lecture 6 currency derivatives

Dr. Baoying Lai FEM207 International Finance L6 1

Lecture 6 Currency Derivatives (1)

• the end of this session students should be able to: Understand the purposes of using derivatives Explain how forward contracts are used to hedge based on

anticipated exchange rate movements Describe how currency futures contracts are used to speculate

or hedge based on anticipated exchange rate movements

• Essential reading incl. lecture notes: Madura, J. and Fox, R. (2007). International Financial

Management, 1st Edition, Thomson Learning. Chap 5 Eiteman, D. K., Stonehill, A. I. and Moffett, M. H. (2006).

Multinational Business Finance, 11th Edition, Prentice Hall.Chap 7


Financial Derivatives

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

• These derivatives, so named because their values are derived from underlying assets, are a powerful tool used in business today.

• 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


Forward Contract (1)

• A forward contract is an agreement between a corporation and a commercial bank to exchange a specified amount of a currency at a specified exchange rate (called the forward rate) on a specified date in the future.

• The party that has agreed to buy has a long

position.

• The party that has agreed to sell has a short position.


Forward Contract (2)• When multinational corporations (MNCs) anticipate a future need for

or future receipt of a foreign currency, they can set up forward contract to lock in the rate at which they can purchase or sell a particular foreign currency.

• Because forward contract accommodate large corporations, the forward transaction will often be valued for very large sums (e.g., £100m).

• Forward contracts normally are not used by customers or small firms.

• In cases when a bank does not know a corporation well or fully trust it, the bank may request that the corporation make an initial deposit to ensure that it will fulfil its obligation.


Forward Contract (3)

• The most common forward contracts are for 30, 60, 90, 180, and 360 days, although other periods (including longer periods) are available.

• The forward rate of a given currency will typically vary with the length (number of days) of the forward period.


How MNC’s Use Forward Contracts(1)

• MNCs can use the forward contract to hedge their imports. They can lock in the rate at which they can buy foreign currencies.

• Example 1: Pay S$ 1 M in 90 days

import

• Current spot rate:£0.35/S$, so need £350,000(S$1mx£0.35/S$). However, the UK importer does not have the funds right now

• If the exchange rate rises to £0.4/S$ in 90 days, UK importer will need £400,000(S$1mX£0.4/S$), so it will cost the UK importer £50,000 more due to the appreciation of the Singapore dollar.

UK MNCs Singapore firm



• Example 1 (Cont’d)

• Strategy: to avoid exposure to exchange rate risk, the UK importer can negotiate a forward contract with a bank to purchase S$1m 90 days forward and lock in the forward rate, e.g., £0.38/S$.

• However, if the spot rate in 90 days is £0.37, then the UK importer will have paid £0.01 per unit or £10,000 (S$1m X £0.01/S$) more for the Singapore dollars as a result of taking out a forward contract.

• But this cost can also be seen as something of an insurance payment in that the UK importer avoided the possibility of having to pay much more on the spot market (e.g., £0.40/S$)



• MNCs can use the forward contract to hedge their exports. They can lock in the rate at which they can sell foreign currencies.

• Example 2:Export

receive 400,000 euros in 4 months

• Current spot rate:£0.65/euro, the UK exporter expects to receive £260,000 (400,000 euros x £0.65/euro).

• They worry euro depreciate in 4 months, e.g., the forward rate drops to £0.55/euro, then the UK exporter will only receive £220,000(400,000 euro x £0.55/euro). So they will loss £40,000.

UK MNCs French firm



• Example 2 (Cont’d)

• Strategy: the UK exporter can negotiate a forward contract with a bank to sell the 400,000 euros for British pounds at a specified forward rate e.g., £0.6/euro. In 4 months, the UK exporter will exchange its 400,000 euros for £240,000 (400,000 x £0.6/euro)



A. Bid/ask spread • A bank agreed to sell (ask) a firm S$ in 90 days at £0.36/S$.

At the same time, the bank may agree to buy (bid) S$ in 90 days at £0.35/S$. The wider spread gives banks more profit.

B. Premium or discount on the forward rate• Where the forward rate is at premium (discount), the foreign

currency is more (less) expensive than the current cost as given by the spot rate.

• The forward rate is equal to the spot rate multiplied by a premium or discount:

F=S(1+p)



• B. Premium or discount on the forward rate (Cont’d)• annualized forward premium/discount

= forward rate – spot rate 360spot rate n

where n is the number of days to maturity• Example: Suppose £ spot rate = $1.681, 90-day £

forward rate = $1.677.

$1.677 – $1.681 x 360 = – 0.95%

$1.681 90

So, forward discount = 0.95%



C. Arbitrage• Forward rates typically differ from the spot rate for any given

currency. The difference is dictated by arbitrage possibilities.

• In the case of forward rates, the arbitrageur could borrow in the country with the lower interest rate, invest in the countries with higher interest rate and arrange conversion back into the original currency suing the forward rate.

D. Movement in the forward rate over time• any movement over time in the spot rate and the interest

rates of the two countries will affect the forward rate. (will be discussed in details in lecture 7)


How MNC’s Use Forward Contracts(8)• E. Offsetting a forward contract

Bank A Bank B

Company MOriginal contract: Bank A is selling 1m pesos to M at time t for an agreed rate. (M had a forward contract to buy from A)

To close out some time later…: M takes out a forward contract to sell 1m pesos to B. so, Bank B is buying 1m

pesos from M at time t.

