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ECN 230 + ECN 240 > ECN 230: 11/13 Quiz - Currency Derivatives > Flashcards

ECN 230: 11/13 Quiz - Currency Derivatives Flashcards

1
Q

What is a currency derivative?

A

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

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2
Q

Why do we use derivatives?

A

Speculation/being speculators, Hedging/being hedgers

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3
Q

What is a forward contract?

A

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 specified date in the future

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4
Q

Why do MNC’s used forward markets?

A

To hedge their imports by locking in the rate at which they can obtain the currency.

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5
Q

What can be used for emerging market currencies?

A

Non-deliverable forward contracts (NDFs): Where no delivery takes place at place of settlement; instead, one party makes a payment to the other party.

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6
Q

What is the bid/ask spread rate?

A

(ask-bid/ask) x 100

The bid/ask spread rate is also the forward premium on a contract.

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7
Q

What affects the movement in the forward rate over time?

A

It is influenced by the interest rate differential between the two countries.

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8
Q

How can one offset a forward contract?

A

An MNC can offset a forward contract by negotiating with the original counterparty bank

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9
Q

What is a futures contract?

A

A currency future contract is an agreement between 2 counterparties to exchange a specified amount of 2 currencies at a given date in the future at an exchange rate which is predetermined at the moment of the contract.

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10
Q

Where are futures often traded?

A

-Often traded in several markets, such as the Chicago mercantile exchange.
-Brokerage firms own seats on the commodity exchange to execute contracts

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11
Q

Why would someone choose a future over a forward contract?

A

Futures are better/easier in the secondary market due to their higher levels of liquidity. You can sell a set standardized number of contracts, whereas forwards cannot be split.

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12
Q

What risk comes with forward contracts that futures don’t have?

A

Forward contracts involve a counterparty risk, while futures are guaranteed by the exchange.

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13
Q

Who takes what position in a futures contract?

A

A buyer of a currency futures contract takes the long position(hedging payables), while a seller of a currency futures contract takes the short position(hedging receivables).

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14
Q

What is the long position?

A

You profit if the price of the commodity, and hence the value of the contract, rises.

Ex: You suspect the value of Pesos to rise in relation to USD, so you buy a contract for 500,000 pesos at a set price. If Pesos rise by maturity in relation to USD, you can buy Pesos at a lesser amount than the current spot rate.

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15
Q

What is the short position?

A

You profit if the price of the commodity, and hence the value of the contract, declines.

Ex: You suspect the value of Pesos to drop in relation to USD, so you sell a contract for 500,000 Pesos at $0.09/Peso equaling $45,000. Right before fulfilling the contract, you buy 500,000 Pesos at the spot rate of $0.08/Peso equaling $40,000. Thus making $5,000 profit.

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16
Q

What are the similarities of Forward and future contracts?

A

They both allow customers to lock in the exchange rate at which a specific currency is purchased of sold at specific date in the future.

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17
Q

When would a future contract be sold by speculators?

A

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.

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18
Q

How can a firm close out of the futures contract?

A

If a firm no longer wants to maintain their position in a contract, they can close out their position by selling an identical futures contract.

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19
Q

How does the CME minimize the credit risk?

A

The CME will impose margin requirements to cover fluctuations in the value of a contract.

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20
Q

How do you calculate the value at maturity for the short position?

A

Value = -nominal principal x (spot-futures)

Ex:
-MXN 500,000 x ($0.095/MXN - $0.10958/MAX) = $7,290 gain/profit.

21
Q

How do you calculate the value at maturity for the long position?

A

Value = nominal principal x (spot-futures)

Ex:
MXN 500,000 x ($0.11000/MXN - $0.10958/MXN) = $210 gain/profit

22
Q

What is the difference between calculating the short and long position?

A

Short position uses a negative nominal principal, while the long position uses a positive nominal principal.

23
Q

What is a option?

A

An option is the RIGHT to do something.

In this case, the right to buy or sell a currency at a predetermined price sometime in the future. But they’re not obligated to follow through with the transaction.

24
Q

When will the owner of a call option exercise the right to buy?

A

If the spot rate rises above the strike price (In the Money), then they will exercise their right to buy and follow through.

25
Q

What does it mean to be ‘In The Money’(ITM) for a call option?

A

If the spot rate is greater than the strike price the option is considered ‘In the Money’ (ITM).

