Chapter 3 : Exchange rate risk

management
 Some Keywords :
• Exchange rate risk management
• Structural exchange position
• Exchange rate risk measurement
• Hedging techniques (internal/External)
• Leads and lags, Netting, Pooling, options,
put, call, swap.

2
 Chapter plan

• Introduction
• Exchange rate risk measurement
• Internal foreign exchange hedging techniques
• External foreign exchange hedging techniques

3
I/ Intrduction

4
 Framework

• What are the origins of currency risk?

• How to assess this risk?
• What is the purpose of managing the
currency risk?
• How to hedge against the currency risk?

5
 Framework
• A company faces a currency risk if some of its
claims or commitments are denominated in
foreign currencies (affected by exchange
rate)
• The foreign risk management has two
aspects :
- Accurately determine the foreign exchange
position, currency by currency.
- Consider the useful hedging techniques
6
 Framework
• Exchange rate instability : the dollar – yen case

7
 Definitions

The Exchange rate risk :

• The risk of capital loss related to future
exchange rate variations
• An agent is exposed to a currency risk when his
exchange position is open (commitments ≠
claims)

8
 Definitions
• What operations lead to foreign exchange
risk?
• The currency risk can arise from :
- Commercial activities (transactional risk)
- Financial transactions
- Economy (competitiveness risk)

9
 Definitions
• Transaction risk
- Time gap between settlement and engagement
of a commercial transaction.
- Sales (purchases) case : exportations
(importations) are invoiced in foreign currencies
- Call for tenders established in foreign currencies
• Exchange risk related to financial operations
- Lending and/or borrowing in foreign currencies
- Asset portfolio
10
 Definitions
• Economic exchange risk : competitiveness risk
• ~ Impact of exchange rate variations on firm’s
sales and profit (impact of an evolution of
currencies on the company’s position)
• ~ Raw material prices
• ~ Drop in the invoicing currency of a competitor

11
 Example : Economic risk
• For the exchange rate 1 USD = 0.9 EUR
A product is sold for 50 USD which is equivalent to a
flow of :
50 * 0.9 EUR = 45 EUR
• If the USD drops to 1 USD = 0.8 EUR
the flow is no more than 40 EUR
• Alternatively, to maintain the flow to 45 EUR one can
increase the price to :
45/0.8 = 56.26 USD
 You may lose market share
12
 Section 2

Evaluation of the exchange rate

risk

13
 Currency risk measurement
• The currency risk can arise even before its
accounting recognition
• The risk can be detected in advance
• The risk can be :
- Random
- Conditional
- Real

14
 Currency risk measurement
• The currency risk is random when there is no
definite commitment from the exporter or the
importer
• The currency risk is conditional if :
- The commitment of a partner is irreversible while
the other partner has not expressed his will
- The completion of the contract is uncertain
• The currency risk is real if both partners
(supplier/customer) have committed themselves
irreversibly.
 This currency risk will be eliminated at the time
of regulation
15
 Synthesis
Importer case Nature of the risk

Budgeting, setting cost prices Random

through the use of imported goods
Foreign suppliers proposition Conditional

Order, contract signature Real

Invoicing, product shipment Real

Purchase of currency paid for Minimized

settlement
16
 Synthesis
Exporter case Nature of the
risk
Budgeting, catalog preparation, Random
making a tender
Submit a catalog, submit a tender Conditional
Order, contract signature Real
Invoicing, product shipment Real
Selling foreign currency received Minimized
as payment
17
 Netting
• There is exchange rate risk if commitments are
different from claims  open position
• Open long position if the company has net
claims (or awaiting for money entry) in foreign
currency
• Exposure to risk, also known as foreign
exchange position, is the number of currencies
that must be paid or received.
• The net position is obtained after netting assets
and liabilities having the same maturity.

18
 Netting
• Claims and commitments denominated in different
currencies could not be netted
• Example :
A claim denominated in yen and having as
exchange value 100,000 Euros is not netted with a
commitment of the same amount but denominated
in dollars.
An unlucky player woud know a deterioration of his
two positions due to yen depreciation and dollar
appreciation.

19
 Netting

• Claims and commitments for the same

currency can not be netted if their
maturities are different.
• Therefore we should dispose, currency by
currency, of a flow timetable, which is not
usually possible : one had better to adopt
the hedging strategy.

20
 Netting
• A system allowing to periodically settle only
balances (after netting)
• Reduces settlements outside the group by
limiting intercompany flow transfer
• Netting the set of flows resulting from
commercial and financial transactions
• Bilateral/multilateral netting (multi- currencies
or not)
• Feasible only when all settlments are due at
the same date
21
 Netting
• Example : Netting system between subsidiaries

22
 Comments
• The generalization of the netting procedure
(between several subsidiaries) for large groups
will considerably reduce the transaction costs by
minimizing the financial flows
• The creation of a clearing center (netting room)
facilitates such an operation.
 Rationalize the regulations within the group
(lowers the number and / or transaction costs and
absence of redundant hedging).

