7/29/2019 currency future and options
1/60
Currency Futures, Options
& Swaps
Reading: Chapters 7 & 14 (474-485)
7/29/2019 currency future and options
2/60
2
Lecture Outline
Introduction to Derivatives
Currency Forwards and Futures
Currency Options
Interest Rate Swaps Currency Swaps
Unwinding Swaps
7/29/2019 currency future and options
3/60
3
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 distinctmanagement objectives:
Speculationuse of derivative instruments to take a positionin the expectation of a profit.
Hedginguse of derivative instruments to reduce the risksassociated with the everyday management of corporate cashflow.
7/29/2019 currency future and options
4/60
4
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.
7/29/2019 currency future and options
5/60
5
Futures versus Forwards
7/29/2019 currency future and options
6/60
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
monthStop of Trading Two business days prior to
settlement date
http://www.cme.com/trading/dta/del/product_list.html?ProductType=curhttp://www.cme.com/trading/dta/del/product_list.html?ProductType=cur7/29/2019 currency future and options
7/60
7
Futures - The Clearing House
When A sells a futures contract to B, the ClearingHouse 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.
7/29/2019 currency future and options
8/60
8
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
7/29/2019 currency future and options
9/60
9
Purpose of Marking to Market
Daily marking to market means that profits and lossesare 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.
7/29/2019 currency future and options
10/60
10
Marking to MarketExample
Trader buys 1 AUD contract on 1 Feb forUSD0.5000/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 + 1003 Feb 0.5020 50,200 + 300
4 Feb 0.5010 50,100 - 100
7/29/2019 currency future and options
11/60
11
Trouble with Forwards/Futures?
$ Spot
1.80
A$ 1.90/US$
Forward/Futures
Rate
Seller (short)
US$
Buyer (long)
US$
0
+
-
2.00
7/29/2019 currency future and options
12/60
12
Basics of Options
Options give the option holder the right, but not theobligation to buy or sell the specified amount of the
underlying asset (currency) at a pre-determined price
(exercise orstrike price).
The buyer of an option is termed the holder, while theseller of the option is referred to as the writeror
grantor.
Types of options: Call: gives the holder the right to buy
Put: gives the holder the right to sell
7/29/2019 currency future and options
13/60
13
AnAmerican option gives the buyer the right toexercise the option at any time between the date of
writing and the expiration or maturity date.
AEuropean option can be exercised only on its
expiration date, not before.
The premium, or option price, is the cost of the
option.
Basics of Options
7/29/2019 currency future and options
14/60
14
Basics of Options
The Philadelphia Exchange commenced tradingin 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.
http://www.phlx.com/http://www.phlx.com/7/29/2019 currency future and options
15/60
15
Basics of Options
Spot rate, 88.15 /
Size of contract:62,500
Exercise price0.90 /
The indicated contract price is:62,500 $0.0125/ = $781.25
One call option gives the holder the right to purchase62,500 for $56,250 (=62,500 $0.90/)Maturity month
7/29/2019 currency future and options
16/60
16
Buyer of a call: Assume purchase of August call option on Swiss francs
with strike price of 58 ($0.5850/SF), and a premiumof $0.005/SF.
At all spot rates below the strike price of 58.5, thepurchase of the option would choose not to exercisebecause it would be cheaper to purchase SF on the openmarket.
At all spot rates above the strike price, the option
purchaser would exercise the option, purchase SF at thestrike price and sell them into the market netting a
profit (less the option premium).
Options Trading
7/29/2019 currency future and options
17/60
17
7/29/2019 currency future and options
18/60
18
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 currencyat 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 willexperience an opportunity loss.
Options Trading
7/29/2019 currency future and options
19/60
19
7/29/2019 currency future and options
20/60
20
Buyer of a Put:
The basic terms of this example are similar to those just illustratedwith the call.
The buyer of a put option, however, wants to be able to sell theunderlying 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 ofthe 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.
Options Trading
7/29/2019 currency future and options
21/60
21
7/29/2019 currency future and options
22/60
22
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 theoption (falling below break-even).
If the spot price is above $0.585/SF, the option will notbe exercised and the option writer will pocket the entire
premium.
Options Trading
7/29/2019 currency future and options
23/60
23
7/29/2019 currency future and options
24/60
24
An option whose exercise price is the same as thespot price of the underlying currency is said to beat-the-money (ATM).
An option the would be profitable, excluding thecost of the premium, if exercised immediately issaid to be in-the-money (ITM).
An option that would not be profitable, again
excluding the cost of the premium, if exercisedimmediately is referred to as out-of-the money(OTM).
