International Finance Test 3

exercise (strike) price

(for a currency option) the exchange rate at which the option holder can buy/sell the contracted currency

operational techniques (to hedge transaction exposure)

- Hedging through invoice currency - hedging via lead and lag - exposure netting

forecasting exchange rates

- efficient markets approach - fundamental approach - technical approach - performance of the forecasters

three ways of computing gains/losses (futures contract)

1. sum of daily gains and losses 2. contract size times the difference between initial contract price and last settlement price 3. ending balance on the account minus beginning balance on the account, adjusted for deposits or withdrawals

call

An option to buy an underlying asset at a prespecified price.

put

An option to sell an underlying asset at a prespecified price.

valuable

PPP-determined exchange rates still provide a valuable benchmark

major currencies

USD Canadian Dollar British Pound Euro Swiss Franc Mexican Peso Japanese Yen everything else is a minor currency (Thai Bhat, Swedish Krona, etc)

long; short

With a futures contract/daily resettlement: if the price goes down, the _____ pays the _____

out of the money

____ ____ _____ options can still have value

exposure netting

a MNC should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions ex: consider a US-based MNC with korean won receivables and japanese yen payables. since the won and the yen tend to move in similar directions against the USD, the firm can just wait until these accounts come due and buy yen with won even if it's not a perfect hedge, it may be too expensive/impractical to hedge each currency separately

derivative security (contingent claim)

a financial instrument whose value depends on the value of some other, more basic underlying variable(s) - underlying variable is often the price of a traded asset, but does not have to be stock option forward contract weather derivative our focus is on currency/foreign exchange derivatives

currency swap contract (hedging recurrent exposure)

agreement to exchange one currency for another at a predetermined rate ("swap rate") on a specified sequence of future dates

option premium

amount paid for the option

forward contract

an agreement to buy (long position) or sell (short position) foreign exchange at a certain future time for a specified delivery price

derivatives

an important type of financial instrument - hedging - speculating - arbitrage (recall IRP) received a lot of bad publicity in the mid-90s; seen as potentially dangerous and detrimental to the financial system - Barings PLC and Nick Leeson (p. 173) - Orange County school board - Proctor and Gamble 2008: Societe Generale (p. 173)

currency futures option

an option on a currency futures contract - exercise results in a long futures position for the owner of a call or the writer of a put - exercise results in a short futures position for the writer of a call or the owner of a put - if the futures position is not offset prior to its expiration, foreign currency will change hands

same

at expiry, an american option is worth the ____ as a european option with the same characteristics

swaps

available in longer-terms than futures and forwards

long

buyer of a futures/forward contract

options

can be bought or sold (written); the owner decides whether or not to exercise

american options

can be exercised at any time up to and including the expiration date; usually worth more, other things equal

currency options

can be traded on exchanges or OTC - OTC volume is much bigger than exchange volume - exchange traded options or listed options are standardized with predetermined exercise prices and standard expiration months

european options

can only be exercised on the expiration date

forward exchange rate

derived from the spot exchange rate, the domestic and foreign interest rates, and the time to maturity

swap contract

essentially like having a portfolio of forward contracts with different maturities - firms that have recurrent exposure can often hedge their exchange risk at a lower cost with this tool than with a program of hedging each exposure as it comes along - available in longer-terms than futures and forwards

absoute; relative

even if ____ PPP does not hold, _____ PPP may hold

big mac index

evidence on PPP; clever, but use caution in applying it

owner; writer

exercise of a currency futures option results in a long futures position for the _____ of a call or the _____ of a put

writer; owner

exercise of a currency futures option results in a short futures position for the _____ of a call or the ______ of a put

efficient markets approach (random walk)

financial markets are efficient if prices reflect all available and relevant information - if this is so, exchange rates will only change when new information arrives - predicting exchange rates using this approach is affordable and hard to beat St = E [St+1] and Ft = E [St+1| It]

forward rate

forecasting is difficult, especially with regard to the future - as a whole, forecasters cannot do a better job of forecasting future exchange rates than the _____ ______ the founder of forbes magazine once said: "you can make more money selling financial advice than following it"

expected

given the difficulty in measuring _____ inflation, managers often use a "quick and dirty" shortcut

option

gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset in the future at prices agreed upon today

call option

holder has the right, but not the obligation, to buy a given quantity of some asset at some time in the future at prices agreed upon today

put option

holder has the right, but not the obligation, to sell a given quantity of some asset at some time in the future at prices agreed upon today

