International Finance Session 7

Long vs. Short Position in Futures

Long Position in Futures: A position in which foreign currency assets exceed foreign currency liabilities. Short Position in Futures: Foreign currency assets are below foreign currency liabilities

Currency Options and Currency Futures Options

* A currency option is a contract that grants the buyer the right, but not the obligation, to buy or sell a specified currency at a specified exchange rate on or before a specified date. * A currency futures option gives the holder the right, but not the obligation, to buy (for a call) or sell (for a put) a currency futures contract;, which is a contract to exchange two currencies at an agreed-upon exchange rate at a certain point in the future, regardless of what the exchange rate is at that future time. This helps the holder manage his/her foreign exchange risk.

European Options vs. American Options

* American Options - An option contract that may be exercised at any time between the date of purchase and the expiration date. * European Options - An option contract that may be exercised only during a specified period of time just prior to its expiration.

Call Options vs. Put Options

* Call Options: An option with the right, but not the obligation, to buy foreign exchange or another financial contract at a specified price within a specified time. * Put Options: An option to sell foreign exchange or financial contracts; A financial contract or derivative which guarantees the holder the right to buy or sell a specific amount of foreign currency at a specific rate by a stated expiration or maturity date. - A put option is an insurance policy. Therefore, by buying a put option, you are buying an insurance policy. - A put option, or the insurance policy, becomes valuable in the bear market.

Managing Interest Rate Risk - Credit Risk vs. Repricing Risk

* Credit Risk - the risk that lenders will reclassify the borrowing firm's credit worthiness when it is time to renew a loan, driving up the price of credit - It is also called rollover risk, as it relates to risk of higher rates, higher fees, reduced credit lines available, or even denial of credit when it is time to renew a debit commitment. * Repricing risk - the risk that interest rates charged change at the time a financial contract is extended or its rate is reset

In-the-Money vs. Out-of-the-Money Options

* In-the-money (ITM) options: Circumstance in which an option is profitable, excluding the cost of the premium, if exercised immediately. * Out-of-the Money (OTM) options: An option that would not be profitable, excluding the cost of the premium, if exercised immediately.

Intrinsic Value vs. Time Value of Option

* Intrinsic value: The financial gain if an option is exercised immediately. * The time value of an option exists because the price of the underlying currency, the spot rate, can potentially move further and further into the money before the option's expiration.

Derivative Securities = Contingent Claims Securities

* 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. - Permits 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)

Reversing Trade

- A clearinghouse also makes it possible for traders to liquidate positions easily. - If you are currently long in a contract and want to undo your position, you simply instruct your broker to enter a short side of a contract to close out your position.

Writing a Covered Call Option = Writing one call for each unit of currency

- A covered call is the purchase of a underlying asset with a simultaneous scale of a call option written on that asset. - The call option is "covered" in that the potential obligation to deliver the underlying asset is covered by the asset held in the portfolio. Uncovered or naked. - The covered call position limited their upside profit potential and provides only a limited amount of downside protection. - Therefore, it is a strategy to be adopted when the price of the underlying asset is expected to fluctuate in a very narrow range. - Downside risk is reduced by the amount of call premium. However, it should be noted that we are giving up the potential profit from the bull market.

Forward Rate Agreement (FRA)

- A firm could lock in the future interest payments with a forward rate agreement, which is similar to a forward currency contract. - The forward rate agreement (FRA) is a contract to buy or sell interest rate payments. The buyer of the FRA obtains a right to lock in an interest rate for a specified period. - If interest rates (LIBOR) rise, the buyer receives a cash payment from the seller that effectively reduces the interest payment to the "fixed" rate. - If the interest rates fall, then the buyer makes a cash payment to the seller that effective raises the interest payment to the "fixed" rate.

Protective Put

- A protective put is the purchase of underlying asset with a simultaneous purchase of a put option written on the same asset. - The protective put strategy provides the protection against a bear market, and at the same time it allows you to participate in a bull market.

