Currency Derivatives Flashcards
Define a currency derivative and why they are used by MNCs
A currency derivative is a contract whose price is derived from the value of an underlying currency.
Derivatives are used by MNCs to:
1. Speculate on future exchange rate movements. 2. Hedge exposures to exchange rate risk.
Define a forward contract
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 specific date in the future.
How can forwards help corporations with hedging
Corporations also use the forward market to lock in the rate at which they can sell foreign currencies. - hedging against the possibility of those currencies depreciating over time.
Forwards can be purchased by a firm to hedge payables or sold by a firm to hedge receivables.
How does bank quote forward rates? talk about offsetting trade also
Bank Quotes for forward rates will be a bid ask structure- spread will be 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.
Formula for the premium forward rate
F=S(1+P) where S is the spot rate and p is a premium
What is a discount forward rate?
When the premium is negative
Why can the forward rate nto be equal to the spot rate?
Arbitrage would be possible
What can move the forward rate over time?
The forward premium is influenced by the interest rate differential between the two countries and can change over time.
How are forwards used for swap transations?
Involves a spot transaction along with a corresponding forward contract that will ultimately reverse the spot transaction.
What are NDFs?
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
Define a futures contract
Similar to forward contracts in terms of obligation to purchase or sell currency on a specific settlement date in the future except futures have standard contract specifications.
They have a standardized number of units per contract, offer greater liquidity than forward contracts, typically based on US dollar but may be offered on cross rates.
Where are futures sold?
Chicago Mercantile Exchange, Electronic trading platforms are often used for trades or firms can execute orders by calling brokerage
When would futures be purchased by a corporation for hedging
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.
Also they allow a firm to lock in the exchange rate at which a specific currency is purchased or sold for a specific date
Sellers (buyers) can close out their positions by buying (selling) identical futures contracts prior to settlement - very common practice
Compare forward and futures in terms of size of contract, delivery and participants
Forward: tailored to individual need and participants are banks, brokers and MNCs public speculation is not encouraged
Futures: Standardised and participants are banks, brokers and MNCs, qualified public speculation is encouraged
Compare forward and futures in terms of security deposits clearing and marketplace
Forward: No security deposit but compensating bank balances or line of credit required, there is no separate clearing house function - handled by banks/broker, market is telecommunications network.
Futures: Small security deposit, handled by an exchange clearing house and central exchange floor with worldwide communications is market.
Compare forward and futures in terms of regulation
Forward: self regulating
Future: commodity futures trading commission, national futures association
Compare forward and futures in terms of liquidation and transaction cost
Forward: most are settled by actual delivery some offset but at a cost. Transaction costs set by spread between buy and sell price in bank
Future: Most by offset, few by delivery. Transaction costs are broker fees.
Why should futures and forwards of a given currency and settlement date have same price?
Should have the same price, or else guaranteed Profits are possible buy purchasing the cheaper rate and selling the higher rate at same time. (assuming no transaction costs).
How does CME minimise its credit risk for futures positions
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.
How does speculation dictate futures purcahse/sale?
Currency futures contracts are sometimes purchased by speculators attempting to capitalize on their expectation of a currency’s future movement.
They 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.
Define the over the counter market for currency options
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.
What is a currency call option
Currency call option: Grants the right to buy a specific currency at a designated strike price or exercise price within a specific period of time. Buyer will pay a premium for this option.
Describe when a call option is in the money/out of the money etc
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.
What factors affect the currency call option premium?
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.
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.
