Curre Currency Sncy Option V

7/28/2019 Curre Currency Sncy Option V

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Currency Options and Swaps:

Hedging Currency Risk

By Louis Morel

ECON 826 International FinanceQueens Economics Department

January 23, 2004

Table of Contents

1. Introduction ........................................................ ...................................... 22. Currency risk exposure........................................ ...................................... 2

3. Currency options ................................................. ...................................... 4

4. Currency swaps............................................................................... ..........6

5. Statistics about currency options and swaps ...................................... .......... 7

6. Conclusion ................................................ ............................................... 8

7. References............................................................................. ...................9


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1. Introduction

According to the World Trade Organisation (WTO, 2003), the world volume of exports has

increased by 325% since 1950, compared to an increase of 200% in the world production of

goods and services. This implies that the economic environment in which firms have to interact

on a daily basis is now worldwide. It also implies that, currently, around 2,000 billion US dollars

circulate on the foreign exchange markets per day.

In addition to the extraordinary growth in world trade over the last 20 years, the financial markets

have also been affected by an important revolution in financial techniques. Effectively,

technological progress has allowed a multitude of new products to replace the old ones and now,

firms have access to broader and cheaper sources of financing. The foreign exchange markets

didnt escape that trend. Financial innovations, such as currency options and currency swaps,

have completely changed the way that central banks, commercial banks, financial institutions,

multinational corporations and brokers deal with currencies in international transactions.

The objective of this paper is to examine the different aspects of currency options and currency

swaps. Those two financial instruments are mostly used as a hedge against exchange rate risks

and to reduce borrowing cost. So, as a start, section 2 explains the different issues concerning

foreign exchange rate risk exposure. Section 3 looks how currency options function, while section

4 deals with currency swaps. Section 5 analyses the world market of currency options and swaps

by looking at different statistics. Finally, section 6 concludes.

2. Currency risk exposure1

The different participants in the foreign exchange market are almost always exposed to risk. This

occurs because the exchange rates vary over time and because a commercial transaction always

implies a lag between the time the contract is signed and the time the payment is complete. A

currency risk could also originate from the fact that a firm has subsidiaries in other countries and

thus, all transactions between the headquarters and its subsidiaries are exposed to a currency risk.

Moreover, in the sticky-price economy world, every firm that publishes a catalogue of products

(in which some are imported) is also subject to exchange rate fluctuations, and then, to currency

risk.

1 This section relies mainly Salledem (2004) and on Eur-Export (2004).


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Chart 1: Exchange Rate Volatility*

-12,0

-8,0

-4,0

0,0

4,0

8,0

12,0

80 84 88 92 96 00 04

* Month-over-month % change in the $US/CAD exchange rate

Chart 1 shows the exchange rate volatility

over the last twenty years, expressed as

the monthly percentage change in the

$US/CAD exchange rate. The analysis of

this chart points out the great variability

of the exchange rate, which could increase

by 10% in a month, occurred in the spring

of 2003. These strong fluctuations force

firms to take some actions to insure the

viability of their projects.

The notion of risk on a foreign exchange market is directly connected to the position of an agent

in that market. For example, if a bank has an open position, which means that its currency

commitments are different than its currency holdings, it is exposed to a risk and its strategy

should be (unless it wants to speculate) to close this open position as soon as possible. Banks and

multinationals could use different techniques to hedge themselves against currency risk. Those

are: the choice of the currency, lags and leads, indexation clauses, the netting, the forward

exchange market, the currency borrowing, currency swaps and currency options.

When a firm decides to sell some products to the rest of the world, it has to choose whether to use

the national currency or another currency. If the firm invoices its products in the national

currency, the currency risk is non-existent. However, all the currency risk is now on the foreign

party, which could make trade talks difficult. On the other hand, if the firm uses a foreign

currency, it exposes itself to a currency risk, but wins negotiation power.

