currency future and options

7/29/2019 currency future and options

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Currency Futures, Options

& Swaps

Reading: Chapters 7 & 14 (474-485)


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Lecture Outline

Introduction to Derivatives

Currency Forwards and Futures

Currency Options

Interest Rate Swaps Currency Swaps

Unwinding Swaps


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Introduction

A derivative (or derivative security) is a financial

instrument whose value depends on the value of other,more basic underlying variables/assets: Share options (based on share prices)

Foreign currency futures (based on exchange rates)

These instruments can be used for two very distinctmanagement objectives:

Speculationuse of derivative instruments to take a positionin the expectation of a profit.

Hedginguse of derivative instruments to reduce the risksassociated with the everyday management of corporate cashflow.


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Definition of Futures and Forwards

Currency futures and forward contracts both represent

an obligation to buy or sell a certain amount of a

specified currency some time in the future at an

exchange rate determined now.

But, futures and forward contracts have different

characteristics.


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Futures versus Forwards


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Futures Contract - Example

Specification of the Australian Dollar futures contract(International Money Market at CME)

Size AUD 100,000

Quotation USD / AUD

Delivery Month March, June, September,December

Min. Price Move $0.0001 ($10.00)

Settlement Date Third Wednesday of delivery

monthStop of Trading Two business days prior to

settlement date
http://www.cme.com/trading/dta/del/product_list.html?ProductType=curhttp://www.cme.com/trading/dta/del/product_list.html?ProductType=cur


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Futures - The Clearing House

When A sells a futures contract to B, the ClearingHouse takes over and the result is:

A sells to the Clearing House

Clearing House sells to B

The Clearing House keeps track of all transactions that

take place and calculates the net position of all

members.


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Futures - Marking to Market

Futures contracts are marked to market daily.

Generates cash flows to (or from) holders of foreign

currency futures from (or to) the clearing house.

Mechanics:

Buy a futures contract this morning at the price of f0,T

At the end of the day, the new price is f1,T

The change in your futures account will be:

[f1,T - f0,T] x Contract Face Value = Cash Flow


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Purpose of Marking to Market

Daily marking to market means that profits and lossesare realized as they occur. Therefore, it minimizes the

risk of default.

By defaulting, the investor merely avoids the latest

marking to market outflow. All previous losses have

already been settled in cash.


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Marking to MarketExample

Trader buys 1 AUD contract on 1 Feb forUSD0.5000/AUD

USD value = 100,000 x 0.5000 = USD 50,000.

Date Settlement Value of Contract Margin A/c________________________________________________________________________________

1 Feb 0.4980 49,800 - 200

2 Feb 0.4990 49,900 + 1003 Feb 0.5020 50,200 + 300

4 Feb 0.5010 50,100 - 100


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Trouble with Forwards/Futures?

$ Spot

1.80

A$ 1.90/US$

Forward/Futures

Rate

Seller (short)

US$

Buyer (long)

US$

0

+

-

2.00


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Basics of Options

Options give the option holder the right, but not theobligation to buy or sell the specified amount of the

underlying asset (currency) at a pre-determined price

(exercise orstrike price).

The buyer of an option is termed the holder, while theseller of the option is referred to as the writeror

grantor.

Types of options: Call: gives the holder the right to buy

Put: gives the holder the right to sell


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AnAmerican option gives the buyer the right toexercise the option at any time between the date of

writing and the expiration or maturity date.

AEuropean option can be exercised only on its

expiration date, not before.

The premium, or option price, is the cost of the

option.

Basics of Options


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Basics of Options

The Philadelphia Exchange commenced tradingin currency options in 1982.

Currencies traded on the Philadelphia exchange:

Australian dollar, British pound, Canadian dollar,Japanese yen, Swiss franc and the Euro.

Expiration months:

March, June, September, December plus two near-term

months.
http://www.phlx.com/http://www.phlx.com/


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Basics of Options

Spot rate, 88.15 /

Size of contract:62,500

Exercise price0.90 /

The indicated contract price is:62,500 $0.0125/ = $781.25

One call option gives the holder the right to purchase62,500 for $56,250 (=62,500 $0.90/)Maturity month


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Buyer of a call: Assume purchase of August call option on Swiss francs

with strike price of 58 ($0.5850/SF), and a premiumof $0.005/SF.

At all spot rates below the strike price of 58.5, thepurchase of the option would choose not to exercisebecause it would be cheaper to purchase SF on the openmarket.

