Chap-8

Report
Chapter 8
Foreign Currency
Derivatives and
Swaps
Foreign Currency Derivatives
and Swaps: Learning Objectives
• Explain how foreign currency futures are quoted,
valued, and used for speculation purposes
• Illustrate how foreign currency futures differ from
forward contracts
• Analyze how foreign currency options are quoted,
valued, and used for speculation purposes
• Explain how foreign currency options are valued
• Define interest rate risk, and examine how can it
be managed
8-2
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Foreign Currency Derivatives
and Swaps: Learning Objectives
• Explain interest rate swaps and how they can be
used to manage interest rate risk
• Analyze how interest rate swaps and cross
currency swaps can be used to manage both
foreign exchange risk and interest rate risk
simultaneously
8-3
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Foreign Currency Derivatives
and Swaps
• Financial management in the 21st century needs
to consider the use of financial derivatives
• These derivatives, so named because their values
are derived from the underlying asset, are a
powerful tool used for two distinct management
objectives:
– Speculation – the financial manager takes a position in
the expectation of profit
– Hedging – the financial manager uses the instruments to
reduce the risks of the corporation’s cash flow
8-4
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Foreign Currency Derivatives
and Swaps
• The financial manager must first understand the
basics of the structure and pricing of these tools
• The derivatives that will be discussed will be
–
–
–
–
Foreign Currency Futures
Foreign Currency Options
Interest Rate Swaps
Cross Currency Interest Rate Swaps
• A word of caution – financial derivatives are
powerful tools in the hands of careful and
competent financial managers. They can also be
very destructive devices when used recklessly.
8-5
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Foreign Currency Futures
• A foreign currency futures contract is an
alternative to a forward contract
– It calls for future delivery of a standard amount of
currency at a fixed time and price
– These contracts are traded on exchanges with the largest
being the International Monetary Market located in the
Chicago Mercantile Exchange
8-6
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Foreign Currency Futures
• Contract Specifications
– Size of contract – called the notional principal, trading in
each currency must be done in an even multiple
– Method of stating exchange rates – “American terms” are
used; quotes are in US dollar cost per unit of foreign
currency, also known as direct quotes
– Maturity date – contracts mature on the 3rd Wednesday
of January, March, April, June, July, September, October
or December
8-7
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Foreign Currency Futures
• Contract Specifications
– Last trading day – contracts may be traded through the
second business day prior to maturity date
– Collateral & maintenance margins – the purchaser or
trader must deposit an initial margin or collateral; this
requirement is similar to a performance bond
• At the end of each trading day, the account is marked to
market and the balance in the account is either credited if
value of contracts is greater or debited if value of contracts
is less than account balance
8-8
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Foreign Currency Futures
• Contract Specifications
– Settlement – only 5% of futures contracts are settled by
physical delivery, most often buyers and sellers offset
their position prior to delivery date
• The complete buy/sell or sell/buy is termed a round turn
– Commissions – customers pay a commission to their
broker to execute a round turn and only a single price is
quoted
– Use of a clearing house as a counterparty – All contracts
are agreements between the client and the exchange
clearing house. Consequently clients need not worry
about the performance of a specific counterparty since
the clearing house is guaranteed by all members of the
exchange
8-9
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Using Foreign Currency Futures
• Any investor wishing to speculate on the
movement of a currency can pursue one of the
following strategies
– Short position – selling a futures contract based on view
that currency will fall in value
– Long position – purchase a futures contract based on
view that currency will rise in value
– Example: Amber McClain believes that Mexican peso will
fall in value against the US dollar, she looks at quotes in
the WSJ for Mexican peso futures
8-10
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Exhibit 8.1 Mexican Peso (CME)-MXN 500,000; $ per 10MXN
8-11
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Using Foreign Currency Futures
• Example (cont.): Amber believes that the value of
