1

Chapter 5

Currency Derivatives

Source: http://www.mcdonalds.com/corp/invest/pub/2006_Annual_Report.html

McDonald’s Corporation 2006, Annual Report, p 46

2

Source: http://www.mcdonalds.com/corp/invest/pub/2006_Annual_Report.html

McDonald’s Corporation 2006, Annual Report, p 36

3

Agree today on a price to be paid in the

future for a specified amount of foreign

currency at a specified delivery date

When you enter into a Forward Contract,

four important things must be agreed upon:

• Whether you will buy or sell the foreign currency

• How much of the foreign currency is involved

• The exchange rate

• When the exchange will take place

Forward Contracts

4

Suppose an American tourist plans to

go to England six months (180 days)

from today and he plans to spend

$1,000 while he is there.

1. Buy £’s today at the current

spot rate of S0 = $1.48/ £

How many £’s will he get?

1000

148

,

. £676

What choices does he have for getting

the £’s he will need?

5

2. Buy £’s with a Forward Contract today at

the current forward rate of F180 = $1.44/£

3. Wait six months and buy £’s at the then

current spot rate

Which of the three is the best course of action?

He will not know until six months from today

but he must make a decision today.

$1,

$1. /

000

44 ££694

6

Today’s Spot Rate (S) and Today’s Forward Rate (F)

F = S(1 + p)

p is the forward premium as a percentage

In the previous example:

%7.248.1$

04.0$

48.1$

48.1$44.1$

S

SF1

S

Fp

A negative number indicates a Forward Discount

A positive number indicates a Forward Premium

Frequently calculated as an annual rate,

but we won’t in this class

7

The Forward Rate is better for buying the

foreign currency than the current Spot Rate

(in direct quotations, the Forward

Rate is less than the Spot Rate)

Forward Discount

Forward Premium The Forward Rate is worse for buying the foreign

currency than the current Spot Rate

(in direct quotations, the Forward Rate is more

than the Spot Rate)

8

What influences today’s Forward Rate (F180)?

A major influence is what people today expect

the Spot Rate (S180 ) to be 180 days from now

Suppose today

F180 = $1.50/£ > $1.40/£ = E[S180]

What will happen in the market for

£ Forward Contracts under these conditions?

The 180-day Forward Rate of $1.50/£ will

decrease until it is equal to E[S180 ]

Later in the semester we will investigate other

factors which influence today’s Forward Rates

More people will want to sell £’s at $1.50/£

than will want to buy them at that price

A surplus will exist

9

Currencies Monday, July 9, 2007

U.S.- dollar foreign-exchange rates in late New York trading

US$ vs

----- Mon ----- YTD chg

Country/currency In US$ per US$ (%)

Europe

UK pound 2.0150 0.4963 - 2.8

1-mos forward 2.0140 0.4965 - 2.8

3-mos forward 2.0121 0.4970 - 2.7

6-mos forward 2.0083 0.4979 -2.5

Tuesday, July 10, 2007

On Monday, what was the market expecting the

value of the $ to do over the next 180 days?

The $ will appreciate against the £ over the

next 6 months (180 days)

Wall Street Journal

Spot Rate

10 Source: http://www.bmonesbittburns.com/economics/fxrates/?region=us

11

On Tuesday, October 6, 1998, the spot rate

for the yen was ¥130.18/$. The next day the

spot rate dropped to ¥120.55/$.

Wednesday’s Wall Street Journal reported that

some analysts were predicting “the U.S. currency

could rally to ¥140/$ in six months”.

Wednesday’s 6-month forward rate was

¥117.45/$. Assume you believed the analysts’

prediction and you had $500. How could you

have used a forward contract to make a profit?

Should you “buy” or “sell” yen at the forward

rate of ¥117.45/$?

¥ vs $

12

To apply the rule “buy low and sell high”,

think in terms of $/¥ rather than ¥/$

Spot market in 6 months: ¥140/$ = $0.007143/¥

6-months forward rate: ¥117.45/$ = $0.008514/¥

Sell yen forward at $0.008514/¥ anticipating being

able to buy yen in six months at $0.007143/¥

CAUTION

13

Sell ¥ forward 6 months at a rate of ¥117.45/$

How many ¥?

