28 CHAPTER 8 Currency Derivatives Unlesdersaives contacts are cllateraied oe guarentee, thi ube ale ate arpends othe cvdrwonnines of te coumerparie 19 them In the meantime, hough, before a contrat sete, the counterparts ‘recon prots and loses -often huge ix amount in i cure eaing Stamens hour x0 much as «penny changing hands. The ronge of derivatives ontracs is ted cy bythe imagination ef man (r sometime sotseems,wadmen) ue ut, este say Ar Peet 208 ‘Financial managomen: of tho multinational enterprise in th twenty fist sentry wil rt incude the us of financial devvatives. These derivatives so axed beenae their ‘ales are derived rom an underlying ase ikea stock ora currency, are powerful tole ‘ed in Bsines today two very sinc management objectives, sotltion and hedging The financial manager ofan MINE may purchase these financial derivatives ia order oak poston inthe expectation of profit, specultion, oe maybe thetsisruncts fo reduce fe ska associated mth the everyday management of corporate cash flow, hedging aloe ‘hese fnagcil stunts cine Ud effectively, however, the final manager Mist Understand cet bass out thei stuctore and pene Tnthis chapter, we cove the primary foreign errency Gnancil derivative wed today im mulinaona finan management foreign currency futures, foreign eureny options. interest rate swaps, and cross ervey interos eae swaps. We foc on the fndametale oftheir vation an hr we for pecalaive purposes. Chapter 1 wil dexerie how these foreign eartncy derivatives ean be used to hedge commercial tasnactions, Hedging The Min Case at te endo this chapter. MeDonals Corporation Brtsh Pouad Exposure ilusrate how one maj nitnational company, MeDonals, has we cutenydewatives ite success over ie ‘A word of caution of reservation before proceeding farther. Finacid derivatives re powerful ols in ths has of ere and corpatent Gans managers They can also be destructive devies when used recast and eatlesaly. The history ofincc itered “with ence in which nancial managers either intentionally oc usatetonally took huge Pstions resin in siieant ase or her compas, and oceastonaly, ei outiht olape nthe ight hands and with the proper controls, however, nancial Sasvatines ay ‘roride management with opportunites to enhance and protec her corpo fini performance, User berecarenoyDinaties oHAeTER ® 2 Foreign Currency Futures ‘A oregncurteny futures contrat is an alternative toa forward contract that cals fr future every ofa standard amount of foe exchange at ied time, place and pie I isimilar {o face contret that exit for commodities (bogs, ete umber, le) inerest Dearing Aepasts and gold. ‘Most world mioney centers hive established foreign cuteney futures markets. In the Unite States the mont important marke for foreign curency futures the International Monetary asket (MM) of Chicago,» vin of the Chicago Mercantile Exchange, Contract Specifications ‘Contra specications ae established bythe exchange on which futures are rede. Using the ‘Chicago IMM as an cramp th major features of tendariged futures trading areistated ‘bythe Mexian peso futures traded on the Chicago Mercantile Exchange (CME), es shown in Exhibit 81 ach ues contract for 5000 Mexican petos. This the notional principal Trading in each cutency must be done in an even melipe of currency units The method of sting ttchange ats ein American erm, the US. dla cost (ree fa foreign currency (uni), SIM where he CME i mixing theo ol sybel withthe SO £217 cde for the peso, MON. in Exit thi US. collars per Mexican peso, Contract mature onthe third Wednesday ofanary, Marc, Apr, June, Juy September, Otber or December, Contacts tay be raed though he second business ay pif the Wednesday on which the mature t Unless botdaysinterere the ast wading yf the Monday preceding the maturity date ‘One of the defining characteristic of futures i he requement that the purchaser deposits «sam avant margin or collateral. This regirement snl to requiring 2 performance bond. anditcan be met by aleter of rei fom a bask, Treasury ils or ash. I Th adition, maintenance margin equted. The ale ofthe contacts marked to market {nis and al changes in values pid in cas iy. Marked to marke means thatthe value \ ‘ofthe contract is revalued using the closing price forthe day. The amount to be paid is called } (he nariton marge E ' I ‘Gly sbout $i of all futures contracts ae setled by the physial delivery of foreign xchange between buyer andseller, Most often, buyer and seers their original position foro delivery date by taking an oppesite poston Tats, a investor wil normally lose ‘ut tures postion by selina fares contact fr the sae delivery dae. The complete . ‘uybel orselfbuy i caled around tar (EIEIEIERT ens Pe ev 00, Fars vy feet poe oe poeCHAPTERS. CuronyDenates Customers pay commision to thet bret to execute around tun and a single pice ls quoted This practice difers fom that ofthe interbank market, where detlers quote & ‘bid and en offer and donot charge «commission. All contacts ate aprocments between the cleat and the exchange clearinghouse, rather than Between the tWo cons involved ‘Consequently, cleats need not wor that a specie counterpart inthe market wl ito honor an agreement counterparty isk). The earnghous sovned and guarateed by all ‘members ofthe exchange Using Foreign Currency Futures ‘Anyinvesor wishing to spocuaton the movement ofthe Mexican pes vert the US. dollar ould paren oe ofthe following strates, Keepin aad the pipe os utses contest: aspecalitor bys futures contrac, they are locking th pc at which they mit bay that ‘eucency onthe pei future dete. Ia spcultor sells a futures contrat, they are lacking inthe price at which they must sll that currency on that future dae ‘Short Positions. I Amber McClain, aspeulator working for International Caren Traders, ‘loves thatthe Mica peso wlll in vals vers the US. dolla by Marcy she