FINC3240 International Finance

Chapter 5 Currency Derivatives

Chapter Overview
A. Currency Forwards B. Currency Futures C. Currency Options D. Currency Swaps

Derivatives
A derivative contract involves no actual transfer of ownership of the underlying assets at the time the contract is initiated. A derivative represents an agreement to transfer ownership of underlying assets at a specific place, price, and time specified in the contract. Its value (or price) depends on the value of the underlying assets. The underlying assets: stocks, bonds, interest rates, foreign exchanges, index, commodities, some derivatives, etc.
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Currency Forwards
Definition: an agreement between two parties to exchange a specified amount of a currency at a specified exchange rate (forward rate) on a specified date in the future.
1.

Terms are unique to each individual forward contract. That is, each contract is customized. There is a risk that one side might default on its obligation.
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2.

Forward Contract

Forward bid-ask spread Forward premium or discount

P represents the forward premium (discount), or the percentage by which the forward rate exceeds (less) the spot rate.

Forward Premium/Discount (1)

If the euros spot rate is $1.03, and its one-year forward rate has a forward premium of 2 percent, the one-year forward rate is:

So, euro will appreciates or depreciates? Appreciates!

Forward Premium/Discount (2)

If the euros one-year forward rate is quoted at $1.00 and the euros spot rate is quoted at $1.03, the euros forward premium/discount is :

Exhibit 5.1 Computation of Forward Rate Premiums or Discounts

Forwards Application

Why would MNC use Forward contracts and therefore forward rate if they expect currency exchange in the future? Why not wait till then and exchange the currency with the spot rate of that date?
To lock in the price
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Forwards Application (1)

Buying foreign currency forward Turz, Inc. on page 104

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Forwards Application (2)

Selling foreign currency forward Scanlon, Inc. on page 104

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Currency Futures
A standardized forward contract traded on an organized and regulated futures exchange.
1.

Futures contracts are guaranteed by the exchanges clearinghouse that eliminates the risk of contra-party default. Each contract is standardized on the quantity, quality, delivery place, delivery date, contract expiration date. A deposit called margin is required to both buyers and sellers. http://www.cme.com

2.

3.

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Exhibit 5.2 Currency Futures Contracts Traded on the Chicago Mercantile Exchange

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Forwards vs. Futures

1. 2.

3.

4.

5.

6.

Futures contracts trade on an organized exchange. Futures positions can be closed or transferred easily. Futures contracts have standardized terms (quantity, expiration, etc.) Futures contracts are guaranteed by the clearinghouse associated with the exchange. Futures are subject to daily settlement (marked to the market). Margin is required to both the buyer and seller.
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Clearinghouse

Guarantees that all traders in the futures markets will honor their obligations. Act in a position of buyer to every seller and seller to every buyer. So no default risk as a counter-party to every trader.

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Margin and Daily Settlement

Initial margin ( as little as 10% of the underlying assets value) Maintenance margin Marking to market: realize any loss or profit in cash every day.

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Marking to Market
Euro Futures Buyer bought at ($/euro) 1.4551 initial margin ratio Day 1 2 3 4 5 0.1 Close 1.4565 1.4570 1.4500 1.4535 1.3900 euro amount 125000 contract value ($) 181887.50 initial margin ($) 18188.75 Contract Value ($) Profit/Loss ($) Maintenance Margin ($) margin ratio 182062.50 175.00 18363.75 0.101 182125.00 62.50 18426.25 0.101 181250.00 -875.00 17551.25 0.097 181687.50 437.50 17988.75 0.099 173750.00 -7937.50 10051.25 0.058

Euro Futures Seller sold at ($/euro) 1.4551 initial margin ratio Day 1 2 3 4 5 0.1 Close 1.4565 1.4570 1.4500 1.4535 1.3900

euro amount 125000 contract value ($) 181887.50 initial margin ($) 18188.75 Contract Value ($) Profit/Loss ($) Maintenance Margin ($) margin ratio 182062.50 -175.00 18013.75 0.099 182125.00 -62.50 17951.25 0.099 181250.00 875.00 18826.25 0.104 181687.50 -437.50 18388.75 0.101 17 173750.00 7937.50 26326.25 0.152

Closing a Position by Delivery

example on Page 109

On Feb 10, a futures contract on 62,500 British pounds with a march settlement date is priced at $1.50 per pound. If both buyer and seller of such a futures hold their positions to expiration, then after the settlement date the buyer of this currency futures will receive BP62,500 and will pay $93,750 (62500x1.5). The seller of this contract is obligated to deliver BP62,500 and receive $93,750.
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Closing a Position by Reverse trading

example: Tacoma Co. on page 113.