IRP

if ____ is holding, the forward hedge and the money market hedge result in the same outcome for the firm

depreciating (lead and lag)

if a currency is ______, give incentives to customers who owe you in that currency to pay early; pay obligations denominated in that currency as late as your contracts will allow

appreciating (lead lag)

if a currency is _______, pay bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency

hedging via lead and lag

if a currency is appreciating, pay bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency if a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay obligations denominated in that currency as late as your contracts will allow particularly useful for handling with intrafirm payables and receivables

in the money

if immediate exercise is profitable, an option is _____ ___ _______

discount

if next year's inflation rate is expected to be 3% in US and 5% in eurozone, then the euro will trade at a ____ in the forward market

hedging contingent exposure

if only certain contingencies give rise to exposure, then options can be effective insurance Ex: if your firm is bidding on a hydroelectric dam project in canada, you will need to hedge the canadian-USD exchange rate only if your bid wins the contract. your firm can hedge this contingent risk with options

put

if the ____ is: in-the-money, it's worth E-St out-of-the-money, it's worthless (buyer loses entire premium)

call

if the _____ is: in-the-money, it's worth St-E. out-of-the-money, it's worthless (buyer loses entire premium)

owe

if you are going to ____ foreign currency in the future, agree to buy the foreign currency now by entering into long position in a forward contract (forward market hedge)

receive

if you are going to ____ foreign currency in the future, agree to sell the foreign currency now by entering into short position in a forward contract (forward market hedge)

absolute PPP

ignores transport costs, government restrictions such as tariffs and quotas, and product differentiation

appreciate

in the context of a domestic currency, a decrease (increase) in a foreign exchange rate relative to another currency when stated in terms of the domestic (foreign) currency

depreciate

in the context of a domestic currency, an increase (decrease) in a foreign exchange rate relative to another currency when stated in terms of the domestic (foreign) currency

PPP

in theory, price levels should be equal worldwide when expressed in a common currency; a unit of home currency should have the same purchasing power around the world

market value (american options)

intrinsic value + time value = ____ _____

fundamental approach

involves econometrics to develop models that use a variety of explanatory variables involves three steps: - step 1: estimate the structural model to determine parameter values - step 2: estimate future values of the independent variables - step 3: use the model to develop forecasts the downside is that these models do not work any better than the forward rate model or the random walk model

cross hedging (minor currency exposure)

involves hedging a position in one asset by taking a position in another asset the effectiveness depends upon how well the assets are correlated Ex: a US importer with liabilities in Swedish krona hedging with long or short forward contracts on the euro. If the krona is expensive when the euro is expensive, or even if the krona is cheap when the euro is expensive (inverse or non inverse) it can be a good hedge - but they need to co-vary in a predictable way

minor

it is often difficult, expensive, or impossible to use financial contracts to hedge exposure to ______ currencies

futures contract

like a forward contract in that it specifies that a certain currency will be exchanged for another at a specified time in the future at prices specified today different from a forward contract in that they are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse

call option

limits the potential cost of servicing the payable

reinvoice center (exposure netting)

many multinational firms use a _____ ______, which is a financial subsidiary that nets out the intrafirm transactions - once the residual exposure is determined, then the firm implements hedging

out-of-the-money

not that even an ____ ___ ___ _____ option has value - Time Value

writer

obligated to take the other side of the transaction in an options contract

hedgers

one who attempts to eliminate the risk of an unfavorable price change in an asset by taking an offsetting position in another asset, usually a derivatives contract

speculators

one who attempts to profit from a favorable, but uncertain, price change in an asset by acquiring a position in it

greatest; decreases

open interest is usually _____ in the nearby contract; typically _____ with term to maturity of most futures contracts

lead and lag

particularly useful for handling with intrafirm payables and receivables

weather derivative

payoff is determined by the average temperature at a particular location

PPP

probably doesn't hold precisely in the real world for a variety of reasons: - haircuts cost 10x as much in the developed world as in the developing world - film, on the other hand, is a highly standardized commodity that is actively traded across borders - shipping costs, as well as tariffs and quotas, can lead to deviations

options

provide a flexible hedge against the downside, while preserving the upside potential

law of one price

requirement that similar commodities/securities should be trading at same/similar price - IRP is a manifestation - PPP obtained by applying this

short

seller of a futures/forward contract

futures contracts

standardizing features - contract size - delivery date - daily resettlement (marked to market) require an initial performance bond CME Group is the world's largest market

