5: Currency Derivatives

Chapter Objectives Explain how forward contracts are used to hedge based on anticipated exchange rate movements Describe how currency futures contracts are used to speculate or hedge based on anticipated exchange rate movements Explain how currency option contracts are used to speculate or hedge based on anticipated exchange rate movements What is a Currency Derivative? 1. A currency derivative is a contract whose price is derived from the value of an underlying currency. 2. Examples include forwards/futures contracts and options contracts. 3. Derivatives are used by !"s to#

a. $peculate on future exchange rate movements b. %edge exposure to exchange rate ris& Forward Market 'he forward mar&et facilitates the trading of forward contracts on currencies.

A forward contract is an agreement between a corporation and a ban& to exchange a specified amount of a currency at a specified exchange rate (called the forward rate) on a specified date in the future. *hen !"s anticipate future need or receipt of a foreign currency+ they can set up forward contracts to loc& in the exchange rate. ,orward contracts are often valued at -1 million or more+ and are not normally used by consumers or small firms. As with the case of spot rates+ there is a bid/as& spread on forward rates. How M Cs !se Forward Contracts %edge their imports by loc&ing in the rate at which they can obtain the currency .id/As& $pread is wider for less li/uid currencies. 0ffsetting a ,orward "ontract 1 An !" can offset a forward contract

by negotiating with the original counterparty ban&. !on2deliverable forward contracts (!D,) can be used for emerging mar&et currencies where no currency delivery ta&es place at settlement. 3nstead+ a net payment is made by one party to the other based on the contracted rate and the mar&et rate on the day of settlement. Although !D,s do not involve actual delivery+ they can effectively hedge expected foreign currency cash flows.

"re#iu# or Discount on the Forward $ate ,orward rates may also contain a premium or discount. 3f the forward rate exceeds the existing spot rate+ it contains a pre#iu#. 3f the forward rate is less than the existing spot rate+ it contains a discount. Annuali4ed forward premium/discount 5
forward rate - spot rate 360 x spot rate n

where n is the number of days to maturity 'he forward premium/discount reflects the difference between the home interest rate and the foreign interest rate+ so as to prevent arbitrage. F = S(1 + p) , is the forward rate+ $ is the spot rate+ p is the forward premium+ or the 6 by which the forward rate exceeds the spot rate. %&hibit 5'( Co#putation of Forward $ate "re#iu#s or Discounts

ovements in the ,orward 7ate over 'ime 1 'he forward premium is influenced by the interest rate differential between the 2 countries and can change over time.

Currency Futures Market $imilar to forward contracts in terms of obligation to purchase or sell currency on a specific settlement date in the future. !ormally+ the price of a currency futures contract is similar to the forward rate for a given currency and settlement date+ but differs from the spot rate when the interest rates on the two currencies differ. 'hese relationships are enforced by the potential arbitrage activities that would occur otherwise. "urrency futures contracts have no credit ris& since they are guaranteed by the exchange clearinghouse. 'o minimi4e its ris& in such a guarantee+ the exchange imposes margin re/uirements to cover fluctuations in the value of the contracts. $peculators often sell currency futures when they expect the underlying currency to depreciate+ and vice versa. "urrency futures contracts specify a standard volume of a particular currency to be exchanged on a specific settlement date+ typically the third *ednesdays in arch+ 8une+ $eptember and December.

Differ from forward contracts because futures have standard contract specifications# a. b. c. d. $tandardi4ed number of units per contract ($ee Exhibit 9.2) 0ffer greater li/uidity than forward contracts 'ypically based on :.$. dollar+ but may be offered on cross2rates "ommonly traded on the "hicago ercantile Exchange (" E)

%&hibit 5') Co#parison of the Forward and Futures Market

,utures are used by movements.

!"s to hedge their currency positions+ and by

speculators who hope to capitali4e on their expectations of exchange rate 'he contracts can be traded by firms or individuals through bro&ers on the trading floor of an exchange (e.g. "hicago ercantile Exchange)+ on automated trading systems (e.g. ;<0.E=)+ or over2the2counter. ost currency futures contracts are closed out before their settlement dates. .ro&ers who fulfill orders to buy or sell futures contracts earn a transaction or bro&erage fee in the form of the bid/as& spread.