You anticipate buying ¥ in the spot market in

6 months at a rate of ¥140/$

$500(¥140/$) = ¥70,000

Enter into a forward contract

Wednesday Oct 7

14

Use your $500 in the spot market to buy ¥70,000

Deliver the ¥70,000 on the

forward contract and receive

70 000

117 45

,

.$596

Dollar profit = $96

Six Months Later

15

Non-Deliverable Forward Contracts

Frequently used for currencies in

emerging markets

Similar to Forward Contract: specified currency,

specified amount, specified future settlement

date, specified rate (reference index)

Different from Forward Contract: no actual

exchange of currencies in future, instead a $

payment is made based on reference index at

the settlement date

16 Source: http://www.cme.com/files/renminbi_factcard.pdf

17

Specifies a standard amount of a currency to be delivered at

a specified settlement date in the future at a specific price

Futures Contracts

Source: http://www.cme.com/trading/prd/fx/

18

CURRENCY FUTURES

Monday, July 9, 2007

Sept contracts opened at $0.008179/¥

Open

Open High Low Settle Chg Interest

Sept .8179 .8189 .8158 .8180 .0001 310,150

June ’08 .8445 .8453 .8440 .8448 .0001 15,360

At the end of the trading day Monday, there

were 310,150 Sept contracts outstanding

Japan Yen (CME) 12.5 million; $ per 100¥

CME = Chicago Mercantile Exchange

Tuesday, July 10, 2007

Wall Street Journal

19

Forward: Tailored to individual needs

Futures: Standardized

Comparison of Forward

and Futures Contracts

Size of contract

Forward: Tailored to individual needs

(30, 60, 90 or 180 days)

Futures: Standardized (third Wednesday in

March, June, September, December)

Delivery date

20

Forward: Banks, brokers, MNC’s

(public speculation not encouraged)

Futures: Banks, brokers, MNC’s

(Qualified public speculation is

encouraged)

Participants

Forward: Over the telephone, worldwide

Futures: Central exchange floor with

worldwide communications

Marketplace

21

Forward: Usually none (relationship with

bank) but compensating balance or

line of credit sometimes required

Futures: Small security deposit required

(buy on margin, subject to daily

margin calls)

Security deposit

(collateral)

22

Forward: Most settled by actual delivery

(Some by offset, at a cost)

Futures: Most by offset (very few by delivery)

Liquidation

Forward: Set by “spread” between bank’s

buy & sell prices

Futures: Negotiated brokerage fees

Transactions costs

23

Forward: Self-regulating

Futures: Commodity Futures Trading

Commission, National Futures

Association

Regulation

Forward: you enter into a forward contract

Futures: you buy or sell futures contracts

Terminology

24

Futures Contract

The buyer of this contract agrees to

purchase 125,000 Swiss Francs on the third

Wednesday in March for

$0.76(125,000) = $95,000

The seller of this contract agrees to

deliver 125,000 Swiss Francs on the third

Wednesday in March and will receive

$95,000

125,000 Swiss Francs per contract

$0.76/SF on a March contract

January 5

25

On this investment you lost

$95,000 - $92,500 = $2,500

or 2.63% of your investment

Suppose three weeks after purchasing

the contract you decide you do not

want Swiss Francs in March

Approximately 44% annual rate

Sell a March SF contract at the current

price of $0.74/SF you would receive

0.74(125,000) = $92,500

Closing out your position

26

To make money by “making a market”.

What concern does the buyer of a futures

contract have about the seller of the contract?

Why is the CME in business?

That the seller won’t deliver the foreign currency.

That the buyer won’t deliver the home currency.

What can the CME do to make sure both

parties honor the contract?

What concern does the seller of a futures

contract have about the buyer of the contract?

The CME guarantees delivery on contracts by

requiring a margin when the contract is sold.

