TECHNICAL

Foreign currency exposure management: part 1

Hedging currency risk using the money markets and forward contracts
Nigel Brown BA FCA is a senior lecturer in Financial Strategy at the University of Wales College, Newport

his is the first of a series of five articles. The aim of the series is to develop an understanding of the effect a movement in foreign currency exchange rates referred to as foreign currency risk may have on a firm and of some of the techniques that are available for eliminating or reducing that exposure referred to as hedging techniques. This topic is an important part of the syllabus for paper 14, Financial Strategy. In this first article we will consider the types of currency risk to which a firm may be exposed. Then we will look at two methods which can be used to protect a firm against that risk: forward contracts and a money market hedge. In subsequent articles we will deal with futures contracts and option contracts.

The indirect quote is described by Brown et al (1994) as the number of foreign currency units needed to buy one unit of domestic currency. Hence from a UK viewpoint: US$1.56 = 1 which is quoted as US$1.56/ . Two points to note about these alternative methods: they are two ways of expressing the same information; the indirect quote is simply the reciprocal of the direct quote. in the UK indirect quotes are used whereas elsewhere generally direct quotes are used. (The British like to be different!) Appreciation and depreciation of currencies It is important to understand the significance of a movement in the exchange rate to the relative strength of the two currencies. For example, if the $/ exchange rate moves from US$1.56/ to US$1.63/ the has strengthened; each will now buy more $. Alternatively one could say that the $ has weakened. Spot exchange rate Brealey and Myers (1991) define the spot exchange rate as the exchange rate on currency for immediate delivery. Example 2: The $/ spot rate may be quoted as follows: 1.4215 1.4225

rates is the banks profit: 1.4225 1.4215 = $0.001. Dealers at the banks make the market by quoting the bid and offer prices at which they are prepared to buy and sell. The size of the spread between bid and offer rates varies depending on: the stability of the market at the time. If a currency exchange rate is more volatile and therefore subject to large fluctuations then the spread will be wider than if the exchange rate is stable. the depth of the market. Depth refers to the volume of transactions in the market. A deep market has a high volume of transactions and several dealers in which case the spread will be narrower than for a shallow or thin market where there is a low volume of transactions and few dealers.

Foreign exchange rates

The foreign exchange rate is defined by French (1991) as the number of units of one currency which may be bought or sold for one unit of another currency. It is the price of one currency relative to another currency. Foreign currency may be viewed as an asset, a store of value. That currency has purchasing power. Example 1: If an English person is planning a holiday in France it will be necessary to buy French Francs so as to be able to purchase goods in France. The exchange rate between the French Franc and sterling () will determine the amount of French purchasing power it is possible to buy with each . Direct quote or indirect quote The exchange rate may be expressed as a direct quote or an indirect quote. Direct quote is described by Brown et al (1994) as the number of domestic currency units needed to buy one unit of foreign currency. From a UK viewpoint this would be shown as: US$1 = 0.64. This indicates that $1 is worth 0.64 or 64 pence.

Foreign currency exposure or currency risk or foreign exchange risk or exchange risk
Shapiro (1995) defines exchange risk as the variability of a firms value that is due to uncertain exchange rate changes. A movement in the exchange rate can have a major effect on the value of a firm. The uncertain nature of exchange rates makes it important for a firm to manage its exchange risk. Types of exposure to currency risk There are three types of currency risk: (1) Economic exposure (or operating exposure). Economic exposure is defined by Shapiro (1995) as the extent to which the value of the firm will change due to an exchange rate change. Economic exposure can be viewed as the total foreign currency exposure. It relates to future cash flows. As those cash flows come to be received or paid then part of the exposure crystallises.

offer or ask price

bid price

If buying $ from the bank the company would receive the offer rate of $1.4215 for every 1; the smaller, least favourable, to the company, of the two rates. If selling $ to the bank the company would have to give the bank $1.4225 for every 1 it receives. Again the least favourable of the two rates i.e. the bank always wins! The difference or spread between the two

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There are many ways in which economic exposure can occur. We will look at two contrasting examples to demonstrate how it can arise. Example 3 looks at a situation where, on the face of it, it appears that there is no currency risk whereas there could well be significant economic exposure. Example 4 looks at a situation where currency risk appears to be much higher than it is. Example 3: Is a UK company, which is not engaged in any form of foreign trade and therefore not involved in any transactions denominated in a foreign currency, exposed to currency risk? Solution: YES! Since this company is not involved in any transactions denominated in a foreign currency it appears there is no exposure to currency risk but: one of the UK firms competitors could be foreign (e.g. Italian), or could import its product from another country. Hence if, for example, the strengthened against the lira the UK firms competitors would gain an advantage; they could charge a lower price for their product and therefore potentially take market share from the UK company but still receive the same value in lira. the UK company may have UK suppliers who import raw materials and may therefore find it necessary to pass on any adverse effects of exchange rate movements. Purchasing Power Parity (PPP) The next example requires an understanding of Purchasing Power Parity (PPP) which is a theory about the relationship between todays spot exchange rate, the expected future spot exchange rate and inflation rates. It is based on the rationale that the price of goods in one country should be the same as the price of the same goods in another country. PPP proposes that the difference between the inflation rates in two countries will be reflected in a movement in the exchange rate between the two countries currencies. If, for example, the UK has higher inflation than Germany this will, according to PPP, cause the to weaken against the D-Mark. The reason being that the purchasing power of the has fallen by more than the purchasing power of the D-Mark and is therefore worth less D-Marks. The amount of the expected movement in the exchange rate is, according to PPP, given by the following formula: Expected future spot rate = todays spot rate x (1 + foreign inflation rate)/(1 + UK inflation rate) = todays spot rate x (1 + if)/(1 + iUK).

Example 4: Kelly PLC, a UK company, has a subsidiary in Brazil which manufactures compact discs. The Brazilian currency is the cruzeiro(Cr$). The product presently has the following cost structure: Cr$ selling price 486,000 variable cost per unit 270,000 contribution per unit 216,000 The spot rate is 43,200 Cr$/. Therefore Kelly PLC can expect to receive a equivalent of: 216,000/43,200 = 5 contribution for every compact disc sold. Assume Kelly PLC achieves sales of 40,000 compact discs in the first year. Required: (i) Calculate the amount of sterling contribution earned by Kelly PLC if there is no inflation and the exchange rate holds at 43,200 Cr$/. (ii) Calculate the amount of sterling contribution earned by Kelly PLC if Brazil experiences inflation over the next year of 1,800% while the inflation rate in the UK over the same year is only 4% and PPP holds. Assume that Kellys costs increase by 1,800% and that Kelly is able to increase revenues by 1,800%. Solution to Kelly PLC: (i) No inflation Contribution: In Cr$: 216,000 x 40,000 = Cr$ 8,640,000,000 In : 8,640,000,000/43,200 = 200,000.

= 43,200 x (1 + 18)/(1 + .04) = 789,231 Cr$/ Hence Kelly PLC can expect to receive contribution of: 4,104,000/789,231= 5.20 for every disc sold. Total contribution: 40,000 x 5.20 = 208,000 i.e. 200,000 x (1.04). Hence Kelly has earned 200,000 increased by 4% to compensate for the effect of UK inflation. The company is as well off as if there had been no inflation. The high Brazilian inflation and the depreciation in the Brazilian currency have not affected the value of the transactions. Or, put another way, Kelly PLC would earn the same value in real terms as it would have done without inflation. This would only be the case if: PPP holds, and Brazilian selling prices can be increased in line with inflation. Therefore, if selling in a country with high inflation it is vital not to enter into contracts where selling prices are fixed for long periods. Alternatively the risk from a depreciation in the Brazilian currency could be avoided by invoicing in sterling; this would have the effect of shifting the risk to the Brazilian customers. (2) Transaction exposure Shapiro (1995) defines transaction exposure as the extent to which a given exchange rate change will alter the (home currency) value of foreign-currency-denominated transactions already entered into. Examples of transactions: purchase/sale of goods or services; repayment of loan and interest; payment of dividend. Note that the essential feature of transaction exposure is that it refers to identified transactions. Hence, we are likely to know the amounts of currency involved and the timing of receipt or payment of the currency. This makes it easier to manage transaction exposure than economic exposure. (3) Translation exposure (or accounting exposure) Translation exposure is the possibility that the book value of shareholders funds may change as a result of a movement in exchange rates. Translation exposure is more controversial than transaction exposure or economic exposure. It arises due to the requirement to prepare periodic financial statements for a group with foreign subsidiaries.

(ii) With inflation and PPP holds Adjust costs and revenues by a factor of 1 + the rate of inflation. The inflation rate is extremely high in this example. To help us understand the calculation lets take a more reasonable price increase of 20%. To find the new price we would take the old price and multiply it by 120/100 or, in decimal terms, multiply by 1 + (20/100) = 1.2. Hence in this case the revised price would be found by multiplying the old price by: 1 + (1,800/100) = 1 + 18 = 19

Therefore contribution in Brazil will increase to: 216,000 x 19 = Cr$ 4,104,000 The revised exchange rate will, according to PPP, be: Expected future spot rate = todays spot rate x (1 + if)/(1 + iUK) = 43,200 x (1 + i Brazil)/(1 + i UK)

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Translation exposure is an accounting concept which may affect future cash flows and should therefore be treated with caution. Demirag and Goddard (1994) state that It has become clear to many managers and accountants alike that retrospective accounting techniques, no matter how refined, cannot truly account for the economic effects of devaluation or revaluation on the value of a company. As a result of this accounting distortion of economic reality, many multinational firms are now taking a longer-term look at their degree of exchange risk. This involves focusing on a companys economic exposure. The main focus of the remainder of this series of articles will be on how to manage transaction exposure. Lets look at the potential impact of transaction exposure on a firms cash flows. Example 5: Assume it is now October 1995. Sophieclare PLC, a UK company, owes Benjaminpaul Inc., a US supplier, $370,000 payable 3 months later in January 1996. The spot rate in October 1995 is $1.5766 $1.5775/ and Sophieclare PLC is concerned that the $ may strengthen against the before payment is made. Required: Calculate the sterling cost of the transaction if Sophieclare PLC decides not to hedge the currency and the spot rate in January 1996 turns out to be: (a) $1.3800 $1.3809/ (b) $1.8500 $1.8510/ It is important to appreciate that, in October 1995, Sophieclare PLC would not know which way the exchange rate is going to move. Solution: Since Sophieclare has decided not to hedge the currency exposure the company will purchase the $ on the spot market in January 1996. This will cost: (a) $1.3800 $1.3809/ (the US$ has strengthened) When choosing between the two spot rates, $1.3800/ or $1.3809/, you should always use the rate which is least beneficial to the company: 370,000/1.3800 = 268,116. 370,000/1.3809 = 267,941. The relevant cost is therefore 268,116. Note that if Sophieclare PLC were to buy the $ in October 1995 it would cost 370,000/ 1.5766 = 234,682. Hence if the $ strengthens to $1.3800/ the transaction will cost Sophieclare PLC an

additional 33,434 (268,116 234,682). It is the risk of this additional cost which Sophieclare PLC will want to avoid. (b) $1.8500 $1.8510/ (the US$ has weakened) 370,000/1.8500 = 200,000. Therefore if the $ weakens to $1.8500 $1.8510/ Sophieclare PLC would save 34,682 (234,682 200,000). In this case it would, with the benefit of hindsight, have been best not to hedge the currency risk. However if, in October 1995, the accountant took the view that the $ was likely to strengthen and therefore did not hedge the transaction it would amount to speculation; lots of explanation would be necessary if no hedge was arranged and the $ moved to $1.3800! Using the data in Sophieclare PLC above we will analyse ways of hedging/insuring against foreign exchange exposure. One key difference between the methods is the timing of the cash flows. When working through the examples check to make sure you understand when each of the cash flows will affect Sophieclare PLC.

where the foreign currency is bought or sold today). once entered into the forward foreign exchange contract must be completed. forward contracts are tailor made i.e. they meet the exact requirements of the user in terms of quantity of foreign currency and date of delivery. It is beneficial for a company to be able to hedge the exact amount it requires but fixing the date on which exchange takes place could create problems. It is possible to have a choice of dates by using an option forward contract which will be explained later in this article. the forward exchange rate will reflect the differential in interest rates between the two countries.(This is as per interest rate parity.) Interest rate parity theory Interest rate parity is neatly defined by Buckley (1992) as the condition that the interest differential should equal the forward differential between two currencies. This may be expressed as: Forward rate = Spot rate x (1 + rf)/(1 + rUK) where rf is the foreign interest rate and rUK is the UK interest rate on an equivalent risk investment for the same period. If interest rate parity did not hold it would be possible to carry out covered interest arbitrage. Covered interest arbitrage Covered interest arbitrage is defined by Buckley (1992) as the process of borrowing a currency, converting it to a second currency where it is invested, and selling this second currency forward against the initial currency. Risk-less profits are derived from discrepancies between interest rate differentials and the percentage discount or premium between the currencies involved in the forward transaction. Example 6: Assume the spot rate between the and the US$ is $1.40/ and that the 12 month riskfree interest rates (e.g. on government stocks) are: US 5%, UK 8%. The 12 month forward rate, as predicted by IRP, will be: Forward rate = Spot rate x (1 + rf)/(1 + rUK) Forward rate = 1.40 x (1 + .05)/(1 + .08) = $1.361/ The higher UK interest rate will cause the to weaken against the $ on the forward market (put another way: the $ will stand at a forward premium against the ). IRP suggests that any gain that can be achieved from the higher UK interest rates will be countered by a corresponding depreciation in the value

The forward markets

Forward foreign exchange contracts are traded on an over-the-counter market (OTC). French (1991) refers to over-the-counter as used to describe a purchase of securities from, or sale of securities to, a dealer otherwise than on a stock exchange. Forward contracts are normally obtained from one of the major commercial banks and can be for periods of up to 10 years. The market in contracts for periods of more than one year is fairly thin which can lead to wide rate fluctuations. There are active markets in all the major currencies. For the currencies of less developed countries (LDCs) markets either do not exist or are very limited. Forward foreign exchange contracts normally mature on standard month end dates but contracts can be for exact dates; if the maturity date of the forward foreign exchange contract is not a standard month end prices are normally higher. The forward foreign exchange contract This is an agreement, entered into today, to purchase or sell a fixed quantity of a foreign currency on a fixed future date at a rate fixed today. The important features of forward contracts are: the exchange rate is agreed today but the currencies are exchanged in the future (this contrasts with use of a money market hedge, covered later in the article,

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of the on the forward market. Let us see what would happen if interest rate parity did not hold and therefore the forward rate only moves to, for example, $1.39/. The higher UK interest rates would make it possible to make a profit by: (a) raising a loan in $ at the low interest rate; (b) selling the $ at the spot rate in order to buy ; (c) placing the on deposit to earn the high interest rate; (d) buy back the $ which will be needed in 12 months in order to pay off the loan. This can be done by using a forward contract which will fix the exchange rate for 12 months time thereby removing the exchange rate risk. Required: Take an investor who borrows $2,000. Calculate the risk-free profit that could be made by carrying out covered interest arbitrage. Follow stages (a) to (d) above. Solution: (a) raise loan: $2,000; (b) sell the $ at the spot rate and receive: 2,000/1.40 = 1,429 (c) place the 1,429 on deposit to accrue to: 1,429 x (1.08) = 1,543; (d) buy back $ using a forward contract in order to pay off the loan: Buy $ for 1,543 x $1.39 = $2,145 Amount of $ loan plus interest: 2,000 x 1.05 = $2,100 Risk-free profit $45

have to pay if the currency risk is hedged using a forward contract. Solution: Sophieclare PLC needs to buy $. Therefore the appropriate rate is $1.568 which is the least favourable rate to the company (i.e. the bank always wins!). Cost in of buying $370,000 in 3 months time, in January 1996. 370,000/1.568 = 235,969. With a forward contract Sophieclare PLC agrees to buy the $ for 235,969 in October 1995 but does not take delivery of the $ or have to pay for the $ until January 1996. When, later in the article, we compare use of forward contracts with the money market hedge, it is important to appreciate when the cash flow occurs. Use of money markets for hedging currency risk (a synthetic forward) With a money market hedge the idea is either to buy or sell the foreign currency at the spot rate today thereby fixing the exchange rate today and eliminating the exchange rate risk. In the Sophieclare PLC example this would involve buying the $ (and therefore selling ) at the spot rate in October 1995. This fixes the exchange rate. The company then has a dollar asset which can be placed on deposit and then the deposit, plus interest, can be used to pay the $ liability to the supplier in January 1996. Because the $ are purchased in October 1995 it will be necessary to finance the full cost of those $ from October 1995 until January 1996. We therefore need to take into account the cost of borrowing for the three month period so we can compare the cost of the money market hedge with the cost under the forward contract which is payable in January 1996. Example 8: Use the information in Example 5 for Sophieclare PLC together with the following interest rate quotes: US$ 3 month rate: 515/16 513/16% per annum. (The higher rate is the rate at which the company can borrow $ and the lower rate is the rate at which the company can lend/ invest $, the difference being the banks profit). 3 month rate: 613/16 611/16 % per annum. Note that these rates are quoted as rates per annum. To find the actual rate charged or earned for the 3 month period you just take the rate per annum and multiply by 3/12. Required: Explain how Sophieclare PLC could use the money market in October 1995 to hedge the currency risk on the creditor of $370,000 payable in January 1996.

