Chapter 5

Hedging Foreign
Exchange Risk and
Derivatives

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Introduction (I)
In the financial marketplace some instruments are regarded as fundamentals,
while others are regarded as derivatives.

Financial Marketplace

Derivatives Fundamentals

Simply another way to catagorize the diversity in the FM*.

*Financial Market
Introduction (II)

Financial Marketplace

Derivatives Fundamentals

• Futures • Stocks
• Forwards • Bonds
• Options • Etc.
• Swaps
What is a Derivative? (I)

Options

The value of the

derivative instrument is
Futures DERIVED from the
Forwards
underlying security

Swaps

Underlying instrument such as a commodity, a stock, a stock index, an exchange

rate, a bond, another derivative etc..
 The financial derivative is an asset whose value is derived
from the value of some other asset(s) or derivatives, known
as underlying asset(s).
Example:
•An orange juice can be considered as a derivative of the
oranges since its price can be derived from that of oranges.
•An financial contract on selling 100 barrels of crude oil at
$70/barrel in three months. (Forward or futures contract)

It can also extend to something like a reimbursement program for

college credit. Consider that if your firm reimburses 100% of costs for
an “A”, 75% of costs for a “B”, 50% for a “C” and 0% for anything
less.
Your “right” to claim this reimbursement, then is tied to the grade you earn. The
value of that reimbursement plan, therefore, is derived from the grade you earn.
We also say that the value is contingent upon the grade you earn. Thus, your
claim for reimbursement is a “contingent” claim.
The terms contingent claims and derivatives are used interchangeably.
Types is a Derivative? (II)

Futures The owner of a future has the OBLIGATION to sell or buy

something in the future at a predetermined price.

The owner of a forward has the OBLIGATION to sell or buy

Forwards something in the future at a predetermined price. The difference
to a future contract is that forwards are not standardized.

Options The owner of an options has the OPTION to buy or sell

something at a predetermined price and is therefore more costly
than a futures contract.

Swaps A swap is an agreement between two parties to

exchange a sequence of cash flows.
 Forward Contracts
A forward contract is an agreement between
two parties to buy or sell an asset at a certain
future time for a certain future price.
– Forward contracts are normally not exchange
traded.
– The party that agrees to buy the asset in the
future is said to have the long position.
– The party that agrees to sell the asset in the
future is said to have the short position.
– The specified future date for the exchange is
known as the delivery (maturity) date.
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 Forward Contracts
The specified price for the sale is known as the
delivery price, we will denote this as K.
– Note that K is set such that at initiation of the contract
the value of the forward contract is 0.
As time progresses the delivery price doesn’t
change, but the current spot (market) rate does.
Thus, the contract gains (or loses) value over
time.
– Consider the situation at the maturity date of the
contract. If the spot price is higher than the delivery
price, the long party can buy at K and immediately sell
at the spot price ST, making a profit of (ST-K), whereas
the short position could have sold the asset for ST, but
is obligated to sell for K, earning a profit (negative) of
(K-ST).

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 Forward Contracts
• Example:
– Let’s say that you entered into a forward contract to buy
wheat at Birr 4.00/ kilogram, with delivery in December
– Let’s say that the delivery date was December 14 and that
on December 14th the market price of wheat is unlikely to
be exactly Birr 4.00/ kilogram , but that is the price at
which you have agreed (via the forward contract) to buy
your wheat.
– If the market price is greater than Birr 4.00/ kilogram, you
are pleased, because you are able to buy an asset for less
than its market price.
– If, however, the market price is less than Birr 4.00/
kilogram, you are not pleased because you are paying
more than the market price for the wheat.
– Indeed, we can determine your net payoff to the trade by
applying the formula: payoff = ST – K, since you gain an
asset worth ST, but you have to pay birr K for it.
– We can graph the payoff function:
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Forward Contracts

