ibf 2010 s 12-14 mod 4

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Foreign Exchange Exposure & Risk Management

Module 4Sessions 12 to 14

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Module Outline

SECTIONS1. Management of Transaction Exposure2. Management of Economic Exposure3. Management of Translation Exposure4. Interest Rate and Currency Swaps5. Futures and Options on Foreign Exchange

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1. Management of Transaction ExposureSection Outline

• Forward Market Hedge• Money Market Hedge• Options Market Hedge• Cross-Hedging Minor Currency Exposure• Hedging Contingent Exposure• Hedging Recurrent Exposure with Swap

Contracts

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Section Outline (continued)

• Hedging Through Invoice Currency• Hedging via Lead and Lag• Exposure Netting• Should the Firm Hedge?• What Risk Management Products do Firms

Use?

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Section 1 Objectives

• This Section discusses various methods available for the management of transaction exposure facing multinational firms.

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Three Types of Exposure

1. Transaction Exposure2. Economic Exposure3. Translation Exposure

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Transaction Exposure: definition

• Defined as sensitivity – Of realized domestic currency values– Of the firm’s contractual cash flows denominated

in foreign currencies – To unexpected exchange rate changes.

• Transaction exposure arises from fixed price contracting, even though exchange rates are changing randomly.

8

Economic Exposure: definition

• Defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates.

• All anticipated exchange rate changes are already reflected in firm’s value.

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Translation Exposure:

• Defined as the potential that the firm’s consolidated financial statements can be affected by changes in exchange rates.

• Consolidation involves translation of foreign subsidiaries’ financial statements from their local currencies to the home currency of the holding company.

10

Transaction exposures: Example

• A firm is subject to transaction exposure when it faces contractual cash flows that are fixed in foreign currencies.

• Assume that a US firm has sold its product to a German client on three month credit term and invoiced EUR 1 mn.

• When the US firm receives the money in 3 months, it will have to convert (if it has not already hedged) the EUR to USD, at the spot rate.

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Example

• So, the USD receipt from this sale becomes uncertain.– If the EUR appreciates, USD receipt will be higher– If the EUR depreciates, it will be lower.

• If the firm does nothing about the exposure (at the time of contracting the sale), it is speculating on the future course of the exchange rate.

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Example

• Hence, whenever a firm has receivables or payables denominated in foreign currency, it is subject to transaction exposure.

• The magnitude of the transaction exposure is the same as the amount of foreign currency that is receivable or payable.

13

Hedging Transaction Exposures

• Transaction exposures may be hedged using– Various financial contracts

• Forward market hedge• Money market hedge• Option market hedge• Swap market hedge

– Operational techniques.• Choice of invoice currency• Lead / lag strategy• Exposure netting

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Forward Market Hedge

• If you are going to owe foreign currency in the future, agree to buy the foreign currency now by entering into long position in a forward contract.

• If you are going to receive foreign currency in the future, agree to sell the foreign currency now by entering into short position in a forward contract.

15

You are a U.S. importer of British woolens and have just ordered next year’s inventory. Payment of £100M is due in one year.

Question: How can you fix the cash outflow in dollars?

Forward Market Hedge: an Example

Answer: One way is to put yourself in a position that delivers £100M in one year—a long forward contract on the pound.

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Money Market Hedge With the assumptions given in the table below, importer of British

woolens can hedge his £100 million payable with a money market hedge:

Borrow $112.05 million in the U.S.Translate $112.05 million into pounds at the spot rate S($/£) = $1.25/£Invest £89.64 million in the UK at i£ = 11.56% for one year.In one year your investment will have grown to £100 million.

Spot exchange rate S($/£) = $1.25/£

360-day forward rate F360($/£) = $1.20/£

U.S. discount rate i$ = 7.10%

British discount rate i£ = 11.56%

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Money Market Hedge

Where do the numbers come from?We owe our supplier £100 million in one year—so we know that we

need to have an investment with a future value of £100 million. Since i£ = 11.56% we need to invest £89.64 million at the start of the year.

How many dollars will it take to acquire £89.64 million at the start of the year if the spot rate S($/£) = $1.25/£?

1.1156

£100 £89.64

£1.00

$1.25£89.64$112.05

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Money Market Hedge

Suppose you want to hedge a payable in the amount of £y with a maturity of T:i. Borrow $x at t = 0 on a loan at a rate of i$ per year.

(Note that $x = £y/(1+ i£)T at the spot rate.)

ii. Exchange $x for £y/(1+ i£)T at the prevailing spot rate, invest £y/(1+ i£)T at i£ for the maturity of the payable to achieve £y.

At maturity, you will owe a $x(1 + i$). Your British investments will have grown enough to service

your payable and you will have no exposure to the pound.

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Another possibility

• Another money market route for hedging would be to – borrow USD for 1 year and – book a forward contract for buying GBP, to mature

at the end of 1 year.

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Money Market Hedge

Suppose you want to hedge a £ receivable in the amount of £y with a maturity of T:

i. Borrow £y/(1+ i£)T at t = 0.ii. Exchange £y/(1+ i£)T for $x at the prevailing spot rate.

At maturity, you will owe £ y which can be paid with your receivable.

You will have no exposure to the dollar-pound exchange rate.

21

Options Market Hedge

• Options provide a flexible hedge against the downside, while preserving the upside potential.

• To hedge a foreign currency payable, buy calls on the currency.– If the currency appreciates, your call option lets you

buy the currency at the exercise price of the call.• To hedge a foreign currency receivable, buy puts

on the currency.– If the currency depreciates, your put option lets you

sell the currency for the exercise price.

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Cross-Hedging Minor Currency Exposure

• The major currencies are the: U.S. dollar, Canadian dollar, British pound, Euro, Swiss franc, Mexican peso, and Japanese yen

• Everything else is a minor currency, like the Polish zloty.

• It is difficult, expensive, or impossible to use financial contracts to hedge exposure to minor currencies.

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Cross-Hedging Minor Currency Exposure

• Cross-Hedging involves hedging a position in one asset by taking a position in another asset.

