fx risk mng all slides
TRANSCRIPT
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Master in International Business
FOREIGN EXCHANGERISK MANAGEMENT
Lecturer tefan N M Ungureanu, PhD
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Course Outline
1. The foreign exchange market
2. International parity conditions
3. Foreign currency derivatives
4. Measuring and managing transaction exposure tocurrency risk
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Exchange rates and intl. business
Any time a transaction has crossed borders, it hasbeen subject to the influence of changes inexchange rates
Basic problem posed by exchange rates on cross-
border transactions: money across borders has nofixed value
Our course purposes:
to understand, categorize and define the types ofexchange rate risks that firms face across borders
to address how managers can plan for, manage, andhedge these risks
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Foreign exchange reported losses
Company Country Loss (in millions) PeriodAbbot Lab. USA USD 41.3 1993
Bank Negara Malaysia USD 2,100 1993
Citizen Japan JPY 15 Q2, 2002
Penoles Mexico USD 15.8 2000
ReadersDigest USA USD 2.2 Q1-Q3, 1994
PepsiCo USA USD 53 1998
Toyota Japan JPY 1,200 Q1-Q4, 2004
Gazprom Russia USD 4,500 2009, Q1
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Exchange rate fluctuations
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Exchange rate fluctuations
USD/EUR, January 1999 October 2011
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Exchange rate fluctuations
RON/EUR, July 2005 October 2011
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Exchange rate fluctuations
Source: McKinsey Global InstituteGlobal capital markets: Entering a new era, October 2009
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Before a manager can start to grapple with the
effective or potential consequences of exchange
rates changes on the business, it is necessary to
understand some of the underlying forces in the
foreign exchange market
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FOREIGN EXCHANGERISK MANAGEMENT
Topic 1 Foreign Exchange Market (FOREX)
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Topic 1 Outline
1. Currency terminology
2. FOREX organization and structure
3. The spot market
4. The forward market
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1. Currency terminology
Exchange rate / foreign currency exchange rate
Exchange rate regime/system
Exchange rate regimes
Free float Managed float
Fixed-rate regime
Devaluation versus depreciation Revaluation versus appreciation
Hard versus soft currencies
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Free Float
The value of a free floating exchange rate isexclusively established by demand and supply inthe foreign exchange market, with no outsideinterventions
Over time, the exchange rate will fluctuaterandomlyas market participants assess and reactto new information
Central bank (monetary authority) does notintervene in the process of currency valuedetermination
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Managed Float
Assumes central bank intervention, whichmanipulates the exchange rate given itsobjectives:
smoothing out exchange rate fluctuations
leaning against the wind
unofficial pegging of exchange rate
Central bank support of the rate is not automatic
Central bank reserves fluctuate quite heavily, buttypically around a certain level
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Fixed-Rate System
Currencies maintained within a band (% of changearound a central value -parity)
Central banks actively buy or sell their currenciesin the foreign exchange market whenever the
exchange rate deviated from par value In order to intervene on the FOREX, central bank
maintains reserves, which absorb the burden ofexchange rate adjustment high volatility ofreserves
Currency devaluation and revaluation is common
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2. Organization of FOREX
The first global 24-hour market in the world and by farthe largest OTC market 2 tiers:
Wholesale tierliquid inter-bank market
60 to 70% of transactions
about 700 banks worldwide stand ready to make a marketin foreign exchange
there are FX brokerswho match buy and sell orders but donot carry inventory and FX specialists(dealers)
most inter-bank dealing is by phone & computer networks there are corresponding banking relationships that
facilitate the functioning of the market
Retail tierclient market
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FOREX Participants
Bank and non-bank FX dealers market makers
Individuals and firms conducting commercial andinvestment transactions
Speculators and arbitragers
Central banks and treasuries
FX brokers
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Markets by delivery date
Spot (rate: St)
immediate(t) payment and delivery of currencies
settlement day : 1 or 2 working days
Forward (rate: Ft,T)
payment and delivery at some future date (T)
common maturities: 30, 90, 180, 270, and 360 days,and up to ten years
FX swap transactions involve both a spot and a forward transaction, for
instance, buy spot and sell forward, or sell spot andbuy forward, with the same counterparty
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Motives for FX transactions
Arbitrage is the simultaneous, or nearly simultaneous,purchase of securities in one market for sale in anothermarket with the expectation of a risk-free profit
Speculation entails more than the assumption of a
risky position it implies financial transactionsundertaken when an individuals expectations differfrom the markets expectation
Hedging is the avoidance of foreign exchange risk byentering into a transaction that lays off the risk to awilling counter party
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Foreign exchange market turnover
Global net turnover (2010) = US$ 3,210 billion per business day
Turnover = total US dollar value of all spot, outright forward, andforeign exchange swap transactions concluded (not settled) during themonth of April
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Currency distribution of FOREX
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FOREX turnover by geographicaldistribution, 2010
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3. Spot Exchange Markets
1. Definition of exchange rates
2. Quoting conventions
3. Bid and ask rates
4. Cross exchange rates
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Definition of Exchange Rates
Exchange rate
amount of currency that one has to pay in order tobuy one unit of another currency
amount of currency that one receives when sellingone unit of another currency
Which money is being bought or sold? dependson home currency
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Quoting conventions
Professional dealers and brokers quote currenciesin either of two ways:
direct basis HC/FCsuch as Canadian dollars perUS dollar or Romanian leu per US dollar when thisquote involves the USD as HC :American terms
indirect basis FC/HCsuch as US dollar per BritishPound (GBP) when this quote involves the USD asHC : European terms
Most currencies are quoted on a direct basis, theexception being some currencies from the formerCommonwealth - the most important ones are theBritish poundand the Euro
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Quoting conventions
Every exchange transaction involves two currencies
1.5625 CHF/USD
A trader always buys or sells a fixed amount of thebasecurrency
How to interpret changes in exchange rates: numerator increases the base currency is
strengthening the base currency appreciates and theterms currency depreciates
numerator decreasesthe base currency is weakeningthe base currency depreciates and the terms currencyappreciates
base/quoted currencyterms/counter currency
numerator denominator
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Measuring a change in spot rates
Example: 1.5625 CHF/USD to 1.2800 CHF/USD % change in the value of the USD in terms of the CHF is:
% change in the value of the CHF in terms of the USD is:
18.08%
1.5625
1.5625-1.2800
rateBeginning
rateBeginning-rateEnding
22.09%1.2800
1.2800-1.5625
rateEnding
rateEnding-rateBeginning
USD depreciatedby 18.08% against the CHF
CHF appreciatedby 22.09% against the USD
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Spot bid and ask quotations
Market makers will quote the rate at which they arewilling to buy the base currency (Bid) (in terms of theother currency) and the rate at which they are readyto sell the basecurrency (Ask)
1.5130 - 1.5145 CHF/USD
Often the quotation will be shortened to 30/45. Thesenumbers are points a point is the fourth place tothe right of the decimal point (0.0001)
The difference between the bid and the ask price isthe spread SPREAD = S
ask,t
Sbid,t
> 0
Market maker sells USDMarket maker buys USD
Client sells USD Client buys USD
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Inverting exchange rates in the
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Inverting exchange rates in thepresence of spreads
Rule: the inverse of a bid quote is an ask quote, and vice
versa
