forwards, futures and options investment & portfolio mgt
TRANSCRIPT
Forwards, Futures and Options
Investment & Portfolio Mgt
Derivative Securities vs. Stocks/Bonds
Currently, there are approximately 300 million derivative contracts outstanding with a market value of around $50 Trillion!!!Derivative securities can be used for hedging or for speculation
Stocks and Bonds represent claims to specific future cash flows
Derivative securities on the other hand represent contracts that designate future transactions
Porsche expects $12.5M in US sales over the next month that that it would like to repatriate back to Germany
Porsche is worried that the dollar might depreciate over the next month
Mercedes need to acquire $12.5M to meet its payroll for its Tuscaloosa, Alabama plant
Mercedes is worried that the dollar might appreciate over the next month
Both Porsche and Mercedes could avoid their potential currency risk by entering into a forward contract.
Deutsche Bank
Deutsche Bank negotiates a price of $1.25 per Euro
Forward contracts are individualized contracts to buy/sell a currency at a pre-specified date and for a pre-specified price.
Porsche approaches Deutsche Bank with an offer to buy Euro 30 days forward
Mercedes approaches Deutsche Bank with an offer to sell Euro 30 days forward
In 30 days, Porsche will buy 10 Million Euro from Mercedes for $12.5M
1.255
1.26
1.265
1.27
1.275
1.28
1.285
1.29
1.295
0 4 8 12 15 18 23 27
On Settlement day, Porsche delivers its $12.5M and acquires 10M Euro. Had it instead bought Euro in the spot market, It would’ve needed $12.9M to buy 10M Euro – Porsche “gains” $400,000
Note that Mercedes has an equal “loss” of $400,000
Days
EU
R/U
SD
e = 1.29
F = 1.25
Futures56%
Forward11%
Spot33%
EUR/USD 1.2762
1 month 1.2786
3 months 1.2836
6 months 1.2905
12 months 1.3026
Forward contracts are available on all the major currencies
The published prices are not actual contract prices but the average of contracts made at major banks.
In 1972, the Chicago Mercantile Exchange began trading currency Futures. By 2004, the number of currency futures outstanding stood at 48M with a value of approximately $5T!!
Futures are standardized (size and maturity), exchange traded commodities
Jan Mar June Dec.Sept.
Currency futures trade in a March, June, September, December expiration cycle – Delivery is made on the 3rd Wednesday of the month and the contracts are traded up to two days prior to delivery.
Currencies Agriculture Metals & Energy
Financial
British Pound Lumber Copper Treasuries
Euro Milk Gold LIBOR
Japanese Yen Cocoa Silver Municipal Index
Canadian Dollar Coffee Platinum S&P 500
Mexican Peso Sugar Oil DJIA
Cotton Natural Gas Nikkei
Wheat Eurodollar
Cattle
Soybeans
Futures are available for a wide range of commodities and assets
Currency Contract Size
Australian Dollar AUD 100,000
Brazilian Real BRR 100,000
British Pound GBP 62,500
Canadian Dollar CAD 100,000
Czech Koruna CZK 4,000,000
Euro EUR 125,000
Hungarian Forint HUF 30,000,000
Japanese Yen JPY 12,500,000
Mexican Peso MXN 500,000
New Zealand Dollar NZD 100,000
Norwegian Krone NKR 2,000,000
Polish Zlotny PLZ 500,000
Russian Ruble RUB 2,500,000
South African Rand ZAR 500,000
Swiss Franc CHF 125,000
There are also cross rate futures traded (EUR/GBP, EUR/JPY, and EUR/CHF) in contract sizes of EUR 125,000
Strike Open High Low Settle Pt Chge
Volume Interest
Mar06 1.2700 1.2804 1.2698 1.2756 +170 3500 8993
Jun06 1.2850 1.2987 1.2800 1.2799 -150 3 34
Sept06 ------ ------ ------ ----- UNCH ----- -----
EUR 125,000
Settlement Date Change From Prior Day (in Pips)
Opening, High, Low, and Closing Price
Contracts Outstanding (000s)
Total Contracts bought/sold that day (000s)
Futures are standardized (size and maturity), exchange traded commodities (Chicago Mercantile Exchange)
Chicago Mercantile Exchange
The CME simultaneously buys 80 contracts from Mercedes and sells 80 contracts to Porsche
Porsche goes long on 80 Euro contracts
Mercedes goes short on 80 Euro contracts
From the previous example, if Porsche is buying 10M Euro, it would need to purchase 80 Euro futures contracts (125,000 x 80 = 10M )
May 1 June 21
Futures contracts are marked to market daily. That is, profits and losses are kept track of on a daily basis.
