TECHNICAL

Foreign currency exposure management: part 1

his is the first of a series of fivearticles. The aim of the series is todevelop an understanding of the ef-

Hedging currency risk

using the money markets

and forward contracts

The indirect quote is described by Brown etal (1994) as the number of foreign currencyunits needed to buy one unit of domesticcurrency. Hence from a UK viewpoint:US$1.56 = £1 which is quoted as US$1.56/£. Two points to note about these alternativemethods:

they are two ways of expressing the sameinformation; the indirect quote is simplythe reciprocal of the direct quote.

in the UK indirect quotes are used whereaselsewhere generally direct quotes areused. (The British like to be different!)

Appreciation and depreciation ofcurrenciesIt is important to understand the significanceof a movement in the exchange rate to therelative strength of the two currencies. Forexample, if the $/£ exchange rate movesfrom US$1.56/£ to US$1.63/£ the £ hasstrengthened; each £ will now buy more $.Alternatively one could say that the $ hasweakened.

Spot exchange rateBrealey and Myers (1991) define the ‘spotexchange rate’ as the exchange rate on cur-rency for immediate delivery.

Example 2:The $/£ spot rate may be quoted as follows:

1.4215 – 1.4225

offer or ask price bid price

If buying $ from the bank the companywould receive the offer rate of $1.4215for every £1; the smaller, least favour-able, to the company, of the two rates.

If selling $ to the bank the companywould have to give the bank $1.4225 forevery £1 it receives. Again the leastfavourable of the two rates i.e. the bankalways wins!

The difference or spread between the two

rates is the bank’s profit: 1.4225 – 1.4215 =$0.001.

Dealers at the banks make the market byquoting the bid and offer prices at which theyare prepared to buy and sell. The size of thespread between bid and offer rates variesdepending on:

the stability of the market at the time. Ifa currency exchange rate is more volatileand therefore subject to large fluctua-tions then the spread will be wider than ifthe exchange rate is stable.

the depth of the market. ‘Depth’ refers tothe volume of transactions in the market.A ‘deep’ market has a high volume oftransactions and several dealers in whichcase the spread will be narrower than fora ‘shallow’ or ‘thin’ market where thereis a low volume of transactions and fewdealers.

Foreign currency exposure

— or currency risk or

foreign exchange risk or

exchange riskShapiro (1995) defines exchange risk as thevariability of a firm’s value that is due touncertain exchange rate changes.

A movement in the exchange rate can have amajor effect on the value of a firm. Theuncertain nature of exchange rates makes itimportant for a firm to manage its exchangerisk.

Types of exposure to currency riskThere are three types of currency risk:

(1) Economic exposure (or operating ex-posure). Economic exposure is defined byShapiro (1995) as the extent to which thevalue of the firm will change due to anexchange rate change.

Economic exposure can be viewed as thetotal foreign currency exposure. It relates tofuture cash flows. As those cash flows cometo be received or paid then part of the expo-sure crystallises.

Nigel Brown BA FCA is a senior lecturer inFinancial Strategy at the University of Wales College, Newport

Tfect a movement in foreign currency ex-change rates — referred to as foreign cur-rency risk — may have on a firm and ofsome of the techniques that are available foreliminating or reducing that exposure —referred to as hedging techniques.

This topic is an important part of the syllabusfor paper 14, Financial Strategy.

In this first article we will consider the typesof currency risk to which a firm may beexposed. Then we will look at two methodswhich can be used to protect a firm againstthat risk: forward contracts and a moneymarket hedge. In subsequent articles we willdeal with futures contracts and option con-tracts.

Foreign exchange ratesThe foreign exchange rate is defined byFrench (1991) as the number of units of onecurrency which may be bought or sold forone unit of another currency. It is the price ofone currency relative to another currency.

Foreign currency may be viewed as an asset,a store of value. That currency has purchas-ing power.

Example 1:If an English person is planning a holiday inFrance it will be necessary to buy FrenchFrancs so as to be able to purchase goods inFrance. The exchange rate between the FrenchFranc and sterling (£) will determine theamount of French purchasing power it ispossible to buy with each £.

Direct quote or indirect quoteThe exchange rate may be expressed as adirect quote or an indirect quote.

Direct quote is described by Brown et al(1994) as the number of domestic currencyunits needed to buy one unit of foreign cur-rency. From a UK viewpoint this would beshown as: US$1 = £0.64. This indicates that$1 is worth £0.64 or 64 pence.

TECHNICAL 3

There are many ways in which economicexposure can occur. We will look at twocontrasting examples to demonstrate how itcan arise. Example 3 looks at a situationwhere, on the face of it, it appears that thereis no currency risk whereas there could wellbe significant economic exposure. Example4 looks at a situation where currency riskappears to be much higher than it is.

Example 3:Is a UK company, which is not engaged inany form of foreign trade and therefore notinvolved in any transactions denominated ina foreign currency, exposed to currency risk?

Solution:YES!

Since this company is not involved in anytransactions denominated in a foreign cur-rency it appears there is no exposure tocurrency risk but:

one of the UK firm’s competitors couldbe foreign (e.g. Italian), or could importits product from another country. Henceif, for example, the £ strengthened againstthe lira the UK firm’s competitors wouldgain an advantage; they could charge alower £ price for their product and there-fore potentially take market share fromthe UK company but still receive thesame value in lira.

the UK company may have UK supplierswho import raw materials and may there-fore find it necessary to pass on anyadverse effects of exchange rate move-ments.

Purchasing Power Parity (PPP)The next example requires an understandingof Purchasing Power Parity (PPP) which is atheory about the relationship between to-day’s spot exchange rate, the expected futurespot exchange rate and inflation rates. It isbased on the rationale that the price of goodsin one country should be the same as the priceof the same goods in another country.

PPP proposes that the difference between theinflation rates in two countries will be re-flected in a movement in the exchange ratebetween the two countries’ currencies. If, forexample, the UK has higher inflation thanGermany this will, according to PPP, causethe £ to weaken against the D-Mark. Thereason being that the purchasing power of the£ has fallen by more than the purchasingpower of the D-Mark and is therefore worthless D-Marks.

The amount of the expected movement in theexchange rate is, according to PPP, given bythe following formula:

Expected future spot rate= today’s spot rate x (1 + foreign

inflation rate)/(1 + UK inflation rate)= today’s spot rate x (1 + if)/(1 + iUK).

= 43,200 x (1 + 18)/(1 + .04)

= 789,231 Cr$/£

Hence Kelly PLC can expect to receive con-tribution of:

4,104,000/789,231= £5.20 for every disc sold.

Total contribution: 40,000 x 5.20 = £208,000i.e. 200,000 x (1.04).

Hence Kelly has earned £200,000 increasedby 4% to compensate for the effect of UKinflation. The company is as well off as ifthere had been no inflation. The high Brazil-ian inflation and the depreciation in the Bra-zilian currency have not affected the value ofthe transactions.

Or, put another way, Kelly PLC would earnthe same value in real terms as it would havedone without inflation. This would only bethe case if:

PPP holds, and

Brazilian selling prices can be increasedin line with inflation.

Therefore, if selling in a country with highinflation it is vital not to enter into contractswhere selling prices are fixed for long peri-ods. Alternatively the risk from a deprecia-tion in the Brazilian currency could be avoidedby invoicing in sterling; this would have theeffect of shifting the risk to the Braziliancustomers.

(2) Transaction exposureShapiro (1995) defines transaction exposureas the extent to which a given exchange ratechange will alter the (home currency) valueof foreign-currency-denominated transac-tions already entered into.

Examples of ‘transactions’:

purchase/sale of goods or services;

repayment of loan and interest;

payment of dividend.

Note that the essential feature of transactionexposure is that it refers to identified transac-tions. Hence, we are likely to know theamounts of currency involved and the timingof receipt or payment of the currency. Thismakes it easier to manage transaction expo-sure than economic exposure.

(3) Translation exposure (or accountingexposure)Translation exposure is the possibility thatthe book value of shareholders’ funds maychange as a result of a movement in exchangerates.

Translation exposure is more controversialthan transaction exposure or economic expo-sure. It arises due to the requirement to pre-pare periodic financial statements for a groupwith foreign subsidiaries.

Example 4:Kelly PLC, a UK company, has a subsidiaryin Brazil which manufactures compact discs.The Brazilian currency is the cruzeiro(Cr$).The product presently has the following coststructure:

Cr$selling price 486,000variable cost per unit 270,000

contribution per unit 216,000

The spot rate is 43,200 Cr$/£. ThereforeKelly PLC can expect to receive a £ equiva-lent of:

216,000/43,200 = £5 contribution for everycompact disc sold.

Assume Kelly PLC achieves sales of 40,000compact discs in the first year.

Required:(i) Calculate the amount of sterling contri-bution earned by Kelly PLC if there is noinflation and the exchange rate holds at 43,200Cr$/£.

(ii) Calculate the amount of sterling contri-bution earned by Kelly PLC if Brazil experi-ences inflation over the next year of 1,800%while the inflation rate in the UK over thesame year is only 4% and PPP holds. Assumethat Kelly’s costs increase by 1,800% andthat Kelly is able to increase revenues by1,800%.

Solution to Kelly PLC:

(i) No inflation

Contribution:

In Cr$: 216,000 x 40,000= Cr$ 8,640,000,000

In £: 8,640,000,000/43,200= £200,000.

(ii) With inflation and PPP holdsAdjust costs and revenues by a factor of 1 +the rate of inflation.

The inflation rate is extremely high in thisexample. To help us understand the calcula-tion let’s take a more reasonable price in-crease of 20%. To find the new price wewould take the old price and multiply it by120/100 or, in decimal terms, multiply by 1+ (20/100) = 1.2. Hence in this case therevised price would be found by multiplyingthe old price by:

1 + (1,800/100) = 1 + 18 = 19

Therefore contribution in Brazil will increaseto: 216,000 x 19 = Cr$ 4,104,000

The revised exchange rate will, according toPPP, be:

Expected future spot rate

= today’s spot rate x (1 + if)/(1 + iUK)

= 43,200 x (1 + i Brazil)/(1 + i UK)

TECHNICAL

Translation exposure is an accounting con-cept which may affect future cash flows andshould therefore be treated with caution.

Demirag and Goddard (1994) state that ‘Ithas become clear to many managers andaccountants alike that retrospective account-ing techniques, no matter how refined, can-not truly account for the economic effects ofdevaluation or revaluation on the value of acompany. As a result of this accounting dis-tortion of economic reality, many multina-tional firms are now taking a longer-termlook at their degree of exchange risk. Thisinvolves focusing on a company’s economicexposure.’

The main focus of the remainder of this seriesof articles will be on how to manage transac-tion exposure. Let’s look at the potentialimpact of transaction exposure on a firm’scash flows.

Example 5:Assume it is now October 1995. SophieclarePLC, a UK company, owes BenjaminpaulInc., a US supplier, $370,000 payable 3months later in January 1996. The spot rate inOctober 1995 is $1.5766 – $1.5775/£ andSophieclare PLC is concerned that the $ maystrengthen against the £ before payment ismade.

Required:Calculate the sterling cost of the transactionif Sophieclare PLC decides not to hedge thecurrency and the spot rate in January 1996turns out to be:

(a) $1.3800 – $1.3809/£

(b) $1.8500 – $1.8510/£

It is important to appreciate that, in October1995, Sophieclare PLC would not knowwhich way the exchange rate is going tomove.

Solution:Since Sophieclare has decided not to hedgethe currency exposure the company willpurchase the $ on the spot market in January1996. This will cost:

(a) $1.3800 – $1.3809/£ (the US$ hasstrengthened)

When choosing between the two spot rates,$1.3800/£ or $1.3809/£, you should alwaysuse the rate which is least beneficial to thecompany:

370,000/1.3800 = £268,116.

370,000/1.3809 = £267,941. The relevant £cost is therefore £268,116.

Note that if Sophieclare PLC were to buy the$ in October 1995 it would cost 370,000/1.5766 = £234,682.

Hence if the $ strengthens to $1.3800/£ thetransaction will cost Sophieclare PLC an

additional £33,434 (268,116 – 234,682). It isthe risk of this additional cost whichSophieclare PLC will want to avoid.

(b) $1.8500 – $1.8510/£ (the US$ has weak-ened)

370,000/1.8500 = £200,000.

Therefore if the $ weakens to $1.8500 –$1.8510/£ Sophieclare PLC would save£34,682 (234,682 – 200,000).

In this case it would, with the benefit ofhindsight, have been best not to hedge thecurrency risk. However if, in October 1995,the accountant took the view that the $ waslikely to strengthen and therefore did nothedge the transaction it would amount tospeculation; lots of explanation would benecessary if no hedge was arranged and the $moved to $1.3800!

Using the data in Sophieclare PLC above wewill analyse ways of hedging/insuring againstforeign exchange exposure.

One key difference between the methods isthe timing of the cash flows. When workingthrough the examples check to make sureyou understand when each of the cash flowswill affect Sophieclare PLC.

The forward marketsForward foreign exchange contracts aretraded on an over-the-counter market (OTC).

French (1991) refers to ‘over-the-counter’ as‘used to describe a purchase of securitiesfrom, or sale of securities to, a dealer other-wise than on a stock exchange.’

Forward contracts are normally obtained fromone of the major commercial banks and canbe for periods of up to 10 years. The marketin contracts for periods of more than one yearis fairly thin which can lead to wide ratefluctuations. There are active markets in allthe major currencies. For the currencies ofless developed countries (LDCs) marketseither do not exist or are very limited. For-ward foreign exchange contracts normallymature on standard month end dates butcontracts can be for exact dates; if the matu-rity date of the forward foreign exchangecontract is not a standard month end pricesare normally higher.

The forward foreign exchange contractThis is an agreement, entered into today, topurchase or sell a fixed quantity of a foreigncurrency on a fixed future date at a rate fixedtoday.

The important features of forward contractsare:

the exchange rate is agreed today but thecurrencies are exchanged in the future(this contrasts with use of a money mar-ket hedge, covered later in the article,

where the foreign currency is bought orsold today).

once entered into the forward foreignexchange contract must be completed.

forward contracts are tailor made i.e.they meet the exact requirements of theuser in terms of quantity of foreign cur-rency and date of delivery. It is beneficialfor a company to be able to hedge theexact amount it requires but fixing thedate on which exchange takes place couldcreate problems. It is possible to have achoice of dates by using an option for-ward contract which will be explainedlater in this article.

the forward exchange rate will reflect thedifferential in interest rates between thetwo countries.(This is as per interest rateparity.)

Interest rate parity theoryInterest rate parity is neatly defined byBuckley (1992) as the condition that theinterest differential should equal the forwarddifferential between two currencies. Thismay be expressed as:

Forward rate = Spot rate x (1 + rf)/(1 + rUK)where r

f is the foreign interest rate and r

UK is

the UK interest rate on an equivalent riskinvestment for the same period.

If interest rate parity did not hold it would bepossible to carry out covered interestarbitrage.

Covered interest arbitrageCovered interest arbitrage is defined byBuckley (1992) as the process of borrowinga currency, converting it to a second cur-rency where it is invested, and selling thissecond currency forward against the initialcurrency. Risk-less profits are derived fromdiscrepancies between interest rate differen-tials and the percentage discount or premiumbetween the currencies involved in the for-ward transaction.

Example 6:Assume the spot rate between the £ and theUS$ is $1.40/£ and that the 12 month risk-free interest rates (e.g. on government stocks)are: US 5%, UK 8%.

The 12 month forward rate, as predicted byIRP, will be:

Forward rate = Spot rate x (1 + rf)/(1 + r

UK)

Forward rate = 1.40 x (1 + .05)/(1 + .08) =$1.361/£

The higher UK interest rate will cause the £to weaken against the $ on the forward mar-ket (put another way: the $ will stand at aforward premium against the £). IRP sug-gests that any gain that can be achieved fromthe higher UK interest rates will be counteredby a corresponding depreciation in the value

TECHNICAL 4

of the £ on the forward market.

Let us see what would happen if interest rateparity did not hold and therefore the forwardrate only moves to, for example, $1.39/£.

The higher UK interest rates would make itpossible to make a profit by:

(a) raising a loan in $ at the low interest rate;

(b) selling the $ at the spot rate in order tobuy £;

(c) placing the £ on deposit to earn the highinterest rate;

(d) buy back the $ which will be needed in 12months in order to pay off the loan. This canbe done by using a forward contract whichwill fix the exchange rate for 12 month’s timethereby removing the exchange rate risk.

