Chapter 8

Foreign Currency Derivatives and Swaps

 Questions
1. Options versus Futures. Explain the difference between foreign currency options and futures and
when either might be most appropriately used.
A foreign currency option is a contract that gives the option purchaser (the buyer) the right, but not
the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a
specified time period (until the maturity date). A foreign currency futures contract calls for future
delivery of a standard amount of foreign exchange at a fixed time, place, and price.
The essence of the difference is that an option leaves the buyer with the choice of exercising or not
exercising. The future requires a mandatory delivery.
2. Trading Location for Futures. Check the Wall Street Journal to find where in the United States
foreign exchange future contracts are traded.
The Wall Street Journal reports on foreign exchange futures trading for Chicago Mercantile
Exchange (CME).
3. Futures Terminology. Explain the meaning and probable significance for international business of
the following contract specifications:
Specific-sized contract. Trading may be conducted only in pre-established multiples of currency
units. This means that a firm wishing to hedge some aspect of its foreign exchange risk may not be
able to match the contract size with the size of the risk.
Standard method of stating exchange rates. Rates are stated in “American terms,” meaning the
U.S. dollar value of the foreign currency, rather than in the more generally accepted “European
terms,” meaning the foreign currency price of a U.S. dollar. This has no conceptual significance,
although financial managers used to viewing exposure in European terms will find it necessary to
convert to reciprocals.
Standard maturity date. All contracts mature at a pre-established date, being on the third Wednesday
of eight specified months. This means that a firm wishing to use foreign exchange futures to cover
exchange risk may not be able to match the contract maturity with the risk maturity.
Collateral and maintenance margins. One of the defining characteristics of futures is the requirement
that the purchaser deposits a sum as an initial margin or collateral. This requirement is similar to
requiring a performance bond, and it can be met by a letter of credit from a bank, Treasury bills, or
cash. In addition, a maintenance margin is required. The value of the contract is marked-to-market
daily, and all changes in value are paid in cash daily. Marked-to-market means that the value of the
contract is revalued using the closing price for the day. The amount to be paid is called the variation
margin.
Counterparty. All futures contracts are with the clearing house of the exchange where they are traded.
Consequently, a firm or individual engaged in buying or selling futures contracts need not worry about
the credit risk of the opposite, or counter, party.

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32 Moffett/Stonehill/Eiteman • Fundamentals of Multinational Finance, Fourth Edition

4. A Futures Trade. A newspaper shows the prices below for the previous day’s trading in U.S. dollar-
euro currency futures. What do the terms shown indicate?

This data reports that 29,763 contracts, each contract being for €125,000, were traded for settlement
on the third Wednesday of the following December. The total euro value of all contracts traded
on the day for which data are reported is the product of the two numbers: 29,763 × €125,000 =
€3,720,375,000. The highest price during the day at which euro futures traded was $0.9147/€. The
lowest price was $0.9098/€. The first trade of the day was at $0.9124/€ and the last trade, called
“settlement,” was at $0.9136/€. This closing price was 0.0027 above the previous day’s close, from
which one can determine that on the previous day euro contracts closed at $0.9136/€ − $0.0027/€ =
$0.9109/€. The closing “settlement” price is the price used by futures exchanges to determine margin
calls. Open interest is the sum of all long (buying futures) and short (selling futures) contracts
outstanding.
5. Puts and Calls. What is the basic difference between a put on British pounds sterling and a call on
sterling?
A put on pounds sterling is a contract giving the owner (buyer) the right, but not the obligation, to sell
pounds sterling for dollars at the exchange rate stated in the put. A call on pounds sterling is a contract
giving the owner (buyer) the right, but not the obligation, to buy pounds sterling for dollars at the
exchange rate stated in the call.
6. Call Contract Elements. You read that exchange-traded American call options on pounds sterling
having a strike price of 1.460 and a maturity of next March are now quoted at 3.67. What does this
mean if you are a potential buyer?
If you buy such an option, you have the right to force the writer/seller of the option to deliver pounds
sterling to you and you will pay $1.460 for each pound. $1.460/£ is called the “strike price.” You
have this right (this “option”) until next March, and for this right you will pay 3.67¢ per pound. The
information provided to you does not tell you the size of each option contract, which you would have
to know from general experience or from asking your broker. The contract size for pounds sterling on
the Chicago Mercantile Exchange is £62,500 per contract, meaning that the option will cost you
£62,500 × $0.0367 = $2,293.75.
7. The Option Cost. What happens to the premium you paid for the above option in the event you
decide to let the option expire unexercised? What happens to this amount in the event you do decide
to exercise the option?
The amount you pay for the option is gone forever, whether or not you exercise the option. This is the
amount paid to the writer/seller of the option, who undertakes the open-ended obligation to deliver
pounds to you should you so wish. If you do not exercise the option, this is the sunk cost of buying
options. If you in fact do exercise the option, your direct profit on the option is reduced by this
amount which has already been paid out.