23
 Comments
• All payments are taken into account
• Invoices are no more established for subsidiary
clients but ordered to the reinvoicing center who
settle their invoices in their currencies and thus
ask for settlments from its clients
 The exchange risk is supported by the
reinvoicing center who regularly sets up an
internal exchange rate for the group
 The invoicing center is localized in a country
which is not submitted to exchange regulations

24
 Example

• Invoices of a French subsidiary and

denominated in GBP are set up in the
name of the reinvoicing center
• The reinvoicing center settles the French
subsidiary in euros and encashes GBP
from the clients

25
 Foreign exchange positions

• How many types of foreign exchange

position could exist?

26
 Foreign exchange positions
• There are many types of foreign exchange
positions :

- Spot position
- Forward position
- Overall foreign exchange position

27
 Foreign exchange positions
• To estimate these positions we use a book bill in
which are recorded, maturity by maturity, all
claims and commitments of the company.
• The forward exchange position is the number of
currencies that we should pay or receive in the
future
• The spot foreign exchange position is the
number of currencies we should pay or receive
at time 0
• The overall exchange position is the number of
currencies one holds or owes, all maturities
included.
28
 Bill book
• When setting up a bill book, should appear :
• - currency flows matched with their amounts and
dates of payment
• - flow forecast for which exchange rates are
already fixed (i.e catalog sales)
• - Separatly, commitments on not fixed prices and
which do not necessarily become true (case of
certain tenders)
• On the other hand, should not appear flows for
which a commitment price does not exist from the
company
29
 Foreign exchange positions
Example 1
T T=0 T=1 T=2 T=3 T=4
+8 USD +1 USD +1 CHF +300 JPY +3 USD
+3 CHF -1 CHF -2 CHF +2 GBP +200 JPY
+6 GBP +2 USD +3 USD -3 GBP +1 GBP
+200 JPY -100 JPY
+2 USD
+ 100 JPY
-4 GBP
-3 GBP
-7 CHF

30
 Foreign exchange positions
Example 2
Forward Exchange position
T=0 T=1 T=2 T=3 T=4
In USD +3 USD +3 USD 0 +3 USD
In JPY 0 0 +200 JPY +200 JPY
In GBP 0 0 -1 GBP +1 GBP
In CHF -1 CHF -1 CHF 0 0

 The forward exchange postition at time t = 2 in USD is +3 USD

31
 Foreign exchange positions
Example 3

Spot exchange position

t T=0 T=1 T=2 T=3 T=4

In USD +10 USD
In JPY +300 JPY
IN GBP -1 GBP
In CHF -4 CHF

 The spot exchange postition in JPY is +300 JPY

32
 Foreign exchange positions
Example 4

Overall foreign position

t T=0 T=1 T=2 T=3 T=4
In USD +19 USD
In JPY +700 JPY
IN GBP -1 GBP
In CHF -6 CHF

 The overall exchange postition, all maturities included, in CHF

is -6 CHF

33
 Foreign exchange positions
Example 5
• Assume the following quotations :
** USD/EUR = 0.85
** JPY/EUR = 0.009
** GBP/EUR = 1.50
** CHF/EUR = 0.70
The analysis could be based on the Euro
couterpart of other currencies.
The overall foreign exchange position has a
counterpart in euros :
19 * 0.85 + 700 * 0.009 - 1 * 1.50 – 6 * 0.70 =
16.75 EUR
34
 Synthesis
Currency evolution Consequences
on result

Short Currency value Increase Loss

posititon Currency value decrease Gain

Long Currency value Increase Gain

position Currency value decrease Loss

35
 Framework

• In which case should the company hedge

against the exchange rate risk?
• Companies do not hedge if they anticipate
a favorable evolution of exchange rates
according to their foreign exchange
position.

36
 Framework
• A premium situation (forward rate > spot
rate) on a currency disadvantages the
buyer (advantages the seller) of this
currency.
• A discount situation (forward rate < spot
rate) on a currency advantages the buyer
and disadvantages the seller of this
currency.

37
 Illustration

• Assume the following situations :

- a French importer should settle in 6
months an invoice denominated in USD.
The amount is M.
- a French exporter waits for a settlment of
an amount equals M USD from a customer
in 6 months.