could stl | March fours contrat taking 2 sor poston. BY sling a March content. Amber locks In the right 1 sel 50000 Mexican poss ata set price. Iho pric of the peo alls by the ‘uti tess expose, Amber haa cotrct fo sel peso st apc above their arent ‘icon the spot market. Hence she makes profit ‘Using he quotes on Mexican peso (MXN) Toure in Exhibi1, Amber sls one March {utures contractor 50.00 pesos the clsing price termed the set pric, of $UBSBMN ‘The value of er positon af maturity te expiration othe Fetes contrat Match ie then Value at maturity (Sor positon) ~ ~Notonal principal x (Spot ~ Futures) [Note thatthe shor poston is entered into the valuation a a npative notional principal. I the spot exchange rate at mtu 8S00)MXN, the value of er positon on settlements ‘ale = MXN 500.00 (SCBS0DIMXN — $.1085NMXN) = $7230, ‘Amber's expectation proved core the Mexican pos fllin value versus the US. dole. We ‘could say tat "Amber end up buying at 8.09500 an sel at 10958 per pes.” All that was realy required of Amber to speculate onthe Mexican esos valu was that she formed an opinion onthe Mexican pesos future exchange value versus the US. dolla ln this ese, she opined that it would alin value by the March maturity dat ofthe Tutures Long Positions f Amber McClain expected the peso ore in value vers the dolar in ‘he teu term, she could take a Tong postion, by baying March ature onthe Mexican pss. Buying « Mare future means hat Amber locking the rice a which she ast by ‘Mexican pesos at he ures ati date Amber ftares contract at atari would have ‘he fllowing value ‘Value at maturity (Long poston) = Notional rinspal x (Spat ~ Futures) Again using the March ste price on Mexia peso futures in END 8.1, $109S8MXN, it thespo exchange ate at maturity 8 ODM, Amber as indeed quesscd ght. The value ther potion on etement then ‘ate = MXN SIO 000 (81100HIMIXN ~ $0858MIXN) = $210,‘eumay Dates CHAPTER an In thiscase, Amber makes profit ina matter of months of 200m the single atures contract. ‘Weecold say that Amber bay $1098 nd sells at $1100 pe pose But wiat happens if Amber's expectation abou the fie vale of the Mexican peso proves wrong? For etample if the Mensa goverbmest announces thatthe rat of ination {in Mico has suddenly sen dramatically, andthe peso alt SOSDOMXN by the March maturity date, the value of Amber's futures contract on etleent is Value = MAN SO0Q00 (S8I0DMXN ~ $.1098100N) Futures contracts could obviously be sed In cambinstions to form a variety of ore complex postions. When we are combising contracts however, valation fe fiiy Saightforwatd ond add ia chetocte. (14750) Foreign Currency Futures Versus Forward Contracts Foreign carencyftures contracts ifr from forward ont ia number of inpatant trae ndvidual ind tures contacts weful for speculation bea they uel donot ave ‘custo forward contracts For business, fuures cont at ofenconsiceredineticent ‘ed burdensome because the furs postion marked to market on a dy basi over the eof the contract. Although this doesnot rogue the Dsinsso payor ceive ash dat ‘oes real mor requet magi ells hom final er rovers than the basins ‘ype wants ‘Currency Options [A foreign cuteny option ia contr thst gies the option purchase (the buyer) the right ‘mothe obigation, to buy or sels ven amount of origncxcane a aed price pot unt Tor specified time period (antl the maturity dae). The most pstat pias this orth erry of nding nd financial instatons themselves than of snes firms tan investor wishes 'oparcise an option in the overt coun tate theavevor will aul place a eal othe curreney option desk of major money center Dak, spesy The carrecis matuniy sue tls), and ora edicaton--abitofter goo. The bank ‘wisormally ake afew minutes to afew hours to pice the option aa rete thecal, ptons on Organized Exchanges. Option onthe physical (underlying curency ate traded ‘on anumber of orgnized exchanges worldwide, inating the Philp Stock Exchaage (PHL andthe Chicago Mercantile Exchange. Exchange waded optons ae ted houghuray Daman CHAPTER 8 ae clearinghouse tht buyers do no deal diteety with sellers. The dearinghouse isthe Counterparty ocr option contsact andi guarantees ullinent.Cleriphowse obligations ‘rein tur the olin of ll ender of fhe exchange, lading are number af bn. Tn the case ofthe Philadelphia Stock Exchange, cleringhose services re provided bythe Options Clearing Corporation (OCC) Currency Option Quotations and Prices plea uotsia te Wal Set Juma for options on Swiss franc are shown in Exhibit 82 ‘The Journal's quotes reter to tansectons completed om the Phiadeiptin lock Exchange ‘on the previous day. Quotations are avalabe for more combinations of steke peices ant "pzntion dates thn were actualy traded and thi reported inthe newspaper, Curtency ‘option sik ricesind premiums on he U.S dole ae type quotedas ect quotations fon the US. deli an indirect quotation on te foreign curency (IF. ct) [Exhibit 82 ilutrates the toe different peices that characterize axy foreign carency| ‘option, The thee prices that charactesiae an "Auguet 585 call opin” (highlighted i Exhibi82) ae following 1. Spot rat. In Exhibit §2, “Option and Underying” means hat 58.5 cents, oF the spot dollar pic of one Swi frne a the dove of trading on the 22. Exerc pce The exerci prie or "Strike price” Thedin Ebi 2, means the price [eran tn mist be pai the option exercise. The Aug el opion on anes ExSmeaneS058908F Fatt Pt nine diferente price, ring trom $500) SP 1OSOMONSF, though more wore avaiable on that at tha ested Ree. ‘Premium. The premium isthe costo price ofthe option The rie ofthe August ‘85 call enti on Swiss fanes was O50 US. cents per rane of S000SUSF. There ‘nts no ading ofthe September and December 58 call on ths day The premium [the market valu ofthe option, and therefore the ers prem, cst, pie, and Salve a all intershangeabe when referring to an option Sis Franc