Ch 9

Question 1

Definition of Forex Market

Answer 1

International market in national currencies

Highly competitive

Virtually no difference in price between two markets (e.g. NY and London)

Question 2

Definition - Spot Rate

Answer 2

the rate given for a tx with immediate delivery

in practice, this means settled within two working days

Question 3

Spread

Answer 3

range of rates offered by the bank to ensure they make a profit

e.g. actual rate for 1 GBP = USD 1.5, bank’s published rates are USD 1.45–1.55

a company wanting to BUY the variable currency (USD) will receive the LOWER rate – bank buys GBP LOW

a company wanting to SELL the variable currency (USD) will receive the HIGHER price – bank sells GBP HIGH

Question 4

Cross Rate

Answer 4

Calculating the relationship between currency A and C when only A:B and B:C are given in the question

Question 5

Four reasons entities may wish to forecast exchange rates

Answer 5

important to forecast b/c

FOREIGN DEBTOR/CREDITOR BALANCES

foreign balance may change drastically in local currency

WORKING CAPITAL

overseas subs will require working capital funding in foreign currency

PRICING

foreign pricing strategies may require revision due to forex mvmts - favorable or otherwise

INVESTMENT APPRAISAL OF FOREIGN SUBS

l/t forecast of exch rate mvmt to identify NPV impact of economic risks on a project

Question 6

Reasons for fluctuation in exchange rates

Answer 6

SPECULATORS

BALANCE OF PAYMENTS

GOVERNMENT POLICY

CAPITAL MVMTS BETWEEN ECONOMIES

Question 7

Exchange rate fluctuations - Speculators

Answer 7

enter into a forex tx to make a profit from their expectation of currency’s future mvmts

if they expect a currency to fall in value, they will short sell the currency and hope to buy it back more cheaply in the future

Question 8

Exchange rate fluctuations - Balance of Payments

Answer 8

Currencies are req’d to finance int’l trade - thus changes in trade will affect exch rates

e.g. demand for imports in the US = demand for foreign currency, or a supply of USD

overseas demand for US exports = demand for USD, supply of the currency

thus, a country with current account deficit (imports>exports) will see exchange rate depreciate, b/c supply>demand for currency

anything which affects current account of balance of payments may affect the exch rate

Question 9

Exchange rate fluctuations - Government Policy

Answer 9

govts may wish to change their currency’s value

DIRECTLY by deval/reval, or via forex markets (buying/selling currency onto the markets)

Question 10

Exchange rate fluctuations - Capital Movements between Economies

Answer 10

these txs effectively switch bank deposits from one currency into another - these flows have become more important than volume of trade in gds/svcs

supply/demand for a currency may reflect events on the capital account - affected by several factors:

INTEREST RATE changes = increasing (dec’ing) rates will attract capital inflow (outflow) and a demand (supply) for the currency

INFLATION RATES = asset holders will not wish to hold financial assets in a currency whose value is falling due to inflation

Question 11

Three related theories giving insight into exchange rate movements

Answer 11

Purchasing Power Parity Theory (PPPT)

Interest Rate Parity Theory (IRPT)

International Fisher Effect

Question 12

Purchasing Power Parity Theory (PPPT)

Answer 12

suggests that exch rate will be directly determined by relative rates of inflation suffered by each currency - thus US inflation > UK means USD worth comparatively less than GBP

basis of PPPT is “LAW OF ONE PRICE” (separate cards)

Question 13

Law of One Price

Answer 13

Basis of Purchasing Power Parity Theory (PPPT)

Identical goods must cost the same irrespective of currency

If not, ARBITRAGE will occur (buying low, selling high) until a single price is charged

• e.g. commodity purchased “cheaply” by traders, they then realize they can sell on due to popularity
• demand then falls due to higher price and potential profits have been competed away

Question 14

Example - Purchasing Power Parity Theory (PPPT)

Answer 14

Company purchasing an NCA at $30m. Exch rate GBP1/$1.5 means GBP 20m.

Assuming US inflation 8% and UK 5%, what would prices in one year be?