Solution: Firstly, we need to identify the amount in $ that Sophieclare PLC will need to place on deposit in October to accrue to $370,000 by January 1996. We need the interest rates for the 3 month period: US$ 3 month lending rate (since the company will be placing $s on deposit): 513/16 x 3/12 = 1.4531% i.e. 0.014531 Let x be the number of $ that Sophieclare PLC needs to invest now. Therefore: x (1 + 0.014531) = 370,000 Therefore x = 370,000/(1.014531) = $364,700. Sophieclare PLC will buy this quantity of $ in October 1995 at the spot rate. (The company is buying $ and will therefore obtain the least favourable rate of $1.5766/), thereby fixing the exchange rate, at a sterling cost of: $364,700/$1.5766 = 231,321. Note With a forward contract Sophieclare PLC agrees to buy the $ for 235,969 in October 1995 but does not have to pay for them until January 1996. For comparison purposes we therefore assume that Sophieclare PLC would need to borrow 231,321 between October 1995 and January 1996. We therefore need the 3 month borrowing rate: 613/16 x 3/12 = 1.7031% i.e. 0.017031. Therefore the liability in January 1996 including interest on the loan would be: 231,321 x (1 + 0.017031) = 235,261. The money market hedge is therefore the cheaper alternative resulting in a more favourable exchange rate (than the forward rate) of 370,000/235,261 = $1.5727. This is slightly worse than the spot rate in October 1995 and is a reflection of the difference between UK and US interest rates. The company has borrowed at 1.7031% and lent $ at 1.4531% resulting in a small additional cost. It is important to note that the example has ignored transaction costs which, in practice, will probably be lower when hedging using the forward market than if using a money market hedge. A significant feature of both the forward contract and the money market hedge is that, once the hedge has been arranged Sophieclare PLC is locked into an exchange rate of $1.568/ with a forward contract or an effective

As a result of many people carrying out this transaction the $ will weaken on the spot market (because of people selling $ and therefore increasing the supply of the $) and strengthen on the forward market (because of people buying back $) causing the $ to stand at a forward premium (over the spot rate) in terms of , as predicted by IRP. This is a simplified example of covered interest arbitrage. It ignores the spread on the forward exchange rates and the spread between borrowing and lending rates which would, in practice, make it more difficult to profit from arbitrage. Let us now see how forward contracts can be used by Sophieclare PLC. Example 7: Use the information in Example 5 for Sophieclare PLC together with the following forward quote obtained from the companys banker in October 1995: 3 months forward $1.568 $1.583. Required: Calculate the amount that Sophieclare will

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exchange rate of $1.5727/ with the money market hedge. This is because the forward contract fixes the rate in October 1995 and with the money market hedge the foreign currency is bought and the borrowing and lending agreed in October 1995. If the spot rate in January 1996 had in fact moved to $1.8500/ then the forward contract and the money market hedge would, with hindsight, result in a higher cost than could have been obtained by using the spot market in January 1996, i.e. the company is prevented from benefiting from the favourable spot rate. Example 9: In recent years there have been cases where German and Japanese airlines have made the mistake of hedging using forward contracts. These airlines pay for their aircraft in US$ and are therefore concerned that the US$ may strengthen against the D-Mark or the Yen between the time of placing an order for the aircraft and paying for the aircraft. Unfortunately for the airlines they purchased US$ using forward contracts. In the period between taking out the forward contracts and paying for the aircraft the US$ weakened against the D-Mark and the Yen resulting in losses or, put another way, the aircraft cost more than would have been incurred if the airlines had not entered into forward contracts. Such losses may have been alleviated by using currency options which are a more flexible, albeit more costly, approach to hedging. Currency options will be discussed in a later article. Option forward contracts (also known as a forward option contract, option date forward contract or forward option dated contract) This is not the same as a currency option contract explained in a later article. An option forward contract offers the same arrangement as a forward contract except that there is a choice of dates on which the user can exercise the contract. This is either: on any date up to a specified date; or at any time between two future dates. In either case the forward rate that applies would be the forward rate, in the period in which the contract can be exercised, that is least favourable to the purchaser of the contract. Example 10: Assume it is now May 1996. A UK company is due to receive US$ from a US customer in August 1996. The UK company decides to sell the $ using a forward contract. If the customer is late paying the company would still have the obligation to sell the $ to the

bank in August 1996. The company could be forced to buy $ on the spot market in August 1996 in order to meet the obligation to the bank, leaving the problem of what to do with the $ receivable from the customer when he/ she eventually pays. This situation should not be allowed to arise. Now try the following example which requires you to use a forward contract and a money market hedge. Example 11: Assume it is now October 1995. William PLC is a UK company which exports goods to the USA. Rachel Inc., one of the customers of William PLC, is due to pay $2,140,000 in 6 months time in April 1996. William PLC is concerned that the $ may weaken against the before the $ are received. Exchange rates Spot rate: $1.5766 $1.5775/. Forward rates: 6 month forward rate $1.5708 $1.5739/ 9 month forward rate $1.5665 $1.5709/ Interest rates: US$ 6 month rates: 57/8 511/16 % per annum and 6 month rates: 613/16 611/16 % per annum. Required: (a) Evaluate which is the best method for William PLC to hedge the currency risk on this transaction: (i) a money market hedge; or (ii) a forward contract. (b) You are told that, in the past, Rachel Inc. has not always paid on the due date and has sometimes paid up to three months late. What amount would be received if William PLC used an option forward contract to hedge the risk? Solution: (a) (i) Money market hedge. In this example William PLC will need to borrow $ in October 1995 and then use the $ received from Rachel Inc. in April 1996 to pay off the loan plus interest. The $ borrowed in October can be sold at the spot rate. Then the proceeds can be lent for 6 months. Relevant interest rates (note it is a 6 month period, not 3 months as in the previous example): US$ 6 month borrowing rate: 57/8 x 6/12 = 2.9375% i.e. 0.029375. 6 month lending rate: 611/16 x 3.3437% i.e. 0.033437.
6

Let $ x be the amount borrowed now so that: $x(1 + 0.029375) = $2,140,000. Therefore $x = $2,140,000/1.029375 = $2,078,931 = amount of loan taken out in October. In effect we are calculating the present value of the $2,140,000 using the rate of interest on the loan (for the appropriate time period) as the discount rate. The $2,078,931 proceeds from the loan can now be converted to at the spot rate. This fixes the exchange rate in October and therefore eliminates the exchange risk. Amount of received: $2,078,931/1.5775 = 1,317,864. (The $2,140,000,when received, will exactly pay off the loan, assuming the customer pays on time!) The proceeds can be used now for investment. Value in April 1996: 1,317,864 x (1 + 0.033437) = 1,361,929. This figure is comparable with the proceeds from a forward contract which will also be received in April 1996. (a) (ii) Forward contract. William PLC will receive: $2,140,000/1.5739 = 1,359,680. Hence in this case William PLC will be better off using the money market to hedge the risk. (b) Using an option forward contract to hedge the risk William PLC will get the worst of the 6 month and the 9 month forward rates. 6 month forward rate: 2,140,000/1.5739 = 1,359,680. 9 month forward rate: 2,140,000/1.5709 = 1,362,276. The proceeds will therefore be 1,359,680. In the next article we will consider futures contracts and the ways in which they can be used to hedge currency risk. References Brealey, R.A. and Myers, S.C. (1996) Principles of Corporate Finance, McGraw Hill, New York. Brown, N., Kaur, P., Maugham, S. and Rendall, J. (1994) Financial Strategy, Certified Accountants Educational Projects, London. Buckley, A. (1992) Multinational Finance, Prentice Hall, New York. French, D. (1991) Dictionary of Accounting Terms, The Institute of Chartered Accountants in England and Wales, London. Demirag, I and Goddard, S. (1994) Financial Management for International Business, McGraw Hill. Shapiro, A. (1995) Multinational Financial Management, Allyn and Bacon, Boston.

/12 =

It is first necessary to calculate the amount of $ to borrow now in order to have a balance outstanding (initial loan + interest) of $2,140,000.

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Foreign currency exposure management: part 2

Futures contracts
Nigel Brown BA FCA is a senior lecturer in Financial Strategy at the University of Wales College, Newport

his is the second in a series of five articles. The aim of the series is to develop an understanding of the effect foreign currency risk may have on a firm and of some of the techniques that are available for eliminating or reducing that risk. In the first article we examined the types of currency risk to which a firm may be exposed. Then we looked at two methods which can be used to protect a firm against that risk: forward contracts and a money market hedge. In this and the next article we continue our study of methods of hedging risk by considering futures contracts.

rency futures and stock index futures. Our main concern in this series of articles is with currency futures. Futures contracts are traded on recognised exchanges with prices generally agreed on an open outcry basis on the floor of the exchange (by people dressed in brightly coloured jackets!). Open outcry is described by Buckley (1992) as a kind of auction system used by futures markets under which all bids and offers are made openly by public, competitive outcry and hand signals. Please note that futures contracts are NOT traded on an over-the-counter (OTC) market and therefore are not tailor-made to the customers requirements. The specifications of each contract e.g. quantity of currency and date for delivery of that currency are determined by the futures exchange. A firm wishing to use these contracts to hedge currency risk therefore has to decide on: the number of standard contracts; and the delivery date (there are only a limited number of delivery dates each year) which best suits their requirements; they may well not get an exact match with the sum of foreign currency they need to hedge. We will use the Sophieclare PLC example from the first article, which is reproduced below, to illustrate these limitations.

US$ is the home currency and therefore is the foreign currency. The contract size is 62,500 (i.e. this is the quantity of foreign currency you can buy or sell with each contract) and in October 1995 the following contracts were quoted in the Financial Times: Contract December (1995) March (1996) Price $1.5744/ $1.5710/

What is a futures contract?

A futures contract is an agreement to sell or buy a standard quantity of a particular financial instrument or commodity on a predetermined delivery date in the future. In the case of currency futures contracts the financial instrument is a foreign currency.

So how can Sophieclare PLC use currency futures contracts to hedge the risk? We will tackle this problem in stages in this article and the following article as we introduce the various features of currency futures. It is first necessary to decide: Which delivery date? Sophieclare PLC needs to buy US$ for delivery in January 1996 but there are no contracts with a January delivery date. The December contract cannot be used since the delivery date is before Sophieclare is due to pay the US supplier Benjaminpaul Inc. (Sophieclare would then have to purchase the currency before it was needed which would involve unnecessary additional financing costs). The company will therefore have to use the March contract. The delivery date for the March contract is too late but it is still possible, as will be explained later, to use the contract to hedge the currency risk. How many contracts? This is awkward since the standard contract size is expressed in whereas the company has to pay its supplier US$370,000. To give us an approximation of the contract size in US$s we can use the currency futures price in March: 62,500 x 1.5710 = $98,187. Therefore the number of contracts needed is: $370,000/98,187 = 3.77 contracts. It is not possible to buy or sell part of a contract. Hence Sophieclare PLC will need to choose the nearest whole number of contracts. i.e. 4 contracts. The difficulty with delivery dates and contract sizes does not arise with a forward contract since the firm can specify its exact requirement and the bank will then quote the terms of a forward contract which will meet those requirements. Before we can show how currency futures can be used by Sophieclare PLC we need to study some other features of futures contracts.

Commodity futures
There is a wide range of commodity futures which cover everything from pork bellies and live cattle to copper and gold. For example, gold futures contracts are traded on the New York Commodity Exchange (COMEX). Each gold futures contract is for 100 troy ounces (a troy ounce is part of the system of weights used for precious metals and gems) and prices are quoted in US$ per troy ounce. Prices are quoted daily in the Financial Times. For example, on 7 February 1996 prices were quoted for February 1996, April 1996, June 1996, August 1996, October 1996 and December 1996 contracts; the month of the contract is the month in which the purchaser of the futures contract would take delivery of the underlying 100 ounces of gold. Commodity futures contracts may be used to protect a firm from volatile market prices. For example farmers can use commodity futures to fix, in advance, the price at which they can sell their produce. Chocolate manufacturers can use cocoa futures contracts to fix, in advance, the price they pay for cocoa, which is one of the main raw materials in chocolate (suddenly I feel hungry!).

