International Finance: Futures, Options, and Political Risk

Foreign Currency Futures

An exchange-traded contract for future delivery of standard foreign exchange.

Major Futures Exchange

Chicago Mercantile Exchange International Monetary Market.

Notional Principal

The standardized size or amount of a futures contract.

Initial Margin

The collateral deposit required to open a futures position.

Maintenance Margin

The minimum account balance required before receiving a margin call.

Marking to Market

Daily adjustment of accounts based on settlement prices.

Round Turn

A complete buy/sell or sell/buy offsetting futures position.

Clearing House Counterparty

Central entity guaranteeing all exchange-traded futures contracts.

Basis Risk

The difference between spot price and futures price at maturity.

Foreign Currency Option

A contract giving the holder the right to buy or sell currency.

Call Option

An option giving the holder the right to buy currency.

Put Option

An option giving the holder the right to sell currency.

American Option Style

An option that may be exercised at any time before maturity.

European Option Style

An option that may be exercised only at maturity.

Strike Price

The exchange rate at which the option can be exercised.

Option Premium

The cost or price paid to purchase an option.

In-The-Money Option

An option that would be profitable if exercised immediately.

Out-Of-The-Money Option

An option that would not be profitable if exercised immediately.

Intrinsic Value

The immediate financial gain if an option is exercised.

Time Value

The option premium less its intrinsic value.

Delta (The Greek)

Measures the option price change per dollar increase in the underlying.

Implied Volatility

Volatility calculated by backing out of the market option premium.

Foreign Direct Investment (FDI)

Investment providing the largest external source of finance for developing economies.

Political Risk

Uncertainty over property rights due to government actions or non-market events.

Macro Political Risk

Country-specific political risk affecting all firms within a nation.

Micro Political Risk

Industry or firm-specific political risk within a country.

Operational Political Risk

Changes in what a firm can do or business terms within a country.

Ownership Political Risk

Changes in firm ownership, such as government asset seizure.

Discriminatory Political Risk

Political events or changes pertaining only to foreign firms.

Capital Flight

The export of citizens' savings due to fears about capital safety.

Why FDI matters (2017 WIR)

The 2017 World Investment Report says FDI remains the largest and most constant external source of finance for developing economies, compared with portfolio investment, remittances and official development assistance.

Least developed countries and energy investment (2023 WIR)

Least developed countries rely on external sources for almost three quarters of their energy investment, but may pay up to seven times more than developed countries to access international capital markets.

Global FDI flows 2020-2022

FDI flows dropped severely in 2020, rebounded strongly in 2021, then declined 12% in 2022 to $1.3 trillion. Flows to least developed countries fell 16% in 2022.

FDI outlook 2023-2025

2023 had a negative FDI outcome. FDI inflows to China decreased in 2024. Global FDI fell 11% in 2024. Clean and effective energy is expected to be a driving force of FDI going forward.

Source of conflict for firms operating abroad

Conflict arises from differences in goals between the host country (where the firm operates) and the home country (where the firm is headquartered). This conflict is a source of political risk.

Average monthly salary comparison (slide example)

Highest: Switzerland $8,218; Luxembourg $6,740; US $6,562; Iceland $6,548; Norway $5,772; Denmark $5,749; Canada $5,188; Ireland $4,729. Lowest: Zimbabwe $169; Bangladesh $173; Sri Lanka $175; Pakistan $177; Rwanda $185. Philippines $393, Peru $490, Brazil $509.

Define political risk

The potential for a change in future cash flows, and consequently the asset's value, due to government actions or other non-market events that are political in nature.

Political risk from an economic standpoint

Uncertainty over property rights.

Examples of political risk

Revisions of tax regulations; new regulations on hiring or local production; government seizing control of the firm; civil uprising or civil war; corruption, extortion and bribes.

Macro political risk

Country-specific risk that affects all firms within a country (contrast with micro).

Micro political risk

Industry-specific or firm-specific political risk within a country (contrast with macro).

Operational political risk

Changes in what the firm can do or in the terms of business within a country, i.e. how a firm can operate. Examples: environmental regulations, local hiring requirements.

Ownership political risk

Changes in the ownership of the firm, such as assets being seized by the government (expropriation). Fair compensation is the key issue.

Discriminatory political risk

Changes or events that apply only to foreign firms. Examples: a new restriction on foreign ownership in specific sectors; an increase in taxes on dividends paid to foreigners.

Nondiscriminatory political risk

Changes that affect both domestic and foreign firms. Examples: an increase in corporate taxes; foreign exchange restrictions.

Three main classifications of political risk

1) Macro vs. micro; 2) operational vs. ownership; 3) discriminatory vs. nondiscriminatory.

Why political risk is hard to measure

It is subjective and difficult to measure, but a firm needs to consider the probability of adverse political events and their potential outcomes.

Four areas used to analyze political risk

Political factors, economic factors, micro factors and subjective factors (note: not four classifications; these are the four areas of analysis).

Political factors in risk analysis

Focus on political stability. Determine how long the current regime will stay in power and whether it will enforce its policies.

