Currency Futures, Options

1
Currency Futures, Options Swaps

• Reading Chapters 7 14 (474-485)

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Lecture Outline

• Introduction to Derivatives
• Currency Forwards and Futures
• Currency Options
• Interest Rate Swaps
• Currency Swaps
• Unwinding Swaps

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Introduction

• A derivative (or derivative security) is a
  financial instrument whose value depends on the
  value of other, more basic underlying
  variables/assets
• Share options (based on share prices)
• Foreign currency futures (based on exchange
  rates)
• These instruments can be used for two very
  distinct management objectives
• Speculation use of derivative instruments to
  take a position in the expectation of a profit.
• Hedging use of derivative instruments to reduce
  the risks associated with the everyday management
  of corporate cash flow.

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Definition of Futures and Forwards

• Currency futures and forward contracts both
  represent an obligation to buy or sell a certain
  amount of a specified currency some time in the
  future at an exchange rate determined now.
• But, futures and forward contracts have different
  characteristics.

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Futures versus Forwards
6
Futures Contract - Example

• Specification of the Australian Dollar futures
  contract (International Money Market at CME)
• Size AUD 100,000
• Quotation USD / AUD
• Delivery Month March, June, September,
  December
• Min. Price Move 0.0001 (10.00)
• Settlement Date Third Wednesday of delivery
  month
• Stop of Trading Two business days prior to
  settlement date

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Futures - The Clearing House

• When A sells a futures contract to B, the
  Clearing House takes over and the result is
• A sells to the Clearing House
• Clearing House sells to B
• The Clearing House keeps track of all
  transactions that take place and calculates the
  net position of all members.

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Futures - Marking to Market

• Futures contracts are marked to market daily.
• Generates cash flows to (or from) holders of
  foreign currency futures from (or to) the
  clearing house.
• Mechanics
• Buy a futures contract this morning at the price
  of f0,T
• At the end of the day, the new price is f1,T
• The change in your futures account will be
• f1,T - f0,T x Contract Face Value Cash Flow

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Purpose of Marking to Market

• Daily marking to market means that profits and
  losses are realized as they occur. Therefore, it
  minimizes the risk of default.
• By defaulting, the investor merely avoids the
  latest marking to market outflow. All previous
  losses have already been settled in cash.

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Marking to Market Example

• Trader buys 1 AUD contract on 1 Feb for
  USD0.5000/AUD
• USD value 100,000 x 0.5000 USD 50,000.
• Date Settlement Value of
  Contract Margin A/c
• __________________________________________________
  ______________________________
• 1 Feb 0.4980 49,800
  - 200
• 2 Feb 0.4990 49,900
  100
• 3 Feb 0.5020 50,200
  300
• 4 Feb 0.5010 50,100
  - 100

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Trouble with Forwards/Futures?

Seller (short) US
Buyer (long) US
0
Spot
1.80
2.00
A 1.90/US Forward/Futures Rate
-
12
Basics of Options

• Options give the option holder the right, but not
  the obligation to buy or sell the specified
  amount of the underlying asset (currency) at a
  pre-determined price (exercise or strike price).
• The buyer of an option is termed the holder,
  while the seller of the option is referred to as
  the writer or grantor.
• Types of options
• Call gives the holder the right to buy
• Put gives the holder the right to sell

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Basics of Options
0

• An American option gives the buyer the right to
  exercise the option at any time between the date
  of writing and the expiration or maturity date.
• A European option can be exercised only on its
  expiration date, not before.
• The premium, or option price, is the cost of the
  option.

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Basics of Options

• The Philadelphia Exchange commenced trading in
  currency options in 1982.
• Currencies traded on the Philadelphia exchange
• Australian dollar, British pound, Canadian
  dollar, Japanese yen, Swiss franc and the Euro.
• Expiration months
• March, June, September, December plus two
  near-term months.
• 
  

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Basics of Options
The indicated contract price is 62,500 ?
0.0125/ 781.25
One call option gives the holder the right to
purchase 62,500 for 56,250 ( 62,500 ? 0.90/)
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Options Trading
0

• Buyer of a call
• Assume purchase of August call option on Swiss
  francs with strike price of 58½ (0.5850/SF), and
  a premium of 0.005/SF.
• At all spot rates below the strike price of 58.5,
  the purchase of the option would choose not to
  exercise because it would be cheaper to purchase
  SF on the open market.
• At all spot rates above the strike price, the
  option purchaser would exercise the option,
  purchase SF at the strike price and sell them
  into the market netting a profit (less the option
  premium).

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Options Trading
0

• Writer of a call
• What the holder, or buyer of an option loses, the
  writer gains.
• The maximum profit that the writer of the call
  option can make is limited to the premium.
• If the writer wrote the option naked, that is
  without owning the currency, the writer would now
  have to buy the currency at the spot and take the
  loss delivering at the strike price.
• The amount of such a loss is unlimited and
  increases as the underlying currency rises.
• Even if the writer already owns the currency, the
  writer will experience an opportunity loss.

