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Futures Contracts
Similar to forward contracts. Two counterparties agree to exchange currencies of a fixed amount at a predetermined exchange rate at some fixed future date. Used to speculate on or to hedge FX risk.
Exchange
Traded on exchanges such as the Chicago Mercantile Exchange (CME) rather than over-the-counter (OTC) in the interbank market. Standardizations enhance liquidity with specific delivery dates and lot sizes.
Credit Risk and Settlement
Futures contracts have lower credit risk, margin requirements, and daily settlement (mark-to-market) than forward contracts. Most futures contracts are closed out with offsetting trades prior to the delivery date.
CME Euro FX Futures
Example: Euro futures contracts Euro vs US with a contract size of 125,000 Euro. Initial performance bond for speculators/non-members: US$2640 per contract. For hedgers/members: US$2400 per contract. Maintenance performance bond: US$2400 per contract.
Daily Cash Flows
Suppose a US exporter shorts 30 futures contracts of Euro at the prevailing futures price of US$106.61. If we observe prices of this futures contract in the next 3 days as 106.68, 106.92, and 106.56, calculate the daily cash flows and accumulated gain/loss from the futures contract and determine the hedging of the company's FX risk.
Cash Flows Scenario 2
If the prices observed over the next 3 days are 106.59, 106.65, and 106.70, calculate the daily cash flows to determine if the company's FX risk is hedged.
Forward Contracts vs. Futures Contracts
Compare the cash flows and risk hedging if the company had shorted forward contracts rather than futures contracts.
Daily Mark-to-Market
Daily mark-to-market ensures that loss/gain will not be accumulated into a large amount. The bond requirement guarantees a minimum payment of US$2400 per contract.
Client Order Cancellation
If the client cancels the order on the next day, determine the appropriate action, such as entering into offsetting futures contracts or a long futures contract to hedge against foreign currency payable in the future.
Market Players and Motives
Hedgers hedge their cash flows and asset values. FX exposures are managed by arbitrageurs who exploit any price inefficiencies in the market.
Client cancels the order on the next day
If the client cancels the order on the next day, the company can enter into offsetting futures contracts to mitigate the risk.
Hedgers
Hedgers use futures contracts to hedge their cash flows and asset values in order to manage FX exposures.
Arbitrageurs
Arbitrageurs exploit any departure from Interest Rate Parity (IRP) and profit from trading in money markets, interest rate differentials, spot, and futures contracts.
Speculators
Speculators seek exposure in the FX market and trade on their expectations of FX rate movements.
Market Makers/Dealers
Market makers and dealers profit from bid-ask spreads by providing liquidity and facilitating short-term demand/supply in the market.
Currency Options
In contrast to forward and futures contracts, currency options give the buyer the right but not the obligation to exchange currencies.
Buyer of Currency Option
The buyer of a currency option has the right but not the obligation to buy or sell the contracted currency at a pre-specified FX rate (exercise price) and on a pre-specified date (expiration date).
Writer of Currency Option
The writer or seller of a currency option is at the mercy of the buyer and is obliged to fulfill whatever choice the buyer makes. The writer receives an upfront cash premium from the buyer, which is the price of the option.
American Option
An American currency option can be exercised at any time up to the expiration date.
European Option
A European currency option can only be exercised at the expiration date.
In-the-Money Option
An option that is profitable to exercise at the current spot FX rate is in-the-money.
Out-of-the-Money Option
An option that is not profitable to exercise at the current spot FX rate is out-of-the-money.
European option buyer will only exercise option if it is in the money at expiration.
The buyer of a European option will only exercise the option if the prevailing spot FX rate at expiration is favorable (higher for a call option, lower for a put option) compared to the strike price.
Exchange-Traded Currency Options
Similar to futures contracts, currency options are exchange-traded. For example, options against the US dollar are traded in 10,000 unit contracts, and the option premium is in US cents per unit in exchanges like PHLX and CME.
Call Option Payoff Patterns
If a European 730 call option (strike rate US0.730) is trading at 103 cents and the spot FX rate turns out to be US0.720, the call option buyer will not exercise. If the spot FX rate is US0.740, the call option buyer will exercise. The breakeven point is the strike price plus the premium.
