Lecture 4

Foreign
Currency
Derivatives
and Swaps
Multinational Business Finance
 Global Economy
 Corporate Ownership, Goal, and Governance
 International Monetary System
 Balance of Payments
 Foreign Exchange Market
 International Parity Conditions
 Foreign Exchange Forecasting
 Foreign Currency Derivatives and Swaps
 Transaction Exposure
 Translation Exposure
 Operating Exposure
 Global Cost of Capital
 Raising Capital Globally
 Multinational Tax Management
 International Trade Finance
 Foreign Direct Investments
 Multinational Capital Budgeting
 Foreign Currency Futures

• 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.
• 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
 Foreign Currency Futures

Number of pesos per futures contract   500,000

Number of contracts   1.00

Ending spot rate ($/peso)   $0.12000
June futures settle price ($/peso) $0.10773
• Long Payoff = N x (S – F)
• Long Payoff = 500,000 x ($0.12 – $0.10773)=
= $6,135.00
• Short Payoff = - N x (S – F)
• Short Payoff = - 500,000 x ($0.12 – $0.10773)=
= - $6,135.00
 Another example
• Jamie Rodriguez, a currency trader for Chicago-based Ventosa
Investments, uses the following futures quotes on the British pound (£)
to speculate on the value of the pound.
Assumptions   Values
Pounds (₤) per futures contract   £62,500
Pound futures contract, settle price ($/₤) $1.4162
• If Jaime buys 3 June pound futures, and the spot rate at maturity is
$1.3990/£, what is the value of her position?
• Long Payoff = 3*62,500*(1.3990-1.4162) =
= -$3,225.00
 Foreign Currency Options
• An option gives the holder the right, but not
the obligation, to buy or sell a given quantity
of an asset in the future, at prices agreed
upon today.
• Call vs. Put options. Call/Put options gives the
holder the right, to buy/sell a given quantity
of some asset at some time in the future, at
prices agreed upon today.
• European vs. American options. In-the-
money, at-the-money, out-of-the money.
• Underlying – currency and currency futures
 Currency Options
Profit = Payoff - Premium
Breakeven price is when Profit = 0
Example: FX rate is $/SFr. Strike = $0.585,
Premium = $0.005, Spot = $0.595
Long call
Profit = Spot – (Strike + Premium)
= 0.595 – (0.585+ 0.005) = 0.005
Breakeven price = Strike + Premium = 0.590
Short call
Profit = Premium – (Spot – Strike)
= 0.005 – (0.595 – 0.585) = - 0.005
 Currency Options - continued
Example: FX rate is $/SFr. Strike = $0.585,
Premium = $0.005, Spot = $0.575
Long put
Profit = Strike – (Spot + Premium)
= 0.585 – (0.575+ 0.005) = 0.005
Breakeven price = Strike - Premium = 0.580
Short put
Profit = Premium – (Strike – Spot)
= 0.005 – (0.585 – 0.575) = - 0.005
 Currency option pricing
(𝑟 ¿¿ 𝑑 − 𝑟 )𝑇 ¿
𝐹=𝑆
  𝑒 𝑓

• Theoretical price for a call option

−𝑟 𝑑 𝑇
𝐶 = [ 𝐹𝑁 ( 𝑑 1 ) − 𝐸𝑁 ( 𝑑 2 ) ] 𝑒
 
• Theoretical price for a put option

− 𝑟𝑑 𝑇
[
 𝑃= 𝐸 ( 1 − 𝑁 ( 𝑑 2 ) ) − 𝐹 ( 1 − 𝑁 ( 𝑑 1 ) ) 𝑒 ]
2
  𝑙𝑛 𝐹 + 𝜎 𝑇
( )( )
𝐸 2 -
𝑑 1=
𝜎 √𝑇
 
S – spot rate rd – domestic interest
where F – forward rate σ – volatility (std. dev) of
C – call premium T – time to expiry exchange rates
P – put premium N() normal CDF ln – natural log
E – strike rate rf – foreign interest e – base of natural log
 Call premium example
• A US firm is planning to purchase GBP and wants to protect
against appreciation of the pound. Current market conditions as
follows: S= $1.8674/£, interest rate is 1.453% in the USA and
4.525% in the UK, exchange rate volatility is estimated at
9.400%. The call option has strike rate of $1.8000/£ and expires
in 180 days. What is the theoretical call option premium?
T = 180/365 = 0.4932
F = 1.8674*e((0.01453-0.04525)*0.4932)=1.8393
=  0.3602

- 

N(0.3602)=0.6407 and N(0.2942)=0.6157

 
 Put premium example
A US firm is expecting a payment in GBP from a British importer and
wants to protect against depreciation of the pound. Current market
conditions as follows: S= $1.8674/£, interest rate is 1.453% in the
USA and 4.525% in the UK, exchange rate volatility is estimated at
9.400%. The put option has strike rate of $1.8000/£ and expires in
180 days. What is the theoretical put option premium?
T = 180/365 =0.4932
F = 1.8674*e((0.01453-0.04525)*0.4932)=1.8393
=  0.3602

- 

N(0.3602)=0.6407 and N(0.2942)=0.6157

− 0.01453∗0.4932
 𝑃= [ 1.8000 ∗ ( 1− 0.6157 ) −1.8393 ∗(1− 0.6407 ) ] ∗ 𝑒
  $0.0307 per £
 Currency option pricing features
• Option premium = intrinsic value + time value
• The more out of the money, the cheaper the option
– Option premium drops very quickly
– Significant consideration for hedging, much cheaper
to use out of the money options than at the money
options
• Option price sensitivities (the Greeks). Used in
hedging portfolio construction
– Spot rate (delta) Two more, no Greeks
– Time (theta) – Forward rate
– Volatility (lambda) – Strike rate
– Domestic interest (rho) and foreign interest (phi)
 Cost of debt

