b821 Block4unit8 Foreign Exchange and Contingent Risk

Published on May 2016 | Categories: Documents | Downloads: 25 | Comments: 0 | Views: 406
of 120
Download PDF   Embed   Report

Foreign Exchange and Contingent Risk

Comments

Content

B821 Financial Strategy Block 4 Financial Risk Management

Unit 8

Foreign Exchange and Contingent Risk
Prepared by the Course Team

Masters

This publication forms part of an Open University course B821, Financial Strategy. Details of this and other Open University courses can be obtained from the Student Registration and Enquiry Service, The Open University, PO Box 625, Milton Keynes, MK7 6YG, United Kingdom: tel. +44 (0)1908 653231, email [email protected] Alternatively, you may visit the Open University website at http://www.open.ac.uk where you can learn more about the wide range of courses and packs offered at all levels by The Open University. To purchase a selection of Open University course materials visit http://www.ouw.co.uk, or contact Open University Worldwide, Michael Young Building, Walton Hall, Milton Keynes MK7 6AA, United Kingdom for a brochure. tel. +44 (0)1908 858785; fax +44 (0)1908 858787; email [email protected]

The Open University Walton Hall, Milton Keynes MK7 6AA First published 1998. Second edition 1999. Third edition 2000. Fourth edition 2003. Fifth edition 2006. Sixth edition 2006. Reprinted 2007. Copyright # 1998, 1999, 2000, 2003, 2006, 2007 The Open University All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, transmitted or utilised in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without written permission from the publisher or a licence from the Copyright Licensing Agency Ltd. Details of such licences (for reprographic reproduction) may be obtained from the Copyright Licensing Agency Ltd of 90 Tottenham Court Road, London W1T 4LP. Open University course materials may also be made available in electronic formats for use by students of the University. All rights, including copyright and related rights and database rights, in electronic course materials and their contents are owned by or licensed to The Open University, or otherwise used by The Open University as permitted by applicable law. In using electronic course materials and their contents you agree that your use will be solely for the purposes of following an Open University course of study or otherwise as licensed by The Open University or its assigns. Except as permitted above you undertake not to copy, store in any medium (including electronic storage or use in a website), distribute, transmit or retransmit, broadcast, modify or show in public such electronic materials in whole or in part without the prior written consent of The Open University or in accordance with the Copyright, Designs and Patents Act 1988. Edited and designed by The Open University. Typeset in India by Alden Prepress Services, Chennai. Printed and bound in the United Kingdom by Hobbs the Printers Limited, Brunel Road, Totton, Hampshire, SO40 3WX. ISBN 978 0 74922 3946 6.2

CONTENTS
1 Introduction 2 What is foreign exchange risk? 2.1 The nature of foreign exchange exposure 2.2 Transaction exposure 2.3 Translation exposure 2.4 Economic exposure 2.5 Measurement of foreign exchange exposure Summary 3 The market for foreign exchange 3.1 What and where is the foreign exchange market? 3.2 The size of the world’s currency markets 3.3 Why and for whom does the foreign exchange
market exist? Summary 4 The mechanics of foreign exchange 4.1 Spot rates 4.2 Cross rates 4.3 Forward exchange rates 4.4 The advantages and disadvantages of using forward
contracts Summary 5 Forecasting foreign exchange rates 5.1 Fundamental approaches to forecasting
exchange rates 5.2 Technical analysis 5.3 Currency histograms Summary 6 Techniques for exposure management 6.1 Internal techniques 6.2 External techniques 6.3 Arguments for not hedging 6.4 The ‘solution’ of currency unions Summary 5
7
7
7
8
10
13
16
17
17
18
18
21
23
23
27
28
33
35
37
37
45
46
48
49
51
54
59
60
65


7 Contingent risk 8 Options 8.1 Options – where did they come from? 8.2 Options on shares 8.3 Pay-off diagrams 8.4 Currency options 8.5 Interest-rate options 8.6 Options pricing Summary Summary and conclusions Appendix 1 Appendix 2 Proofs of propositions concerning
option valuation Valuing share and currency options

67
69
69
70
74
81
84
88
89
90
92
97
105
112
113


Answers to exercises References and further reading Acknowledgements

1 INTRODUCTION

1

INTRODUCTION

In this middle unit of the block on Financial Risk Management we look at two key elements of financial risk: namely, foreign exchange risk and contingent risk. You will study foreign exchange risk first – what it consists of, how to measure it and manage it; this is covered in Sections 2 to 6. The discussion also covers the main financial instruments used in foreign exchange management. The unit then moves on to consider contingent risk. This is the risk to which you become exposed if a particular event occurs – whether the risk materialises depends (or is contingent) on such a particular event happening. Sections 7 and 8 examine the types of contingent risks organisations can be exposed to and then explore the means of managing these risks. ‘Managing risk’ brings us into the world of financial ‘options’ – instruments that are, in effect, insurance policies which you can buy to protect yourself against a risk which may materialise. Entering the world of financial options with its complex mathematics, jargon and complicated diagrams may appear daunting. Please relax though! You will not be expected to delve into the intricacies of options models. Rather, to use a motoring analogy, you will be opening the bonnet to see that there is an engine, a radiator, a starter motor and an alternator among other things, but you will not be dismantling the constituent pieces, simply investigating why they are there.

Learning outcomes
By the end of this unit, you should be able to:

l

explain the differences between transaction, translation and
economic foreign exchange exposure; understand spot and forward exchange rates; describe the linkage between forward exchange rates and interest rates; describe some of the determinants of exchange-rate variability; design a hedging strategy to manage foreign exchange risk; understand the rationale for establishing a common currency – such as the euro – across a number of nation states; understand contingent risk;

l l

l l l

l

OU BUSINESS SCHOOL

5

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

l

describe the main elements of financial options contracts and their use; describe the key factors involved in the valuation of financial options; make use of computer software for valuing options.

l

l

��������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������

6

OU BUSINESS SCHOOL

2 WHAT IS FOREIGN EXCHANGE RISK ?

2
l l l l

WHAT IS FOREIGN EXCHANGE RISK?

Irrespective of the nature of their activities, organisations need to
understand and, where necessary, control the degree of foreign
exchange variability to which they are exposed. In order to do this,
every organisation must find answers to the following key questions:
What is the nature of our foreign exchange exposure?
How can this risk be measured?
Does our organisation need to hedge this risk ...
... and, if so, what techniques are available to hedge our exposure?


An exchange rate is simply the price of a currency expressed as a value of another currency.

2.1

THE NATURE OF FOREIGN EXCHANGE EXPOSURE
Foreign exchange, FX and ‘forex’. In this unit, we use all these terms interchangeably’ because that is what happens in the financial markets.

What is meant by foreign exchange (or FX or forex) risk? It is the risk of financial loss caused by variations in exchange rates that affect an organisation’s business. Sometimes the change is represented by an actual cash-flow difference; sometimes it is reflected in a change in recorded value, although no funds move. This is a broad-brush definition and we need to refine it. It is usual to divide FX risk into three categories of exposure:
l l l

transaction exposure; translation exposure; economic exposure.

Let us look at each of these.

ACTIVITY 2.1
Before reading further, list the ways in which you believe the organisation you work for is exposed to FX risk. Note which currencies are involved. Keep this list for a further review later on in this unit.

2.2

TRANSACTION EXPOSURE
FX transactions involve
the exchange of one
currency for another;
when selling one you
must buy the other.


This is the exposure that most people would normally associate with movements in exchange rates. Transaction exposure is the cash-flow consequence that changes in foreign exchange rates have on existing contractual obligations. For example, a US company makes a sale, denominated in euros, to an Italian company. Until

OU BUSINESS SCHOOL

7

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

the Italian company pays for the sale, there is a risk that fluctuations in the USD/EUR exchange rate will affect the final amount the US company receives. Other typical types of transaction exposure are the repayments on loans denominated in overseas currencies, purchases from overseas companies and dividends from overseas subsidiaries. Transaction exposure occurs whenever foreign-currency cash flows are agreed. Even before formal contracts are made (for example, when a price is quoted, but before an order is confirmed) potential exposure may arise. Table 2.1 shows an example of actual and potential transaction exposure. Table 2.1
Company creates new product

An example of where transaction exposure exists
Builds up stocks Fixes foreign price for product : Potential transaction exposure Actual transaction exposure Receives order Invoice date Receipt of foreign funds Conversion into domestic currency : Gain or loss due to exchange-rate movement crystallised

An organisation designs a product for export. It builds up stocks, fixes the product’s prices, receives an order, sends an invoice and is eventually paid. After fixing the product price, but before actually receiving payment and converting into its domestic currency, the organisation is subject to transaction exposure, potential at first, then actual once the order is received. Transaction exposure therefore involves precisely identified cash flows and results in realised gains and losses that will affect the profit and loss account (or income statement under IFRS). Thus, transaction exposure is likely to have a tax effect, with realised gains being taxable and losses deductible.

2.3
In this unit we use SWIFT codes for currencies. For example USD for US dollars, or EUR for the euro. A guide to these codes can be found in the Glossary. SWIFT is a co-operative owned by the financial industry and supplies standardised messaging services to institutions. SWIFT stands for Society for Worldwide Interbank Financial Telecommunication.

TRANSLATION EXPOSURE

Translation exposure (also called accounting exposure) arises from the need to translate the foreign-currency financial statements of overseas subsidiaries into the home currency in order to prepare a set of financial statements for the group in the home currency. An example would be a US company with a Spanish subsidiary. To prepare the full accounts for the US company, the accounts of the Spanish subsidiary would need to be translated into USD and added to the results of the US company. Every time the Spanish accounts are translated into USD, a uniform USD/EUR exchange rate would be used, usually the financial year-end rate. Even if there were no activity in the Spanish subsidiary over a year, changes in the USD/EUR exchange rate would mean that, over

8

OU BUSINESS SCHOOL

2 WHAT IS FOREIGN EXCHANGE RISK ?

time, the US translated accounts for the Spanish subsidiary could show different results when looked at in terms of the USD equivalent. Indeed, it is not uncommon with translation exposure for there to be no associated cash flows in a reporting period when the relevant assets and liabilities have been in the subsidiary from earlier years. Should the organisation sell its foreign assets and repatriate the proceeds (or repay its foreign liabilities) there would, of course, be actual cash flows and hence transaction exposures. Note that it does not require the presence of an overseas subsidiary for translation exposure to exist. Exposure can even arise where a company simply has overseas assets that need to be translated to the reporting currency on the balance sheet date. Different approaches to dealing with translation exposure may lead to two organisations, with identical overseas subsidiaries, presenting different group balance sheets. This arises in particular from the choice of exchange rates to use for translation. There is an accounting standard in most countries on foreigncurrency translation that prescribes which exchange rates to use and when. In the European Union from 2005 this is International Accounting Standard (IAS) 21. This standard has been adopted within the International Financial Reporting Standards (FRS 23). Generally, this prescribes that foreign-currency monetary assets and liabilities arising from overseas operations should be reflected at the rate applying at the end of the financial year (the ‘closing rate’). By contrast, non-monetary items (such as shares in a company) may be measured at either historical cost or market (‘fair’) value: in the former case, translation is at the exchange rate at the date of the transaction; in the latter case, at the rate the market value was last established. Exchange differences arising when translating monetary items at rates different from those applying initially are, in most cases, recognised in the consolidated profit and loss account and are subject to tax at this point. The treatment of non-monetary items is that any gains or losses on translation are reflected in the parent company’s balance-sheet reserves and are not recognised in the profit and loss account (and subject to tax) until the items are disposed of. Examples of translation accounting policy are shown in Box 2.1.

BOX 2.1 ACCOUNTING POLICIES
Allied Domecq, 12 months to 31 August 2004
Foreign currencies Monetary assets and liabilities from transactions in foreign currencies are translated at the rate of exchange prevailing at the date of transaction. Subsequent movements in exchange rates

OU BUSINESS SCHOOL

9

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

are included in the group profit and loss account. The results of the undertakings outside the United Kingdom are translated at weighted average exchange rates each month. The closing balance sheets of undertakings outside the United Kingdom are translated at year end rates. Exchange rate differences arising from the translation of foreign currency denominated balance sheets to closing rates are dealt with through reserves.
(Allied Domecq plc, Report and Accounts 2004)

Boots, 12 months to 31 March 2005
Foreign currencies The results and cash flows of overseas subsidiaries and the results of joint ventures are translated into sterling on an average exchange rate basis, weighted by the actual results of each month. Assets and liabilities including currency swaps are translated into sterling at the rates of exchange ruling at the balance sheet date. Exchange differences arising from the translation of the results and net assets of overseas subsidiaries, less offsetting exchange differences on foreign currency borrowings and currency swaps hedging those assets (net of any related tax effects) are dealt with through reserves. Where foreign currency hedges are taken out for committed future foreign currency purchases, the fair value of those hedges are not included in the profit and loss account and balance sheet. All other exchange differences are dealt with in the profit and loss account. The cost of the company investment in shares in overseas subsidiaries is stated at the rate of exchange in force at the date each investment was made, except where hedge accounting applies in which case the year end rate is used.
(Boots Group plc, Annual Report and Accounts 2005)

It is important to emphasise that translation exposure does not have a cash-flow impact on the organisation, but it does affect the total balance sheet and the profit and loss figures shown in the accounts. This may therefore affect how outsiders perceive the organisation.

2.4

ECONOMIC EXPOSURE

Economic exposure (sometimes called operating exposure or strategic exposure) ‘measures the change in the present value of the firm resulting from any change in the future operating cash

10

OU BUSINESS SCHOOL

2 WHAT IS FOREIGN EXCHANGE RISK ?

flows of the firm caused by an unexpected change in exchange rates. The change in value depends on the effect of the exchange rate change on future sales volume, prices or costs’ (Eiteman et al., 2003). Economic exposure can be thought of as encompassing transaction exposure, but generally takes a broader perspective, in that it looks at the whole operation of an organisation and how cost and price competitiveness could be affected by movements in exchange rates. It also encompasses the impact on an organisation of the effect that FX movements have on the cash flows of its competitors. A way to see the difference between them is that transaction exposure only refers to that associated with cash flows that have already been contracted (for example, sales invoiced), but which have not yet taken place. By contrast, economic exposure is much wider, covering certain cash flows (that is, cash flows contracted for) and those that are likely to arise in the future as the organisation goes about its business. For example, a company manufacturing luxury cars in Germany for sale to the US will be exposed to transaction risk on all sales to the US denominated in USD. The German company will, however, also be economically exposed. Over time, the German company will be exposed to shifts in the USD/EUR exchange rate. If the competitors of the German-based manufacturer are all based in the US, any increase of the USD/EUR exchange rate (that is, an appreciation of the value of the EUR) will increase its sales prices in the US, which may mean a loss of market share to those US competitors.

EXERCISE 2.1
Après GmbH is a German company selling skiing holidays in Switzerland to German customers. Après GmbH faces economic and transaction exposure since it sells Swiss holidays to German customers. Its future profitability will depend on the EUR/CHF rate. If the CHF strengthens against the EUR, Après’s costs will increase. Unless it can pass on the price increases, it will generate less profit. If it does pass on the price increases, it may lose market share to those companies not exposed to the EUR/CHF rate – for example, companies selling skiing holidays in France to German customers. What will determine whether Après GmbH can pass on to its customers cost increases due to movements in foreign exchange?

OU BUSINESS SCHOOL

11

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

BOX 2.2 DOLLAR WOES
In 2003 and 2004 the US Dollar weakened sharply with the USD/GBP rate moving from $1.60 to $1.90. The economic impact of this was reported in the Sunday Times in the United Kingdom. The chief executive of a United Kingdom based manufacturer of high-tech simulators observed: ‘The real hit to us from the [fall in the] dollar is not just the fact that all our competitors are American. It is that we are competing in third markets such as the Middle East against [US] dollar priced competitors’. The chairman of a firm exporting specialist cleaning materials to the US echoed this sentiment: ‘We’re only just breaking even on our exports to the States as it is, and we are not looking for new business’. Clearly with such a huge change in the value of the world’s major currency it was inevitable that the vulnerability of organisations worldwide to FX economic exposure would surface.
(Sunday Times, 21 November 2004)

As Exercise 2.1 and Box 2.2 have shown, identifying economic exposure to movements in exchange rates is very difficult. It is, for example, easy to understand that a German organisation, with a production base in Germany, is exposed to changes in the USD/ EUR, as sales in its industry may be denominated in USD. Further analysis may highlight that some of its competitors are based in Japan and, even though sales may be in USD, there may be an indirect exposure to the USD/JPY exchange rate and, by implication, the EUR/JPY exchange rate, since these will affect the ability of the German company to compete with its Japanese competitors. Once you look at the range of exchange rates that affect the market you trade in as a whole, rather than just those exchange rates that apply to your direct business in that market, you start to understand just how complex it is to quantify economic exposure. As you can see, economic exposure is an important strategic risk for organisations. While we have focused on the nature of FX risk on the sales activities of organisations, note that FX exposure also has an impact on the purchases made by an organisation.

ACTIVITY 2.2
Revisit the notes you made about your organisation’s FX exposure and consider whether you can now refine your list. How easy would it be for you to quantify these exposures?

12

OU BUSINESS SCHOOL

2 WHAT IS FOREIGN EXCHANGE RISK ?

BOX 2.3 WHERE DID YOU GET THAT HAT ?
In an interview on BBC Radio 4’s Today programme, when questioned about the impact of the strong GBP on his exports, the owner of a small manufacturer of chef's hats said he had dealt with a strong GBP by producing hats in Germany, to which much of his exports from the United Kingdom had been going. This is one example of how to deal with economic exposure – but note that by establishing a German subsidiary the company opened itself up to translation exposure.

ACTIVITY 2.3
Read the article from the Course Reader, ‘Operating Exposure’ by Lessard and Lightstone. Throughout the article, in your mind, please replace their term ‘operating’ by ‘economic’ when talking about exposure. Both words can be used, so it was felt inappropriate to change the authors’ preferred term, although ‘economic’ is more common in Europe (which is why we use it). Note how this article highlights the complexity of economic, or operating, exposure. Although many organisations might decide that there is very little that they can do about economic exposure in the short term, it is an area that has to be managed over the long term.

2.5

MEASUREMENT OF FOREIGN EXCHANGE EXPOSURE

How do you measure the amount of the FX exposure your organisation has?

OU BUSINESS SCHOOL

13

14

Table 2.2(a)
Currency £ Forecast period 6 months to 30.6.06 Prepared by Date prepared AB 24.12.05

Measurement of transaction exposure. Source: Buckley (1996)
Rate: $ v. £ as at 24.12.05 Spot: 1.7200 1 mth 1.7300 3 mths 1.7500

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

OU BUSINESS SCHOOL

Company Country

US Sub Inc. USA

Jan
2000 3000 2000 5000 3000 2000 3000 (1000) 1000 1000 1000 1.8.05 Jan 1.7530 1000 1.9.05 Feb 1.7450 1000 30.9.05 Mar 1.7550 1000 1000 1000 2000 1000 2000 (1000) 1000 3000 2000 2000 1000 (2000) 1000 1000 1000 1000 2000 3000 1000 1000 2000

Feb

Mar

Apr

May

June

Beyond June
Due Sept ’06

RECEIPTS Third party Inter-company Swedish sub

TOTAL RECEIPTS

PAYMENTS Third party Inter-company German sub

Due Oct ’06

TOTAL PAYMENTS

NET RECEIPTS/(PAYMENTS)

Sept ’06 Oct ’06

COVER AGAINST RECEIPTS COVER AGAINST PAYMENTS

NET EXPOSURE

DETAILS OF FORWARD COVER* (specify contract date; settlement date; rate; amount)

16.10.05 Oct 1.7580 2000

* Details of forward cover frequently appear on a separate schedule. Note that the details of forward foreign exchange will be covered later in this unit.

2 WHAT IS FOREIGN EXCHANGE RISK ?

Table 2.2(b)
Jan Currencies with a forward market E countries where we do business Belgium Holland France Germany Italy Other Euro amounts Total E Canadian $ Japanese yen Swedish krona Swiss franc US $ Others (specify) Total No forward market Argentinian peso Brazilian cruzeiro Others (specify) Total
Source: adapted from Multinational Finance, A. Buckley (1996)

Feb

Mar

Apr

May

June

Beyond June

Transaction exposure could be measured in the format shown in Table 2.2(a) and Table 2.2(b). These show the currency flows emanating from a company’s business and the net foreign exchange exposure that results. A decision has to be taken, however, on how many months of sales or purchases should be included in the transaction-exposure position. This varies between companies, depending on each company’s pricing flexibility and how fast it can increase selling prices to offset the effect of a currency change. Economic exposure is more difficult to pin down. It is necessary to include both certain, quantifiable exposures (transaction exposure) and those where risk is less clearly defined (situations such as Après GmbH in Exercise 2.1). Organisations usually need a system
OU BUSINESS SCHOOL 15

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

that can handle both hard quantifiable data and less precise information. To achieve this you could produce a strategic DCF model for the whole organisation. This might highlight the direct effects of exchange rate movements, but also the indirect effects, through the influence on competitors, customers and suppliers. In essence, you would be performing scenario analysis based on, for example, Porter’s five forces. Measuring economic exposure would involve the following considerations.
l

‘Strategic’ consideration of expected future cash inflows and outflows – which would require discussions with the sales and marketing arms of the organisation. ‘Interrogation’ of the model by testing it with ‘what if’ scenarios – perhaps based on Porter’s five forces. Establishing the key currencies relevant to the organisation. Assessing what would happen if a relevant currency changed by, say, ±10% or ±20%. This could feed into different possible strategies: the short term (six months), medium term (one to two years) and long term (say, more than two years). Evaluating the likelihood of the different scenarios occurring: for example, how likely is it that the USD/EUR rate will be, say, USD1.50/EUR1 in one year from now?

l

l l

l

SUMMARY
FX exposure concerns the risk that the value of assets, liabilities, profits, losses or cash flows might change with changes in FX rates. In this section you have looked at the three different types of FX exposure that may arise as currency movements alter home currency values: transaction, translation and economic exposure. We now move on to examine the FX markets, what determines the values of currencies and why these values change over time.
��������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������

16

OU BUSINESS SCHOOL

3 THE MARKET FOR FOREIGN EXCHANGE

3

THE MARKET FOR FOREIGN EXCHANGE

When we take holidays overseas, buy goods from abroad or work in organisations where some purchases or sales are in foreign currencies, we are affected by movements in FX rates. For example the USD fell substantially against the GBP and EUR in 2003 and 2004, losing approximately 15% and 25% of its value respectively. Changes in FX rates can, therefore, have a dramatic impact on the revenues of any organisation that deals with selling its services and products overseas – for example, The Open University! We need to understand what makes exchange rates move and what we can do to minimise our exposure (or, perhaps, to take advantage of these movements). Let us begin with the foreign exchange market, how it works and the meanings of some terms. One small point: as exchange rates can change so rapidly, the rates we use in this text may seem out of date by the time you actually read them. The mechanics, however, will be the same.

London – the capital of foreign exchange

3.1

WHAT AND WHERE IS THE
FOREIGN EXCHANGE MARKET?


