9/6/2021

International Corporate Finance 5 Currency Derivatives

11th Edition Chapter Objectives

by Jeff Madura
• Explain how forward contracts are used to hedge based on
anticipated exchange rate movements
1.

• Describe how currency futures contracts are used to speculate

or hedge based on anticipated exchange rate movements
2.

• Explain how currency option contracts are used to speculate or

hedge based on anticipated exchange rate movements
3.

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P&G CASE STUDY

5 Currency Derivatives
Case study:
Reading Materials:
Today is 16 Sept 2020. Spot rate (Euro/Usd) = 1.1000
a/ P&G (in the U.S) intends to import some machinery from German. It
must make payments of 100,000 Euro in the next 90 days from today.
[1] Jeff Madura, [2015], International Financial Management, Cengage
Learning, Stamford, Chapter 5 (P108 – P114) b/ Also, in the next 90 days, P&G will receive 500,000 Euro from selling
their goods to France.
[2] Nguyễn Văn Tiến chủ biên, [2018], Giáo trình tài chính quốc tế, NXB As a financial expert, let’s analyse the exchange rate risk that may occur to
Thống kê, Hà Nội. Chapter 3 (P182– P197) P&G.

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What is a Currency Derivative? Forward Market

A forward contract is an agreement between a corporation and a

A currency derivative is a contract whose price is derived financial institution:
from the value of an underlying currency § To exchange a specified amount of currency
§ At a specified exchange rate called the forward rate
§ On a specified date in the future
- Forward
- Futures
- Options
- Swaps

- Speculate on future exchange rate movements

- Hedge exposure to exchange rate risk

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Forward Market Forward Market

Case study: Case study:

P&G (in the U.S) intends to import some machinery from ABC (a U.S. firm) intends to make payments of 100,000
German. It must make payments of 100,000 Euro in the next 90 days Euro for their imported chemicals from European countries in the
from today. next 90 days.

Sign a forward contract to

purchase 100,000 Euro with
ANZ Bank at F (EUR/USD)
=1.1030

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Premium or Discount on the Forward Rate Premium or Discount on the Forward Rate

F = S(1 + p) F = S(1 + p)
where: Example:
F is the forward rate
S is the spot rate 1. If the euro’s spot rate is $1.40 and if one-year forward rate has a
p is the forward point (%) forward premium of 2%. Calculate the one-year forward rate.
2. If the euro’s one-year forward rate is quoted at $1.35 and the
If p (%) > 0, F>S and vice versa  Forward Premium euro’s spot rate is quoted at $1.40. Calculate the forward rate?
If p < (%) 0, F <S and vice versa  Forward Discount

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Exhibit 5.1 Computation of Forward Rate Premiums or Premium or Discount on Forward Rate
Discounts

Forward point Forward rate

Spot 1.3000 -1.3005 1.3000-1.3005

3 months 42-44 1.3042-1.3049
6 months 85-88 1.3085-1.3093
9 months 44-42 1.2956-1.2963
12 months 88-85 1.2912-1.2920

point Bid < pointAsk => F=S+p

point Bid > pointAsk => F=S – p
F bid = S bid +/- p bid
F ask = S ask +/- p ask

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Computation of Forward Rate Premiums or Discounts Premium or Discount on the Forward Rate

Question 1: Compute the forward discount or premium for the Mexican Question 3: The one-year forward rate of the British pound is quoted at
peso where 90-day forward rate is $.102 and spot rate is $.10. State whether
$1.61, and the spot rate of the British pound is quoted at $1.64. The
your answer is a discount or premium and calculate annualized forward
rate. forward ____ is ____ percent.

Question 2:. Graylon, Inc., based in Washington, exports products to a a/ discount; 1.83
German firm and will receive payment of 200,000 Euro in three months. b/ discount; 1.92
On June 1, the spot rate of the euro is $1.10 - $1.15. The forward discount
c/ premium; 1.83
is 1%. What is the amount payment received if Graylon hedge their cash by
using forward contract. d/ premium; 1.92

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How MNCs Use Forward Contracts Discuss

1. What are the advantages and disadvantages of forward contract?

1. Hedge their imports by locking in the rate at which they 2. How may forward contract best serve for MNCs?
can obtain the currency

2. May negotiate an offsetting trade if an MNC enters into a

forward sale and a forward purchase with the same bank.

3. Non-deliverable forward contracts (NDF) can be used

for emerging market currencies where no currency
delivery takes place at settlement, instead one party makes
a payment to the other party.