• The effectiveness of cross-hedging depends upon how well the assets are correlated.– An example would be a U.S. importer with liabilities

in Czech koruna hedging with long or short forward contracts on the euro. If the koruna is expensive when the euro is expensive, or even if the koruna is cheap when the euro is expensive it can be a good hedge. But they need to co-vary in a predictable way.

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Hedging Contingent Exposure

• If only certain contingencies give rise to exposure, then options can be the only effective insurance.

• For example, if your firm is bidding on a hydroelectric dam project in Canada, you will need to hedge the Canadian-U.S. dollar exchange rate only if your bid wins the contract. Your firm can hedge this contingent risk with options.

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Hedging Recurrent Exposure with Swaps

• Recall that swap contracts can be viewed as a portfolio of forward contracts.

• Firms that have recurrent exposure can very likely hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along.

• It is also the case that swaps are available in longer-terms than futures and forwards.

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Hedging through Invoice Currency

• The firm can shift, share, or diversify:– shift exchange rate risk

• by invoicing foreign sales in home currency

– share exchange rate risk• by pro-rating the currency of the invoice between

foreign and home currencies

– diversify exchange rate risk• by using a market basket index

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Hedging via Lead and Lag

• If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency.

• If a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow.

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Exposure Netting

• A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions.– As an example, consider a U.S.company with Korean

won receivables and Japanese yen payables.– Since the won and the yen tend to move similarly

against USD, the firm can wait until these accounts come due and just buy yen with won.

– Even if it’s not a perfect hedge, it may be too expensive or impractical to hedge each currency separately.

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Exposure Netting

• Many multinational firms use a reinvoice center. Which is a financial subsidiary that nets out the intrafirm transactions.

• Once the residual exposure is determined, then the firm implements hedging.

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Exposure Netting: an Example

Consider a U.S. MNC with three subsidiaries and the following foreign exchange transactions:

$10 $35 $40$30

$20

$25 $60

$40$10

$30

$20$30

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Bilateral Netting would reduce the number of foreign exchange transactions by half:

$10 $35 $40$30

$20

$25 $60

$40$10

$30

$20$30

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$10 $35 $40$30$25

$60

$40$10

$10

$20$30

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$10 $35 $40$30$25

$60

$40$10

$10

$20$30

34



$10 $35 $10$25

$60

$40$10

$10

$20$30

35



$10 $35 $10$25

$60

$40$10

$10

$20$30

36



$10 $35 $10$25

$60

$40$10

$10

$10

37



$10 $35 $10$25

$60

$40$10

$10

$10

38



$25 $10$25

$60

$40$10

$10

$10

39



$25 $10$25

$60

$40$10

$10

$10

40



$25 $10$25

$20 $10

$10

$10

41



$25 $10$25

$20 $10

$10

$10

42



$25 $10$15 $20

$10

$10

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Consider simplifying the bilateral netting with multilateral netting:

$25 $10$15 $20

$10

$10

44



$15 $10$15 $20

$10

$10

$10

45



$15 $10$15 $20

$10

$10

46



$15 $10$15 $20

$10

$10

47



$15 $10$15 $30

$10

48



$15 $10$15 $30

$10

49



$15 $10$15 $30

$10

50



$10

$15

$30

$10

51



$10

$15

$30

$10

52



$10

$15

$30

$10

53



$10

$15

$30

54



$10

$15

$30

55



$15

$40

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Clearly, multilateral netting can simplify things greatly.

$15

$40

57


Compare this:

$10 $35 $40$30

$20

$25 $60

$40$10

$30

$20$30

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With this:

$15

$40

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Should the Firm Hedge?

• Not everyone agrees that a firm should hedge:– Hedging by the firm may not add to shareholder

wealth if the shareholders can manage exposure themselves.

– Hedging may not reduce the non-diversifiable risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges.

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• In the presence of market imperfections, the firm should hedge.– Information Asymmetry

• The managers may have better information than the shareholders.

– Differential Transactions Costs• The firm may be able to hedge at better prices than the

shareholders.– Default Costs

• Hedging may reduce the firm’s cost of capital if it reduces the probability of default.

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• Taxes can be a large market imperfection.– Corporations that face progressive tax rates may

find that they pay less in taxes if they can manage earnings by hedging than if they have “boom and bust” cycles in their earnings stream.

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What Risk Management Products do Firms Use?

• Most U.S. firms meet their exchange risk management needs with forward, swap, and options contracts.

• The greater the degree of international involvement, the greater the firm’s use of foreign exchange risk management.

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End Section 1

64

2. Management of Economic ExposureSection Outline

• Three Types of Exposure• How to Measure Economic Exposure• Operating Exposure: Definition• An Illustration of Operating Exposure• Determinants of Operating Exposure• Managing Operating Exposure

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Section Objectives

• This section provides a way to measure economic exposure, discusses its determinants, and presents methods for managing and hedging economic exposure.

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Three Types of Exposure

• Economic Exposure– Exchange rate risk as applied to the firm’s

competitive position.• Transaction Exposure

– Exchange rate risk as applied to the firm’s home currency cash flows. The subject of Section 1.

• Translation Exposure– Exchange rate risk as applied to the firm’s

consolidated financial statements. The subject of Section 3

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How to Measure Economic Exposure

• Economic exposure is – the sensitivity– of the future home currency value of the firm’s

assets and liabilities and the firm’s operating cash flow

– to random changes in exchange rates.• There exist statistical measurements of

sensitivity.

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• If a U.S. MNC were to run a regression on the dollar value (P) of its British assets on the dollar pound exchange rate, S($/£), the regression would be of the form:

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Regression of dollar value of British assets on the $/£ exchange rate

eSbaP Where • P is the dollar value of the assets• a is the regression constant• The regression coefficient b measures the sensitivity of the dollar value of the assets (P) to the exchange rate, S• S is the $/£ exchange rate, and• e is the random error term with mean zero.

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The exposure coefficient, b, is defined as follows:

)Var(

),Cov(

S

SPb

Where Cov(P,S) is the covariance between the dollar value of the asset and the exchange rate, and Var(S) is the variance of the exchange rate.