27

If the buyer refuses, CME will sell an offsetting

futures contract for $94,375 and close out

buyer’s position and give buyer

$1,500 - $625 = $875

Suppose the buyer and seller put up a margin

of $1,500 on January 5 when they bought/sold

the $0.76/SF March futures contract

If the price of SF’s falls the next day to $0.755,

the contract is worth only $94,375. Who might

not show up, the buyer or the seller?

CME may choose to increase the buyer’s

margin by $95,000 - $94,375 = $625

28

Source: http://www.mcdonalds.com/corp/invest/pub/2006_Annual_Report.html

McDonald’s Corporation 2006, Annual Report, p 36

29

Source: http://www.mcdonalds.com/corp/invest/pub/2006_Annual_Report.html

McDonald’s Corporation 2006, Annual Report, p 36

30

Currency Options

Grants the right to buy a specific

amount of a specific currency

The “premium” is what it costs to

buy the Call Option

At a specific price (strike price or exercise price)

Within a specific period of time (expires on Saturday

before third Wednesday of contract month)

“European style” can be exercised

only on the expiration date

Call Option

Sold on exchanges and offered by

commercial banks and brokerage firms

31

Why do people buy automobile insurance?

32

So that if their car is in an accident, the

insurance will pay for repairing the car.

33

Insurance provides protection for the

car’s owner in the event something

“bad” happens to the car.

The cost of automobile insurance (the

premium) depends on the total amount of

coverage and the size of the deductible.

Currency options are similar to insurance

in that they provide protection against

something “bad” happening to the value

of a foreign currency.

34 Source: http://www.phlx.com/products/currency/cug.pdf

Source: http://www.cme.com/

35

Strike January 5

Price Calls Puts

British Pound (£) Options

£62,000 per contract

cents per pound

Jan Feb March Jan Feb March

1500 6.06 6.23 6.50 ---- 0.16 0.44

1525 3.71 3.94 4.42 0.04 0.40 0.90

1550 1.26 2.12 2.80 0.20 1.06 1.74

1575 0.16 0.92 1.62 1.60 2.36 3.04

1600 0.14 0.34 0.86 4.01 4.26 4.76

1625 0.10 0.16 0.42 6.54 6.62 6.80

Current spot rate $1.56/£

Premium (price) for these options

36

How much did it cost on January 5 to buy a

March Call with a strike price of $1.50?

6.5¢/£ 0.065(62,000) = $4,030

Suppose on January 5 the

Premium on a March Call

with a strike price of $1.50 is

2¢/£ instead of 6.5¢/£. The

spot rate on January 5 is

$1.56/£. Any ideas about

how you could make money

under these circumstances?

37

Buy a Call option for (2¢)(62,000) = $1,240

Step 1:

Step 2:

Exercise it immediately, receive £’s at $1.50/£

$1.50(62,000) = $93,000

total cost of $1,240 + $93,000 = $94,240

Step 3:

Sell £’s in spot market at $1.56 and collect

$1.56(62,000) = $96,720

profit of $96,720 - $94,240 = $2,480

with no risk

38

If markets are efficient then

premium > spot - strike

The lower the strike price is

relative to the spot rate

higher premium

The longer until Call expires

higher premium

The greater the variability in a currency

higher premium

General Observations about

Call premiums

39

If the purchaser of the March Call

exercises it, what is the cost of each £?

$1.50 + $0.065 = $1.565 per £

Strike Price Premium

40

It guarantees the MNC that it can buy

the £’s it needs in March for no more

than $1.565 per £

How is buying the March Call option

like buying insurance for an MNC?

41

In deciding whether or not to exercise the

March Call, should the owner of the Call

compare the current spot rate to

Strike price $1.50

Cost of £’s by

exercising Call

or

$1.565

42

?

Spot

Market

Exercise

Call

Premium

$4,030

January 5

43

Since the premium is a sunk cost, it

should be ignored in this decision.

The owner of the Call wants to buy £’s

where they are the cheapest.

