5 Derivatives On FXJN
5 Derivatives On FXJN
Sections
Futures
Options
Swaps
Futures contracts
A futures contract is similar to a forward contract in
that it specifies that a certain currency will be
exchanged for another at a specified time in the future
at prices specified today.
A futures contract is different from a forward contract
in that futures are standardized contracts trading on
organized exchanges with daily marked-to-market
resettlement through a clearinghouse.
Settle price: a price representative of futures
transaction price at the end of daily trading, which is
determined by a settlement committee.
HIGH
LOW
SETTLE
OPEN
CHG INTEREST
1.3118
1.3126
1.3054
1.3062
1.3087
1.3094
.0005
.0006
233,380
6,814
Example
Consider a long position in the CME /$ contract.
It is written on 125,000 and quoted in $ per .
The purchase price is $1.30 per . The maturity is 3
months.
At initiation of the contract, the long posts an initial
performance bond of $6,500.
The maintenance performance bond is $4,000.
You get a margin call when your (equity) position erodes by
$2,500. If you fail to do so, the position will be closed out
with an offsetting short position.
Daily resettlement
With futures contracts, we have daily
resettlement of gains and losses rather than
one big settlement at maturity.
Futures payoffs are a zero-sum game.
Every trading day:
If the price goes down, the long pays the short.
If the price goes up, the short pays the long.
Example - continued
Over the first 3 days, the euro strengthens then
depreciates in dollar terms:
Settle
Gain/Loss
Account Balance
$1.31
$1,250
$1.30
$1,250
$6,500
$1.27
$3,750
Futures pricing
The pricing of futures contracts is similar to that of
forward contracts.
Thus, we can use the interest rate parity (IRP) to price
futures:
In American terms, (F S) / S = (iD iF) / (1 + iD) iD iF
Options contracts
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
(i.e., exercise price).
Calls vs. Puts:
Call options give the holder the right, but not the
obligation, to buy a given quantity of some asset at some
time in the future at prices agreed upon today.
Put options give the holder the right, but not the
obligation, to sell a given quantity of some asset at some
time in the future at prices agreed upon today.
Options
European versus American options:
European options can only be exercised on the
expiration date while American options can be
exercised at any time up to and including the
expiration date.
American options are usually worth more than
European options, other things equal.
Premium: option price; the cost of acquiring an
option.
Options market
The over-the-counter market written by
international banks, investment banks, and
brokerage houses is very active. Generally, these
contracts are tailor-made and are written for large
amounts, at least worth of $1 million of the
currency serving as the underlying asset. These
contracts are often European style.
Philadelphia Stock Exchange (PHLX), part of the
NASDAQ QMX Group, have currency options as well.
But the trading volume is much smaller than that
in the OTC market.
Contract Size
Australian dollar
AUD 10,000
British pound
GBP 10,000
Canadian dollar
CAD 10,000
Euro
EUR 10,000
Japanese yen
JPY 1,000,000
NZD 10,000
Swiss franc
CHF 10,000
Example
Consider a PHLX European call option. The standard contract size
is 10,000. The premium paid was $0.0252 per . The exercise
price is $1.30 per .
Suppose the spot rate at expiration is $1.3425/.
The call has an exercise payoff of 10000 0.0425 (=1.3425 1.30) =
$425.
The call cost the investor 10000 0.0252 = $252.
Thus, the profit for this trade is: 425 252 = $173.
Now suppose that the spot rate at expiration is below $1.30/. The
investor will simply throw away this option and incur a loss for this
trade in the amount of $252.
g
n
Lo
Loss
E + c0
E
Out-of-the-money In-the-money
ST
t
or
Sh call
l
l
a
Short put
ST
p0
Long put
E p0
Loss
In-the-money
Out-of-the-money
ue
l
a
tV
e
k
r
a
M
Long call
Intrinsic value
Time value
Out-of-the-money
In-the-money
ST
Hedging outcomes
If the euro appreciates to 1.3000 $/, the payment
without the option would be $81,250 (=62500
1.3). Adamant Inc. will surely exercise the option
and purchase the euro for 1.2750, which is a
payment of $79,687.5 (= 62500 1.275)+ premium
of $312.5.
If the euro depreciates to 1.2000 $/, the firm will
be better of buying euro on the spot market, so it
let the option expire unused. The payment is then
$75,000 + premium of $312.5
Swaps
Forwards, futures, and options have maturities no longer
than 1 year. Swaps are often multiple years.
In a swap, two counterparties agree to a contractual
arrangement wherein they will exchange cash flows at
periodic intervals.
There are two types of interest rate swaps.
Single currency interest rate swap
Plain vanilla fixed-for-floating swaps are often just called interest rate
swaps.
Swap market
The notational principal of:
Interest rate swaps is about $400 trillion USD.
