International Financial Management

13th Edition
by Jeff Madura

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 5 Currency Derivatives
Chapter Objectives

 Describe the characteristics and use of forward

contracts.
 Describe the characteristics and use of currency futures
contracts.
 Describe the characteristics and use of currency call
option contracts.
 Describe the characteristics and use of currency put
option contracts.

2
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 What is a Currency Derivative?

A currency derivative is a contract whose price

is derived from the value of an underlying
currency.
Examples include forwards/futures contracts
and options contracts.
Derivatives are used by MNCs to:
 Speculate on future exchange rate movements
 Hedge exposure to exchange rate risk

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 Forward Market (1 of 4)

A forward contract is an agreement between a

corporation and a financial institution:
 To exchange a specified amount of currency
 At a specified exchange rate called the forward
rate
 On a specified date in the future

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 Forward Market (2 of 4)

How MNCs Use Forward Contracts

 Hedge their imports by locking in the rate at which
they can obtain the currency.
Bank Quotations on Forward Rates
 Bid/Ask Spread is wider for less liquid
currencies.
 May negotiate an offsetting trade if an MNC
enters into a forward sale and a forward purchase
with the same bank.
 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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 Forward Market (3 of 4)

Premium or Discount on the Forward Rate

(Exhibit 5.1)
F = S(1 + p)
where:
F is the forward rate
S is the spot rate
p is the forward premium, or the percentage by which
the forward rate exceeds the spot rate.

 Arbitrage — If the forward rate was the same as the spot

rate, arbitrage would be possible.
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 Exhibit 5.1 Computation of Forward Rate Premiums or
Discounts

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 Forward Market (4 of 4)

Movements in the Forward Rate over Time — The forward

premium is influenced by the interest rate differential between
the two countries and can change over time.
Offsetting a Forward Contract — An MNC can offset a
forward contract by negotiating with the original counterparty
bank.
Using Forward Contracts for Swap Transactions — Involves a
spot transaction along with a corresponding forward contract that
will ultimately reverse the spot transaction.
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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 Currency Futures Market (1 of 6)

Similar to forward contracts in terms of obligation to

purchase or sell currency on a specific settlement date
in the future.
Contract Specifications: Differ from forward contracts
because futures have standard contract specifications:
 Standardized number of units per contract (See
Exhibit 5.2)
 Offer greater liquidity than forward contracts
 Typically based on U.S. dollar, but may be offered on
cross-rates
 Commonly traded on the Chicago Mercantile
Exchange (CME)

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 Exhibit 5.2 Currency Futures Contracts Traded on the
Chicago Mercantile Exchange

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 Currency Futures Market (2 of 6)

Trading Currency Futures

 Firms or individuals can execute orders for
currency futures contracts by calling brokerage
firms.
 Trading platforms for currency futures:
Electronic trading platforms facilitate the trading of
currency futures. These platforms serve as a
broker, as they execute the trades desired.
 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 Market

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 Currency Futures Market (3 of 6)

Comparing Futures to Forward Contracts

 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. (Exhibit 5.3)
 Pricing Currency Futures — The price of currency
futures will be similar to the forward rate
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.
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 Currency Futures Market (4 of 6)

How Firms Use Currency Futures

 Purchasing Futures to Hedge Payables — The
purchase of futures contracts locks in the price at
which a firm can purchase a currency.
 Selling Futures to Hedge Receivables — The
sale of futures contracts locks in the price at
which a firm can sell a currency.
 Closing Out a Futures Position (Exhibit 5.4)
 Sellers (buyers) of currency futures can close out
their positions by buying (selling) identical futures
contracts prior to settlement.
 Most currency futures contracts are closed out
before the settlement date.
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 Exhibit 5.4 Closing Out a Futures Contract

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 Currency Futures Market (5 of 6)

Speculation with Currency Futures (Exhibit 5.5)

 Currency futures contracts are sometimes purchased by
speculators attempting to capitalize on their expectation
of a currency’s future movement.
 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
Futures

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 Currency Futures Market (6 of 6)

Speculation with Currency Futures (cont.)

