Foreign Exchange

Exposure & Risk

Management
Module 4
Sessions 12 to 14

1
 Module Outline
 SECTIONS
1.Management of Transaction
Exposure
2.Management of Economic Exposure
3.Management of Translation Exposure
4.Interest Rate and Currency Swaps
5.Futures and Options on Foreign
Exchange
2
1. Management of Transaction
Exposure
Section Outline
• Forward Market Hedge
• Money Market Hedge
• Options Market Hedge
• Cross-Hedging Minor Currency
Exposure
• Hedging Contingent Exposure
• Hedging Recurrent Exposure with
Swap Contracts
3
 Section Outline (continued)
• Hedging Through Invoice Currency
• Hedging via Lead and Lag
• Exposure Netting
• Should the Firm Hedge?
• What Risk Management Products do
Firms Use?

4
 Section 1 Objectives
• This Section discusses various
methods available for the
management of transaction
exposure facing multinational firms.
•

5
 Three Types of Exposure
1.Transaction Exposure
2.Economic Exposure
3.Translation Exposure

6
 Transaction Exposure:
definition
• Defined as sensitivity
– Of realized domestic currency values
– Of the firm’s contractual cash flows
denominated in foreign currencies
– To unexpected exchange rate
changes.
• Transaction exposure arises from
fixed price contracting, even
though exchange rates are
changing randomly.
7
 Economic Exposure:
definition
• Defined as the extent to which the
value of the firm would be affected
by unanticipated changes in
exchange rates.
• All anticipated exchange rate
changes are already reflected in
firm’s value.

8
 Translation Exposure:
• Defined as the potential that the
firm’s consolidated financial
statements can be affected by
changes in exchange rates.
• Consolidation involves translation of
foreign subsidiaries’ financial
statements from their local
currencies to the home currency of
the holding company.
9
 Transaction exposures:
Example
• A firm is subject to transaction
exposure when it faces contractual
cash flows that are fixed in foreign
currencies.
• Assume that a US firm has sold its
product to a German client on three
month credit term and invoiced EUR 1
mn.
• When the US firm receives the money
in 3 months, it will have to convert (if
it has not already hedged) the EUR to 10
 Example
• So, the USD receipt from this sale
becomes uncertain.
– If the EUR appreciates, USD receipt
will be higher
– If the EUR depreciates, it will be lower.
• If the firm does nothing about the
exposure (at the time of
contracting the sale), it is
speculating on the future course of
the exchange rate.
11
 Example
• Hence, whenever a firm has
receivables or payables
denominated in foreign currency, it
is subject to transaction exposure.
• The magnitude of the transaction
exposure is the same as the
amount of foreign currency that is
receivable or payable.

12
 Hedging Transaction
Exposures
• Transaction exposures may be
hedged using
– Various financial contracts
• Forward market hedge
• Money market hedge
• Option market hedge
• Swap market hedge
– Operational techniques.
• Choice of invoice currency
• Lead / lag strategy
• Exposure netting
– 13
 Forward Market Hedge
• If you are going to owe foreign
currency in the future, agree to buy
the foreign currency now by
entering into long position in a
forward contract.
• If you are going to receive foreign
currency in the future, agree to sell
the foreign currency now by
entering into short position in a
forward contract. 14
 Forward Market Hedge: an
Example

You are a U.S. importer of British
woolens and have just ordered next
year’s inventory. Payment of £100M
is due in one year.


Question: How can you fix the cash



outflow in dollars?
A n sw e r: O n e w a y is to p u t yo u rse lf in a
p o sitio n th a t d e live rs £ 1 0 0 M in o n e
ye a r—a lo n g fo rw a rd co n tra ct o n th e
pound.
15
 Money Market Hedge
W ith th e a ssu m p tio n s g ive n in th e ta b le b e lo w ,
im p o rte r o f B ritish w o o le n s ca n h e d g e h is £ 1 0 0
m illio n p a ya b le w ith a m o n e y m a rke t h e d g e :
B o rro w $ 1 1 2 . 0 5 m illio n in th e U . S .
Tra n sla te $ 1 1 2 . 0 5 m illio n in to p o u n d s a t th e sp o t ra te
S($/£) = $1.25/£
Invest £89.64 million in the UK at i£ = 11.56% for one
year.
In one year your investment will have grown to £100
million .
Spot exchange rate S($/£) = $1.25/£
360-day forward rate F360 ($/£) = $1.20/£
U.S. discount rate i$ = 7.10%
British discount rate i£ = 11.56%

16
 Money Market Hedge
Where do the numbers come from?
We owe our supplier £100 million in one year—so we know
that we need to have an investment with a future
value of £100 million. Since i£ = 11.56% we need to
invest £89.64 million at the start of the year.
£100
£89.64 =
1.1156
How many dollars will it take to acquire £89.64
million at the start of the year if the spot rate
S($/£) = $1.25/£?
$1.25
$112.05 = £89.64×
£1.00
17
 Money Market Hedge
 Suppose you want to hedge a payable
in the amount of £y with a maturity of
T:
 i. Borrow $xat t = 0 on a loan at a rate of
i$ per year.
 (Note that $x = £y/(1+ i£)T at the spot
rate.)


 ii. Exchange $xfor £y/(1+ i£)Tat the

prevailing spot rate, invest £y/(1+ i£)T at i£
for the maturity of the payable to achieve £y.
At maturity, you will owe a $x(1 + i ).
$
Your British investments will have grown 18
 Another possibility
• Another money market route for
hedging would be to
– borrow USD for 1 year and
– book a forward contract for buying
GBP, to mature at the end of 1 year.

19
 Money Market Hedge
 Suppose you want to hedge a £
receivable in the amount of £y with a
maturity of T:
 i. Borrow £y/(1+ i£)Tat t = 0.
 ii. Exchange £y/(1+ i£)T for $x at the
prevailing spot rate.


At maturity, you will owe £ y which can

be paid with your receivable.
You will have no exposure to the dollar-

pound exchange rate. 20

 Options Market Hedge
• Options provide a flexible hedge
against the downside, while
preserving the upside potential.
• To hedge a foreign currency payable,
buy calls on the currency.
– If the currency appreciates, your call
option lets you buy the currency at the
exercise price of the call.
• To hedge a foreign currency receivable,
buy puts on the currency.
– If the currency depreciates, your put
option lets you sell the currency for the21
exercise price.
 Cross-Hedging
Minor Currency Exposure
• The major currencies are the: U.S.
dollar, Canadian dollar, British
pound, Euro, Swiss franc, Mexican
peso, and Japanese yen
• Everything else is a minor currency,
like the Polish zloty.
• It is difficult, expensive, or impossible
to use financial contracts to hedge
exposure to minor currencies.
22
 Cross-Hedging
Minor Currency Exposure
• Cross-Hedging involves hedging a
position in one asset by taking a
position in another asset.
• The effectiveness of cross-hedging
depends upon how well the assets are
correlated.
– An example would be a U.S. importer
with liabilities in Czech koruna hedging
with long or short forward contracts on
the euro. If the koruna is expensive
when the euro is expensive, or even if
the koruna is cheap when the euro is 23
 Hedging Contingent
Exposure
• If only certain contingencies give rise
to exposure, then options can be
the only effective insurance.
• For example, if your firm is bidding
on a hydroelectric dam project in
Canada, you will need to hedge the
Canadian-U.S. dollar exchange rate
only if your bid wins the contract.
Your firm can hedge this contingent
risk with options.
24
 Hedging Recurrent Exposure
with Swaps
• Recall that swap contracts can be
viewed as a portfolio of forward
contracts.
• Firms that have recurrent exposure
can very likely hedge their
exchange risk at a lower cost with
swaps than with a program of
hedging each exposure as it comes
along.
• It is also the case that swaps are 25
 Hedging through
Invoice Currency
• The firm can shift, share, or diversify:
– shift exchange rate risk
• by invoicing foreign sales in home
currency
– share exchange rate risk
• by pro-rating the currency of the
invoice between foreign and home
currencies
– diversify exchange rate risk
• by using a market basket index

26
 Hedging via Lead and Lag
• If a currency is appreciating, pay
those bills denominated in that
currency early; let customers in
that country pay late as long as
they are paying in that currency.
• If a currency is depreciating, give
incentives to customers who owe
you in that currency to pay early;
pay your obligations denominated
in that currency as late as your
contracts will allow. 27
 Exposure Netting
• A multinational firm should not consider
deals in isolation, but should focus on
hedging the firm as a portfolio of
currency positions.
– As an example, consider a U.S.company
with Korean won receivables and
Japanese yen payables.
– Since the won and the yen tend to move
similarly against USD, the firm can wait
until these accounts come due and just
buy yen with won.
– Even if it’s not a perfect hedge, it may
be too expensive or impractical to 28
 Exposure Netting
• Many multinational firms use a
reinvoice center. Which is a
financial subsidiary that nets out
the intrafirm transactions.
• Once the residual exposure is
determined, then the firm
implements hedging.