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Options Trading
0

• Buyer of a Put
• The basic terms of this example are similar to
  those just illustrated with the call.
• The buyer of a put option, however, wants to be
  able to sell the underlying currency at the
  exercise price when the market price of that
  currency drops (not rises as in the case of the
  call option).
• If the spot price drops to 0.575/SF, the buyer
  of the put will deliver francs to the writer and
  receive 0.585/SF.
• At any exchange rate above the strike price of
  58.5, the buyer of the put would not exercise the
  option, and would lose only the 0.05/SF premium.
• The buyer of a put (like the buyer of the call)
  can never lose more than the premium paid up
  front.

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Options Trading
0

• Seller (writer) of a put
• In this case, if the spot price of francs drops
  below 58.5 cents per franc, the option will be
  exercised.
• Below a price of 58.5 cents per franc, the writer
  will lose more than the premium received fro
  writing the option (falling below break-even).
• If the spot price is above 0.585/SF, the option
  will not be exercised and the option writer will
  pocket the entire premium.

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Option Pricing Valuation
0

• An option whose exercise price is the same as the
  spot price of the underlying currency is said to
  be at-the-money (ATM).
• An option the would be profitable, excluding the
  cost of the premium, if exercised immediately is
  said to be in-the-money (ITM).
• An option that would not be profitable, again
  excluding the cost of the premium, if exercised
  immediately is referred to as out-of-the money
  (OTM).

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Option Pricing Valuation
26
Option Pricing Valuation

• current exchange rate (S) as S ?, Call ? and
  Put ?
• strike price (X) as X ?, Call ? and Put ?
• time to expiration (T) as T ?, both ?
• volatility of the exchange rate (?) as ? ?,
  both ?
• domestic interest rate (id) as id ?, Call ? and
  Put ?
• foreign interest rate (if) as if ?, Call ? and
  Put ?
• 
  

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Option Pricing Valuation
0
28
Forwards versus Options
29
What are Swaps?

• Swaps are contractual agreements to exchange or
  swap a series of cash flows.
• These cash flows are most commonly the interest
  payments associated with debt service.
• If the agreement is for one party to swap its
  fixed interest rate payments for the floating
  interest rate payments of another, it is termed
  an interest rate swap.
• If the agreement is to swap currencies of debt
  service obligation, it is termed a currency swap.
• A single swap may combine elements of both
  interest rate and currency swaps.

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What are Swaps?

• The swap itself is not a source of capital, but
  rather an alteration of the cash flows associated
  with payment.
• What is often termed the plain vanilla swap is an
  agreement between two parties to exchange
  fixed-rate for floating-rate financial
  obligations.
• This type of swap forms the largest single
  financial derivative market in the world.

31
What are Swaps?

• There are two main reasons for using swaps
• A corporate borrower has an existing debt service
  obligation. Based on their interest rate
  predictions they want to swap to another exposure
  (e.g. change from paying fixed to paying
  floating).
• Two borrowers can work together to get a lower
  combined borrowing cost by utilizing their
  comparative borrowing advantages in two different
  markets.

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What are Swaps?

• For example, a firm with fixed-rate debt that
  expects interest rates to fall can change
  fixed-rate debt to floating-rate debt.
• In this case, the firm would enter into a pay
  floating/receive fixed interest rate swap.

33
Swap Bank

• A swap bank is a generic term used to describe a
  financial institution that facilitates swaps
  between counterparties.
• The swap bank serves as either a broker or a
  dealer.
• A broker matches counterparties but does not
  assume any of the risk of the swap. The swap
  broker receives a commission for this service.
• Today most swap banks serve as dealers or market
  makers. As a market maker, the swap bank stands
  willing to accept either side of a currency swap.
  
  

34
Example of an Interest Rate Swap

• Bank A is a AAA-rated international bank located
  in the U.K. that 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 for the bank to issue
  floating-rate notes at LIBOR to finance the
  floating-rate Eurodollar loans.
• 
  

35
Example of an Interest Rate Swap

• Company B is a BBB-rated U.S. company. It needs
  10,000,000 to finance an investment with a
  five-year economic life, and it would prefer to
  borrow at a fixed rate.
• 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 floating rate notes at LIBOR ½
  percent.
• Firm B would prefer to borrow at a fixed rate.

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Example of an Interest Rate Swap

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

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Example of an Interest Rate Swap

• Bank A has an absolute advantage in borrowing
  relative to Company B
• Nonetheless, Company B has a comparative
  advantage in borrowing floating, while Bank A has
  a comparative advantage in borrowing fixed.
• That is, the two together can borrow more cheaply
  if Bank A borrows fixed, while Company B borrows
  floating.

