RM Lecture 3

Risk Management
Foreign Exchange Risk
Lecture 3
Prof Youwei Li
1
Lecture Plan
l Interest rate options
l Commodity risk
l Foreign exchange risk
2
Main Types of Derivatives –
Interest Rate Options
l Interest rate options include:
1. Caps
2. Floors
3. Collars
l These financial products are used to protect against different

reference interest rates or prices of underlying assets over time.
3
l The business of the options is analogous to insurance. One party
pay to reduce or eliminate the risk, while the other party accepts the
risk in exchange for option premium.
l Option premium paid increases the effective borrowing cost, or

decreases the effective return on assets.
l Although options strategies usually involve over-the-counter options,

they can also be constructed from exchange-traded options.
4
l The price of interest rate options depends on several factors such
as:
a) Term to expiry
b) Strike (exercise) rate
c) Volatility of the reference interest rate
l Prices are normally quoted in basis points of the notional contract

amount.
l Purchased interest rate options can be costly if the underlying rate
is volatile.
5
l Caps and Floors
l A Cap is a series of interest rate options (caplet) to protect
against rising interest rates.
l A cap buyer is protected from higher rates (above the cap strike
rate) for the period of time covered by the cap.
l At the expiry date of each individual option (caplet), the cap seller
reimburses the cap buyer if the reference rate is above the cap
strike rate. If rate is below the cap rate, the caplet is left to expire,
and the funding can be obtained at lower market rates.
Unexpired portions of the cap (caplets) remain for future
borrowing dates.
6
l A U.S. manufacturer borrows by rolling over short-term debt every
quarter. Concerned about the possibility of a rising in the interest
rates, the company decided to buy a 2 years interest rate cap to
cover its $100 million floating rate debt. The cap strike rate is 5.0
percent, the reset period is quarterly, and the reference rate is the
LIBOR. Suppose that at the first and the second rollover, the LIBOR
is 4.5% and 6.1%, respectively.
l Rollover 1: at the first rollover and cap date, the average reference rate is 4.5%. The
company will do nothing, and borrow at the lower market rates. So the cap will remain for
subsequent rollover dates until its expiry.
l Rollover 2: at the second rollover and cap date, the average reference rate is 6.1%. The
company will be reimbursed for the difference between the cap strike rate and the reference
rate.
7
l Caps and Floors
l A floor is similar to a cap except that it provides protection
against falling rates below the floor strike rate.
l A floor provides the floor buyer with reimbursement if the

reference rate falls below the floor strike rate.
8
l Interest Rate Collar
l An interest rate collar comprises a cap and a floor, one
purchased and one sold.
l Collars are often used when caps (or floors) are deemed too
expensive. The purchased option provides protection against
adverse interest rate movements.
l The sold option trades away some of the benefits of favourable
rates in order to pay for the protective option.
9
l Interest Rate Collar
l Like caps and floors, collars typically consist of a series of
interest rate options with expiry dates customized to the hedger’s
schedule.
l If at expiry each option comprising the collar, the reference rate is
between the cap and floor rates, neither the cap nor the floor will
be exercised. However, if the rates move above the cap or below
the floor rate, the appropriate option (cap or floor) will be
exercised.
§ Effectively, rates will be capped at the cap rate or prevented
from falling below the floor rate.
10
l Closing Out an Interest Rate Option
l If an interest rate option is no longer required and there is time
remaining to expiry, it can be sold at market value.
§ For a strategy involving several purchased options, market value is the
total of the options that comprise it, and the maximum loss is the cost of
the options.
l A sold option remains an obligation to the option seller unless

it has been closed out by purchasing an offsetting one and the
outstanding option is cancelled.
11
Commodity Risk
l Organizations that produce or purchase commodities, may exposure
to commodity price or quantity risk.
l Some commodities cannot be hedged because there is no effective
forward market for the product.
l Commodity Price Risk
l Occurs when there is potential for changes in the price of a commodity that
must be purchased or sold.
l Commodity exposure can arise from non-commodity business if inputs or
products and services have a commodity component.
l Commodity prices risk affects consumers and end-users such as
manufacturers, governments, processors, and wholesalers. If a commodity
price rise, the cost of commodity purchases increases, reducing profit from
transactions.
12
Commodity Risk (cont.)
l Commodity Quantity Risk
l Organizations are exposed to quantity risk through the demand for commodity
assets. For example a farmer expects demand for product to be high and
plans the season accordingly, there is a risk that the quantity the market
demands will be less than has been produced. If so a farmer may face a loss
by being unable to sell all the product, even if prices do not change
dramatically.
l This might be managed using a fixed price contract covering a minimum
quantity of commodity as a hedge.
l Commodities differ from financial contracts in several ways,

