swaps are contractual agreements to
exchange or swap a series of cash
flows.
• These cash flows are most commonly
the interest payments associated with
debt service, such as that on a
Interest Rate floating-rate loan.
• If the agreement is for one party to swap its
Swaps fixed interest rate payments for the floating
interest rate payments of another, it is
termed an interest rate swap
• If the agreement is to swap currencies of
debt service obligation, it is termed a
currency swap
• A single swap may combine elements of
both interest rate and currency swaps
 The swap itself is not a source of
capital, but rather an alteration of the
cash flows associated with payment.

What is often termed the plain vanilla

swap is an agreement between two
Interest Rate parties to exchange fixed-rate for
Swaps floating-rate financial obligations.

This type of swap forms the largest

single financial derivative market in
the world.
 • The two parties may have various motivations for
entering into the agreement.
• A very common situation is as follows:
• A corporate borrower of good credit standing has
existing floating-rate debt service payments.
Interest Rate • The borrower may conclude that interest rates
are about to rise.
Swaps • In order to protect the firm against rising debt-
service payments, the company’s treasury may
enter into a swap agreement to pay fixed/receive
floating.
• This means the firm will now make fixed interest
rate payments and receive from the swap
counterparty floating interest rate payments.
Similarly, a firm with fixed-rate
debt that expects interest rates to
fall can change fixed-rate debt to
floating-rate debt.

In this case, the firm would enter Interest Rate

into a pay floating/receive fixed Swaps
interest rate swap.

Interest rate swaps are also

known as coupon swaps.
Interest Rate Swap Strategies
Since all swap rates are derived from the yield curve in each
major currency, the fixed- to floating-rate interest rate swap
existing in each currency allow firms to swap across currencies.

The usual motivation for a currency swap is to replace cash

flows scheduled in an undesired currency with flows in a
desired currency.

The desired currency is probably the currency in which the

firm’s future operating revenues (inflows) will be generated.

Currency
Firms often raise capital in currencies in which they do not
possess significant revenues or other cash flows.
Swaps
The utility of the currency swap market to an MNE is
significant. An MNE wishing to swap a 10-year fixed 6.04% U.S.
dollar cash flow stream could swap to 4.46% fixed in euro,
3.30% fixed in Swiss francs, or 2.07% fixed in Japanese yen.
It could swap from fixed dollars not only to fixed rates, but also
to floating LIBOR rates in the various currencies as well.
Interest Rate and Currency Swap Quotes