26
Q

What does it mean to be ‘At The Money’(ATM) for a call option?

A

If the spot rate is equal to the strike price, it is ‘At The Money’(ATM).

27
Q

What does it mean to be ‘Out of The Money’(OTM) for a call option?

A

If the spot rate is lower than the strike price, the option is ‘Out of The Money’(OTM).

The buyer of the option often will let it expire, not following through with the transaction.

28
Q

What is the difference between a ‘call option’ and a ‘put option’?

A

A call option gives the holder the right to PURCHASE the currency involved. While a put option gives the holder the right to SELL the currency.

29
Q

What is the ‘underlying currency’?

A

The currency in which the option is granted.

30
Q

What is the ‘counter currency’?

A

The currency in which the option is paid in.

31
Q

What is the premium?

A

It is the cost/price/value of the option/Having the right to buy/sell the underlying currency at a specified price.

Paid at the time that the option is given. Paid regardless if the option is exercised or not.

32
Q

What are the benefits of the Over-The-Counter(OTC) market?

A

OTC options can be tailored to the specific needs of the firms in terms of notional principal, strike price, and maturity.

33
Q

What are the downsides of the Over-The-Counter(OTC) market?

A

OTC options can expose firms to counterparty risk.

34
Q

What benefits come from options that come organized exchanges?

A

They are standardized and settled through a cleaning house, essentially eliminating counter party risk.

35
Q

The call option premium formula is:

A

C = F(S-X, T, S.D.)

S = Spot rate
X = Strike price
T = time to maturity
S.D. = the currencies volatility

36
Q

How do firms use currency call options?

A

-Using call options to hedge payables.
-Using call options to hedge project bidding to lock in the dollar cost of potential expenses.
-Using call options to hedge target bidding of a possible acquisition.

37
Q

What is the spot rate, exercise price, and premium?

A

The spot rate is the exchange rate at the time/day that exercise price is due to be used.

The exercise price is the same as the strike price. The price that must be paid if the option is exercised.

Premium is the cost or price of the option.

38
Q

What does the buyer of a call option thus possess?

A

-Limited Loss
-Unlimited profit potential

39
Q

What does the seller of a call option thus possess?

A

-Unlimited loss potential
-Limited Profit

40
Q

What happens if a writer writes the option ‘naked’

A

Writing a option naked means they wrote it without owning the currency, thus the writer will need to buy the currency at the spot rate and take the loss.

41
Q

Buyer of put options want to do what?

A

Buyers want to be able to sell the underlying currency at the exercise price when the market price of that currency drops (not rises as in the case of the call option)

42
Q

What are the ITM, ATM, and OTM of put options?

A

-If the spot ER is less than the strike price, the option is IN THE MONEY. Thus being profitable
-If the spot ER is equal than the strike price, the option is AT THE MONEY.
-If the spot ER is higher than the strike price, the option is OUT OF THE MONEY. Thus they will let it expire.

43
Q

What does it mean when a put option is ‘deep out of the money’?

A

When put options exercise price is substantially lower than the prevailing exchange rate. These options are often cheaper as they’re unlikely to be exercised b/c their exercise price is too low.

44
Q

What is the buyer’s call option profit/loss formula?

A

Profit = Spot rate - (Strike price + Premium)

Ex:
Profit = $0.595/SF - ($0.585/SF + $0.005/SF)
= $0.005/SF

45
Q

What is the seller’s call option profit/loss formula?

A

Profit = Premium - (Spot rate - Strike price)

Ex:
Profit = $0.005/SF - ($0.595/SF - $0.585/SF)
= $-0.005/SF

46
Q

What is the buyer’s put option profit/loss formula?

A

Profit = Strike price - (Spot rate + Premium)

Ex:
Profit = $0.585/SF - ($0.575/SF + $0.005/SF)
= $0.005/SF

47
Q

What is the seller’s put option profit/loss formula?

A

Profit = Premium - (Strike price - Spot rate)

Ex:
Profit = $0.005/SF - ($0.585/SF - $0.0575/SF)
= $-0.005/SF

48
Q

Buyers of put options experience what?

A

-minimal loss
-potential for unlimited profit

49
Q

Writers of put options experience what?

A

-minimal profit from the premium
-potential for unlimited loss

ECN 230 + ECN 240 (2 decks)

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