38
 Example 1
• Case of an exporter to the US  reception
of foreign currency (dollars)
• The direct spot is : USD/EUR = 1
• The forward rate is : USD/EUR = 1.1 (the
dollar is in premium). Your anticipation of
the forward rate is 1.2 (dollar’s
appreciation higher than the premium)
• What to do? Hedge or not hedge?
39
 Example 1
• On the basis of 1 billion of dollars, if the
company hedges, it gets 1.1 billions of euros
• If the company does not hedge and anticipation
holds, the company gets 1.2 billions of euros
In this case, on the basis of this anticipation it is
more profitable to not hedge
In contrast, if one anticipated the forward
USD/EUR = 1, it is more interesting to hedge
because hedging allows to get 1.1 billions of
euros whereas not hedging allows to get only 1
billion of euros
40
 Premium case
• There is no need to hedge if :
* The exporter anticipates an appreciation of the
dollar higher than the premium
* The importer anticipates an appreciation of the
dollar less than the premium
• The signature of a forward contract is justified if :
* The exporter anticipates an appreciation of the
dollar less than the premium
* The importer anticipates an appreciation of the
dollar higher than the premium
41
 Premium case

• An exporter signing a forward contract

accepts to limit his gain to (F - S) * amount
• An importer signing a forward contract
accepts to incur a loss of (F - S) * amount

42
 Discount case
• There is no need to hedge if :
* The exporter anticipates a depreciation of the
dollar less than the discount
* The importer anticipates a depreciation of the
dollar higher than the discount
• The signature of a forward contract is justified if :
* The exporter anticipates a depreciation of the
dollar higher than the discount
* The importer anticipates a depreciation of the
dollar less than the discount
43
 Discount case

• The exporter accepts to incur a loss of

(F – S) * amount
• The importer accepts to limits his gain to
(F – S) * amount

44
 Section 3

Internal foreign exchange

hedging techniques

45
 Objectives
• These are techniques that don’t lodge an
appeal to a bank or a market (i.e external
institutions)
• Internal foreign exchange risk management has
two main objectives :
* Preventive minimization of the exchange risk
* Allows for a global foreign exchange risk
management
* Many possibilities exist in this context

46
1/ Choice of the invoicing currency
• The invoicing currency is the currency in which
is denominated the purchasing or the sale
contract
• It is often the domestic currency
• It could also be a third currency (not the seller’s
currency nor the buyer’s currency)
• One of the contractors can require an escalator
clause to hedge against the exchange rate risk.
• Further hedging means
 Choose a strong currency for exportations
 Choose a weak currency for importations
47
 2/ Leading and lagging
2.1/ Framework
• Facing a transaction risk, multinational
company treasurers adopt a dynamic method
of exchange risk management going beyond
hedging instruments : leading and lagging
• The company tries to modify the maturity of
some contracts in a suitable way in order to
minimize the exchange risk or even draw a
gain from it.
 Speed up settlments of incomings denominated in weak
currencies
48
 2/ Leading and lagging
2.2/ Forms of the leading and lagging process
►Modification of the invoicing currency
• Exporters try to denominate their claims in
currencies for which they anticipates an
appreciation
• In contrast, importers try to denominate
their commitments in currencies for which
they anticipate a depretiation

49
 2/ Leading and lagging
2.2 / Forms of the leading and lagging process
►A modification of the purchasing or selling time
of currencies (leadings and laggings) i.e
accelerate or delay time laps.
• Leads consists in advanced payments : an
exporter anticipating a depreciation of the
invoicing currency will try to accelerate the
encashment of his claim.
• Lags consists in postponed payments : an
exporter anticipating an appreciation of the
invoicing currency will try to postpone the
encashment of his claim
50
 3/ Escalator clause
3.1/ Principle

• Include an indexation clause in the purchasing or

selling contract allowing prices to change with
inflation or interest differential
•  Protect against the foreign exchange risk
• The company does no more support an exchange
risk of the same type of the interest rate one (IRP) or
the inflation one (PPP)
•  The risk is not definitely discarded
51
 3/ Escalator clause
3.2/ Clause examples
• Monetary indexation (escalator) clauses
•  Adaptation of prices to exchange rate fluctuations
•  Indexation to a currency or a basket of currencies
•  « Tunnel » indexation clause
• Shared (divided) risk clauses
•  Exchange rate risk is shared between the two parties
to the contract (buyer and seller)
• Multicurrency clauses :
• → Write the contrat in many currencies at time 0
• → By the term of the contract, one of the parties to the
contract chooses the settlement currency

52
 Other techniques : Pooling

• All treasury flows are centralized

• The foreign currency excess of certain
subsidiaries is used to finance the foreign
currency needs of other subsidiaries.