Option Qutatons (US. catSF) suierce agape yhCHAPTER®. Cineney Datathos ‘The August 8c pton premium s.0 cents pee ane, and in his et the Agu 585 pus premium also 0.0 cents per tran Since one option const onthe Pildelphi Stok Exchange const 62,50 fans, the total ost of ane option contact fr thecal (oF ‘uti ti cae) S62 500 % SONSOSE = $3120, Buyer ofa Cal ‘Options ite froma ober ypes of nancial nstruments in the pater of rik hey produce. "The option owner, the holder, as the ebaice af eercng the option oral fo expe ‘snsed, Th ones wilenersteitonly when exerci i potable, wiih meas ly when the ‘option sin the mone. Inthe case cll option, ste spot pico he underyngcrency ‘moves up the hoe asthe posit of unlimited peat. On the dows side, however, the holder cn bandon th pton and walk away with a loss never eater than th emis pi. “Hans Schmid a cuceney spcilator in Zrich The poston of Hans ara buyer o calli ilustated in Exhibit 83, Ammo he purchases the Age cll option ot Swi fancy Aescrbed previous, the one witha srk prc 058.5 ($0.50), anda premium of $0005) SE The vertical ans meatues prot or low forthe option buyer enh of eeveal ferent Spot prices forthe tane up othe ine of matty ‘Atal pot rats below th sik price of S85; Hans would choose not to exercise his option. Tiss obvious because asp rate of 58.0 for example, he would per to buy 8 ‘Sis fan for $5800 the pot market rather than exeriing his option fo aya franc at ‘$0585. Ifthe spt rate remains below KD unt August when the option expired Hans would ‘not exer the opin Hs otal lous woul belied to only wha be parle option, he ‘SOOOS/S purchase pice. At any lower price forthe fans, hs os would simile ined ‘othe original SOOISS cost. EIEIEIIERET om ence torte eof Coston yk ato ‘etune lac ote ws he tO ce rasan Feo tt on 335 fo oe Nrorh an a our sercns cba oscanas teiemary_Atteratvely a allot rates above the strike pee of $8.3, Hans would exercise the ‘tion, paying onthe ke pice foreach Sia rae For example, ifthe spot rate vere 5.5 ‘Ents perfor et matory, he would exerci cl option, buying Sri rans fr $0.58 ‘Sash stn of prehaig them on the spot market t 80.59 each, He could salle Swiss “rans immediatly in the spot market fr 90.5 ech, pocketing» gos profi of SLOLOS, ‘Sat profitol SOUS ater deducing the original ot of the opton of SO ISSF. Hans ‘rot ifthe spo rate eget than the strike price, wih sue price SOS, a prem of ‘S008, and spot ate of S095, Profit = Spot Rate ~ (Strike Price + Premium) ShSISSE — (S0SKGSF + SOOUSSF) S109 More tikly, Hans would realize the profit through exeuting an offsetting contract on she cpio exchange rer than aking delivery ofthe caren. Because the doll pice of {ane cout ise toa nite lve (ot the upper right-hand sde of Exhibit 8.) rex ‘profits unliited. The bayer af al option thus peseses an atacive combination ot ‘Sutcome ited los a unlimited prof potential ‘Nate tht break-even price o SD SSF the pice at which Hans nies gansnor loses on exerising the option The premium cost of $0.08, combined with the eos of exes the ‘tion of 0585, exact ual othe procedsfrom selling the franc in he spot market t ‘3590, Note that he ill exercise he call option atthe reak-ven price. This because iyenercning it heat eal coups the premium pic forte option. Atay sot price above ‘he exer price but beow the breakeven pie, the gros prof earned on exercising the ‘Spon and ling the underlying crreny over part (bu 0 al ofthe preiumeost ‘Wter of a Call “The positon ofthe write (ls) ofthe sme cal option is istated in Exhibit £4 If the “option expres when the sp price of he underying corenc x Below the exerci: pie of SES. the option holder dies tence, What the older loes, the weiter galas. The water keeps profit the entire premium paid of SODISSP. Above the execs pie of 585, tae rte the cal mst diner the underlying caren for SOSKSSF ala Ue Wheathe value [rie frames above $1.5 if the writer wrote the opton “rake,” thats, without ovairg the urreny, that iter wilmow have o buy the etreney at spo and take the los. The amour ‘such lo sunlit end cree the pie ofthe undelag currency ries Once "ota what the holder sins he writer tse, nd ie versa Even i the wer aeady owns the eizrency, the writer will experience an opportunity ls, surtenderingepans Ge Open the sane careny that mld have bev sold for more tb open mare, Forexample the prot tothe writer ofacal option a sre price 1.58, prema S005, aspotrate of M398 ‘Profit = Premium ~ (Spot Rate ~ Surke Price) SUISSE ~ (S0598SF ~ S0S8SSF) “suas ‘nut ony the spot rate greater than or equal the suke rte. At spot ates es than the ‘ike pie, the option wil expire worthless an the weiter of the cll option wll Keep the ‘emium eraod, The maximum prot thatthe whiter of the call option can makes ited {othe premium. The wer of cll option would hae a atherunatactie combination of potential outcomes: oie ptt potental and ulimit low potential, bu tere ae Ways {olinitsuch lowes through other effseting echiques.CHAPTERS Currey Daas ear ca opin cn tna et art naar rt 1550 cs ott ra han anon iss be por hee Sato te artes deena Buyer of a Put “Hans’s poston as buyer of puts stated in ib 85. The basi ers his pt are ‘inl fo thowe we just wed fo tate x eall‘The buyer pt option, however wots tobe ale o sll the underlying currency at the exercise rice when the markt pce of tht ‘Stem drops (aut ste a cae al opin) Ue op pee ane drop, Say, $OS7SISF, Hans wil dlr anes tothe weiter and rosie SDSSSSF. The ancy can ‘ow be purchased onthe pot maret for 8.575 each and the cost ofthe option was $0.00 SF, soe willhaye a net gun of 1.0055. [Expicy, theprofitto the holder of apt opion fhe spo ate ies than the strike rice, witha ike pric $0 S8SSF, premium of $0 CONF, anda spot ate of 0575/5, Profit = Strike Price ~ (Spot Rate + Premium) SDSESISF ~ (S0S7SSF * SOOIS'SE) SOS ‘The break-even price forthe put option ithe