International Corporate Finance Chp 8:Foreign currency derivatives Xin Chen Visiting Associate Professor Aarhus School of Business
1 International Corporate Finance Chp 8: Foreign currency derivatives Xin Chen Visiting Associate Professor Aarhus School of Business
What is a Derivative A derivative is a financial instrument whose value today or at some future date is derived entirely from the value of another asset,known as the underlying asset. Counterparty risk (exchange traded futures and options are settled through clearing house) 袋 Widely 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
What is a Derivative A derivative is a financial instrument whose value today or at some future date is derived entirely from the value of another asset, known as the underlying asset. Counterparty risk (exchange traded futures and options are settled through clearing house) Widely 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
Benefits to use derivatives Permit firms to achieve payoffs that they would not be able to achieve without derivatives,or could achieve only at greater cost 图 Hedge risks that otherwise would not be possible to hedge 图 Make underlying markets more efficient Reduce volatility of stock returns 图 Minimize earnings volatility Reduce tax liabilities Motivate management (agency theory effect)
Benefits to use derivatives Permit firms to achieve payoffs that they would not be able to achieve without derivatives, or could achieve only at greater cost Hedge risks that otherwise would not be possible to hedge Make underlying markets more efficient Reduce volatility of stock returns Minimize earnings volatility Reduce tax liabilities Motivate management (agency theory effect)
Benefits to use derivatives Permit firms to achieve payoffs that they would not be able to achieve without derivatives,or could achieve only at greater cost 图 Hedge risks that otherwise would not be possible to hedge 图 Make underlying markets more efficient Reduce volatility of stock returns 图 Minimize earnings volatility Reduce tax liabilities Motivate management (agency theory effect)
Benefits to use derivatives Permit firms to achieve payoffs that they would not be able to achieve without derivatives, or could achieve only at greater cost Hedge risks that otherwise would not be possible to hedge Make underlying markets more efficient Reduce volatility of stock returns Minimize earnings volatility Reduce tax liabilities Motivate management (agency theory effect)
Forward A forward contract represents the obligation to buy (sell)a security or commodity at a pre-specified price, known as the forward price,at some future date. At maturity the agent with the long position pays the forward price to agent with the short position,who then delivers the underlying asset. --No up-front payment (value of the contract is zero on the issue) --Everything is settled at maturity
Forward A forward contract represents the obligation to buy (sell) a security or commodity at a pre-specified price, known as the forward price, at some future date. At maturity the agent with the long position pays the forward price to agent with the short position, who then delivers the underlying asset. --No up-front payment (value of the contract is zero on the issue) --Everything is settled at maturity
Foreign Currency Futures A foreign currency futures contract is an alternative to a forward contract that calls for future delivery of a standard amount of foreign exchange at a fixed time,place and price. It is similar to futures contracts that exist for commodities such as cattle,lumber,interest- bearing deposits,gold,etc. In the US,the most important market for foreign currency futures is the International Monetary Market (IMM),a division of the Chicago Mercantile Exchange
Foreign Currency Futures A foreign currency futures contract is an alternative to a forward contract that calls for future delivery of a standard amount of foreign exchange at a fixed time, place and price. It is similar to futures contracts that exist for commodities such as cattle, lumber, interest- bearing deposits, gold, etc. In the US, the most important market for foreign currency futures is the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange
Features of Futures 能 Contract specifications are established by the exchange on which futures are traded. Major features that are standardized are: Contract size 图 Method of stating exchange rates Maturity date 留 Last trading day 图 Collateral and maintenance margins Settlement Commissions Use of a clearinghouse as a counterparty
Features of Futures Contract specifications are established by the exchange on which futures are traded. Major features that are standardized are: Contract size Method of stating exchange rates Maturity date Last trading day Collateral and maintenance margins Settlement Commissions Use of a clearinghouse as a counterparty
EXHIBIT 7.1 Mexican Peso Futures,USS/Peso (CME) Open Maturity Open High LOW Settle Change High Low Interest Mar .10953 .10988 .10930 10958 .11000 .09770 34,481 June .10790 .10795 .10778 .10773 .10800 .09730 3,405 Sept .10615 .10615 .10610 .10573 10615 .09930 1,481 All contracts are for 500,000 new Mexican pesos."Open"means the opening price on the day."High"means the high price on the day."Lowindicates the lowest price on the day."Settleis the closing price on the day."Change"indicates the change in the settle price from the previous day's close."High"and"Low"to the right of Change indicate the highest and lowest prices this specific contract(as defined by its maturity)has experienced over its trading history."Open Interest" indicates the number of contracts outstanding. Source:The Wall Street Joumal,February 22,2002,p.C13
Difference between Futures and Forwards Foreign currency futures contracts differ from forward contracts in a number of important ways: Futures are standardized in terms of size while forwards can be customized 的 Futures have fixed maturities while forwards can have any maturity (both typically have maturities of one year or less) 图 Trading on futures occurs on organized exchanges while forwards are traded between individuals and banks Futures have an initial margin that is market to market on a daily basis while only a bank relationship is needed for a forward 图 Futures are rarely delivered upon (settled)while forwards are normally delivered upon (settled)
Difference between Futures and Forwards Foreign currency futures contracts differ from forward contracts in a number of important ways: Futures are standardized in terms of size while forwards can be customized Futures have fixed maturities while forwards can have any maturity (both typically have maturities of one year or less) Trading on futures occurs on organized exchanges while forwards are traded between individuals and banks Futures have an initial margin that is market to market on a daily basis while only a bank relationship is needed for a forward Futures are rarely delivered upon (settled) while forwards are normally delivered upon (settled)
EXHIBIT 7.2 Currency Futures and Forwards Compared Characteristic Foreign Currency Futures Forward Contracts Size of contract Standardized contracts per currency Any size desired Maturity Fixed maturities,longest typically Any maturity up to one year,sometimes longer being one year Location Trading occurs on an organized exchange Trading occurs between individuals and banks with other banks by telecom linkages Pricing Open outcry process on the exchange Prices are determined by bid and ask quotes floor Margin/Collateral Initial margin that is marked to market on No explicit collateral,but standard bank relationship a daily basis necessary Settlement Rarely delivered upon;settlement Contract is normally delivered upon,although the normally takes place through purchase taking of offsetting positions is possible of offsetting position Commissions Single commission covers both purchase No explicit commission;banks earn effective and sale ("roundtrip") commissions through the bid-ask spreads Trading hours Traditionally traded during exchange Negotiated by phone or Internet 24 hours a day hours;some exchanges have moved to through bank global networks 24 hours Counterparties Unknown to each other due to the auction Parties are in direct contact in settling forward market structure specifications Liquidity Liquid but relatively small in total sales Liquid and relatively large in sales volume compared volume and value to futures contracts
