Chapter

5
Currency Derivatives

By
Md Zahidur Rahman
Junior Lecturer
College of Business Administration
IUBAT
Email: zahidur.rahman@iubat.edu

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.

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.
Forward
contracts
mainly
accommodate
large
corporations and normally are not used by individuals
and small firms.
MNCs use forward contracts to hedge theirs financial
risks so that they can lock in the rate at which they
obtain a currency needed to purchase imports.

Forward Market
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.

How MNCs use Forward

Contract
Suppose Pran RFL in Bangladesh will need 2 million Rupee in
90 days to purchase Indian imports. It can buy immediate
delivery at the spot rate of 1.15 BDT per Indian Rupee.
Therefore, Pran RFL would need 2.3 (2x1.15) million BDT.
However, Pran RFL does not have 2.3 million BDT now to
exchange for rupee. It could wait 90 days then exchange at the
spot rate on that time. But Pran RFL does not know what the
spot rate will be on that time. If the rate rise to 1.30 BDT then
Pran RFL need 2.6 (2x1.30) million BDT, an additional 0.3
million BDT. Therefore to avoid exchange rate risk Pran RFL can
lock a forward rate of 1.15 BDT by negotiation with a bank.
But, what happen if the price drops to 1.05 BDT after 90 days.
Pran RFL had to pay 2.1(2x1.05) million BDT if it did not lock
the forward rate and could have saved 0.2 million BDT.

Class Activity!
Suppose a MNC in USA will need 250,000 British
Pound(GBP) in 60 days to purchase British
imports. It can buy immediate delivery at the spot
rate of 1.44 USD per GBP. However, the MNC
want to lock the forward rate to 1.44 USD as it
believes GBP will appreciate on that time.
Now what happen ,
If the rate rise to 1.55 USD after 60 days
if the price drops to 1.20 BDT after 60 days

Currency Futures
Market
Currency futures contracts specify a standard
volume of a particular currency to be exchanged on
a specific settlement date,
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.

Forward Vs Future
Forward MarketsFutures Markets
Contract size

Customized.

Standardized.

Delivery date

Customized.

Standardized.

Participants
Banks, brokers,
Banks, brokers,
MNCs. Public MNCs. Qualified
speculation notpublic speculation
encouraged.
encouraged.

Forward Vs Future
Clearing
operation

Marketplace

Forward Markets

Futures Markets

Handled by
individual banks
& brokers.

Handled by
exchange
clearinghouse.
Daily settlements
to market prices.

Worldwide
telephone
network.

Central exchange
floor with global
communications.

Forward Vs Future
Regulation

Forward Markets

Futures Markets

Self-regulating.

Commodity
Futures Trading
Commission,
National Futures
Association.

Liquidation Mostly settled byMostly settled by

actual delivery.

Transaction
Costs

offset.

Banks bid/ask
spread.

Negotiated

brokerage fees.

Currency Options
Market
A currency option is another type of contract that
provide the right to purchase or sell currencies at
specified price.

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.

Currency Options
Market
In addition to the exchanges, there is an over-thecounter 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.

Currency Call Options

Speculators who expect a foreign
currency to appreciate can purchase
call options on that currency.
Profit = Spot price buying (strike) price
option premium
It should not exercise the option if the
foreign currency depreciate on the spot
market.

Example!
Suppose Pran RFL need 2 million rupee in 3
months therefore the company need to buy some
rupee. Pran speculate that the Indian Rupee will
appreciate in 3 month therefore want to buy a
option with a strike rate of 1.15 BDT with a
premium of 0.05 BDT. Now Pran need to take
decision whether it will exercise the option or not
for the following prices:
1 BDT, 1.15 BDT, 1.17 BDT, 1.20 BDT, 1.25 BDT, 1.30 BDT

Currency Call Options

Firms 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.

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.

Currency Put Options

Speculators who expect a foreign
currency to depreciate can purchase
put options on that currency.
Profit = selling (strike) price Spot price
option premium

Example!
Suppose Grameenphone(GP) Ltd. has received
$100,000 from its parent company Telenor for a
project which will start after 30 days. GP can
exchange the USD to BDT at today's spot rate of
80BDT per dollar. GP speculate that the USD will
depreciate in 30 days therefore want to buy a
option with a strike rate of 79.80 BDT with a
premium of 0.5 BDT. Now GP need to take
decision whether it will exercise the option or not
for the following prices:
76 BDT, 78 BDT, 79.5 BDT, 80 BDT, 80.5 BDT, 82 BDT