stke price les the premium, o¥ $0580" Sin this case. As the spot rato falls urher and farther below the strike pie the prot potential would continual increase, and Hans profit ould be wafimited (upto 2 max ‘um of SOS, when th price oa rane would he Yero). At any exchange ate above te Stik peice of 585, Hans would aot exces the option, and 0 woul lose ony the SOS premium pid forthe put option. The buyer of s put option hasan almost unlimited prot Potential witha ited les poteaia.Liks the bayer a call the buyer of pa can never lose more than the premium pid up fontTEED Pot ara Lae forthe Byer of a Put Oton iter of a Put ‘The postion ofthe writer who sod the pt to Hans is shown in Extiit 86, Note the sy ety of profits, trike price, nd break-even pies hetmeen the ber andthe wero the put. Ifthe spt pice of francs drop Blow 38.5 cems per rane, Hens wl exer the ‘option. Below 2 price of 85 cents per franc, he weiter wl oe more thao the pris ‘eeived from wring the opin (SDOISSF), fling balow breakeven, Between $0 SBISE {and SOSRSSF the wer wil ase past, but oot al ofthe premium received. Ihe spot pice |sahove S0S8SSF, Hans wll pot exercise the option, sa the epson writer il pocket the cote premium of S008SF. "The profit le) earned by the writer of 0S strike pice pu, premium S05, at» spot rite oF $0573 ‘efi ts) ~ Premium ~ (Strike Price Spot Rate) SLOOSISE ~ (SOSESSF ~ $0575). SDOISSE but only for spot ate that are ess than or equal othe strike price. Atspt rte greater than the trite pie, th eptionexptes outa the-money andthe writer Kees the premium, The verter ofthe put optoa has the same basi combination of outcomes svaablet the waiter ‘of call: mied prot pteaial and unlimited loss potent. Giabal nance ie Proce 8 “describes one ofthe gest ani moe sce cuteny option specuaions ever made thal by Andeew Kriger gaat the New Zealand Ki,8 CHAPTER 8 Cenay Deas (EQUINE Protaras tr ti toro Put Opon “Ate stem) Te Now Zealand Ki, Koy, and Kiger “at ae note corti ne rst anaco tor tea Zoning vce Jon Kya to Pr Nngorn Neer 20 Kose tus tes srr ote eee ot cing spect no fen Stang om Kay ac a ne ne waa ‘hin nner cere cut Sete Koa ho Seer meget St ew Then kor Ke ae eS yearn ace ‘cromosTran tNe Yok) Footy MOUS. cook ‘rowed py at he dlr Mary oe wots oer ‘Siren chy ark once wr wen saeco ‘Rj ol east Ao Ts wor cuerey Yad durosd Siteopt ove tm vant nt ona Teper betnod tat he mate ware oat, a oul oven ut, 59 ees shat poston nha on, beting an ts ntl A 20 ‘in wr, ot mgs sstons to ape eat fo ‘ard meres pone, St Owouh caenoy atone ek frger sappy had coor polars re ‘Shanty $70 ron ses ser BT rs ‘rere roti to $50 min) Kee, ott of BT. ‘eee Zasnaeey apy aie von flor in earoy gu BT. ia yh ‘gee tom when ayaa bran ete ‘Serco 8 en ‘muah, th Nw Zenon era bot oged amps wih BF ntonh CEO at het Chat. ‘Sb sour abs al ny wee oa (strove Gt ok oo bu os Bark fru two my bm B 9 oao aOption Pricing and Valuation cite illustrates the pots pri of Earopeansye cll opionon British pounds ‘The cll pion allon the older to buy Dito pound take pie of 1.705 1s © soy mary “The vlucof tical opin i setellythe sm of two componens ‘Tal Value (premium) nrnsie Value + Tine Vtve “The ping of any currency option combines sx elements. Fr expt, this European style ell eption on Bish pounds as «premium of $0.33 (3.3 ens per pound) ata spot {ate of $170. This premium i aut using the flowing assumpé on: spot rate of SLT,» 0-do maturity, «SLE forward ate, both US. dll and Bris pound interest "tes of (0% pet ant, and an option vat er the 9-day period of 0.00% pe annum, Tring values the franc pin he option exercised mest shown by the solid ine Exist 87 whic er un techs the sri rie then is neal (cet fr ‘ich Ler icra inthe spot ra) nth ale wil be zero when the pion out of the ‘moneys when the tke pe above he mark rice o gan cb deed fom, ‘hereng he opin, When the pte es above the sire pie, the otis value becomes postive Beats the option alas worth teas this vale if exercd. One date of mat ‘roption vilhaves lie qual totais ale (eo tne remaining mesos eo me vale) When the spot ate i $1.74, the option i rthemaney and as an nase valve S174 SLE, or ces per pound 1 When the spot ati $1.70, the option is arshe money and ba an nen valve of 1 7145170, er cents er pound 1 When the spot rte $1.66, the option i outofehemoney and has no intinse ‘nie This shown bythe nr value ping 8 the ozo als Only foot ‘ould exerci thie option hsp ate ntesd of ying pounds more cheaply ‘nthe spot ark ERED stn a Tn Vn, Te Veto ta a any250 CHAPTERS. CireneyDenates “The time vale ofan option exis Hecate the rice ofthe underlying currency the pot rate, con potentially tove further andfrther nt the money before the opin’ exptation. “Time val shown in Exhibit 87m he area betwen the Yul vale of he option ad is inns value An investor il pay something today for en out-of the-money option ie oro lati vale) on the change tat the spot ate wil ove fa enough before matsiy to move te option inthe money. Consegucny, the pris of sn option always somewhat ‘rate than nn vale sce there aly some chance that the atin value wll Fs between the preset andthe exptatin date eareney option re tobe used effete, ithe far the purposes of speculation or risk management (sovered in Chapters ID nd 1) the individual eader needs to Know how Sptonvalues_promlums-react o tei ris eomponens. Exhibit 83 summarizes sx bien, ward ate boca the cute spot rate and bath the domestic ad foreign interest rates {home caeteney nad foreign surency ses) are incladed inthe option peamivm calcula fiom Regarleas ofthe speie strike rate choen and price the fortard eae i eontal to talustion. The option prising formula cleats a subjective probability dstbation entered the forward ate Tis approach does not mean thatthe macket expects the forward rat tobe equal tothe future spot rat, spy azvat ofthe arbitrage-pricing Erte of