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Pcf week 18 risk management forex 2
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Pcf week 18 risk management forex 2

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  • 1. Foreign exchange risk management 21
  • 2. Background Growing world trade over the past 25 years Companies involved in transactions involving foreign currencies  about 22% of sales in FTSE 350 companies directly exposed to the US  further 11% in regions tied to the dollar  Pike & Neale, chapter 21 Foreign exchange rate exposure of increasing importance Companies need to insure against adverse movements in exchange rates 2
  • 3. Scenario A UK company expects to receive $300,000 in 3 months time. It is concerned that the pound will appreciate relative to the dollar and decides to hedge the transaction risk Current exchange rate is $1.50 How much is $300,000 worth currently? How much would it be worth in three months time if the exchange rate moved to $1.60? 3
  • 4. Scenario A UK company expects to receive $300,000 in 3 months time. Current exchange rate is $1.50 How much is $300,000 worth currently?  $300,000/1.50 = £200,000 How much would it be worth in three months time if the exchange rate was $1.60?  $300,000/1.60 = £187,500  Unhedged, this is a LOSS to the company 4
  • 5. FuturesA financial futures contract is an agreement to buy or sell, through an organised exchange a standard amount of a financial instrument for delivery at a specified date in the future at a price which is agreed on the trade date Only members of the exchange can trade  Chicago Mercantile Exchange (CME); Euronext.liffe Contracts are standardised in terms of contract amounts, dealing dates and size Delivery in the future at a price agreed today 5
  • 6. Futures - background Commodity futures have been traded for more than 100 years in the US Financial futures are similar to commodity futures However, the underlying asset is a financial instrument, not wheat, soya beans or another crop Only a small percentage of futures reach final delivery Speculators dominate the market 6
  • 7. Jargon Holding futures contract – long position Selling futures contract – short position Party and counterparty Clearing house 7
  • 8. Example using Futures(adapted from Watson and Head)A UK company expects to receive $300,000 in 3 months time. It is concerned that the pound will appreciate relative to the dollar and decides to use futures to hedge its transaction risk Delivery in the future at a price agreed today 8
  • 9. Using futures contracts Holding a futures contract means delivery at a specified date in the future of a pre-agreed amount of foreign currency The company will buy sterling futures This means it will take delivery of sterling and pay with the dollars it expects to receive 9
  • 10. Example using FuturesCME rates at 1 JanSpot rate: $1.54 - $1.55£ futures price (Apr): $1.535Standard contract size: £62,500CME : the Chicago Mercantile Exchange 10
  • 11. Futures contractSpot rate: $1.54 - $1.55£ futures price (Apr): $1.535Standard contract size: £62,500The futures price quoted is the amount of dollars needed to buy one unit of foreign currency (one pound)To work out the number of contracts needed, divide the sterling amount by the standard contract sizeEach contract will cost £62,500 x $1.535 = $95,937.50i.e. to take delivery of £62,500 in three months time, will cost $95,937.50 11
  • 12. Using futures contractsHow many contracts? divide amount in dollars by sterling futures price $300,000/1.535 = £195,440 now divide sterling amount by standard contract size £195,440/£ 62,500 = 3.13, or 3Three contracts will provide £187,500 in three months timeThis will cost the company $287,813 = 187,500 x1.535The difference (300,000 – 287,813) is unhedged(could be sold spot in 3 months or a forward contract arranged) 12
  • 13. What has happened?The UK company expects dollars in the future and wants to fix the exchange rate now buys 3 futures contracts now receives a known amount of sterling in the future (from the contracts) settles in dollars from its dollar payment 13
  • 14. Differences between forwards andfutures contractsForward Contracts Futures Contracts Over-the-counter  Traded on an exchange Each contract is tailor -made  Standardised contracts The market is operated by  Formal margin requirements the banks and is self  The contract is marked-to- regulatory market on a daily basis 90% contracts are carried out  Requires a brokerage fee Cost of the forward contract  The exchange is the counterparty is based on the bid-ask spread  Less than 1% of futures contracts are carried out → No margin is required liquid market High transaction costs  Speculation as well as hedging14