primarily due to the fact that most have the potential to involve
physical delivery. With exception of electricity, commodities
involve issues such as quality, delivery location, transportation,
spoilage, shortages, and storability. These issues affect price and
trading activity.
13
Contango and Backwardation
l In a contango (normal) market, the price of a commodity

for future delivery is higher than the spot price.
l The higher forward price accommodates the cost of owning the
commodity from the trade date to the delivery date, including
financing, insurance and storage costs.
l Although the spot commodity buyer incurs these costs, the
futures buyer does not.
l In a backwardation market, the spot price of a
commodity is higher than the future delivery price.
l The development of a backwardation is associated with current
supply shortage.
14
Foreign exchange risk
l Transaction
l It arises from ordinary transactions of an organization, including
purchase from suppliers and vendors, contractual payments in
other currencies, royalties or license fees and sales to
customers in currencies other than the domestic one.
l Translation
l Refers to the fluctuations that result from the accounting
translation of financial statements, particularly assets and
liabilities on the balance sheet.
l Economic Exposures
l A firm whose domestic currency has appreciated dramatically
may find its products are too expensive in international markets
despite its efforts to reduce costs of production and minimize
prices.
15
Transaction Exposure
Horcher (2005), page 31
Ø A Canadian company receives services revenues from its international customers, mostly in U.S. Dollars (USD)
Ø The company’s costs, primarily research and development, are in Canadian (CAD).
Ø The following exchange rates prevailed over a certain period:
Revenues Exchange Revenues

Quarter
(USD) rate (CAD)
1
10.000.000 1,5280 15.280.000
(actual)
2
10.000.000 1,4326 14.326.000
(actual)
3
10.000.000 1,3328 13.328.000
(actual)
4
10.000.000 1,2910 12.910.000
(estimated)
USD – US dollars
CAD – Canadian dollars
16
Translation Exposure
Horcher (2005), page 32
Ø A U.S. Company has founded its operations with a Canadian $10.000.000 liability.
Ø Without offsetting assets or cash flows, the value of the liability fluctuates with exchange rates.
Ø If exchange rates moves from 0.7000 to 0.9000 (USD/CAD), it increases the company’s liability by $2.000.000.
Exchange rate Liability

(USD/CAD) USD
0,6500 $6.500.000,0
0,7000 $7.000.000,0
0,7500 $7.500.000,0
0,8000 $8.000.000,0
0,9000 $9.000.000,0
USD – US dollars
CAD – Canadian dollars
17
Hedging techniques
• Currency Forward Contracts

• Currency Swaps
• Currency Futures
• Foreign Exchange Options
18
Management
1- Forward Contract
l Forward foreign exchange markets facilitate the movement of capital

between domestic and international money markets and the hedging
of foreign exchange risk.
l A foreign exchange forward is a customized contract that locks in an
exchange rate for the purchase or sale of a predetermined amount
of currency at a future delivery date.
l Since foreign exchange always involves two currencies, a contract
to buy one currency is a contract to sell the other currency.
l By locking in an exchange rate, the organization eliminates the
potential for adverse currency movements, but it also gives up the
potential for favourable movements.
l Forwards typically have maturity dates as far as one to two years
forward, although if credit concerns are not an issue they can have
longer maturities
19
Management
1- Forward Contract (cont.)
l Forwards are traded over-the-counter, and the forward price

includes a profit for the dealer.
l The forward price reflects the difference in interest rates between

the two currencies over the period of time covered by the forward.
The interest rate may be positive or negative, resulting in a forward
price that is at a premium or discount to the spot rate.
l Changes in either the spot rate or the underlying interest rates will
change the forward price.
20
Management
1- Forward Contract (cont.)
l Closing out a Forward Contract

l Once a contract has been transacted, the exchange rate is fixed for the
amount and delivery date. To take delivery under the terms of the
forward at maturity, the organization should provide instructions to the
financial institution at least one or two days prior to maturity.
l A forward contract can be closed out in one of the following ways:

l Undertake delivery according to the terms of the forward contract.
l Close out the forward contract by buying or selling an offsetting contract at
prevailing market rates, with a resultant gain or loss.
l Extend or roll over the forward contract to another date at current rates.
21
Management
2- Swaps
l Swaps trade in the over-the-counter market between