Required:Take an investor who borrows $2,000. Cal-culate the risk-free profit that could be madeby carrying out covered interest arbitrage.Follow stages (a) to (d) above.

Solution:(a) raise loan: $2,000;

(b) sell the $ at the spot rate and receive:2,000/1.40 = £1,429

(c) place the £1,429 on deposit to accrue to:1,429 x (1.08) = £1,543;

(d) buy back $ using a forward contract inorder to pay off the loan:

Buy $ for 1,543 x $1.39 = $2,145

Amount of $ loan plus interest:2,000 x 1.05 = $2,100

Risk-free profit $45

As a result of many people carrying out thistransaction the $ will weaken on the spotmarket (because of people selling $ andtherefore increasing the supply of the $) andstrengthen on the forward market (becauseof people buying back $) causing the $ tostand at a forward premium (over the spotrate) in terms of £, as predicted by IRP.

This is a simplified example of covered inter-est arbitrage. It ignores the spread on theforward exchange rates and the spread be-tween borrowing and lending rates whichwould, in practice, make it more difficult toprofit from arbitrage.

Let us now see how forward contracts can beused by Sophieclare PLC.

Example 7:Use the information in Example 5 forSophieclare PLC together with the followingforward quote obtained from the company’sbanker in October 1995:

3 months forward $1.568 – $1.583.

Required:Calculate the amount that Sophieclare will

have to pay if the currency risk is hedgedusing a forward contract.

Solution:Sophieclare PLC needs to buy $. Thereforethe appropriate rate is $1.568 which is theleast favourable rate to the company (i.e. thebank always wins!).

Cost in £ of buying $370,000 in 3 month’stime, in January 1996.

370,000/1.568 = £235,969.

With a forward contract Sophieclare PLCagrees to buy the $ for £235,969 in October1995 but does not take delivery of the $ orhave to pay for the $ until January 1996.When, later in the article, we compare use offorward contracts with the money markethedge, it is important to appreciate when thecash flow occurs.

Use of money markets for hedging cur-rency risk (a synthetic forward)With a money market hedge the idea is eitherto buy or sell the foreign currency at the spotrate today thereby fixing the exchange ratetoday and eliminating the exchange rate risk.

In the Sophieclare PLC example this wouldinvolve buying the $ (and therefore selling £)at the spot rate in October 1995. This fixesthe exchange rate. The company then has adollar asset which can be placed on depositand then the deposit, plus interest, can beused to pay the $ liability to the supplier inJanuary 1996.

Because the $ are purchased in October 1995it will be necessary to finance the full £ costof those $ from October 1995 until January1996. We therefore need to take into accountthe cost of borrowing £ for the three monthperiod so we can compare the cost of themoney market hedge with the cost under theforward contract which is payable in January1996.

Example 8:Use the information in Example 5 forSophieclare PLC together with the followinginterest rate quotes:

US$ 3 month rate: 515/16

– 513/16

% perannum. (The higher rate is the rate at whichthe company can borrow $ and the lower rateis the rate at which the company can lend/invest $, the difference being the bank’sprofit).

£ 3 month rate: 613/16

– 611/16

% per annum.Note that these rates are quoted as rates perannum. To find the actual rate charged orearned for the 3 month period you just takethe rate per annum and multiply by 3/

12.

Required:Explain how Sophieclare PLC could use themoney market in October 1995 to hedge thecurrency risk on the creditor of $370,000payable in January 1996.

Solution:Firstly, we need to identify the amount in $that Sophieclare PLC will need to place ondeposit in October to accrue to $370,000 byJanuary 1996.

We need the interest rates for the 3 monthperiod:

US$ 3 month lending rate (since the com-pany will be placing $s on deposit):

513/16

x 3/12

= 1.4531% i.e. 0.014531

Let x be the number of $ that SophieclarePLC needs to invest now. Therefore:

x (1 + 0.014531) = 370,000

Therefore x = 370,000/(1.014531)

= $364,700.

Sophieclare PLC will buy this quantity of $in October 1995 at the spot rate. (The com-pany is buying $ and will therefore obtain theleast favourable rate of $1.5766/£), therebyfixing the exchange rate, at a sterling cost of:

$364,700/$1.5766 = £231,321.

NoteWith a forward contract Sophieclare PLCagrees to buy the $ for £235,969 in October1995 but does not have to pay for them untilJanuary 1996. For comparison purposes wetherefore assume that Sophieclare PLC wouldneed to borrow £231,321 between October1995 and January 1996.

We therefore need the £ 3 month borrowingrate:

613/16

x 3/12

= 1.7031% i.e. 0.017031.

Therefore the £ liability in January 1996including interest on the loan would be:

231,321 x (1 + 0.017031)

= £235,261.

The money market hedge is therefore thecheaper alternative resulting in a more fa-vourable exchange rate (than the forwardrate) of 370,000/235,261 = $1.5727.

This is slightly worse than the spot rate inOctober 1995 and is a reflection of the differ-ence between UK and US interest rates. Thecompany has borrowed £ at 1.7031% andlent $ at 1.4531% resulting in a small addi-tional cost.

It is important to note that the example hasignored transaction costs which, in practice,will probably be lower when hedging usingthe forward market than if using a moneymarket hedge.

A significant feature of both the forwardcontract and the money market hedge is that,once the hedge has been arranged SophieclarePLC is locked into an exchange rate of $1.568/£ with a forward contract or an effective

TECHNICAL

exchange rate of $1.5727/£ with the moneymarket hedge. This is because the forwardcontract fixes the rate in October 1995 andwith the money market hedge the foreigncurrency is bought and the borrowing andlending agreed in October 1995.

If the spot rate in January 1996 had in factmoved to $1.8500/£ then the forward con-tract and the money market hedge would,with hindsight, result in a higher cost thancould have been obtained by using the spotmarket in January 1996, i.e. the company isprevented from benefiting from the favour-able spot rate.

Example 9:In recent years there have been cases whereGerman and Japanese airlines have made themistake of hedging using forward contracts.These airlines pay for their aircraft in US$and are therefore concerned that the US$may strengthen against the D-Mark or theYen between the time of placing an order forthe aircraft and paying for the aircraft.

Unfortunately for the airlines they purchasedUS$ using forward contracts. In the periodbetween taking out the forward contracts andpaying for the aircraft the US$ weakenedagainst the D-Mark and the Yen resulting inlosses or, put another way, the aircraft costmore than would have been incurred if theairlines had not entered into forward con-tracts.

Such losses may have been alleviated byusing currency options which are a moreflexible, albeit more costly, approach to hedg-ing. Currency options will be discussed in alater article.

Option forward contracts (also known asa forward option contract, option dateforward contract or forward option datedcontract)

This is not the same as a currency optioncontract explained in a later article.

An option forward contract offers the samearrangement as a forward contract exceptthat there is a choice of dates on which theuser can exercise the contract. This is either:

on any date up to a specified date; or

at any time between two future dates.

In either case the forward rate that ap-plies would be the forward rate, in theperiod in which the contract can be exer-cised, that is least favourable to the pur-chaser of the contract.

Example 10:Assume it is now May 1996. A UK companyis due to receive US$ from a US customer inAugust 1996. The UK company decides tosell the $ using a forward contract. If thecustomer is late paying the company wouldstill have the obligation to sell the $ to the

bank in August 1996. The company could beforced to buy $ on the spot market in August1996 in order to meet the obligation to thebank, leaving the problem of what to do withthe $ receivable from the customer when he/she eventually pays. This situation shouldnot be allowed to arise.

Now try the following example which re-quires you to use a forward contract and amoney market hedge.

Example 11:Assume it is now October 1995. WilliamPLC is a UK company which exports goodsto the USA. Rachel Inc., one of the customersof William PLC, is due to pay $2,140,000 in6 months’ time in April 1996. William PLCis concerned that the $ may weaken againstthe £ before the $ are received.

Exchange rates

Spot rate: $1.5766 – $1.5775/£.

Forward rates:6 month forward rate $1.5708 – $1.5739/£9 month forward rate $1.5665 – $1.5709/£

Interest rates:US$ 6 month rates: 57/

8 – 511/

16 % per annum

and£ 6 month rates: 613/

16 – 611/

16 % per annum.

Required:(a) Evaluate which is the best method forWilliam PLC to hedge the currency risk onthis transaction:

(i) a money market hedge; or

(ii) a forward contract.

(b) You are told that, in the past, Rachel Inc.has not always paid on the due date and hassometimes paid up to three months late.What £ amount would be received if WilliamPLC used an option forward contract to hedgethe risk?

Solution:(a) (i) Money market hedge.In this example William PLC will need toborrow $ in October 1995 and then use the $received from Rachel Inc. in April 1996 topay off the loan plus interest. The $ borrowedin October can be sold at the spot rate. Thenthe £ proceeds can be lent for 6 months.

Relevant interest rates (note it is a 6 monthperiod, not 3 months as in the previous exam-ple):

US$ 6 month borrowing rate: 57/8 x 6/

12 =

2.9375% i.e. 0.029375.

£ 6 month lending rate: 611/16

x 6/12

=3.3437% i.e. 0.033437.

It is first necessary to calculate the amount of$ to borrow now in order to have a balanceoutstanding (initial loan + interest) of$2,140,000.

Let $ x be the amount borrowed now so that:

$x(1 + 0.029375) = $2,140,000.

Therefore $x = $2,140,000/1.029375 =$2,078,931 = amount of loan taken out inOctober. In effect we are calculating thepresent value of the $2,140,000 using the rateof interest on the loan (for the appropriatetime period) as the discount rate.

The $2,078,931 proceeds from the loan cannow be converted to £ at the spot rate. Thisfixes the exchange rate in October and there-fore eliminates the exchange risk.

Amount of £ received: $2,078,931/1.5775 =£1,317,864.

(The $2,140,000,when received, will exactlypay off the loan, assuming the customer payson time!)

The £ proceeds can be used now for invest-ment. Value in April 1996:

£1,317,864 x (1 + 0.033437) = £1,361,929.This figure is comparable with the proceedsfrom a forward contract which will also bereceived in April 1996.

(a) (ii) Forward contract.William PLC will receive:

$2,140,000/1.5739 = £1,359,680.

Hence in this case William PLC will be betteroff using the money market to hedge the risk.

(b) Using an option forward contract to hedgethe risk William PLC will get the worst of the6 month and the 9 month forward rates.

6 month forward rate: 2,140,000/1.5739 =£1,359,680.

9 month forward rate: 2,140,000/1.5709 =£1,362,276.

The proceeds will therefore be £1,359,680.

In the next article we will consider futurescontracts and the ways in which they can beused to hedge currency risk.

ReferencesBrealey, R.A. and Myers, S.C. (1996) Prin-ciples of Corporate Finance, McGraw Hill,New York.

Brown, N., Kaur, P., Maugham, S. andRendall, J. (1994) Financial Strategy, Certi-fied Accountants Educational Projects, Lon-don.

Buckley, A. (1992) Multinational Finance,Prentice Hall, New York.

French, D. (1991) Dictionary of AccountingTerms, The Institute of Chartered Account-ants in England and Wales, London.

Demirag, I and Goddard, S. (1994) Finan-cial Management for International Business,McGraw Hill.

Shapiro, A. (1995) Multinational FinancialManagement, Allyn and Bacon, Boston.

TECHNICAL

his is the second in a series of fivearticles. The aim of the series is todevelop an understanding of the ef-

rency futures and stock index futures. Ourmain concern in this series of articles is withcurrency futures.

Futures contracts are traded on recognisedexchanges with prices generally agreed onan open outcry basis on the floor of theexchange (by people dressed in brightlycoloured jackets!).

Open outcry is described by Buckley (1992)as a kind of auction system used by futuresmarkets under which all bids and offers aremade openly by public, competitive outcryand hand signals.

Please note that futures contracts are NOTtraded on an over-the-counter (OTC) mar-ket and therefore are not tailor-made to thecustomers’ requirements. The specificationsof each contract — e.g. quantity of currencyand date for delivery of that currency — aredetermined by the futures exchange. A firmwishing to use these contracts to hedgecurrency risk therefore has to decide on:

the number of standard contracts; and

the delivery date (there are only a lim-ited number of delivery dates each year)which best suits their requirements; theymay well not get an exact match with thesum of foreign currency they need tohedge.

We will use the Sophieclare PLC examplefrom the first article, which is reproducedbelow, to illustrate these limitations.

Example 1Assume it is now October 1995. SophieclarePLC, a UK company, owes BenjaminpaulInc., a US supplier, $370,000 payable 3months later in January 1996. The spot ratein October 1995 is $1.5766 – $1.5775/£ andSophieclare PLC is concerned that the $may strengthen against the £ before pay-ment is made.

Since currency futures contracts are nottraded in London the relevant contracts forSophieclare to use are sterling (£) futureswhich are traded on the International Mon-etary Market (IMM) in Chicago. These con-tracts enable firms to:

buy £ (and therefore sell $); or

sell £ (and therefore buy $)

for future delivery.

Since the contracts are traded in the USA the

US$ is the home currency and therefore £ isthe foreign currency. The contract size is£62,500 (i.e. this is the quantity of ‘foreigncurrency’ you can buy or sell with eachcontract) and in October 1995 the followingcontracts were quoted in the FinancialTimes:

Contract Price

December (1995) $1.5744/£

March (1996) $1.5710/£

So how can Sophieclare PLC use currencyfutures contracts to hedge the risk? We willtackle this problem in stages in this articleand the following article as we introduce thevarious features of currency futures. It isfirst necessary to decide:

Which delivery date?Sophieclare PLC needs to buy US$ for de-livery in January 1996 but there are nocontracts with a January delivery date. TheDecember contract cannot be used since thedelivery date is before Sophieclare is due topay the US supplier Benjaminpaul Inc.(Sophieclare would then have to purchasethe currency before it was needed whichwould involve unnecessary additional fi-nancing costs). The company will thereforehave to use the March contract. The deliverydate for the March contract is too late but itis still possible, as will be explained later, touse the contract to hedge the currency risk.

How many contracts?This is awkward since the standard contractsize is expressed in £ whereas the companyhas to pay its supplier US$370,000. To giveus an approximation of the contract size inUS$s we can use the currency futures pricein March: £62,500 x 1.5710 = $98,187.Therefore the number of contracts neededis: $370,000/98,187 = 3.77 contracts. It isnot possible to buy or sell part of a contract.Hence Sophieclare PLC will need to choosethe nearest whole number of contracts. i.e. 4contracts.

The difficulty with delivery dates and con-tract sizes does not arise with a forwardcontract since the firm can specify its exactrequirement and the bank will then quotethe terms of a forward contract which willmeet those requirements. Before we canshow how currency futures can be used bySophieclare PLC we need to study someother features of futures contracts.

Foreign currency exposure management: part 2

Futures contractsNigel Brown BA FCA is a senior lecturer in Financial Strategy at theUniversity of Wales College, Newport

Tfect foreign currency risk may have on afirm and of some of the techniques that areavailable for eliminating or reducing thatrisk. In the first article we examined thetypes of currency risk to which a firm may beexposed. Then we looked at two methodswhich can be used to protect a firm againstthat risk: forward contracts and a moneymarket hedge. In this and the next article wecontinue our study of methods of hedgingrisk by considering futures contracts.

What is a futures contract?A futures contract is an agreement to sell orbuy a standard quantity of a particular fi-nancial instrument or commodity on a pre-determined delivery date in the future. Inthe case of currency futures contracts thefinancial instrument is a foreign currency.

Commodity futuresThere is a wide range of commodity futureswhich cover everything from pork belliesand live cattle to copper and gold. For exam-ple, gold futures contracts are traded on theNew York Commodity Exchange(COMEX). Each gold futures contract is for100 troy ounces (a troy ounce is part of thesystem of weights used for precious metalsand gems) and prices are quoted in US$ pertroy ounce. Prices are quoted daily in theFinancial Times. For example, on 7 Febru-ary 1996 prices were quoted for February1996, April 1996, June 1996, August 1996,October 1996 and December 1996 contracts;the month of the contract is the month inwhich the purchaser of the futures contractwould take delivery of the underlying 100ounces of gold. Commodity futures con-tracts may be used to protect a firm fromvolatile market prices.

For example farmers can use commodityfutures to fix, in advance, the price at whichthey can sell their produce. Chocolate manu-facturers can use cocoa futures contracts tofix, in advance, the price they pay for cocoa,which is one of the main raw materials inchocolate (suddenly I feel hungry!).

Financial futuresThere are three main types of financial fu-tures contract: interest rate futures, cur-

TECHNICAL 5

Clearing houseThe futures exchange uses a clearing housewhich has as its main objective the guaran-teeing of performance of the transactionscarried out on the floor of the futures ex-change. It also administers the system ofmargins which are explained in the nextsection.