In the invoicing process, a company could decide to use a foreign currency that is expected to

depreciate or appreciate. For example, if the invoicing currency is expected to appreciate, the

importer will like to speed up the payment (to minimize its cost) and the exporter will like to

postpone the payment (to maximize its revenue). The opposite is also true for the case of a

depreciation. This leads and lags technique is risky, because it relies on the forecasted evolution

of the exchange rate.

When two international firms trade, they can include an indexation clause in the contract to

specify how the currency risks are shared by both parties, if the exchange rate fluctuates between

the time the contract is signed and the time the payment is complete. The netting is another

technique used for hedging currency risks. It consists of taking advantage of the entries of


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currency to carry out some payments in the same currency. The exchange position is then limited

to the balance.

The main part of foreign exchange market transactions is currently hedged by forward contracts.

Forward contracts consist of fixing, when the contract is signed, the exchange rate on which the

transaction will be made in the future. The level of this exchange rate, called the forward

exchange rate, is function of the spot exchange rate and the interest rate differential between the

two countries. The following formula is then used:

Forward exchange rate = Spot exchange rate x (1 + National interest rate) / (1 + Foreign exchange rate)

If an exporter signs a contract with a foreign firm that stipulates that the payment will be made in

foreign currency in one month, the exporter can then borrow from a bank a corresponding amount

in foreign currency and reimburse the bank when payment is received in one month. The amount

paid in interest represents the cost of having the money available right now and the opportunitycost of being hedged against currency risk.

The last two instruments, currency options and currency swaps, will be explained in the next two

sections.

3. Currency options

A currency option is a financial instrument that gives its owner the right (but not the obligation)

to buy or to sell a certain amount of currency at a predetermined price, up to a certain time in the

future. There are two possible types of currency options: a call option gives the right to buy

currencies, while put options give the right to sell currencies. The predetermined price of the

option is called the exercise price (or strike price) and is defined as a regular exchange rate (cents

per euro, for example).2

The term of the option is set in advance and could go up to the expiry date, depending if it is a

European or a American option. With European options, the firm has to wait until the expiry date

to use the call/put option. With American options, the firm can use its option at anytime beforethe expiry date, but most of the time, firms wait until the expiry date to use it. If a firm wants to

have access to a currency option (or to buy a currency option), it must pay a premium, measured

2 Someone interested in the complex theory behind option pricing, including the Black-Scholes pricing model, could

see Brealey (1992), chapter 20.


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in percent. This premium may vary for different reasons, including the time to expiry, the

volatility of the currencies involved and the interest rate differential between the two countries.

For currency options, there are three possible outcomes: the option is abandoned if the purchaser

thinks that it is not advantageous to use it, the option is used before the expiry date or at the end

of the term or the option is resold to another firm, if the option still has a certain value.

An importer, who wants to hedge against an increase in the currency in which the imports are

priced, will buy a call option (to buy currencies), and then, if the exchange rate increases

substantially, make use of the option. On the other hand, if the exchange rate decreases (so that

this decrease covers the premium of the option), the importer will just let the option go to the

expiry date without using it. An exporter would like to buy a put option (to sell currencies) to

hedge against a depreciation in the home currency. If the exchange rate decreases a lot, the

exporter will use the option, but if the exchange rate increases to cover the premium, the exporter

will keep the option unexercised, because the exporter will gain from the appreciation of the

currency.

An example will help understanding the process behind options. The example will take the

perspective of the importer, but the case for the exporter is very similar. It is January 16, 2004.

The spot exchange rate is 0.7705 $US/CAD (it is also the exercise price in the case of the

importer). A Canadian firm wants to import parts for its production process. It needs 10,000 USD

worth of parts, that will be paid in three months, on April 16. The premium is 3.2%, so that the

purchasing price of the option is 320 USD (3.2% x 10,000 USD) or 415.31 CAD (320

USD/0.7705). The maximum cost of its imports in 3 months is then (10,000 USD/0.7705 +

415.31 CAD) = 13,393.90 CAD.

If the US dollar has appreciated in April, the importer exercises the option and pays a cost of

13,393.90 CAD. If the US dollar has depreciated, lets say to 0.8005 $US/CAD, the importer will

not exercise the option and will buy US dollars according to the spot rate that occurs in three

months (0.8005$US/CAD). The cost of the parts will then be (10,000 USD/0.8005 + 415.31

CAD) = 12,907.50 CAD. Finally, if the spot rate on April 16 is still 0.7705 $US/CAD, the

importer is indifferent between using the option or not and the cost of the imports will be

13,393.90 CAD.