Option Pricing & Valuation
7/29/2019 currency future and options
25/60
25
Call Put
Intrinsic value max(ST - X, 0) max(X - ST, 0)
in the money STX > 0 XST > 0
at the money STX = 0 XST = 0
out of the money STX < 0 XST < 0
Time Value CTInt. value PTInt. value
Option Pricing & Valuation
7/29/2019 currency future and options
26/60
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
7/29/2019 currency future and options
27/60
27
Option Pricing & Valuation
7/29/2019 currency future and options
28/60
28
Forwards versus Options
-$0.90-$0.75
-$0.60
-$0.45
-$0.30
-$0.15
$0.00
$0.15
$0.30
$0.45
$0.60
$0.75
$0.90
$0.
00
$0.
10
$0.
20
$0.
30
$0.
40
$0.
50
$0.
60
$0.
70
$0.
80
$0.
90
$1.
00
$1.
10
$1.
20
$1.
30
$1.
40
$1.
50
$1.
60
$1.
70
$1.
80
Spot Rate at Expiration
Valu
eofForward/PutOptionatExpiration.
Value of Forward Sale at Expiration
Value of Put at Expiration
7/29/2019 currency future and options
29/60
29
Swaps are contractual agreements to exchangeor swap a series of cash flows.
These cash flows are most commonly theinterest payments associated with debt service.
If the agreement is for one party to swap its fixedinterest 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 serviceobligation, it is termed a currency swap.
A single swap may combine elements of both interestrate and currency swaps.
What are Swaps?
7/29/2019 currency future and options
30/60
30
The swap itself is not a source of capital, butrather an alteration of the cash flows associatedwith payment.
What is often termed theplain 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.
What are Swaps?
7/29/2019 currency future and options
31/60
31
There are two main reasons for using swaps:1. 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).2. Two borrowers can work together to get a lower
combined borrowing cost by utilizing their
comparative borrowing advantages in two different
markets.
What are Swaps?
7/29/2019 currency future and options
32/60
32
For example, a firm with fixed-rate debt thatexpects interest rates to fall can change fixed-rate
debt to floating-rate debt.
In this case, the firm would enter into apay
floating/receive fixedinterest rate swap.
What are Swaps?
7/29/2019 currency future and options
33/60
33
Swap Bank
A swap bankis a generic term used to describe afinancial 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 acommission 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.
7/29/2019 currency future and options
34/60
34
Example of an Interest Rate Swap
Bank A is a AAA-rated international bank locatedin the U.K. that wishes to raise $10,000,000 to
finance floating-rate Eurodollar loans.
Bank A is considering issuing 5-year fixed-rateEurodollar 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.
7/29/2019 currency future and options
35/60
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 + percent.
Firm B would prefer to borrow at a fixed rate.
7/29/2019 currency future and options
36/60
36
Example of an Interest Rate Swap
The borrowing opportunities of the two firms are shown inthe following table.
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + 0.50% LIBOR 0.50%
7/29/2019 currency future and options
37/60
37
Example of an Interest Rate Swap
Bank A has an absolute advantage in borrowingrelative 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.
7/29/2019 currency future and options
38/60
38
Example of an Interest Rate Swap
To see the potential advantages to a swap, imagine the twoentities trying to minimize their combined borrowing costs:
COMPANY B BANK A TOGETHER
Borrow preferredmethod
11.75% LIBOR LIBOR + 11.75%
Borrow oppositeand swap
LIBOR + 0.50% 10% LIBOR + 10.50%
POTENTIAL SAVINGS: 1.25%
7/29/2019 currency future and options
39/60
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% = LIBOR0.5%
- Company B pays 11.75% - 0.5% = 11.25%
COMPANY B BANK A TOGETHERBorrow preferred
method11.75% LIBOR LIBOR + 11.75%
Borrow oppositeand swap
LIBOR + 0.50% 10% LIBOR + 10.50%
POTENTIAL SAVINGS: 1.25%
7/29/2019 currency future and options
40/60
40
Example of an Interest Rate Swap
10 3/8%
LIBOR1/8%
Bank
A
Swap
Bank
The swap bank makesthis offer to Bank A: You
pay LIBOR1/8 % per
year on $10 million for 5
years, and we will pay
you 10 3/8% on $10million for 5 years.
7/29/2019 currency future and options
41/60
41
Example of an Interest Rate Swap
10 3/8%
LIBOR1/8%
Bank
A
Swap
Bank
Why is this swap
desirable to Bank A?
10%
With the swap, Bank A
pays LIBOR-1/2%
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + 0.50% LIBOR 0.50%
7/29/2019 currency future and options
42/60
42
Example of an Interest Rate Swap
LIBOR%
10 %
Swap
Bank
Company
B
The swap bank makes this
offer to Company B: Youpay us 10 % per year on
$10 million for 5 years,
and we will pay you
LIBOR % per year on
$10 million for 5 years.
7/29/2019 currency future and options
43/60
43
Example of an Interest Rate Swap
LIBOR%
10 %
Swap
Bank
Company
B
Why is this swap
desirable to Company B?