29
 Exposure Netting: an
Example
 Consider a U.S. MNC with three subsidiaries and
the following foreign exchange transactions:

$2
$0 3
0
$4
0 $1
$1 $3 $30 $40
0 5 $2 0
5 $60
$2
0$ 3
0 30
 Exposure Netting: an
Example
 Bilateral Netting would reduce the number of
foreign exchange transactions by half:

$2
$0 3
0
$4
0 $1
$1 $3 $30 $40
0 5 $2 0
5 $60
$2
0$ 3
0 31
 Exposure Netting: an
Example
 Bilateral Netting would reduce the number of
foreign exchange transactions by half:

$1
0
$4
0 $1
$1 $3 $30 $40
0 5 $2 0
5 $60
$2
0$ 3
0 32
 Exposure Netting: an
Example
 Bilateral Netting would reduce the number of
foreign exchange transactions by half:

$1
0
$4
0 $1
$1 $3 $30 $40
0 5 $2 0
5 $60
$2
0$ 3
0 33
 Exposure Netting: an
Example
 Bilateral Netting would reduce the number of
foreign exchange transactions by half:

$1
0
$4
0 $1
$1 $3 $10
0 5 $2 0
5 $60
$2
0$ 3
0 34
 Exposure Netting: an
Example
 Bilateral Netting would reduce the number of
foreign exchange transactions by half:

$1
0
$4
0 $1
$1 $3 $10
0 5 $2 0
5 $60
$2
0$ 3
0 35
 Exposure Netting: an
Example
 Bilateral Netting would reduce the number of
foreign exchange transactions by half:

$1
0
$4
0 $1
$1 $3 $10
0 5 $2 0
5 $60
$1
0
36
 Exposure Netting: an
Example
 Bilateral Netting would reduce the number of
foreign exchange transactions by half:

$1
0
$4
0 $1
$1 $3 $10
0 5 $2 0
5 $60
$1
0
37
 Exposure Netting: an
Example
 Bilateral Netting would reduce the number of
foreign exchange transactions by half:

$1
0
$4
0 $1
$2 $10
5 $2 0
5 $60
$1
0
38
 Exposure Netting: an
Example
 Bilateral Netting would reduce the number of
foreign exchange transactions by half:

$1
0
$4
0 $1
$2 $10
5 $2 0
5 $60
$1
0
39
 Exposure Netting: an
Example
 Bilateral Netting would reduce the number of
foreign exchange transactions by half:

$1
0
$20
$2 $1 $10
5 $2 0
5
$1
0
40
 Exposure Netting: an
Example
 Bilateral Netting would reduce the number of
foreign exchange transactions by half:

$1
0
$20
$2 $1 $10
5 $2 0
5
$1
0
41
 Exposure Netting: an
Example
 Bilateral Netting would reduce the number of
foreign exchange transactions by half:

$1
0
$20 $1
$2 5 $10
5

$1
0
42
 Exposure Netting: an
Example
 Consider simplifying the bilateral netting with
multilateral netting:

$1
0
$2 $1
$2 0 5 $10
5

$1
0
43
 Exposure Netting: an
Example
 Consider simplifying the bilateral netting with
multilateral netting:

$1
0
$2 $1
$1 $1 0 5 $10
5 0

$1
0
44
 Exposure Netting: an
Example
 Consider simplifying the bilateral netting with
multilateral netting:

$1
0
$2 $1
$1 0 5 $10
5
$1
0

45
 Exposure Netting: an
Example
 Consider simplifying the bilateral netting with
multilateral netting:

$1
0
$2 $1
$1 0 5 $10
5
$1
0

46
 Exposure Netting: an
Example
 Consider simplifying the bilateral netting with
multilateral netting:

$1
0
$3 $1
$1 0 5 $10
5

47
 Exposure Netting: an
Example
 Consider simplifying the bilateral netting with
multilateral netting:

$1
0
$3 $1
$1 0 5 $10
5

48
 Exposure Netting: an
Example
 Consider simplifying the bilateral netting with
multilateral netting:

$1
0
$3 $1
$1 0 5 $10
5

49
 Exposure Netting: an
Example
 Consider simplifying the bilateral netting with
multilateral netting:

$1
0 $1
$3 5
0 $10

50
 Exposure Netting: an
Example
 Consider simplifying the bilateral netting with
multilateral netting:

$1
0 $1
$3 5
0 $10

51
 Exposure Netting: an
Example
 Consider simplifying the bilateral netting with
multilateral netting:

$1
0 $1
$3 5
0 $10

52
 Exposure Netting: an
Example
 Consider simplifying the bilateral netting with
multilateral netting:

$1
$3 5
0

$10

53
 Exposure Netting: an
Example
 Consider simplifying the bilateral netting with
multilateral netting:

$1
$3 5
0

$10

54
 Exposure Netting: an
Example
 Consider simplifying the bilateral netting with
multilateral netting:

$1
5
$4
0

55
 Exposure Netting: an
Example
 Clearly, multilateral netting can simplify things
greatly.

$1
5
$4
0

56
 Exposure Netting: an
Example
 Compare this:

$2
$0 3
0
$4
0 $1
$1 $3 $30 $40
0 5 $2 0
5 $60
$2
0$ 3
0 57
 Exposure Netting: an
Example
 With this:

$1
5
$4
0

58
 Should the Firm Hedge?
• Not everyone agrees that a firm
should hedge:
– Hedging by the firm may not add to
shareholder wealth if the
shareholders can manage exposure
themselves.
– Hedging may not reduce the non-
diversifiable risk of the firm.
Therefore shareholders who hold a
diversified portfolio are not helped
when management hedges.
59
 Should the Firm Hedge?
• In the presence of market
imperfections, the firm should
hedge.
– Information Asymmetry
• The managers may have better
information than the shareholders.
– Differential Transactions Costs
• The firm may be able to hedge at
better prices than the shareholders.
– Default Costs
• Hedging may reduce the firm’s cost of
capital if it reduces the probability of
default.
60
 Should the Firm Hedge?
• Taxes can be a large market
imperfection.
– Corporations that face progressive tax
rates may find that they pay less in
taxes if they can manage earnings
by hedging than if they have “boom
and bust” cycles in their earnings
stream.

61
 What Risk Management
Products do Firms Use?
• Most U.S. firms meet their exchange
risk management needs with
forward, swap, and options
contracts.
• The greater the degree of
international involvement, the
greater the firm’s use of foreign
exchange risk management.

