5 Currency Derivatives

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5: Currency Derivatives

Chapter Objectives

Explain how forward contracts are used to hedge based on anticipated

exchange rate movements

Describe how currency futures contracts are used to speculate or hedge

based on anticipated exchange rate movements

Explain how currency option contracts are used to speculate or hedge

based on anticipated exchange rate movements

What is a Currency Derivative?

1. A currency derivative is a contract whose price is derived from the value

of an underlying currency.

2. Examples include forwards/futures contracts and options contracts.

3. Derivatives are used by !"s to#

a. $peculate on future exchange rate movements

b. %edge exposure to exchange rate ris&

Forward Market

'he forward mar&et facilitates the trading of forward contracts on

currencies.

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A forward contractis an agreement between a corporation and a ban&

to exchange a specified amount of a currency at a specified exchange

rate (called the forward rate) on a specified date in the future.

*hen !"s anticipate future need or receipt of a foreign currency+ theycan set up forward contracts to loc& in the exchange rate.

,orward contracts are often valued at -1 million or more+ and are not

normally used by consumers or small firms.

As with the case of spot rates+ there is a bid/as& spread on forward rates.

How MCs !se Forward Contracts

%edge their imports by loc&ing in the rate at which they can obtain the

currency

id/As& $pread is wider for less liuid currencies.

0ffsetting a ,orward "ontract An !" can offset a forward contract

by negotiating with the original counterparty ban&.

!ondeliverable forward contracts (!D,) can be used for emerging

mar&et currencies where no currency delivery ta&es place at settlement.

nstead+ a net payment is made by one party to the other based on the

contracted rate and the mar&et rate on the day of settlement.

Although !D,s do not involve actual delivery+ they can effectively

hedge expected foreign currency cash flows.

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"re#iu# or Discount on the Forward $ate

,orward rates may also contain a premium or discount.

f the forward rate exceeds the existing spot rate+ it contains a

pre#iu#.

f the forward rate is less than the existing spot rate+ it contains a

discount.

Annuali4ed forward premium/discount 5forward rate - spot rate 360

xspot rate n

where n is the number of days to maturity'he forward premium/discount reflects the difference between the home

interest rate and the foreign interest rate+ so as to prevent arbitrage.

F = S(1 + p)

, is the forward rate+ $ is the spot rate+ p is the forward premium+ or the

6 by which the forward rate exceeds the spot rate.

%&hibit 5'( Co#putation of Forward $ate "re#iu#s or Discounts

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ovements in the ,orward 7ate over 'ime 'he forward premium is

influenced by the interest rate differential between the 2 countries and

can change over time.

Currency Futures Market

$imilar to forward contracts in terms of obligation to purchase or sell

currency on a specific settlement date in the future.

!ormally+ the price of a currency futures contract is similar to theforward rate for a given currency and settlement date+ but differs from

the spot rate when the interest rates on the two currencies differ.

'hese relationships are enforced by the potential arbitrage activities that

would occur otherwise.

"urrency futures contracts have no credit ris& since they are guaranteed

by the exchange clearinghouse. 'o minimi4e its ris& in such a guarantee+

the exchange imposes margin reuirements to cover fluctuations in the

value of the contracts.

$peculators often sell currency futures when they expect the underlying

currency to depreciate+ and vice versa.

"urrency futures contracts specify a standard volume of a particularcurrency to be exchanged on a specific settlement date+ typically the

third *ednesdays in arch+ 8une+ $eptember and December.

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Differ from forward contracts because futures have standard contract

specifications#

a. $tandardi4ed number of units per contract ($ee Exhibit 9.2)

b. 0ffer greater liuidity than forward contracts

c. 'ypically based on :.$. dollar+ but may be offered on crossrates

d. "ommonly traded on the "hicago ercantile Exchange ("E)

%&hibit 5') Co#parison of the Forward and Futures Market

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,utures are used by !"s to hedge their currency positions+ and by

speculators who hope to capitali4e on their expectations of exchange rate

movements.

'he contracts can be traded by firms or individuals through bro&ers on thetrading floor of an exchange (e.g. "hicago ercantile Exchange)+ on

automated trading systems (e.g. ;


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+radin, Currency Futures

,irms or individuals can execute orders for currency futures contracts by

calling bro&erage firms.

Electronic trading platforms facilitate the trading of currency futures.

'hese platforms serve as a bro&er+ as they execute the trades desired.

"urrency futures contracts are similar to forward contracts in that they

allow a customer to loc& in the exchange rate at which a specific

currency is purchased or sold for a specific date in the future.

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>ricing "urrency ,utures 'he price of currency futures will be similar

to the forward rate

"redit 7is& of "urrency ,utures "ontracts 'o minimi4e its ris&+ the

"E imposes margin reuirements to cover fluctuations in the value ofa contract+ meaning that the participants must ma&e a deposit with their

respective bro&erage firms when they ta&e a position.

How Fir#s !se Currency Futures

>urchasing ,utures to %edge >ayables 'he purchase of futures

contracts loc&s in the price at which a firm can purchase a currency.

$elling ,utures to %edge 7eceivables 'he sale of futures contracts

loc&s in the price at which a firm can sell a currency.

C-osin, Out a Futures "osition

$ellers (buyers) of currency futures can close out their positions by

buying (selling) identical futures contracts prior to settlement.

ost currency futures contracts are closed out before the settlement date.

%&hibit 5'. C-osin, Out a Futures Contract

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/pecu-ation with Currency Futures

1. "urrency futures contracts are sometimes purchased by speculators

attempting to capitali4e on their expectation of a currency?s future

movement.

2. "urrency futures are often sold by speculators who expect that the spot

rate of a currency will be less than the rate at which they would be

obligated to sell it.

%&hibit 5'5 /ource of 0ains fro# 1uyin, Currency Futures

%olders of futures contracts can close out their positions by selling similar

futures contracts. $ellers may also close out their positions by purchasing

similar contracts.

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8anuary 1@ ,ebruary 19 arch 1

1. "ontract to buy

A-1@@+@@@ B -.93/A-

(-93+@@@) on arch 1.

2. "ontract to sell

A-1@@+@@@ B -.9@/A-

(-9@+@@@) on arch 1.

3. ncurs -3@@@ loss

from offsetting

positions in futures

contracts.

Currency Futures Market %fficiency

1. f the currency futures mar&et is efficient+ the futures price should

reflect all available information.

2. 'hus+ the continual use of a particular strategy to ta&e positions in

currency futures contracts should not lead to abnor#a- profits.

3. 7esearch has found that the currency futures mar&et may be inefficient.

%owever+ the patterns are not necessarily observable until after they

occur+ which means that it may be difficult to consistently generate

abnormal profits from speculating in currency futures.

Currency Options Market

A currency option is another type of contract that can be purchased orsold by speculators and firms. "urrency options provide the right to

purchase or sell currencies at specified prices.

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'he standard options are traded on an exchange through bro&ers are

guaranteed and reuire margin maintenance.

:.$. option exchanges (e.g. "hicago oard 0ptions Exchange) are

regulated by the $ecurities and Exchange "ommission.'here are no credit guarantees for these 0'" options+ so some form of

collateral may be reuired.

0ptions Exchanges

1C2 exchanges in Amsterdam+ ontreal+ and >hiladelphia first

allowed trading in standardi4ed foreign currency options.

2@@ "E and "0' merged to form "E group

Exchanges are regulated by the $E" in the :.$.

0verthecounter mar&et# *here currency options are offered by

commercial ban&s and bro&erage firms. :nli&e the currency optionstraded on an exchange+ the overthecounter mar&et offers currency

options that are tailored to the specific needs of the firm.

Currency Ca-- Options

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A currency ca-- option grants the holder the right to buy a specific

currency at a specific price (called the exerciseor strikeprice) within a

specific period.

A call option is

o in the money if spot rate stri&e price+

o at the money if spot rate 5 stri&e price+

o out of the money if spot rate F stri&e price.

0ption owners can sell or exercise their options. 'hey can also choose to

let their options expire. At most+ they will lose the premiums they paid for

their options.

Factors 2ffectin, Currency Ca-- Option "re#iu#s

'he premium on a call option (") is affected by three factors#

/pot price re-ative to the strike price 3/ 4 6# 'he higher the spot rate

relative to the stri&e price+ the higher the option price will be.