ask,t
bid,tS(USD/CAD)
1S(CAD/USD)
bid,t
ask,tS(USD/CAD)
1S(CAD/USD)
Example: 1.3727 1.3730 CAD/USD
0.7283 - 0.7285 USD/CAD
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Cross exchange rates
Cross exchange rate = exchange rate between 2currency pairs where neither currency is the USD
USD/GBPtS(EUR/USD)tS(EUR/GBP)tS
Example: S(EUR/USD) = 1.2823
S(USD/GBP) = 1.4128
Cross exchange rate EUR/GBP is:
S(EUR/GBP) = 1.2823 x 1.4128 = 1.8116
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3. Forward Markets
1. Forward market quotations
2. Forward premium or discount
3. Interest rate parity
4. Long and short forward positions
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Forward market quotations
Buying and selling currencies for delivery on astipulated future date, at a rate agreed upon now
Practice: forward price spot
Premium versus discount When base currency is more expensive in the future
than it is now in terms of the other currency, theformer is said to be at a premium (assuming direct
quotes)
When base currency is less expensive, it is said tostand at a discount(assuming direct quotes)
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Forward market quotations
Outright rate
Spot 1.5130 - 1.5145 CHF/USD
3-month forward 1.5053 - 1.5078
Swap points
Spot 1.5130 - 1.5145 CHF/USD
3-month forward 77 - 67
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Forward market quotations
Recovering the outright forward price from theswap points rule :
1. If the points are decreasing, subtract from the spotprice
2. If the points are increasing, add to the spot price
Spread on
spot
15
Spread on
forward points
10
Spread on
outright forward
25
+ =
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Forward market quotations
Suppose you read the following quotations: Spot 1.4815 29 CAD/USD
3-month forward 40 38
Spot 0.6556 70 CHF/USD
6-month forward 51 64
The 3-month CAD/USD outright forward rate is: F(CAD/USD) = 1.4775 - 1.4791
The 6-month CHF/USD outright forward rate is: F(CHF/USD) = 0.6607 0.6634
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Forward quotations in percentage terms
100n
360
S
S-FscountPremium/Di
F - forward price
S - spot price n - number of days in the contract
Discount on base currency is different from thepremium on terms currency
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Forward quotations in percentage terms
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Forward quotations in percentage terms -example
Suppose the following:
Spot rate 1.5437 CHF/USD
3-month forward rate 1.5398 CHF/USD
The discount on the USDis:
Thepremium on CHFis:
-1.01%p.a.=10090
360
1.5437
1.5437-1.5398
.a.p1.013%=10090
360
1.5398
1.5398-1.5437
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Interest rate parity
Interest rate parity(IRP) is an arbitrage condition that
establishes a relationship between spot and forwardexchange rates, and risk-equivalent domestic andforeign nominal interest rates
Forward premium/discount Interest differential
between currencies
The currency with the higher interest rate is at adiscount, the one with the lower interest rate is at apremium
)i+(1
)i+(1
S
F
FC
HC
HC/FC
HC/FC
FCHC i-iS
SF
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Interest rate parity
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Interest Rate Parity example
90-day CHF interest rate 4%
90-day USD interest rate 8%
Spot rate (CHF/USD) 1.4800
90-day forward rate 1.4655
Is 1.4655 the correct forward price?
Note that because we do not use bid and ask rates, buyingand selling, as well as borrowing and lending, are done atthe same rates
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Interest Rate Parity example
Start End
S=CHF1.4800/$
CHF1,480,000
$1,000,000 $1,020,000
CHF1,494,000
x 1.02
x 1.01
i$= 8.00% p.a.
(2.00% per 90 days)
ICHF= 4.00% p.a.(1.00% per 90 days)
Dollar money market
Swiss franc money market
90 daysF90 =CHF1.4655/$
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IRP and Covered Interest Arbitrage
If IRP failed to hold, an arbitragewould exist Example: Consider the following set of foreign
and domestic interest rates and spot and forwardexchange rates
Spot exchange rate S($/) = 1.25
360-day forward rate F360($/) = 1.20
US interest rate i$ = 7.10% p.a.
UK interest rate i= 11.56% p.a.
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IRP and Covered Interest Arbitrage
According to IRP only one 360-day forward rate,F360($/), can exist this is
Why?
If F360($/) $1.20/, an arbitrageur could
engage in covered interest arbitrage (CIA)and make money with one of the followingstrategies:
$/1.200.115610.071011.25
360F
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Arbitrage Strategy 1
If F360($/) > $1.20/1. Borrow $1,000 at t= 0 at i$= 7.10%.
2. Exchange $1,000 for 800 at the prevailing spotrate, (note that 800 = $1,000$1.25/)
3. Invest 800 at 11.56% (i) for one year to achieve892.48
4. Translate 892.48 back into dollars if F360($/) >$1.20/, 892.48 will be more than enough torepay your dollar obligation of $1,071
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Arbitrage Strategy 2
IfF
360($/) < $1.20/
1. Borrow 800 at t= 0 at i= 11.56% .
2. Exchange 800 for $1,000 at the prevailing spotrate,
3. Invest $1,000 at 7.1% for one year to achieve$1,071.
4. Translate $1,071 back into pounds if F360($/) Ft,t+1buyer gains
St+1< Ft,t+1buyer looses
Sell a currency = taking a short position
St+1> Ft,t+1seller looses
St+1< Ft,t+1seller gains
Example: F180 days= 105 /$
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Payoff profiles for forward contracts
loss
0S180(/$)
F180(/$) = 105
120
If, in 180 days, S180(/$) = 120, the long willmake a profit by selling $ at S180(/$) = 120and receiving $ at F180(/$) = 105.
15
profitlong position
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Payoff profiles for forward contracts
If, in 180 days, S180
(/$) = 120, the shortwill loseby having to buy $ at S180(/$) =120 and delivering $ at F180(/$) = 105.
loss
0
F180(/$) = 105
profit
120
15
S180(/$)
short position
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Payoff profiles for forward contracts
0S180(/$)
F180(/$) = 105
short position
long position
Since this is a zero-sum game,
the long position payoff is theopposite of the short.
loss
profit
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FOREIGN EXCHANGERISK MANAGEMENT
Topic 2 International Parity Conditions
T i 2 O tli
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Topic 2 Outline
1. The Parity Framework
2. Law of One Price and Purchasing Power Parity
3. Interest Rate Parity
4. Fisher Effects
5. Forward Rate Unbiased Property
6. Empirical evidence on parity conditions andmanagerial implications
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1 Th P it F k
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1. The Parity Framework
The framework is founded upon:
assumptions of rational economic behavior
the ability to transact freely at no cost in the marketsfor goods and credit as well as the market for foreignexchange
Simple models that describe relationshipsbetween:
the spot exchange rate
the forward exchange rate
the interest rates
the inflation rates
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R l d f l
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Relevance and usefulness
Empirical evidence supporting each individual
parity condition is mixed How much do they hold in the real world?
depends on the extent to which trade barriers
restrain the activities of traders from enforcing thelaw of one price through arbitrage
Collectively, they constitute a useful way ofordering ones thinking about the economic forces
governing exchange rate movements international financial benchmarks or break-even values
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P rchasing Po er Parit (PPP)
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Purchasing Power Parity (PPP)
PPP establishes a formal link between a countrys price
level or inflation rates (relative to another country)and the prevailing exchange rate between the twocountries
Absolute PPPbased on price levels in 2 countries:
Pt[US] = Spott[USD/GBP] x Pt[UK]
the exchange rate will adjust to eliminate
discrepancies in price levels OR price levels will adjust to eliminate discrepancies in
exchange rates
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Purchasing Power Parity (PPP)
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Purchasing Power Parity (PPP)
Relative PPPbased on price indexes in 2 countries:
The spot exchange rate adjusts perfectly to inflationdifferentials: if goods prices rise in HC relative to FC,
then HCs currency must depreciate to maintain asimilar real price for the goods in the two countries
The change in the exchange rate is roughly equal tothe difference in inflation rates(inflation differential)
rateinflation-;+1
+1=S
S
FC
HC
0
HC/FC
1HC/FC
FCHCFC
HC
0
01
PPP
PPP 11
1
S
SS
S
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Purchasing Power Parity example
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Purchasing Power Parity - example
Example:
Switzerland inflation rate 4% p.a.
US inflation rate 2% p.a.