62
End Section 1

63
 2. Management of Economic
Exposure
Section Outline
• Three Types of Exposure
• How to Measure Economic Exposure
• Operating Exposure: Definition
• An Illustration of Operating Exposure
• Determinants of Operating Exposure
• Managing Operating Exposure
•

64
 Section Objectives
• This section provides a way to
measure economic exposure,
discusses its determinants, and
presents methods for managing
and hedging economic exposure.
•

65
 Three Types of Exposure
• Economic Exposure
– Exchange rate risk as applied to the
firm’s competitive position.
• Transaction Exposure
– Exchange rate risk as applied to the
firm’s home currency cash flows. The
subject of Section 1.
• Translation Exposure
– Exchange rate risk as applied to the
firm’s consolidated financial
statements. The subject of Section 3
66
 How to Measure
Economic Exposure
• Economic exposure is
– the sensitivity
– of the future home currency value of
the firm’s assets and liabilities and
the firm’s operating cash flow
– to random changes in exchange
rates.
• There exist statistical measurements
of sensitivity.
67
 How to Measure
Economic Exposure
• If a U.S. MNC were to run a regression
on the dollar value (P) of its British
assets on the dollar pound exchange
rate, S($/£), the regression would be
of the form:

68
 Regression of dollar value of
British assets on the $/£
exchange rate
P = a + b× S + e
ts

easures the sensitivity of the dollar value of the as

h mean zero.

69
 How to Measure
Economic Exposure
 The exposure coefficient, b, is defined
as follows:
Cov(P, S )
b=
Var(S )

W h e re C o v ( P, S ) is the covariance
b e tw e e n th e d o lla r va lu e o f th e a sse t
a n d th e exch a n g e ra te , a n d V a r( S ) is the
va ria n ce o f th e exch a n g e ra te .
70
 How to Measure
Economic Exposure
The exposure coefficient shows that


there are two sources of economic

exposure: the variance of the
exchange rate and the covariance
between the dollar value of the asset
and exchange rate.
Cov(P , S )
• b=
Var(S )

71
 Operating Exposure:
Definition
• The effect of random changes in
exchange rates on the firm’s
competitive position
• An alternative definition of operating
exposure is the extent to which the
firm’s operating cash flows are
affected by the exchange rate.

72
 Not readily measurable
• Operating exposure is not readily
measurable, unlike the exposure of
foreign currency denominated
assets and liabilities, listed in the
accounting statements.
• Operating exposure depends on
effect of random exchange rate
changes on the firm’s competitive
position.
73
• It is important that the firm properly
manages operating exposure as
well as asset exposure.
• In many cases, operating exposure
may account for a larger portion of
the firm’s total exposure, compared
to contractual exposure.

74
 An Illustration of
Operating Exposure
• There was an enormous shortage in
the shipping market from Asia, due
to the Asian currency crisis.
• This affected not only the shipping
companies, which enjoyed “boom
times”.
• But also retailers in Europe and US,
who experienced increased costs
and delays.
75
 An Illustration of
Operating Exposure
• Note that the exposure for the
retailers has two components:
nT h e C o m p e titive E ffe ct
uD ifficu ltie s a n d in cre a se d co sts o f
nT h e C osh ip prsi
n ve in go. n E ffe ct
uLo w e r d o lla r p rice s o f im p o rts d u e to
fo re ig n cu rre n cy exch a n g e ra te
d e p re cia tio n .

76
 Determinants of Operating
Exposure
• Recall that operating exposure cannot
be readily determined from the
firm’s accounting statements as can
transaction exposure.
• The firm’s
nT h e m a rkeoperating
t stru ctu re ofexposure is
inputs and products :
determined by:
h o w co m p e titive o r h o w m o n o p o listic th e
m a rke ts fa cin g th e firm a re .
nT h e firm ’ s a b ility to a d ju st its m a rke ts,
p ro d u ct m ix , a n d so u rcin g in re sp o n se to
exch a n g e ra te ch a n g e s.
77
 Managing Operating
Exposure
• Selecting Low Cost Production Sites
• Flexible Sourcing Policy
• Diversification of the Market
• R&D and Product Differentiation
• Financial Hedging

78
 Selecting Low Cost
Production Sites
• A firm may wish to diversify the
location of their production sites to
mitigate the effect of exchange
rate movements.
ne.g. Honda built North American
factories in response to a strong yen,
but later found itself importing more
cars from Japan due to a weak yen.

79
 Flexible Sourcing Policy
• Sourcing does not apply only to
components, but also to “guest
workers”.
ne.g.Japan Air Lines hired foreign crews
to remain competitive in international
routes in the face of a strong yen, but
later contemplated a reverse strategy in
the face of a weak yen and rising
domestic unemployment.

80
Diversification of the Market
• Selling in multiple markets to take
advantage of economies of scale
and diversification of exchange rate
risk.

81
 R&D and Product
Differentiation
• Successful R&D that allows for
– cost cutting
– enhanced productivity
– product differentiation.
• Successful product differentiation
gives the firm less elastic demand
—which may translate into less
exchange rate risk.

82
 Financial Hedging
• The goal is to stabilize the firm’s
cash flows in the near term.
• Financial Hedging is distinct from
operational hedging.
• Financial Hedging involves use of
derivative securities such as
currency swaps, futures, forwards,
currency options, among others.

83
End Section Two

84
 3. Management of Translation
Exposure
Section Outline
• Translation Methods
• FASB Statement 8
• FASB Statement 52
• Management of Translation Exposure
• Empirical Analysis of the Change
from FASB 8 to FASB 52

85
 FASB
• FASB: Financial Accounting Standards
Board
• Since 1973, FASB has been the
designated organization in the
private sector for establishing
standards of financial accounting
that govern the preparation of
financial reports by
nongovernmental entities.
• 86
 FASB
• Those standards are officially
recognized as authoritative by the
Securities and Exchange
Commission (SEC) and the
American Institute of Certified
Public Accountants.
•

87
• The SEC has statutory authority to
establish financial accounting and
reporting standards for publicly
held companies.
• Throughout its history, however, the
SEC’s policy has been to rely on the
private sector for this function
•

88
 Section Objectives
• This section discusses the impact
that unanticipated changes in
exchange rates may have on the
consolidated financial statements
of the multinational company.
•

89
 Translation Methods
• Current/Noncurrent Method
• Monetary/Nonmonetary Method
• Temporal Method
• Current Rate Method

90
Current/Noncurrent Method
• The underlying principle is that
assets and liabilities should be
translated based on their maturity.
– Current assets translated at the spot
rate.
– Noncurrent assets translated at the
historical rate in effect when the
item was first recorded on the
books.
• This method of foreign currency
translation was generally accepted
in the United States from the 1930s
until 1975, at which time FASB 8 91
 Summary of Statement
No. 8
Accounting for the Translation of Foreign
Currency Transactions and Foreign
Currency Financial Statements (Issued
10/75)
Summary