US 30m + 8% = 32.4m // UK 20m + 5% = 21.m

Effective exch rate = 32.4 / 21 = 1.5429

Thus NCA = $30m / 1.5429 = GBP 19.44m

Question 15

RULE of Purchasing Power Parity Theory (PPPT)

Answer 15

The country with the higher inflation will suffer a fall (depreciation) in currency

Question 16

PPPT - Calculation of Future Spot Rate

Answer 16

Future spot rate = current spot rate * [( 1 + i_f ) / ( 1 + i_h )]

i_f = rate of inflation in foreign country

i_h = rate of inflation of home country

Question 17

Problems with Purchasing Power Parity Theory (PPPT)

Answer 17

(1) justification of “law of one price” - in many markets suppliers/manufs charge what the market will bear - this varies from one market to the next
(2) costs of physically moving some prods from one place to another => a premium will always exist in some markets vs others
(3) different tax regimes => dramatic differences in costs of products in one mkt vs another
(4) manufactures can differentiate products in each mkt to limit amount of arbitrage that takes place

Question 18

Purchasing Power Parity Theory (PPPT) - as a predictor of future spot rate

Answer 18

While PPPT does explain the reasoning behind many exch rate mvmts, it is not a very good predictor of rates in short to medium term

• future inflation rates are only estimates, thus not fully reliable
• market is dominated by speculation and currency investment > trade in physical goods
• govt direct (manipulation) and indirect (tax policies) intervention can nullify PPPT impact

Question 19

Interest Rate Parity Theory (IRPT)

Answer 19

Very similar principle to that of Purchasing Power Parity Theory

Claims that the difference between spot and forward exchange rates = differential between interest rates available in the two currencies

Question 20

Definition - Forward Rate

Answer 20

A future exchange rate, agreed now, for buying or selling an amount of currency on an agreed future date

Question 21

Example - Interest Rate Parity Theory

Answer 21

An investor has $5m to investor over one year in either USD or GBP:

• invest in USD at 10.16%, or
• convert to GBP at prevailing spot rate (GBP 1 / USD 1.5) and invest in GBP at 7.1%

One-year forward rate is GBP 1 / USD 1.5429

DOLLARS = 5m * 1.1016 = USD 5.508m

POUNDS = 5m / 1.5 = GBP 3.333m * 1.071 = GBP 3.57m

In one year’s time, USD 5.51m must equal GBP 3.57m - what is gained in extra interest in lost in adverse exch rate mvmts

Effective exch rate = 5.508 / 3.57 = 1.5429 (forward rate from above)

Question 22

Rule - Interest Rate Parity Theory

Answer 22

IRPT predicts that the country with the higher interest rate will see the forward rate for its currency subject to a depreciation

Question 23

Formula - Interest Rate Parity Theory

Answer 23

Forward Rate = Current Spot Rate * [( 1 + ints_f ) / ( 1 + ints_h)]

ints_f = money risk-free rate of interest for foreign currency

ints_h = money risk-free rate of interest for home currency

Question 24

Interest Rate Parity Theory in Practice

Answer 24

IRPT model suggests it may be possible to predict exch rate mvmts by referring to differences in nominal exchange rates

If the forward exchange rate for GBP vs USD was no higher than spot rate but US interest rates were higher:

• UK investors would invest in US to access higher interest rates, b/c no exch loss when converting back to GBP
• capital flow from UK to US would increase UK interest rates and force up the spot rate for USD

IRPT works because of ARBITRAGE - arbitrageurs seeking out anomalies in forex market and buying low/selling high. En masse, they will alter the exch rate (differences in S+D will alter the price) and anomaly will disappear

Question 25

Applicability of Interest Rate Parity Theory to determining forward rates

Answer 25

Primary limitation on applicability of this relationship is government intervention:

CONTROLS ON CAPITAL MARKETS

govt may limit range/type of mkts within their F/Svcs system

CONTROLS ON CURRENCY TRADING

e.g. limit on amount of currency that may be removed from country; use of “official” exchange rate which does not reflect “effective” rate mkt wishes to use

GOVT INTERVENTION IN THE MARKET

govt may attempt to control/manipulate the exch rate by buying/selling their own currency

Question 26

International Fisher Effect

Answer 26

The Intl Fisher Effect claims that the interest rate differentials between two countries provide an unbiased predictor of future changes in the spot rate of exch.