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 Chapter 8 Foreign Currency Derivatives and Swaps 33

8. Buying a European Option. You have the same information as in Question 4 above, except that the
pricing is for a European option. What is different?
The only difference is that you may exercise the option only on the day that it matures. Of course,
you may sell the option to another investor at any time, as the option would still have some “time
value” above its “intrinsic value” before the expiration date.

9. Writing Options. Why would anyone write an option, knowing that the gain from receiving the
option premium is fixed but the loss if the underlying price goes in the wrong direction can be
extremely large?
From the option writer’s point of view, only two events can take place:
a. The option is not exercised. In this case the writer gains the option premium and still has the
underlying stock. Historically, 75% − 80% of options expire and are not exercised.
b. The option is exercised. If the option writer owns the stock and the option is exercised, the option
writer (a) gains the premium and (b) experiences only an opportunity cost loss. In other words,
the loss is not a cash loss, but rather the opportunity cost loss of having foregone the potential of
making even more profit had the underlying shares been sold at a more advantageous price. This
is somewhat equivalent of having sold (call option writer) or bought (put option writer) at a price
better than current market, only to have the market price move even further in a beneficial
direction. If the option writer does not own the underlying shares, the option is written “naked.”
Only in this instance can the cash loss to the option writer be a very large amount.

10. Option Valuation. The value of an option is stated to be the sum of its intrinsic value and its time
value. Explain what is meant by these terms.
a. Intrinsic value is the financial gain if the option is exercised immediately. The intrinsic value for
a call option is zero until it reaches the strike price, then rises linearly (1 cent for each 1-cent increase
in the spot rate). Intrinsic value will be zero when the option is out-of-the-money—that is, when
the strike price is above the market price—as no gain can be derived from exercising the option.
When the spot rate rises above the strike price, the intrinsic value becomes positive because the
option is always worth at least this value if exercised.
For a put option, the intrinsic value is zero until the price falls to equal the strike price, then rises
linearly (1 cent for each 1-cent decrease in the spot rate). Intrinsic value will be zero when the
option is out-of-the-money—that is, when the strike price is below the market price—as no gain
can be derived from exercising the option. When the spot rate falls below the strike price, the
intrinsic value becomes positive because the option is worth at least this value if exercised.
On the date of maturity, both call and put option s will have a value equal to its intrinsic value
(zero time remaining means zero time value).
b. Time value The time value of an option exists because the price of the underlying currency, the
spot rate, can potentially move further and further into the money before the option’s expiration.
Time value is the difference between the total value of the option and its intrinsic value. An
investor will pay something today for an out-of-the-money option (i.e., zero intrinsic value) on
the chance that the spot rate will move far enough before maturity to move the option in-the-
money. Consequently, the price of an option is always somewhat greater than its intrinsic value,
since there is always some chance that the intrinsic value will rise between the present and the
expiration date.

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34 Moffett/Stonehill/Eiteman • Fundamentals of Multinational Finance, Fourth Edition

11. Reference Rates. What is an interest “reference rate” and how is it used to set rates for individual
borrowers?
A reference rate—for example, the prime rate, the rate on a specific-maturity U.S. Treasury security,
or the U.S. dollar LIBOR is the rate of interest used in a standardized quotation, loan agreement, or
financial derivative valuation. LIBOR, the London Interbank Offered Rate, is by far the most widely
used and quoted. It is officially defined by the British Bankers Association (BBA). U.S. dollar
LIBOR is the mean of 16 multinational banks’ interbank offered rates as sampled by the BBA at
approximately 11 A.M. London time in London. Similarly, the BBA calculates the Japanese yen
LIBOR, euro LIBOR, and other currency LIBOR rates at the same time in London from samples of
banks.