This Statement requires that all amounts

measured in a foreign currency be
translated at the exchange rate in effect at
the date at which the foreign currency
transaction was measured. All exchange
gains and losses were required to be
included in income in the period in which
they arose, i.e., when the rates changed.
92
Current/Noncurrent Method
– Current Balance Sheet Local Current/
asset Currency Noncurrent
s
transl Cash 2,100 DM $1,050
ated Inventory 1,500 DM $750
at the Net fixed assets
spot 3,000 DM $1,000
rate. Total Assets 6,600 DM $2,800
 e.g. Current liabilities 1,200 DM $600
DM2=$ Long-Term debt 1,800 DM $600
1
Common stock 2,700 DM $900
– Noncurr
ent Retained earnings 900 DM $700
asset CTA -------- --------
s Total Liabilities and 6,600 DM $2,800
transl
ated Equity 93
at the
 Monetary/Nonmonetary
Method
• The underlying principle is that monetary
accounts have a similarity because their
value represents a sum of money whose
value changes as the exchange rate
changes.
• All monetary balance sheet accounts (cash,
marketable securities, accounts
receivable, etc.) of a foreign subsidiary
are translated at the current exchange
rate.
• All other (nonmonetary) balance sheet
accounts (owners’ equity, land) are
translated at the historical exchange rate 94
in effect when the account was first
 Monetary/Nonmonetary
Method
• All monetary Balance Sheet Local Monetary/
balance Currency Nonmonetary
sheet Cash 2,100 DM $1,050
accounts are Inventory
1,500 DM $500
translated at
the current Net fixed assets 3,000 DM $1,000
exchange Total Assets 6,600 DM $2,550
rate. e.g. Current liabilities 1,200 DM $600
DM2=$1 Long-Term debt 1,800 DM $900
• All other Common stock 2,700 DM $900
balance sheetRetained earnings 900 DM $0
accounts are CTA -------- --------
translated at Total Liabilities and 6,600 DM $2,400
the historical Equity
exchange 95
rate in effect
 Temporal Method
• The underlying principle is that
assets and liabilities should be
translated based on how they are
carried on the firm’s books.
• Balance sheet accounts are
translated at the current spot
exchange rate if they are carried on
the books at their current value.
• Items that are carried on the books
at historical costs are translated at
the historical exchange rates in
effect at the time the firm placed
the item on the books. 96
 Temporal Method
• Items carried Balance Sheet Local Temporal
on the books Currency
at their Cash 2,100 DM $1,050
current value
are Inventory 1,500 DM $900
translated at Net fixed assets 3,000 DM $1,000
the spot Total Assets 6,600 DM $2,950
exchange Current liabilities 1,200 DM $600
rate.
Long-Term debt 1,800 DM $900
 e.g. DM2=$1 Common stock
2,700 DM $900
• Items that are Retained earnings 900 DM $0
carried on
the books at CTA -------- --------
historical Total Liabilities and 6,600 DM $2,400
costs are Equity
translated at 97
the historical
 Current Rate Method
• All balance sheet items (except for
stockholder’s equity) are translated
at the current exchange rate.
• Very simple method in application.
• A “plug” equity account named
cumulative translation
adjustment is used to make the
balance sheet balance.

98
 Current Rate Method
• All balance Balance Sheet Local Current
sheet items Currency Rate
(except for Cash
stockholder’s DM2,100 $1,050
equity) are Inventory DM1,500 $750
translated at Net fixed assets DM3,000 $1,500
the current Total Assets DM6,600 $3,300
exchange
rate. Current liabilities DM1,200 $600
• A “plug” equity Long-Term debt DM1,800 $900
account Common stock DM2,700 $900
named Retained earnings DM900 $360
cumulative CTA -------- $540
translation
adjustment Total Liabilities DM6,600 $3,300
is used to and Equity
make the 99
 How Various Translation Methods
Deal with a Change from DM3 to
DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earning 900 DM $700 $150 $550 $360
earnings s
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and
Spot exchange
Equity rate 100
 How Various Translation Methods
Deal with a Change from DM3 to
DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Book
Current 1,200 DM $600 value $600 $600 $600
liabilities of
Long-Term 1,800 DM $600invento $900 $900 $900
ry
debt histori
Common stock 2,700 DM $900 c rate $900 $900 $900
Retained earning 900 DM $700 $150 $550 $360
earnings s
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and Book value of Current value of
Equity inventory
exchange rate
at spot inventory at spot
exchange rate . 101
 How Various Translation Methods
Deal with a Change from DM3 to
DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earning 900 DM $700 $150 $550 $360
earnings s
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and histor spot exchange rate .
ic
Equity rate 102
 How Various Translation Methods
Deal with a Change from DM3 to
DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earning 900 DM $700 $150 $550 $360
earnings s
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and spot rate
Equity
103
 How Various Translation Methods
Deal with a Change from DM3 to
DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earning 900 DM $700 $150 $550 $360
earnings s
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and historical spot rate
Equity rate
104
 How Various Translation Methods
Deal with a Change from DM3 to
DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earning 900 DM $700 $150 $550 $360
earnings s
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and historical
Equity rate
105
 How Various Translation Methods
Deal with a Change from DM3 to
DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earning 900 DM $700 $150 $550 $360
earnings s
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and From income statement
Equity
106
 How Various Translation Methods
Deal with a Change from DM3 to
DM2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050
Inventory 1,500 DM $750 $500 $900 $750
Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300
Current 1,200 DM $600 $600 $600 $600
liabilities
Long-Term 1,800 DM $600 $900 $900 $900
debt
Common stock 2,700 DM $900 $900 $900 $900
Retained earning 900 DM $700 $150 $550 $360
earnings s
CTA -------- -------- -------- -------- $540
Total 6,600 DM $2,800 $2,550 $2,950 $3,300
Liabilities and Under the current rate method, a “plug” equity account
Equity named cumulative translation adjustment makes the
balance sheet balance.107
 How Various Translation Methods
Deal with a Change from DM3 to
DM2 = $1
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales 10,000 DM $4,000 $4,000 $4,000 $4,000
COGS 7,500 DM $3,000 $2,500 $3,000 $3,000
Depreciation 1,000 DM $333 $333 $333 $400
Net operating income 1,500 DM $667 $1,167 $667 $600
Income tax (40%) 600 DM $267 $467 $267 $240
Profit after tax 900 DM $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income 900 DM $700 $150 $550 $360
Dividends 0 DM $0 $0 $0 $0
Addition to Retained
Earnings 900 DM $700 $150 $550 $360
Sales translate at average exchange rate over the
period , DM2 . 50 = $1
For notes, see
Exhibit108
14.1
 How Various Translation Methods
Deal with a Change from DM3 to
DM2 = $1
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales 10,000 DM $4,000 $4,000 $4,000 $4,000
COGS 7,500 DM $3,000 $2,500 $3,000 $3,000
Depreciation 1,000 DM $333 $333 $333 $400
Net operating income 1,500 DM $667 $1,167 $667 $600
Income tax (40%) 600 DM $267 $467 $267 $240
Profit after tax 900 DM $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income 900 DM $700 $150 $550 $360
Dividends 0 DM $0 $0 $0 $0
Addition to Retained
Earnings 900 DM $700 $150 $550 $360
Translate at DM2 . 50 Translate at new exchange rate ,
= $1 DM2 . 00 = $1
For notes, see
Exhibit109
14.1
 How Various Translation Methods
Deal with a Change from DM3 to
DM2 = $1
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales 10,000 DM $4,000 $4,000 $4,000 $4,000
COGS 7,500 DM $3,000 $2,500 $3,000 $3,000
Depreciation 1,000 DM $333 $333 $333 $400
Net operating income 1,500 DM $667 $1,167 $667 $600
Income tax (40%) 600 DM $267 $467 $267 $240
Profit after tax 900 DM $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income 900 DM $700 $150 $550 $360
Dividends 0 DM $0 $0 $0 $0
Addition to Retained
Earnings 900 DM $700 $150 $550 $360
Translate at DM3 = Translate at average exchange rate ,
$1 DM2 . 5 = $1
For notes, see
Exhibit110
14.1
 How Various Translation Methods
Deal with a Change from DM3 to
DM2 = $1
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales 10,000 DM $4,000 $4,000 $4,000 $4,000
COGS 7,500 DM $3,000 $2,500 $3,000 $3,000
Depreciation 1,000 DM $333 $333 $333 $400
Net operating income 1,500 DM $667 $1,167 $667 $600
Income tax (40%) 600 DM $267 $467 $267 $240
Profit after tax 900 DM $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income 900 DM $700 $150 $550 $360
Dividends 0 DM $0 $0 $0 $0
Addition to Retained
Earnings 900 DM $700 $150 $550 $360
Note the effect on after - tax profit .
For notes, see
Exhibit111
14.1
 How Various Translation Methods
Deal with a Change from DM3 to
DM2 = $1
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales 10,000 DM $4,000 $4,000 $4,000 $4,000
COGS 7,500 DM $3,000 $2,500 $3,000 $3,000
Depreciation 1,000 DM $333 $333 $333 $400
Net operating income 1,500 DM $667 $1,167 $667 $600
Income tax (40%) 600 DM $267 $467 $267 $240
Profit after tax 900 DM $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income 900 DM $700 $150 $550 $360
Dividends 0 DM $0 $0 $0 $0
Addition to Retained
Earnings 900 DM $700 $150 $550 $360
Note the effect that foreign exchange gains ( losses ) has on
net income .
For notes, see
Exhibit112
14.1
 FASB Statement 8
• Essentially the temporal method,
with some subtleties.
– Such as translating inventory at
historical rates, which is a hassle.
• Requires taking foreign exchange
gains and losses through the
income statement.
• This leads to variability in reported
earnings.
• Which leads to irritated corporate 113
 FASB Statement 52
• The Mechanics of the FASB 52
Translation Process
– Function Currency
– Reporting Currency
• Highly Inflationary Economies

114
 The Mechanics of FASB
Statement 52
• Function Currency
– The currency that the business is
conducted in.
• Reporting Currency
– The currency in which the MNC
prepares its consolidated financial
statements.

