FINC3240 International Finance

Chapter 5 Currency Derivatives 1

Chapter Overview

A. Currency Forwards B. Currency Futures C. Currency Options D. Currency Swaps 2

Derivatives

A derivative contract involves no actual transfer of ownership of the underlying assets at the time the contract is initiated. A derivative represents an agreement to transfer ownership of underlying assets at a specific place, price, and time specified in the contract. Its value (or price) depends on the value of the underlying assets.

The underlying assets: stocks, bonds, interest rates, foreign exchanges, index, commodities, some derivatives, etc.

Currency Forwards

Definition: an agreement between two parties to exchange a specified amount of a currency at a specified exchange rate (forward rate) on a specified date in the future.

1.

Terms are unique to each individual forward contract. That is, each contract is customized.

2.

There is a risk that one side might default on its’ obligation.

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Forward Contract

 Forward bid-ask spread  Forward premium or discount P represents the forward premium (discount), or the percentage by which the forward rate exceeds (less) the spot rate.

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Forward Premium/Discount (1)

If the euro’s spot rate is $1.03, and its one-year forward rate has a forward premium of 2 percent, the one-year forward rate is: So, euro will appreciates or depreciates?

Appreciates!

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Forward Premium/Discount (2)

If the euro’s one-year forward rate is quoted at $1.00 and the euro’s spot rate is quoted at $1.03, the euro’s forward premium/discount is : 7

Exhibit 5.1 Computation of Forward Rate Premiums or Discounts

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Forwards Application

 Why would MNC use Forward contracts and therefore forward rate if they expect currency exchange in the future? Why not wait till then and exchange the currency with the spot rate of that date?

To lock in the price 9

Forwards Application (1)

Buying foreign currency forward Turz, Inc. on page 104 10

Forwards Application (2)

Selling foreign currency forward Scanlon, Inc. on page 104 11

Currency Futures

A standardized “forward contract” traded on an organized and regulated futures exchange.

1.

Futures contracts are guaranteed by the exchange’s clearinghouse that eliminates the risk of contra-party default.

2.

Each contract is standardized on the quantity, quality, delivery place, delivery date, contract expiration date.

3.

A deposit called “margin” is required to both buyers and sellers.

http://www.cme.com

Exhibit 5.2 Currency Futures Contracts Traded on the Chicago Mercantile Exchange

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Forwards vs. Futures

1.

2.

3.

4.

5.

6.

Futures exchange.

contracts trade on an organized Futures positions can be closed or transferred easily.

Futures contracts have standardized terms (quantity, expiration, etc.) Futures contracts are guaranteed by clearinghouse associated with the exchange.

the Futures are subject to daily settlement (marked to the market).

Margin is required to both the buyer and seller.

Clearinghouse

 Guarantees that all traders in the futures markets will honor their obligations.

 Act in a position of buyer to every seller and seller to every buyer. So no default risk as a counter-party to every trader.

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Margin and Daily Settlement

 Initial margin ( as little as 10% of the underlying asset’s value)  Maintenance margin  Marking to market: realize any loss or profit in cash every day.

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Marking to Market

Euro Futures Buyer bought at ($/euro) initial margin ratio Day 1 2 3 4 5 1.4551

0.1

Close Contract Value ($) 1.4565

182062.50

1.4570

1.4500

1.4535

1.3900

182125.00

181250.00

181687.50

173750.00

euro amount contract value ($) initial margin ($) Profit/Loss ($) 175.00

62.50

-875.00

437.50

-7937.50

125000 181887.50

18188.75

Maintenance Margin ($) margin ratio 18363.75

0.101

18426.25

17551.25

17988.75

10051.25

0.101

0.097

0.099

0.058

Euro Futures Seller sold at ($/euro) initial margin ratio Day 1 2 3 4 5 1.4551

0.1

Close Contract Value ($) 1.4565

182062.50

1.4570

182125.00

1.4500

1.4535

1.3900

181250.00

181687.50

173750.00

euro amount contract value ($) initial margin ($) Profit/Loss ($) -175.00

-62.50

875.00

-437.50

7937.50

125000 181887.50

18188.75

Maintenance Margin ($) margin ratio 18013.75

0.099

17951.25

0.099

18826.25

18388.75

26326.25

0.104

0.152

Closing a Position by Delivery

example on Page 109  On Feb 10, a futures contract on 62,500 British pounds with a march settlement date is priced at $1.50 per pound. If both buyer and seller of such a futures hold their positions to expiration, then after the settlement date the buyer of this currency futures will receive BP62,500 and will pay $93,750 (62500x1.5). The seller of this contract is obligated to deliver BP62,500 and receive $93,750. 18

Exhibit 5.5

Closing a Position by Reverse trading

example: Tacoma Co. on page 113.