Spot rate0 1.50 CHF/USD
(The USD will appreciate and CHF depreciate accordingly)
PPP predicts a 2% appreciation of USD against CHF and a2% depreciation of CHF against USD
CHF/USD1.52951.02
1.041.50S
1
PPP
2%-4%1.96%1.021.04SPPP 1
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Purchasing Power Parity Line
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Purchasing Power Parity Line
Given an Sactual: SHC-FC= HC- HC
we are on the PPP line
and PPP holds SHC-FCHC- HC
we are not on the PPP
line and PPP does nothold
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
6
7
-7 - 6 - 5 - 4 -3 - 2 - 1 0 1 2 3 4 5 6 7
0
01
actual
HC/FC S
SSS
FCHC
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Real exchange rate
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Real exchange rate
Assume FC> HCand HCis constant FC is expected
to depreciate against HC, according to PPP this does not necessarily mean that the realvalue of HC
purchases of goods and services across borders hasbecome cheaper
if the increase in PFC has exactly offset the decline invalue of the FC, then PPP would remain the same
there has been a nominaldepreciation of FC, but not arealdepreciation
What matters for PPP across any two countries is thechange in the nominal value of a currency afteradjustment for changes in the relative inflation ratesbetween the two countries
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Real exchange rate example
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Real exchange rate example
Case 1
Sactual=1.50 CHF/USD
SPPP=1.50 CHF/USD
CHF and USD areat their values
Case 2Sactual=1.55 CHF/USD
SPPP=1.50 CHF/USD
USD overvalued
CHF undervalued
Case 3
Sactual=1.45 CHF/USD
SPPP=1.50 CHF/USD
USD undervalued
CHF overvalued
11.50
1.50q
1.0331.50
1.55q
0.9671.50
1.45q
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Changes in real exchange rate
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Changes in real exchange rate
Example: S0=1USD/EUR; $=5% p.a.; =10% p.a.
PPPactualPPP
PPPactual SSS
SSq
0
0
1
actual
S
SS
0
0
1
PPP
S
SS
USD/EUR0.95451.10
1.051S1PPP
4.55%11.10
1.05SPPP
PPP predicts a 4.55% depreciation of EUR against USD
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Changes in real exchange rate
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Changes in real exchange rate
Example (contd)
3 possible cases regarding S1actual:
S1actual(USD/EUR)
Sactual(%) SPPP(%) q(%) Interpretation
0.9545 -4.55 -4.55 0 No change in q
0.9600 -4.00 -4.55 +0.55 EUR appreciated inreal terms by 0.55%against USD
0.9500 -5.00 -4.55 -0.45% EUR depreciated in
real terms by 0.45%against USD
Nominal depreciation of EUR
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3 Interest rate parity
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Interest rate parity (IRP) states that the forward
premium or discount for the quoted currency reflectsthe difference in interest rates for banking deposits inthe two currencies
The currency with the higher interest rate is at adiscount, the one with the lower interest rate is at a
premium If IRP did not hold, then it would be possible for an
arbitrageur to make money exploiting the arbitrageopportunity covered interest arbitrage
3. Interest rate parity
)i+(1S
F
=)i+(1 FCHC/FC
HC/FC
HC
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4 The Fisher Effects
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4. The Fisher Effects
Fisher parities describe how information regarding
expected inflation and expected exchange rates arecaptured in interest rates
Fisher closed equation that links nominal interestrate and inflation expectations for a single economy
Fisher closed represents another example of arbitrage between real assets and financial assets within asingle economy
)(1r)(1i(1 )
ri (approximation)
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The International Fisher Effect (Fisher
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Open or UIP)
Interest rates across countries must be set with an eye
toward expected exchange rate changes The derivation of IFE is another straightforward
application of arbitrage an interest arbitrage butuncovered
the expected spot exchange rate between two currencies
should change by an equal amount but in opposite directionto the difference in interest rates between the two countries
i-iS
S-)E(Selyapproximator
i+1
i+1=
S
E(SFCHC
0
01
FC
HC
0
1 )
% expected exchange = % interest differentialrate change
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IFE and Exchange Rate Predictions
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IFE and Exchange Rate Predictions
IFE predictions
HC interest rates > FC interest rates HC is expectedto depreciate E(S1) > S0 logic: investors must bepaid a higher interest rate to compensate them for aunit of account that is expected to depreciate in value
HC interest rates < FC interest rates HC is expectedto appreciate E(S1) < S0 logic: investors willinglyaccept a lower interest rate when they hold a unit ofaccount that is expected to appreciate in value
Computation of the markets implied future spotrate:
t
FC
HC1+t S
i+1
i+1=)E(S
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IFE and Real Interest Rate Parity
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IFE and Real Interest Rate Parity
Suppose Fisher closed is valid in HC and FC
HCHCHC ri FCFCFC ri
)()r(rii FCHCFCHCFCHC
FCHCFCHC ii
(IFE)S
S)E(Sii0
01FCHC
0rrassume FCHC
holdsPPPassume
IFE implicitly assumes that real interest rates are equal across
countriesMPI FX Risk Management tefan N M Ungureanu, PhD
5 The Forward Rate Unbiased Property
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5. The Forward Rate Unbiased Property
Follows directly from IRP and IFE:
% Forward premium = % Expected Exchange Rate Change
t
t1+t
t
t1+tt,
S
S)E(S=
S
SF --
Forward rate is an unbiased predictor of the future spotrate forward rates and interest differentials neithersystematically over- and underestimate the future spot rate
Ft,t+1
St=1+ iHC
1+ iFC=E(St+1)
St Ft,t+1= E(St+1)
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Combining the parity relations
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Combining the parity relations
S0= 1.3250 CHF/USD
F0,360= 1.3509 CHF/USD
CHF= 4% pa; USD= 2% pa CHF- USD = 2%
iCHF= 5% pa; iUSD= 3% pa iCHFiUSD= 2%
Forward premium on USD
Forecast change in the spot rate
2%2%4%S
SF
0
00,360
)appreciatetoexpected(USD2%2%4%S
SS
0
0360
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International parity relations in equilibrium
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International parity relations in equilibrium
Forecast change in spotexchange rate
+2%
(USD strengthens)
Forecast premium onforeign currency
+2%
Difference in nominalinterest rates
+2%
(higher in Switzerland)
Forecast difference inrates of inflation
+2%
(higher in Switzerland)
Interest rate parity(2)
Forward rateunbiased property
(5)
International FisherEffect
(4)
Fisher closed(3)
Purchasing PowerParity
(1)
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6 Empirical evidence on parity conditions
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6. Empirical evidence on parity conditions
Parity conditions play an important role in theformation of strategies toward international financialmarkets formulated by people in private enterprise
When parities hold, a source of risk and a source ofopportunity disappear a decision point is removed
If all parity conditions were valid at each and everymoment in time no important financial managerialdecisions to make
If parity conditions are not valid at each and every
moment in time two categories of financialdecisions:
Profit maximizing
Risk managing
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Empirical evidence on parity conditions
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Empirical evidence on parity conditions
Managers can identify deviations that are small and growing
larger, or already large and likely to persist activeprofit-maximizingstrategies will follow
Assumptions that managers can move quickly enough tocapture a parity deviation and that the risks involved are
not excessive Managers believe that parity conditions hold on average,
but are not able to detect whether a deviation is likely tobe transitory or persistent strategies that aim at
reducing the firm
s exposure to the deviation risk Understanding the magnitude and duration of deviationsfrom parity conditions forms the foundation for many ofinternational financial managersdecisions
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Empirical evidence on LOP and PPP
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Empirical evidence on LOP and PPP
LOP is fragrantly and systematically violated
Tests on PPP show that it is strongly violated on theshort-run, but describes a long-run phenomenon
PPP does not hold precisely in the real world for avariety of reasons :
transportation costs
existence of non-tradables
differences in consumption preferences
PPP-determined exchange rates still provide a valuablebenchmark for:
currency forecasting
determining over- and under-valuation of currencies
management of foreign exchange risk
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A test of PPP - Big Mac Index
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A test of PPP Big Mac Index
One test of the Law ofOne Price is the Big Macindex, which has beenpublished annually in
The Economist since1986.
It was devised as alight-hearted guide towhether currencies areat their correctlevel,based on PPP.