If spot < $1.50 do not exercise March call

If spot > $1.50 exercise March call

Strike price $1.50

44

On January 5 an MNC bought a March call

option because it must pay £’s in March to

one of its British suppliers. The Call’s

strike price was $1.50/£. It is now the

Saturday before the third Wednesday in

March and the spot rate is $1.53.

Should the Call be exercised ?

45

?

Spot

Market

Exercise

Call

strike price

$1.50

Saturday

before

third

Wednesday

in March

$1.53

Premium

$4,030

January 5

46

Calculate the total cost of the £’s if the

MNC exercises the Call

( $1.50 + 6.5¢ )(62,000) = $93,000 + $4,030 =

$97,030

Compare this to the total cost of the £’s if the MNC

does not exercise the Call

Buying £’s in the spot market will cost

($1.53)(62,000) = $94,860

Total cost of not exercising the Call is

$94,860 + $4,030 = $98,890

Remember that the MNC had to pay the $4,030

even if it does not exercise the option

47

?

Spot

Market

$98,890

Exercise

Call

$97,030

Saturday

before

third

Wednesday

in March

Premium

$4,030

January 5

48

Exercising the Call is less expensive

than not exercising it by

$98,890 - $97,030 = $1,860

Or, ignoring the premium (sunk cost)

$94,860 - $93,000 = $1,860

49

Suppose it is January 5 when the MNC is

considering whether or not to purchase the

March Call with a strike price of $1.50, and it

forecasts the March spot rate to be $1.53

Should the MNC

purchase the March

Call or go uncovered ?

50

? Uncovered

forecast

spot rate

$1.53

Exercise

Call

strike price

$1.50

Buy

Call

Premium

6.5 ¢

January

5

51

Cost of the £’s if MNC purchases

and exercises the Call

($1.50 + 6.5¢)(62,000) = $93,000 + $4,030 =

$97,030

Cost of the £’s if the MNC goes

uncovered and forecast is correct

($1.53)(62,000) = $94,860

52

?

Uncovered

$94,860

Exercise

Call

$97,030

January

5

By going uncovered, MNC anticipates

buying £’s at a lower cost, thus saving

$97,030 - $94,860 = $2,170 RISK

53

1. MNC must deliver the foreign

currency in the future 2. MNC feels spot will rise above

strike + premium

1. MNC has the foreign currency on hand and

wants to make an additional return on it 2. MNC feels spot will go below the strike price

(so the owner of the Call will not exercise it)

Under what circumstances would an MNC be interested in buying a Call option?

Under what circumstances would an MNC be interested in selling a Call option?

54

Sell a Call, receive $4,030 and hope Call

is never exercised so he gets to keep

the entire $4,030 as profit

A speculator hopes to profit from changes in

the exchange rate. He does not currently

have the foreign currency, does not need to

pay foreign currency in the future and will

not receive foreign currency in the future

Speculators

Suppose a speculator thinks £’s will depreciate.

Would the speculator want to

buy or sell a Call?

55

Speculator must buy £’s in spot market at $1.53

for $1.53(62,000) = $94,860

Delivers £’s and receives

$1.50(62,000) = $93,000 for a profit of

$93,000 + $4,030 - $94,860 = $2,170

What happens if the spot rate is $1.53 and

the Call is exercised?

56

1. He feels spot will rise above strike + premium

1. He feels spot will fall below the strike

price and the Call will never be

exercised so the entire premium is profit

Under what circumstances would a speculator be interested in

buying a Call option?

Under what circumstances would a speculator be interested in

selling a Call option?