Measures of political stability

Frequency of government changes, level of violence, number of armed insurrections, conflicts with other countries, etc.

Economic factors in risk analysis

Focus on the economic environment: inflation, balance of payments (BOP) position, GDP growth rate, taxes, etc. Determine the health of the economy and the pressure for a quick fix if problems arise.

Micro factors in risk analysis

Focus on religion, culture and environment. Not all firms face the same level of political risk; specific operating and financial characteristics largely determine the degree. Example: expropriation is more likely in oil/gas than in manufacturing.

Subjective factors in risk analysis

The general perception of a country's attitude toward foreign investment and ownership: is foreign investment seen as a necessary evil, or actively welcomed?

Capital flight

The export of savings by a nation's citizens because of fears about the safety of their capital. Generally a good indicator of political risk.

Indicators used to measure political risk

Capital flight (generally a good indicator), the regulatory/legal system, and political risk indices/models.

Political risk indices/models

Incorporate various economic, social and political factors to assess the level of political risk in a country.

Transparency International

A service that publishes corruption ratings based on surveys of professionals working in each country.

Other political risk services named in the lecture

Morgan Stanley, the IMF (assessment) and the Political Risk Group.

General prescription for managing political risk

Make the firm valuable to the host country. Example: link management's compensation to the value of the firm.

Managing political risk before FDI: avoidance

Avoid the investment or minimize the amount invested. Trade-off: this could reduce the benefits and returns.

Managing political risk before FDI: other modes of investment

Export, licensing, franchising, joint ventures, etc. Each mode has trade-offs.

Managing political risk before FDI: formal agreement

Establish a formal agreement with the host country outlining dividend payments, local employment guidelines, pricing, taxes, environmental concerns, etc.

Managing political risk before FDI: political risk insurance

Provides protection against the risk. In the US, the International Development Finance Corporation (DFC) helps manage risk and insures firms.

Operating strategies: production

Locally source inputs; diversify operations over several countries; control technology.

Operating strategies: marketing

Build a brand name; control the distribution network; increase exports.

Operating strategies: financial

Limit equity; borrow locally; diversify borrowing; form joint ventures.

Actions to take after expropriation

Negotiation and/or legal remedies.

WIR definition of developed economies

OECD member countries (other than Chile, Colombia, Costa Rica, Mexico and Türkiye); EU members that are not OECD members (Bulgaria, Croatia, Cyprus, Malta, Romania); plus Albania, Andorra, Belarus, Bosnia and Herzegovina, Liechtenstein, Monaco, Montenegro, North Macedonia, Moldova, Russia, San Marino, Serbia, Ukraine; and the territories of Bermuda, Faroe Islands, Gibraltar, Greenland, Guernsey and Jersey.

WIR definition of developing economies

In general, all economies not specified as developed. For statistical purposes, China's data exclude Hong Kong SAR, Macao SAR and Taiwan Province of China.

Lecture 8 summary: key takeaways

FDI is key to financial growth but can be a source of political risk. Political risk is uncertainty over property rights. It is hard to measure, but agencies report risk metrics. Strategies to minimize and manage it involve costs, benefits and trade-offs.

Foreign currency futures contract

An exchange-traded agreement (an alternative to a forward) calling for future delivery of a standard amount of foreign exchange at a fixed time, place and price.

Major FX futures exchanges

CME's International Monetary Market (IMM, the most important US market); LIFFE (now part of NYSE/ICE); CBOT; SIMEX (now Singapore Exchange, Eurocurrency futures); PHLX/PBOT (now NASDAQ); New York Board of Trade FINEX division; MIDAM.

Contract size (notional principal)

The standard size of a futures contract; trading in each currency must be done in even multiples of it. The GBP contract at CME is £62,500.

Maturity dates of FX futures

Some CME contracts follow the March quarterly cycle (plus January and February) with physical delivery four times a year on the third Wednesday of March, June, September and December. Some (e.g. Mexican peso) trade all 12 months. Cash-settled contracts (e.g. Brazilian real, Russian ruble) also trade all 12 months.

American terms (futures quotes)

Quotes are in US dollar cost per unit of foreign currency. For an American trader these are also known as direct quotes.

Last trading day

Typically, contracts may be traded through the second business day before the maturity date.

Initial margin

Collateral (like a performance bond) that the trader must deposit up front. IMM initial margins typically average about $2,000-$4,000 per contract, but can be higher. CME initial margin is 1.1 × the maintenance margin (usually 110-120%).

Maintenance margin and margin call

Maintenance margin is the minimum amount that must stay in the account to guard against severe losses (around $2,000). When the account falls below it, the investor receives a margin call.

Marking to market

At the end of each trading day the account is credited if the value of the contracts rose and debited if it fell.

Futures settlement and round turn

Only about 5% of futures contracts are settled by physical delivery; most buyers and sellers offset before delivery. The complete buy/sell or sell/buy is a round turn, for which customers pay the broker a single commission (a single price is quoted; some have bid/ask).

