2. Background
Growing world trade over the past 25 years
Companies involved in transactions involving foreign
currencies
about 22% of sales in FTSE 350 companies directly
exposed to the US
further 11% in regions tied to the dollar
Pike & Neale, chapter 21
Foreign exchange rate exposure of increasing
importance
Companies need to insure against adverse
movements in exchange rates
2
3. Scenario
A UK company expects to receive $300,000 in 3
months time. It is concerned that the pound will
appreciate relative to the dollar and decides to
hedge the transaction risk
Current exchange rate is $1.50
How much is $300,000 worth currently?
How much would it be worth in three months time if
the exchange rate moved to $1.60?
3
4. Scenario
A UK company expects to receive $300,000 in 3
months time.
Current exchange rate is $1.50
How much is $300,000 worth currently?
$300,000/1.50 = £200,000
How much would it be worth in three months time if
the exchange rate was $1.60?
$300,000/1.60 = £187,500
Unhedged, this is a LOSS to the company
4
5. Futures
A financial futures contract is an agreement to buy or sell,
through an organised exchange
a standard amount of a financial instrument
for delivery at a specified date in the future
at a price which is agreed on the trade date
Only members of the exchange can trade
Chicago Mercantile Exchange (CME); Euronext.liffe
Contracts are standardised in terms of contract amounts,
dealing dates and size
Delivery in the future at a price agreed today
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6. Futures - background
Commodity futures have been traded for more than
100 years in the US
Financial futures are similar to commodity futures
However, the underlying asset is a financial
instrument, not wheat, soya beans or another crop
Only a small percentage of futures reach final
delivery
Speculators dominate the market
6
7. Jargon
Holding futures contract – long position
Selling futures contract – short position
Party and counterparty
Clearing house
7
8. Example using Futures
(adapted from Watson and Head)
A UK company expects to receive $300,000 in 3
months time. It is concerned that the pound will
appreciate relative to the dollar and decides to use
futures to hedge its transaction risk
Delivery in the future at a price agreed today
8
9. Using futures contracts
Holding a futures contract means delivery at a
specified date in the future of a pre-agreed amount
of foreign currency
The company will buy sterling futures
This means it will take delivery of sterling and pay
with the dollars it expects to receive
9
10. Example using Futures
CME rates at 1 Jan
Spot rate: $1.54 - $1.55
£ futures price (Apr): $1.535
Standard contract size: £62,500
CME : the Chicago Mercantile Exchange
10
11. Futures contract
Spot rate: $1.54 - $1.55
£ futures price (Apr): $1.535
Standard contract size: £62,500
The futures price quoted is the amount of dollars
needed to buy one unit of foreign currency (one
pound)
To work out the number of contracts needed, divide
the sterling amount by the standard contract size
Each contract will cost £62,500 x $1.535 = $95,937.50
i.e. to take delivery of £62,500 in three months time,
will cost $95,937.50
11
12. Using futures contracts
How many contracts?
divide amount in dollars by sterling futures price
$300,000/1.535 = £195,440
now divide sterling amount by standard contract size
£195,440/£ 62,500 = 3.13, or 3
Three contracts will provide £187,500 in three months time
This will cost the company $287,813 = 187,500 x1.535
The difference (300,000 – 287,813) is unhedged
(could be sold spot in 3 months or a forward contract
arranged)
12
13. What has happened?
The UK company
expects dollars in the future and wants to fix the
exchange rate now
buys 3 futures contracts now
receives a known amount of sterling in the future
(from the contracts)
settles in dollars from its dollar payment
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14. Differences between forwards and
futures contracts
Forward Contracts Futures Contracts
Over-the-counter Traded on an exchange
Each contract is tailor -made Standardised contracts
The market is operated by Formal margin requirements
the banks and is self The contract is marked-to-
regulatory market on a daily basis
90% contracts are carried out Requires a brokerage fee
Cost of the forward contract The exchange is the
counterparty
is based on the bid-ask
spread Less than 1% of futures
contracts are carried out →
No margin is required liquid market
High transaction costs Speculation as well as hedging
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15. Less than 1% of contracts are carried out
means….
