Currency Derivatives

5
Chapter
South-Western/Thomson Learning 2003
A5 - 2
Chapter Objectives
To explain how forward contracts are used
for hedging based on anticipated
exchange rate movements; and
To explain how currency futures contracts
and currency options contracts are used
for hedging or speculation based on
anticipated exchange rate movements.
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Forward Market
The forward market facilitates the trading
of forward contracts on currencies.
A forward contract is an agreement
between a corporation or international
trader and a commercial bank to exchange
a specified amount of a currency at a
specified exchange rate (called the
forward rate) on a specified date in the
future.
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Forward Market
When MNCs anticipate future need or future
receipt of a foreign currency, they can set up
forward contracts to lock in the exchange rate.
Importers can use the forward contract to avoid
exchange risk in anticipation of depreciation of
local currency (or appreciation of foreign
currency).
Exporters can use forward contract to avoid
foreign exchange risk in anticipation of
appreciation of local currency (or depreciation of
foreign currency).
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As with the case of spot rates, there is a
bid/ask spread on forward rates.
Forward rates may also contain a premium
or discount.
If the forward rate exceeds the existing
spot rate, it contains a premium.
If the forward rate is less than the existing
spot rate, it contains a discount.
Forward Market
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annualized forward premium/discount
=
forward rate spot rate

360
spot rate n
where n is the number of days to maturity
Example: Suppose $ spot rate = Tk.70,
90-day $ forward rate = Tk.71.
Tk.71 Tk.70
x
360
= 5.7%

Tk.70 90
So, forward premium = 5.7%
Forward Market
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The forward premium/discount reflects the
difference between the home interest rate
and the foreign interest rate, so as to
prevent arbitrage.
Forward Market
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A non-deliverable forward contract (NDF)
is a forward contract whereby there is no
actual exchange of currencies. Instead, a
net payment is made by one party to the
other based on the contracted rate and the
market rate on the day of settlement.
Forward Market
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Example: NDF Contract
Suppose in connection of an import well need
$100 after 3 months from now. If we made a 3
month NDF contract with Sonali Bank today then
we would be secured of exchange rate risk.
Suppose the reference index is the 90 day forward
rate today which is $1=Tk.68. Now, if the spot rate
after 3 months from now turns up to be $1=Tk.69,
then the bank will pay us Tk.100 which well need
in excess of the reference index to pay for the
import. Similarly, if the spot rate after 3 months
from now is $1=Tk.67, then we will pay Tk.100 to
Sonali Bank. Dont forget that well need hundred
taka less in that case for the import.
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Currency Futures Market
Currency futures contracts specify a
standard volume of a particular currency to
be exchanged on a specific settlement
date, typically the third Wednesdays in
March, June, September, and December.
They are used by MNCs to hedge their
currency positions, and by speculators
who hope to capitalize on their
expectations of exchange rate movements.
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Currency Futures Market
The contracts can be traded by firms or
individuals through brokers on the trading
floor of an exchange (e.g. Chicago
Mercantile Exchange), on automated
trading systems (e.g. GLOBEX), or over-
the-counter.
Participants in the currency futures
market need to establish and maintain a
margin when they take a position.
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Future Contract: Units per Contract
Currency Units per Contract
US dollar, Australian dollar,
Brazilian Real, Canadian dollar,
NZ dollar
$ 100,000
British pound 62,500
Euro, Swiss Frank 125,000
Japanese Yen 12,500,000
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Forward Markets Futures Markets
Contract size Customized. Standardized.
Delivery date Customized. Standardized.
Participants Banks, brokers, Banks, brokers,
MNCs. Public MNCs. Qualified
speculation not public speculation
encouraged. encouraged.
Security Compensating Small security
deposit bank balances or deposit required.
credit lines needed.
Currency Futures Market
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Clearing Handled by Handled by
operation individual banks exchange
& brokers. clearinghouse.
Daily settlements
to market prices.
Marketplace Worldwide Central exchange
telephone floor with global
network. communications.
Currency Futures Market
Forward Markets Futures Markets
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Liquidation Mostly settled by Mostly settled by
actual delivery. offset.
Transaction Banks bid/ask Negotiated
Costs spread. brokerage fees.
Currency Futures Market
Forward Markets Futures Markets
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Currency futures may be purchased by
MNCs to hedge foreign currency payables,
or sold to hedge receivables.
Most currency futures contracts are
closed out before their settlement dates.
Brokers who fulfill orders to buy or sell
futures contracts earn a transaction or
brokerage fee in the form of the bid/ask
spread.

Currency Futures Market
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Currency Options Market
A currency option is another type of
contract that can be purchased or sold by
speculators and firms.
The standard options that are traded on an
exchange through brokers are guaranteed,
but require margin maintenance.
U.S. option exchanges (e.g. Chicago
Board Options Exchange) are regulated by
the Securities and Exchange Commission.
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In addition to the exchanges, there is an
over-the-counter market where
commercial banks and brokerage firms
offer customized currency options.
There are no credit guarantees for these
OTC options, so some form of collateral
may be required.
Currency options are classified as either
calls or puts.
Currency Options Market
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A currency call option grants the holder
the right to buy a specific currency at a
specific price (called the exercise or strike
price) within a specific period of time.
Option owners can sell or exercise their
options. They can also choose to let their
options expire. At most, they will lose the
premiums they paid for their options.

Currency Call Options
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Example: Currency Call Option
Suppose option is allowed in Dhaka and you
speculate that within next April the dollar rate
would increase by a significant margin. The spot
rate today of $1=Tk.67. The strike rate available is
$1=Tk.67.50 and the option premium is Tk.1 per
dollar. What kind of option should you go for?
Draw a contingency graph for both you and the
other party. Also show the profit or loss if the
price of US dollar in April happens to be exactly
Tk.67, Tk.68 and Tk.69?
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Contingency graph of buyer and seller of
call option
Buyer
67.50
68.50

Profit

0

Loss 1




Profit 1

0

Loss
Seller
Future Spot rate
Future Spot rate
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A currency put option grants the holder
the right to sell a specific currency at a
specific price (the strike price) within a
specific period of time.
Currency Put Options
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Efficiency of
Currency Futures and Options
If foreign exchange markets are efficient,
speculation in the currency futures and
options markets should not consistently
generate abnormally large profits.
A speculative strategy requires the
speculator to incur risk. On the other
hand, corporations use the futures and
options markets to reduce their exposure
to fluctuating exchange rates.
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Impact of Currency Derivatives on an MNCs Value
( ) ( ) | |
( )

=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Currency Futures
Currency Options
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Forward Market
How MNCs Use Forward Contracts
Non-Deliverable Forward Contracts
Chapter Review
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Chapter Review
Currency Futures Market
Contract Specifications
Comparison of Currency Futures and
Forward Contracts
Pricing Currency Futures
Credit Risk of Currency Futures Contracts
Speculation with Currency Futures
How Firms Use Currency Futures
Closing Out A Futures Position
Transaction Costs of Currency Futures
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Chapter Review
Currency Options Market
Currency Call Options
Factors Affecting Currency Call Option
Premiums
How Firms Use Currency Call Options
Speculating with Currency Call Options
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Chapter Review
Currency Put Options
Factors Affecting Currency Put Option
Premiums
Hedging with Currency Put Options
Speculating with Currency Put Options
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Chapter Review
Conditional Currency Options
European Currency Options
Efficiency of Currency Futures and
Options
How the Use of Currency Futures and
Options Affects an MNCs Value