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Big Mac Index
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Big Mac Index
US Big Mac price
(CAD/USD)S
priceMacBigCanadian
actual
priceMacBigUS
priceMacBigCanadian
100
2.90
2.902.33
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Pitfalls of the Big Mac test
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Pitfalls of the Big Mac test
The Big Mac Index shows the extent to whichinternational price discrimination is possible for aparticular product The Big Mac is a non-tradable and nondurable product
It is a differentiated product with an implied warrantyassociated with the reputation of the McDonalds Corp.
Big Macs are generally produced locally, with local laborand on local land, usually with locally producedmaterials
In many countries, Big Macs do not have close
substitutes
McDonalds sets the profit-maximizing price in acountry, ignoring the prospect of Big Mac arbitrage
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Empirical evidence on IRP
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Empirical evidence on IRP
Various empirical studies indicate that IRP holds in
free, deregulated markets (within a transaction costband)
Deviations may occur due to capital controls, taxes (on
repatriated capital), market incompleteness Quite large deviations in closed less-developed
countries, since smaller currencies can be borrowedand lent only domestically
Bankers often use the IRP model to quote forwardrates
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Empirical evidence on IRP
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Empirical evidence on IRP
Covered Interest Arbitrage opportunities
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Empirical evidence on IFE
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Empirical evidence on IFE
1973-1993 little relationship between thecurrent interest differential on Euro-$ and Euro-DEM deposits and the future realized $/DEMexchange rate changes
1973-1993 small average deviation from the IFEfor the pairs $/DEM and other eight majorcurrencies
Long-run tendency for the interest differential tooffset exchange rate changes
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Empirical evidence on Forward ratebi d t
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unbiased property
Empirical tests generally show that the forwardrate is not a good predictor of the level of thefuture spot rate
However, there is strong evidence that the forward
rate does a better job of predicting at least thedirection of changes to future spot rate ratherthan do about two-thirds of the better knownforeign exchange forecasting services
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FOREIGN EXCHANGERISK MANAGEMENT
Topic 3 Foreign currency derivatives
Topic 3 Outline
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p
1. Foreign Currency Futures
2. Foreign Currency Options3. Currency Swaps
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1. Foreign currency futures
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g y
1. What is a currency futures contract?
2. The market for currency futures contracts
3. Quoting currency futures contracts
4. Forward contracts versus futures contracts
5. Hedging with futures contracts
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What is a futures contract? (I)
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( )
A futures contract represents a pure bet on thedirection of price (exchange rate) movement of theunderlying currency
ATTN!!The futures price is not a monetary amountyou pay to anyone, but the variable about whichyou are betting
Your actual gain or loss depends on the positiontaken on the market - long or short
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What is a futures contract? (II)
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( )
If you buya futures contract (golong) and the futures price goes up you make money
the futures price goes down you lose money
If you sella futures contract (go short) and the futures price goes down you make money
the futures price goes up you lose money
Open interest the number of futures contracts outstandingfor which delivery is obligated
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What is a futures contract? (III)
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A futures contract is a binding agreement to payup your bet on a daily basis, for every day themarket is open and your bet is still in effect
You stop an FX futures bet prior to the end oftrading on the last trade day you are notobligated to buy or deliver anything
After last trade dates you will be legallyobligated to acquire (if long) or to deliver (ifshort) the underlying asset on whose price youare betting, if contract is still in force
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What is a futures contract? (IV)
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The size of the bet you take by opening a futurescontract is governed by the face amount of thecontract
Futures long at price P0
at the end of the daythere will be a positive or negative cash flow toyour futures account:
(P1P0) x Face value of contract
Next business day: cash flow to your account is
(P2P1) x Face value of the contract
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What is a futures contract? (V)
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Example: 62,500 futures contract opened at a negotiatedprice of $1.4500/
the settlement pricesat the end of Day 1 and Day 2
are
Opening price 1.4500 $/
Settlement price, end Day 1 1.4460 $/
Settlement price, end Day 2 1.4510 $/
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What is a futures contract? (VI)
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The respective cash flows for long and shortpositions in a single contract opened at $1.4500/are
Long Short
($1.4460/ - $1.4500/) x 62,500 = -$250 + $250
($1.4510/ - $1.4460/) x 62,500 = + $312.50 - $312.50
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The market for futures contracts
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How it emerged? the possibility of default for
forward contracts raised potentially seriousproblem for counterparties overcoming therisk:
1. Making forward contracts only with people of highcharacter, reputation, and credit quality
2. FUTURES CONTRACTS
May 1972 International Monetary Market(IMM) of CME introduces trading in FX futures
July 1986 Philadelphia Board of Tradeintroduces currency futures trading
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Currency futures on CME
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Expiry cycle: March, June, September, December
Delivery date 3rd Wednesday of delivery month
Last trading day is the second business daypreceding the delivery day
CME hours 7:20 a.m. to 2:00 p.m. CST.
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Quoting Futures Contracts
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Quoting Futures Contracts
Source: Financial Times, December 16, 2008
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Forward versus Futures Contracts
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Forward contracts Futures contracts
1. Customized transactions in terms ofsize and delivery dates
1. Standardized contracts in terms ofsize and delivery dates
2. Private contracts between two
parties
2. Standardized contracts between a
customer and a clearinghouse
3. Difficult to reverse a contract 3. Contract may be freely traded onthe market
4. Profit or loss on a position isrealized only on the delivery date
4. All contracts are marked to market,so profits and losses are realizedimmediately
5. Margins are set once, on the day ofthe initial transactions
5. Margins must be maintained toreflect price movements
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Marking-to-market
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Process of updating a margin account on a dailybasis to reflect the market value of theunderlying position
Margins are set by the exchange, subject to
periodic revision Determined by looking at the risk of a given contract
Two types of margin:
Initial margin posted when the client first enters acontract may be formed of cash or interest-bearingsecurities
Maintenance margin minimum level of the marginonly in cash
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Marking-to-market - example
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June 15: purchase a CHF125,000 September CHF futures
contract traded on CME; price = $0.70/CHF. Entering the transaction futures trading account with a
securities or brokerage firm post initial margin assume is $7,000 (8%); maintenance margin = 83% of initial
margin (=$5,810) June 16: Sept. CHF future ends the day at $0.696 new
value of contract: $87,000 you incur a $500 loss theremaining value of your margin account = $6,500
June 17: Sept. CHF future falls to $0.692 new value ofcontract = $86,500 you incur a $500 loss remainingvalue of margin account = $6,000
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Marking-to-market - example
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June 18: Sept. CHF futures falls to $0.689 new value of
contract = $86,125 you incur a $375 lossbalance ofmargin account = $5,625
Because now the balance is lower than the maintenancemargin, the broker will issue a margin call for $1,375
(variation margin) to restore the initial margin of $7,000
Consider now a happier case: CHF appreciates to $0.71/$ the broker will credit your margin account for $1,250(equal to the $0.01 gain on CHF125,000), bringing the
total to $8,250 these excess margin funds could bewithdrawn and put to some other use
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Hedging FX risk using forwards versus futures
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g g g
Assume a bank raised all its liabilities in dollars whileinvesting half of its assets in GBP-denominated loans andthe other half in USD-denominated assets
Assets and liabilities are of a 1 year maturity and duration;interest rate on UK loan: 15% p.a.
Assets LiabilitiesU.S. loans ($) $100 million U.S. CDs $200 million
U.K. loans () 100 million
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Hedging FX risk using forwards
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0 1
Make loan (100 million)Sell principal (100million) plus interest (15million) forward at the
forward exchange rate attime 0
Deliver principal andinterest (115 million) onloan to forward contractbuyer and receive $s at thetime 0 forward exchange
rate
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Hedging FX risk using futures
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Suppose the bank wished to hedge this loan position onSept. 25, 2001 only 2 contracts available on that day forGBP in the futures market: a December 2001 maturity oneand a March 2002 maturity
The bank could use futures only by rolling over the hedgeinto a new futures contract on maturity
How many futures should the bank sell?