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The exposure coefficient shows that there are two sources of economic exposure: the variance of the exchange rate and the covariance between the dollar value of the asset and exchange rate.

)Var(

),Cov(

S

SPb

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Operating Exposure: Definition

• The effect of random changes in exchange rates on the firm’s competitive position

• An alternative definition of operating exposure is the extent to which the firm’s operating cash flows are affected by the exchange rate.

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Not readily measurable

• Operating exposure is not readily measurable, unlike the exposure of foreign currency denominated assets and liabilities, listed in the accounting statements.

• Operating exposure depends on effect of random exchange rate changes on the firm’s competitive position.

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• It is important that the firm properly manages operating exposure as well as asset exposure.

• In many cases, operating exposure may account for a larger portion of the firm’s total exposure, compared to contractual exposure.

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An Illustration of Operating Exposure

• There was an enormous shortage in the shipping market from Asia, due to the Asian currency crisis.

• This affected not only the shipping companies, which enjoyed “boom times”.

• But also retailers in Europe and US, who experienced increased costs and delays.

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An Illustration of Operating Exposure

• Note that the exposure for the retailers has two components:

The Competitive EffectDifficulties and increased costs of shipping.

The Conversion EffectLower dollar prices of imports due to foreign currency

exchange rate depreciation.

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Determinants of Operating Exposure

• Recall that operating exposure cannot be readily determined from the firm’s accounting statements as can transaction exposure.

• The firm’s operating exposure is determined by:

The firm’s ability to adjust its markets, product mix, and sourcing in response to exchange rate changes.

The market structure of inputs and products: how competitive or how monopolistic the markets facing the firm are.

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Managing Operating Exposure

• Selecting Low Cost Production Sites• Flexible Sourcing Policy• Diversification of the Market• R&D and Product Differentiation• Financial Hedging

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Selecting Low Cost Production Sites

• A firm may wish to diversify the location of their production sites to mitigate the effect of exchange rate movements.

e.g. Honda built North American factories in response to a strong yen, but later found itself importing more cars from Japan due to a weak yen.

80

Flexible Sourcing Policy

• Sourcing does not apply only to components, but also to “guest workers”.

e.g. Japan Air Lines hired foreign crews to remain competitive in international routes in the face of a strong yen, but later contemplated a reverse strategy in the face of a weak yen and rising domestic unemployment.

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Diversification of the Market

• Selling in multiple markets to take advantage of economies of scale and diversification of exchange rate risk.

82

R&D and Product Differentiation

• Successful R&D that allows for – cost cutting – enhanced productivity– product differentiation.

• Successful product differentiation gives the firm less elastic demand—which may translate into less exchange rate risk.

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Financial Hedging

• The goal is to stabilize the firm’s cash flows in the near term.

• Financial Hedging is distinct from operational hedging.

• Financial Hedging involves use of derivative securities such as currency swaps, futures, forwards, currency options, among others.

84

End Section Two

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3. Management of Translation ExposureSection Outline

• Translation Methods• FASB Statement 8• FASB Statement 52• Management of Translation Exposure• Empirical Analysis of the Change from FASB 8

to FASB 52

86

FASB

• FASB: Financial Accounting Standards Board• Since 1973, FASB has been the designated

organization in the private sector for establishing standards of financial accounting that govern the preparation of financial reports by nongovernmental entities.

87

FASB

• Those standards are officially recognized as authoritative by the Securities and Exchange Commission (SEC) and the American Institute of Certified Public Accountants.

88

• The SEC has statutory authority to establish financial accounting and reporting standards for publicly held companies.

• Throughout its history, however, the SEC’s policy has been to rely on the private sector for this function

89

Section Objectives

• This section discusses the impact that unanticipated changes in exchange rates may have on the consolidated financial statements of the multinational company.

90

Translation Methods

• Current/Noncurrent Method• Monetary/Nonmonetary Method• Temporal Method• Current Rate Method

91

Current/Noncurrent Method

• The underlying principle is that assets and liabilities should be translated based on their maturity.– Current assets translated at the spot rate.– Noncurrent assets translated at the historical rate in

effect when the item was first recorded on the books.• This method of foreign currency translation was

generally accepted in the United States from the 1930s until 1975, at which time FASB 8 became effective.

92

Summary of Statement No. 8

Accounting for the Translation of Foreign Currency Transactions and Foreign Currency Financial Statements (Issued 10/75)

Summary

This Statement requires that all amounts measured in a foreign currency be translated at the exchange rate in effect at the date at which the foreign currency transaction was measured. All exchange gains and losses were required to be included in income in the period in which they arose, i.e., when the rates changed.

Current/Noncurrent Method

– Current assets translated at the spot rate.

e.g. DM2=$1– Noncurrent

assets translated at the historical rate in effect when the item was first recorded on the books.

e.g. DM3=$1

Balance Sheet Local Currency

Current/ Noncurrent

Cash 2,100 DM $1,050 Inventory 1,500 DM $750 Net fixed assets 3,000 DM $1,000

Total Assets 6,600 DM $2,800 Current liabilities 1,200 DM $600 Long-Term debt 1,800 DM $600 Common stock 2,700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6,600 DM $2,800

14-93

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Monetary/Nonmonetary Method

• The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes.

• All monetary balance sheet accounts (cash, marketable securities, accounts receivable, etc.) of a foreign subsidiary are translated at the current exchange rate.

• All other (nonmonetary) balance sheet accounts (owners’ equity, land) are translated at the historical exchange rate in effect when the account was first recorded.

Monetary/Nonmonetary Method

• All monetary balance sheet accounts are translated at the current exchange rate. e.g. DM2=$1

• All other balance sheet accounts are translated at the historical exchange rate in effect when the account was first recorded. e.g.DM3=$1


Monetary/ Nonmonetary

Cash 2,100 DM $1,050 Inventory 1,500 DM $500 Net fixed assets 3,000 DM $1,000


Equity6,600 DM $2,400

14-95

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Temporal Method

• The underlying principle is that assets and liabilities should be translated based on how they are carried on the firm’s books.

• Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value.

• Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books.

Temporal Method

• Items carried on the books at their current value are translated at the spot exchange rate.

e.g. DM2=$1• Items that are

carried on the books at historical costs are translated at the historical exchange rates.

e.g. DM3=$1


Temporal

Cash 2,100 DM $1,050 Inventory 1,500 DM $900Net fixed assets 3,000 DM $1,000


Equity6,600 DM $2,400

14-97

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Current Rate Method

• All balance sheet items (except for stockholder’s equity) are translated at the current exchange rate.

• Very simple method in application.• A “plug” equity account named cumulative

translation adjustment is used to make the balance sheet balance.

Current Rate Method

• All balance sheet items (except for stockholder’s equity) are translated at the current exchange rate.

• A “plug” equity account named cumulative translation adjustment is used to make the balance sheet balance


Current Rate

Cash DM2,100 $1,050 Inventory DM1,500 $750 Net fixed assets DM3,000 $1,500

Total Assets DM6,600 $3,300 Current liabilities DM1,200 $600 Long-Term debt DM1,800 $900 Common stock DM2,700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6,600 $3,300

14-99

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1


Current/ Noncurrent


Temporal Current Rate

Cash 2,100 DM $1,050 $1,050 $1,050 $1,050 Inventory 1,500 DM $750 $500 $900 $750 Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500

Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300 Current liabilities

1,200 DM $600 $600 $600 $600

Long-Term debt

1,800 DM $600 $900 $900 $900

Common stock 2,700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6,600 DM $2,800 $2,550 $2,950 $3,300

Spot exchange rate

earnings

14-100



Current/ Noncurrent





1,200 DM $600 $600 $600 $600

Long-Term debt

1,800 DM $600 $900 $900 $900


900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540


Equity

6,600 DM $2,800 $2,550 $2,950 $3,300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate.

earnings

14-101



Current/ Noncurrent





1,200 DM $600 $600 $600 $600

Long-Term debt

1,800 DM $600 $900 $900 $900


900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540


Equity

6,600 DM $2,800 $2,550 $2,950 $3,300 historic

ratespot exchange rate.

earnings

14-102



Current/ Noncurrent





1,200 DM $600 $600 $600 $600

Long-Term debt

1,800 DM $600 $900 $900 $900


900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540


Equity

6,600 DM $2,800 $2,550 $2,950 $3,300 spot rate

earnings

14-103



Current/ Noncurrent





1,200 DM $600 $600 $600 $600

Long-Term debt

1,800 DM $600 $900 $900 $900


900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540


Equity

6,600 DM $2,800 $2,550 $2,950 $3,300

spot ratehistorical rate

earnings

14-104



Current/ Noncurrent





1,200 DM $600 $600 $600 $600

Long-Term debt

1,800 DM $600 $900 $900 $900


900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540


Equity

6,600 DM $2,800 $2,550 $2,950 $3,300

historical rate

earnings

14-105



Current/ Noncurrent





1,200 DM $600 $600 $600 $600

Long-Term debt

1,800 DM $600 $900 $900 $900


900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540


Equity

6,600 DM $2,800 $2,550 $2,950 $3,300

From income statement

earnings

14-106



Current/ Noncurrent





1,200 DM $600 $600 $600 $600

Long-Term debt

1,800 DM $600 $900 $900 $900


900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540


Equity

6,600 DM $2,800 $2,550 $2,950 $3,300 Under the current rate method, a “plug” equity account named

cumulative translation adjustment makes the balance sheet balance.

earnings

14-107


For notes, see Exhibit 14.1

Income StatementLocal

CurrencyCurrent/

Noncurrent Monetary/

NonmonetaryTemporal Current

Rate

Sales 10,000 DM $4,000 $4,000 $4,000 $4,000COGS 7,500 DM $3,000 $2,500 $3,000 $3,000Depreciation 1,000 DM $333 $333 $333 $400Net operating income 1,500 DM $667 $1,167 $667 $600Income tax (40%) 600 DM $267 $467 $267 $240Profit after tax 900 DM $400 $700 $400 $360

$300 -$550 $150Net income 900 DM $700 $150 $550 $360Dividends 0 DM $0 $0 $0 $0Addition to Retained

Earnings 900 DM $700 $150 $550 $360

Foreign exchange gain (loss)

Sales translate at average exchange rate over the period, DM2.50 = $1

14-108




CurrencyCurrent/



Rate



Earnings 900 DM $700 $150 $550 $360


Translate at DM2.50 = $1 Translate at new exchange rate, DM2.00 = $1

14-109




CurrencyCurrent/



Rate



Earnings 900 DM $700 $150 $550 $360


Translate at DM3 = $1 Translate at average exchange rate, DM2.5 = $1

14-110




CurrencyCurrent/



Rate



Earnings 900 DM $700 $150 $550 $360


Note the effect on after-tax profit.

14-111




CurrencyCurrent/



Rate



Earnings 900 DM $700 $150 $550 $360


Note the effect that foreign exchange gains (losses) has on net income.

14-112

113

FASB Statement 8

• Essentially the temporal method, with some subtleties.– Such as translating inventory at historical rates,

which is a hassle.• Requires taking foreign exchange gains and

losses through the income statement. • This leads to variability in reported earnings.• Which leads to irritated corporate executives.

114

FASB Statement 52

• The Mechanics of the FASB 52 Translation Process– Function Currency– Reporting Currency

• Highly Inflationary Economies

115

The Mechanics of FASB Statement 52

• Function Currency– The currency that the business is conducted in.

• Reporting Currency– The currency in which the MNC prepares its

consolidated financial statements.

116


• Two-Stage Process– First, determine in which currency the foreign entity

keeps its books.– If the local currency in which the foreign entity keeps

its books is not the functional currency, remeasurement into the functional currency is required.

– Second, when the foreign entity’s functional currency is not the same as the parent’s currency, the foreign entity’s books are translated using the current rate method.

Current Rate

Translation

Parent’s Currency

Foreign entity’s books

kept in?

Pare

nt’s

Curr

ency

Functional Currency?

