International Finance Exam 2

Yesterday, you entered into a futures contract to buy €62,500 at $1.50 per €. Your initial performance bond is $1,500 and your maintenance level is $500. At what settle price will you get a demand for additional funds to be posted?

$1.4840 per €. $93,750 - $1,000 = $92,750 / €62,500 = $1.484

The current spot exchange rate is $1.55 = €1.00 and the three-month forward rate is $1.60 = €1.00. Consider a three-month American call option on €62,500. For this option to be considered at-the-money, the strike price must be

$1.55 = €1.00

The current spot exchange rate is $1.55 = €1.00 and the three-month forward rate is $1.60 = €1.00. Consider a three-month American call option on €62,500 with a strike price of $1.50 = €1.00. If you pay an option premium of $5,000 to buy this call, at what exchange rate will you break-even?

$1.58 = €1.00 $1.55 × €62,500 = $96,875 and $1.50 × €62,500 = $93,750. To buy the call, you also must pay a $5,000 option premium, so if exercised, the total amount paid will be $93,750 + $5,000 = $98,750. Solve the following for X: ($96,875 / $1.55) = ($98,750 / X).

Yesterday, you entered into a futures contract to sell €75,000 at $1.79 per €. Your initial performance bond is $1,500 and your maintenance level is $500. At what settle price will you get a demand for additional funds to be posted?

$1.8033 per €. $134,250 + $1,000 = $135,250 / €75,000 = $1.8033

Your firm has a British customer that is willing to place a $1 million order, but wants to pay in pounds instead of dollars. The spot exchange rate is $1.85 = £1.00 and the one-year forward rate is $1.90 = £1.00. The lead time on the order is such that payment is due in one year. What is the fairest exchange rate to use?

$1.90 = £1.00

The current spot exchange rate is $1.55 = €1.00 and the three-month forward rate is $1.60 = €1.00. Consider a three-month American call option on €62,500 with a strike price of $1.50 = €1.00. Immediate exercise of this option will generate a profit of

$3,125. €62,500 ($1.55 - $1.50) = $3,125

Suppose that Boeing Corporation exported a Boeing 747 to Lufthansa and billed €10 million payable in one year. The money market interest rates and foreign exchange rates are given as follows: The U.S. one-year interest rate: 6.10% per annum The euro zone one-year interest rate: 9.00% per annum The spot exchange rate:$1.50/€ The one-year forward exchange rate$1.46/€ Assume that Boeing sells a currency forward contract of €10 million for delivery in one year, in exchange for a predetermined amount of U.S. dollars. Which of the following is/are true? On the maturity date of the contract Boeing will (i) have to deliver €10 million to the bank (the counter party of the forward contract). (ii) take delivery of $14.6 million (iii) have a zero net euro exposure (iv) have a profit, or a loss, depending on the future changes in the exchange rate, from this British sale.

(i), (ii), and (iii) $14.6 million = $1.46 × €10,000,000. Additionally, the net euro exposure is zero because the euro receivable offsets the euro payable.

When exchange rates change,

- this can alter the operating cash flow of a domestic firm. -this can alter the competitive position of a domestic firm. -this can alter the home currency values of a multinational firm's assets and liabilities.

Translation exposure refers to

-accounting exposure. -the effect that an unanticipated change in exchange rates will have on the consolidated financial reports of an MNC. -the change in the value of a foreign subsidiaries assets and liabilities denominated in a foreign currency, as a result of exchange rate change fluctuations, when viewed from the perspective of the parent firm.

A firm's operating exposure is

-defined as the extent to which the firm's operating cash flows would be affected by the random changes in exchange rates. -determined by the structure of the markets in which the firm sources its inputs, such as labor and materials, and sells its products. -determined by the firm's ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and sourcing.

Consider this graph of a call option. The option is a three-month American call option on €62,500 with a strike price of $1.50 = €1.00 and an option premium of $3,125. What are the values of A, B, and C, respectively? see homework 4, question 9

A = $3,125 (or $.05 depending on your scale); B = $1.50; C = $1.55 The option premium is $3,125, or $3,125/€62,500 = $0.05. This represents A. To find C, A and B (the exercise price) must be added together. Thus, C = $0.05 + $1.50 = $1.55.

Option

A contract giving the owner the right, but not the obligation, to buy or sell a given quantity of an asset at a specified price at some time in the future.