At all spot rates above the strike price, the option

purchaser would exercise the option, purchase SF at thestrike price and sell them into the market netting a

profit (less the option premium).

Options Trading


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Writer of a call: What the holder, or buyer of an option loses, the writer

gains.

The maximum profit that the writer of the call option can

make is limited to the premium. If the writer wrote the option naked, that is without owning

the currency, the writer would now have to buy the currencyat the spot and take the loss delivering at the strike price.

The amount of such a loss is unlimited and increases as the

underlying currency rises.

Even if the writer already owns the currency, the writer willexperience an opportunity loss.

Options Trading


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Buyer of a Put:

The basic terms of this example are similar to those just illustratedwith the call.

The buyer of a put option, however, wants to be able to sell theunderlying currency at the exercise price when the market price of

that currency drops (not rises as in the case of the call option). If the spot price drops to $0.575/SF, the buyer of the put will

deliver francs to the writer and receive $0.585/SF.

At any exchange rate above the strike price of 58.5, the buyer ofthe put would not exercise the option, and would lose only the

$0.05/SF premium. The buyer of a put (like the buyer of the call) can never lose more

than the premium paid up front.

Options Trading


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Seller (writer) of a put: In this case, if the spot price of francs drops below 58.5

cents per franc, the option will be exercised.

Below a price of 58.5 cents per franc, the writer will

lose more than the premium received fro writing theoption (falling below break-even).

If the spot price is above $0.585/SF, the option will notbe exercised and the option writer will pocket the entire

premium.

Options Trading


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An option whose exercise price is the same as thespot price of the underlying currency is said to beat-the-money (ATM).

An option the would be profitable, excluding thecost of the premium, if exercised immediately issaid to be in-the-money (ITM).

An option that would not be profitable, again

excluding the cost of the premium, if exercisedimmediately is referred to as out-of-the money(OTM).

Option Pricing & Valuation


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Call Put

Intrinsic value max(ST - X, 0) max(X - ST, 0)

in the money STX > 0 XST > 0

at the money STX = 0 XST = 0

out of the money STX < 0 XST < 0

Time Value CTInt. value PTInt. value



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current exchange rate (S)as S , Call and Put

strike price (X)as X , Call and Put

time to expiration (T)as T , both

volatility of the exchange rate ()as , both

domestic interest rate (id)as id, Call and Put

foreign interest rate (if)as if, Call and Put


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Forwards versus Options

-$0.90-$0.75

-$0.60

-$0.45

-$0.30

-$0.15

$0.00

$0.15

$0.30

$0.45

$0.60

$0.75

$0.90

$0.

00

$0.

10

$0.

20

$0.

30

$0.

40

$0.

50

$0.

60

$0.

70

$0.

80

$0.

90

$1.

00

$1.

10

$1.

20

$1.

30

$1.

40

$1.

50

$1.

60

$1.

70

$1.

80

Spot Rate at Expiration

Valu

eofForward/PutOptionatExpiration.

Value of Forward Sale at Expiration

Value of Put at Expiration


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Swaps are contractual agreements to exchangeor swap a series of cash flows.

These cash flows are most commonly theinterest payments associated with debt service.

If the agreement is for one party to swap its fixedinterest rate payments for the floating interest rate

payments of another, it is termed an interest rate swap.

If the agreement is to swap currencies of debt serviceobligation, it is termed a currency swap.

A single swap may combine elements of both interestrate and currency swaps.

What are Swaps?


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The swap itself is not a source of capital, butrather an alteration of the cash flows associatedwith payment.

What is often termed theplain vanilla swap is an

agreement between two parties to exchange fixed-rate for floating-rate financial obligations.

This type of swap forms the largest single

financial derivative market in the world.

What are Swaps?


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There are two main reasons for using swaps:1. A corporate borrower has an existing debt service

obligation. Based on their interest rate predictions

they want to swap to another exposure (e.g. change

from paying fixed to paying floating).2. Two borrowers can work together to get a lower

combined borrowing cost by utilizing their

comparative borrowing advantages in two different

markets.

What are Swaps?


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For example, a firm with fixed-rate debt thatexpects interest rates to fall can change fixed-rate

debt to floating-rate debt.

In this case, the firm would enter into apay

floating/receive fixedinterest rate swap.

What are Swaps?


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Swap Bank

A swap bankis a generic term used to describe afinancial institution that facilitates swaps between

counterparties.