the peso will fall, so she sells a March futures
contract
• By taking a short position on the Mexican peso,
Amber locks-in the right to sell 500,000 Mexican
pesos at maturity at a set price above their
current spot price
• Using the quotes from the table, Amber sells one
March contract for 500,000 pesos at the settle
price: $.10958/Ps
Value at maturity (Short position) = -Notional principal
8-12
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(Spot – Forward)
Using Foreign Currency Futures
• To calculate the value of Amber’s position we use
the following formula
Value at maturity (Short position) = -Notional principal 
(Spot – Forward)
• Using the settle price from the table and assuming
a spot rate of $.09500/Ps at maturity, Amber’s
profit is
Value = -Ps 500,000  ($0.09500/ Ps - $.10958/ Ps)
= $7,290
8-13
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Using Foreign Currency Futures
• If Amber believed that the Mexican peso would
rise in value, she would take a long position on the
peso
Value at maturity (Long position) = Notional principal 
(Spot – Forward)
• Using the settle price from the table and assuming
a spot rate of $.11000/Ps at maturity, Amber’s
profit is
Value = Ps 500,000  ($0.11000/ Ps - $.10958/ Ps)
= $210
8-14
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Currency Futures and Forwards
Compared
8-15
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Currency Options
• A foreign currency option is a contract giving
the purchaser of the option the right to buy or sell
a given amount of currency at a fixed price per
unit for a specified time period
– The most important part of clause is the “right, but not
the obligation” to take an action
– Two basic types of options, calls and puts
• Call – buyer has right to purchase currency
• Put – buyer has right to sell currency
– The buyer of the option is the holder and the seller of the
option is termed the writer
8-16
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Foreign Currency Options
• Every option has three different price elements
– The strike or exercise price is the exchange rate at
which the foreign currency can be purchased or sold
– The premium, the cost, price or value of the option itself
paid at time option is purchased
– The underlying or actual spot rate in the market
• There are two types of option maturities
– American options may be exercised at any time during
the life of the option
– European options may not be exercised until the
specified maturity date
8-17
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Foreign Currency Options
• Options may also be classified as per their payouts
– At-the-money (ATM) options have an exercise price
equal to the spot rate of the underlying currency
– In-the-money (ITM) options may be profitable,
excluding premium costs , if exercised immediately
– Out-of-the-money (OTM) options would not be
profitable, excluding the premium costs, if exercised
8-18
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Foreign Currency Options
Markets
• The increased use of currency options has
lead the creation of several markets where
financial managers can access these
derivative instruments
– Over-the-Counter (OTC) Market – OTC
options are most frequently written by banks
for US dollars against British pounds, Swiss
francs, Japanese yen, Canadian dollars and the
euro
• Main advantage is that they are tailored to purchaser
• Counterparty risk exists
• Mostly used by individuals and banks
8-19
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Foreign Currency Options
Markets
– Organized Exchanges – similar to the futures
market, currency options are traded on an
organized exchange floor
• The Chicago Mercantile and the Philadelphia Stock
Exchange serve options markets
• Clearinghouse services are provided by the Options
Clearinghouse Corporation (OCC)
8-20
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Exhibit 8.2 Swiss Franc Option
Quotations (U.S. Cents/SF)
8-21
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Foreign Currency Options
Markets
– The spot rate means that 58.51 cents, or
$0.5851 was the price of one Swiss franc
– The strike price means the price per franc that
must be paid for the option. The August call
option of 58 ½ means $0.5850/Sfr
– The premium, or cost, of the August 58 ½
option was 0.50 per franc, or $0.0050/Sfr
• For a call option on 62,500 Swiss francs, the total cost
would be Sfr62,500 x $0.0050/Sfr = $312.50
8-22
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Foreign Currency Speculation
• Speculating in the spot market
– Hans Schmidt is a currency speculator. He is
willing to risk his money based on his view of
currencies and he may do so in the spot,
forward or options market
– Assume Hans has $100,000 and he believes
that the six month spot for Swiss francs will be
$0.6000/Sfr.
