5

Chapter

Currency Derivatives
 Forward Market in currency
• When MNCs anticipate future need or future
receipt of a foreign currency, they can set up
forward contracts to lock in the exchange rate.
¤ E.g importer who has to pay $100000 by Dec14
can now(Nov14) buy $ in forward market at
forward rate if he expects that $ will appreciate
¤ Similarly exporter can sell $ in forward if he thinks
that it would depreciate by the time he receives
export proceeds
• Forward contracts are often valued at $1 million
or more, and are not normally used by consumers
or small firms.
 Rates of Forward Market

• As with the case of spot rates, there is a

bid/ask spread on forward rates.
• Forward rates may also contain a premium
or discount.
¤ If the forward rate exceeds the existing
spot rate, it contains a premium.
¤ If the forward rate is less than the existing
spot rate, it contains a discount.
 Calculating
Premium/Discount
• annualized forward premium/discount
= forward rate – spot rate  360
spot rate n
where n is the number of days to maturity
• Example: Suppose £ spot rate = $1.681,
90-day £ forward rate = $1.677.

$1.677 – $1.681 x 360 = – 0.95%

$1.681 90
So, forward discount = 0.95%
 What Premium /Discount
indicate?
• The forward premium/discount reflects the
difference between the home interest rate
and the foreign interest rate, so as to
prevent arbitrage.
 non-deliverable forward
contract (NDF)
• A NDF is a forward contract whereby there is no actual exchange
of currencies.
• Instead, a net payment is made by one party to the other based on
the contracted rate and the market rate on the day of settlement.
• Although NDFs do not involve actual delivery, they can effectively
hedge expected foreign currency cash flows.
• E.g If an Indian importer requires 100k USD in 90 days he need not
purchase USD now which may be ruling at Rs60/USD. But if he
waits till 90 days USD may cost Rs70. Instead he can buy 100K
USD in forward for a premium of Rs2/USD. That way his maximum
loss is Rs200000 even if USD touches Rs70. After 90 days he gets
Rs8/USD(70-62) from broker while he buys USD at then spot rate to
pay to his supplier
 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 profit from their
expectations of exchange rate movements.
Trading in 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),
¤ on automated trading systems (e.g.
GLOBEX), or over-the-counter.
• Participants in the currency futures
market need to establish and maintain a
margin when they take a position.
 Difference between
forward/future
Forward Markets Futures Markets
Contract size Customized. Standardized.
Delivery date Customized. Standardized.
Participants Banks, brokers, Banks, brokers,
MNCs. Public MNCs. Qualified
speculation not public speculation
encouraged. encouraged.
Security Compensating Small security
deposit bank balances or deposit required.
credit lines needed.
 Difference between
forward/future
Forward Markets Futures Markets
Clearing Handled by Handled by
operation individual banks exchange
& brokers. clearinghouse.
Daily settlements
to market prices.
Marketplace Worldwide Central exchange
telephone floor with global
network. communications.
 Difference between
forward/future
Forward Markets Futures Markets
Regulation Self-regulating. Commodity
Futures Trading
Commission,
National Futures
Association.
Liquidation Mostly settled by Mostly settled by
actual delivery. offset.
Transaction Bank’s bid/ask Negotiated
Costs spread. brokerage fees.
 Currency Futures Rates

• Normally, the price of a currency futures

contract is similar to the forward rate for a
given currency and settlement date,
¤ Premium or discount

• It differs from the spot rate when the

interest rates on the two currencies differ.
• These relationships are enforced by the
potential arbitrage activities that would
occur otherwise.
 Uses of Currency Futures
• no credit risk
¤ since they are guaranteed by the exchange
clearinghouse.
• exchange imposes margin requirements to cover
fluctuations in the value of the contracts.
• Speculators often sell currency futures
¤ when they expect the underlying currency to
depreciate, and vice versa
• Currency futures may be
¤ purchased by MNCs to hedge foreign currency
payables(Imports), or
¤ sold to hedge receivables.(exports)
Closing of Currency Futures
• Holders of futures contracts can close out their positions
by selling similar futures contracts.
¤ E.g Dec14 $ future buy to be closed by sale of Dec14 $
future
• Sellers may also close out their positions by purchasing
similar contracts.
• Most currency futures contracts are closed out before their
settlement dates.
¤ Eg Dec14 $future buy can be closed in Nov14 itself

• Brokers who fulfill orders to buy or sell futures contracts

earn a transaction or brokerage fee in the form of the
bid/ask spread.
 Currency Options Market

• A type of contract that can be purchased or sold

by speculators and firms.
• Options give right to buy or sell but there is no
obligation
• They are traded on an exchange through brokers
are guaranteed, but require margin maintenance.
• Currency options are classified as
¤ either calls or puts
• In American type of options rights can be
exercised any time. In European type only on
expiry date
 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.
¤ I have a Call option to buy $10000 @ Rs65 on 31-
12-14(present spot rate is Rs62) for which I may
have paid a premium of Rs1/$
• A call option is
¤ in the money if spot rate > strike price,
¤ at the money if spot rate = strike price,
¤ out of the money
if spot rate < strike price.
 Use of Currency Call Options
• Option owners can sell or exercise their options.
¤ I can sell my call option before 31/12 if it has a
premium e.g now $=Rs70
¤ Or I can ask my seller to deliver $@65 on 31/12
which occurs rarely
• They can also choose to let their options expire. At
most, they will lose the premiums they paid for
their options.
¤ If $ falls to <Rs65 I may not exercise

