Tài chính doanh nghiệp - Finance 407: Multinational financial management - Topic 9: Currency forwards and futures

Topic #9: Currency forwards and futuresL. GattisThe Pennsylvania State University1Finance 407: Multinational Financial ManagementReview Poll2What are the CIA profits from borrowing $100,000 and investing in AUS sovereign bonds?A. $513 B. $272 C. -$471 D.-$187Currency6-month Sovereign Yields(ann)6-monthLIBOR Yields (ann)Spot (direct quote)6-month ForwardUSD0.50%1.5%AUS5.00%5.50%$1.0234 - 45$1.0023 – 33Learning Objectives3Students understand and can recallThe costs and benefits of hedgingPayoffs and profits of currency forwards and futuresdifference between a forward and futuresHow to speculate with forwards and futures contractsHow financial managers use forwards and futures to hedge fx riskHow futures are traded and margin calculatedCurrency Speculating: Trading Spots4Suppose you have inside information that the European Central Bank (ECB) will make a surprise announcement next week that they will raise short term interest rates– raising real interest rates.You expect the exchange rate to increase from the current spot rate ($1.4786-7) to $1.55 in one week.You have $5,000 to spend. You can buy 3,381 euros in the spot market. ($5000*€(1/1.4787)/$= €3,381) What is your profit if the euro goes to $1.55 or 1.40?$1.55: €3,381*(1.55-1.4787)=$241$1.40: €3,381*(1.40-1.4787)=-$266You could also “buy” a 1-week forward contract to speculate.Forwards5Forward contracts are negotiated between parties (OTC), the terms includeCurrency pair, Quantity, Price, Delivery date and locationPhysical delivery or cash settlementPhysical: Deliver or Take Delivery of Physical Currency. The majority of currency forwards are physical settlement.Cash Settlement: USD payment based on final spot exchange rate.Positions: Long (buyer of fx, takes delivery, gains if price increases, also called buyer) and Short party (seller of fx, make delivery, gains if price falls, also called seller)Usually requires no upfront payment if between two highly rated financial institutions A margin “Security deposit” may be required depending on creditworthinessExample: 10% Initial Margin, Forward Price=$1.25, Q=100,000 euros: Margin = .1*1.25*100,000=$12,500 (USD Margin = IM% x F0 (Direct) x Qty of Forex)ProfitsLong Unwound Payoff (and Profit) = (ST-F0,T)xQShort Unwound Payoff (and Profit) = (F0,T-ST)xQF0,T= forward price at time 0, for delivery at time TST= Spot price at time T (Delivery of forward contract)EURUSD Forward Quotes (Bloomberg)6Currency Speculating Trading in the Forward Market7You expect the exchange rate to increase from the current spot rate ($1.4787) to about $1.55 in one week.1-week forward asking price is 1.4787+.000535 = 1.478165If you have $5,000 to speculate and initial margin is 5%, you can take a long position for a quantity of 67,651 euros. IM = IM%*Q*F5,000 = .05*Q*1.478165Q=67,651.45 ---- round to 67,651 long position What is your profit from the long forward contract if the euro goes to $1.55 by the maturity of the futures contract? A. -$5,288 B. $5,288 C. $4,860 D. -$4,860What about St = $140?Positions and Hedging 8Hedging is the taking of a position that offsets an existing position. Asset ExamplesExpect to receive euros in 3-months (accounts receivable)Holding yen cashLondon real estate you expect to sell this yearOwn Shares of Novo Nordisk (Danish Stock)Exposed to depreciation of FX, hedge by selling FX forwardLiability ExamplesKroner accounts payableSwiss denominated bondPound line-of-credit balanceExposed to appreciation of FX, hedge by buying FX forwardEURUSD Forward Quotes (Bloomberg)Hedging Example9Suppose a foreign venture involves spending €200,000 today (SP in table) and receiving €75,000 a month for at dates IM1, 1M2, and 1M3 from chart.Are you exposed to a depreciating or appreciating euro after today? A. Appreciating B. DepreciatingIf