large financial institutions and their customers.
l Foreign Exchange Swaps:

l Are used extensively, particularly by financial institutions, to
manage cash balances and exposures in various currencies.
l Consists of a spot transaction and forward transaction. One
currency is bought at the spot date, with a reversing sale at the
forward date. Both the spot and the forward price are set when
the trade is made, and the difference (the forward point) is the
net cost of, or gain resulting from, the swap.
22
Management
2- Swaps (cont.)
l Currency Swaps:
l Enable swap counterparties to exchange payments in different
currencies, changing the effective nature of an asset or liability
without altering the underlying exposure.
l Usually have periodic payments between the counterparties for
the term of the swap and cover a longer period of time than
foreign exchange swaps.
l It is useful for a company that has issued long-term foreign
currency debt to finance capital expenditures. If the company
prefers to make debt payments in its domestic currency, it can
enter into a currency swap to effectively exchange its required
foreign currency payments for domestic currency payments.
l Can also be used to lock in the cost of existing foreign currency
debt or change the revenue stream on an asset.
23
Management
2- Swaps (cont.)
l Currency Swaps:
l Can also be used to lock in the cost of existing foreign currency
debt or change the revenue stream on an asset.
l It is similar to a loan combined with an investment. An exchange
takes place at the beginning of the currency swap. Over the term
of the swap, each party makes regular periodic payments in the
desired currency and receives periodic payments in the other
currency.
l At the swap’s maturity, there is an exchange back to the original
currencies.
24
Typical Uses of a
Currency Swap
l Conversion from l Conversion from

a liability in one an investment in
currency to a one currency to
liability in an investment in
another currency another currency
Management
3- Currency Futures
l Currency Futures:
l Currency futures are exchange-traded forward contracts to buy
or sell a predetermined amount of currency on a future delivery
date. Contract size, expiry dates, and trading are standardized by
the exchange on which they trade.
l The futures contract allows a currency buyer or seller to lock in
an exchange rate for future delivery, removing the uncertainty of
the exchange rate fluctuations prior to the contract’s expiry.
l Commissions and margin requirements apply.
l Several exchanges offer currency futures, such as:
l International Monetary Market (IMM), division of the Chicago Mercantile
Exchange.
l New York Board of Trade.
l Philadelphia Stock Exchange.
26
Management
4- Foreign Exchange Options
l Foreign Exchange Options :
l Can be useful adjunct to a foreign exchange hedging program.
l The purchase of options can reduce the risk of an adverse

currency movement, while maintaining the ability to profit from
favourable exchange rate changes.
27
Management
l Foreign Exchange Options :

l Are similar to insurance. The option buyer pays an option
premium for protection from adverse exchange rate changes,
while the option seller accepts the risk in exchange for the option
premium. The option contract permits the notional amount of a
currency to be bought or sold at the strike rate, until (American
option) or at (European option) the expiry date.
l Most foreign exchange options trade in the over-the-counter

market, although also in the exchange-traded market, such as at
the CME and NYBT.
28
Management
l Option Revision :
l American Options can be exercised at any time in their life.
l European Options can only be exercised at maturity.
l Value at Expiration
l Call Value = Max(Currency Spot Price – Strike Price, 0)
l Put Value = Max(Strike Price – Currency Spot Price, 0)
29
Management
l Foreign exchange options:
l Foreign exchange collar

l Average rate option
l Barrier option
l Compound Options
30
Management
4- Foreign Exchange Options (cont.)
l Foreign Exchange Collar:

l Options can be costly if the exchange rate is volatile. To reduce
the cost of hedging, collars are often used.
l A collar combines the purchase of a call option and the sale of a
put option with the same expiry date on the same currency pair.
l European-style collar options are often used to ensure that only
one of the two options is exercised.
l The sold option generates option premium to pay for the
purchased option. Strike prices are often chosen so that the
premium of the sold offsets the premium of the purchased option
and the collar has a zero cost.
l Since only one option will be exercised, collars limit the effective
exchange rate, the upper exchange rate by the call, and the
lower exchange rate by the put.
31
Management
Example: ABC needs protection against a rising USD (declining