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4. Currency swaps

A swap is a financial operation in which two parties agree to an exchange of cash flows. There

exist different categories of swaps: interest rate swaps, equity swaps, commodity swaps and

currency swaps. A currency swap, as the name indicates, is an exchange, by two foreign

borrowers with opposing needs, of a certain amount of currencies via a financial intermediary

(usually a bank). The main goal of a currency swap is to decrease the cost of financing for both

firms involved. It requires that: 1) their financial needs are opposed and 2) there exists an absolute

(or a comparative) advantage in borrowing for one (both) of the firms involved in the transaction.

Let us look at an example of a currency swap with absolute advantages in borrowing. The spot

exchange rate is 0.7705 $US/CAD. A Canadian company needs to borrow 616,400 US dollars for

one year for refinancing one of its subsidiaries in the United States. At the same time, for similar

reasons, an American company would like to borrow 800,000 Canadian dollars (the same

amount, after conversion: $US 616,400 / 0.7705 = 800,000 CAD). Table 1 presents the interest

rates both firms will face if they borrow in their home country or abroad. The Canadian company

has an absolute advantage of 1.50% in borrowing Canadian dollars, while the American firm has

an absolute advantage of 1.5% in borrowing US dollars. Because they both have an absolute

advantage in borrowing on the home loan market, a swap will benefit both parties.

Table 1: Currency Swap Example - Borrowing Interest Rates

Canadian Loan Market American Loan Market

Canadian Company 6.00% 5.00%American Company 7.50% 3.50%

Absolute Advantage 1.50% 1.50%

The first step is that both firms borrow at a local bank: the Canadian firm borrows 800,000 CAD

at an interest rate of 6% and the American firm borrows 616,400 US dollars at 3.50%. Figure 1

illustrates that transaction. Next, the two firms give their money to a financial intermediary (a

bank, for example) that will make the 616,400 US dollars available to the Canadian firm at an

interest rate of 4% and the 800,000 CAD available to the American firm at an interest rate of

6.5%. This last step is called the currency swap. Compared to the situation where both firms

would have been borrowing abroad, they both save 1% in interest payments. The financial

intermediary, in the currency swap, also makes a profit of 1%.


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At the end of the contract, the transactions just follow the reverse path. The only difference now

is that the money paid back includes a certain amount in interest payments. Also, that transaction

occurs at a forward exchange rate, determined at the beginning of the contract. This currency

swap has allowed both firms to reduce their borrowing cost by taking advantage of their absolute

advantage in borrowing. They also hedge against currency risk by specifying the forward

exchange rate in the original contract.

5. Statistics about currency options and swaps

Currency options and swaps have existed for more than 20 years and currently represent a

significant part of all foreign exchange contracts (FEC). Currency options represented, in June

2003, 20.8% of all international FEC, while the currency swaps made up 23.3% of all FEC, the

remainder being future contracts. By comparing with the situation in June 1998, we realize that

the currency options (24.6%) were a frequently used instrument, but swaps (10.2%) were still

unexploited at that time. Table 2 points out the development of swaps since 1998 as a risk

management instrument in the international foreign exchange markets.

Table 2: Evolution of World Foreign Exchange Derivatives*

1998 1999 2000 2001 2002 2003

Currency options 4,623 3,009 2,385 2,496 3,427 4,159

Currency swaps 1,947 2,350 2,605 3,832 4,215 5,159*Source: BIS (2003). Amounts are in billions of US dollars for the month of June of each year.

