FIN 40500: International Finance

1. FIN 40500: International Finance Forwards, Futures and Options

2. Derivative Securities vs. Stocks/Bonds Derivative securities on the other hand represent contracts that designate future transactions Stocks and Bonds represent claims to specific future cash flows • Currently, there are approximately 300 million derivative contracts outstanding with a market value of around $50 Trillion!!! • Derivative securities can be used for hedging or for speculation

3. Porsche expects $12.5M in US sales over the next month that that it would like to repatriate back to Germany Mercedes need to acquire $12.5M to meet its payroll for its Tuscaloosa, Alabama plant Porsche is worried that the dollar might depreciate over the next month Mercedes is worried that the dollar might appreciate over the next month Both Porsche and Mercedes could avoid their potential currency risk by entering into a forward contract.

4. Forward contracts are individualized contracts to buy/sell a currency at a pre-specified date and for a pre-specified price. Deutsche Bank Deutsche Bank negotiates a price of $1.25 per Euro Porsche approaches Deutsche Bank with an offer to buy Euro 30 days forward Mercedes approaches Deutsche Bank with an offer to sell Euro 30 days forward In 30 days, Porsche will buy 10 Million Euro from Mercedes for $12.5M

5. On Settlement day, Porsche delivers its $12.5M and acquires 10M Euro. Had it instead bought Euro in the spot market, It would’ve needed $12.9M to buy 10M Euro – Porsche “gains” $400,000 e = 1.29 F = 1.25 EUR/USD Days Note that Mercedes has an equal “loss” of $400,000

6. Forward contracts are available on all the major currencies EUR/USD 1.2762 1 month 1.2786 3 months 1.2836 6 months 1.2905 12 months 1.3026 The published prices are not actual contract prices but the average of contracts made at major banks.

7. In 1972, the Chicago Mercantile Exchange began trading currency Futures. By 2004, the number of currency futures outstanding stood at 48M with a value of approximately $5T!! Futures are standardized (size and maturity), exchange traded commodities Currency futures trade in a March, June, September, December expiration cycle – Delivery is made on the 3rd Wednesday of the month and the contracts are traded up to two days prior to delivery. Jan Mar June Sept. Dec.

8. Futures are available for a wide range of commodities and assets

9. There are also cross rate futures traded (EUR/GBP, EUR/JPY, and EUR/CHF) in contract sizes of EUR 125,000

10. Futures are standardized (size and maturity), exchange traded commodities (Chicago Mercantile Exchange) Total Contracts bought/sold that day (000s) Opening, High, Low, and Closing Price EUR 125,000 Contracts Outstanding (000s) Settlement Date Change From Prior Day (in Pips)

11. Chicago Mercantile Exchange Mercedes goes short on 80 Euro contracts The CME simultaneously buys 80 contracts from Mercedes and sells 80 contracts to Porsche Porsche goes long on 80 Euro contracts From the previous example, if Porsche is buying 10M Euro, it would need to purchase 80 Euro futures contracts (125,000 x 80 = 10M )

12. Futures contracts are marked to market daily. That is, profits and losses are kept track of on a daily basis. Suppose that Porsche goes long on 80 Euro contracts at a price of $1.25 per Euro – The total cost of the contract is $12.5M Porsche is required to deposit an initial performance bond equal to 2% of the contract value – this can be in the form of cash or a Treasury bill. 2% of $12.5M = $250,000 May 1 June 21 Delivery Date

13. On May 1, Porsche deposited $250,000 worth of Treasury Bills into its maintenance account. On May 2, the closing price for June Euro futures is $1.27. Porsche’s profit on its contract is $200,000. This is deposited into Porsche’s maintenance account ($450,000 balance). On May 3, the closing price for June Euro futures is $1.24. Porsche’s one day loss on its contract is $300,000. This is withdrawn from Porsche’s maintenance account ($150,000 balance). May 1 May 2 May 3 June 21 Delivery Date When your maintenance account drops below 75% of its original value, you must add to it!!

14. While the overwhelming majority (90%) of forward contracts end with actual delivery of the currency, very few futures contracts (1%) result in delivery. Suppose that on June 3, Porsche wishes to end its futures contract. Suppose that the current price of a June Euro future is $1.28 Porsche goes short on 80 June Euro futures at a price of $1.28. The two contracts offset one another and Porsche goes home with its profit of $300,000 May 1 June 3 June 21 F = $1.25/Euro Delivery Date

15. Essentially, futures positions are making “bets” on the price of the underlying commodity. Profits from price increases Long Position Short Position Profits from price decreases

16. Treasury futures first began trading on the CME in 1976. The underlying commodity is a $1M Treasury Bill with 90 days to maturity. Remember, when interest rates rise, Treasury prices fall! Profits from price increases Profits from decreasing interest rates Long Position Profits from price decreases Profits from increasing interest rates Short Position

17. T-Bill futures are listed using the IMM (International Monetary Market) Index IMM = 100 – Annualized Discount Yield For example, if the Price of a $100, 90 Day Treasury were $98. IMM = 100 – 8 = 92 Note that Every .01 increase in the IMM raises the value of a long T-Bill position by $25 (per basis point).