Hedging with Call Options
A US company can use a call option to hedge against the FX risk of a C50000 payable in 3 months. The net payoff pattern will depend on the difference between the spot rate at expiration and the strike price. Hedging with call options differs from forward or futures contracts in terms of the premium paid and the potential loss being limited to the premium.
Put Option Payoff Patterns
For a European 735 put option (strike rate US0.735) trading at 151 cents, if the spot FX rate is US0.725, the put option buyer will exercise. If the spot FX rate is US0.745, the put option buyer will not exercise. The breakeven point is the strike price minus the premium.
Hedging with Put Options
A US company can use a put option to hedge against the FX risk of a C50000 receivable in 6 months. The net payoff pattern will depend on the difference between the spot rate at expiration and the strike price. Hedging with put options differs from forward or futures contracts in terms of the premium paid and the potential loss being limited to the premium.
Plain Vanilla Interest Rate Swaps
In plain vanilla interest rate swaps, two parties exchange fixed versus floating interest payments. The swap buyer agrees to pay the swap seller a pre-determined fixed rate, while receiving a floating interest rate in return.
Hedging with a forward or futures contract
Locks in the future exchange rate for a specified amount of currency
Payoff pattern for put options
Allows the holder to sell an asset at a predetermined price within a specified time
Should the company hedge with put options or forward/futures contracts?
It depends on the company's specific risk exposure, objectives, and market conditions
Interest Rate Swaps
Agreement between two parties to exchange fixed and floating interest payments
Party B in an interest rate swap
Swap buyer who agrees to pay a predetermined fixed rate on a notional principal
Party A in an interest rate swap
Swap seller who agrees to pay interest at a floating rate on the same notional amount over the same period of time
Notional principal in an interest rate swap
The principal amount on which the exchanged interest payments are based; not physically exchanged
Reference Floating Rate in an interest rate swap
Commonly based on the London Interbank Offered Rate (LIBOR) or other bank interest rate benchmarks
Two-year swap initiated on Sep 1, 2023
Party B agrees to pay Party A a fixed rate of 7% per annum every 6 months on a notional of 100M; Party A agrees to pay Party B the six-month LIBOR floating plus 50 basis points on the same notional
Exchanges of Payments
- Party B's payment amount is fixed and certain: 100M72 35M - Party A's payment amounts are uncertain and depend on the realized 6-month LIBOR except for the first payment.
Payment Schedule
- 1st payment payable on Mar 1, 2024: 100MLIBOR6mSep2023052 - 2nd payment payable on Sep 1, 2024: 100MLIBOR6mMar2024052 - Etc. subsequent payments depend on the evolution of 6-month LIBOR.
Hedging with Interest Rate Swaps
- Party B uses interest rate swaps to transform borrowing at a floating rate to borrowing at a fixed rate to hedge its net cash flow against interest rate risks. - Party A uses swaps to transform borrowing at a fixed rate to borrowing at a floating rate to hedge its interest rate risks.
Party B's Transformation of Borrowings
- Party B transforms floating LIBOR borrowing to an effective fixed rate borrowing of 65 to hedge its interest rate risks. - This is done to protect net interest income, which is vulnerable to interest rate hikes.
Party A's Transformation of Borrowings
- Party A transforms fixed-rate borrowing into an effective floating-rate borrowing of LIBOR 05 to hedge its interest rate risks. - This is done to protect against vulnerability to an interest rate drop.
Motivations of Interest Rate Swaps
- Party A did not borrow at a floating rate because its returns are floating. - Party B did not borrow at a fixed rate because its returns are fixed. - Arbitrage opportunity to exploit differences in perceived credit quality across financial markets.
Financing Options Available to A and B
- Credit differential: Fixed (6 for A, 8 for B), Floating (LIBOR, LIBOR + 0).
Fixed vs Floating Financing
The two financing options available to Party A and Party B differ in terms of fixed and floating interest rates.
Credit Quality Differential
In the fixed market, Party B is considered to be of lower credit quality, requiring 2 more in interest compared to Party A. In the floating market, Party A and Party B are perceived to be of the same credit quality and are charged the same rate.
Exploiting Comparative Advantage
Party A has a comparative advantage borrowing in the fixed-rate market, while Party B has a comparative advantage in the floating-rate market. This anomaly can be exploited via the use of interest rate swaps.
