Week 4

Question 1

What is a forward contract? Why are they useful?

Answer 1

A forward contract is an obligation to either purchase or sell an asset/currency at a specified exchange rate at a and a specified future date. They are useful because they provide certainty of the amount of money that will be earnt. Hedging against the risk of the currencies appreciating or depreciating. They can also be used for speculating on the future change in the exchange rate.

Question 2

What is the forward market? What are some interesting factors to do with bid-ask rates and liquidity.

Answer 2

The forward market facilitates trade of forward contracts. This trade will involve a bid and an ask price for the forward contracts, with the bid-ask spread being larger the further in the future the contract is. Typically the short-term forward contracts will be more liquid because banks can offset (enter into a buy and reverse by sellingto a company that just bought forward) bid and ask positions more easily in the short term.

Question 3

What is a compensating balance with regards to forward contracts?

Answer 3

Companies must keep a compensating balance when they take on a forward contract, this is a minimum amount they must keep in their balance.

Question 4

How do we make money from speculation on the forward market?

Answer 4

If a unit currency is expected to appreciate(more than the forward rate will be) relative to a quoted currency then I can buy a forward contract on the unit currency today, locking in the price. Later, when the unit currency appreciates and the contract expires I can buy the unit currency with my forward contract and sell it in the spot market. I could sell a forward contract and buy the unit currency at the end if I expect it to depreciate.

Question 5

How do we find the premium/discount for a forward contract?

Answer 5

We compare the spot midpoint with the forward contract midpoint cost. If the forward contract is trading at more than the spot price it is a forward premium, or a discount if trading at less. For a unit currency we divide the future value by the current value and subtract 1. We should also convert this to an annual rate by dividing the forward contract by its fraction of a year. For a quoted currency we must divide the spot price by the future price and then subtract 1.

Question 6

What is a swap?

Answer 6

A swap involves selling a currency and buying another and simultaneously buting a forward contract to do the reverse in the future. This helps to hedge risk.

Question 7

What is a non-deliverable forward contract?

Answer 7

NDFs can be used for emerging market currencies where no delivery takes place at settlement, instead, one party makes a payment to the other party, based on the difference between the spot rate and the forward rate when the forward contract ends.

Question 8

What is one of the main reasons for forward premiums/discounts?

Answer 8

Differences between the interest rates in each currency.

Question 9

What are foreign currency futures?

Answer 9

Alternatives to forward contracts, they require future delivery of a standard amount of forex at a fixed time, place, and price. These contracts are standardised on the exchanged by size, quotes, maturity date, last trading day, collateral and maintenance margins, setllement, commissions. the contract will specify the size of the contract, all of which must be in even multiples of the currency unit, typically are in terms of USD.
Some exchanges will also impose margin requirements to cover fluctuations in the value of a contract.

Question 10

What does a futures contract being marked to market mean?

Answer 10

Daily resettlement of any gains and losses are paid every trading day, if the price of the future goes down the long (bought), pays the short, if the price goes up, the short (sold) pays the long. After this daily resettlement, each party has a new contract at the new price with one-day-shorter maturity.

Question 11

What is a round turn?

Answer 11

The completion of a futures contract by covering your position, rather than physical delivery.

Question 12

What are some of the main differences between forward and future contracts?

Answer 12

Forward contracts may be for any size, or maturity, futures contracts are instead standardised.
Large firms use forward contracts for hedging risks. Small businesses and individuals will use futures. Futures require daily settlement while forwards do not. Futures only trade in limited currencies.

Question 13

How can firms use currency futures? How do they close out a futures position?

Answer 13

Purchasing of futures can be done to hedge payables, locking in the price that they can purchase a currency,
selling of futures can be done to hedge receivables locking in the price the firm can sell its currency for.
A futures contract can be closed by performing the reverse transaction for identical futures contracts prior to settlements.

Question 14

How can we speculate using futures contracts?

Answer 14

The speculator’s gain in a short is: the amount of unit currency used * (the futures contract price - the ending spot rate) This means we should short a depreciating currency pairing.
In a long position the gain is the amount of unit currency used * (spot rate - futures rate). As such we should use this when we expect a currency pairing to appreciate.

Question 15

What is an options contract?

Answer 15

A buyer of an options contract has the right, but not the obligation, to sell(put) or buy(call) a given amount of foreign exchange at a fixed price per unit for a specified time period (until expiry).
The strike price is the price that must be paid for the option. To make money a call spot has to be higher than the strike price, for a put the spot has to be less than the strike price.

Question 16

What are the things an option price is made of?

Answer 16

The exercise/strike price, the price that the option can be exercised for. The premium, the cost of the option, usually paid in advance, typically quoted as a percentage of the transaction amount. Lastly is the market spot exchange rate.

Question 17

What are the bank market and over-the-counter market used for in foreign currency options? What about exchange traded contracts?

Answer 17

These can allow for custom tailored options for individuals and banks to hedge forex risk. They are typically written by banks for USD against other major currencies.
Over the counter options vary by amount, strike price and maturity (tailored to firm needs).

Exchange traded contracts are used instead by speculators/individuals who cannot access the bank market. The options are traded on an organized exchange floor. Often banks will also trade options on this exchange to offset their option positions.

Question 18

How do we profit from speculation with options?

Answer 18

We buy a call if we believe a currency will go up, the profit will be the spot rate - (strike price + premium). When we buy a call we have a limited loss (can’t lose more than the premium) and unlimited profit if it goes up.

If we believe the currency will go down or stay the same we can write a call, this makes us obligated to sell, in this case our loss/profit = premium - (spot rate - strike rate) This makes a writer of a naked call option (doesn’t own underlying currency), has limited profit(premium) and unlimited loss potential if it goes up.

If we buy a put we believe the currency will go down. Our profit is the strike price - (spot rate + premium). We have a limited loss and unlimited profit potential if it goes down..

If we believe a currency will go up or stay the same we can sell the right to sell (write a put). In this case our loss/profit = premium - (strike rate - spot price). This gives us limited profit potential and unlimited loss if it goes down.

Question 19

What is a long currency straddle? What about a short currency straddle?

Answer 19

Buy a put and a call with the same expiration date and strike price. In this case we profit as long as the currency moves enough in either direction to cover our premiums.
In a short currency straddle we sell a put and a call with the same expiration date and strike price. We should do this if we expect the currency to not move much, as otherwise we lose if the currency moves further than our premiums in either direction.

Question 20

What is a long currency strangle? What about a short currency strangle?

Answer 20

Buy a put and a call with the same expiration date but different strike prices. In this case we will profit as long as the currency moves far enough over one of the strike prices to cover both premiums.

In a short strangle we sell a put and call with the same expiration date and different strike prices. In this case we expect the currency to be within the two strike prices. We will lose money if the currency goes far enough past either strike price to cover the premiums.