Closed out position:

Bank A can sell 1m pesos directly to Bank B at time t for the rate agreed between M and B. M will have already settle with A any difference between the price with

A and the price with B.

Bank A Bank B



• F. Using forward contacts for swap transactions

• Today: UK MNCs negotiate a forward contract with a bank and specified a forward rate:

• In one year: the UK MNCs is not exposed to exchange rate movements.

UK MNCs French Subsidiary

Invest 1m euros

Repay in one year

UK MNCs BankFrench

Subsidiary

Withdraw £, convert into euro in spot 1m euros

Withdraw 1m euros

Convert euro into £ at specified FW rate


Non-Deliverable Forward Contracts

• New type

• Frequently used for currency in emerging markets

• No delivery required

• One party to the agreement makes a payment to the other party based on the exchange rate at the future date.


Foreign Currency Futures• A foreign currency futures contract is an alternative to a

forward contract– It calls for future delivery of a standard amount of

currency at a fixed time and price

– These contracts are traded on exchanges with the largest being the International Monetary Market located in the Chicago Mercantile Exchange. Others include London International Financial Futures and Options Exchange (LIFFE), The Chicago Board of Trade (CBOT)


Contract Specifications (1)

– Size of contract – called the notional principal, trading in each currency must be done in an even multiple

– Maturity date – contracts have maturity dates. – Last trading day – contracts may be traded through

the second business day prior to maturity date– Initial & maintenance margins – the purchaser or

trader must deposit an initial margin or collateral; this requirement is similar to a performance bond as well as keep to the terms of the maintenance margin.

• At the end of each trading day, the account is marked to market and the balance in the account is either credited if value of contracts is greater or debited if value of contracts is less than account balance


Contract Specifications (2)

– Settlement – only 5% of futures contracts are settled by physical delivery, most often buyers and sellers offset their position prior to delivery date

• The complete buy/sell or sell/buy is termed a round turn

– Commissions – customers pay a commission to their broker to execute a round turn and only a single price is quoted

– Use of a clearing house as a counterparty – All contracts are agreements between the client and the exchange clearing house. Consequently clients need not worry about the performance of a specific counterparty since the clearing house is guaranteed by all members of the exchange


Characteristic Foreign Currency Futures Forward ContractsSize of Contract Standardized Tailored to individual needs

Delivery date standardized Tailored to individual needs

Participants Banks, brokers and multinational Bank, brokers, and multinational companies. Qualified public speculation companies. Qualified public encouraged speculation not encouraged

Security deposit Small security deposit required None as such, but compensating bank balances or lines of credit required

Clearing operation Handled by exchange clearing house. Daily Handling contingent on individual settlement to the market place banks and brokers. No separate

clearing house function

Market place Central exchange floor with worldwide Over the telephone worldwidecommunication

Regulation Commodity Future Trading Commission; Self-regulatingNational Future Association

Liquidation Most by offset, very few by delivery Most settled by actual delivery. Some by offset, at a cost

Transaction costs Negotiated brokerage fees Set by ‘spread’ between bank’s buy and sell prices

Foreign Currency Futures Versus Forward Contracts


Currency Future Market

• Normally, the price of a currency futures contract is similar to the forward rate for a given currency and settlement date, but differs from the spot rate when the interest rates on the two currencies differ.

• These relationships are enforced by the potential arbitrage activities that would occur otherwise.

• Currency futures contracts have no credit risk since they are guaranteed by the exchange clearinghouse.

• To minimize its risk in such a guarantee, the exchange imposes margin requirements to cover fluctuations in the value of the contracts.


• Speculators often sell currency futures when they expect the underlying currency to depreciate, and vice versa.

Speculation with Currency Future (1)

1. Contract to sell 500,000 pesos @ $.09/peso ($45,000) on June 17.

April 4

2. Buy 500,000 pesos @ $.08/peso ($40,000) from the spot market.

June 17

3. Sell the pesos to fulfill contract.Gain $5,000.


• Currency futures may be purchased by MNCs to hedge foreign currency payables, or sold to hedge receivables.

Hedge with Currency Future (2)

1. Expect to receive 500,000 pesos. Contract to sell 500,000 pesos @ $.09/peso on June 17.

April 4

2. Receive 500,000 pesos as expected.

June 17

3. Sell the pesos at the locked-in rate.


• Holders of futures contracts can close out their positions by selling similar futures contracts. Sellers may also close out their positions by purchasing similar contracts.

Closing Out a Futures Position (1)

1. Contract to buy A$100,000 @ $.53/A$ ($53,000) on March 19.

January 10

3. Incurs $3000 loss from offsetting positions in futures contracts.

March 19

2. Contract to sell A$100,000 @ $.50/A$ ($50,000) on March 19.

February 15


Closing Out a Futures Position (2)

• Most currency futures contracts are closed out before their settlement dates.

• Brokers who fulfill orders to buy or sell futures contracts earn a transaction or brokerage fee in the form of the bid/ask spread.

lecture 6 currency derivatives

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