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• Example2:
– In this example you were the long party, but what
about the short party?
– They have agreed to sell wheat to you for Birr 4.00/
kilogram on December 14.
– Their payoff is positive if the market price of wheat is
less than Birr 4.00/ kilogram– they force you to pay
more for the wheat than they could sell it for on the
open market.
• Indeed, you could assume that what they do is buy it on the open
market and then immediately deliver it to you in the forward contract.
– Their payoff is negative, however, if the market price
of wheat is greater than Birr 4.00/ kilogram
• They could have sold the wheat for more than Birr 4.00/ kilogram had
they not agreed to sell it to you.
– So their payoff function is the mirror image of your
payoff function:

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 Forward Contracts
Payoff to Short Futures Position on Wheat
Where the Delivery Price (K) is $4.00/Bushel

2
Payoff to Forwards

0
0 1 2 3 4 5 6 7 8
-1

-2

-3

-4
Wheat Market (Spot) Price, December 14

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 Forward Contracts
• Clearly the short position is just the mirror
image of the long position, and, taken
together the two positions cancel each other
out:

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 Forward Contracts
Long and Short Positions in a Forward Contract
For Wheat at $4.00/Bushel

3
Short Position
2

1
Long Position
Payoff

0
0 1 2 3 4 5 6 7 8
-1
Net
-2
Position
-3

-4
Wheat Price

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 Futures Contracts
• A futures contract is similar to a forward contract in that
it is an agreement between two parties to buy or sell an
asset at a certain time for a certain price. Futures,
however, are usually exchange traded and, to facilitate
trading, are usually standardized contracts. This results in
more institutional detail than is the case with forwards.

• The long and short party usually do not deal with each
other directly or even know each other for that matter.
The exchange acts as a clearinghouse. As far as the two
sides are concerned they are entering into contracts with
the exchange. In fact, the exchange guarantees
performance of the contract regardless of whether the
other party fails.
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 Options Contracts
• The owner of an options has the OPTION to
buy or sell something at a predetermined
price and is therefore more costly than a
futures.
• There are two basic types of options:
– A Call option is the right, but not the obligation,
to buy the underlying asset by a certain date for a
certain price.
– A Put option is the right, but not the obligation,
to sell the underlying asset by a certain date for a
certain price.
• Note that unlike a forward or futures contract, the holder of the
options contract does not have to do anything - they have the option to
do it or not.

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 Options Contracts
• The date when the option expires is known as the exercise
date, the expiration date, or the maturity date.
• The price at which the asset can be purchased or sold is known
as the strike price.
• If an option is said to be European, it means that the holder of
the option can buy or sell (depending on if it is a call or a put)
only on the maturity date. If the option is said to be an
American style option, the holder can exercise on any date up
to and including the exercise date.
• An options contract is always costly to enter as the long party.
The short party always is always paid to enter into the contract
– Looking at the payoff diagrams you can see why…

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 Options Contracts
• Let’s say that you entered into a call option on IBM
stock:
– Today IBM is selling for roughly $78.80/share, so let’s say
you entered into a call option that would let you buy IBM
stock in December at a price of $80/share.
– If in December the market price of IBM were greater than
$80, you would exercise your option, and purchase the
IBM share for $80.
– If, in December IBM stock were selling for less than
$80/share, you could buy the stock for less by buying it in
the open market, so you would not exercise your option.
– Thus your payoff to the option is $0 if the IBM stock is less than $80
– It is (ST-K) if IBM stock is worth more than $80
– Thus, your payoff diagram is:

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 Options Contracts
Long Call on IBM
with Strike Price (K) = $80