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Discuss Currency Futures Market

n Similar to forward contracts in terms of obligation to

Question 4:. The forward rate is commonly used for: purchase or sell currency on a specific settlement date
in the future.
a/ hedging.
b/ immediate transactions. n Differ from forward contracts because futures have
c/ previous transactions. standard contract specifications:
d/ speculation. a. Standardized number of units per contract (See Exhibit 5.2)
b. Offer greater liquidity than forward contracts
c. Typically based on U.S. dollar, but may be offered on cross-
rates.
d. Commonly traded on the Chicago Mercantile Exchange
(CME).

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Exhibit 5.2 Currency Futures Contracts Traded on

Trading Currency Futures
the Chicago Mercantile Exchange

n Firms or individuals can execute orders for currency futures

contracts by calling brokerage firms.
n Electronic trading platforms facilitate the trading of currency
futures. These platforms serve as a broker, as they execute the
trades desired.
n Currency futures contracts are similar to forward contracts in
that they allow a customer to lock in the exchange rate at which
a specific currency is purchased or sold for a specific date in the
future.

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Exhibit 5.3 Comparison of the Forward and Futures

Trading Currency Futures (cont.)
Market

n Pricing Currency Futures - The price of currency futures

will be similar to the forward rate
n Credit Risk of Currency Futures Contracts - To
minimize its risk, the CME imposes margin requirements to
cover fluctuations in the value of a contract, meaning that the
participants must make a deposit with their respective brokerage
firms when they take a position.

Source: Chicago Mercantile Exchange

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How Firms Use Currency Futures Closing Out a Futures Position

n Purchasing Futures to Hedge Payables - The purchase of n Sellers (buyers) of currency futures can close out their
futures contracts locks in the price at which a firm can purchase positions by buying (selling) identical futures
a currency. contracts prior to settlement.
n Selling Futures to Hedge Receivables - The sale of n Most currency futures contracts are closed out before
futures contracts locks in the price at which a firm can sell a
currency.
the settlement date.

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Exhibit 5.4 Closing Out a Futures Contract Speculation with Currency Futures

1. Currency futures contracts are sometimes purchased

by speculators attempting to capitalize on their
expectation of a currency’s future movement.
2. Currency 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.

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Exhibit 5.5 Source of Gains from Buying Currency

Application
Futures

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Currency Futures Market Efficiency Currency Options Market

q Currency options provide the right to purchase or sell

1. If the currency futures market is efficient, the futures price currencies at specified prices.
should reflect all available information.
2. Thus, the continual use of a particular strategy to take positions a. Currency CALL Option: provides the right to BUY
in currency futures contracts should not lead to abnormal currency at a specified strike price within a specified period
profits. of time.
3. Research has found that the currency futures market may be
b. Currency PUT Option: provides the right to SELL
inefficient. However, the patterns are not necessarily observable
currency at specified strike price within a specified period of
until after they occur, which means that it may be difficult to time.
consistently generate abnormal profits from speculating in
currency futures.

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Currency call option example Currency put option example

Unilever in Britain chooses the strategy of buying a ………..option to Unilever in Britain chooses the strategy of buying a ………… option
hedge exchange rate risk for an import in USD with maturity of t years. to hedge exchange rate risk for an receivable from export in USD with
The market parameters at maturity are as follows: maturity of t years. The market parameters at maturity are as follows:

- Exercise (Strike) price X =$1.5 - Exercise (Strike) price X =$1.5

- Option premium C = $ 0.02 - Option premium C = $ 0.03

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Currency call option Currency call option

n If the spot exchange rate is greater than the strike price, the option Question 1: A CALL option has a strike price of $0.5. The spot rate is
is in the money (ITM). currently $0.72. The call is:

n If the spot rate is equal to the strike price, the option is at the
money (ATM). a/out of the money.
n If the spot rate is lower than the strike price, the option is out of b/in the money.
the money (OTM). c/at the money

d/near the money.

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Currency call option example Currency call option Profit for buyers

Unilever in Britain chooses the strategy of buying a CALL option to

hedge exchange rate risk for an import in USD with maturity of t years. The
market parameters at maturity are as follows:

- Exercise (Strike) price X =$1.5

- Option premium C = $ 0.02. Calculate profit for sellers of option in

the case: S=1.54

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Currency call option profit for sellers

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Factors Affecting Currency Call Option

How Firms Use Currency Call Options
Premiums

Firms can use call options to:

n hedge payables
n hedge project bidding to lock in the dollar cost of potential
expenses.
n hedge target bidding of a possible acquisition.
The premium on a call option (C) is affected by three
n Speculate on expectations of future movements in a currency.
factors:
n Spot price relative to the strike price (S – X): +
n Length of time before expiration (T): +
n Potential variability of currency (σ): +

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Currency Put Options Currency put option

1. If the spot rate falls below the strike price, the owner of a put can Question: A PUT option has a strike price of $0.5. The spot rate is
exercise the right to sell currency at the strike price. currently $0.72. The put is:

2. If the spot exchange rate is lower than the strike price, the option is
in the money (ITM). If the spot rate is equal to the strike price, the a/out of the money.
option is at the money (ATM). If the spot rate is greater than the strike
b/in the money.
price, the option is out of the money(OTM).
c/at the money

d/near the money.

