Weeks 3-4

Question 1

what is a currency derivatives?

Answer 1

A currency derivative is a contract whose price is derived
from the value of an underlying currency.
* Forward contracts
* Currency futures contracts
* Currency call option contracts
* Currency put option contracts

Derivatives are used by MNCs to:
* Speculate on future exchange rate movements
* Hedge exposure to exchange rate risk

Question 2

what is 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 specified date in the future

How MNCs Use Forward Contracts
* Hedge their imports by locking in the rate at which they can
obtain the currency.

Bank Quotations on Forward Rates
* Bid/Ask Spread is wider for less liquid currencies.

Question 3

what is the forward premium and annualised forward premium

Answer 3

Forward Premium / Discount:
– The percentage difference between the forward and spot
rates

Annualised Forward Premium / Discount:
– The difference between the forward and spot rates
expressed as an annualised percentage of the spot
exchange rate.

Question 4

how do forward contracts operate?

Answer 4

Movements in the Forward Rate over Time
* The forward premium is influenced by the interest
rate differential between the two countries and can
change over time.
Offsetting a Forward Contract
* An MNC can offset a forward contract by
negotiating with the original counterparty bank.
Using Forward Contracts for Swap Transactions
* Involves a spot transaction along with a
corresponding forward contract that will ultimately
reverse the spot transaction.

Question 5

what are non-deliverable forward contracts?

Answer 5

• 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.
  (1) Determine the amount in HC based on the Forward rate
  (2) Determine the amount in HC based on the Spot rate
  (3) Calculate the difference in HC
  (4) Settle the difference in HC cash

Question 6

what are types of currency futures?

Answer 6

Standardised Exchange Traded Instruments
Pricing Currency Futures:
* The price of currency futures will be similar to the
forward rate.
Trading Currency Futures:
* Firms or individuals can execute orders for currency
futures contracts by calling brokerage firms.
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

Question 7

comparison of currency futures and forward contracts

Answer 7

Currency futures contracts are similar to forward
contracts:
* 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.
Differ from forward contracts because futures have
standard contract specifications:
* Standardized number of units per contract
* Offer greater liquidity than forward contracts
* Typically based on U.S. dollar, but may be offered on cross-
rates
* Traded on exchanges e.g. the Chicago Mercantile Exchange
(CME)

Question 8

How Firms Use Currency Futures

Answer 8

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.
Closing Out a Futures Position
* 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 9

what is the credit risk of currency futures contracts?

Answer 9

To minimize its risk, the exchange (e.g. 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 10

what is futures jargon?

Answer 10

short: a short position, go short, i dont have/i will need
long: a long position, go long, i have/i will get

sell/buy a contract - nothing is bought or sold per se. an investor takes a short or long position in future

Question 11

what is speculation with currency futures?

Answer 11

• Currency futures contracts are sometimes purchased by speculators attempting to capitalise on their expectation of a currency’s future appreciation.
• Currency futures can be sold by speculators who expect that the spot rate of a currency will be less (so cheaper to buy) than the
  rate at which they would be obligated to effectively sell it.

Question 12

what is the efficiency of the currency futures market?

Answer 12

• Efficiency implies the 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.
• 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 13

what are options concepts?

Answer 13

* Definition
– The right but not the obligation to buy or sell underlying assets at a fixed
price for a specified period.
* FX Options
– An option where the underlying asset is the foreign currency itself
* Parties
– Writer (seller) creates the option
– Holder (buyer) purchases the option
* Types
– Call -> Holder has the right to buy from the writer the underlying asset at
the strike price
– Put -> Holder has the right to sell to the writer the underlying asset at the
strike price
– European -> Can only be exercised at maturity
– American -> Able to be exercised at any time up to maturity
* Cost
– Premium -> price paid to buy the option
– Intrinsic value
– Time value

Question 14

how to purchase options

Answer 14

Over-the-counter market
* where currency options are offered by commercial
banks and brokerage firms.
* tailored to the specific needs of the firm.
Options exchanges
* heavily regulated
* set contract sizes and dates
* clearing house
* marking to market
* large markets

Question 15

what are FX options exchanges

Answer 15

• Philadelphia Stock Exchange (1790) => Acquired
  by NASDAQ (2007)
• International Securities Exchange (2000) =>
  Eurex Exchange (2007) => Direct Edge (2008) =>
  Acquired by NASDAQ (2016)
• CBOT (1848) => CME Group (2007)
• European Option Exchange (1978) => Amsterdam
  Stock Exchange (1997) => Euronext (2000) =>
  NYSE Euronext (2007) => Intercontinental Exchange
  (2012) => Euronext (2014)

Question 16

what is an option premium?