The foreign exchange market is the framework that permits individuals, companies, banks and brokers to buy and sell foreign currencies. The market for any one currency such as Japanese yen (JPY) consists of all the locations such as London, New York, Frankfurt and Tokyo where the JPY is bought and sold for other currencies. The market consists of the interbank (‘wholesale’) market and the client (‘retail’) market. Transactions in the interbank market are for large amounts of currency (for example, several million USD). Transactions in the retail market are usually for smaller amounts. Where do you find wholesale transactions in foreign exchange? Transactions take place in the capital of a country or in its main financial centre. The major market for any single currency is its home country and, especially, the city in which most foreign trade

OU BUSINESS SCHOOL

17

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

takes place. For example, Prague, Madrid and Mexico City are national financial centres. There are also a few centres that are truly international markets for foreign exchange business, principally New York, London and Tokyo. One can trade any time of day or night in the global foreign exchange markets. This is because FX dealers use an electronically linked network, connecting them to those who wish to trade currencies. The continuous overlap of foreign exchange trading in different centres is illustrated in Figure 3.1. Banks in Asia Pacific begin trading in Hong Kong, Singapore and Tokyo at about the time most traders in San Francisco are finishing. As Asia Pacific closes, trading in the Middle Eastern financial centres has been going on for two hours and the trading day in Europe is just beginning. Owing to the United Kingdom’s geographical location, banks in London can deal with Asia Pacific, the Middle East and the USA, as well as with the rest of Europe, during a working day. This has helped London to maintain a pre-eminent position in the foreign exchange market.

3.2
Global net turnover of FX transactions means the total value in USD of all spot, outright forward, swap, futures and options transactions.

THE SIZE OF THE WORLD’S CURRENCY MARKETS

Since each currency transaction involves two currencies, the aggregate participation of single currencies in FX transactions amounts to 200% of the trade volume.

In April 2004, the estimated global net turnover in the world’s foreign exchange markets was USD1,900 billion per working day. This had grown by 60% from 1995. These data, produced by the Bank for International Settlements (BIS), showed that the US dollar was the world’s dominant currency, being involved in 89% of all currency trades. In contrast, the euro was involved in 37% of trades, Japanese yen in 20% and the GB pound in 17%. The BIS report showed the global market being dominated by London, New York and Tokyo, with London retaining its position as the world’s FX capital.

3.3

WHY AND FOR WHOM DOES THE FOREIGN EXCHANGE MARKET EXIST?

The world’s economic system is based upon a large number of different currencies, many of which are ‘freely convertible’ into other currencies.
For the latest data on the FX market and FX activity, visit the websites of the Bank of England www.bankofengland.co.uk and the BIS www.bis.org

The economic system does not require all currencies to be ‘freely convertible’, only that a medium of exchange is available. When government controls impede the convertibility of currencies an illegal ‘free market’ (or ‘black market’) may develop.

18

OU BUSINESS SCHOOL

3 THE MARKET FOR FOREIGN EXCHANGE

London Dublin

Frankfurt Zurich Milan Paris Rotterdam Copenhagen Antwerp

Bombay

Hong Kong Manila

Tokyo

Los Angeles

New York

Johannesburg

Dubai

Singapore Kuala Lumpur

Sydney

GMT 0 1

2

3

4

5

6

7

8

9

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Opens 07.30 Local Closes 16.30 Local

New York Closes 17.00 Local

Opens 08.00 Local Opens 08.00 Local

London Closes 18.00 Local

Dubai Closes

Opens 07.00 Local Closes

Singapore Opens 09.30 Local Closes Sydney Opens 09.30 Local Opens 08.30 Local Opens 08.30 Local Jakarta Opens 08.30 Local 0 1 2 3 4 5 6 Bombay 7 8 Taipei Seoul 17.30 Local Closes 17.00 Local Closes 17.30 Local Closes 17.30 Local

18.00 Local

Hong Kong

00.00 Local Opens 07.30 Local

Closes 17.30 Local 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24


Figure 3.1

Standard Chartered Group dealing centres (source: Standard Chartered)

OU BUSINESS SCHOOL

19


UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

BOX 3.1 THE MARKET FOR FOREIGN EXCHANGE
My research indicates that, at the time of writing, there are 167 currencies in the world – although there is a debate about this number largely as a consequence of the status of very minor currencies such as the Jersey pound. This means that any one currency could be priced 166 times or have 166 markets in which to buy or sell the home currency. There are, therefore, potentially 167 currencies 6 166 = 27,722 exchange rates. The actual number, however, is lower because some countries, such as North Korea, do not engage in international trade. In addition, not all currencies in the world are convertible. Nonconvertibility means that either the government has imposed exchange controls or that the foreign trade of the country is relatively small and, consequently, the country’s currency will not be exchanged (and hence priced) in all currency markets. Nonetheless, the number of exchange rates to be priced is still considerable and the actual number changes each year as a result of international trade flows.
(Adapted from Wood and Bátiz-Lazo, 1995)

The participants in the foreign currency market include:
l

organisations (for example, importers and exporters, often multinational companies); investors; recipients and payers of dividends, interest, profits, royalties and loans; speculators; arbitrageurs; central banks.

l l

l l l

A speculator’s purpose is not to hedge, but to take risks on market prices for profit. An arbitrageur seeks to obtain risk-free profits by taking advantage of temporary pricing differences for the same product in different markets. An arbitrageur gains the benefits of the price differences (‘arbitrages away’) by buying and selling the same product at different prices in different markets. Banks are acting in the interbank market on their own behalf and on behalf of their customers. The customers comprise central banks, foreign banks, governments, companies and individuals who wish to dispose of or acquire a particular currency. Note, however, that individuals and most firms do not engage in buying and selling foreign currency directly. Rather, they work through their bank or a foreign exchange broker. Only a fraction of the total volume of daily business in currency is on behalf of customers wishing to finance their trading and capital flows; the vast bulk of currency business is between banks,
20 OU BUSINESS SCHOOL

3 THE MARKET FOR FOREIGN EXCHANGE

trading for their own accounts. But it is the market liquidity generated by the bank’s ‘own account’ trading that ensures retail customers can obtain a fair FX quote whenever they need it.

SUMMARY
In this section we have looked at the ‘who’, ‘where’ and ‘why’ of the world’s trading in foreign currencies. The foreign exchange market consists of two levels: the ‘wholesale’ and the ‘retail’ level, and the main difference between the two is the size of the transactions. The foreign exchange market is not a physical place, but an electronically linked network of institutions – predominantly banks. The market is extremely large and exists to provide currency convertibility to support international trade. A great proportion of foreign exchange transactions, however, are for speculation and arbitrage. In the next section we shall look more closely at the mechanics of trading in the foreign exchange markets.
��������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������

The concept of arbitrage will be particularly important for understanding parts of Section 4.

OU BUSINESS SCHOOL

21

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

22

OU BUSINESS SCHOOL

4 THE MECHANICS OF FOREIGN EXCHANGE

4

THE MECHANICS OF FOREIGN EXCHANGE

In this section we look first at spot rates, which are deals done for settlement now. You have been advised (in Unit 7) that spot interest rates differ from spot exchange rates. In this unit we are talking about foreign exchange whenever we use the term spot rate. We then discuss cross rates which are needed whenever we want to deal currency A against currency B, but where each is quoted only against currency C. In other words, we have a rate for A against C and B against C, but we need to calculate A against B. The third topic for this section is forward exchange rates. These are spot rates adjusted to reflect the fact that delivery is deferred until some future date. In particular, we shall see that a forward exchange rate is not a forecast of a future exchange rate. We conclude with a crucial subject: how to use the foreign exchange markets, be it for spot or forward transactions. This topic will be continued in later sections.
A forward exchange contract is an agreement to purchase foreign exchange at a specified date in the future at an agreed exchange rate. The rate is fixed when the contract is taken out so that the participants know how much they will receive of one currency and pay of the other. The agreement is an over-the-counter (OTC) deal between the counterparties.

4.1

SPOT RATES

In the spot market, currencies are bought or sold for immediate delivery, which in practice means settlement in one or two working days. The rate for such a deal is called the spot exchange rate or spot rate.

BOX 4.1 SPOT SETTLEMENT
As already noted, in a currency deal made for forward delivery, currencies are bought or sold now for future delivery. Though the exchange rate is agreed upon today, payment is at an agreed time in the future. This contrasts with a deal done for spot delivery, where the currencies are typically received and paid in two working days – a time interval to allow for all the back-room procedures needed to allow the settlement to happen – and which is generally thought of as ‘now’. Why two working days? Consider a dealer in Tokyo talking to one in San Francisco. Given time zones and the International Date Line, if it is afternoon of Day t in San Francisco, it is already the

OU BUSINESS SCHOOL

23

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

morning of Day (t + 1) in Tokyo. Since both sides really need at least one day to ensure that all processes are completed satisfactorily, the practical interval which should allow all situations to be catered for is two working days. So ‘spot’ is typically in two days’ time. This does not mean that it is impossible to get an earlier delivery (tomorrow or today) in many circumstances – for example, between countries within Europe – but the international standard for delivery is ‘spot’.

A foreign exchange rate is the price of one currency in terms of another. There are two ways of quoting these rates: the direct quote and the indirect quote. The direct quote gives the quotation in terms of the number of units of home currency needed to buy one unit of foreign currency. The following are examples of direct quotes, written as if we were in New York: GBP1 = USD1.7294 EUR1 = USD1.2013 CHF1 = USD0.7686 The indirect quote gives the quotation in terms of the number of units of foreign currency bought with one unit of home currency. Examples of indirect quotes in London are as follows: GBP1 = USD1.7294 GBP1 = EUR1.4396 GBP1 = CHF2.2502
For discussion of reciprocals, see Vital Statistics, Section 1.2.5.

Whether direct or indirect, it is easy to find the other way of quoting rates since one is the reciprocal (1/x) of the other. If an indirect quotation is given (GBP1 = USD2) the reciprocal of this is USD1 = GBP0.50, a direct quotation. Do not be too concerned about ‘direct’ or ‘indirect’, but always know what is being quoted for what. This is easier than it sounds. Activity 4.1 clarifies what is meant.

ACTIVITY 4.1
If you asked a foreign exchange dealer for a GBP/EUR quotation and you heard ‘1.44’, what would you think was meant? From reading a newspaper or any other general news source, you would know that the rate was about EUR1.50 per pound rather than GBP1.50 per euro. So you would automatically understand what the quoted price meant. Incidentally, this exercise also shows why reliance on the terms ‘direct’ and ‘indirect’ is not really meaningful. Assume that

24

OU BUSINESS SCHOOL

4 THE MECHANICS OF FOREIGN EXCHANGE

you were in London and called a dealer in Frankfurt. Is EUR1.44/GBP1 a direct or an indirect quotation? It is both – or neither. The Frankfurt dealer sees it as direct, you regard it as indirect, but the actual quotation is unaffected by the geographically based terminology.

Table 4.1 shows a against the United trading on 20 July the following day. method. Table 4.1

selection of spot and forward exchange rates Kingdom pound (GBP). The data relate to 2005 and were published in the Financial Times All the exchange rates shown use the indirect

Spot and forward rates against the GBP, 20 July 2005
Currency abbreviation Closing mid­ point Change on day 1 month forward 3 months forward 1 year forward

Europe Denmark Norway Switzerland Euro zone Americas Argentina Brazil Canada Mexico United States Pacific Australia Hong Kong New Zealand AUD HKD NZD 2.2952 13.4523 2.5693 - 0.0215 - 0.0600 - 0.0094 2.2971 13.4368 2.5745 13.4134 2.3258 13.3691 2.6361 ARS BRL CAD MXN USD 4.9440 4.0770 2.1136 18.4143 1.7294 - 0.0270 + 0.0116 - 0.0032 - 0.0424 - 0.0079 2.1098 18.4986 1.7276 2.1036 18.6706 1.7253 2.0878 19.4237 1.7252 DKK NOK CHF EUR 10.7431 11.4660 2.2502 1.4396 - 0.0688 - 0.1435 - 0.0169 - 0.0093 10.7203 11.4408 2.2426 1.4365 10.6766 11.3952 2.2280 1.4306 10.5204 11.2574 2.1726 1.4094

Source: Financial Times, 21 July 2005

Two columns in Table 4.1 are labelled ‘Closing mid-point’ and ‘Change on day’. ‘Closing mid-point’ is the mid-point between the buying rate and the selling rate at the close of trading business (20 July 2005 in this case). ‘Change on day’ is simply the movement from the previous day’s closing price.

OU BUSINESS SCHOOL

25

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

BOX 4.2 BID-TO-OFFER SPREADS
The rates shown in Table 4.1 are the mid-points of the spread between the exchange rate at which the currencies are bought and sold. The difference between these two reflects the margin the banks’ FX dealers seek to extract from their transactions. The size of this bid-to-offer spread varies according to the depth of the market (or the volume of transactions) and the market’s volatility at the time. A quote from a dealer in London of USD1.7285–1.7295 shows a spread of USD0.0010: this is ten ‘points’. A point is a unit of decimal, usually the fourth place to the right of the decimal point (0.0001). A pip is usually the fifth place to the right (0.00001). The FX dealer is the ‘market maker’ – the person quoting the rates; the ‘market user’ is the person (perhaps yourself) who takes the rates as given. This is true whether the quotation is direct or indirect. When you want to buy currency, the FX dealer is then selling that currency to you and vice versa. For example, if FX dealers are quoting you a bid-to-offer spread for AUD against GBP of AUD2.2852–2.2872 it means they are willing to: sell AUD to you at AUD2.2852 for each GBP1 they buy; buy AUD from you at AUD2.2872 for each GBP1 they sell. Therefore you must establish what rate (the ‘buy’ rate or the ‘sell’ rate) the dealer is quoting each time you transact. You experience these bid-to-offer spreads yourself when you buy currencies to take on holiday and (on the assumption you have some left) sell some of it back on your return. The size of the bid-to-offer spread facing an individual is large relative to those faced by institutions in the wholesale markets. The bid-to-offer spread means that, assuming exchange rates are stable, the FX dealers (and their bank) always win. This is because the lower limit of the spread (bid price) is the rate at which the bank will buy from you while the upper limit of the spread (offer price) is the rate at which the bank will sell to you.

EXERCISE 4.1
Using Table 4.1, identify the closing spot exchange rates for GBP against: (a) NOK spot (b) HKD spot (c) EUR spot (d) USD spot.

26

OU BUSINESS SCHOOL

4 THE MECHANICS OF FOREIGN EXCHANGE

4.2

CROSS RATES

So far we have seen how spot rates are normally quoted. That is fine if we want, for example, a USD/CHF exchange rate, because such rates are quoted explicitly. What if we needed to sell Swiss francs against New Zealand dollars? We would require a CHF/NZD exchange rate. If only USD/CHF and USD/NZD rates are immediately available, we would need to be able to calculate the required cross rate from the set of standard quotations (usually against the USD) that are readily available. The procedure is very straightforward: we compute the required rates as if we had bought and sold the ‘intermediate’ currency. So in our CHF/NZD example, given that we know the CHF/USD and NZD/USD spot rates, we should first ‘buy’ USD with our CHF (using the CHF/USD rate), and then ‘sell’ those notional dollars for NZD at the NZD/USD rate. Some actual figures will show how to do the computation, ignoring bid–ask spreads for simplicity. Let us use the exchange rates applying on 20 July 2005 of CHF1.3011/USD1 and NZD1.4857/USD1. If the initial amount were CHF2,000,000, then after Stage 1 we should have USD(2,000,000/1.3011) = USD1,537,160.86 After Stage 2, we should have NZD(1,537,160.86 6 1.4857) = NZD2,283,759.89 We have therefore exchanged CHF2,000,000 for NZD2,283,759.89. This gives us an effective NZD/CHF exchange rate of 2,283,759.89/2,000,000 = 1.1419NZD/CHF

EXERCISE 4.2
If we require a rate to buy CHF with Argentinean pesos (ARS), how should we calculate the right rate? Assume CHF1.3011/USD1 and ARS2.8588/USD1.

We can generalise the system to say: Multiply or divide the known rates so that the unwanted middle currency can be cancelled out. In our example we had exchange rates for CHF/USD and NZD/USD. We therefore had to divide the second exchange rate by the first exchange rate to get the NZD/CHF exchange rate:

NZD/USD NZD USD NZD = × = CHF/USD USD CHF CHF

OU BUSINESS SCHOOL

27

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

Thus

NZD/USD 1.4857 = = 1.1419 NZD/CHF CHF/USD 1.3011
giving us the same result as we calculated above. In Exercise 4.2 you had the exchange rates for CHF/USD and ARS/USD, so to be able to ‘cancel out’ the USD you should multiply the rates, since

ARS USD ARS × = USD CHF CHF
These procedures always work, regardless of whether the rates are spots or forwards.

4.3

FORWARD EXCHANGE RATES

A forward exchange contract is an agreement to deliver a specified amount of one currency for a specified amount of another currency at some agreed future date. For example, if you as a Hong Kong company know that you will be receiving GBP500,000 in six months’ time, your company might well want to know exactly how many HKD they will receive for those GBP. It is possible to obtain a quote for a forward exchange rate, or forward rate, in six months for the GBP/HKD and, by booking a six-month forward contract at this rate for the sale of these GBP, your company will know now exactly how many HKD it will receive in six months’ time. Of course, the forward agreement is a binding contract and must be completed on the due date. Before we go on to see how forward contract rates are quoted and what determines them, we should look at a few terms that are often heard. If a currency is trading at a discount this means that the currency is weaker in the forward market than in the spot market. If a currency is trading at a premium this means that the currency is stronger in the forward market. The impact of this on forward versus spot rates can be shown with an example. If the spot USD/GBP rate is quoted in London as USD1.8000 = GBP1 and the forward rate for three months’ time is quoted as USD1.8400 = GBP1 then we can say that the USD is currently trading at a discount to the GBP. That is, GBP1 will buy more USD for delivery in three months’ time than now. By implication, therefore, the GBP is trading at a premium to the USD. Alternatively, if the spot rate for GBP/CHF is CHF2.4500 = GBP1 and the six-month forward rate is CHF2.3900 = GBP1 then GBP1 will buy fewer CHF for delivery in six months’ time and the CHF is trading at a premium to the GBP. This premium or discount represents the difference between the forward rate and the spot rate for the currencies.

28

OU BUSINESS SCHOOL

4 THE MECHANICS OF FOREIGN EXCHANGE

EXERCISE 4.3
What is the difference between saying ‘sterling is trading at a discount with respect to the Swiss franc’ and saying ‘the Swiss franc is trading at a premium with respect to sterling’?
The FX market is an over-the-counter (OTC) market where there is no central marketplace or exchange and each transaction takes place directly between the counterparties concerned.

Forward rates can be quoted in two ways, either as a forward outright rate or as a forward margin. The forward outright rate is the complete rate that you would apply to calculate how much of currency A was equal to currency B in the forward deal. The forward margin is the difference, measured in points (see Box 4.2 regarding ‘points’), between the forward outright rate and the spot rate: that is Forward outright = Spot + Forward margin Why make this peculiar division? Because, as we shall see, the forward margin depends primarily on the interest differential between the two currencies. It is therefore more stable than the spot rate, because interest rates are normally less volatile than FX rates. As a result, it is more practical to show the volatile part (the spot rate) and the stable part (the forward margin) separately, bearing in mind that banks have to display (through Reuters and other market information systems) continually updated rates. Remember at the beginning of Section 4 we said that the forward rate was just the spot rate adjusted for a delay in settlement. This delay results in the difference between the spot and forward rates being determined – provided the market is working efficiently – by the interest-rate differential between the two currencies. The following example illustrates this. Assume that an investor has GBP100,000 which she wants to invest for a year and she can invest in either GBP or USD. At the end of the period she wants to end up with USD (perhaps she has contracted to buy some US asset in one year’s time). The current spot rate for USD/GBP is USD1.60 = GBP1. The forward rate for exchanging USD into GBP is USD1.57 = GBP1. Annual interest rates in the USA and the United Kingdom for similar risk-free securities are 5% and 7% respectively. The investor has to decide whether she should put her GBP100,000 into USD now and invest in dollars, or invest it in the United Kingdom and book a forward exchange deal to provide the dollars when required.

EXERCISE 4.4
Given the interest rates noted here, would you expect the GBP to purchase more USD in one year’s time or fewer?

What should our investor do? It is easiest to show the decision in a diagram (see Figure 4.1).
OU BUSINESS SCHOOL 29

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

Invest in GBP for period at 7%

Buy USD forward at 1.57

Buy USD spot at 1.60

GBP

USD

Invest in USD for period at 5% Time

Figure 4.1

The ‘rectangle’ model

It is very important to realise that all transactions are booked at the start of the deal, whichever ‘route’ is chosen. Thus ‘buy USD forward’ is shown at the end of the rectangle because that is when settlement takes place. The rate, however, is locked in right at the beginning of the period, as are also the spot rate and the two currencies’ interest rates. As you can see from Figure 4.1, the investor should be indifferent as to whether she invests in USD or in GBP because she is just choosing between alternative routes around the rectangle. Let us work out the numbers and see if they are actually equivalent.

Route 1

Invest in GBP and book forward exchange

This will involve investing at the sterling interest rate of 7% for one year and exchanging the funds at 1.57, the forward exchange rate. As mentioned before, the forward rate will have been booked at the start of the deal and it is only the settlement which is delayed by one year. Thus the end result of taking Route 1 would be: Investment GBP100,000 6 1.07 = GBP107,000 Exchange GBP107,000 6 1.57USD/GBP = USD167,990

Route 2

Buy USD spot and invest in USD

This choice would give figures of: Exchange GBP100,000 6 1.60USD/GBP = USD160,000 Investment USD160,000 6 1.05 = USD168,000 The very small difference of USD10 is caused by rounding errors due to only quoting the exchange rates to two decimal places. In practice, rates would usually be specified to four decimal places. Thus the two routes can legitimately be seen as equal.

30

OU BUSINESS SCHOOL

4 THE MECHANICS OF FOREIGN EXCHANGE

This is an example of what is known as interest rate parity. The forward rate for GBP against the USD reflects the difference between the interest rate on GBP and the interest rate on USD. If it did not, opportunities for risk-free gains, or arbitrage, would arise; price movements in the markets would then rapidly ensure that the two routes returned to equivalence.

ACTIVITY 4.2
Work out what would happen if the interest rates were the same as in the preceding example, but a trader quoted the forward rate at the same level as the spot rate. What transactions would you do to make a profit out of the trader? If the investor stays in GBP she will get GBP107,000 at the end of the year. If she moves into USD immediately and converts back into GBP at the end of the year she will only get GBP105,000. To make a profit out of the trader, the investor should borrow USD, convert it into GBP at the 1.60 rate and put the GBP on deposit. The investor should also take out a forward contract to buy USD in one year’s time to pay off the initial USD loan. Such arbitrage opportunities – even of much smaller size – are very quickly eliminated by movements in exchange rates and interest rates.

You have now learnt how it is possible to calculate the forward exchange rate if you are given the spot rate and relevant interest rates. For everyday use it is better, however, to encapsulate available information in an equation which can be applied directly and quickly. The formula below is used to calculate the forward margin rather than the forward outright rate itself, for the reason previously discussed about relative stability of exchange and interest rates. Thus the equation for the forward margin (FM) is

FM =

Period in days × Spot rate × [i (F) − i (L)] 360 + [Period in days × i (L)]

where i(F) and i(L) are the interest rate per annum on the foreign currency, F, and the local currency, L, respectively, both written as decimals not percentages (i.e. 0.07 not 7%). Also, the currencies F and L are connected by the spot rate, S, such that: F = S 6 L. In other words, the spot rate is defined as the number of units of currency F per unit of currency L (it is very important to get this the right way round). The figure 360 in the equation is a market convention, meant to represent the number of days in the year. Box 4.3 explains why.