Each transaction is reported to the clearinghouse by members of the exchange so thatboth sides of the transaction can be matchedand confirmed to the parties to the transac-tion. Once a transaction has been confirmedits performance is guaranteed by the clear-ing house. Each party to the transaction isthen obligated to the clearing house to carryout the transaction; this has the effect oftransferring the credit risk on the transac-tion to the clearing house. (credit risk is therisk that the buyer or seller of the contractmay default on his or her obligations).

MarginsThe market price of the futures contract,which in the case of currency futures is theexchange rate, will change throughout thetime between the date of someone buying orselling a futures contract and the deliverydate. There is a possibility that the price willmove against the person/company buyingor selling the contract resulting in a loss. Insome cases the person/company may not beable to pay the loss thereby defaulting on thecontract. This is a potential problem withfutures contracts because, if there were nomargins, contracts could initially be boughtor sold without having to pay any considera-tion. The idea of the margin is to minimisethe possibility of defaults occurring oncontracts and goes together with the factthat the clearing house takes on the creditrisk of the futures contracts.

Consequently a company wishing to buy orsell a futures contract must deposit a spe-cific amount of cash, referred to as an initialmargin or deposit margin, with the clearinghouse of the exchange.

The profit or loss on the position held by theperson/company is calculated at the end ofeach trading day and transferred to or fromthe margin account. This procedure is re-ferred to as marking to market the account.This adjustment to the margin account re-sults in variation margin being:

received from the clearing house whenprofits are accruing on the contract; or

paid to the clearing house when lossesare accruing on the contract.

The following example shows the relation-ship between movements in the futures priceand the margin cash flows.

Example 2Assume it is now October 1995. Clive is a

farmer who takes life very seriously. Oneparticular concern for him is the fact hewants to buy 300oz of gold but he does notwant to buy it just yet, he wants to wait untilafter Christmas. Clive is concerned that theprice of gold may go up before he is able tobuy it. His brother Paul, who has just at-tended a course at Newport Business School,about futures contracts, suggests that Clivecould use the gold futures contracts tradedon the New York Commodity Exchange(COMEX). These contracts have a contractsize of 100 troy ounces and are priced inUS$ per ounce. In October 1995 Paul ob-tains the following quotes:

Contract Price ($ per troy oz)

Nov. $385.4

Dec. $386.6

Jan. $388.4

Assume the initial margin on this contract is$2,000. On the morning of 25 OctoberClive decides to buy 3 January gold futurescontracts at the price quoted of $388.4. Ineffect he is agreeing to buy gold in advanceat a price of $388.4. In the first few daysfollowing purchase the January contractprice moves as follows:

Date Price of January futurescontract at close of business

25 October $390.3

26 October $386.2

27 October $380.5

On 28 October Clive changes his mind anddecides to sell (referred to as closing out)the futures contracts at $385.6.

Required:Calculate the initial margin payment and thevariation margin transactions that will arise.

Solution:Purchase of 3 contracts involves a total of 3x 100 = 300 ounces of gold and an initialmargin of $2,000 x 3 = $6,000.

Calculation of profit or loss25 OctoberPrice has increased therefore profit= ($390.3 – $388.4) x 300 = $570

26 OctoberPrice has decreased therefore loss= ($386.2 – $390.3 ) x 300 = –$1,230

27 OctoberPrice has decreased therefore loss= ($380.5 – $386.2 ) x 300 = –$1,710

28 OctoberPrice has increased therefore profit= ($385.6 – $380.5) x 300 = $1,530

The overall position is a loss of ($570 –$1,230 – $1,710 + $1,530) $840 which isequal to the net price movement over theperiod.

If we take the period as a whole Clive has, ineffect:

bought 300 ounces of gold for($388.40 x 300) = $116,520 and

sold it for ($385.60 x 300) = $115,680

Loss $840

Margin account

Date Cash Variation Closingpayments margin balanceto/from on marginClive account

25 Oct. Clive pays$6,000 $570 $6,570

26 Oct. Clive receives$570 – $1,230 $4,770

27 Oct. Clive pays$1,230 –$1,710 $4,290

28 Oct. Clive pays$1,710 $1,530 $7,530

29 Oct. Clive receives$7,530

Netpayment $840

This example shows that it is possible to buyand sell futures contracts without takingdelivery of the underlying instrument orcommodity (in this case the gold).

It may be desirable to do this if, as in the caseof Sophieclare PLC the delivery date of thefutures contract does not meet the compa-ny’s requirements. We will see how thisapproach can be applied to Sophieclare PLCin the next article.

Taking a position in a

futures contractA person or firm can buy a futures contractwhich is referred to as taking a long posi-tion. A long position is defined by Buckley(1992), in terms of currencies, as “havingmore assets than liabilities in a given cur-rency”. In Example 2 Clive took a longposition in gold futures contracts — havingbought 3 contracts — as a result of which hewould have been able to take delivery of 300ounces of gold at the price of $388.4.

Alternatively a person or firm can, as a firststep, sell a futures contract. This is referredto as taking a short positon.

A short sale is defined by Brealey andMyers (1996) as a “sale of a security that theinvestor does not own”.

If, in Example 2, Clive believed that goldwas going to fall in price and wished to tryto make a profit from that opinion he could,on 25 October, sell gold futures contractsinstead of buying them. In effect he wouldbe selling gold he did not own. He couldthen, if the price did fall, buy the goldfutures contracts back more cheaply andmake a profit.

TECHNICAL

Once a firm has initially either bought orsold a futures contract the firm then has an‘open’ contract on which profits or losseswill accrue until the contract is ‘closed out’.In Example 2 Clive has an open position in3 contracts between the time they are pur-chased on 25 October to the time they aresold on 28 October. During that period prof-its or losses accrued on those contracts.

How to close out a position

in a futures contractAssuming one has bought a futures contractthe contract can be closed out by either:

selling the same futures contract in themarket, before the delivery date, to realisethe profit or loss. In Example 2 this is thecourse of action that Clive took on 28 Octo-ber when he sold the contracts; or

taking delivery of the underlying com-modity or financial instrument at the pricefixed when the futures contract was origi-nally bought or sold. Clive could, if he hadnot sold the contracts on 28 October, havetaken delivery of 300 ounces of gold inJanuary at the price of $388.40 per ounce,the price that was fixed when the contractswere purchased in October.

In practice, taking delivery of the underly-ing commodity or financial instrument isless likely to occur than selling the samefutures contract in the market. This is be-cause, as was shown in the case ofSophieclare PLC in Example 1, the deliv-ery dates are unlikely to suit the firm’srequirements.

Currency futures contracts are described interms of the month in which delivery is totake place (usually March, June, Septemberor December).

The importance of the

market price of futures

contractsThe market prices of futures contracts alteras a direct result of a change in the price ofthe underlying commodity or financial in-strument on the spot market. So, for exam-ple, the market prices of currency futurescontracts alter as a direct result of a changein the currency exchange rate on the under-lying spot market. Because of the standardnature of the contracts, the delivery dates ofthe contracts are unlikely to be suitable.Hence futures contracts are mainly used totake advantage of their market price move-ments. Therefore, in the case of currencyfutures contracts, the actual foreign cur-rency would be bought or sold in the spotmarket.

T icksThe futures exchange specifies the mini-mum price movement permitted for each

type of contract. These minimum pricemovements are referred to as ticks (not to beconfused with tiny insects!). In the case ofsterling futures contracts, which have a con-tract size of £62,500, the tick size is 0.01cents (or $0.0001) per £1. Therefore, on thiscontract, each price movement of 1 tick hasa value of: 0.0001 x 62,500 = $6.25. Thisvalue can be used to calculate the profit orloss made on the futures contract. It mayseem strange to be multiplying £ by $ but thetick value is in $ because this particularcurrency futures contract is traded in theUSA on the IMM. The price of this contractis quoted daily in the Financial Times.

Rollover of futures

contractsIf the delivery dates of the available futurescontracts are prior to the date to which ahedge is needed a firm may roll the hedgeforward. This is achieved by closing out onefutures contract and simultaneously takingthe same position in another futures contractwith a later delivery date. There is a risk thatthe price at which the futures contract isclosed out is not the same as the price of thenew futures contract.

GearingFutures contracts enable users to take aposition in a quantity of commodity or fi-nancial instrument without having to incurthe full cost at the outset. The bulk of thecontract is paid at the time of delivery, if thecontract is not closed out beforehand. Whena firm takes a position in a contract the onlycost is the initial margin which is usuallybetween 1% and 5% of the value of theunderlying instrument. This makes it possi-ble to gear up the returns on the transaction:enlarging gains (in relation to the size of theinitial investment) if the market moves inthe user’s favour and similarly enlarginglosses if the market moves against the user.

Example 3In Example 2, in return for a margin pay-ment of 3 x $2,000 = $6,000 Clive was ableto obtain a beneficial position in gold with atotal future value of $388.4 x 3 x 100 =$116,520. Let’s compare the % profit or lossthat could be made by:

(i) buying futures contracts; and

(ii) buying the underlying gold.

Assume Clive is able to buy gold on the spotmarket on 25 October at a price of $388.4.

Date Profit % profit % profit oror (loss) or (loss) (loss) on

on futures goldcontracts

25 Oct. $570 570/6,000 570/116,520= 9.5% = 0.5%

26 Oct. ($1,230) 1,230/6,000 1,230/116,520= (20.5%) = (1%)

The futures contracts can therefore be usedto enhance or ‘gear’ the size of profits butunfortunately this will also ‘gear’ the size ofpotential losses. It is important to note thatthis gearing only applies if the futures con-tracts are held with no corresponding posi-tion in the underlying asset.

If, as with Example 1 Sophieclare PLC, acompany has a $ liability and therefore buysthose $ forward using futures contracts theprofit or loss on the futures contracts will beapproximately equal to the profit or loss onthe $ liability to the supplier.

A far more risky strategy would be for a UKfirm, with no $ due from suppliers, to take aview that the $ was going to strengthen andtherefore use currency futures to buy $s.Here is an example of how such a strategycan go horribly wrong.

Showa Shell SekiyuThe treasury department of a Japanese com-pany 50% owned by Shell became involvedin speculating: they formed the opinion thatthe US$ was going to strengthen against theYen. As a consequence of this belief theybought a number of US$/Yen currency fu-tures contracts with a total value of $6.4billion. Unfortunately (to say the least!) forthem the US$ weakened against the Yenresulting in a loss on the futures contracts.Perhaps the most alarming part of this caseis what happened next: the treasury depart-ment rolled over the currency futures con-tracts apparently in the belief that the US$would still strengthen against the Yen. Need-less to say this did not happen. Rolling overthe currency futures contracts had the effectof preventing the losses from coming tolight (though one has to ask where were theinternal auditors?) and over a period of threeyears losses accumulated to $1 billion andcould reach $11.35 billion!

Hedging efficiencyA perfect hedge is a hedge which exactlycovers the risk. A forward contract providesa perfect hedge. A perfect hedge wouldresult in any loss on the spot market beingavoided by making a profit on the futurescontract equal to that loss (we’ll see howlater). When using futures contracts it isdifficult to achieve a perfect hedge (or hedg-ing efficiency of 100%).

One reason for this is the standard size of thefutures contracts which may not exactly fitthe requirements of the firm.

The other reason for this is referred to asbasis risk.

Basis and basis riskBasis is explained well by Buckley (1992):“with respect to futures contracts, the basisrepresents the difference between the priceof the cash commodity and the related fu-

TECHNICAL 5

tures contract, a difference that widens ornarrows as the cash and futures prices fluc-tuate.”

If you think back to the previous article youshould recall that the difference between thespot exchange rate and the forward exchangerate is, as per interest rate parity, caused bya difference in interest rates of the twocurrencies. This difference in interest rates,if any, will cause a similar difference, thebasis, between the spot exchange rate andthe currency futures price.

Basis risk is the risk that the price of thefutures contract may not move exactly inline with the price of the commodity orfinancial instrument being hedged.

We can see from the figures in Example 4that the spot prices and futures prices do notmove together and therefore the size of thebasis alters daily. The basis is caused byseveral factors, such as differences in sup-ply and demand in each of the two markets.The existence of basis results in basis risk.A full analysis of basis and basis risk isbeyond the scope of this article and of thepaper 14 syllabus.

There is also basis risk in the case of cur-rency futures contracts. The exchange ratespecified by the price of the currency fu-tures contract will not necessarily move inline with the exchange rate in the spot mar-ket.

Comparison of currency

futures contracts with

forward contractsThe following are the ways in which cur-rency futures differ from forward contracts:

Size and delivery dates of contractsavailable. Forward contracts are tailor madeto the customers’ specific requirements interms of size and date. Currency futures areonly available in standard contract sizes fordelivery on a limited number of dates whichmay make it impossible for a firm to obtainthe exact cover it requires.

Hedging efficiency. A forward contractfixes the exchange rate for the firm andtherefore provides a perfect hedge. A cur-rency futures contract is likely to lock in theexchange rate at a different level to theforward market hedge and may not providea perfect hedge. The position taken in thecurrency futures contract should result in aprofit if the spot rate moves against the firm.However the loss a firm incurs on the spotmarket may be more than the profit made bythe firm on the futures contract because ofbasis risk.

Margin requirements. Forward con-tracts do not have a margin requirement andtherefore no payment has to be made untilthe contract is settled. Currency futures in-volve the firm in having to deposit an initial

margin and therefore incur the financingcost thereof (though margins may be inter-est bearing).

Commissions. The commission on aforward contract may either be subject toagreement between the parties to the con-tract or implied in the dealers’ spread (be-tween bid and offer rates). In the case ofcurrency futures there is always a commis-sion, payable either when the position isclosed out or when delivery takes place,which is a flat rate for small transactions ormay be negotiable for larger deals. Com-missions are usually ignored in examinationquestions.

Uncertain dates. If a firm is unsure ofexactly when it will need to buy or sell theforeign currency it can, in the case of for-ward contracts use a forward option datedcontract. This will result in the firm gettingthe least favourable exchange rate over theoption period. In the case of currency fu-tures contracts the firm has more flexibilitysince it can alter the day on which it closesout its position in the futures contract (aslong as this is prior to the delivery date of thefuture contracts).

Uncertain cashflows. If a firm is unsurewhether it will actually need to buy/sellforeign currency as in the case of tenderingfor a contract then it should not use a for-ward contract: once entered into the forwardcontract must be fulfilled.

Similarly use of currency futures is notrecommended in these circumstances: tak-ing a position in a currency futures contractcommits the company to incurring a profitor loss on that contract until it is closed out.Hence, if a position is taken in a currencyfutures contract and the associated foreigncurrency transaction fails to materialise thecompany is left with the profit or loss on thefutures contracts. When cash flows are un-certain a firm should use currency optionswhich we will examine in a later article.

Potential for profits. If the exchangerate moves in favour of the firm then, if it hasused a forward contract to hedge against anadverse exchange rate movement, it will notbe able to take advantage of the favourablespot rate; the forward contract must be hon-oured. The position is similar for currencyfutures: a favourable movement in the ex-

change rate means that the firm will make aprofit when using the spot market but willincur a loss when it closes out its position inthe currency futures contracts.

Trading methods. Forward contractsmay be obtained via telephone or telexwhereas futures contracts are traded by openoutcry in a trading pit on the floor of afutures exchange.

Access to the markets. It is difficult forindividuals and small companies to accessthe forward market whereas individuals andcompanies may use the futures markets.

Delivery of currencies. Forward con-tracts are normally entered into with a viewto taking delivery of the currencies whereascurrency futures are normally closed outbefore the delivery date.

Price quotation. With forward contractsa bid and offer price is quoted and the size ofthe spread depends on the value of thecontract and on the size of the customer.With currency futures a single price isquoted.

Overall, forward contracts are easier to un-derstand and report and tend to be morepopular than currency futures.

Before employing either method in practicethe corporate treasurer would need to checkthe local tax treatment of these instruments.

In the next article we will look at howcurrency futures contracts can be used tohedge currency risk.

ReferencesBrealey, R.A. and Myers, S.C. (1996) Prin-ciples of Corporate Finance, McGraw Hill,New York.Brown, N., Kaur, P., Maugham, S. andRendall, J. (1994) Financial Strategy, Cer-tified Accountants Educational Projects,London.Buckley, A. (1992) Multinational Finance,Prentice Hall, New York.French, D. (1991) Dictionary of AccountingTerms, The Institute of Chartered Account-ants in England and Wales, London.Demirag, I and Goddard, S. (1994) Finan-cial Management for International Busi-ness, McGraw Hill.Shapiro, A. (1995) Multinational FinancialManagement, Allyn and Bacon, Boston.

