Managing Global Financial and Foreign Exchange Rate Risk

Preface xv

Chapter 1 Global Markets: Transactions and Risks 1

Savings and Loans Problems 2

Agency Problems 3

Types of Markets 5

Types of Transactions 7

Types of Risks 10

Chapter 2 Balance of Payments Exposure Management 15

Balance of Payments as a Source and Use of Funds 17

Components of Balance of Payments 17

Current Account and Economic Fundamentals 19

Capital Account, Expectation, and Interest Rate 21

U.S. Balance of Payments: Recent Evidence 21

Exposure Related to Capital Account 23

Exchange Rate Arrangements, Dollarization, and Peg 28

Managing Balance of Payment Exposure in the Emerging Market Economies 32

Case Study: Kairos Capital 33

Chapter 3 Foreign Exchange Rate Dynamics: Managing Exposure 39

Foreign Exchange Markets 39

Foreign Exchange Transactions 39

Foreign Exchange Market Functions 45

Foreign Exchange Quotations 45

Cross-Exchange Rate 46

Bid and Offer Quotations in the Interbank Market 47

Arbitrage in the Foreign Exchange Market 47

Major Players in the Foreign Exchange Market 47

Speculative Transactions 50

Foreign Exchange Loss 50

Settlement Risk 51

Spot Rate and the Law of One Price 51

Big Mac Index 52

Central Bank Intervention 54

Relative Version of Purchasing Power Parity 56

Exchange Rate Pass-Through 59

Spot Exchange Rate and Nominal Interest Rate 61

Forward Exchange Rate and Covered Interest Parity 62

Forward Premium or Discount for Selected Currencies 65

International Parity Relationship 66

Real Exchange Rate 66

Real Exchange Rate and East Asian Currency Crisis 68

Case Study: Real-World Furniture, Inc. 69

Chapter 4 Application of Options and Futures for Managing Exposure 75

Determinants of the Option Price (Premium) 75

Options Traded in Organized Exchanges 77

Sensitivity of Put and Call Price to Underlying Factors 79

Functions of Options and Futures 82

Hedging Receivables Denominated in Foreign Currency 86

Speculation on the Futures Premium or Discount 91

Hedge Ratio 93

Price Discovery of Options and Futures 95

Regulatory Arbitrage 96

Binomial Option Pricing 96

Hedged Portfolio 99

Derivatives Application in Practice 100

Synthetic Forward Contract 101

Case Study: Applications of Futures Contracts in Portfolio Hedging 102

Chapter 5 Principles of Futures: Pricing and Applications 107

Cost of Carry 107

Stock Index Futures 108

Index Arbitrage 109

Portfolio Insurance 113

Hedging with Stock Index Futures Options 115

Basis Risk 119

Changing the Beta of the Portfolio with Futures 120

Anticipatory Hedge with Stock Index Futures 122

Case Study: Competition for Safeway, PLC 123

Managing Exposure of an Individual Stock 124

Currency Futures 124

Hedging with Currency Futures 126

Anticipatory Hedging of Weakening Currency 128

Rolling Over the Futures Hedge 129

Marking to Market and Margin 131

Commodity Futures 132

Spread Position 133

Hedging with Commodities Futures 134

Empirical Evidence: Forward and Future Prices 138

Case Study: Chockletto International Hedging 140

Chapter 6 Interest Rate Futures: Pricing and Applications 143

Treasury Bills Futures 144

Spot Rate 144

Forward Rate 146

Determinants of the Shape of the Term Structure of Interest Rates 148

Approximate Duration 154

Pricing Treasury Bill Futures 155

Eurodollar Futures 156

Treasury Notes Futures 158

Treasury Bond Futures 160

Conversion Factor 162

Arbitrage in the Interest Rates Futures Market 165

Pricing Synthetic Futures or Forward 165

Hedging with Futures: Duration-Based Approach 168

Chapter 7 Swaps 177

Interest Rate Swaps 178

Forward Rate Agreement 178

Interest Rate Conventions 181

Stripes of Forward Rate Agreements 181

Motivations for Swaps 183

Swaps Due to Comparative Advantage 185

Swap Valuation 188

Interest Rate Caps, Floors, Collars, and Corridors 190

Volatility of Interest Rates 198

Swaptions 200

Callable Swap 201

Putable Swap 202

Warehousing Swap 203

Swaps Risks 203

Exotic Swaps 206

Currency Swaps 207

Break-Even Analysis of Swap and Refinancing 211

Options Embedded in Currency Swaps 212

Three-Way Swaps 213

Chapter 8 Translation, Transaction, and Operating Exposure 217

Translation Exposure 217

Case Study: Accounting Exposure 220

Functional Currency 222

Managing Translation Exposure 223

Balance Sheet Hedging 223

Transaction Exposure 224

Operating Exposure 224

Hedging in Practice: Nike and DuPont 225

Exposure Netting 226

Forward Hedging: Example 226

Money Market Hedge 228

Hedging with Futures 231

Option Hedging 233

Value at Risk 235

Two Assets Portfolio 237

Lufthansa Buys Aircraft from Boeing 238

Managing Operating Exposure 243

Fixed for Fixed Currency and Interest

Rate Swaps 249

Chapter 9 Debt, Equity, and Other Synthetic Structures 253

Inverse Floater 253

Creating a Synthetic Fixed Rate 256

Synthetic Structures 258

Mortgage- and Asset-backed Derivatives 259

Prepayment Risks 259

Sequential-Pay Collateralized Mortgage Obligations 261

Interest Only and Principal Only 261

Equity-Linked Debt 263

Zero Coupon Bond Linked to Goldman Sachs Commodity Index 264

Global Diversification with Swaps 265

Catastrophe Bonds 266

Liability Management with Derivatives 266

Spread on Treasury Yield Curve 275

Chapter 10 Options on Futures 279

Spreads 281

Bull Spreads 281

Bear Spreads 283

Butterfly Spreads 284

Box Spreads 285

Long Straddle 288

Short Straddle 289

Calendar Spread 290

Strips 292

Straps 294

Price and Yield Volatility 296

Spread Trades on Treasury Curves 297

Exotic Options 301

Chapter 11 Credit Derivatives: Pricing and Applications 307

Credit Derivatives Products 308

Credit Event/Default Swap 309

Pricing Credit Default Swap 312

Unwinding and Assignability of Credit Default Swaps 315

Default Probability 318

Break-Even High-Yield Bonds 320

Default Risk/Return 321

Creating Synthetic Assets 321

Synthetic Credit Default Swaps 323

Credit Default Swap Applications 323

Restructuring 324

Credit-Linked Notes 326

Synthetic Collateralized Loan Obligations 327

Objectives of Structuring Collateralized Loan Obligations 329

Synthetic Collateralized Loan Obligations 329

Synthetic Arbitrage Collateralized Loan Obligations 331

Synthetic Balance Sheet Collateralized Loan Obligations 332

Capital Adequacy Requirements 333

Credit Exposure Method 334

Total Return Swaps 335

Chapter 12 Credit and Other Exotic Derivatives 341

Credit Spread Forward 342

Credit Spread Option 342

Asset Swap Switch 344

Callable Step-ups 347

Transfer and Convertibility Protection 348

Pricing Transfer and Convertibility Protection 353

Speculative Capital 354

Emerging Market Debts and Brady Bonds 354

International Swaps and Derivatives Association Master Agreement 356

Weather Derivatives 357

Weather Derivatives Market 358

Exchange-Traded Weather Derivatives 359

CME Futures 360

CME Options 362

Swaps 363

References 365

Index 373