eiteman ppt

8/9/2019 Eiteman PPT

1/49

Copyright 2007 Pearson Addison-Wesley. All rights reserved.Copyright 2007 Pearson Addison-Wesley. All rights reserved.

Chapter 7

Foreign CurrencyDerivatives


2/49

Copyright 2007 Pearson 7-2


Financial management of the MNE in the 21 st centuryinvolves financial derivatives .

These erivatives! so name "ecause their values are

erive from un erlying assets! are a po#erful tooluse in "usiness to ay.

These instruments can "e use for t#o very istinctmanagement o"$ectives%

& Speculation & use of erivative instruments to ta'e a positionin the e(pectation of a profit

& Hedging & use of erivative instruments to re uce the ris'sassociate #ith the every ay management of corporate cashflo#


3/49



Derivatives are use "y firms to achieve one ofmore of the follo#ing in ivi ual "enefits% & )ermit firms to achieve payoffs that they #oul not

"e a"le to achieve #ithout erivatives! or coulachieve only at greater cost

& *e ge ris's that other#ise #oul not "e possi"le tohe ge

& Ma'e un erlying mar'ets more efficient

& +e uce volatility of stoc' returns & Minimi,e earnings volatility & +e uce ta( lia"ilities & Motivate management -agency theory effect


4/49


Foreign Currency Futures

/ foreign currency futures contract is analternative to a for#ar contract that calls forfuture elivery of a stan ar amount of foreigne(change at a fi(e time! place an price.

0t is similar to futures contracts that e(ist forcommo ities such as cattle! lum"er! interest

"earing eposits! gol ! etc.

0n the 3! the most important mar'et forforeign currency futures is the 0nternationalMonetary Mar'et -0MM ! a ivision of theChicago Mercantile E(change.


5/49



Contract specifications are esta"lishe "y the e(changeon #hich futures are tra e .

Ma$or features that are stan ar i,e are%

& Contract si,e & Metho of stating e(change rates & Maturity ate & 4ast tra ing ay

& Collateral an maintenance margins & 3ettlement & Commissions & se of a clearinghouse as a counterparty


6/49



Foreign currency futures contracts iffer from for#arcontracts in a num"er of important #ays% & Futures are stan ar i,e in terms of si,e #hile for#ar s

can "e customi,e

& Futures have fi(e maturities #hile for#ar s can have anymaturity -"oth typically have maturities of one year or less

& Tra ing on futures occurs on organi,e e(changes #hilefor#ar s are tra e "et#een in ivi uals an "an's

& Futures have an initial margin that is mar'et to mar'et on aaily "asis #hile only a "an' relationship is nee e for afor#ar

& Futures are rarely elivere upon -settle #hile for#ar sare normally elivere upon -settle


7/49Copyright 2007 Pearson 7-7

Foreign Currency Options

/ foreign currency option is a contract givingthe option purchaser -the "uyer the right! "utnot the o"ligation! to "uy or sell a given

amount of foreign e(change at a fi(e price perunit for a specifie time perio -until thematurity ate .

There are t#o "asic types of options! puts ancalls . & / call is an option to "uy foreign currency & / put is an option to sell foreign currency




The "uyer of an option is terme the holder !#hile the seller of the option is referre to asthe writer or grantor .

Every option has three ifferent price elements% & The exercise or strike price & the e(change rate at

#hich the foreign currency can "e purchase -callor sol -put

& The premium & the cost! price! or value of theoption itself & The un erlying or actual spot e(change rate in the

mar'et




/n American option gives the "uyer theright to e(ercise the option at any time

"et#een the ate of #riting an thee(piration or maturity ate.

/ European option can "e e(ercise only

on its e(piration ate! not "efore. The premium! or option price! is the cost

of the option.


10/49



/n option #hose e(ercise price is the same asthe spot price of the un erlying currency is saito "e at-the-money -/TM .

/n option the #oul "e profita"le! e(clu ingthe cost of the premium! if e(erciseimme iately is sai to "e in-the-money -0TM .

/n option that #oul not "e profita"le! againe(clu ing the cost of the premium! if e(erciseimme iately is referre to as out-of-the money -5TM


11/49



0n the past three eca es! the use of foreigncurrency options as a he ging tool an forspeculative purposes has "lossome into a

ma$or foreign e(change activity. 5ptions on the over the counter -5TC mar'et

can "e tailore to the specific nee s of the firm "ut can e(pose the firm to counterparty risk .

5ptions on organi,e e(changes arestan ar i,e ! "ut counterparty ris' issu"stantially re uce .


12/49


Foreign CurrencySpeculation

3peculation is an attempt to profit "y tra ingon e(pectations a"out prices in the future.