PHLX (philedelphia stock exchange)

started trading currency options in 1983; part of NASDAQ now trading is in 7 major currencies against the USD

random walk

suggests that today's exchange rate is the best predictor of tomorrow's exchange rate

technical approach

technical analysis looks for patterns in the past behavior of exchange rates - clearly it is based upon the premise that history repeats itself - it is at odds with the EMH

intrinsic value

the amount that the option is "in-the-money," or the amount you would receive if you exercise the option for Call's: Max[St-E, 0] for Put's: Max[E-St, 0]

time value

the difference between the option price and its intrinsic value; represents the "speculative" value of an option for Call's: Ct - Max[St-E, 0] for Put's: Pt - Max[E-St, 0] at option expiration = 0.

PPP

the exchange rate between two currencies should equal the ratio of the countries' price levels - another application of the law of one price

hedging through invoice currency

the firm can shift, share, or diversify: shift exchange rate risk: - by invoicing foreign sales in home currency share exchange rate risk - by pro-rating the currency of the invoice between foreign and home currencies diversify exchange rate risk - by using a market basket index (SDR) as invoice currency

open interest

the number of contracts outstanding for a particular delivery month - good proxy for demand for a contract - notice that it's greatest in the nearby contract - typically decreases with term to maturity of most futures contracts

transaction exposure

the potential change in the value of financial positions due to changes in the exchange rate between the inception of a contract and settlement of the contract - impact of unanticipated changes in exchange rates on the value of foreign-currency-denominated transactions the firm has already entered - well-defined (in sense that we know exact amount of foreign currency payable/receivable) and exposure tends to be short term (1 yr or less)

relative PPP

the rate of change in the exchange rate is equal to differences in the rates of inflation - roughly 2%

parity

the state or condition of being equal, especially regarding status or pay.

payable

to hedge a foreign currency ______ buy calls on the currency - if the currency appreciates, your call option lets you buy the currency at the exercise price of the call

receivable

to hedge a foreign currency ______, buy puts on the currency - if the currency depreciates, your put option lets you sell the currency for the exercise price

buy; present value

to hedge a foreign currency payable, ___ the _____ _____ of that foreign currency payable today at the spot exchange rate and put it in the bank at interest (invest that amount at the foreign rate) - at maturity your investment will have grown enough to cover your foreign currency payable (money market hedge)

borrow; present value

to hedge a foreign currency receivable, ______ the _____ ____ of that foreign currency receivable today, convert to USD at spot rate, and invest - pay off loan when get receivable; use receivable money to pay off loan

currency options

traded on: - PHLX - HKFE - European Options Exhchange (Amsterdam) - Chicago Mercantile Exchange - Montreal Stock Exchange

stock option

value dependent on the price of a stock

forward contract

value dependent on the spot exchange rate

daily resettlement (marking to market)

with a futures contract, there is _____ ______ of gains and losses, rather than one big settlement at maturity at the end of each trading day a settlement price is determined - if the price goes down, the long pays the short - if the price goes up, the short pays the long after this happens, each party effectively has a new contract at the new price with one-day-shorter maturity - prevents build up of large losses; avoids defaults

short; long

with a futures contract/daily resettlement: if the price goes up, the ____ pays the ______

importers; owe

with an exercise price denominated in local currency.... _____ who ___ foreign currency in the future should buy call options - if the price of the currency goes up, the call will lock in an upper limit on the dollar cost of firm's imports - if the price of the currency goes down, the firm will have the option to buy the foreign currency at a lower price

exporters

with an exercise price denominated in local currency.... ______ with accounts receivable denominated in foreign currency should buy put options - if the price of the currency goes down, the put will lock in a lower limit on the dollar value of firm's exports - if the price of the currency goes up, the firm will have the option to sell the foreign currency at a higher price

exporter

with an options market hedge, _____ buys a put option to protect the dollar value of its receivable

futures contract payoffs

zero-sum game; the long position payoff is the opposite of the short position payoff clearing house takes the opposite position