• Speculation in the spot market requires that view is
currency appreciation
8-23
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Foreign Currency Speculation
• Speculating in the spot market
– Hans should take the following steps
– Use the $100,000 to purchase Sfr170,910.96 today at a
spot rate of $0.5851/Sfr
– Hold the francs indefinitely, because Hans is in the spot
market he is not committed to the six month target
– When target exchange rate is reached, sell the
Sfr170,910.96 at new spot rate of $0.6000/Sfr, receiving
Sfr170,910.96 x $0.6000/Sfr = $102,546.57
– This results in a profit of $2,546.57 or 2.5% ignoring cost
of interest income and opportunity costs
8-24
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Foreign Currency Speculation
• Speculating in the forward market
– If Hans were to speculate in the forward market, his
viewpoint would be that the future spot rate will differ
from the forward rate
– Today, Hans should purchase Sfr173,611.11 forward six
months at the forward quote of $0.5760/Sfr. This step
requires no cash outlay
– In six months, fulfill the contract receiving Sfr173,611.11
at $0.5760/Sfr at a cost of $100,000
– Simultaneously sell the Sfr173,611.11 in the spot market
at Hans’ expected spot rate of $0.6000/Sfr, receiving
Sfr173,611.11 x $0.6000/Sfr = $104,166.67
– This results in a profit of $4,166.67 with no investment
required
8-25
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Foreign Currency Speculation
• Speculating in the options market
– If Hans were to speculate in the options
market, his viewpoint would determine what
type of option to buy or sell
– As a buyer of a call option, Hans purchases the
August call on francs at a strike price of 58 ½
($0.5850/Sfr) and a premium of 0.50 or
$0.0050/Sfr
– At spot rates below the strike price, Hans would
not exercise his option because he could
purchase francs cheaper on the spot market
than via his call option
8-26
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Foreign Currency Speculation
• Speculating in the options market
– Hans’ only loss would be limited to the cost of
the option, or the premium ($0.0050/Sfr)
– At all spot rates above the strike of 58 ½ Hans
would exercise the option, paying only the
strike price for each Swiss franc
• If the franc were at 59 ½, Hans would exercise his
options buying Swiss francs at 58 ½ instead of 59 ½
8-27
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Foreign Currency Speculation
• Speculating in the options market
– Hans could then sell his Swiss francs on the
spot market at 59 ½ for a profit
Profit
= Spot rate – (Strike price + Premium)
= $0.595/Sfr – ($0.585/Sfr + $0.005/Sfr)
= $.005/Sfr
8-28
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Foreign Currency Speculation
• Speculating in the options market
– Hans could also wait to see if the Swiss franc
appreciates more, this is the value to the holder
of a call option – limited loss, unlimited upside
– Hans’ break-even price can also be calculated
by combining the premium cost of $0.005/Sfr
with the cost of exercising the option,
$0.585/Sfr
• This matched the proceeds from exercising the option
at a price of $0.590/Sfr
8-29
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Exhibit 8.3 Profit and Loss for the
Buyer of a Call Option
8-30
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Foreign Currency Speculation
• Speculating in the options market
– Hans could also write a call, if the future spot
rate is below 58 ½, then the holder of the
option would not exercise it and Hans would
keep the premium
– If Hans went uncovered and the option was
exercised against him, he would have to
purchase Swiss francs on the spot market at a
higher rate than he is obligated to sell them at
– Here the writer of a call option has limited profit
and unlimited losses if uncovered
8-31
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Foreign Currency Speculation
• Speculating in the options market
– Hans’ payout on writing a call option would be
Profit = Premium – (Spot rate - Strike price)
= $0.005/Sfr – ($0.595/Sfr + $0.585/Sfr)
= - $0.005/Sfr
8-32
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Exhibit 8.4 Profit and Loss for the
Writer of a Call Option
8-33
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Foreign Currency Speculation
• Speculating in the options market
– Hans could also buy a put, the only difference from
buying a call is that Hans now has the right to sell
currency at the strike price
– If the franc drops to $0.575/Sfr Hans will deliver to the
writer of the put and receive $0.585/Sfr
– The francs can be purchased on the spot market at
$0.575/Sfr
– With the cost of the option being $0.005/Sfr, Hans
realizes a net gain of $0.005/Sfr
– As with a call option - limited loss, unlimited gain
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Foreign Currency Speculation
• Speculating in the options market
– Hans’ payout on buying a put option would be
Profit = Strike price – (Spot rate + Premium)
= $0.585/Sfr – ($0.575/Sfr + $0.005/Sfr)
= $0.005/Sfr
8-35
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Exhibit 8.5 Profit and Loss for the
Buyer of a Put Option
8-36
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Foreign Currency Speculation
• Speculating in the options market
– And of course, Hans could write a put, thereby
obliging him to purchase francs at the strike
price
– If the franc drops below 58 ½ Hans will lose
more than the premium received
– If the spot rate does not fall below 58 ½ then
the option will not be exercised and Hans will
keep the premium from the option
– As with a call option - unlimited loss, limited
gain
8-37
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Foreign Currency Speculation
• Speculating in the options market
– Hans’ payout on writing a put option would be
Profit = Premium – (Strike price - Spot rate)
= $0.005/Sfr – ($0.585/Sfr + $0.575/Sfr)
= - $0.005/Sfr
8-38
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Exhibit 8.6 Profit and Loss for the
Writer of a Put Option
8-39
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Option Pricing and Valuation
• The pricing of any option combines six
elements
– Present spot rate, $1.70/£
– Time to maturity, 90 days
– Forward rate for matching maturity (90 days),
$1.70/£
– US dollar interest rate, 8.00% p.a.