Example 1
Assume it is now October 1995. Sophieclare PLC, a UK company, owes Benjaminpaul Inc., a US supplier, $370,000 payable 3 months later in January 1996. The spot rate in October 1995 is $1.5766 $1.5775/ and Sophieclare PLC is concerned that the $ may strengthen against the before payment is made. Since currency futures contracts are not traded in London the relevant contracts for Sophieclare to use are sterling () futures which are traded on the International Monetary Market (IMM) in Chicago. These contracts enable firms to: buy (and therefore sell $); or sell (and therefore buy $) for future delivery. Since the contracts are traded in the USA the

Financial futures
There are three main types of financial futures contract: interest rate futures, cur-

TECHNICAL 5

Clearing house
The futures exchange uses a clearing house which has as its main objective the guaranteeing of performance of the transactions carried out on the floor of the futures exchange. It also administers the system of margins which are explained in the next section. Each transaction is reported to the clearing house by members of the exchange so that both sides of the transaction can be matched and confirmed to the parties to the transaction. Once a transaction has been confirmed its performance is guaranteed by the clearing house. Each party to the transaction is then obligated to the clearing house to carry out the transaction; this has the effect of transferring the credit risk on the transaction to the clearing house. (credit risk is the risk that the buyer or seller of the contract may default on his or her obligations).

farmer who takes life very seriously. One particular concern for him is the fact he wants to buy 300oz of gold but he does not want to buy it just yet, he wants to wait until after Christmas. Clive is concerned that the price of gold may go up before he is able to buy it. His brother Paul, who has just attended a course at Newport Business School, about futures contracts, suggests that Clive could use the gold futures contracts traded on the New York Commodity Exchange (COMEX). These contracts have a contract size of 100 troy ounces and are priced in US$ per ounce. In October 1995 Paul obtains the following quotes: Contract Nov. Dec. Jan. Price ($ per troy oz) $385.4 $386.6 $388.4

If we take the period as a whole Clive has, in effect: bought 300 ounces of gold for ($388.40 x 300) = $116,520 and sold it for ($385.60 x 300) = $115,680 Loss Margin account Date Cash payments to/from Clive Variation Closing margin balance on margin account $570 $6,570 $4,770 $4,290 $7,530 $840

25 Oct. Clive pays $6,000

26 Oct. Clive receives $570 $1,230 27 Oct. Clive pays $1,230 28 Oct. Clive pays $1,710 29 Oct. Clive receives $7,530 Net payment $840 $1,710 $1,530

Margins
The market price of the futures contract, which in the case of currency futures is the exchange rate, will change throughout the time between the date of someone buying or selling a futures contract and the delivery date. There is a possibility that the price will move against the person/company buying or selling the contract resulting in a loss. In some cases the person/company may not be able to pay the loss thereby defaulting on the contract. This is a potential problem with futures contracts because, if there were no margins, contracts could initially be bought or sold without having to pay any consideration. The idea of the margin is to minimise the possibility of defaults occurring on contracts and goes together with the fact that the clearing house takes on the credit risk of the futures contracts. Consequently a company wishing to buy or sell a futures contract must deposit a specific amount of cash, referred to as an initial margin or deposit margin, with the clearing house of the exchange. The profit or loss on the position held by the person/company is calculated at the end of each trading day and transferred to or from the margin account. This procedure is referred to as marking to market the account. This adjustment to the margin account results in variation margin being: received from the clearing house when profits are accruing on the contract; or paid to the clearing house when losses are accruing on the contract. The following example shows the relationship between movements in the futures price and the margin cash flows.

Assume the initial margin on this contract is $2,000. On the morning of 25 October Clive decides to buy 3 January gold futures contracts at the price quoted of $388.4. In effect he is agreeing to buy gold in advance at a price of $388.4. In the first few days following purchase the January contract price moves as follows: Date 25 October 26 October 27 October Price of January futures contract at close of business $390.3 $386.2 $380.5

This example shows that it is possible to buy and sell futures contracts without taking delivery of the underlying instrument or commodity (in this case the gold). It may be desirable to do this if, as in the case of Sophieclare PLC the delivery date of the futures contract does not meet the companys requirements. We will see how this approach can be applied to Sophieclare PLC in the next article.

On 28 October Clive changes his mind and decides to sell (referred to as closing out) the futures contracts at $385.6. Required: Calculate the initial margin payment and the variation margin transactions that will arise. Solution: Purchase of 3 contracts involves a total of 3 x 100 = 300 ounces of gold and an initial margin of $2,000 x 3 = $6,000. Calculation of profit or loss 25 October Price has increased therefore profit = ($390.3 $388.4) x 300 = $570 26 October Price has decreased therefore loss = ($386.2 $390.3 ) x 300 = $1,230 27 October Price has decreased therefore loss = ($380.5 $386.2 ) x 300 = $1,710 28 October Price has increased therefore profit = ($385.6 $380.5) x 300 = $1,530 The overall position is a loss of ($570 $1,230 $1,710 + $1,530) $840 which is equal to the net price movement over the period.

Taking a position in a futures contract

A person or firm can buy a futures contract which is referred to as taking a long position. A long position is defined by Buckley (1992), in terms of currencies, as having more assets than liabilities in a given currency. In Example 2 Clive took a long position in gold futures contracts having bought 3 contracts as a result of which he would have been able to take delivery of 300 ounces of gold at the price of $388.4. Alternatively a person or firm can, as a first step, sell a futures contract. This is referred to as taking a short positon. A short sale is defined by Brealey and Myers (1996) as a sale of a security that the investor does not own. If, in Example 2, Clive believed that gold was going to fall in price and wished to try to make a profit from that opinion he could, on 25 October, sell gold futures contracts instead of buying them. In effect he would be selling gold he did not own. He could then, if the price did fall, buy the gold futures contracts back more cheaply and make a profit.

Example 2
Assume it is now October 1995. Clive is a

TECHNICAL

Once a firm has initially either bought or sold a futures contract the firm then has an open contract on which profits or losses will accrue until the contract is closed out. In Example 2 Clive has an open position in 3 contracts between the time they are purchased on 25 October to the time they are sold on 28 October. During that period profits or losses accrued on those contracts.

How to close out a position in a futures contract

Assuming one has bought a futures contract the contract can be closed out by either: selling the same futures contract in the market, before the delivery date, to realise the profit or loss. In Example 2 this is the course of action that Clive took on 28 October when he sold the contracts; or taking delivery of the underlying commodity or financial instrument at the price fixed when the futures contract was originally bought or sold. Clive could, if he had not sold the contracts on 28 October, have taken delivery of 300 ounces of gold in January at the price of $388.40 per ounce, the price that was fixed when the contracts were purchased in October. In practice, taking delivery of the underlying commodity or financial instrument is less likely to occur than selling the same futures contract in the market. This is because, as was shown in the case of Sophieclare PLC in Example 1, the delivery dates are unlikely to suit the firms requirements. Currency futures contracts are described in terms of the month in which delivery is to take place (usually March, June, September or December).

type of contract. These minimum price movements are referred to as ticks (not to be confused with tiny insects!). In the case of sterling futures contracts, which have a contract size of 62,500, the tick size is 0.01 cents (or $0.0001) per 1. Therefore, on this contract, each price movement of 1 tick has a value of: 0.0001 x 62,500 = $6.25. This value can be used to calculate the profit or loss made on the futures contract. It may seem strange to be multiplying by $ but the tick value is in $ because this particular currency futures contract is traded in the USA on the IMM. The price of this contract is quoted daily in the Financial Times.

The futures contracts can therefore be used to enhance or gear the size of profits but unfortunately this will also gear the size of potential losses. It is important to note that this gearing only applies if the futures contracts are held with no corresponding position in the underlying asset. If, as with Example 1 Sophieclare PLC, a company has a $ liability and therefore buys those $ forward using futures contracts the profit or loss on the futures contracts will be approximately equal to the profit or loss on the $ liability to the supplier. A far more risky strategy would be for a UK firm, with no $ due from suppliers, to take a view that the $ was going to strengthen and therefore use currency futures to buy $s. Here is an example of how such a strategy can go horribly wrong.

Rollover of futures contracts

If the delivery dates of the available futures contracts are prior to the date to which a hedge is needed a firm may roll the hedge forward. This is achieved by closing out one futures contract and simultaneously taking the same position in another futures contract with a later delivery date. There is a risk that the price at which the futures contract is closed out is not the same as the price of the new futures contract.

Showa Shell Sekiyu

The treasury department of a Japanese company 50% owned by Shell became involved in speculating: they formed the opinion that the US$ was going to strengthen against the Yen. As a consequence of this belief they bought a number of US$/Yen currency futures contracts with a total value of $6.4 billion. Unfortunately (to say the least!) for them the US$ weakened against the Yen resulting in a loss on the futures contracts. Perhaps the most alarming part of this case is what happened next: the treasury department rolled over the currency futures contracts apparently in the belief that the US$ would still strengthen against the Yen. Needless to say this did not happen. Rolling over the currency futures contracts had the effect of preventing the losses from coming to light (though one has to ask where were the internal auditors?) and over a period of three years losses accumulated to $1 billion and could reach $11.35 billion!

Gearing
Futures contracts enable users to take a position in a quantity of commodity or financial instrument without having to incur the full cost at the outset. The bulk of the contract is paid at the time of delivery, if the contract is not closed out beforehand. When a firm takes a position in a contract the only cost is the initial margin which is usually between 1% and 5% of the value of the underlying instrument. This makes it possible to gear up the returns on the transaction: enlarging gains (in relation to the size of the initial investment) if the market moves in the users favour and similarly enlarging losses if the market moves against the user.

The importance of the market price of futures contracts

The market prices of futures contracts alter as a direct result of a change in the price of the underlying commodity or financial instrument on the spot market. So, for example, the market prices of currency futures contracts alter as a direct result of a change in the currency exchange rate on the underlying spot market. Because of the standard nature of the contracts, the delivery dates of the contracts are unlikely to be suitable. Hence futures contracts are mainly used to take advantage of their market price movements. Therefore, in the case of currency futures contracts, the actual foreign currency would be bought or sold in the spot market.

Hedging efficiency
A perfect hedge is a hedge which exactly covers the risk. A forward contract provides a perfect hedge. A perfect hedge would result in any loss on the spot market being avoided by making a profit on the futures contract equal to that loss (well see how later). When using futures contracts it is difficult to achieve a perfect hedge (or hedging efficiency of 100%). One reason for this is the standard size of the futures contracts which may not exactly fit the requirements of the firm. The other reason for this is referred to as basis risk.

Example 3
In Example 2, in return for a margin payment of 3 x $2,000 = $6,000 Clive was able to obtain a beneficial position in gold with a total future value of $388.4 x 3 x 100 = $116,520. Lets compare the % profit or loss that could be made by: (i) buying futures contracts; and (ii) buying the underlying gold. Assume Clive is able to buy gold on the spot market on 25 October at a price of $388.4. Date Profit % profit % profit or or (loss) or (loss) (loss) on on futures gold contracts 25 Oct. $570 570/6,000 570/116,520 = 9.5% = 0.5%

Basis and basis risk

Basis is explained well by Buckley (1992): with respect to futures contracts, the basis represents the difference between the price of the cash commodity and the related fu-

Tic k s
The futures exchange specifies the minimum price movement permitted for each

26 Oct. ($1,230) 1,230/6,000 1,230/116,520 = (20.5%) = (1%)

TECHNICAL 5

tures contract, a difference that widens or narrows as the cash and futures prices fluctuate. If you think back to the previous article you should recall that the difference between the spot exchange rate and the forward exchange rate is, as per interest rate parity, caused by a difference in interest rates of the two currencies. This difference in interest rates, if any, will cause a similar difference, the basis, between the spot exchange rate and the currency futures price. Basis risk is the risk that the price of the futures contract may not move exactly in line with the price of the commodity or financial instrument being hedged. We can see from the figures in Example 4 that the spot prices and futures prices do not move together and therefore the size of the basis alters daily. The basis is caused by several factors, such as differences in supply and demand in each of the two markets. The existence of basis results in basis risk. A full analysis of basis and basis risk is beyond the scope of this article and of the paper 14 syllabus. There is also basis risk in the case of currency futures contracts. The exchange rate specified by the price of the currency futures contract will not necessarily move in line with the exchange rate in the spot market.

Example 4
The following data has been extracted from the Financial Times, February 1996: Date Price of April futures contract $417.7 $415.9 $414.6 1.8 1.3 Price Spot movement market price $415.4 $414.5 $411 0.9 3.5 $4.4 change rate means that the firm will make a profit when using the spot market but will incur a loss when it closes out its position in the currency futures contracts. Trading methods. Forward contracts may be obtained via telephone or telex whereas futures contracts are traded by open outcry in a trading pit on the floor of a futures exchange. Access to the markets. It is difficult for individuals and small companies to access the forward market whereas individuals and companies may use the futures markets. Delivery of currencies. Forward contracts are normally entered into with a view to taking delivery of the currencies whereas currency futures are normally closed out before the delivery date. Price quotation. With forward contracts a bid and offer price is quoted and the size of the spread depends on the value of the contract and on the size of the customer. With currency futures a single price is quoted. Overall, forward contracts are easier to understand and report and tend to be more popular than currency futures. Before employing either method in practice the corporate treasurer would need to check the local tax treatment of these instruments. In the next article we will look at how currency futures contracts can be used to hedge currency risk. References Brealey, R.A. and Myers, S.C. (1996) Principles of Corporate Finance, McGraw Hill, New York. Brown, N., Kaur, P., Maugham, S. and Rendall, J. (1994) Financial Strategy, Certified Accountants Educational Projects, London. Buckley, A. (1992) Multinational Finance, Prentice Hall, New York. French, D. (1991) Dictionary of Accounting Terms, The Institute of Chartered Accountants in England and Wales, London. Demirag, I and Goddard, S. (1994) Financial Management for International Business, McGraw Hill. Shapiro, A. (1995) Multinational Financial Management, Allyn and Bacon, Boston. Price movement Basis = spot price futures price $415.4 $417.7 = $2.3 $414.5 $415.9 = $1.4 $411 $414.6 = $3.6

Feb. 5 Feb. 6 Feb. 7

Total price movement $3.1 margin and therefore incur the financing cost thereof (though margins may be interest bearing). Commissions. The commission on a forward contract may either be subject to agreement between the parties to the contract or implied in the dealers spread (between bid and offer rates). In the case of currency futures there is always a commission, payable either when the position is closed out or when delivery takes place, which is a flat rate for small transactions or may be negotiable for larger deals. Commissions are usually ignored in examination questions. Uncertain dates. If a firm is unsure of exactly when it will need to buy or sell the foreign currency it can, in the case of forward contracts use a forward option dated contract. This will result in the firm getting the least favourable exchange rate over the option period. In the case of currency futures contracts the firm has more flexibility since it can alter the day on which it closes out its position in the futures contract (as long as this is prior to the delivery date of the future contracts). Uncertain cashflows. If a firm is unsure whether it will actually need to buy/sell foreign currency as in the case of tendering for a contract then it should not use a forward contract: once entered into the forward contract must be fulfilled. Similarly use of currency futures is not recommended in these circumstances: taking a position in a currency futures contract commits the company to incurring a profit or loss on that contract until it is closed out. Hence, if a position is taken in a currency futures contract and the associated foreign currency transaction fails to materialise the company is left with the profit or loss on the futures contracts. When cash flows are uncertain a firm should use currency options which we will examine in a later article. Potential for profits. If the exchange rate moves in favour of the firm then, if it has used a forward contract to hedge against an adverse exchange rate movement, it will not be able to take advantage of the favourable spot rate; the forward contract must be honoured. The position is similar for currency futures: a favourable movement in the ex-

Comparison of currency futures contracts with forward contracts

The following are the ways in which currency futures differ from forward contracts: Size and delivery dates of contracts available. Forward contracts are tailor made to the customers specific requirements in terms of size and date. Currency futures are only available in standard contract sizes for delivery on a limited number of dates which may make it impossible for a firm to obtain the exact cover it requires. Hedging efficiency. A forward contract fixes the exchange rate for the firm and therefore provides a perfect hedge. A currency futures contract is likely to lock in the exchange rate at a different level to the forward market hedge and may not provide a perfect hedge. The position taken in the currency futures contract should result in a profit if the spot rate moves against the firm. However the loss a firm incurs on the spot market may be more than the profit made by the firm on the futures contract because of basis risk. Margin requirements. Forward contracts do not have a margin requirement and therefore no payment has to be made until the contract is settled. Currency futures involve the firm in having to deposit an initial

TECHNICAL

Foreign currency exposure management: part 3

Currency futures contracts T

his is the third in a series of five articles. The aim of the series is to develop an understanding of the effect foreign currency risk may have on a firm and of some of the techniques that are available for eliminating or reducing that risk. In the second article we introduced futures contracts. In this article we will continue our study of futures contracts by considering currency futures contracts in more detail. or

Nigel Brown BA FCA is a senior lecturer in Financial Strategy at the University of Wales College, Newport

of the standard futures contract;

2 Close out its position in the futures contracts by selling the futures contracts, just before delivery, at 0.5842 $/DM resulting in a profit. The company would then need to buy the DMs in the spot market. The amount of profit on the futures contracts is calculated as follows:
(number of contracts) x (number of ticks by which x (the tick value) the price has changed)

What is a currency futures contract?

