Lecture 6 & 7:
Currency and interest
rate Derivatives
Outline
Currency futures vs. interest rate
futures
Currency Options
Interest rate vs. currency swaps
Financial management of the MNE in the 21st century
involves financial derivatives.
These derivatives, so named because their values are
derived from underlying assets, are a powerful tool used
Foreign in business today.
Currency These instruments can be used for two very distinct
management objectives:
Derivatives 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.
Foreign Currency Futures
vs. Forward
A foreign currency futures contract is an alternative to
a forward contract that calls for future delivery of a
standard amount of foreign exchange at a fixed time,
place and price.
It is similar to futures contracts that exist for
commodities such as cattle, lumber, interest-bearing
deposits, gold, etc.
In the U.S., the most important market for foreign
currency futures is the International Monetary Market
(IMM), a division of the Chicago Mercantile Exchange.
Exchanges
trading futures
CBOT and CME (now CME Group)
Intercontinental Exchange
NYSE Euronext
Eurex
China Financial Futures
Exchange (CFFEX)
Shanghai Futures Exchange (SHFE)
Singapore Commodity
Exchange (SICOM)
HNX, HOSE, MXV (Vietnam)
Foreign Currency Futures
Contract specifications are established by the
exchange on which futures are traded.
Major features that are standardized are:
Contract size
Method of stating exchange rates
Maturity date
Last trading day
Collateral and maintenance margins
Settlement
Commissions
Use of a clearinghouse as a counterparty
Mexican Peso (CME)-MXN 500,000; $ per
MXN
Example
Example
Example
Source: bsc.com.vn
Example
Source: bsc.com.vn
Short position: If a
speculator sells a futures
contract, they are locking in
Foreign the price at which they must
sell that currency on a
Currency specified date.
Futures
Long position: If a speculator
buys a futures contract, they
are locking in the price at
which they must buy that
currency on a specified
future date.
Notional principal.
Initial margin or collateral: amount of money the
purchasers must put into the account as
collateral.
Marked to market: means that the value of the
contract is revalued using the closing price for the
day
Foreign
Maintenance margin: the minimum amount of
Currency equity that must be maintained in a margin
account
Futures Variation margin: the amount of funds needed to
ensure margin levels for trading.
5% of all futures contracts are settled by the
physical delivery. Most often, buyers and sellers
offset their original position prior to delivery date
by taking an opposite position close out a
futures position
Foreign Currency Futures
Example: long position in March MXN futures contract at the price $0.10958/MXN
Notional principal: a futures contract is for delivery of MXN500,000 (equivalent to
$55,479)
The method of stating exchange rates is in American terms, the U.S. dollar cost
(price) of a foreign currency (unit), $/10MXN.
The delivery date is the third Wednesday of delivery month.
The last trading day is the second business day preceding the delivery day.
The initial margin is 5% of the futures contract value (=$2,773.95)
The maintenance margin is $1,000
If the prices go down, long position pay the short
If the prices go up, short position pay the long
Foreign Currency Futures
Short position: If a speculator sells a futures contract, they are locking
in the price at which they must sell that currency on that future date.
Example: If Amber McClain believes that the Mexican peso will fall in
value versus the U.S. dollar by March, Amber sells one March futures
contract for 500,000 pesos at the settle price, of $.10958/MXN.
The value of her short position at maturity is:
Value at maturity = Notional principal*(Futures - Spot)
If the spot rate at maturity (in March) = $.09500/MXN
Value at maturity = ?
Foreign Currency Futures
Long position: If a speculator buys a futures contract, they are
locking in the price at which they must buy that currency on the
specified future date.
Example: If Amber expected the peso to rise in value versus the
dollar in the near term, she could take a long position, by
buying a March futures on 500,000 pesos at the settle price, of
$.10958/MXN.
Value at maturity = Notional principal * (Spot - Futures)
What is the value of her position if the spot exchange rate at
maturity is $.1100/MXN and $0.0800/MXN?
Foreign Currency Futures
Foreign currency futures contracts differ from forward
contracts in a number of important ways:
Futures are standardized in terms of size while forwards can be
customized
Futures have fixed maturities while forwards can have any
maturity (both typically have maturities of one year or less)
Trading on futures occurs on organized exchanges while forwards
are traded between individuals and banks
Futures have an initial margin that is marked to market on a daily
basis while only a bank relationship is needed for a forward
Futures are rarely delivered upon (settled) while forwards are
normally delivered upon (settled)
Futures vs Forward
Interest Rate Risk
All firms – domestic or multinational, small or large,
leveraged or unleveraged – are sensitive to interest rate
movements in one way or another.
