International Financial Management
Abridged 12th Edition
by Jeff Madura
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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
2
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What is a Currency Derivative?
A currency derivative is a contract whose price is
derived from the value of an underlying currency.
Examples include forwards/futures contracts and
options contracts.
Derivatives are used by MNCs to:
Speculate on future exchange rate movements
Hedge exposure to exchange rate risk
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3 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Forward Market
A forward contract is an agreement between a
corporation and a financial institution:
To exchange a specified amount of currency
At a specified exchange rate called the forward rate
On a specified date in the future
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4 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Forward Market
How MNCs Use Forward Contracts
Hedge their imports by locking in the rate at which
they can obtain the currency
Bank Quotations on Forward Rates
Bid/Ask Spread is wider for less liquid currencies.
May negotiate an offsetting trade if an MNC enters
into a forward sale and a forward purchase with the
same bank.
Non-deliverable forward contracts (NDF) can be used
for emerging market currencies where no currency
delivery takes place at settlement, instead one party
makes a payment to the other party.
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5 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Forward Market
Premium or Discount on the Forward Rate
(Exhibit 5.1)
F = S(1 + p)
where:
F is the forward rate
S is the spot rate
p is the forward premium, or the percentage by which the
forward rate exceeds the spot rate.
Arbitrage – If the forward rate was the same as the spot
rate, arbitrage would be possible.
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6 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 5.1 Computation of Forward Rate Premiums or
Discounts
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7 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Forward Market
Movements in the Forward Rate over Time – The forward
premium is influenced by the interest rate differential between
the two countries and can change over time.
Offsetting a Forward Contract – An MNC can offset a forward
contract by negotiating with the original counterparty bank.
Using Forward Contracts for Swap Transactions - involves a
spot transaction along with a corresponding forward contract that
will ultimately reverse the spot transaction.
Non-deliverable forward contracts (NDF) - can be used for
emerging market currencies where no currency delivery takes
place at settlement; instead one party makes a payment to the
other party.
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8 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Futures Market
Similar to forward contracts in terms of obligation to
purchase or sell currency on a specific settlement date in the
future.
Contract Specifications: Differ from forward contracts
because futures have standard contract specifications:
Standardized number of units per contract (See Exhibit 5.2)
Offer greater liquidity than forward contracts
Typically based on U.S. dollar, but may be offered on cross-
rates.
Commonly traded on the Chicago Mercantile Exchange
(CME).
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9 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 5.2 Currency Futures Contracts Traded on the
Chicago Mercantile Exchange
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10 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Futures Market
Trading Currency Futures
Firms or individuals can execute orders for currency
futures contracts by calling brokerage firms.
Trading platforms for currency futures: Electronic
trading platforms facilitate the trading of currency
futures. These platforms serve as a broker, as they
execute the trades desired.
Currency futures contracts are similar to forward
contracts in that they allow a customer to lock in the
exchange rate at which a specific currency is purchased
or sold for a specific date in the future.
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11 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 5.3 Comparison of the Forward and Futures Market
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Currency Futures Market
Comparing Futures to Forward Contracts
Currency futures contracts are similar to forward contracts in
that they allow a customer to lock in the exchange rate at which
a specific currency is purchased or sold for a specific date in the
future. (Exhibit 5.3)
Pricing Currency Futures - The price of currency futures will
be similar to the forward rate
Credit Risk of Currency Futures Contracts - To minimize
its risk, the CME imposes margin requirements to cover
fluctuations in the value of a contract, meaning that the
participants must make a deposit with their respective
brokerage firms when they take a position.
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13 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Futures Market
How Firms Use Currency Futures
Purchasing Futures to Hedge Payables - The
purchase of futures contracts locks in the price at
which a firm can purchase a currency.
Selling Futures to Hedge Receivables - The sale of
futures contracts locks in the price at which a firm can
sell a currency.
Closing Out a Futures Position (Exhibit 5.4)
Sellers (buyers) of currency futures can close out their
positions by buying (selling) identical futures contracts
prior to settlement.