Effect assumes that all countries will have same real interest rate, although nominal/money rates may differ due to expected inflation rates

thus the interest rate differential between two countries should be equal to the expected inflation differential

thus countries with higher expected inflation rates will have high nominal interest rates, and vice versa

Question 27

Example - Fisher Effect

Answer 27

examines the relationship between interest rates and inflation

INFLATION = difference between real ROI (real interest) and nominal return (nominal interest rate)

[1 + nominal] = [1 + real] * [1 + inflation rate]

e.g. UK interest 5.06%, inflation 3%

Real interest rate = 1.0506/1.03 = 1.02 or 2%

Thus the NOMINAL rate in a country must be sufficient to reward investors with a suitable REAL return (here 2%) plus an additnl return to allow for effects of inflation

Question 28

Definition - Arbitrage

Answer 28

The simultaneous purchase and sale of a security in different markets with the aim of making a risk-free profit through the exploitation of any price differences between the two markets

Mainly used by speculators as a hedging tool

Arbitrage differences are s/t - when other traders see commodity price differences they will exploit them and prices will converge - thus differences will vanish as equilibrium reached

Question 29

Pure Arbitrage

Answer 29

Pure arbitrage = abritrage which is completely risk-free

e.g. if EUR are available more cheaply in London than New York, arbitrageurs can make a risk-free profit by buying in London and selling in New York

globalization of markets and proliferation of internet => pure arbitrage opportunities have all but dried up

moreover, access to real-time market prices costs money, as done transaction fees - thus heavy heavy investment is req’d to make the above example practicable

Question 30

Example - Arbitrage

Answer 30

fruit & veg stall at market

customer asks for 1kg of apples

you have none but know where to get them

you ascertain customer WTP at GBP 1/kg and know a competitor supplier selling at 90p

you make a profit of 10p

if enough people ask for apples, the commpetitor will realize there is an increased demand for apples - which appear in short supply - and will increase price

thus eliminating opportunity for arbtirage profits

Question 31

Day-trading on exchange rates

Answer 31

Day-trader believes they can spot s/t speculative movements and benefit from them - re. exch rates: looks for a “cheap” currency and sells it quickly at a profit to someone needing it

e.g. day trader thinks there is a difference in market for USD

he can buy USD 2 for EUR 1.50 - he can buy EUR 1 for GBP 0.80 - he can sell USD 1.5 for GBP 1 - he has GBP 100k available

convert GBP to EUR = 100k / 0.8 = EUR 125k

convert EUR to USD = (EUR 125k / 1.5) * 2 = USD 166,667

sell USD = USD 166.7k / 1.5 = GBP 111k

thus GBP 11.1k risk-free profit

Question 32

Stages in the Financial Risk Management Process

Answer 32

(1) identify risk exposures
(2) quantify exposures
(3) decide whether or not to hedge
(4) implement and monitor hedging program

Question 33

Hedging

Answer 33

involves the reduction or elimination of financial risk by passing onto someone else

– or internal hedging techniques which involve reducing risk by creating an offsetting position that has a tendency to cancel any risk

Question 34

Benefits of hedging

Answer 34

can provide certainty of CF which assists budgeting

reduces risk - thus mgmt may be more inclined to undertake investment projects

reduction in probability of bankruptcy

mgrs often risk-averse since job is at risk - thus a company with hedging policy will be seen as a more attractive employer

Question 35

Arguments against hedging

Answer 35

sh/h have diversified their own portfolios - thus further hedging by business may harm sh/h interests

tx costs associated with hedging can be significant

lack of expertise within business, esp regarding use of derivative instruments

complexity of a/c and tax issues associated with derivative use

Question 36

Definition - Derivatives

Answer 36

A financial instrument whose value depends on the price of some other financial asset or underlying factor (e.g. oil, gold, interest rates, currencies)