Local currency Temporal Remeasurement

Parent’s currency

Nonparent

Currency Third currency


14-117

118

Highly Inflationary Economies

• Foreign entities are required to remeasure financial statements using the temporal method “as if the functional currency were the reporting currency”.

119

Management of Translation Exposure

• Translation Exposure vs. Transaction Exposure• Hedging Translation Exposure

– Balance Sheet Hedge– Derivatives Hedge

• Translation Exposure vs. Operating Exposure

120

Translation Exposure versus Transaction Exposure

• Translation Exposure– The effect that unanticipated changes in exchange

rates has on the firm’s consolidated financial statements.

– An accounting issue.• Transaction Exposure

– The effect that unanticipated changes in exchange rates has on the firm’s cash flows.

– A finance issue and the subject of Section 1.• It is generally not possible to eliminate both

translation exposure and transaction exposure.

121

Hedging Translation Exposure

• If the managers of the firm wish to manage their accounting numbers as well as their business, they have two methods for dealing with translation exposure.– Balance Sheet Hedge– Derivatives Hedge

122

Balance Sheet Hedge

• Eliminates the mismatch between net assets and net liabilities denominated in the same currency.

• May create transaction exposure, however.

123

Derivatives Hedge

• An example would be the use of forward contracts with a maturity of the reporting period to attempt to manage the accounting numbers.

• Using a derivatives hedge to control translation exposure really involves speculation about foreign exchange rate changes, however.

124

Translation Exposure versus Operating Exposure

• The effect that unanticipated changes in exchange rates has on the firm’s ongoing operations.

• Operating exposure is a substantive issue with which the management of the firm should concern itself with.

125

Empirical Analysis of the Change from FASB 8 to FASB 52

• There did not appear to be a revaluation of firms’ values following the change.

• This suggests that market participants do not react to cosmetic earnings changes.

• Other researchers have found similar results when investigating other accounting changes.

• This highlights the futility of attempting to manage translation gains and losses.

126

End Section 3

127

Section 4

Currency & Interest Rate Swaps

128

Section Objective:

•This section discusses currency and interest rate swaps, which are relatively new instruments for hedging long-term interest rate risk and foreign exchange risk.

129

Section Outline

• Types of Swaps• Size of the Swap Market• The Swap Bank• Interest Rate Swaps• Currency Swaps

130


• Swap Market Quotations• Variations of Basic Currency and Interest Rate

Swaps• Risks of Interest Rate and Currency Swaps• Swap Market Efficiency• Concluding Points About Swaps

131

Definitions

• In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals.

• There are two types of interest rate swaps:– Single currency interest rate swap

• “Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps.

– Cross-Currency interest rate swap• This is often called a currency swap; fixed for fixed rate

debt service in two (or more) currencies.

132

Size of the Swap Market

• In 1995 the notional principal of:interest rate swaps was $12,810,736,000,000.Currency swaps $1,197,395,000,000

• The most popular currencies are (1995):– U.S.$ (34%)– ¥ (23%)– DM (11%)– FF (10%)– £ (6%)

133

The Swap Bank

• A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties.

• The swap bank can serve as either a broker or a dealer.– As a broker, the swap bank matches counterparties

but does not assume any of the risks of the swap.– As a dealer, the swap bank stands ready to accept

either side of a currency swap, and then later lay off their risk, or match it with a counterparty.

134

An Example of an Interest Rate Swap

• Consider this example of a “plain vanilla” interest rate swap.

• Bank A is a AAA-rated international bank located in the U.K. who wishes to raise $10,000,000 to finance floating-rate Eurodollar loans.– Bank A is considering issuing 5-year fixed-rate

Eurodollar bonds at 10 percent.– It would make more sense to for the bank to issue

floating-rate notes at LIBOR to finance floating-rate Eurodollar loans.

135

Example

• Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life.– Firm B is considering issuing 5-year fixed-rate

Eurodollar bonds at 11.75 percent.– Alternatively, firm B can raise the money by

issuing 5-year FRNs at LIBOR + ½ percent.– Firm B would prefer to borrow at a fixed rate.

136


The borrowing opportunities of the two firms are shown in the following table:

COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%

Floating rate LIBOR + .5% LIBOR .5%

QSD = 1.25%

137

10 3/8%

LIBOR – 1/8%


Bank

A

Swap

Bank

The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on $10 million for 5 years


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%

138

10 3/8%

LIBOR – 1/8%


Bank

A

Swap

Bank

Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of

-10 3/8 + 10 + (LIBOR – 1/8) =

LIBOR – ½ % which is ½ % better than they can borrow floating without a swap.


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%

10%

½ % of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years.

139

LIBOR – ¼%

10 ½%


Swap

Bank

Company

B

The swap bank makes this offer to company B: You pay us 10 ½ % per year on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on $10 million for 5 years.


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%

140

LIBOR – ¼%

10 ½%


Swap

Bank

Company

B


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%

They can borrow externally at LIBOR + ½ % and have a net borrowing position of

10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½ % better than they can borrow floating without a swap.

LIBOR + ½%

Here’s what’s in it for B:½ % of $10,000,000 = $50,000 that’s quite a

cost savings per year for 5 years.

141

LIBOR + ½%

10 3/8 %

LIBOR – 1/8%LIBOR – ¼%

10 ½%

B saves ½ %


Bank

A

Swap

Bank

Company

B

A saves ½ %

The swap bank makes money too.


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%

10%

¼ % of $10 million = $25,000 per year

for 5 years.

LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8

10 ½ - 10 3/8 = 1/8

¼

142

LIBOR + ½%

10 3/8 %

LIBOR – 1/8%LIBOR – ¼%

10 ½%

B saves ½ %


Bank

A

Swap

Bank

Company

B

A saves ½ %

The swap bank makes ¼ %


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%

10% Note that the total savings ½ + ½ + ¼ = 1.25 % = QSD

143

The QSD

• The Quality Spread Differential represents the potential gains from the swap that can be shared between the counterparties and the swap bank.

• There is no reason to presume that the gains will be shared equally.

• In the above example, company B is less credit-worthy than bank A, so they probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.

