Foreign Exchange Risk Management (2)
1 Introduction
In the previous chapter we looked at various ways of reducing the risk due to changes in exchange rates. In this chapter we will look at three more, rather different, possibilities – options, swaps, and swaptions!
2 Options
If we know that we are going to need to convert currency at a future date but we think that the exchange rate is going to move in our favour, then it would be more sensible to leave the transaction to be converted at spot on the relevant date, rather than hedge against the risk and therefore not receive the benefit of the exchange rate movements.
The above would be perfectly sensible if we were certain that the rate was going to move in our favour, but of course it is impossible to be completely certain and therefore there would still be a risk that we were wrong and that the rate moved against us.
In this situation – where we are reasonable confident that the rate will move in our favour – then it might be worthwhile considering a currency option. With a currency option we have the right (or option) to convert at a fixed rate on a future date (as with the use of a forward rate), but we do not have to exercise the right.
As a result, if the exchange rate does move in our favour then we will throw away the option and simply convert at whatever the spot rate happens to be. If, however, the exchange rate moves against us then we will use the option and convert at the fixed rate.
Since we will get the benefit of any movement in our favour, but not suffer if the exchange rate moves against us, options do not come free! We will have to pay (now) for the option whether or not we eventually decide to use it. The amount we have to pay is called the option premium.
2.1 OTC options
OTC stands for ‘over-the-counter’ and refers to the buying of an option as a private deal from a bank. The company will approach the bank stating the amount, the future date, and the exchange rate required, and the bank will quote a premium. It is then up to the company whether or not to accept the quote and purchase the option.
It is 1 April and X plc expects to receive $2 million on the 30th June.
The current spot rate is $/£ 1.5190 and X expects that this rate will move in their favour.
They have purchased from the bank an option to sell $2 million on 30 June at an exercise price of $/£ 1.5200, and the bank have charged a premium of £50,000.
Show the outcome on 30 June if the exchange rate on that date is:
$/£ 1.5180
$/£ 1.6153
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2.2 Traded options
As an alternative to buying a ‘tailor-made’ OTC option from a bank, it is possible to buy and sell currency option on the currency exchanges. A benefit of this is that the premiums are driven by market forces and the company can therefore be more certain of paying a fair price. However, traded options are only available between major currencies, at various quoted exchange rates, exercisable on various quoted dates, and for fixed size units.
The option premia are published in a table which you must be able to interpret in the examination. The table will appear as in the following illustration:
$/£ Options £31,250 (cents per £1)
Calls | Puts | |||||
Strike price | Mar | Apr | May | Mar | Apr | May |
1.425 | 6.29 | 6.32 | 6.49 | 0.02 | 0.14 | 0.45 |
1.450 | 3.81 | 4.17 | 4.54 | 0.03 | 0.48 | 0.98 |
1.475 | 1.53 | 2.45 | 2.92 | 0.13 | 1.20 | 1.84 |
Using the above table, explain the following:
what is the ‘strike price’?
what do ‘call’ and ‘put’ mean?
what do the months above each column mean?
what do the numbers in the columns mean?
what does the ‘£31,250 (cents per £)’ mean?
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2.3 European and American options
European options can only be exercised on the last day of the relevant month. American options can be exercised at any time up to the last day of the relevant month. This makes American options more flexible (and therefore generally more expensive!). (Although do appreciate that as these options are traded they can always be sold at any time.)
The terms European and American refer to the style of the option and are nothing to do with where they are actually sold.
Set out an options hedge the way the answer to Example 3 below does — puts or calls, the month, the strike price and a whole number of contracts — and only then the premium. Take the premium's unit from the table heading: here it is cents per £1, so 22 contracts × £31,250 × 1.20 cents gives a premium in dollars, which a UK company converts to pounds at today's spot rate. If the premium is already in the currency the company works in, there is nothing to convert.
A UK company owes a US supplier $1,000,000 payable in April.
The spot rate is $/£ 1.4850 – 1.4870 and the UK company is concerned that the $ might strengthen.
Traded options are available at prices as shown in the following table:
$/£ Options £31,250 (cents per £1)
Calls | Puts | |||||
Strike price | Mar | Apr | May | Mar | Apr | May |
1.425 | 6.29 | 6.32 | 6.49 | 0.02 | 0.14 | 0.45 |
1.450 | 3.81 | 4.17 | 4.54 | 0.03 | 0.48 | 0.98 |
1.475 | 1.53 | 2.45 | 2.92 | 0.13 | 1.20 | 1.84 |
Show how traded $/£ currency options can be used to hedge the risk at 1.475
Show what will happen if the spot rate in April is $/£1.4100 – 1.4120
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3 Currency swaps
Currency swaps are much less popular than interest rate swaps (which will be explained in a later chapter).
They are best explained by way of a short illustration:
A UK company is intending to invest in the US and will therefore be earning income in $’s. They need to borrow money for the investment and have decided to borrow $’s (as a way of reducing the impact of changes in exchange rate – the closer their interest payments are to their receipts the less the effect on them of exchange rate movements).
Another company in the US is intending to invest in the UK and for the same reasons as above they wish to borrow £’s.
Both companies can organise their borrowing independently, but a US company is likely to be able to borrow $’s at a lower interest rate than a UK company (and vice versa).
A solution which stands to benefit both companies is as follows:
The UK company borrows £’s and the US company borrows an equivalent amount of $’s. The two parties then swap funds at the current spot rate.
The UK company agrees to pay the US company the annual cost of the interest on the $ loan. In return the US company pays the £ interest cost of the £ borrowing by the UK company.
At the end of the period the two parties then swap back the principal amounts. This could be at the prevailing spot rates or at a predetermined amount in order to reduce foreign exchange transaction exposure.
Swaps are generally arranged by banks (who act as a ‘dating agency’ finding the parties to a swap). The bank will arrange guarantees, but they will charge commissions for their service.
More recently there has been a tendency for large companies to arrange swaps directly with each other (and not using banks, thus saving costs). The tendency is known as ‘disintermediarisation’(!!).
4 Swaption
Suppose a company wants to borrow money on a future date and might want a swap to be arranged on that date. However, they are not sure and do not want to make the decision until the date on which they want to borrow the money.
In this situation it is possible to arrange with the bank to have the right (or option) to swap on a future date. This is known as a swaption (and obviously the bank will charge a premium, whether or not the option is exercised).