Lec 6+7 - Chapter 8

Chapter 8
Currency and
interest rate
Derivatives
Outline
• Currency futures vs. interest rate futures

• Currency Options
• Interest rate vs. currency swaps
1-2
8-2 © 2013 Pearson Education
Foreign Currency Derivatives and
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 in business today.
• These instruments can be used for two very distinct
management objectives:
– 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
1-3
Foreign Currency Derivatives
• Derivatives are used by firms to achieve one of

more of the following individual benefits:
– Permit firms to achieve payoffs that they would not be able
to achieve without derivatives, or could achieve only at
greater cost
– Hedge risks that otherwise would not be possible to hedge
– Make underlying markets more efficient
– Reduce volatility of stock returns
– Minimize earnings volatility
– Reduce tax liabilities
– Motivate management (agency theory effect)
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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, VNX(Vietnam)
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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.
1-6
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
1-7
Exhibit 8.1 Mexican Peso (CME)-
MXN 500,000; $ per 10MXN
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• 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
• 5% of all futures contracts are settled by the physical
delivery of foreign exchange between buyer and seller.
Most often, buyers and sellers offset their original
position prior to delivery date by taking an opposite
position → close out a futures position
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Example: long position in March MXN futures contract at
the price $1.10958/MXN10
• 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),
$/MXN,
• 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
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• 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 = ?
1-11
• 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)
→If the spot exchange rate at maturity is $.1100/MXN,

Amber buys at $.10958 and sells at $.11000 per peso
→the value of her position on settlement is ?
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• 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 market 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)
1-13
Futures vs Forward
1-14
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 multicurrency dimension of
interest rate risk for the MNE is of serious concern.
• Exhibit 8.9, shows that even the interest rate
calculations vary on occasion across currencies and
countries.
1-15
Exhibit 8.9 International Interest
Rate Calculations
1-16
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.
1-17
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.
1-18
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
1-19
Exhibit 8.10 Eurodollar Futures
Prices
1-20
Interest Rate Futures
• Common interest rate futures strategies:
– Paying interest on a future date (sell a futures contract/short
position)
• If rates go up, the futures price falls and the short earns a profit
(offsets loss on interest expense)
• If rates 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
• If rates go down, the futures price rises and the long earns a
profit
• Exhibit 8.11 provides an overview of these two basic
interest rate exposures
1-21
Exhibit 8.11 Interest Rate Futures
Strategies for Common Exposures
1-22
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 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.
1-23
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
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• 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
1-25
• 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.
1-26
• 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).
1-27
• 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.
1-28
Exhibit 8.2 Swiss Franc Option
Quotations (U.S. cents/SF)
1-29
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.
1-30
Exhibit 8.3 Profit and Loss for the
1-31
St ≤ X St > X
Do not exercise Exercise
Net Profit/loss -c -c + St – X
• Pay off (Intrinsic value) = Max (St - X; 0)

• Profit = Max (St – X - c; -c)
• Break-even price St = X + c
Example: the spot rate at maturity is St = $0.595/SF
→Break-even price; net profit/loss = ?
X= $0.585/SF; c = $0.005/SF; 1option = SF62,500
1-32
Writer of a call
St ≤ X St >X
Call buyer Do not exercise Exercise
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?
1-33
Writer of a Call Option
1-34
Writer of a call
• Naked position: writer does not actually own
the foreign currency → if the option is exercised,
the writer 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
1-35
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.
• Pay-off (Intrinsic value) = Max(X - St; 0)
• Profit/loss = Max (X - St - p; -p)
• Break-even price = X - c
St < X St ≥X
Put buyer Exercise Do not exercise
Net Profit/loss X – St - p -p
1-36
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
1-37
Buyer of a Put Option
1-38
Seller of a put
St < X St ≥X
Put buyer Exercise Do not exercise
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 ?
1-39
Writer of a Put Option
1-40
Option Pricing and Valuation
• 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)
1-41
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.
– Currency swap: the agreement to swap currencies of
debt service obligation
– A single swap may combine elements of both interest rate
and currency swaps
1-42
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.
1-43
8-43 . © 2013 Pearson Education
Exhibit 8.13 Interest Rate and
Currency Swap Quotes
1-44

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Chapter 8

• Currency futures vs. interest rate futures

• Derivatives are used by firms to achieve one of

• CBOT and CME (now CME Group)

• Contract specifications are established by the

• Short position: If a speculator sells a futures contract,

Value at maturity = Notional principal*(Futures - Spot)

If the spot rate at maturity (in March) = $.09500/MXN

• Long position: If a speculator buys a futures contract,

Value at maturity = Notional principal * (Spot - Futures)

→If the spot exchange rate at maturity is $.1100/MXN,

• Foreign currency futures contracts differ from forward

• All firms – domestic or multinational, small or

• The second most prevalent source of interest rate

• Prior to describing the management of the most

• Unlike foreign currency futures, interest rate futures are

• A forward rate agreement (FRA) is an interbank-traded

• A foreign currency option is a contract

• The buyer of an option: holder,

• American option: gives the buyer the right

• An option whose exercise price is the same as the

• In the past three decades, the use of foreign

Do not exercise Exercise

• Pay off (Intrinsic value) = Max (St - X; 0)

• What the holder, or buyer of an option loses, the

• The buyer of a put option wants to be able to sell

Example: Buyer of the August put option on Swiss

Example: The seller of August put option on Swiss

• The pricing of any currency option combines

• Swaps are contractual agreements to exchange or

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