exchange rate remains at 1.4786, profit is =-200,000*1.4787+75,000*3*1.4786 = $36,945 Hedged profits are = -200,000*1.4787+75,000*1.47648 +75,000*1.46944+75,000*1.46292= $34,923 Advantages and Disadvantages of Hedging10Hedging AdvantagesMore predictable cashflows which facilitates long term planningReduced earnings volatility could increase investor demand and stock valuationReduce taxes (smoother profit with progressive tax rates)Easier to measure and reward management performance based on profitability because uncontrollable factors are hedged.Hedging DisadvantagesTrading costs (premiums, transaction costs, reporting requirements)Stockholders can hedge more cheaply by simply holding a diversified portfolio of stocks. Management is not diversified and often conducts hedging activity that benefits management at the expense of the stockholder. Derivatives can be misused either through fraud or error Spot, Forwards and Futures110t=0: Agree upon asset, quantity, price, and delivery date/placeSpot (Cash) TransactionNear Immediate delivery and paymentT0t=0: Agree upon asset, quantity, price, and delivery date/placeForward TransactionDelayed delivery and paymentT0t=0: pay margin requirements “security deposit” to exchange – Choose to “buy” or “sell” contract (pairs, price, delivery month, and quantities are not negotiable – they are determined by the exchange)Futures Transaction (Trade-able Forward)Delayed delivery and paymentTCan unwind position recognizing gain or lossReading WSJ Futures Prices12Size of contract:€125,000Futures Price of €1 at $1.2030Maturity monthFutures Price of ¥1 at $.008861 (or ¥ 112.85/$)Futures Problems13Suppose Dell has a €500,000 December receivableIf unhedged, what is the US$ receivable value if the spot price is $1.3115 or $1.1225 in December?St = $1.3115: V = €500,000 * $1.3115 = $655,750St = $1.1225: V= €500,000 * $1.1225 = $561,250 If hedged with a short $1.2228 forward, what is the US$ receivable value if the spot price is $1.3115 or $1.1225 in December? Guaranteed to sell euros at the forward price. Delivery euros receive the forward.St = $1.3115: V = €500,000 * $1.2228 = $611,400St = $1.1225: V= €500,000 * $1.2228 = $611,400Futures Problems14If the margin requirement for hedgers is 5% of the USD contract value (FxQ). What is the USD margin requirement for a short position in 500,000 euros at futures price of $1.2228?A. $10,394 B.$30,570 C. $60,4920 D.$112,500 Forwards vs. Futures15ForwardsFuturesTradingOTCExchangeDeliv. Date, QuantityNegotiated between partiesStandardized by exchangeQuotesUsually FX/$Usually $/FXTransaction CostsBid-Ask SpreadBroker FeesCredit RiskCounterparty (High)Exchange (low)Margin (Bond Req.)None UsuallyRequired, Paid upfrontClose Out90% Physical Delivery99% Offsetting TradeSettlementAt MaturityDaily mark-to-marketDaily Settlement(Mark-to-Market Process)16Futures contracts require a margin prior to taking a position. The margin requirement is Margin ($) = Initial Margin % x F0 x Quantity e.g. (8%, F=$1.25, Q=€125,000, 2 contracts) Margin =.08*1.25*125000*2 = $25,000The margin balance will change daily based on the change in the market price of the futures contract Daily Margin Change (if long) = ΔF x Quantity Daily Margin Change (if short) = -ΔF x Quantity e.g. (after going long at $1.25, the futures price goes to $1.26) You also get 1-day’s interest on your Margin balance (e.g., 4% APR, daily compounding) New Margin =25,000*(1+.04/365)+(1.26-1.25)*250,000 = $27,502.74Closing Out Position “Unwinding”1799% of futures contracts are “unwound” prior to settlement and delivery by taking an offsetting position (long/short) in the contract at the current contract price (FT).Long Unwound Payoff at t (t<T)= (FtT-F0T)xQShort Unwound Payoff = (F0T-FtT)xQLong at time 0, (Contract Mat=T)ShortLongExample: Short on Monday AM at $.937 (F0), long on Mon. PM at $.9315 (F1), profit = (.937-.9315) x125,000=$687.50Short at time t (<T) (Contract Mat=T)Initial futures price (Long)New futures price (short)Poll18Suppose you take a long position in 5 yen futures contracts at ¥78.12. What is your profit if you unwind your position when the futures price is ¥80.00. Each contract is for 500,000 yen.