options “The forward rate foci ako provides elp(l information forthe trader managing a postion. When the market prise foreign currency uplion, t Joes o without any ball [Bh or beri sentiment on tho direction of the foreign eureney’s value relative fo the tlomestic currency. Ifthe iader has specific expectations about the future spt ates ‘dvection, thos expectations cin be pot to work. A trader wll ot be inherent betting pains he market Interest Rate Rsk ‘All firms —domestior multinational smal or lags, leveraged or unleveraged —arsonstve {ointret rate movement in one way or another’ Although variety of ttre rate rks ‘ttn theory and industry, hs ook oeses on the nani managemeatof the powfinancial firm. Henee, our dacasion sine tothe ners rat ks assoc With the multinational firm The intrest at ike of financial firms, och a banks, sre not covered here arma of Opton Prem Compenens ae Geet agenigerenparimiawal Taf tha Pena eset mee Goran ne seoperintr sora! Pew owe tay Saige tangn nate ‘carga anor“The single largest interest ate rek ofthe nonfinanial frm is dent serve. The debt structure o the MNE wil poses fering matures of debt, differ nerest ate 4 tare (ouch s ined venus Hosting, and diferent currencies oferomination, Interest Fates ste currency spel, Each currency has its own interest rate ytd curve and credit {reads for borrowers, Therefore the multurrency dimension of fterest rate ek for {BeMNE ts stioo concern. As usrated in Exhibit 89, even the interest at cleu- ome vary on oveaionacroscutrenies and counties. Gobel France in Practice 82 [provides atonal evidence on the use of fed versus Moatng fate imstrments in today's marketplace Th accond most prevalent vource of aerest rate is fr the MNEs nits dings “of interestsensveseeurtes Unlike debt, whic is recorded on the xahthané side ofthe fs blanc sec the marketable scares port ofthe frm appears on the le-hand ‘Sse Marketable secures represent potential earnings or interes infews othe im, Ever- ‘nerensng compete press ave pushed nancial manages totightn their management tof oth th left and ght sda ofthe firm's lane shee, Credit Risk and Repricing Risk Prior to describing the management of the most common interest te pricing sk, tis Important to dstinguish between credit risk nd repriing rik, Credit, sometimes termed rover sk isthe possiblity that a borrowers recitworth athe tne of renewing a credit, ‘Rrecasfied by the lender. Tis ean reat ia changing fees, changing lees rate, altered {ret ine commitments or even deni. Repecing isk the rik of change in interes rates ‘harged (cared) atthe tea iancial omtacs rate reset "Zonder te following deb statis being considered by a corporate borrower. Eachis intended to provide SI milion nancig for three-year period Swategy 1: Bortow $1 milion for thee year at fed rae of intrest Swategy 2: Borrow Si silin fr three years a floating rate, LIBOR + 2% 10 be reset enna Srategy3: Borrow milion for oe year a fied sate, then enew the credit nual imaoal tres Rae Cations tonalite ee casos iby the nmbar oie ust nite pero aston end hr ‘Seon thaw mary doe Were ae frre papas, The eng exam ats ocr arore nnd seul Georet anh parent fron aSi0 mono, 00% premiere ator por ot 78 6. Pratoe Day Coe in Feed2 CHAPTER 8 Careney Donates CEES 7 | AFixed-Rate or Fioating-Rate World? ‘TieBS Gury otf Mach 2003 powdee aces ‘Tteara bua bye ok 6% he pars incon eat ate pee tral nee rd Wg W, BeApanon ye, ant Se ea Coron ns ard ourng Oy am Oy pat le Inerrer. ad by ero 0! danrintion. Tho saa Dros sone mresing mags mo bo Piratond 1h oa cothuse to spot wo rating unserer popes lew tort te ars Simon a © needs nono einaascnan ~ [7m svt connen mere eo Serutrarcoanioctioatoyaypeamanane ~teiimaendeney mean tah 2 Thoma ominmintn nad wom Secon. he ose means a i ha pen hte Tear cata aan ve Stn ot ho marl. Aout sige frre Stance ast ae Wotena aK ansoamoms ee. S24 en ‘sey co ba ph eet ae ‘eaten mare Sena esr peraes oasae * Tansee sty fcontarcn wn etn ee comes na Ucarcannargiomentorg bares Sr fang 2 oy ed indasancen mekrg were ten theta st nwaoeasusssaeshn Although the loves oto funds is alvays« major selection exten, its not the only ‘one If the frm choos strategy 1, aeaes el of the funding forthe ful hee ours at 8 own ntret ae, thar maximized the preictaii of cashflows fo the debt obligation, ‘Whar it as saciced,o sme dere, the abity 1 eno alowernteest rate inthe event that interes ite fl over he period, Of core, bas lo eliminated sk that interest rates could ise over the period increasing debt serviig costs. ‘Steg 2 offers whatstatey ai ot, Melty feprcing ist, oo asuresthe fm ot tl nding forthe tree yea period Ts eiminaes reir Repcng sks ower, Sliveand well in strategy 2 1 LIBOR changes dramatically by the send or thd eat, the LLIBOR rate changer pase though ful tothe borrower, The sre, however, remains Fixed (elsing the ros wanding that has bee locke infor heal eas). Fenty mes ta coat nth ase, the rk that interest ates could go up as wl ss don, cr) offer ore Hlexblty and more isk. Fr the rm booing athe shorter endo he eld cv It the yl cveepositvely sloped ss commonly the ase in major instal markets the base interest ate shuld te lower. Bat he shorten ofthe ye curve ‘lo the moce volatile Ie erponds to shorter events ina much more pronounced fishin ‘han longer-term ates, The sategy se exposes the no the possi tht is ered rating, ‘may change dramatically bythe me for rei vencwal for better o worse, Noting hat rei ‘tng in general sro extabished on the premise that a fim can meets dbtservce obliga ‘Sons under worsening esonomie condition, rms that are highly erdwerthy Caves redgrades) may vw strategy as amor relevant alternative than dots of ower quality (Gpenuative grades) Ticino strategy fo financially weak msCarne Detvties OHA 2s Athough th previous example pve nly part picture ofthe compet of funding ecslons within