Chapter 5 - Currency Derivatives

Question 1

What is a Currency Derivative?

Answer 1

A currency derivative is a contract whose price is derived from the value of an underlying currency.

Examples include forwards/futures contracts and options contracts.

Derivatives are used by M N Cs to:
1. Speculate on future exchange rate movements
2. Hedge exposure to exchange rate risk
–> Managers must understand how derivatives can be used to achieve corporate goals

Note: managers must understand how these derivatives can be used to achieve corporate goals

Question 2

A forward contract is an agreement between a corporation and a financial institution:

Answer 2

To exchange a specified amount of currency

At a specified exchange rate called the forward rate

On a specified date in the future

Because forward contracts accommodate large corporations, the forward transaction will often be valued at $1millionor more.

By contrast, consumers and small firms rarely use forward contracts.

In cases where a bank does not know a corporation well (or does not fully trust it), the bank may request that the corporation make an initial deposit as assurance that it intends to fulfill its obligation. Such a deposit, called a compensating balance, typically does not pay interest.

The most common forward contracts are for30,60,90,180, and360days, although other periods are available. Forward contracts can also be customized to the specific needs of the MNC.

Note: The forward market facilitates the trading of forward contracts on currencies.

When MNCs anticipate a future need for or the future receipt of some foreign currency, they can set up forward contracts to lock in the rate at which they can purchase or sell that currency. Nearly all large MNCs use forward contracts to some extent.

Question 3

Bank Quotations on Forward Rates:

Answer 3

Forward rates also have Bid/Ask Spread: wider for less liquid currencies.

Bid/Ask Spread = (Ask Rate - Bid Rate) / Ask Rate

Question 4

How M N Cs Use Forward Contracts:

Answer 4

Hedge against appreciation over time. They can lock in the rate at which they obtain a currency needed to purchase those imports.

Hedge against depreciation over time. Corporations also use the forward market to lock in the rate at which they can sell foreign currencies.

Question 5

Premium or Discount on the Forward Rate:

Answer 5

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.

–> P=(F/S) -1=(F-S)/S

Question 6

Solving for Forward Rate Premium or Discount with maturity:

Answer 6

Forward rate premium or discount =
(F-S)/S * 360/Time to Maturity

For example:
Spot Rate = $1.681
30 Day Forward rate = $1.680

Premium = (1.680-1.681) / 1.681 * (360/30)= -0.71%

Question 7

Price: Forward rates

Answer 7

Price: Forward rates typically differ from the spot rate for any given currency. If a currency’s spot and forward rates were the same and if the foreign currency’s interest rate was higher than the U.S. rate, then U.S. speculators could achieve a higher return on the foreign savings deposit than a U.S. savings deposit by following these steps:

1. Purchase the foreign currency at the spot rate.
2. Invest the funds at the attractive foreign interest rate.
3. Simultaneously sell forward contracts in that foreign currency for a future date when the savings deposit matures.

These actions would place upward pressure on the spot rate of the foreign currency and downward pressure on the forward rate, causing the forward rate to fall below the spot rate (exhibit a discount).

Question 8

Movements in the Forward Rate over Time

Answer 8

The forward premium is influenced by the interest rate differential between the two countries and can change over time.

Question 9

Offsetting a Forward Contract

Answer 9

— An M N C can offset a forward contract by negotiating with the original counterparty bank.

Example of offsetting a forward:
On March 10, Green Bay, Inc., hired a Canadian construction company to expand its office and agreed to payfor the work on September 10. It negotiated a six-month forward contract to obtainatper unit, which would be used to pay the Canadian firm in six months. On April 10, the construction company informed Green Bay that it would not be able to perform the work as promised. In response, Green Bay offset its existing contract by negotiating a forward contract to sellfor the date of September 10. However, the spot rate of the Canadian dollar had decreased over the last month, such that the prevailing forward contract price for September 10 is now. Green Bay now has a forward contract to sellon September 10, which offsets the other contract it has to buyon September 10. The forward rate wasper unitless on its sale than on its purchase, resulting in a cost of.

Question 9

Using Forward Contracts for Swap Transactions

Answer 9

— Involves a spot transaction along with a corresponding forward contract that will ultimately reverse the spot transaction.

Question 10

Non-deliverable forward contracts (N D F)

Answer 10

— 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. The NDF will specify the currency; the settlement date; and a reference rate

Example: Jackson, Inc will need 100 mil Chilean peso in July to buy supplies
Spot rate now: $0.0020/peso the USD amount is $0.0020/peso100 mil peso=$200,000
Spot rate July 1st: $0.0023/peso the USD amount is $0.0023/peso100 mil peso=$230,000
Because the value of Jackson’s NDF position is higher than that when the agreement was created
Jackson will receive $230,000-$200,000=$30,000 from the bank
Because the peso’s spot rate rose from April 1 to July 1, the company will need to pay $30,000 more for the imports than if it had paid for them on April 1. At the same time, however, Jackson will have received a payment of $30,000 due to its NDF. Thus the NDF hedged the exchange rate risk.