The single largest interest rate risk of the nonfinancial
firm (our focus in this discussion) is debt service;
The debt structure of the MNE will possess differing
maturities of debt, different interest rate structures (such
as fixed versus floating-rate), and different currencies of
denomination. Interest rates are currency-specific.
the multicurrency dimension of interest rate risk for the
MNE is of serious concern.
Interest Rate Risk
The second most prevalent source of interest rate risk
for the MNE lies in its holdings of interest-sensitive
securities.
Unlike debt, which is recorded on the right-hand side of
the firm’s balance sheet, the marketable securities
portfolio of the firm appears on the left-hand side.
Marketable securities represent potential earnings for
the firm.
Interest Rate Risk
Prior to describing the management of the most common
interest rate pricing risks, it is important to distinguish
between credit risk and repricing risk.
Credit risk, sometimes termed roll-over risk, is the
possibility that a borrower’s credit worthiness, at the time
of renewing a credit, is reclassified by the lender (resulting
in changes to fees, interest rates, credit line commitments
or even denial of credit).
Repricing risk is the risk of changes in interest rates
charged (earned) at the time a financial contract’s rate is
reset.
Interest Rate Risk
Consider the following debt strategies being considered by a corporate
borrower intended to provide $1 million in financing for a three-year period.
Strategy 1 : Borrow $1 million for three years at a fixed rate of interest.
Strategy 2 : Borrow $1 million for three years at a floating rate, LIBOR + 2%
to be reset annually.
Strategy 3 : Borrow $1 million for one year at a fixed rate, then renew the
credit annually.
The reference rate
Reference rate: the rate of interest used in a standardized
quotation, loan agreement, or financial derivative valuation.
Most reference rates used are widely quoted interbank rates,
the rate of interest for lending between major financial
institutions on an overnight, daily, or multiple day basis. E.g.
LIBOR, SIBOR, EURIBOR, VNIBOR,…
A second source of reference rates is government borrowing
rates. E.g. The U.S. Treasury bill, note, and bond rate
Due to recent scandals and questions around its validity as a
benchmark rate, LIBOR is being phased out beginning after
2021.
London Interbank Offered Rate
• LIBOR is short for London Interbank Offered Rate. It is an unsecured short-term
borrowing rate between banks.
• LIBOR rates are quoted for a number of different currencies and borrowing
periods. The borrowing periods range from one day to one year. These rates are
calculated daily by the British Bankers Association.
• One popular derivatives transaction that uses LIBOR as a reference interest
rate is an interest rate swap.
• The banks submitting quotes typically have an AA credit rating. LIBOR is
therefore usually considered to be an estimate of the unsecured borrowing rate
for an AA-rated bank.
• Abolished in 2/2021 and replaced with rates based on transactions observed in
the overnight market.
New Reference Rates
• US dollar: SOFR (secured overnight funding rate)*
• GBP: SONIA (sterling overnight index average)
• EU: ESTER (euro short-term rate)
• Switzerland: SARON (Swiss average overnight rate)
• Japan: TONAR (Tokyo average overnight rate)
• SOFR is calculated from repos and is therefore a secured rate. It is used as a risk-
free interest rate.
• The other rates are calculated from unsecured overnight borrowing and lending
between banks.
International Interest Rate Calculations
Interest Rate Futures
Unlike foreign currency futures, interest rate futures are
relatively widely used by financial managers and treasurers of
nonfinancial companies.
Their popularity stems from the relatively high liquidity of the
interest rate futures markets, their simplicity in use, and the
rather standardized interest-rate exposures most firms
possess.
The two most widely used futures contracts are the Eurodollar
futures traded on the Chicago Mercantile Exchange (CME) and
the US Treasury Bond Futures of the Chicago Board of Trade
(CBOT).
For an example, see Exhibit 8.10
3-month Eurodollar Futures contracts
The yield of a futures contract is calculated from the settlement
price:
Yield (%) = (100 – settlement price) (%)
Interest Rate Futures
Common interest rate futures strategies:
Paying interest on a future date (sell a futures contract/short
position)
Ifrates go up, the futures price falls and the short earns a profit
(offsets loss on interest expense)
Ifrates go down, the futures price rises and the short earns a
loss
Earning interest on a future date (buy a futures
contract/long position)
If rates go up, the futures price falls and the short earns a loss
Ifrates go down, the futures price rises and the long earns a
profit
Interest Rate Futures Strategies for
Common Exposures
Forward Rate Agreements
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 (lender) of the FRA will pay
the buyer (borrower) 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.