Example 4The following data has been extracted from the Financial Times, February 1996:

Date Price of Price Spot Price Basis =April movement market movement spot price – futuresfutures price pricecontract

Feb. 5 $417.7 $415.4 $415.4 – $417.7 = –$2.3

Feb. 6 $415.9 –1.8 $414.5 –0.9 $414.5 – $415.9 = –$1.4

Feb. 7 $414.6 –1.3 $411 –3.5 $411 – $414.6 = –$3.6

Total price movement –$3.1 –$4.4

TECHNICAL

his is the third in a series of five articles. The aim of the seriesis to develop an understanding of the effect foreign currencyrisk may have on a firm and of some of the techniques that are

of the standard futures contract;

or

2 Close out its position in the futures contracts by selling the futurescontracts, just before delivery, at 0.5842 $/DM resulting in a profit.The company would then need to buy the DMs in the spot market.

The amount of profit on the futures contracts is calculated as follows:

(number of contracts) x (number of ticks by which x (the tick value) the price has changed)

Required:(a) Calculate the $ cost of taking delivery under the futures contract.

(b) Calculate the amount of profit earned from closing out the futurescontracts together with the cost of buying the DM in the spot marketand therefore the net $ cost of the transaction.

Solution(a) $ cost of taking delivery of the DM under the futures contract:

125,000 x 3 x 0.5729 = 375,000 x 0.5729 = $214,837

(b) Profit from futures contract:

There is a profit since Clinton has effectively boughtDM in January for $0.5729/DM and then sold DMin March for $0.5842/DM.

The price movement as a number of ticks:(0.5842 – 0.5729)/0.0001 = 113 ticks

The profit is therefore:3 contracts x 113 ticks x 12.50 = ($4,237)

In practice Clinton would receive this profit in theform of variation margin, as it arises during the3 month period. (As happened with Clive inExample 2 in the previous article.)

Purchase of the DM on the spot market at a cost of:375,000 x 0.5839 = $218,962

Net cost $214,725

which is similar to the cost in (a).The difference is caused by basisrisk (the risk that the price of the futures contract may not moveexactly in line with the exchange rate on the spot market) whichaffects the cost of (b).

Examples of currency futures contractsIn addition to the DM contracts mentioned in Example 1, thefollowing currency futures contracts are traded on the InternationalMonetary Market (IMM) in Chicago:

Foreign currency exposure management: part 3

Currency futures

contractsNigel Brown BA FCA is a senior lecturer in FinancialStrategy at the University of Wales College, Newport

Tavailable for eliminating or reducing that risk. In the second article weintroduced futures contracts. In this article we will continue our studyof futures contracts by considering currency futures contracts in moredetail.

What is a currency futures contract?A currency futures contract is a contract to purchase or sell a standardquantity of a foreign currency for delivery, at a specified location, onone of a limited number of future dates.

Most currency futures contracts are expressed in terms of the US$against other major currencies. Hence the ‘home’ currency is theUS$.

Pricing of a currency futures contractCurrency futures contracts are priced in terms of the underlyingexchange rate.

Example 1Assume that in January 1996 a March 1996 $/DM futures contract isquoted at $0.5729 (this is the direct quote which is the number ofdomestic currency units, the $, needed to buy one unit of foreigncurrency, the Deutsche Mark [DM]).

This means that the futures market will buy or sell DM for US$ forfuture delivery, in March, at an exchange rate of US$0.5729/DM.

If a US company Clinton Inc. wished to hedge the risk of the DMstrengthening against the US$ it would buy an appropriate numberof $/DM currency futures contracts — referred to as a long hedge,i.e. this means the firm has agreed to buy DM on the future deliverydate at the exchange rate specified by the futures price.

The $/DM contracts, which are traded on the International MonetaryMarket (IMM) in Chicago, are for DM125,000 with a tick size(minimum price movement) of .01c, which is .01/100 = $.0001 andtherefore a tick value of 125,000 x .0001 = $12.50. This value can beused to calculate the profit or loss made on the futures contract.

Clinton Inc. is due to pay DM375,000 to a German supplier in March1996 which just happens to be the date on which the March currencyfutures contracts mature.

In January 1996 Clinton Inc. buys 3 March futures contracts at a priceof $0.5729/DM. The spot rate in January 1996 is $0.5726/DM.

In March 1996, immediately prior to delivery, the futures contractprice has changed to $0.5842/DM and the spot rate to $0.5839/DM.

In this case the firm has two choices:

1 Take delivery of the DM at the futures rate of $0.5729/DM.NB. This choice is only available because the quantity of DM and thedate the currency is required both happen to match the specification

TECHNICAL 2

Contract Contract size Tick size Tick value

$/SFr SFr 125,000 .01c per SFr 125,000 x .01 = $12.50100

(SFr = Swiss Franc)

$/Yen Yen 12.5m .0001c per Yen 12,500,000 x .0001 = $12.50100

$/£ £62,500 .01c per £ 62,500 x .01 = $6.25100

As the above selection suggests most currency futures contracts areexpressed in terms of the US$ against other major currencies. Tradingof currency futures contracts on LIFFE (The London InternationalFinancial Futures and Options Exchange) has been discontinued dueto lack of demand; currency futures contracts are now handled on theUS markets.

Now try the following example.

Example 2Festina Inc. is a US company which buys components from Germany.Assume it is now January 1st. The company is due to pay DM5.1million in 4 months’ time, in April, and the finance director is worriedthat the DM may strengthen against the US$.

On January 1st the spot rate is $0.6901–$0.6905/DM and the price ofthe June currency futures contracts is $0.6958/DM and the forwardrate for April, quoted by the bank, is $0.6904–$0.6936/DM.

Required:Evaluate whether, with the benefit of hindsight, the company wouldhave been better to use currency futures contracts or a forwardcontract to hedge the currency risk if the currency futures price inApril was $0.6894/DM and the spot rate in April was $0.6895–$0.6898/DM.

Ignore margin requirements.

Solution:

Currency futures contracts:

Number of contracts: 5,100,000/125,000 = 40.8

Since the firm can only obtain a whole number of contracts it will needto use 41 (nearest whole number to 40.8) contracts which will resultin a position in 41 x 125,000 = DM5,125,000. This mismatch isunavoidable if using futures contracts and is likely to result in lessthan a perfect hedge. (A perfect hedge is a hedge which exactly coversthe risk).

Action required:January: Buy 41 contracts (i.e. need to buy DM, the foreigncurrency) at a price of $0.6958/DM.

April: Close out the futures contracts by selling 41 contracts (sellingthe DM) at $0.6894/DM, receiving less $ than the cost in Januarywhich would result in a loss.

No. of ticks: (0.6894 – 0.6958)/.0001 = –64 ticks

There is therefore a loss on the futures contracts of:

41 contracts x 64 ticks x $12.50 = $32,800

Buy the DM on the spot market in April at a cost of:5,100,000 x $0.6898 = $3,517,980

Total cost $3,550,780*

* before allowing for margin.

In practice Festina would have had to deposit a margin with theclearing house in January. The loss on the futures contracts will thenhave been paid as it arose during the period from January to April asa variation margin.

Forward contract

US$ cost:5,100,000 x 0.6936 = $3,537,360

Therefore the forward contract is, with hindsight, the better choice.

To hedge or not to hedge?In Example 2 both methods have resulted in the company achievinga less favourable rate than could have been achieved if no hedge hadbeen used. The hedge was to insure against the DM strengthening.Unfortunately it weakened!

Having taken a position in futures contracts in January, the companyis committed to that position and, in April, cannot avoid the loss onthose contracts. Similarly if the company had bought DM forward inJanuary it would have to honour the forward contract in April eventhough the rate has moved against the firm.

The important point is that, in January, the company does not knowwhat the exchange rate will be in April.

If the firm wishes to hedge the risk in January it must take action inJanuary. If the company chooses to use forward contracts, a moneymarket hedge or futures contract there is a possibility that theexchange rate will move in the company’s favour and that thecompany would therefore, with hindsight, be better off without thehedge. But that’s like saying that if we insure our homes against a firetaking place over the next year and it turns out that there is no fire thenwe would have been better off without fire insurance. The key pointis that in the case of fire insurance the risk I would have to take (oflosing my house) in order to save the fire insurance premium is, to meand the provider of my mortgage, too high to take.

For a company deciding how and whether to hedge currency risk onekey element of the decision is how large is the risk? If the transactionis of small value it may be acceptable not to hedge the risk. In the caseof transactions of a material size it is advisable for firms to hedge thecurrency risk.

Currency options offer the ability to hedge the risk (protecting thefirm against adverse movements in the exchange rate) while allowingthe firm to benefit from favourable movements in the exchange rate.We will discuss currency options in the next two articles.

Futures contracts in paper 14

examination questionsBefore we look at a more comprehensive example on currency futuresit may be helpful to summarise the main steps that are necessary inorder to derive an answer:

Stage 1: Identify contract specification and calculate tick value.The details of the relevant contract should be stated in thequestion.

Stage 2: How many contracts are needed?Remember to select the nearest whole number of contracts.

Stage 3: Calculate the initial margin.You may be able to ignore margin payments. If necessarycalculate the initial margin (number of contracts x marginper contract) which will be in $. The company will thereforeneed to buy $ at the spot rate.

Stage 4: Close out the contracts.At the end of the period for which the hedge is needed thecompany will need to:

(a) Buy/sell the appropriate currency on the spot market:

(b) Close out the futures contracts.Alternatively, though extremely unlikely, the firm may

TECHNICAL

simply take delivery of the currency under the futurescontracts at the initial futures price.

Stage 5: Calculate the gain or loss on the margin.This will arise since, when the hedge is arranged, the firmhas to buy $ at the spot rate in order to deposit the marginwith the clearing house. At the end of the period the marginwill be converted back into £ at the spot rate resulting in aprofit or loss.

Example 3Let us now return to the example we have used in each of the first twoarticles concerning Sophieclare PLC.

Just to remind you, we calculated the following £ costs in thosearticles:

Money market hedge: £235,261Forward contract: £235,969

We now need to see how Sophieclare could use currency futurescontracts. The data from the original example is repeated for conven-ience.

Assume it is now October 1995. Sophieclare PLC, a UK company,owes Benjaminpaul Inc., a US supplier, $370,000 payable 3 monthslater in January 1996. The spot rate is $1.5766–$1.5775/£ andSophieclare PLC is concerned that the $ may strengthen against the£ before payment is made.

The finance director has obtained the following quotes from theInternational Monetary Market in Chicago:

Sterling futures £62,500 (tick size 0.01c)

Contract PriceDecember $1.5744/£March $1.5710/£

Initial margin $2,500 per contract.

Required:Calculate whether, with the benefit of hindsight, the sterling cost ofhedging the currency risk using currency futures contracts is better(i.e. lower) than the cost of using a money market hedge of £235,261.Assume for the purposes of your evaluation that in January 1996:

(a) the spot rate was $1.3800–$1.3809 and the March currencyfutures were priced at $1.3823/£;

(b) the spot rate was 1.8500–1.8510 $/£ and the March currencyfutures were priced at $1.8524/£.

Ignore taxation and any interest that Sophieclare PLC could earn onthe margin.

SolutionWe noted in the second article that, of the two futures contracts listedin the example, Sophieclare can only use the March contract since theDecember contract will have expired by January. Also it is notpossible to use the March contract to actually buy the currency sincethe currency is not delivered under the contract until March.

The company will therefore have to close out the contracts in Januaryto realise the profit or loss.

Stages 1 to 3 will be common to both parts of the answer. We havedealt with certain aspects of this answer in the second article but, forthe sake of clarity, the answer is shown here in full.

Stage 1: Identify contract specification and calculate tick value.Contract size £62,500, tick size .01c/£ and therefore tick value:

62,500 x .01/100 = $6.25.

Stage 2: How many contracts are needed?At the March futures price of $1.5710 /£ the $370,000 is equivalentto 370,000/1.5710 = £235,519.

To hedge the exposure it is necessary to sell sterling futures contracts(since the company wants to sell £, which is the ‘foreign currency’,in order to buy $, the ‘home currency’, to pay the supplier). It willneed:

£235,519/62,500 = 3.8 contracts ( i.e. 4 contracts, to the nearest wholenumber). Hence, the company will need to sell 4 contracts at a priceof 1.5710 $/£.

Stage 3: Calculate the initial margin.This has to be paid to the clearing house in October 1995.

Sophieclare PLC will need to deposit an initial margin of 4 x 2,500= $10,000 which, at the spot rate in October 1995, will cost:

$10,000/1.5766 = £6,343.

(a) Spot rate in January 1996: $1.3800 – $1.3809/£, March futurescontract price $1.3823/£.

Stage 4: Close out the contracts.In January 1996 the company will need to carry out two transactions:

(i) Buy $ on the spot market:Cost: $370,000/1.3800 = £268,116

(ii) Close out the futures contractsby buying 4 contracts at the price of 1.3823$/£.

The price has changed by:(1.5710 – 1.3823)/.0001 = 1,887 ticks.

Therefore the total futures gain is:4 contracts x 1,887 ticks x $6.25 = $47,175.

The company will sell the $ profit, at the spot ratein January, to realise: 47,175/1.3809 = (£34,162)

(In practice this will have been received asvariation margin from the clearing houseduring the period from October to January)

Because the $ has strengthened there is a margin gain:

When the initial margin is returned it is worth:$10,000/1.3809 = £7,242

less initial cost (£6,343)

Margin gain (£899)

Net cost £233,055

Hence the futures contract is cheaper than the money market hedge.This is partly because with the futures hedge a larger position is beingtaken in the $, which strengthened, since we used 4 contracts whereasonly 3.8 contracts were needed.

TECHNICAL 3

The exports to Eastern Europe will be paid for by a barter exchangeof 100,000 tins of meat. BID has arranged for this tinned meat to beexchanged for 70 tons of coffee by its customer in West Africa wheretinned meat is in demand. The West African country’s currency is tiedto the French franc.

Exchange rates

A$/£ Lire/£ Franc/£Spot 2.1400–2.1425 2,208–2,210 10.38–10.39

3 months forward 2–2.5 cents dis 3–6 lire dis 5–3 centimes pm

6 months forward 3.5–4.5 cents dis 5–8 lire dis 7–5 centimes pm

Commodities Futures rate (£/tonne)Coffee beansMarch 791June 860

Interest ratesBorrowing Lending

UK bank 15% 10.5%Australian bank 16% 13%Italian bank Not available 16%French bank 9% 6%

Assume that interest rates will not change during the next six months.

BID proposes to invest net sterling proceeds from foreign trade in aUK bank. The company wishes to hedge against all foreign exchangerisk, and currently has no surplus cash.

Taxation, transaction costs and margin requirements on futurescontracts may be ignored.

Required:Using the forward market, money market or commodity futuresmarket, as appropriate, estimate the maximum size of cashsurplus or the minimum size of cash deficit that will result fromBID’s foreign trade at the end of six months.

(15 marks)

(1) Calculation of forward rates: BID UK Ltd

A$/£ Lire/£ Franc/£Spot 2.1400–2.1425 2208 – 2210 10.38 –10.39Add discount .02 – .025 3 – 6Less premium .05 – .03

3 months forward 2.16 –2.1675 2211 – 2216 10.33 –10.36

Spot 2.14 –2.1425 2208 – 2210 10.38–10.39Add discount .035 – .045 5 – 8Less discount .07 – .05

6 months forward 2.175 –2.1875 2213 – 2218 10.31 –10.34

(2) Calculation of size of cash surplus or deficit at the end of sixmonths.

Australian $

31 March Either use forward contract hedge:

Sell: A$120,000 3 months forward

Receive: 120,000/2.1675 = £55,363 in 3 months

or money market hedge: let amount borrowed be x.

x(1 + (.16/4)) = 120,000

x = 120,000/(1 + (.16/4)) = A$115,385

Therefore, SELL at the spot rate: 115,385/2.1425 = £53,855. ThenINVEST for 3 months to get 53,855 (1 + (.105/4)) = £55,269.The forward contract should be used since it yields higher £ proceeds.

(b) The spot rate was 1.8500 – 1.8510 $/£ and the Marchcurrencies futures were priced at $1.8524/£.

Stage 4: Close out the contracts.In January 1996 the company will need to carry out two transactions:

(i) Buy $ on the spot market:Cost: $370,000/1.8500 = £200,000

(ii) Close out the futures contractsby buying 4 contracts at the price of 1.8524$/£.