Question 37

Uses of Derivatives

Answer 37

HEDGING

used a RM tool to reduce/eliminate financial risk

SPECULATION

used to make a profit from predicting mkt mvmts

ARBITRAGE

used to exploit s/t price differences between markets

Question 38

Primary Functions of Treasury

Answer 38

MANAGING RELATIONSHIPS WITH BANKS

investment of surplus cash, arrangements to allow cash deficits, hedging

WORKING CAPITAL AND LIQUIDITY MANAGEMENT

ensure sufficient (not excessive) daily cash available to fund inv, A/P and A/R

LONG-TERM FUNDING MANAGEMENT

cash for l/t investments e.g. NCA or mortgages/debentures

CURRENCY MANAGEMENT

multi currency implies internal and external hedging techniques, sourcing currencies, managing foreign currency bank accounts

Question 39

Organizational Structure of Treasury Function

Answer 39

Treasurer has capacity to make large gains or loss in short period of time - esp when trading in fin derivatives - thus careful role defintiion and monitoring key

Question 40

Two Primary Debates regarding role of Treasury Function

Answer 40

Profit Center vs Cost Center

Centralized vs Decentralized

Question 41

Treasury - Profit Center vs Cost Center

Answer 41

Advantages of PROFIT CENTER approach

• mkt rate charge to all business units, meaning operating costs are realistic
• treasurer is motivated to provide svcs as efficiently and economically as possible

Disadvantages of PROFIT CENTER approach

• profit concept drives temptation to speculate and take excessive risk
• mgmt time wasted on discussing internal charges for treasury activities
• additional admin costs

Question 42

Treasury - Centralized or Decentralized

Answer 42

RISKS associated with centralized

• lack of motivation at sub level to manage cash, as any cash received is swept up to head office and managed at group level
• risk that, should head office commit an error in treasury ops, entire group is in jeopardy

RISKS associated with decentralized

• one sub may pay large overdraft interest costs whereas another has cash balances on hand earning low interest rates
• risk of not generating group profits that would be earned if group funds were actively managed by a profit-oriented treasury > individual executives seeking to reduce costs

Question 43

Two methods of Managing Transaction Risks

Answer 43

INTERNAL METHODS

Invoicing in home currency

leading / lagging

Offsetting: matching / netting / pooling

countertrade

EXTERNAL METHODS

netting centers

forward contracts

money market hedges

currency futures / options / swaps

Question 44

Differences between Internal and External Methods of Hedging

Answer 44

internal hedging often more effective for dealing with economic risk

internal hedging often cheaper and simpler to understand

external hedging more complex and thus requires more skilled staff in treasury depts

Question 45

Internal Hedging Techniques - Invoicing in Home Currency

Answer 45

UK business sending and receiving invoices exclusively in GBP partly removes currency risk by transferring onto customer or supplier

economic risk is not removed - b/c business value will still fall if overseas competition are “winning” with their overseas trade in foreign currencies

PRACTICAL ISSUES:

• cust/suppliers may not want to accept currency risk => won’t trade with us
• other parties may not accept same prices, will require discounts (sales) or premiums (purchases)
• other ways exist of hedging risks which render risk of transacting in foreign currency acceptable

Question 46

Internal Hedging Techniques - Leading and Lagging

Answer 46

a way of trying to make gains on foreign currency payments

leading = paying before due date // lagging = holding off as long as possible

in both cases b/c of a strong view on future exch rate mvmts

PROBLEMS

• early payment costs us interest foregone on funds which have been disbursed early
• payee not happy if payment may be overdue - especially if currency expected to fall
• company required to speculate => risk of getting it wrong

Question 47

Example - Leading / Lagging

Answer 47

Company has to pay a US supplier $100k

Payment due in two months - but could be paid now or in three months

Sterling expected to depreciate vs USD - meaning better to pay ASAP otherwise more of our currency required to make up 100k

e.g. rate expected to go from GBP 1/$2 to GBP 1/$1.5, payment would go from GBP 50k to 66.7k

Question 48

Internal Hedging Techniques - Offsetting

Answer 48

MATCHING

matching assets/liabs in same currency

e.g. financing foreign inv’ment with foreign loan - favorable rate changes on one would mean adverse on the other - thus exch risk reduced