The amount that produces a sufficient profit on the GBPfutures contract to just offset any exchange rate losseson the GBP loan portfolio should the GBP fall in valuerelative to USD
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Hedging FX risk using futures
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Two cases to consider:
1. The futures USD/GBP price is expected to change inexactly the same fashion as the spot USD/GBP priceover the course of the year NO BASIS RISK
2. Futures and spot prices, while expected to change in
the same direction, are not perfectly correlatedTHERE IS BASIS RISK
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Hedging FX risk using futures Case 1
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Sept. 25, 2001: St = 1.4713 USD/GBP; ft for Dec. 2001 =1.4640 USD/GBP
Forecasts for 1 years time spot and futures: St+1 = 1.4213USD/GBP; ft+1= 1.4140 USD/GBP
Over the year:
St= -5 cents;
ft= -5 cents Number of futures contract to be sold:
Loss on GBP loan: 115 million (-5 cents) = $5.75 mill. Gain on futures contract:
115 million (5 cents) = $5.75 mill.
contracts1,84062,500
00115,000,0
contractfuturesofSize
positionlongofSizeNf
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Hedging FX risk using futures Case 2
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Sept. 25, 2001: St = 1.4713 USD/GBP; ft for Dec. 2001 =1.4640 USD/GBP
Forecasts for 1 years time spot and futures: St+1 = 1.4213USD/GBP; ft+1= 1.4340 USD/GBP
Over the year:
St= -5 cents;
ft= -3 cents BASIS RISK Suppose the bank manager ignored the basis risk and sold1,840 futures contracts
Loss on GBP loan: 115 million (-5 cents) = $5.75 mill.
Gain on futures: (1,840 62,500) 3 cents = $3.45 mill. Net loss = $5.75 - $3.45 = $2.3 mill.
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Hedging FX risk using futures Case 2
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The bank manager should take into account the lowersensitivity of futures prices relative to spot rates changesby selling more than 1,840 futures contracts to fully hedgethe GBP loan risk
Hedge ratio: how many futures should be sold to hedge the
long position in the GBP when the spot and futures pricesare imperfectly correlated
Since spot rates are 66% more sensitive than futuresprices, for every 1 in the long asset position, 1.66futures contracts should be sold
1.66$0.03
$0.05
f
Sh
t
t
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Hedging FX risk using futures Case 2
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Suppose now the bank manager does not ignore the basisrisk
Number of futures contracts sold:
Computing losses and gains:
Loss on GBP loan: 115 million (-5 cents) = $5.75 mill.
Gain on futures: (3,054 62,500) 3 cents = $5.73 mill. Net loss = $5.75 - $5.73 = -$0.02 mill. (due to rounding)
contracts3,0541.6662,500
00115,000,0
hcontractfuturesofSize
positionlongofSize
Nf
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Deciding on futures versus forwards
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Depends on the purpose and scale of thetransaction
Hedgers if similar prices, will prefer interbankforward contracts(if access to the market exists)
Speculators
Short-term speculator exchange-traded futurescontracts
Larger-scale speculators interbank market, butmore likely the trade is in spot contracts
MPI FX Risk Management tefan N M Ungureanu, PhD
2. Foreign currency options
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1. What is an option?
2. The market for currency options
3. Quoting prices for currency options
4. Introduction to FX option pricing and valuation
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What is an option? (I)
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Unique type of financial contract with a throwawayfeature they give you the right, but not theobligation, to do something
No daily cash flows on the long side of an option Limited potential loss on a long position
Call versusput options
American versusEuropean options
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What is an option? (II)
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A call on spot a contract between a buyerand a writer/seller whereby the buyer pays aprice (the premium) to the writer in order to
acquire the right, but not the obligation, topurchasea given amount (size) of one currencyfrom the writer at purchase price (exerciseprice, strike price) stated in terms of a second
currency
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What is an option? (III)
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Example: CME December 2001 call option on GBP31,250;exercise price = $1.50/GBP; premium = $322
American option: you can buy GBP31,250 at any timebefore the Saturday prior to the third Wednesday inDecember 2001
European option: you can buy GBP31,250 only on theSaturday prior to the third Wednesday in December 2001
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What is an option (IV)
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A put on spota contract between a buyeranda writer/seller whereby the buyer pays a price(thepremium) to the writer in order to acquire
the right, but not the obligation, to sell a givenamount (size) of one currency to the writer atselling price (exercise price, strike price) statedin terms of a second currency
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What is an option? (V)
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Example: CME June 2001 put option on JPY1,000,000;exercise price = JPY150/$; premium = $320
American option: you can sell JPY1,000,000 at any timebefore the Saturday prior to the third Wednesday inJune 2001
European option: you can sell JPY1,000,000 only on theSaturday prior to the third Wednesday in June 2001
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Currency Options Markets
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Philadelphia Stock Exchange
Hong Kong Financial Exchange
20-hour trading day.
OTC volume is much bigger than exchangevolume.
Trading is in seven major currencies plus the euroagainst the U.S. dollar.
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Currency Options Contracts - example (PSE)
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Contract type: European-style call option on PSE
Underlying asset: GBP
Expiration date: Third Wednesday in December
Exercise price: $1.45/ spot rate
Contract size: 31,250
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Currency options quotes - PSE
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PHILADEPHIA Sterling Options 31,250 (cents per pound)
Strikeprice
CALLS PUTS
Mar Apr May Mar Apr May
1.620 2.01 2.63 3.11 0.63 1.32 1.77
1.630 1.38 2.10 2.56 0.97 1.75 2.21
1.640 0.94 1.67 2.13 1.44 2.22 2.69
Previous days vol., Calls-Puts 422. Prev. day
s open int., Calls 1553 Puts 19,754
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Writing FX options
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The writer of a FX option is in a different positionform the buyer of the option
The writer is a source of credit risk once the
premium has been paid the clearing houserequires margin to be posted
Writing options is a form of risk-exposure of
importance at least equal to that of buyingoptions
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Moneyness
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In the money (ITM) A call/put option on spot is in the money if the currentspot rate is higher/lower than the option exercise price
Out of the money (OTM)
A call/put option on spot is out of the money if thecurrent spot rate is lower/higher than the optionexercise price
At the money (ATM)
A call/put option on spot is at the money if the currentspot rate is equal to the option exercise price
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Payoff profiles for options
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Buyer of an option limited loss, unlimitedprofit
Writer of an option unlimited loss, limitedprofit
Example:
1. Call option on CHF; strike price = 58.5 UScents/CHF; premium = 0.5 US cents/CHF
2. Put option on CHF; strike price = 58.5 UScents/CHF; premium = 0.5 US cents/CHF
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Payoff profile for buyer of a call option
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-1
-0.5
0
0.5
1
57 57.5 58 58.5 59 59.5 60
Spot price of underlying currency (US cents/CHF)
Profit(UScents/CHF
Strike priceAt-the-moneyOut-of-the-money In-the-money
Limited loss
Unlimited profit
Break-even
price
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Payoff profile for writer of a call option
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-1
-0.5
0
0.5
1
57 57.5 58 58.5 59 59.5 60
Spot price of underlying currency (US cents/CHF)
Profit(USc
ents
/CHF)
Strike price
At-the-moneyOut-of-the-money In-the-money
Limited profit
Unlimited
loss
Break-even
price
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Payoff profile for buyer of a put option
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-1
-0.5
0
0.5
1
57 57.5 58 58.5 59 59.5 60
Spot price of underlying currency (US cents/CHF)
Profit(USc
ents/CHF
Strike price
At-the-moneyIn-the-money Out-of-the-money
Unlimited profit
up to 58 cents
Limited lossBreak-even
price
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Payoff profile for writer of a put option
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-1
-0,5
0
0,5
1
57 57,5 58 58,5 59 59,5 60
Spot price of underlying currency (US cents/CHF)
Profit(USc
en
ts/CHF)
Strike price
At-the-moneyIn-the-money Out-of-the-money
Unlimited
loss up to
58 cents
Limited profitBreak-even
price
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Basic Option Pricing Relationships at Expiry
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At expiry, an American call option is worth thesame as a European option with the samecharacteristics.