Answer 16

Typically quoted in cents of the Home
Currency per unit of the Foreign Currency.
e.g.
An option written on the CAD in the US.
Quoted premium = 7.45c US per CAD
This option which if written on 10,000 CAD would
cost the buyer:
(0.0745)(10,000) = 745 USD

Question 17

what are the price components of options

Answer 17

Intrinsic Value
* Immediate exercise value of the option
* Call max (0,s - X)
* Put max (0,X - s)
Time Value
* Excess of the option value over the intrinsic
value
* The portion of option value that accounts for
time, volatility and other factors.

Question 18

what are european currency options

Answer 18

• 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.

Question 19

american vs european options

Answer 19

* American Option
– Able to exercise at any time up to maturity
– Time Value is always positive or zero
– Possibly exercised early
* Holding an option on FC is similar to holding an option on a
stock which pays continuous dividends (you would invest the
foreign currency if you exercised today)
* Call (put) options on relatively high (low) foreign interest
currencies are most likely to be exercised early
* European Option
– Time value is not as obvious
* Changing maturity  different products
– Expectations matter: Possibly OTM at longer expiry

Question 20

what are option pricing factors?

Answer 20

1) FX rate (S)
2) Strike Price (X)
1 & 2 both affect the intrinsic value of the option
3) Time to Expiry
Greater probability of extreme results. Greater chance of the final
exercise value being further ITM or OTM.
* American option: increases value
– The longer duration American option offers everything that
the shorter duration option does, plus more.
* European option: usually increases value

Question 21

what are option pricing factors - currency volatility

Answer 21

– High volatility increases options value
* Greater chance of extreme high or low results
– Very low result
» Don’t exercise and option value is zero
– Very high result
» High positive payoff
– Unobservable (The only judgemental component)
* Must use an estimate of future volatility
– Can use historical volatility
* Typically use implied volatility from an actively traded option
– Calculated by backing out the implied volatility from
alternative instruments’ observed market prices

Question 22

what are option pricing factors - interest rate differentials

Answer 22

• Call value when exercised (st - X)
  – When option is purchased
• European type expected exercise value
  = (ŝt - X)
• American type expected exercise value
  = max (ŝt - X , ŝt-n - X)
  (A more complex pricing framework)
  – Unbiased Expectations Hypothesis (Week 5) :
• F0 as an unbiased predictor of ŝt
  – If UEH holds then today’s expected value of a European call
  option when exercised is (F0 - X)
  ➢ Pricing of European options is dependent upon the future
  distribution of prices centred around F0

Question 23

what are option pricing factors - interest rate parity

Answer 23

Demonstrates the relationships between
* Spot Rates, Forward Rates, Domestic Interest Rates and
Foreign Interest Rates
* Expected European Option Exercise Value:
* Call = (F0 - X) Put = (X - F0)
* Relative foreign interest rates increase (domestic interest rates decrease)
– Foreign currency will sell at a relative forward discount
– Call option value decrease Put option value increase
* Relative foreign interest rates decrease (domestic interest rates increase)
– Foreign currency will sell at a relative forward premium
– Call option value increase Put option value decrease

Question 24

what are option pricing factors - domestic/foreign interest rates

Answer 24

Domestic Interest Rates
* An option is a claim over an underlying asset, to buy or sell at a
fixed price.
– From this perspective : Option is a right to defer payment or sale
* Domestic Interest Rate increase -> PV (X) decrease
– Call Value increase (PV (cost to buy later) is now cheaper)
– Put Value decrease (PV (cost to sell later) is now lower)
Foreign Interest Rates
* Holding an option on FC is similar to holding an option on a stock
which pays continuous dividends (you would invest the foreign
currency if you exercised today)
* Foreign Interest Rate increase
– Expected value of the underlying asset falls (No claim over dividend)
– Call Value decrease Put Value increase

Question 25

moving from a qualitative to a quantitative pricing model

Answer 25

• Create a new portfolio with payoffs that duplicate the option’s
  payoffs
• Begin with a 2-state model
• Price the alternative portfolio and apply the law of one price

Question 26

black and sholes option pricing

Answer 26

• Extend the two-state model
• Assumptions
  – Future spot rates have a lognormal distribution centred at the Forward
  rate
  – Assumes that interest rates are continuous
  – Interest is earned on foreign currency investments
• Applies to European options

Question 27

what is speculation

Answer 27

Using short term expectations in taking positions of
uncertain outcomes, with a goal of profiting from future
price changes.
Speculators hold uncovered positions
Benefits
* Liquidity
– Price Stability
– Source of instruments others can use for risk management
* Market Efficiency
– Price Discovery
– Finding arbitrage opportunities which equalise prices across
markets
– Economic Signals

Question 28

what is FX speculation

Answer 28

Choice of Investment depends upon Speculator’s
Expectations:
* Foreign currency appreciation
 Desire a Long Exposure
Buy foreign currency
Long FX forward / futures
Buy FX call option
* Foreign currency depreciation
 Desire a Short Exposure
Sell foreign currency
Sell FX forward / futures
Buy a FX put option
Magnified results: Leverage / Derivatives

Question 29

what are market expectations?