NETTING

using foreign bank a/c and reducing risk by using foreign receipts to cover foreign payments - works best if dates line up

at group level, can work such that one bus unit’s payments are netted against another’s receipts

POOLING

end-of-day cash sweep into central account (including overdrafts too) to maximize interest earned, minimize any bank charges

although not hedging against FX, does avoid overdraft costs and enables more efficient use of surpluses

best operated by a central treasury function

POOLING

Question 49

Internal Hedging Techniques - Countertrade

Answer 49

parties exchanging goods/svcs of equivalent value

old fashioned bartering and avoids any type of currency exchange

tax authorities do not like this – without cash changing hands, difficult to estblish value and thus sales tax payable

risk of tax authority dispute + associated mgmt time => unpopular

Question 50

Extertnal Hedging Techniques - Netting Centers

Answer 50

Treasury mgmt technique used by large companies to manage their interco payment processes, usually involving many currencies

can yield significant savings from reduced foreign exchange trading

netting ctr collates batches of CF between a defined set of orgs and offsets them such that only a single CF to or from each company takes place to settle the net result

cyclical basis - usually monthly - managed centrally by netting center

several currencies involved - all CF converted into equivalent domestic amounts such that the org has only a single net position to settle

objective is to reduce overall forex volume traded and thereby cut forex spread paid by the company (b/c direct billing in multicurrency implies excessive buying/selling of foreign currencies over and over)

Question 51

Diagram - Multicurrency payment WITH and WITHOUT netting center use

Answer 51

Question 52

Points to agree upon in order for netting to be successful

Answer 52

CURRENCIES

which one used for invoicing? buyer’s, seller’s, another?

CREDIT PERIOD

ideally the same for all participants - some variations for those who are long or short of funds

SETTLEMENT DATES

timetable of the cycle must be known and followed, as should frequency of netting

EXCHANGE RATES

spot, or mid at 11am, or budgeted - needs agreeing - should be “arms length” to avoid tax issues

CONFLICT RESOLUTION

process for resolving disagreements so as not to slow down the process - may be complex to agree who owes what to whom

MANAGEMENT

internal or by the bank

Question 53

Definition - Currency Forward Contract

Answer 53

Agreement to buy or sell a specific amount of foreign currency at a given future date using an agreed forward rate

most popular hedge for foreign currency tx risk - setting your rate in advance

risk is taken by the bank who is better able to manage exposure - a proportion of their exposue will normally be avoided by writing forward contracts for opposite trades on the same day

Question 54

Features of Currency Forward Contract

Answer 54

binding commitment

often quoted at discount (“dis”) or premium (“prem”) - “dis” meaning currency being quoted (USD) is expected to fall vs other currency (GBP), thus more USD req’d to purchase a single unit of GBP

rule: add a fwd discount to spot “add:dis” // subtract a forward premium from spot

Question 55

Advantages of Currency Forward Contracts

Answer 55

Simple, thus low tx costs

purchased from high street bank

fixed exchange rate

tailored - thus flexible in terms of amount and time period

Question 56

Disadvantages of Currency Forward Contracts

Answer 56

(1) Contractual Commitment

Thus potential credit risk as org may be awaiting overseas customer payment and wishing to convert using the contract

“option date” forward exchange contract can be arranged - gives companies a range of dates within which it can settle at the agreed rate - thus more flex

(2) generaly inflexible - eliminates downside risk of adverse mvmt, but no upside potential / no participation in a favorable mvmt

Question 57

Definition - Money Market Hedges (MMH)

Answer 57

Money Markets are for wholesale (large scale) lending and borrowing, or trading in s/t financial instruments

many orgs able to borrow/deposit funds through their bank in the money markets

instead of hedging currency exposure with a forward contract, company could use money markets to lend/borrow and achieve a similar result

since foreward exch rates are derived from spot rates and money mkt interest rates (IRPT), end result should be similar in either method

Question 58

Features of Money Market Hedging

Answer 58

Basic idea is to create assets and liabilities which “mirror” the future assets/liabilities

RULE: money req’d for tx is exchanged at today’s spot rate, is then deposited/borrowed on the money market to accrue at the amount req’d for the future tx

NOTE: interest rates used for the depositing/borrowing - usually quoted per annum.