Interest Rate Swap
Party A borrows in the fixed-rate market and enters into an interest rate swap to swap cash flows, while Party B borrows in the floating-rate market and does the same. This results in a win-win situation for both parties.
Role of Financial Intermediary
It is difficult for two nonfinancial companies to get in touch with each other directly to arrange a swap. Financial institutions serve as intermediaries to matchup the counterparties; they take position when a match cannot be found (i.e., warehousing). Compensated by charging a spread fee. For example, an intermediary (e.g., a bank) charging 15 basis points.
What is the new range of possible cost savings that the parties can realize?
Range of savings plus the spread fee charged by the intermediary (e.g., 15 basis points from a bank).
What is the range of possible swap terms that can be agreed on by the parties?
The range of swap terms is determined by the swap agreement and the spread fee charged by the financial intermediary.
Currency Swaps
Two parties exchange both principal and fixed-rate interest payments on a loan in one currency for principal and fixed-rate interest on an equivalent loan in another currency.
Suppose the current spot rate is US1 = 45, Party A and B enter into a three-year currency swap. Today, Party B lends $1M principal to Party A in exchange for A lending US$45M principal to B. Every 12 months, Party A pays an interest of 11% on the $1M borrowed, i.e., an interest payment of $110,000. Party B pays an interest of 8% on the US$45M it owed, i.e., an interest payment of US$116,000. At the end of 3 years, Party B returns the US$45M principal to A and A returns $1M to B.
Details of the currency swap agreement and the interest payments.
Equivalent Forward Contracts
This currency swap is equivalent to Party B and Party A taking long and short positions in a portfolio of four forward contracts.
Effective forward rate for the exchange of interest payments at the end of year 1, 2, and 3
The effective forward rate for the exchange of interest payments due at the end of these periods.
Effective forward rate for the exchange of principal at the end of year 3
The effective forward rate for the exchange of the principal amount at the end of the third year.
Motivation for Currency Swaps
To exploit comparative advantage in borrowing in financial markets of different currencies. Typically, it is cheaper for a firm to borrow domestically than from abroad because the firm is well-known domestically but a relatively unknown credit in foreign markets. However, multinational corporations (MNCs) want to hedge FX risks by borrowing in the same currency in which their returns from foreign investments are denominated.
Exploit Comparative Advantage
The aim is to benefit from the cost differences in borrowing between financial markets of different currencies. MNCs may borrow in one currency where they have a competitive advantage (e.g., domestic market) and use currency swaps to convert the loan into another currency to match their foreign investments.
Why is it generally cheaper for a firm to borrow domestically than from abroad?
A firm is well-known domestically but relatively unknown credit in foreign markets, making it easier to borrow domestically.
How do multinational corporations (MNCs) hedge FX risks related to borrowing?
MNCs borrow in the same currency in which their returns from foreign investments are denominated.
What is the concept of exploiting comparative advantage in borrowing?
It involves two parties with credit differences and different market perceptions borrowing in each other's markets to save on financing costs.
How can two parties exploit the comparative advantage in borrowing using a currency swap?
The parties enter into a currency swap to swap interest payments and principal, enabling them to effectively borrow at lower rates in the desired currency.
What is the total savings achieved through exploiting the comparative advantage in borrowing using a currency swap?
The total savings equals the size of the anomaly, which is determined by the credit differences and market perceptions of the two parties.
What is the translation method used in Canada for balance sheet items, land, buildings, and equipment?
Variation of the current rate method where all balance sheet items are translated at the current rate except for land, buildings, and equipment at the historical rate.
How are income statement items translated in the Canadian method?
All income statement items are translated at the average FX rate over the period, except for depreciation, which is translated at the historical rate.
What happens to the translation unrealized gain/loss in the Canadian method?
It bypasses the income statement and is directly reflected in the parent's equity account in the balance sheet as cumulative translation adjustment.
Provide an example of the Canadian translation method with a Canadian mining company leasing a gold mine in Australia.
Initial investment of A20 million is required, with A18 million for fixed assets and A2 million for working capital. If A depreciates to C100A, the translation gain/loss of the subsidiary can be calculated.
What is the objective of managing translation exposure in international business?