115
 The Mechanics of FASB
Statement 52
• Two-Stage Process
– First, determine in which currency the
foreign entity keeps its books.
– If the local currency in which the foreign
entity keeps its books is not the
functional currency, remeasurement
into the functional currency is required.
– Second, when the foreign entity’s
functional currency is not the same as
the parent’s currency, the foreign
entity’s books are translated using the
current rate method.
116
 The Mechanics of FASB
Statement 52
Parent’s currency
Foreign NonparenFunctional
entity’s Currency?
books kept t
Third
in?
Currency currency
Local currencyTemporal Remeasurement

Current
Rate
Currency
Parent’s

Translation

Parent’s Currency

117
 Highly Inflationary
Economies
• Foreign entities are required to
remeasure financial statements
using the temporal method “as if
the functional currency were the
reporting currency”.
•

118
 Management of Translation
Exposure
• Translation Exposure vs. Transaction
Exposure
• Hedging Translation Exposure
– Balance Sheet Hedge
– Derivatives Hedge
• Translation Exposure vs. Operating
Exposure

119
 Translation Exposure versus
Transaction Exposure
• Translation Exposure
– The effect that unanticipated changes in
exchange rates has on the firm’s
consolidated financial statements.
– An accounting issue.
• Transaction Exposure
– The effect that unanticipated changes in
exchange rates has on the firm’s cash
flows.
– A finance issue and the subject of
Section 1.
• It is generally not possible to eliminate
both translation exposure and
transaction exposure. 120
 Hedging Translation
Exposure
• If the managers of the firm wish to
manage their accounting numbers
as well as their business, they have
two methods for dealing with
translation exposure.
– Balance Sheet Hedge
– Derivatives Hedge


121
 Balance Sheet Hedge
• Eliminates the mismatch between
net assets and net liabilities
denominated in the same currency.
• May create transaction exposure,
however.
•

122
 Derivatives Hedge
• An example would be the use of
forward contracts with a maturity of
the reporting period to attempt to
manage the accounting numbers.
• Using a derivatives hedge to control
translation exposure really involves
speculation about foreign exchange
rate changes, however.

123
 Translation Exposure versus
Operating Exposure
• The effect that unanticipated
changes in exchange rates has on
the firm’s ongoing operations.
• Operating exposure is a substantive
issue with which the management
of the firm should concern itself
with.

124
 Empirical Analysis of the
Change from FASB 8 to FASB
52
• There did not appear to be a
revaluation of firms’ values
following the change.
• This suggests that market
participants do not react to
cosmetic earnings changes.
• Other researchers have found similar
results when investigating other
accounting changes.
• This highlights the futility of 125
End Section 3

126
 Section 4
 Currency & Interest Rate
Swaps
•

127
 Section Objective:
•
This section discusses currency and
interest rate swaps, which are
relatively new instruments for
hedging long-term interest rate risk
and foreign exchange risk.

128
 Section Outline
• Types of Swaps
• Size of the Swap Market
• The Swap Bank
• Interest Rate Swaps
• Currency Swaps

129
Section Outline (continued)
• Swap Market Quotations
• Variations of Basic Currency and
Interest Rate Swaps
• Risks of Interest Rate and Currency
Swaps
• Swap Market Efficiency
• Concluding Points About Swaps

130
 Definitions
• In a swap, two counterparties
agree to a contractual arrangement
wherein they agree to exchange
cash flows at periodic intervals.
• There are two types of interest rate
swaps:
– Single currency interest rate swap
• “Plain vanilla” fixed-for-floating swaps
are often just called interest rate
swaps.
– Cross-Currency interest rate swap
• This is often called a currency swap; 131
 Size of the Swap Market
• In 1995 the notional principal of:
 interest rate swaps was
$12,810,736,000,000.
 Currency swaps $1,197,395,000,000
• The most popular currencies are
(1995):
– U.S.$ (34%)
– ¥ (23%)
– DM (11%)
– FF (10%)
– £ (6%) 132
 The Swap Bank
• A swap bank is a generic term to
describe a financial institution that
facilitates swaps between
counterparties.
• The swap bank can serve as either a
broker or a dealer.
– As a broker, the swap bank matches
counterparties but does not assume
any of the risks of the swap.
– As a dealer, the swap bank stands
ready to accept either side of a
currency swap, and then later lay off
their risk, or match it with a 133
counterparty.
An Example of an Interest Rate
Swap
• Consider this example of a “plain
vanilla” interest rate swap.
• Bank A is a AAA-rated international
bank located in the U.K. who wishes
to raise $10,000,000 to finance
floating-rate Eurodollar loans.
– Bank A is considering issuing 5-year
fixed-rate Eurodollar bonds at 10
percent.
– It would make more sense to for the
bank to issue floating-rate notes at
LIBOR to finance floating-rate
Eurodollar loans. 134
 Example
• Firm B is a BBB-rated U.S. company.
It needs $10,000,000 to finance an
investment with a five-year
economic life.
– Firm B is considering issuing 5-year
fixed-rate Eurodollar bonds at 11.75
percent.
– Alternatively, firm B can raise the
money by issuing 5-year FRNs at
LIBOR + ½ percent.
– Firm B would prefer to borrow at a 135
 An Example of an Interest Rate
Swap
The borrowing opportunities of the two


firms are shown in the following table:

•
COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%

Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%

136
An Example of an Interest Rate
Swap
Sw ap T h e sw a p b a n k
m a ke s th is o ffe r to
B ank B a n k A : Yo u p a y
10 3 / 8 %
LIB O R – 1 / 8 % p e r
LIBOR – 1 / 8 % ye a r o n $ 1 0 m illio n
B ank fo r 5 ye a rs a n d w e
w illp a y yo u 1 0
A 3 /8 % o n $ 1 0
m illio n fo r 5 ye a rs
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%
137
 An Example of an Interest Rate
Swap
½ % of $10,000,000 = Here’s what’s in it for
$50,000. That’s quite Sw ap Bank A: They can borrow
a cost savings per externally at 10% fixed
year for 5 years. B ank and have a net borrowing
10 3 / 8 % position of
LIBOR – 1 / 8 % -10 3/8 + 10 + (LIBOR –
1/8) =
B ank
10 % LIBOR – ½ % which is ½ %
A better than they can
borrow floating without a
swap.
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%
138
 An Example of an Interest Rate
Swap
T h e sw a p b a n k Sw ap
m a ke s th is o ffe r to
co m p a n y B : Yo u p a y B ank
10 ½ %
u s 1 0 ½ % p e r ye a r LIBOR – ¼ %
o n $ 1 0 m illio n fo r 5
ye a rs a n d w e w ill C om pa
p a y yo u LIB O R – ¼ ny
% per year on $10
B
m illio n fo r 5 ye a rs.
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%
139
 An Example of an Interest Rate
Swap
½ % of $10,000,000 =
Here ’ s what ’ s in it Sw ap $50,000 that’s quite
for B : a cost savings per
B ank year for 5 years.
10 ½ %
They can borrow externally at LIBOR +LIBOR – ¼ %
½ % and have a net borrowing position
of
C om pa LIBOR
10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = ny + ½%
11 . 25 % which is ½ % better than they
can borrow floating without a swap. B
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%
140
 An Example of an Interest Rate
Swap
T h e sw a p Sw ap ¼% of $10
b a n k m a ke s million =
m o n e y to o . B ank $25,000 per year
10 3 / 8 % 10 ½ %
for 5 years.
LIBOR – ¼ %
LIBOR – 1 / 8 %
B ank LIBOR – 1/8 – [LIBOR – ¼ ]=
C om pa LIBOR
10 % + ½%
1/8 ny
A
10 ½ - 10 3/8 = 1/8
A sa ve s ½ ¼ B Bsaves ½ %
% COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%
141
An Example of an Interest Rate
Swap
T h e sw a p Sw ap
b an k m akes
B ank
10¼ 3 / %
8 % 10 ½ %