%&hibit 5'* Currency Futures Contracts +raded on the Chica,o Mercanti-e %&chan,e

+radin, Currency Futures ,irms or individuals can execute orders for currency futures contracts by calling bro&erage firms. Electronic trading platforms facilitate the trading of currency futures. 'hese platforms serve as a bro&er+ as they execute the trades desired. "urrency futures contracts are similar to forward contracts in that they allow a customer to loc& in the exchange rate at which a specific currency is purchased or sold for a specific date in the future.

>ricing "urrency ,utures 2 'he price of currency futures will be similar to the forward rate "redit 7is& of "urrency ,utures "ontracts 2 'o minimi4e its ris&+ the " E imposes margin re/uirements to cover fluctuations in the value of a contract+ meaning that the participants must ma&e a deposit with their respective bro&erage firms when they ta&e a position. How Fir#s !se Currency Futures >urchasing ,utures to %edge >ayables 2 'he purchase of futures contracts loc&s in the price at which a firm can purchase a currency. $elling ,utures to %edge 7eceivables 2 'he sale of futures contracts loc&s in the price at which a firm can sell a currency.

C-osin, Out a Futures "osition $ellers (buyers) of currency futures can close out their positions by buying (selling) identical futures contracts prior to settlement. ost currency futures contracts are closed out before the settlement date. %&hibit 5'. C-osin, Out a Futures Contract

/pecu-ation with Currency Futures 1. "urrency futures contracts are sometimes purchased by speculators attempting to capitali4e on their expectation of a currency?s future movement. 2. "urrency futures are often sold by speculators who expect that the spot rate of a currency will be less than the rate at which they would be obligated to sell it. %&hibit 5'5 /ource of 0ains fro# 1uyin, Currency Futures

%olders of futures contracts can close out their positions by selling similar futures contracts. $ellers may also close out their positions by purchasing similar contracts.
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8anuary 1@ 1. "ontract to buy A-1@@+@@@ B -.93/A(-93+@@@) on arch 1A.

,ebruary 19 2. "ontract to sell A-1@@+@@@ B -.9@/A(-9@+@@@) on arch 1A.

arch 1A 3. 3ncurs -3@@@ loss from offsetting positions in futures contracts.

Currency Futures Market %fficiency 1. 2. 3f the currency futures mar&et is efficient+ the futures price should reflect all available information. 'hus+ the continual use of a particular strategy to ta&e positions in currency futures contracts should not lead to abnor#a- profits. 3. 7esearch has found that the currency futures mar&et may be inefficient. %owever+ the patterns are not necessarily observable until after they occur+ which means that it may be difficult to consistently generate abnormal profits from speculating in currency futures. Currency Options Market A currency option is another type of contract that can be purchased or sold by speculators and firms. "urrency options provide the right to purchase or sell currencies at specified prices.

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'he standard options are traded on an exchange through bro&ers 2 are guaranteed and re/uire margin maintenance. :.$. option exchanges (e.g. "hicago .oard 0ptions Exchange) are regulated by the $ecurities and Exchange "ommission. 'here are no credit guarantees for these 0'" options+ so some form of collateral may be re/uired. 0ptions Exchanges 1AC2 2 exchanges in Amsterdam+ ontreal+ and >hiladelphia first

allowed trading in standardi4ed foreign currency options. 2@@D 1 " E and ".0' merged to form " E group Exchanges are regulated by the $E" in the :.$. 0ver2the2counter mar&et# *here currency options are offered by commercial ban&s and bro&erage firms. :nli&e the currency options traded on an exchange+ the over2the2counter mar&et offers currency options that are tailored to the specific needs of the firm.

Currency Ca-- Options

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 A currency ca-- 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. A call option is o in the money o at the money o out of the money if spot rate E stri&e price+ if spot rate 5 stri&e price+ if spot rate F stri&e price.