53
 Other techniques : Discount

• Exporters give a discount for anticipated

payments
•  Additional costs supported by exporters

54
 Other techniques :Currency
diversification
• ► Foreign treasury management centralization
permits to:
• Cover the balance in every currency
• Reduce the global exchange risk by currency
diversification (portfolio diversification)
• Foreign exchange losses and gains of different
currencies compensate, at least partially
 Only balances are concerned with hedging
• Important : Currency diversification should be
considered only when foreign treasury
management is centralized
55
 Example of currency diversification
• Assume an American mother company having two
subsidiaries : European (X) and Japanese (Y)
• In one month :
• X should settle a debt of 5 B EUR and receive 500 B
JPY
• Y should pay 700 B JPY and receive 7 B EUR
•  Centralization allows to record a receipt of 2 B
EUR and a spending of 200 B JPY
•  The group has to hedge against a depreciation of
the EUR and an appreciation of the JPY
56
Example of currency diversification
• According to the currency diversification
principle, EUR fluctuations can be
compensated by those of the JPY
• → If the Spot rates are USD/EUR = 1 and
USD/JPY = 100, the treasury balance = 0
• → If the forward rates in one month are
USD/EUR = 0.8 and USD/JPY = 80, the
treasury balance = 0
• → A currency gain can compensate an
other currency loss
57
 Section 4

External foreign exchange

hedging techniques

58
 Introduction

• When internal hedging techniques are

insufficient, traders (mainly those operating
on business transactions) can hedge by tying
up contractual relationships with third parties.
• Resort to specialized financial institutions
(banks) and market institutions (market of
foreign exchange hedge and banks)

59
 Introduction
• The foreign exchange hedging can be
related to a short position or a long position
• To hedge against a long (short) position,
the used instrument must allow to minimize
the consequential loss resulting from a
decrease (increase) in the exchange rate
without being exposed to the risk of
increase (decrease)

60
1. Hedging in the monetary market:
Definition

• And/or in the interbank market

• Lending (borrowing) in a given currency to
compensate a loan (lending) in an other
currency for the same amount and maturity

61
1. Hedging in the monetary market:
Example
• A French exporter waits for 100,000 USD
in 3 months.
• The spot rate is USD/EUR = 1
• The 3 month premium rate of the dollar
against euro is 3.125%
• The annual interest rate in the American
market is 5%
• How to make a gain in this situation?
62
 1. Hedging in the monetary market:
Example
• The hedging operation is the following :
• At time t = 0 the exporter borrows an amount M USD (for
the period of 3 months) from the market. This amount
allows him to return 100,000 USD to the bank by using the
expected incomings from the exportation
•  M = 100,000/(1+5%/4) = 98 765 USD
• He converts the borrowed amount M at the spot rate
USD/EUR = 1 to get an amount M’ EUR
M '  M *1  98765 *1  98765 EUR
• Investing the obtained amount M’ in the European
monetary market at the annual European interest rate

63
1. Hedging in the monetary market:
Example
• Calculation of the european interest rate
according to the IRP principle :
F  S i  i'
  i  i'
S 1  i'

•  5%+(3.125%*4) = 17.5% (in annual term)

• After 3 months, the exporter obtains :
98765 * (17 . 5 % / 4 )  103086 EUR
• The 100,000 USD of the client pay back the first
loan
64
 2. Foreign currency advance:
Definition
• Ask for an advance (lending) in foreign currency
from the bank in case of a claim (debt) in foreign
currency for a given maturity
• The demand should be for the same amount,
same currency and same maturity
• The currency advance has a double advantage :
•  Hedging against the exchange rate risk
•  A technique to finance importations

65
 2. Foreign currency advance:
Principle
• The European exporter requests a loan
from his bank. The amount of the loan
should equal the claim from the foreign
client
• He sells the advanced foreign currency
and improves his treasury in euros
• He gives back the foreign currency
advance to the bank using the settlment
from the foreign client
66
 2. Foreign currency advance:
Example
• A European exporter, who will receive 100,000 USD in 3
months, obtains an advance of the same amount with an
annual interest rate = 10%.
•  Today, his loan should amounts to :
100000 /(1  10% / 4)  97561 USD
•  This represents the net loan amount
• He converts this amount into euros using the spot
exchange rate USD/EUR
•  improving his treasury in euros
• After 3 months he uses the exportation payment to
reimburse the loan of 100000 USD