57

Buyer does not exercise the Call

Seller keeps entire premium as profit

If $1.35 < spot < $1.40 the buyer recoups part

of the Call’s 5¢ premium by purchasing the

foreign currency in the spot market

If spot < $1.35 the buyer recoups more

than Call’s 5¢ premium by purchasing

foreign currency in spot market

Suppose the strike price of a Call Option

is $1.40/£ and the premium is 5¢

General Conclusions

spot < $1.40 If spot < strike

58

Buyer exercises Call and recoups some of

the Call’s premium

Seller’s profit is only part of the premium

Buyer exercises Call and recoups more

than the 5¢ premium

Seller loses all of the premium and more

if the foreign currency must be

purchased in the spot market

$1.40 < spot < $1.45

If strike < spot < strike + premium

$1.45 < spot

If strike + premium < spot

59

Contingency Graph

Consider a Call Option with a strike

price of $1.40/ £ and a premium of 5¢

This is a picture of the “profit/loss” position

of a speculator buying or selling a Call

Option or a Put Option. The magnitude of the

profit or loss depends on what the strike

price is and can be shown “per unit” of the

foreign currency or for the entire size of the

contract.

60

Net Profit

per Unit

Spot Rate $1.40 $1.45

0¢

- 5¢

in the money

spot > strike at the

money

out of the

money spot < strike

Buyer of Call

61

Net Profit

per Unit

Spot Rate $1.40 $1.45

0¢

+ 5¢

Seller of Call

62

Grants the right to sell a specific

amount of a specific currency

The “premium” is what it costs to buy a

Put Option

At a specific price (strike price or exercise price)

Within a specific period of time (expires on Saturday

before third Wednesday of contract month)

Put Option

63

Strike January 5

Price Calls Puts

British Pound (£) Options

£62,000 per contract

cents per pound

Jan Feb March Jan Feb March

1500 6.06 6.23 6.50 - 0.16 0.44

1525 3.71 3.94 4.42 0.04 0.40 0.90

1550 1.26 2.12 2.80 0.20 1.06 1.74

1575 0.16 0.92 1.62 1.60 2.36 3.04

1600 0.14 0.34 0.86 4.01 4.26 4.76

1625 0.10 0.16 0.42 6.54 6.62 7.00

Current spot rate $1.56/£

64

How much would it cost to buy a

March Put with a strike price of $1.625?

The premium is 7¢/£ $0.07(62,000) = $4,340

Suppose on January 5 the

premium on a March Put with a

strike price of $1.625 was 4¢/£

instead of 7¢/£. The spot rate at

that time was $1.56/£. Any

ideas about how you could

make money under these

circumstances?

65

Step 1:

Buy Put option for (4¢)(62,000) = $2,480

Or $1.625 - ($1.56 + $0.04) = $0.025/£

With NO RISK

Step 2:

Buy £’s in spot market at $1.56 for

$1.56(62,000) = $96,720

total cost is $96,720 + $2,480 = $99,200

Step 3:

Exercise Put deliver £’s and receive

$1.625(62,000) = $100,750

profit = $100,750 - $99,200 = $1,550

66

If Markets are efficient then

premium > strike - spot

The lower the spot price is relative to

the strike price higher premium

The longer until put expires

higher premium

The greater the variability in a currency

higher premium

General Observations

about Put premiums

67

If the purchaser of the March Put with

a strike price of $1.625 exercises it,

how much will he actually receive for

each £ he sells?

$1.625 - $0.07 = $1.555 per £

Strike Price Premium

68

It guarantees the MNC that it can sell

the £’s it receives in March for a

minimum of $1.555 per £

How is buying the March Put option like buying insurance for an MNC?

69

In deciding whether or not to exercise the

March Put, should the owner of the Put

compare the current spot rate to

Strike price $1.625

Received for £’s

by exercising Put

or

$1.555

70

?

Spot

Market

Exercise

Put

Premium

$4,340

January 5

71

The owner wants to sell £’s where he receives

the most for each £. Since the premium is a

sunk cost, it should be ignored when making

this decision.

If spot < $1.625 exercise March Put

If spot > $1.625 do not exercise March Put

Strike price $1.625

72

On January 5 an MNC bought a March Put option

because it will receive £’s in March from one

of its British customers. The Put’s strike price

is $1.625/£. It is the Saturday before the third

Wednesday in March and the spot rate is $1.58.

Should the Put be exercised ?