OU BUSINESS SCHOOL

31

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

BOX 4.3 TRADE CALCULATIONS WITHOUT CALCULATORS
Remember that the sterling LIBOR market, which you encountered in Unit 7, uses 365 days per year.

Why does the international banking market seem to think that the world goes round the sun once every 360 days rather than the more common notion that it takes about 365.25 days? This is a continuation of a habit developed by the medieval ancestors of today’s bankers. When allowing credit for trade goods, typically evidenced by a Bill of Exchange, the merchants would usually give the customer 30, 60, 90 or 180 days before payment became due. Before the advent of electronic calculators (or even the older, mechanical sort) to work out the interest payable it was much easier to divide by 360 rather than 365. The typical periods could then be derived by dividing by 12, 6, 4 or 2 corresponding to 30, 60, 90 or 180 days. This practice survives to this day. It also meant that the actual interest rate being charged was a tiny bit higher, by a factor of 365/360, but your average medieval customer was not highly trained in the devilry of arithmetic – and the merchants weren’t going to tell them!

You do not need to be able to prove the formula, just be able to use it and to understand the principle of the ‘round the rectangle’ arbitrage relationship it comes from. Let us apply the forward margin equation to our ‘round the rectangle’ example. If we take GBP as our local currency, L, and USD as our foreign currency, F, and use the rates from our previous example then

FM =

360 × 1.60 × (0.05 − 0.07) 360 + (360 × 0.07)


= − 0.03

The forward outright rate for USD/GBP is given by Forward outright = Spot + Forward margin = 1.60 – 0.03 = 1.57 USD/GBP The forward outright rate of 1.57 is thus the same as in our original computation.
Organisations use forward exchange agreements to secure the value of future cash flows.

In the foreign exchange market, then, dealers calculate the forward margin for the forward rate for currency exchange by reference to the difference in interest rates between the two currencies. Dealers do not, as many of the public believe, simply guess where the exchange rate will be. There is no guesswork in calculating forward exchange rates.

32

OU BUSINESS SCHOOL

4 THE MECHANICS OF FOREIGN EXCHANGE

ACTIVITY 4.3
From a recent edition of a financial newspaper (such as the Financial Times or the Wall Street Journal) pick an exchange rate that is particularly important for your industry, an industry you are familiar with or for the country where you live. Identify the interest rates for the relevant forward period for the two countries concerned – such interest rates are shown, for example, in the ‘Market Data’ page of the Financial Times in the ‘Companies and Markets’ section. Then use the equation for the forward margin to calculate whether the exchange rate is trading at a premium or at a discount.

4.4

THE ADVANTAGES AND DISADVANTAGES OF USING FORWARD CONTRACTS

By entering into a forward foreign exchange contract United Kingdom importers or exporters can:
l

fix at the time of the contract a price for the purchase or sale of a fixed amount of foreign currency at a specified future time; eliminate their exchange risk due to future fluctuations in foreign exchange rates; calculate the exact value in their domestic currency (GBP) of an international commercial contract despite the fact that payment is to be made in the future in a foreign currency.

l

l

If the foreign currency is trading at a ‘premium’ it shows that the currency is ‘stronger’ than GBP in the forward market. This means that when entering into a forward contract:
l

a United Kingdom exporter will receive more GBP for the proceeds of the foreign currency export at the future date than at the spot rate current at the time the contract is taken out; a United Kingdom importer will have to pay more GBP to settle its foreign-currency debts at the future date than at the spot rate current at the time the contract is taken out.

l

If the foreign currency is trading at a ‘discount’ it shows that the currency is ‘weaker’ than GBP in the forward market. This means that when entering into a forward contract:
l

a United Kingdom exporter will receive fewer GBP for the proceeds of the foreign currency export at the future date than at the spot rate current at the time the contract is taken out a United Kingdom importer will have to pay fewer GBP to settle its foreign-currency debts at the future date than at the spot rate current at the time the contract is taken out.

l

OU BUSINESS SCHOOL

33

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

In deciding whether to use the forward market, an organisation will be led by its policy towards risk, but it should in any case make an assessment of what the future spot rate is likely to be. Assume that a company has a one-month forward payment of USD to make: that is, it wants to sell forward GBP. The organisation has three choices: first, it can sell GBP forward now; secondly, it can sell GBP spot for USD, put the USD on deposit for one month and pay out when the deposit matures. The third option is to wait for one month and then sell GBP spot.

EXERCISE 4.5
Are there really three independent options?

The next step is to calculate the forward outright rate – that is, the spot rate plus the forward margin. Assume the rates are as follows: spot exchange rate, USD1.8060; one-month interest rates, USD 2% p.a. and GBP 6% p.a. (You may ignore bid–offer spreads.) Taking the period as thirty days, we can use the ‘rectangle diagram’ approach we looked at in the preceding sub-section (see Figure 4.2).

Invest in GBP at 6% Value in 30 days = 1.0049 Buy USD forward Buy USD spot GBP Spot rate = 1.8060 USD Value in 30 days = 1.8090 Invest in USD at 2% 30 days Forward rate = 1.8090/1.0049 = 1.8002

Figure 4.2
For the sterling interest calculation, remember to use a 365-day year. For the US dollar interest calculation, use a 360-day year.

To clarify the numbers in the diagram, if the importer invests in sterling for thirty days at 6% per annum, GBP1 would grow to GBP1.0049. Similarly, if it invests in dollars at 2%, USD1.8060 (that is, GBP1 6 spot rate) would grow to USD1.8090. Thus the forward rate will be 1.8090/1.0049 = 1.8002. If the importer thinks that the spot dollar rate for the pound will actually be USD1.81/GBP1 in a month’s time, what should it do?

34

OU BUSINESS SCHOOL

4 THE MECHANICS OF FOREIGN EXCHANGE

This decision involves individual judgement, but look at the risks as opposed to the benefits. If the importer’s estimate (guess) is correct and it backs its opinion (by not covering forward) it will have ‘won’ compared with the safe strategy. But what if the GBP has a bad month? The importer could lose far more. In general, it can be said that the importer should normally lock in the rate by using the forward market, unless there is a very clear reason for not doing so. If the importer chooses not to hedge because it believes the spot rate will be USD1.81/GBP1, it is effectively saying it knows better than the market. Even by doing nothing, the importer is in effect speculating against the market. The importer would do well to remember that the market comprises a lot of people who make an excellent living by taking bets from corporate treasury departments. We can see from the above that forward cover can be a cost or a benefit, but that the removal of uncertainty – allowing for more accurate budgeting – is often of prime importance. Companies operating on high turnover and small profit margins are usually advised to take out forward cover, since the uncertainty involved in not hedging may cause fluctuations in the eventual net proceeds that are greater than the firm’s overall margin. To put it another way, considering that currency fluctuations are often of the order of 10 –15% a year, an exporting or importing business that trades on gross margins of the same order would be diversifying 50% of its activity (in profit terms) into currency speculation. If its management feels they are not in the business of currency speculation, they should really have a policy for hedging foreign currency cash flows.

SUMMARY
In this section we have covered a lot of ground, starting with the basic FX market conventions of direct and indirect quotations discussed in the context of the spot market. That was followed by a demonstration of the way to calculate cross rates. We then moved on to the forward market, discussing the terms ‘premium’ and ‘discount’, ‘forward outright’ and ‘forward margin’. This led to a very important result: the forward margin equals the difference in interest rates between the two currencies involved. The last part of the section looked at the pros and cons of taking out a forward contract. We shall return to this in later sections. Indeed, our analysis of contingent risk later in this unit will introduce you to a further way of hedging FX risk – through the purchase of FX options. Before we do so, we need to consider another important aspect involved with managing FX exposure – forecasting foreign exchange rates.
��������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������

OU BUSINESS SCHOOL

35

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

36

OU BUSINESS SCHOOL

5 FORECASTING FOREIGN EXCHANGE RATES

5

FORECASTING FOREIGN EXCHANGE RATES

Once its total FX exposure is defined, as discussed in Section 2, an organisation can then decide, given the costs of hedging policies and its attitude to risk, the degree to which it should hedge or remain exposed. Unless it wishes to hedge all its currency transactions, it will have to consider likely future exchange rates. The organisation can employ in-house personnel to forecast exchange rates, as is done in the largest companies, such as General Motors, or it may use exchange rate forecasts from banks or forecasting specialists. There are generally two types of approach to forecasting exchange rates: fundamental approaches and technical approaches. We shall discuss both types in this section. Major examples of fundamental approaches are the four-way equivalence model, the balance-of­ payments approach and the monetarist approach. An example of the technical approach is chartist analysis.

5.1

FUNDAMENTAL APPROACHES TO
FORECASTING EXCHANGE RATES


Four-way equivalence model or parity conditions
Four concepts are thought to explain foreign exchange rates: purchasing-power parity, the Fisher effect, interest-rate parity and expectations theory. These four concepts form the four-way equivalence model (see Figure 5.1 overleaf).

Purchasing-power parity (PPP)
Purchasing-power parity, or PPP, is based on the common sense idea that something should cost essentially the same anywhere in the world, otherwise people would try to buy the product in the cheaper market and sell it in the more expensive market (arbitrage). Prices, when converted to a common currency, should be the same everywhere: price rises due to inflation in one country are compensated by a change in the exchange rate, so that the real cost of products remains the same. When one country has a higher inflation rate than others, its exchange rate will adjust downwards so that the real cost of products remains the same between the countries. Therefore, if the inflation rate in the United Kingdom is 3% and that in the USA is 1% and the spot rate is USD1.8 = GBP1,
OU BUSINESS SCHOOL 37

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

Fisher effect

iF – iL
1 + iL
Interest - rate parity

=

InfF – InfL 1 + InfL
Purchasing - power parity theory

Key S 0 = Spot now i = Interest (annual %) F = Foreign F 0 = Forward now St = Spot at time t Inf = Inflation L = Local

International Fisher effect = =

F0 – S0 S0

=

St – S0 S0

Expectations theory

Figure 5.1

The four-way equivalence model

we should expect the GBP to deteriorate against the USD by, on average, 2% a year. In a year’s time you might expect the exchange rate to have fallen to USD1.764/GBP1. Though PPP does not hold in the short term, as there are so many market imperfections (taxes, problems of information, quotas), there is evidence to suggest that PPP does hold, on average, in the long term. It therefore should be of interest to those who wish to forecast future exchange rates, as these should move in line with predicted future inflation differentials. This is particularly useful if you need to predict over a long span of time – for example, if you are thinking of building a new factory in a foreign location.

T he Fisher effect
Vital Statistics, Section 4.4.2, discusses the Fisher effect in greater detail.

The Fisher effect states that the nominal interest rate is made up of two components: a required real rate of return and an inflation premium equal to the expected rate of inflation. Thus (1 + Nominal rate) = (1 + Real rate)(1 + Expected inflation rate) As with PPP theory above, the Fisher effect relies on the activities of arbitrageurs, who will move capital from countries with low rates of return to countries with high rates of return. If real rates of interest are thought to be the same worldwide, the difference in nominal interest rates between countries should be due to differences in inflation rates. The Fisher effect and purchasing-power parity together make up the international Fisher effect, which holds that interest rate differentials between countries should be reflected in the expectation of the future spot rate of exchange. PPP states that a rise in the home country’s inflation rate will also be accompanied by a devaluation of the home country’s currency. However, the

38

OU BUSINESS SCHOOL

5 FORECASTING FOREIGN EXCHANGE RATES

international Fisher effect states that the increase in inflation means that an increase in the home country’s interest rate relative to foreign interest rates will also take place.

Interest-rate parity
The theory of interest-rate parity (IRP) states that the difference in the national interest rates for securities of similar risk and maturity should be equal to the difference between forward and spot rates of exchange (ignoring transaction costs). That is, the forward premium or discount is equal to the interest differential. The key to this parity condition is the arbitrage mechanism discussed in the Section 4 when dealing with forward rates: if the forward premium or discount is not equal to the interest differential, there are opportunities for risk-free arbitrage. In effect, this parity condition means that a country with a lower interest rate than another will find the value of its forward currency at a premium in terms of the other country’s currency.

EXERCISE 5.1
If the annual interest rate in the United Kingdom is 5%, that in the USA 2% and the current spot rate between the two countries is USD1.50 = GBP1, assuming interest rate parity holds, what is the one-year forward rate of exchange?

Expectations theory
Expectations theory is the last parity condition. Central to this theory is the efficient markets hypothesis that states that all relevant information should be reflected rapidly and accurately in the market rates. For example, changes in expectations about inflation and interest rates are rapidly incorporated into spot and forward exchange rates. Expectations theory also leads to the conclusion that the forward rate of exchange reflects what people expect the future spot rate to be – on average – in the long term. The forward rate is an ‘unbiased’ estimate of the future spot rate – in the long term. Any changes in expectations are therefore likely to cause upward or downward movements of the rates. However, given that this is a long-term average, the forward rate will not always reflect the actual future spot rate, as shown in Box 5.1. The above collective theory of exchange-rate determination is called the four-way equivalence model. The crucial part of this model is that all the parity conditions arrive, eventually, at the same conclusion: namely, that the difference between spot and forward rates is just the interest differential between two currencies. For example, IRP shows it directly as an arbitrage condition, whereas PPP ends up at the same position from the standpoint of the longterm economic equivalence of values.
If you would like to refresh your memory on the efficient markets hypothesis, see Unit 1.

OU BUSINESS SCHOOL

39

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

BOX 5.1 ESTIMATION AND PREDICTION IN THE FOUR-WAY EQUIVALENCE MODEL
There is evidence that parts of this model may hold in the long term, but in the short term there may be many market imperfections that mean it does not all hold. Note though that IRP always holds, except for very short periods (measured in minutes rather than days, before the imbalance is arbitraged away). Is the forward rate a good estimator of the future spot rate? Yes, in a way. In a statistical sense, it is the ‘best estimate’ we can achieve in that it is an unbiased projection of the trend. Is it a good predictor of the future spot rate? Empirical evidence says, ‘no’, resoundingly. How can something be a good estimate, but a poor prediction? It is the difference between being right on average and being right on a specific day. Even if the trend in spot-rate movement is consistent and follows PPP, the fluctuations around the trend line are so severe – the data are so ‘noisy’ – that it is seldom much use when trying to predict the actual spot rate for a specific date weeks, months or years in the future. This is assuming the trend, which itself is based on expected inflation rates (which can change), remains unaltered. Figure 5.2 should give a feel for the problem of ‘noisy’ data around a trend line.

Actual spot rate Trend line Value

Time

Figure 5.2

Trend with ‘noisy’ data

To complete this part of our review of theory, let us look at an amusing but worthwhile use of the PPP concept – with apologies to our vegetarian (and gourmet) students! Every year The Economist produces its so-called ‘Big Mac Index’. To decide whether currencies are relatively overvalued or undervalued, it looks at an item standardised (more or less) around

40

OU BUSINESS SCHOOL

5 FORECASTING FOREIGN EXCHANGE RATES

the globe – the McDonald’s Big Mac hamburger. Box 5.2 provides the text of their 2005 survey.

BOX 5.2 FAST FOOD AND STRONG CURRENCIES
How much burger do you get for your euro, yuan or Swiss franc? Italians like their coffee strong and their currencies weak. That, at least, is the conclusion one can draw from their latest round of grumbles about Europe’s single currency. But are the Italians right to moan? Is the euro overvalued? Our annual Big Mac index [see Table 5.1] suggests they have a case: the euro is overvalued by 17% against the dollar. How come? The euro is worth about $1.22 on the foreign exchange markets. A Big Mac costs E2.92, on average, in the euro zone and $3.06 in the United States. The rate needed to equalise the burger’s price in the two regions is just $1.05. To patrons of McDonald’s, at least, the single currency is overpriced. The Big Mac Index, which we have compiled since 1986, is based on the notion that a currency's price should reflect its purchasing power. According to the late, great economist Rudiger Dornbusch, this idea can be traced back to the Salamanca school in 16th-century Spain. Since then, he wrote, the doctrine of purchasing-power parity (PPP) has been variously seen as a ‘truism, an empirical regularity or a grossly misleading simplification’. Economists lost some faith in PPP as a guide to exchange rates in the 1970s, after the world’s currencies abandoned their anchors to the dollar. By the end of the decade, exchange rates seemed to be drifting without chart or compass. Later studies showed that a currency's purchasing power does assert itself over the long run. But it might take three to five years for a misaligned exchange rate to move even halfway back into line. Our index shows that burger prices can certainly fall out of line with each other. If he could keep the burgers fresh, an ingenious arbitrageur could buy Big Macs for the equivalent of $1.27 in China, whose yuan is the most undervalued currency in our table, and sell them for $5.05 in Switzerland, whose franc is the most overvalued currency. The impracticality of such a trade highlights some of the flaws in the PPP idea. Trade barriers, transport costs and differences in taxes drive a wedge between prices in different countries. More important, the $5.05 charged for a Swiss Big Mac helps to pay for the retail space in which it is served, and for the labour that serves it. Neither of these two crucial ingredients can be easily traded across borders. David Parsley, of Vanderbilt University,

OU BUSINESS SCHOOL

41

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

and Shang-Jin Wei, of the International Monetary Fund, estimate that non-traded inputs, such as labour, rent and electricity, account for between 55% and 64% of the price of a Big Mac. The two economists disassemble the Big Mac into its separate ingredients. They find that the parts of the burger that are traded internationally converge towards purchasing-power parity quite quickly. Any disparity in onion prices will be halved in less than nine months, for example. But the non-traded bits converge much more slowly: a wage gap between countries has a ‘half-life’ of almost 29 months. Seen in this light, our index provides little comfort to Italian critics of the single currency. If the euro buys less burger than it should, perhaps inflexible wages, not a strong currency, are to blame.
(The Economist, 9 June 2005)

Table 5.1

The hamburger standard
Big Mac price (dollars) Implied PPP** of the dollar
– 1.55 1.06 1.93 1.63## 1.07 490 3.43 18.4 9.07 2.94 1.05### 3.92 173 4,771

Under (-) / over (+) valuation against dollar (%)
– –46 –18 –22 +12 –14 –17 –59 –25 +50 –49 +17 –50 –15 –50

United States*** Argentina Australia Brazil Britain Canada Chile China Czech Rep. Denmark Egypt Euro area Hong Kong Hungary Indonesia

3.06 1.64 2.50 2.39 3.44 2.63 2.53 1.27 2.30 4.58 1.55 3.58# 1.54 2.60 1.53

42

OU BUSINESS SCHOOL

5 FORECASTING FOREIGN EXCHANGE RATES

Japan Malaysia Mexico New Zealand Peru Philippines Poland Russia Singapore South Africa South Korea Sweden Switzerland Taiwan Thailand Turkey Venezuela

2.34 1.38 2.58 3.17 2.76 1.47 1.96 1.48 2.17 2.10 2.49 4.17 5.05 2.41 1.48 2.92 2.13

81.7 1.72 9.15 1.45 2.94 26.1 2.12 13.7 1.18 4.56 817 10.1 2.06 24.5 19.6 1.31 1,830

–23 –55 –16 +4 –10 –52 –36 –52 –29 –31 –19 +36 +65 –21 –52 –5 –30

* At prevailing exchange rates ** Purchasing-power parity: local price (in local currency) divided by price in USA (in US$) *** Average of New York, Chicago, San Francisco and Atlanta # Weighted average of member countries ## Dollars per pound ### Dollars per euro Source: McDonald’s; The Economist, 9 June 2005.

Balance-of-payments model
As you might know, the balance of payments is a summary of all economic transactions between a country and all other countries. Changes in the balance of payments originate in the current account, the capital account or in both the current and capital accounts. The flows emanating from these accounts do affect exchange rates and so many analysts focus on the balance of payments when estimating future FX rates. Let us concentrate on how changes to the current account modify the balance of payments and, in turn, the foreign exchange rate. If the current account worsens, that means the country’s imports are growing at a greater rate than its exports of goods and services. Under a fixed exchange rate, this leads to an increased demand for
The current account measures an economy’s international trade in goods and services. The capital account measures movements in financial assets and liabilities.

OU BUSINESS SCHOOL

43

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

foreign currency to pay for imports and pressure will mount for the foreign currency to strengthen and the local currency to weaken. The local exchange rate will eventually be adjusted, but by a ‘step’ change: that is, a devaluation of the currency – usually as a result of a decision made by the government in consultation with its central bank. By contrast, with a floating exchange rate, if imports are growing at a greater rate than exports then the foreign currency will strengthen and, in this free-market environment, the exchange rate will adjust almost immediately. The downside of a floating-rate regime, however, is that exchange rates are more volatile and particularly susceptible to short-term variations in the terms of trade. Modern adherents to the balance-of-payments approach to forecasting future exchange rates also look at movements in a country’s capital account. The capital account details international movements of financial assets and liabilities: for example, overseas direct investment by multinationals, investments from overseas in local bond and stock markets (sometimes called ‘hot money’) and loans from international banks and foreign multinationals to local companies. The capital account does not consider, however, profits or dividends paid by foreign companies to local companies or individuals. An example of how you must consider both current and capital accounts when looking at balance-of-payments data to forecast future exchange rates is the USA between 1981 and 1985. During that period the USA had a large and deteriorating current account. However, the factors promoting investment demand for US dollars through the capital account were so strong that the flows necessary to finance the current account deficit were easily forthcoming. Only when the factors promoting capital flows started to move against the dollar (interest-rate differentials narrowed, banking problems limited the willingness to hold dollar deposits and so on) did the current account stand out as a problem as far as the dollar was concerned.

Monetarist approach
The final example of a fundamental approach to forecasting exchange rates is the monetarist approach. Since monetary policy is an attempt to control the supply of money to the economy, the monetarist approach must be concerned with interest rates – the ‘price’ of money. We have seen that interest rates affect exchange rates both by altering the attractiveness of holding a currency as an income generator and by impacting on sentiment about the currency’s future prospects. We have also seen the impact of interest rates through our analysis of the forward margin formula. Monetarist theory says that too much money chasing too few goods in an economy is a prime cause of inflation – the available cash will increase demand, but supply will not increase accordingly, so
44 OU BUSINESS SCHOOL

5 FORECASTING FOREIGN EXCHANGE RATES

prices rise and/or imports increase. This results in the monetary authorities raising interest rates to curb inflation. We know that if local interest rates are higher than foreign interest rates the forward margin formula dictates that forward FX rates are lower than spot rates. Thus, an economy with a relatively high money supply growth will experience a weakening exchange rate. This is why exchange dealers and forecasters spend a lot of time analysing money supply figures.

5.2

TECHNICAL ANALYSIS

Technical analysis refers to the study of the behaviour of the market over time, in particular market prices and trading volumes, rather than the fundamental approaches which look at the behaviour of companies, countries or traded goods flows. Chartist analysis is one branch of technical analysis which concentrates on graphical representations of prices and trading volumes over time. Technical analysts and chartists do not believe that fundamental analysis is irrelevant, merely that other market forces, mainly psychological, are more important when trying to forecast future price movements. The technical analyst studies price changes and trading volumes over short or long time periods, in order to identify patterns that will persist into the future. Some analysts look at daily or weekly price changes; others look at intra-day price changes to forecast very short-term movements. Technical analysts base their approach on two factors. First, they argue that studying price trends and patterns enables them to remove the ‘noise’ of random price movements. Second, they believe that prices are relatively slow to adjust to new information, leaving trends in prices that will persist long enough for them to make money out of exploiting them. At the heart of the technical analysis is the ‘herd instinct’ – the belief that a collective market psychology will dictate market trends rather than a considered interpretation of fundamental factors. Technical analysts also believe that trends are predictable because history has a habit of repeating itself. Fundamental analysts largely reject technical analysis. They say that technical analysts look for (and find!) patterns that do not exist. After all, the weak form of the efficient markets hypothesis states that there are no identifiable patterns in prices and that, as a result, technical analysis is a waste of time. Additionally, it could be argued that even if there were any identifiable patterns, such information would be immediately reflected in the level of prices with the result that there would be no real advantage to be gained from technical analysis. However, one of the key assumptions of the efficient markets hypothesis (that of rational and thus profit-maximising behaviour by participants) may not be true for currency markets. For example,

OU BUSINESS SCHOOL

45

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

when a government interferes in currency markets to support its currency at a particular level, there may indeed be identifiable patterns in currency prices over time.