he firm, demonstrates the many ay eet risks and epicing sks ate Inextncalyntenwined. The expression otrest ate cxposie ia comple concep. and the [Proper metarement a the expsure prior toi management iscrital We now proceed to {estrte the intestate a ofthe moet comnon form of corporate debt Sting rae kan Interest Rate Derivatives Like foreign cane, interest rates have derivatives in the form of furs, forward, end ‘pons In adit, and key of more importance the itera rate sw. Interest Rate Futures Unlike foreign cuzency ftures, irs vate fae: ate relatively widely wsed by nancial anager and teasers of onfinancl companies, Tel popularity stems rom the relatively igh bguity of the interest rate futures markets, thet simplicity in ws, andthe rather ‘undendized ites ate expossrs most fim poses. The fo met wily used flues ‘contacts are the Eurodolarftares traded onthe Chicago Mere Exclunge (CME) ad the US. Treasury Honé Futures ofthe Chiesgo Bosed of Teade (CBOT) Interestingly, the thzdarges voime of traded futures contact nthe ate 198s asthe US. dll Brazan real urenc ures contract raded 8 the Bos de Meradorssy Furs in Braz, ‘Toillisrat he seo tures for manaping interest ates we wl fea on he three month Eurodoli futures contacts, Exhibit 10 presents Eurodallar furs for wo Years (they actually trae 10 yeas iat the fate). "Phe yield of futures contrac x cakalatd from testament price, whichis the dosing price for that rading dey For example nancial manager examining the Euradollr quotes {Enh 80 fore March 2011 contract would re that the relent pre onthe previous ay was 4.76, at annul ye of 524% ‘Yall = (1000 ~ 96:76) = 524% Since each conta for tree month period (quite) and notional princal of milion, ach tai pont stall worth $2,500.01 % $1,000.00» S13). (SQEIERERIGN foro Fres Prices a oat suy oun otar east oot ose ead ean arCHAPTER® Cuter Dates IWatnancie! manager wee interested in hdping a Moning interest payment ein ‘ManhbotT ae would nced tose future, to ake a shor posinan, This srtey i fered were ar pein tecause the masager selling something she does oto (sin short eaetntock) intrest rates ie by Marcas the manage fears—the futures price ‘ai arid sh lb able tocloe the postion at prot, Tas pot wil oughly ofet he rane aretcd wh hing nets payments on ber debt Ihe managers wrong, howeves, Gh nern rte eon fl byt atsity date casing the futures rice 1 ssh wil aa tes at il wipe ou the saving derived Wy making a ower Holing-ate interest aca nm sh exponodSo by eling the Mah 201 are cone the manage wil ooking in am interest rato of 324. ‘Sov acres rte tures potions cod be—and are om aga basis—purchased prey a apaatve purposes. Algh tht ispot the focus the magi context hers, Fascha shows now any speclaor with dicctinal view on inetest rats could ake posns expectations of profi. rte previously. the most common interest ae exposure of the nonfnania fim terest papal on debt Sur expomue isn, however, the only interstate isk se ound nce fms aaressively anager entice bane she, the terest carvings eee etctund side ave under increasing sewing If nani managers ae expected 19 ae ier ntrest om intrest hearing secs, cy may wel mend seo snk cae nantes to lock nt infront craigs, Txibit 811 provides an overview Ei to bus interest ate exposures and he statgis needed 1o-manage intrest ate faces, Forward Rate Agrooments ‘Ryorword rate green (FRA) a nstbanktaded contract to bay o el interest rate ede ons nicl pina. Tse cons are settled in cash. The buyer ofan FRA atu th ight to lock nan intrest rite for a sred era that begins at fur date. The okt species that he elo the FRA wl py the buyer the need ines expense Forres eer sn he nosonal pina) money aerest ate seo the reed ate, Peein baper il uy the etre difersatial tees expense inert ates al Below the pret ate Matures avaiable are tpl 1,369, and 12 months much ike rons orvrd ntact for exerci Tike forign catency forward contracts, FRA ae wef on individual exposure, “They a conta commitments ofthe He that allow ile elit to enjoy favorable [FEMUR tivstheirs Sieger Connon pons ‘eae Pete to thin fiom FaarneesantaredsSelshans pam Wome Fase mb ere nrg rove on tars don 81y2Puee mpi) nies Raptor ne SomeCurencyDatates ciarrens ass ‘moverents, sch 2s when LIBOR alin as esrb i he previous seton, Firms ali {se FRAS if thy plant nest in secs at ute dates far that nee cates igh Tal prioe wo the investment date enue othe ited tris snd carrencies ava however, FRAS are not widely sed ete the anges ingots economies and caren, Intorost Rate Swaps, ‘Swaps ate contractual agreements to exchange or swap 2 eres of cash flows. These cash ‘ows are most commonly the intrest payments sociated with debt service, such asthe ‘esting rate loan described inthe previo section. Ite apreement i for one party to swap ts fined interest rate payment fr the ‘ating intrest ate payment of sherk tem interes te sap. 1 tthe agreementstosvapeurenies of dex service obligation for example, Sis ‘sane interest payments in exchange for US. dla interentpayments—it termed © A siole skap may combine elements of bth neon rte and currency swaps. In any case, however, the swap serves to alte the firm's cath low obligation, ain ‘hanging Moat rate payment nto fined rate payments asocated with an existing debt ‘blgnton. The swap tlt nota source of capt but rather a altration ofthe cash lows associated with payment What often termed the pln sana sp an areement between two pas to exchange fied ate for floating rate france obligations Tas pe of swap ‘oom the largest single nancial dereatine market nthe wor, The Iwo parties may have various motivations for emerng into the agreement, For example 2 very common psi sas allows. corporate borower of ond re sanding has existing oating-ate debt sevice payne. Te Dormer fer reviewing cuent markt ‘conditions snd forming expectation abou the ftre, may cnelde that