A currency futures contract is a contract to purchase or sell a standard quantity of a foreign currency for delivery, at a specified location, on one of a limited number of future dates. Most currency futures contracts are expressed in terms of the US$ against other major currencies. Hence the home currency is the US$. Pricing of a currency futures contract Currency futures contracts are priced in terms of the underlying exchange rate.

Required: (a) Calculate the $ cost of taking delivery under the futures contract. (b) Calculate the amount of profit earned from closing out the futures contracts together with the cost of buying the DM in the spot market and therefore the net $ cost of the transaction. Solution (a) $ cost of taking delivery of the DM under the futures contract: 125,000 x 3 x 0.5729 = 375,000 x 0.5729 = $214,837

Example 1
Assume that in January 1996 a March 1996 $/DM futures contract is quoted at $0.5729 (this is the direct quote which is the number of domestic currency units, the $, needed to buy one unit of foreign currency, the Deutsche Mark [DM]). This means that the futures market will buy or sell DM for US$ for future delivery, in March, at an exchange rate of US$0.5729/DM. If a US company Clinton Inc. wished to hedge the risk of the DM strengthening against the US$ it would buy an appropriate number of $/DM currency futures contracts referred to as a long hedge, i.e. this means the firm has agreed to buy DM on the future delivery date at the exchange rate specified by the futures price. The $/DM contracts, which are traded on the International Monetary Market (IMM) in Chicago, are for DM125,000 with a tick size (minimum price movement) of .01c, which is .01/100 = $.0001 and therefore a tick value of 125,000 x .0001 = $12.50. This value can be used to calculate the profit or loss made on the futures contract. Clinton Inc. is due to pay DM375,000 to a German supplier in March 1996 which just happens to be the date on which the March currency futures contracts mature. In January 1996 Clinton Inc. buys 3 March futures contracts at a price of $0.5729/DM. The spot rate in January 1996 is $0.5726/DM. In March 1996, immediately prior to delivery, the futures contract price has changed to $0.5842/DM and the spot rate to $0.5839/DM. In this case the firm has two choices: 1 Take delivery of the DM at the futures rate of $0.5729/DM. NB. This choice is only available because the quantity of DM and the date the currency is required both happen to match the specification

(b) Profit from futures contract: There is a profit since Clinton has effectively bought DM in January for $0.5729/DM and then sold DM in March for $0.5842/DM. The price movement as a number of ticks: (0.5842 0.5729)/0.0001 = 113 ticks The profit is therefore: 3 contracts x 113 ticks x 12.50 = In practice Clinton would receive this profit in the form of variation margin, as it arises during the 3 month period. (As happened with Clive in Example 2 in the previous article.) Purchase of the DM on the spot market at a cost of: 375,000 x 0.5839 = Net cost $218,962 $214,725 ($4,237)

which is similar to the cost in (a).The difference is caused by basis risk (the risk that the price of the futures contract may not move exactly in line with the exchange rate on the spot market) which affects the cost of (b). Examples of currency futures contracts In addition to the DM contracts mentioned in Example 1, the following currency futures contracts are traded on the International Monetary Market (IMM) in Chicago:

TECHNICAL 2

Contract
$/SFr

Contract size
SFr 125,000

Tick size
.01c per SFr

Tick value
125,000 x .01 = $12.50 100

Forward contract US$ cost: 5,100,000 x 0.6936 = $3,537,360

(SFr = Swiss Franc) $/Yen $/ Yen 12.5m 62,500 .0001c per Yen 12,500,000 x .0001 = $12.50 100 .01c per 62,500 x .01 = $6.25 100

Therefore the forward contract is, with hindsight, the better choice.

To hedge or not to hedge?

In Example 2 both methods have resulted in the company achieving a less favourable rate than could have been achieved if no hedge had been used. The hedge was to insure against the DM strengthening. Unfortunately it weakened! Having taken a position in futures contracts in January, the company is committed to that position and, in April, cannot avoid the loss on those contracts. Similarly if the company had bought DM forward in January it would have to honour the forward contract in April even though the rate has moved against the firm. The important point is that, in January, the company does not know what the exchange rate will be in April. If the firm wishes to hedge the risk in January it must take action in January. If the company chooses to use forward contracts, a money market hedge or futures contract there is a possibility that the exchange rate will move in the companys favour and that the company would therefore, with hindsight, be better off without the hedge. But thats like saying that if we insure our homes against a fire taking place over the next year and it turns out that there is no fire then we would have been better off without fire insurance. The key point is that in the case of fire insurance the risk I would have to take (of losing my house) in order to save the fire insurance premium is, to me and the provider of my mortgage, too high to take. For a company deciding how and whether to hedge currency risk one key element of the decision is how large is the risk? If the transaction is of small value it may be acceptable not to hedge the risk. In the case of transactions of a material size it is advisable for firms to hedge the currency risk. Currency options offer the ability to hedge the risk (protecting the firm against adverse movements in the exchange rate) while allowing the firm to benefit from favourable movements in the exchange rate. We will discuss currency options in the next two articles.

As the above selection suggests most currency futures contracts are expressed in terms of the US$ against other major currencies. Trading of currency futures contracts on LIFFE (The London International Financial Futures and Options Exchange) has been discontinued due to lack of demand; currency futures contracts are now handled on the US markets. Now try the following example.

Example 2
Festina Inc. is a US company which buys components from Germany. Assume it is now January 1st. The company is due to pay DM5.1 million in 4 months time, in April, and the finance director is worried that the DM may strengthen against the US$. On January 1st the spot rate is $0.6901$0.6905/DM and the price of the June currency futures contracts is $0.6958/DM and the forward rate for April, quoted by the bank, is $0.6904$0.6936/DM. Required: Evaluate whether, with the benefit of hindsight, the company would have been better to use currency futures contracts or a forward contract to hedge the currency risk if the currency futures price in April was $0.6894/DM and the spot rate in April was $0.6895 $0.6898/DM. Ignore margin requirements. Solution: Currency futures contracts: Number of contracts: 5,100,000/125,000 = 40.8 Since the firm can only obtain a whole number of contracts it will need to use 41 (nearest whole number to 40.8) contracts which will result in a position in 41 x 125,000 = DM5,125,000. This mismatch is unavoidable if using futures contracts and is likely to result in less than a perfect hedge. (A perfect hedge is a hedge which exactly covers the risk). Action required: January: Buy 41 contracts (i.e. need to buy DM, the foreign currency) at a price of $0.6958/DM. April: Close out the futures contracts by selling 41 contracts (selling the DM) at $0.6894/DM, receiving less $ than the cost in January which would result in a loss. No. of ticks: (0.6894 0.6958)/.0001 = 64 ticks $32,800

Futures contracts in paper 14 examination questions

Before we look at a more comprehensive example on currency futures it may be helpful to summarise the main steps that are necessary in order to derive an answer: Stage 1: Identify contract specification and calculate tick value. The details of the relevant contract should be stated in the question. Stage 2: How many contracts are needed? Remember to select the nearest whole number of contracts. Stage 3: Calculate the initial margin. You may be able to ignore margin payments. If necessary calculate the initial margin (number of contracts x margin per contract) which will be in $. The company will therefore need to buy $ at the spot rate. Stage 4: Close out the contracts. At the end of the period for which the hedge is needed the company will need to: (a) Buy/sell the appropriate currency on the spot market: (b) Close out the futures contracts. Alternatively, though extremely unlikely, the firm may

There is therefore a loss on the futures contracts of: 41 contracts x 64 ticks x $12.50 = Buy the DM on the spot market in April at a cost of: 5,100,000 x $0.6898 = $3,517,980 Total cost * before allowing for margin. In practice Festina would have had to deposit a margin with the clearing house in January. The loss on the futures contracts will then have been paid as it arose during the period from January to April as a variation margin. $3,550,780*

TECHNICAL

simply take delivery of the currency under the futures contracts at the initial futures price. Stage 5: Calculate the gain or loss on the margin. This will arise since, when the hedge is arranged, the firm has to buy $ at the spot rate in order to deposit the margin with the clearing house. At the end of the period the margin will be converted back into at the spot rate resulting in a profit or loss.

Solution We noted in the second article that, of the two futures contracts listed in the example, Sophieclare can only use the March contract since the December contract will have expired by January. Also it is not possible to use the March contract to actually buy the currency since the currency is not delivered under the contract until March. The company will therefore have to close out the contracts in January to realise the profit or loss. Stages 1 to 3 will be common to both parts of the answer. We have dealt with certain aspects of this answer in the second article but, for the sake of clarity, the answer is shown here in full. Stage 1: Identify contract specification and calculate tick value. Contract size 62,500, tick size .01c/ and therefore tick value: 62,500 x .01/100 = $6.25. Stage 2: How many contracts are needed? At the March futures price of $1.5710 / the $370,000 is equivalent to 370,000/1.5710 = 235,519. To hedge the exposure it is necessary to sell sterling futures contracts (since the company wants to sell , which is the foreign currency, in order to buy $, the home currency, to pay the supplier). It will need: 235,519/62,500 = 3.8 contracts ( i.e. 4 contracts, to the nearest whole number). Hence, the company will need to sell 4 contracts at a price of 1.5710 $/. Stage 3: Calculate the initial margin. This has to be paid to the clearing house in October 1995. Sophieclare PLC will need to deposit an initial margin of 4 x 2,500 = $10,000 which, at the spot rate in October 1995, will cost: $10,000/1.5766 = 6,343. (a) Spot rate in January 1996: $1.3800 $1.3809/, March futures contract price $1.3823/. Stage 4: Close out the contracts. In January 1996 the company will need to carry out two transactions: (i) Buy $ on the spot market: Cost: $370,000/1.3800 = (ii) Close out the futures contracts by buying 4 contracts at the price of 1.3823$/. The price has changed by: (1.5710 1.3823)/.0001 = 1,887 ticks. Therefore the total futures gain is: 4 contracts x 1,887 ticks x $6.25 = $47,175. The company will sell the $ profit, at the spot rate in January, to realise: 47,175/1.3809 = (In practice this will have been received as variation margin from the clearing house during the period from October to January) Because the $ has strengthened there is a margin gain: When the initial margin is returned it is worth: $10,000/1.3809 = 7,242 less initial cost Margin gain Net cost (6,343) (899) 233,055 (34,162) 268,116

Example 3
Let us now return to the example we have used in each of the first two articles concerning Sophieclare PLC. Just to remind you, we calculated the following costs in those articles: Money market hedge: 235,261 Forward contract: 235,969 We now need to see how Sophieclare could use currency futures contracts. The data from the original example is repeated for convenience. Assume it is now October 1995. Sophieclare PLC, a UK company, owes Benjaminpaul Inc., a US supplier, $370,000 payable 3 months later in January 1996. The spot rate is $1.5766$1.5775/ and Sophieclare PLC is concerned that the $ may strengthen against the before payment is made. The finance director has obtained the following quotes from the International Monetary Market in Chicago: Sterling futures 62,500 (tick size 0.01c) Contract December March Price $1.5744/ $1.5710/

Initial margin $2,500 per contract. Required: Calculate whether, with the benefit of hindsight, the sterling cost of hedging the currency risk using currency futures contracts is better (i.e. lower) than the cost of using a money market hedge of 235,261. Assume for the purposes of your evaluation that in January 1996: (a) the spot rate was $1.3800$1.3809 and the March currency futures were priced at $1.3823/; (b) the spot rate was 1.85001.8510 $/ and the March currency futures were priced at $1.8524/. Ignore taxation and any interest that Sophieclare PLC could earn on the margin.

Hence the futures contract is cheaper than the money market hedge. This is partly because with the futures hedge a larger position is being taken in the $, which strengthened, since we used 4 contracts whereas only 3.8 contracts were needed.

TECHNICAL 3

(b) The spot rate was 1.8500 1.8510 $/ and the March currencies futures were priced at $1.8524/. Stage 4: Close out the contracts. In January 1996 the company will need to carry out two transactions: (i) Buy $ on the spot market: Cost: $370,000/1.8500 = (ii) Close out the futures contracts by buying 4 contracts at the price of 1.8524$/. The price has changed by: (1.5710 1.8524)/.0001 = 2,814 ticks. This is a loss since, in effect, the company has sold for $1.5710 and then bought back for a higher number of $. Therefore the total futures loss is: 4 contracts x 2,814 ticks x $6.25 = $70,350. The company will have to buy $ to pay over the loss: (In practice this will have been paid as variation margin to the clearing house during the period from October to January.) $70,350/1.8500 = Because the $ has weakened there is a margin loss: When the initial margin is returned it is worth: $10,000/1.8510 = less initial cost Margin loss Net cost 5,402 (6,343) 941 238,968 38,027 200,000

The exports to Eastern Europe will be paid for by a barter exchange of 100,000 tins of meat. BID has arranged for this tinned meat to be exchanged for 70 tons of coffee by its customer in West Africa where tinned meat is in demand. The West African countrys currency is tied to the French franc. Exchange rates A$/
Spot 2.14002.1425 3 months forward 22.5 cents dis

Lire/
2,2082,210 36 lire dis

Franc/
10.3810.39 53 centimes pm 75 centimes pm

6 months forward 3.54.5 cents dis 58 lire dis

Commodities Coffee beans March June

Futures rate (/tonne) 791 860 Interest rates Borrowing Lending 15% 10.5% 16% 13% Not available 16% 9% 6%

UK bank Australian bank Italian bank French bank

Assume that interest rates will not change during the next six months. BID proposes to invest net sterling proceeds from foreign trade in a UK bank. The company wishes to hedge against all foreign exchange risk, and currently has no surplus cash. Taxation, transaction costs and margin requirements on futures contracts may be ignored. Required: Using the forward market, money market or commodity futures market, as appropriate, estimate the maximum size of cash surplus or the minimum size of cash deficit that will result from BIDs foreign trade at the end of six months. (15 marks) (1) Calculation of forward rates: BID UK Ltd Spot Add discount Less premium Spot Add discount Less discount A$/ Lire/ Franc/ 2.1400 2.1425 2208 2210 10.38 10.39 .02 .025 3 6 .05 .03 2.1675 2211 2216 10.33 10.36 2.14 2.1425 2208 2210 10.3810.39 .035 .045 5 8 .07 .05

Hence if the $ weakens the futures contract is more expensive than the money market hedge. Again this is partly due to the futures contracts hedge involving a larger position in $ which have lost value against the . The futures contract has a similar effect to the forward contract in that it removes most of the risk: it removes the risk of a loss (downside risk) but it also removes the risk of a profit (upside risk). It is worth mentioning that the exchange rate movements in this example are large and, in practice, may not arise over such a short period; but then again they might! Now that we have seen how to apply a number of hedging techniques it will be beneficial for you to tackle the following past examination question taken from the December 1990 examination.

