International Finance- Derivative Management.pptx

Presenting

1. International Finance / Derivatives Management

2. International Finance Corporations (businesses) extend their operations into international markets (foreign nations) Firms continually devise strategies to improve their cash flows, and hence value maximisation They encounter new opportunities They also encounter new costs and risks

3. International Finance Challenge of international financial manager – To successfully develop and execute business as well as manage finances in more than one culture or business environment. Foreign Exchange Market- allows currencies to be exchanged to facilitate international trade and financial transactions. The market for immediate exchange of currencies is known as the spot market . The market for enabling future exchange of currencies is known as the forward market . The forward markets enable MNCs to lock in the exchange rate at which they will buy or sell certain quantities of currencies on some specified future date.

4. Derivatives I nternational Opportunities Derivatives are financial securities or financial instruments whose value are derived from the value of one or more other financial assets called underlying assets. Derivatives serve as risk management tools to protect against unexpected movements in exchange rates, interest rates, commodity prices and their price movements. These underlying assets include financial assets such as foreign exchange interest bearing securities eg : equities or stocks, short term securities such as T-bills, commercial papers, and commodities such as Oil, Gold, Cocoa, Timber, Maize; intangible assets such as copyrights. In other words, it can be used to trade in the most commonly traded financial derivatives: forward, futures, options, swaps etc.

5. EXCHANGE TRADED DERIVATIVES Opportunities Exchange traded derivatives such as Forward contract , Futures contract Options , and Swaps . Forward Contract : there is a binding contract or agreement. It is traded Over-the-counter (OTC), It protects the undertaker against fluctuations, It assists consumers to budget for the product. Main Features The contract is usually between two parties. The quantity is decided today, the price is decided today, the quality is decided today, settlement will take place sometime in the future. No margins (or premium) are generally payable by any of the parties to the other. It is usually used in the commodity market where there is short due date It is usually used for underlying in the foreign exchange market. E.g. the Foreign currency market of Ghana

6. EXCHANGE TRADED DERIVATIVES Forward Contract Main Features The contract is usually between two parties. The quantity is decided today, the price is decided today, the quality is decided today, settlement will take place sometime in the future. No margins (or premium) are generally payable by any of the parties to the other. It is usually used in the commodity market where there is short due date It is usually used for underlying in the foreign exchange market. E.g. the Foreign currency market of Ghana

7. EXCHANGE TRADED DERIVATIVES Forward Contract ADVANTAGES It is flexible It can be customized to suit a party’s needs DISADVANTAGE It is difficult to find a counter party.

8. International Opportunities Example of Forward Contract OMEGA Company located in Accra has contracted to purchase a high technology equipment from a dealer in London. The purchase price will be £1,000,000 which is to be paid when the equipment is delivered in six (6) months time. Omega could wait for 6 months to purchase the British pounds but during this time, they will be at risk to an increase in the value of the pound relative to the cedi. i . Assume that on April 01, when the contract to purchase the equipment was made thus the exchange rate is £1 - GH¢3,750. ii. Six months later when the delivery is made assume that the exchange rate is £1 - GH¢3,925. iii. Assume that six months later when the delivery is made, assume that the exchange rate is £1 -GH¢3,650 If Omega company had wanted to purchase the sterling: What would have been the cost in ii What would be the cost in iii What would be the outcome supposing he did not wait.

9. International Opportunities SOLUTION Cost in ii £1 = GH¢3,925 £1,000,000 x GH¢3,925 (6 months) = GH¢3,925m. £1,000,000 x GH¢3,750 (Spot price) Cost = GH¢3,750m. Gain: Gain = GH¢3,925m - GH¢3,750m = GH¢175m So the gain for an increase in exchange rate after 6 months is GH¢175m Cost in iii 6 months rate = £1 = GH¢3,650 £1,000,000 x GH¢3,650 Cost = GH¢3,650m

10. International Opportunities SOLUTION Loss = GH¢3,750m - GH¢3,650m = GH¢100m Loss = GH¢100m GH¢3,750 -GH¢3,650 = GH¢100m (Loss) So there a loss of GH¢100m due to a drop in the exchange rate after 6 months. Because by buying the pound on the forward basis Omega Company will lock in the cost for the currency at £1,000,000 x GH¢3,750 = GH¢3,750m (the then spot price). Note well the first case: This will help Omega company to gain (GH¢3,925 - GH¢3,750) x 1,000,000 the gain is GH¢3,925 - GH¢3.750 x 1,000,000 which amounted to Gh¢175m gain and hence manage (reduce) their risk exposure to foreign exchange fluctuations.