CAD). Spot price for fx rate is 1.25 CAD/USD. ABC enters with
its bank on zero-cost collar by buying a call option with strike
price at 1.27 CAD/USD and selling a put option with strike price
at 1.23 CAD/USD. Both options are European style with the
same 1-month expiry dates.
§Scenario 1. Spot fx > 1.27 CAD/USD – ABC will exercise the call and
buy USD @1.27 CAD/USD
§Scenario 2. Spot fx < 1.23 CAD/USD – the bank will exercise the sold
put option and ABC will be required to sell USD from the bank @1.23
CAD/USD
§Scenario 3. 1.23 < Spot fx < 1.27 – neither option will be exercised,
both they will expire worthless.
1.32
Management
l Average Rate (Asian) Options:

l Average rate (Asian) options have a payoff that depends on the
average exchange rate during, at least part of, the life of the
option.
l They allow an organization to hedge an exchange rate for a
number of currency transactions over a period of time.
l At expiry date of the option, the average rate is calculated from
the periodic fixings made during the term of the option and
compared with the strike price.
l There are several variants, for instance, with fixed and floating
strike rates.
33
Management
l Barrier Option:
l Its payoff is contingent on the exchange rate reaching the barrier
level. Once reached, the option may become exercisable (knock-
in option) or become unexercisable (knock-out option).
l Knock-in options normally become conventional European-style

options if the knock-in rate is reached.
l Barrier options have both a strike rate and a barrier (knock-in or

knock-out) rate.
34
Management
l Barrier Option (cont.):

l Both knock-in and knock-out options are popular due to their
lower cost and simplicity. Since there is no guarantee that the
option will be exercisable, there is less risk to the option seller,
and they normally cost less than a conventional option as a result.
l The buyer of a knock-out option pays an option premium for a

European-style option that exists unless the exchange rate
passes a predetermined level, at which the option knocks out and
becomes unexercisable and worthless.
l The knock-out level is chosen by the option buyer and maybe a

rate at which a hedge is no longer required.
35
Management
l Barrier Option (cont.):

l The closer the knock-out level is to the current market price, the
more likely it is that the option will be knocked out and not be
exercisable, the less premium will be needed to pay the option.
l If a knock-out option becomes unexercisable and has to be

replaced because a hedge is still needed, this will increase the
cost of hedging.
l However, if the exchange rate does not reach the barrier level (in
the case of a knock-in option) or is knocked-out (in the case of the
knock-out option), the hedger has no option, and therefore no
protection against unfavourable exchange rate movements.
Therefore, a strike price should be chosen carefully.
36
Management
l Example: A US importer estimates that GBP will rise against the

USD, reducing its profit margins. The company buys a up-knock-in
option on sterling with a strike price of $1.85. The knock-in rate is
set at $1.87. (the option premium is cheaper than conventional
option)
§ Scenario 1. If GBP does not increase to $1.87 at any point during

the life of the option, it would expire worthless.
§ Scenario 2. If GBP increase to $1.87, the call option would come

into existence.
37
Management

USD, reducing its profit margins. The company buys a down-knock-
out option on sterling with a strike price of $1.85. The knock-out rate
is set at 1.81, at which rate the company will be more comfortable
locking it with a forward. (the option premium paid for the option
increases the sterling’s cost under all scenarios)
§ Scenario 1. If GBP increases the option can be exercised if needed,

purchase sterling with $1.85
§ Scenario 2. If GBP decreases the option may get knocked-out, but

rates will be more attractive, purchase sterling with less $1.85
38
Management

USD, reducing its profit margins. The company buys a down-knock-
out option on sterling with a strike price of $1.85. The knock-out rate
is set at 1.81, at which rate the company will be more comfortable
locking it with a forward. (the option premium paid for the option
increases the sterling’s cost under all scenarios)
§ Scenario 3. (worst-case scenario) . The option gets knocked-out and

GBP subsequently rises, leaving the company exposed. Therefore,
the company should consider another hedge if the option gets
knocked-out and protection is still required
39
Management
l Compound Options
l Compound options are options on options. Usually, European-
style, they give the option holder the right, but not the obligation,
to buy or sell an option contract at the compound option’s expiry
date at a predetermined option premium
l They are usually cheaper than the standard options, however, if

both the compound option and its underlying option are
purchased, the total hedging cost may be greater than compared
to an ordinary put or call option.
40
Management
l A number of techniques have been used to
rearrange business activities to reduce foreign
exchange exposure, including:
1. Currency Netting
2. Foreign Currency Debt
3. Changes to Purchasing/Processing
4. Transfer Exchange Rate Risk
41
Business Restructuring
1. Currency Netting
l On an organizational or centralized basis, it may be possible to net

currency requirements internally.
l In effect, the organization centralizes some of its banking activities