0ption owners can sell or exercise their options. 'hey can also choose to let their options expire. At most+ they will lose the premiums they paid for their options. Factors 2ffectin, Currency Ca-- Option "re#iu#s 'he premium on a call option (") is affected by three factors# /pot price re-ative to the strike price 3/ 4 56# 'he higher the spot rate relative to the stri&e price+ the higher the option price will be. 7en,th of ti#e before e&piration 3+6: 'he longer the time to expiration+ the higher the option price will be. "otentia- variabi-ity of currency 36: 'he greater the variability of the currency+ the higher the probability that the spot rate can rise above the stri&e price. $peculators who expect a foreign currency to appreciate can purchase call options on that currency.
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>rofit 5 depreciate.

selling price 1 buying (stri&e) price

1 option premium

'hey may also sell (write) call options on a currency that they expect to >rofit 5 option premium 1 buying price G selling (stri&e) price 'he purchaser of a call option will brea& even when o selling price 5 buying (stri&e) price G option premium 'he seller (writer) of a call option will brea& even when o buying price 5 selling (stri&e) price G option premium

How Fir#s !se Currency Ca-- Options ,irms can use call options to# hedge payables hedge proHect bidding to loc& in the dollar cost of potential expenses. hedge target bidding of a possible ac/uisition. $peculate on expectations of future movements in a currency. Currency "ut Options

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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. A put option is o in the money o at the money if spot rate F stri&e price+ if spot rate 5 stri&e price+

o out of the money if spot rate E stri&e price. "orporations with open foreign currency positions may use currency put options to cover their positions. ,or example+ firms may purchase put options to hedge future receivables $peculators who expect a foreign currency to depreciate can purchase put options on that currency. o >rofit 5 selling (stri&e) price 1 buying price 1 option premium 'hey may also sell (write) put options on a currency that they expect to appreciate. o >rofit 5 option premium G selling price Factors 2ffectin, "ut Option "re#iu#s >ut option premiums are affected by three factors# /pot rate re-ative to the strike price 3/456: 'he lower the spot rate relative to the stri&e price+ the higher the probability that the option will be exercised.
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1 buying (stri&e) price

7en,th of ti#e unti- e&piration 3+6: 'he longer the time to expiration+ the greater the put option premium 8ariabi-ity of the currency 36: 'he greater the variability+ the greater the probability that the option may be exercised. Hed,in, with Currency "ut Options 1. 2. "orporations with open positions in foreign currencies can use currency put options in some cases to cover these positions. $ome put options are deep out of the #oney+ meaning that the prevailing exchange rate is high above the exercise price. 'hese options are cheaper (have a lower premium)+ as they are unli&ely to be exercised because their exercise price is too low. 3. 0ther put options have an exercise price that is currently above the prevailing exchange rate and are therefore more li&ely to be exercised. "onse/uently+ these options are more expensive. /pecu-atin, with Currency "ut Options 1. 2. 3ndividuals may speculate with currency put options based on their expectations of the future movements in a particular currency. $peculators can attempt to profit from selling currency put options. 'he seller of such options is obligated to purchase the specified currency at the stri&e price from the owner who exercises the put option.

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3.

'he net profit to a speculator is based on the exercise price at which the currency can be sold versus the purchase price of the currency and the premium paid for the put option. 0ne possible speculative strategy for volatile currencies is to purchase both a put option and a call option at the same exercise price. 'his is called a straddle. .y 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.

%&hibit 5'9 Contin,ency 0raphs for Currency Options

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Conditiona- Currency Options A currency option may be structured such that the premium is conditioned on the actual currency movement over the period of concern. $uppose a conditional put option on I has an exercise price of -1.D@+ and a trigger of -1.DJ. 'he premium will have to be paid only if the I?s value exceeds the trigger value.

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 $imilarly+ a conditional call option on I may specify an exercise price of -1.D@+ and a trigger of -1.KD. 'he premium will have to be paid only if the I?s value falls below the trigger value. 3n both cases+ the payment of the premium is avoided conditionally at the cost of a higher premium. %&hibit 5': Co#parison of Conditiona- and 1asic Currency Options

%uropean Currency Options %uropean;sty-e currency options must be exercised on the expiration date if they are to be exercised at all. 'hey do not offer as much flexibilityL however+ this is not relevant to some situations.

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3f European2style options are available for the same expiration date as American2style options and can be purchased for a slightly lower premium+ some corporations may prefer them for hedging.

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