FOREIGN CURRENCY

DERIVATIVES AND SWAP

Group 4
Derivatives
• derived from underlying asset
• Financial derivatives- managers may purchase this in order to
take positions in the expectations of profit and speculations;
with proper control this may provide management with
opportunities to enhance and protect their corporate financial
performances
• Primary foreign currency financial derivatives:
1. foreign currency futures
2. foreign currency options
3. interest rate swaps
4. cross currency interest rate swaps
Foreign Currency Futures Contract
• Alternative to a forward contract
• specifies the price at which a currency can be bought
or sold at a future date
Similar to future contract- commodities, interest-
bearing deposits and gold
• International Monetary Market (IMM) of Chicago-
most important market for foreign currency futures, a
division of the Chicago Mercantile Exchange (CME)
 Contract Specifications
• Established by the exchange on which futures are
traded
• Example:
Mexican Peso (CME)-MXN 500,000 $per 10MXN Lifetime

Maturity Open High Low Settle Change High Low Open

Interest

Mar .10953 .10988 .10930 .10958 ... .11000 .09770 34,481

June .10790 .10795 .10778 .10773 ... .10800 .09730 3,406

Sept .10615 .10615 .10610 .10573 ... .10615 .09930 1,481

© Wall Street Journal
• Initial margin or collateral- one of the defining characteristics of
futures; property or asset that a borrower offers as a way for a
lender to secure the loan
• Maintenance margin- minimum amount of equity that must be
maintained in a margin account
• Marked to market- the value of the contract is revalued using
the closing price for the day
• Variation margin- amount to be paid
• Round turn- complete buy/sell or sell/buy
Using Foreign Currency Futures
• It’s a must to keep in mind the principles of a future
contract:
-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
-if a speculator sell a futures contract, they are locking
in the price at which they must sell that currency on
the specified future date
• Includes short and long positions
Short Positions
EXAMPLE: If Amber McClain, a speculator working for
International Currency Traders believes that the Mexican peso
will fall in the value versus the U.S. Dollar by March she could sell
MXN 500,000 at a set price. If the price of the peso falls by the
maturity date as she expects, Amber has a contract to sell pesos
at a price above their current price on the spot market. Hence
she makes a profit.

FORMULA: Value at maturity (Short position)= -Notional

Principal x (Spot-Futures)
SOLUTION: Value= -MXN 500,000 x ($.09500/MXN-
$10958/MXN)= $7,290
Long Positions
EXAMPLE:
Scenario 1- If Amber McClain expected the peso to rise in value
versus the dollar in the near term, she could take a long
position, by buying a March future on the Mexican peso. Buying
a March future means that Amber is locking in the price at which
she must buy Mexican pesos at the future’s maturity date.

FORMULA: Value at maturity (Long position)= Notional Principal

x (Spot-Futures)
SOLUTION: Value= MXN 500,000 x ($.11000/MXN-
$10958/MXN)= $210
Scenario 2- If the Mexican government announces that the rate
of inflation in Mexico has suddenly risen dramatically, and the
peso falls to $.08000/MXN by the March maturity date.

FORMULA: Value at maturity (Long position)= Notional Principal

x (Spot-Futures)
SOLUTION: Value= MXN 500,000 x ($.08000/MXN-
$10958/MXN)= ($14.790)
Foreign Currency Futures vs. Forward Contracts
Foreign Currency Futures
• exchange-traded and, therefore,
are standardized contracts
• marked-to-market daily, which
means that daily changes are
settled day by day until the end of
the contract
• can occur over a range of dates
• are quite frequently employed
by speculators, who bet on the
direction in which an asset's price
will move, they are usually closed
out prior to maturity and delivery
usually never happens
© Investopedia
Forward Contracts
• private agreements between two
parties and are not as rigid in their
stated terms and conditions
• settlement of the contract occurs
at the end of the contract
• only possess one settlement date
• are mostly used by hedgers that
want to eliminate the volatility of
an asset's price, and delivery of the
asset or cash settlement will
usually take place.
Foreign Currency Option
• giving the option purchaser (the buyer) the
right, but not the obligation

Two basic types of options:

• Call - buy
• Put - sell
Options Buyers vs. Sellers

BUYERS SELLERS
Foreign Currency Option
Three different price elements:
• Exercise or strike price
• Premium
• The underlying or actual spot exchange rate in the
market
American Options Versus European Options
• An American option
• right to exercise the option at any time

• A European option
• can be exercised only on its expiration date
Foreign Currency Option
• At-The-Money
• Spot = the strike

• In-The-Money
• Call: Spot > strike
• Put: Spot < strike

• Out- of-The-Money
• Call: Spot < strike
• Put: Spot > strike
Option Pricing and Valuation
• An approach for calculating the fair value of an option
• Intrinsic Value- financial gain if the option is exercised immediately
Total value (premium)=Intrinsic value + Time value
Summary of Option Premium Components
Greek Definition
Delta Expected change in the option premium for a
small change in the spot rate
Theta Expected change in the option premium for a
small change in time to expiration
Lambda Expected change in the option premium for a
small change in volatility
Rho Expected change in the option premium for a
small change in the domestic interest rate
Phi Expected change in the option premium for a
small change in the foreign interest rate
Interpretation
The higher the delta, the more
likely the option will move-in-
the-money
Premiums are relatively
insensitive until the final 30 or
so days
Premiums rise with increases
in volatility
Increases in domestic interest
rates cause increasing call
option premiums
Increases in foreign interest
rates cause decreasing call
option premiums
Interest rate risk
Debt service- the single largest interest rate risk of non financial
firm.

Debt structure of MNE:

>differing maturities of debt
>different interest rate structures (fixed versus floating rate)
> different currencies of denomination
Interest rates are
currency specific.
• Credit risk sometimes called roll-over risk

• Reprising risk is the risk of changes in interest rates

charged at the time a financial contracts rate is
reset.

Strategy 1: Borrow 1 million for 3 years at a fixed

rate of interest.
Strategy 2: Borrow 1 million for 3 years at a floating
rate, LIBOR+2%, to be reset annually.
Strategy 3: Borrow 1 million for 1 year at a fixed
rate, then renew credit annually.
Interest Rate Swaps
• An over-the-counter derivative transaction
• Two parties involved in the trade periodically exchange interest
payments

Fixed Interest
Party A Party B

Floating Interest
Valuation of Interest Rate Swaps

In order to convert fixed rate liability to floating

rate liability, a company should enter into an interest
rate swap contract where it receives fixed cash flow and
pays floating cash flow that may be tied to, for
example, LIBOR rates.