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Participants in Futures Markets

 Hedgers: hedging, risk management  Speculators: make money by taking risk  Brokers: receive commission fee  Regulators: futures exchanges and clearinghouses, the National Futures Association 20

Futures Application (1)

    Spot=$1.4550/BP 1-year Future =$1.4550/BP 1-year US interest rate=5% 1-year UK interest rate=10% Can you speculate on this information?

Yes. Purchase Pound at spot rate $1.4550 and invest in UK bonds or saving account; simultaneously sell Pound 1-year Futures (Forward) at $1.4550. What is the effect of this strategy on the exchange rate?

Upward pressure on the spot rate and downward pressure on future price.

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Futures Application (2)

Expect the foreign currency to appreciate. (Example on page 111)  A speculator expects the British pound to appreciate in the future. He purchases a futures contract that will lock in the price at which he buys pounds at settlement date. On the settlement date, he purchases pounds at the rate specified by the futures contract and then sell these pounds at the spot rate. He will profit if the pound goes up. 22

Futures Application (3)

Expect the foreign currency to depreciate. (Example on page 111) On April 4, a futures contract on 500,000 Mexican pesos and a June settlement date is priced at $0.09. On April 4, speculators who expect the peso will decline sell futures contracts on pesos. On June 17 (settlement date), the spot rate of the peso is $0.08. The gain on this strategy is $5,000.

$0.09/p*p500000-$0.08/p*p500000=$5000 23

Futures Application (3)

Purchasing Futures to hedge payables (example on page 112) Teton Co. orders Canadian goods and will need to send C$500,000 to the Canadian exporter. Thus, Teton purchase 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.

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Futures Application (4)

Selling Futures to hedge receivables (example on page 113) Karla Co. sells futures contracts when it plans to receive a foreign currency from exporting that it will not need. It locks in the price at which it will be able to sell this currency as of the settlement date. Such an action is appropriate if Karla expects the foreign currency to depreciate against Karla’s home currency.

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Currency Options

A contract that is associated with a right to buy or sell a currency until after a specific date with a predetermined price (strike price) and amount. There are Call options and Put options.

1.

The buyer of a Call option has the right, not the obligation, to buy a currency.

2.

The buyer of a Put option has the right, not the obligation, to sell a currency.

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Options Features

There are always two positions in each option contract: Long for the buyer vs. Short for the seller (1) (2) Buying a Call → Selling a Call → Long a Call Short a Call (3) Buying a Put → (4) Selling a Put → Long a Put Short a Put 27

Options Features

 The buyer of an option has to pay a “price”, option premium. The seller of an option receives the option premium.

 The option premium is an immediate expense for the buyer and an immediate return for the seller, whether or not the buyer ever exercises the option. 28

Long vs. Short

Buyer (Long) Seller (Short) Call

- Right to buy the underlying (i.e. to exercise the option) - Pays the premium - Obligation to deliver the underlying, if buyer exercises the option - Receives the premium

Put

Right to sell the underlying (i.e. to exercise the option) - Pays the premium - Obligation to buy the underlying, if buyer exercises the option - Receives the premium 29

In-the-money (ITM) At-the-money (ATM) Out-of-the-money (OTM)

Moneyness

Call Exercise price < Present price Exercise price = Present price Exercise price > Present price Put Exercise price > Present price Exercise price = Present price Exercise price < Present price

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Options Exchanges

   Chicago Mercantile Exchange Chicago Board Options Exchange Over-the-counter market (contracts are customized) 31

Contingency (payoff) Graphs for Currency Options

1. Contingency Graph for a Buyer of a Call Option 2. Contingency Graph for a Seller of a Call Option 3. Contingency Graph for a Buyer of a Put Option 4. Contingency Graph for a Seller of a Put Option 32

Contingency Graphs for Currency Options Insert exhibit 5.6 page 123 33

Currency Call Options

 Factors Affecting Currency Call Option Premiums a. Level of existing spot price relative to strike price b. Length of time before the expiration date c. Potential variability of currency 34

Currency Put Options

 Factors Affecting Currency Put Option Premiums a. Level of existing spot price relative to strike price b. Length of time before the expiration date c. Potential variability of currency 35

Call Options Application (1)

 Hedge payables (Example on page 116) Pike Co. orders Australian goods and makes a payment in Australian dollars (A$) upon delivery. This company can buy an A$ call option that locks in a maximum rate. If the A$’s value remains below the strike price, Pike can purchase A$ at the prevailing spot rate and simply let its call option expire. If the A$’s value rises above the strike price, Pike will execute the option and buy A$ at the strike price.