144

An Example of a Currency Swap

• Suppose a U.S. MNC wants to finance a £10,000,000 expansion of a British plant.

• They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds.– This will give them exchange rate risk: financing a

sterling project with dollars.• They could borrow pounds in the international

bond market, but pay a lot since they are not as well known abroad.

145


• If they can find a British MNC with a mirror-image financing need they may both benefit from a swap.

• If the exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.

146


Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a U.K.–based multinational.

Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below. $ £

Company A 8.0% 11.6%

Company B 10.0% 12.0%

147


Company A

Swap

Bank

$8% £12%

$8%

£11% £12%

$9.4%

$ £


Company B 10.0% 12.0%

Company

B

148


Company A

Swap

Bank

$8% £12%

$8%

£11% £12%

$9.4%

$ £


Company B 10.0% 12.0%

Company

BA’s net position is to borrow at £11%

A saves £.6%

149


Company A

Swap

Bank

$8% £12%

$8%

£11% £12%

$9.4%

$ £


Company B 10.0% 12.0%

Company

BB’s net position is to borrow at $9.4%

B saves $.6%

150


Company A

Swap

Bank

$8% £12%

$8%

£11% £12%

$9.4%

$ £


Company B 10.0% 12.0%

Company

B

The swap bank makes money too:

At S0($/£) = $1.60/£, that is a gain of $124,000 per year for 5 years.

The swap bank faces exchange rate risk, but maybe they can lay it off in another swap.

1.4% of $16 million financed with 1% of £10

million per year for 5 years.

151

A is the more credit-worthy of the two firms.

Comparative Advantage as the Basis for Swaps

$ £


Company B 10.0% 12.0%

A has a comparative advantage in borrowing in dollars.

B has a comparative advantage in borrowing in pounds.

A pays 2% less to borrow in dollars than BA pays .4% less to borrow in pounds than B:

152

B has a comparative advantage in borrowing in £.


$ £


Company B 10.0% 12.0%

B pays 2% more to borrow in dollars than A

B pays only .4% more to borrow in pounds than A:

153

A has a comparative advantage in borrowing in dollars.

B has a comparative advantage in borrowing in pounds.

If they borrow according to their comparative advantage and then swap, there will be gains for both parties.


154

Swap Market Quotations

• Swap banks will tailor the terms of interest rate and currency swaps to customers’ needs

• They also make a market in “plain vanilla” swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread.

• For example, 6.60 — 6.85 means the swap bank will pay fixed-rate DM payments at 6.60% against receiving dollar LIBOR or it will receive fixed-rate DM payments at 6.85% against receiving dollar LIBOR.

155

Variations of Basic Currency and Interest Rate Swaps

• Currency Swaps– fixed for fixed – fixed for floating– floating for floating– amortizing

• Interest Rate Swaps – zero-for floating– floating for floating

• For a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit.

156

Risks of Interest Rate and Currency Swaps

• Interest Rate Risk– Interest rates might move against the swap bank

after it has only gotten half of a swap on the books, or if it has an unhedged position.

• Basis Risk– If the floating rates of the two counterparties are

not pegged to the same index.• Exchange rate Risk

– In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.

157

Risks of Interest Rate and Currency Swaps (continued)

• Credit Risk– This is the major risk faced by a swap dealer—the risk

that a counter party will default on its end of the swap.• Mismatch Risk

– It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time.

• Sovereign Risk– The risk that a country will impose exchange rate

restrictions that will interfere with performance on the swap.

158

Pricing a Swap

• A swap is a derivative security so it can be priced in terms of the underlying assets:

• How to:– Plain vanilla fixed for floating swap gets valued just

like a bond.– Currency swap gets valued just like a nest of

currency futures.

159

Swap Market Efficiency

• Swaps offer market completeness and that has accounted for their existence and growth.

• Swaps assist in tailoring financing to the type desired by a particular borrower.

• Not all types of debt instruments are available to all types of borrowers

• Hence both counterparties can benefit (as well as the swap dealer) through financing that is more suitable for their asset maturity structures.

160

Concluding Remarks

• The growth of the swap market has been astounding.

• Swaps are off-the-books transactions.• Swaps have become an important source of

revenue and risk for banks

161

End Section 4

162

Section 5

Futures and Options on Foreign Exchange

163

Section Objective:

• This section discusses exchange-traded currency futures contracts, options contracts, and options on currency futures.

164

Section Outline

• Futures Contracts: Preliminaries• Currency Futures Markets• Basic Currency Futures Relationships• Eurodollar Interest Rate Futures Contracts• Options Contracts: Preliminaries• Currency Options Markets• Currency Futures Options

165


• Basic Option Pricing Relationships at Expiry• American Option Pricing Relationships• European Option Pricing Relationships• Binomial Option Pricing Model• European Option Pricing Model• Empirical Tests of Currency Option Models

166

Futures Contracts: Preliminaries

• A futures contract is like a forward contract:– It specifies that a certain currency will be

exchanged for another at a specified time in the future at prices specified today.

• A futures contract is different from a forward contract:– Futures are standardized contracts trading on

organized exchanges with daily resettlement through a clearinghouse.

167

Futures Contracts: Preliminaries

• Standardizing Features:– Contract Size– Delivery Month– Daily resettlement

• Initial Margin (about 4% of contract value, cash or T-bills held at your brokers).

168

Daily Resettlement: An Example

• Suppose you want to speculate on a rise in the $/¥ exchange rate (specifically you think that the dollar will appreciate).

Currently $1 = ¥140. The 3-month forward price is $1=¥150.

Currency per U.S. $ equivalent U.S. $

Wed Tue Wed TueJapan (yen) 0.007142857 0.007194245 140 1391-month forward 0.006993007 0.007042254 143 1423-months forward 0.006666667 0.006711409 150 1496-months forward 0.00625 0.006289308 160 159

169


• Currently $1 = ¥140 and it appears that the dollar is strengthening.