The objective is to equalize the amount of foreign currency-denominated assets and liabilities to zero translation loss regardless of FX movements.
What are some methods for managing translation exposure in international business?
Funds adjustment, using financial derivatives (e.g., forward contracts, futures contracts, currency options, currency swap), and exposure netting.
How can exposure netting be used to manage translation exposure?
Exposure netting involves offsetting hard currency exposures with soft currency exposures to reduce the overall translation exposure.
In the Canadian translation method, how can financial derivatives be used to offset translation exposure?
A long or short forward contract can be used to offset translation exposure. For example, a long A3M one-year forward contract can offset translation exposure due to A appreciation/depreciation.
Necessarily Economic Exposure
The extent to which a company is affected by the movements in foreign exchange rates and commodity prices.
Exposure Netting
The process of offsetting a company's exposures in one currency or commodity with its exposures in another, in order to reduce risk.
Transaction Exposure
Arises when a firm has entered into a contract involving future cash flows in foreign currency, affecting the firm's present value (PV).
Offset Exposures
Offset exposures in one currency with exposures in the same or another similar currency within a single subsidiary or across subsidiaries.
Foreign Currency Depreciation
Results in loss on a net foreign asset in Subsidiary X being offset by gain in a net foreign liability in Subsidiary Y.
Correlated Movement
Foreign currencies need not be identical, only need to move in a correlated positive or negative fashion.
Portfolio Diversification
Ensures a lower consolidated currency exposure even if exposures are uncorrelated.
Managing Transaction Exposure
Objective: enter into foreign currency transaction whose cash flows (CFs) exactly offset CFs of transaction exposure. Eg: forward market hedge, money-market hedge, currency option and its combinations, risk shifting/sharing, price adjustment clauses.
Forward Market Hedge
Fixes the home currency (HC) value of future foreign currency (FC) cash flows. Short FC forward if receiving FC, long FC forward if paying FC.
Use of Forward/Futures Contracts
Used to hedge for single CFs. Use swaps for a series of FC CFs. Entering into fwd contracts is free, but it eliminates downside risk, sacrificing upside gain unlike options.
Example of Forward Market Hedge
A US importer who has entered into a purchase agreement to buy $1M worth of machinery from a German supplier can use a short forward contract if they will be receiving euros or a long forward contract if they will be paying euros.
Forward Contract
A contract that locks in the exchange rate for a future foreign currency transaction, reducing the uncertainty of exchange rate movements.
Forward Market Hedge
Using a forward contract to hedge against foreign exchange risk by locking in a future exchange rate, thereby offsetting the risk of exchange rate fluctuations.
Spot Rate
The current exchange rate for immediate delivery of currency, representing the rate at which currencies can be bought or sold on the spot date.
30-Day Forward Rate
The exchange rate agreed upon now for the purchase or sale of currency at a future date, typically 30 days from the present.
Exchange Gain/Loss
The difference between the amount paid for foreign currency and the amount of foreign currency received, due to fluctuations in exchange rates.
Realized Payment
The actual payment made in a foreign currency transaction, affected by the spot exchange rate at the time of payment.
Foreign Currency
Currency used in a transaction that is not the domestic currency of the country in which the transaction takes place.
Money Market Hedge
A strategy that involves simultaneous borrowing and lending in different currencies to lock in the domestic currency value of a future foreign currency cash flow.
Homemade Forward Contract
A self-created forward contract achieved through a combination of borrowing, lending, and spot exchange transactions, based on the Interest Rate Parity (IRP) principle.
Interest Rate Parity (IRP)
An economic theory stating that the difference in interest rates between two countries is equal to the difference between the forward exchange rate and the spot exchange rate, accounting for the present value of the expected future exchange rate.
Realized Payment
The actual settlement of an obligation or payment.
Money Market
The market in which short-term borrowing, lending, buying, and selling of financial instruments takes place.
Gain/Loss
The positive or negative difference between the cost of an asset and the price at which it is currently valued.
Total
The sum of all components or parts.
Spot FX
The exchange rate for immediate delivery of currencies.
Draw
To receive or obtain funds from a specific source.
Payoff Patterns
The set of potential outcomes or returns from a particular financial strategy or position.
Unhedged
Exposing to financial risk without implementing any hedging strategy.