80

60

40
Payoff

20

0
0 20 40 60 K =80 100 120 140 160
-20
IBM Terminal Stock Price

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 Options Contracts
– What if you had the short position?
– Well, after you enter into the contract, you have
granted the option to the long-party.
– If they want to exercise the option, you have to do so.
– Of course, they will only exercise the option when it is
in there best interest to do so – that is, when the
strike price is lower than the market price of the stock.
• So if the stock price is less than the strike price (ST<K), then the long party will
just buy the stock in the market, and so the option will expire, and you will
receive $0 at maturity.
• If the stock price is more than the strike price (ST>K), however, then the long
party will exercise their option and you will have to sell them an asset that is
worth ST for $K.
– We can thus write your payoff as:
payoff = min(0,ST-K),
which has a graph that looks like:
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 Options Contracts
Short Call Position on IBM Stock
with Strike Price (K) = $80

21.25

0
Payoff to Short Position

0 20 40 60 80 100 120 140 160

-21.25

-42.5

-63.75

-85
Ending Stock Price

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 Options Contracts
• This is obviously the mirror image of the long
position.
• Notice, however, that at maturity, the short
option position can NEVER have a positive payout
– the best that can happen is that they get $0.
– This is why the short option party always demands an
up-front payment – it’s the only payment they are
going to receive. This payment is called the option
premium or price.

• Once again, the two positions “net out” to zero:

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 Options Contracts

Long and Short Call Options on IBM

with Strike Prices of $80

100
80
60 Long Call
40

Net Position
20
Payoff

0
-20 0 20 40 60 80 100 120 140 160

-40
-60
-80 Short Call
-100
Ending Stock Price

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 Options Contracts
• Traders frequently refer to an option as being “in the money”, “out
of the money” or “at the money”.
– An “in the money” option means one where the price of the
underlying is such that if the option were exercised immediately,
the option holder would receive a payout.
• For a call option this means that St>K
• For a put option this means that St<K
– An “at the money” option means one where the strike and
exercise prices are the same.
– An “out of the money” option means one where the price of the
underlying is such that if the option were exercised immediately,
the option holder would NOT receive a payout.
• For a call option this means that St<K
• For a put option this means that St>K.

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 Types of traders
• So who trades options contracts? Generally
there are three types of options traders:
– Hedgers
– Speculators
– Arbitrageurs

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 Types of traders

Hedger
The hedgers can use the derivatives to reduce their risk on
the unfavorable movement of market variables such as
exchange rates and commodity prices.
Example 1.3
Suppose ABC Airline Co. knows that it will have to buy on
31 Dec 2011 (date T) 1 million tons of fuel. To hedge
against the possible increase in fuel price between today and
T, he could

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 In summary, forward contracts are designed to neutralize
the risk by fixing price. By contrast, option contracts offer
a way for investors to protect themselves against adverse
price movements in the future while still allowing them to
benefit from favorable price movements. Unlike
forwards, options involve the payment of an upfront fee.

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 Types of traders

Speculator
 The speculator wishes gain profit from taking the market
movement. Either they are betting that the price of the
asset will go up or go down.
 The financial derivatives allow them to create the
speculative position in a much lower cost than by
actually trading the underlying asset. This is called
leverage.

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Arbitrageur
An arbitrage is a deal that produces risk-free profit by
exploiting a mispricing in the market.
An arbitrageur can purchase an asset cheaply in one
location and simultaneously sell it in another at a higher
price.
The arbitrage opportunities cannot last for long.
More complicated arbitrage trading strategies can be
created from financial derivatives.

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 Summary
• A forward or futures contract involves an
obligation to buy or sell an asset at a certain
time in the future for a certain price.
• There are two types of options: calls and puts.
A call option gives the holder the right to buy
an asset by a certain date for a certain price.
A put option gives the holder the right to sell
an asset by a certain date for a certain price.
• Three main types of traders can be identified:
hedgers, speculators, and arbitrageurs.

Hedgers are in the position where they face

risk associated with the price of an asset. They
use derivatives to reduce or eliminate this
risk.
Speculators wish to bet on future movements
in the price of an asset. They use derivatives
to get extra leverage.
Arbitrageurs are in business to take advantage
of a discrepancy between prices in two
different markets.