73

? Spot

Market

$1.58

Exercise

Put

strike price

$1.625

Saturday

before

third

Wednesday

in March

Premium

$4,340

January 5

74

Compare this to the total revenue from the sale of

the £’s if the NMC does not exercise the Put

and sells them in the spot market

$1.58(62,000) = $97,960

from selling £’s in the spot market

Total revenue if MNC sells £’s in spot market

instead of exercising Put is

$97,960 - $4,340 = $93,620

Remember that the NMC had to pay the $4,340

premium even if it does not exercise the option

Calculate the total revenue the MNC receives

from selling £’s if it exercises the Put

( $1.625 - 7¢ )(62,000) = $100,750 - $4,340 =

$96,410

75

? Spot

Market

$93,620

Exercise

Put

$96,410

Premium

$4,340

January 5 Saturday

before

third

Wednesday

in March

76

Exercising the Put generated more revenue

than selling the £’s in the spot market by

$96,410 - $93,620 = $2,790

Or, ignoring the premium (sunk cost)

$100,750 - $97,960 = $2,790

77

Suppose it is January 5 when the MNC is

considering whether or not to purchase the

March Put with a strike price of $1.625/£, and it

forecasts the March spot rate to be $1.58/£

Should the MNC purchase the March Put or go uncovered ?

78

? Uncovered

forecast

spot rate

$1.58

Exercise

Put

strike price

$1.625

Buy

Put

Premium

7¢

January

5

79

Revenue from selling the £’s if MNC

purchases a Put and exercises it.

Revenue from selling the £’s if the MNC goes

uncovered and its forecast is correct

($1.58)(62,000) = $97,960

($1.625 - 7¢ )(62,000) = $100,750 - $4,340 =

$96,410

80

?

Uncovered

$97,960

Exercise

Put

$96,410

January

5

The MNC anticipates receiving

more revenue by going uncovered

than from selling £’s by exercising

the Put

$97,960 - $96,410 = $1,550 RISK

81

1. It will receive foreign currency in the future

2. It feels spot will fall below strike - premium

NOTE: If MNC feels spot will rise above strike,

buying a Call option is a better hedge

1. It will deliver foreign currency in the future

2. It feels (strike - premium) < spot < strike

Under what circumstances would an MNC be interested

in buying a Put option?

Under what circumstances would an MNC be interested

in selling a Put option?

82

RECALL: A speculator hopes to profit from

changes in the exchange rate. He does not

currently have the foreign currency, does not

need to pay foreign currency in the future and

will not receive foreign currency in the future

1. He feels spot will fall below strike - premium

1. He feels spot will rise above strike and the

Put will never be exercised so

the entire premium is profit

Under what circumstances would a speculator be interested in buying a Put option?

Under what circumstances would a speculator be interested in selling a Put option?

83

Buyer does not exercise Put

Seller keeps entire premium as profit

If $1.60 < spot < $1.66 the buyer recoups

part of the 6¢ premium by selling foreign

currency in spot market

If $1.66 < spot the buyer recoups more

than the 6¢ premium by selling foreign

currency in spot market

Suppose the strike price is $1.60/£

and the premium is 6¢

General Conclusions

$1.60 < spot If strike < spot

84

Buyer exercises Put and recoups some of the

6¢ premium

Seller’s profit is only part of the 6¢ premium

Buyer exercises Put and recoups more

than the 6¢ premium

Seller loses all of the 6¢ premium and

more if the foreign currency must be

sold in the spot market

$1.54 < spot < $1.60

If strike - premium < spot < strike

spot < $1.54

If spot < strike - premium

85

Contingency Graph

for Put Options

Net Profit

per Unit

Spot Rate $1.54 $1.60

0¢

- 6¢

Buyer of Put

in the money

spot < strike

at the

money out of the money

spot > strike

strike price is $1.60/£ and the premium is 6¢

86

Net Profit

per Unit

Spot Rate $1.54 $1.60

0¢

+ 6¢

Seller of Put

87

On Tuesday, October 6, 1998, the spot rate

for the yen was ¥130.18/$ . The next day the

spot rate dropped to ¥120.55/$.