3 months forward 2.16

Example 4
BID (UK) Ltd trades with several countries. During the next six months export and import receipts and payments are due as a result of business with companies in Australia, North Africa, Eastern Europe and Italy. The transactions are in the currencies specified. It is now 31 December. Australia Italy North Africa Italy Payment date 31 March 31 March 31 March Exports A$120,000 Lire 400m Francs 565,000 Imports 40,000 Lire 220m A$260,000 Tinned meat Lire 700m

6 months forward 2.175 2.1875 2213 2218 10.31 10.34

(2) Calculation of size of cash surplus or deficit at the end of six months. Australian $ 31 March Either use forward contract hedge: Sell: Receive: A$120,000 3 months forward 120,000/2.1675 = 55,363 in 3 months

Between 31 March and 30 June Lire 500m Tinned meat A$180,000 Coffee 30 June 30 June 30 June

or money market hedge: let amount borrowed be x. x(1 + (.16/4)) = 120,000 x = 120,000/(1 + (.16/4)) = A$115,385 Therefore, SELL at the spot rate: 115,385/2.1425 = 53,855. Then INVEST for 3 months to get 53,855 (1 + (.105/4)) = 55,269. The forward contract should be used since it yields higher proceeds.

Eastern Europe 30 June Australia West Africa Italy

TECHNICAL

30 June Payment (260 180) 80,000 Either use a forward contract to buy A$ Cost: 80,000/2.175 = (36,782) or use the money market let amount of A$ invested be x x(1 + (.13/2)) = 80,000 Therefore x = 80,000/(1 + (.13/2)) = A$75,117 Hence the company will need to buy A$ 75,117 now at the spot rate: Cost in in December: 75,117/2.14 = 35,101. To compare with the cost under the forward contract which would be incurred on 30 June, it is necessary to take into account the cost of borrowing 35,101 for 6 months: Total cost: 35,101 x (1 + (.15/2)) = 37,734 The company should therefore use the forward contract since it is cheaper. Italian lira 31 March Net receipt: (400 220) 180m lire NOTE: Since the company cannot borrow lira it cannot hedge this transaction using the money market. Therefore: sell forward and receive (180 x 106)/2216 = 81,227 Lire receivable between 31 March and 30 June. Since it does not know the exact date of receipt the company could sell the 500m lire using an option dated forward contract. If it were to do this it would receive the least favourable rate which is the 6 month rate of 2,218. It would then have to purchase forward 700m lire for 30 June. This would be expensive in terms of the spread between the buying and selling rates. It is better to set off (referred to as netting) the 500m lire receipt against the 700m lire payment and hedge the net amount of 200m lire. Either buy forward: (200 x 106)/2213 = 90,375 If the customer pays before 30 June the 500m lire can be lent in Italy and the accrued interest returned to England on 30 June. or money market. Let amount lent be x x(1 + (.16/2)) = 200m x = 200/(1 + (.16/2)) = 185.18m

The lire would then be bought at the spot rate: Cost = (185.18 x 106)/2,208 = 83,868 This will accrue by 30 June to: 83,868 (1 + (.15/2)) = 90,158 Hence the money market is better. North Africa Either sell 565,000 francs 3 months forward Receive: 565,000/10.36 = 54,537 or use the money market: Amount borrowed x: x(1 + (.09)/4) = 565,000 Therefore x = 565,000/(1 + (.09/4)) = 552,567 Sell: 552,567/10.39 = 53,183 Invest for 3 months: 53,183 x (1 + (.105/4)) = 54,579 Hence the money market is better. West Africa The tinned meat is not relevant from the viewpoint of hedging risk since the amount received from Eastern Europe is to be sent to the West African customer. This leaves price risk on the receipt of coffee from the West African customer. There is a risk that coffee prices could fall before the coffee is received and sold. This risk can be hedged by selling the coffee in advance on the futures market. Proceeds from this sale, in 6 months time, when the coffee is delivered will be: 70 x 860 = 60,200. Net cash surplus/deficit on 30 June: Receipts/(payments): 31 March Australia: forward contract Sterling outlay Italy forward contract North Africa: money market This can be lent for 3 months: Proceeds: 151,169 x (1 + (.105/4)) = 30 June Australia: forward contract Italy: money market West Africa coffee futures market Net surplus on 30 June 155,137 (36,782) (90,158) 60,200 88,397 55,363 (40,000) 81,227 54,579 151,169

In the next two articles we will deal with options and see how they can be used to hedge currency risk. References Brealey, R.A. and Myers, S.C. (1996) Principles of Corporate Finance, McGraw Hill, New York. Brown, N., Kaur, P., Maugham, S. and Rendall, J. (1994) Financial Strategy, Certified Accountants Educational Projects, London. Buckley, A. (1992) Multinational Finance, Prentice Hall, New York. French, D. (1991) Dictionary of Accounting Terms, The Institute of Chartered Accountants in England and Wales, London. Demirag, I and Goddard, S. (1994) Financial Management for International Business, McGraw Hill. Shapiro, A. (1995) Multinational Financial Management, Allyn and Bacon, Boston.

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ACCA Students Newsletter September 1996

TECHNICAL

by Nigel Brown

Foreign currency exposure management: part 4a

Option contracts
Nigel Brown BA FCA is a senior lecturer in Financial Strategy at the University of Wales College, Newport

Relevant to paper 14

his is the fourth in a series of five articles. The aim of the series is to develop an understanding of the effect foreign currency risk may have on a firm and of some of the techniques that are available for eliminating or reducing that risk. In the third article we explained currency futures contracts. In this and the fifth article we will introduce and explain option contracts. Options can be used for foreign currency exposure management and interest rate risk management. In this article we will develop an understanding of the main features of option contracts in general and then in the fifth and final article we will focus on currency options and the ways in which they can be used to hedge currency risk.

Example 1 The following table includes some of the LIFFE equity options quoted in the Financial Times on 31 October 1995:

Exchange traded options v over-the-counter options

Option contracts are available as either:

Table 1 LIFFE Equity options

Calls Option ASDA (*103) 100 110 Jan 71/ 2 3
1

l l

Puts Apr Jul 5 1/2 11 22 56 6 1/2 12 31 65 1/2

Apr 10 6

Jul 13 9

Jan 31/2 9
1

exchange traded options (or traded options) which are standardised, marketable contracts. These contracts are traded on recognised exchanges or; over-the-counter options which are tailor-made to the companys requirements. These contracts may be obtained from banks who will quote a premium based on the terms required by the purchaser.

Allied Domecq 500 (*509) Argyll (*323) BAA (*4911/2 ) Bass (*660) Boots (*5551/2 ) Brit Airways (*4581/2 ) BP (*4621/2 ) British Steel (*1631/2 ) 550

20 30 / 2 31 /2 11 1/ 2 351 /2 19 50 26 39 18 351 /2 141 /2 55 30

35 17 15 40 24 56 32 1/2 45 1/2 24 1/ 2 42 1/2 21 62

/2

54 5 18 5 21 21 1/2 56 16 51 4

300 28 1/ 2 330 460 500 650 700 11 38 14 26 6

9 13 1/2 22 8 1/2 24 1/2 30 61 1/2 21 1/ 2 53 1/2 7 1/2 22 19 1/2 45 29 13 1/2 30 34 1/2 65 28 58 12 1/2 28 23 1/2 48

550 221 /2 600 420 460 5 45 19

The exercise price (or strike price)

The exercise price is the price at which the underlying financial instrument can be bought or sold under the option contract. In the case of a currency option this is the exchange rate at which the foreign currency can be bought or sold. Features of exchange traded options:

What are options?

An option provides the purchaser of the option with the right (opportunity) but not the obligation to buy from or sell to the seller (or writer) of the option a commodity or financial instrument in the future at a price fixed today. Options, as the name suggests, offer the purchaser (the person or company paying the premium) a choice as to whether or not to carry out a particular course of action. The purchaser of an option contract can choose the course of action that is the most beneficial. The purchaser of an option has to pay the seller (writer) a premium at the time of entering into the contract. In the case of a currency option the premium can be viewed as the cost of the currency hedge. The seller or writer of the contract has, in return for receiving the premium, the obligation to fulfill the conditions required by the contract.

37 17 1/2 30 1/2 15 16 71/2 13 42 6 20

460 161 /2 24 1 /2 500 150 180 31 /2 8

1/

91 /2 13 51 /2

8 11 1/2 21 24

11 /2

Each option contract is an option on 1,000 ordinary shares in the respective company. The first equity option listed is for ASDA PLC. All the figures shown are in pence. The figure shown in brackets below the companys name, 103p for ASDA, is the market price of the underlying share. The figures in the first column, 100p and 110p for ASDA, are the strike prices or exercise prices. These are the prices at which, under the option contract, you can buy (call) or sell (put) the shares. The months of January, April and July are the months, in 1996, in which the option contracts expire. If you wanted to obtain the option to buy 1,000 ASDA shares at 100p per share in July 1996 you would need to buy a call option which has a premium of 13p per share. Each option contract would therefore cost 130 (13p x 1,000). (This is before allowing for the commission which is payable to a broker and the dealers bid offer spread which we will not consider in this article.) The premium is the price or cost, to the purchaser, of the option.

l l l l l l l

They are bought and sold on recognised exchanges. A market price is therefore readily available. They are only available in standardised contract sizes for a limited number of financial instruments. They have a limited number of strike prices which, in the case of currency options, are generally quoted in US cents per unit of the other currency; the home currency is the US$. They expire/mature on a fixed day each month/quarter up to one year ahead. i.e. they are relatively short dated. They involve the seller of the option contract in payment of a margin (similar to the margin on a futures contract which we discussed in the second and third articles). Are obtained via a broker, to whom a commission is payable. The main option exchanges include Chicago, London, New York, Philadelphia, Amsterdam and Montreal.

Call option v put option

An option to buy the underlying commodity or financial instrument is referred to as a call option. An option to sell the underlying commodity or financial instrument is referred to as a put option.

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ACCA Students' Newsletter September 1996

A traded option can be resold during its life. This means the contracts can be easily resold by the purchaser which is not the case with over-the-counter options.

l l l l l

available for any pair of currencies that have an active spot and forward market). May be for any maturity from overnight to 5 years. Can be for virtually any strike price which, in the case of currency options, is usually quoted on the same basis as the foreign exchange market. Do not involve a margin but do require the company to have a credit line with the bank. Are available from banks which do not charge a commission; the banks charges are inclusive in the premium. Difficult if not impossible to sell before expiry date (if sold there could be a large spread on sale).

The option premium, which is not refundable, represents the maximum loss that will be incurred by the purchaser of the option. Option contracts provide: Protection from downside risk (the risk of a loss). If market conditions, for the underlying financial instrument, move against the purchaser of an option then the purchaser is protected from loss by exercising the option. The primary objective of hedging currency risk or interest rate risk is protection from downside risk.

In London traded options are dealt on the London International Financial Futures and Options Exchange (LIFFE). There are two basic types of option contract traded on LIFFE. These are: 1 Options on a financial instrument or cash These option contracts give the purchaser the right but not the obligation to purchase or sell the underlying financial instrument or cash. The Equity options in Example 1 are an example of traded options. For these traded options the underlying financial instruments are the ordinary shares of the respective companies. Since these are traded options they can be bought or sold at any time until the expiry date. 2 Options on futures Options on futures (or futures options) give the purchaser the right but not the obligation to take a long or short position in a futures contract. Example 2 One of the contracts traded on LIFFE is the short sterling option. Each Short Sterling option contract gives the purchaser the opportunity to, if beneficial, take a position in one short sterling futures contract at the exercise price. Each Short Sterling contract is based on a notional 500,000 three month sterling deposit. Short sterling options are American-style contracts which means that the option buyer can exercise the option at any time prior to expiry. Short sterling options may be used for hedging interest rate risk which is another important topic on the paper 14 syllabus. It is outside the scope of this series of articles to cover interest rate risk. Features of over-the-counter (OTC) options

l Participation in upside risk (the risk of a

The option premium

As mentioned above the purchaser of an option has to pay the seller (writer) a premium at the time of entering into the contract.

profit). If the market moves in favour of the option buyer, the option can be allowed to lapse enabling the purchaser to take advantage of the favourable market rates. This opportunity is not available with the other hedging techniques we have considered (forward contracts, money market hedges and futures contracts).

Traded options In the case of traded options the premium is the price, determined through open outcry on the trading floor, that the purchaser of an option pays and the seller of the option receives for the right/opportunity conveyed by the option. This premium is determined on an ongoing basis via competition between option buyers and option sellers in the trading pits on the exchange. Therefore at any point in time through the life of a traded option the premium is a reflection of supply and demand for that option at that moment. Example 3 Take the options on ASDA shares shown in Example 1. What would happen if some news is published which suggests the shares are undervalued? This will result in more people wanting to buy the shares causing the price of the shares to increase above 103p. Similarly this will make the 100p July 1996 call option more attractive. More people will buy the call options which will increase the premium above 13p.

European options v American options

An option which can only be exercised on the maturity date is referred to as a European option. An option which can be exercised on any working day between 2 dates (the option period) is called an American option. American options involve a higher premium than European options since they offer the purchaser more opportunity to exercise the option (which is only done when profitable to do so). American and European options are available on LIFFE. For example there are two options contracts on the FT-SE 100 Index (the Financial Times index of the share prices of the top 100 UK companies by market capitalisation): one is American-style and one is European-style.

In the money, out of the money or at the money

A call option is referred to as being in the money if the current market price of the asset to which it relates is above the exercise price. In other words if the option were to be exercised at that time the purchaser of the option would make a profit equal to the market price of the asset less the exercise price. Example 4 Using the details in Example 1 the ASDA 100p call options are in the money since they entitle the purchaser to buy ASDA shares at 100p when the shares have a market price of 103p. There is a potential profit, before commission, of 3p (sell in the market for 103p and buy under the option contract for 100p).

l l l l

The option contract can be written to the purchasers specific requirements. The terms of each contract are subject to individual negotiation and tend to involve marginally lower premiums than on exchange traded or listed options. The option contract may be for any amount above a certain minimum. A wider range of contracts is available (for example, OTC currency options are

OTC options With OTC options the premium is fixed by the seller at the time the contract is entered into and will therefore depend on the terms required by the purchaser and on market conditions at the time. For example, take a firm which wishes to hedge against an increase in interest rates. Any increase in market interest rates which occurred before the option contract is entered into will cause the bank to quote a higher premium.

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ACCA Students Newsletter September 1996

TECHNICAL

A call option is out of the money when the current market price of the asset is below the exercise price. The ASDA 110p call option is out of the money: on 31 October it is not worth exercising since this would result in a loss of 7p (buy under the option contract for 110p and sell in the market for 103p). Similarly a put option is in the money when the current market price of the asset is below the exercise price. The ASDA 110p put option is in the money: exercising this option would result in a profit of 7p (sell under the option contract for 110p and buy in the market for 103p). A put option is out of the money when the market price of the asset is above the exercise price. The ASDA 100p put option is out of the money: on 31 October it is not worth exercising since this would result in a loss of 3p (buy in the market for 103p and sell under the option contract for 100p). If the market price of the asset is equal to the exercise price the option is referred to as being at the money. Gearing Gearing (or financial leverage) is defined by Brealey (1996) as the use of debt to increase the expected return on equity. Option contracts can be used to create the gearing effect of increasing the expected return.

