Chapte

Currency Derivatives
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.

• Customized.
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.
• Forward contracts are often valued at $1 million
or more, and are not normally used by
consumers or small firms.
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.
Forward Market . . .
• annualized forward
premium/discount

= forward rate – spot rate  360

• Example spot rate

Suppose £ spot rate = $1.681,
: 90-day
n
£ forward rate =
$1.677.
where n is the number of days to
$1.677 – $1.681 x 360 = –950%
maturity .
$1.681 90
So, forward discount =
Forward Market . . .
• The forward premium/discount reflects the
difference between the home interest rate and
the foreign interest rate, so as to prevent
arbitrage.
Forward Market . . .
• 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.
 Currency Futures
•Market
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.
 Currency Futures
Market Forward Markets Futures Markets
Contract size Standardized.
Customized.
Delivery date Standardized.
Participants Customized.
Banks, brokers,
Banks, brokers,
MNCs. Public MNCs. Qualified
speculation not public speculation
encouraged. encouraged.

Securit Compensating Small security

y
deposit bank balances or deposit required.
credit lines needed.
 Currency Futures
Market
Forward Markets Futures Markets
Clearing Handled by Handled by
operation individual banks exchange
& brokers. clearinghouse.
Daily settlements
to market
prices.
Marketplace Worldwid
e Central
telephone exchange floor
network. with global
communications.
 Currency Futures
Market
Forward Markets Futures Markets
Regulation Self-regulating. Commodity
Futures Trading
Commission,
National Futures
Association.
Liquidation Mostly settled by Mostly settled by
actual delivery. offset.
Transaction Bank’s bid/ask Negotiated
Costs spread. brokerage fees.
 Currency Futures
•Market
Normally, the price of a currency futures contract
is similar to the forward rate for a given currency
and settlement date,
• These relationships are enforced by the
potential arbitrage activities that would occur
otherwise.
 Currency Futures
•Market
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.
 Currency Futures
Market
• 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 @ $.08/peso
pesos @ ($40,000) from the
$.09/peso spot market.
($45,000) on 3. Sell the pesos to
June 17. fulfill contract.
Gain $5,000.
 Currency Futures
•Market
Currency futures may be purchased by MNCs to
hedge foreign currency payables, or sold to
hedge receivables.

April June
4 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 the
@ locked-in rate.
$.09/peso on June
17.
 Currency Futures
•Market
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 February March

10 15 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.
 Currency Futures
•Market
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.
Currency Options Market
• 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
• at the money price, if spot rate =
• out of the money strike price,
if spot rate < strike
price.
Currency Call Options
• 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.
Currency Call Options
• 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.
Currency Call Options
• Speculators who expect a foreign currency
to appreciate can purchase call options on
that currency.
• Profit = selling price – buying (strike) price –
option premium
• They may also sell (write) call options on a
currency that they expect to depreciate.
• Profit = option premium – buying price +
selling (strike) price
Currency Call Options
• 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
• at the money price, if spot rate =
• out of the money strike price,
if spot rate > strike
price.
Currency Put Options
• 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.
Currency Put Options
• Speculators who expect a foreign currency
to depreciate can purchase put options on
that currency.
• Profit = selling (strike) price – buying price –
option premium
• They may also sell (write) put options on a
currency that they expect to appreciate.
• Profit = option premium + selling price – buying
(strike) price
Currency Put Options
• 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.
Contingency Graphs for Currency Options
For Buyer of £ Call Option For Seller of £ Call
Option
Strike price = $1.50 Strike price = $1.50
Premium = $ .02 Premium = $ .02
Net Net
Profit Profit
per Unit per Unit
+ +
$.04 $.04 Futur
+ + e
$.02 $.02 Spot
0 0 Rate
$1.46 $1.50 $1.54 $1.46 $1.50 $1.54
- Futur -
$.02 e $.02
- Spot -
$.04 Rate $.04
Contingency Graphs for Currency Options
For Buyer of £ Put Option For Seller of £ Put
Option
Strike price = $1.50 Strike price = $1.50
Premium = $ .03 Premium = $ .03
Net Net
Profit Profit
per Unit per Unit
+ +
$.04 Futur $.04
+ e +
$.02 Spot $.02
0 Rate 0
$1.46 $1.50 $1.54 $1.46 $1.50 $1.54
- - Futur
$.02 $.02 e
- - Spot
$.04 $.04 Rate
Conditional Currency Options
• A currency option may be structured such that
the premium is conditioned on the actual
currency movement over the period of concern.
• Suppose a conditional put option on £ has an
exercise price of $1.70, and a trigger of $1.74.
The premium will have to be paid only if the £’s
value exceeds the trigger value.
Conditional Currency Options
Option Type Exercise Price Trigger Premium
basic put $1.70 - $0.02
conditional put $1.70 $1.74 $0.04

$1.7 Basi
8 c
Put
$1.7
6 Condition Condition
Net Amount

al Put al Put
$1.7
Received

4
$1.7
2
$1.7 Spo
0 t
$1.6 $1.7 $1.74 $1.7 $1.8
Rat
$1.6 6 0 8 2
Conditional Currency Options
• Similarly, a conditional call option on £ may
specify an exercise price of $1.70, and a trigger
of $1.67. The premium will have to be paid only
if the £’s value falls below the trigger value.
• In both cases, the payment of the premium
is avoided conditionally at the cost of a
higher premium.
European Currency
Options
• European-style currency options are similar to
American-style options except that they can
only be exercised on the expiration date.
• For firms that purchase options to hedge future
cash flows, this loss in terms of flexibility is
probably not an issue. Hence, if their premiums
are lower, European-style currency options may
be preferred.
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.
Impact of Currency Derivatives on an MNC’s Value

Currency Futures
Currency
Options

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n   E j,
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