inst ts ste bout ie fn order to prove the firm ages seg debt service payment, the comps ‘neasry ny enter into a swap agreement to pay fence floating, This means the i wl ‘ow make fed seres rte payment and recive the sp counterparty Moti intrest ‘ate payments. The eating rate payment thatthe fen receves are wed to veri the debt ‘bignon ofthe am, the rm, on tne asi tow aking fic inferest ate payment Using derivatives it has synthetically changed ftng ate deb into fnedate debt Tt hes done so without gong tough the cosa ntsc of relnacing exiting deb cians ‘Simla, firm with fxed-rate det that expecs intrest rast fll ean change ined rate deb oeting-tate debt In this cae, the fre woul ener nt pay oatmgheceve sed terest ate sep, Exit 12 presents» summary table ofthe teconende interest Tate sap strategies for Gums holding ether fede debt rflstingtate debt. ‘Thecash flows ofan interstate sap ae interes rates appli to st umount of cpt (notional principal), For tis reason they sre sso relered Wat coupon sup Fats enteing Ino intrest rate swaps sc the notional principals thatthe eas Sow resting fr the Interest ate sap cover tei infre rate management needs, Totes rte wap ae contacts comments betwee firm ad a swap dear and re completely independeot of the interest rate exposure ofthe fen. That he firm a "ter int swap for any ean it see aod then swap ational eins tat ses tha, qua oof even gests thn the total poston Weng managed. Por exatpl, frm with “arity floating-rate loans oni bok may enlernt interes ate saps for ony 1% of the existing princpal ft wishes. The ean foretsrng into a rap andthe wap position the frm enters into is purely at managements dieton It shoul also be noted thatthe interest rate wap market ling a gap se market eliiency. Il re had fee and256 CHAPTERS. Cureney Darts Imorest Rate Swae Strategies econ resto Sey ato po seo Paynes Fis tomee Payee og ces to capital markets, regards of intrest ate srutur or arency of denomination, the swap market would os ely ot ext. The thatthe swap rnrietoot only xis bu iso larshes and provides bene tall pacs sn some ways the provi french = Currency Swaps Since al sap cates ae derived from the yield eave in each major currency, the neo Echt 815 lss ypleal swap rte for the ear the US. dolar the Japanese Yen a the ‘Sos rane These swap rates ae based onthe government security ye in each ofthe Individual eareney market, plus a eredt read uppliable to investnen: grade botowers Inthe espotve markets, [Note that te swap rates ia Exhibit 8.13 ae nt rated or eategorized by crediting, ‘This is becuse he swap markt itself does not cary the cet ak ssotatad with ind borrowers Individual borrowers wih ogation priced at LIBOR psa spread wil erp tne spread, The fixed spread credit risk premium stl born by the firm sell For example, lower-tatd fins may pay spreads of 3% of 1% over LIBOR, while some ofthe word's Jaret and most nani sound MINES may actually rave copa atten LIBOR ~0 40% The swap markt dos nt liferemiate the eat by the parteipat al ep at Had ates ‘versus LIBOR in the especie crea. ‘The sta motivation oa curreneysapist replace cash Rowsscheduldia a undesired ‘currency with fos ina desired currency, The desired currency probaby the cutee) in ‘which the Grn’ Tutte operating revenues willbe generted. Frms often rae cap in ‘uence in which they do not pase significant revenue other naturel cashflows The ‘eaon they do sos cost peices may find eaptl contin speificcuteniesttractvely priced to them under pec conditions Having rated the cpt, however, he fem may Wit ‘o-map ts repayment into a currency i which it has future aerating events ‘The uly ofthe currency swap market to an MNE is saicat. An MNE wishing to ‘vap 10-year fied 604% US. dll cashflow stream coud swap t 449% nad in euro, 330% ine in Swiss francs, or 207% fed in Japanese yen, I ould swap orn ined delay not onl to fied tes, Dut als oflsting LIBOR ates the various cates a el All ate posible a the rats quoted in Exo 813, Prudence in Practice 1m the following chapters we wil illustrate how derivatives can be usa t edace the sks !ssocnted withthe conduct of multinational nancial manageiet Ie ital, however, "atthe we of anyfnanil too or eeigue— nud inal decvaties follow sound ‘rincpes and paces Mana fm hasbeen ruined ares ofthe misuse of eaten [A wot tothe wise: Do ot fall itn to wht many tle to the gambler dilemma onsing ik ah letCanney Cetatiee CHAPTER & ar | oe ee Se [ See ee sete Major corporate financial disasters slated 0 financial drvativescontnge 0 be & ‘problem in lobal busines. AS the case wih So many sues in moder secety technology ‘oot a al ether human ero ine. SUMMARY POINTS regn currency fares contrac ce unearned sped amount of aga echnge a2 pedeter foemard contac Une forward contac, boweer, mae pe anor efor set mati de. "ding oso the or oan ogsiedeachangs The we fx caren option wa secltve device ‘aterthan betwee banka eusomers Furs 80 rhe pera mein ae heft hat ah reucatirjnd wera etic pn gna a ig ae) Cpr ancl taney recanted Sn potion ite Fan prs Tye we of sremy opin wpa ese ay et rca son ives te wt el) ofa pon a he Poegn cron options oe tania contaets tat Expres outofthe money (values), the witer fv the Bolter he ight bat nt the obligation, ofthe option has chmod, tad tetany the etic ty Gn the ea of ale) oll Gn the cn pus) prema258 CHAPTER 8. CuneneyDenats Speciation in an stempt to rot by eading 08 ‘pesation abut rosin the fro fore ‘setang marke one specter nag poston ins foreign creny and then sig that poston "ecw rt fsa nl te ae ave 4 Curany opin vation, he dtrmiton fhe ‘pvons remiun,u compe combo ec Featopotrat he peers th forward te (ch ise epee’ on the earet spo ate ad Inet fret), cresyl and met The total value fan pin ithe no nin ‘ale tnd tn ale. vate depend oi ‘ape pon cs dhe tine eae bow nn mn ong forte hetero to mt 1 Thesngeugstinurest eter ofthe onic