With the swap, CompanyB pays 11%
COMPANY B BANK A DIFFERENTIALFixed rate 11.75% 10% 1.75%
Floating rate LIBOR + 0.50% LIBOR 0.50%
7/29/2019 currency future and options
44/60
44
Example of an Interest Rate Swap
10 3/8 %
LIBOR%
10 %
Bank
A
Swap
Bank
Company
B
Will the swap bank
make money?
7/29/2019 currency future and options
45/60
45
Example of an Interest Rate Swap
LIBOR
+ %
10 3/8 %
LIBOR1/8%LIBOR%
10 %
B saves %
Bank
A
Swap
Bank
Company
B
A saves %
The swap bank
makes %
10%Note that the total savings
+ + = 1.25 % = QSD
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + 0.50% LIBOR 0.50%
QSD = 1.25%
7/29/2019 currency future and options
46/60
46
The QSD
The Quality Spread Differential (QSD) represents thepotential 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.
7/29/2019 currency future and options
47/60
47
Since all swap rates are derived from the yield curve in
each major currency, the fixed-to-floating-rate interest rateswap existing in each currency allows firms to swap acrosscurrencies.
The usual motivation for a currency swap is to replace cash
flows scheduled in an undesired currency with flows in adesired currency.
The desired currency is probably the currency in which thefirms future operating revenues (inflows) will begenerated.
Firms often raise capital in currencies in which they do notpossess significant revenues or other natural cash flows (asignificant reason for this being cost).
Currency Swaps
7/29/2019 currency future and options
48/60
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 wellknown 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.
7/29/2019 currency future and options
49/60
49
Example continued..
IfCompany A can find a British MNC with amirror-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.
7/29/2019 currency future and options
50/60
50
Example continued..
Company A is the U.S.-based MNC and Company B isa 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 borrowingopportunities are given below.
$
Company A8.0% 11.6%
Company B 10.0% 12.0%
7/29/2019 currency future and options
51/60
51
As Comparative Advantage
A is the more credit-worthy of the two.
A pays 2% less to borrow in dollars thanB.
A pays 0.4% less to borrow in pounds thanB:
$
Company A 8.0% 11.6%
Company B10.0% 12.0%
7/29/2019 currency future and options
52/60
52
Bs Comparative Advantage
B has a comparative advantage in borrowing in .
B pays 2% more to borrow in dollars thanA.
B pays only 0.4% more to borrow in pounds thanA:$
Company A 8.0% 11.6%
Company B 10.0% 12.0%
7/29/2019 currency future and options
53/60
53
Potential Savings = 2.0% - 0.4% = 1.6%
If Swap Bank takes 0.4% and A&B split the rest:
Company A pays 11.6% - 0.6% = 11%
Company B pays 10% - 0.6% = 9.4%
$
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Differential (B-A) 2.0% 0.4%
Potential Savings
E l f C S
7/29/2019 currency future and options
54/60
54
Example of a Currency Swap
Company
A
Swap
Bank
i$=8%
i$=8%
i=11%
i=12%
i$=9.4%
CompanyB
i=12%
$
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Differential (B-A) 2.0% 0.4%
E l f C S
7/29/2019 currency future and options
55/60
55
Example of a Currency Swap
Company
A
Swap
Bank
i$=8%
i$=8%
i=11%
i=12%
i$=9.4%
CompanyB
i=12%
$
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Differential (B-A) 2.0% 0.4%
As net position is to borrow at i=11%
A saves i=0.6%
E l f C S
7/29/2019 currency future and options
56/60
56
Example of a Currency Swap
Company
A
Swap
Bank
i$=8%
i$=8%
i=11%
i=12%
i$=9.4%
CompanyB
i=12%
$
Company A 8.0% 11.6%Company B 10.0% 12.0%
Bs net position is to borrow at i$=9.4%
B saves i$=0.6%
E l f C S
7/29/2019 currency future and options
57/60
57
Example of a Currency Swap
Company
A
Swap
Bank
i$=8%
i$=8%
i=11%
i=12%
i$=9.4%
CompanyB
i=12%
$
Company A 8.0% 11.6%Company B 10.0% 12.0%
The swap bank makesmoney too:
1.4% of $16 millionfinanced with 1% of 10
million per year for 5
years.
At S0 = 1.60 $/, that is again of $64,000 per year
for 5 years.
The swap bank
faces exchange raterisk, but maybe
they can lay it off
in another swap.
U i di S
7/29/2019 currency future and options
58/60
58
Unwinding a Swap
Discount the remaining cash flows under the swapagreement 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.
U i di S
7/29/2019 currency future and options
59/60
59
Unwinding a Swap
Suppose in the previous example, Company A wantedto 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 S=1.65 $/.
What will the net settlement amount be?
U i di S
7/29/2019 currency future and options
60/60
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:
+ (16*0.08)/1.0775 + (16*0.08)/(1.0775)2 + 16/(1.0775)2
[(10*0.11)/1.1125 + (10*0.11)/(1.1125)2 + 10/(1.1125)2]x1.65
= -0.358 million dollars (must pay this amount to unwind swap)