Rauli Susmel FINA 4360 – International Financial Management

Dept. of Finance
Univ. of Houston

Chapter 5 - Currency Derivatives (FX Management Tools)

Currency Derivatives can reduce the risk in FX transactions.
1. Currency Futures/Forwards
2. Currency options
3. Money Market (Replication of IRP. Chapter 10)
4. Other hedging tools (Ch 10-12): - Pricing in DC
- Risk-sharing
- Matching Outflows & Inflows

This Lecture
We will present two FX Derivatives:
- Currency Futures/Forwards (agreement to buy/sell FC at a given price at time T)
- Currency Options (right to buy/sell FC at a given price during a period of time, t to T)

• Currency Risk
Definition: The risk that the value of an asset/liability/financial instrument will (negatively) change
due to changes in FX rates. (Financial risk applied to international finance!)

Example: ABYZ, a U.S. company, imports wine from France. ABYZ has to pay EUR 5,000,000 on
January 2. Today, September 4, the exchange rate is 1.29 USD/EUR.

Situation: Payment due on January 2: EUR 5,000,000.

SSep 4 = 1.29 USD/EUR.

Problem: St is difficult to forecast  Uncertainty.

Uncertainty  Risk.
Example: on January 2, St=Jan 2 > or < 1.29 USD/EUR.

At SSep 4, ABYZ total payment would be: EUR 5M x 1.29 USD/EUR = USD 6.45M.

On January 2 we have two potential scenarios relative to Sep 4:

If the SJan 2  (USD appreciates)  ABYZ will pay less USD.
If the SJan 2  (USD depreciates)  ABYZ will pay more USD.

The second scenario introduces Currency Risk. ¶

If the value of an asset/liability does not change “a lot” when St moves, we will consider the
asset/liability to have low currency risk. (Of course, if it does not change in value at all, it does not

Ch.5.1
face currency risk.)

In finance, we relate “a lot” to the variance or volatility. For currency risk, we will look at the
volatility of FX rates: => more volatile currencies, higher currency risk.

Example (continuation): Consider the following situations:

(A) SJan 2 can be with 50% either scenario:
(i) 1.28 USD/EUR, for a total payment: EUR 5M x 1.28 USD/EUR = USD 6.40M.
(ii) 1.30 USD/EUR, for a total payment: EUR 5M x 1.30 USD/EUR = USD 6.50M.

(B) SJan 2 can be with 50% either scenario:

(i) 1.09 USD/EUR, for a total payment: EUR 5M x 1.09 USD/EUR = USD 5.45M.
(ii) 1.49 USD/EUR, for a total payment: EUR 5M x 1.49 USD/EUR = USD 7.45M.

Both situations have the same expected value (expected payment: USD 6.45 M), but different levels
of risk. Situation B is riskier (more volatile) for ABYZ, since it may result in a higher payment.

Note: Under situation B, ABYZ may end up paying a lot less than in situation A. That’s the usual
risk/reward trade-off in finance: No pain (risk, volatility), no gain (in this case, lower payments)! ¶

Currency (financial) risk is evaluated using probability distributions. For example: the normal
distribution. Two different normal distributions are plotted in Figure 5.1 with the same mean (0), but
different volatilities (standard deviations, SD). The blue distribution (SD=2) would be considered
riskier than the red distribution.

Figure 5.1: Normal Distributions with Different Standard Deviations

Recall that a probability distribution completely describes the behavior of a random variable. (For
us: the random variable: St. The behavior we want to be described: the variability of St.)

Before making decisions regarding FX derivative instruments, a company should take into

Ch.5.2
consideration the distribution (the behavior) of future St. In the previous example, under Situation A,
ABYZ can ignore FX risk; but under Situation B, ignoring FX risk is risky!
• Brief Aside: Characteristics of the Distribution of FX Rates

Below, Table 5.1 shows the distribution of ef,t for selected currencies (annualized mean & SD), using
1990-2017 monthly data (336 observations).

TABLE 5.1: Descriptive Statistics for selected currencies (1990-2017) using monthly data

Standard Excess
Currency Mean Deviation Skewness Kurtosis Normal?
GBP/USD 0.0090 0.0951 0.9681 3.4004 No
CHF/USD -0.0097 0.1101 0.2171 1.3365 No
DKK/USD 0.0118 0.1030 0.4803 1.2113 No
EUR/USD 0.0166 0.1102 0.5253 1.2145 No
INR/USD 0.0565 0.0820 3.0932 24.1434 No
JPY/USD -0.0010 0.1056 -0.1936 1.9347 No
KRW/USD 0.0295 0.1247 1.7968 15.9320 No
THB/USD 0.0179 0.1055 2.6493 32.3567 No
SGD/USD -0.0095 0.0563 0.5677 2.9251 No
CNYUSD* -0.0122 0.0160 -0.4484 7.9325 No
KWD/USD 0.0024 0.0446 2.1568 74.9592 No
SAR/USD 0.0000 0.0030 3.3228 119.9623 No
CAD/USD 0.0106 0.0792 0.8378 5.7371 No
MXN/USD 0.0818 0.1359 5.0008 51.7441 No
ZAR/USD 0.08053 0.14163 0.08053 2.1010 No
EGP/USD* 0.04084 0.05303 0.04084 216.7728 No
NGN/USD* 0.1666 0.5804 15.7821 259.9828 No
AUD/USD 0.01062 0.11436 0.01062 4.3249 No

Ch.5.3
 Average 0.0349 0.1180 2.7443 38.4349 No

Notes: * shorter sample: CNY (9/1994-12/2017), EGP (1/1995-12/2017) & NGN (1/1994-12/2017).