fem i des erin The de sate he MNE ‘ilps tring tres een et (escorted vers ting), Shien cuense enonsaton @. SEs {0deounties costes ts guy nvextnnt a foreig, steep schist ajo bdpng depen lngon be nil coy. ures. ana mute Brish Subsidiary as an Exposure MeDeesl’ parent ompny ba hee deren pound nominated exposures sing om st oer 1. The Bri ty hey cpa wich a nd ninth pc. 2 Inadinto the eit captives Bib tttate he tet compa ros tcp ‘etre ose eo Te ito i emote Bish pounds andere ‘cS per sn intr oye 3. The Best sbsiiry py fined ecole of 08 sia ecw pany To ‘Stomp xpnrepobien o: cDom ‘arate cbt by foe wold, hs ed ey ems toss manage theres rate rate Sorc vesting an lnm de sevice 1 The wetiqus and instrament seiner ie ‘ak mragement in anyway evel the od Seuremy rk mngemest To psmiy tere (Salior murntrate sk managed oor? rae aremons (RAS). forward sap, eet ate ‘rend inet map, tro he bv ted cos specie cures and Inet ne sesso gin nt elie lo toe Tht nn low hse eo maa ht tareayand inte et a eect, 9A romance rate ap al ft 0 tr bon the cueney of esointion of sh am fing o-dimeret rt te MeDonald's Corporation's British Pound Exposure ‘se sation When the pen compary mart ints erapany Tun hat the Beh saben, ma ‘Snigatesccording to US scouting to ex le Bracces—heter the loan Gonidred ob perme ony nese in at oat (Atop onthe Sac ‘senile to comer four ere “permanest the ean esl spy be comin lleva bythe pret compiny and never acta be ropa) I ot co ‘Sere permanent he oegy exchange eis es, ‘ied tof oun Bow ety othe pret comp Protitand iow taenent (P&L), acotng a FAS 2 ‘changed lanes ltd oe ntact a ‘renown tothe CTA coms trlston at ‘eno teams aes het To dete, Meum ‘rh chosen dengan sprang. Te funciona corene ofthe Bris atatetorcoeation upon ithe ol eseny, the Bri pound Ant Goh he Mgt ac‘ving te exiting hdeng eens employed by Ins been ang the pound exposure y eterna ‘The een swap i sevenyea upto fesse Jl Ins an py posts. Lie a renews saps te rcement gues MeDonl's (US) to make replat [utd denomiosed inet paymeats and a bl a Sialepaement aaa pal at theese be ap cement McDona conscer he ng estar mets tt gy ete _ zara o rconing pra, camps aay ‘ress. Seominto ln and ary th dey the pent company's PAL This hasbeen doe in he pst, fn McDonald rom he aon of i interes payment. "FAS #3, Aeounng fr Deri Inruments ad Hedging Acie, eed ia fue 1998 wat igi Yeats egg ate June 15199 (for mst fs is ‘ett Jnr 200), The ow tnd, howe, at {© canylex and potently of sch ate ntueos to {Usted MNEs tat he Fane! Accounting Stan Aas Board has Been appre by dozens of mor ems an aed pose enn) énlenestaton, ‘he saad compet combied wi he workloads sssoaited wah Y2K (ea 00) ak cote pred QUESTIONS 1. Options Vers Fates Eaplan the deren ‘then ihr might be mos apropily ed. 2 Trading Location for ates. Check the Wal Set ‘eons inal st Sted et ingen 4 rae Tne wt sh he i ney Ontntins COUETERS 259 ‘35rmandsiory nplenieniaton dt dente. Iaaues for Discussion [Ants Gopi however, sil wesw comer the ipa {CAS #135 onthe eigenen employe ‘Under Fas 13th vl ve mask mae tie rw careacy ap asin, ring. and ‘ith ttheramorenenatename (OT). OC ow Srp nb tea ancient Serra ea dle ute a reat on he apt nee, har ot rev Ba ‘Gopsens poses sobs mate sk © OC, ‘She tepmby ing be prosad:esot theca ee ‘paring tse to srnte tage sd on ee ‘ttf antigo be oestoa tt ie case Questions 1 How doe the erscuete peel Madge ‘het primary expos MeDenlds slate 2 How docs the ersten sap Bag the one: ‘eeu ely poo ia crs right ‘Stolk —and MeDons—wory about OCT” ee a mam 5 Patsand Cas, Wht ste teen betes 6 Cam Contact Elements, You rad tht exchange (eedes Amacai pisnron pandering Sesame bra en i260 CHAPER® CineneyDenatee ‘The Option Cot What happens ote peau ou id forte sore pion nt ee ou dee et. Te eton ep snes) What hp i towmtinieecyoudo ode oenrese ep? 1 Buying Earopem Option. Youhavethe sane in maton sin qssto except tht he pig for 9, Weling Options Why would anyone write an {poe Eeuwing iba the pin on revenge pti prem ie bo the orf te udering egos the mons decom can be exe fe? 10, Option Vatatin. The vl ofan tons sated toe rotate al sad te me 1 Creiand Repeng Bie Fromthe oi oven of ' borowingsoporton what rete and epee "kt api sp» company mug aks 0 mi ish 12, Forma Rate Agremeat, How cana buns ‘wadvate prement to feduce interest at ra? iven June Purodolla fares sete a 9838, What {Sth anual ld? How many dollars doe hie 14, Detling ona intern Rate Sap. Sith Company Jones Company eterno tres rt sm, ‘th Sth ping fed terest to Jones, bd Jats Pong tng oS Sunn ocr bn faptands dens nf emainig tres payens ‘What sth fal dma ones Company? 15. Caren Srape Wilde conan hin eas Oi pou eng wa oa toe opments payment due U.S dla? 16 Counterparty Rk. How docs exchanging ‘ap cemove ay athe oenerpay nap reement wilt conte gest? PROBLEMS 1. Aner MCh, Amber NC the eure pe re. ts td) wacty Ope WL Se Cpe ah Opt Uso ne met the cape, ell ight Fe fares ‘Shira for 50000 peat tel pce utd Wht aloe of her point matty ithe teding spot ts 0.12005 9 Wate ie terrence Whats te valu othe pontion tury te aig sot ates OOP eles Pat. Ph wit pat oto oa pane Jon with asks price 0 SDOINOOME (F008) {ta premium of aD jer yen and with am erp fan atc oats ow, The option ft ‘12sinp00: What Pls rotor ow mate yf the ending spat terre VIO AS, sh 808, 15%, ana aa? ‘Venton teenie Jani Roi, erecy {ser for Cheapo hse Verto ivetman ae ‘hetues quotes aown athe oto the us) nthe Heth pou (tape on he alae of ‘he pound dam bye 5 Jane pundits ad the spt ‘ate ema SLD, what be vl dames 12 March pond ore. and the pot fat at aur SL, what he vale a ber postion? ‘ate tary S10, wht he vale a Sorption? Tn sel 12 June pron ues, and the pt fate atu SLANE, wi the vals ot for Keystone Punds in Jaarta. Sb foexses nearly Singapore dota (5) crests The curteat spat fate SOSODSS. Aer comer stay he once ta the Singapore dle wl apres onrn = 8200 pats