Financial news

Exchange rate risk

admin — Tue, 29 Nov 2011 17:42:57 +0000

Exchange rate risk is the uncertainty of returns to an investor who acquires securities denominated in a currency different from his or her own. The likelihood of incurring this risk is becoming greater as investors buy and sell assets around the world, as opposed to only assets within their own countries. A U.S. investor who buys Japanese stock denominated in yen must consider not only the uncertainty of the return in yen but also any change in the exchange value of the yen relative to the U.S. dollar. That is, in addition to the foreign firm’s business and financial risk and the security’s liquidity risk, the investor must consider the additional uncertainty of the return on this Japanese stock when it is converted from yen to U.S. dollars.
As an example of exchange rate risk, assume that you buy 100 shares of Mitsubishi Electric at 1,050 yen when the exchange rate is 115 yen to the dollar. The dollar cost of this investment would be about $9.13 per share (1,050/115). A year later you sell the 100 shares at 1,200 yen when the exchange rate is 130 yen to the dollar. When you calculate the HPY in yen, you find the stock has increased in value by about 14 percent (1,200/1,050), but this is the HPY for a Japanese investor. A U.S. investor receives a much lower rate of return, because during this period the yen has weakened relative to the dollar by about 13 percent (that is, it requires more yen to buy a dollar—130 versus 115). At the new exchange rate, the stock is worth $9.23 per share (1,200/130). Therefore, the return to you as a U.S. investor would be only about 1 percent ($9.23/$9.13) versus 14 percent for the Japanese investor. The difference in return for the Japanese investor and U.S. investor is caused by the decline in the value of the yen relative to the dollar. Clearly, the exchange rate could have gone in the other direction, the dollar weakening against the yen. In this case, as a U.S. investor, you would have experienced the 14 percent return measured in yen, as well as a gain from the exchange rate change.
The more volatile the exchange rate between two countries, the less certain you would be regarding the exchange rate, the greater the exchange rate risk, and the larger the exchange rate risk premium you would require.
There can also be exchange rate risk for a U.S. firm that is extensively multinational in terms of sales and components (costs). In this case, the firm’s foreign earnings can be affected by changes in the exchange rate. As will be discussed, this risk can generally be hedged at a cost.

Equity swaps

admin — Sun, 13 Dec 2009 17:54:15 +0000

In this section, we explore how to price and value three types o f equity swaps: ( I ) a swap to pay a fixed rate and receive the return on the equity, (2) a swap to pay a floating rate and receive the return on the equity, and ( 3 )a swap to pay the return on one equity and receive the return on another.
To price or value an equity swap, we must determine a combination of stock and bonds that replicates the cash flows on the swap. As we saw with interest rate and currency swaps, such a replication is not difficult to create. W e issue a bond and sell a bond, with one being a fixed-rate bond and the other being a floating-rate bond. I f we are dealing with a currency swap, we require that one o f the bonds be denominated in one currency and the other be denominated in the other currency. With an equity swap, it would appear that a replicating strategy would involve issuing a bond and buying the stock or vice versa, but this is not exactly how to replicate an equity swap. Remember that in an equity swap, we receive cash payments representing the return on the stock, and that is somewhat different from payments based on the price.
Pricing a Swap to Pay a Fixed Rate and Receive the Return on the Equity: By example, we will demonstrate how to price an n-payment m-day rate swap to pay a fixed rate and receive the return on equity. Suppose the notional principal is $1, the swap involves annual settlements and lasts for two years (n = 2),and the returns on the stock for each o f the two years are 10 percent for the first year and 15 percent for the second year. The equity payment on the swap would be $0.10 the first year and $0.15 the second. I f , however, we purchased the stock instead o f doing the equity swap, we would have to sell the stock at the end o f the first year or we would not generate any cash. Suppose at the end o f the first year, the stock is at $1.10. W e sell the stock, withdraw $0.10, and reinvest $1.OO in the stock. At the end o f the second year the stock would be at $1.15. W e then \ell the stock, taking cash of $0.15. But we have $1.OO left over. To get rid of,or offset,this cash flow, suppose that when we purchased the stock we borrowed the present value of $1.00 for two years. Then two years later, we would pay back $1.00 on that loan. This procedure would offset the $1.00 in cash we have from the stock. The fixed payments on the swap can be easily replicated. I f the fixed payment is denoted as FS(O,n,m),we simply borrow the present value o f FS(O,n,m) for one year and also borrow the present value of FS(O,n,m)for two years. When we pay those loans back, we will have replicated the fixed payments on the swap.Equity