ACTIVITY 5.1
Read the short article posted on the course website, ‘Chart analysis and the foreign exchange market’ from the Bank of England Quarterly Bulletin.

EXERCISE 5.2
Do the graphs in Chart 3 in the reading for Activity 5.1 show that the chartists were good forecasters over the period assessed? Is there an irreconcilable conflict between the efficient-markets hypothesis and the evidence given about technical analysis in the London FX market?

The article for Activity 5.1 gives you a flavour of what goes on in the dealing rooms of the City of London. The answers to the questions posed in Exercise 5.2 indicate that at 7.30 a.m. a trader may consider lunch-time to be the long term, whereas a corporate treasurer may be concerned about what will happen in three years’ time. Technical analysis and the efficient-markets hypothesis may also have different time horizons. Most academic tests of the efficient markets hypothesis use daily closing rates. The hypothesis may be true for that sort of horizon, but that does not disprove that chartism might be able to predict the tiny minute-by-minute movements of a market.
NatWest Bank was taken over by the Royal Bank of Scotland in 2000.

The economists responsible for forecasting movements in exchange rates at NatWest Bank, explained in an interview (Kern, 1996) that they arrived at their forecasts mainly on fundamentals. Chartism was not a big part of the bank’s foreign exchange forecasting, but they noted what chartists were saying. It is something you have to take into account, because there is a body of market opinion that swears by it.

5.3

CURRENCY HISTOGRAMS

Once an organisation has reviewed the available forecasts, it can analyse the impact on its business of the forecast FX movements. One means of combining differing estimates of exchange-rate movements, as recommended in various textbooks (for example, Shapiro, 2002), is by the use of currency histograms. In this way the exchange-rate forecasts from different experts may be weighted by their perceived reliability. This is demonstrated in Figure 5.3.

46

OU BUSINESS SCHOOL

5 FORECASTING FOREIGN EXCHANGE RATES

EXAMPLE 5.1
Assume that a number of foreign exchange advisers have been surveyed and that their views are summarised in Figure 5.3.

100

80

Six months forward rate

Probability factor

60

40 70% Spot rate on decision day

20 20% 10% 0 $1.80 1.815 1.85 1.87 1.90 1.95

Figure 5.3

A currency histogram

Seventy per cent believe the USD/GBP rate in six months’ time will be between USD1.80 and USD1.85; 20% believe it will be between USD1.85 and USD1.90; 10% believe it will be between USD1.90 and USD1.95. Assume also that a United Kingdom company has an import duty of USD500,000 payable in six months. On the day on which it must decide on a hedge strategy, the exchange rate for six months forward is USD1.8150 and the spot rate is USD1.8700. What should the company do? From the histogram it can be seen that there is a very high probability that the rate will be around USD1.8000–1.8500 i.e. there is a clear bias towards the view that the USD will appreciate against GBP. Given the company needs to purchase USD for use in six months’ time, the company would benefit from buying USD through the spot market now since, according to the histogram, there is a good chance that the dollar will have strengthened in six months’ time. Another possibility – and probably a more realistic one as the company may well not have the cash available to buy spot – would be to buy dollars forward. As you know, this is equivalent to buying at today’s spot rate, with the forward margin merely reflecting the interest differential for the period to settlement. Doing nothing exposes the company to the risk that the actual spot rate in six months’ time is less favourable than the current six months forward rate.

OU BUSINESS SCHOOL

47

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

Strictly speaking, the histogram does not show that ‘there is a very high probability’ that the rate will be around USD1.80–1.85. It shows that ‘in the opinion of those surveyed, there is a ...’: in other words, the information is only as good as those from whom it is obtained and is not absolute. This does not prevent you from using it – a manager always makes the best use of what he or she has to hand – but it is important to include an estimation of the quality of information in your deliberation. Having reviewed the various forecasts of future exchange rates, the organisation has to decide what action to take with regard to hedging and exposure management. This is the subject of the next section.

SUMMARY
This section has looked at various methods used for forecasting exchange-rate movements. The approach in Section 5.1 was to apply aspects of economic theory to the problem. The first technique used a number of ideas combined into what is called the four-way equivalence model. This consisted of purchasing-power parity, the Fisher effect, interest-rate parity and expectations theory. They all combined to produce a significant result, that the difference between spot and forward rates is solely due to the interest differential between the currencies and that the forward rate was an unbiased estimate for the future spot rate. Unfortunately, it is unlikely to be a good predictor, but you cannot have everything! Other economic viewpoints were also introduced in the form of the balance-of-payments and the monetarist approaches. Section 5.2 discussed technical analysis, a topic that is regarded with deep suspicion by academics – it offends the ideas of the efficient-markets hypothesis for a start – but one that is used quite often in the financial markets. The last topic, discussed in Section 5.3, looked at one way of making use of exchange-rate forecasts and currency histograms, realising all the while that they are never more than educated guesses. The impression may have been given that forecasting exchange rates is rather a pointless activity, given the empirical evidence for its marked lack of success. This may be a reasonable viewpoint when thinking about relatively near-term and quantifiable exposures (for example, most transaction exposure), because there are good methods available for negating such risk – booking a forward FX contract as an example. However, when thinking about the broader aspects of, say, economic exposure, it becomes less realistic to expect the organisation to be able to hedge away all its FX risk – at least not completely. Forecasting then becomes an important tool, however good or bad it may be, as a provider of information for managing such exposure.
��������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������

48

OU BUSINESS SCHOOL

6 TECHNIQUES FOR EXPOSURE MANAGEMENT

6

TECHNIQUES FOR EXPOSURE MANAGEMENT

Having learnt about FX rates and the means of forecasting their future levels, this section reviews the various techniques to manage or ‘hedge’ FX exposure, be it transaction, translation or economic. As with policy towards interest-rate risk (Unit 7), the starting point for management policy is a review of an organisation’s appetite for risk. If the risk of loss from adverse FX movements is small relative to the annual profits and/or net worth of the organisation it would not be irrational to dispense with a hedging policy and live with the consequences of movements in the value of currencies. This would avoid the need for management’s time to be spent on forecasting future exchange rates and determining which hedging strategy to employ. Indeed, this is the course of action taken by many organisations. Other organisations may be more averse to risk, believing that, at the least, a considered and active policy for managing FX risk can add to profitability and hence to shareholders’ value or, at the other extreme, that a hedging policy is an imperative to avert the risk of bankruptcy resulting from adverse currency movements. Whatever decision is taken about hedging FX risk, it should be taken actively by the organisation rather than, as some companies do, simply adopting the attitude of ignoring the risk and hoping it will go away.

BOX 6.1 AVERSION THERAPY
In preparing this unit, one of the Course Team interviewed the management of a United Kingdom company with a turnover of GBP40 million about its hedging policies to foreign exchange exposure. The company had been owner managed until very recently and had used a wide range of hedging techniques (options and forwards) as well as deciding in some circumstances, given forecast currency movements, not to hedge. Since the company had been taken over by a large multinational enterprise, its local management had had to follow very strict instructions from head office about the hedging of foreign-currency exposure. These had included the requirement that they always had to hedge transaction exposure, that they always had to use forward contracts and that these contracts could only be taken out once the amount of the actual transaction exposure was known

OU BUSINESS SCHOOL

49

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

(for example, the purchase invoice in foreign currency had been received). This is an example of a very risk-averse approach by head office to currency management.

If an organisation decides to hedge its foreign exchange exposure there are two broad categories of actions it can take. 1 Internal hedging describes those activities within an organisation which alter the composition of its exposure to FX risk. Some of these may involve reorganisation of the company’s structure. 2 External hedging describes those techniques which involve the use of outside institutional services and financial markets. Setting off EUR receipts against EUR payments would be an internal hedge, but selling EUR forward to a bank for GBP would be an external hedge. It is good practice first to use as many internal techniques as possible before resorting to external ones, because on the whole internal techniques work out cheaper overall and may on occasion even prove more efficient. Note that minimisation techniques involve costs of one sort or another and, clearly, only if the benefits outweigh the costs will the techniques be worthwhile. The main techniques we shall cover are listed in Table 6.1. Table 6.1 Possible techniques for reducing foreign exchange risk
Internal
Exposure netting Matching Pricing adjustments

External
Exchange-risk guarantees Long-term borrowing in foreign currencies Financial instruments (spots, forwards, futures, options, currency swaps)

This list is by no means exhaustive and there are many other different methods of hedging exposure, but these six techniques cover some of the more obvious approaches. Note that one of the financial instruments mentioned in Table 6.1 – options – will be covered later in this unit. Later in this section we shall look in more detail at the case for not hedging at all. We finish the section with what may be described as the hedger’s dream solution: the removal of FX risk by the establishment of a currency union. On 1 January 1999, FX risk across a large area of Europe was removed by the transition to the common currency of the euro. Since January 2002, euro notes and coins have been
50 OU BUSINESS SCHOOL

6 TECHNIQUES FOR EXPOSURE MANAGEMENT

introduced for all members of the euro zone. For trade within the zone, at least, FX risk has been removed. We look at the benefits of the euro to member states and those, like the United Kingdom, potentially looking to join the zone in the future. We shall also look at the economic issues that may arise with a common currency.

6.1

INTERNAL TECHNIQUES Exposure netting

Technique 1

Bilateral or multilateral exposure netting involves companies in the same group which trade with each other. In bilateral netting, the two associated companies net off the currency amounts that they owe to each other. An example would be where a Hong Kong subsidiary owes a German subsidiary of the same group the HKD equivalent of USD3 million and at the same time the German subsidiary owes the Hong Kong subsidiary the EUR equivalent of USD4 million. The actual remittance to clear the intercompany accounts would be netted to the equivalent of USD1 million to be paid to the Hong Kong subsidiary. In this way the two subsidiaries have saved on transfer and exchange costs. With multilateral netting, a central treasury function is usually involved. An example would be as follows. In a group of companies, a French subsidiary buys, during the monthly netting period, USD3 million worth of goods and services from a German subsidiary and the French subsidiary sells USD1 million worth of goods to the United Kingdom subsidiary. During the same month, the German subsidiary buys USD1 million worth of goods from the United Kingdom subsidiary. Settlement of the intercompany debt within the three subsidiaries means a single payment equivalent to USD2 million from the French subsidiary to the German subsidiary. Multilateral netting can bring large savings in exchange and transfer costs, but it requires a centralised communications system. Exchange controls may also put restrictions on these approaches to netting.

Technique 2

Matching

To illustrate matching, consider an organisation’s assets and liabilities, grouped by currency, as amounts in the pans of a group of balance scales (one per currency). If you add up the amounts of all the assets and all the liabilities, the overall total must be equal. The individual scales, however, need not be in balance. For example, the firm might be financing an Indian factory (rupee assets) with a USD loan (dollar liability). Matching may involve rearranging the balance sheet to try to keep each scale individually in balance as much as possible – meaning, for example, financing a rupee asset with a rupee loan. In other words, to reduce the translation exposure before the event rather than deal with it after the event. In practice, you have to use mostly external methods (for example, foreign currency borrowing) to match long-term assets with longterm liabilities, so we shall consider those later in this section.
OU BUSINESS SCHOOL 51

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

On the other hand, internal methods can often be applied to current cash inflows and outflows with good effect, simply because they are more amenable to influence by managers in the short run. Receipts in a particular currency are used to make payments in that currency, thereby reducing the need for a group of companies to go through the foreign exchange markets. The way in which matching is run in a large organisation is similar to netting. It often involves a group treasury and centralised information on all third-party currency receipts and payments. The group or central treasury then buys or sells externally any balance of ‘unnetted’ currency. In this system, the central treasury acts, effectively, as banker to all the other units. As soon as an office has a receipt or must pay a foreign currency it sells it to, or buys it from, the treasury. If one department receives, say, USD and another unit needs to pay out USD, the ‘internal-banker’ method will automatically net out as much as possible. The treasury would usually fix the internal rates (typically monthly) to be used within this system. Note that this works for all foreign flows, whether they originate in another part of the same organisation or externally. As long as everyone only deals with the central treasury, netting is automatic. This system may only be cost effective, however, for large organisations able to justify running, in effect, a mini-bank. Developments in computer and information systems in recent years have, though, meant that units within organisations have the capability to take localised action in managing FX flows and the associated risks, albeit within a control structure overseen centrally.

Technique 3

Pricing adjustments

Let us illustrate pricing adjustments with an example of a pricing policy in need of reassessment. The situation at present is shown below in Table 6.2. With receivables in a currency that is devalued and payables in a currency that is revalued, the exporter loses. In this case we are being wise after the event, but what could have been done at the start to avoid this problem? Table 6.2 Exports invoiced in GBP, imports in USD, GBP devaluation
Due to receive
Month 1 Month 2 GBP = USD1.6 GBP = USD1.4 GBP10,000 GBP10,000

Due to pay
USD16,000 = GBP10,000 USD16,000 = GBP11,429

Gain / loss
Nil –GBP1,429

Even though the sales and purchases were on budget, a loss was caused in Month 2 because of the fall in GBP over the period. What are the company’s options? 1 It could increase its sales price, but that might make it uncompetitive.

52

OU BUSINESS SCHOOL

6 TECHNIQUES FOR EXPOSURE MANAGEMENT

2 It could hedge by purchasing dollars forward, but that would lock it into buying USD16,000 regardless of how much stock it found it needed. Also, that would only provide a hedge for the length of time of the forward purchase: that is, for as long as the exporter felt confident in predicting the required level of payables. 3 4 5 It could set its sales price in dollars.
It could ask to be invoiced in GBP.
It could both set its sales price and be invoiced in a third currency.


All of the last three options would ensure that sales and purchases
were inherently off-setting and so automatically hedging each other
to the extent that they matched. Note, though, that any profit
margin which would remain exposed after netting the sales
receivables and the purchase payables.
So apart from the profit element, the company would be hedged
whatever currency was chosen, provided it was the same for both
sales and purchases. Given this, the decision as to which currency
to use would normally be influenced at least as much by marketing
concerns as by risk reduction ones. In some companies, however,
there may be little choice about which currency to use, as the
companies may operate in industries that are strongly influenced by
one currency. For example, the production and development of
aluminium is a USD-denominated industry, with aluminium prices
denominated in USD everywhere in the world.


EXERCISE 6.1
How could the company ensure that the profit was also inherently hedged?

The price rise option, number one in the list, is probably only available in two main scenarios – either the company’s sales are not price sensitive, or all competitors are subject to the same exchange rate pressure, as for example the oil industry and the price of petrol. Box 6.2 illustrates the former scenario.

BOX 6.2 AVOIDING FINANCIAL DISCORD
A United Kingdom organisation provided very specialised tailormade tour packages for orchestras and other specialist groups that wished to tour abroad (‘abroad’ being outside the groups’ home country). The organisation dealt with all aspects of travel, including the conveyance of musical instruments, and accommodation and the hire of local halls. As this was a very specialist service and there were very few competitors, the organisation was able to price

OU BUSINESS SCHOOL

53

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

its services in GBP. If FX movements pushed up the price of its operations in GBP terms, price increases could be readily passed on to the customers, given the limited competition from alternative suppliers.

Intercompany or intersubsidiary sales often allow considerable leeway in price setting. Transfer pricing, the choice of pricing of goods transferred between subsidiaries of an organisation, can operate to the organisation’s advantage, since it is relatively easy to set fairly arbitrary prices for intracompany transfers of goods and services, as long as you do not go to extremes. The volatility of exchange rates often gives considerable room for manoeuvre: when the usual goal is to maximise profit in the company operating under the lower tax regime, a suitable choice of exchange rate can be very helpful. Tax laws are often designed to prevent excessive manipulation of exchange rates, but if an exchange rate fluctuates by around 10% over the life of an intracompany sales contract, it is usually possible to justify using a ‘suitable’ rate! The degree of subjectivity involved means management’s choice of a ‘fair’ price can often lie between rather broad limits. Transfer pricing can help to eliminate exchange losses in areas of the world where continual devaluation of the currency take place and can involve exchange gains where continual revaluations occur. Often countries with chronic inflation or balance-of-payments difficulties may limit capital outflows by various means. Transfer pricing may provide the only means for the investor to repatriate earnings from an economy experiencing devaluation and with capital outflow controls. Intracompany transfers of goods and services to the subsidiary in question may be marked up in price; alternatively, its exports to affiliated companies may be priced as low as possible. As mentioned in the preceding paragraph, groups operating in several countries ideally make high profits in strongcurrency, low-tax areas. On the other hand, if, as a result of the transfer pricing, earnings were increased in a country with a higher tax rate, this might well be more advantageous than having profits eroded by a continual depreciation of the local currency. Transfer pricing does, however, incur costs. It is expensive to administer and it may cause the company to run foul of the tax and customs authorities at home and overseas.

6.2

EXTERNAL TECHNIQUES

Remember, as with internal techniques, external techniques involve costs (often in terms of profits forgone) and the organisation must ensure that the benefits outweigh the costs before committing itself to one particular technique.

54

OU BUSINESS SCHOOL

6 TECHNIQUES FOR EXPOSURE MANAGEMENT

Technique 4 Exchange-risk guarantees
Most governments are willing to give some type of guarantee for certain types of exchange risk. Governments, perceiving the benefits of exporting, will normally assist exporters in many ways, including the provision of exchange-risk guarantees. These guarantees are often for protecting officially sponsored overseas borrowing. Examples might be socially or economically favoured projects with very long lead times or in countries with no forward markets, so that in either instance forward market cover is not available. In such cases, the state accepts responsibility for the exchange risk, thus ensuring that the project is undertaken. In essence, the government enables the project’s sponsors and investors to concentrate on the non-exchange risks. Such guarantees might be provided as a concession or a fee might be charged. In any event, the project’s organisers know in advance their costs in terms of local currency. The guaranteeing organisation might be the state itself, a state-owned, but self-financing body (for example, the Export Credit Guarantee Department in the United Kingdom guarantees long-term credits), or a private organisation. If it is a private organisation, it must have a good enough reputation – and sound enough finances – to be trusted as a guarantor. Note that the guaranteeing of exchange risk might be part of a wider package of export support guarantee – against, for example, the blocking of payment by the importer’s government, usually referred to as ‘country risk’. It may, on the other hand, be only the exchange rate risk that is insured. These guarantees are of most use for covering transaction exposure.

Technique 5 Long-term borrowing in foreign currencies
Long-term borrowing in foreign currencies – mainly used for reducing economic exposure – is simple, yet effective. While in the past it was mainly open only to large well-known borrowers – IBM, ICI, Shell and so on – competition in modern banking has ensured the development of techniques that enable almost any organisation to arrange loans in foreign currency, subject, of course, to any legal restrictions. If a United Kingdom company has a Canadian factory, it can minimise CAD economic exposure on its fixed assets by financing them with CAD liabilities – i.e. a CAD loan. Assuming the Canadian factory is mainly supplying its own domestic market, this method also helps to reduce the transaction exposure, at least from the subsidiary’s viewpoint. Note, however, that it is usually difficult for a subsidiary to borrow 100% against its assets – lenders like to see some equity capital, even in 100%-owned subsidiaries of major foreign parents. If very high levels of gearing are seen in such subsidiaries, it is quite common for the parent to have to stand as specific guarantor for the loans, rather than just offer its implicit support.
OU BUSINESS SCHOOL 55

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

EXERCISE 6.2
In this case, how does a Canadian-dollar loan, taken out to provide a balance-sheet hedge, also aid in reducing transaction exposure?

Rearranging the group’s loan portfolio can often be one of the most effective methods of reducing exposure. If, however, it involves increasing the proportion of total borrowing that is in high interest rate currencies, the management must once again balance the costs and benefits. Also, a significant restructuring, should it be required, would probably require a board-level policy decision. You need also to bear in mind that such operations can, while reducing real exposure, create some translation risk, depending on the particular accounting framework that applies.

Technique 6

Financial instruments

Once all other methods of reducing exposure have been used to the extent consistent with the organisation’s hedging policy, the balance – which may be substantial – may require hedging with the main FX products: spot and forward exchange transactions, FX futures, currency swaps and options. Options are dealt with later in this unit. You have read about interest rate futures in Unit 7; the equivalents for FX are very close analogues. Here we look more closely at forward contracts and, briefly, at currency swaps. You will recall that in Section 3 we covered how to calculate spot rates, cross rates and forward margins.

Forward contracts
The interest rate equivalent of a forward contract is a Forward Rate Agreement (FRA). This was discussed in Unit 7.

The simple forward exchange contract is very easy to obtain in most major currencies and has the merit of being simple as a means of hedging currency exposure. There are, however, many variations on the traditional forward contract that are on offer by banks: for example, an optional-date forward contract, where the precise maturity date is left open. Forward contracts are one of the main external means of hedging foreign exchange exposure. It is therefore worth considering the advantages and disadvantages of using forward currency contracts to hedge exposure as opposed to the alternative of using the spot market and borrowing/depositing in the two currencies. Sometimes there is not a readily available forward market – perhaps due to limited trade between the countries in question – and it can be necessary to create a synthetic forward. This is no more than actually undertaking the transactions implied by the ‘round the rectangle’ idea. Remembering the equivalence, described in Section 4, between borrowing, lending and outright forward exchange rates,

56

OU BUSINESS SCHOOL

6 TECHNIQUES FOR EXPOSURE MANAGEMENT

it is possible to replicate the effect of a forward purchase or sale by borrowing, lending and trading spot. It should be stressed that synthetic forwards are most common in cases that involve a minor currency (an ‘exotic’) that does not support a ‘deep’ forward market: for example the Argentinian peso. When using major currencies, it is almost always cheaper for non-financial organisations to book forward contracts directly. However, with the growth of investment in emerging markets, there is now a greater demand for exotic currencies. In most such cases the bank will still be willing to quote a forward rate even when there is no external forward market. In fact, by so doing, it is undertaking to do the spot/borrow/lend set of transactions and it is probably able to do so more cheaply than the customer – but it is wise for customers to check if this is the case!

BOX 6.3 AVOIDING A CORPORATE HANGOVER

A wine company operating in the United Kingdom imported wines from Spain, Australia and New Zealand. It sold these wines to highstreet supermarkets in the United Kingdom. As its sales were in GBP and its purchases in overseas currencies, it had a large exposure to potential exchange rate movements between the GBP and the EUR, AUD and NZD. A core amount of sales orders for the year ahead could be predicted, but there was often a substantial variation in sales of wine around Christmas and Easter each year, which were also the peak times for wine sales. Wine prices to the high street supermarkets were fixed each year in advance. Potential transaction exposure therefore arose as soon as

OU BUSINESS SCHOOL

57

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

these prices were fixed. The company dealt with this by covering 75% of the resultant foreign exchange exposures, using forward contracts. The company did not hedge all its foreign exchange transaction exposure as it felt that GBP was trading at too great a discount to those foreign currencies.