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Call Options Application (1)

   A payment in A$1,000,000 will be delivered at the end of June.

On March 1, an option on A$500,000 that expires on June 28 has a strike price of A$1.1000/$.

Pike Co. buys 2 A$ Call options on March 1 and pay $100 premium for each option.

  On June 28, If the spot rate is A$1.0000/$, Pike purchases A$ at the prevailing spot rate, A$1.000/$, and simply let its call options expire. If the spot rate is A$1.2050, Pike executes the options and buy A$ at the strike price, A$1.1000/$.

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Put Options Application (1)

   Hedge receivables ABC Co. will receive payment in C$2,000,000 at the end of September.

On March 1, an option on C$500,000 that expires on September 28 has a strike price of C$1.5300/$.

ABC Co. buy 4 C$ Put options on March 1 and pay $100 premium for each option.

  On September 28, If the spot rate is C$1.4500/$, Pike executes the options and sell C$ at the strike price, CA1.5300/$.

If the spot rate is C$1.6000/$, ABC sells C$ at the prevailing spot rate, A$1.6000/$, and simply let its call options expire. 38

Speculation with Call Options (1)

example on page 118       Spot rate on June,1 =$1.3900

Call option premium=$0.012/BP Strike price=$1.4000/BP Settlement date=December, 31 Contract amount=31,250 BP No brokerage fees. One investor buy one Call option on June, 1.

  Just before expiration, spot rate=$1.4100/BP.

Q1: Will the investor exercise the Call option? Yes. He exercises the Call option and then sell pounds with spot rate of $1.3000/BP.

Q2: What is his profit/loss?

See the tables in the textbook 39

Speculation with Call Options (2)

Q&A 19    Call option premium=$0.03/C$ Strike price=$0.75/C$ Fill in the net profit(or loss) per unit based on the listed possible spot rates of the C$ on the expiration date.

Possible spot rate of C$ on expiration date $0.76

0.78

0.80

0.82

0.85

0.87

net Profit (loss)/C$ -0.02

0.00

0.02

0.04

0.07

0.09

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Speculation with Put Options (1)

example on page 121        Spot rate on June,1 =$1.3900

Put option premium=$0.04/BP Strike price=$1.4000/BP Settlement date=December, 31 Contract amount=31,250 BP No brokerage fees. One investor buy one Put option on June, 1.

 Just before expiration, spot rate=$1.3000/BP.

Q1: Will the investor exercise the Put option? Yes. He will buy pounds from spot market at $1.3000/BP and then execute the put option.

Q2: What is his profit/loss?

See the tables in the textbook 41

Speculation with Put Options (2)

Q&A 20    Put option premium=$0.02/C$ Strike price=$0.86/C$ Fill in the net profit(or loss) per unit based on the listed possible spot rates of the C$ on the expiration date.

Possible spot rate of C$ on expiration date $0.76

0.79

0.84

0.87

0.89

0.91

net Profit (loss)/C$ 0.08

0.05

0.00

-0.02

-0.02

-0.02

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American-style vs. European-style

 American-style options: can be exercised before or on the expiration date.

 European-style options: must be exercised on the expiration date.

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Currency Swap

 An agreement in which one party provides a certain principal in one currency to its counterparty in exchange for another currency, pays fixed or floating rate of interest on the currency it receives, and exchange the principal at the maturity of the contract.

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SWAP Application

    Spot rate= $1.2500/euro r = 10% in US, r =8% in EU.

Party A exchange 1 million euro for 1.25 million $.

Contract tenor is five years. The interest is paid every year. Principal USD Euro 1,250,000 1,000,000 0 Year Fixed rate in USD Fixed rate in Euro Party A USD Euro 1,250,000 -1,000,000 1 10% 8.0% -125,000 80,000 2 10% 8.0% -125,000 80,000 3 10% 8.0% -125,000 80,000 4 10% 8.0% -125,000 80,000 5 10% 8.0% -1,375,000 1,080,000 Party B USD Euro -1,250,000 1,000,000 125,000 -80,000 125,000 -80,000 125,000 -80,000 125,000 -80,000 1,375,000 -1,080,000 45

Homework

 Chapter 5 Q&A: 1,2,3,4,6,7,10,11,12,13,17,21,22.

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