MIRPUR UNIVERSITY OF SCIENCE AND TECHNOLOGY (MUST), MUST Business

School
INTERNATIONAL FINANCE
MC-639

LECTURE 5:Currency Derivatives

Nadia Murtaza
(Lecturer)

Date:
 Currency Derivatives

The specific objectives of this chapter are to:

■ 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, and
■ explain how currency options contracts are used to speculate or
hedge based on anticipated exchange rate movements

International Finance 3
 Currency Derivatives
• Currency derivatives are financial instruments (e.g., futures, forwards,
and options) whose prices are determined by the underlying value on
the currency under consideration.
• • Currency derivatives therefore make sense only in a flexible/floating
exchange rate system where the value of the underlying asset, i.e.,
the currency keeps changing.

International Finance 4
 Forward Market

A forward contract is an agreement between a firm 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 are sold in volumes of $1 million or more, and are
not normally used by consumers or small firms.

International Finance 5
 Forward Market
When MNCs anticipate a future need (AP) or future receipt (AR) of a foreign
currency, they can set up forward contracts to lock in the exchange rate.

The % by which the forward rate (F ) exceeds the spot rate (S ) at a given
point in time is called the forward premium (p ).
• p = (F – S)/S
F exhibits a discount when p < 0.

International Finance 6
 Forward Market
Example
S = $1.681/£, 90-day F = $1.677/£
annualized p = (F – S)/S * 360/n
= (1.677 – 1.681)/ 1.681* 360/90 = –.95%

• The forward premium (discount) usually reflects the difference between the
home and foreign interest rates, thus preventing arbitrage (Chapter-7).

International Finance 7
 Forward Market

• A swap transaction involves a spot exchange transaction along with a

corresponding forward contract that will reverse the spot transaction.
• A non-deliverable forward contract (NDF) does not result in an actual
exchange of currencies on settlement date. Instead, one party makes a net
payment to the other based on a market exchange rate on the day of
settlement.

International Finance 8
 Forward Market
• An NDF can effectively hedge future foreign currency payments or receipts:

April 1 July 1
Expect need (AP) for 100M Buy 100M Chilean pesos
Chilean pesos. from market.
Negotiate an NDF to buy Index = $.0023/peso ----
100M Chilean pesos on Jul 1. receive $30,000 from
bank due to NDF.
Reference index (closing Index = $.0018/peso -----
rate quoted by Chile’s pay $20,000 to bank.
central bank) = $.0020/peso.

International Finance 9
 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.

International Finance 10
 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), automated
trading systems (e.g. GLOBEX), or the over-the-counter market.

Brokers who fulfill orders to buy or sell futures contracts typically charge a
commission.

International Finance 11
 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), automated
trading systems (e.g. GLOBEX), or the over-the-counter market.

Brokers who fulfill orders to buy or sell futures contracts typically charge a
commission.

International Finance 12
Comparison of the Forward & Futures
Markets

International Finance 13
 Currency Futures Market

Because of potential arbitrage activities, the prices of currency futures are

closely related to their corresponding currency forward and spot rates.

Currency futures contracts are guaranteed by the exchange clearinghouse,

which in turn minimizes its own credit risk by imposing margin requirements
on those market participants who take a position.

International Finance 14
 Currency Futures Market

Because of potential arbitrage activities, the prices of currency futures are

closely related to their corresponding currency forward and spot rates.

Currency futures contracts are guaranteed by the exchange clearinghouse,

which in turn minimizes its own credit risk by imposing margin requirements
on those market participants who take a position.

International Finance 15
 Currency Futures
Market
• Speculators often sell currency futures when they
anticipate the underlying currency to depreciate, and
vice versa.
April 4 June 17

1. Contract to 2. Buy 500,000

sell 500,000 pesos @
pesos @ $.08/peso
$.09/peso ($40,000) from
($45,000) on the spot market.
June 17. 3. Sell the pesos to
fulfill contract.
Gain $5,000.
 Currency Futures
Market
• MNCs may purchase currency futures to hedge their foreign
currency payables, or sell currency futures to hedge their
receivables.
April 4 June 17

1. Expect to 2. Receive 500,000

receive 500,000 pesos as
pesos. expected.
Contract to sell 3. Sell the pesos at
500,000 pesos the locked-in
@ $.09/peso on rate.
June 17.
 Currency Futures
Market
• Change in business plans can cause holders of futures contracts to
close out their positions by selling similar futures contracts. Sellers may
also close out their positions by purchasing similar contracts.

January 10 February 15 March 19

1. Contract 2. Contract 3. Incurs

to buy to sell $3000 loss
from
A$100,000 A$100,000 offsetting
@ $.53/A$ @ $.50/A$ positions in
($53,000) ($50,000) futures
on March on March contracts.
19. 19.
 Currency Options Market

• Currency options provide the right to purchase or

sell currencies at specified prices. They are
classified as calls or puts.
• Standardized options are traded on exchanges
through brokers.
• Customized options offered by brokerage firms
and commercial banks are traded in the over-the-
counter market.
 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 exchange rate > strike price,
• at the money if exchange rate = strike price,
• out of the money
if exchange rate < strike price.
 Currency Call Options

• Option owners can sell or exercise their options,

or let their options expire.
• 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.
• Firms may purchase currency call options to
hedge payables, project bidding, or target bidding.
 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 exchange rate < strike price,
• at the money if exchange rate = strike price,
• out of the money
if exchange 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.

• Firms may purchase currency put options to

hedge future receivables.
 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.
 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.
 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 Profit Net Profit
per Unit per Unit

+$.04 +$.04
Future
+$.02 +$.02 Spot
Rate
0 0
$1.46 $1.50 $1.54 $1.46 $1.50 $1.54
– $.02 Future – $.02
Spot
– $.04 Rate – $.04 5. 26
 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 Profit Net Profit
per Unit per Unit

+$.04 +$.04
Future
+$.02 Spot +$.02
Rate
0 0
$1.46 $1.50 $1.54 $1.46 $1.50 $1.54
– $.02 – $.02 Future
Spot
– $.04 – $.04 Rate
5. 27
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
$1.78
Basic
Net Amount Received

$1.76 Put
$1.74
$1.72 Conditional Conditional
Put Put
$1.70

$1.68
$1.66
Spot
Rate
$1.66 $1.70 $1.74 $1.78 $1.82
 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 flexibility is probably not an issue.
Hence, if their premiums are lower, European-style
currency options may be preferred.