67
 4. Forward hedging :
Principle
• The main external hedging instrument
• Consists in taking a forward position of the same
amount and in opposite direction relative to the initial
foreign exchange position
• Currency delivery takes place at an ulterior date (1
month, 3 months, 6 months) but the exchange rate is
the one fixed at time t = 0
• All exchange conditions are fixed in advance (at time
t = 0) but the contract execution is fixed to a future
date
• The forward hedging can be done with forward
contracts or with futures contracts
68
 4. Forward hedging :
Forward contract
• Hedging a long (short) exchange position
by forward selling (purchasing) the
expected foreign currency amount
• The contract is perfectly adapted to the
company needs (adjusted according to the
company demand)
• The delivery date is fixed in advance
• The settlment takes place by the term of
the contract
69
 4. Forward hedging :
Example of forward contract

• Let’s consider a French exporter who will

receive 100 000 CHF in 3 months
• The spot rate is CHF/EUR = 0.62
• The 3 month forward rate is CHF/EUR =
0.6060
• How to hedge in this situation?

70
 4. Forward hedging :
Example of forward contract
• The forward contract consists in selling CHF
against EUR in 3 months
• By the end of the contract, the exporter receives
100 000 CHF that he exchanges against 60600
EUR according to his contract which was set up
at time t = 0
• The exporter suffers from a loss of profit of
62000 – 60600 = 1340 EUR relative to the spot
rate
• The loss would be more important if the spot
rate were higher (i.e 0.64)
71
 4. Forward hedging :
Futures contract
• A definite engagement to sell or purchase
a given amount of a currency or an asset
at a price and a date fixed in advance (at
time t = 0)
• The operations related to futures contracts
take place in an organized market with a
clearing house where are exchanged
standardized contracts
72
 4. Forward hedging :
Futures contract
• 4 questions are to be clarified when choosing a
futures contract :
•  Contract direction : evolution of the exchange
poisition function of the evolution of the
exchange rate
•  Determination of the number of contracts to
buy or sell
•  Contract maturity : ideally maturity = portfolio
hedging horizon
•  Contract choice : the contract concerns the
same asset to be hedged

73
 4. Forward hedging :
Example of Futures contract
• A Swiss exporter will receive 1,000,000
EUR in 3 months
• The standard amount of a futures contract
is 125,000 EUR
• The spot rate is EUR/CHF = 1.6172 and
the future contract rate is 1.5950
• What to do in this situation?

74
 4. Forward hedging :
Example of Futures contract
• The sale of futures contracts on CHF should
lead, at maturity, to a sale of 1,000,000 EUR
• The standard amount of a futures contract is
125,000 EUR
•  one should thus sell 1,000,000/125,000 = 8
contracts
• At maturity, in return of 1,000,000 EUR, the
exporter will receive certainly 1 000 000 * 1.5950
= 1,595,000 CHF
75
 4. Forward hedging :
Mechanics of futures trading
• Before placing an order to trade futures
contracts, an individual must open an account
with a broker. Because, the risk of futures
trading can be quite high, the individual must
make a minimum deposit – usually at least
$5000 – and sign a disclosure statement
acknowkedging the possible risks.

76
 4. Forward hedging :
Mechanics of futures trading
• Placing an order
Under a pit trading system, when an investor places an
order, the broker phones the firm’s trading desk on the
exchange floor and relays the order to the firm’s floor
broker.
The floor broker goes to the pit in which the contract
trades. The pit is an octagonal- or polygonal-shaped ring
with steps descending to the center. Hand signals and a
considerable amount of verbal activity are used to place
bids and make offers. This process is called open outcry.
When the order is filled, the information is relayed back,
ultimately to the broker’s office, where the broker 77
telephones the customer to confirm the trade.
 4. Forward hedging :
Mechanics of futures trading
• Role of the clearinghouse
For each transaction, obviously, there is both a
buyer, usually called the long, and a seller
typically called the short. In the absence of a
clearinghouse, each party would be responsible
to the other. If one party defaulted, the other
would be left with a worthless claim. The
clearinghouse assumes the role of intermediary
to each transaction. It guarantees the buyer that
the seller willl perform and guarantees the seller
78
that the buyer will perform.
 4. Forward hedging :
Mechanics of futures trading

• The clearinghouse keeps track only of its

member firms. The clearing firms, in turn,
monitor the long and short positions of
individual traders and firms. All parties to
futures transactions must have an account with
a clearing firm or with a firm that has an
account with a clearing firm.