On Tuesday, the yen options prices as

reported in the Wall Street Journal were as

follows:

¥ vs $

88

Japanese Yen (CME) Tuesday, Oct 6, 1998

12,500,000 yen; cents per 100 yen

Calls - Settle Puts - SettleStrike

Price Oct Nov Dec Oct Nov Dec

7600 1.49 2.39 2.87 0.28 1.19 1.67

7650 1.12 2.11 2.59 0.42 1.40 1.89

7700 0.83 1.85 2.35 0.62 1.64 2.14

7750 0.60 1.60 2.12 …. …. ….

7800 0.42 1.40 1.91 1.21 …. 2.69

7850 0.28 …. 1.71 …. …. ….

What should you have done on Tuesday

in order to benefit from what happened

on Wednesday?

Strike price 7600 means $0.007600/¥

89

Should you use a Call or a Put?

Should you buy a call or sell a call?

Tuesday

CALL

BUY

HINT: ¥120.55/$ = $0.008295/¥ tomorrow

90

Step 1: Exercise the Oct Call Option

cost: $0.007600(12,500,000) = $95,000

Step 2: Sell ¥12,500,000 in the spot market at

the current spot rate of $0.008295/¥

Receive: $0.008295(12,500,000) = $103,687.50

Profit: $103,687.50 - $95,000 - $1,862.50 = $6,825

Buy an October Call Option with a strike price

of $0.0076/¥ for a premium of 1.49¢ per 100¥

cost: $0.0149(125,000) = $1,862.50

Tuesday

Wednesday

91

Conditional Currency

Option Currency Option with a conditional premium:

Payment of the premium is conditioned on

the actual movement of the spot rate

EXAMPLE:

£ Put Option with a strike price of $1.60 and a

conditional premium of 4¢ with a trigger of

$1.66. If the future spot rate is $1.66 or lower,

the buyer does not pay the premium.

92

Spot Rate

$1.60 $1.66

$99,200

$100,440

Net Amount

Received

$102,920

$97,960

Normal Put Option

2¢ premium

93

STRADDLE

If a currency is highly volatile, a speculator may

buy both a Call (anticipating appreciation) and a

Put (anticipating depreciation)

Spot may move strongly in one

direction and profit on that option

may exceed premium on the other option

Spot rate may fluctuate enough to

exercise both and profit on both

94

Forward Contracts:

Forward Premium

Futures Contracts

margin

Call

Options

Put

Options

Arbitrage Contingency

Graph

Building Blocks

for FINC 445

Skills:

Communication

Problem Solving

Motives:

Involved in foreign

financial markets

Familiar Setting:

U.S. grocery store

Buyer vs seller

Currency Conversion:

The basics, value, appreciate,

depreciate, purchasing power

Spot Market:

Bid & ask rates, direct &

indirect, cross rates,

arbitrage

Bank participation in

foreign exchange

markets

Trade Agreements:

U.S.-Canada, NAFTA,

Mercosur, FTAA, CAFTA,

Mexico, EU, GATT, WTO

FX Systems:

Euro, Dollarization,

Floating Exchange

Rate System

Balance of Payments:

Current Account

Capital Account

Official Reserve Acct

Trade Issues:

Japan & China,

deficits, surpluses,

trading partners

Economic Factors:

Inflation, national income,

interest rates, trade barriers,

capital controls

Intl

Agencies:

World Bank

IMF

Problem of Scarcity:

Comparative Advantage

Interdependence

Economic

Systems:

Capitalism,

Socialism

Communism

Goal of Corp:

Max. wealth of

shareholders

Ethical

Considerations

MNC vs

domestic

firm

Risk of doing

business

internationally

PV of

MNC’s

cashflows

Perfect

Markets:

labor

interest

Exchange Rate Determination:

Exports and imports

pair of currency markets

supply, demand, equilibrium

Adjustment of Market Equilibrium:

Inflation, interest rates, income levels,

expectations about future exchange rates

Speculating on

anticipated exchange

rate movement

MNC’s and consumers

Investors

Central Banks

Speculators