The price has changed by:

(1.5710 – 1.8524)/.0001 = –2,814 ticks.

This is a loss since, in effect, the company has sold£ for $1.5710 and then bought £ back for a highernumber of $.

Therefore the total futures loss is:4 contracts x 2,814 ticks x $6.25 = $70,350.

The company will have to buy $ to pay over the loss:(In practice this will have been paid as variationmargin to the clearing house during the periodfrom October to January.)

$70,350/1.8500 = 38,027

Because the $ has weakened there is a margin loss:

When the initial margin is returned it is worth:

$10,000/1.8510 = £5,402

less initial cost (£6,343)

Margin loss 941

Net cost £238,968

Hence if the $ weakens the futures contract is more expensive than themoney market hedge. Again this is partly due to the futures contractshedge involving a larger position in $ which have lost value againstthe £.

The futures contract has a similar effect to the forward contract in thatit removes most of the risk: it removes the risk of a loss (downsiderisk) but it also removes the risk of a profit (upside risk).

It is worth mentioning that the exchange rate movements in thisexample are large and, in practice, may not arise over such a shortperiod; but then again they might!

Now that we have seen how to apply a number of hedging techniquesit will be beneficial for you to tackle the following past examinationquestion taken from the December 1990 examination.

Example 4BID (UK) Ltd trades with several countries. During the next sixmonths export and import receipts and payments are due as a resultof business with companies in Australia, North Africa, EasternEurope and Italy. The transactions are in the currencies specified. Itis now 31 December.

Payment date Exports ImportsAustralia 31 March A$120,000 £40,000

Italy 31 March Lire 400m Lire 220m

North Africa 31 March Francs 565,000 —

Italy Between 31 Marchand 30 June Lire 500m —

Eastern Europe 30 June Tinned meat —

Australia 30 June A$180,000 A$260,000

West Africa 30 June Coffee Tinned meat

Italy 30 June — Lire 700m

TECHNICAL

30 June Payment (260 – 180) 80,000Either use a forward contract to buy A$

Cost: 80,000/2.175 = (£36,782)

or use the money market

let amount of A$ invested be x

x(1 + (.13/2)) = 80,000

Therefore x = 80,000/(1 + (.13/2)) = A$75,117

Hence the company will need to buy A$ 75,117 now at the spot rate:Cost in £ in December: 75,117/2.14 = £35,101.

To compare with the cost under the forward contract which would beincurred on 30 June, it is necessary to take into account the cost ofborrowing £35,101 for 6 months:

Total cost: 35,101 x (1 + (.15/2)) = £37,734

The company should therefore use the forward contract since it ischeaper.

Italian lira31 March Net receipt: (400 – 220) 180m lireNOTE: Since the company cannot borrow lira it cannot hedge thistransaction using the money market.Therefore: sell forward and receive (180 x 106)/2216 = £81,227Lire receivable between 31 March and 30 June.Since it does not know the exact date of receipt the company could sellthe 500m lire using an option dated forward contract. If it were to dothis it would receive the least favourable rate which is the 6 month rateof 2,218. It would then have to purchase forward 700m lire for 30June. This would be expensive in terms of the spread between thebuying and selling rates. It is better to set off (referred to as ‘netting’)the 500m lire receipt against the 700m lire payment and hedge the netamount of 200m lire.

Either buy forward: (200 x 106)/2213 = £90,375If the customer pays before 30 June the 500m lire can be lent in Italyand the accrued interest returned to England on 30 June.

or money market. Let amount lent be x

x(1 + (.16/2)) = 200m

x = 200/(1 + (.16/2)) = 185.18m

The lire would then be bought at the spot rate:Cost = (185.18 x 106)/2,208 = £83,868

This will accrue by 30 June to:

83,868 (1 + (.15/2)) = £90,158

Hence the money market is better.

North AfricaEither sell 565,000 francs 3 months forwardReceive: 565,000/10.36 = £54,537

or use the money market:Amount borrowed x:x(1 + (.09)/4) = 565,000Therefore x = 565,000/(1 + (.09/4)) = 552,567

Sell: 552,567/10.39 = £53,183Invest for 3 months: 53,183 x (1 + (.105/4)) = £54,579

Hence the money market is better.

West AfricaThe tinned meat is not relevant from the viewpoint of hedging risksince the amount received from Eastern Europe is to be sent to theWest African customer. This leaves price risk on the receipt of coffeefrom the West African customer. There is a risk that coffee pricescould fall before the coffee is received and sold. This risk can behedged by selling the coffee in advance on the futures market.Proceeds from this sale, in 6 months time, when the coffee is deliveredwill be:

70 x 860 = £60,200.

Net cash surplus/deficit on 30 June:£

Receipts/(payments):

31 March Australia: forward contract 55,363

Sterling outlay (40,000)

Italy forward contract 81,227

North Africa: money market 54,579

151,169

This can be lent for 3 months:

Proceeds: 151,169 x (1 + (.105/4)) = 155,137

30 June Australia: forward contract (36,782)

Italy: money market (90,158)

West Africa coffee futures market 60,200

Net surplus on 30 June 88,397

In the next two articles we will deal with options and see how they canbe used to hedge currency risk.

ReferencesBrealey, R.A. and Myers, S.C. (1996) Principles of CorporateFinance, McGraw Hill, New York.

Brown, N., Kaur, P., Maugham, S. and Rendall, J. (1994) FinancialStrategy, Certified Accountants Educational Projects, London.

Buckley, A. (1992) Multinational Finance, Prentice Hall, New York.

French, D. (1991) Dictionary of Accounting Terms, The Institute ofChartered Accountants in England and Wales, London.

Demirag, I and Goddard, S. (1994) Financial Management forInternational Business, McGraw Hill.

Shapiro, A. (1995) Multinational Financial Management, Allyn andBacon, Boston.

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Foreign currency exposure management: part 4a

Option contracts

Example 1The following table includes some of theLIFFE equity options quoted in the Finan-cial Times on 31 October 1995:

Table 1 — LIFFE Equity optionsCalls Puts

Option Jan Apr Jul Jan Apr Jul

ASDA 100 71/2 10 13 31/2 51/2 61/2

(*103) 110 3 6 9 9 11 12

Allied Domecq 500 20 301/2 35 171/2 22 31

(*509) 550 31/2 111/2 15 54 56 651/2

Argyll 300 281/2 351/2 40 5 9 131/2

(*323) 330 11 19 24 18 22 29

BAA 460 38 50 56 5 81/2 131/2

(*4911/2) 500 14 26 321/2 21 241/2 30

Bass 650 26 39 451/2 211/2 30 341/2

(*660) 700 6 18 241/2 56 611/2 65

Boots 550 221/2 351/2 421/2 16 211/2 28

(*5551/2) 600 5 141/2 21 51 531/2 58

Brit Airways 420 45 55 62 4 71/2 121/2

(*4581/2) 460 19 30 37 171/2 22 28

BP 460 161/2 241/2 301/2 13 191/2 231/2

(*4621/2) 500 31/2 91/2 15 42 45 48

British Steel 150 81/2 13 16 6 8 111/2

(*1631/2) 180 11/2 51/2 71/2 20 21 24

Each option contract is an option on 1,000ordinary shares in the respective company.The first equity option listed is for ASDAPLC. All the figures shown are in pence.

The figure shown in brackets below thecompany’s name, 103p for ASDA, is themarket price of the underlying share.

The figures in the first column, 100p and110p for ASDA, are the strike prices orexercise prices. These are the prices at which,under the option contract, you can buy (call)or sell (put) the shares. The months ofJanuary, April and July are the months, in1996, in which the option contracts expire.If you wanted to obtain the option to buy1,000 ASDA shares at 100p per share in July1996 you would need to buy a call optionwhich has a premium of 13p per share. Eachoption contract would therefore cost £130(13p x 1,000). (This is before allowing forthe commission which is payable to a brokerand the dealer’s bid — offer spread whichwe will not consider in this article.) Thepremium is the price or cost, to the pur-chaser, of the option.

Exchange traded optionsv over-the-counter optionsOption contracts are available as either:

l exchange traded options (or traded op-tions) which are standardised, market-able contracts. These contracts aretraded on recognised exchanges

or;

l over-the-counter options which are tai-lor-made to the company’s require-ments. These contracts may be obtainedfrom banks who will quote a premiumbased on the terms required by the pur-chaser.

The exercise price(or strike price)The exercise price is the price at which theunderlying financial instrument can bebought or sold under the option contract. Inthe case of a currency option this is theexchange rate at which the ‘foreign cur-rency’ can be bought or sold.

Features of exchange traded options:

l They are bought and sold on recognisedexchanges. A market price is thereforereadily available.

l They are only available in standardisedcontract sizes for a limited number offinancial instruments.

l They have a limited number of strikeprices which, in the case of currencyoptions, are generally quoted in UScents per unit of the other currency; the‘home currency’ is the US$.

l They expire/mature on a fixed day eachmonth/quarter up to one year ahead.i.e. they are relatively short dated.

l They involve the seller of the optioncontract in payment of a margin (similarto the margin on a futures contract whichwe discussed in the second and thirdarticles).

l Are obtained via a broker, to whom acommission is payable.

l The main option exchanges include Chi-cago, London, New York, Philadelphia,Amsterdam and Montreal.

his is the fourth in a series of fivearticles. The aim of the series is todevelop an understanding of the

effect foreign currency risk may have ona firm and of some of the techniques that areavailable for eliminating or reducing thatrisk. In the third article we explained cur-rency futures contracts. In this and the fiftharticle we will introduce and explain optioncontracts.

Options can be used for foreign currencyexposure management and interest rate riskmanagement. In this article we will developan understanding of the main features ofoption contracts in general and then in thefifth and final article we will focus on cur-rency options and the ways in which theycan be used to hedge currency risk.

What are options?An option provides the purchaser of theoption with the right (opportunity) but notthe obligation to buy from or sell to theseller (or writer ) of the option a commod-ity or financial instrument in the future at aprice fixed today.

Options, as the name suggests, offer thepurchaser (the person or company payingthe premium) a choice as to whether or notto carry out a particular course of action.The purchaser of an option contract canchoose the course of action that is the mostbeneficial.

The purchaser of an option has to pay theseller (writer) a premium at the time ofentering into the contract. In the case of acurrency option the premium can be viewedas the cost of the currency hedge.

The seller or writer of the contract has, inreturn for receiving the premium, the obli-gation to fulfill the conditions required bythe contract.

Call option v put optionAn option to buy the underlying commodityor financial instrument is referred to as acall option.

An option to sell the underlying commodityor financial instrument is referred to as a putoption.

Nigel Brown BA FCA is a senior lecturer in Financial Strategyat the University of Wales College, Newport

T

by Nigel Brown

Relevant topaper 14

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l A traded option can be resold during itslife. This means the contracts can beeasily resold by the purchaser which isnot the case with over-the-counter op-tions.

In London traded options are dealt on theLondon International Financial Futures andOptions Exchange (LIFFE). There are twobasic types of option contract traded onLIFFE. These are:

1 Options on a financial instrument orcashThese option contracts give the purchaserthe right but not the obligation to purchaseor sell the underlying financial instrumentor cash.

The Equity options in Example 1 are anexample of traded options. For these tradedoptions the underlying ‘financial instru-ments’ are the ordinary shares of the respec-tive companies.

Since these are traded options they can bebought or sold at any time until the expirydate.

2 Options on futuresOptions on futures (or futures options) givethe purchaser the right but not the obliga-tion to take a long or short position in afutures contract.

Example 2One of the contracts traded on LIFFE is theshort sterling option. Each Short Sterlingoption contract gives the purchaser the op-portunity to, if beneficial, take a position inone short sterling futures contract at theexercise price. Each Short Sterling contractis based on a notional £500,000 three monthsterling deposit.

Short sterling options are ‘American-style’contracts which means that the option buyercan exercise the option at any time prior toexpiry.

Short sterling options may be used for hedg-ing interest rate risk which is another impor-tant topic on the paper 14 syllabus. It isoutside the scope of this series of articles tocover interest rate risk.

Features of over-the-counter (OTC)options

l The option contract can be written to thepurchaser’s specific requirements.

l The terms of each contract are subject toindividual negotiation and tend to in-volve marginally lower premiums thanon exchange traded or listed options.

l The option contract may be for anyamount above a certain minimum.

l A wider range of contracts is available(for example, OTC currency options are

available for any pair of currencies thathave an active spot and forward mar-ket).

l May be for any maturity from overnightto 5 years.

l Can be for virtually any strike pricewhich, in the case of currency options, isusually quoted on the same basis as theforeign exchange market.

l Do not involve a margin but do requirethe company to have a credit line withthe bank.

l Are available from banks which do notcharge a commission; the bank’s chargesare inclusive in the premium.

l Difficult if not impossible to sell beforeexpiry date (if sold there could be a large‘spread’ on sale).

The option premiumAs mentioned above the purchaser of anoption has to pay the seller (writer) a pre-mium at the time of entering into the con-tract.

l Traded optionsIn the case of traded options the premiumis the price, determined through open out-cry on the trading floor, that the purchaser ofan option pays and the seller of the optionreceives for the right/opportunity conveyedby the option. This premium is determinedon an ongoing basis via competition be-tween option buyers and option sellers in thetrading pits on the exchange. Therefore atany point in time through the life of a tradedoption the premium is a reflection of supplyand demand for that option at that moment.

Example 3Take the options on ASDA shares shown inExample 1.

What would happen if some news is pub-lished which suggests the shares are under-valued? This will result in more peoplewanting to buy the shares causing the priceof the shares to increase above 103p. Simi-larly this will make the 100p July 1996 calloption more attractive. More people willbuy the call options which will increase thepremium above 13p.

l OTC optionsWith OTC options the premium is fixed bythe seller at the time the contract is enteredinto and will therefore depend on the termsrequired by the purchaser and on marketconditions at the time.

For example, take a firm which wishes tohedge against an increase in interest rates.Any increase in market interest rates whichoccurred before the option contract is en-tered into will cause the bank to quote ahigher premium.

The option premium, which is not refund-able, represents the maximum loss that willbe incurred by the purchaser of the option.

Option contracts provide:l Protection from downside risk (the riskof a loss).If market conditions, for the underlyingfinancial instrument, move against the pur-chaser of an option then the purchaser isprotected from loss by exercising the op-tion. The primary objective of hedging cur-rency risk or interest rate risk is protectionfrom downside risk.

l Participation in upside risk (the risk of aprofit). If the market moves in favour of the optionbuyer, the option can be allowed to lapseenabling the purchaser to take advantage ofthe favourable market rates. This opportu-nity is not available with the other hedgingtechniques we have considered (forwardcontracts, money market hedges and futurescontracts).

European options v AmericanoptionsAn option which can only be exercised onthe maturity date is referred to as a Euro-pean option. An option which can be exer-cised on any working day between 2 dates(the option period) is called an Americanoption. American options involve a higherpremium than European options since theyoffer the purchaser more opportunity to ex-ercise the option (which is only done whenprofitable to do so). American and Euro-pean options are available on LIFFE.

For example there are two options contractson the FT-SE 100 Index (the FinancialTimes index of the share prices of the top100 UK companies by market capitalisa-tion): one is American-style and one is Eu-ropean-style.

In the money, out of the money orat the moneyA call option is referred to as being in themoney if the current market price of theasset to which it relates is above theexercise price. In other words if the optionwere to be exercised at that time the pur-chaser of the option would make a profitequal to the market price of the asset less theexercise price.

Example 4Using the details in Example 1 the ASDA100p call options are in the money sincethey entitle the purchaser to buy ASDAshares at 100p when the shares have a mar-ket price of 103p. There is a potential profit,before commission, of 3p (sell in the marketfor 103p and buy under the option contractfor 100p).

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A call option is out of the money when thecurrent market price of the asset is belowthe exercise price.

The ASDA 110p call option is out of themoney: on 31 October it is not worth exer-cising since this would result in a loss of 7p(buy under the option contract for 110p andsell in the market for 103p).

Similarly a put option is in the money whenthe current market price of the asset is belowthe exercise price. The ASDA 110p putoption is in the money: exercising this op-tion would result in a profit of 7p (sell underthe option contract for 110p and buy in themarket for 103p).

A put option is out of the money when themarket price of the asset is above the exer-cise price. The ASDA 100p put option is outof the money: on 31 October it is not worthexercising since this would result in a loss of3p (buy in the market for 103p and sell underthe option contract for 100p).

If the market price of the asset is equal to theexercise price the option is referred to asbeing at the money.