• Interest rate = base rate + premium

• Base rate is often LIBOR
• Premium based on risks, i.e. credit risk
• Risk is assessed by credit rating agencies, issuer
gets credit rating
• Credit rating is subjective opinion of an agency
given available information, can change any time
• Risk premium depends on issuer risk and risk
appetite of investors
 Debt service
• Single largest interest rate risk of the nonfinancial
firm
• Example: borrow $1 million for 3 years
• Possibilities
1. Fixed rate for 3 years (no risk, may overpay if
interest rates drop)
2. Floating rate for 3 years (risk if interest rates
increase)
3. Fixed rate for 1 year, renew every year (most
flexibility, highest risk, especially if credit rating or
market conditions change)
 Debt Service
Consider strategy #2, LIBOR=5% for 3 years

Loan Interest Year 0 Year 1 Year 2 Year 3

LIBOR (floating) 5.00% 5.00% 5.00%
Credit spread (fixed) 1.25% 1.25% 1.25%
Total interest payable 6.25% 6.25% 6.25%
Principal Payments
Loan principal $10,000,000
Origination fees 1.50% -150,000
Loan proceeds $9,850,000
Principal repayment -$10,000,000
Interest Cash Flows
LIBOR (floating) -$500,000 -$500,000 -$500,000
Credit spread (fixed) -$125,000 -$125,000 -$125,000
Total interest payable -$625,000 -$625,000 -$625,000
Total loan cash flows $9,850,000 -$625,000 -$625,000 -$10,625,000
All-in-Cost (AIC) or IRR 6.820%
 Eurodollar Interest Rate Futures
• Widely used futures contract for hedging short-term
U.S. dollar interest rate risk.
• The underlying asset is a $1,000,000 90-day
Eurodollar deposit—the contract is cash settled.
• Traded on the CME and the Singapore International
Monetary Exchange.
• Eurodollar futures prices are stated as an index
number of three-month LIBOR calculated as
F = 100 – LIBOR
• For example, if the closing price for is 98.23, the
implied yield is 1.77 percent = 100 – 98.23
• Hedging/speculation just like with forwards, except
standardized amounts and daily resettlement
 Hedging with interest rate futures
• Now it is April 15, 2020
• Eurodollar futures price is 94.76 for March 2021
• Implied rate = 100-94.76=5.24%
• Floating interest payment is due in March 2021
• Concern: rising interest rates
• Hedge: sell the Eurodollar futures
• If rates rise to 8.00% in March 2021:
• New futures price = 100 – 8.00 = 92.00
• Gain from short position = -(92.00 - 94.76) = 2.76%
• Pay at March 2021 rate @ 8.00% and receive a gain
from futures contract = 8.00 – 2.76 = 5.24%
• See more in Exhibit 8.10
 Forward Rate Agreement
Firenza Motors of Italy is considering a forward rate agreement with a
notional amount of € 5,000,000. Now LIBOR is 4.00%. According to the
agreement, Firenza would pay to the Dealer at the end of the year the
difference between its initial interest cost of LIBOR+2.50%=6.50% and any
fall in interest cost due to a fall in LIBOR. Conversely, the Dealer would pay
to Firenza 70% of the difference between Firenza’s initial interest cost and
any increase in interest costs caused by a rise in LIBOR. This forward rate
agreement covers only one payment.

If LIBOR = 3.00% next year, then Firenza pays to the Dealer

(0.04-0.03)*5,000,000= € 75,000
If LIBOR = 6.00% next year, then the Dealer pays to Firenza
0.70*(0.06-0.04)*5,000,000= € 70,000
 Interest Rate 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, such as the floating-rate loan
described earlier.
• If the agreement is for one party to swap its fixed interest
rate payments for the floating interest rate payments of
another, it is called an interest rate swap
• If the agreement is to swap currencies of debt service
obligation, it is called a currency swap
• A single swap may combine elements of both interest rate
and currency swaps
 Interest Rate Swap
MedStat has $40 million in floating rate loans, paying a floating interest rate of LIBOR +
1.250%. Over the past year LIBOR has been trending upward. Company management is now
considering swapping its floating-rate debt for fixed-rate payments—a pay fixed, receive
floating—plain vanilla interest rate swap. If it swaps now it can lock-in a fixed rate payment of
3.850% (pay fixed component) in exchange for LIBOR (received floating component).

Now LIBOR is 1.885%

Loan interest = (note: floating rate) =1.885%+1.25%=3.135%

Swap agreement: pay 3.85%, receive LIBOR

Loan interest with swap =5.10% (fixed rate)
= (LIBOR+1.25%)+3.85% - LIBOR = 1.25+3.85
 Currency swap
MedStat just borrowed $10 million for 3 years and bought new equipment. Also, 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% fixed British pound interest and receive 1.26% fixed U.S. dollars and the notional amount is $10
million. Current spot rate is $1.56/£.

GBP notional= $10,000,000/1.56 $/£ = £6,410,256

MedStat will pay to swap dealer

= £6,410,256 * 0.0115 = £73,718

Swap dealer will pay to MedStat

= $10,000,000* 0.0126 = $126,000
 Conclusion
• Currency futures can be used to manage
risk, they protect from downside and
upside
• Options protect from downside and allow to
participate in upside market moves, for a
price
• Interest rate futures, FRAs are used for
hedging short-term U.S. dollar interest rate
risk.
• Swaps allow more choice in borrowing