The clearing house

The counterparty to every contract; brokerage firms are registered with the CFTC. It imposes margin requirements and daily settlement. Clients need not worry about a specific counterparty's performance because the clearing house is guaranteed by all exchange members.

Open price, settle price, open interest

Open price = first trade price. Settle price = the final futures trading day price. Open interest = the number of open positions in that futures contract.

Convergence and basis risk

At expiration the futures price and spot price should converge (convergence property). If they do not, there is basis risk: the difference between the spot price at time T and the futures price at time T.

Basis equation

Basis = Spot price − Futures price = S(t) − f(t). Basis risk is a bigger concern when you cannot hedge the underlying. Forward and futures prices typically equal each other but may differ because future interest rates are not always known.

Open outcry trading

Traders stand in a pit and call out prices and quantities (using hand signals) to show willingness to buy or sell. It is an efficient means of price discovery, letting buyers and sellers reach the best price given supply and demand.

CME Globex

CME's global electronic trading platform, launched June 1992 for after-hours trading; now available nearly 23 hours a day, five days a week for products such as Eurodollars, S&P 500, NASDAQ-100, FX and E-mini index futures. Linked to the CME open outcry floor.

LIFFE and LIFFE CONNECT

LIFFE (London International Financial Futures Exchange) is the derivatives business of Euronext (Amsterdam, Brussels, Lisbon, London, Paris), now part of NYSE; Euronext bought it in 2001. LIFFE CONNECT replaced its open outcry floor, and LIFFE became fully electronic in 2000.

How futures positions are closed out

Rarely (about 5%) by physical delivery at a specified location. Far more commonly by taking an offsetting position in the same contract: to close a long, take a new short; to close a short, take a new long.

Futures payoff formulas

Closing before expiration (also the mark-to-market equation): long = f(t+1) − f(t) times contract size; short = f(t) − f(t+1) times contract size. Closing immediately before expiration: long = (S_T − f0) × contract size; short = (f0 − S_T) × contract size.

Futures hedge example: setup steps (Example 1)

US MNC owes £10,000,000 in March 2027 and fears the pound will rise. Step 1: contracts = £10,000,000 ÷ £62,500 = 160. Step 2: BUY £ futures (long). Step 3: use the 10/19/26 MAR 27 settle price of $1.3311/£, locking in a purchase of £10,000,000 at that price.

Futures hedge example: margin account (Example 1)

Initial margin = $2,200 × 160 = $352,000; maintenance = $2,000 × 160 = $320,000. Settles: 1.3386 (+$75,000, account $427,000); 1.3389 (+$3,000, $430,000); 1.3402 (+$13,000, $443,000); 1.3373 (−$29,000, $414,000). Day 1 gain = (1.3386 − 1.3311) × 160 × 62,500 = $75,000. No margin call because the account never fell below $320,000.

Futures vs. forwards: contract terms

Size: standardized (futures) vs. custom (forwards). Location: organized exchange vs. trading between individuals and banks. Maturity: fixed, max 1 year vs. typically any maturity. Pricing: open outcry or electronic exchange vs. bid/ask quotes set by dealers.

Futures vs. forwards: costs and users

Margin: initial margin vs. no explicit fee. Settlement: rarely delivered vs. normally delivered. Commissions: single round-trip commission vs. dealers earn the bid/ask spread. Hours: exchange hours (becoming 24h) vs. 24 hours. Counterparty: unknown (clearinghouse) vs. direct contact. Liquidity: liquid vs. less liquid. Users: speculators vs. financial managers.

Foreign currency option

A contract giving the purchaser the right, but not the obligation, to buy or sell a given amount of currency at a fixed price per unit for a specified time period. The key phrase is right but not the obligation.

Call, put, holder, writer

Call = buyer has the right to purchase currency. Put = buyer has the right to sell currency. The buyer of the option is the holder; the seller is the writer.

American vs. European options

American options may be exercised at any time during the life of the option. European options may not be exercised until the specified maturity date.

Three price elements of an option

1) Strike (exercise) price: the exchange rate at which currency can be bought or sold. 2) Premium: the cost/price of the option, paid when it is purchased (always buy at the ask, sell at the bid). 3) The underlying: the actual spot rate in the market.

At-the-money, in-the-money, out-of-the-money

ATM: exercise price = spot rate. ITM: profitable if exercised immediately (excluding premium): call when spot > strike, put when spot < strike. OTM: not profitable if exercised: call when spot < strike, put when spot > strike.

Where currency options trade (exchanges)

Organized exchanges with clearing by the Options Clearing Corporation (OCC). NASDAQ OMX: options on spot FX, contract size half of the IMM/PBOT futures contract, both American and European (PHLX recently added customized contracts). CME: options on FX futures, all American style, same contract size as the IMM. NY Board of Trade FINEX: US dollar index.

Over-the-counter (OTC) options

Written by banks, most often for USD against GBP, CHF, JPY, CAD and EUR. Main advantage: tailored to the purchaser. Drawback: counterparty risk. Mostly used by individuals and banks.