12. Risks and Return. Some corporate treasury departments are organized as service centers (cost centers),
while others are set up as profit centers. What is the difference and what are the implications for the
firm?
Before they can manage interest rate risk, treasurers and financial managers of all types must resolve
a basic management dilemma: the balance between risk and return. Treasury has traditionally been
considered a service center (cost center) and is therefore not expected to take positions that incur risk
in the expectation of profit. Treasury activities are rarely managed or evaluated as profit centers.
Treasury management practices are therefore predominantly conservative, but opportunities to reduce
costs or actually earn profits are not to be ignored. History, however, is littered with examples in
which financial managers have strayed from their fiduciary responsibilities in the expectation of
profit. Unfortunately, much of the time they have realized only loss.

13. Forecast Types. What is the difference between a specific forecast and a directional forecast?
A spot (specific) forecast of an interest rate would be the forecast of an ending value for a specific
period. A directional forecast is just that, where the focus is on whether interest rates are expected to
rise or fall over the coming target forecast period.

14. Policy Statements. Explain the difference between a goal statement and a policy statement.
Major derivative disasters of the past have highlighted the need for the proper construction and
implementation of corporate financial management policy statements. Policy statements are,
however, frequently misunderstood by those writing and enforcing them. A few helpful fundamentals
may be in order.
• A policy is a rule, not a goal. A policy is intended to limit or restrict management actions, not set
priorities or goals. For example, “thou shalt not write uncovered options” is a policy. “Management
will pursue the lowest cost of capital at all times” is a goal.
• A policy is intended to restrict some subjective decision making. Although at first glance this
aspect seems to indicate that management is not to be trusted, it is actually intended to make
management’s decision making easier in potentially harmful situations.
• A policy is intended to establish operating guidelines independently of staff. Although many policies
may appear overly restrictive given the specific talents of financial staff, the fiduciary responsibility
of the firm needs to be maintained independently of the specific personnel on-board. Changes in
personnel frequently place new managers in uncomfortable and unfamiliar surroundings. Errors
in judgment may result. Proper policy construction provides a constructive and protective base for
management’s learning curve.

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 Chapter 8 Foreign Currency Derivatives and Swaps 35

15. Credit and Repricing Risk. From the point of view of a borrowing corporation, what are credit and
repricing risks? Explain steps a company might take to minimize both.
Credit risk, sometimes termed roll-over risk, is the possibility that a borrower’s creditworthiness, at
the time of renewing a credit, is reclassified by the lender. This can result in changing fees, changing
interest rates, altered credit line commitments, or even denial. Repricing risk is the risk of changes in
interest rates at the time a financial contract’s rate is reset. Consider the following three different debt
strategies being considered by a corporate borrower. Each is intended to provide $3 million in
financing for a five-year period.
• Strategy 1: Borrow $3 million for five years at a fixed rate of interest.
• Strategy 2: Borrow $3 million for five years at a floating rate, LIBOR + 2%, to be reset annually.
• Strategy 3: Borrow $3 million for one year at a fixed rate, then renew the credit annually.
Although the lowest cost of funds is always a major selection criteria, it is not the only one. If the
firm chooses Strategy 1, it assures itself of the funding for the full five years at a known interest rate.
It has maximized the predictability of cash flows for the debt obligation. What it has sacrificed, to
some degree, is the ability to enjoy a lower interest rate in the event that interest rates fall over the
period. Of course, it has also eliminated the risk that interest rates could rise over the period,
increasing debt servicing costs.
Strategy 2 offers what Strategy 1 did not, flexibility (repricing risk). It too assures the firm of full
funding for the five-year period. This eliminates credit risk. Repricing risk is, however, alive and well
in Strategy 2. If LIBOR changes dramatically, the rate change is passed through fully to the borrower.
The spread, however, remains fixed (reflecting the credit standing that has been locked in for the full
five years). Flexibility comes at a cost in this case, the risk that interest rates could go up as well as
down.
Strategy 3 offers more flexibility and more risk. First, the firm is borrowing at the shorter end of the
yield curve. If the yield curve is positively sloped, as is commonly the case, the base interest rate should
be lower. But the short end of the yield curve is also the more volatile. It responds to short-term events
in a much more pronounced fashion than longer-term rates. The strategy also exposes the firm to the
possibility that its credit rating may change dramatically by the time of the credit renewal, for better
or worse. Noting that credit ratings in general are established on the premise that a firm can meet its
debt-service obligations under worsening economic conditions, firms that are highly creditworthy
(investment rated grades) may view Strategy 3 as a more relevant alternative than do firms of lower
quality (speculative grades). This is not a strategy for firms that are financially weak.