7en,th of ti#e before e&piration 3+6: 'he longer the time to

expiration+ the higher the option price will be.

"otentia- variabi-ity of currency 36: 'he greater the variability of the

currency+ the higher the probability that the spot rate can rise above the

stri&e price.

$peculators who expect a foreign currency to appreciate can purchase call

options on that currency.

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>rofit 5 selling price buying (stri&e) price option premium

'hey may also sell (write) call options on a currency that they expect to

depreciate.

>rofit 5 option premium buying price G selling (stri&e) price

'he purchaser of a call option will brea& even when

o selling price 5 buying (stri&e) price G option premium

'he seller (writer) of a call option will brea& even when

o buying price 5 selling (stri&e) price G option premium

How Fir#s !se Currency Ca-- Options

,irms can use call options to#

hedge payables

hedge proHect bidding to loc& in the dollar cost of potentialexpenses.

hedge target bidding of a possible acuisition.

$peculate on expectations of future movements in a currency.

Currency "ut Options

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A currency put option grants the holder the right to sell a specific

currency at a specific price (the strikeprice) within a specific period of

time.

A put option is

o in the money if spot rate F stri&e price+

o at the money if spot rate 5 stri&e price+

o out of the money if spot rate stri&e price.

"orporations with open foreign currency positions may use currency put

options to cover their positions.

,or example+ firms may purchase put options to hedge future receivables

$peculators who expect a foreign currency to depreciate can purchase put

options on that currency.

o >rofit 5 selling (stri&e) price buying price option premium

'hey may also sell (write) put options on a currency that they expect to

appreciate.

o >rofit 5 option premium G selling price buying (stri&e) price

Factors 2ffectin, "ut Option "re#iu#s

>ut option premiums are affected by three factors#

/pot rate re-ative to the strike price 3/46: 'he lower the spot rate

relative to the stri&e price+ the higher the probability that the option will

be exercised.

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7en,th of ti#e unti- e&piration 3+6: 'he longer the time to expiration+

the greater the put option premium

8ariabi-ity of the currency 36: 'he greater the variability+ the greater

the probability that the option may be exercised.

Hed,in, with Currency "ut Options

1. "orporations with open positions in foreign currencies can use currency

put options in some cases to cover these positions.

2. $ome put options are deep out of the #oney+ meaning that theprevailing exchange rate is high above the exercise price. 'hese options

are cheaper (have a lower premium)+ as they are unli&ely to be exercised

because their exercise price is too low.

3. 0ther put options have an exercise price that is currently above the

prevailing exchange rate and are therefore more li&ely to be exercised."onseuently+ these options are more expensive.

/pecu-atin, with Currency "ut Options

1. ndividuals may speculate with currency put options based on their

expectations of the future movements in a particular currency.

2. $peculators can attempt to profit from selling currency put options. 'he

seller of such options is obligated to purchase the specified currency at

the stri&e price from the owner who exercises the put option.

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3. 'he net profit to a speculator is based on the exercise price at which the

currency can be sold versus the purchase price of the currency and the

premium paid for the put option.

0ne possible speculative strategy for volatile currencies is to purchase

both a put option and a call option at the same exercise price. 'his is

called a straddle. y 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.

%&hibit 5'9 Contin,ency 0raphs for Currency Options

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Conditiona- Currency Options

A currency option may be structured such that the premium is conditioned

on the actual currency movement over the period of concern.

$uppose a conditional put option on I has an exercise price of -1.@+ and

atriggerof -1.J. 'he premium will have to be paid only if the I?s value

exceeds the trigger value.

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$imilarly+ a conditional call option on I may specify an exercise price of

-1.@+ and a trigger of -1.K. 'he premium will have to be paid only if the

I?s value falls below the trigger value.

n both cases+ the payment of the premium is avoided conditionally at the

cost of a higher premium.

%&hibit 5' Co#parison of Conditiona- and 1asic Currency Options

%uropean Currency Options

%uropean;sty-e currency options must be exercised on the expiration

date if they are to be exercised at all.

'hey do not offer as much flexibilityL however+ this is not relevant to

some situations.

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f Europeanstyle options are available for the same expiration date as

Americanstyle options and can be purchased for a slightly lower

premium+ some corporations may prefer them for hedging.

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5 Currency Derivatives