79
 4. Forward hedging :
Synthesis
Forward Futures

Private contract between 2 parties Compound in a market

OTC Standardized

Specified delivery date Many dates

Settlement by the term of the Daily settlement

contract
Definite delivery by the term of the Often settled before maturity
contract
Counterparty risk No counterparty risk

80
 5. SWAP : Definition
• Is a derivative contract
• A swap is an exchange of financial flows between two
entities during a certain period of time
• The swap is particularly adapted to a long-term risk
management
• The swap, also called broker swap, is a transaction by
which two parties exchange financial flows of the same
kind denominated in two different currencies
•  Simultaneous operations of borrowing and lending

81
 5. SWAP : Principle
• At time t = 0, the two counterparties
exchange the amounts of their
commitments at the spot rate of time 0
•  Spot exchange operation
• At the maturity, they pay back the amounts
at the prefixed forward rate
•  Exchange operation with a forward rate
•  Double exchange operation (spot and
forward)
82
 5. SWAP : Example
• A French company has to start a building site in
the United States
• The company is asked to pay a guarantee
deposit in US dollars in order to guaranty the
good execution of the project
• This amount will be refunded to the company if
its work corresponds to engagements. In
contrast, if there is a delay or non conformity, this
amount would be booked.
• The deposit amounts to 500,000 USD. It should
be paid on October 24th, 2013 and restituted on
October 24th, 2014 if engagements are
respected.
83
 5. SWAP : Example
• Confident about respecting its engagements, the
company decides to set up a broker swap allowing to
hedge this operation
• The bank transmits the following quotes to the
company
• Spot : EUR/USD = 0.9263 – 68
• 1 year EUR discount : 0.0138 – 0.0115
• The 1 year forward rate is then :
EUR/USD : 0.9125 – 53  USD/EUR : 1.0925 - 59
• The spot rate USD/EUR : 1.0790 - 96
84
5. SWAP : Example

85
 5. SWAP : Example
• On October 24th, 2013 the company receives from
the bank the 500,000 USD swap counterpart that
it uses to pay the guarantee
• In return the company pays 539,800 EUR to the
bank (500 000 * 1.0796)
• On October 24th, 2014, the French company gets
back its guarantee deposit, the 500,000 USD
• It gives the 500,000 USD to the bank and gets in
return 546,250 EUR (500,000 * 1.0925)

86
 6. Currency swap :
Definition
• This form of hedging is also called cross
currency swap
• A currency swap consists in spot purchasing
and forward selling (or inversely) a foreign
currency in order to get an exchange hedging
• It is used to benefit from an attractive
differential between the domestic market and
the foreign market

87
 6. Currency swap :
Principle
• Today (time t = 0) : exchange of capital
Flows denominated in two different
currencies
• Interest calculated on the corresponding
currency
• At maturity, exchange of capital

88
6. Currency swap :
Principle

89
 6. Currency swap :
Example
• A French company hopes to establish a sales
point in Switzerland
• By this sales point the company will receive a
turnover denominated in CHF
• In order to minimize its exhibition to foreign
exchange risk the company hopes to finance this
establishment by a loan in CHF
• However, it is not well known by the Swiss
banks to benefit from attractive loan conditions

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 6. Currency swap :
Example
• Thus, it decides to borrow 500,000 EUR for a 5 year period
from a French bank at a 6% interest rate
• After that it is engaged in a currency swap which allows it
to exchange its committment in EUR against a
commitment in CHF that a Swiss company wanting to
establish a sales point in France contracts
• The French company pays the interests of the Swiss
company commitment thanks to the incomings of the new
sales point
• The Swiss company, counterparty of the currency swap,
does the same thing thanks to its sales point in France

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 6. Currency swap :
Example
• The currency swap characteristics are the
following :
• Interest rate on the commitment in euros
for the French company is : 6%
• Interest rate on the commitment in CHF for
the Swiss company is : 4%
• Exchange rate EUR/CHF = 1.4800 used
for the initial exchange in 2013 and the
final exchange in 2018
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 6. Currency swap :
Example
• On October 2013, the French company borrows 500,000
EUR and receives, in return, 740,000 CHF from the swiss
company who has borrowed them from a Swiss bank (500
000 * 1.4800)
• Every October until 2018 the two companies exchange the
amounts of interest
• The French company indirectly pays the interests on the
loan in CHF
•  740,000 * 4% = 29,600 CHF
• The Swiss company indirectly pays the interests on the
loan in EUR
•  500,000 * 6% = 30,000 EUR
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 6. Currency swap :
Example
• On October 2018, the French company
pays 740,000 CHF to the Swiss company
against 500,000 EUR which it uses to pay
back its loan to the French bank
• The Swiss company does the same thing
to reimburse the Swiss bank with the
740,000 CHF

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 7. Currency option :
Definition
• Foreign exchange options are grown even faster
than currency futures
• They are traded mainly in the over the counter
market but they are also well developed in the
organized markets (PHLX, LIFFE,…)
• An option is a contract between two
counterparties by which one counterparty grants
the other the right (but not the obligation) to
purchase from him or sell to him a financial
asset at a fixed price.

