GHASSEM A. HOMAIFAR

John Wiley & Sons, Inc.

Managing GlobalFinancial and ForeignExchange Rate Risk

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Managing GlobalFinancial and ForeignExchange Rate Risk

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John Wiley & Sons

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GHASSEM A. HOMAIFAR

John Wiley & Sons, Inc.

Managing GlobalFinancial and ForeignExchange Rate Risk

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This book is printed on acid-free paper.

Copyright 2004 by John Wiley & Sons, Inc., Hoboken, New Jersey. All rights reserved.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data

Homaifar, Ghassem.Managing global financial and foreign exchange rate risk /

Ghassem A. Homaifar.p. cm.(The Wiley finance series)

Includes bibliographical references and index.ISBN 0-471-28115-8 (CLOTH)1. Foreign exchange. 2. Foreign exchange rates. 3. Risk management.4. Foreign exchangeUnited States. 5. Foreign exchange ratesUnited States.6. Risk managementUnited States. I. Title. II. Series.

HG3851.H63 2004332.4'5dc22 2003015159

Printed in the United States of America.

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http://www.copyright.comhttp://www.wiley.com

To my wife and daughters

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contents

Preface xv

CHAPTER 1Global Markets: Transactions and Risks 1

Savings and Loans Problems 2Agency Problems 3Types of Markets 5Types of Transactions 7Types of Risks 10

CHAPTER 2Balance of Payments Exposure Management 15

Balance of Payments as a Source and Use of Funds 17Components of Balance of Payments 17Current Account and Economic Fundamentals 19Capital Account, Expectation, and Interest Rate 21U.S. Balance of Payments: Recent Evidence 21Exposure Related to Capital Account 23Exchange Rate Arrangements, Dollarization, and Peg 28Managing Balance of Payment Exposure in the

Emerging Market Economies 32Case Study: Kairos Capital 33

CHAPTER 3Foreign Exchange Rate Dynamics: Managing Exposure 39

Foreign Exchange Markets 39Foreign Exchange Transactions 39Foreign Exchange Market Functions 45

vii

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Foreign Exchange Quotations 45Cross-Exchange Rate 46Bid and Offer Quotations in the Interbank Market 47Arbitrage in the Foreign Exchange Market 47Major Players in the Foreign Exchange Market 47Speculative Transactions 50Foreign Exchange Loss 50Settlement Risk 51Spot Rate and the Law of One Price 51Big Mac Index 52Central Bank Intervention 54Relative Version of Purchasing Power Parity 56Exchange Rate Pass-Through 59Spot Exchange Rate and Nominal Interest Rate 61Forward Exchange Rate and Covered Interest Parity 62Forward Premium or Discount for

Selected Currencies 65International Parity Relationship 66Real Exchange Rate 66Real Exchange Rate and East Asian Currency Crisis 68Case Study: Real-World Furniture, Inc. 69

CHAPTER 4Application of Options and Futures for Managing Exposure 75

Determinants of the Option Price (Premium) 75Options Traded in Organized Exchanges 77Sensitivity of Put and Call Price to Underlying Factors 79Functions of Options and Futures 82Hedging Receivables Denominated in Foreign Currency 86Speculation on the Futures Premium or Discount 91Hedge Ratio 93Price Discovery of Options and Futures 95Regulatory Arbitrage 96Binomial Option Pricing 96Hedged Portfolio 99Derivatives Application in Practice 100

viii CONTENTS

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Synthetic Forward Contract 101Case Study: Applications of Futures Contracts in

Portfolio Hedging 102

CHAPTER 5Principles of Futures: Pricing and Applications 107

Cost of Carry 107Stock Index Futures 108Index Arbitrage 109Portfolio Insurance 113Hedging with Stock Index Futures Options 115Basis Risk 119Changing the Beta of the Portfolio with Futures 120Anticipatory Hedge with Stock Index Futures 122Case Study: Competition for Safeway, PLC 123Managing Exposure of an Individual Stock 124Currency Futures 124Hedging with Currency Futures 126Anticipatory Hedging of Weakening Currency 128Rolling Over the Futures Hedge 129Marking to Market and Margin 131Commodity Futures 132Spread Position 133Hedging with Commodities Futures 134Empirical Evidence: Forward and Future Prices 138Case Study: Chockletto International Hedging 140

