Hedging Foreign Exchange Exposure

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 today's 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