Question 59

Money Market Interest Rates

Answer 59

available for any length of borrowing/deposit period up to circa 1 year

Two rates quoted: higher is that banks charge for loans, lower is on deposits

e.g. 1-mo USD LIBOR 3.250 – 3.1250

thus 3.25%/year if you wanted to borrow from them

for exam purposes, assume that 1 month of interest = 3.25% / 12 = 0.271%

Question 60

Characteristics of Money Market Hedging

Answer 60

Basic idea = avoid future exch rate uncertainty by making the exch at today’s spot rate

Achieved by depositing/borrowing the foreign currency until the actual tx cash flows occur

Question 61

Advantages of Money Market Hedging

Answer 61

ensure no currency risk b/c exch takes places today

fairly low tx costs

flexibility - especially if customer delays payment

Question 62

Disadvantages of Money Market Hedging

Answer 62

complex

may be difficult to get an overseas loan in case of foreign currency receipt

Question 63

Money Market Hedging and CF

Answer 63

interest rate parity implies that money market hedge should give same result as forward contract

CF implications may prevent company from using this method - if org has considerable overdraft, it may not be able to borrow funds right away

Question 64

Definition - Currency Futures

Answer 64

form of hedging very similar to use of forward contracts

key difference is that, whereas forward contract requires a tailor-made instrument for the specific tx, futures are standardized for fixed amounts of money for a limited range of future dates

Question 65

Features and Operation - Currency Futures

Answer 65

futures are derivatives contracts, thus can be traded on futures exchanges

the “futures contract” which guarantees the price is separate from the tx thus easily tradable

futures contracts usually denominated in USD - thus they are known as the “other” currency, e.g. the GBP1/USD future is known as GBP contracts

example - Chicago Mercantile Exchange trades sterling futures contracts with standard size of GBP 62,500 and one can only purchase multiples of this amount - thus somewhat inflexible

Question 66

Process - Currency Futures Contract

Answer 66

STEP 1: THREE KEY QUESTIONS

do we initially buy or sell futures? (if we want to buy GBP, buy a GBP contract)

which expiry date should we choose? (3-month settlement cycle, usually the one after required conversion date is used)

how many contracts?

STEP 2: CONTRACT EXCHANGE

pay the initial MARGIN then wait for tx/settlement date

margin = initial deposit to the exchange which is returned when position is closed

STEP 3: CLOSING OUT

on contract expiry the trading position is automatically reversed, any P/L is computed and cleared and underlying commodity retained by the trader

margin refunded by exchange

value of tx calculated using spot rate on tx date

most futures are closed out before settlement dates by undertaking the opposite tx on initial futures tx - i.e. if buying currency futures was initial tx, closed out by selling currency futures

Question 67

Concept - Currency Futures Contract

Answer 67

Hedging or speculating on the movement of the exchange rate on the futures market

effectively a future is a bet - if an org expected a USD receipt in 3 months, it will lose if USD depreciated vs GBP - the futures contract lets the org “bet” the USD will depreciate - if it does, the win on the bet cancels out the loss on the tx - if the USD strengthens, the gain on the tx covers the loss on the bet

Question 68

Currency Futures Contract - Margin

Answer 68

Initial Margin - paid to exchange when futures contract is bought / sold

If losses are incurred, buyer/seller may be required to deposit additional “variation margin” with the exchange

Similarly, profits credited to the margin account on daily basis as the contract is “marked to market”

Question 69

Worked Example - Futures Contracts

Answer 69

today is Oct 15, an org needs to convert EUR into USD to pay USD12m on Nov 20

December Euro Futures = contract size EUR200k, prices given in USD per EUR, tick size USD 0.0001 / USD 20 per contract