GearingGearing (or financial leverage) is defined byBrealey (1996) as the use of debt to increasethe expected return on equity. Option con-tracts can be used to create the gearing effectof increasing the expected return.

l Buying a call option is referred to astaking a position in the underlying as-set. This means the purchaser of the calloption can take advantage of an increasein the market price of the underlyingasset by using less money than if theasset is bought directly.

Example 5The following example is based on tradedoptions in British Airways PLC. These con-tracts are shown in Table 1 on page 64.

On 31.10.95 the share price of British Air-ways (shown in brackets) was £4.58 1/2 (i.e.£4.585). On the same day the price (i.e.premium) of the LIFFE July 1996 call op-tion, with a strike price of £4.60, was £0.37.Since the exercise price is above the marketprice the option is out of the money.

Calculate what the profit or loss per sharewill be for someone who, on 31.10.95:

l purchases a British Airways share andsubsequently sells the share in July 1996;

l purchases a British Airways July 1996call option with an exercise price of£4.60 and subsequently, if beneficial,exercises the call option (i.e. buys theshares) in July 1996 and then sells theunderlying shares.

Assume that the price of the share on the

exercise date i.e. in July 1996 is:

(i) £6;(ii) £4.80;(iii) £3.

This example highlights the followingpoints:

l If you buy the share then the % profit orloss that you make is, not surprisingly,equal to the % change in the price of theshare itself.

l This is in sharp contrast to buying thecall option: the option has the effect ofamplifying the effect of the price move-ment.

l With the call option the good news isthat the upside risk, (i.e. the potentialgain) is greater than if investing in theshare: in (i) a share price increase of

31% is converted into a profit of 278%;the option has geared up the return. Theoption enables the buyer to profit fromthe share price increase by investing£0.37 instead of £4.585. In this contextthe option could be viewed as a loan:place a deposit on the share in October1995 of £0.37 and delay paying thebalance until the option is exercised inJuly 1996. Hence the level of interestrates has an influence on the size of theoption premium.

l The bad news with the call option is thatthe downside risk is also greater. In (iii)the loss of 35% on the share becomes100% if one had held the call option. Afurther crucial point is that, if one hadpurchased the share it may be possibleto wait to allow time for the share priceto recover; there is no such waiting time

Solution to Example 5

(i) Selling price £6(a) Share (b) Call option

Selling price £6 £6

Cost on 31.10.95 –£4.585 –£0.37

Cost on July 1996 N/A –£4.60

Profit/–Loss £1.415 £1.03

Profit/–Loss as a

% of the initial cost 1.415/4.585 1.03/0.37

= 31% 278%

(ii) Selling price £4.80(a) Share (b) Call option

Selling price £4.80 £4.80

Cost on 31.10.95 –£4.585 –£0.37

Cost in July 1996 N/A –£4.60

Profit/–Loss £0.215 –£0.17

Profit/–Loss as a

% of the cost initial

cost 0.215/4.585 –0.17/0.37

= 4.7% –46%

In this case the option is exercised to make a profit of 20p (480 – 460)

This is not sufficient to cover the premium of 37p

(iii) Selling price £3.00

(a) Share (b) Call option

Selling price £3 N/A

Cost on 31.10.95 –£4.585 –£0.37

Cost in July 1996 N/A N/A

Profit/–Loss –£1.585 –£0.37

Profit/–Loss as a

% of the initial

cost –1.585/4.585 –0.37/0.37

= –35% –100%

TECHNICAL 67A

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with the call option since it expires inJuly 1996.

l In (ii) a small profit on the share of4.7% has changed to a loss of 46% onthe call option. Looked at another way,for the option to be profitable the shareprice has got to increase to an amountequal to the premium plus the strikeprice. i.e. to £4.60 + £0.37 = £4.97. Thisis (4.97 – 4.585) £0.385 above the priceof the share when the option is pur-chased in October. So an (0.385/4.585)8.4% increase in the price of the share isneeded in order to break even on theoption contract. If the share price in July1996 were £4.97 or below the optioncontract results in a loss.

l These profits or losses are before allow-ing for the time value of money. This isan important factor which would have agreater impact on the purchase of theshare since, between October 1995 andJuly 1996, it is necessary to finance thefull cost of the share (£4.585) ratherthan just the option premium (£0.37).

l In practice, as mentioned above, eachequity option contract is for 1,000 shares.So if, for example, you wanted a calloption on 7,000 shares you would haveto buy 7,000/1,000 = 7 contracts. Thiswould cost 7,000 x 37p = £2,590 (beforecommission).

A naked optionA naked option is an option that is held on itsown, that is not held as a hedge against losson a holding of an asset or another option.The profits/losses on the British Airwayscall option in Example 5 would arise if theoption is held on its own. Corporate treasur-ers should not normally be involved in suchspeculative investments.

What affects option prices/values?The value of an option, its premium, is equalto the sum of the intrinsic value and thetime value.

The intrinsic valueIntrinsic means basic, fundamental, essen-tial or real. The intrinsic value of an optionis the profit the purchaser of the optioncould make if the option is exercised imme-diately. An option will only have an intrin-sic value greater than zero if it is in themoney: the intrinsic value is the differencebetween the price of the underlying finan-cial instrument and the exercise price. Anoption that is out of the money has anintrinsic value of zero. Let’s look at anexample using a call option.

Intrinsic value of a call optionExample 6Take the British Airways January 1996 call

options in table 1. The intrinsic values are:Share price Strike price Intrinsic value Premium

458.5p 420p 458.5 – 420 = 38.5p 45p

458.5p 460p nil 19p

The strike price of 420p would enable thepurchaser to make a profit if the option wereexercised immediately whereas a profit isnot immediately available with the strikeprice of 460p. Therefore the 420p option hasa higher intrinsic value and is valued morehighly in the market i.e. the premium ishigher.

The intrinsic value of the 460p call option iszero; the 460p call option is out of themoney. The intrinsic value cannot be nega-tive because of the basic nature of an optioncontract: if exercising the option is not ben-eficial the purchaser does not have to exer-cise it; there would be no benefit in buyingthe share at 460p if the selling price is only458.5p.

Hence the intrinsic value is dependent onthe market price of the financial instrumentand the exercise price.

If the call option can only be exercisedimmediately (i.e. when it is about to mature)it cannot be worth more than the intrinsicvalue because there is no opportunity for themarket price to increase above today’s price.The British Airways options in Example 6have premiums in excess of the intrinsicvalue because there is, on 31 October 1995,still 3 months to go before the options expirein January 1996. This period of time has avalue which we will look at later in thisarticle.

Intrinsic value of a put optionThe intrinsic value of a put option is theexercise price of the option less the marketprice of the underlying asset. Again it has aminimum value of zero but has a maximumvalue which is equal to the exercise price: ifthe underlying asset is worth zero the putoption will enable the asset to be sold at theexercise price and therefore make a profitequal to that amount.

Example 7We will use the British Airways January1996put options in Table 1. The intrinsic valuesare:

Share price Strike price Intrinsic value Premium

458.5p 420p nil 4p

458.5p 460p 460 – 458.5 = 1.5p 17.5p

The 420 put option has no intrinsic valuesince it is not beneficial to buy shares in themarket at 458.5p in order to sell them underthe option contract for 420p.

Part 4b will be published in the Octoberissue of the Students’ Newsletter. n

4 TECHNICAL

his is part b of the fourth article ina series of five. The aim of theseries is to develop an understand-

October 1995 the April 1996 option with 6months to expiry is worth more than theJanuary 1996 option which only has 3 monthsto run to expiry. We now need to think aboutwhy this is the case.

What causes an option to

have a positive time value? The level of interest rates

By buying a call option the purchaser avoidshaving to finance the full cost of the assetnow. Instead it is only necessary to financethe cost of the option (the premium) nowand then, assuming the price of the asset isin excess of the exercise price, buy the asseton expiry of the option. The call option cantherefore be viewed as equivalent to buyingthe asset with part of the finance from a loan.Therefore the higher the level of interestrates the higher will be the value of theoption.

Example 9This example is based on the figures inTable 1 (see article 4a). If, in October 1995,an investor wishes to buy 5,000 shares inBritish Airways the cost would be:

5,000 x £4.585 = £22,925 which would bepayable in October 1995.

Alternatively the investor could buy 5 (5,000/1,000 since each option contract is for 1,000shares) July 1996 460 call option contractswhich would, assuming it to be beneficial toexercise the options in July 1996, involve acost of:

October 1995: 5,000 x 0.37 = £1,850

July 1996: 5,000 x £4.60 = £23,000

Total cost £24,850

The option contract enables the purchaser todelay paying the bulk of the purchase cost ofthe shares until July 1996. This time delaywill be more valuable to the purchaser ifinterest rates are higher.

ing of the effect foreign currency risk mayhave on a firm and some of the techniquesthat are available for eliminating or reduc-ing that risk. In this and the fifth article wewill introduce and explain option contracts.

The time value

(time value premium)The time value of an option is the differencebetween the market price of an option andits intrinsic value. An option will usuallyhave a time value, regardless of whether it isin the money, at the money or out of themoney, if there is time to run before theoption expires. Time value is the value placedon the chance that the option will becomein the money, and therefore worth exercis-ing before or at expiry. It also takes intoaccount the fact that, in the case of a calloption, the option can be viewed as a form ofborrowing.

Time value can be determined using thefollowing formula:

Time value of a call option =option price – [price of underlying – exercise]

[asset price]

. . Time value of a call option =option price – intrinsic value of the option

As the time to maturity increases the timevalue of the option increases: an option with7 months to expiry is worth more than anoption with 4 months to expiry.

Example 8Take the British Airways call options inTable 1, (see article 4a) with a strike priceof 420p. The time values are shown in Table2 below.

As the time to maturity increases the timevalue of each of the options increases. In

Foreign currency exposure management: part 4b

Option contractsNigel Brown BA FCA is a senior lecturer in Financial Strategyat the University of Wales College, Newport

Time to run before the option expiresThere are two reasons why the length oftime to expiry influences the value of anoption:

(i) Interest rates. In the case of a call optionone effect is, as illustrated in example 9, toavoid having to finance the full cost of theasset now. Consequently the longer the pe-riod to expiry the greater the saving infinancing costs.

(ii) The chance or likelihood of the optionbeing in the money by the time the optionexpires. The higher the degree of volatilityof the price of the asset (i.e. the more riskinherent in the price) the more chance thereis that, in the case of a call option, the priceof the asset will exceed the exercise price(and make the option worth exercising). If ashare price is very volatile it means therewill be large increases and decreases in theprice. If a large price increase occurs, whichcauses the price of the share to rise above theexercise price, then the call option can beexercised at a profit.

The time value therefore increases with thelevel of variation in the price of the asset.Not surprisingly an increase in the volatilityof the underlying asset will cause the sellers(writers) of options to require a higher re-turn for the risk they are taking on by writingthe option. The overall effect is for thepremium to increase as volatility increases.

There is more opportunity to take advantageof this volatility with an American option(where the option may be exercised at anytime between two dates). Also the furtherinto the future the expiry date the greater thechance that the price of the asset will in-crease above the exercise price enabling theoption to be exercised at that time at a profit.

The time value, for a given time to expiry, isat its highest when the price of the underly-ing asset is equal to the exercise price; anyfavourable change in price of the underlyingasset will result in the option being in themoney.

The effect of increased volatility in themarket price of an asset on the value of anoption to buy that asset is illustrated inExample 10.This example examines the value of a call

Maturity date Share price Intrinsic value Premium Time value

January 1996 458.5p 458.5 – 420 = 38.5p 45p 45 – 38.5 = 6.5p

April 1996 458.5p 38.5p 55p 55 – 38.5 = 16.5p

July 1996 458.5p 38.5p 62p 62 – 38.5 = 23.5p

Table 2 — Time values

.

T

TECHNICAL 5

option on two shares at expiry. The possibleshare prices and associated probabilities atexpiry of the options are as in Table 3.

Required:Calculate the expected intrinsic value of acall option, with an exercise price of £4, oneach share. (Hint: if the market price isbelow the exercise price the option will beallowed to lapse and therefore has a value ofzero.)

Solution to Example 10If the shares are purchased they will haveexpected values as per the question. Thevalue of the option is the amount by whichthe expected value with the option is higherthan the expected value without the option.

The price of share B can be identified asbeing more risky since there can be largervariations from the expected value. This canbe expressed more formally by calculatingthe standard deviations which are £1.265for share A and £2.214 for share B (you maywish to calculate these standard deviationsas a separate exercise). If the call optionswere purchased the worst outcome would,subject to the initial premium, be zero ineach case. If the investor had purchased theunderlying shares the worst outcome forshare A (£2) is preferable to share B (£0.5).Hence, using the call option instead of buy-ing the underlying share protects the inves-tor from the less favourable outcome ofshare B but the investor can take advantageof the larger price increase that is possiblewith share B. Unfortunately the writer of theoptions will also require a higher premiumfor writing the £4 call option on share Brather than on share A.

The risk of an optionThere are some important points to noteregarding the risk of an option:

An option that is in the money is saferthan an option that is out of the money.

The risk of a call option decreases as theprice of the underlying asset increases.

An option is more risky than the underly-ing asset and consequently has a higher betavalue (which measures the systematic risk)and standard deviation (which measures thetotal risk) of return.

The risk of an option changes, virtually ona daily basis, as variables such as the priceand volatility of the underlying asset alter.

Black and Scholes options

pricing modelYou may well be horrified when you see theBlack and Scholes options pricing modelformulae but don’t panic because, for thepaper 14 Financial Strategy examination,you only(!) need to be aware of the variablesthat go into the formulae; you will not beexpected to apply the formulae.

Table 3

Share A Share BProbability Price £ Expected Probability Price £ Expected

value value

.2 2 .4 .2 0.5 0.1

.6 4 2.4 .6 4 2.4

.2 6 1.2 .2 7.5 1.5

£4.0 £4.0

The normal distributionTo understand the Black and Scholes op-tions pricing model it will help to review themain characteristics of the normal distribu-tion.

A normal distribution can be completelydefined by 2 parameters, the mean and thestandard deviation and when plotted on agraph, appears as follows:

Diagram 1

ity that the variable will have a value lessthan d1 and a 0.025 (1 – 0.975) probabilitythat the variable will have a value greaterthan d1.

The Black and Scholes options pricingmodel provides a way of estimating thevalue of a call option exercisable on a par-ticular date i.e. a European option.

The model is explained in the context of anoption on a share and comprises the follow-ing 3 equations:

V = Po[N(d1)] – Xe–rt [N(d2)] ........1

logn

(Po/X) + r + σ2 t ........2 σ t 2

d2 = d1 – σ t ........3

where:V = the current value of a European calloption with time t until expiry.

Po = current price of the share to which the

option relates.

N(d1) = the probability that a random vari-able, that is normally distributed, will beless than d1. As mentioned above this valuecan be obtained from the normal distribu-tion tables.

N(d2) = the probability that a random vari-able, that is normally distributed, will beless than d2.

X = the exercise price of the option.

Share APrice at Is option Value Probability Expected valueexpiry exercised? of option £

2 no nil .2 nil4 no nil .6 nil6 yes (6–4) = 2 .2 .4

£0.40

Share BPrice at Is option Value Probability Expected valueexpiry exercised? of option £

0.5 no nil .2 nil4 no nil .6 nil7.5 yes (7.5–4) = 3.5 .2 .70

Therefore an option on share B is more valuable than an option on share A. £0.70

Solution to Table 3

Expected value assuming a call option has been purchased.

Normal distribution

If the value of a random variable is normallydistributed the probability of the value of thevariable being less than d1 may be obtainedfrom normal distribution tables. d1 can becalculated as a number of standard devia-tions from the mean and is sometimes re-ferred to as the Z value.

For example if d1 = 1.96 the associatedprobability, from the normal distributiontables, is .975. i.e. there is a 0.975 probabil-

d1 = ( )

6 TECHNICAL

e = the base of the natural logarithm i.e.2.718282.

logn(P

o/X) = the natural logarithm of P

o/X

r = risk free interest rate expressed as adecimal.

t = time until the option expires, measured inyears and expressed as a decimal (e.g. 3months would appear as .25).

σ = standard deviation of the rate of returnon the share.

Let’s look at the basic relationship betweenthe input variables and the value of theoption:

The current price of the underlying share

Po ; if the price of the share increases the call

option value will increase.

The exercise price (X); the higher theexercise price the lower the value of the calloption.

The risk free interest rate (r); the higherthe risk free interest rate the higher the valueof the option.

Time to expiry(t); the longer the period tomaturity the higher the value of the option.