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Example of an Interest Rate Swap

• To see the potential advantages to a swap,
  imagine the two entities trying to minimize their
  combined borrowing costs

39
Example of an Interest Rate Swap

• Now, we must determine how to split the swap
  savings!
• If Swap Bank takes 0.25 that leaves 1 for Bank
  A Company B. If they share this equally then
• - Bank A pays LIBOR - 0.5 LIBOR 0.5
• - Company B pays 11.75 - 0.5 11.25

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Example of an Interest Rate Swap
SwapBank
10 3/8
LIBOR 1/8
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.
BankA
41
Example of an Interest Rate Swap
SwapBank
10 3/8
Why is this swap desirable to Bank A?
LIBOR 1/8
BankA
With the swap, Bank A pays LIBOR-1/2
10
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Example of an Interest Rate Swap
Swap Bank
10 ½
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.
LIBOR ¼
Company B
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Example of an Interest Rate Swap
Swap Bank
10 ½
Why is this swapdesirable to Company B?
LIBOR ¼
Company B
With the swap, Company B pays 11¼
44
Example of an Interest Rate Swap
Will the swap bank make money?
Swap Bank
10 3/8
10 ½
LIBOR 1/8
LIBOR ¼
Bank A
Company B
45
Example of an Interest Rate Swap
The swap bank makes ¼
Swap Bank
10 3/8
10 ½
LIBOR ¼
LIBOR 1/8
Bank A
Company B
LIBOR ½
10
Note that the total savings ½ ½ ¼ 1.25
QSD
B saves ½
A saves ½
46
The QSD

• The Quality Spread Differential (QSD) 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.

47
Currency Swaps

• Since all swap rates are derived from the yield
  curve in each major currency, the
  fixed-to-floating-rate interest rate swap
  existing in each currency allows firms to swap
  across currencies.
• The usual motivation for a currency swap is to
  replace cash flows scheduled in an undesired
  currency with flows in a desired currency.
• The desired currency is probably the currency in
  which the firms future operating revenues
  (inflows) will be generated.
• Firms often raise capital in currencies in which
  they do not possess significant revenues or other
  natural cash flows (a significant reason for this
  being cost).

48
Currency Swaps

• Example Suppose a U.S. MNC, Company A, 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 dollars for pounds.
  This results in exchange rate risk, OR
• They could borrow pounds in the international
  bond market, but pay a lot since they are not
  well known abroad.

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Example continued..

• If Company A can find a British MNC with a
  mirror-image financing need, both companies may
  benefit from a swap.
• If the exchange rate is S0 1.60 /, Company A
  needs to find a British firm wanting to finance
  dollar borrowing in the amount of 16,000,000.

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Example continued..

• Company A is the U.S.-based MNC and Company B is
  a U.K.-based MNC.
• Both firms wish to finance a project of the same
  size in each others country (worth 10,000,000
  or 16,000,000 as S 1.60 /). Their borrowing
  opportunities are given below.

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As Comparative Advantage

• A is the more credit-worthy of the two.
• A pays 2 less to borrow in dollars than B.
• A pays 0.4 less to borrow in pounds than B

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Bs Comparative Advantage

• B has a comparative advantage in borrowing in .
• B pays 2 more to borrow in dollars than A.
• B pays only 0.4 more to borrow in pounds than A

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Potential Savings

• Potential Savings 2.0 - 0.4 1.6
• If Swap Bank takes 0.4 and AB split the rest
• Company A pays 11.6 - 0.6 11
• Company B pays 10 - 0.6 9.4

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Example of a Currency Swap
Swap Bank
i9.4
i8
i12
i11
i12
i8
CompanyB
Company A
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Example of a Currency Swap
Swap Bank
i9.4
i8
i12
i11
i12
i8
CompanyB
Company A
As net position is to borrow at i11
A saves i0.6
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Example of a Currency Swap
Swap Bank
i9.4
i8
i12
i11
i12
i8
CompanyB
Company A
Bs net position is to borrow at i9.4
B saves i0.6
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Example of a Currency Swap
1.4 of 16 million financed with 1 of 10
million per year for 5 years.
The swap bank makes money too
Swap Bank
i9.4
i8
i12
i11
i12
i8
CompanyB
Company A
At S0 1.60 /, that is a gain of 64,000 per
year for 5 years.
The swap bank faces exchange rate risk, but maybe
they can lay it off in another swap.
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Unwinding a Swap

• Discount the remaining cash flows under the swap
  agreement at current interest rates, and then (in
  the case of a currency swap) convert the target
  currency back to the home currency of the firm.
• Payment of the net settlement of the swap
  terminates the swap.

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Unwinding a Swap

• Suppose in the previous example, Company A wanted
  to unwind its (5 year) currency swap with the
  Swap Bank at the end of Year 3. Assume that at
  Year 3, the applicable dollar interest rate is
  7.75 per annum, the applicable pound interest
  rate is 11.25 per annum, and S1.65 /.
• What will the net settlement amount be?

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Unwinding a Swap

• There are two years of interest payments and
  repayment of face values remaining.
• For Company A
• Paying 11 p.a. on 10,000,000
• Receiving 8 p.a. on 16,000,000
• Must return 10,000,000 and receive 16,000,000
  at end
• Net settlement for Company A is
• (160.08)/1.0775 (160.08)/(1.0775)2
  16/(1.0775)2
• (100.11)/1.1125 (100.11)/(1.1125)2
  10/(1.1125)2x1.65
• -0.358 million dollars (must pay this amount
  to unwind swap)