Delivery Date
Suppose that Porsche goes long on 80 Euro contracts at a price of $1.25 per Euro – The total cost of the contract is $12.5M
Porsche is required to deposit an initial performance bond equal to 2% of the contract value – this can be in the form of cash or a Treasury bill.
2% of $12.5M = $250,000
May 1 June 21Delivery Date
On May 1, Porsche deposited $250,000 worth of Treasury Bills into its maintenance account.
May 2
On May 2, the closing price for June Euro futures is $1.27. Porsche’s profit on its contract is $200,000. This is deposited into Porsche’s maintenance account ($450,000 balance).
May 3
On May 3, the closing price for June Euro futures is $1.24. Porsche’s one day loss on its contract is $300,000. This is withdrawn from Porsche’s maintenance account ($150,000 balance).
When your maintenance account drops below 75% of its original value, you must add to it!!
May 1 June 21Delivery Date
June 3
While the overwhelming majority (90%) of forward contracts end with actual delivery of the currency, very few futures contracts (1%) result in delivery.
F = $1.25/Euro
Suppose that on June 3, Porsche wishes to end its futures contract. Suppose that the current price of a June Euro future is $1.28
Porsche goes short on 80 June Euro futures at a price of $1.28. The two contracts offset one another and Porsche goes home with its profit of $300,000
Long Position
Short Position
Profits from price increases
Profits from price decreases
Essentially, futures positions are making “bets” on the price of the underlying commodity.
Treasury futures first began trading on the CME in 1976. The underlying commodity is a $1M Treasury Bill with 90 days to maturity. Remember, when interest rates rise, Treasury prices fall!
Long Position
Short Position
Profits from price increases
Profits from price decreases
Profits from decreasing interest rates
Profits from increasing interest rates
100360
nFV
PFVDY
T-Bill futures are listed using the IMM (International Monetary Market) Index
IMM = 100 – Annualized Discount Yield
For example, if the Price of a $100, 90 Day Treasury were $98.
IMM = 100 – 8 = 92
Note that Every .01 increase in the IMM raises the value of a long T-Bill position by $25 (per basis point).
%810090
360
100
98$100$
DY
The underlying commodity is a $1M, 3 month Eurodollar time deposit. However, these deposits are not marketable. Therefore, Eurodollar futures are settled on a cash basis
Eurodollar futures can be treated like a T-Bill Future
IMM = 100 – Annualized LIBOR
Every .01 increase in the IMM raises the value of the long position by $25 (per basis point)
Eurodollar futures were introduced in 1981 as an alternative to Treasury futures.
Eurodollar Futures vs. T-Bill Futures
T-Bill Futures Contract
Eurodollar Futures Contracts
Volume (2001) 123 730,000
As the Eurodollar market grew, it became more liquid relative to the T-Bill market
LIBOR is a “risky” rate. Therefore, it correlates better with other risks
May 1 SeptemberJune
LIBOR = 2.91%
Suppose that you expect to receive $20M in June. You do not need the $20M until September. The current 3 month LIBOR rate is 2.91% (Annualized)
$20M received
$20M needed
IMM = 96.56
June Eurodollar futures are currently trading at 96.56
This $20M should be invested from June to September to earn interest, but currently the interest rate from June to September is uncertain.
May 1 SeptemberJune
$20M received
$20M needed
IMM = 96.56
The June Eurodollar futures with a 96.56 price implies an annualized rate of return equal to 3.44% from June to September
3.44%
You can “lock in” the 3.44% interest rate by taking a long position in Eurodollar futures. Suppose that you purchase 20 Eurodollar contracts at the current price of 96.56.
May 1 SeptemberJune
IMM = 96.90
You paid 96.56 per contract in May (20 contracts)
Suppose that in June, the LIBOR rate is 3.10% Annualized.
3.10%
You receive your $20M in June and deposit it in a Eurodollar account at 3.1% (annual) interest. Your interest earned well be $155,000 - $20M*(.031/4)
Your profit from the Future is (96.90-96.56)(100)($25)(20) = $17,000
Your total gain is $17,000 + $155,000 = $172,000 (3.44% Annualized return)
Unlike a future, an option gives the owner the right, but not the obligation to buy or sell the underlying commodity.
Call Option
The owner (long position) on a call option has the right but not the obligation to buy the underlying commodity at the predetermined price
The seller (writer) of the call option has the obligation to sell the underlying commodity if the option is exercised.
