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Second BGSU International Management Conference Global Risk Management Hyatt Regency, Cleveland, OH 17-18 April 2002 Managing Global Financial Risk Using Currency Futures and Currency Options Sung C. Bae Ashel G. Bryan/Mid American Bank Professor Department of Finance Bowling Green State University Corporate Risk Management Corporate Risk Financial Derivatives Commodity Risk Commodity Price Derivatives · Ex-traded commodity futures · Risk associated with movement in commodity prices · Operational risk · Ex-traded commodity options · Commodity swaps Interest Rate Risk Interest Rate Derivatives · Risk associated with movement in interest rates · Financing and Investment risk · Forward rate agreements · Ex-traded interest rate futures · Ex-traded interest rate options · Interest rate swaps · Over-the-counter (OTC) options Foreign Exchange Risk Foreign Exchange Derivatives · Risk associated with movement in foreign exchange (currency) rates · Operational, financing, & investment risk · Forward currency contracts · Ex-traded currency futures · Ex-traded currency options · OTC options · Currency swaps Bae 2 What Derivatives U.S. Corporations Use? BI 1989 Greenwich 1992 II 1992 Treasury 1993 JKF 1995 99% 20 64 48 91% --- 64% 11 51 45 40 70% 9 6 53 93% 20/17 53 49 35 25 68 43 11 12 35 19 --- --- 29 79 14 17 83 16 --- --- 15 10 10 5 3 6 Foreign Ex. Derivatives Forward contracts Ex-traded futures/options Currency swaps OTC options --- Interest Rate Derivatives Forward rate agreements (FRAs) Ex-traded futures/options Interest rate swaps OTC Options (caps, etc.) Commodity Price Deriv. 7 6 Ex-traded futures/options Commodity swaps Equity Derivatives Ex-traded futures/options Equity swaps Bae 3 Hedging w/ Currency Futures Now Cash Market Position Short Futures Market Position Long => BUY Later Long => BUY Short => SELL Profit/Loss Loss/Profit Now Long Short => SELL Later Short => SELL Long => BUY Profit/Loss Loss/Profit Net Position Net position Bae 4 Case Study: Using Forward Prices to Reduce Capital Costs (1/5) Hewlett Packard (HP) Company: Type: Multinational corporation Major Products: computer, computer system, printer, electronic & analytical instruments Employees: 96,200 Annual Sales: $28,000,000 from 65 countries Sales distribution: US (50.1%), Europe (28.7%), Asia, Canada, and Latin America (21.2%) Bae 5 Case Study: Using Forward Prices to Reduce Capital Costs (2/5) HP Microwave Technology Division Leybold Technologies Co. Buys from a German company and has to pay in DM. Sell a thin film deposition system Quoted Prices in Purchasing Contract: •German DM: DM1,314,720 in four installments; fixed price •U.S. $: $792,000 (rate = DM1.660/$); varies based on rate on payment date. Bae 6 Case Study: Using Forward Prices to Reduce Capital Costs (3/5) Sales and Capital Budget of Microwave Technology Division, HP Annual Sales Capital Budget (equipment only) 1990 1992 $15,000,000 $23,000,000 $10,000,000 ($2,500,000) $22,000,000 ($7,500,000) Foreign Sources of Equipment Purchases by MT Division Country Japan Amount Percentage (%) $4,500,000 60.0 Germany 1,200,000 16.0 Austria 1,000,000 13.3 800,000 10.7 $7,500,000 100.0% England Total Bae 7 Case Study: Using Forward Prices to Reduce Capital Costs (4/5) Payment Schedule: 7/90 9/90 0 2 month DM 262,944 (20%) 12/90 5 month 262,944 (20%) 3/91 8 month 5/91 10 month 591,624 (45%) 197,208 (15%) Hedging Through Forward Contracts: Payment rate DM1.66/$ Payment in $ 158,400 158,400 356,400 118,800 Total: $792,000 Actual rate 1.5701 1.4982 1.6122 1.7199 $ Equivalent 167,470 175,507 366,967 114,663 Total: $825,407 Profit (loss) $9,070 $17,107 $10,567 ($4,137) Net Profit = $32,607; 4.1% of total purchase amount Bae 8 Case Study: Using Forward Prices to Reduce Capital Costs (5/5) Strategy/Action: Examining the forward rates of DM against US dollar over the future payment dates, HP concluded that DM would strengthen against US dollar over this period. Based on this expectation, HP made forward contracts with its bank to purchase DM at the rate of DM1.660/$ (the rate available on May 1990) on payment dates. By doing this, HP: • Was able to maintain the desired dollar cost regardless of the dollar/DM movement;. • Was able to eliminate currency risk for the Germany supplier. Bae 9 Currency Futures versus Currency Options Currency Futures Obligation to buy/sell FC Currency Options Right to buy/sell FC No premium payable Premium payable Only one forward rate for Wide range of strike prices a particular delivery date Fixed delivery date of currency Flexible delivery date (can buy