Currency swaps
For longer-term foreign exchange exposures, including hedging borrowings and investments in foreign currencies, it may be appropriate to use a currency swap. To examine this area we return to the subject of the swap market first introduced in Unit 7. It is possible to use currency swaps (sometimes referred to as cross-currency swaps) to separate the source of financing from the basis on which the organisation pays interest. If a United Kingdom organisation has a French subsidiary which generates EUR revenues, it may be possible to take out a GBP fixed-rate loan and then swap the interest payments for this loan into EUR floating-rate interest payments. Thus the EUR interest payments can be matched against the EUR revenues, thereby providing a hedge against movements in the EUR/GBP rate.

Example of a currency swap
As US company wants to establish a new subsidiary in Holland. Although it needs EUR to fund this development and meet the EUR denominated costs that will subsequently arise, it is easier for it to borrow USD in the US capital market. This is because investor recognition of the company reduces the cost of funds relative to issuing EUR denominated debt in Europe. The company borrows USD125 million for ten years at a fixed annual rate of interest of 6% p.a., although it actually wants to borrow EUR100 million, paying a floating rate of interest. At the time the spot exchange rate is USD1.25/EUR1. The company now enters the swap market – but it now has to ‘swap’ more than just the interest payments. It agrees with the market-making bank to swap the USD125 million for EUR, raising EUR100 million at the prevailing exchange rate. The bank pays the company the fixed interest of 6% per annum on the USD125 million debt against the company paying the bank three-month Euribor +1.5% on the EUR100 million. At the end of the ten-year swap agreement, the principal sums are re-exchanged enabling the US company to repay its USD denominated debt. Until then, though, the US company has created floating-rate EUR funds to finance the development of its Dutch-based subsidiary. Figure 6.1 summarises the position. These currency swap arrangements are more complex than the simple interest rate swap transactions we looked at in Unit 7. The market is less liquid and for the market-making bank the risks are
58 OU BUSINESS SCHOOL

6 TECHNIQUES FOR EXPOSURE MANAGEMENT

Company raises USD125m via bond issue in the US Contract date: initial currency exchange Company Company Pays USD125m to Receives EUR100m from Bank Bank

From contract date to maturity date (10 years) Company Company Note: during this time – Company Pays 6% annually on USD125m to So net interest payment by company is 3-month Euribor +1.5% on EUR100m Maturity date: final currency exchange Company Company Receives USD125m from Pays EUR100m to Bank Bank Bond investors Pays 3-month Euribor +1.5% on EUR100m to Receives 6% annually on USD125m from Bank Bank

Enabling the company to repay USD125m to US investors

Figure 6.1

Currency swap and bond flows

more complex given the currency and interest-rate exposures it opens itself up to. Additionally, since the cash flows tend not to match up as neatly as they do for interest rate swaps, there is usually a greater degree of credit risk for the parties involved in currency swaps. Naturally, the market-making bank will, or at least should, reflect all these risks in the price it quotes. The bank will attempt to make its money out of the swap deal either by using the swaps to establish trading positions where it profits from forecasting correctly future movements in interest and currency rates, or by simply setting off each swap against those with other companies. In the latter instance, the bank will trade on terms that enable it to take a profit margin (or ‘turn’) through sitting in the middle of the transactions.

6.3

ARGUMENTS FOR NOT HEDGING

We have looked at a variety of ways companies can hedge their FX risk. Some organisations, however, do not hedge their foreign-currency flows. They work on the basis that the overall gains and losses due to currency movements tend to cancel out when everything is consolidated. The assumption is that the activities of the companies involved are so large, varied and evenly spread across currencies that all the individual plus (‘long’) and minus (‘short’) positions approximately cancel out. This requirement is only really fulfilled at the group level of large multinationals, but may be close enough to the truth for smaller organisations to believe that it is not cost-effective to manage the exchange exposure more actively. Making decisions on exposure management does involve a close examination of the organisation’s
OU BUSINESS SCHOOL 59

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

economic exposure and an understanding of the currency trading blocs that operate around the world. An example is trading in Central and Eastern Europe. Many of the emerging economies of Central Europe, such as Poland and the Czech Republic, though they have their own currencies, originally pegged their exchange rates closely to the DEM, as Germany was and still is often their largest trading partner. Since the euro is now Germany’s currency, it has replaced the Deutschmark as the ‘peg’ for the Polish zloty or Czech koruna. Thus currency exposure to movements in the Polish or Czech currencies is now linked to movements in the EUR exchange rate – although this has not prevented a degree of volatility in the relationship between these currencies in recent years. For a United Kingdom business, outside the euro bloc, this change may make little practical difference; similarly for a German company dealing with Poland or the Czech Republic. In the first instance, the zloty or koruna is still pegged to a foreign currency; in the second case, it is still pegged to the company’s local currency. For a Spanish or Italian organisation, however, the difference could be important. The Czech and Polish currencies used to be pegged to a foreign currency (the Deutschmark), but now it is linked to the Spanish or Italian local currency – the euro. For many organisations, then, hedging may be a loss-making activity – among other reasons, because the bank collects a spread and because hedging activity usually requires the purchase of some computer systems to support such operations. It could therefore be cheaper only to hedge against the high risks involved in major transactions. Smaller transactions which, after netting, leave an acceptable level of risk are then not hedged.

EXERCISE 6.3
Some small United Kingdom companies, if involved in
overseas trade, handle currency exposure by invoicing in GBP.
Why might this not be an appropriate way of dealing with
currency exposure?


6.4

THE ‘SOLUTION’ OF CURRENCY UNIONS

The ultimate solution to the risks associated with the variability of exchange rates is to have a single currency. For trade within the single currency area, there is no exchange rate risk. The single currency has no others to be priced against. The emergence over the past decade of the euro and the euro zone has focused considerable attention on this method of eradicating exchange rate risk – although, of course, a highly successful forerunner as a single currency zone has been the US!
60 OU BUSINESS SCHOOL

6 TECHNIQUES FOR EXPOSURE MANAGEMENT

The motives behind the establishment of the euro were more substantial than a desire to eliminate exchange rate risks within the euro zone and make FX dealers redundant. The emergence of the euro should be seen as an integral part of the process of integrating the European economy. This commenced soon after the Second World War, first with the establishment of the European Coal and Steel Community in 1951 and then the EEC or Common Market (eventually to become the European Union) following the Treaty of Rome in 1957.

BOX 6.4 THE TERMS THEY ARE A CHANGING ...
The term applying to the economic union of European countries has changed over the years. The 1951 Treaty of Paris established the European Coal and Steel Community (ECSC) – in effect the first element of post-war economic union within Europe. The 1957 Treaty of Rome established the European Economic Community (EEC) known colloquially as the ‘Common Market’. This term was later changed to the European Community (EC) as the nature of European integration became increasingly political and not just economic. The Treaty of Maastricht in 1992 then established the European Union (EU) as the structure incorporating all aspects of intergovernmental and supranational union. The term European Community (EC) is still used, however, as the term for the economic aspects of union and is now is called the ‘first pillar’ of the EU.

From the mid-1970s, members of the EEC started to use intervention in the foreign exchange markets to maintain the exchange rates between them within narrow ranges. This process, which was termed the ‘snake in the tunnel’, led to currencies that were appreciating too much in value being sold in the FX markets to deflate the exchange rate, while those currencies falling too far in value had their exchange rate supported by being purchased. The objective, which was not without periodic difficulties, was to maintain some consistency between the exchange rates of the member countries, thereby reducing FX risks for those engaged in cross-border trade. The nature of the ‘snake’ is portrayed in Figure 6.2 overleaf, which shows the exchange rate of an EEC member having, in this example, its FX rate maintained within a DEM band of DEM2.9 to DEM3.3. By the late 1970s, momentum towards a single currency gained pace with the introduction in 1979 of the ECU, the ‘European Currency Unit, which was an artificial ‘basket’ currency used by member states of the EEC as the accounting unit for their currency area called the European Monetary System (EMS).

OU BUSINESS SCHOOL

61

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

3.4 DEM exchange rate 3.2 3 2.8 2.6 Time FX upper limit (DEM) FX lower limit (DEM) Market rate (DEM)

Figure 6.2

Operation of the ‘snake’

The ‘snake’ mechanism became formalised by the establishment of the European Monetary System (EMS). Here most of the member countries of the EEC pegged their currencies against each other by reference to the Deutschmark, which was the dominant currency. A tolerance band of plus or minus 2.25% of value around the central rate was permitted – although the Italian lire was permitted a wider margin. If the exchange rates looked as if they would move outside this tolerance range then intervention in the FX markets was used by the member countries to maintain the currencies within the EMS band. The EMS was not without its problems. Differences in the economic conditions in the member countries and the activities of currency speculators periodically put extreme pressure on these quasi-fixed exchange rates. Most notoriously, the United Kingdom, which joined the EMS belatedly in 1990, was forced to suspend its membership in September 1992, finding itself unable to keep sterling above the minimum level of its exchange-rate band. Indeed, throughout 1992 and 1993 the EMS was on the verge of collapse as currency speculators attacked one currency after another within the system. Temporarily, a wider band of plus or minus 15% around the central rate was permitted to accommodate the volatility in the FX market. The EMS survived, however, and later in the 1990s we saw the move to the introduction of the single currency, the euro. On 1 January 1999, the eleven initial members of the European Monetary Union (EMU) – the new ‘Euro zone’ – irrevocably fixed their currencies against each other at precise exchange rates. Only three members of the EU declined to enter the Euro zone – the United Kingdom, Denmark and Sweden. For three years the euro existed only as electronic money. This allowed financial markets instruments, like bonds, that had been denominated in the national currencies, to be redenominated in euros. The final stage was the replacement of the national currencies (now termed the ‘legacy currencies’) by euro notes and coins on 1 January 2002. At this point, the then twelve members of the Euro zone (Greece joined in 2001) truly had a single currency.

62

OU BUSINESS SCHOOL

6 TECHNIQUES FOR EXPOSURE MANAGEMENT

BOX 6.5 AS AT MAY 2005 ...
The EU currently comprises twenty-five member states, of which twelve are members of the euro zone while the other thirteen still employ their national currencies, although some of these are likely to join the zone in the near future. Those in the euro zone are Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain. Those in the EU, but outside the euro zone are Cyprus, the Czech Republic, Denmark, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, Slovenia, Sweden and the United Kingdom. Several more countries, including Bulgaria, Croatia and Romania, seem likely to join the EU and potentially the euro zone in the coming years.

The Euro zone should not be confused with the European Union (EU), which includes many countries such as the United Kingdom that do not have the euro as their currency. For some of these countries, though, it is likely to be only a short period of time before they jettison their national currencies in favour of the euro. The United Kingdom has a history of a cautious approach to European integration – it did not become a member of the Common Market until 1973. The government has laid down five criteria, established in 1997, to test if the economic conditions are right for joining the single currency.
l

Are the business cycles and economic structures sufficiently compatible between the United Kingdom and the euro zone to enable the United Kingdom to live comfortably with euro interest rates on a permanent basis? If economic problems emerge, is there sufficient flexibility in the euro zone (particularly in respect of the labour market) to deal with them? What impact would joining the euro zone have on the United Kingdom’s financial-services industry, particularly its wholesale markets? Would joining the euro zone create better conditions for firms making long-term decisions to invest in the United Kingdom? Would joining the euro zone promote higher growth, stability and a lasting increase in jobs?

l

l

l

l

Realistically, though, any decision by the United Kingdom to join the single currency would be a political rather than solely an economic decision, particularly as approval would probably have to be sought from the electorate through a referendum.

OU BUSINESS SCHOOL

63

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

Whatever the case for closer political and economic links with Europe, our focus here is on the benefits of a single currency in terms of eliminating FX risk. On the face of it, the single currency does provide a complete solution since those trading within the zone will never again have to do ‘what if’ analysis about the impact on their costs and earnings of movements in FX rates. The single currency removes ‘bid-to-offer’ spreads, the need to buy insurance through the use of financial instruments and the paying of brokerage to FX dealers. Leaving aside issues about the impact a single currency has in terms of centralising economic and political decision making, the fact is that a single currency is, however, not a panacea for FX risk for all those in a currency zone. Firstly, of course, there will still be FX risk when trading with those outside the zone. In recent years, for example, the fall of the euro in value against the US dollar between 1999 and 2001 and then its subsequent rise against the weakening dollar in 2003 and 2004, has had a material impact on trade and companies in Europe and the US. Secondly, one currency means that there is one official interest rate across the entire currency zone. This means that the level of interest rates is at risk of being too high for those member countries experiencing weak economic conditions or too low for those experiencing strong economic growth and high inflation. Many members of the euro zone, including Ireland, have experienced lower interest rates than, in all likelihood, they would have had if they had stayed outside the euro zone. This is because the low level of euro rates has reflected the low inflation conditions in France and Germany – the two largest economies in the euro zone. Does the risk of inappropriate interest rates really matter? In the long term it does, since those areas of the euro zone with the higher rates of price inflation may find that their exports are uncompetitive when compared with those of the low-inflation countries within the zone. Prior to the single currency, highinflation countries would often see their currency depreciate in value, offsetting the impact of higher local prices and enabling the country’s output to remain competitive. Within a single currency, this policy option does not exist. The risk for a single-currency area, therefore, is that differential price inflation within the member countries will affect the pattern of demand for the output of each country, in the same way that this was achieved prior to the single currency by currencies being over- or undervalued. Perhaps this just highlights a general rule in economics that when you fix one thing you force other things to become either unfixed or less predictable!

64

OU BUSINESS SCHOOL

6 TECHNIQUES FOR EXPOSURE MANAGEMENT

ACTIVITY 6.1
Why did the United Kingdom adopt the five economic tests to assess when membership of the euro is appropriate? What do you think is the likelihood of all tests being met simultaneously? The main reason for introducing the tests was to ensure that there are no material adverse economic consequences for the United Kingdom if it joins the euro zone. This will largely depend upon the compatibility of the United Kingdom economy with economic conditions in the other euro zone countries and the cohesion between the United Kingdom and the euro zone’s economic cycles. Given that there are five tests to be satisfied, it could be argued that the likelihood of all being met simultaneously in an ever changing economic climate is not high – posing an interesting dilemma if a consensus view ever materialises in the United Kingdom in favour of entry into the euro zone.

While currency unions provide a complete fix to FX risk within a trading area, they are not without wider economic consequences for organisations. Since the decision to join a single currency lies with the government and the electorate this means of managing FX risk should clearly not be seen as a policy option for individual organisations.

SUMMARY
Having identified and quantified exchange exposure in Section 2, in this part of the unit we have been concerned with ways of managing the risk caused by such exposure. The techniques range from ones that involve just the managing organisation (internal methods) to those that are direct contracts with outside parties entered into solely for foreign exchange reasons (external methods). Exposure netting is an example of the former and a forward purchase contract an example of the latter. Between the two extremes are techniques that involve outside parties, but are modifications to activities that would be conducted anyway; changing the currency of sales invoicing would be an example. Some of the methods discussed provide a long-term elimination of exposure: for example, matching foreign fixed assets with foreign loan liabilities. Such systems are particularly appropriate to control economic and translation exposure. On the other hand, they are less useful when dealing with the (typically) shorter-term and more variable elements of transaction exposure. As organisations go about their normal activities the levels of transaction exposure will continually change; it consequently needs to be managed in a more active way.
OU BUSINESS SCHOOL 65

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

Finally, we looked at the way currency unions can eliminate FX risks for member countries, focusing on the emergence of the euro zone in recent years. We have now looked extensively at FX risk and how to manage it. The rest of Unit 8 examines contingent risk and how this may be managed by options contracts. The coverage will include one final means of managing FX exposure – the use of FX options.
��������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������

66

OU BUSINESS SCHOOL

7 CONTINGENT RISK

7

CONTINGENT RISK

What do we mean by contingent risk? Our exposure to contingent risk is triggered only if a particular event or sequence of events occurs. The risk depends on – is contingent on – the trigger. Assume a European company has submitted a bid for a large, overseas contract to provide a distance-learning service in Ethiopia, the bid being in US dollars. The ‘trigger’ here is winning the award of the contract, which will create considerable FX risk for the organisation plus some interest risk and credit risk – the credit risk depending on which party is underwriting the project. None of this risk exposure is incurred until the company is appointed as supplier. The company was liable to become exposed, however, from the moment the fixed price, non-retractable bid was submitted. The risk is contingent on the bidder receiving the contract, but the company must take the potential outcome into account from the moment it decides to bid. In particular, the risk to be taken needs to be included as a factor in the pricing of the bid. In essence, the company has sold to the potential client (for no cash, if the contract is lost) an option from the date of submission until the date of acceptance or rejection or expiry of the bid. If managers decide to hedge away the risk associated with this option, the bidding company needs to buy an equivalent option itself. As you will see this may be feasible – at a price – when considering foreign exchange, interest rates, some stocks/shares, bonds and commodities. In other situations, you may simply have to acknowledge the potential outcome and accept the exposure.

BOX 7.1 ‘ I NEVER BUY ANYTHING AS ESOTERIC AS OPTIONS ’
It is a common misunderstanding that options are financial instruments only used by highly sophisticated and/or daring financial experts. In fact, we all purchase and sell contingent claims as part of ordinary life and business. If a bolt of lightning burns down your house, what do you do? If someone steals your car, what do you do? If you fall ill on an overseas trip, what do you do? In all the above – unless you had been excessively optimistic and had not insured – you would claim from your insurance company.

OU BUSINESS SCHOOL

67

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

Why would the company pay? Because it is contractually bound so to do by the premium you paid before the event. For a pre-agreed amount, the insurer has committed to take over from you the risk exposure related to the relevant unhappy event, should it occur.

The amount you pay is related to the estimated probability of the situation arising, but this likelihood is usually very low for any particular individual, so the premium is (reasonably) affordable.Insurance is, therefore, no more or less than an out-of-the-money option.

Terms such as ‘out-of-the-money’ and ‘put option’ will be defined shortly, but you can nevertheless see the point of Box 7.1: we all deal in contingent risks regularly, even if we do not call them that. You may already be reflecting on the examples of hedging FX risk examined earlier in this unit and asking the questions:
l

If I was not sure that the FX exposure would materialise, what hedge could I use? Even if I was sure the FX exposure would materialise, hedging by using the forward market could mean I lose out. On maturity of the forward deal, FX rates could be more attractive to me than the forward rate. Could I hedge my exposure without taking an outright forward position?

l

The answer to both of these questions is to consider the use of options. Financial options do not exist in a vacuum. You will always find an underlying financial transaction that triggers a potential exposure to risk. Actually, this is the reason why we call options and futures ‘derivatives’; because to ascertain their value we have to derive information on prices prevailing in another market. Section 8.1 will explain this idea in more detail.
��������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������

68

OU BUSINESS SCHOOL

8 OPTIONS

8

OPTIONS

An option is a financial instrument that enables contingent risk to be traded. The importance of options has grown explosively in the last forty years. Before we discuss the characteristics of options in more detail, it is worth having a brief look at their history. We shall then study the language, definitions and conventions of the world of options and look at examples of how options can be used. We will examine share, currency and interest rate options and identify the factors that determine options prices. In Appendix 1 we examine some key rules, referred to as propositions, relating to option prices. Additionally, Appendix 2 describes in more detail how options are priced. This inevitably involves some mathematics – although the approach adopted in the appendix concentrates more on the factors affecting pricing rather than on the arcane algebra!

8.1

OPTIONS – WHERE DID THEY COME FROM?

Options already had a long history by the time the first registered options exchange, the Chicago Board Options Exchange (CBOE), was established in 1973. The pioneering academic work on options took place as long ago as the late nineteenth century. In Chicago, futures trading had already taken place for many years and options use essentially the same systems and practices as futures, including a ‘clearing house’ (see Unit 7). The CBOE started modestly, trading call options on only sixteen shares in major companies quoted on the New York Stock Exchange. The volume and range of its option products expanded rapidly. Other US exchanges began trading in options and, in 1977, put options (the right to sell a security) were introduced on all of them. Trading grew so much on the New York Stock Exchange that within ten years the value of options on shares traded often exceeded that of the underlying shares. As a result of this success, the range of securities on which options were traded was gradually extended to options on stock indices, foreign currencies,

The Chicago Board Options Exchange

OU BUSINESS SCHOOL

69

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

government fixed-interest securities, swaps (swaptions) – even options based on the right to buy (or sell, if a put) a futures contract – for example, stock-index futures and commodity futures. Following the US pattern, options exchanges were opened in other major financial centres, including London, Tokyo, Singapore, Amsterdam, Paris, and Frankfurt. Another parallel development has been the growth of the ‘over-the­ counter’ (OTC) market, mainly through banks offering customers options specially tailored to their needs. The four main kinds of financial options are:
l l l l

options on shares options on interest rates options on currencies options on commodities (for example, metals or agricultural crops).

We start our analysis of options by looking at options on shares.

8.2

OPTIONS ON SHARES

Option dealing has its own language and you need to know some of its terms. A call option is a contract giving its owner the right, but not the obligation, to buy a given number of shares at a fixed price (known as the exercise price) at any time on or before a given date (known as the expiry date). A put option is a contract giving its owner the right, but not the obligation, to sell a given number of shares at a fixed price at any time on or before a given date. In the definitions note the phrase ‘ ... at any time on or before a given date’. Strictly speaking, there are two major types of option: an American option can be exercised ‘on or before’ the expiry date; a European option can only be exercised ‘on’ the expiry date. In this unit we usually talk just about an option without adding American/European prefix – but do remember the difference.
Both put and call options may be bought and sold.

Let us start with call options. Puts will be discussed later. Many principles are similar for both calls and puts. Euronext.Liffe gave the information in Table 8.1 for equity options in respect of the shares in Boots on 23 May 2005. Table 8.1 Boots call-option prices
June
64.5 22.5

Exercise price (p per share)
550 600
Boots current share price 610p

September
68 33

December
73 42.5

70

OU BUSINESS SCHOOL

8 OPTIONS

All quoted figures are in pence, so for Boots, then at 610p a share, the first column shows the exercise price for the share for particular options. The other columns give the expiry months for the options and the premiums (prices) for each call option. As an example, suppose Francis Spencer, a fund manager, decides to buy a contract of June 550 calls. The unit of dealing – or the size of each contract – is 1,000 shares, so he pays 64.5p a share or GBP645 (1,000 6 64.5p). For this he purchases the right, but not the obligation, to buy 1,000 shares in Boots at any time up to the expiry date in June at a fixed price of 550p a share. If he buys the 1,000 shares, he exercises the option. Alternatively, he can sell his option at the market price any time up to the expiry date. If he neither sells nor exercises his option (perhaps because the share price abruptly fell to less than 550p and stayed there), he would let the option lapse at the expiry date. There are two parties to every new option, a buyer and a seller (the latter is known as the writer). The buyer pays the writer for the option and the payment is called the premium. Writers are usually large shareholders, for example, pension funds and assetmanagement companies. The writer is obliged to sell the shares at the exercise price when the buyer chooses to exercise. Francis’s profit or loss on expiry, if he still holds the contract, is set out in Table 8.2. Table 8.2 Profit on expiry of the call option
Gross profit per share (p)
0 0 50 100 150 200
Remember, Francis paid 64.5p a share for the call option.

Share price at expiry date (p)
500 550 600 650 700 750

Net profit per share (p)
-64.5 -64.5 -14.5 35.5 85.5 135.5

The position at the expiry date clearly depends on what the share price is at that time. Francis has the right to buy shares at 550p and will only do so if the share price is above the exercise price of 550p. If the share price on expiry is less than or equal to 550p, as in the first two rows of Table 8.2, he will let the option lapse. If the share price is above the exercise price, he will buy the shares at 550p and sell them at the market price, the excess being his gross profit. The net profit is the gross profit minus the premium paid.