Solution to Example 5 (i) Selling price 6 (a) Share Selling price Cost on 31.10.95 Cost on July 1996 Profit/Loss Profit/Loss as a % of the initial cost = (ii) Selling price 4.80 (a) Share Selling price Cost on 31.10.95 Cost in July 1996 Profit/Loss Profit/Loss as a % of the cost initial cost = 0.215/4.585 4.7% 0.17/0.37 46% 4.80 4.585 N/A 0.215 (b) Call option 4.80 0.37 4.60 0.17 1.415/4.585 31% 1.03/0.37 278% 6 4.585 N/A 1.415 (b) Call option 6 0.37 4.60 1.03

In this case the option is exercised to make a profit of 20p (480 460) This is not sufficient to cover the premium of 37p (iii) Selling price 3.00 (a) Share Selling price Cost on 31.10.95 Cost in July 1996 Profit/Loss Profit/Loss as a % of the initial cost = 1.585/4.585 35% 0.37/0.37 100% 3 4.585 N/A 1.585 (b) Call option N/A 0.37 N/A 0.37

Buying a call option is referred to as taking a position in the underlying asset. This means the purchaser of the call option can take advantage of an increase in the market price of the underlying asset by using less money than if the asset is bought directly.

Example 5 The following example is based on traded options in British Airways PLC. These contracts are shown in Table 1 on page 64. On 31.10.95 the share price of British Airways (shown in brackets) was 4.58 1/2 (i.e. 4.585). On the same day the price (i.e. premium) of the LIFFE July 1996 call option, with a strike price of 4.60, was 0.37. Since the exercise price is above the market price the option is out of the money. Calculate what the profit or loss per share will be for someone who, on 31.10.95:

exercise date i.e. in July 1996 is: (i) 6; (ii) 4.80; (iii) 3. This example highlights the following points:

l l l

l l

purchases a British Airways share and subsequently sells the share in July 1996; purchases a British Airways July 1996 call option with an exercise price of 4.60 and subsequently, if beneficial, exercises the call option (i.e. buys the shares) in July 1996 and then sells the underlying shares.

If you buy the share then the % profit or loss that you make is, not surprisingly, equal to the % change in the price of the share itself. This is in sharp contrast to buying the call option: the option has the effect of amplifying the effect of the price movement. With the call option the good news is that the upside risk, (i.e. the potential gain) is greater than if investing in the share: in (i) a share price increase of

31% is converted into a profit of 278%; the option has geared up the return. The option enables the buyer to profit from the share price increase by investing 0.37 instead of 4.585. In this context the option could be viewed as a loan: place a deposit on the share in October 1995 of 0.37 and delay paying the balance until the option is exercised in July 1996. Hence the level of interest rates has an influence on the size of the option premium. The bad news with the call option is that the downside risk is also greater. In (iii) the loss of 35% on the share becomes 100% if one had held the call option. A further crucial point is that, if one had purchased the share it may be possible to wait to allow time for the share price to recover; there is no such waiting time

Assume that the price of the share on the

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ACCA Students' Newsletter September 1996

with the call option since it expires in July 1996. In (ii) a small profit on the share of 4.7% has changed to a loss of 46% on the call option. Looked at another way, for the option to be profitable the share price has got to increase to an amount equal to the premium plus the strike price. i.e. to 4.60 + 0.37 = 4.97. This is (4.97 4.585) 0.385 above the price of the share when the option is purchased in October. So an (0.385/4.585) 8.4% increase in the price of the share is needed in order to break even on the option contract. If the share price in July 1996 were 4.97 or below the option contract results in a loss. These profits or losses are before allowing for the time value of money. This is an important factor which would have a greater impact on the purchase of the share since, between October 1995 and July 1996, it is necessary to finance the full cost of the share (4.585) rather than just the option premium (0.37). In practice, as mentioned above, each equity option contract is for 1,000 shares. So if, for example, you wanted a call option on 7,000 shares you would have to buy 7,000/1,000 = 7 contracts. This would cost 7,000 x 37p = 2,590 (before commission).

options in table 1. The intrinsic values are:

Share price Strike price 458.5p 458.5p 420p 460p Intrinsic value 458.5 420 = 38.5p nil Premium 45p 19p

The strike price of 420p would enable the purchaser to make a profit if the option were exercised immediately whereas a profit is not immediately available with the strike price of 460p. Therefore the 420p option has a higher intrinsic value and is valued more highly in the market i.e. the premium is higher. The intrinsic value of the 460p call option is zero; the 460p call option is out of the money. The intrinsic value cannot be negative because of the basic nature of an option contract: if exercising the option is not beneficial the purchaser does not have to exercise it; there would be no benefit in buying the share at 460p if the selling price is only 458.5p. Hence the intrinsic value is dependent on the market price of the financial instrument and the exercise price. If the call option can only be exercised immediately (i.e. when it is about to mature) it cannot be worth more than the intrinsic value because there is no opportunity for the market price to increase above todays price. The British Airways options in Example 6 have premiums in excess of the intrinsic value because there is, on 31 October 1995, still 3 months to go before the options expire in January 1996. This period of time has a value which we will look at later in this article. Intrinsic value of a put option The intrinsic value of a put option is the exercise price of the option less the market price of the underlying asset. Again it has a minimum value of zero but has a maximum value which is equal to the exercise price: if the underlying asset is worth zero the put option will enable the asset to be sold at the exercise price and therefore make a profit equal to that amount. Example 7 We will use the British Airways January1996 put options in Table 1. The intrinsic values are:
Share price Strike price 458.5p 458.5p 420p 460p Intrinsic value nil 460 458.5 = 1.5p Premium 4p 17.5p

A naked option
A naked option is an option that is held on its own, that is not held as a hedge against loss on a holding of an asset or another option. The profits/losses on the British Airways call option in Example 5 would arise if the option is held on its own. Corporate treasurers should not normally be involved in such speculative investments.

What affects option prices/ values?

The value of an option, its premium, is equal to the sum of the intrinsic value and the time value. The intrinsic value Intrinsic means basic, fundamental, essential or real. The intrinsic value of an option is the profit the purchaser of the option could make if the option is exercised immediately. An option will only have an intrinsic value greater than zero if it is in the money: the intrinsic value is the difference between the price of the underlying financial instrument and the exercise price. An option that is out of the money has an intrinsic value of zero. Lets look at an example using a call option. Intrinsic value of a call option Example 6 Take the British Airways January 1996 call

The 420 put option has no intrinsic value since it is not beneficial to buy shares in the market at 458.5p in order to sell them under the option contract for 420p. Part 4b will be published in the October issue of the Students Newsletter. n

TECHNICAL

Foreign currency exposure management: part 4b

Option contracts
Nigel Brown BA FCA is a senior lecturer in Financial Strategy at the University of Wales College, Newport
his is part b of the fourth article in a series of five. The aim of the series is to develop an understanding of the effect foreign currency risk may have on a firm and some of the techniques that are available for eliminating or reducing that risk. In this and the fifth article we will introduce and explain option contracts.

October 1995 the April 1996 option with 6 months to expiry is worth more than the January 1996 option which only has 3 months to run to expiry. We now need to think about why this is the case.

Time to run before the option expires There are two reasons why the length of time to expiry influences the value of an option: (i) Interest rates. In the case of a call option one effect is, as illustrated in example 9, to avoid having to finance the full cost of the asset now. Consequently the longer the period to expiry the greater the saving in financing costs. (ii) The chance or likelihood of the option being in the money by the time the option expires. The higher the degree of volatility of the price of the asset (i.e. the more risk inherent in the price) the more chance there is that, in the case of a call option, the price of the asset will exceed the exercise price (and make the option worth exercising). If a share price is very volatile it means there will be large increases and decreases in the price. If a large price increase occurs, which causes the price of the share to rise above the exercise price, then the call option can be exercised at a profit. The time value therefore increases with the level of variation in the price of the asset. Not surprisingly an increase in the volatility of the underlying asset will cause the sellers (writers) of options to require a higher return for the risk they are taking on by writing the option. The overall effect is for the premium to increase as volatility increases. There is more opportunity to take advantage of this volatility with an American option (where the option may be exercised at any time between two dates). Also the further into the future the expiry date the greater the chance that the price of the asset will increase above the exercise price enabling the option to be exercised at that time at a profit. The time value, for a given time to expiry, is at its highest when the price of the underlying asset is equal to the exercise price; any favourable change in price of the underlying asset will result in the option being in the money. The effect of increased volatility in the market price of an asset on the value of an option to buy that asset is illustrated in Example 10. This example examines the value of a call

What causes an option to have a positive time value?

The level of interest rates By buying a call option the purchaser avoids having to finance the full cost of the asset now. Instead it is only necessary to finance the cost of the option (the premium) now and then, assuming the price of the asset is in excess of the exercise price, buy the asset on expiry of the option. The call option can therefore be viewed as equivalent to buying the asset with part of the finance from a loan. Therefore the higher the level of interest rates the higher will be the value of the option. Example 9 This example is based on the figures in Table 1 (see article 4a). If, in October 1995, an investor wishes to buy 5,000 shares in British Airways the cost would be: 5,000 x 4.585 = 22,925 which would be payable in October 1995. Alternatively the investor could buy 5 (5,000/ 1,000 since each option contract is for 1,000 shares) July 1996 460 call option contracts which would, assuming it to be beneficial to exercise the options in July 1996, involve a cost of: October 1995: 5,000 x 0.37 = July 1996: 5,000 x 4.60 Total cost = 1,850 23,000 24,850

The time value (time value premium)

The time value of an option is the difference between the market price of an option and its intrinsic value. An option will usually have a time value, regardless of whether it is in the money, at the money or out of the money, if there is time to run before the option expires. Time value is the value placed on the chance that the option will become in the money, and therefore worth exercising before or at expiry. It also takes into account the fact that, in the case of a call option, the option can be viewed as a form of borrowing. Time value can be determined using the following formula:
Time value of a call option = option price [price of underlying exercise] [asset price] . . . Time value of a call option = option price intrinsic value of the option

As the time to maturity increases the time value of the option increases: an option with 7 months to expiry is worth more than an option with 4 months to expiry. Example 8 Take the British Airways call options in Table 1, (see article 4a) with a strike price of 420p. The time values are shown in Table 2 below. As the time to maturity increases the time value of each of the options increases. In

The option contract enables the purchaser to delay paying the bulk of the purchase cost of the shares until July 1996. This time delay will be more valuable to the purchaser if interest rates are higher.

Table 2 Time values

Maturity date January 1996 April 1996 July 1996 Share price 458.5p 458.5p 458.5p Intrinsic value 458.5 420 = 38.5p 38.5p 38.5p Premium 45p 55p 62p Time value 45 38.5 = 6.5p 55 38.5 = 16.5p 62 38.5 = 23.5p

TECHNICAL 5

option on two shares at expiry. The possible share prices and associated probabilities at expiry of the options are as in Table 3. Required: Calculate the expected intrinsic value of a call option, with an exercise price of 4, on each share. (Hint: if the market price is below the exercise price the option will be allowed to lapse and therefore has a value of zero.) Solution to Example 10 If the shares are purchased they will have expected values as per the question. The value of the option is the amount by which the expected value with the option is higher than the expected value without the option. The price of share B can be identified as being more risky since there can be larger variations from the expected value. This can be expressed more formally by calculating the standard deviations which are 1.265 for share A and 2.214 for share B (you may wish to calculate these standard deviations as a separate exercise). If the call options were purchased the worst outcome would, subject to the initial premium, be zero in each case. If the investor had purchased the underlying shares the worst outcome for share A (2) is preferable to share B (0.5). Hence, using the call option instead of buying the underlying share protects the investor from the less favourable outcome of share B but the investor can take advantage of the larger price increase that is possible with share B. Unfortunately the writer of the options will also require a higher premium for writing the 4 call option on share B rather than on share A.

Table 3
Probability .2 Share A Price 2 Expected value .4 Probability .2 Share B Price Expected value

.6 .2

4 6

2.4 1.2 4.0

.6 .2

0.5 4 7.5

0.1 2.4 1.5 4.0

Expected value assuming a call option has been purchased.

Solution to Table 3
Share A Price at expiry 2 4 6 Is option exercised? no no yes Value of option nil nil (64) = 2 Probability .2 .6 .2 Expected value nil nil .4 0.40 Share B Price at expiry 0.5 4 7.5

Is option exercised? no no yes

Value of option nil nil (7.54) = 3.5

Probability .2 .6 .2

Expected value nil nil .70 0.70

Therefore an option on share B is more valuable than an option on share A.

The normal distribution To understand the Black and Scholes options pricing model it will help to review the main characteristics of the normal distribution. A normal distribution can be completely defined by 2 parameters, the mean and the standard deviation and when plotted on a graph, appears as follows: Diagram 1

ity that the variable will have a value less than d1 and a 0.025 (1 0.975) probability that the variable will have a value greater than d1. The Black and Scholes options pricing model provides a way of estimating the value of a call option exercisable on a particular date i.e. a European option. The model is explained in the context of an option on a share and comprises the following 3 equations: V = Po[N(d1)] Xert [N(d2)] ........1 logn (Po/X) + r + 2 d1 = t 2 d2 = d1 t

The risk of an option

There are some important points to note regarding the risk of an option: An option that is in the money is safer than an option that is out of the money. The risk of a call option decreases as the price of the underlying asset increases. An option is more risky than the underlying asset and consequently has a higher beta value (which measures the systematic risk) and standard deviation (which measures the total risk) of return. The risk of an option changes, virtually on a daily basis, as variables such as the price and volatility of the underlying asset alter.

( )t

........2 ........3

where: V = the current value of a European call option with time t until expiry. Normal distribution If the value of a random variable is normally distributed the probability of the value of the variable being less than d1 may be obtained from normal distribution tables. d1 can be calculated as a number of standard deviations from the mean and is sometimes referred to as the Z value. For example if d1 = 1.96 the associated probability, from the normal distribution tables, is .975. i.e. there is a 0.975 probabilPo = current price of the share to which the option relates. N(d1) = the probability that a random variable, that is normally distributed, will be less than d1. As mentioned above this value can be obtained from the normal distribution tables. N(d2) = the probability that a random variable, that is normally distributed, will be less than d2. X = the exercise price of the option.

Black and Scholes options pricing model

You may well be horrified when you see the Black and Scholes options pricing model formulae but dont panic because, for the paper 14 Financial Strategy examination, you only(!) need to be aware of the variables that go into the formulae; you will not be expected to apply the formulae.

TECHNICAL

e = the base of the natural logarithm i.e. 2.718282. logn(Po/X) = the natural logarithm of Po/X r = risk free interest rate expressed as a decimal. t = time until the option expires, measured in years and expressed as a decimal (e.g. 3 months would appear as .25). = standard deviation of the rate of return on the share. Lets look at the basic relationship between the input variables and the value of the option: The current price of the underlying share Po ; if the price of the share increases the call option value will increase. The exercise price (X); the higher the exercise price the lower the value of the call option. The risk free interest rate (r); the higher the risk free interest rate the higher the value of the option. Time to expiry(t); the longer the period to maturity the higher the value of the option. Standard deviation of rate of return on the share ; the higher the standard deviation of rate of return on the share the higher the value of the option. Once the value of a call option has been derived it is possible to find the value of a put option on the same security.

proportion of the underlying share. There are no penalties attached to short selling (selling shares that the seller does not own). The model is very sensitive to the value of which is difficult to estimate. The model normally uses the historic for the option price for a future period.