Exhibit 5.5

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Participants in Futures Markets

Hedgers: hedging, risk management Speculators: make money by taking risk Brokers: receive commission fee Regulators: futures exchanges and clearinghouses, the National Futures Association
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Futures Application (1)

Spot=$1.4550/BP 1-year Future =$1.4550/BP 1-year US interest rate=5% 1-year UK interest rate=10%

Can you speculate on this information? Yes. Purchase Pound at spot rate $1.4550 and invest in UK bonds or saving account; simultaneously sell Pound 1-year Futures (Forward) at $1.4550. What is the effect of this strategy on the exchange rate? Upward pressure on the spot rate and downward pressure on future price.
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Futures Application (2)

Expect the foreign currency to appreciate. (Example on page 111)

A speculator expects the British pound to appreciate in the future. He purchases a futures contract that will lock in the price at which he buys pounds at settlement date. On the settlement date, he purchases pounds at the rate specified by the futures contract and then sell these pounds at the spot rate. He will profit if the pound goes up.
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Futures Application (3)

Expect the foreign currency to depreciate. (Example on page 111) On April 4, a futures contract on 500,000 Mexican pesos and a June settlement date is priced at $0.09. On April 4, speculators who expect the peso will decline sell futures contracts on pesos. On June 17 (settlement date), the spot rate of the peso is $0.08. The gain on this strategy is $5,000.
$0.09/p*p500000-$0.08/p*p500000=$5000

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Futures Application (3)

Purchasing Futures to hedge payables (example on page 112) Teton Co. orders Canadian goods and will need to send C$500,000 to the Canadian exporter. Thus, Teton purchase Canadian dollar futures contracts today, thereby locking in the price to be paid for Canadian dollars at a future settlement date. By holding futures contracts, Teton does not have to worry about changes in the spot rate of the Canadian dollar over time.
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Futures Application (4)

Selling Futures to hedge receivables (example on page 113) Karla Co. sells futures contracts when it plans to receive a foreign currency from exporting that it will not need. It locks in the price at which it will be able to sell this currency as of the settlement date. Such an action is appropriate if Karla expects the foreign currency to depreciate against Karlas home currency.

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Currency Options
A contract that is associated with a right to buy or sell a currency until after a specific date with a predetermined price (strike price) and amount. There are Call options and Put options.
1.

The buyer of a Call option has the right, not the obligation, to buy a currency. The buyer of a Put option has the right, not the obligation, to sell a currency. 26 26

2.

Options Features
There are always two positions in each option contract: Long for the buyer vs. Short for the seller
(1) (2) (3) (4) Buying a Call Long a Call Selling a Call Short a Call Buying a Put Long a Put Selling a Put Short a Put
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Options Features

The buyer of an option has to pay a price, option premium. The seller of an option receives the option premium.

The option premium is an immediate expense for the buyer and an immediate return for the seller, whether or not the buyer ever exercises the option.

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Long vs. Short

Buyer (Long) Seller (Short)

Call

- Right to buy the underlying (i.e. to exercise the option) - Pays the premium Right to sell the underlying (i.e. to exercise the option) - Pays the premium
-

- Obligation to deliver the underlying, if buyer exercises the option - Receives the premium - Obligation to buy the underlying, if buyer exercises the option - Receives the premium
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Put

Moneyness
Call
Exercise price < Present price

Put
Exercise price > Present price

In-the-money (ITM)

At-the-money (ATM)

Exercise price = Present price

Exercise price = Present price

Out-of-the-money (OTM)

Exercise price > Present price

Exercise price < Present price

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Options Exchanges

Chicago Mercantile Exchange Chicago Board Options Exchange Over-the-counter market (contracts are customized)

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Contingency (payoff) Graphs for Currency Options

1. Contingency Call Option 2. Contingency Call Option 3. Contingency Put Option 4. Contingency Put Option Graph for a Buyer of a Graph for a Seller of a Graph for a Buyer of a

Graph for a Seller of a

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Contingency Graphs for Currency Options

Insert exhibit 5.6 page 123

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Currency Call Options

Factors Affecting Currency Call Option Premiums

a. Level of existing spot price relative to strike price b. Length of time before the expiration date c. Potential variability of currency

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Currency Put Options

Factors Affecting Currency Put Option Premiums

a. Level of existing spot price relative to strike price b. Length of time before the expiration date c. Potential variability of currency

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Call Options Application (1)

Hedge payables (Example on page 116) Pike Co. orders Australian goods and makes a payment in Australian dollars (A$) upon delivery. This company can buy an A$ call option that locks in a maximum rate. If the A$s value remains below the strike price, Pike can purchase A$ at the prevailing spot rate and simply let its call option expire. If the A$s value rises above the strike price, Pike will execute the option and buy A$ at the strike price.
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Call Options Application (1)

A payment in A$1,000,000 will be delivered at the end of June. On March 1, an option on A$500,000 that expires on June 28 has a strike price of A$1.1000/$. Pike Co. buys 2 A$ Call options on March 1 and pay $100 premium for each option.