Standard deviation of rate of return on theshare σ; the higher the standard deviation ofrate of return on the share the higher thevalue of the option.

Once the value of a call option has beenderived it is possible to find the value of aput option on the same security.

The assumptions underlying

the Black and Scholes

options pricing modelThe Black and Scholes options pricingmodel, though widely used by option trad-ers, does have a number of assumptions/limitations. These are:

In the case of a share option there isassumed to be no dividend payable on theshare during the life of the option. (Thoughit is possible for the formula to be amendedto take into account dividends.)

The option is a European option.(Thoughan American option is likely to have a valueof at least the value of a similar Europeanoption.)

We know the short term risk free interestrate which is fixed throughout the life of theoption.

The share price follows a random walkand the possible share prices at the end ofany finite period are log-normally distrib-uted.

There are no transaction costs or taxeffects relating to purchase or sale of theunderlying asset or the option.

It is possible to borrow, at the risk-freerate, the amount needed to buy or hold any

proportion of the underlying share.

There are no penalties attached to shortselling (selling shares that the seller doesnot own).

The model is very sensitive to the value ofσ which is difficult to estimate.

The model normally uses the historic σfor the option price for a future period.

Changes in the value of

optionsThe Black and Scholes model enables us tovalue an option at a particular time. Optionvalues change continually throughout theirlives; these changes can be large and occurin a very short period of time.

It will help to understand the way optionvalues change if we consider, at an introduc-tory level, how a writer of an option cancover the risk on that option. i.e. how thewriter can obtain protection from a loss ifthe price of the underlying asset movesagainst him/her; writing an option with pro-tection against loss is referred to as:

covered call writing, which is usuallywriting one option for each share held; or

fiduciary call writing when using a deltahedge which is explained in the next sec-tion.

The delta hedgeThe delta (or hedge ratio) of an option meas-ures the change in price of the option thatcorresponds with a given change in the priceof the underlying instrument. It is only validfor small price changes.

the change in the price of the call optionthe change in the price of the underlyingsecurity

The delta value is referred to in the Blackand Scholes model as N(d1).

By identifying the delta it is possible todetermine the amount of the underlyinginstrument in which the option writer needsto take a position in order to hedge theoption position. In other words this enablesthe option writer to eliminate the risk, to thewriter, of the option. If a 2p change in theprice of the underlying security results in a1p change in the price of the associatedoption the delta is: 1p/2p = 0.5. This meansthat the option writer needs to hold half ofthe number of underlying shares to elimi-nate the loss on the options. If the optionwriter owns one share and the share pricegoes up by 2p this 2p profit made by theoption writer will compensate for the corre-sponding loss of 1p the option writer willmake on each of two options. So a calloption on 2,000 shares would need a hold-ing of 1,000 shares (2,000 x 0.5) to eliminatethe risk.

Hence to be protected against an adverse

movement in the share price the optionwriter can hold a lower number of underly-ing shares than the number of shares onwhich the option is exercisable. This isbecause the movement in price of the sharesmay be larger than the corresponding move-ment in price of the option (in the aboveexample 2p versus 1p). From the viewpointof the call option writer an adverse move-ment is an increase in the share price. Henceto cover the risk the option writer will buythe appropriate number of shares.

The tricky bit is keeping track of the deltavalue which tends to change throughout thelife of the option with the consequence that,to eliminate the risk, the writer’s positioncontinually needs re-balancing by alteringthe size of the holding of the underlyingshares.

The gamma valueThe last concept we will consider is thegamma value. This is the ratio of the changein the delta value that occurs for a givenchange in the price of the underlying finan-cial instrument.

change in delta valuechange in value of the underlying

financial instrument

This gives a measure of the sensitivity of thedelta value: the more volatile the delta valuethe more difficult it is for an option writer toremove the risk from writing a call option(by buying the appropriate number of un-derlying securities). This will cause the sellerof the option to require a higher premium.

Gamma has the highest value when an op-tion has a short time to run before expiry andis at the money.

We have considered some of the main char-acteristics of option contracts in general. Inthe next article we will look at the way inwhich currency options can be used to hedgecurrency risk.

ReferencesBrealey, R.A. and Myers, S.C. (1996) Prin-ciples of Corporate Finance, McGraw Hill,New York.

Brown, N., Kaur, P., Maugham, S. andRendall, J. (1994) Financial Strategy, Cer-tified Accountants Educational Projects,London.

Buckley, A. (1992) Multinational Finance,Prentice Hall, New York.

French, D. (1994) Dictionary of AccountingTerms, The Institute of Chartered Account-ants in England and Wales, London.

Demirag, I. and Goddard, S. (1994) Finan-cial Management for International Busi-ness, McGraw Hill.

Shapiro, A. (1995) Multinational FinancialManagement, Allyn and Bacon, Boston.

delta =

i.e. Gamma =

TECHNICAL by Nigel Brown

his is the last article in a series of five articles. The aim of theseries is to develop an understanding of the effect foreigncurrency risk may have on a firm and of some of the

Foreign currency exposure management: part 5a

Currency option

contractsNigel Brown BA FCA is a senior lecturer in Financial Strategy

at the University of Wales College, Newport

Ttechniques that are available for eliminating or reducing that risk. Inthe third article we explained currency futures contracts. In this articlewe examine the main characteristics of currency options and the wayin which currency options can be used to hedge currency risk.

Currency options (or foreign currency

option contracts)A currency option is the right, but not the obligation, to purchase (acall option) or sell (a put option) a particular ‘foreign currency’ at aspecified exchange rate (the strike price). This may be on the maturitydate (a European option) or on any business day before maturity (anAmerican option). The following currency option contracts aretraded on the Philadelphia Stock Exchange (in the USA):

Currency Contract sizeAustralian $ A$ 50,000

British £ £31,250

Canadian $ C$ 50,000

Deutsche Mark DM 62,500

French franc FF 250,000

Japanese yen Y 6.25m

Swiss franc SF 62,500

The ECU ECU 62,500

These contracts are quoted against the US$. This is because they aretraded in the USA and therefore the ‘home currency’ is the US$ andthe other currencies, including £ are the ‘foreign currencies’. Conse-quently option premiums are payable in US$ so we have to take carewhen considering the use of these contracts by a UK company.

Currency options have the following benefits:

Protection against adverse movements in the exchange rate(downside risk).

Opportunity to benefit if there is a favourable movement in theexchange rate (upside risk). This opportunity is not available if afirm uses a forward foreign exchange contract, money markethedge or currency futures contracts.

Enables a firm to hedge currency risk when there is uncertaintyregarding whether the foreign currency transaction will material-ise. e.g. tendering for a contract.

A firm can choose, from a range of rates (strike prices) quoted, thelevel of insurance it requires and the cost of that insurance. Themore protection the option contract provides the higher thepremium will be.

£/$ optionsIf a firm wished to take out an option to buy or sell sterling it coulduse currency options traded on the Philadelphia SE referred to above.These traded currency option contracts have a contract size of£31,250. The following table reproduces the information regardingthis contract that is published daily in the Financial Times:

Table 1: Philadelphia SE £/$ options (cents per £)

Strike Calls Puts

Price Mar Apr May Jun Mar Apr May June1.375 5.54 5.75 6.05 6.34 — 0.57 1.18 1.741.400 3.05 3.89 4.35 4.75 0.03 1.18 1.96 2.581.425 0.87 2.42 2.95 3.42 0.23 2.15 3.00 3.731.450 0.04 1.38 1.97 2.44 1.84 3.55 4.45 5.l81.475 — 0.72 1.22 1.66 4.21 5.38 6.18 6.871.500 — 0.32 0.71 1.08 6.71 7.48 8.11 8.721.525 — 0.11 0.37 0.69 9.16 9.71 10.26 10.79

Previous day’s open int: Calls 818,836 Puts 605,022 (All currencies)

Previous day’s volume: Calls 13,466 Puts 14,651 (All currencies)

Source: Financial Times, 12 March 1993.

There are several useful observations that can be made about Table1. For example:

If the firm wanted the option to buy £ (and sell $) in April 1993it would need to buy a call option on sterling (£ is the ‘foreign’currency). If it wanted the option to buy £s at an exchange rate of$1.375/£, it would have to pay a premium of 5.75 cents whereasbuying £s at the less favourable exchange rate of $1.45/£ wouldinvolve a lower premium of 1.38 cents.

A put option (an option to sell £, which is the foreign currency, inexchange for $) with a strike price of $1.450/£, exercisable inApril 1993 carries a premium of 3.55 cents per £ which is cheaperthan an April put option exercisable at $1.500 which carries apremium of 7.48 cents per £. The difference between the twopremiums reflects the fact that the exchange rate of $1.450 is lessfavourable to the purchaser of the option and is therefore cheaper;the purchaser of the $1.450 option will receive less $ for each £sold than at the exchange rate of $1.500/£ and

A call option, with a strike price of $1.375/£ exercisable in May1993 would involve a premium of 6.05 cents. The same strikeprice carries a lower premium when exercisable in April 1993(5.75 cents).This difference in premium reflects the fact that theMay option has longer to run and therefore:

(i) there is more likelihood of it being beneficial to exercise theoption; and

(ii) the time value of money is higher; the May call option

TECHNICAL 4

enables the firm to delay paying for the currency for a furthermonth; and

(iii) the market’s view of the direction in which the exchangerate will move between April and May; this in turn will reflectthe differential between £ and $ interest rates. (This isinterest rate parity which we covered in the first article ofthe series.)

We can now look at how a company could use traded currency optionsto hedge currency risk. For convenience the example will use thepremiums quoted in Table 1.

Example 1Assume it is now 12 March 1993. Anderson PLC, a UK company,owes Bishop Inc., a US supplier, $340,000 payable in June 1993. Thespot rate is $1.4330 – $1.4355 /£ and Anderson PLC is concerned thatthe $ may strengthen against the £ before payment is made.

Required:Show how traded £/$ currency options, contract size £31,250, can beused to hedge the currency risk on this transaction. Assume AndersonPLC decides to use an option with a strike price of $1.425/£.Calculate the sterling cost of the transaction if the spot rate in June is:

(a) $1.3800 – $1.3834/£

(b) $1.5200 – $1.5245/£

Solution to Example 1This example is awkward because the UK company is having to useoption contracts traded in the USA. Therefore the premium is payablein $s and the $ is the ‘home currency’ so we need to think of the £ asthe ‘foreign currency’.

Stage 1: Does Anderson need to use call or put options?The company needs to sell £s in order to buy $s. Because, from theviewpoint of the Philadelphia option market, the £ is the foreigncurrency Anderson needs to buy £/$ put options: options to sell £s inexchange for $s.

Stage 2: How many contracts?For the exercise price of $1.425/ £ the company will need to sell:340,000/1.425 = £238,596. . the number of contracts required is:238,596/31,250 = 7.6 i.e. 8 contracts (can only buy a whole numberof contracts so take the nearest whole number).

Stage 3: How much is the premium?31,250 x 3.73/100 = $ 1,166 per contract. The premium is in $s sincethe option contract is traded in the USA. In effect it costs 3.73 centsto fix the exchange rate at which one is able to sell £1 (and thereforebuy $1.425).Total premium:1,166 x 8 = $9,328 which, at the spot rate of $1.4330/£, will cost:9,328/1.4330 = £6,509.

Stage 4: What action will the firm take?This will depend on the spot rate in June 1993.

(a) Spot rate in June $1.3800 – $1.3834/£.The firm has a choice. It can either:

(i) buy $ on the spot market at $1.3800/£ at a cost of:340,000/1.3800 = £246,377; or

(ii) exercise the put option to sell £s in exchange for $s at a rate of$1.425 (which is more favourable to Anderson PLC than the spotrate). The firm should therefore exercise the put options.

Sterling cost: 8 contracts involve selling 8 x 31,250 = £250,000.Each contract will result in proceeds of: 31,250 x 1.425 = $44,531.25

Total proceeds for 8 contracts is therefore:44,531.25 x 8 = $356,250Amount to pay supplier $340,000

Surplus $ $ 16,250

This surplus arises because, in this example, the firm is usingexchange traded contracts and therefore has to accept the standardcontract size which does not exactly match their requirements. Wewill assume the firm will sell the excess $s.

£ proceeds: 16,250/1.3834 = £11,746.

. . net sterling cost:250,000 – 11,746 = £238,254 + premium of £6,509 = £244,763which is, as we would expect, cheaper than using the spot market.(since the option contract rate is better than the spot rate).

(b) Spot rate in June $1.5200 – $1.5245/£. The firm has thefollowing choice:

(i) Buy $ on spot market at $1.5200/£ at a cost of: 340,000/1.5200 =£223,684 or

(ii) Exercise the put option to sell £s in exchange for $s at $1.425which is less beneficial since the exercise price of $1.425 is lessfavourable than the spot rate of $1.5200:

Summary:

Spot rate Cost with no Cost within June currency option option

(a) $1.38/£ £246,377 £238,254 +£6,509 =

£244,763 (effective rate 340,000/244,763

= $1.389/£1)

(b) $1.52/£ £223,684 £223,684 +£6,509 =

£230,193 (effective rate 340,000/230,193

= $1.477/£1)

N.B.

The use of the put options has reduced the risk of the transaction.

If the $ strengthened against the £, as in (a), the currency optionswould have been beneficial however most of the saving would, inthis case, be paid as premium.

Not surprisingly, if the $ had weakened against the £ the companyis better off to use the spot market which, with option contracts,it can do by choosing not to exercise the option and thereforeallowing the options to lapse.

If the company had used a forward foreign exchange contract,money market hedge or currency futures contracts to hedge thecurrency risk then it would not have been able to take advantageof a favourable spot rate.

We now need to return to the example involving Sophieclare PLCwhich we have featured in the earlier articles to see how Sophieclarecould use currency option contracts. This will enable us to comparethe use of traded currency option contracts for hedging currency riskwith the other methods covered in the first three articles. The datafrom the original example is repeated for convenience.

Example 2Assume it is now October 1995. Sophieclare PLC, a UK company,owes Benjaminpaul Inc., a US supplier, $370,000 payable 3 monthslater in January 1996. The spot rate is $1.5766 – $1.5775/£ andSophieclare PLC is concerned that the $ may strengthen against the£ before payment is made. The finance director has obtained the

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TECHNICAL

following quotes from the Philadelphia Stock Exchange:

As per Financial Times 31.10.95

Phildaelphia SE £/$ options £31,250 (cents per pound).

Strike CALLS PUTSPrice Nov Dec Jan Nov Dec Jan

1.540 3.52 3.79 4.20 0.02 0.36 0.81

1.550 2.54 3.01 3.49 0.06 0.55 1.11

1.560 1.68 2.36 2.86 0.16 0.85 1.47

1.570 0.92 1.75 2.34 0.31 1.25 1.90

1.580 0.40 1.49 1.85 0.79 1.48 2.42

1.590 0.12 1.26 1.44 1.50 1.76 2.95

Previous day’s vol. Calls 27,528 Puts 7,601. Prev. day’s open int.Calls 274,824 Puts 291,536

The finance director is thinking of using currency options with a strikeprice of either $1.54 or $1.59.

Required: Calculate whether, with the benefit of hindsight, thesterling cost of hedging the currency risk using traded currency optioncontracts is better (i.e. lower) than the cost of using currency futurescontracts of £233,055 for (a) and £238,968 for (b) (derived in the thirdarticle).

Assume for the purposes of your evaluation that in January 1996:

(a) the spot rate was $1.3800 – $1.3809 /£.

(b) the spot rate was $1.8500 – $1.8510 /£.

Ignore taxation.

Solution to Example 2.

Stage 1: Does Sophieclare need to use call or put options?The firm needs to sell £ in order to buy $, therefore need to buy £/$put options: options to sell £ in exchange for $.

Stage 2: How many contracts?For the exercise price of $1.54/£ the company will need to sell:370,000/1.54 = £240,260.. . the number of contracts required is:£240,260/31,250 = 7.7 i.e. 8 contracts.

Stage 3: How much is the premium?Since the hedge is required until January it will be necessary to useJanuary 1996 option contracts since the November 1995 and Decem-ber 1995 contracts will have expired. The premium will depend on theexercise price:

Exercise price: $1.54.

Premium: 31,250 x 0.81/100 = $253 per contract, giving a total of:253 x 8 = $2,024 which, at the spot rate of $1.5766/£ (the companywill have to buy $s in order to pay the premium), will cost: 2,024/1.5766 = £1,284.

Exercise price: $1.59.

