Chap 8 Foreign Currency Derivatives

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Financial management of the MNE in the 21st century involves financial derivatives.

These derivatives, so named because their values are derived from underlying assets

These instruments can be used for two very distinct management objectives: Speculation – use of derivative instruments to take a

position in the expectation of a profit Hedging – use of derivative instruments to reduce the

risks associated with the everyday management of corporate cash flow

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Derivatives are used by firms to achieve one of more of the following individual benefits: Permit firms to achieve payoffs that they would

not be able to achieve without derivatives, or could achieve only 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)

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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 price.

It is similar to futures contracts that exist for commodities such as cattle, lumber, interest-bearing deposits, gold, etc.

In the US, the most important market for foreign currency futures is the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange.

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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 Maturity date Last trading day Collateral and maintenance margins Settlement Commissions Use of a clearinghouse as a counterparty

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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 of one year or less)

Trading on futures occurs on organized exchanges while forwards are traded between individuals and banks

Futures have an initial margin that is market 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)

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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 exchange at a fixed price per unit for a specified time period (until the maturity date).

There are 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

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The buyer of an option is termed the holder, while the seller of the option is referred to as the writer or grantor.

Every option has three different price elements: The exercise or strike price – the exchange rate at which

the foreign currency can be purchased (call) or sold (put) The premium – the price, or value of the option itself The underlying or actual spot exchange rate in the

market

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An American option gives the buyer the right to exercise the option at any time between the date of writing and the expiration date.

A European option can be exercised only on its expiration date, not before.

The premium, or option price, is the cost of the option.

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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 the would be profitable, excluding the cost of the premium, if exercised immediately is said to be in-the-money (ITM).

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)

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In the past three decades, the use of foreign currency options as a hedging tool and for speculative purposes has blossomed into a major foreign exchange activity.

Options on the over-the-counter (OTC) market can be tailored to the specific needs of the firm but can expose the firm to counterparty risk.

Options on organized exchanges are standardized, the counterparty risk is substantially reduced.

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Buyer of a call: Assume purchase of August call option on Swiss

francs with strike price of 58½ ($0.5850/SF), and a premium of $0.005/SF

At the expiration day, At all spot rates below the strike price of 58.5,

the purchase of the option would choose not to exercise because it would be cheaper to purchase SF on the open market

At all spot rates above the strike price, the option purchaser would exercise the option, purchase SF at the strike price and sell them into the market netting a profit (less the option premium)

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Speculation is an attempt to profit by trading on expectations about prices in the future.

Speculators can attempt to profit in the: Spot market – when the speculator believes the foreign

currency will appreciate in value Forward market – when the speculator believes the spot

price at some future date will differ from today’s forward price for the same date

Options markets – extensive differences in risk pattens produced depending on purchase or sale of put and/or call

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Writer of a call: The maximum profit that the writer of the call option can

make is limited to the premium If the writer wrote the option naked, that is without

owning the currency, the writer would have to buy the currency at the spot at the expiration day and take the loss to deliver 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

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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 $0.585/SF when the market price of that currency drops

If the spot price drops to $0.575/SF, the buyer of the put will deliver francs to the writer and 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 $0.005/SF premium

The buyer of a put (like the buyer of the call) can never lose more than the premium paid up front

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Seller (writer) of a put: In this case, if the spot price of francs drops

below 58.5 cents per franc, the option will be exercised

Below a price of 58.0 cents per franc, the writer will lose more than the premium received from writing the 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

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The pricing of any currency option combines six elements: Present spot rate Time to maturity Forward rate for matching maturity US dollar interest rate Foreign currency interest rate Volatility (standard deviation of daily

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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 price, the intrinsic

value become positive 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.

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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.

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Forward rate sensitivity: Standard foreign currency options are priced around the

forward rate because the current spot rate and both the domestic and foreign interest rates are included in the option premium calculation

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

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Spot rate sensitivity (delta): The sensitivity of the option premium to

a small change in the spot exchange rate is called the delta

delta =

The higher the delta, the greater the probability of the option expiring in-the-money

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Δ spot rateΔ premium

Time to maturity – value and deterioration (theta): Option values increase with the length of

time to maturitytheta =

A trader will normally find longer-maturity option better values, giving the trader the ability to alter an option position without suffering significant time value deterioration

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Δ timeΔ premium

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Sensitivity to volatility (lambda): Option volatility is defined as the standard deviation of

daily percentage changes in the underlying exchange rate

Volatility is important to option value because of an exchange rate’s perceived likelihood to move either into or out of the range in which the option will be exercised

lambda =

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Δ volatilityΔ premium

Volatility is viewed in three ways: Historic Forward-looking Implied

Because volatilities are the only judgmental component that the option writer contributes, they play a critical role in the pricing of options.

All currency pairs have historical series that contribute to the formation of the expectations of option writers.

In the end, the truly talented option writers are those with the intuition and insight to price the future effectively.

Traders who believe that volatilities will fall significantly in the near-term will sell (write) options now, hoping to buy them back for a profit immediately volatilities fall, causing option premiums to fall.

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Sensitivity to changing interest rate differentials (rho and phi): Currency option prices and values are focused on the

forward rate The forward rate is in turn based on the theory of Interest

Rate Parity Interest rate changes in either currency will alter the

forward rate, which in turn will alter the option’s premium or value

A trader who is purchasing a call option on foreign currency should do so before the domestic interest rate rises. This timing will allow the trader to purchase the option before its price increases.

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The expected change in the option premium from a small change in the domestic interest rate (home currency) is the term rho.

rho =

The expected change in the option premium from a small change in the foreign interest rate (foreign currency) is termed phi.

phi =

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Δ US $ interest rateΔ premium

Δ foreign interest rateΔ premium

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The sixth and final element that is important to option valuation is the selection of the actual strike price.

A firm must make a choice as per the strike price it wishes to use in constructing an option (OTC market).

Consideration must be given to the tradeoff between strike prices and premiums. See next slide.

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In his 2002 letter to shareholders, what does Warren Buffett seem to fear most about financial derivatives?

In his 2007 letter to shareholders, what does Warren Buffett admit that he and Charlie had done?

Do you think there is an underlying consistency in his viewpoint on the proper use of derivatives?

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