Chapter

5
Currency Derivatives

South-Western/Thomson Learning 2006

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
A forward contract is an agreement
between a firm 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.

Forward contracts are often valued at $1

million or more, and are not normally used by consumers or small firms.
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Forward Market
When MNCs anticipate a future need for or
future receipt of a foreign currency, they can set up forward contracts to lock in the exchange rate.

The % by which the forward rate (F )

exceeds the spot rate (S ) at a given point in time is called the forward premium (p ). F = S (1 + p )

F exhibits a discount when p < 0.

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Forward Market
Example S = $1.681/, 90-day F = $1.677/ annualized p = F S 360 S n 1.677 1.681 360 = .95% = 1.681 90
The forward premium (discount) usually reflects the difference between the home

and foreign interest rates, thus preventing arbitrage.

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Forward Market
A swap transaction involves a spot transaction
along with a corresponding forward contract that will reverse the spot transaction.

A non-deliverable forward contract (NDF) does

not result in an actual exchange of currencies. Instead, one party makes a net payment to the other based on a market exchange rate on the day of settlement.

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Forward Market
An NDF can effectively hedge future
foreign currency payments or receipts:
April 1 Expect need for 100M Chilean pesos. Negotiate an NDF to buy 100M Chilean pesos on Jul 1. Reference index (closing rate quoted by Chiles central bank) = $.0020/peso. July 1 Buy 100M Chilean pesos from market. Index = $.0023/peso receive $30,000 from bank due to NDF. Index = $.0018/peso pay $20,000 to bank.
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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.

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), automated trading systems (e.g. GLOBEX), or the over-thecounter market.

Brokers who fulfill orders to buy or sell

futures contracts typically charge a commission.
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Comparison of the Forward & Futures Markets

Contract size Delivery date Participants Forward Markets Customized Customized Banks, brokers, MNCs. Public speculation not encouraged. Compensating bank balances or credit lines needed. Handled by individual banks & brokers. Futures Markets Standardized Standardized Banks, brokers, MNCs. Qualified public speculation encouraged. Small security deposit required. Handled by exchange clearinghouse. Daily settlements to market prices.
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Security deposit
Clearing operation

Comparison of the Forward & Futures Markets

Forward Markets Marketplace Worldwide telephone network Self-regulating Futures Markets Central exchange floor with worldwide communications. Commodity Futures Trading Commission, National Futures Association. Mostly settled by offset.

Regulation

Liquidation

Mostly settled by actual delivery.

Transaction Costs

Banks bid/ask spread.

Negotiated brokerage fees.

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Currency Futures Market

Enforced by potential arbitrage activities,
the prices of currency futures are closely related to their corresponding forward rates and spot rates.

Currency futures contracts are guaranteed

by the exchange clearinghouse, which in turn minimizes its own credit risk by imposing margin requirements on those market participants who take a position.
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Currency Futures Market

Speculators often sell currency futures
when they expect the underlying currency to depreciate, and vice versa.
April 4
1. Contract to sell 500,000 pesos @ $.09/peso ($45,000) on June 17.

June 17
2. Buy 500,000 pesos @ $.08/peso ($40,000) from the spot market. 3. Sell the pesos to fulfill contract. Gain $5,000.
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Currency Futures Market

MNCs may purchase currency futures to
hedge their foreign currency payables, or sell currency futures to hedge their receivables.
April 4 1. Expect to receive 500,000 pesos. Contract to sell 500,000 pesos @ $.09/peso on June 17. June 17 2. Receive 500,000 pesos as expected. 3. Sell the pesos at the locked-in rate.

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Currency Futures Market

Holders of futures contracts can close out
their positions by selling similar futures contracts. Sellers may also close out their positions by purchasing similar contracts.
January 10 1. Contract to buy A$100,000 @ $.53/A$ ($53,000) on March 19. February 15 2. Contract to sell A$100,000 @ $.50/A$ ($50,000) on March 19. March 19 3. Incurs $3000 loss from offsetting positions in futures contracts.
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Currency Options Market

Currency options provide the right to
purchase or sell currencies at specified prices. They are classified as calls or puts.

Standardized options are traded on

exchanges through brokers.

Customized options offered by brokerage

firms and commercial banks are traded in the over-the-counter market.

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Currency Call Options

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.

A call option is

in the money if exchange rate > strike price, at the money if exchange rate = strike price, out of the money if exchange rate < strike price.

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Currency Call Options

Option owners can sell or exercise their
options, or let their options expire.

Call option premiums will be higher when:

(spot price strike price) is larger; the time to expiration date is longer; and the variability of the currency is greater.

Firms may purchase currency call options

to hedge payables, project bidding, or target bidding.
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Currency Call Options

Speculators may purchase call options on
a currency that they expect to appreciate. Profit = selling (spot) price option premium buying (strike) price At breakeven, profit = 0.

They may also sell (write) call options on a

currency that they expect to depreciate. Profit = option premium buying (spot) price + selling (strike) price
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Currency Put Options

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.

A put option is

in the money if exchange rate < strike price, at the money if exchange rate = strike price, out of the money if exchange rate > strike price.

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Currency Put Options

Put option premiums will be higher when:

(strike price spot rate) is larger; the time to expiration date is longer; and the variability of the currency is greater.

Firms may purchase currency put options

to hedge future receivables.

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Currency Put Options

Speculators may purchase put options on
a currency that they expect to depreciate. Profit = selling (strike) price buying price option premium

They may also sell (write) put options on a

currency that they expect to appreciate. Profit = option premium + selling price buying (strike) price

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Currency Put Options

One possible speculative strategy for
volatile currencies is to purchase both a put option and a call option at the same exercise price. This is called a straddle.

By purchasing both options, the

speculator may gain if the currency moves substantially in either direction, or if it moves in one direction followed by the other.
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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.

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Contingency Graphs for Currency Options

For Buyer of Call Option For Seller of Call Option

Strike price = $1.50 Premium = $ .02

Net Profit per Unit +$.04 +$.02 0 $1.46

Strike price = $1.50 Premium = $ .02

Net Profit per Unit +$.04 +$.02 0 Future Spot Rate $1.46

$1.50

$.02 $.04

$1.54 Future Spot Rate

$1.50

$1.54

$.02 $.04
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Contingency Graphs for Currency Options

For Buyer of Put Option For Seller of Put Option

Strike price = $1.50 Premium = $ .03

Net Profit per Unit +$.04 +$.02 0 $1.46

Strike price = $1.50 Premium = $ .03

Net Profit per Unit +$.04

Future Spot Rate $1.50 $1.54

+$.02 0 $1.46

$1.50

$.02 $.04

$.02 $.04

$1.54 Future Spot Rate

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