International Corporate Finance

11th Edition
by Jeff Madura

Chapter 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

2
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 Financial Derivatives

1. In finance, a derivative is a financial instrument (or, more

simply, an agreement between two parties) that has a value
based on the expected future price movements of the asset it
is linked to—called the underlying such as a share or a
currency. There are many kinds of derivatives, with the most
common being currency forward/futures and options.

2. Derivatives are a form of alternative investment.

3. Derivatives are used by MNCs to:

a. Speculate on future exchange rate movements
b. Hedge exposure to exchange rate risk

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 Financial Derivatives

Cont ｒ act Types

Exchange- Exchange- OTC swap OTC forward OTC option

Underlying traded Traded
futures options

Foreign Currency Option on Currency Currency Currency

exchange Future currency Swap forward Option
future

Interest rate Eurodollar Option on Interest Rate Forward Interest Rate

future Eurodollar Swap Rate Cap,
future Agreement Bond Option

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 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.

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 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

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 Turf. Inc., is an MNC based in Chicago, will need
S$1,000,000 in 90 days to purchase Singapore imports. It
can buy Singapore dollars for immediate delivery at the spot
rate of $.50 per Singapore dollar . At this spot rate, the firm
would need $500,000 (computed as S$1,000.000 x $.50 per
Singapore dollar). However, it does not have the funds right
now to exchange for Singapore dollars. It could wait 90 days
and then exchange dollars for Singapore dollars at the spot
rate existing at that time. But, Turf does nor know what the
spot rate will be at that time.

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 If the forward rate exceeds the existing spot rate, it contains a premium.
If it is less than the existing spot rate, it contains a discount. This
premium or discount is normally computed on an annual basis.

FR  S 360
Forward rate premium  
S n
The forward premium reflects the percentage by which
the forward rate exceeds the spot rate on an annualized
basis

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 How MNCs Use Forward Contracts

 Hedge their imports by locking in the rate at which

they can obtain the currency
 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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 Premium or Discount on the Forward Rate

Formula:
F = S(1+p)
=> F/S = 1+p
=> (F/S) – 1 = p or p = (F/S) – 1

Where, F = Forward Rate, S = Spot

Rate,
p = premium/negative premium (discount)

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 Exhibit 5.1 Computation of Forward Rate Premiums or
Discounts

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 Settlement of A Forward Contract

A forward contract can be settled in two ways:

• Delivery (a deliverable forward contract), or

• Cash Settlement.

In case of a deliverable forward contract, the party that is short the

forward contract will actually deliver the underlying asset to the party
that is long the forward contract. The underlying will be delivered on the
settlement date or the expiration date as specified in the contract and
the forward price will be received.

In case of a cash settled forward contract, the party for whom the
contract has a negative value will pay the amount of negative value to
the party with the positive value.

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 Currency Futures Market

 Similar to forward contracts in terms of obligation to

purchase or sell currency on a specific settlement date
in the future.
 Differ from forward contracts because futures have
standard contract specifications:
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 the
Chicago Mercantile Exchange

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 Trading Currency Futures

 Firms or individuals can execute orders for currency

futures contracts by calling brokerage firms.
 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

Source: Chicago Mercantile Exchange

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 Trading Currency Futures (cont.)

 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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 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.

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 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.

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 Exhibit 5.4 Closing Out a Futures Contract

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 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
Futures

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 Currency Futures Market Efficiency

1. If the currency futures market is efficient, the futures

price should reflect all available information.
2. Thus, the continual use of a particular strategy to take
positions in currency futures contracts should not lead
to abnormal profits.
3. 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

 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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 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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 How Firms Use Currency Call Options

Firms can use call options to:

 hedge payables
 hedge project bidding to lock in the dollar cost of
potential expenses.
 hedge target bidding of a possible acquisition.
 Speculate on expectations of future movements in a
currency.

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 CURRENCY CALL OPTIONS

Problem

Jim, a speculator, buys a British pound call option from Linda. We

have the following information for the deal.
 Call option strike price is $1.40 with Dec. settlement date.
Total units in the contract were 30,000 units (of £).
 Current Spot price $1.39.
 Premium paid per unit = $.012, but no brokerage fee.
 Before the expiration day, the spot rate for £ is $1.41.
 Jim exercise the call option and immediately sells the £ in the
market.
 Find profit or loss for the contracting parties.

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 Currency Put Options

1. Grants the right to sell a currency at a specified strike

price or exercise price within a specified period of
time.
2. 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.
3. The buyer of the options pays a premium.
4. 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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 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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 Hedging with Currency Put Options

1. Corporations with open positions in foreign currencies

can use currency put options in some cases to cover these
positions.
2. 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.
3. 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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 Speculating with Currency Put Options

1. Individuals may speculate with currency put options

based on their expectations of the future movements in a
particular currency.
2. 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.
3. 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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 Exhibit 5.6 Contingency Graphs for Currency Options

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 Conditional Currency Options

1. 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.
2. Firms also use various combinations of currency options.

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 Exhibit 5.7 Comparison of Conditional and Basic
Currency Options

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 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

 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.
 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.

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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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