CURRENCY DERIVATIVES

OBJECTIVES

- 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 and swap contracts are
used to speculate or hedge based on anticipated
exchange rate movements.
 INTRODUCTION
A currency derivative is a contract whose price is partially
derived from the value of the underlying currency that it
represents.

Some individuals and financial firms take positions in

currency derivatives to speculate on future exchange rate
movements.

Types of currency derivatives are futures contract, forward

BENEFITS OF CURRENCY DERIVATIVES

- Hedging against currency risk.

- Speculation and investment opportunities

- Arbitrage possibilities.
FORWARD MARKET

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

 FORWARD MARKET
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.
FORWARD MARKET

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.
FORWARD MARKET
FORWARD MARKET
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.
 FUTURES MARKET
Currency futures contracts are contracts specifying a standard volume of a
particular currency to be exchanged on a specific settlement date. 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
 EXHIBIT 5.2 CURRENCY FUTURES CONTRACTS
TRADED
Example ON THE
of Standardized CHICAGO
transaction: CurrencyMERCANTILE
EXCHANGE
Futures Contracts Traded on the Chicago Mercantile
Exchange

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 FUTURES MARKET

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.
 FUTURES MARKET
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.
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.
FUTURES MARKET
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

 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.
FUTURE MARKET
EXAMPLE

On January 10, Tacoma Co. anticipates that it will need Australian dollars
(A$) in Marchwhen it orders supplies from an Australian supplier.
Consequently, Tacoma purchases a futures contract specifying A$100,000
and a March settlement date (which is March 19 for this contract). On
January 10, the futures contract is priced at $.53 per A$. On February 15,
Tacoma realizes that it will not need to order supplies because it has
reduced its production levels. Therefore, it has no need for A$ in March. It
sells a futures contract on A$ with the March settlement date to offset the
contract it purchased in January. At this time, the futures contract is priced
at $.50 per A$. On March 19 (the settlement date), Tacoma has offsetting
positions in futures contracts.
FUTURES MARKET
Speculation with Currency Futures
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.
EXAM PLE

Teton Co. orders Canadian goods and upon delivery will need to send
C$500,000 to the Canadian exporter. Thus, Teton purchases Canadian dollar
futures contracts today, thereby locking in the price to be paid for Canadian
dollars at a future settlement date. By holding futures contracts, Teton does
not have to worry about changes in the spot rate of the Canadian dollar over
time.
Source of Gains from Buying Currency Futures
FORWARD MARKET
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.
 CURRENCY OPTIONS MARKETS
CURRENCY OPTIONS

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)

CURRENCY OPTIONS

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. 22
 CURRENCY CALL OPTIONS (2 OF 5)

CURRENCY OPTIONS
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.

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 Potential variability of currency (σ): The greater the variability of the currency, the
 CURRENCY CALL OPTIONS (3 OF 5)

CURRENCY OPTIONS

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)

CURRENCY OPTIONS
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)

CURRENCY OPTIONS

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

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)

CURRENCY PUT OPTIONS

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 be exercised.
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 CURRENCY PUT OPTIONS (3 OF 8)

CURRENCY PUT OPTIONS

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)

CURRENCY PUT OPTIONS

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)

CURRENCY PUT OPTIONS

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)

CURRENCY PUT OPTIONS

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 5.6 CONTINGENCY GRAPHS FOR
CURRENCY CALL OPTIONS

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EXHIBIT 5.7 CONTINGENCY GRAPHS FOR
CURRENCY PUT OPTIONS

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EXHIBIT 5.7 CONTINGENCY GRAPHS FOR
CURRENCY PUT OPTIONS

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 CURRENCY PUT OPTIONS (7 OF 8)

CURRENCY PUT OPTIONS

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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COMPARISON OF CONDITIONAL AND BASIC
CURRENCY OPTIONS

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 CURRENCY PUT OPTIONS (8 OF 8)

CURRENCY PUT OPTIONS

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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