 Efficiency of the currency futures market
 If the currency futures market is efficient, the futures
price should reflect all available information.
 Thus, the continual use of a particular strategy to take
positions in currency futures contracts should not lead to
abnormal profits.
 Research has found that the currency futures market
may be inefficient. However, 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.

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 Currency Options Markets

Currency options provide the right to purchase or sell

currencies at specified prices.
Options Exchanges
 1982 — Exchanges in Amsterdam, Montreal, and
Philadelphia first allowed trading in standardized
foreign currency options.
 2007 — CME and CBOT merged to form CME group.
 Exchanges are regulated by the SEC in the U.S.
Over-the-counter market — Where currency options
are offered by commercial banks and brokerage firms.
Unlike the currency options traded on an exchange, the
over-the-counter market offers currency options that are
tailored to the specific needs of the firm.
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 Currency Call Options (1 of 5)

Grants the right to buy a specific currency at a

designated strike price or exercise price within
a specific period of time.
If the spot rate rises above the strike price, the
owner of a call can exercise the right to buy
currency at the strike price.
The buyer of the option pays a premium.
If the spot exchange rate is greater than the strike
price, the option is in the money. If the spot rate
is equal to the strike price, the option is at the
money. If the spot rate is lower than the strike
price, the option is out of the money.
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 Currency Call Options (2 of 5)

Factors Affecting Currency Call Option Premiums

The premium on a call option (C) is affected by three

factors:
 Spot price relative to the strike price (S – X): The
higher the spot rate relative to the strike price, the higher
the option price will be.
 Length of time before expiration (T): The longer the
time to expiration, the higher the option price will be.
 Potential variability of currency (σ): The greater the
variability of the currency, the higher the probability that
the spot rate can rise above the strike price.
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 Currency Call Options (3 of 5)

How Firms Use Currency Call Options

 Using call options to hedge payables
 Using call options to hedge project bidding to lock
in the dollar cost of potential expenses
 Using call options to hedge target bidding of a
possible acquisition

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 Currency Call Options (4 of 5)

Speculating with Currency Call Options

 Individuals may speculate in the currency options
based on their expectations of the future movements
in a particular currency.
 Speculators who expect that a foreign currency will
appreciate can purchase call options on that security.
 The net profit to a speculator is based on a
comparison of the selling price of the currency
versus the exercise price paid for the currency and
the premium paid for the call option.

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 Currency Call Options (5 of 5)

Speculating with Currency Call Options (cont.)

 Break-even point from speculation
 Break even if the revenue from selling the currency
equals the payments made for the currency plus the
option premium.
 Speculation by MNCs.
 Some institutions may have a division that uses
currency options to speculate on future exchange rate
movements.
 Most MNCs use currency derivatives for hedging and
not speculation.

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 Currency Put Options (1 of 8)

Grants the right to sell a currency at a specified strike

price or exercise price within a specified period of
time.
If the spot rate falls below the strike price, the owner of
a put can exercise the right to sell currency at the
strike price.
The buyer of the options pays a premium.
If the spot exchange rate is lower than the strike price,
the option is in the money. If the spot rate is equal to
the strike price, the option is at the money. If the spot
rate is greater than the strike price, the option is out of
the money.
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 Currency Put Options (2 of 8)

Factors Affecting Put Option Premiums

Put option premiums are affected by three factors:

 Spot rate relative to the strike price (S–X): The
lower the spot rate relative to the strike price, the
higher the probability that the option will be
exercised.
 Length of time until expiration (T): The longer
the time to expiration, the greater the put option
premium.
 Variability of the currency (σ): The greater the
variability, the greater the probability that the option
may
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 Currency Put Options (3 of 8)