– British pound interest rate, 8.00% p.a.
– Volatility, the standard deviation of daily spot
rate movement, 10.00% p.a.
8-40
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Option Pricing and Valuation
• The intrinsic value is the financial gain if the
option is exercised immediately (at-the-money)
– This value will reach zero when the option is out-of-themoney
– When the spot rate rises above the strike price, the
option will be in-the-money
– At maturity date, the option will have a value equal to its
intrinsic value
8-41
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Option Pricing and Valuation
• When the spot rate is $1.74/£, the option is ITM
and has an intrinsic value of $1.74 - $1.70/£, or 4
cents per pound
• When the spot rate is $1.70/£, the option is ATM
and its intrinsic value is $1.70 - $1.70/£, or zero
cents per pound
• When the spot rate is is $1.66/£, the option is
OTM and has no intrinsic value, only a fool would
exercise this option
8-42
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Exhibit 8.7 Option Intrinsic Value,
Time Value & Total Value
8-43
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Option Pricing and Valuation
• The time value of the option exists because the
price of the underlying currency can potentially
move further into the money between today and
maturity
– In the exhibit, time value is shown as the area between
total value and intrinsic value
8-44
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Interest Rate Risk
• All firms, domestic or multinational, are sensitive
to interest rate movements
• The single largest interest rate risk of a non-financial
firm is debt service (for an MNE, differing
currencies have differing interest rates thus
making this risk a larger concern – see exhibit)
• The second most prevalent source of interest rate
risk is its holding of interest sensitive securities
• Ever increasing competition has forced financial
managers to better manage both sides of the
balance sheet
8-45
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Exhibit 8.8 Summary of Option
Premium Components
8-46
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Exhibit 8.9 International
Interest Rate Calculations
8-47
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Credit and Repricing Risk
• Credit Risk or roll-over risk is the possibility
that a borrower’s creditworthiness at the time of
renewing a credit, is reclassified by the lender
– This can result in higher borrowing rates, fees, or even
denial
• Repricing risk is the risk of changes in interest
rates charged (earned) at the time a financial
contract’s rate is being reset
8-48
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Credit and Repricing Risk
• Strategy #1 assures itself of funding at a known
rate for the three years; what is sacrificed is the
ability to enjoy a lower interest rate should rates
fall over the time period
• Strategy #2 offers what #1 didn’t, flexibility
(repricing risk). It too assures funding for the
three years but offers repricing risk when LIBOR
changes
• Strategy #3 offers more flexibility and more risk;
in the second year the firm faces repricing and
credit risk, thus the funds are not guaranteed for
the three years and neither is the price
8-49
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Interest Rate Futures
• Interest Rate futures are widely used; their
popularity stems from high liquidity of interest
rate futures markets, simplicity in use, and the
rather standardized interest rate exposures firms
posses
• Traded on an exchange; two most common are
the Chicago Mercantile Exchange (CME) and the
Chicago Board of Trade (CBOT)
• The yield is calculated from the settlement price
– Example: March ’03 contract with settlement price of
94.76 gives an annual yield of 5.24% (100 – 94.76)
8-50
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Exhibit 8.10 Eurodollar Futures
Prices
8-51
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Exhibit 8.11 Interest Rate Futures
Strategies for Common Exposures
8-52
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Interest Rate Swaps
• Swaps are contractual agreements to exchange or
swap a series of cash flows
• If the agreement is for one party to swap its fixed
interest payment for a floating rate payment, its is
termed an interest rate swap
• If the agreement is to swap currencies of debt
service it is termed a currency swap
• A single swap may combine elements of both
interest rate and currency swap
• The swap itself is not a source of capital but an
alteration of the cash flows associated with
payment
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Interest Rate Swaps
• If firm thought that rates would rise it would enter
into a swap agreement to pay fixed and receive
floating in order to protect it from rising debtservice payments
• If firm thought that rates would fall it would enter
into a swap agreement to pay floating and receive
fixed in order to take advantage of lower debtservice payments
• The cash flows of an interest rate swap are
interest rates applied to a set amount of capital,
no principal is swapped only the coupon payments
8-54
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Exhibit 8.12 Interest Rate Swap
Strategies
8-55
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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 allows firms to swap across
currencies.