Of course, Francis may choose to hold on to the shares, in which case the figures are the same, but the profit would not be realised.

OU BUSINESS SCHOOL

71

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

EXERCISE 8.1
What would be the net profit or loss position on expiry for an investor who bought a call option on 1,000 shares with a premium of 35p and an exercise price of 600p, if the share price at expiry was: (a) 550p? (b) 600p? (c) 650p?

Notice how the exercise price is not the same as the share price. The exercise price can be above the share price, the same as the share price, or below it. A call option with a share price above the exercise price is called in the money. This is because, if exercised today, such an option would have value – the difference between the exercise price and the higher current share price. Such value is called intrinsic value. On the other hand, a call option where the share price is below the exercise price is called out of the money. It would not be worth exercising such an option today as the price at which the option could be exercised is higher than the current share price. Why exercise an option when you can buy the shares more cheaply in the market? Finally, if the exercise price is exactly the same as the share price, an option is said to be at the money. It is just not quite worth exercising. For example, in Table 8.1, with a share price for Boots of 610p, the call options with an exercise price of 550p are in the money. There is intrinsic value in these options. If the June 550p option were bought and exercised today, Francis Spencer could make a gross profit per share (before the cost of the option) of 610p – 550p, or 60p. This 60p is the intrinsic value inherent in this option, but the option is quoted at 64.5p – i.e. 4.5p more than its intrinsic value. We shall see later that the extra 4.5p, is what is known as time value. This is the extra amount that investors are prepared to pay, over and above intrinsic value, since the share price could rise further before expiry, making the intrinsic value even greater than the current level of 60p. Figure 8.1 shows the value of a call option plotted against the share price. The exercise price is represented by the vertical line. The broken line in the graph shows the intrinsic value of a call option and the solid line shows the total value of the call option, including time value. Notice how, in the out-of-the-money section of the graph, where the share price is less than the exercise price, the call option only has time value. There is no intrinsic value in the call option. On the right-hand side of the graph, where the call option is in the money, intrinsic value makes up a substantial element of the total value of the call option. Of course, as the time to expiry shrinks, the time value element of value will also shrink, becoming zero on the date of expiry. So, the value of a call option on the

72

OU BUSINESS SCHOOL

8 OPTIONS

expiry date will not be the curved solid line, but the broken line. It will either have intrinsic value or be worthless.

Out of the money

At the money

In the money

Option value

Intrinsic value

Option value

Exercise price Current share price

Figure 8.1

Value of a call option before expiry for different current share

prices

Returning to the Boots example, why should Francis be willing to spend 64.5p per share or a total of GBP645 for the June 550p option contract? We have already noted that the cost of the contract is more than he could get from exercising it today, so why is he willing to pay time value for an option when he could buy the underlying shares instead? One reason could be caution: although he could lose money on his investment, the worst that could happen is that he loses the whole of the GBP645, but since GBP645 is the maximum possible loss he has limited his ‘downside’ risk. This maximum possible loss is because buying a call option gives the right to exercise or sell, but no obligation to do so and is the main difference between the buying of options and the buying of forwards or futures, where the only way to limit losses is to get out of the contract. This feature of call options is important in portfolio insurance and guaranteed funds, which use options to guarantee a minimum value or return on a portfolio and hence offer limited downside risk for investors. Another reason for buying a call option on Boots is that, if the share price goes up, the percentage return – or, in effect, the ‘gearing’ – is much greater on the option than on an investment in the underlying shares. Suppose, for instance, that Boots shares are at 750p on the expiry date in June. At that time Francis would exercise his option at 550p a share, giving a gross profit of 200p per share, equivalent to a pre-tax return of (200 – 64.5)/64.5 or 210% on his initial investment. If, on the other hand, he had invested directly in the shares at the price of 610p and then sold them at 750p, his gross return would be (750 – 610)/610 or 23% on the initial investment. Thus, options can give a much higher percentage return than buying the shares directly. Conversely, of course, the percentage losses are higher with options than with shares, but with the safeguard that no more than the original option investment in value terms can be lost.
OU BUSINESS SCHOOL 73

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

Where does this gearing effect come from? If we consider in-the­ money calls, we can see from Figure 8.1 that as the share price rises the graph of the option value is getting closer and closer to a 45° line. This means that the value of the call begins to rise or fall very close to the ‘one-for-one’ rate (that is, 1p profit or loss per 1p rise or fall in share price) we would be exposed to if we had bought the shares themselves. We would have only paid out the cost of the premium, however, much less than the cost to purchase the shares themselves. Thus the rate of change in profit or loss is geared up. For out-of-the money options the value graph rises or falls more slowly (the curve is much flatter), but the investment required to buy the option is also small, so the rate of change in the return on the investment is also relatively rapid. Indeed, in terms of ‘percentage of investment’ out-of-the-money options can prove to be even more highly geared, because the premium paid is so small compared with that for an at-the-money option or in-the­ money option.
Strictly speaking, the ‘loss’ here is only the loss due to adverse market movement. Transaction costs (broker’s commission and/or a ‘bid–ask’ spread) would also be incurred, but the premium is usually a much bigger component of total cost.

Thus, a call option offers a much higher percentage profit (or loss) than investing directly in shares and, in that respect, is similar to buying shares partly with borrowed money, which would also ‘gear up’ returns. However, remember that the maximum possible loss that can occur is limited to the initial premium.

EXERCISE 8.2
The curve shown in Figure 8.1 is the generic shape for a call option. What would the equivalent curve look like for a put option?

8.3

PAY-OFF DIAGRAMS

So far we have looked at the basic principles of options. We now go one step further by looking at the pay-offs from options. This involves looking at the value of an option on its expiry date and is of great practical use for anyone using options, particularly for hedging purposes. The intention is that you start to get a ‘feel’ for what an option is worth at the end of its life, that is, when it becomes certain whether or not you should exercise your rights. This analysis uses pay-off diagrams. These do not do anything that cannot be done in other ways, but they are designed to make assimilation of the information easier than staring at a table of numbers. Pay-off diagrams give, in graphical form, the results of an options transaction at the expiry date. Figure 8.2 shows, in the left-hand diagram, the net pay-off for the buyer of a call against the share price at expiry. This is the graphical form of Table 8.2 and the dotted line of Figure 8.1. The right-hand diagram gives the net pay-off for the seller (or writer) of the call, which is the same
74 OU BUSINESS SCHOOL

8 OPTIONS

graph with the signs reversed. This means that if the net pay-off for the buyer is positive at a certain share price, it is exactly the same amount, but negative, for the writer. If it is negative for the buyer, it is the same amount, but positive, for the writer. In other words, the buyer’s profit is the writer’s loss and vice versa. Looking at Figure 8.2, it is clear that writing call options is extremely risky, since the potential for losses is unlimited: the more the share price rises, the bigger the writer’s loss. The buyer of a call option has limited downside risk. All that he or she can lose is the option premium. It makes a difference, however, as we shall shortly show, whether the writer also possesses the shares on which the call is written (it is then known as a covered call) or if he or she does not, as in the pay-off diagram, when it is known as a naked call.

Buyer Net profit/loss Net profit/loss Exercise price 0 Premium paid

Writer

0 Exercise price

Premium received

Share price at expiry

Share price at expiry

Figure 8.2

Call option: net pay-off at expiry (net of initial premium)

ACTIVITY 8.1
These pay-off diagrams are all made up of straight lines, so where has the option-value curve of Figure 8.1 gone? Pay-off diagrams show the net profit or loss from an option at the date of expiry. The curve in Figure 8.1 shows the value of an option at some time before expiry. Thus Figure 8.1 will look more and more like the left-hand diagram in Figure 8.2 as the time to expiry gets shorter.

A great strength of pay-off diagrams is that they can show the aggregate position for a complex investment by adding the diagrams of the components. Thus, Figure 8.3 overleaf shows the diagrams for owning the share and for writing a call, together with the resulting combined position, known as a ‘covered call’. The combined position is arrived at by the following procedure. For a fixed set of share prices on expiry, the corresponding net profits for (a) the written call and (b) the net profit on buying the shares are calculated and then the two figures are added together to give the combined net profit.

Remember, writing a call is the same as selling a call.

OU BUSINESS SCHOOL

75

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

Share pay-off Overall pay-off of owning share + writing call

Net profit/loss

0

Premium received Option pay-off Price originally paid for shares Exercise price of written call option Share price at expiry

Figure 8.3

Writing a ‘covered call’

On looking at Figure 8.3, which shows the net pay-off for writing a covered call, it is easy to see why many fund managers are tempted to use this strategy. If the share price stays below the exercise price, the fund manager retains the shares, collects the dividends and also receives the call premium. If the share goes above the exercise price, the fund manager collects the exercise price for the shares and the premium and may or may not get the dividends (depending on when the call is exercised). In short, it is a prudent policy if the fund manager feels that the share price is likely to fall or stay stable. Mind you, if the fund manager is proved wrong and the price rises, then the portfolio loses the gains it would have obtained from continuing to hold the share without writing the option. As we shall see shortly, writing a ‘covered call’ is nothing more than writing a put. So we now turn our attention to the other kind of option – the put option. Remember that the definition of a put is: ‘a contract giving its owner the right, but not the obligation, to sell a given number of shares at a fixed price at any time on or before a given date’. The put option, by fixing the selling price, is an important tool for hedging against a fall in the market. While both buying a share and buying a call option enable investors to profit from a rise in the price, it is only the put option that enables them to profit from a fall, unless they are lucky enough to be dealing in a market and instrument that allows for short selling. Even in those markets that can arrange for short sales, it is usually a relatively expensive thing to do in terms of transaction costs. The position at the expiry date can be charted for the put option in a similar way to that in which we produced for the call option. On 23 May 2005 the price of a June 550 put on Boots shares (taken from the same Euronext.Liffe source that was used for the call options) was 5p. The profit/loss table is as shown in Table 8.3.

Short selling is the practice of selling shares that you do not own in the expectation of buying them back more cheaply at a later date. Major stock markets such as New York allow short selling, subject to strict guidelines.

76

OU BUSINESS SCHOOL

8 OPTIONS

Table 8.3

Profit per share on expiry of put option
Gross profit (p)
150 100 50 0 0 0

Share price at expiry date (p)
400 450 500 550 600 650

Net profit (p)
145 95 45 –5 –5 –5

From Table 8.3 we can see that above the exercise price the end value is –5p, while below the exercise price the value of the option rises 50p for every 50p fall in the share price. We can generalise this to draw the typical net pay-off diagrams for buying or writing a put, as illustrated in Figure 8.4.

Buyer Net profit/loss Net profit/loss Exercise price 0 Premium paid

Writer

Premium received 0 Exercise price

Share price at expiry

Share price at expiry

Figure 8.4

Puts: net pay-off at expiry (net of initial premium)

ACTIVITY 8.2
Look at the right-hand diagram in Figure 8.4. Does it look familiar? You should recognise this shape from the broken line in Figure 8.3, which represented holding a share and writing or selling a call option against it (i.e. a covered call).

So by comparing Figures 8.3 and 8.4, you can see that selling a put option is the same strategy as holding a share and writing a call option. Writing what is called a naked put is the same as writing a covered call. From this, we know that once we have valued a call option, the value of a put option is derived from the equality defined above.

OU BUSINESS SCHOOL

77

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

Combining the buying or selling of calls and puts (with possibly different exercise prices) and an appropriate number of shares can be designed to give a particular combination, which professional investors may use to back their views about where the share price is going. To each combination there is a net pay-off diagram that can be derived – spreadsheet packages can quickly display these graphs. Many of the combinations that are widely used have commonly accepted names and we illustrate just one of these to give an idea of the possible range of combinations.

ACTIVITY 8.3
Go to the payoff diagrams software on your B821 disc. From the menu, choose ‘Straddle’ strategy and see the effect on the ‘straddle’ graph of changing the suggested parameters.

Figure 8.5 illustrates a straddle, where a call and a put with the same exercise price and same expiry date are bought for one share. Investors who buy a straddle expect the share price to move substantially before expiry, either up or down. Note that they are not guessing in which direction the share price will move, simply that it will end up substantially different from the present figure – so a straddle is a bet on volatility.

Buy put

Buy call

Net profit/loss

Overall position Exercise price 0

Share price at expiry

Figure 8.5

A straddle

BOX 8.1 VOLATILE OR NOT VOLATILE, THAT IS THE QUESTION ...
As we shall see shortly, the value of an option depends crucially on the expected volatility of the price of the underlying share (or FX rate or interest rate or other reference rate). For a straddle, the decision to buy is based on comparing an investor’s – more

78

OU BUSINESS SCHOOL

8 OPTIONS

realistically, a speculator’s – view of future volatility with the market’s opinion. If the market’s quotes for option premiums are ‘fair’ – and the working of supply and demand would lead us to expect that they would be – then built into each price is the market participants’ average expectation of future volatility. If investors are of the opinion that volatility will actually prove to be higher than this implied volatility then it is sensible for them to buy a straddle. As always, speculators are backing their predictions against the average expectation of the other market players.

ACTIVITY 8.4
Box 8.1 points out that straddles exploit a difference between the views of volatility taken by the market and by an investor/ speculator. What is the attitude of option users to volatility (after all, we express risk in terms of volatility)? To answer this question, access the Valuing Equity Options part of the Option Valuation software. Set the strike price and current price to 500p and consider two shares, Lo and Hi. Lo is a safe share with low price volatility. Hi, on the other hand, has a volatile share price (maybe because it is a hightech business with little revenue, but exciting prospects). Hi and Lo today have an identical share price of 500p. Look at the premium cost of buying a three-month call option for either Hi or Lo, both with an exercise price of 500p. For Lo use the default volatility level of 30%. For Hi adjust the volatility level to 50%. Which option do you think would cost you more? It may seem peculiar, but the option for Hi will be worth more than that for Lo, even though – no, precisely because – it is more risky. As a buyer of options, volatility is good. Why? You can choose not to exercise the option, which reduces the downside of volatility. The upside potential remains, however, and the more volatile – the riskier – the share price, the greater the possible rise in the share price.

If you answered Activity 8.4 correctly, you have a good feel for the concept of options. If you thought that risk (volatility) is always bad, remember that the shape of an option’s pay-off diagram differs fundamentally from that for buying or selling the underlying shares. In options, volatility is valuable because you are protected from the downside risk.

OU BUSINESS SCHOOL

79

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

EXERCISE 8.3
Draw the net pay-off diagram for a position that involves buying a July 460 call option at 73p and writing a July 500 call option at 54p.

There are a huge number of options products, although most are usually of interest only to institutional investors or traders. In an active market, though, such trades benefit everybody. The reason is that if the price of an option (relative to other options, or to the underlying security) is too high or too low, traders would try to benefit from the mispricing by doing combination trades. This would cause the price to move to its proper level. An infinite number of option combinations can be created. Using puts and calls, bought or written, various exercise prices, plus long or short holdings of the shares, it is not surprising how varied the final pay-off positions can be. With ingenuity, it is usually possible – at a price – to ‘engineer’ a pay-off to suit almost any hedge or investment profile.

BOX 8.2 AMERICAN AND EUROPEAN OPTIONS
Virtually all traded options are American, which means they can be exercised at any time up to the expiry date, so that the buyer of the option can obtain the share (for a call) or sell it (for a put) at any time. Further, the majority of shares on which options are traded have one or more dates where they go ex-dividend up to the expiry date. This can affect the exercise decision, since option holders do not receive dividends. American options are therefore complex because the decision whether to exercise or not has to be borne in mind at every instant between purchase and expiry. As a result, the need to bear in mind the possibility of early exercise makes the pricing of American options more intricate than pricing European options. This is why studies of valuation models usually deal with European options, which can only be exercised at the expiry date, and assume that European options are on shares which pay no dividends, avoiding the problem of early exercise completely. In practice, the value of an American option can usually be taken to be the value of the equivalent European option, as we now show in Proposition 4 in Appendix 1.

‘Ex-dividend’ means the point at which any new buyers of a share are not entitled to the most recent share dividend announced by the company. Dividends are only paid to those holding shares immediately prior to the ex-dividend point.

80

OU BUSINESS SCHOOL

8 OPTIONS

8.4

CURRENCY OPTIONS

You should now be familiar with the basics of put and call options and the pay-offs that result for both from different share prices. So far our analysis of the basics of options has just looked at options on shares. Having gained an understanding of the key features of options, we can now turn to currency options. In doing this we return to the subject of hedging FX risk, which we covered earlier in this unit. Currency options provide organisations with another route to hedging FX exposures and is particularly suited to those exposures that might arise as opposed to those that are going to arise. First, let us see what currency options look like. Table 8.4 shows the prices for GBP/USD currency options at the close of business on the Philadelphia stock exchange on 10 June 2005, when the spot price was GBP/USD1.8244. Table 8.4 Philadelphia stock exchange GBP/USD options
Premium: cents per GBP1
Calls June 2005 1.820 1.830 1.840 1.54 1.07 0.72 July 2005 2.37 1.90 1.50 August 2005 2.90 2.39 1.98 June 2005 1.29 1.83 2.48 Puts July 2005 2.36 2.96 3.55 August 2005 3.09 3.63 4.09

Contract size: GBP31,250
Exercise price (USD)

Table 8.4 is very similar to those tables showing share options. In the middle of the table we see the call premiums for the right to buy (call) GBP for USD at the defined exercise prices. The right of the table shows the premiums for the right to sell (put) GBP for USD at the various exercise prices. You should already understand that the greater the time to expiry of the contract the higher the premium (due to the greater ‘time value’ in the option). Of course, the greater the intrinsic value in the option once again the greater the premium – so the option to put (sell) GBP1 for USD1.840 is bound to be costlier than the option to put GBP1 for USD1.830. The expiry dates for the options are around the middle of each month, on the Friday before the third Wednesday of the month. The prices quoted are in US cents so, for example, an investor pays 1.90 cents to have the right, but not the obligation, to buy (call) GBP1 for USD1.830, the exercise price, up to the July expiry date. The contract size is GBP31,250, so all dealings must be for multiples of this amount.

OU BUSINESS SCHOOL

81

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

An example of the use of currency options
Dorcas Spencer, the Production Director of Francis & Co., is very pleased to hear that the company could well receive a large order from one of its US customers. She understands that Francis & Co. are quoting in competition with other companies, so that they are not absolutely sure of getting the order, but they still appear to have a good chance. The order is for USD2.5 million, so the United Kingdom supplier has to take the currency risk and, in the light of the way that the exchange rate has been moving up and down, this worries her. She puts the facts to Jan Parkinson, the Finance Director, and after doing some homework they have a meeting on 1 May 2006 to decide what to do. Jan starts by saying: ‘As I understand it, if we get the order we will be paid in the middle of August, so that what concerns us is what the spot rate will then be. The current rate is USD1.820/GBP1 and I think it realistic to take an upper rate of USD1.950/GBP1 in August and a lower rate of USD1.700/GBP1 – barring serious changes the rate should lie somewhere in that range. We also need to look at where we shall be if we do get the order and where we shall be if we don’t, so there are a number of cases to consider and I have summarised the outcomes in Table 8.5.’ Table 8.5 Possible GBP receipts from USD2.5 million order, with receipts rounded to the nearest GBP000
If we get the order
Spot USD/GBP rate in August USD1.95 USD1.70

If we do not get the order
USD1.95 USD1.70

Possible receipts (GBP000) No hedge taken Forward sale Options bought 1,282 1,378 1,366 1,471 1,378 1,447 0 96 84 0 –92 –23

‘There are basically three courses of action we can take, as set out in the table. ‘We can take a risk by not taking any hedging action at all, so that we sell the dollars in August at the then spot rate. If, for instance, the rate has risen to USD1.95/GBP1 then what we should get is USD2,500,000/1.95 = GBP1,282,051. If we do get the order, the danger we run is that the rate rises by then. If we don’t get the order we run no risk under this strategy. ‘We can sell the dollars forward and I have checked with our bank that the mid-August rate is USD1.8139/GBP1. If we get paid in midAugust then we would get USD2,500,000/1.8139 = GBP1,378,246 whatever the spot rate is then. We run a risk, however, if we don’t get the order, since we would then need to buy the dollars in to deliver them. Thus, if the rate falls to USD1.70/GBP1, we would
82 OU BUSINESS SCHOOL

8 OPTIONS

end up with GBP1,378,245 less GBP1,470,588 or a loss of GBP92,343. Note that if we don’t get the order and have to buy the dollars to deliver them at the higher rate of USD1.95, this would produce a profit of GBP96,194. ‘Our third strategy is to buy options on the Philadelphia exchange. I have found that we can get call options with an exercise price of USD1.800 at 3.03 cents for August. My calculations are that we would need to get options on USD2,500,000/1.800 = GBP1,388,889. I’ve not taken into account the need to buy an exact number of contracts. This would cost us GBP1,388,889 6 3.03/(1.820 6 100) = GBP23,123 ‘If we do get the contract, we still sell the dollars on the open market and if the August spot rate is below USD1.800/GBP1, the call option lapses and we get the receipts less our initial cost of GBP23,123. If the August spot rate is above USD1.800/GBP1, then we get, after the initial cost, GBP1,365,766, regardless of the then spot rate, since the loss in the receipt due to the higher spot rate is exactly matched by the gain on the call option. ‘If we don’t get the contract, the maximum we can lose is our initial investment of GBP23,123, which is less than the GBP92,343 we lose on selling forward if the rate is USD1.70/GBP1 – and the loss on forward sale could be even higher. Indeed, if we don’t get the contract at the higher rate of USD1.95/GBP1 we can exercise our option to buy GBP at USD1.80 and sell them immediately at that higher rate. This would produce a profit of GBP = 106,838, less the options cost of GBP23,123 = GBP83,715. ‘Our decision really depends on how certain we are to get the order. If we are absolutely certain, the best bet is to sell forward, particularly since the worst outcome then would be the highest for the three strategies. If we are not sure about getting the order, we should take the options route.’
The premium is paid at the start of the contract and so the current spot rate of 1.820 is used to calculate the sterling cost of the premium.

Where to use currency options
The situations where currency options have real advantages in hedging are well set out in Ross et al. (1987). They can be summarised as follows:
l

The loss to the hedger is limited to the premium paid, but the profit opportunity is unlimited. Options are thus a good way of limiting downside risk while retaining the potential for upside gain. They are a good way of hedging contingent cash flows, which may or may not occur. They provide a range of different ways of hedging, through the availability of different striking prices, unlike forward and futures markets which deal at a single price. They may not require daily margins (although Philadelphia options do) or a bank line of credit, as the forward market does.

l

l

l

Notice how the symmetrical pay-off from entering into a forward contract contrasts with the asymmetric pay-off from an option. With a forward, you lock into a defined rate and you profit or lose out with this position symmetrically if the actual spot rate on the forward date is worse or better than that you contracted to with your forward contract. Not so with an option. If the spot rate is better than your exercise rate you take the better rate and abandon the option; if the spot rate is worse than the exercise price you exercise your option. The ‘kink’ in the options pay-off diagrams displays the asymmetrical pay-off from holding options.