  • 15. Less than 1% of contracts are carried outmeans…. Liquid market in contracts Euronext.liffe has an average daily volume of around 3 million contracts worth hundreds of billions of pounds Standardised legal agreements Wide market appeal It is the contracts that are bought and sold, not the commodity Liquidity is good 15
  • 16. Options An option gives the owner the right but not the obligation to take delivery of a physical asset at or before a pre-agreed date Examples of options  share options  currency options The physical asset is called the underlying asset 16
  • 17. Currency Options The right to buy/sell currency  at a given price  at a given date CALL option - the right to buy PUT option - the right to sell Types of options  American  European 17
  • 18. What are you buying? Buying a currency option - a call - gives you the right, but not the obligation, to buy currency at a pre- agreed exchange rate at or before a pre-agreed time The pre-agreed exchange rate is called the strike The pre-agreed date is called the exercise date or the expiry The price you pay is called the premium If you do not trade at or before the exercise date, then the option expires worthless 18
  • 19. Option terminology In-the-money - profitable at the current exchange rate Out-of-the-money - not profitable at the current exchange rate At-the-money - exercise price = spot rate Intrinsic value – the value the holder of the option could realise if the option traded today  positive if option in-the-money  otherwise zero For the buyer of options, loss is limited to premium, potential gain is unlimited 19
  • 20. Example using options(adapted from Watson and Head)A UK company expects to receive $1m in 3 months and decides to hedge its transaction risk with currency options.Currently $1.63/£.£ is the foreign currency (on CME) and so company buys £ call options, strike price $1.65/£ 20
  • 21. Using options The company will buy CME sterling currency options The underlying is a futures contract Contract size is £62,500 Sterling is the foreign currency The company will buy call options This gives the company the right but not the obligation to sell dollars and buy sterling at a pre- agreed exchange rate 21
  • 22. Example using optionsCME contractStrike $1.65Standard contract size: £62,500Premium 7centsEach contract costs $4,375 22
  • 23. Using optionsHow many contracts? divide amount in dollars by strike $1,000,000/1.65 = £606,060 now divide sterling amount by standard contract size £606,060/£ 62,500 = 9.7Company can buy 9 contracts or 10 contracts 23
  • 24. Decision 10 contracts  cost: $43,750  amount hedged: $1,031,250 (=62,500x10x1.65) 9 contracts  cost : $39,375  amount hedged: $928,125 (=62,500x9x1.65) 24
  • 25. MechanismIn 3 months time if the spot rate is below $1.65 the company will allow the option to expire it will exchange its dollars in the spot market if the spot rate is above $1.65 it will exercise the option 1,000,000/1.65 = £606,061 AT-THE-MONEY 1,000,000/1.75 = £571,428 IN-THE-MONEY 1,000,000/1.60 = £625,000 OUT-OF-THE- MONEY 25
  • 26. Buying a call optionProfit Strike Underlying Price 0 P P = premiumLoss26
  • 27. Buying a put optionProfit 0 Strike Underlying Price PLoss27
  • 28. The difference between options andfutures An option confers the right not the obligation to trade A premium is payable The seller (writer) of the option is obliged to honour the contract Options: one party purchases all the rights; the other has all the obligations Futures: commit both parties to obligations 28
  • 29. Risk ManagementPros Cons Maintaining  Complexity of competitiveness instruments  Costs Reduction of bankruptcy risk  Complex fin reporting and tax Reduction in volatility of cash flows 29
  • 30. Key Points: currency risk Considered use of futures and options to hedge forex risk Differences between forward/futures plus options/futures discussed Forex exposure management strategies discussed 30
  • 31. Reading Watson, D. & Head, A. Corporate Finance Principles and Practice, Chapter 12 Arnold, G. Corporate Financial Management, Chapter 24 Pike, R. & Neale, B. Corporate Finance and Investment, Chapter 21 31