Settlement price

A price representative of futures transaction prices at the close the daily trading on the exchange (determined by a settlement committee for the commodity--arbitrary)

A forward contract

A vehicle for buying or selling a stated amount of foreign exchange at a stated price per unit at a specified time in the future.

If an investor's performance bond account falls below a maintenance performance bond (roughly 90% of the initial performance bond)

Additional funds must be deposited into the account to bring back to the initial performance bond level in order to keep the position open.

An exporter faced with exposure to an appreciating currency can reduce transaction exposure with a strategy of

An exporter faced with exposure to an appreciating currency can reduce transaction exposure with a strategy of

Speculators

Attempts to profit from a change in the futures prices by taking a long or short position in a futures contract depending on their expectations of future price movement.

Futures: Trading Costs

Bid-ask spread plus broker's commission

Forwards: Trading costs

Bid-ask spread plus indirect bank charges via compensating balance requirements.

Forwards: Traded

By bank dealers via a network of telephones and computerized dealing systems

American option

Can be exercised at any time during the contract

European option

Can be exercised only at the maturity or expiration date of the contract

Reversing Trade

Can be made in both futures and fowards markets that will close out, or neutralize, a position.

Forward and Futures Contracts

Classified as derivative or contingent claim securities (value derived from or contingent upon the value of the underlying security.

Clearinghouse is made up of

Clearing Members

Futures: Traded

Competitively on organized exchanges

Standardized features for futures contracts

Contract size specifying the amount of the underlying foreign currency for future purchase or sale and the maturity date of the contract.

Futures: Settlement

Daily settlement, or marking to market, done by the futures clearinghouse through the participant's performance bond account

Forwards: Delivery

Delivery of the underlying asset is commonly made.

Futures: Delivery

Delivery of the underlying asset is seldom made. Usually a reversing trade is transacted to exit the market.

A European option is different from an American option in that

European options can only be exercised at maturity; American options can be exercised prior to maturity.

Tailor-made for a client by their international bank

Forward Contracts

States a price for the future transaction

Forward contract

Settled up (or marked to market) daily at the settlement price

Future contract

Standardized features and is exchange-traded, that is, traded on organized exchanges rather than over the counter.

Futures Contracts

Zero sum game

Futures trading--the sum of the long and short's daily settlement is zero.

What paradigm is used to define the futures price?

IRP

Hedgers

Looks to avoid price variation by locking in a purchase price of the underlying asset through a long position in the futures contract or a sales price through a short position.

Forwards: Settlement

Participant buys or sells the contractual amount of the underlying asset from the bank at maturity at the forward (contractual) price

A Japanese exporter has a €1,000,000 receivable due in one year. Spot and forward exchange rate data is given: Spot exchange rates: $1.20=€1.00 $1.00=¥100 1-year Forward Rates: $1.25=€1.00 $1.00=¥120 Contract size: €62,500 ¥12,500,000 The one-year risk free rates are i$ = 4.03%; i€ = 6.05%; and i¥ = 1%. Detail a strategy using forward contracts

Sell €1m forward using 16 contracts at the forward rate of $1.25 per €1. Buy ¥150,000,000 forward using 12 contracts, at the forward rate of $1.00 = ¥120.

Types of market participants in derivatives markets

Speculators and Hedgers

Futures: Contractual Size

Standardized amount of the underlying asset

Futures: Expiration Date

Standardized delivery dates

Generally speaking, a firm with recurrent exposure can best hedge using which product?

Swaps

Forwards: Contractual Size

Tailor made to the needs of the participant

Forwards: Expiration Date

Tailor-made delivery date that meets the needs of the investor.

Intrinsic Value

The immediate exercise value of an American option

Exercise price (strike price)

The prespecified price paid or received when an option is exercised

Open interest

The total number of short or long contracts outstanding for a particular delivery month in the derivative markets

Major difference between a forward contract and futures contract

The way the underlying asset is priced for future purchase or sale.

Chicago Mercantile Exchange (CME)

Trading in currency futures contracts began in 1972 here

An investor who suffers a liquidity crunch and cannot deposit additional funds

Will have his position liquidated by his broker

Seller of an option

Writer (the short)

An "option" is

a contract giving the owner (buyer) of the option the right, but not the obligation, to buy (call) or sell (put) a given quantity of an asset at a specified price at some time in the future.

If you owe a foreign currency denominated debt, you can hedge with

a long position in a currency forward contract, or buying the foreign currency today and investing it in the foreign county.

