Ch 9 Flashcards
Definition of Forex Market
International market in national currencies
Highly competitive
Virtually no difference in price between two markets (e.g. NY and London)
Definition - Spot Rate
the rate given for a tx with immediate delivery
in practice, this means settled within two working days
Spread
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
Cross Rate
Calculating the relationship between currency A and C when only A:B and B:C are given in the question
Four reasons entities may wish to forecast exchange rates
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
Reasons for fluctuation in exchange rates
SPECULATORS
BALANCE OF PAYMENTS
GOVERNMENT POLICY
CAPITAL MVMTS BETWEEN ECONOMIES
Exchange rate fluctuations - Speculators
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
Exchange rate fluctuations - Balance of Payments
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
Exchange rate fluctuations - Government Policy
govts may wish to change their currency’s value
DIRECTLY by deval/reval, or via forex markets (buying/selling currency onto the markets)
Exchange rate fluctuations - Capital Movements between Economies
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
Three related theories giving insight into exchange rate movements
Purchasing Power Parity Theory (PPPT)
Interest Rate Parity Theory (IRPT)
International Fisher Effect
Purchasing Power Parity Theory (PPPT)
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)
Law of One Price
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
Example - Purchasing Power Parity Theory (PPPT)
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
RULE of Purchasing Power Parity Theory (PPPT)
The country with the higher inflation will suffer a fall (depreciation) in currency
PPPT - Calculation of Future Spot Rate
Future spot rate = current spot rate * [( 1 + if ) / ( 1 + ih )]
if = rate of inflation in foreign country
ih = rate of inflation of home country
Problems with Purchasing Power Parity Theory (PPPT)
(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
Purchasing Power Parity Theory (PPPT) - as a predictor of future spot rate
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
Interest Rate Parity Theory (IRPT)
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
Definition - Forward Rate
A future exchange rate, agreed now, for buying or selling an amount of currency on an agreed future date
Example - Interest Rate Parity Theory
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)
Rule - Interest Rate Parity Theory
IRPT predicts that the country with the higher interest rate will see the forward rate for its currency subject to a depreciation
Formula - Interest Rate Parity Theory
Forward Rate = Current Spot Rate * [( 1 + intsf ) / ( 1 + intsh)]
intsf = money risk-free rate of interest for foreign currency
intsh = money risk-free rate of interest for home currency
Interest Rate Parity Theory in Practice
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
Applicability of Interest Rate Parity Theory to determining forward rates
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
International Fisher Effect
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
Example - Fisher Effect
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
Definition - Arbitrage
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
Pure Arbitrage
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
Example - Arbitrage
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
Day-trading on exchange rates
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
Stages in the Financial Risk Management Process
(1) identify risk exposures
(2) quantify exposures
(3) decide whether or not to hedge
(4) implement and monitor hedging program
Hedging
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
Benefits of hedging
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
Arguments against hedging
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
Definition - Derivatives
A financial instrument whose value depends on the price of some other financial asset or underlying factor (e.g. oil, gold, interest rates, currencies)
Uses of Derivatives
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
Primary Functions of Treasury
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
Organizational Structure of Treasury Function
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
Two Primary Debates regarding role of Treasury Function
Profit Center vs Cost Center
Centralized vs Decentralized
Treasury - Profit Center vs Cost Center
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
Treasury - Centralized or Decentralized
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
Two methods of Managing Transaction Risks
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
Differences between Internal and External Methods of Hedging
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
Internal Hedging Techniques - Invoicing in Home Currency
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
Internal Hedging Techniques - Leading and Lagging
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
Example - Leading / Lagging
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
Internal Hedging Techniques - Offsetting
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
Internal Hedging Techniques - Countertrade
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
Extertnal Hedging Techniques - Netting Centers
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)
Diagram - Multicurrency payment WITH and WITHOUT netting center use
Points to agree upon in order for netting to be successful
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
Definition - Currency Forward Contract
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
Features of Currency Forward Contract
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
Advantages of Currency Forward Contracts
Simple, thus low tx costs
purchased from high street bank
fixed exchange rate
tailored - thus flexible in terms of amount and time period
Disadvantages of Currency Forward Contracts
(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
Definition - Money Market Hedges (MMH)
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
Features of Money Market Hedging
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.
Money Market Interest Rates
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%
Characteristics of Money Market Hedging
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
Advantages of Money Market Hedging
ensure no currency risk b/c exch takes places today
fairly low tx costs
flexibility - especially if customer delays payment
Disadvantages of Money Market Hedging
complex
may be difficult to get an overseas loan in case of foreign currency receipt
Money Market Hedging and CF
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
Definition - Currency Futures
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
Features and Operation - Currency Futures
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
Process - Currency Futures Contract
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
Concept - Currency Futures Contract
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
Currency Futures Contract - Margin
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”
Worked Example - Futures Contracts
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
Ticks - Futures Contract
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
Basis & Basis Risk
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
Example - Basis
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
Basis Risk
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
Advantages of Currency Futures Contracts
offer an effective “fixing” of exchange rate
no tx costs
tradable instruments
Disadvantages of Currency Futures Contracts
foreign futures market must be used for GBP futures
require up front margin payments
not usually for the precise tailored amounts required
Definition - Currency Option
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
Features of Currency Options
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
Calculating gains/losses on use of options
Two types of option
CALL OPTION
gives the holder the right to buy the underlying currency
PUT OPTION
gives the holder the right to sell
Illustration - Currency Options
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
Step-by-step in calculating options hedging
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
In- and out-of-the-money options
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
Advantages of Currency Options
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
Disadvantages of Currency Options
traded sterling currency options are only available in foreign markets
high up-front premium costs (non-refundable)
Definition - Black-Scholes Model
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
Black-Scholes Model - Two Elements and Five Variables
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
Limitations of the Black-Scholes Model
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
Options other than currency options
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)
Swaps
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
Summary regarding hedging
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