The Bank of International Settlements (BIS), through its Quarterly Review, follows the evolution

of the FEC and its different aspects. One of those aspects is the counterparty the broker is trading

with. Table 3 presents some statistics regarding that. We see that, in June 2003, options were

traded in the same proportions with other brokers, with other financial institutions and with non-

Canadian

Bank

American

Bank

Canadian

Company

American

Company

Financial

Intermediary

Figure 1: The mechanism behind a currency swap

800,000 CAD @ 6% $US 616,400 @ 3.5%

800,000 CAD @ 6%

800,000 CAD @ 6.5%

$US 616,400 @ 3.5%

$US 616,400 @ 4%


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financial customers. The data about swap counterparties suggests that these financial instruments

are traded more often with other financial institutions, but that the difference with other

counterparties is small.

Table 3: Distribution of World Foreign Exchange Derivatives by Counterparty*

With other brokers With other financialinstitutions

With non-financialcustomers

Total

Currency options 31.3% 35.4% 33.3% 100.0%Currency swaps 34.4% 42.6% 23.0% 100.0%

*Source: BIS (2003). Numbers are in percent for the month of June 2003.

Table 4, also extracted from the BIS Quarterly Review, shows the currencies involved in the

different FEC for June 2003 at an international level. Non-surprisingly, the US dollar was

involved in 43.9% of all currency transactions. The euro is following with 22.4% of all FEC. The

Canadian dollar was only used for 2.2% of all foreign exchange contracts. These proportions have

been relatively constant over the last 5 years.

Table 4: Distribution of World Foreign Exchange Derivatives by Currency*

For All Foreign ExchangeContracts

USDollar

EuroJapanese

YenPound

SterlingOthers Total

June 1998 43.2% 21.8% 14.9% 6.4% 13.7% 100.0%June 2003 43.9% 22.4% 11.1% 7.0% 15.5% 100.0%

*Source: BIS (2003). Numbers are in percent. Foreign exchange contracts include: outrightforwards and forex swaps (currency futures), currency swaps and options.

Finally, table 5 presents the distribution of currency options and swaps according to theirmaturities. The analysis of that table points out the fact that currency options tend to be a short-

run financial instrument, 90.3% of all options are involved in a one year or less contract. The

swaps are also a short-run instrument, but are much more likely to be used for longer terms, like 5

years and over for example.

Table 5: Distribution of World Foreign Exchange Derivatives by Maturity*

One year or lessOver 1 year and up

to 5 yearOver 5 years Total

Currency options 90.3% 8.6% 1.1% 100.0%

Currency swaps 76.7% 15.6% 7.7% 100.0%

*Source: BIS (2003). Numbers are in percent for the month of June 2003.

6. Conclusion

In conclusion, currency options and swaps are mostly used by corporations and are part of a

category of tools used to prevent currency risk exposure. As a financial instrument created in


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1982 on the Philadelphia Stock Exchange, currency options are currently widely used by financial

markets. This financial instrument allows a lot of flexibility when exchange rates are volatile.

Currency swaps, first used in 1981 between IBM and the World Bank, have grown over the last 5

years and are currently as popular as currency options. Currency swaps allow firms to decrease

their borrowing cost and to hedge against large variations in the exchange rate.

7. References

BIS (2003), Quarterly Review: International Banking and Financial Market Developments,Statistical Annex, December 2003, http://www.bis.org/publ/qtrpdf/r_qa0312.pdf

Brealey, Richard (1992), Principles of corporate finance (2nd Canadian edition), McGraw-HillRyerson, Toronto, 1047 pp.

Eur-Export (2004), Techniques for covering the risk of exchange,

http://www.eur-export.com/anglais/apptheo/finance/rischange/techcouverturea.htm

Salledem (2004), Le march des changes et la salle des marchs, http://salledem.free.fr/

WTO (2003), International Trade Statistics 2003, Long-term trends, World Trade Organisation,http://www.wto.org/english/res_e/statis_e/its2003_e/its03_bysubject_e.htm

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