Currency swaps is about $30 trillion USD.
Swap bank
Swap bank is a generic term to describe a financial
institution (international commercial bank,
investment bank, or independent operator) that
facilitates swaps between counterparties.
The swap bank can serve as either a broker or a
dealer (most likely a dealer nowadays).
As a broker, the swap bank matches counterparties
but does not assume any of the risks of the swap.
As a dealer (market maker), the swap bank stands
ready to accept either side of a currency swap and
then later lay off the risk, or match it with a
counterparty.
Swap products
Swap banks can tailor the terms of interest rate
and currency swaps to customers needs.
They also make a market in plain vanilla (i.e.,
rather generic, standardized) swaps and provide
quotes for these. Since the swap banks are dealers
for these swaps, there is a bid-ask spread.
Ask
1 year
0.32
0.36
2 year
0.44
0.48
3 year
0.59
4 year
0.77
5 year
0.95
6 year
1.14
7 year
1.30
8 year
Sterling
Bid
0.51
Ask
0.54
Swiss franc
U.S. $
Bid
Ask
Bid
Ask
0.06
0.12
0.32
0.35
1.741.78
means 0.11
the swap
will 0.46
0.68
0.72
0.19 bank0.42
0.63 pay
0.81
0.85 euro
0.20payments
0.28
fixed-rate
at0.63
1.74%0.66
0.81 against
0.97 receiving
1.02
0.34
0.42
0.89
0.92
USD LIBOR
or it will
0.99
1.15
1.20
0.49
0.57
1.17
receive
fixed-rate
euro payments
at 1.20
1.18
1.35
1.40
0.66
0.74
1.45
1.48
1.78%
against
receiving
USD LIBOR.
1.34
1.55
1.60
0.83
0.91
1.69
1.72
1.46
1.50
1.74
1.79
0.98
1.06
1.91
1.94
9 year
1.60
1.64
1.92
1.97
1.11
1.19
2.09
2.12
10 year
1.74
1.78
2.08
2.13
1.21
1.29
2.25
2.28
A case, II
Company B is a BBB-rated manufacturing firm that
needs $10 million to finance a new investment project
with a life of 5 years.
Maturity matching: ideally, company B prefers the
issuance of 5-year fixed-rate bonds at 11.25%.
Alternatively, company B can issue 5-year floating-rate
notes at LIBOR + 0.5% (credit premium because of BBB).
The swap bank instructs company B to do the
alternative financing: issue floating-rate notes at LIBOR
+ 0.5%.
A case, III
Bank
A
Swap
LIBOR Bank
10.375%
Firm
B
LIBOR
10.50%
A case, IV
All-in cost (net cash outflows) for bank A: LIBOR
10.375% + 10% (the alternative fixed-rate bond APR) =
LIBOR 0.375%.
This is cheaper (by 0.375%) than the ideal LIBOR
financing.
All-in cost for company B: 10.50% - LIBOR + [LIBOR +
0.5% ] = 11%, where {LIBOR + 0.5%] is the alternative
financing cost.
11% is cheaper (by 0.25%) than the ideal fixed-rate bond
APR of 11.25%.
In short
It is a win-win-win situation.
Swap bank creates business.
Bank A got its LIBOR cash flows with a saving of 0.375%.
Company B got its fixed-rate cash flows with a saving of
0.25%.
But how does this happen?
A case, II
A German MNC has a mirror-image financing need. It desires
to finance a new investment project in the amount of $52
million in the U.S. This U.S. operation has a life of 5 years.
FX risk management: ideally, the firm would prefer to issue $denominated 5-year fixed-rate bonds at 9%. Note that 9% is
fairly high by the Americans standard because the German
firm is less known in the U.S.
Alternatively, the firm can raise 40 million by issuing 5-year
fixed-rate -denominated bonds at 6%, then convert 40
million into $52 million (= 40 1.3).
The swap bank instructs the firm to do the alternative
financing: issue fixed-rate -denominated bonds in the
Eurozone at 6%.
A case, III
U.S.
MNC
$ @ 8%
@ 6.1%
Swap
Bank
$ @ 8.1%
@6%
German
MNC
A case, IV
All-in cost (net cash outflows) for the U.S. MNCs
borrowing via swap: 6.1%.
This is cheaper (by 0.9%) than the ideal 7% borrowing.
All-in cost for the German MNC: 8.1%.
This is cheaper (by 0.9%) than the ideal 9% $ borrowing.
The efficiency arises because the U.S. MNC has
comparative advantage issuing debt in the U.S., and the
German MNC has comparative advantage issuing debt in
the Eurozone.
End-of-chapter
Chapter 7: Questions 1, 2, 5, 6; Problems 1, 2, 4-8.
Chapter 14: Questions 1-5, 9; Problems 1-3.