Premium: 31,250 x 2.95/100 = $922 per contract, giving a total of:922 x 8 = $7,376 which, at the spot rate of $1.5766/£ (the companywill have to buy $ in order to pay the premium), will cost:

7,376/1.5766 = £4,678.

Stage 4: What action will the firm take?(a) Spot rate in January $1.3800 – $1.3809/£: Sophieclare PLChas a choice. It can either:

(i) Buy $s on spot market at $1.3800/£ at a cost of: 370,000/1.3800

.

.

(use $1.3800 since the firm is buying $s) = £268,116 or

(ii) Exercise the put option to sell £s in exchange for $s at a rate of$1.54 or $1.59 (which is more favourable to Anderson PLC thanthe spot rate). The firm should therefore exercise the options:

Exercise price: $1.54

Sterling cost: 8 contracts involve selling 8 x 31,250 = £250,000.Each contract will result in proceeds of: 31,250 x 1.54 = $48,125.Total proceeds for 8 contracts is therefore:

48,125 x 8 = $385,000amount to pay supplier $370,000

Surplus $ $ 15,000

£ proceeds: 15,000/1.3809 (use $1.3809 since the firm is selling $s)= £10,862

. . net sterling cost:250,000 – 10,862 = £239,138 + premium of £1,284 = £240,422 whichis, as we would expect, cheaper than using the spot market.

Exercise price: $1.59.

Sterling cost: 8 contracts involve selling £250,000. Each contract willresult in proceeds of: 31,250 x 1.59 = $49,687 (to the nearest $). Totalproceeds for 8 contracts is therefore:

49,687 x 8 = $397,496amount to pay supplier $370,000

Surplus $ $ 27,496

£ proceeds: 27,496/1.3809 = £19,912.

. . net sterling cost: 250,000 – 19,912 = £230,088 + premium of £4,678= £234,766.

This demonstrates that the choice of exercise price can have asignificant effect on the final cost. In this case (for this particular spotrate) the exercise price of $1.59, which has a higher premium, resultsin a lower overall cost.

(b) Spot rate in January $1.8500–1.8510/£. The firm has thefollowing choice:

(i) Buy $ on spot market at $1.8500/£ at a cost of: 370,000/1.8500 =£200,000; or

(ii) Exercise the put option to sell £ in exchange for $ at $1.54 or $1.59both of which are less beneficial since the exercise prices are lessfavourable than the spot rate of $1.8500).

Hence the total cost would be:£200,000 + £1,284 = £201,284 for the strike price of $1.54 and£200,000 + £4,678 = £204,678 for the strike price of $1.59.

We can now summarise the costs that would have been incurred bySophieclare PLC for each of the hedging methods. The underlyingcalculations for no hedge, money market hedge, forward contractsand futures contracts are shown in the first three articles in the series.

Method used (a) Spot rate (b) Spot rate$1.3800 – $1.3809 $1.8500 – $1.8510

£ cost £ cost

No hedge £268,116 £200,000

Money market £235,261 £235,261 hedge

Forward contract £235,969 £235,969

Futures contracts £233,055 £238,968

Option contracts – £240,422 £201,284 strike price $1.54

Option contracts –£234,766 £204,678

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TECHNICAL 4

strike price $1.59

Comments:

Forward contracts, futures contracts and the money market hedgeremove the risk and therefore protect the firm if the $ strengthens,as in (a), but prevent the firm from benefiting from the weaknessof the $ in (b).

Because of their standard size, futures contracts result in adifferent cost for each exchange rate. The solution is based on 4contracts for £62,500.

If the exercise price of $1.54 had been chosen and the $ hadstrengthened as in (a) options would have been the most expen-sive method of hedging.

Option contracts enable the firm to take advantage of the favour-able spot rate in (b).

Examination style questionThe following examination question is taken from the ACCA Decem-ber 1989 examination. I suggest you work the question within a timelimit of 31 minutes.

Example 3Fidden is a medium-sized UK company with export and import tradewith the USA. The following transactions are due within the next sixmonths. Transactions are in the currency specified.

Purchases of components, cash payment due in three months: £116,000.Sale of finished goods, cash receipt due in three months: $197,000.

Purchase of finished goods for resale, cash payment due in sixmonths: $447,000.

Sale of finished goods, cash receipt due in six months: $154,000.

Exchange rates (London market)

$/£Spot 1.7106–1.7140

Three months forward 0.82–0.77 cents premiumSix months forward 1.39–1.34 cents premium

Interest rates

Three months or six months Borrowing LendingSterling 12.5% 9.5%Dollars 9% 6%

Foreign currency option prices (New York market)Prices are cents per £, contract size £12,500

CALLS PUTSExercise price ($) March June Sept March June Sept

1.60 — 15.20 — — — 2.75

1.70 5.65 7.75 — — 3.45 6.40

1.80 1.70 3.60 7.90 — 9.32 15.35

Assume that it is now December with three months to expiry of theMarch contract and that the option price is not payable until the endof the option period, or when the option is exercised.

Required:(i) Calculate the net sterling receipts/payments that Fiddenmight expect for both its three and six month transactions if thecompany hedges foreign exchange risk on:

(1) the forward foreign exchange market;(2) the money market. (7 marks)

(ii) If the actual spot rate in six months time was with hindsightexactly the present six months forward rate, calculate whetherFidden would have been better to hedge through foreigncurrencyoptions rather than the forward market or moneymarket. (7 marks)

(iii) Explain briefly what you consider to be the main advantageof foreign currency options. (3 marks)

The answer to this question and the remainder of the article willbe published in next month’s issue.

TECHNICAL

Foreign currency exposure management: part 5b

Currency option

contracts

i.e. annual rate divided by 4.) Let amount borrowed be x.

x (1 + (0.09/4)) = 197,000

x = 197,000/(1 + 0.0225) = $192,665

Sell the dollars at the spot rate to receive:

192665/1.7140 = £112,407.

This can be placed on deposit for 3 months (so as to compare with theamount receivable in 3 months time using a forward foreign exchangecontract).

Amount receivable: 112,407 x (1 +( 0.095/4)) = £115,077.

Therefore the forward foreign exchange contract is the better choice.

6 months: The company is due to pay dollars so it will need to lenddollars now and then use the amount lent plus interest to pay thesupplier. Let the amount lent be x (6 month interest rate = annual rate/2).

x (1+ (0.06/2)) = £293,000

x = 293,000/1.03 = $284,466

The dollar should be purchased at the spot rate at a cost of:

284,466/1.7106 = £166,296

With the forward contract the sterling cost of the dollars will not haveto be paid until 6 months time. Therefore for comparison we need totake account of borrowing the sterling for 6 months. This will accruto:

166,296 (1 + (0.125/2)) = 166,296 (1.0625)

= £176,690.

Again the forward contract is the better choice.

(ii) With the 6 months transactions, the Company needs to buy dollarsin June. In the case of the currency options the ‘foreign’ currency thatis bought (via a put option) is sterling. Therefore to buy $s thecompany will need to buy £ put options (i.e. be able to sell £s inexchange for $s).

Exercise price: $1.70It is first necessary to calculate the number of contracts needed at thisexercise price:

Sterling equivalent of dollars required: 293,000/1.70 = £172,353

This will require 172,353/12,500 = 13.8 contracts.

Hence the company could buy 14 contracts or 13 contracts combinedwith a forward contract for the balance.

his is the last article in the series the aim of which is to developan understanding of the effect foreign currency risk mayhave on a firm and of some of the techniques that are available

for eliminating or reducing that risk. In this article we examine themain characteristics of currency options and the way in whichcurrency options can be used to hedge currency risk.

Solution to Fidden

(i) Calculation of net sterling receipts/payments:

Preliminary workings.

Working 1: identify the transactions3 months: purchases for £116,000. Payment is in sterling therefore nocurrent risk.

Sales for $197,000 which needs to be hedged.

6 months: It is only necessary to hedge the net payment.

Purchases $447,000Less expected receipt from sales $154,000

Net $293,000

Working 2: calculation of forward rates:

$/£Spot 1.7106 1.7140less Premium 0.0082 0.0077

3 months forward 1.7024 1.7063

Spot 1.7106 1.7140Less Premium 0.0139 0.0134

6 months forward 1.6967 1.7006

(1) Forward Foreign exchange market3 months: Company will receive dollars so hedge risk by selling thedollars forward.

Sterling Proceeds in 3 months’ time will be:197,000/1.7063 = £115,454

6 months: Company will pay dollars therefore currency risk will behedged by buying the dollars forward.

£ cost = $293,000/1.6967 = £172,688

(2) The money market3 months’ time: The company will receive dollars therefore it isnecessary to borrow an appropriate amount of dollars now and sellthem at the spot rate. The dollar receipt will then be used to pay offthe dollar loan. (The relevant interest rate is 3/12 of the annual rate.

Nigel Brown BA FCA is a senior lecturer in Financial Strategyat the University of Wales College, Newport

T

TECHNICAL 2

The company would need to buy 14 £ put option contracts. (Thisalternative is considered first since the question states one should useoption contracts or forwards contracts.) If the spot rate in 6 monthstime is $1.6967 the company would exercise the put options.

$

Proceeds: 14 x 12,500 x 1.70 297,500

Less premium:(i.e. the price of the contract) 14 x 12500 x 0.0345 =(6,037)

less amount needed to pay supplier (293,000)

Additional dollars needed ($1,537)

Hence overall sterling cost: £

14 contracts @ 12,500 175,000

Additional $ purchased at spot rate1,537/1.6967 = 906

Total sterling cost £175,906

Note 1:It is possible to see, by inspection, that the exercise price of $1.70would result in a less favourable outcome:

$

Exercise price 1.70

i.e. price at which the £ are sold

Less the option premium 0.0345

Effective rate at which £s are being sold 1.6655

which is considerably less favourable than the forward rate of$1.6967/£.

Note 2:The company could have purchased 13 contracts and hedged theremaining risk by using a forward contract:

$

Proceeds from 13 contracts: 13 x 12,500 x 1.70 276,250

Less premium: 13 x 12,500 x 0.0345 (5,606)

amount needed to pay supplier (293,000)

Additional $s needed (22,356)

Purchase this requirement using a forward foreign exchange contract:

Cost 22,356/1.6967 = £13,176

Add sterling cost of the 13 contracts: 13 x 12,500 =162,500

Total sterling cost £175,676

This is slightly lower than the cost using 14 contracts reflecting thefact that the forward foreign exchange contract gives us a better ratein this example.

Note 3:In practice the option premium would be payable at the time ofpurchasing the contracts whereas under the forward contract the $s donot have to be paid for until the end of the 6 month period. The dollarcost of the premium would therefore be converted at the spot rate. Itwould also be necessary to take into account the opportunity cost offinancing the premium for the 6 months period which would not beincurred with a forward foreign exchange contract.

Exercise price: $1.80.Number of contracts required:Sterling equivalent at exchange rate of 1.80:

293,000/1.80 = £162,778

Number of contracts = 162,778/12,500 = 13.02 contracts.

In order to use currency option contracts only it will be necessary topurchase 14 sterling put option contracts:

£

Proceeds: 14 x 12500 x 1.80 315,000

Less premium: 14 x 12500 x .0932 (16,310)

Amount needed to pay the supplier (293,000)

Surplus $ 5,690

If the spot rate is $1.6967 it will be best to exercise the put options andsell the pound at $1.80.

£

Sterling cost: 14 x 12,500 = 175,000

Less proceeds from selling the surplus $ at thespot rate in 6 months time: 5,690/1.7006 = (3,346)

Net cost £171,654

Therefore overall the company would, with the benefit of hindsight,have been better off hedging the risk with currency options exercis-able at $1.80.

(iii) The main advantage of foreign currency options is that they offerthe firm the opportunity of not exercising the option. This is beneficialin two ways:

(1) If the spot exchange rate moves in the firm’s favour. The companycan take advantage of the favourable spot rate and allow the option tolapse. In this example if the dollar weakened to say $1.90/£ then thecurrency option would be allowed to lapse and the dollar purchasedat the spot rate of $1.90. Alternatively if the spot rate moved to say$1.60 the company could exercise the option at $1.80 or since theprice of the put option would go up the option could be sold at a profit.

(2) If the company is unsure as to whether the foreign currencytransaction will arise (as in the case of tendering for a contract) theoption contract allows the company to hedge the risk and allow theoption to lapse if the currency exchange is not needed (unless as in (1)a profit could be made by exercising the option at one rate and thentaking advantage of a more favourable spot rate.

Low cost or zero cost options(Sometimes referred to as exotic options or currency option deriva-tives). The aim of these exotic currency options is to reduce oreliminate the cost of buying the option i.e. the premium. In order toreduce the cost of buying an option the firm may have to accept areduction in the potential benefits from the option.

Boston optionThe premium is normally payable at the time of entering the optioncontract but can be postponed by having it built into the strike price(which will therefore be less favourable) if the currency option isexercised. If the option is not exercised the premium would bepayable when the option matures. The premium payable will beincreased to take into account the cost of funds for the period betweenthe time the premium is normally payable and the revised later

TECHNICAL

payment date.

A collarA collar (or cylinder or range forward) is a transaction which sets anupper and lower limit to the exchange rate in order to provide a hedgeagainst currency risk at a lower cost.

Example 4Rayer PLC, a company in the UK, is expecting to receive $220,000in three months time. The spot rate is $1.4500 – $1.4530/£. Rayer’sobjective is to hedge the downside risk which is the risk that the $ mayweaken. This it can achieve by buying an option to sell $s. Rayer PLChas been offered an over-the-counter put option (to sell $s) by itsbank. The option, which is exercisable in three months time, has astrike price of $1.49/£ and a premium payable of 5 cents.

The advantage of using the put option rather than other methods ofhedging, such as a forward contract, is that if the $ strengthens Rayercan allow the option to lapse and profit by selling the $s in the spotmarket for a higher £ proceeds. This is the upside risk.

The disadvantage of just using the put option is the premium Rayerhas to pay. This premium can be reduced by limiting the amount ofupside risk that Rayer is able to participate in. This is achieved byselling (writing) an option to the bank in order to receive a premiumfrom the bank. In effect Rayer can sell part of the upside risk to thebank.

Let us assume that Rayer PLC has the opportunity of reducing the costof this option to zero by writing a call option to sell the same numberof $s to the bank at $1.39/£ for a premium of 5 cents. Hence thepremium Rayer PLC receives for the option it writes compensatesfor the premium the company has to pay for the option it buys fromthe bank.

The combination of buying the $1.49/£ put and selling the $1.39/£ callis referred to as a collar. The effect of this collar is that, in return fora nil premium, the company has limited the exchange rate it achievesto a range of $1.39 to $1.49/£. The currency risk has been reduced atzero cost.

Valuation of currency optionsThe Black and Scholes option pricing model has been adapted invarious ways to value currency options. We need to be aware of thefactors which contribute to the value of a currency option. These are:

the spot rate and forward exchange rate for the period to which theoption applies. The forward rate reflects the interest rate differ-

ential: the difference between the domestic interest rate and theequivalent foreign interest rate.

the strike rate(the exchange rate at which the option is exercis-able). The premium is higher for a strike price which is morefavourable to the purchaser of the option.

the domestic risk free interest rate; this reflects the interest thatcould be earned on the option premium.

the standard deviation of the continuously compounded annualrate of movement in the exchange rate. The higher the risk themore chance there is that the option is worth exercising andtherefore the higher the premium will be.

the time to run before the option expires. As the time to expiryincreases the option premium increases.

the type of option contract. An American option (which isexercisable at any time to maturity) will involve a higher pre-mium than a European option (which is only exercisable atmaturity).

ConclusionCurrency risk is an important issue which is relevant to manycompanies in practice. We have looked at methods which can be usedfor hedging currency risk. Before making a final decision between thevarious hedging instruments it is necessary to ascertain the local taxtreatment of each instrument.

Currency risk is an extremely important topic in the paper 14Financial Strategy syllabus. For success in the examination it isadvisable to work through plenty of examination-style questions,preferably worked within an appropriate time limit.

ReferencesBrealey, R.A. and Myers, S.C., Principles of Corporate Finance,McGraw Hill, New York (1996).

Brown, N., Kaur, P., Maugham, S. and Rendall, J., Financial Strategy,Certified Accountants Educational Projects, London (1994).

Buckley, A., Multinational Finance, Prentice Hall, New York (1992).

French, D., Dictionary of Accounting Terms, The Institute of Char-tered Accountants in England and Wales, London (1991).

Demirag, I and Goddard, S., Financial Management for Interna-tional Business, McGraw Hill (1994).

Shapiro, A., Multinational Financial Management, Allyn and Bacon,Boston (1995).