derivatives

Currency DerivativesCurrency Derivatives

55 Chapter Chapter

South-Western/Thomson Learning © 2003

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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

• The forward market facilitates the trading of forward contracts on currencies.

• A forward contract is an agreement between a corporation or international trader 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.

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Forward Market

• When MNCs anticipate future need or future receipt of a foreign currency, they can set up forward contracts to lock in the exchange rate.

• Importers can use the forward contract to avoid exchange risk in anticipation of depreciation of local currency (or appreciation of foreign currency).

• Exporters can use forward contract to avoid foreign exchange risk in anticipation of appreciation of local currency (or depreciation of foreign currency).

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• 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.

Forward Market

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• annualized forward premium/discount

= forward rate – spot rate 360

spot rate nwhere n is the number of days to maturity

• Example: Suppose $ spot rate = Tk.70, 90-day $ forward rate = Tk.71.

Tk.71 – Tk.70 x 360 = 5.7% Tk.70 90

So, forward premium = 5.7%

Forward Market

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• The forward premium/discount reflects the difference between the home interest rate and the foreign interest rate, so as to prevent arbitrage.

Forward Market

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• 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.

Forward Market

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Example: NDF Contract

• Suppose in connection of an import we’ll need $100 after 3 months from now. If we made a 3 month NDF contract with Sonali Bank today then we would be secured of exchange rate risk. Suppose the reference index is the 90 day forward rate today which is $1=Tk.68. Now, if the spot rate after 3 months from now turns up to be $1=Tk.69, then the bank will pay us Tk.100 which we’ll need in excess of the reference index to pay for the import. Similarly, if the spot rate after 3 months from now is $1=Tk.67, then we will pay Tk.100 to Sonali Bank. Don’t forget that we’ll need hundred taka less in that case for the import.

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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, 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.

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• 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.

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Future Contract: Units per Contract

Currency Units per Contract

US dollar, Australian dollar, Brazilian Real, Canadian dollar, NZ dollar

$ 100,000

British pound £ 62,500

Euro, Swiss Frank €125,000

Japanese Yen ￥ 12,500,000

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Forward Markets Futures Markets

Contract size Customized. Standardized.

Delivery date Customized. Standardized.

Participants Banks, brokers, Banks, brokers,MNCs. Public MNCs. Qualified

speculation not public speculationencouraged. encouraged.

Security Compensating Small securitydeposit bank balances or deposit required.

credit lines needed.


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Clearing Handled by Handled byoperation individual banks exchange

& brokers. clearinghouse.Daily settlementsto market prices.

Marketplace Worldwide Central exchangetelephone floor with globalnetwork. communications.



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Liquidation Mostly settled by Mostly settled byactual delivery. offset.

Transaction Bank’s bid/ask NegotiatedCosts spread. brokerage fees.



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• Currency futures may be purchased by MNCs to hedge foreign currency payables, or sold to hedge receivables.

• 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.


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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.

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• 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 Options Market

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• 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.

• 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.

Currency Call Options

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Example: Currency Call Option

• Suppose option is allowed in Dhaka and you speculate that within next April the dollar rate would increase by a significant margin. The spot rate today of $1=Tk.67. The strike rate available is $1=Tk.67.50 and the option premium is Tk.1 per dollar. What kind of option should you go for? Draw a contingency graph for both you and the other party. Also show the profit or loss if the price of US dollar in April happens to be exactly Tk.67, Tk.68 and Tk.69?

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Contingency graph of buyer and seller of call option

Buyer

67.50

68.50

Profit

0

Loss 1

Profit 1

0

Loss

Seller

Future Spot rate

Future Spot rate

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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.

Currency Put Options

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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.

• A speculative strategy requires the speculator to incur risk. On the other hand, corporations use the futures and options markets to reduce their exposure to fluctuating exchange rates.

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Impact of Currency Derivatives on an MNC’s Value

n

tt

m

jtjtj

k1=

1 , ,

1

ER ECF E

= Value

E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period tE (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period tk = weighted average cost of capital of the parent

Currency FuturesCurrency Options

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• Forward Market¤ How MNCs Use Forward Contracts¤ Non-Deliverable Forward Contracts

Chapter Review

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Chapter Review

• 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

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Chapter Review

• Currency Options Market

• Currency Call Options¤ Factors Affecting Currency Call Option

Premiums¤ How Firms Use Currency Call Options¤ Speculating with Currency Call Options

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Chapter Review

• Currency Put Options¤ Factors Affecting Currency Put Option

Premiums¤ Hedging with Currency Put Options¤ Speculating with Currency Put Options

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Chapter Review

• Conditional Currency Options

• European Currency Options

• Efficiency of Currency Futures and Options

• How the Use of Currency Futures and Options Affects an MNC’s Value

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