Most currency futures contracts are closed out before
the settlement date.
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14 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 5.4 Closing Out a Futures Contract
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15 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Futures Market
Speculation with Currency Futures (Exhibit 5.5)
Currency futures contracts are sometimes purchased by
speculators attempting to capitalize on their expectation of a
currency’s future movement.
Currency 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.
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16 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 5.5 Source of Gains from Buying Currency
Futures
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17 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Futures Market
Speculation with Currency Futures (cont.)
Efficiency of the currency futures market
If the currency futures market is efficient, the futures price
should reflect all available information.
Thus, the continual use of a particular strategy to take
positions in currency futures contracts should not lead to
abnormal profits.
Research has found that the currency futures market may be
inefficient. However, 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.
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18 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Options Markets
Currency options provide the right to purchase or sell
currencies at specified prices.
Options Exchanges
1982 - exchanges in Amsterdam, Montreal, and
Philadelphia first allowed trading in standardized foreign
currency options.
2007 – CME and CBOT merged to form CME group
Exchanges are regulated by the SEC in the U.S.
Over-the-counter market - Where currency options are
offered by commercial banks and brokerage firms. Unlike the
currency options traded on an exchange, the over-the-counter
market offers currency options that are tailored to the specific
needs of the firm.
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19 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Call Options
Grants the right to buy a specific currency at a
designated strike price or exercise price within a
specific period of time.
If the spot rate rises above the strike price, the owner of
a call can exercise the right to buy currency at the
strike price.
The buyer of the option pays a premium.
If the spot exchange rate is greater than the strike price,
the option is in the money. If the spot rate is equal to
the strike price, the option is at the money. If the spot
rate is lower than the strike price, the option is out of
the money.
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20 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Call Options
Factors Affecting Currency Call Option Premiums
The premium on a call option (C) is affected by three factors:
Spot price relative to the strike price (S – X): The higher the
spot rate relative to the strike price, the higher the option price
will be.
Length of time before expiration (T): The longer the time
to expiration, the higher the option price will be.
Potential variability of currency (σ): The greater the
variability of the currency, the higher the probability that the
spot rate can rise above the strike price.
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21 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Call Options
How Firms Use Currency Call Options
Using call options to hedge payables
Using call options to hedge project bidding to lock in
the dollar cost of potential expenses.
Using call options to hedge target bidding of a possible
acquisition.
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22 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Call Options
Speculating with Currency Call Options
Individuals may speculate in the currency options based
on their expectations of the future movements in a
particular currency.
Speculators who expect that a foreign currency will
appreciate can purchase call options on that security.
The net profit to a speculator is based on a comparison of
the selling price of the currency versus the exercise price
paid for the currency and the premium paid for the call
option.
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23 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Call Options
Speculating with Currency Call Options (cont.)
Break-even point from speculation
Break even if the revenue from selling the currency equals
the payments made for the currency plus the option
premium.
Speculation by MNCs.
Some institutions may have a division that uses currency
options to speculate on future exchange rate movements
Most MNCs use currency derivatives for hedging and not
speculation.
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24 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Put Options
Grants the right to sell a currency at a specified strike price
or exercise price within a specified period of time.
If the spot rate falls below the strike price, the owner of a
put can exercise the right to sell currency at the strike price.
The buyer of the options pays a premium.
If the spot exchange rate is lower than the strike price, the
option is in the money. If the spot rate is equal to the strike
price, the option is at the money. If the spot rate is greater
than the strike price, the option is out of the money.
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25 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Put Options
Factors Affecting Put Option Premiums
Put option premiums are affected by three factors:
Spot rate relative to the strike price (S–X): The lower
the spot rate relative to the strike price, the higher the
probability that the option will be exercised.
Length of time until expiration (T): The longer the
time to expiration, the greater the put option premium
Variability of the currency (σ): The greater the
variability, the greater the probability that the option
may be exercised.