On June 28,

If the spot rate is A$1.0000/$, Pike purchases A$ at the prevailing spot rate, A$1.000/$, and simply let its call options expire. If the spot rate is A$1.2050, Pike executes the options and 37 buy A$ at the strike price, A$1.1000/$.

Put Options Application (1)

Hedge receivables

ABC Co. will receive payment in C$2,000,000 at the end of September. On March 1, an option on C$500,000 that expires on September 28 has a strike price of C$1.5300/$. ABC Co. buy 4 C$ Put options on March 1 and pay $100 premium for each option.

On September 28,

If the spot rate is C$1.4500/$, Pike executes the options and sell C$ at the strike price, CA1.5300/$. If the spot rate is C$1.6000/$, ABC sells C$ at the prevailing spot rate, A$1.6000/$, and simply let its call options expire.
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Speculation with Call Options (1)

example on page 118

Spot rate on June,1 =$1.3900 Call option premium=$0.012/BP Strike price=$1.4000/BP Settlement date=December, 31 Contract amount=31,250 BP No brokerage fees. One investor buy one Call option on June, 1.

Just before expiration, spot rate=$1.4100/BP. Q1: Will the investor exercise the Call option? Yes. He exercises the Call option and then sell pounds with spot rate of $1.3000/BP. Q2: What is his profit/loss? 39 See the tables in the textbook

Speculation with Call Options (2)

Q&A 19

Call option premium=$0.03/C$ Strike price=$0.75/C$ Fill in the net profit(or loss) per unit based on the listed possible spot rates of the C$ on the expiration date.
Possible spot rate of C$ on expiration date $0.76 0.78 0.80 0.82 0.85 0.87 net Profit (loss)/C$ -0.02 0.00 0.02 0.04 0.07 0.09

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Speculation with Put Options (1)

example on page 121

Spot rate on June,1 =$1.3900 Put option premium=$0.04/BP Strike price=$1.4000/BP Settlement date=December, 31 Contract amount=31,250 BP No brokerage fees. One investor buy one Put option on June, 1.

Just before expiration, spot rate=$1.3000/BP. Q1: Will the investor exercise the Put option? Yes. He will buy pounds from spot market at $1.3000/BP and then execute the put option. Q2: What is his profit/loss? See the tables in the textbook

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Speculation with Put Options (2)

Q&A 20

Put option premium=$0.02/C$ Strike price=$0.86/C$ Fill in the net profit(or loss) per unit based on the listed possible spot rates of the C$ on the expiration date.
Possible spot rate of C$ on expiration date $0.76 0.79 0.84 0.87 0.89 0.91 net Profit (loss)/C$ 0.08 0.05 0.00 -0.02 -0.02 -0.02
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American-style vs. European-style

American-style options: can be exercised before or on the expiration date. European-style options: must be exercised on the expiration date.

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Currency Swap

An agreement in which one party provides a certain principal in one currency to its counterparty in exchange for another currency, pays fixed or floating rate of interest on the currency it receives, and exchange the principal at the maturity of the contract.

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SWAP Application

Spot rate= $1.2500/euro r = 10% in US, r =8% in EU. Party A exchange 1 million euro for 1.25 million $. Contract tenor is five years. The interest is paid every year.
Principal USD Euro 1,250,000 1,000,000

Year
Fixed rate in USD Fixed rate in Euro Party A USD Euro

1
10% 8.0%

2
10% 8.0% -125,000 80,000

3
10% 8.0% -125,000 80,000

4
10% 8.0% -125,000 80,000

5
10% 8.0% -1,375,000 1,080,000

1,250,000 -1,000,000

-125,000 80,000

Party B

USD Euro

-1,250,000 1,000,000

125,000 -80,000

125,000 -80,000

125,000 -80,000

125,000 -80,000

1,375,000 -1,080,000 45

Homework

Chapter 5 Q&A: 1,2,3,4,6,7,10,11,12,13,17,21,22.

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