• 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.
Use of Currency Call Options

• Firms with open positions in foreign

currencies may use currency call options
to cover those positions.
• They may purchase currency call options
¤ to hedge future payables;
¤ to hedge potential expenses when bidding
on projects; and
¤ to hedge potential costs when attempting
to acquire other firms.
 Use of Currency Call Options
• Speculators who expect a foreign currency to
appreciate can purchase call options on that
currency.
¤ Profit = selling price – buying (strike) price –
option premium
¤ E.g if $=Rs70 on 31/12 my profit =70-65-1=4

• They may also sell (write) call options on a

currency that they expect to depreciate.
¤ Profit = option premium – buying price +
selling (strike) price
¤ My seller of call option profits only if $<65 , say
$=60 , then his profit =1-60+65=6
 Currency Call Options

• The purchaser of a call option will break

even when
selling price = buying (strike) price
+ option premium
• The seller (writer) of a call option will
break even when
buying price = selling (strike) price
+ option premium
 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.
• I have a put option to sell $10000 @ Rs65 on 31-12-
14(present spot rate is Rs62 for which I may have
paid a premium of Rs1/$

• A put option is
¤ in the money if spot rate < strike price,
¤ at the money if spot rate = strike price,
¤ out of the money
if spot 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.
• Corporations with open foreign currency
positions may use currency put options to
cover their positions.
¤ For example, firms may purchase put
options to hedge future receivables.
 Currency Put Options
• Speculators who expect a foreign currency to depreciate
can purchase put options on that currency.
¤ Profit = selling (strike) price – buying price – option
premium
¤ Eg 65-62-1=2

• They may also sell (write) put options on a currency that

they expect to appreciate.
¤ Profit = option premium + selling price – buying
(strike) price
¤ My seller of put option makes money only when $>65 e.g
when$=66 the seller has profit =1+66-65=2 whereas I ,
buyer of put option lose Rs2
 Other types of
derivatives/transactions in forex
• Arbitrage-two point or three point arbitrages
¤ Exploiting the difference in forex rates of two markets(banks)
¤ It is three point arbitrage if it covers three currencies
• Option forwards
¤ Option to enter into forward within a stipulated time band
• Swaps(currency swaps)-forward
¤ Spot –forward= sell /buy spot and exchange for forward of another
¤ Forward –forward=buy/sell both forward of different currencies
¤ FSA(HSBC)=forward spread agreements
¤ FRA(Barclays)=forward rate agreements
¤ FXA(Midland Bank)=forward exchange agreements
• Futures
¤ Hedging -Direct with timing mismatch
¤ Cross Hedging= hedging with correlated currency
¤ IRF & interest rate hedging
Impact of Currency Derivatives on an MNC’s Value

Currency Futures
Currency Options

m 
n 
E CFj , t  E ER j , t 
 j 1 
Value =   
t =1  1  k  t

 
E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
 MCQs
• 2009
• Assume that as of May 15, a
futures contract on 125,000
euros (€) with a June
settlement date is priced at
$1.00 per euro. The ______ of
this currency futures contract
will ________ for the euros on
the settlement date.
• a. seller; pay $125,000
b. buyer; pay $125,000
c. seller; receive $125,000
d. buyer; receive $125,000
e. answers b and c are correct
• 2017
• The Swiss franc spot rate is
$.90 and the Swiss franc 90-
day forward rate is $.88. At
what discount or premium is
the Swiss franc selling?
• a. 2.22%, premium
b. -2.22%, discount
c. -9.09%, discount
d. 8.89%, premium
e. -8.89%, discount
 MCQs
• 2044
• Which of the following is a
similarity between the
currency futures market and
the forward market?
• a. both are self-regulating
b. both use standardized
contract sizes
c. both use standardized
delivery dates
d. all of the above are
similarities
e. none of the above are
similarities
• 2050
• Which of the following factors
does not affect the premium
of a currency call option?
• a. level of existing spot price
relative to strike price
b. length of time before the
expiration date
c. the currency of the call
option
d. potential variability of
currency
e. all of the above are factors
 MCQs
• 2069
• The forward rate will usually
contain a premium (or
discount) that reflects the
difference between the home
inflation rate and the foreign
inflation rate.
• a. True
b. False
• 2079
• Forward contracts are used
primarily by small firms and
individuals because they can
be tailored to the needs of
those clients.
• a. True
b. False
 MCQs
• 2100 • 2123
• A company expects to receive • A European-style currency
a foreign currency from the option may only be exercised
sale of merchandise. Because on the expiration date.
it is nervous about possible • a. True
exchange rate movements in b. False
this currency, it wants to
hedge its position with an
option in the currency. The
appropriate action for them to
hedge is to buy a call option.
a. True
b. False
 MCQs

• 2110
• If the spot rate of a
currency increased
substantially over a
period, the futures
price would likely
increase by about the
same amount.
• a. True
b. False