Example 2: Now suppose that, instead of rising, the Chilean peso had depreciated to$0.0018. Then Jackson’s position in its NDF would have been valued at $180,000 =100mil pesos *$0.0018at the settlement date, which is $20,000less than the value when the agreement was created. In this case, Jackson would have owed the bank$20,000at that time. However, the decline in the spot rate of the peso also means that Jackson would payless for the imports than if it had paid for them on April 1. Thus an offsetting effect occurs in this example as well.

Question 11

An NDF can ____ the exchange rate risk.

Answer 11

hedge

Question 12

Currency Futures Market:

Answer 12

Similar to forward contracts in terms of obligation to purchase or sell currency on a specific settlement date in the future.

Currency futures contracts usually specify the third Wednesday in March, June, September, or December as the settlement date.

An OTC (over-the-counter) currency futures market is also available, where financial intermediaries facilitate the trading of currency futures contracts with other settlement dates.

Question 13

Contract Specifications: Differ from forward contracts in how they are traded because futures have standard contract specifications:

Answer 13

Standardized number of units per contract (See Exhibit 5.2). For some currencies, the Chicago Mercantile Exchange (CME) offers “E-mini” futures contracts, which specify half the number of units of a typical standardized contract.

Offer greater liquidity than forward contracts due to standardization

Typically based on U.S. dollar, but may be offered on cross-rates (between non-USD currencies)

Commonly traded on the Chicago Mercantile Exchange (CME)

Question 14

Trading Currency Futures

Answer 14

Firms or individuals can execute orders for currency futures contracts by calling brokerage firms which will send the orders to CME to be executed electronically by Globex.

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.

Question 15

Credit Risk of Currency Futures Contracts —:

Answer 15

Neither party needs to worry about the credit risk of the counterparty, because the exchange clearinghouse assumes this risk: It assures that you will receive whatever is owed to you as a result of your currency futures position.

To minimize its risk, the C M E imposes margin requirements to cover fluctuations in the value of a contract, meaning that the participants must make a deposit, initial margin, with their respective brokerage firms when they take a position.

If the value of the futures contract declines over time, however, the buyer may be asked to maintain an additional margin, called the “maintenance margin.”

Question 15

Pricing Currency Futures:

Answer 15

The price of currency futures will be similar to the forward rate

Question 16

Comparison of the Forward and Futures Market:

Answer 16

1. Size of contract
2. Delivery date
3. Participants
4. Security deposit
5. Clearing operation
6. Marketplace
7. Regulation
8. Liquidation
9. Transaction costs

Question 17

Size of Contract Forward Market:

Answer 17

Tailored to individual needs.

Question 18

Size of Contract Futures Market:

Answer 18

Standardized.

Question 19

Delivery date Forward Market:

Answer 19

Tailored to individual needs.

Question 20

Delivery date Futures Market:

Answer 20

Standardized.

Question 21

Participants, Forward Market:

Answer 21

Banks, brokers, and multinational companies. Public speculation not encouraged.

Question 21

Participants, Futures Market:

Answer 21

Banks, brokers, and multinational companies. Qualified public speculation encouraged.

Question 22

Security deposit, Forward Market:

Answer 22

None as such, but compensating bank balances or lines of credit required.

Question 23

Clearing operation, Forward Market:

Answer 23

Handling contingent on individual banks and brokers. No separate clearinghouse function.

Question 23

Security deposit, Futures Market:

Answer 23

Small security deposit required.

Question 24

Clearing operation, Futures Market:

Answer 24

Handled by exchange clearinghouse. Daily settlements to the market price.

Question 25

Marketplace, Forward Market:

Answer 25

Telecommunications network.

Question 26

Regulation, Forward Market:

Answer 26

Self-regulating.

Question 26

Regulation, Futures Market:

Answer 26

CFTC (Commodity Futures Trading Commission);

NFA (National Futures Association).

Question 27

Marketplace, Futures Market:

Answer 27

Globex computerized trading platform with worldwide communications.

Question 28

Liquidation, Forward Market:

Answer 28

Most settled by actual delivery; some by offset, but at a cost.

Question 29

Liquidation, Futures Market:

Answer 29

Most by offset; very few settled by delivery.

Question 30

Transaction costs, Futures Market:

Answer 30

Negotiated brokerage fees.