Currency swaps

admin — Fri, 11 Dec 2009 17:53:03 +0000

Recall the four types of currency swaps: (1) pay one currency fixed, receive the other fixed, (2) pay one currency fixed, receive the other floating, (3) pay one currency floating, receive the other fixed, and (4) pay one currency floating, receive the other floating. In determining the fixed rate on a swap, we must keep in mind one major point: The fixed rate is the rate that makes the present value of the payments made equal the present value of the payments received. In the fourth type of currency swap mentioned here, both sides pay floating so there is no need to find a fixed rate. But all currency swaps have two notional principals, one in each currency. We can arbitrarily set the notional principal in the domestic currency at one unit. We then must determine the equivalent notional principal in the other currency. This task is straightforward: We simply convert the one unit of domestic currency to the equivalent amount of foreign currency, dividing 1.0 by the exchange rate.
Consider the first type of currency swap, in which we pay the foreign currency at a fixed rate and receive the domestic currency at a fixed rate. What are the two fixed rates? We will see that they are the fixed rates on plain vanilla interest rate swaps in the respective countries.
Because we know that the value of a floating-rate security with $1 face value is $1, we know that the fixed rate on a plain vanilla interest rate swap is the rate on a $1 par bond in the domestic currency. That rate results in the present value of the interest payments and the hypothetical notional principal being equal to 1.0 unit of the domestic currency. Moreover, for a currency swap, the notional principal is typically paid, so we do not even have to call it hypothetical. We know that the fixed rate on the domestic leg of an interest rate swap is the appropriate domestic fixed rate for a currency swap in which the domestic notional principal is 1.0 unit of the domestic currency.
What about the fixed rate for the foreign payments on the currency swap? To answer that question, let us assume the point of view of a resident of the foreign country. Given the term structure in the foreign country, we might be interested in first pricing plain vanilla interest rate swaps in that country. So, we know that the fixed rate on interest rate swaps in that country would make the present value of the interest and principal payments equal 1.0 unit of that currency.
Now let us return to our domestic setting. We know that the fixed rate on interest rate swaps in the foreign currency makes the present value of the foreign interest and principal payments equal to 1.0 unit of the foreign currency. We multiply by the spot rate, So, to obtain the value of those payments in our domestic currency: 1.0 times So equals So, which is now in terms of the domestic currency. This amount does not equal the present value of the domestic payments, but if we set the notional principal on the foreign side of the swap equal to l/So, then the present value of the foreign payments will be So(l/So) = 1.0 unit of our domestic currency, which is what we want.

Interest rate swaps

admin — Tue, 08 Dec 2009 17:49:12 +0000

Pricing an interest rate swap means finding the fixed rate that equates the present value of the fixed payments to the present value of the floating payments, a process that sets the market value of the swap to zero at the start. Using the time line illustrated earlier, the swap cash flows will occur on days hl, h2,…,hn-l, and h,, so there are n cash flows in the swap. Day h, is the expiration date of the swap. The time interval between payments is m days. We can thus think of the swap as being on an m-day interest rate, which will be LIBOR in our examples.
As previously mentioned, the payments in an interest rate swap are a series of fixed and floating interest payments. They do not include an initial and final exchange of notional principals. As we already observed, such payments would be only an exchange of the same money. But if we introduce the notional principal payments as though they were actually made, we have not done any harm. The cash flows on the swap are still the same. The advantage of introducing the notional principal payments is that we can now treat the fixed and floating sides of the swap as though they were fixed- and floating-rate bonds.
So we introduce a hypothetical final notional principal payment of $1 on a swap starting at day 0 and ending on day h,, in which the underlying is an m-day rate. The fixed swap interest payment rate, FS(O,n,m), gives the fixed payment amount corresponding to the $1 notional principal.

Exchange Rate or Currency Risk

admin — Sat, 05 Dec 2009 17:48:00 +0000

An asset whose payments are not in the domestic currency of the investor has unknown cash flows in the domestic currency. The cash flows in the investor’s domestic currency are dependent on the exchange rate at the time the payments are received from the asset. For example, suppose an investor’s domestic currency is the U.S. dollar and that the investor purchases an asset whose payments are in euros. If the euro depreciates relative to the U.S. dollar at the time a euro payment is received, then fewer U.S. dollars will be received.
The risk of receiving less of the domestic currency than is expected at the time of purchase when an asset makes payments in a currency other than the investor’s domestic currency is called exchange rate risk or currency risk.