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 7. Currency option :
Definition
• The transaction will take place at a future date
and at a price fixed in advance
• The holder of the contract has the possibility to
run or not this opertation
• In contrast, the seller has the obligation to run it
• The option allows to its buyer to hedge against a
possible exchange loss, but the latter has the
possibility to not run his option in order to benefit
from a favorable evolution of exchange rates

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 7. Currency option :
Definition
• Two kinds of options exist :
•  European option : the exercise of the option
could take place only on its expiration date
•  American option : The option can be
exercised during the life time of the contract until
its expiration date. This kind of options is more
widespread and flexible
• All things being equal, the premium related to an
American option is higher than the one of a
European option

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 7. Currency option :
Definition
• The two negociated contracts are :
•  Call option : the right to purchase a currency
X is called « X call »
•  Put option : the right to sell a currency Y is
called « Y put »
• Since the purchasing or selling of a currency X
assumes a counterpart in a currency Y, a Call
option (Put option) of a currency X is also a Put
option (Call option) of a currency Y

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 7. Currency option :
Definition
• When the exercise price, K, of the option is higher than
the spot rate, S (the forward rate for a European option),
the option is called « in the money » for a put and « out
of the money » for a call.
• If K > S, one would benefit from exercising the put but
not the call
• Inversely, if K < S, one would benefit from exercising the
call but not the put
• When the exercise price equals the spot rate, the option
is called « at the money »
• The result (gain/loss) of an option is always calculated
relative to the spot rate (forward rate for the European
options) of the traded currency

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 7. Currency option :
Princinple
• The buyer of a currency call acquires the right -
and not the obligation - to purchase a certain
amount of a currency at a price fixed in advance
(date of purchase of the call), called strike-price,
K, before or at a given date, called strike-date
• The buyer of a currency put acquires the right -
and not the obligation – to sell a certain amount
of a currency. As in the case of a call, the strike-
price and strike-date are fixed in advance.

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 7. Currency option :
Princinple
• Then the holder of an option can freely decide whether
to exercise it or not = purchase or sell the currency at the
exercise price. But he can also renounce to use this right
if the exchange rate he can obtain in the foreign
exchange market is more attractive.
• The currency option allows therefore its holder to hedge
against exchange rate risk and preserving the
opportunity to make an exchange rate gain in case of a
favorable evolution of exchange rates
• During the lifetime of the option, if the spot rate is more
interessant than the forward rate, the holder of the option
would decide to not exercise his right.

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 7. Currency option :
Princinple
• In return, for the service and the risk incurred
by the seller of the option (generally a banker),
a premium - whose value depends on the
currency, hedging period, strike-price - should
be paid by the buyer of the option.
• The risk incurred by the buyer of the option is
limited to the value of this premium

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 7. Currency option :
Princinple
• The outcome of an option occurs according to 3
ways :
•  The abandonment of the option if the buyer of
the option finds advantageous to purchase (or to
sell) his currency in the foreign exchange market
•  The exercise of the option in the opposite case
•  The resale of the option when it still has a
positive value and the buyer still has not yet
exercised it

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 7. Currency option :
Princinple
• When would a company exercise an option?
• A importer - who wants to hedge against an
appreciation of the currency in which he is charged
- buys a currency call
•  If the price of the currency has effectively
strongly increased and is above the strike-price,
the company has interest to exercise the option
•  If, in contrast, the price of the currency has
strongly decreased (under the strike-price) the
company has interest to abandon the exercise of
the option and exchange its currency in the spot
market
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 7. Currency option :
Princinple
• When would a company exercise an option?

• An exporter purchases a put to hedge against a

depreciation of the currency in which he charged
his foreign client
•  If the price of the currency has effectively
strongly decreased and is below the strike-price,
the company has interest to exercise the put
•  If, in contrast, the price of the currency has
strongly increased and is above the strike-price,
the company has interest to not exercise the put
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 7. Currency option :
Advantages and Disadvantages
• the main advantage of this instrument compared to the
forward instrument and the futures instrument is based on
its conditional character
• The option gives to its holder the right and not the
obligation to purchase or to sell a given amount of a
foreign currency
• The currency option is a particular instrument adapted to
hedge not only certain risks but also uncertain risks
• The use of options is interesting only if one deals with
operations having important amounts of foreign currency :
the realized gain should compensate for the paid premium

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 7. Currency option :
Illustration
• An exporter responds, in foreign currency, to an
invitation of tenders and does not know if its
supply would be accepted
• In case of decrease of the concerned currency,
his margin risks to be amputated in some
proportion that would implicate the profitability of
the project
• Inverse to forward heging and currency leading
the holding of an option allows to not to commit
himself to deliver the foreign currency of which
he is not sure to encash as much as his
proposal is not accepted
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 7. Currency option :
Illustration
• In case of acceptance of his proposal, the
option allows him to benefit from a favorable
evolution of underlying currency by
abandonment of the put
• Companies selling on the basis of catalogs
also face an uncertain foreign exchange risk
related to a random estimated turnover that
they have better to hedge by a currency put