11. International Opportunities Futures Contract : it has a more formalized and standard contract. This is similar to forward contracts except that there is standardization with respect to: Assets, Quality, Quantity, Delivery (time and place). Only price is not standardized but it is determined by market competition (i.e. forces of demand and supply) between buyers and sellers. Delivery and payment is guaranteed by a clearing organization which is the contra party to all the transactions. Trading takes place on an exchange but does not take place in an open market. ADVANTAGES Liquidity (highly liquid) There is standardization Performance guaranteed because of difficulty to default. DISADVANTAGES It cannot be transferred to a third party Fluctuations in prices affects trading Trading is cumbersome due to standardization.

12. International Opportunities Participants in the Future Market Hedgers Speculators Hedgers A party who is at risk of an adverse movement in the price of the underlying and uses the future market to reduce this risk. E.g. A farmer who grows maize will be at risk to fallen maize prices prior to harvest and sale at the market. To prevent this risk, this farmer will sell future contract on this maize to lock in a high sale price for the crop. E.g. 2. A jewelry manufacturer who is at risk for rising prices for gold, the jewelry manufacturer could buy gold futures to lock in the purchase price and reduce risk. E.g. 3. An airline that is at risk to rising prices in oil could buy oil futures contract at a lesser price to lock in the price and reduce this risk.

13. Hedgers A hedge can be for a position already held or for an anticipated position. In the above, examples, the airline buys oil features to anticipate a need for oil at a later time. This could be an anticipatory hedge. Other examples of hedging in anticipation of a later spot market transaction could include; A portfolio manager who anticipates a receipts of funds in the future which he intends to invest in, if the portfolio manager believes that for instance bond prices are attractive and are likely to rise prior to receipt of the funds for investment (due to falling interest rate), he could hedge this anticipated purchase by buying bonds futures contract.

14. Hedgers A manufacturer who knows he will be paid in foreign currency at some that in the future, he will have to sell the foreign currency and convert it into his local currency. This indicates an anticipated sale of foreign currency. The hedge can be accomplished by the sale of futures contract on the foreign currency. Hedging therefore is an act of taking equal and opposition in the cash (spot) and futures market. The hedger does know in the future market what he expects to do at a later time in the spot market. In this way, the futures position serves as a temporal substitute for the later spot market transaction thereby transferring the risk of buying or selling in the spot market to someone at the other side of the transaction.

15. Speculators Speculators on the other hand are a major category of participants in the futures market unlike the hedges, the speculators seeks to take risk by buying or selling futures contracts in anticipation of favourable price movements. Speculators provide the liquidity necessary for a futures market. The major or majority of transactions are typically between speculators resulting in price discovery whereby the prices for futures contracts are competitively established and made known to all who might be concerned. Examples of speculators; A trader who believe that the price of cocoa is likely to rise due to an expected reduction in supply to meet a rising demand. Although this trader has no interest in owing cocoa (having no facilities for storage or transporting) he can participate in this anticipated rise in cocoa price by buying cocoa futures. If he is right, he can profit wholefully or handsomely although if he is incorrect, he will have to choose out his position at a loss.

16. Speculators A trader after studying economic data is firmly convinced that interest rates will be rising. If he is correct, this will result in lower prices for bonds. He could act on this conviction by selling bond futures contract. Since the price of the bond futures and bonds in the spot markets will tend to move in tandem (downwards direction). If he is correct, he will be able to repurchase these futures contract at a lower price resulting in profit at a future date when bond prices rise. None of the above traders starts with a risk in the spot market so they are in no way hedging a risk rather they are assuming risk. If they are incorrect, this will result in a lose but if they are correct, they can release significant profit. Speculating therefore is the act of assuming risk in the futures market by buying or selling futures contract with the goal of making a profit of favorable market price movement.

17. International Opportunities Market Efficiency: The efficiency of a market is the function of the number of active participants- Hedgers and Speculators Although proving a facility for risk transfer (hedging) is the primary function of the futures markets. Hedgers alone will not provide enough activities to facilitate the market. Speculators acting for their own self interest compete with each other and as a result in an efficient market will discount all relevant information resulting in price discovery that is each of these participants will determine the value of their opinion of the futures contract based on all available data. The result of the large number of the market participants encourage competitiveness and in this process will result collectively in price discovery that is an efficiently determine price.  