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26 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Put Options
Hedging with Currency Put Options
Corporations with open positions in foreign currencies can use
currency put options in some cases to cover these positions.
Some put options are deep out of the money, meaning that
the prevailing exchange rate is high above the exercise price.
These options are cheaper (have a lower premium), as they are
unlikely to be exercised because their exercise price is too low.
Other put options have an exercise price that is currently
above the prevailing exchange rate and are therefore more
likely to be exercised. Consequently, these options are more
expensive.
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27 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Put Options
Speculating with Currency Put Options
Individuals may speculate with currency put options based on
their expectations of the future movements in a particular
currency.
Speculators can attempt to profit from selling currency put
options. The seller of such options is obligated to purchase
the specified currency at the strike price from the owner who
exercises the put option.
The 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..
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28 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Put Options
Speculating with Currency Put Options (cont.)
Speculating with combined put and call options
Straddle - uses both a put option and a call option at the same
exercise price
Good for when speculators expect strong movement in one
direction or the other
Efficiency of the currency options market
Research has found that, when transaction costs are controlled
for, the currency options market is efficient.
It is difficult to predict which strategy will generate abnormal
profits in future periods.
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29 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Put Options
Contingency graph for the caller of a call option
Compares price paid for the option to the payoffs received under
various exchange rate scenarios. (Exhibit 5.6)
Contingency graph for the seller of a call option
Compares premium received from selling the option to the payoffs
made to the options buyer under various exchange rate scenarios.
(Exhibit 5.6)
Contingency graph for the buyer of a put option
Compares premium paid for put option to the payoffs received
under various exchange rate scenarios. (Exhibit 5.6)
Contingency graph for the seller of a put option
Compares premium received for put option to the payoffs made
under various exchange rate scenarios. (Exhibit 5.6)
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30 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 5.6 Contingency Graphs for Currency Options
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Currency Put Options
Conditional Currency Options (Exhibit 5.7)
A currency option can be structured with a conditional
premium, meaning that the premium paid for the option is
conditioned on the actual movement in the currency’s value
over the period of concern.
Firms also use various combinations of currency options.
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32 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 5.7 Comparison of Conditional and Basic
Currency Options
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Currency Put Options
European Currency Options
European-style currency options must be exercised on the
expiration date if they are to be exercised at all.
They do not offer as much flexibility; however, this is not
relevant to some situations.
If European-style options are available for the same
expiration date as American-style options and can be
purchased for a slightly lower premium, some corporations
may prefer them for hedging.
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34 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
SUMMARY
A forward contract specifies a standard volume of a
particular currency to be exchanged on a particular date.
Such a contract can be purchased by a firm to hedge
payables or sold by a firm to hedge receivables. A currency
futures contract can be purchased by speculators who expect
the currency to appreciate; it can also be sold by speculators
who expect the currency to depreciate. If the currency
depreciates then the futures contract declines, allowing
those speculators to benefit when they close out their
positions.
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35 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
SUMMARY
Futures contracts on a particular currency can be purchased
by corporations that have payables in that currency and
wish to hedge against the possible appreciation of that
currency. Conversely, these contracts can be sold by
corporations that have receivables in that currency and wish
to hedge against the possible depreciation of that currency
and wish to hedge against its possible depreciation.
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36 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
SUMMARY (Cont.)
Currency options are classified as call options or put
options. A call option gives its owner the right to purchase a
specified currency at a specified exchange rate by a
specified expiration date. Likewise, put options give the
right to sell a specified currency at a specified exchange rate
by a specified expiration date.
Call options on a specific currency can be purchased by
speculators who expect the currency to appreciate. Put
options on a specific currency can be purchased by
speculators who expect that currency to depreciate.
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37 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
SUMMARY (Cont.)
Currency call options are commonly purchased by
corporations that have payables in a currency that is
expected to appreciate. Currency put options are commonly
purchased by corporations that have receivables in a
currency that is expected to depreciate.
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38 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