Put Option
The owner (long position) on a put option has the right but not the obligation to sell the underlying commodity at the predetermined price
The seller (writer) of the put option has the obligation to buy the underlying commodity if the option is exercised.
The stated price that the underlying commodity is bought or sold at is known as the strike price.
In December 1982, the Philadelphia Stock Exchange started trading American and European options on foreign currency.
Can be exercised at any time during the life of the contract
Can only be exercised at maturity
Currency Contract Size
Australian Dollar AUD 50,000
British Pound GBP 62,500
Canadian Dollar CAD 50,000
Japanese Yen JPY 6,250,000
Swiss Franc CHF 62,500
Euro EUR 62,500
Traded options have an expiration cycle March, June, September and December with original maturities of 3,6,9,and 12 months.
At expiration, an American option and a European option that has not been exercised will have the same terminal value.
Call option
0,max ESC 0,max SEP
Put option
Spot price of the underlying asset
Exercise price of the option contract
Remember, as the owner of the option, you will not exercise if it is unprofitable!!
Suppose that you purchase a call option on Euro at an exercise price of 130 ($1.30 per Euro). The standard Euro contract is 62,500 Euro.
Expiration Value
Spot Exchange Rate
Here, the option is “out of the money” and will not be exercised.
$1.30 $1.35
125,3$)500,62)(30.1$35.1($ V
Note that the writer of the call has the opposite payout (as with futures, this is a zero sum game)
Expiration Value
Spot Exchange Rate$1.30 $1.35
125,3$)500,62)(35.1$30.1($ V
Options have a premium attached to them. This is the price that the buyer pays for the option contract. Suppose that the premium on this Euro call is 4.59 cents per Euro (the option will cost .0459*62,500 = $2,868.75)
Expiration Value
Spot Exchange Rate
$1.30 $1.35
25.256$75.868,2)500,62)(30.1$35.1($ V
-$2,868.75
$1.3459
Suppose that you purchase a put option on Euro at a strike price of $1.30. The premium on this option is 3.50 cents per Euro (.035*62,500 = $2,187.50)
Expiration Value
Spot Exchange Rate
$1.30
$1.25
50.937$50.187,2$)500,62)(25.1$30.1($ V
-$2,187.50
$1.2650
The previous example dealt with “vanilla options”. There are many, many more “exotic” options.
Bermuda Options: Can be exercised at various, predetermined dates over the life of the contract
Asian Option: Also known as an average option – exercised at maturity and the payoff is based on the average price of the underlying commodity over the life of the contract.
Barrier options: The payoff is contingent on whether or not the underlying commodity has reached a predetermined price
Compound Options: The underlying commodity is an option
Digital Option: Also known as a binary option – the payout is fixed once the strike price has been reached.
You can also buy options on futures contracts.
Currency swaps are contracts to convert known income/payment streams from one currency to another – think of them as a portfolio of forwards with varying maturities/strikes
As with forward contracts, swaps are individualized and not traded.
Suppose that IBM wishes to raise funds by issuing a 5 year Swiss Franc denominated Eurobond with a face value of CHF 100,000 and fixed annual coupon payments of 6%. Up front, IBM receives CHF 100,000. IBM plans on using the proceeds to finance domestic operations
0 Yrs 5 Yrs1 Yrs 2 Yrs 3 Yrs 4 Yrs
IBM Collects CHF 100,000
IBM owes CHF 106,000
IBM owesCHF 6,000
IBM owesCHF 6,000
IBM owesCHF 6,000
IBM owesCHF 6,000
IBM Wishes to hedge its currency exposure
0 Yrs0 Yrs 5 Yrs5 Yrs1 Yrs1 Yrs 2 Yrs2 Yrs 3 Yrs3 Yrs 4 Yrs4 Yrs
IBM Sells IBM Sells CHF CHF 100,000 100,000 @ .844@ .844
IBM buys CHF IBM buys CHF 106,000106,000@ .836@ .836
IBM buysCHF 6,000@ .845
IBM buysCHF 6,000@ .830
IBM buysCHF 6,000@ .800
IBM buysCHF 6,000@ .840
IBM enters into a swap agreement with
This swap is very similar to buying/selling six separate futures contracts and is priced in a similar fashion
The Bottom Line…
There is a virtually endless set of options (pardon the pun) for hedging currency exposure. However, your ability to effectively and efficiently hedge depends on your understanding of the specific exposure that you face!!