Foreign Currency Options
A foreign currency option is a contract giving 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).
There are two basic types of options, puts and calls.
A call is an option to buy foreign currency
A put is an option to sell foreign currency
Foreign Currency Options
The buyer of an option: holder,
The seller of the option: writer or grantor.
Every option has three different price elements:
Exercise/strike price (X) – the exchange rate at which the foreign
currency can be purchased (call) or sold (put) if the option is exercised
Premium (c; p) – the cost/price/value of the option paid in advance by
buyers to sellers (% transaction amount or cost per unit of foreign
currency)
Spot rate (S): The underlying or actual spot exchange rate in the market
Foreign Currency Options
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.
European option: can be exercised only
on its expiration date, not before.
Foreign Currency Options
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 that 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).
Foreign Currency Options
In the past three decades, the use of foreign currency
options as a hedging tool and for speculative purposes has
blossomed into a major foreign exchange activity.
Options on the over-the-counter (OTC) market can be
tailored to the specific needs of the firm but can expose
the firm to counterparty risk.
Options on organized exchanges are standardized, but
counterparty risk is substantially reduced.
Swiss Franc Option Quotations (U.S.
cents/SF)
Buyer of a Call Option
Buyer of an option only exercises his/her rights if the
option is profitable.
The spot price of the underlying currency moves up, the
call holder has the possibility of unlimited profit.
Example: Hans Schmidt is a currency speculator in Zurich.
He purchases the August call option on Swiss francs with a
strike price of 58.5 ($0.5850/SF), and a premium of
$0.005/SF.
Profit and Loss for the Buyer of a Call
Option
Buyer of a Call Option
St ≤ X St > X
Do not exercise Exercise
Pay-off (gross profit) 0 St – X
Net Profit/loss -c St – X - c
• Pay off (Intrinsic value) = Max (St - X; 0)
• Profit = Max (St – X - c; -c)
• Break-even price St = X + c
Example: X= $0.585/SF; c = $0.005/SF, the spot rate at maturity is St =
$0.595/SF
Break-even price =
Net profit/loss =
Writer of a call
St ≤ X St >X
Call buyer Do not exercise Exercise
Pay-off (gross profit) 0 -(St – X)
Net Profit/loss c C - (St – X)
What the holder, or buyer of an option loses, the writer gains.
Example: the spot rate at maturity is $0.595/SF, X =
$0.585/SF, c =$0.005/SF
What is the break-even price and net profit/loss?
Break-even price =
Net profit/loss =
Profit and Loss for the Writer of a Call
Option
Writer of a call
• Naked position: writer does not actually own the
foreign currency if the option is exercised, the
writers have to buy the currency at the spot and take
the loss delivering at the strike price.
The 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
Buyer of a Put
• The buyer of a put option wants to be able to sell the underlying
currency at the exercise price when the market price of that
currency drops.
• Example: Buyer of the August put option on Swiss francs with a
strike price of 58.5 ($0.5850/SF), and a premium of $0.005/SF.
Profit and Loss for the Buyer of a Put
Option
Buyer of a Put
St < X St ≥X
Put buyer Exercise Do not exercise
Pay-off (gross profit) X – St 0
Net Profit/loss X – St - p -p
• Pay-off (Intrinsic value) = Max(X - St; 0)
• Profit/loss = Max (X - St - p; -p)
• Break-even price = X – c
Example: X = 58.5 ($0.5850/SF), and p = $0.005/SF.
Break-even price =
S = $0.575/SF Net profit/loss =
S = $0.595/SF Net profit/loss =
Buyer of a Put
Example: Buyer of the August put option on Swiss francs with a
strike price of 58.5 ($0.5850/SF), and a premium of $0.005/SF.
What is the Break-even price and profit/loss if the spot rate is
$0.575/SF or $0.595/SF ?
• BE price = X – p = 0.585 – 0.005 = $0.58/SF
• If St=0.575 exercise
Net profit = X – S – p = 0.595-0.575-0.005 = $0.005/SF
• If St=0.595 do not exercise
Loss = premium = -$0.005/SF
Seller of a put
St < X St ≥X
Put buyer Exercise Do not exercise
Pay-off (gross profit) – (X – St ) 0
Net Profit/loss p – (X – St ) p
Example: The seller of August put option on Swiss francs with a
strike price of 58.5 ($0.5850/SF), and a premium of $0.005/SF.