If you have a long position in a foreign currency, you can hedge with

a short position in a currency forward contract.

Initial performance bond

a.k.a margin, must be deposited into a collateral account to establish a futures position (generally, 2% of contract value)

A minor currency is

anything other than the "big six": U.S. dollar, British pound, Japanese yen, euro, Canadian dollar, and Swiss franc.

The link between the home currency value of a firm's assets and liabilities and exchange rate fluctuations is

asset exposure.

To hedge a foreign currency payable,

buy call options on the foreign currency.

To hedge a foreign currency receivable,

buy put options on the foreign currency with a strike in the domestic currency.

An option to buy the underlying asset option

call

Investments in R&D

can allow the firm to maintain and strengthen its competitive position, as well as cut costs and enhance productivity.

From the perspective of a corporate CFO, when hedging a payable versus a receivable

credit risk considerations are more germane for a receivable.

The most direct and popular way of hedging transaction exposure is by

currency forward contracts.

A purely domestic firm that sources and sells only domestically,

faces exchange rate risk to the extent that it has international competitors in the domestic market.

With regard to contractual size,

futures contracts are characterized by a standardized amount of the underlying asset.

Delivery months

futures contracts are delivered during the year in which contracts mature on a specified day of the month.

With regard to trading location,

futures contracts are traded competitively on organized exchanges.

With regard to expiration date,

futures contracts have standardized delivery dates.

With regard to trading costs,

futures contracts involve the bid-ask spread plus the broker's commission.

The price elasticity of demand for commodity products tends to be

highly elastic.

The firm may not be able to pass through changes in the exchange rate

in markets with low product differentiation or in markets with high price elasticities.

The choice between a forward market hedge and a money market hedge often comes down to

interest rate parity.

An exporter can shift exchange rate risk to their customers by

invoicing in their home currency.

A CME contract on €125,000 with September delivery

is an example of a futures contract.

Buyer of an option

long holder owner (long)

With regard to operational hedging versus financial hedging,

operational hedging provides a more stable long-term approach than does financial hedging.

Contingent exposure can best be hedged with

options.

Marking to market feature of futures contracts

participants realize their profits or losses on a day-to-day basis rather than all at once at maturity as with a forward contract

An exporter faced with exposure to a depreciating currency can reduce transaction exposure with a strategy of

paying late, collecting early.

an option to sell the underlying asset option

put

A financial subsidiary used for centralizing exposure management functions is also referred to as a(an)

reinvoice center

Currency risk

represents random changes in exchange rates.

In futures markets, a clearinghouse

serves as the third party to all transactions. (buyers buy and sellers sell through them)

Futures contract--buyer, long position--positive

settlement price is higher than the previous day.

Futures contract--buyer, long position--negative

settlement price is lower than the previous day

An exporter can share exchange rate risk with their customers by

splitting the difference, and invoicing half of sales in local currency and half of sales in home currency, as well as invoicing sales in a currency basket such as the SDR as the invoice currency.

Operating exposure measures

the extent to which the firm's operating cash flows will be affected by unexpected changes in exchange rates.

Economic exposure refers to

the extent to which the value of the firm would be affected by unanticipated changes in exchange rate.

When cross-hedging,

the main thing is to find one asset that covaries with another asset in some predictable way.

Transaction exposure is defined as

the sensitivity of realized domestic currency values of the firm's contractual cash flows denominated in foreign currencies to unexpected exchange rate changes.

Exchange rate risk of a foreign currency payable is an example of

transaction exposure.

The sensitivity of "realized" domestic currency values of the firm's contractual cash flows denominated in foreign currency to unexpected changes in the exchange rate is

transaction exposure.

A CFO should be least worried about

translation exposure.

In general, open interest (loosely an indicator of demand)

typically decreases with the term-to-maturity of most futures contracts

Suppose a U.S.-based MNC maintains a vacation home for employees in the British countryside and the local price of this property is always moving together with the pound price of the U.S. dollar. As a result,

whenever the pound depreciates against the dollar, the local currency price of this property goes up by the same proportion. Additionally, the firm is not exposed to currency risk even if the pound-dollar exchange rate fluctuates randomly.

A firm with a highly elastic demand for its products

will be unable to pass increased costs following unfavorable changes in the exchange rate without significantly lowering the quantity sold.

With any hedge,

your losses on one side should about equal your gains on the other side.