- On average, since 1990, the USD appreciated against international currencies at an annualized
mean of 3.49%. The average annualized SD is 11.80%.
- USD against developed currencies (in blue): 0.5% annualized appreciation, with a 9.51% SD.
- Excess Kurtosis. It describes the fatness of the tails. Under normality, excess kurtosis equals 0. All
the currencies show excess kurtosis, that is, the tails are fatter than the tails of a normal –i.e.,
probability of a tail event is higher than what the normal distribution implies. The tails are very
thick, reflecting higher extremes, in emerging markets.
- Skewness. If the distribution is symmetric (mean=median, for example, a normal), skewness is 0.
Almost all the currencies show positive skewness (mean>median); that is, the fat part of the curve is
on the left. Again, emerging market currencies show higher skewness.
- From the last column, which shows the results of a test of normality, the Jarque-Bera (1980) test,
we can say that ef,t does not follow a normal distribution. Not a surprising result, given the big
skewness and excess kurtosis.

The last three results are typical of financial time series.

• Currency Futures or Forward Contracts

FX Forward/Futures are agreements that set, today, the price of the exchange rate at a given future
date. The agreement specifies a given quantity.

• Basic Terminology
⋄ Short: Agreement to Sell.
⋄ Long: Agreement to Buy.
⋄ Contract size: Number of units of foreign currency in each contract.
⋄ Maturity (T): Date in which the agreement has to be settled.
⋄ Futures/Forward price (Ft,T): Price at which the forward transaction at maturity will be executed.

• Forwards vs Futures
⋄ Forward markets: Tailor-made contracts.
Location: none (OTC traded contracts).
Reputation/collateral guarantees the contract.

⋄ Futures markets: Standardized contracts (standardized duration, size, collateral).

Location: organized exchanges (CME, Euronext (LIFFE), Tokyo FX)
Clearinghouse guarantees the contract.

Ch.5.4
CME Standardized sizes: GBP 62,500, AUD 100,000, EUR 125,000, JPY 12.5M
CME expiration dates: Mar, June, Sep, and Dec + Two nearby months
Margin account: Amount of money you deposit with a broker to cover your possible losses involved
in a futures/forward contract. Two important quantities:
- Initial Margin: Initial level of margin account.
- Maintenance Margin: Lower bound allowed for margin account.
Mechanism: If margin account goes below maintenance level, a margin call is issue:
 Funds have to be added to restore the account to the initial level.

Example: GBP/USD CME futures

Initial margin: USD 2,800
Maintenance margin: USD 2,100

If losses do not exceed USD 700, no margin call will be issued.

If losses accumulate to USD 850, USD 850 will be added to account. ¶

Table 5.2 summarizes the main differences between the two contracts.

TABLE 5.2: Comparison of Futures and Forward Contracts

Futures Forward
Amount Standardized Negotiated
Delivery Date Standardized Negotiated
Counter-party Clearinghouse Bank
Collateral Margin account Negotiated
Market Auction market Dealer market
Costs Brokerage and exchange fees Bid-ask spread
Secondary market Very liquid Highly illiquid
Regulation Government Self-regulated
Location Central exchange floor Worldwide

• Real Life Examples of Forwards and Futures

Pizza delivery: Customer buys future pizza; pays with USD (domestic currency)
Pizza Hut sells future pizza; gets paid with USD (domestic currency)
Terms of contract:
Size: One pizza
Duration: 30’ or less.
Collateral: Credit card or None

• Using FX Forwards and Futures

Q: Who buys/sells FX Forward and Futures Contracts?

Ch.5.5
A: Hedgers and Speculators

Example: IBM has to pay in 90 days EUR 5M to a French supplier.

Problem: IBM is concerned about a depreciation of the USD against the EUR in the near future.
Solution: IBM buys from Chase a EUR forward contract.
Size = EUR 5M
Maturity = 90 days.
Ft,90 = 1.31 USD/AUD

Note: IBM knows that, in 90 days, it will pay USD 6.55M (=EUR 5M*1.31 USD/EUR) to the
supplier. As shown in Figure 5.2, there is no uncertainty whatsoever about this amount: St+90 does
not affect the amount to receive in 90 days. (No uncertainty, no volatility => No FX risk).

Figure 5.2: CFs under an FX Futures

Payoff Diagram for IBM

Amount
Received
in t+90

Forward
USD 6.55M

St+90

Hedging Note:
- Underlying position: Short EUR 5 M.
- Hedging position: Long 90 days futures for EUR 5 M. ¶

Example: A U.S. investor has GBP 1 million invested in British gilts (UK government bonds).
Problem: Uncertain about future value of USD/GBP in December.
Solution: Sell GBP Dec futures.
Situation: It is Sep 12.
Underlying position: British bonds worth GBP 1,000,000.
FSep 12,Dec = 1.55 USD/GBP
Futures contract size: GBP 62,500.
SSep 12: 1.60 USD/GBP.
number of contracts = ?

Hedging position: The investor sells GBP 1,000,000/(62,500 GBP/contract) = 16 contracts.

Ch.5.6
Note: If the U.S. investor decides to sell her British gilts in December she will receive exactly USD
1.55M. No uncertainty whatsoever about this amount.

But, if she decides not to sell the gilts, there will be a cash flow from the difference between SDec -
FDec,Dec. ¶

Hedging Note:
- Underlying position: Long GBP 1 M.
- Hedging position: Short futures for GBP 1 M.

From both hedging notes  Hedging is very simple: Take an opposite position!

We call the hedger with a long FX futures/forward position, the long hedger. Similarly, we call the
hedger with a short FX futures/forward position, the short hedger.

Ch.5.7