The swap bank serves as either a broker or a dealer. A broker matches counterparties but does not assume any of

the risk of the swap. The swap broker receives acommission for this service.

Today most swap banks serve as dealers or market makers.As a market maker, the swap bank stands willing to accept

either side of a currency swap.


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Example of an Interest Rate Swap

Bank A is a AAA-rated international bank locatedin the U.K. that wishes to raise $10,000,000 to

finance floating-rate Eurodollar loans.

Bank A is considering issuing 5-year fixed-rateEurodollar bonds at 10 percent.

It would make more sense for the bank to issue

floating-rate notes at LIBOR to finance the floating-rate

Eurodollar loans.


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Company B is a BBB-rated U.S. company. It needs$10,000,000 to finance an investment with a five-

year economic life, and it would prefer to borrow at

a fixed rate.

Firm B is considering issuing 5-year fixed-rate

Eurodollar bonds at 11.75 percent.

Alternatively, Firm B can raise the money by issuing 5-

year floating rate notes at LIBOR + percent.

Firm B would prefer to borrow at a fixed rate.


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The borrowing opportunities of the two firms are shown inthe following table.

COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%

Floating rate LIBOR + 0.50% LIBOR 0.50%


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Bank A has an absolute advantage in borrowingrelative to Company B

Nonetheless, Company B has a comparative

advantage in borrowing floating, while Bank A has a

comparative advantage in borrowing fixed.

That is, the two together can borrow more cheaply if

Bank A borrows fixed, while Company B borrows

floating.


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To see the potential advantages to a swap, imagine the twoentities trying to minimize their combined borrowing costs:

COMPANY B BANK A TOGETHER

Borrow preferredmethod

11.75% LIBOR LIBOR + 11.75%

Borrow oppositeand swap

LIBOR + 0.50% 10% LIBOR + 10.50%

POTENTIAL SAVINGS: 1.25%


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Now, we must determine how to split the swap savings!

If Swap Bank takes 0.25% that leaves 1% for Bank A &

Company B. If they share this equally then:- Bank A pays LIBOR - 0.5% = LIBOR0.5%

- Company B pays 11.75% - 0.5% = 11.25%

COMPANY B BANK A TOGETHERBorrow preferred

method11.75% LIBOR LIBOR + 11.75%

Borrow oppositeand swap

LIBOR + 0.50% 10% LIBOR + 10.50%

POTENTIAL SAVINGS: 1.25%


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10 3/8%

LIBOR1/8%

Bank

A

Swap

Bank

The swap bank makesthis offer to Bank A: You

pay LIBOR1/8 % per

year on $10 million for 5

years, and we will pay

you 10 3/8% on $10million for 5 years.


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10 3/8%

LIBOR1/8%

Bank

A

Swap

Bank

Why is this swap

desirable to Bank A?

10%

With the swap, Bank A

pays LIBOR-1/2%


Fixed rate 11.75% 10% 1.75%



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LIBOR%

10 %

Swap

Bank

Company

B

The swap bank makes this

offer to Company B: Youpay us 10 % per year on

$10 million for 5 years,

and we will pay you

LIBOR % per year on

$10 million for 5 years.


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LIBOR%

10 %

Swap

Bank

Company

B

Why is this swap

desirable to Company B?

With the swap, CompanyB pays 11%

COMPANY B BANK A DIFFERENTIALFixed rate 11.75% 10% 1.75%



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10 3/8 %

LIBOR%

10 %

Bank

A

Swap

Bank

Company

B

Will the swap bank

make money?


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LIBOR

+ %

10 3/8 %

LIBOR1/8%LIBOR%

10 %

B saves %

Bank

A

Swap

Bank

Company

B

A saves %

The swap bank

makes %

10%Note that the total savings

+ + = 1.25 % = QSD


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%


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The QSD

The Quality Spread Differential (QSD) represents thepotential gains from the swap that can be shared

between the counterparties and the swap bank.

There is no reason to presume that the gains will be

shared equally. In the above example, Company B is less credit-worthy

than Bank A, so they probably would have gotten less

of the QSD, in order to compensate the swap bank for

the default risk.


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Since all swap rates are derived from the yield curve in

each major currency, the fixed-to-floating-rate interest rateswap existing in each currency allows firms to swap acrosscurrencies.

The usual motivation for a currency swap is to replace cash

flows scheduled in an undesired currency with flows in adesired currency.