LIBOR – ¼ %
LIBOR – 1 / 8 %
B ank C om pa LIBOR
10 % + ½%
Note that the total ny
A savings ½ + ½ + ¼ =
A sa v e s ½
1 . 25 % = QSD
BB saves ½
% COMPANY B BANK A DIFFERENTIAL %
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%
142
 The QSD
• The Quality Spread Differential
represents the potential gains from
the swap that can be shared between
the counterparties and the swap
bank.
• There is no reason to presume that the
gains will be shared equally.
• In the above example, company B is
less credit-worthy than bank A, so
they probably would have gotten less
of the QSD, in order to compensate 143
 An Example of a Currency
Swap
• Suppose a U.S. MNC wants to finance
a £10,000,000 expansion of a
British plant.
• They could borrow dollars in the U.S.
where they are well known and
exchange for dollars for pounds.
– This will give them exchange rate
risk: financing a sterling project with
dollars.
• They could borrow pounds in the
international bond market, but pay
a lot since they are not as well
known abroad. 144
 An Example of a Currency
Swap
• If they can find a British MNC with a
mirror-image financing need they
may both benefit from a swap.
• If the exchange rate is S0($/£) =
$1.60/£, the U.S. firm needs to find
a British firm wanting to finance
dollar borrowing in the amount of
$16,000,000.

145
 An Example of a Currency
Swap
Consider two firms A and B: firm A is a
U.S.–based multinational and firm B
is a U.K.–based multinational.
Both firms wish to finance a project in

each other’s country of the same

size. Their borrowing opportunities
are given in the table below.
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
146
 An Example of a Currency
Swap
Sw a
p
$8 B an $ 9 .4
% k £12 %
£11
% C om pa
$ 8 C om pany A % £12
% ny %
B
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%

147
 An Example of a Currency
Swap
Sw a
p
$8 B an $ 9 .4
% k £12 %
£11
C o m p a n y A % C om pa £12
$8 %
% ny %
A ’ s n e t p o sitio n is to b o rro w B
at £11% $ £
A sa v e s
£ .6 % Company A 8.0% 11.6%
Company B 10.0% 12.0%

148
 An Example of a Currency
Swap
Sw a
p
$8 B an $ 9 .4
% k £12 %
£11
% C om pa
$ 8 C om pany A % £12
% ny %
B ’ s n e t p o sitio n is to Bb o rro w
a t $ 9 . 4 %$ £
Company A 8.0% 11.6% B sa v e s
Company B 10.0% 12.0% $ .6 %
149
 An Example of a Currency
Swap
1 . 4 % of $16
T h e sw a p b a n k Sw a million financed
m akes m on ey p with 1 % of £10
to o : million per year
$8 B an $ 9 . 4 for 5 years .
% k £12 %
£11
C o m p a n y A % C om pa £ 1 2
$8 At S 0 ( $ / £ ) =
%
% $1 . 60 / £ , that is a ny %
gain of $124 , 000
per year for 5 The Bswap bank
years . $ £ faces
exchange rate
Company A 8.0% 11.6%
risk , but
Company B 10.0% 12.0% maybe they
can lay it
off in 150
 Comparative Advantage
as the Basis for Swaps
A is the more credit-worthy of the two


A firms.
pays 2% less to borrow in dollars
than B
A pays .4% less to borrow in pounds
than B:
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
A has a comparative advantage in borrowing in dollars.
B has a comparative advantage in borrowing in pounds.

151
 Comparative Advantage
as the Basis for Swaps
 B has a comparative advantage in
borrowing in £.
B pays 2 % more to borrow in dollars
than A
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%

B pays only .4% more to borrow in pounds

than A:
152
 Comparative Advantage
as the Basis for Swaps
A has a comparative advantage in
borrowing in dollars.
B has a comparative advantage in

borrowing in pounds.


 If they borrow according to their

comparative advantage and then
swap, there will be gains for both
parties.

153
 Swap Market Quotations
• Swap banks will tailor the terms of interest
rate and currency swaps to customers’
needs
• They also make a market in “plain vanilla”
swaps and provide quotes for these. Since
the swap banks are dealers for these
swaps, there is a bid-ask spread.
• For example, 6.60 — 6.85 means the swap
bank will pay fixed-rate DM payments at
6.60% against receiving dollar LIBOR or it
will receive fixed-rate DM payments at
6.85% against receiving dollar LIBOR. 154
 Variations of Basic Currency
and Interest Rate Swaps
• Currency Swaps
– fixed for fixed
– fixed for floating
– floating for floating
– amortizing
• Interest Rate Swaps
– zero-for floating
– floating for floating
• For a swap to be possible, a QSD
must exist. Beyond that, creativity
is the only limit.
155
 Risks of Interest Rate
and Currency Swaps
• Interest Rate Risk
– Interest rates might move against the
swap bank after it has only gotten
half of a swap on the books, or if it
has an unhedged position.
• Basis Risk
– If the floating rates of the two
counterparties are not pegged to
the same index.
• Exchange rate Risk
– In the example of a currency swap
given earlier, the swap bank would
be worse off if the pound 156
 Risks of Interest Rate
and Currency Swaps
(continued)
• Credit Risk
– This is the major risk faced by a swap
dealer—the risk that a counter party
will default on its end of the swap.
• Mismatch Risk
– It’s hard to find a counterparty that
wants to borrow the right amount of
money for the right amount of time.
• Sovereign Risk
– The risk that a country will impose
exchange rate restrictions that will
interfere with performance on the
swap.
157
 Pricing a Swap
• A swap is a derivative security so it
can be priced in terms of the
underlying assets:
• How to:
– Plain vanilla fixed for floating swap
gets valued just like a bond.
– Currency swap gets valued just like a
nest of currency futures.

158
 Swap Market Efficiency
• Swaps offer market completeness
and that has accounted for their
existence and growth.
• Swaps assist in tailoring financing to the
type desired by a particular borrower.
• Not all types of debt instruments are
available to all types of borrowers
• Hence both counterparties can benefit
(as well as the swap dealer) through
financing that is more suitable for
their asset maturity structures. 159
 Concluding Remarks
• The growth of the swap market has
been astounding.
• Swaps are off-the-books transactions.
• Swaps have become an important
source of revenue and risk for
banks

160
End Section 4

161
 Section 5
 Futures and Options
on Foreign Exchange


162
 Section Objective:
• This section discusses exchange-
traded currency futures contracts,
options contracts, and options on
currency futures.
•

163
 Section Outline
• Futures Contracts: Preliminaries
• Currency Futures Markets
• Basic Currency Futures Relationships
• Eurodollar Interest Rate Futures
Contracts
• Options Contracts: Preliminaries
• Currency Options Markets
• Currency Futures Options
164
Section Outline (continued)
• Basic Option Pricing Relationships at
Expiry
• American Option Pricing
Relationships
• European Option Pricing
Relationships
• Binomial Option Pricing Model
• European Option Pricing Model
• Empirical Tests of Currency Option
Models 165
 Futures Contracts:
Preliminaries
• A futures contract is like a forward
contract:
– It specifies that a certain currency
will be exchanged for another at
a specified time in the future at
prices specified today.
• A futures contract is different from
a forward contract:
– Futures are standardized contracts
trading on organized exchanges
with daily resettlement through a 166
 Futures Contracts:
Preliminaries
• Standardizing Features:
– Contract Size
– Delivery Month
– Daily resettlement
• Initial Margin (about 4% of contract
value, cash or T-bills held at your
brokers).

