Chapter 5

Question 1

Foward Contract

Answer 1

is an agreement between a corporation and a financial institution (such as a commercial bank) to exchange a specified amount of a currency at a specified exchange rate (called the forward rate) on a specified date in the future.

Question 2

Premium/Discount on Foward rate **

Answer 2

F = S(1+p)
or
p=(F/S)-1

F>S premium
F<S discount
F=S arbitrage possible (choose higher interest)

Question 3

Nondeliverable foward contracts

Answer 3

an be used for emerging market currencies where no currency delivery takes place at settlement; instead, one party makes a payment to the other party.

Question 4

Currency Future Contracts

Answer 4

specifying a standard volume of a particular currency to be exchanged on a specific settlement date.

Hedge payables (buy), or receivables (sell)

Question 5

How to reduce credit risk of future contracts

Answer 5

Margin requirements to cover fluctuations in contract value

Question 6

How do fowards and futures differ?

Answer 6

Foward:
tailored to individual needs
non security deposit
Handled by banks/brokes
Self regulated
Most actually delivered
Transactions cost (buy vs sell price)

Futures:
standardized
security deposit required
Handled by clearinghouse
Regulated
Most offse
Brokerage fees

Question 7

How do MNCs use currency futures?

Answer 7

Hedge payables: lock price to buy
Hedge receivables: lock price to sell
Closing out future positions (opposite)

Question 8

Long vs Short Position *

Answer 8

Long position: Speculators purchase a futures contract based on expectations that currency will rise in value

Short position: selling a currency futures contract based on view that currency will fall in value.

Question 9

What are call options

Answer 9

grants right to buy a specific currency at designated price within a specified time period

Exercise/Strike price: price owner allowed to buy currency
Spot rate: current market price

Question 10

Spot vs strike price meaning (>,<,=) (Call options)

Answer 10

Spot > strike = in the money (exercise option)
Spot = strike = at the money
Spot < striek = out the money (loss)

Question 11

Factors impacting Currency Call option premiums

Answer 11

S - X = difference b/w spot and strike price (+)

T = time to maturity (+)

Std dev (Sigma) = currency volatility (+)

Question 12

How MNCs use currency call options

Answer 12

Hedge payables
Hedge project bidding (lock cost of potential expenses)
Hedge target bidding of possible acquisition

Question 13

Speculating with Currency Call Options

What to do when expect appreciate? depreciate?

Answer 13

Expect appreciate = purchase call

Expect depreciate = sell call??

MNCs use for hedging, not sm for speculation

Question 14

What are put options?

Answer 14

Have right to sell a currency at a specified strike price or exercise price within a specified period of time.

Exercise when spot < strike price

Question 15

Spot vs strike price meaning (>,<,=) (Put options)

Answer 15

Spot rate < strike price = in the money. (exercise)

Spot rate = strike price = at the money.

Spot rate > strike price = out of the money

Question 16

Factors impacting Currency Put option premiums

Answer 16

S - X = difference b/w spot and strike price (-) (higher spot vs strike)

T = time to maturity (+)

Std dev (Sigma) = currency volatility (+)

Question 17

EXAMPLE:

Put option Premium on pound: $.04 per unit

Strike Price = 1.40

Contract = 31,250 pound (foreign)

Spot rate = 1.30

Seller and buyer perpective (profit/loss)

Answer 17

Buyer = 1875
Seller = -1875

Seller cound wait to sell until spot rises

Question 18

What is a straddle?

Answer 18

a combination of a call option and a put option with the same exercise price.

Currency may depreciate (put) and then appreciate (call)

Question 19

What are conditonal currency options?

Answer 19

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.

EXAMPLE: Put
If spot fall below exercise price - exercise option (receive 1.70 per pound) and pay no premium

If spot between exercise price ($1.70) and trigger ($1.74) - no exercise option + no premium

If spot above exercise trigger ($1.74) - pay premium ($.04 per unit)

EXAMPLE: Call
If spot above trigger (1.67) - no premium

If spot below trigger (1.67) - large premium

Question 20

What are European Currency Options

Answer 20

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;

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.