CaT= CeT= Max[ST- X, 0]
Call in-the-money STX
Call out-of-the-money worthless
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Basic Option Pricing Relationships at Expiry
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At expiry, an American put option is worth thesame as a European option with the samecharacteristics
PaT= PeT= Max[X - ST, 0]
Put in-the-money X ST
Put out-of-the-money worthless
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Option Pricing and Valuation
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The price (premium) of an option has two components:
Intrinsic value the amount the option is in the money
Time value the option premium minus the intrinsicvalue
OptionPremium
=IntrinsicValue
+Time
Value
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Option Pricing and Valuation
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Example:$1.25 call on GBP is priced at $0.030 when thespot price is $1.27
Intrinsic value= Spot price - Strike price
= $1.27 - $1.25 = $0.02
Time value = Premium - Intrinsic value= $0.03 - $0.02 = $0.01
MPI FX Risk Management tefan N M Ungureanu, PhD
Total Value of a Call Option
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0
1
2
3
4
5
6
7
8
1,64 1,65 1,66 1,67 1,68 1,69 1,7 1,71 1,72 1,73 1,74 1,75 1,76
Spot rate ($/)
Optionpremium(U
Scents/)
Total value
Time value
Intrinsic value
MPIFX Risk Management Alexandra Horobet, PhD
FX options price determinants
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Premium rises if :
For a Call For a Put
1. Spot rate
2. Exercise price
3. Interest rate in HC
4. Interest rate in FC
5. Volatility
6. Time to maturity
MPI FX Risk Management tefan N M Ungureanu, PhD
3. Currency Swaps
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1. The short-term swap
2. Back-to-back and parallel loans
3. The modern currency swap
4. Absolute and comparative advantage in swaps
5. Valuation of swaps
MPI FX Risk Management tefan N M Ungureanu, PhD
Some useful definitions
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In a swap, two counterparties agree to acontractual arrangement wherein they agree toexchange cash flows related to debt obligations atperiodic intervals
Two types of swaps:
Single currency interest rate swap interest rateswap fixed for floating swap
Cross-Currency interest rate swap currency swap fixed for fixed swap
The market for currency swaps evolved first, buttoday the market for interest rate swaps is larger
MPI FX Risk Management tefan N M Ungureanu, PhD
The Short-term Currency Swap
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Bank of England (BoE) wants to borrow USD fromthe Bundesbank (Buba)
Buba asks, as security, an equivalent amount of GBP(to be deposited by the BoE with the Buba)
Barring default, on the expiration day the USD and theGBP would each be returned, with interest, to the
respective owners
MPI FX Risk Management tefan N M Ungureanu, PhD
The Short-term Currency Swap An Example
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ExampleS = 2.50 $/, r$= 3%, r = 5%
Time t:
BoE receives $100m from the Buba for six months
BoE deposits 100m/2.5 = 40m into an escrowaccount with the Buba
Time T:
Buba returns 40m x 1.05 = 42m BoE returns $100m x 1.03 = $103m
MPI FX Risk Management tefan N M Ungureanu, PhD
Back-to-back Loans
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UK institutional investor (UKII) wants to invest inUS, but an investment dollar premium makesforeign investments expensive to UK investors
UKII wants to avoid the spot market at t and T
UKII sets up a deal with a foreign firm (USCo) thatwants to invest in the UK
USCo lends $ to UKII
UKII lends to USCo (or its UK subsidiary)
Right of offset between these two loan contractsif (say) UKII cannot pay back, USCo can withholdits payments and sue for the net loss (if any)
MPI FX Risk Management tefan N M Ungureanu, PhD
Back-to-back Loans
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USD
Flow of initial principals under a back-to-back loan
USD capital
market
UKIIUSCos
subsidiary
USCo
GBP
MPI FX Risk Management tefan N M Ungureanu, PhD
Parallel Loans (I)
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USCo faces capital export controls
she cannotexport USD to its UK subsidiary
UKCo wants to lend to its US subsidiary, but there
is a dollar premium
Both can avoid the spot market by granting loans to
each other (or to each others subsidiary), with aright of offset in the two loan contracts
MPI FX Risk Management tefan N M Ungureanu, PhD
Parallel Loans (II)
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The initial flows of principal under a parallel loan
UKCos
subsidiary
UKCo
USCos
subsidiary
USCoUSD
GBP
MPI FX Risk Management tefan N M Ungureanu, PhD
The Modern Currency Swap
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Two parties agree to exchange, at time t, two initially equivalent principals
denominated in different currencies may beskipped
return these principals to each other at T
pay the normal interest, periodically, to each other onthe amounts borrowed
One single contract, with a right of offset
MPI FX Risk Management tefan N M Ungureanu, PhD
The Swap Bank
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A swap bank a financial institution thatfacilitates swaps between counterparties
The swap bank can serve as either a broker or a
dealer. Broker it matches counterparties but does notassume any of the risks of the swap
Dealer it stands ready to accept either side of a
currency swap, and then later lay off their risk, ormatch it with a counterparty
MPI FX Risk Management tefan N M Ungureanu, PhD
Absolute advantage in borrowing
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A US MNC needs to borrow CHF 1.6m for the next 4 years
A Swiss MNC needs to borrow $1m for the same period
Spot rate: 0.625$/CHF
Borrowing opportunities:
US dollar CHF
US MNC 6.00% p.a. 5.00% p.a.
Swiss MNC 7.50% p.a. 3.50% p.a.
Absolute advantage 1.50% 1.50%
MPI FX Risk Management tefan N M Ungureanu, PhD
Absolute advantage in borrowing
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US MNC
Swap
Bank
$6%
$6%
CHF 4% CHF 3.5%
$6.5%
SwissMNC
CHF 3.5%
US
Bank
Swiss
Bank
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Absolute advantage in borrowing
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US MNC
Swap
Bank
$6%
$6%
CHF4% CHF3.5%
$6.5%
SwissMNC
CHF3.5%
US
Bank
Swiss
Bank
US MNCs net position is to borrow at CHF4%
US MNC saves CHF1%
MPI FX Risk Management tefan N M Ungureanu, PhD
Absolute advantage in borrowing
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US MNC
Swap
Bank
$6%
$6%
CHF4% CHF3.5%
$6.5%
SwissMNC
CHF3.5%
US
Bank
Swiss
Bank
Swiss MNCs net position is to borrow at $6.5%
Swiss MNC saves $1%
MPI FX Risk Management tefan N M Ungureanu, PhD
Absolute advantage in borrowing
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US MNC
Swap
Bank
$6%
$6%
CHF4% CHF3.5%
$6.5%
SwissMNC
CHF3.5%
US
Bank
Swiss
Bank
The swap bankmakes money too:
+0.5% on CHF
+0.5% on $
The swap bank facesexchange rate risk, butmaybe they can lay itoff in another swap.
MPI FX Risk Management tefan N M Ungureanu, PhD
Comparative advantage inborrowing
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Consider two firms A and B: Firm A U.S.based multinational Firm B U.K.based multinational
Both firms wish to finance a project in each otherscountry of the same size borrowingopportunities
$
Company A 8.0% 11.6%Company B 10.0% 12.0%
MPI FX Risk Management tefan N M Ungureanu, PhD
Comparative advantage inborrowing
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Ais the more credit-worthy of the two firms
Still,Ahas a comparative advantage in borrowingin dollars it borrows at 2% less than B
B has a comparative advantage in borrowing inpounds it borrows at only 0.4% less than A
If they borrow according to their comparative
advantage and then swap, there will be gains forboth parties
MPI FX Risk Management tefan N M Ungureanu, PhD
Comparative advantage inborrowing
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CompanyA
Swap
Bank
$8% 12%
$8%
11%12%
$9.4%
Company
B
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Comparative advantage inborrowing
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$8% 12%
$8%
11%12%
$9.4%
As net position is to borrow at 11%
A saves 0.6%
Swap
Bank
CompanyA
Company
B
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Comparative advantage inborrowing
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$8% 12%
$8%
11%12%
$9.4%
Bs net position is to borrow at $9.4%
B saves $0.6%
Swap
Bank
CompanyA
Company
B
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Comparative advantage inborrowing
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$8% 12%
$8%
11%12%
$9.4%
The swap bankmakes money too:
At S0($/) =$1.60/, that is a
gain of $64,000 peryear for 5 years.