Oct 15 spot rate 1.3300, futures price 1.3350

Nov 20 spot rate 1.3190, futures price 1.3240

STEP ONE - three questions

buy or sell – need to sell EUR to buy USD, thus SELL FUTURES now

which expiry – Nov 20 – thus choose December futures

how many – to cover 12m/1.3350 = EUR 8.99m / 0.2m (per contract) = 45 contracts

STEP TWO - contract

sell 45 December futures at futures price of EUR1 / USD 1.3350

STEP 3 - close position and calculate P/L

Initially sell at 1.3350

close out buy at 1.3240

difference is USD 0.011 per EUR 1

thus total profit = 0.011 * 45 * 200,000 = USD 99,000

tx at spot rate on Nov 20 = USD 12m less 99k profit = USD 11.901m

at spot rate EUR1/USD1.3190 = EUR 9,022,744

Question 70

Ticks - Futures Contract

Answer 70

the minimum price mvmt for a contract

e.g. sterling futures of GBP 62,500 are priced at exch rate in USD and tick size is USD 0.0001

thus if price changes from USD 1.7105 to USD 1.7120, increase is 0.0015 or 15 ticks

every one tick mvmt in price has the same money value for futures trading

e.g. 1 tick of mvmt in the contract above costs 62,500 * 0.0001 = USD 6.25

Question 71

Basis & Basis Risk

Answer 71

the current futures price varies from current “cash market” price

re. currency futures, current mkt price of currency future and current spot rate will be different, will only start to converge when the final settlement date for futures contract aproaches - this is known as the “basis”

at final settlement date of contract, future prices and market price of underlying item ought to be the same; otherwise speculators would make an instant profit trading between the two

most futures positions closed out before contract reaches settlement date - thus there will be an inevitable differences in futures price at close-out and current spot market price of underlying item - thus “there will still be some basis”

b/c basis exists, an estimate can be made when a hedge is created with futures about what the size of the basis will be when the futures position is closed

Question 72

Example - Basis

Answer 72

February, UK org wishes to hedge currency exposure arising from USD payment that will have to be made in May

current spot exch rate is USD 1.5670 and current June futures price is USD 1.5530 - thus basis of 140 pts in Feb

if we assumed basis will decline from 140 to 0 in June, we can predict a 3/4 fall of 105 points by May when payment is due

Question 73

Basis Risk

Answer 73

The risk that when a hedge is constructed, the size of the basis when the futures position is closed out is different from the expectation of what the basis ought to be (from when the hedge was created)

thus if initial spot was GBP 1 : USD 1.5670 an June futures price was USD 1.5530 – but rate falls to USD 1.5500 – the pound has fallen in value more than expected thus a higher payment will be req’d to settle the US obligation

Question 74

Advantages of Currency Futures Contracts

Answer 74

offer an effective “fixing” of exchange rate

no tx costs

tradable instruments

Question 75

Disadvantages of Currency Futures Contracts

Answer 75

foreign futures market must be used for GBP futures

require up front margin payments

not usually for the precise tailored amounts required

Question 76

Definition - Currency Option

Answer 76

The right - but not obligation - to buy or sell a currency at an exercise price on a future date

Favorable mvmt = company allows option to lapse to take advantage of favorable mvmt

Adverse mvmt = option is exercised to protect against adverse mvmt

Question 77

Features of Currency Options

Answer 77

they carry a COST - b/c options limit downside risk but allow holder to benefit from upside risk, the writer of the option will charge a non-refundable premium for writing the option

Question 78

Calculating gains/losses on use of options

Answer 78

Question 79

Two types of option

Answer 79

CALL OPTION

gives the holder the right to buy the underlying currency

PUT OPTION

gives the holder the right to sell

Question 80

Illustration - Currency Options

Answer 80

Using attached table

The option to buy a contract with an expiry date of September and a strike price of EUR 1 = USD 1.17 would cost 1.55/euro as a premium

If the contract was EUR 125k => premium of USD 1,937.50

Or an option to sell in June at strike price of EUR 1 = USD 1.15 would cost 0.64 cents per euro as commission => USD 800

Question 81

Step-by-step in calculating options hedging

Answer 81

STEP ONE: FOUR KEY QUESTIONS

• call or put?
• which expiry date?
• what strike price?
• how many contracts?