longer-maturity one) Eliminates upside potential & downside risk Unlimited profit potential & limited downside risk Bae 10 Hedging w/ Currency Options Future FC Position Future FC Flow When Short When Long Position in FC is Position in FC is Expected Expected FC to be paid at FC to be received future date at future date Type of Firm Importer of raw materials Exporter of finished goods Purpose of Hedging Hedging Strategy To limit loss from To limit loss from possible FC possible FC Buy Call Option Buy Put Option Bae 11 Usefulness of Currency Options Currency options are especially useful when: FC cash flows are contingent that cannot be hedged with forward contracts. Ø Example) acceptance of a bid The quantity of FC to be received or paid out is uncertain. Ø Uncertain FC accounts receivables Ø Uncertain FC accounts payables Bae 12 General Rules General Rules on Using Currency Options versus Currency Futures When the quantity of FC cash outflow is known, buy currency forward; when unknown, buy a currency call option. When the quantity of a FC cash inflow is known, sell currency forward; when unknown, buy a currency put option. When quantity of a FC cash flow is partially known and partially uncertain, use a forward to hedge the known portion and a currency option to hedge the maximum value of the uncertain remainder. Bae 13 Case Study: Using Currency Options to Hedge FX Risk of Uncertain Payables (1/3) Cadbury Schweppes (CS) Company: Type: British multinational corporation Major Products: soft drink (55%) and candy (45%) Employees: 39,066 Annual Sales: $5,730,000,000 Operations: Markets in more than 170 countries Britain (43%); Erope (20%); North America (17%); Asia (14%). Bae 14 Case Study: Using Currency Options to Hedge FX Risk of Uncertain Payables (2/3) Situation: The price of CS’s key product input, cocoa, is quoted in sterling, but is really a dollar-based product. => As the value of the dollar changes, the sterling price of cocoa changes as well. The objective of CS’s foreign exchange strategy is to eliminate the currency element in the decision to purchase the commodity, thus leaving the company’s purchasing managers able to concentrate on fundamentals. This task is complicated by the fact that the company’s projections of its future purchases is highly uncertain. Bae 15 Case Study: Using Currency Options to Hedge FX Risk of Uncertain Payables (3/3) Strategy/Action: CS has turned to currency options. After netting its total exposure, the company covers with forward contracts base amount of exposed, known payables. It covers the remaining, uncertain, portion with dollar-put-options up to its maximum amounts. In this strategy, the put options act as an insurance policy. Bae 16 Case Study: Using Currency Options as a Competitive Tool (1/7) Allied Signal, Inc. (AS) Company: Type: N.J.-based U.S. multinational corporation Major Products: aerospace (38%), automotive (38%), engineered materials (24%). Employees: 86,400 Annual Sales: $11,827,000,000 Operations: U.S. (78%); Europe (16%); Canada (2%). Bae 17 Case Study: Using Currency Options as a Competitive Tool (2/7) Situation: Was submitting an overseas bid to sell scientific equipment to a Scandinavian firm for $20 million. Payments to be made in unequal disbursements at six irregularly spaced dates over two years. The principal competitor was a French firm. Had superior technology and lower cost, but was concerned about presenting a bid denominated only in U.S. dollars, since the French firm’s bid was in Norwegian kroner. Hence, AS was confronted with: (1) a high degree of uncertainty about success of the bid, (2) a need to establish costs and revenues in local currency. Bae 18 Case Study: Using Currency Options as a Competitive Tool (3/7) Strategy/Action: AS bought from its bank a multiple option facility: a two-year American-style call option on the dollar, with puts against each of the four non-dollar currencies--deutsche marks, French francs, Finnish markka, or Norwegian kroner. => Through this option contract, the Scandinavian customer could choose its preferred currency of payment on each successive payment date. Bae 19 Case Study: Using Currency Options as a Competitive Tool (4/7) Strategy/Action: The strike prices for the options were set at the spot levels when the deal was struck (1.7 deutsche marks, 5.7 French francs, 6.5 Finnish markka, and 4.0 Norwegian kroner). => These strike levels give the Scandinavian customer a ceiling on the amount of foreign currency it will have to pay at any time, while guaranteeing that the U.S. firm will always receive the full dollar price. Bae 20