Changes in the value of options

The Black and Scholes model enables us to value an option at a particular time. Option values change continually throughout their lives; these changes can be large and occur in a very short period of time. It will help to understand the way option values change if we consider, at an introductory level, how a writer of an option can cover the risk on that option. i.e. how the writer can obtain protection from a loss if the price of the underlying asset moves against him/her; writing an option with protection against loss is referred to as: covered call writing, which is usually writing one option for each share held; or fiduciary call writing when using a delta hedge which is explained in the next section.

movement in the share price the option writer can hold a lower number of underlying shares than the number of shares on which the option is exercisable. This is because the movement in price of the shares may be larger than the corresponding movement in price of the option (in the above example 2p versus 1p). From the viewpoint of the call option writer an adverse movement is an increase in the share price. Hence to cover the risk the option writer will buy the appropriate number of shares. The tricky bit is keeping track of the delta value which tends to change throughout the life of the option with the consequence that, to eliminate the risk, the writers position continually needs re-balancing by altering the size of the holding of the underlying shares.

The gamma value

The last concept we will consider is the gamma value. This is the ratio of the change in the delta value that occurs for a given change in the price of the underlying financial instrument.
i.e. Gamma = change in delta value change in value of the underlying financial instrument

The delta hedge

The delta (or hedge ratio) of an option measures the change in price of the option that corresponds with a given change in the price of the underlying instrument. It is only valid for small price changes.
delta = the change in the price of the call option the change in the price of the underlying security

The assumptions underlying the Black and Scholes options pricing model
The Black and Scholes options pricing model, though widely used by option traders, does have a number of assumptions/ limitations. These are: In the case of a share option there is assumed to be no dividend payable on the share during the life of the option. (Though it is possible for the formula to be amended to take into account dividends.) The option is a European option.(Though an American option is likely to have a value of at least the value of a similar European option.) We know the short term risk free interest rate which is fixed throughout the life of the option. The share price follows a random walk and the possible share prices at the end of any finite period are log-normally distributed. There are no transaction costs or tax effects relating to purchase or sale of the underlying asset or the option. It is possible to borrow, at the risk-free rate, the amount needed to buy or hold any

This gives a measure of the sensitivity of the delta value: the more volatile the delta value the more difficult it is for an option writer to remove the risk from writing a call option (by buying the appropriate number of underlying securities). This will cause the seller of the option to require a higher premium. Gamma has the highest value when an option has a short time to run before expiry and is at the money. We have considered some of the main characteristics of option contracts in general. In the next article we will look at the way in which currency options can be used to hedge currency risk. References Brealey, R.A. and Myers, S.C. (1996) Principles of Corporate Finance, McGraw Hill, New York. Brown, N., Kaur, P., Maugham, S. and Rendall, J. (1994) Financial Strategy, Certified Accountants Educational Projects, London. Buckley, A. (1992) Multinational Finance, Prentice Hall, New York. French, D. (1994) Dictionary of Accounting Terms, The Institute of Chartered Accountants in England and Wales, London. Demirag, I. and Goddard, S. (1994) Financial Management for International Business, McGraw Hill. Shapiro, A. (1995) Multinational Financial Management, Allyn and Bacon, Boston.

The delta value is referred to in the Black and Scholes model as N(d1). By identifying the delta it is possible to determine the amount of the underlying instrument in which the option writer needs to take a position in order to hedge the option position. In other words this enables the option writer to eliminate the risk, to the writer, of the option. If a 2p change in the price of the underlying security results in a 1p change in the price of the associated option the delta is: 1p/2p = 0.5. This means that the option writer needs to hold half of the number of underlying shares to eliminate the loss on the options. If the option writer owns one share and the share price goes up by 2p this 2p profit made by the option writer will compensate for the corresponding loss of 1p the option writer will make on each of two options. So a call option on 2,000 shares would need a holding of 1,000 shares (2,000 x 0.5) to eliminate the risk. Hence to be protected against an adverse

TECHNICAL

by Nig el Brown

Foreig nc urrency exposure management: part 5a

Currency option contracts

his is the last article in a series of five articles. The aim of the series is to develop an understanding of the effect foreign currency risk may have on a firm and of some of the techniques that are available for eliminating or reducing that risk. In the third article we explained currency futures contracts. In this article we examine the main characteristics of currency options and the way in which currency options can be used to hedge currency risk.

Nigel Brown BA FCA is a senior lecturer in Financial Strategy at the University of Wales College, Newport

/$ options
If a firm wished to take out an option to buy or sell sterling it could use currency options traded on the Philadelphia SE referred to above. These traded currency option contracts have a contract size of 31,250. The following table reproduces the information regarding this contract that is published daily in the Financial Times:

Currency options (or foreign currency option contracts)

A currency option is the right, but not the obligation, to purchase (a call option) or sell (a put option) a particular foreign currency at a specified exchange rate (the strike price). This may be on the maturity date (a European option) or on any business day before maturity (an American option). The following currency option contracts are traded on the Philadelphia Stock Exchange (in the USA): Currency Australian $ British Canadian $ Deutsche Mark French franc Japanese yen Swiss franc The ECU Contract size A$ 50,000 31,250 C$ 50,000 DM 62,500 FF 250,000 Y 6.25m SF 62,500 ECU 62,500

Table 1: Philadelphia SE /$ options (cents per )

Strike Price 1.375 1.400 1.425 1.450 1.475 1.500 1.525 Mar 5.54 3.05 0.87 0.04 Apr 5.75 3.89 2.42 1.38 0.72 0.32 0.11 Calls May 6.05 4.35 2.95 1.97 1.22 0.71 0.37 Jun 6.34 4.75 3.42 2.44 1.66 1.08 0.69 Mar 0.03 0.23 1.84 4.21 6.71 9.16 Puts Apr May June 0.57 1.18 1.74 1.18 1.96 2.58 2.15 3.00 3.73 3.55 4.45 5.l8 5.38 6.18 6.87 7.48 8.11 8.72 9.71 10.26 10.79

Previous days open int: Calls 818,836 Puts 605,022 (All currencies) Previous days volume: Calls 13,466 Puts 14,651 (All currencies) Source: Financial Times, 12 March 1993. There are several useful observations that can be made about Table 1. For example: If the firm wanted the option to buy (and sell $) in April 1993 it would need to buy a call option on sterling ( is the foreign currency). If it wanted the option to buy s at an exchange rate of $1.375/, it would have to pay a premium of 5.75 cents whereas buying s at the less favourable exchange rate of $1.45/ would involve a lower premium of 1.38 cents. A put option (an option to sell , which is the foreign currency, in exchange for $) with a strike price of $1.450/, exercisable in April 1993 carries a premium of 3.55 cents per which is cheaper than an April put option exercisable at $1.500 which carries a premium of 7.48 cents per . The difference between the two premiums reflects the fact that the exchange rate of $1.450 is less favourable to the purchaser of the option and is therefore cheaper; the purchaser of the $1.450 option will receive less $ for each sold than at the exchange rate of $1.500/ and A call option, with a strike price of $1.375/ exercisable in May 1993 would involve a premium of 6.05 cents. The same strike price carries a lower premium when exercisable in April 1993 (5.75 cents).This difference in premium reflects the fact that the May option has longer to run and therefore: (i) (ii) there is more likelihood of it being beneficial to exercise the option; and the time value of money is higher; the May call option

These contracts are quoted against the US$. This is because they are traded in the USA and therefore the home currency is the US$ and the other currencies, including are the foreign currencies. Consequently option premiums are payable in US$ so we have to take care when considering the use of these contracts by a UK company. Currency options have the following benefits: Protection against adverse movements in the exchange rate (downside risk). Opportunity to benefit if there is a favourable movement in the exchange rate (upside risk). This opportunity is not available if a firm uses a forward foreign exchange contract, money market hedge or currency futures contracts. Enables a firm to hedge currency risk when there is uncertainty regarding whether the foreign currency transaction will materialise. e.g. tendering for a contract. A firm can choose, from a range of rates (strike prices) quoted, the level of insurance it requires and the cost of that insurance. The more protection the option contract provides the higher the premium will be.

TECHNICAL 4

enables the firm to delay paying for the currency for a further month; and (iii) the markets view of the direction in which the exchange rate will move between April and May; this in turn will reflect the differential between and $ interest rates. (This is interest rate parity which we covered in the first article of the series.) We can now look at how a company could use traded currency options to hedge currency risk. For convenience the example will use the premiums quoted in Table 1. Example 1 Assume it is now 12 March 1993. Anderson PLC, a UK company, owes Bishop Inc., a US supplier, $340,000 payable in June 1993. The spot rate is $1.4330 $1.4355 / and Anderson PLC is concerned that the $ may strengthen against the before payment is made. Required: Show how traded /$ currency options, contract size 31,250, can be used to hedge the currency risk on this transaction. Assume Anderson PLC decides to use an option with a strike price of $1.425/. Calculate the sterling cost of the transaction if the spot rate in June is: (a) $1.3800 $1.3834/ (b) $1.5200 $1.5245/ Solution to Example 1 This example is awkward because the UK company is having to use option contracts traded in the USA. Therefore the premium is payable in $s and the $ is the home currency so we need to think of the as the foreign currency. Stage 1: Does Anderson need to use call or put options? The company needs to sell s in order to buy $s. Because, from the viewpoint of the Philadelphia option market, the is the foreign currency Anderson needs to buy /$ put options: options to sell s in exchange for $s. Stage 2: How many contracts? For the exercise price of $1.425/ the company will need to sell: . 340,000/1.425 = 238,596 . . the number of contracts required is: 238,596/31,250 = 7.6 i.e. 8 contracts (can only buy a whole number of contracts so take the nearest whole number). Stage 3: How much is the premium? 31,250 x 3.73/100 = $ 1,166 per contract. The premium is in $s since the option contract is traded in the USA. In effect it costs 3.73 cents to fix the exchange rate at which one is able to sell 1 (and therefore buy $1.425). Total premium: 1,166 x 8 = $9,328 which, at the spot rate of $1.4330/, will cost: 9,328/1.4330 = 6,509. Stage 4: What action will the firm take? This will depend on the spot rate in June 1993. (a) Spot rate in June $1.3800 $1.3834/. The firm has a choice. It can either: (i) buy $ on the spot market at $1.3800/ at a cost of: 340,000/1.3800 = 246,377; or (ii) exercise the put option to sell s in exchange for $s at a rate of $1.425 (which is more favourable to Anderson PLC than the spot rate). The firm should therefore exercise the put options. Sterling cost: 8 contracts involve selling 8 x 31,250 = 250,000. Each contract will result in proceeds of: 31,250 x 1.425 = $44,531.25

Total proceeds for 8 contracts is therefore: 44,531.25 x 8 = Amount to pay supplier Surplus $

$356,250 $340,000 $ 16,250

This surplus arises because, in this example, the firm is using exchange traded contracts and therefore has to accept the standard contract size which does not exactly match their requirements. We will assume the firm will sell the excess $s. proceeds: 16,250/1.3834 = 11,746. . ... net sterling cost: 250,000 11,746 = 238,254 + premium of 6,509 = 244,763 which is, as we would expect, cheaper than using the spot market. (since the option contract rate is better than the spot rate). (b) Spot rate in June $1.5200 $1.5245/. The firm has the following choice: (i) Buy $ on spot market at $1.5200/ at a cost of: 340,000/1.5200 = 223,684 or (ii) Exercise the put option to sell s in exchange for $s at $1.425 which is less beneficial since the exercise price of $1.425 is less favourable than the spot rate of $1.5200: Summary: Spot rate in June (a) $1.38/ Cost with no Cost with currency option option 246,377 238,254 + 6,509 = 244,763 (effective rate 340,000/244,763
= $1.389/1)

(b) $1.52/

223,684

223,684 + 6,509 = 230,193

(effective rate 340,000/230,193 = $1.477/1)

N.B. The use of the put options has reduced the risk of the transaction. If the $ strengthened against the , as in (a), the currency options would have been beneficial however most of the saving would, in this case, be paid as premium. Not surprisingly, if the $ had weakened against the the company is better off to use the spot market which, with option contracts, it can do by choosing not to exercise the option and therefore allowing the options to lapse. If the company had used a forward foreign exchange contract, money market hedge or currency futures contracts to hedge the currency risk then it would not have been able to take advantage of a favourable spot rate. We now need to return to the example involving Sophieclare PLC which we have featured in the earlier articles to see how Sophieclare could use currency option contracts. This will enable us to compare the use of traded currency option contracts for hedging currency risk with the other methods covered in the first three articles. The data from the original example is repeated for convenience. Example 2 Assume it is now October 1995. Sophieclare PLC, a UK company, owes Benjaminpaul Inc., a US supplier, $370,000 payable 3 months later in January 1996. The spot rate is $1.5766 $1.5775/ and Sophieclare PLC is concerned that the $ may strengthen against the before payment is made. The finance director has obtained the

TECHNICAL

following quotes from the Philadelphia Stock Exchange: As per Financial Times 31.10.95 Phildaelphia SE /$ options 31,250 (cents per pound). Strike Price 1.540 1.550 1.560 1.570 1.580 1.590 CALLS Nov Dec 3.52 2.54 1.68 0.92 0.40 0.12 3.79 3.01 2.36 1.75 1.49 1.26 Jan 4.20 3.49 2.86 2.34 1.85 1.44 Nov 0.02 0.06 0.16 0.31 0.79 1.50 PUTS Dec 0.36 0.55 0.85 1.25 1.48 1.76 Jan 0.81 1.11 1.47 1.90 2.42 2.95

(use $1.3800 since the firm is buying $s) = 268,116 or (ii) Exercise the put option to sell s in exchange for $s at a rate of $1.54 or $1.59 (which is more favourable to Anderson PLC than the spot rate). The firm should therefore exercise the options: Exercise price: $1.54 Sterling cost: 8 contracts involve selling 8 x 31,250 = 250,000. Each contract will result in proceeds of: 31,250 x 1.54 = $48,125. Total proceeds for 8 contracts is therefore: 48,125 x 8 = amount to pay supplier Surplus $ $385,000 $370,000 $ 15,000

Previous days vol. Calls 27,528 Puts 7,601. Prev. days open int. Calls 274,824 Puts 291,536 The finance director is thinking of using currency options with a strike price of either $1.54 or $1.59. Required: Calculate whether, with the benefit of hindsight, the sterling cost of hedging the currency risk using traded currency option contracts is better (i.e. lower) than the cost of using currency futures contracts of 233,055 for (a) and 238,968 for (b) (derived in the third article). Assume for the purposes of your evaluation that in January 1996: (a) the spot rate was $1.3800 $1.3809 /. (b) the spot rate was $1.8500 $1.8510 /. Ignore taxation. Solution to Example 2. Stage 1: Does Sophieclare need to use call or put options? The firm needs to sell in order to buy $, therefore need to buy /$ put options: options to sell in exchange for $. Stage 2: How many contracts? For the exercise price of $1.54/ the company will need to sell: . 370,000/1.54 = 240,260. . . the number of contracts required is: 240,260/31,250 = 7.7 i.e. 8 contracts. Stage 3: How much is the premium? Since the hedge is required until January it will be necessary to use January 1996 option contracts since the November 1995 and December 1995 contracts will have expired. The premium will depend on the exercise price: Exercise price: $1.54. Premium: 31,250 x 0.81/100 = $253 per contract, giving a total of: 253 x 8 = $2,024 which, at the spot rate of $1.5766/ (the company will have to buy $s in order to pay the premium), will cost: 2,024/ 1.5766 = 1,284. Exercise price: $1.59. Premium: 31,250 x 2.95/100 = $922 per contract, giving a total of: 922 x 8 = $7,376 which, at the spot rate of $1.5766/ (the company will have to buy $ in order to pay the premium), will cost: 7,376/1.5766 = 4,678. Stage 4: What action will the firm take? (a) Spot rate in January $1.3800 $1.3809/: Sophieclare PLC has a choice. It can either: (i) Buy $s on spot market at $1.3800/ at a cost of: 370,000/1.3800

proceeds: 15,000/1.3809 (use $1.3809 since the firm is selling $s) . = 10,862 . . net sterling cost: 250,000 10,862 = 239,138 + premium of 1,284 = 240,422 which is, as we would expect, cheaper than using the spot market. Exercise price: $1.59. Sterling cost: 8 contracts involve selling 250,000. Each contract will result in proceeds of: 31,250 x 1.59 = $49,687 (to the nearest $). Total proceeds for 8 contracts is therefore: 49,687 x 8 = amount to pay supplier Surplus $ . proceeds: 27,496/1.3809 = 19,912. $397,496 $370,000 $ 27,496