18. International Opportunities Example of Futures Contract Beta Company is a manufacturer of telecommunication equipment. It has an opportunity to compete for a contract to sell equipment to another large company in Ghana. This contract will require that they deliver a large quantity of the equipment in six months. Beta Company is anxious to win this contract therefore engaged in the futures contract. They expect to know whether they have won this contract in two months. Copper in the spot market is currently priced at GH¢5.5kg. Copper futures for delivery in two months are priced at GH¢5.75kg. Beta buys futures contract for enough copper to cover their project. Two months later beta companies have indeed won the competition and must now begin production of the telecommunication equipment. At the same time, the price of the copper in the spot has increased to GH¢6.5kg. Has Beta Company gained or lose by locking in the futures contract?

19. International Opportunities Solution Spot market price - GH¢5.5/kg Futures price - GH¢5.75/kg Spot market in two months - GH¢6.5/kg Therefore, GH¢6.6 – GH¢5.75 Gain = GH¢0.75/kg Although Beta Company has paid more for the copper than they would have if the contract was initially given to them, they have avoided the cost of financing and storing this commodity pending the award of the contract. Also had they not won the contract, beta company would have faced the inconvenience of liquidating the physical copper in the spot market. The use of the futures contract have served beta company well in this situation hedging their anticipated purchase in the spot market with purchase of copper futures contract. When they entered the competition for the contract, they did as at that time in the futures market what they would do later in the spot market. Although they would have paid GH¢6.5 per copper in the spot market, they can offset this price by the profit they have made of the futures contract resulting in an effectives reduction of the cost of the copper (GH¢6.5 – GH¢ 5.75 = 0.75p).

20. Options Contract: An option gives the holder to the right to buy or sell a specific quantity of a specified financial instrument at a specific price for a specific period of time. Options contract terms specify; Assets Quantity Price Time Fee paid (option premium) Currency Options An option is a contract on which the writer of the option grants the buyer the rights to buy from or sell to the writer. Currency at the exercise (or strike) price within a specified period of time. An option is only a right not an obligation. The price paid by the option buyer is the option price or the option premium. In option hence, call option and put option. Options are traded on an organized exchange or in the over-the-counter.

21. Options Contract:   Features Options are standardized. Premium is paid and it is traded on the exchange but it is sometimes traded on the over the counter (OTC) It is limited to means of liquidity. It is difficult to enforce the terms of delivery and hence default risk is high. It has an underlying asset. Maturity ( ie . the time the contract will mature). Strike price (exercise price) is the price at which one exercise an option. Types Of Options There are two main types of options namely; Call option Put option Call option means right to buy (buyer) an asset. Put option means right to sell (seller) an asset.

22. International Opportunities Rules of Options According to the rules of options, a call option is In the money : if the spot rate is greater than the strike price. At the money : if the spot rate is equal to the strike price. Out of the money : if the spot is less than the strike price. Call option premium Call option premium will be higher if the- Spot rate or price – strike rate or price is larger. The time to expiration date is longer. The variability (difference) of the currency is greater.

23. International Opportunities Parties to Option The holder is the participant who pays the option premium that is, the one who has the right. The writer is the participant who receives the option premium.   Forms of Options American option : The holder can exercise at any time up to expiry date (maturity date). European option : The holder can only exercise at the end of the expiry date ( maturity date). Call Buyer Maximum gain is unlimited Maximum loss is the premium Break-even point that is, the strike price (exercise price) + premium paid. Call Writer The maximum gain is the premium The maximum loss is unlimited Break-even point that is, the strike price + premium received.

24. International Opportunities Call Option vrs Put Option Call Option Call option grants the holder the rights to buy a specified currency at a specified price called the exercise or strike price within a specified period of time. Put Option A put option grants the holder the rights to sell a specified currency at a specified price (strike price) within a specified period of time.

25. International Opportunities FORMULA: Call Option (Buyer) Profit = selling price – buying price (strike price) – option premium Call option (writer/seller) Profit = option premium – buying price + selling price (strike price) The purchaser of a call option will break even when: Selling price = buying price (strike price) + option premium The seller or a writer of a call option will break even when: Buying price = selling price (strike price) + option premium.

26. International Opportunities Put option A put option is: In the money if the spot rate is less than the strike price. At the money if the spot rate is equal to the strike price. Out of the money if the spot is greater than the strike price. Put Option Premium A put option premium will be higher when- Strike price – spot rate is larger. The time to expiration is longer. The variability of the currency is greater.