in-house, making excess currency available to other parts of the
organization.
l Cumulative gaps between cash inflows and outflows are those that
may require hedging.
42
2. Foreign Currency Debt
l The issuance of foreign currency debt is sometimes used to reduce

foreign exchange exposure. There are several reasons for borrowing
in a foreign currency:
a) Issuers may want to entice specific institutional investors by issuing debt in a
desirable currency.
b) Lower foreign interest rates might be seen as a way to reduce funding costs
c) Foreign currency debt may be required to finance an overseas expansion or
investment in foreign plant and operations.
l The risk of debt denominated in a foreign currency can be reduced

when the borrower has an offsetting asset denominated in the same
currency, such as an income-producing subsidiary.
l If income from the asset is adequate to offset the payments on the
liability, and it can be expected to continue for the life of the debt, the
organization can take advantage of it.
l However, offsetting foreign currency debt with foreign currency revenues does not take into account how
demand and revenues change in response to exchange rates.
43
3. Changes to Purchasing/Processing
l Managing foreign exchange transaction risk can sometimes be

accomplished through offsetting transactions to reduce
currency exposure.
l This might involve different sources or locations for
manufacturing.
l A company with foreign currency sales might use a supplier
whose products are priced in the same currency.
l Longer-term strategies might involve manufacturing in key
customer locations or obtaining new customers where inputs
are sourced.
l Exploiting exchange rate differences is often a reason to
relocate manufacturing or sourcing, although there are other
ramifications.
44
4. Transfer Exchange Rate Risk
l It is sometimes possible to transfer exchange rate risk to customers

or suppliers.
l For instance, changes may be made to pricing methodology to
better reflect exchange rates.
l In some industries, surcharges help to offset exchange rate risk and
pass it to the final customer.
l It might be possible to obtain fixed prices in two currencies from
suppliers and pay the lower price when invoiced.
l Offering customers the opportunity to pay in another currency, which
may help them offset their own currency exposure.
45

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Risk Management

Foreign Exchange Risk

l Interest rate options

l Foreign exchange risk

l These financial products are used to protect against different

l Option premium paid increases the effective borrowing cost, or

l Although options strategies usually involve over-the-counter options,

l Prices are normally quoted in basis points of the notional contract

l A floor provides the floor buyer with reimbursement if the

l A sold option remains an obligation to the option seller unless

l Commodities differ from financial contracts in several ways,

l In a contango (normal) market, the price of a commodity

Revenues Exchange Revenues

Exchange rate Liability

• Currency Forward Contracts

l Forward foreign exchange markets facilitate the movement of capital

l Forwards are traded over-the-counter, and the forward price

l The forward price reflects the difference in interest rates between

l Closing out a Forward Contract

l A forward contract can be closed out in one of the following ways:

l Swaps trade in the over-the-counter market between

l Foreign Exchange Swaps:

l Conversion from l Conversion from

l Foreign Exchange Options :

l Can be useful adjunct to a foreign exchange hedging program.

l The purchase of options can reduce the risk of an adverse

l Foreign Exchange Options :

l Most foreign exchange options trade in the over-the-counter

l Foreign exchange options:

l Foreign exchange collar

l Foreign Exchange Collar:

Example: ABC needs protection against a rising USD (declining

l Average Rate (Asian) Options:

l Knock-in options normally become conventional European-style

l Barrier options have both a strike rate and a barrier (knock-in or

l Barrier Option (cont.):

l The buyer of a knock-out option pays an option premium for a

l The knock-out level is chosen by the option buyer and maybe a

l Barrier Option (cont.):

l If a knock-out option becomes unexercisable and has to be

l Example: A US importer estimates that GBP will rise against the

§ Scenario 1. If GBP does not increase to $1.87 at any point during

§ Scenario 2. If GBP increase to $1.87, the call option would come

l Example: A US importer estimates that GBP will rise against the

§ Scenario 1. If GBP increases the option can be exercised if needed,

§ Scenario 2. If GBP decreases the option may get knocked-out, but

l Example: A US importer estimates that GBP will rise against the

§ Scenario 3. (worst-case scenario) . The option gets knocked-out and

l They are usually cheaper than the standard options, however, if

l On an organizational or centralized basis, it may be possible to net

l In effect, the organization centralizes some of its banking activities

l The issuance of foreign currency debt is sometimes used to reduce

l The risk of debt denominated in a foreign currency can be reduced

l Managing foreign exchange transaction risk can sometimes be

l It is sometimes possible to transfer exchange rate risk to customers

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