167
 Daily Resettlement: An
Example
• Suppose you want to speculate on a
rise in the $/¥ exchange rate
(specifically you think that the dollar
will appreciate). Currency per
U.S. $ equivalent U.S. $
Wed Tue Wed Tue
Japan (yen) 0.007142857 0.007194245 140 139
1-month forward 0.006993007 0.007042254 143 142
3-months forward 0.006666667 0.006711409 150 149
6-months forward 0.00625 0.006289308 160 159

C u rre n tly $ 1 = ¥ 1 4 0 . T h e 3 -m o n th fo rw a rd p rice

is $ 1 =¥ 1 5 0 . 168
 Daily Resettlement: An
Example
• Currently $1 = ¥140 and it appears
that the dollar is strengthening.
• If you enter into a 3-month futures
contract to sell ¥ at the rate of $1 =
¥150 you will make money if the yen
depreciates. The contract size is
¥12,500,000
• Your initial margin is 4% of the$1
$3,333.33
contract = .04 × ¥12,500,000 ×
value:
¥150
 169
 Daily Resettlement: An
Example
If tomorrow, the futures rate closes at
$1 = ¥149, then your position’s value
drops.
Your original agreement was to sell

¥12,500,000 and receive $83,333.33

But now ¥12,500,000 is worth

$83,892.62 $1
$83,892.62 = ¥12,500,000 ×
¥149
You have lost $559.28 overnight.

170
 Daily Resettlement: An
Example
• The $559.28 comes out of your
$3,333.33 margin account, leaving
$2,774.05
• This is short of the $3,355.70 required
for a $3,355.70
new position. $1
= .04 × ¥12,500,00 0 ×
¥149
lYour broker will let you slide until you run through
your maintenance margin. Then you must post additional
funds or your position will be closed out. This is
usually done with a reversing trade.

171
 Currency Futures Markets
• The Chicago Mercantile Exchange
(CME) is by far the largest.
• Others include:
– The Philadelphia Board of Trade
(PBOT)
– The MidAmerica commodities
Exchange
– The Tokyo International Financial
Futures Exchange
– The London International Financial
Futures Exchange
172
 The Chicago Mercantile
Exchange
• Expiry cycle: March, June,
September, December.
• Delivery date 3rd Wednesday of
delivery month.
• Last trading day is the second
business day preceding the delivery
day.
• CME hours 7:20 a.m. to 2:00 p.m.
CST.
173
 Globex
• An electronic trading platform used
for derivative, futures, and
commodity contracts.
• Globex runs continuously, so it is not
restricted by borders or time zones.
• Globex was introduced in 1992 by
Reuters.
• The popularity of this platform has
declined as exchanges such as the
CBOT have moved towards
different vehicles for matching and174
 CME After Hours
• Extended-hours trading on GLOBEX
runs from 2:30 p.m. to 4:00 p.m
dinner break and then back at it
from 6:00 p.m. to 6:00 a.m. CST.
• Singapore International Monetary
Exchange (SIMEX) offer
interchangeable contracts.
• There’s other markets, but none are
close to CME and SIMEX trading
volume. 175
 SIMEX and CME
• Futures contracts that trade on
SIMEX use the CME’s final
settlement price.
• These two exchanges designed a
system that permits futures
contracts traded on SIMEX to be
completely interchangeable with
contracts that trade on the CME.
• The contract specifications on both
exchanges are identical except for 176
 SIMEX and CME
• However, a contract that trades on
the floor of the CME can be
transferred through the mutual
offset system to SIMEX, and
cancelled there.
• Similarly, a contract traded on the
floor of SIMEX can be transferred to
the CME.
• As a result, the trading hours of
these contracts extends beyond the
trading hours of either exchange. 177
 Basic Currency
Futures Relationships
• Open Interest refers to the number of
contracts outstanding for a
particular delivery month.
• Open interest is a good proxy for
demand for a contract.
• Some refer to open interest as the
depth of the market. The breadth of
the market would be how many
different contracts (expiry month,
currency) are outstanding.
178
 Reading a Futures Quote
Open Hi Lo Settle Change Lifetime Lifetime Open
High Low Interest

Sept .9282 .9325 .9276 .9309 +.0027 1.2085 .8636 74,639

H ig h e st a n d
D a ily C h a n gleo w e st p rice s
C lo sin g o ve r th e
Lo w epstrice
p rice th a t life tim e o f th e
H ig h de asty p rice th a t co n tra ct.
O p e dn ainyg
N um ber of open
E xppiry
rice
co n tra cts
m o n th 179
 Eurodollar Interest Rate
Futures Contracts
• Widely used futures contract for
hedging short-term U.S. dollar
interest rate risk.
• The underlying asset is a
hypothetical $1,000,000 90-day
Eurodollar deposit—the contract is
cash settled.
• Traded on the CME and the Singapore
International Monetary Exchange.
• The contract trades in the March,
June, September and December 180
 Reading Eurodollar Futures
Quotes
EURODOLLAR ( CME )— $1 million ; pts of  
100 %
 
  Open High Low Sett Chg Yield Open
le Settle Intere
Change st
Jul 94.69 94.69 94.68 94.68 -.01 5.32 +.01 47,417
y
Eurodollar futures prices are stated as an index number
of three-month LIBOR calculated as F = 100-LIBOR.
  The closing price for the July contract is 94.68 thus
the implied yield is 5.32 percent = 100 – 94.68

The change was .01 percent of $1 million representing

$100 on an annual basis. Since it is a 3-month contract
one basis point corresponds to a $25 price change.
181
 Eurodollar futures
• Contract Size = US$ 1,000,000
• 1 % p.a -> US$ 10,000 p.a
• 1 bp = 0.01 % -> US$ 100 p.a. ->
US$ 25 per quarter per contract.

182
 Options Contracts:
Preliminaries
• An option gives the holder the right, but
not the obligation, to buy or sell a
given quantity of an asset in the
future, at prices agreed upon today.
• Calls vs. Puts
– Call options give the holder the right, but
not the obligation, to buy a given
quantity of some asset at some time in
the future, at prices agreed upon
today.
– Put options give the holder the right, but
not the obligation, to sell a given
quantity of some asset at some time in 183
 Options Contracts:
Preliminaries
• European vs. American options
– European options can only be
exercised on the expiration date.
– American options can be exercised at
any time up to and including the
expiration date.
– Since this option to exercise early
generally has value, American
options are usually worth more than
European options, other things
equal. 184
 Options Contracts:
Preliminaries
• In-the-money
– The exercise price is less than the
spot price of the underlying asset.
• At-the-money
– The exercise price is equal to the spot
price of the underlying asset.
• Out-of-the-money
– The exercise price is more than the
spot price of the underlying asset.

185
 Options Contracts:
Preliminaries
• Intrinsic Value
– The difference between the exercise
price of the option and the spot price
of the underlying asset.
• Speculative Value
– The difference between the option
premium and the intrinsic value of the
Option Premium Intrinsic Speculative Value
option. = Value +

186
 Currency Options Markets
• PHLX
• HKFE
• 20-hour trading day.
• OTC volume is much bigger than
exchange volume.
• Trading is in seven major currencies
plus the euro against the U.S.
dollar.