27. International Opportunities FORMULA: Put Option (Buyer) Profit = selling (strike price) – buying price – option premium Put option (seller) Profit = option premium + selling price – buying price (strike price) The purchaser or buyer of a put option will break even when: Buying price = selling price (strike price) + option premium The seller or writer of a put option will break even when: Selling price = buying price (strike price) + option premium

28. QUESTION Assume ABA corporation purchase British pound, calulate options for speculative purposes. If each option was purchased for a premium of $0.03/£ with exercise price (strike price) of $1.75/£. ABA plans to wait until the expiration date before considering whether to exercise the options. In the table, fill in the net profit or loss per unit to ABA Company based on the listed possible spot rate of the pound that may exist on the expiration date. Possible spot rate of the pound on expiration date Net profit or loss per unit to ABA should spot rate occur 1.76 xxx 1.78 xxx 1.80 xxx 1.82 xxx 1.85 xxx 1.87 xxx

29. International Opportunities SOLUTION Option premium = $0.03/£ Strike price = $1.75/£ Profit = selling price – strike price – option premium at spot rate $1.76/£ Profit = 1.76 – 1.75 – 0.03 = 0.01 – 0.03 Profit / loss = -0.02 (negative) Therefore loss = - 0.02 /£

30. QUESTION A company has sold euro put options at a premium of $0.01 per unit and with a strike price of $1.16 per unit. Assume that the put options are exercised at the levels indicated in the tables below. Determine the profit or loss per unit to the company in each case. Possible values of euros (future spot rate) Net profit/loss if the value occurs 1.12 xxx 1.13 xxx 1.14 xxx 1.15 Xxx 1.16 xxx 1.18 xxx 1.19 xxx 2.20 xxx

31. International Opportunities SOLUTION Option premium = $ 0.01 Strike price = $ 1.16 per unit Profit/ loss = option premium + selling price – buying price (strike price). = 0.01 + 1.12 – 1.16 loss = $ -0.03 per unit

32. QUESTIONS 1. A speculator purchased a call option on Swiss France at a strike price of $0.70 and for a premium of $0.06 per unit. At the time the option was exercised, if the Swiss France spot rate was 0.75. i ) Calculate the net profit per unit to the speculator. ii) What is the net profit for one contract of 62500 units? iii) What should the spot price have to be if the option was exercise for the speculator to break-even. iv) What was the net profit per unit to the seller of this option?

33. SOLUTION i ) Spot rate/selling price = 0.75 Strike price = 0.70 Option premium = 0.06 Profit/loss = selling price – buying price (strike price) – option premium Profit/loss = 0.75 – 0.70 – 0.06 Loss = -0.01 ii) Net loss = $ 0.01 unit So for 62500 units Net loss = 0.01 x 62,500 Net loss =$625 iii) The spot rate for the speculator to break even. Selling price = buying price + option premium Selling price = 0.70 + 0.06 Selling price = 0.76 The speculator will break even at $0.76 as spot rate, iv) Net profit per unit to the seller: Net profit = option premium - buying price + selling price (strike price) Net profit = 0.06 – 0.75 + 0.70 Net profit = $0.01

34. International Opportunities SWAPTION (SWAPS) Is an agreement between two counter parties to exchange two assets or payment streams. Maximization of Profit Risk Time value of money Premium ASSETS SWAPS Swap as a substitution examples include maturity swap, yield swap, currency swap, stream of payment swap. An agreement to exchange future cash flows such as interest payments (fixed or floating / varying) is usually the practice. Interest bearing assets are what are normally swapped.

35. International Opportunities GENERIC INTEREST RATE SWAPS Also called plain vanilla swaps is the most common and elementary types of swaps. Nominal principal is fixed in currency. Example of Swaps Company A – Floating contract Fixed Rate Floating Rate 18% TBill + 5% Company B – Fixed contract Fixed Rate Floating Rate 20% TBill + 3% Company A interested in a floating rates takes the fixed rates with a lower interest rate of 18% and swaps with Company B who is interested in a fixed rate, who also (Company B) takes a floating rate at TBill rate plus 3% which is lower for him to contract.

36. International Opportunities Uses of swaps Swaps can be beneficial to any entity that borrows or lends funds as in the eg above. A company that has previously entered into a borrowing or lending commitment may find themselves locked in, should the company later wish to change the nature of their commitment from fixed rates into floating rates or vice versa. It will have to seek the concurrence of the other party to the transaction on (look for someone who is interested in the transaction). Absent, such agreements the company could not unilaterally change the nature of the commitment. A swap provides an alternative for accomplishing such an objective. Some entities may find lenders aren’t willing to provide funds to them on the terms that they desire, this may be a result of their lack of experience, poor operating results or any other consideration that might impact their credit worthiness. Also lenders may, due to their expectations for the credit market be unwilling to make the type of loan that the borrower prefers. A lender expecting interest rates to rise will be reluctant to make a long term fixed rates loans while a lender expecting interest rates to fall will be reluctant to make a long term floating rate loans. Borrowers facing these problems can benefit by the use of interest rates swaps.  

37. International Opportunities Thank you All the Best