18. Eurodollar futures were introduced in 1981 as an alternative to Treasury futures. • The underlying commodity is a $1M, 3 month Eurodollar time deposit. However, these deposits are not marketable. Therefore, Eurodollar futures are settled on a cash basis • Eurodollar futures can be treated like a T-Bill Future IMM = 100 – Annualized LIBOR Every .01 increase in the IMM raises the value of the long position by $25 (per basis point)

19. Eurodollar Futures vs. T-Bill Futures • As the Eurodollar market grew, it became more liquid relative to the T-Bill market • LIBOR is a “risky” rate. Therefore, it correlates better with other risks

20. Suppose that you expect to receive $20M in June. You do not need the $20M until September. The current 3 month LIBOR rate is 2.91% (Annualized) This $20M should be invested from June to September to earn interest, but currently the interest rate from June to September is uncertain. June Eurodollar futures are currently trading at 96.56 IMM = 96.56 $20M received $20M needed LIBOR = 2.91% May 1 June September

21. The June Eurodollar futures with a 96.56 price implies an annualized rate of return equal to 3.44% from June to September You can “lock in” the 3.44% interest rate by taking a long position in Eurodollar futures. Suppose that you purchase 20 Eurodollar contracts at the current price of 96.56. 3.44% IMM = 96.56 $20M received $20M needed May 1 June September

22. Suppose that in June, the LIBOR rate is 3.10% Annualized. You receive your $20M in June and deposit it in a Eurodollar account at 3.1% (annual) interest. Your interest earned well be $155,000 - $20M*(.031/4) Your profit from the Future is (96.90-96.56)(100)($25)(20) = $17,000 Your total gain is $17,000 + $155,000 = $172,000 (3.44% Annualized return) 3.10% You paid 96.56 per contract in May (20 contracts) IMM = 96.90 May 1 June September

23. Unlike a future, an option gives the owner the right, but not the obligation to buy or sell the underlying commodity. • Call Option • The owner (long position) on a call option has the right but not the obligation to buy the underlying commodity at the predetermined price • The seller (writer) of the call option has the obligation to sell the underlying commodity if the option is exercised. • Put Option • The owner (long position) on a put option has the right but not the obligation to sell the underlying commodity at the predetermined price • The seller (writer) of the put option has the obligation to buy the underlying commodity if the option is exercised. The stated price that the underlying commodity is bought or sold at is known as the strike price.

24. In December 1982, the Philadelphia Stock Exchange started trading American and European options on foreign currency. Can only be exercised at maturity Can be exercised at any time during the life of the contract Traded options have an expiration cycle March, June, September and December with original maturities of 3,6,9,and 12 months.

25. At expiration, an American option and a European option that has not been exercised will have the same terminal value. Put option Call option Exercise price of the option contract Spot price of the underlying asset Remember, as the owner of the option, you will not exercise if it is unprofitable!!

26. Suppose that you purchase a call option on Euro at an exercise price of 130 ($1.30 per Euro). The standard Euro contract is 62,500 Euro. Expiration Value Spot Exchange Rate $1.30 $1.35 Here, the option is “out of the money” and will not be exercised.

27. Note that the writer of the call has the opposite payout (as with futures, this is a zero sum game) Expiration Value Spot Exchange Rate $1.30 $1.35

28. Options have a premium attached to them. This is the price that the buyer pays for the option contract. Suppose that the premium on this Euro call is 4.59 cents per Euro (the option will cost .0459*62,500 = $2,868.75) Expiration Value $1.3459 Spot Exchange Rate -$2,868.75 $1.30 $1.35

29. Suppose that you purchase a put option on Euro at a strike price of $1.30. The premium on this option is 3.50 cents per Euro (.035*62,500 = $2,187.50) Expiration Value $1.2650 $1.30 Spot Exchange Rate $1.25 -$2,187.50

30. The previous example dealt with “vanilla options”. There are many, many more “exotic” options. • Bermuda Options: Can be exercised at various, predetermined dates over the life of the contract • Asian Option: Also known as an average option – exercised at maturity and the payoff is based on the average price of the underlying commodity over the life of the contract. • Barrier options: The payoff is contingent on whether or not the underlying commodity has reached a predetermined price • Compound Options: The underlying commodity is an option • Digital Option: Also known as a binary option – the payout is fixed once the strike price has been reached. You can also buy options on futures contracts.

31. Currency swaps are contracts to convert known income/payment streams from one currency to another – think of them as a portfolio of forwards with varying maturities/strikes • As with forward contracts, swaps are individualized and not traded. Suppose that IBM wishes to raise funds by issuing a 5 year Swiss Franc denominated Eurobond with a face value of CHF 100,000 and fixed annual coupon payments of 6%. Up front, IBM receives CHF 100,000. IBM plans on using the proceeds to finance domestic operations

32. 0 Yrs 1 Yrs 2 Yrs 3 Yrs 4 Yrs 5 Yrs IBM owes CHF 6,000 IBM owes CHF 6,000 IBM owes CHF 6,000 IBM owes CHF 6,000 IBM Collects CHF 100,000 IBM owes CHF 106,000 IBM Wishes to hedge its currency exposure

33. IBM enters into a swap agreement with 0 Yrs 1 Yrs 2 Yrs 3 Yrs 4 Yrs 5 Yrs IBM buys CHF 6,000 @ .830 IBM buys CHF 6,000 @ .845 IBM buys CHF 6,000 @ .800 IBM buys CHF 6,000 @ .840 IBM Sells CHF 100,000 @ .844 IBM buys CHF 106,000 @ .836 This swap is very similar to buying/selling six separate futures contracts and is priced in a similar fashion

34. The Bottom Line… There is a virtually endless set of options (pardon the pun) for hedging currency exposure. However, your ability to effectively and efficiently hedge depends on your understanding of the specific exposure that you face!!