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CH 8
CH 8
CH 8
Currency
Derivatives
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
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Foreign Currency Derivatives
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Foreign Currency Futures
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Foreign Currency Futures
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Exhibit 8.1 Mexican Peso (CME)-
MXN 500,000; $ per 10MXN
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Foreign Currency Futures
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Foreign Currency Options
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Foreign Currency Options
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Foreign Currency Options
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Foreign Currency Options
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Foreign Currency Options
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Exhibit 8.2 Swiss Franc Option
Quotations (U.S. cents/SF)
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Buyer of a Call Option
• Buyer of an option only exercises his/her rights if
the option is profitable.
• In the case of a call option, as the spot price of the
underlying currency moves up, the holder has the
possibility of unlimited profit.
• Exhibit 8.3 shows a static profit and loss diagram
for the purchase of a Swiss Franc Call Option.
Notice how the purchaser makes a profit as the
franc appreciates vs. the dollar – this is because
the purchaser has the right to purchase the franc
at a pre-specified, and in this case, lower price
than the current spot price.
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Exhibit 8.3 Profit and Loss for the
Buyer of a Call Option
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Option Market Speculation
• Writer of a call: (see Exhibit 8.4)
– What the holder, or buyer of an option loses, the
writer gains
– The maximum profit that the writer of the call
option can make is limited to the premium
– If the writer wrote the option naked, that is
without owning the currency, the writer would
now have to buy the currency at the spot and
take the loss delivering at the strike price
– The amount of such a 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
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Exhibit 8.4 Profit and Loss for the
Writer of a Call Option
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Option Market Speculation
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Exhibit 8.5 Profit and Loss for the
Buyer of a Put Option
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Option Market Speculation
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Exhibit 8.6 Profit and Loss for the
Writer of a Put Option
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Option Pricing and Valuation
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Option Pricing and Valuation
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Exhibit 8.7 Option Intrinsic Value,
Time Value, and Total Value
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Currency Option Pricing
Sensitivity
• If currency options are to be used effectively, either for the
purposes of speculation or risk management, the individual
trader needs to know how option values – premiums – react
to their various components. Summarized in Exhibit 8.8.
• Forward rate sensitivity:
– Standard foreign currency options are priced around the forward
rate because the current spot rate and both the domestic and
foreign interest rates are included in the option premium
calculation
– The option-pricing formula calculates a subjective probability
distribution centered on the forward rate
– This approach does not mean that the market expects the
forward rate to be equal to the future spot rate, it is simply a
result of the arbitrage-pricing structure of options
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Exhibit 8.8 Summary of Option
Premium Components
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Interest Rate Risk
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Exhibit 8.9 International Interest
Rate Calculations
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Interest Rate Risk
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Interest Rate Risk
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Interest Rate Futures
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Exhibit 8.10 Eurodollar Futures
Prices
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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
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Exhibit 8.11 Interest Rate Futures
Strategies for Common Exposures
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Forward Rate Agreements
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Interest Rate Swaps
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Interest Rate Swaps
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Interest Rate Swaps
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Interest Rate Swaps
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Exhibit 8.12 Interest Rate Swap
Strategies
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Currency Swaps
• Since all swap rates are derived from the yield curve in each major
currency, the fixed- to floating-rate interest rate swap existing in
each currency allow firms to swap across currencies.
• 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 (a significant reason
for this being cost).
• The utility of the currency swap market to an MNE is significant. An
MNE wishing to swap a 10-year fixed 6.04% U.S. dollar cash flow
stream could swap to 4.46% fixed in euro, 3.30% fixed in Swiss
francs, or 2.07% fixed in Japanese yen. It could swap from fixed
dollars not only to fixed rates, but also to floating LIBOR rates in the
various currencies as well. All are possible at the rates quoted in
Exhibit 8.13.
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Exhibit 8.13 Interest Rate and
Currency Swap Quotes
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