Hedging with Currency Put Options

 Corporations with open positions in foreign currencies
can use currency put options in some cases to cover
these positions.
 Some put options are deep out of the money, meaning
that the prevailing exchange rate is high above the
exercise price. These options are cheaper (have a lower
premium), as they are unlikely to be exercised because
their exercise price is too low.
 Other put options have an exercise price that is currently
above the prevailing exchange rate and are therefore
more likely to be exercised. Consequently, these options
are more expensive.
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 Currency Put Options (4 of 8)

Speculating with Currency Put Options

 Individuals may speculate with currency put options
based on their expectations of the future movements in
a particular currency.
 Speculators can attempt to profit from selling currency
put options. The seller of such options is obligated to
purchase the specified currency at the strike price from
the owner who exercises the put option.
 The 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.

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 Currency Put Options (5 of 8)

Speculating with Currency Put Options (cont.)

 Speculating with combined put and call options
 Straddle — Uses both a put option and a call option at
the same exercise price.
 Good for when speculators expect strong movement in
one direction or the other.
 Efficiency of the currency options market
 Research has found that, when transaction costs are
controlled for, the currency options market is efficient.
 It is difficult to predict which strategy will generate
abnormal profits in future periods.

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 Currency Put Options (6 of 8)

Contingency graph for the caller of a call option

 Compares price paid for the option to the payoffs received
under various exchange rate scenarios. (Exhibit 5.6)
Contingency graph for the seller of a call option
 Compares premium received from selling the option to the
payoffs made to the options buyer under various exchange
rate scenarios. (Exhibit 5.6)
Contingency graph for the buyer of a put option
 Compares premium paid for put option to the payoffs
received under various exchange rate scenarios. (Exhibit
5.7)
Contingency graph for the seller of a put option
 Compares premium received for put option to the payoffs
made under various exchange rate scenarios. (Exhibit 5.7)
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 Exhibit 5.6 Contingency Graphs for Currency Call
Options

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 Exhibit 5.7 Contingency Graphs for Currency Put Options

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 Currency Put Options (7 of 8)

Conditional Currency Options (Exhibit 5.8)

 A currency option can be structured with a conditional
premium, meaning that the premium paid for the
option is conditioned on the actual movement in the
currency’s value over the period of concern.
 Firms also use various combinations of currency
options.

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 Exhibit 5.8 Comparison of Conditional and Basic
Currency Options

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 Currency Put Options (8 of 8)

European Currency Options

 European-style currency options must be exercised
on the expiration date if they are to be exercised at all.
 They do not offer as much flexibility; however, this is
not relevant to some situations.
 If European-style options are available for the same
expiration date as American-style options and can be
purchased for a slightly lower premium, some
corporations may prefer them for hedging.

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 SUMMARY (1 of 4)

 A forward contract specifies a standard volume of a

particular currency to be exchanged on a particular
date. Such a contract can be purchased by a firm to
hedge payables or sold by a firm to hedge receivables.
A currency futures contract can be purchased by
speculators who expect the currency to appreciate; it
can also be sold by speculators who expect the
currency to depreciate. If the currency depreciates
then the futures contract declines, allowing those
speculators to benefit when they close out their
positions.

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 SUMMARY (2 of 4)

 Futures contracts on a particular currency can be

purchased by corporations that have payables in that
currency and wish to hedge against the possible
appreciation of that currency. 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 and wish to
hedge against its possible depreciation.

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 SUMMARY (3 of 4)

 Call options allow the right to purchase a specified

currency at a specified exchange rate by a specified
expiration date. They are used by MNCs to hedge
future payables. They are commonly purchased by
speculators who expect that the underlying currency
will appreciate.
 Put options allow the right to sell a specified currency
at a specified exchange rate by a specified expiration
date. They are used by MNCs to hedge future
receivables. They are commonly purchased by
speculators who expect that the underlying currency
will depreciate.

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 SUMMARY (4 of 4)

 Call options on a specific currency can be purchased

by speculators who expect that currency to appreciate.
Put options on a specific currency can be purchased
by speculators who expect that currency to depreciate.

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