The swap bank faces exchange rate risk, but maybe they canlay it off in another swap.
1.4% of $16 million
financed with 1% of10 million per year
for 5 years.
Swap
Bank
CompanyA
Company
B
MPI FX Risk Management tefan N M Ungureanu, PhD
Swap rates
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The interest payments for each currency are basedon the currencys swap (interest) rate yieldsat par for near-riskless bonds with the same
maturity as the swap
Why risk-free rates?
Right-of-offset clause
Probability of default is small
MPI FX Risk Management tefan N M Ungureanu, PhD
Costs
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A commission of, say, USD500 on a USD1m swap, for eachpayment to be made
Equivalent up-front fee is asked
Example
7-year yields at par: 7.17% on USD and 9.9% on DEM
The swap dealer quotes:
USD 7.13% - 7.21%
DEM 9.85% - 9.95%
If you borrowDEM and lendUSD you pay 9.95%on the DEM, and you receive 7.13% on the USD
MPI FX Risk Management tefan N M Ungureanu, PhD
Valuation of currency swaps (I)
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A company swaps a loan of GBP 50m into USD 100m for 7years swap rates: 10% on USD leg and 12% on GBP leg
Spot rate at the beginning of the swap: 2 USD/GBP
Two years after the inception of the swap, the swap rateshave changed: 8% on the USD leg and 14% on the GBP leg
Also, the spot rate has changed to 1.7 USD/GBP
Which is the value of this swap at the inception and aftertwo years?
MPI FX Risk Management tefan N M Ungureanu, PhD
Valuation of currency swaps (II)
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The initial exchange of principals is a zero-valuetransaction, since the amounts are initially equivalent
The future interest payments have also equal presentvalues
At inception:
At the spot rate of 2 USD/GBP, the two legs are equivalentswap value =0
$100m1.1
100m
1.1
10mPV
7
7
1ttUSD
GBP50m1.12
50m
1.12
6mPV
7
7
1ttGBP
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Valuation of currency swaps (III)
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After two years:
Swap value = PV of inflows PV of outflows
For the company paying USD:
PV of swap in USD = GBP46.567m 1.7 USD/GBP
USD107.985m
= -USD28.821 NET LIABILITY
$107.985m1.08100m
1.0810mPV
5
5
1ttUSD
GBP46.567m1.14
50m
1.14
6mPV
5
5
1ttGBP
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FOREIGN EXCHANGERISK MANAGEMENT
Topic 4 Managing and Measuring Exposureto FX Risk
Topic 4 Outline
1 FX Exposure taxonomy
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1. FX Exposure taxonomy
2. Measuring transaction exposure (TREX)
3. Managing transaction exposure using financial
instruments
Forward contracts
Money market operations
Currency options
MPI FX Risk Management tefan N M Ungureanu, PhD
Risk and exposure to risk
Exchange risk uncertainty about the future spot rate
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Exchange risk= uncertainty about the future spot rate
measured by2
(St)or (St) currency variability levels may change over time
Currency 1981-1993 1994-1998
British pound 0.0309 0.0148Canadian dollar 0.0100 0.0110Japanese yen 0.0279 0.0298
New Zealand dollar 0.0289 0.0190Swedish krona 0.0287 0.0195Swiss franc 0.0330 0.0246Singapore dollar 0.0111 0.0174
Standard Deviations of Exchange Rate MovementsBased on Monthly Data
MPI FX Risk Management tefan N M Ungureanu, PhD
Risk and exposure to risk
Exchange rate exposure: measures how sensitive the
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Exchange rate exposure: measures how sensitive the
(home-currency) value of a firm, an asset/liability, orcash flow is to changes in the exchange rate
Example A portfolio contains (1) a CHF (=FC) T-bill maturing at
time t, with face value CHF100,000, and (2) a USD (=HC)T-bill with face value at time t of USD50,000
Vt= USD50,000 + CHF100,000 x St Exposure = CHF100,000
t
t
tt
tt
S
V
)E(SS
)E(VVExposure
MPI FX Risk Management tefan N M Ungureanu, PhD
Types of foreign exchange exposure
Transaction (contractual) exposure
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Transaction (contractual) exposure
measures changes in the value of outstanding financialobligationsincurred prior to a change in exchange ratesbut not due to be settled until after the exchange rateschange
deals with changes in cash flows the result from existing
contractual obligations Vt= HC value of contractually fixed cash flows
Operating (economic, competitive, strategic) exposure measures the change in the market value of the firm
resulting from any change in future operating cash flowsof the firm caused by an unexpectedchange in exchangerates
Vt= market value of the firm
MPI FX Risk Management tefan N M Ungureanu, PhD
Types of exchange rate exposure
Accounting (translation) exposure
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Accounting (translation) exposure
Occurs because of the need to translate FC financialstatements of foreign affiliates into a single currency toprepare worldwide consolidated financial statements
Vt= book value of the firm when consolidation occurs
Moment in time whenexchange rate changes
Accounting exposure
Transaction exposure
Operating exposure
Time
MPI FX Risk Management tefan N M Ungureanu, PhD
Which exposure matters most?A survey of corporate treasurers and CFOs
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Jesswein, Kwok, Folks Adoption of Innovative Products in Currency RiskManagement: Effects of Management Orientations and ProductCharacteristics,Journal of Applied Corporate Finance, Fall 1995
Mean score of
level ofagreement
Managing transaction exposure is important 1.4
Managing operating exposure is important 1.8
Managing translation exposure is important 2.4
(1) strongly agreed(5) strongly disagreed
MPI FX Risk Management tefan N M Ungureanu, PhD
Do companies hedge FX risk?
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GM is exposed to market risk from changes in foreigncurrency exchange rates, interest rates, and certaincommodity prices. In the normal course of business, GMenters into a variety of foreign exchange, interest rate, andcommodity forward contracts, swaps, and options, with the
objective of minimizing exposure arising from these risks. Arisk management control system is utilized to monitorforeign exchange, interest rate, commodity, and relatedhedge positions.
General Motors Annual Report, 2004
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Do companies hedge FX risk?
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In the normal course of business, we are exposed toforeign currency exchange rate, interest rate and equityprice risks that could impact our financial position resultsof operations. Our risk management strategy with respectto these three market risks includes the use of derivative
financial instruments. We use derivatives only to manageexisting underlying exposures of HP. Accordingly, we do notuse derivative contracts for speculative purposes.
Hewlett-Packard Annual Report, 2004
MPI FX Risk Management tefan N M Ungureanu, PhD
Measuring TREX
Sources of TREX:
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f
Purchasing or selling on credit goods or services whoseprices are stated in foreign currencies
Borrowing or lending funds when repayment is due inforeign currencies
Being a party to an existing foreign exchange forwardcontract
Otherwise acquiring assets or incurring liabilitiesdenominated in foreign currencies
Attributes of TREX:
It is typically a short-termexposure
High certainty regarding the exposure timing andamount
MPI FX Risk Management tefan N M Ungureanu, PhD
Measuring TREX from transactions at aparticular date
Inflows: FC accounts receivables
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Inflows: FC accounts receivables
FC long-term sales contractsFC deposits, bonds, notes
Forward purchase of FC
Outflows: FC accounts payableFC long-term purchase contracts
FC loans, bonds, notes
Forward sales of FC
Net Exposure= Total inflows Total outflows
Only this amount is hedged
MPI FX Risk Management tefan N M Ungureanu, PhD
Measuring TREX from transactions at aparticular date
Example:
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Example:
Spanish firm with USD commitments recorded on May 1:
1. A/Rs:USD 100,000 - June 1; USD 2,200,000 - July 1
2. Expiring deposits: USD 3,000,000 - June 1
3. A/Ps: USD 2,300,000 - June 1; USD 1,000,000 - July 1
4. Loan due: USD 2,300,000 - July 1
MPI FX Risk Management tefan N M Ungureanu, PhD
Measuring TREX from transactions at aparticular date
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Transaction June 1 July 1
INFLOWS A/R 100,000 2,200,000
Deposit 3,000,000OUTFLOWS A/P -2,300,000 -1,000,000
Loan -2,300,000
NET EXPOSURE 800,000 -1,100,000
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging using forward contracts
If you are going to owe foreign currency in the future
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If you are going to oweforeign currency in the future,
agree to buythe foreign currency now by entering intolong position in a forward contract.
