Currency Derivatives

Question 1

Define a currency derivative and why they are used by MNCs

Answer 1

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.

Question 2

Define a forward contract

Answer 2

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.

Question 3

How can forwards help corporations with hedging

Answer 3

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.

Question 4

How does bank quote forward rates? talk about offsetting trade also

Answer 4

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.

Question 5

Formula for the premium forward rate

Answer 5

F=S(1+P) where S is the spot rate and p is a premium

Question 6

What is a discount forward rate?

Answer 6

When the premium is negative

Question 7

Why can the forward rate nto be equal to the spot rate?

Answer 7

Arbitrage would be possible

Question 8

What can move 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

How are forwards used for swap transations?

Answer 9

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

Question 10

What are NDFs?

Answer 10

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

Question 11

Define a futures contract

Answer 11

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.

Question 12

Where are futures sold?

Answer 12

Chicago Mercantile Exchange, Electronic trading platforms are often used for trades or firms can execute orders by calling brokerage

Question 13

When would futures be purchased by a corporation for hedging

Answer 13

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

Question 14

Compare forward and futures in terms of size of contract, delivery and participants

Answer 14

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

Question 15

Compare forward and futures in terms of security deposits clearing and marketplace

Answer 15

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.

Question 16

Compare forward and futures in terms of regulation

Answer 16

Forward: self regulating
Future: commodity futures trading commission, national futures association

Question 17

Compare forward and futures in terms of liquidation and transaction cost

Answer 17

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.

Question 18

Why should futures and forwards of a given currency and settlement date have same price?

Answer 18

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).

Question 19

How does CME minimise its credit risk for futures positions

Answer 19

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.

Question 20

How does speculation dictate futures purcahse/sale?

Answer 20

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.

Question 21

Define the over the counter market for currency options

Answer 21

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.

Question 22

What is a currency call option

Answer 22

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.

Question 23

Describe when a call option is in the money/out of the money etc

Answer 23

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.

Question 24

What factors affect the currency call option premium?

Answer 24

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.

Question 25

How do firms use call options?

Answer 25

To hedge payables
To hedge project bidding to lock in the dollar cost of potential expenses.
To hedge target bidding of a possible acquisition.

Question 26

When would speculators use call options and how do they calculate profit?

Answer 26

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 27

Where is the breakeven point with options

Answer 27

The Break-even point from speculation happens if the revenue from selling the currency equals the payments made for the currency plus the option premium - speculators would not purchase call option if they think the spot rate will not surpass the break even point by the expiration.

Question 28

Define a put option

Answer 28

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.

Question 29

Describe when a put option is in the money/ out of the money etc

Answer 29

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.

Question 30

What factors affect the put option premium?

Answer 30

Spot price 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 before expiration (T): The longer the time, the higher the put option premium.
Variability of currency (σ): The greater the variability of the currency, the higher the probability that the option will be exercised

Question 31

How do firms use put options

Answer 31

Corporations with open positions in foreign currencies can use currency put options in some cases to cover these positions.
Put options on a specific currency can be purchased by speculators who expect that currency to depreciate or by corporations with receivables in that currency expected to depreciate.

Question 32

Describe when put option would be cheap and expensive based on the current exchange rates

Answer 32

Some put options are deep out of the money, meaning the prevailing exchange rate is high above the exercise price. These options are cheaper, as they are unlikely to be exercised.
Other put options have an exercise price that is currently above the prevailing exchange rate and are therefore more likely to be exercised and more expensive.

Question 33

How do speculators act with put options and what does their profit depend on?

Answer 33

Speculators can attempt to profit from selling currency put options. The seller of must purchase the specified currency at the strike price from the owner who exercises the put option.
The net profit to a speculator is based on 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.

Question 34

What is straddle

Answer 34

Speculating with combined put and call options: Straddle - uses both a put option and a call option at the same exercise price. This is good for when speculators expect strong movement in one direction or the other

Question 35

What are European currency options features?

Answer 35

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.