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 7. Currency option :
Profile of the result of a call buyer
• The buyer pays a premium, p, and the underlying
strike-price is K
• The buyer of a call would exercise his option if the
direct quote of the underlying currency (Spot price of
the underlying currency at the exercise date) is
superior to the contract price (strike-price)
• This is the case when S > K, because if S increases
this means that the foreign currency appreciates and
thus becomes more expensive to the purchase
relative to the secondary currency
• Call return = max(0, S – K) - p

Future Spot 109

 7. Currency option :
Profile of the result of a call buyer

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 7. Currency option :
Profile of the result of a put buyer
• The buyer pays a premium, p, and the underlying strike-
price is K
• Inversely, the buyer of a put profits from the option if the
price of the underlying currency is inferior to the contractual
price
• For the USD/EUR quote, if S < K, the principal currency
(USD) depreciates relative to the secondary currency (EUR)
• By selling the principal currency (USD) against the
secondary one (EUR), one chooses the most advantageous
price = the one allowing us to make the lowest money loss
when selling the principal currency
• Put return = max(0, K - S) - p

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 7. Currency option :
Profile of the result of a put buyer

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 7. Currency option :
Example
• Foreign exchange hedging of an importation by purchasing a currency put
• A European company imports a given product from
the United States for an amount of 1 billion USD on
March 1st, 2005.
• This product is payable in 3 months
• The European company hopes to hedge against an
appreciation of the USD relative to EUR
• The spot rate is 1 EUR = 1.6 USD

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 7. Currency option :
Example
• The bank proposes to the European company the
following put :
Strike-price : 1 EUR = 1.6 USD
Expiration date : June 2007
premium : 3%
* At the time of purchase of the put the importer pays
the premium of 1,000,000 * 3% = 30,000 USD =
30000/1.6 = 18,750 EUR
* Thus, the importer ensures a maximum cost of
1,000,000/1.6 + 18,750 = 643,750 EUR
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 7. Currency option :
Example
• At the expiration date, 3 cases are imaginable :
•  the USD appreciates : i.e 1 EUR = 1.5 USD. The importer
exercises the put and the cost of his importation amounts to
643,750 EUR
•  The USD depreciates : i.e 1 EUR = 1.7 USD. The importer
does not exercise the put and buys the USD in the spot market.
The cost of his importation is : 1,000,000/1.7 + 18750 =
606,985.29 EUR. This amount is inferior to the above amount
•  The USD remains unchanged : 1 EUR = 1.6 USD. The
importer is indifferent about exercising or not the put. The cost
of his importation amounts to 643,750 EUR
• By hedging, the importer ensures a maximum cost of his
importation but can benefit from a depreciation of the USD

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 7. Currency option :
Example
• Foreign exchange hedging of an exportation by purchasing a currency call

• On January 1st, 2007 a European company exports a

given product to the UK for an amount of 500,000
GBP
• This product is payable at the 3 months’ date
• The European company hopes to hedge against a
depreciation of the GBP relative to the EUR
• The spot rate is 1 EUR = 0.7 GBP

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 7. Currency option :
Example
• The bank proposes to the European company the
following call :
•  Strike-price : 1 EUR = 0.71 GBP
•  Expiration date : March 2007
•  Premium : 2.8%
• At the time of purchase of the call, the exporter pays
500,000 * 2.8% = 14,000 GBP = 14,000/0.7 = 20,000
EUR
• Thus, the exporter ensures, for 500,000 GBP, a
minimum amount of (500,000/0.71) – 20,000 =
684,225 EUR

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 7. Currency option :
Example
• At the expiration date, 3 cases are imaginable :
•  the GBP depreciates : i.e 1 EUR = 0.74 GBP. The
exporter exercises the call and the cost of his exportation
amounts to 684,225 EUR
•  The GBP appreciates : i.e 1 EUR = 0.67 GBP. The
exporter does not exercise the call and sells the GBP in
the spot market. The cost of his exportation is :
500,000/0.67 – 20,000 = 726,269 EUR. This amount is
superior to the above amount
•  The GBP remains unchanged : 1 EUR = 0.71 GBP.
The exporter is indifferent about exercising or not the call.
The cost of his importation amounts to 684,225 EUR
• By hedging, the exporter ensures a minimum cost of his
exportation but can benefit from an appreciation of the
GBP
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