• If you enter into a 3-month futures contract to sell ¥ at the rate of $1 = ¥150 you will make money if the yen depreciates. The contract size is ¥12,500,000

• Your initial margin is 4% of the contract value:

¥150

$10¥12,500,00.04 $3,333.33

170


If tomorrow, the futures rate closes at $1 = ¥149, then your position’s value drops.

Your original agreement was to sell ¥12,500,000 and receive $83,333.33

But now ¥12,500,000 is worth $83,892.62

¥149

$10¥12,500,0062.892,83$

You have lost $559.28 overnight.

171


• The $559.28 comes out of your $3,333.33 margin account, leaving $2,774.05

• This is short of the $3,355.70 required for a new position.

¥149

$10¥12,500,00.04 $3,355.70

Your broker will let you slide until you run through your maintenance margin. Then you must post additional funds or your position will be closed out. This is usually done with a reversing trade.

172

Currency Futures Markets

• The Chicago Mercantile Exchange (CME) is by far the largest.

• Others include:– The Philadelphia Board of Trade (PBOT)– The MidAmerica commodities Exchange– The Tokyo International Financial Futures

Exchange– The London International Financial Futures

Exchange

173

The Chicago Mercantile Exchange

• Expiry cycle: March, June, September, December.

• Delivery date 3rd Wednesday of delivery month.

• Last trading day is the second business day preceding the delivery day.

• CME hours 7:20 a.m. to 2:00 p.m. CST.

174

Globex

• An electronic trading platform used for derivative, futures, and commodity contracts.

• Globex runs continuously, so it is not restricted by borders or time zones.

• Globex was introduced in 1992 by Reuters. • The popularity of this platform has declined as

exchanges such as the CBOT have moved towards different vehicles for matching and executing trades.

175

CME After Hours

• Extended-hours trading on GLOBEX runs from 2:30 p.m. to 4:00 p.m dinner break and then back at it from 6:00 p.m. to 6:00 a.m. CST.

• Singapore International Monetary Exchange (SIMEX) offer interchangeable contracts.

• There’s other markets, but none are close to CME and SIMEX trading volume.

176

SIMEX and CME

• Futures contracts that trade on SIMEX use the CME’s final settlement price.

• These two exchanges designed a system that permits futures contracts traded on SIMEX to be completely interchangeable with contracts that trade on the CME.

• The contract specifications on both exchanges are identical except for trading hours.

177

SIMEX and CME

• However, a contract that trades on the floor of the CME can be transferred through the mutual offset system to SIMEX, and cancelled there.

• Similarly, a contract traded on the floor of SIMEX can be transferred to the CME.

• As a result, the trading hours of these contracts extends beyond the trading hours of either exchange.

178

Basic Currency Futures Relationships

• Open Interest refers to the number of contracts outstanding for a particular delivery month.

• Open interest is a good proxy for demand for a contract.

• Some refer to open interest as the depth of the market. The breadth of the market would be how many different contracts (expiry month, currency) are outstanding.

179

Reading a Futures Quote Open Hi Lo Settle Change Lifetime

High Lifetime

Low Open

Interest

Sept .9282 .9325 .9276 .9309 +.0027 1.2085 .8636 74,639

Expiry monthOpening price

Highest price that day

Lowest price that dayClosing price

Daily ChangeHighest and lowest

prices over the lifetime of the

contract.

Number of open contracts

180

Eurodollar Interest Rate Futures Contracts

• Widely used futures contract for hedging short-term U.S. dollar interest rate risk.

• The underlying asset is a hypothetical $1,000,000 90-day Eurodollar deposit—the contract is cash settled.

• Traded on the CME and the Singapore International Monetary Exchange.

• The contract trades in the March, June, September and December cycle.

181

Reading Eurodollar Futures Quotes

EURODOLLAR (CME)—$1 million; pts of 100%

Open High Low Settle Chg YieldSettle Change

Open Interest

July 94.69 94.69 94.68 94.68 -.01 5.32 +.01 47,417

Eurodollar futures prices are stated as an index number of three-month LIBOR calculated as F = 100-LIBOR.The closing price for the July contract is 94.68 thus the implied yield is 5.32 percent = 100 – 94.68

The change was .01 percent of $1 million representing $100 on an annual basis. Since it is a 3-month contract one basis point corresponds to a $25 price change.

182

Eurodollar futures

• Contract Size = US$ 1,000,000• 1 % p.a -> US$ 10,000 p.a• 1 bp = 0.01 % -> US$ 100 p.a. -> US$ 25 per

quarter per contract.

183

Options Contracts: Preliminaries

• An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset in the future, at prices agreed upon today.

• Calls vs. Puts– Call options give the holder the right, but not the

obligation, to buy a given quantity of some asset at some time in the future, at prices agreed upon today.

– Put options give the holder the right, but not the obligation, to sell a given quantity of some asset at some time in the future, at prices agreed upon today.

184


• European vs. American options– European options can only be exercised on the

expiration date.– American options can be exercised at any time up

to and including the expiration date.– Since this option to exercise early generally has

value, American options are usually worth more than European options, other things equal.

185


• In-the-money– The exercise price is less than the spot price of the

underlying asset.• At-the-money

– The exercise price is equal to the spot price of the underlying asset.

• Out-of-the-money– The exercise price is more than the spot price of

the underlying asset.

186


• Intrinsic Value– The difference between the exercise price of the

option and the spot price of the underlying asset.• Speculative Value

– The difference between the option premium and the intrinsic value of the option.

Option Premium=

Intrinsic Value Speculative Value+

187

Currency Options Markets

• PHLX• HKFE• 20-hour trading day.• OTC volume is much bigger than exchange

volume.• Trading is in seven major currencies plus the

euro against the U.S. dollar.

PHLX Currency Option Specifications

Currency Contract SizeAustralian dollar AD50,000British pound £31,250Canadian dollar CD50,000Deutsche mark DM62,500French franc FF250,000Japanese yen ¥6,250,000Swiss franc SF62,500Euro 62,500

14-188

189

Currency Futures Options

• Are an option on a currency futures contract.• Exercise of a currency futures option results in

a long futures position for the holder of a call or the writer of a put.