Question 30

How Firms Use Currency Futures

Answer 30

1. Purchasing Futures to Hedge Payables — The purchase of futures contracts locks in the price at which a firm can purchase a currency.
2. Selling Futures to Hedge Receivables — The sale of futures contracts locks in the price at which a firm can sell a currency.
3. Closing Out a Futures Position (Exhibit 5.4)
   –>. 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.

Question 30

Transaction costs, Forward Market:

Answer 30

Set by the spread between the bank’s buy and sell prices.

Question 31

Speculation with Currency Futures:

Answer 31

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.

Question 32

Over-the-counter market

Answer 32

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.

Question 32

Efficiency of the currency futures market:

Answer 32

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 in some years the futures price has been consistently higher than the corresponding spot exchange rate at the settlement date, whereas in other years the futures price has been consistently lower. This suggests 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.

Question 33

Currency Call Options

Answer 33

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 (S) is greater than the strike price (X), 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.

S>X : the call option is in the money
S=X: the call option is at the money
S<X: the call option is out of the money

Question 33

Currency Options Markets:

Answer 33

Currency options provide the right to purchase or sell currencies at specified prices.

Currency Options Exchanges
1982 — Exchanges in Amsterdam, Montreal, and Philadelphia first allowed trading in standardized foreign currency options.
2007 — C M E and C B O T (Chicago Board of Trade) merged to form C M E group.

Options exchanges are regulated by the S E C (Securities and Exchange Commission) and CFTC (Commodity Futures Trading Commission) in the U.S.

Question 34

Factors Affecting Currency Call Option Premiums:

Answer 34

C= f (S-X, T, σ)

The premium on a call option (C) is affected by three factors:

1. 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.
2. Length of time before expiration (T): The longer the time to expiration, the higher the option price will be.
3. Volatility of the Currency(σ): The greater the variability of the currency, the higher the probability that the spot rate can rise above the strike price.

Question 35

Speculating with Currency Call Options

Answer 35

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.

Question 35

How Firms Use Currency Call Options:

Answer 35

Using call options to hedge payables

Using call options to hedge (foreign) project bidding to lock in the dollar cost of potential expenses

Using call options to hedge target bidding of a possible acquisition

Question 36

Break-even point from speculation:

Answer 36

Break even if the revenue from selling the currency equals the payments made for the currency plus the option premium.

Break even: S=X+Pc=$1.5+$0.02=$1.52

Question 37

Contingency Graph for Speculators Selling a Call Option:

Answer 37

A contingency graph for the seller of a call option compares the premium received from selling that option to the payoffs made to the option’s buyer under various exchange rate scenarios

Question 38

Contingency Graph for Speculators Buying a Call Option

Answer 38

A contingency graph for the buyer of a call option compares the price paid for that option to the payoffs received under various exchange rate scenarios.

Question 39

Speculation by M N Cs.:

Answer 39

Some institutions may have a division that uses currency options to speculate on future exchange rate movements.

Most M N Cs use currency derivatives for hedging and not speculation.

Question 40

Currency Put Options:

Answer 40

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.

S<X--> in the money
S=X--> at the money
S>X--> out of the money</X-->

Question 40

Contingency graph for the buyer of a put option:

Answer 40

Compares premium paid for put option to the payoffs received under various exchange rate scenarios. (Exhibit 5.7)
Break even: S=X - Pp =$1.5-$0.03=$1.47

Question 40

How M N Cs Use Currency Put Options:

Answer 40

Corporations (e.g. exporters) 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.

Question 41

Factors Affecting Put Option Premiums:

Answer 41

P = f (S-X, T, σ)

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.

Question 41

Speculating with Currency Put Options:

Answer 41

Individuals may speculate with currency put options based on their expectations of the future movements in a particular currency.

Speculators who expect that a foreign currency will depreciate can purchase put options on that security.

The net profit to a speculator from trading put options on a currency is based on a comparison of 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.

Speculators can also 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.

Question 42

Contingency graph for the seller of a put option:

Answer 42

Compares premium received for put option to the payoffs made under various exchange rate scenarios. (Exhibit 5.7)

Question 43

Speculating with combined put and call options:

Answer 43

Straddle — Uses both a put option and a call option at the same exercise price.

For volatile currencies. A speculator might anticipate that a currency will be substantially affected by current economic events, yet be uncertain of the effect’s direction.

Good for when speculators expect strong movement in one direction or the other.

Question 43

Efficiency of the currency options market:

Answer 43

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.

Question 44

Conditional Currency Options (Exhibit 5.8):

Answer 44

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.

Question 45

European Currency Options:

Answer 45

The currency options we learned so far are American-style that can be exercised within a specific period of time.

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.