OU BUSINESS SCHOOL

83

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

So far, our discussion has proceeded as if traded options, particularly those in the Philadelphia exchange, were the main market for currency options. This, however, is not the case. The growth in the market for currency options known as overthe-counter or OTC currency options was the one that gave rise to the market for traded options. Additionally, whilst it is true that Philadelphia is a major market for traded options, there are other organised markets for currency derivatives, such as the ones in Chicago and London and in many other financial centres. Traded options have the advantage over OTC options of being readily marketable and often they can be cheaper (per currency unit). In contrast, some of the ways in which OTC options have advantages are that they are available:
l

in many more currencies than traded options, which are only offered in the main currencies; for longer maturities than traded options; for maturities and amounts that match the exact requirements of the company (they are tailored to the precise financial requirements of the buyer).

l l

In comparison with traded options, OTC options do not normally require a daily margin to be maintained. In some instances, however, they might modify the company’s credit standing with its banks. Thus, the OTC market offers additional services to the traded-option markets.

8.5

INTEREST-RATE OPTIONS

The final group of options that we need to look at are interest-rate options. This brings us back, albeit briefly, to the subject matter of much of Unit 7 – interest-rate risk and how to manage it. Options are widely used to hedge against movements in interest rates with the most common being interest-rate ‘caps’ and ‘floors’. An interest-rate cap protects the buyer from movements in rates above the agreed exercise price, which in this case is an interest rate. This rate is usually a defined LIBOR – typically three-month LIBOR. An interest-rate floor protects the buyer from movements in rates below the agreed exercise price: that is, a defined interest rate. In their most simple form these contracts can be used by both borrowers and investors to protect against adverse interest-rate contingencies. The borrower can protect against the upside of interest-rate costs on floating-rate debt by buying a cap. If rates rise above the cap, the higher costs on the floating-rate debt are offset by receipts under the contract for the interest-rate cap. If rates fall, the borrower can benefit from a lower cost on the floating-rate debt.
84 OU BUSINESS SCHOOL

LIBOR means London Interbank Offering Rate. LIBORs are the rates for cash deposits for defined maturity terms in the money market.

8 OPTIONS

While the rate remains below the level of the cap, however, the borrower will get nothing back from the cap contract. In effect, under these circumstances the contract is an insurance policy that is not paying out. The reverse circumstances apply to investors. For those investing in floating-rate assets, the purchase of a floor protects against rates falling and effectively places a minimum return on the assets. If rates fall below the agreed floor, the investor will be compensated for the lower return on the floating-rate assets by receipts under the interest-rate floor contract. If rates rise, the investor can benefit from a higher return on the floating-rate assets, although while the interest rate remains above the level of the floor, the investor will get nothing back from the contract. In each case it may appear that buyers of the interest-rate option win regardless of whether rates go up or down. They are protected in both instances against the adverse outcome in respect of rate movements, while still benefiting from the favourable outcome. The fact is, though, that this position does come at a cost: the option premium. The options buyer is always at risk of buying insurance against a contingent risk that does not materialise.
8

6 LIBOR (%)

4

2

Strictly speaking caps and floors are multiple option structures, since they involve a series of expiry dates at which strike rate (i.e. the cap or floor rate) is compared with the market rate. In our examples this occurs every three months until the final expiry of the contracts.

0 Q1 Q2 Cap rate (%) Q3 Q4 Q5 Quarter year Floor rate (%) Q6 Q7 Market rate (%) Q8

Figure 8.6

Cap and floor

An example of both a cap and a floor are provided in Figure 8.6. In both cases the contracts are for two years, with the interest-rate cap set at 6% and the floor at 3%. Every three months, the threemonth LIBOR prevailing in the market is measured against the cap and the floor. If the market rate exceeds the cap, as it does in our example in the third and fourth quarters, the buyer of the cap will be compensated by the seller for the net difference between the two rates. If the market rate falls below the floor, the buyer of the floor receives compensation from the seller of the floor, once again for the net difference between the two rates. In our example this only happens in the eighth quarter. If the market rate remains between 3% and 6%, neither the buyer of the cap nor the buyer of the floor receive anything. No payments are made from the options sellers to the buyers.
OU BUSINESS SCHOOL 85

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

These interest-rate-option contracts will have a defined term (say, five years), the agreed cap or floor rate (usually a defined LIBOR rate) and, of course, the notional principal amount involved in the transaction. If the contract is based on three-month LIBOR then, throughout the term of the contract, every three months the prevailing rate of three-month LIBOR will be compared with the agreed cap or floor. To illustrate the compensation due, let us look at the following contract.

Term Cap rate Principal amount

Five years 5% against three-month LIBOR GBP10 million

If on the first LIBOR fixing date, at the commencement of the contract, three-month LIBOR is 4.5%, the buyer of the cap gets nothing. If on the next fixing date, three-months later, the prevailing threemonth LIBOR has risen to 5.5%, the buyer of the cap will be compensated by receiving 5.5% less the cap rate of 5% (that is, 0.5%) on GBP10 million for three months (ninety-one days). This would be GBP10m 6 0.5% 6 91/365 = GBP12,465.75 By receiving this compensation, buyers of the cap have their interest cost for this three-month period capped at 5%. This process of refixing to determine if compensation is due would then continue for each three-month period until the end of the five-year term of the contract. The same mathematics apply for floors, although with the difference that compensation is paid to the floor holder when the LIBOR is below the floor rate.

EXERCISE 8.4
Under the terms of the above cap contract (with the cap at 5%) what happens if the next three-month LIBOR fixing for ninety-two days is: (a) 4.9%; (b) 5.0%; (c) 6.2%?

86

OU BUSINESS SCHOOL

8 OPTIONS

While we have looked at how the options buyer gets compensated, we have not yet considered what determines the cost of the insurance that is being acquired. Fundamentally the costs of interest-rate options will depend on three things.
l

The relationship between the cap or floor rate and the market expectations for future interest rates. If rates are expected to rise in the future the caps will cost more than in circumstances where they are expected to fall. The reverse applies to the cost of floors – the cost of these will rise the more the market believes that rates will fall in the future. The term of the contract: everything else being equal, the longer the term, the higher the cost. The volatility of interest rates: the more volatile the market, the greater the costs of interest-rate options.

l

l

You should see the logic behind these rules – particularly if you look at the matter from the view point of the seller of interest-rate options. The greater the potential value of the option you are selling, based on market expectations for future levels of interest rates, the greater the premium you will charge to the options buyer. Similarly, the greater the market volatility and, hence, interest-rate uncertainty, the more you will charge. Finally, the longer the forward period for which you are selling interest-rate protection to the option buyer, the greater will be the recompense you will want to reflect the greater risk of future uncertainty you are providing insurance against. These factors will principally determine the options price. Note that interest-rate options are normally expressed as a flat rate on the principal sum. If the five-year cap we looked at above is priced at 125bps (or 1.25%), it means the buyer has to pay 125bps of the principal sum upfront to the seller. In our example, this is 0.0125 6 GBP10,000,000 = GBP125,000 How much the buyer gets back for this investment clearly depends on what actually happens to rates over the five-year term and, specifically, if LIBOR rises above the agreed cap rate. In addition to simple cap and floor interest-rate options, there are a number of different structures that employ a combination of interest-rate options positions. Perhaps the best known of these is an interest-rate collar. Under this option structure the buyer or acquirer of the collar buys a capped rate at an agreed level, but also sells a floor rate at a lower level of interest. An example of this is a collar for three years with a cap rate of 6% and a floor rate of 3%. Indeed, you saw in Figure 8.6 a diagrammatic representation of a two-year collar with these cap and floor rates. What are the consequences of this? With a cap of 6%, the buyer of the collar would receive compensation if LIBOR rises above this level. The buyer’s effective upside interest rate during this period would therefore be 6%. By contrast, if LIBOR falls below 3% the buyer of the collar pays out
OU BUSINESS SCHOOL 87

A basis point is onehundredth (0.01) of one per cent (1%).

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

compensation to the seller of the collar. Thus, from the perspective of the buyer of the collar, the minimum interest rate payable after allowing for payments under the collar contract is 3%. Therefore the buyer of the collar has put a collar (or a range) around the possible interest rate payable of 3% to 6%. The buyer or acquirer of a collar buys the cap and sells the floor. The seller or provider of a collar sells the cap and buys the floor. What is the incentive to do this? Principally the incentive is that it cuts the cost of buying options. The premium cost of the collar will, in effect, be the difference between the cost of the cap bought and the return from the floor sold within the collar structure. Indeed, many collars are structured so that the price of the cap and the floor are equalised. The resultant cost is zero – since there is no difference between the cost of the two components of the collar. Consequently, such structures are known as ‘zero-cost collars’.

EXERCISE 8.5
Assume you have bought a zero-cost collar where the cost of the cap, against three-month LIBOR at 5.5%, matches the receipt from selling a floor against a three-month LIBOR of 4%. Draw a graph depicting the pay-off from this option at LIBOR rates from 2.5% to 8%

Interest-rate options therefore provide a further means to hedge interest-rate risks. They have the advantage when compared with FRAs, futures and interest-rate swaps of not committing the party hedging to an outright position (for example, locking into a fixed rate for a period in the future by using an FRA). They enable the buyer, as with all options, to benefit from the protection provided if the worst happens to interest rates without committing now to a future rate that may turn out to be worse than if the position had been unhedged. We have now covered share, currency and interest-rate options. We have looked at the basic features of these contracts and how they can be used by organisations to manage balance-sheet risks. Finally in this unit we turn to the subject of options pricing.

8.6

OPTIONS PRICING

One matter we have not examined in detail are the determinants of options prices and the relationships among them. This is a very technical subject and, you will be are relieved to know, an area where you are not required to have or develop a detailed expertise. Consequently, the analysis of options pricing is dealt with in two appendices to this unit. First, in Appendix 1, we examine some of the key propositions about options prices. This is not
88 OU BUSINESS SCHOOL

8 OPTIONS

overtly technical, but rather it gives you a few ‘golden rules’ about options valuation and the relationships between different options. In addition, Appendix 2 is provided for those students who want to get immersed in the mathematical details of options pricing. This appendix covers the valuation of share and currency options and is necessarily very technical in nature. Do not worry if you find it too challenging. For B821 it is sufficient for you only to grasp the key features of options explored in Sections 7 and 8.

SUMMARY
This section began with a brief look at the history of financial options. We then defined more exactly what is meant by call and put options, together with a number of crucial terms associated with these instruments. We did this by looking at share options. Please ensure that you are comfortable with the meaning of terms such as ‘out of the money’ and ‘intrinsic value’. Having reviewed the basics, we then moved on to looking at option pay-off diagrams to understand the value of options under different outturns in the price of the underlying instrument (e.g. the share price). With the basics understood, we then looked at currency options and the way these offer an alternative to using an outright forward contract to hedge FX risk. Next we looked at interest-rate options and the scope these provide to manage interest-rate risks. With all this analysis, however, we have largely been taking the option price as ‘given’ numbers. While noting that the key components of the price of an option are the time to expiry of the contract (time value) the prevailing value of the contract (intrinsic value) and market volatility we have not ‘drilled down’ to the core of options pricing. In Appendixes 1 and 2 we look at options pricing in some detail – so when you are ready, read on!
��������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������

OU BUSINESS SCHOOL

89

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

SUMMARY AND CONCLUSIONS
This has been both a lengthy and, in places, complex unit. If you have been unable to grasp all the mathematical detail do not worry. The key thing is to appreciate the key principles and to be able to compute the basics about FX pricing and the pay-offs from options. We first looked at how foreign exchange exposure can be defined, identified and measured. From that, you will now be aware that there are three types of foreign exchange exposure – transaction, translation and economic exposure. We then provided you with some simple approaches that can help you measure the degree of transaction exposure and, to some extent, economic exposure. We went on to look at the foreign exchange market in general and then at some of the basic terminology of foreign exchange so that you could gain some familiarity with such terms as premiums and discounts, spot and forward contracts. You then looked at some of the more theoretical and pragmatic approaches to forecasting future exchange rates. You learnt how important forecasting future exchange rates can be for decisions about how to deal with foreign exchange exposure and the different approaches to forecasting foreign exchange rates. We looked at approaches to hedging foreign exchange exposure. You learnt that it is better, usually, to look at possible internal techniques of hedging (netting and matching being examples) before looking at external techniques (such as forward contracts). We also looked at how international initiatives can eliminate FX risk by combining currencies within a fixed-rate currency system and through the adoption of common currencies like the euro, although such developments are controversial as we in the United Kingdom know. The final two sections of the unit turned to contingent risk and the role in managing this risk presented by options. First we looked at the terminology for options including the meaning of calls and puts. We then explored share, currency and interest-rate options, interspersing this analysis by looking at the pay-offs that can result from options positions. Additionally, in Appendices 1 and 2 you can explore of the complexities of options pricing and the mathematical rules that relate to the relationships between call and put prices and the prices of the underlying instruments they relate to (for example, shares). While this material has been challenging, we should repeat what was said earlier: understanding the concepts and the basic consequences of options pay-offs is important. Understanding the mathematics behind those options prices is a bonus! Options are already a very useful group of instruments for risk management and as their range increases – and as understanding grows – they will assume an increasing significance in any system of financialrisk control.
90 OU BUSINESS SCHOOL

SUMMARY AND CONCLUSIONS

Learning outcomes
At the end of this unit, you should now be able to:

l l l

use a spot currency quotation for currency transactions;
calculate a forward exchange rate;
describe the link between forward exchange rates and interest
rates; describe some of the determinants of exchange-rate variability; explain the difference between transaction, translation and economic exposure; design a hedging strategy to control foreign exchange risk; understand contingent risk; understand call and put options both in general and specifically in the case of share options and currency options; understand interest-rate options, including caps, floors and collars; compute the results from holding options positions, using pay-off diagrams; have some appreciation of how options are valued and of the relationships between the prices of calls, puts and their underlying instruments.

l l

l l l

l

l

l

��������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������

OU BUSINESS SCHOOL

91

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

APPENDIX 1 PROOFS OF PROPOSITIONS CONCERNING OPTION VALUATION
Table A1.1 shows the prices or premiums of twelve call and put options for Boots. Since all these options are just different ways of taking a view on a single share price, it is only reasonable to think that there must be some relationships among the option prices. Looking more closely at the table we can see, for example, that call-option prices decrease as the exercise price increases and that call-option prices increase as the time to expiry increases. In this appendix we now show that these two characteristics of call-option prices are not peculiar to Boots, but hold for all call options. We also analyse some other properties of call-option prices and then investigate the connections between put and call options. Table A1.1 LIFFE option premiums, Boots 23 May 2005

Current share price: 610p
Exercise price June 2005 Calls September 2005 December 2005 June 2005 Puts September 2005 December 2005 550p 64.5 68.0 73.0 5.0 12.0 24.5 600p 22.5 33.0 42.5 25.0 32.0 48.0

The technique we use is to explore arbitrage possibilities inherent in combinations of options that traders could use to make risk-free profits. In practice, any mispricing of options that allowed such arbitrages could not last long in a liquid market – they would very soon be traded away. An arbitrage opportunity is defined as a situation where a riskless profit can be made by exploiting different prices for the same product. An arbitrage yields a positive amount immediately and also yields non-negative amounts in the future under all possible circumstances. In this definition, ‘non-negative’ is a shorthand expression for either positive or zero – that is, the investor will not have to pay any more. If arbitrage opportunities exist, something can in effect be acquired for nothing. In real life, though, there are seldom ‘free lunches’ on offer long enough for the most people to spot them, let alone eat their fill.

92

OU BUSINESS SCHOOL

APPENDIX 1 PROOFS OF PROPOSITIONS CONCERNING OPTION VALUATION

The following propositions are examples of what can be proved if we assume there can be no ‘free lunches’: that is, they are not in contradiction of earlier comments about the possibility of arbitrages. Rather, they simply acknowledge that any arbitrage opportunity will usually have been eroded to nothing by exploitation long before the average investor has a chance to benefit.

Proposition 1
The premium of a call option is: (a) less than or equal to the current price of the underlying security; (b) greater than or equal to the difference between the price of the underlying security and the exercise price; (c) non-negative. In mathematical terms

S ≥ C ≥ max (0, S − K )
where S = current share price, C = call premium, K = exercise price and max (0, S – K) denotes the maximum of 0 and (S – K).

Proof
Proposition 1(a)
We first prove that the call price is less than or equal to the current share price. We do this by assuming the opposite. That is, we assume C > S and show that this leads to an arbitrage opportunity. Combination: Buy a share and write a call on it. According to our assumption this yields a positive amount. There are two possibilities here. Before the expiry date: if the call is exercised against you, you get the exercise price and deliver the share so that you get a positive amount of (C + K – S). This must be positive as C > S. Expiry date and after: if the call expires unexercised you are left with the share, which cannot have a negative price. Thus you end up with a non-negative amount, increased possibly by any dividends paid. Hence the assumption C > S leads to an arbitrage opportunity and, since we reject the feasibility of such opportunities, the opposite must actually be true, with C � S.

Proposition 1(b)
Again, assume that the opposite of what needs to be proved is true. That is, (S – K) > C. Combination: Buy the call, exercise it and sell the stock. The net amount received is S – K – C, which on our assumption is positive. There is no further step, as the position is liquidated. Hence the assumption leads to an arbitrage opportunity and so the opposite must be true, C � (S – K).

OU BUSINESS SCHOOL

93

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

Strictly speaking this proof is only correct for an American option, as it requires immediate exercise of the option, but an equivalent proof – though more complicated and involving the short sale of the share and investing the proceeds – can be made for a European option.

Proposition 2
For the same exercise price and share, the price of a call option increases as the time to expiry increases.

Proof
Again assume the opposite, for example, that the September 550 call is priced below the June 550 call. Combination: Buy a September 550 call and write an June 550 call, giving you a positive amount now. Again there are two possibilities. Up to the June expiry: if the June 550 is exercised against you, exercise the September 550 and you are no worse off – you obtain the shares by paying 550p and pass it on at 550p.
Alternatively, the June option lapses.
After the June expiry: you are left with the September option,
which cannot have a negative price.
Thus, in either case, you end up with a non-negative amount. Hence the assumption holds only in an arbitrage opportunity, which completes the proof. Again, the simple form of the proof is really only true for an American option, but an equivalent proof can be produced for a European option.

Proposition 3
For the same expiry date, the prices of call options decrease as their exercise prices increase.

Proof
Again assume the opposite, for example, that the June 600 call has a higher price than the June 550 call. Combination: Buy a June 550 call and write a June 600 call, which gives you a positive amount now. Consider the following two possibilities. At or before the June expiry: if the 600 call is exercised against you, exercise your own call, so that you end up with 600 – 550
= 50p a share. Otherwise the 600 call lapses.
At the June expiry, the June 600 is not exercised against you:
you are left with the June 550 call, which cannot have a
negative price.
Thus an arbitrage opportunity has been created, which completes the proof i.e. if we assume no arbitrage then Proposition 3 is proved.
94 OU BUSINESS SCHOOL

APPENDIX 1 PROOFS OF PROPOSITIONS CONCERNING OPTION VALUATION

Proposition 4
If there is no ex-dividend date until after the time to expiry, American call options should not be exercised until expiry, and the value of an American call option is the same as that of an equivalent European call option.

Proof
This is very straightforward. If there are no cash flows during the option’s life to which you become entitled by actual share ownership then there can be no advantage to early exercise as it would destroy the benefit of the downside protection given by the option without offering any countervailing gain. Thus there is no value to the early exercise characteristic of an American option and its value is the same as for a European contract with the same exercise terms.

Proposition 5
For European options without dividends, the value of a put option, P, is equal to the value of an otherwise identical call option, C, minus the current share price, S, plus the present value of the exercise price, PV(K), for the put, or the call. That is

P = C − S + PV( K )
(which may also be written as S + P = C + PV(K)) Once the value of a call option or a put option is known, the value of the other, provided it has the same exercise price and time to expiry, can be found from Proposition 5.

Proof
The proof of this proposition follows directly from the fact that the two portfolios of (a) the share and the put and (b) the call and the present value of the exercise price have exactly the same pay-off at the expiry date. Hence the two portfolios must have the same price now. Table A1.2 brings this out, where S is the current price of the share; S1 the price of the share at expiry; K is the exercise price and PV(K) is the present value of the exercise price at expiry. Table A1.2 Pay-off at expiry
If S1 > K
Portfolio A Own share Own put Total S1 0 S1 S1 K – S1 K

A worked example of this proof is given in Vital Statistics, Section 5.6.3.

If S1 < K

OU BUSINESS SCHOOL

95

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

Portfolio B Own call Invest PV(K) Total S1 – K K S1 0 K K

Thus, the value of a put option can be determined from the value of a call option plus the present value of the exercise price minus the share price.
��������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������

96

OU BUSINESS SCHOOL

APPENDIX 2

VALUING SHARE AND CURRENCY OPTIONS

APPENDIX 2 VALUING SHARE AND CURRENCY OPTIONS
In Appendix 2 we investigate the valuation of options. The main valuation model we shall look at is called Black–Scholes model, but we shall also investigate briefly another approach: the binomial model. Both of these are designed primarily with share-option valuation in mind, but the principles involved are much more general. We shall show this when looking at the Merton model, the principal variation of the Black–Scholes equations to value share options. We shall then move on to value currency options. We shall discuss how to apply the Merton model to value currency options as well as another variant of Black–Scholes designed to value currency options. This is known as the Garman–Kohlhagen model after the researchers who made the adaptation from shares to currencies. This may all seem a little intimidating, but the important thing is to understand the principles behind options pricing. In practice, if you ever need to calculate the value of an option, you will probably simply input the variable numbers into a special calculator or spreadsheet and read off the answer. Understanding why you input those particular variables will, however, give you a good chance of spotting whether or not the answer is realistic or unexpected. If it is not what you were expecting, rechecking the input and output would be a good idea!
You have the Option Valuation software on your B821 disc to value equity options and currency options. Read the relevant sections of the Software Guide to assist you in using the valuation models. In addition, note that in certain cases you have to insert your own ‘risk-free’ interest rate and days to expiry to obtain an option valuation.

Valuing share options
A considerable number of attempts were made to produce a formula that could value call or put options on shares before a radically new approach was adopted by Fischer Black and Myron Scholes in their seminal paper of 1973. Their valuation model only required observable quantities to be measured to give the call or put value. In particular, it needed no information on the investors’ views of the likely return on the stock or on their attitudes towards risk. The Black–Scholes model quickly became a success among both professional investors and the academic community and has retained its place ever since as the most popular tool for valuing options. One problem in explaining the derivation of the Black–Scholes formula is that it is based on advanced mathematics. We therefore set out in Vital Statistics, Section 5.6.2, the binomial method as given by Cox, Ross and Rubinstein (1979). It is simpler to understand than Black and Scholes and not only leads to the Black–Scholes formula, but also enables more complex options, such as options on bonds, to be priced as well as options on shares. Note that the Black–Scholes equation can, though, be

OU BUSINESS SCHOOL

97

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

programmed into a spreadsheet, albeit with considerable care since it is easy to get wrong!

BOX A2.1 THE BLACK – -SCHOLES FORMULA
In Vital Statistics, Section 5.6.2, we derive a value for a European call option on a share using the binomial method. The main difference between this approach and the Black–Scholes approach is that the binomial method looks at what happens to the price of the call option over discrete elements of time, whereas the Black–Scholes model is in continuous time. (Those of you with a penchant for mathematics will realise that this assumption allows the use of calculus.) However, the two models, Cox, Ross and Rubinstein’s binomial model and the Black–Scholes model, can be reconciled. It can be shown (but not here!) that, if we increase the number of intervals to infinity, the binomial model’s call value can be directly expressed by the Black–Scholes formula.

The Black–Scholes equation is given below. We know that it does not look very friendly, but we shall concentrate on its constituents rather than on the mathematics. Once you know what factors affect the value of an option, your computer can do the actual calculations for you.
The course website has a link to the transcript of a television programme on the importance of the Black–Scholes equation.

