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    Currency Derivatives

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    Subhan Imran
    This document discusses currency derivatives such as futures and options. It provides details on: 1) The currency futures market, including contract specifications, pricing, credit risk, how firms use futures to hedge and speculate, and transaction costs. 2) The currency options market, including factors affecting call and put option premiums, and how firms use options to hedge and speculate. 3) Forward contracts between banks and corporations to exchange currencies at a future date, and how forward rates incorporate interest rate differentials.

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    Currency Derivatives

    Uploaded by

    Subhan Imran
    91 views33 pages
    This document discusses currency derivatives such as futures and options. It provides details on: 1) The currency futures market, including contract specifications, pricing, credit risk, how firms use futures to hedge and speculate, and transaction costs. 2) The currency options market, including factors affecting call and put option premiums, and how firms use options to hedge and speculate. 3) Forward contracts between banks and corporations to exchange currencies at a future date, and how forward rates incorporate interest rate differentials.

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    Introduction to account and finance

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    This document discusses currency derivatives such as futures and options. It provides details on: 1) The currency futures market, including contract specifications, pricing, credit risk, how firms use futures to hedge and speculate, and transaction costs. 2) The currency options market, including factors affecting call and put option premiums, and how firms use options to hedge and speculate. 3) Forward contracts between banks and corporations to exchange currencies at a future date, and how forward rates incorporate interest rate differentials.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    91 views33 pages

    Currency Derivatives

    Uploaded by

    Subhan Imran
    This document discusses currency derivatives such as futures and options. It provides details on: 1) The currency futures market, including contract specifications, pricing, credit risk, how firms use futures to hedge and speculate, and transaction costs. 2) The currency options market, including factors affecting call and put option premiums, and how firms use options to hedge and speculate. 3) Forward contracts between banks and corporations to exchange currencies at a future date, and how forward rates incorporate interest rate differentials.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 33

    Currency

    Derivatives
    A financial
    instrument whose characteristics and value
    depend upon the characteristics and value of an
    underlier (A security or commodity which
    is subject to delivery upon exercise of an option
    contract or convertible security), typically
    a commodity, bond, equity or currency. Examples
    of derivatives include futures and options..
    What is in this chapter
    • 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
    • Currency Options Market
    • Currency Call Options
    – Factors Affecting Currency Call Option
    Premiums
    – How Firms Use Currency Call Options
    – Speculating with Currency Call Options
    • Currency Put Options
    – Factors Affecting Currency Put Option
    Premiums
    – Hedging with Currency Put Options
    – Speculating with Currency Put Options
    • Contingency Graphs for Currency Options
    – Contingency Graphs for the Buyers and
    Sellers of Call and Put Options
    • Conditional Currency Options
    • European Currency Options
    • Efficiency of Currency Futures and Option
    Forward Market
    • The forward market facilitates the trading
    of forward contracts on currencies.
    • A forward contract is an agreement
    between a corporation 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.
    • When MNCs anticipate future need or
    future receipt of a foreign currency, they
    can set up forward contracts to lock in the
    exchange rate.
    • Forward 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/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.
    • 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 = $1.681,
    90-day £ forward rate = $1.677.

    $1.677 – $1.681 x 360 = – 0.95%


    $1.681 90
    So, forward discount = 0.95%
    • The forward premium/discount reflects the
    difference between the home interest rate
    and the foreign interest rate, so as to
    prevent arbitrage.
    • 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.
    • Although NDFs do not involve actual
    delivery, they can effectively hedge
    expected foreign currency cash flows.
    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.
    • 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.
    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.
    Markets Forward Markets Futures

    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.
    Markets Forward Markets Futures

    Regulation Self-regulating. Commodity


    Futures Trading
    Commission,
    National Futures
    Association.

    LiquidationMostly settled byMostly settled


    by
    actual delivery. offset.
    Transaction Bank’s bid/ask Negotiated
    Costs spread. brokerage fees.
    • Normally, 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.
    • These relationships are enforced by the
    potential arbitrage activities that would
    occur otherwise.
    • Currency futures contracts have no credit
    risk since they are guaranteed by the
    exchange clearinghouse.
    • To minimize its risk in such a guarantee,
    the exchange imposes margin
    requirements to cover fluctuations in the
    value of the contracts.
    • Speculators often sell currency futures
    when they expect the underlying currency
    to depreciate, and vice versa.

    April 4 June 17
    1. Contract to sell 2. Buy 500,000 pesos
    500,000 pesos @ $.08/peso
    @ $.09/peso ($40,000) from the
    ($45,000) on spot market.
    June 17. 3. Sell the pesos to
    fulfill contract.
    Gain $5,000.
    • Currency futures may be purchased by
    MNCs to hedge foreign currency payables,
    or sold to hedge receivables.

    April 4 June 17
    1. Expect to receive 2. Receive 500,000
    500,000 pesos. pesos as expected.
    Contract to sell
    500,000 pesos 3. Sell the pesos at
    @ $.09/peso on the locked-in rate.
    June 17.
    • 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 February 15 March 19


    1. Contract to 2. Contract to 3. Incurs $3000
    buy sell loss from
    A$100,000 A$100,000 offsetting
    @ $.53/A$ @ $.50/A$ positions in
    ($53,000) on ($50,000) on futures
    March 19. March 19. contracts.
    • 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 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.
    • 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 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 spot rate > strike price,
    – at the money if spot rate = strike price,
    – out of the money
    if spot rate < strike price.
    • 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.
    • 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 with open positions in foreign
    currencies may use currency call options
    to cover those positions.
    • They may purchase currency call options
    – to hedge future payables;
    – to hedge potential expenses when bidding on
    projects; and
    – to hedge potential costs when attempting to
    acquire other firms.
    • Speculators who expect a foreign currency
    to appreciate can purchase call options on
    that currency.
    Profit = selling price – buying (strike) price
    – option premium
    • The purchaser of a call option will break
    even when
    selling price = buying (strike) price
    + option premium
    • The seller (writer) of a call option will break
    even when
    buying price = selling (strike) price
    + option premium
    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 spot rate < strike price,
    – at the money if spot rate = strike price,
    – out of the money
    if spot rate > strike price.
    • 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.
    • Corporations with open foreign currency
    positions may use currency put options to
    cover their positions.
    – For example, firms may purchase put options
    to hedge future receivables.
    • Speculators who expect a foreign currency
    to depreciate can purchase put options on
    that currency.
    – Profit = selling (strike) price – buying price
    – option premium
    • 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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