Liquid market in contracts
Euronext.liffe has an average daily volume of around
3 million contracts worth hundreds of billions of
pounds
Standardised legal agreements
Wide market appeal
It is the contracts that are bought and sold, not the
commodity
Liquidity is good
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16. Options
An option gives the owner the right but not the
obligation to take delivery of a physical asset at or
before a pre-agreed date
Examples of options
share options
currency options
The physical asset is called the underlying asset
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17. Currency Options
The right to buy/sell currency
at a given price
at a given date
CALL option - the right to buy
PUT option - the right to sell
Types of options
American
European
17
18. What are you buying?
Buying a currency option - a call - gives you the
right, but not the obligation, to buy currency at a pre-
agreed exchange rate at or before a pre-agreed time
The pre-agreed exchange rate is called the strike
The pre-agreed date is called the exercise date or
the expiry
The price you pay is called the premium
If you do not trade at or before the exercise date,
then the option expires worthless
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19. Option terminology
In-the-money - profitable at the current exchange
rate
Out-of-the-money - not profitable at the current
exchange rate
At-the-money - exercise price = spot rate
Intrinsic value – the value the holder of the option
could realise if the option traded today
positive if option in-the-money
otherwise zero
For the buyer of options, loss is limited to
premium, potential gain is unlimited
19
20. Example using options
(adapted from Watson and Head)
A UK company expects to receive $1m in 3 months
and decides to hedge its transaction risk with
currency options.
Currently $1.63/£.
£ is the foreign currency (on CME) and so company
buys £ call options, strike price $1.65/£
20
21. Using options
The company will buy CME sterling currency options
The underlying is a futures contract
Contract size is £62,500
Sterling is the foreign currency
The company will buy call options
This gives the company the right but not the
obligation to sell dollars and buy sterling at a pre-
agreed exchange rate
21
22. Example using options
CME contract
Strike $1.65
Standard contract size: £62,500
Premium 7cents
Each contract costs $4,375
22
23. Using options
How many contracts?
divide amount in dollars by strike
$1,000,000/1.65 = £606,060
now divide sterling amount by standard contract size
£606,060/£ 62,500 = 9.7
Company can buy 9 contracts or 10 contracts
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25. Mechanism
In 3 months time
if the spot rate is below $1.65
the company will allow the option to expire
it will exchange its dollars in the spot market
if the spot rate is above $1.65
it will exercise the option
1,000,000/1.65 = £606,061 AT-THE-MONEY
1,000,000/1.75 = £571,428 IN-THE-MONEY
1,000,000/1.60 = £625,000 OUT-OF-THE-
MONEY
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26. Buying a call option
Profit
Strike Underlying Price
0
P P = premium
Loss
26
27. Buying a put option
Profit
0 Strike Underlying Price
P
Loss
27
28. The difference between options and
futures
An option confers the right not the obligation to trade
A premium is payable
The seller (writer) of the option is obliged to honour
the contract
Options: one party purchases all the rights; the other
has all the obligations
Futures: commit both parties to obligations
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29. Risk Management
Pros Cons
Maintaining Complexity of
competitiveness instruments
Costs
Reduction of bankruptcy
risk Complex fin reporting
and tax
Reduction in volatility of
cash flows
29
30. Key Points: currency risk
Considered use of futures and options to hedge
forex risk
Differences between forward/futures plus
options/futures discussed
Forex exposure management strategies discussed
30
31. Reading
Watson, D. & Head, A. Corporate Finance
Principles and Practice, Chapter 12
Arnold, G. Corporate Financial Management,
Chapter 24
Pike, R. & Neale, B. Corporate Finance and
Investment, Chapter 21
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