Taking a deep breath, have a look at the Black–Scholes equation for pricing a call.

C = SN( x ) − Ke −rt N( x − σ t )
where

x=

ln( S / K ) + ( r + σ 2 / 2 )t σ t

and ln is the natural logarithm function. The meaning of each symbol is: C = price of the call option S = current price of the share K = exercise price, or strike price t = time to expiry (in years) r = continuously compounded risk-free interest rate s = volatility of the share price as measured by standard deviation (per annum). The continuously compounded interest rate is obtained directly from the annual interest rate by the formula r = ln (1 + Annual interest rate) where ‘Annual interest rate’ is expressed as a decimal.

98

OU BUSINESS SCHOOL

APPENDIX 2

VALUING SHARE AND CURRENCY OPTIONS

The only additional form of notation is that of N(x), which is the cumulative normal distribution function and for which tables are widely available. In practice, nowadays anyone using a spreadsheet package can construct a formula to calculate N(x) and thus needs only to enter the values for the parameters for S, K, t, r and s and the computer will do the rest. This is demonstrated in the Option Valuation software on the B821 CD-ROM. So far, you have used this software as a ‘black box’, not really knowing what was behind it. Slowly, but steadily, we are now disentangling the internal workings of that ‘black box’ for you. In the software you will notice there is a label not considered by the Black–Scholes. This parameter [Div Yld (%)] helps to estimate the price of a European option on shares with known dividends. We shall discuss why this is important later on. For the time being, consider that this innovation was introduced by Robert Merton and involved replacing S with Se-qt in the Black–Scholes equation. In plain words, Merton substituted the strike price (S) with the product of the strike price (S) multiplied by an estimate of the average dividend yield rate (q) per annum. Hence, the option-valuation model estimates the Merton equation. You can choose to include the dividend yield rate and then you get the valuation of the Black–Scholes model in the software. Whichever computational option you use, bear in mind that the software usually has a difference with the spreadsheet estimates at the second or third decimal level. For our purposes, this is trivial, but you will understand that would not be the case in a real life situation. Let us move on, as our purpose is to look at what factors are involved in determining the option value and why they are important. What are the important variables?
Warning! Watch out for rounding differences.

The current and exercise price difference, S - K
The difference between the current price and the exercise price, S - K, is obviously going to be important. For example, if the strike price is much higher than the current price (out of the money) then the likelihood of the option being exercised is small and so is its value. Vice versa, if K < S (in the money) then the option is already worth money if exercised and the lower K is, the higher that intrinsic value.

Volatility, s
The volatility, s, is also important. If the share price is very volatile and jumps around a lot then the chances of S being much higher or lower at expiry than now is relatively high. If, however, we hold a call option we can take the benefit if it ends up that S > K, but

Think back to Activity 8.4, with companies Hi and Lo.

OU BUSINESS SCHOOL

99

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

are not concerned if S < K, in which case we just let the option expire. For option prices, volatility is therefore good, because we are protected from the downside consequences if the share price moves adversely.

The time to expiry, t
The longer the option has to run, the greater the chance that the price will end up above the exercise price, so as t gets longer, the option value goes higher, everything else being equal. As you might remember, this is the same as Proposition 2 in Appendix 1. You might also remember that Proposition 2 need not hold for European options on shares which paid a dividend. This would mean that, in principle, the Black–Scholes model would be good to price all commodity options except for those on shares. But wait, this can’t be the right stuff for a Nobel Prize, can it? Enter Robert Merton, to the rescue! What Merton did was to modify the Black–Scholes equation making it easier to price share options near the date companies announce their dividends. How? Very simply, by taking the idea behind the Gordon growth model (see 5.3.1. in Vital Statistics), which simply put says that: dividends are expected to grow at a constant rate of growth each year. The parameter, q, therefore, is an estimate of the annual compounded dividend yield rate and provides a way to value European options on shares while complying with Proposition 2.

The Nobel Prize for Economics was awarded to Myron Scholes (jointly with Robert Merton) in 1997 for his work on options. Sadly, Fischer Black died in 1995, before the Nobel committee decided to present the prize, which cannot be awarded posthumously.

The risk-free interest rate, r
This is involved because the Black–Scholes model takes into account the time value of money, so the higher the interest rate, the higher the option value.
If this is not clear to you, look back at Figure 8.1 and your answer to Exercise 8.2.

Bearing in mind Proposition 5 in Appendix 1, ‘Put–call parity’, and the linkage between call and put options, it is not surprising that these same four factors affect the value of put options, though for the latter an out-of-the-money option is where K is less than S. The last ‘conceptual’ point you need to think about concerning the Black–Scholes model is: what is the key premise underlying the formula? While the mathematics is fairly horrendous, the concept is straightforward. In essence, the idea is that at any instant the profit or loss of holding an option for small changes in S (i.e. DC for DS) can be reproduced exactly by an equivalent portfolio consisting of a suitable number of the underlying shares and cash. ‘All’ one then has to do is ascertain the constituent proportions of that instantaneous portfolio and then double integrate over t and S – simple! For a practising mathematician, at least; but the rest of us can at least reasonably expect to follow the process once it has been derived by those eligible for the Nobel Prize.

100

OU BUSINESS SCHOOL

APPENDIX 2

VALUING SHARE AND CURRENCY OPTIONS

ACTIVITY A2.1
Read about the binomial model in Section 5.6.2 of Vital Statistics. It is useful for you to see that the problem of option valuation can be attacked from another viewpoint and that the final result ends up converging on that given by the Black–Scholes model. Even if you actually use the Black–Scholes model, the ideas behind the binomial method can prove helpful in thinking about options and their valuation.

Before we leave the Black–Scholes formula for a call option, note an important point about the four parameters needed to value the call. Three of them (current share and exercise price differential, time to expiry and interest rate) are the same for all market traders. Only the volatility value can be argued about. What is needed is an estimate of the volatility for the period to expiry of the option. What is used is an historical measure of volatility – the standard deviation of the share price for the past six days, six weeks, six months or a year. Each period used will give a different estimate of volatility and hence a different call-option value. Aczel (1987) gives a summary of these and other estimation methods. What you can also do is to input the market price of the option into the Black–Scholes formula and work out the implied volatility – that is, the volatility which gives the call value equal to the market price. Then, according to the investor’s view on future volatility, the option can be seen as cheap or dear. The more volatile an asset, the more expensive are call or put options on the asset, just as the more likely your house is to burn down, the more expensive the insurance is. This gives traders a whole new perspective to investing in options since money can be made or lost, not just from price movements, but from changes in volatility. Holders of options will make money if markets are volatile, writers of options will lose. Indeed, many people use options as a means of taking a view on volatility – if they expect a market crash, they will buy put options. They are unlikely to hold the put options to expiry if their prediction is accurate: before the volatility element disappears from the option price, they will cash in after the market fall, making money both from the price fall and the increase in volatility. To see the latter point, think of insurance premiums: the higher the risk, the higher the premium. Volatility speculators buy when volatility is low, so the premiums are (relatively) low; when the market falls they sell on their options, but now the new higher volatility is included in the premiums they charge. To conclude this look at the Black–Scholes model, consider a worked example. The parameters are as follows: S = 400p; K = 350p; t = 4/12 or 0.3333 (in years) or 120 days; r = ln(1.05), since the interest rate is 5%; s = 30%.
The Option Valuation software can help you find implied volatility. Try it for each of the combinations in Table A1.1. There is nothing special about these periods. It is just an educated guess as to which past period will give the best estimate of future volatility.

OU BUSINESS SCHOOL

101

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

ACTIVITY A2.2
Access the Option Valuation software on the B821 disc and put in the five parameters from the share example as follows. volatility: 30.0 current price: 400.0 strike price: 350.0 interest rate: 5.0 dividend yield: 0 maturity: 120 If you look at the resulting call/put prices you will see: call-option price: 62.3326, which is 15.5832% of S; put-option price: 6.7632, which is 1.6908% of S. So the prices of the call and put options are 62.3p and 6.8p respectively. Notice how the software estimates whole days rather than fractions of a year. Actually, 121.667 days is equivalent to 4/12 of a financial year. To see the importance of such small differences, look how the premium value changes to 62.4410 for the call and 6.8256 for the put when the maturity changes to 121 days.

EXERCISE A2.1
Use the Option Valuation software or the equity-option calculation spreadsheet Valuing Equity Options to value a call option on a share priced at 100p with an exercise price of 75p, an interest rate of 10%, a volatility of 30% and a time to expiry of 60 days and 58 days.

Valuing currency options
A straightforward modification of the Black–Scholes formula has been developed for currency options by Garman and Kohlhagen (1983) and this is generally accepted by traders as giving the ‘fair value’ of these options. Even if it does not always fit exactly, it gives the market standard and is therefore valuable to have. The Garman–Kohlhagen formula is

C = e −rFt SN( x ) − Ke −rDt N( x − σ t )
where

x=

ln( S / K + ( rD − rF + σ 2 / 2 )t σ t

102

OU BUSINESS SCHOOL

APPENDIX 2

VALUING SHARE AND CURRENCY OPTIONS

The meaning of each symbol is: C = call option price S = spot price of the currency K = exercise price t = time to expiry rD = 1 + continuously compounded domestic interest rate rF = 1 + continuously compounded foreign interest rate s = exchange-rate volatility or standard deviation as a percentage (per annum). The Merton model we used for valuing share options can also be used to value currency options. This is possible by assuming that a foreign currency is analogous to a share paying a known dividend yield: the owner of foreign currency receives a ‘dividend yield’ equal to the risk-free rate in that country, rF. We can now use either formula to value the July 2005 USD1.83 call option in Table 8.4. The parameters are as follows. S = USD1.8244/GBP1 K = USD1.8300/GBP1 t = 1.25/12 or 0.104 years (37.5 days) rF = ln(1.02125) since the interest rate is 2.125% rD = ln(1.45) since the interest rate is 4.5% s = 8.5%, a rough figure based on the average at the time.
Use the ‘Valuing Currency Option’ sheet in the Option Valuation software.

ACTIVITY A2.4
Access the currency-option valuation model in the B821 computer software and input the following six parameters in the requested format. domestic interest rate: 4.5%
foreign interest rate: 2.125%
volatility: 8.5%
maturity: 0.104 years
spot price: 1.8244
exercise price: 1.830
You should get the following value for the call-option price: 0.0192, which is 1.0524% of S.

The ‘fair’ value of the call option according to the Garman–Kohlhagen model is therefore 1.92 cents, not far from the quoted price of 1.90 cents for the July $1.83 call option in Table 8.4.

OU BUSINESS SCHOOL

103

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

EXERCISE A2.2
Use the computer software to value the August 2005 1.840 sterling put option in Table 8.4 with the same volatility and interest-rate assumptions as in the previous example. Let t = 2.25/12 years.

SUMMARY
Valuing options was the topic of this appendix. First you were guided through a number of key propositions underpinning options prices. You were then introduced to the Black–Scholes formula for share options and its Garman–Kohlhagen variant for currency options. Both formulae look very complex, but actually they are very amenable to programming into a spreadsheet. You have Option Valuation software on your B821 disc (as well as the EQOP and CURROP spreadsheets), which you can use for valuing simple transactions with share and currency options. You also took a brief look, via Vital Statistics, at the binomial model. The key things to remember from this appendix on valuation are the variables that can affect the value of a an option:
l

the differences between the underlying asset price and the exercise price; volatility; the time to expiry of the option; the risk-free interest rate.

l l l

All the rest of the genuinely complex mathematics is unnecessary for a general manager’s understanding of financial options. Do remember, however, that there are many other options markets such as options on stock indexes, gold, oil, bonds and many agricultural commodities.
��������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������

104

OU BUSINESS SCHOOL

ANSWERS TO EXERCISES

ANSWERS TO EXERCISES

EXERCISE 2.1
Issues such as price sensitivity and overall competition in the market will determine whether Après GmbH can pass on such cost increases. The greater the competition, the more difficult it would be to pass on the costs without losing customers. The ability to pass on cost increases will also depend on whether the contracts with its customers allow this to happen. Some airlines and holiday companies, for example, may pass on to customers higher costs (such as fuel surcharges) arising from adverse FX movements.

EXERCISE 4.1
Closing mid-point spot rates (a) NOK11.4660/GBP1 (b) HKD13.4523/GBP1 (c) EUR1.4396/GBP1 (d) USD1.7294/GBP1

EXERCISE 4.2
Follow the same procedure: ‘buy’ USD with ARS and then ‘sell’ USD for CHF. So ‘buy’ USD0.3498 (= 1/2.8588) with each ARS and ‘buy’ CHF1.3011 with each USD. This gives 0.3498 6 1.3011 = CHF0.4551 for each ARS.
This then gives ARS1/0.4551 for CHF1.
Thus ARS2.1973/CHF1 is the calculated cross rate.


EXERCISE 4.3
There is no difference at all. The two statements are equivalent.

OU BUSINESS SCHOOL

105

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

EXERCISE 4.4
The answer is that, as the US interest rate is lower, you would expect the USD to appreciate against the GBP and therefore the GBP would purchase fewer USD in a year.

EXERCISE 4.5
No. As long as the forward rates are in line with the interest rates, there should be no significant difference between the first two options. We can therefore effectively ignore the ‘spot plus deposit’ borrowing choice. The third option relies on using the spot rate in one month’s time. This is fundamentally different from the other two options, as the cost of the third option is not known with certainty. The forward rate is the market’s best estimate of what the future spot rate will be, but it is only an estimate. The third option could end up costing considerably more than the others.

EXERCISE 5.1
In one year, at an annual interest rate of 5% p.a., GBP100 becomes GBP105. In one year, at an annual interest rate of 2% p.a., USD150 becomes USD153. Therefore, in one year

forward rate = USD153/GBP105
= USD1.46/GBP1


EXERCISE 5.2
Although superficially the median predictions seem quite accurate, closer examination shows rather poorer results. To start with, use of an averaged statistic (strictly the median – the middle forecast – is an average, but not the one we typically regard as the average, the mean) will tend to

106

OU BUSINESS SCHOOL

ANSWERS TO EXERCISES

flatter the forecasts. Oddly enough, this effect is stronger the more independent the different forecasts are; but the chartists are all supposed to be looking for the same things in the same data, so they should come up with similar analyses. However, the article states that there were wide variations in the predictions, so the benefits of averaging become significant! The predicted rates lag the actual rates by about the forecast period – the chart forecasts do little more (on average) than say that the rates will not change much over a week or four weeks. That is on the whole about right, but we do not need an expensive chartist’s prediction to use that as a forecast. The graphs shown do not really offer much good evidence for or against the accuracy of the chartists’ forecasts and we also do not know how much of their individual analysis was influenced by fundamental as opposed to technical factors. With regard to the efficient-markets hypothesis, the article’s evidence neither conflicts nor agrees with the hypothesis. As said in the preceding paragraph, the graphs do not show that the chartists’ forecasts are any more accurate than a simple strategy of predicting that the near-future spot will be little different from today’s rate. If there was clear evidence of accurate chartists’ predictions, then there would be an a priori conflict with efficient-markets hypothesis, since it holds that past price data (known to everybody) should not carry information about future price movements. Even then, the conflict could be resolved by finding that the forecasters were in fact using significant amounts of economic fundamental analysis instead of relying solely on past chart data. Finally, it is important always to remember that tests of efficient-markets hypothesis normally use closing or other periodic prices and with this sort of data the evidence for the hypothesis is strong. For example, corporate treasurers, investment managers and civil servants all operate in the sort of time frame in which efficient-markets hypothesis holds; market makers and currency speculators work on a minuteby-minute time horizon and for those participants technical analysis may be valuable. As the article says, the majority of them take ‘the charts’ into account if for no other reason than they know that their competitors are doing so. This difference in outlook is most clearly shown by the forecasting period chosen for the survey: one week and four weeks. To a treasurer, six months is quite soon – to a foreign exchange trader, four weeks is the very long term.

OU BUSINESS SCHOOL

107

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

EXERCISE 6.1
The company could ensure that the profit was also inherently hedged by buying and selling in GBP – its domestic currency. Of course, requiring that it be charged in GBP rather than USD might in itself be quite costly, since the non-United Kingdom supplier is likely now to set the price to include the exchange risk that is being taken on.

EXERCISE 6.2
If the factory is selling to the local market, its revenue will be mostly in CND. If the loan taken out to finance the operations is also in CND, the interest and principal expenses will be in the same currency as the revenue, reducing the subsidiary’s exposure.

EXERCISE 6.3
If you only invoice in your home currency, for example a United Kingdom company invoicing into France in GBP, then you are passing on the currency risk to your customers. This might lead to the loss of competitive advantage with local currency suppliers.

EXERCISE 8.1
(a) The option is ‘out of the money’ because the share price of 550p is below the exercise price of 600p. An investor will let the option lapse and so lose the premium. Net loss = 1000 6 35p = GBP350 (b) The option is ‘at the money’ because the share price exactly equals the exercise price. The investor did not really ‘need’ the option and has lost the premium. Net loss = GBP350 (c) The option is ‘in the money’ because the share price is above the exercise price. So the investor will exercise the option and buy shares at 600p each. Net gain = 1000 6 (650 – 600p) - GBP350 = GBP150

108

OU BUSINESS SCHOOL

ANSWERS TO EXERCISES

EXERCISE 8.2

In the money

At the money

Out of the money

Option value

Intrinsic value

Exercise price

Option value Current share price

Figure A.1

This graph is a mirror image to that in Figure 8.1. The difference between the solid and broken lines reflect the time to expiry. You will notice that both in Figure 8.1 and in Figure A.1, the graphs show unlimited upside potential when the option is in the money. In the case of Figure A.1, however, for put options to have intrinsic value the current share price has to be below the exercise price (remember, a put option gives you the right to sell at the exercise price). By the same token, the graph shows that put options are out of the money when the exercise price is below the share price: the greater the share price, relative to the exercise price, the less likely it is that holders of the contract will make a profit. Note that the put option’s intrinsic value is zero at the exercise price, but the solid line showing the option value is not yet there because there is a chance things may change in the time before expiry. Remember that when the current share price is equal to the exercise price, the put option is at the money.

OU BUSINESS SCHOOL

109

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

EXERCISE 8.3

60 54 50 40 30 20

Write call at 500

Net position 21

Pay-off (p)

10 0 -10 -20 -30 -40 -50 -60 -70 –73 -80 Buy call at 460 400 –19 460 450 500 550 Share price 600

Figure A.2

In this example, the investor has limited downside risk and limited upside potential. The investor has less upside potential than just buying the call option, but has reduced the cost or protection against downside risk from 73p to (73p – 54p) = 19p.

EXERCISE 8.4
(a) No payment is made to the cap buyer – the market LIBOR rate is below the cap of 5%. (b) Again no payment is made to the cap buyer – the market LIBOR rate matches, but does not exceed, the cap of 5%. (c) The cap is exceeded by 6.2 - 5% = 1.2%. The cap buyer therefore receives a payment from the cap seller of 1.2% on GBP10 million for ninety-two days. Thus the payment is GBP10,000,000 6 0.012 6 92/365 = GBP30,246.58

EXERCISE 8.5
The pay-off is shown in Figure A.3. For LIBOR rates of between 4% and 5.5% there are no payments since neither the cap nor the floor has been activated, rates being too low to activate the cap at 5.5% and too high to activate the floor at 4%. Below 4% the holder of the collar will have to pay interest to the seller of the collar to the extent of the difference

110

OU BUSINESS SCHOOL

ANSWERS TO EXERCISES

between the floor rate of 4% and the market LIBOR rate. Above 5.5%, by contrast, the holder of the collar will be compensated with the difference between the market LIBOR rate and 5.5%
3

%payoff for collar buyer

2 1 0 –1 –2
2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5 8.0 LIBOR (%) p.a.

Figure A.3

Collar receipts

EXERCISE A2.1
Using the parameter values as given, the software gives a value for the call option of 26.1872p (the percentage figure is the same as S = 100). Note that this is only a little higher than the intrinsic value of 25p; an option that is so far in the money has little downside protection, since S can fall all the way to 75p before the safety net (i.e. where the option cannot fall further in intrinsic value) kicks in. Using the Option Valuation software, look at the difference of estimating the price of the call using 60-day maturity (26.1872p) and 58-day maturity (26.1459p).

EXERCISE A2.2
With an exercise price of 1.840, t equal to 2.25/12 = 0.1875 years (67.5 days) and other parameters as before, the value of the put option is 3.06 cents. This compares with 4.09 cents in Table 8.4. In fact, using a volatility figure of 11.81% would match the market result.

��������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������������

OU BUSINESS SCHOOL

111

UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

REFERENCES AND FURTHER READING
Aczel, M. (1987) ‘Updating option valuation systems’, Euromoney, November. Buckley, A. (1996) Multinational Finance, FT Prentice Hall. Cox, J., Ross, S. and Rubinstein, M. (1979) ‘Option pricing, a simplified approach’, Journal of Financial Economics, September, pp. 229–63. Das, S. (1998) Risk Management and Financial Derivatives: A Guide to the Mathematics, McGraw-Hill. Douch, N. (1989) The Economics of Foreign Exchange, Quorum Books. Eiteman, D. K., Stonehill, A. I. and Moffett, M. H. (2003) Multinational Business Finance, 10th edn, Addison Wesley. Galitz, L. (1992) Financial Engineering: Tools and Techniques to Manage Financial Risk, McGraw-Hill. Garman, M. and Kohlhagen, S. (1983) ‘Foreign currency option values’, Journal of International Money and Finance, 2, pp. 231–7. Kern, D. (1996) ‘Tremors that spoil the distant view’, Corporate Finance, September. Ross, D., Clark, I. and Taiyeb, S. (1987) International Treasury Management, Woodhead-Faulkner. Shapiro, A. (2002) Multinational Financial Management, 7th edn, Wiley. Smithson, C. W. (1998) Managing Financial Risk: A Guide to Derivative Products, Financial Engineering and Value Maximization, McGraw-Hill. Tygier, C. (1984) Basic Handbook of Foreign Exchange: A Guide to Foreign Exchange Dealing, International Publications Service. Wood, D. and Bátiz-Lazo, B. (1995) Introduction to International Banking. Part I: Basic Concepts and Operations, Manchester, Manchester Business School, mimeo.

112

OU BUSINESS SCHOOL

ACKNOWLEDGEMENTS

ACKNOWLEDGEMENTS
Grateful acknowledgement is made to the following sources:

Text
Box 5.2 and Table 5.1: ‘Fast food and strong currencies – Big Mac Index’, The Economist, # The Economist Newspaper Limited, London, 11 June 2005.

Tables
Tables 2.2a and 2.2b: Buckley, A. (1996) Multinational Finance, Pearson Education Limited; Table 4.1: ‘Spot forward against the pound’, Financial Times, 7 August 1998, Financial Times Syndication.

Figures
Figure 3.1: ‘Standard Chartered Group dealing centres’, courtesy of Standard Chartered plc.

Illustrations
Page 13: Sterling, H. and Selesnick, H. (1990) Stockworth: An American CEO, McGraw-Hill Inc.; Page 17: # Skyscan; Page 57: Copyright # Photolibrary.com; Page 68: # David Paterson/Getty Images; Page 71: # PowerStock/Zefa.

OU BUSINESS SCHOOL

113

Sponsor Documents

Or use your account on DocShare.tips

Hide

Forgot your password?

Or register your new account on DocShare.tips

Hide

Lost your password? Please enter your email address. You will receive a link to create a new password.

Back to log-in

Close