3peculators can attempt to profit in the% & 3pot mar'et & #hen the speculator "elieves the

foreign currency #ill appreciate in value & For#ar mar'et & #hen the speculator "elieves the

spot price at some future ate #ill iffer fromto ay6s for#ar price for the same ate

& 5ptions mar'ets & e(tensive ifferences in ris' patters pro uce epen ing on purchase or sale of put an or call


13/49


Option Market Speculation

8uyer of a call% & /ssume purchase of /ugust call option on 3#iss

francs #ith stri'e price of 9:; -


14/49


15/49


Option Market Speculation

8uyer of a )ut% & The "asic terms of this e(ample are similar to those $ust

illustrate #ith the call

& The "uyer of a put option! ho#ever! #ants to "e a"le to sell theun erlying currency at the e(ercise price #hen the mar'et priceof that currency rops -not rises as in the case of the call option

& 0f the spot price rops to


16/49


17/49


18/49


Option Pricing andValuation The total value -premium of an option is e@ual to the intrinsic value

plus time value. 0ntrinsic value is the financial gain if the option is e(ercise

imme iately. & For a call option! intrinsic value is ,ero #hen the stri'e price is

a"ove the mar'et price & >hen the spot price rises a"ove the stri'e price! the intrinsic

value "ecome positive & )ut options "ehave in the opposite manner & 5n the ate of maturity! an option #ill have a value e@ual to its

intrinsic value -,ero time remaining means ,ero time value The time value of an option e(ists "ecause the price of the

un erlying currency! the spot rate! can potentially move further anfurther into the money "et#een the present time an the option6se(piration ate.


19/49


Currency Option PricingSensitivity

0f currency options are to "e useeffectively! either for the purposes ofspeculation or ris' management! thein ivi ual tra er nee s to 'no# ho#option values & premiums & react to theirvarious components.


20/49



For#ar rate sensitivity% & 3tan ar foreign currency options are price aroun

the for#ar rate "ecause the current spot rate an

"oth the omestic an foreign interest rates areinclu e in the option premium calculation

& The option pricing formula calculates a su"$ective pro"a"ility istri"ution centere on the for#ar rate

& This approach oes not mean that the mar'ete(pects the for#ar rate to "e e@ual to the futurespot rate! it is simply a result of the ar"itrage

pricing structure of options


21/49


22/49



Time to maturity & value aneterioration -theta %

& 5ption values increase #ith the length oftime to maturity

theta A B premium

& / tra er #ill normally fin longer maturityoption "etter values! giving the tra er thea"ility to alter an option position #ithoutsuffering significant time value eterioration

B time


23/49


Exhibit 7 !! "heta#Option Pre$iu$ "i$e ValueDeterioration


24/49



3ensitivity to volatility -lam" a % & 5ption volatility is efine as the stan ar

eviation of aily percentage changes in theun erlying e(change rate

& ?olatility is important to option value "ecause of ane(change rate6s perceive li'elihoo to move eitherinto or out of the range in #hich the option #ill "ee(ercise

lam" a A B premiumB volatility


25/49



?olatility is vie#e in three #ays% & *istoric & For#ar loo'ing & 0mplie

8ecause volatilities are the only judgmental component that the option#riter contri"utes! they play a critical role in the pricing of options.

/ll currency pairs have historical series that contri"ute to the formationof the e(pectations of option #riters.

0n the en ! the truly talente option #riters are those #ith the intuitionan insight to price the future effectively.

Tra ers #ho "elieve that volatilities #ill fall significantly in the near term#ill sell -#rite options no#! hoping to "uy them "ac' for a profitimme iately volatilities fall! causing option premiums to fall.


26/49



3ensitivity to changing interest rate ifferentials -rho an phi %

& Currency option prices an values are focuse on the for#arrate

& The for#ar rate is in turn "ase on the theory of 0nterest +ate)arity

& 0nterest rate changes in either currency #ill alter the for#arrate! #hich in turn #ill alter the option6s premium or value

/ tra er #ho is purchasing a call option on foreign currency shoulo so "efore the omestic interest rate rises. This timing #ill allo#the tra er to purchase the option "efore its price increases.


27/49



The e(pecte change in the option premiumfrom a small change in the omestic interestrate -home currency is the term rho .

rho A B premium

The e(pecte change in the option premiumfrom a small change in the foreign interest rate-foreign currency is terme phi .

phi A B premium

B 3 < interest rate

B foreign interest rate


28/49


Exhibit 7 !% &nterestDi''erentials and Call

Option Pre$iu$s


29/49



The si(th an final element that is important tooption valuation is the selection of the actualstri'e price.

/ firm must ma'e a choice as per the stri'e price it #ishes to use in constructing an option-5TC mar'et .

Consi eration must "e given to the tra eoff "et#een stri'e prices an premiums.


30/49


Exhibit 7 !( OptionPre$iu$s 'or )lternative

Strike *ates


31/49


32/49


Mini,Case -uestions# *ogue"rade. /ick 0eeson

>hat #as Nic' 4eeson6s strategy to earntra ing profits on erivatives

>hat #ent #rong that cause his strategy to

fail >hy i Nic' 4eeson esta"lish a "ogus error

account -::::: #hen a legitimate account- ==2 alrea y e(iste

>hy i 8arings an its au itors not iscoverthat the error account #as use "y 4eeson forunauthori,e tra ing


33/49


Mini,Case -uestions 1cont2d3#*ogue "rade. /ick 0eeson

>hy i none of the regulatory authorities in3ingapore! apan! an the nite ing om

iscover the true use of the error account

>hy #as 8arings 8an' #illing to transferlarge cash sums to 8arings Futures 3ingapore >hy i the attempt "y the 8an' of Englan to

organi,e a "ailout for 8arings fail

3uggest regulatory an management reformsthat might prevent a future e"acle of the typethat "an'rupte 8arings.


34/49

Copyright 2007 Pearson Addison-Wesley. All rights reserved.Copyright 2007 Pearson Addison-Wesley. All rights reserved.

/ itionalChapterE(hi"its


35/49


36/49


37/49



38/49



39/49



40/49



41/49



42/49



43/49



44/49


45/49



46/49


47/49



48/49



49/49

eiteman ppt

Documents