-$4,700,000 -$752.05 = (F1-F0)Q=(1/80-1/78.12)*500000*5+$752.05$4,700,000Why Unwind?19“Lock-in” gains or lossesAvoid delivery (hassle and expensive) or because no longer need it (receivable or payable does not materialize)Change timing to match payable/receivable datesCoverage and Hedge Ratio20The choice to hedge is not all or noneMost firms have a policy of hedging a certain percentage of risk which is called a coverage or hedge ratioWhy?Forex positions are only estimates – sales may not materialize or receivable may not be paidFirms are willing to accept some riskExample: IBM estimates that it will receive €100M euro in one year. It hedges its position by shorting €50M @1.30. What is the USD value of IBMs total position if the euro is selling at $1.20 at maturity.V(50% Hedge Ratio) = €50*$1.3+€50*$1.2=$125MAssigned Problems 21What is your USD profit if you short 5 swissie forwards at $1.1245 and the swissie is selling for $1.2232 or $1.0833 at maturity. Each contract is for 125,000 Swiss francs.St=1.2242; Profit=(F-St)Q=(1.1245-1.2232)*5*125000=-$61,687.50St=1.0833; Profit=(F-St)Q=(1.1245-1.0833)*5*125000=$25,750What is your USD profit if you long 3 yen forwards at 89.12 and the yen is selling for 87 or 95 at maturity? Each contract is for 12.5 million yen. St=87; Profit=(St-F)Q=(1/87-1/89.12)*3*12,500,000=$10.253.51St=95; Profit=(St-F)Q=(1/95-1/89.12)*3*12,500,000=-$26,044.13 What is the USD initial margin for buying 10 euro futures when the futures price is $1.3345, the quantity is 125,000 per contract, and the initial margin is 5%?IM=IM%=F=Q= .05*1.3345*10*125000*=$83,406.251. What is your margin balance after 2 days if the futures price falls to $1.3103 and interest is compounded at 6% per year.New Margin = Initial Margin (1+r) + (Change in Futures Price) x QMargin = $83,406.25*(1+.06*(2/365))+(1.3103-1.3345)*10*125,000=53,183.67You have an aussie payable of A$1,100,000 that you have hedged with futures contracts (each worth A$100,000). How many futures contracts do you need? What is the hedged USD value of the payable if the futures price is $0.88?# futures contracts = Exposure/Contract Size = 1,100,000/100,000=11; Hedged Value = FQ = $.88*1,100,000=$968,000Assigned Problems 22You have speculated on the yuan by longing 50 forward contracts at ¥6.4 per USD. Each contract is for 500,000 yuan. What is your USD profit if the yuan is selling for 5.8 at maturity?Profit = 50*500,000*(1/5.8-1/6.4)=$404,094.83Your short a yen futures and the Japanese central bank announces that inflation is unexpectedly rising. Will you win or lose? Explain.Win; Inflation will devalue the YenYou are long the euro futures and Greece announces it is defaulting on its government bonds. Will you win or lose? Explain.Lose; less demand for Greek bonds and the euroYou take a long position in 3 euro futures at 1.2523 (each is for 125,000 euros). The euro futures price rallies to $1.2856 when the ECB announces higher GDP growth. You decide to unwind by shorting 3 contracts at $1.2856. What was your USD profit? Profit from Long Unwind = (Ft-F0)Q = (1.2856-1.2523)* 3*125000 =$12,487.50You short 125,000 euro using a forward contract and the euro rallies (appreciates) 5 pips. What’s your USD profit? (Hint:Euro is a 4 decimal place currency)Profit = (F0 – Ft)Q; Ft = (F0 + .0005); F0 – Ft= -.0005 (Could write St (for Ft) if held to maturity)Profit = -.0005*125,000=-$62.5Textbook23Shapiro and Sarin’s Foundation of Multinational Finance 6th Ed. Chapter 7 covers the use of forwards, futures, and optionsiClicker: Class Evaluation24How would you rate today’s class? Highest Lowest