Topic 4: Foreign Currency Derivatives

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OPTIONS
What is the difference between an American and a European option? Which one should
trade at a higher price?
If the exchange rate is $0.66/EUR, the strike price of a call option expiring in 3 months is
$0.70/EUR and the option premium is $0.06/EUR, what is the intrinsic value of the
option? Does it have time value?
What is the difference between options on spot currency and options on currency futures?
Suppose you can buy on the PHLX a call option [contract size is Yen 6,250,000] to buy
yen at $0.01/Yen for maturity in two months. The premium is 1.26 cents per 100 yen.
What would be the total cost of purchasing this call option?
Citicorp sells a call option on Deutsche marks [contract size is EUR 500,000 (EUR
62,500 8)] at a premium of $0.04 per EUR. If the exercise price is $0.71 and the spot
price of the EUR at expiration date is $0.73, what is Citicorp’s profit (loss) on the call
option?
Suppose that Bechtel Group wants to hedge a bid on a Japanese construction project. But
because the yen exposure is contingent on acceptance of its bid, Bechtel decides to buy a
put option for the ¥15 billion bid amount rather than sell it forward. In order to reduce its
hedging cost, however, Bechtel simultaneously sells a call option for ¥15 billion with the
same strike price. Bechtel reasons that it wants to protect its downside risk on the
contract and is willing to sacrifice the upside potential in order to collect the call
premium. Comment on Bechtel’s hedging strategy.
A trader executes a “bear spread” on the Japanese yen consisting of a long PHLX 103
March put and a short PHLX 101 March put.
a. If the price of the 103 put is 2.81 (100ths of ¢/¥), while the price of the 101 put is 1.6
(100ths of ¢/¥), what is the net cost of the bear spread?
b. What is the maximum amount the trader can make on the bear spread in the event the
yen depreciates against the dollar?
c. Redo your answers to parts a and b assuming the trader executes a “bull spread”
consisting of a long PHLX 97 March call priced at 0.0321¢/¥ and a short PHLX 103
March call priced at 0.0196¢/¥. What is the trader’s maximum profit? Maximum loss?
[contract size is Yen 6,250,000]
International Financial Management
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FUTURES
Explain the basic differences between the operation of the currency forward market and
the futures market.
Why are most future positions closed out through a reversing trade rather than held to
delivery?
What is the major difference in the obligation of one with a long position in a futures (or
forward) contract in comparison to an options contract?
Assume today’s settlement price on a CME EUR futures contract is $0.9716/EUR. You
have a short position in one contract. Your margin account currently has a balance of
$1,700. The next three days’ settlement prices are $0.9702, $0.9709 and $0.9625.
Calculate the changes in the margin account from daily marking-to-market and the balance
of the margin account after the third day. [Contract Size is EUR125,000]
Do question 4 again assuming you have a long futures position in the futures contract.
The price of the March 2002 Mexican Peso (MXP) futures contract is $ 0.10068. You
believe the spot price in December will be $ 0.11000. What speculative position would
you enter into to attempt to profit from your beliefs? Calculate your anticipated profit
assuming you take a position in three contracts. What is the size of your profit (loss) if the
futures price is indeed an unbiased predictor of the future spot price and this price
materializes? [Contract Size is MXP 500,000]
On Monday morning, an investor takes a long position in a Pound futures contract that
matures on Wednesday afternoon. The agreed-upon price is $1.78 for £62,500. At the
close of trading on Monday, the futures price has risen to $1.79. At Tuesday close, the
price rises further to $1.80. At Wednesday close, the price falls to $1.785, and the contract
matures. The investor takes delivery of the Pounds at the prevailing price of $1.785. Detail
the daily settlement process. What will be the investor’s profit (loss)?
Suppose that DEC buys a Swiss Franc futures contract (size is SFr $125,000) at a price of
$0.83. If the spot rate for the Swiss Franc at the date of settlement is SFr 1 = $0.8250,
what is DEC’s gain or loss on this contract?