If you are going to receive foreign currency in the
future, agree to sell the foreign currency now byentering into short position in a forward contract.
Example: Swiss exporter, A/R $1 million, 3 monthsmaturity, S0= 1.5000 CHF/$, F90= 1.4960 CHF/$
MPI FX Risk Management tefan N M Ungureanu, PhD
1 51
Hedging using forward contracts
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1.49
1.492
1.494
1.496
1.498
1.5
1.502
1.504
1.506
1.508
1.51
1.490 1.492 1.494 1.496 1.498 1.500 1.502 1.504 1.506 1.508 1.510
Spot rate in 3 months
A/Rvalue(C
HF,millions) Unhedged
Forward hedgeGains fromforward hedge
Losses from
forward hedge
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging using forward contracts
Forward contracts eliminate FX risk certainty over
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Forward contracts eliminate FX risk certainty overfuture revenues and payments in FC, when translated inHC
Which is the cost of using forwards for hedging?
Realcost compare forward rate with the future spot
Expectedcost = 0 (if forward rate is unbiased)
Possibility of bias in forward rate SELECTIVE
HEDGING: Long FC hedge when FC is at a forward discount
Short FC hedge when FC is at a forward premium
1
10,1
S
SFcostReal
It can be known only at contract
maturity
MPI FX Risk Management tefan N M Ungureanu, PhD
Money market hedge Sunrise
Sunrise Corp. (US) has sold umbrellas to a Spanish
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p ( ) pcompany and billed it 1m euros, to be paid in 1 year
A/R of 1m euros, 1 year maturity S0: 1.1933$/euro, F12m:1.1850$/euro, i$=3.5% p.a.,
ieuro= 4% p.a.
Money market hedge: Borrow euros now 1m/1.04 = 0.9615m euros Sell 0.9615m euros against $ at 1.1933$/euro
1.1474m$
Invest 1.1474m$ at 3.5% 1.1876m$ in one year hence
In one year, use the 1m euro from the contract to paythe loan
Total result (certain): 1.1876m$
MPI FX Risk Management tefan N M Ungureanu, PhD
Forward vs. money market hedge
When should you use them?
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When should you use them?
If IRP is holding the results of forward hedge andmoney market hedge will be the same
If IRP is not holding proceeds from money markethedge will not be the same as those from forward hedgeone hedging method will dominate the other
Be aware of the fact that there might be highertransaction costs associated to hedging using money
market as compared to forward: Bid-ask spread on the forward contract
Difference between borrowing and lending rates
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging using options
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Options provide a flexible hedge against thedownside, while preserving the upside potential.
To hedge aforeign currency receivable/asset buyputs on the currency
If the FC depreciates, your put option lets you sell thecurrency for the exercise price.
Options provide a floor price on the domestic
currency value of foreign exchange:
Floor price = Exercise price of put Put premium
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging an A/R using FX options
Boeing has anA/R of 10m GBP for 1 year
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Boeing buys a put option on 10m GBP, X=$1.46/GBP,
Pr=$0.02/GBP ($200,000 for the option)
13.80
14.00
14.20
14.40
14.60
14.8015.00
15.20
15.40
15.60
1.40 1.42 1.44 1.46 1.48 1.50 1.52 1.54
Spot rate in one year ($/GBP)
A/Rv
alue($,
millions) Unhedged
Hedging with a put
Floor price
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Hedging using options
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To hedge a foreign currency payable/liability buycalls on the currency.
If the FC appreciates, your call option lets you buythe currency at the exercise price of the call.
Options provide a ceiling price on the domesticcurrency value of foreign exchange:
Ceiling price = Exercise price of call + Call premium
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging an A/P using FX options
Boeing has anA/P of 5m GBP for 1 year
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6.90
7.00
7.10
7.20
7.30
7.40
7.50
7.60
7.70
7.80
1.40 1.42 1.44 1.46 1.48 1.50 1.52 1.54
Spot rate in one year ($/GBP)
A/Pvalu
e($,
millions)
Boeing buys a call option on 5m GBP, X=$1.46/GBP,Pr=$0.025/GBP ($125,000 for the option)
Unhedged
Hedging with a call
Ceiling price
MPI FX Risk Management tefan N M Ungureanu, PhD
Hedging an A/R - Dayton Manufacturing
Dayton Manufacturing, US-based maker of gasbi i ld i M h bi
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turbine equipment, sold in March a turbine generator
to Crown, a British firm, for 1,000,000. Paymentdue three months later, in June.
The following information is available to the CFO ofDayton:
Spot exchange rate: $1.7640/
3-month forward rate: $1.7540/
UK 3-month interest rates: 8.0% - 10.0% US 3-month interest rates: 6.0% - 8%
MPI FX Risk Management tefan N M Ungureanu, PhD
Dayton Manufacturing
June put option; OTC market for 1,000,000: strike
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p p ; , ,
price $1.7500 (nearly ATM); 1.5% premium paid atcurrent spot
June put option; OTC market for 1,000,000: strikeprice $1.7100 (OTM); 1.0% premium paid at current
spot Daytons foreign exchange advisory service forecasts
that the spot rate in 3 months will be $1.7600/
The minimum acceptable margin for the contract is at
a sale price of $1,700,000 the budget rate =$1.7000/
MPI FX Risk Management tefan N M Ungureanu, PhD
Dayton Manufacturing
F lt ti il bl t D t
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Four alternatives are available to Dayton:
1. Remain unhedged
2. Hedge in the forward market
3. Hedge in the money market
4. Hedge in the options market
MPI FX Risk Management tefan N M Ungureanu, PhD
Dayton Manufacturing
1. Unhedged position
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g p
Today Three months hence
Do nothingReceive 1,000,000
Sell 1,000,000 spot and
receive $ at spot rateexisting then
MPI FX Risk Management tefan N M Ungureanu, PhD
Dayton Manufacturing
2. Forward Market Hedge
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g
Three months hence
Sell 1,000,000 forward@$1.7540/
Receive 1,000,000
Deliver 1,000,000 againstforward sale
Receive $1,754,000
Today
MPI FX Risk Management tefan N M Ungureanu, PhD
Dayton Manufacturing
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3. Money market hedge
Today
Receive 1,000,000
Repay 975,610 loan plus24,390 interest, for a total of
1,000,000
Receive 1,746,790 $
Three months hence
Borrow 975,610 @ 10% p.a.
Exchange 975,610 for $ @$1.7640/
Receive $1,720,976 cash
Invest $1,720,976 @ 6% p.a.
MPI FX Risk Management tefan N M Ungureanu, PhD
Dayton Manufacturing
4. Options market hedge (ATM option illustrated)
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p g ( p )
Today Three months hence
Buy put option to sell @$1.75/
Pay $26,460 for put option
Receive 1,000,000
Either deliver 1,000,000 againstput, receiving 1,750,000; or sell
1,000,000 spot if current spot rate> $1.75/
MPI FX Risk Management tefan N M Ungureanu, PhD
Dayton Manufacturing
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Put Option Strike Price ATM Option
$1.75/
OTM Option
$1.71/
Option cost $26,460 $17,640
Proceeds if exercised $1,750,000 $1,710,000
Minimum net proceeds $1,723,540 $1,692,360
Maximum net proceeds Unlimited Unlimited
MPI FX Risk Management tefan N M Ungureanu, PhD
1,84$)
Dayton Manufacturing
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1,68
1,7
1,72
1,74
1,76
1,78
1,8
1,82
1,84
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Ending spot exchange rate ($/)
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