• Exercise of a currency futures option results in a short futures position for the seller of a call or the buyer of a put.

• If the futures position is not offset prior to its expiration, foreign currency will change hands.

190

Basic Option Pricing Relationships at Expiry

• At expiry, an American call option is worth the same as a European option with the same characteristics.

• If the call is in-the-money, it is worth ST – E.• If the call is out-of-the-money, it is worthless.

CaT = CeT = Max[ST - E, 0]

191

Basic Option Pricing Relationships at Expiry

• At expiry, an American put option is worth the same as a European option with the same characteristics.

• If the put is in-the-money, it is worth E - ST.• If the put is out-of-the-money, it is worthless.

PaT = PeT = Max[E - ST, 0]

192

Basic Option Profit Profiles


profit

loss

E E+CST

Long 1 call

193



profit

loss

EE+C

STshort 1 call

194


PaT = PeT = Max[E - ST, 0]

profit

loss

EE - p

ST

long 1 put

195



profit

loss

EST

Short 1 put

E - p

196

American Option Pricing Relationships

• With an American option, you can do everything that you can do with a European option—this option to exercise early has value.

CaT > CeT = Max[ST - E, 0]

PaT > PeT = Max[E - ST, 0]

197

Market Value, Time Value and Intrinsic Value for an American Call

CaT > Max[ST - E, 0]

Profit

loss

E ST

Market Value

Intrinsic value

S T - E

Time value

Out-of-the-money In-the-money

198

European Option Pricing Relationships

Consider two investments1 Buy a call option on the British pound futures

contract. The cash flow today is -Ce

2 Replicate the upside payoff of the call by 1 Borrowing the present value of the exercise price

of the call in the U.S. at i$ The cash flow today is E /(1 + i$)

2 Lending the present value of ST at i£ The cash flow is - ST /(1 + i£)

199


When the option is in-the-money both strategies have the same payoff.

When the option is out-of-the-money it has a higher payoff than the borrowing and lending strategy.

Thus:

0,)1()1(

max$£

i

E

i

SC T

e

200


Using a similar portfolio to replicate the upside potential of a put, we can show that:

0,)1()1(

max£$

i

S

i

EP T

e

201

Binomial Option Pricing Model

Imagine a simple world where the dollar-euro exchange rate is S0($/ ) = $1 today and in the next year, S1($/ ) is either $1.1 or $.90.

$1

$.90

$1.10

S0($/ ) S1($/ )

202


$1

$.90

$1.10

S0($/ ) S1($/ )$.10

$0

C1($/ )

A call option on the euro with exercise price S0($/ ) = $1 will have the following payoffs.

203

$1

$.90

$1.10

S0($/ ) S1($/ )$.10

$0

C1($/ )


• We can replicate the payoffs of the call option. With a levered position in the euro.

204

$1

$.90

$1.10

S0($/ ) S1($/ )$.10

$0

C1($/ )


debt

-$.90

-$.90

portfolio

$.20

$.00

Borrow the present value of $.90 today and buy 1. Your net payoff in one period is either $.2 or $0.

205


$1

$.90

$1.10

S0($/ ) S1($/ )

$.10

$0

C1($/ )debt

-$.90

-$.90

portfolio

$.20

$.00

• The portfolio has twice the option’s payoff so the portfolio is worth twice the call option value.

206

$1

$.90

$1.10

S0($/ ) S1($/ )

$.10

$0

C1($/ )debt

-$.90

-$.90

portfolio

$.20

$.00


The portfolio value today is today’s value of one euro less the present value of a $.90 debt: )1(

90$.1$

$i

207


$1

$.90

$1.10

S0($/ ) S1($/ )

$.10

$0

C1($/ )debt

-$.90

-$.90

portfolio

$.20

$.00

We can value the option as half of the value of the portfolio:

)1(

90$.1$

2

1

$0 i

C

208


• The most important lesson from the binomial option pricing model is:

the replicating portfolio intuition. Many derivative securities can be valued by valuing portfolios of primitive securities

when those portfolios have the same payoffs as the derivative securities.

209

European Option Pricing Formula

• We can use the replicating portfolio intuition developed in the binomial option pricing formula to generate a faster-to-use model that addresses a much more realistic world.

210


The model is TredNEdNFC $)]()([ 210

WhereC0 = the value of a European option at time t = 0

TrrteSF )( £$

r$ = the interest rate available in the U.S.

r£ = the interest rate available in the foreign country—in this case the U.K.

,5.)/ln( 2

1T

TEFd

Tdd 12

211


Find the value of a six-month call option on the British pound with an exercise price of $1.50 = £1

The current value of a pound is $1.60The interest rate available in the U.S. is r$ = 5%.The interest rate in the U.K. is r£ = 7%.The option maturity is 6 months (half of a year).The volatility of the $/£ exchange rate is 30% p.a.Before we start, note that the intrinsic value of the option

is $.10—our answer must be at least that.

212


Let’s try our hand at using the model. If you have a calculator handy, follow along.

Then, calculate d1 and d2

106066.05.4.

5.)4.0(5.)50.1/485075.1ln(5.)/ln( 22

1

T

TEFd

First calculate

485075.150.1 50.0)07.05(.)( £$ eeSF Trrt

176878.05.4.106066.012 Tdd

213


N(d1) = N(0.106066) = .5422

N(d2) = N(-0.1768) = 0.4298TredNEdNFC $)]()([ 210

157.0$]4298.50.15422.485075.1[ 5.*05.0 eC

485075.1F

106066.01 d

176878.02 d

214

Option Value Determinants

Call Put1. Exchange rate + –2. Exercise price – +3. Interest rate in U.S. + –4. Interest rate in other country + –5. Variability in exchange rate + +6. Expiration date + +

The value of a call option C0 must fall within

max (S0 – E, 0) < C0 < S0.

The precise position will depend on the above factors.

215

Empirical Tests

The European option pricing model works fairly well in pricing American currency options.

It works best for out-of-the-money and at-the-money options.

When options are in-the-money, the European option pricing model tends to underprice American options.

216

End Section Five

ibf 2010 s 12-14 mod 4

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