Hedging Foreign Exchange Exposure
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Chapter 5 – Foreign Currency Derivatives
Use of Derivatives
Speculation: To make money
Hedging: To reduce the risk of future cash flows
Questions: 9, 10
Problems: 2, 5, 9
Futures Contract
Def: Is similar to a Forward contract in the sense that it is an agreement between two parties about a future delivery of an amount of foreign exchange at a fixed price, time, and place. The main difference is that futures are a standardized contract traded on an exchange while forwards are negotiated.
Short Position: Want to sell. (eg. p96) You are expecting the currency to fall in value. Therefore you chose to sell the currency in the future to make a speculative profit.
Short Position (value at maturity) = – contract amount x (spot rate at maturity- futures rate/settle price)
Long Position: Want to buy (eg p 96). You are expecting the currency to gain in value. Therefore you chose to buy the currency in the future to make a speculative profit.
Long Position (value at maturity) = contract amount x (spot rate at maturity – futures rate/settle price)
Example of a Future: Slide 5-4
Contract Specifications of Futures: Slide 5-6
Futures vs. Forwards: (full list on p98) Main points below
Futures involve a margin account (a minimum amount of cash at the brokers. Can be waved for trusted clients)
Gains and losses are settled immediately (mark to market). They are added/subtracted from the margin account
If the margin account gets too low (a previously agreed amount), the client is asked to put more money in. Known as a Margin Call. This results in Futures having little risk for the bank.
Closing a Future contract: It can be closed by taking an opposite contract (short/long). The Margin account (whatever is left of it) is returned back to the investor. (eg. Slide 5-16)
Advantages of Forwards
Freedom to specify the contract
No daily settlement of cash flows, only at the delivery date. Less paper work
Disadvantage of Forwards
Hard to get out of the contract
Credit risk: the counterparty might go bankrupt
Advantages of futures
High trading volume on the exchange market
Easy to get out
No credit risk due to daily settlement of gain/loss in the margin account
Disadvantage of futures
Cannot be custom made to your needs
Margin calls can be a pain if the amounts are large. Can cause unplanned cash flow problems for companies
Foreign Currency Option
Def: Gives the buyer the right (option), to buy or sell a given amount of foreign exchange at a fixed price during a given period of time
Def:
Call Option: The option to buy foreign currency
Put Option: The option to sell foreign currency
The buyer (holder) takes a long position
The Seller (writer) takes a short position
Option Premium: The price of the option that the buyer pays to the seller of the option
Exercising an option: When the buyer decides to use the option
A European option can be exercised only at the maturity date.
An American option can be exercised at any time before or on the maturity date.
Possible outcomes from options. (Premium cost is not included)
In the Money: If exercised, it profitable.
Out of the money: If exercised will result in a loss
At the Money: The exercise price is the same as the spot price.
Contract Specifications of Options: Slide 5-21
Example of an option: Slide 5-22, 23
Foreign Currency Speculation
Speculators can attempt to make a profit in:
Spot Market: When the speculator believes that the foreign currency will appreciate. Eg: Buying euros because you think they will go up in value
Forward Market: When the speculator believes the spot price in the future will differ from todays forward price for the same date
Options Market: Many options possible.
Option Market Speculation: See Slide 5-29 – 5-36
How to calculate Net Profit from an option (Gross profit: exclude premium):
Buyer of a call: Profit= spot rate – (strike price + premium)
– Writer of a call: Profit = Premium – (Spot rate – strike price)
Buyer of a put: Profit= strike price – (spot rate + premium)
Seller (writer) of a put: Profit = Premium – (strike price – Spot rate)
Break even buyer call = Strike Price + Premium
Break even buyer put = Strike Price – Premium
To calculate break even, set Profit = 0 and solve for Spot rate.
The total value (premium) of an option is equal to