STEP TWO

Contact exchange, pay up-front premium, then await tx/settlement date

STEP THREE
on tx date, compare option price with spot rate and determine whether to exercise or allow to lapse

STEP FOUR

Calculate the net CF - if the number of contracts need rounding, some exchange at prevailing spot rate will be req’d even if option is exercised

Question 82

In- and out-of-the-money options

Answer 82

strike price for an option may be < or > than current mkt price

e.g. call option may give right to buy GBP at GBP 1 / USD 1.79 – spot rate may be higher, lower, or bang on

if exercise price for an option is more favorable to the option holder than the current “spot” rate = “in-the-money” option

if less favorable = “out-of-the-money”

if the same = “at-the-money”

an option will only ever be exercised if “in-the-money”

BEAR IN MIND - this relates to EXERCISE PRICE (thus at the “end” of the contract) - an option may start out-of-the-money and move in - although it may also stay out

Question 83

Advantages of Currency Options

Answer 83

offer the perfect hedge - downside risk covered, can participate in upside potential

many choices of strike price, dates, premia

option can be allowed to lapse if the future transaction does not arise

Question 84

Disadvantages of Currency Options

Answer 84

traded sterling currency options are only available in foreign markets

high up-front premium costs (non-refundable)

Question 85

Definition - Black-Scholes Model

Answer 85

setting premium level for options requires complex models - these are also used to calculate FV of an option at given date (for fin rptg)

Black-Scholes model is the most common option pricing model used

basic principle is that the market value (or price) of a call option consists of two elements:

• intrinsic value of the option
• time value of the option

between these two elements there are five variables affecting the price of a call option

Question 86

Black-Scholes Model - Two Elements and Five Variables

Answer 86

ELEMENT ONE: INTRINSIC VALUE OF OPTION

difference between current price of underlying asset and option strike (exercise) price – for the market value of a call option to rise, one/both of the following variables must change:

(1) current price of underlying asset must increase
(2) strike price must fall - thus increasing likelihood that option is exercised - which has some worth

ELEMENT TWO: TIME VALUE

reflects the uncertainty surrounding the intrinsic value, impacted by three variables:

(1) st dev in daily value of underlying asset - more variability means higher chance of option “in-the-money” and thus will be exercised
(2) time period until expiry - longer time means more likely increase in asset value, thus option is exercised
(3) risk free interest rates - a call option means purchase can be deferred - thus owning a call option is more valuable with higher interest rates, since money left in the bank generates a higher return

Question 87

Limitations of the Black-Scholes Model

Answer 87

the basic form is widely used by traders in option markets to give an estimate of option values - there are several limitations:

• assumes that the risk-free interest rate is known and constant throughout the life of the option
• st dev of returns from underlying security must be accurately estimated and must be constant throughout asset life - in practice st dev will vary depending on the period over which it is calculated; the model is unfortunately very sensitive to its value
• assumes no tx costs of taxation effects involved in buying/selling option or underlying item

Question 88

Options other than currency options

Answer 88

e. g. interest rate options, options for other assets/liabilities
e. g. a company may wish to buy an option to purchase a factory currently under construction

company may pay a premium to the builder entitling them to first option to buy (not comitment)

if the council then changes planning guidelines and prevents further development in the area, the option becomes very valuable since no other companies can build new factories - thus the option could be sold on at a profit (if the builder allows it)

Question 89

Swaps

Answer 89

Cross-currency swap - allows a company to swap a currency it currently holds for a different currency for a fixed period, then same back at the same rate at the end of the period

counterparty is usually a bank

two elements:

(1) exchange of principals in different currencies, which are swapped back at the original spot rate
(2) exchange of interest rates - timing of these depends on the individual contract

Question 90

Summary regarding hedging

Answer 90

Some risks better covered by internal methods, others by external - key is matching a suitable hedging method to the specific risk

consider options beyond financial instruments

e.g. UK company exporting to the US could suffer if USD weakens - could hedge by matching USD revenues with USD costs - ideally by importing materials priced in USD – rather than going for a limited-term external hedging instrument