Pricing and valuation

admin — Wed, 02 Dec 2009 17:46:45 +0000

Our goal is to determine the market value of the derivative transaction of interest, in this case, swaps. At the start of a swap, the market value is set to zero.
The process of pricing the swap involves finding the terms that force that market value to zero. To determine the market value of a swap, we replicate the swap using other instruments that produce the same cash flows. Knowing the values of these other instruments, we are able to value the swap. This value can be thought of as what the swap is worth if we were to sell it to someone else. In addition, we can think of the value as what we might assign to it on our balance sheet. The swap can have a positive value, making it an asset, or a negative value, making it a liability.
Swaps are equivalent to a variety of instruments, but we prefer to use the simplest instruments to replicate the swap. The simplest instruments are the underlying assets: bonds, stocks, and currencies. Therefore, we shall use these underlying instruments to replicate the swap.
To understand the pricing of currency, interest rate, and equity swaps, we shall have to first take a brief digression to examine an instrument that plays an important role in their pricing. We shall see that the floating-rate security will have a value of 1.0, its par, at the start and on any coupon reset date. Recall that we have made numerous references to floating rates and floating payments. Accordingly, we must first obtain a solid understanding of floating-rate notes.

SWAPS AND OPTIONS

admin — Mon, 23 Nov 2009 17:44:42 +0000

Finally, we note that swaps can be equated to combinations of options. Buying a call and selling a put would force the transacting party to make a net payment if the underlying is below the exercise rate at expiration, and would result in receipt of a payment if the underlying is above the exercise rate at expiration. This payment will be equivalent to a swap payment if the exercise rate is set at the fixed rate on the swap. Therefore, a swap is equivalent to a combination of options with expirations at the swap payment dates. The connection between swaps and options is relatively straightforward for interest rate instruments, but less so for currency and equity instruments. Nonetheless, we can generally consider swaps as equivalent to combinations of options.
In this series of posts, we have learned that swaps can be shown to be equivalent to combinations of assets, combinations of forward contracts, combinations of futures contracts, and combinations of options. Thus, to price and value swaps we can choose any of these approaches. We choose the simplest: swaps and assets.

Swaps and futures contracts

admin — Sun, 15 Nov 2009 17:41:57 +0000

It is a fairly common practice to equate swaps to futures contracts. This practice is partially correct, but only to the extent that futures contracts can be equated to forward contracts. Futures contracts are equivalent to forward contracts only when future interest rates are known. Obviously this condition can never truly be met, and because swaps are often used to manage uncertain interest rates, the equivalence of futures with swaps is not always appropriate. Moreover, swaps are highly customized contracts, whereas futures are standardized with respect to expiration and the underlying instrument. Although it is common to equate a swap with a series of futures contracts, this equality holds true only in very limited cases.

Swaps and forward contracts

admin — Fri, 13 Nov 2009 17:40:56 +0000

Recall that a forward contract, whether on an interest rate, a currency, or an equity, is an agreement for one party to make a fixed payment to the other, while the latter party makes a variable payment to the former. A swap extends this notion by combining a series of forward contracts into a single transaction. There are, however, some subtle differences between swaps and forward contracts. For example, swaps are a series of equal fixed payments, whereas the component contracts of a series of forward contracts would almost
always be priced at different fixed rates.I4 In this context we often refer to a swap as a series of off-market forward contracts, reflecting the fact that the implicit forward contracts that make up the swap are all priced at the swap fixed rate and not at the rate at which they would normally be priced in the market. In addition, in interest rate swaps, the next payment that each party makes is known. That would obviously not be the case for a single forward contract. Other subtleties distinguish currency swaps from a series of currency forwards and equity swaps from a series of equity forwards, but in general, it is acceptable to view a swap as a series of forward contracts.

Swaps and assets

admin — Wed, 11 Nov 2009 17:40:49 +0000

We have already alluded to the similarity between swaps and assets. For example, a currency swap is identical to issuing a fixed- or floating-rate bond in one currency, converting the proceeds to the other currency, and using the proceeds to purchase a fixed- or floating- rate bond denominated in the other currency. An interest rate swap is identical to issuing a fixed- or floating-rate bond and using the proceeds to purchase a floating- or fixed-rate bond. The notional principal is equivalent to the face value on these hypothetical bonds.
Equity swaps appear to be equivalent to issuing one type of security and using the proceeds to purchase another, where at least one of the types of securities is a stock or stock index. For example, a pay-fixed, receive-equity swap looks like issuing a fixed-rate bond and using the proceeds to buy a stock or index portfolio. As it turns out, however, these two transactions are not exactly the same, although they are close. The stock position in the transaction is not the same as a buy-and-hold position; some adjustments are required on the settlement dates to replicate the cash flows of a swap.
The equivalence of a swap to transactions we are already familiar with, such as owning assets, is important because it allows us to price and value the swap using simple instruments, such as the underlying currency, interest rate, or stock. We do not require other derivatives to replicate the cash flows of a swap. Nonetheless, other derivatives can be used to replicate the cash flows of a swap, and it is worth seeing why this is true.