Borrowing/Lending
The process of obtaining or providing financial resources with the intention of repayment along with interest.
Hedged
Protected against financial risk through the implementation of hedging techniques or instruments.
Transaction Costs
The direct and indirect expenses incurred during the execution of a financial transaction.
Arbitrage Opportunity
A situation where an investor can take advantage of price or interest rate differentials in different markets to make a profit without risk.
Forward Market Hedge
A strategy to protect against adverse movements in exchange rates by using forward contracts to lock in a future exchange rate.
Money Market Hedge
A technique used to hedge against exchange rate risk by borrowing or lending in a foreign currency with the same maturity as the transaction.
Currency Options
Financial instruments that give the holder the right, but not the obligation, to buy or sell a specified amount of foreign currency at a pre-determined price within a specified period.
Long/Short Forward Position
A commitment to buy or sell a currency at a specified future date at an agreed-upon price.
Put Option
An option contract that gives the holder the right to sell a specified amount of foreign currency at a pre-determined price within a specified period.
Call Option
An option contract that gives the holder the right to buy a specified amount of foreign currency at a pre-determined price within a specified period.
Strike Price
The pre-determined price at which a specified amount of foreign currency can be bought or sold using an option contract.
Premium
The amount paid for an option contract to secure the right to buy or sell foreign currency.
Currency Collars
A strategy that involves simultaneously buying a call option and selling a put option on a foreign currency, with the aim of limiting the potential exchange rate movement within a specific range.
Operating Exposure
The risk that a firm faces due to changes in exchange rates affecting its future cash flows and competitive position, beyond the impact of transaction exposure.
PV (Present Value)
The current worth of a future sum of money or stream of cash flows, given a specified rate of return.
Operating FX Exposure
Operating FX Exposure refers to the risk a company faces due to changes in the real exchange rate, impacting sales volume, foreign unit price, and home unit cost in the long run.
Transaction FX Exposure
Transaction FX Exposure is the risk a company faces due to short-term changes in the nominal exchange rate, impacting sales volume, foreign unit price, and home unit cost.
Economic Exposure
Economic Exposure refers to the risk of a company's market value and cash flows being impacted by changes in exchange rates, leading to potential changes in the present value of its future cash flows.
Real Exchange Rate
The Real Exchange Rate is the rate at which the currency of one country can be exchanged for the currency of another country, adjusted for changes in price levels or inflation.
PPP (Purchasing Power Parity)
PPP holds that in the absence of transportation costs and government intervention, the price of an identical basket of goods and services should be the same in any two countries, and any change in the nominal exchange rate should be offset by changes in relative price levels.
Operating Exposure and Real Exchange Rate
Operating exposure refers to the potential impact of exchange rate changes on a company's future operating cash flows. It can be analyzed in the context of real exchange rate and purchasing power parity (PPP).
Effect of Constant Real Exchange Rate
If the real exchange rate remains constant, firms have zero operating exposure. Any decrease in home currency cash flows due to depreciation of a foreign currency will be offset by an increase in cash flows due to an increase in foreign price level.
Example: Boeing's Projected Cash Flow
Boeing plans to sell 20 commercial airplanes in Europe at a unit cost of $55M and a competitive unit price of $65M. If the spot rate is $1 = €1.10, the projected cash flow in USD is $330M with a unit margin of $165M.
Effect of 10% Depreciation
If the euro depreciates by 10%, and PPP holds with the US price level unchanged, the change in European price level should be 9.09%. There is no operating exposure for Boeing in this scenario because PPP is satisfied.
Effect of Real Exchange Rate Changes
If PPP does not hold, especially in the short run due to sticky prices and wages, firms like Boeing may face difficulties. For example, a depreciation in real terms without inflation in Europe can impact the firm's market share and sales, affecting the projected cash flows.
CF
Cash Flow
U
Units
X
Cross (Multiplier)
7222
Unspecified code for accounting purposes
U099
Unit code for specific investment type
U55M
Unit code for specific investment type 55
12
Indicates number of units or amount
Margin
The difference between the cost of goods sold and the selling price
Remains the same
Continues at the same level
U198M
Unit code for specific investment type 198 with margin
U330M
Unit code for specific investment type 330 with margin
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