187
PHLX Currency Option
Specifications
Currency Contract Size
Australian dollar AD50,000
British pound £31,250
Canadian dollar CD50,000
Deutsche mark DM62,500
French franc FF250,000
Japanese yen ¥6,250,000
Swiss franc SF62,500
Euro 6 2 ,5 0 0
188
 Currency Futures Options
• Are an option on a currency futures
contract.
• Exercise of a currency futures option
results in a long futures position for
the holder of a call or the writer of
a put.
• Exercise of a currency futures option
results in a short futures position
for the seller of a call or the buyer
of a put.
• If the futures position is not offset 189
 Basic Option Pricing
Relationships at Expiry
• At expiry, an American call option is
worth the same as a European
option with the same
characteristics.
• If the call is in-the-money, it is worth
ST – E.
• If the call is out-of-the-money, it is
worthless.
 CaT = CeT = Max[ST - E, 0]
190
 Basic Option Pricing
Relationships at Expiry
• At expiry, an American put option is
worth the same as a European
option with the same
characteristics.
• If the put is in-the-money, it is worth
E - ST.
• If the put is out-of-the-money, it is
worthless.
 PaT = PeT = Max[E - ST, 0]
191
Basic Option Profit Profiles
 CaT = CeT = Max[ST - E, 0]

p ro fit g 1
n
Lo ll
ca

ST
E+ C
E
lo s
s
192
Basic Option Profit Profiles
 CaT = CeT = Max[ST - E, 0]

p ro fit

E sh ST
c or
E + C ll t 1
a

lo s
s
193
Basic Option Profit Profiles
 PaT = PeT = Max[E - ST, 0]

p ro fit
lo
pu ng
t 1

ST
E -p
E
lo s
s
194
Basic Option Profit Profiles
 CaT = CeT = Max[ST - E, 0]

p ro fit

1 ST
ort E - p E
h
S t
pu
lo s
s
195
 American Option Pricing
Relationships
• With an American option, you can do
everything that you can do with a
European option—this option to
exercise early has value.
 CaT > CeT = Max[ST - E, 0]
 PaT > PeT = Max[E - ST, 0]


•
196
 Market Value, Time Value and
Intrinsic Value for an American
Call
 CaT > Max[ST - E, 0]
Pro fit
- E
ST
Market Value

Time
value Intrinsic
value ST
Out-of-the-money E In-the-money
lo s
s
197
 European Option Pricing
Relationships
Consider two investments


1 Buy a call option on the British pound

futures contract. The cash flow
today is -Ce
2 Replicate the upside payoff of the call
by
1 Borrowing the present value of the
exercise price of the call in the U.S.
at i$ The cash flow today is
E /(1 + i$) 198
 European Option Pricing
Relationships
 When the option is in-the-money
both strategies have the same
payoff.
 When the option is out-of-the-
money it has a higher payoff
than the borrowing and lending
strategy.  
ST E
 Ce ≥ max
Thus: − ,0
 (1 + i£ ) (1 + i$ ) 
199
 European Option Pricing
Relationships
 Using a similar portfolio to
replicate the upside potential of
a put, we can show that:

 E ST 
Pe ≥ max − ,0 
 (1 + i$ ) (1 + i£ ) 

200
 Binomial Option Pricing
Model
lIm a g in e a sim p le w o rld w h e re th e
d o lla r-e u ro exch a n g e ra te is S 0 ( $ / ) =
$ 1 to d a y a n d in th e n ext ye a r, S 1 ( $ / )
S0($/ ) S1($/ )
is e ith e r $ 1 . 1 o r $ . 9 0 .
$1.10

$1

$.90

201
 Binomial Option Pricing
Model
lA call option on the euro with exercise
price
S0($/ ) = $1 will have the following
payoffs.
S0($/ ) S1($/ ) C1($/
$1.10 ) $.10

$1

$.90 $0

202
 Binomial Option Pricing
Model
• We can replicate the payoffs of the
call option. With a levered position
in the euro.
S0($/ ) S1($/ ) C1($/
$1.10 ) $.10

$1

$.90 $0

203
 Binomial Option Pricing
Model
Borrow the present value of $.90 today and
buy 1. Your net payoff in one period is
either $.2 or $0.
l

S0($/ ) S1($/ ) debt portfolio

C1($/
$1.10 -$.90 $.20 ) $.10

$1

$.90 -$.90 $.00 $0

204
 Binomial Option Pricing
Model
• The portfolio has twice the option’s
payoff so the portfolio is worth
twice the call option value.
S0($/ ) S1($/ ) debt portfolio C1($/ )

$1.10 -$.90 $.20 $.10

$1

$.90 -$.90 $.00 $0

205
 Binomial Option Pricing
Model

The portfolio value today is
today’s value of one euro less $.90
$1 −
the present value of a $.90 (1 + i$ )
debt:
S0($/ ) S1($/ ) debt portfolio C1($/ )

$1.10 -$.90 $.20 $.10

$1

$.90 -$.90 $.00 $0

206
 Binomial Option Pricing
Model
 We can value the option
1 $.90 
as half of the value of C0 =  $1 − 
2 (1 + i$ ) 
the portfolio:
S0($/ ) S1($/ ) debt portfolio C1($/ )

$1.10 -$.90 $.20 $.10

$1

$.90 -$.90 $.00 $0

207
 Binomial Option Pricing
Model
• The most important lesson from the
binomial option pricing model is:
 the replicating portfolio
lMany
intuition.
derivative securities can be valued by valuing portfolios of
primitive securities when those portfolios have the same payoffs as
the derivative securities.

208
 European Option Pricing
Formula
• We can use the replicating portfolio
intuition developed in the binomial
option pricing formula to generate
a faster-to-use model that
addresses a much more realistic
world.

209
 European Option Pricing
Formula
− r$T
The model C
 is0 = [ F × N (d1 ) − E × N ( d 2 )]e
W h e re
C0= the value of a European option at time t =
0 ( r − r )T
F = St e $ £

r$ = the interest rate available in the U.S.

r£ = the interest rate available in the
foreign country—in this case the U.K.
ln(F / E ) + .5σ 2T
d1 = , d 2 = d1 − σ T
σ T
210
 European Option Pricing
Formula
Find the value of a six-month call option on
the British pound with an exercise price of
$1.50 = £1
The current value of a pound is $1.60

The interest rate available in the U.S. is r

$ =
5%.
The interest rate in the U.K. is r
£ = 7%.
The option maturity is 6 months (half of a

year).
The volatility of the $/£ exchange rate is 30%

p.a.
211
Before we start, note that the intrinsic value
 European Option Pricing
Formula
 Let’s try our hand at using the model. If you have a
calculator handy, follow along.
First
calculate ( r$ − r£ )T (.05−.07 ) 0.50
F = St e = 1.50e = 1.485075
T h e n , ca lcu la te d1 and d2

ln(F / E ) + .5σ 2T ln(1.485075/ 1.50) + .5(0.4) 2 .5

d1 = = = 0.106066
σ T .4 .5

d 2 = d1 − σ T = 0.106066 − .4 .5 = −0.176878
212
 European Option Pricing
Formula
F = 1.485075
d1 = 0.106066
d 2 = −0.176878
N(d1) = N(0.106066) = .5422
N(d2) = N(-0.1768) = 0.4298
− r$T
C0 = [ F × N (d1 ) − E × N (d 2 )]e

C0 = [1.485075× .5422 − 1.50 × .4298]e −.05*.5 = $0.157

213
Option Value Determinants
C a ll
Pu t
1 . E xch a n g e ra te + –
2. Exercise price – +
3. Interest rate in U.S. + –
4. Interest rate in other country +
–
5. Variability in exchange rate+ +
6. Expiration date + +

The value of a call option C0 must

fall within
max (S0 – E, 0) < C0 < S0.
214
 Empirical Tests
The European option pricing model
works fairly well in pricing American
currency options.
It works best for out-of-the-money and

at-the-money options.
When options are in-the-money, the

European option pricing model tends

to underprice American options.

215
End Section Five

216