Suppose that Texas Instruments (TI) must pay a French supplier €10 million in 90 days.
a. Explain how TI can use currency futures to hedge its exchange risk. How many futures
contracts will TI need to fully protect itself? [Contract size is €125,000]
b. Explain how TI can use currency options to hedge its exchange risk. How many options
contracts will TI need to fully protect itself? [Contract size is €62,500]
International Financial Management
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c. Discuss the advantages and disadvantages of using currency futures versus currency
options to hedge TI’s exchange risk.
Suppose the interbank forward bid for December on AUD is $0.7515 and at the
same time the price of a futures contract for delivery in December is $0.7511.
How can the dealer use arbitrage to profit from this situation? [Contract Size is
AUD100,000]
SWAPS
Discuss the basic motivation for companies to enter into currency swaps.
Explain how Cisco Systems can use arbitrage to create a forward forward to fix the
interest rate on a three-month $10 million loan to be taken out in nine months. The loan
will be priced off LIBOR.
Deleted.
Suppose that IBM would like to borrow fixed-rate yen, whereas Korea Development
Bank (KDB) would like to borrow floating-rate dollars. IBM can borrow fixed-rate yen
at 4.5 percent or floating-rate dollars at LIBOR + 0.25 percent. KDB can borrow fixedrate
yen at 4.9 percent or floating-rate dollars at LIBOR + 0.8 percent.
a. What is the range of possible cost savings that IBM can realize through an interest
rate/currency swap with KDB?
b. Assuming a notional principal equivalent to $125 million, and a current exchange rate of
¥105/$, what do these possible cost savings translate into in yen terms?
c. Redo Parts a and b assuming that the parties use Bank of America, which charges a fee of
8 basis points to arrange the swap.
Company A, a low-rated firm, desires a fixed-rate, long-term loan. A currently has
access to floating interest rate funds at a margin of 1.5% over LIBOR. Its direct
borrowing cost is 13% in the fixed-rate bond market. In contrast, company B, which
prefers a floating-rate loan, has access to fixed-rate funds in the Eurodollar bond market
at 11% and floating-rate funds at LIBOR + ½%.
a. How can A and B use a swap to advantage?
b. Suppose they equally split the cost savings. How much would A pay for its fixed-rate
funds? How much would B pay for its floating-rate funds?
What factors underlie the economic benefits of swaps?
International Financial Management
4
In May 1988, Walt Disney Productions sold to Japanese investors a 20-year stream of
projected yen royalties from Tokyo Disneyland. The present value of that stream of
royalties, discounted at 6 percent (the return required by the Japanese investors), was ¥93
billion. Disney took the yen proceeds from the sale, converted them to dollars, and
invested the dollars in bonds yielding 10 percent. According to Disney’s chief financial
officer, Gary Wilson, “In effect, we got money at a 6 percent discount rate, reinvested it
at 10 percent, and hedged our royalty stream against yen fluctuations–all in one
transaction.”
a. At the time of the sale, the exchange rate was ¥124 = $1. What dollar amount did Disney
realize from the sale of its yen proceeds?
b. Demonstrate the equivalence between Walt Disney’s transaction and a currency swap.
c. Comment on Gary Wilson’s statement. Did Disney achieve the equivalent of a free lunch
through its transaction?
A medium-sized Australian Company (A) needs to borrow £6.7 million ($10 million at the
current exchange rate of S(£/$) = 0.67) for five years to establish a division in the U.K. A
British firm (B) needs to borrow $10 million for five years to set up an Australian.
division. The two face the following borrowing costs (annual coupon payments):
r($) r(£)
A 5.5% 8.5%
B 5.25% 8.0%
Consider the following arrangement. A borrows $10 million, B borrows £6.7 million.
Each agrees to pay the principal repayment obligation of the other, and in addition A will
pay B £562,800 at the end of each year, and B will pay A $550,000 at the end of each
year. (Past Exam Question)
(a) What are the effective yearly payments for each party? What are the interest rates (no
compounding)?
(b) Who gains more from the swap, A or B? Why?

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