. . net sterling cost: 250,000 19,912 = 230,088 + premium of 4,678 = 234,766. This demonstrates that the choice of exercise price can have a significant effect on the final cost. In this case (for this particular spot rate) the exercise price of $1.59, which has a higher premium, results in a lower overall cost. (b) Spot rate in January $1.85001.8510/. The firm has the following choice: (i) Buy $ on spot market at $1.8500/ at a cost of: 370,000/1.8500 = 200,000; or (ii) Exercise the put option to sell in exchange for $ at $1.54 or $1.59 both of which are less beneficial since the exercise prices are less favourable than the spot rate of $1.8500). Hence the total cost would be: 200,000 + 1,284 = 201,284 for the strike price of $1.54 and 200,000 + 4,678 = 204,678 for the strike price of $1.59. We can now summarise the costs that would have been incurred by Sophieclare PLC for each of the hedging methods. The underlying calculations for no hedge, money market hedge, forward contracts and futures contracts are shown in the first three articles in the series. Method used (a) Spot rate $1.3800 $1.3809 cost No hedge Money market hedge Forward contract Futures contracts 268,116 235,261 235,969 233,055 (b) Spot rate $1.8500 $1.8510 cost 200,000 235,261 235,969 238,968 201,284 204,678

Option contracts 240,422 strike price $1.54 Option contracts 234,766

TECHNICAL 4

strike price $1.59 Comments: Forward contracts, futures contracts and the money market hedge remove the risk and therefore protect the firm if the $ strengthens, as in (a), but prevent the firm from benefiting from the weakness of the $ in (b). Because of their standard size, futures contracts result in a different cost for each exchange rate. The solution is based on 4 contracts for 62,500. If the exercise price of $1.54 had been chosen and the $ had strengthened as in (a) options would have been the most expensive method of hedging. Option contracts enable the firm to take advantage of the favourable spot rate in (b).

Three months forward Six months forward Three months or six months Sterling Dollars

0.820.77 cents premium 1.391.34 cents premium Interest rates Borrowing 12.5% 9% Lending 9.5% 6%

Foreign currency option prices (New York market) Prices are cents per , contract size 12,500 CALLS Exercise price ($) March June 1.60 1.70 1.80 5.65 1.70 15.20 7.75 3.60 Sept 7.90 PUTS March June 3.45 Sept 2.75 6.40

9.32 15.35

Examination style question

The following examination question is taken from the ACCA December 1989 examination. I suggest you work the question within a time limit of 31 minutes. Example 3 Fidden is a medium-sized UK company with export and import trade with the USA. The following transactions are due within the next six months. Transactions are in the currency specified. Purchases of components, cash payment due in three months: 116,000. Sale of finished goods, cash receipt due in three months: $197,000. Purchase of finished goods for resale, cash payment due in six months: $447,000. Sale of finished goods, cash receipt due in six months: $154,000. Exchange rates (London market) $/ Spot 1.71061.7140

Assume that it is now December with three months to expiry of the March contract and that the option price is not payable until the end of the option period, or when the option is exercised. Required: (i) Calculate the net sterling receipts/payments that Fidden might expect for both its three and six month transactions if the company hedges foreign exchange risk on: (1) the forward foreign exchange market; (2) the money market. (7 marks)

(ii) If the actual spot rate in six months time was with hindsight exactly the present six months forward rate, calculate whether Fidden would have been better to hedge through foreign currencyoptions rather than the forward market or money market. (7 marks) (iii) Explain briefly what you consider to be the main advantage of foreign currency options. (3 marks)

The answer to this question and the remainder of the article will be published in next months issue.

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Foreign currency exposure management: part 5b

Currency option contracts

Nigel Brown BA FCA is a senior lecturer in Financial Strategy at the University of Wales College, Newport
his is the last article in the series the aim of which is to develop an understanding of the effect foreign currency risk may have on a firm and of some of the techniques that are available for eliminating or reducing that risk. In this article we examine the main characteristics of currency options and the way in which currency options can be used to hedge currency risk.

i.e. annual rate divided by 4.) Let amount borrowed be x. x (1 + (0.09/4)) = 197,000 x = 197,000/(1 + 0.0225) = $192,665 Sell the dollars at the spot rate to receive: 192665/1.7140 = 112,407. This can be placed on deposit for 3 months (so as to compare with the amount receivable in 3 months time using a forward foreign exchange contract). Amount receivable: 112,407 x (1 +( 0.095/4)) = 115,077. Therefore the forward foreign exchange contract is the better choice. 6 months: The company is due to pay dollars so it will need to lend dollars now and then use the amount lent plus interest to pay the supplier. Let the amount lent be x (6 month interest rate = annual rate/ 2). x (1+ (0.06/2)) = 293,000 x = 293,000/1.03 = $284,466 The dollar should be purchased at the spot rate at a cost of: 284,466/1.7106 = 166,296

Solution to Fidden
(i) Calculation of net sterling receipts/payments: Preliminary workings. Working 1: identify the transactions 3 months: purchases for 116,000. Payment is in sterling therefore no current risk. Sales for $197,000 which needs to be hedged. 6 months: It is only necessary to hedge the net payment. Purchases Less expected receipt from sales Net $447,000 $154,000 $293,000

Working 2: calculation of forward rates: $/ Spot less Premium 3 months forward Spot Less Premium 6 months forward 1.7106 0.0082 1.7024 1.7106 0.0139 1.6967 1.7140 0.0077 1.7063 1.7140 0.0134 1.7006

With the forward contract the sterling cost of the dollars will not have to be paid until 6 months time. Therefore for comparison we need to take account of borrowing the sterling for 6 months. This will accru to: 166,296 (1 + (0.125/2)) = 166,296 (1.0625) = 176,690. Again the forward contract is the better choice.

(1) Forward Foreign exchange market 3 months: Company will receive dollars so hedge risk by selling the dollars forward. Sterling Proceeds in 3 months time will be: 197,000/1.7063 = 115,454 6 months: Company will pay dollars therefore currency risk will be hedged by buying the dollars forward. cost = $293,000/1.6967 = 172,688 (2) The money market 3 months time: The company will receive dollars therefore it is necessary to borrow an appropriate amount of dollars now and sell them at the spot rate. The dollar receipt will then be used to pay off the dollar loan. (The relevant interest rate is 3/12 of the annual rate.

(ii) With the 6 months transactions, the Company needs to buy dollars in June. In the case of the currency options the foreign currency that is bought (via a put option) is sterling. Therefore to buy $s the company will need to buy put options (i.e. be able to sell s in exchange for $s). Exercise price: $1.70 It is first necessary to calculate the number of contracts needed at this exercise price: Sterling equivalent of dollars required: 293,000/1.70 = 172,353 This will require 172,353/12,500 = 13.8 contracts. Hence the company could buy 14 contracts or 13 contracts combined with a forward contract for the balance.

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The company would need to buy 14 put option contracts. (This alternative is considered first since the question states one should use option contracts or forwards contracts.) If the spot rate in 6 months time is $1.6967 the company would exercise the put options. $ Proceeds: 14 x 12,500 x 1.70 297,500 Less premium: (i.e. the price of the contract) 14 x 12500 x 0.0345 =(6,037) less amount needed to pay supplier Additional dollars needed Hence overall sterling cost: 14 contracts @ 12,500 Additional $ purchased at spot rate 1,537/1.6967 = Total sterling cost (293,000) ($1,537) 175,000 906 175,906

Exercise price: $1.80. Number of contracts required: Sterling equivalent at exchange rate of 1.80: 293,000/1.80 = 162,778 Number of contracts = 162,778/12,500 = 13.02 contracts. In order to use currency option contracts only it will be necessary to purchase 14 sterling put option contracts: Proceeds: 14 x 12500 x 1.80 Less premium: 14 x 12500 x .0932 Amount needed to pay the supplier Surplus $ 315,000 (16,310) (293,000) 5,690

If the spot rate is $1.6967 it will be best to exercise the put options and sell the pound at $1.80. Sterling cost: 14 x 12,500 = Less proceeds from selling the surplus $ at the spot rate in 6 months time: 5,690/1.7006 = Net cost 175,000 (3,346) 171,654

Note 1: It is possible to see, by inspection, that the exercise price of $1.70 would result in a less favourable outcome: $ Exercise price i.e. price at which the are sold Less the option premium Effective rate at which s are being sold 0.0345 1.6655 1.70

Therefore overall the company would, with the benefit of hindsight, have been better off hedging the risk with currency options exercisable at $1.80.

which is considerably less favourable than the forward rate of $1.6967/.

(iii) The main advantage of foreign currency options is that they offer the firm the opportunity of not exercising the option. This is beneficial in two ways: (1) If the spot exchange rate moves in the firms favour. The company can take advantage of the favourable spot rate and allow the option to lapse. In this example if the dollar weakened to say $1.90/ then the currency option would be allowed to lapse and the dollar purchased at the spot rate of $1.90. Alternatively if the spot rate moved to say $1.60 the company could exercise the option at $1.80 or since the price of the put option would go up the option could be sold at a profit. (2) If the company is unsure as to whether the foreign currency transaction will arise (as in the case of tendering for a contract) the option contract allows the company to hedge the risk and allow the option to lapse if the currency exchange is not needed (unless as in (1) a profit could be made by exercising the option at one rate and then taking advantage of a more favourable spot rate. Low cost or zero cost options (Sometimes referred to as exotic options or currency option derivatives). The aim of these exotic currency options is to reduce or eliminate the cost of buying the option i.e. the premium. In order to reduce the cost of buying an option the firm may have to accept a reduction in the potential benefits from the option. Boston option The premium is normally payable at the time of entering the option contract but can be postponed by having it built into the strike price (which will therefore be less favourable) if the currency option is exercised. If the option is not exercised the premium would be payable when the option matures. The premium payable will be increased to take into account the cost of funds for the period between the time the premium is normally payable and the revised later

Note 2: The company could have purchased 13 contracts and hedged the remaining risk by using a forward contract: $ Proceeds from 13 contracts: 13 x 12,500 x 1.70 Less premium: 13 x 12,500 x 0.0345 amount needed to pay supplier Additional $s needed 276,250 (5,606) (293,000) (22,356)

Purchase this requirement using a forward foreign exchange contract: Cost 22,356/1.6967 = 13,176

Add sterling cost of the 13 contracts: 13 x 12,500 =162,500 Total sterling cost 175,676

This is slightly lower than the cost using 14 contracts reflecting the fact that the forward foreign exchange contract gives us a better rate in this example.

Note 3: In practice the option premium would be payable at the time of purchasing the contracts whereas under the forward contract the $s do not have to be paid for until the end of the 6 month period. The dollar cost of the premium would therefore be converted at the spot rate. It would also be necessary to take into account the opportunity cost of financing the premium for the 6 months period which would not be incurred with a forward foreign exchange contract.

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payment date. A collar A collar (or cylinder or range forward) is a transaction which sets an upper and lower limit to the exchange rate in order to provide a hedge against currency risk at a lower cost. Example 4 Rayer PLC, a company in the UK, is expecting to receive $220,000 in three months time. The spot rate is $1.4500 $1.4530/. Rayers objective is to hedge the downside risk which is the risk that the $ may weaken. This it can achieve by buying an option to sell $s. Rayer PLC has been offered an over-the-counter put option (to sell $s) by its bank. The option, which is exercisable in three months time, has a strike price of $1.49/ and a premium payable of 5 cents. The advantage of using the put option rather than other methods of hedging, such as a forward contract, is that if the $ strengthens Rayer can allow the option to lapse and profit by selling the $s in the spot market for a higher proceeds. This is the upside risk. The disadvantage of just using the put option is the premium Rayer has to pay. This premium can be reduced by limiting the amount of upside risk that Rayer is able to participate in. This is achieved by selling (writing) an option to the bank in order to receive a premium from the bank. In effect Rayer can sell part of the upside risk to the bank. Let us assume that Rayer PLC has the opportunity of reducing the cost of this option to zero by writing a call option to sell the same number of $s to the bank at $1.39/ for a premium of 5 cents. Hence the premium Rayer PLC receives for the option it writes compensates for the premium the company has to pay for the option it buys from the bank. The combination of buying the $1.49/ put and selling the $1.39/ call is referred to as a collar. The effect of this collar is that, in return for a nil premium, the company has limited the exchange rate it achieves to a range of $1.39 to $1.49/. The currency risk has been reduced at zero cost. Valuation of currency options The Black and Scholes option pricing model has been adapted in various ways to value currency options. We need to be aware of the factors which contribute to the value of a currency option. These are: the spot rate and forward exchange rate for the period to which the option applies. The forward rate reflects the interest rate differ-

ential: the difference between the domestic interest rate and the equivalent foreign interest rate. the strike rate(the exchange rate at which the option is exercisable). The premium is higher for a strike price which is more favourable to the purchaser of the option. the domestic risk free interest rate; this reflects the interest that could be earned on the option premium. the standard deviation of the continuously compounded annual rate of movement in the exchange rate. The higher the risk the more chance there is that the option is worth exercising and therefore the higher the premium will be. the time to run before the option expires. As the time to expiry increases the option premium increases. the type of option contract. An American option (which is exercisable at any time to maturity) will involve a higher premium than a European option (which is only exercisable at maturity).

Conclusion
Currency risk is an important issue which is relevant to many companies in practice. We have looked at methods which can be used for hedging currency risk. Before making a final decision between the various hedging instruments it is necessary to ascertain the local tax treatment of each instrument. Currency risk is an extremely important topic in the paper 14 Financial Strategy syllabus. For success in the examination it is advisable to work through plenty of examination-style questions, preferably worked within an appropriate time limit.

References Brealey, R.A. and Myers, S.C., Principles of Corporate Finance, McGraw Hill, New York (1996). Brown, N., Kaur, P., Maugham, S. and Rendall, J., Financial Strategy, Certified Accountants Educational Projects, London (1994). Buckley, A., Multinational Finance, Prentice Hall, New York (1992). French, D., Dictionary of Accounting Terms, The Institute of Chartered Accountants in England and Wales, London (1991). Demirag, I and Goddard, S., Financial Management for International Business, McGraw Hill (1994). Shapiro, A., Multinational Financial Management, Allyn and Bacon, Boston (1995).