CHAPTER 6Interest Rate Futures: Pricing and Applications 143

Treasury Bills Futures 144Spot Rate 144Forward Rate 146Determinants of the Shape of the Term Structure of

Interest Rates 148Approximate Duration 154

Contents ix

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Pricing Treasury Bill Futures 155Eurodollar Futures 156Treasury Notes Futures 158Treasury Bond Futures 160Conversion Factor 162Arbitrage in the Interest Rates Futures Market 165Pricing Synthetic Futures or Forward 165Hedging with Futures: Duration-Based Approach 168

CHAPTER 7Swaps 177

Interest Rate Swaps 178Forward Rate Agreement 178Interest Rate Conventions 181Stripes of Forward Rate Agreements 181Motivations for Swaps 183Swaps Due to Comparative Advantage 185Swap Valuation 188Interest Rate Caps, Floors, Collars,

and Corridors 190Volatility of Interest Rates 198Swaptions 200Callable Swap 201Putable Swap 202Warehousing Swap 203Swaps Risks 203Exotic Swaps 206Currency Swaps 207Break-Even Analysis of Swap and Refinancing 211Options Embedded in Currency Swaps 212Three-Way Swaps 213

CHAPTER 8Translation, Transaction, and Operating Exposure 217

Translation Exposure 217

x CONTENTS

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Case Study: Accounting Exposure 220Functional Currency 222Managing Translation Exposure 223Balance Sheet Hedging 223Transaction Exposure 224Operating Exposure 224Hedging in Practice: Nike and DuPont 225Exposure Netting 226Forward Hedging: Example 226Money Market Hedge 228Hedging with Futures 231Option Hedging 233Value at Risk 235Two Assets Portfolio 237Lufthansa Buys Aircraft from Boeing 238Managing Operating Exposure 243Fixed for Fixed Currency and Interest

Rate Swaps 249

CHAPTER 9Debt, Equity, and Other Synthetic Structures 253

Inverse Floater 253Creating a Synthetic Fixed Rate 256Synthetic Structures 258Mortgage- and Asset-backed Derivatives 259Prepayment Risks 259Sequential-Pay Collateralized Mortgage Obligations 261Interest Only and Principal Only 261Equity-Linked Debt 263Zero Coupon Bond Linked to Goldman Sachs

Commodity Index 264Global Diversification with Swaps 265Catastrophe Bonds 266Liability Management with Derivatives 266Spread on Treasury Yield Curve 275

Contents xi

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CHAPTER 10Options on Futures 279

Spreads 281Bull Spreads 281Bear Spreads 283Butterfly Spreads 284Box Spreads 285Long Straddle 288Short Straddle 289Calendar Spread 290Strips 292Straps 294Price and Yield Volatility 296Spread Trades on Treasury Curves 297Exotic Options 301

CHAPTER 11Credit Derivatives: Pricing and Applications 307

Credit Derivatives Products 308Credit Event/Default Swap 309Pricing Credit Default Swap 312Unwinding and Assignability of Credit Default Swaps 315Default Probability 318Break-Even High-Yield Bonds 320Default Risk/Return 321Creating Synthetic Assets 321Synthetic Credit Default Swaps 323Credit Default Swap Applications 323Restructuring 324Credit-Linked Notes 326Synthetic Collateralized Loan Obligations 327Objectives of Structuring Collateralized

Loan Obligations 329Synthetic Collateralized Loan Obligations 329Synthetic Arbitrage Collateralized Loan Obligations 331Synthetic Balance Sheet Collateralized Loan Obligations 332

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Capital Adequacy Requirements 333Credit Exposure Method 334Total Return Swaps 335

CHAPTER 12Credit and Other Exotic Derivatives 341

Credit Spread Forward 342Credit Spread Option 342Asset Swap Switch 344Callable Step-ups 347Transfer and Convertibility Protection 348Pricing Transfer and Convertibility Protection 353Speculative Capital 354Emerging Market Debts and Brady Bonds 354International Swaps and Derivatives Association

Master Agreement 356Weather Derivatives 357Weather Derivatives Market 358Exchange-Traded Weather Derivatives 359CME Futures 360CME Options 362Swaps 363

References 365

Index 373

Contents xiii

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