• These swap rates are based on the government security yields
in each of the individual currency markets, plus a credit spread
applicable to investment grade borrowers in the respective
markets.
• 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
8-57
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Summary of Learning Objectives
• A foreign currency futures contract is an
exchange-traded agreement calling for future
delivery of a standard amount of foreign currency
at a fixed time, place and price
• Foreign currency futures contracts are in reality
standardized forward contracts. Unlike forward
contracts, however, trading occurs on the floor of
an organized exchange. They also require
collateral and are normally settled through the
purchase of an offsetting position
8-58
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Summary of Learning Objectives
• Futures differ from forward contracts by size of
contract, maturity, location of trading, pricing ,
collateral/margin requirements, method of
settlement, commissions, trading hours,
counterparties and liquidity
• Financial managers typically prefer foreign
currency forwards over futures out of simplicity of
use and position maintenance. Financial
speculators prefer futures over forwards because
of the liquidity of the market
8-59
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Summary of Learning Objectives
• Foreign currency options are financial contracts that give
the holder the right, but not the obligation, to buy or sell
a specified amount of currency at a predetermined price
on or before a specified maturity date
• The use of currency options as a speculative device for a
buyer arise from the fact that an option gains in value as
the underlying currency rises or falls. The amount of loss
when the underlying currency moves opposite the desired
direction is limited to the premium of the option
• The use of currency options as a speculative device for a
seller arise from the option premium. If the option
expires out-of-the-money, the writer has earned and
retains the entire premium
8-60
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Summary of Learning Objectives
• Speculation is an attempt to profit by trading on
expectations about prices in the future.
– In the foreign exchange market, one speculates by taking
position on a currency and then closing that position after the
exchange rate has moved.
– A profit results only if the rate moves in the direction that was
expected
• Currency option valuation is a complex combination of the
current spot rate, the specific strike price, the forward rate,
currency volatility and time to maturity
• The total value of an option is the sum of its intrinsic and
time value.
– Intrinsic value depends on the relationship between the option’s
strike price and the spot rate at any single point in time,
whereas time value estimates how the intrinsic value may
change prior to the option’s maturity
8-61
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Summary of Learning Objectives
• The single largest interest rate risk of the nonfinancial firm
is debt-service. The debt structure of the MNE will possess
differing maturities of debt, different interest rate structures
(such as fixed versus floating rate), and different currencies
of denomination.
• The increasing volatility of world interest rates, combined
with the increasing use of short-term and variable rate debt
by firms worldwide, has led many firms to actively manage
their interest rate risks.
8-62
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Summary of Learning Objectives
• The primary sources of interest rate risk to a multinational
nonfinancial firm are short-term borrowing and investing, as
well as long-term sources of debt.
• The techniques and instruments used in interest rate risk
management in many ways resemble those used in currency
risk management: the old tried and true methods of lending
and borrowing.
• The primary instruments and techniques used for interest
rate risk management include forward rate agreements
(FRAs), forward swaps, interest rate futures, and interest
rate swaps.
8-63
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Summary of Learning Objectives
• The interest rate and currency swap markets allow firms that
have limited access to specific currencies and interest rate
structures to gain access at relatively low costs. This in turn
allows these firms to manage their currency and interest rate
risks more effectively.
• A cross currency interest rate swap allows a firm to alter
both the currency of denomination of cash flows in debt
service, but also to alter the fixed-to-floating or floating-tofixed interest rate structure.
8-64
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