The desired currency is probably the currency in which thefirms future operating revenues (inflows) will begenerated.

Firms often raise capital in currencies in which they do notpossess significant revenues or other natural cash flows (asignificant reason for this being cost).

Currency Swaps


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Currency Swaps

Example: Suppose a U.S. MNC, Company A,wants to finance a 10,000,000 expansion of a

British plant.

They could borrow dollars in the U.S. where they are wellknown and exchange dollars for pounds. This results in

exchange rate risk, OR

They could borrow pounds in the international bond market,

but pay a lot since they are not well known abroad.


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Example continued..

IfCompany A can find a British MNC with amirror-image financing need, both companies

may benefit from a swap.

If the exchange rate is S0 = 1.60 $/, Company

A needs to find a British firm wanting to finance

dollar borrowing in the amount of $16,000,000.


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Example continued..

Company A is the U.S.-based MNC and Company B isa U.K.-based MNC.

Both firms wish to finance a project of the same size in

each others country (worth 10,000,000 or

$16,000,000 as S = 1.60 $/). Their borrowingopportunities are given below.

$

Company A8.0% 11.6%

Company B 10.0% 12.0%


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As Comparative Advantage

A is the more credit-worthy of the two.

A pays 2% less to borrow in dollars thanB.

A pays 0.4% less to borrow in pounds thanB:

$

Company A 8.0% 11.6%

Company B10.0% 12.0%


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Bs Comparative Advantage

B has a comparative advantage in borrowing in .

B pays 2% more to borrow in dollars thanA.

B pays only 0.4% more to borrow in pounds thanA:$


Company B 10.0% 12.0%


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Potential Savings = 2.0% - 0.4% = 1.6%

If Swap Bank takes 0.4% and A&B split the rest:

Company A pays 11.6% - 0.6% = 11%

Company B pays 10% - 0.6% = 9.4%

$


Company B 10.0% 12.0%

Differential (B-A) 2.0% 0.4%

Potential Savings

E l f C S


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Example of a Currency Swap

Company

A

Swap

Bank

i$=8%

i$=8%

i=11%

i=12%

i$=9.4%

CompanyB

i=12%

$


Company B 10.0% 12.0%


E l f C S


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Company

A

Swap

Bank

i$=8%

i$=8%

i=11%

i=12%

i$=9.4%

CompanyB

i=12%

$


Company B 10.0% 12.0%


As net position is to borrow at i=11%

A saves i=0.6%

E l f C S


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Company

A

Swap

Bank

i$=8%

i$=8%

i=11%

i=12%

i$=9.4%

CompanyB

i=12%

$

Company A 8.0% 11.6%Company B 10.0% 12.0%

Bs net position is to borrow at i$=9.4%

B saves i$=0.6%

E l f C S


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Company

A

Swap

Bank

i$=8%

i$=8%

i=11%

i=12%

i$=9.4%

CompanyB

i=12%

$

Company A 8.0% 11.6%Company B 10.0% 12.0%

The swap bank makesmoney too:

1.4% of $16 millionfinanced with 1% of 10

million per year for 5

years.

At S0 = 1.60 $/, that is again of $64,000 per year

for 5 years.

The swap bank

faces exchange raterisk, but maybe

they can lay it off

in another swap.

U i di S


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Unwinding a Swap

Discount the remaining cash flows under the swapagreement at current interest rates, and then (in the case

of a currency swap) convert the target currency back to

the home currency of the firm.

Payment of the net settlement of the swap terminates

the swap.

U i di S


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Unwinding a Swap

Suppose in the previous example, Company A wantedto unwind its (5 year) currency swap with the Swap

Bank at the end of Year 3. Assume that at Year 3, the

applicable dollar interest rate is 7.75% per annum, the

applicable pound interest rate is 11.25% per annum,and S=1.65 $/.

What will the net settlement amount be?

U i di S


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Unwinding a Swap

There are two years of interest payments and repayment of face

values remaining.

For Company A:

Paying 11% p.a. on 10,000,000

Receiving 8% p.a. on $16,000,000

Must return 10,000,000 and receive $16,000,000 at end

Net settlement for Company A is:

+ (16*0.08)/1.0775 + (16*0.08)/(1.0775)2 + 16/(1.0775)2

[(10*0.11)/1.1125 + (10*0.11)/(1.1125)2 + 10/(1.1125)2]x1.65

= -0.358 million dollars (must pay this amount to unwind swap)

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currency future and options