What is the profit/loss for the writer if the spot rate is $0.575/SF
or $0.595/SF ?
S= $0.575/SF Net profit/loss =
S= $0.595/SF Net profit/loss =
Profit and Loss for the Writer of a Put
Option
Option Pricing and Valuation
Total Value (premium) = Intrinsic Value + Time Value
The pricing of any currency option combines six elements:
Present spot rate
Time to maturity
Forward rate for matching maturity
U.S. dollar interest rate
Foreign currency interest rate
Volatility (standard deviation of daily spot price movements)
Option Pricing and Valuation
European style call option on British pounds has a premium of
$0.033/£ (3.3 cents per pound) at a spot rate of $1.70/£.
Assumptions: a spot rate of $1.70/£, a 90-day maturity, a $1.70/£
forward rate, both U.S. dollar and British pound interest rates of
8.00% per annum, and an option volatility for the 90-day period of
10.00% p.a.
Interest Rate vs. Currency 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.
Types:
Interest rate swap: the agreement for one party to swap its
fixed interest rate payments for the floating interest rate
payments of another (plain-vanilla swap).
Currency swap: the agreement to swap currencies of debt
service obligation
A single swap may combine elements of both interest rate and
currency swaps
Interest rate swaps
Example: MedStat is a U.S.-based firm with a $40 million
floating-rate bank loan. The company is finishing the first
two years of the loan agreement (it is the end of the third
quarter of 2017), with three years remaining. The loan is
priced at the 3-month LIBOR rate plus a 1.250% credit risk
premium.
LIBOR has started moving upward in the past year. MedStat’s
management is now worried that interest rates will continue
to rise and that the company’s interest costs will rise with
them. Management is considering entering into a pay-fixed
receive floating plain-vanilla interest rate swap.
Interest rate swaps
Interest rate swaps
Currency Swaps
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 (e.g. cost).
All swap rates are derived from the yield curve in each major
currency and LIBOR rate plus a credit spread applicable to investment
grade borrowers in the respective markets.
.
Interest Rate and Currency Swap Quotes
Currency Swaps
Example: MedStat decides that it would prefer to make its debt service
payments in British pounds. MedStat had recently signed a sales
contract with a British buyer that will be paying pounds to MedStat over
the next 3-year period. This would be a natural inflow of British pounds
for the coming three years, and MedStat wishes to match the currency of
denomination of the cash flows through a cross-currency swap.
MedStat enters into a 3-year pay-British-pounds and receive-U.S.-
dollars cross-currency swap. Both interest rates are fixed. MedStat will
pay 1.15% (the ask rate) fixed British pound interest and receive 1.26%
(the bid rate) fixed U.S. dollars.
Currency Swaps
Unwinds a Currency Swap
It may happen that at some future date the partners to a swap
may wish to terminate the agreement before it matures.
For example, after one year, MedStat Corporation’s British sales
contract is terminated, MedStat will no longer need the swap as
part of its hedging program. MedStat could terminate or unwind
the swap with the swap dealer.
Unwinding a currency swap requires the discounting of the
remaining cash flows under the swap agreement at current
interest rates, then converting the target currency (British
pounds in this case) back to the home currency of the firm
(U.S. dollars for MedStat).
Unwinds a Currency Swap
If MedStat has two payments remaining on the swap agreement
(an interest-only payment, and a principal and interest
payment), and the 2-year fixed rate of interest for pounds is
now 1.50%, the present value of MedStat’s commitment in
British pounds is
The present value of the remaining cash flows on the dollar side
of the swap is determined using the current 2-year fixed dollar
interest rate, which is now 1.40%:
Unwinds a Currency Swap
MedStat’s currency swap, if unwound at this time, would yield a
present value of net inflows of $9,972,577.21 and a present value of
outflows of £6,366,374.41.
If the exchange rate is now $1.65/£, the net settlement of this
currency swap will be:
Settlement = $9,972,577.21 - (£6,366,374.41 * $1.65/£) = - $531,940.57
MedStat must therefore make a cash payment to the swap dealer of
$531,941 to unwind the swap.
Summary
Forward: currency forward vs FRA
Futures: currency vs interest futures
Option: currency options
Swap: interest vs currency swaps