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Currency put option for buyers example Currency put option Profit for buyers

Unilever in Britain chooses the strategy of buying a PUT option to hedge exchange
rate risk for an receivable from export in USD with maturity of t years. The market
parameters at maturity are as follows:

- Exercise price X =$1.5

- Option premium C = $ 0.03

a. S =1.54 b. S =1.46

Calculate profit for buyers of option.

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I
Currency put option example Currency put option profit for sellers

Unilever in Britain chooses the strategy of buying a PUT option to hedge

exchange rate risk for an receivable from export in USD with maturity of t
years. The market parameters at maturity are as follows:

- Exercise price X =$1.5

- Option premium C = $ 0.03

Suppose S =1.46. Calculate profit for sellers of option.

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Exhibit 5.6 Contingency Graphs for Currency

Factors Affecting Put Option Premiums
Options

Put option premiums are affected by three factors:

n Spot rate relative to the strike price (S–X): -
n Length of time until expiration (T): +
n Variability of the currency (σ): +

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IMPLICATIONS IMPLICATIONS

1. Speculating with Currency Call Options. Randy Rudecki purchased a 2. Speculating with Currency Put Options. Alice purchased a put option on
call option on British pounds for $.02 per unit. The strike price was British pounds for $.04 per unit. The strike price was $1.80 and the spot rate
$1.45 and the spot rate at the time the option was exercised was $1.46. at the time the pound option was exercised was $1.59. Assume there are
Assume there are 31,250 units in a British pound option. What was 31,250 units in a British pound option. What was Alice’s net profit on the
Randy’s net profit on this option? option?

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IMPLICATIONS IMPLICATIONS

3. Mike Suerth sold a call option on Canadian dollars for $.01 per 4. Brian Tull sold a put option on Canadian dollars for $.03 per unit.
unit. The strike price was $.76, and the spot rate at the time the The strike price was $.75, and the spot rate at the time the option was
option was exercised was $.82. Assume Mike did not obtain exercised was $.72. Assume Brian immediately sold off the Canadian
Canadian dollars until the option was exercised. Also assume that dollars received when the option was exercised. Also assume that there
there are 50,000 units in a Canadian dollar option. What was Mike’s are 50,000 units in a Canadian dollar option. What was Brian’s net
net profit on the call option? profit on the put option?

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Speculating with Currency Put Options Implications

1. Individuals may speculate with currency put options 5. LSU Corp. purchased Canadian dollar call options for speculative
based on their expectations of the future movements in a purposes. If these options are exercised, LSU will immediately sell the
particular currency.
Canadian dollars in the spot market. Each option was purchased for a
2. Speculators can attempt to profit from selling currency
premium of $.03 per unit, with an exercise price of $.75. LSU plans to wait
put options. The seller of such options is obligated to
purchase the specified currency at the strike price from until the expiration date before deciding whether to exercise the options. Of
the owner who exercises the put option. course, LSU will exercise the options at that time only if it is feasible to do
3. The net profit to a speculator is based on the exercise so. In the following table, fill in the net profit (or loss) per unit to LSU Corp.
price at which the currency can be sold versus the based on the listed possible spot rates of the Canadian dollar on the
purchase price of the currency and the premium paid for
expiration date
the put option..

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European Currency Options SUMMARY

n European-style currency options must be exercised on the § A forward contract specifies a standard volume of a
expiration date if they are to be exercised at all. particular currency to be exchanged on a particular date.
n They do not offer as much flexibility; however, this is not Such a contract can be purchased by a firm to hedge
relevant to some situations. payables or sold by a firm to hedge receivables.
n If European-style options are available for the same § Futures contracts on a particular currency can be purchased
expiration date as American-style options and can be by corporations that have payables in that currency and wish
purchased for a slightly lower premium, some corporations to hedge against the possible appreciation of that currency.
may prefer them for hedging. Conversely, these contracts can be sold by corporations that
have receivables in that currency and wish to hedge against
the possible depreciation of that currency.

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SUMMARY (Cont.)

§ Currency options are classified as call options or put

options. Call options allow the right to purchase a specified
currency at a specified exchange rate by a specified
expiration date. Put options allow the right to sell a
specified currency at a specified exchange rate by a
specified expiration date. Currency call options are
commonly purchased by corporations that have payables in
a currency that is expected to appreciate. Currency put
options are commonly purchased by corporations that have
receivables in a currency that is expected to depreciate.

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