16. Forward Rate Agreement. How can a business firm that has borrowed on a floating rate basis use a
forward rate agreement to reduce interest rate risk?
A forward rate agreement (FRA) is an interbank-traded contract to buy or sell interest rate payments
on a notional principal. These contracts are settled in cash. The buyer of an FRA obtains the right to
lock in an interest rate for a desired term that begins at a future date. The contract specifies that the
seller of the FRA will pay the buyer the increased interest expense on a nominal sum (the notional
principal) of money if interest rates rise above the agreed rate, but the buyer will pay the seller the
differential interest expense if interest rates fall below the agreed rate. Maturities available are
typically 1, 3, 6, 9, and 12 months, much like traditional forward contracts for currencies.
To offset the risk of borrowing on a floating rate basis, the business would take a forward position
such that the change in the value of the forward position would offset the change in interest expense
on the borrowings. Selling a FRA would reduce the interest rate risk. If interest rates go up, the FRA
would increase in value, offsetting the higher interest expense. If interest rates go down, the FRA
would fall in value, counteracting the lower interest expense.

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36 Moffett/Stonehill/Eiteman • Fundamentals of Multinational Finance, Fourth Edition

17. Eurodollar Futures. A newspaper reports that a given June Eurodollar futures settled at 93.55. What
was the annual yield? How many dollars does this represent?
The annual yield is calculated as:
Annual yield = 100.00 − 93.55 = 6.45%.
Each Eurodollar contract is for a notional principal of $1 million.

18. Defaulting on an Interest Rate Swap. Smith Company and Jones Company enter into an interest
rate swap, with Smith paying fixed interest to Jones, and Jones paying floating interest to Smith.
Smith now goes bankrupt and so defaults on its remaining interest payments. What is the financial
damage to Jones Company?
The financial damage to Jones Company is the difference in the interest rate payments. The principal
is not at risk. Since Jones is paying floating/receiving fixed, they likely have a fixed-rate debt and
expected interest rates to fall. With the default of Smith Company, Jones will not benefit in the event
rates do fall.

19. Currency Swaps. Why would one company, with interest payments due in pounds sterling, want to
swap those payments for interest payments due in U.S. dollars?
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 firm’s
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. The reason they do so is cost;
specific firms may find capital costs in specific currencies attractively priced to them under special
conditions. Having raised the capital, however, the firm may wish to swap its repayment into a currency
in which it has future operating revenues.

20. Counterparty Risk. How does exchange trading in swaps remove any risk that the counterparty in a
swap agreement will not complete the agreement?
Counterparty risk is the potential exposure any individual firm bears that the second party to any
financial contract will be unable to fulfill its obligations under the contract’s specifications. Concern
over counterparty risk has risen in the interest rate and currency swap markets as a result of a few
large and well-publicized swap defaults. The rapid growth in the currency and interest rate financial
derivatives markets has actually been accompanied by a surprisingly low default rate to date, particularly
in a global market that is, in principle, unregulated.
Counterparty risk has long been one of the major factors that favor the use of exchange-traded rather
than over-the-counter derivatives. Most exchanges, like the Philadelphia Stock Exchange for currency
options or the Chicago Mercantile Exchange for Eurodollar futures, are themselves the counterparty
to all transactions. This allows all firms a high degree of confidence that they can buy or sell exchange-
traded products quickly, and with little concern over the credit quality of the exchange itself. Financial
exchanges typically require a small fee of all traders on the exchanges, to fund insurance funds created
expressly for the purpose of protecting all parties. Over-the-counter products, however, are direct
credit exposures to the firm because the contract is generally between the buying firm and the selling
financial institution. Most financial derivatives in today’s world financial centers are sold or brokered
only by the largest and soundest financial institutions. This structure does not mean, however, that
firms can enter continuing agreements with these institutions without some degree of real financial
risk and concern.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall