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    FINC13-307INTERNATIONAL FINANCE

    Topic 4

    Foreign Exchange Risk Management: Part I

    Reading Eun and Resnick Chapter 7, 8(Note: ensure you have read Chapter 3

    of Eun and Resnick before class.)

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    The aim of this lecture is to provide students with aninsight into some recent developments and issues in foreign

    exchange risk (particularly transaction exposure) hedging.

    Particularly this lecture will consider the issues of usingfutures and options to hedge foreign exchange risk

    exposure, as well as the issues of hedge ratios and margin

    hedging.

    This chapter discusses various methods available for the

    management of transaction exposure facing multinational

    firms.

    Aim

    1 of 52

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    Outline

    Forward Market Hedge (see Topic 2)

    Money Market Hedge (see Topic 3)

    Future Market Hedge Options Market Hedge

    8-2

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    Future Market

    Futures Contracts: Preliminaries

    Currency Futures Markets

    Futures Market Hedging

    7-3

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    Futures Contracts: Preliminaries

    A futures contract is like a forward contract:

    It specifies that a certain currency will be

    exchanged for another at a specified time in the

    future at prices specified today.

    A futures contract is different from a forward

    contract:

    Futures are standardized contracts trading onorganized exchanges with daily resettlement

    (known as marking to market ) through aclearinghouse.

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    Futures Contracts: Preliminaries

    Standardizing Features: Contract Size

    Delivery Month

    Daily resettlement

    Initial performance bond (about 2 percent ofcontract value, cash or T-bills held in a street

    name at your brokerage). Maintenance performance bond (about 75% of

    the initial performance bond)

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    Daily Resettlement: An Example (1)

    Consider a long position in the CME Euro/U.S.

    Dollar contract.

    It is written on 125,000 and quoted in $ per .

    The strike price is $1.30 the maturity is 3 months.

    At initiation of the contract, the long posts an initial

    performance bond of $6,500 (=125,000x1.3x0.04).

    The maintenance performance bond is $4,000(=6,500x.75).

    7-6

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    Daily Resettlement: An Example (2)

    Recall that an investor with a long position gainsfrom increases in the price of the underlying asset.

    Our investor has agreed to BUY 125,000 at

    $1.30 per euro in three months time. With a forward contract, at the end of three

    months, if the euro was worth $1.24, he wouldlose $7,500 = ($1.24 $1.30) 125,000.

    If instead at maturity the euro was worth $1.35,the counterparty to his forward contract wouldpay him $6,250 = ($1.35 $1.30) 125,000.

    7-7

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    Daily Resettlement: An Example (3)

    With futures, we have daily resettlement of

    gains an losses rather than one big settlement at

    maturity.

    Every trading day:

    if the price goes down, the long pays the short

    if the price goes up, the short pays the long

    After the daily resettlement, each party has a

    new contract at the new price with one-day-

    shorter maturity.

    7-8

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    Performance Bond Money

    Each days losses are subtracted from theinvestors account.

    Each days gains are added to the account.

    In this example, at initiation the long posts aninitial performance bond of $6,500.

    The maintenance level is $4,000.

    If this investor loses more than $2,500 he has adecision to make: he can maintain his long positiononly by adding more fundsif he fails to do so, hisposition will be closed out with an offsetting shortposition.

    7-9

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    Daily Resettlement: An Example (4)**

    Over the first 3 days, the euro strengthens thendepreciates in dollar terms:

    $1,250

    $1,250

    $1.31

    $1.30

    $1.27 $3,750

    Gain/LossSettle

    = ($1.31

    $1.30)125,000

    $7,750

    $6,500

    $2,750

    Account Balance

    = $6,500 + $1,250

    On third day suppose our investor keeps his long

    position open by posting an additional $3,750.

    + $3,750 = $6,500

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    Daily Resettlement: An Example (5)

    Over the next 2 days, the long keeps losing moneyand closes out his position at the end of day five.

    $1,250

    $1,250

    $1.31

    $1.30

    $1.27$1.26

    $1.24

    $3,750$1,250

    $2,500

    Gain/LossSettle

    $7,750

    $6,500

    $2,750 + $3,750 = $6,500$5,250

    $2,750

    Account Balance

    = $6,500 $1,250

    7-11

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    Toting Up

    At the end of his adventures, our investor hasthree ways of computing his gains and losses:Sum of daily gains and losses

    $7,500 = $1,250 $1,250 $3,750 $1,250 $2,500Contract size times the difference between initialcontract price and last settlement price.

    $7,500 = ($1.24/$1.30/)125,000

    Ending balance on account minus beginning balance onaccount, adjusted for deposits or withdrawals.

    $7,500 = $2,750 ($6,500 + $3,750)

    7-12

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    Daily Resettlement: An Example (6)

    Total loss = $7,500

    $1,250

    $1,250

    $1.31

    $1.30

    $1.27

    $1.26

    $1.24

    $3,750

    $1,250

    $2,500

    Gain/LossSettle

    $7,750

    $6,500

    $2,750 + $3,750

    $5,250

    $2,750

    Account Balance

    = $2,750 ($6,500 + $3,750)

    $$1.30 $6,500

    = ($1.24 $1.30) 125,000

    7-13

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    Currency Futures Markets

    The Chicago Mercantile Exchange (CME) is by

    far the largest.

    Others include:

    The Philadelphia Board of Trade (PBOT)

    The MidAmerica Commodities Exchange

    The Tokyo International Financial Futures Exchange

    The London International Financial Futures Exchange

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    Reading Currency Futures Quotes

    OPEN HIGH LOW SETTLE CHG

    OPEN

    INT

    Euro/US Dollar (CME)125,000; $ per

    1.4748 1.4830 1.4700 1.4777 .0028Mar 172,396

    1.4737 1.4818 1.4693 1.4763 .0025Jun 2,266

    Highest price that day

    Lowest price that day

    Closing price

    Daily Change

    Number of open contracts

    Expirymonth

    Opening price

    7-15

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    Basic Currency Futures Relationships

    Open Interestrefers to the number of contracts

    outstanding for a particular delivery month.

    Open interest is a good proxy for demand for a

    contract.

    Some refer to open interest as the depth of the

    market. The breadth of the market would be

    how many different contracts (expiry month,currency) are outstanding.

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    Futures In Australia

    In Australia the main Foreign Exchange Futures Contract was the USD

    contract traded on the Sydney Futures Exchange.

    This contract was delisted on 24th September 1991, and re-listed on 6February 2001.

    This contract has the following attributes:

    CONTRACT SIZE: One Hundred Thousand Australian Dollars.

    PRICE QUOTATIONS: The price is quoted in terms of USD per one AUD, theminimum price change is USD 0.0001

    MINIMUM PRICE MOVEMENT: Minimum Price Movement is USD $0.0001 orUSD$10 per point.

    CASH SETTLEMENT MONTHS: Every month up to Twelve (12) months ahead.

    TERMINATION OF TRADING: The termination of Trading of each cash settlementis the third Wednesday of the month or other such time as the Board may determine.

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    The Clearing House

    In Futures Contracts the role of the CLEARING

    HOUSE is to act as a guarantor for all contracts.

    This acts to reduce the risk of the counterpartyto your contract defaulting.

    The EXCHANGE provides a place for trading

    and acts to 'referee' any disputes.

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    Basis Risk (1)

    As we are concerned with hedging, BASIS RISKis an important issue.

    Due to the Transactions costs associated with the

    Margin requirements and brokerage, it is notpossible to costlessly arbitrage between the

    physical and futures markets.

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    Basis Risk (2)

    It is possible for the physical price implied by

    a futures price to be different from the

    physical market price, without an arbitrage

    being possible.

    This difference is usually limited to a small margin,

    determined by the transactions costs.