Currency swap

- Single-currency interest rate swap: one counterpart exchanges the interest payments of a floating-rate debt for the fixed-rate interest payments of the other counter party - Cross-currency interest rate swap (currency swap):when one counter party exchanges the debt service obligations of a bond denominated in one currency for the debt service obligations of the other counter party denominated in another country - The usual motivation for a currency swap is to replace cash flows scheduled in an undesired currency with flows in a desired currency. - The desired currency is probably the currency in which the firm's future operating revenues (inflows) will be generated. Firms often raise capital in currencies in which they do not possess significant revenues or other natural cash flows. The reason they do is cost; specific firms may find capital costs in specific currencies attractively priced to them under special conditions. Having raised the capital, however, the firm may wish to swap its repayment into a currency in which it has future operating revenues. - Unlike with interest rate swaps, currency swaps actually involve the exchange of the set principal amount. - Interest payments aren't netted as with interest rate swaps, because they are denominated in different currencies. - Currency swaps can be negotiated for various types of maturities of up to thirty years. Furthermore, many currency swaps are also traded on organized exchanges.

Interest Rate Swaps

- The firm could enter an agreement with a bank or swap dealer to exchange cash flows so that the payments on the floating-rate loan become fixed. - With an interest rate swap, one party swaps its fixed interest payment for the floating interest rate payment of another. - Plain-vanilla swap: an agreement between two parties to exchange fixed-rate for floating-rate obligations; it is the most common financial derivative traded in the international financial markets - A firm's strategy for swapping fixed-rate for floating-rate payments, or vice versa, depends on the firm's expectations regarding future rate changes. - A firm with fixed-rate debt, expecting interest rates to go up, would not enter a swap arrangement. However, that same firm, expecting rates to go down, would seek to exchange the fixed-rate for floating-rate in order to receive fixed-rate payments at the current fixed rate and make payments at the floating rate (which the firm expects to be lower than the fixed rate).

Boundaries of Currency Option Values

In Session 7-1 notes

Initial Margin and Maintenance Margin

Initial margin is the percentage of the purchase price of securities (that can be purchased on margin) that the investor must pay for with his own cash or marginable securities; it is also called the initial margin requirement. According to Regulation T of the Federal Reserve Board, the initial margin is currently 50%, but this level is only a minimum and some brokerages require you to deposit more than 50%. For futures contracts, initial margin requirements are set by the exchange. A maintenance margin is the minimum amount of equity that must be maintained in a margin account. In the context of the NYSE and FINRA, after an investor has bought securities on margin, the minimum required level of margin is 25% of the total market value of the securities in the margin account. Keep in mind that this level is a minimum, and many brokerages have higher maintenance requirements of 30-40%.

Factors that affect the value of currency options - S, E, T, σ2, rd, rf

S = Spot exchange rate - If this variable increases, the call option value will increase while the put option will decrease. E = Exercise price - If this value increases, the call option value will decrease while the put option value will increase. T = Time to expiration - If this variable increases, the call option value and the put option value will increase. σ2 = volatility - If this variable increases, the call option value and the put option value will increase. rd = Domestic risk-free rate - If this variable increases, the call option value will increase while the put option value will decrease. rf = Foreign risk-free rate - If this variable increase, the call option value will decrease while the put option value will increase.

Market-to-Market = Daily Settlement

Since the clearing-houses assume all the risk in the future markets, a future's contract is settled-up, or market-to-market, daily at the settlement price. The settlement price is the new future's price at the close of daily closing. * The process by which profits or losses accrue to traders is called market-to-market.

Counterparty risk

The potential exposure any individual firm bears that the second party to any financial contract may be unable to fulfill its obligations under the contract's specifications.

Quality Spread Differential (QSD) in an Interest Rate Swap

The quality spread differential (QSD) is the difference between the interest differential on the fixed rate debts and the interest differential on the floating-rate debts.