Answer 29

In an efficient market expected movements are
already incorporated into the prices of our derivative
instruments
* e.g. Lock in the forward rate
Thus, when speculating with regards to direction using
market priced instruments, you should be picking the
direction relative to market expectations
* e.g. The market expects the value of the Pound to depreciate.
– Depending on your own forecasts, this could be a signal to
either buy or sell Pounds in the forward market

Question 30

example

what is speculation in a forward market?

Answer 30

• Spot : GBP / AUD 1.93
• 6-month Forward Rate : 1.99

(1) Australian speculator’s belief
GBP is going to appreciate vs. the AUD to 2.06
Action : Buy GBP Forward
(2) Australian speculator’s belief
GBP is going to appreciate vs. the AUD to 1.96
Action : Sell GBP Forward

Question 31

how does volatility affect speculation?

Answer 31

• Options markets allow traders to take advantage of their
  expectations regarding volatility.
  – Volatility is a factor in the value of options.
• Example:
  – Where the hedger’s expectation is that the volatility is
  going to be greater than the market prediction, a hedger
  can lock in a forward rate to cover their exposure with
  respect to direction and use a ‘Straddle’ as the bet on
  volatility.
  – A speculator would simply enter the Straddle.
• Long Straddle: Buying a Call and a Put Option at the same
  strike price.

Question 32

speculating with currency options

Answer 32

Speculating with combined put and call options
▪ Straddle - uses both a put option and a call option at the
same exercise price
▪ Good for when speculators expect strong movement in one
direction or the other
Efficiency of the currency options market
▪ Research has generally 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 33

what is arbitrage

Answer 33

arbitrage in financial markets requires
no capital and entails no risk…[it involves]
the simultaneous purchase and sale of the
same, or essentially similar, security in two
different markets for advantageously
different prices”

Question 34

what is international arbitrage?

Answer 34

• Assigned readings:
  – Defined as capitalising on a discrepancy in quoted
  prices by making a riskless profit.
• Arbitrage will cause prices to realign
• Three forms of FX arbitrage:
  – Locational arbitrage
  – Triangular arbitrage
  – Covered interest arbitrage

Question 35

what is locational arbitrage?

Answer 35

• Defined as the process of buying a currency at
  the location where it is priced cheap and
  immediately selling it at another location where it
  is priced higher.
• Gains from locational arbitrage are based on the
  amount of money used and the size of the
  discrepancy.
• Realignment due to locational arbitrage drives
  prices to adjust in different locations to eliminate
  discrepancies.

Question 35

what is triangular arbitrage?

Answer 35

* Defined as currency transactions in the spot market to capitalise on discrepancies in the cross-exchange rates between two currencies.
* Gains from triangular arbitrage:
– Currency transactions are conducted in the spot
market to capitalise on the discrepancy in the cross-
exchange rate between two countries.
* Accounting for the Bid/Ask Spread:
– Transaction costs (bid/ask spread) can reduce or even
eliminate the gains from triangular arbitrage.
* Realignment due to triangular arbitrage forces
exchange rates back into equilibrium.

Question 36

what is the impact of triangular arbitrage?

Answer 36

1. participants use dollars to purchase pounds
   - bank increases its ask price of pounds with respect to the dollar
2. participants use pounds to purchase malaysian ringgit
   - bank reduces its bid price of the british pound with respect to the ringgit, it reduces the number of ringitt to be exchnaged per pound received e
3. participants use malaysian ringgit to purchase us dollars
   - bank reduces its bid price of ringgit with respect to the dollar

Question 37

what is the foward rate a function of?

Answer 37

1. The current spot rate
2. The domestic interest rate
3. The foreign interest rate
   If ihome > iforeign….foreign currency sells at a forward premium.
   If iforeign > ihome…foreign currency sells at a forward discount.
   Do we use bid or ask quotations?
   We should not use the same for both as will become evident
   when we see the actual cash flows.

Question 38

forward bid or forward ask?

Answer 38

Use theoretical forward rate F*
* If F* = F no arbitrage
If F* < > F
=> Possible Arbitrage
F* > F
=> F relatively undervalued
=> Buy Fwd Foreign Currency (Fwd Ask)
F* < F
=> F relatively overvalued
=> Sell Fwd Foreign Currency (Fwd Bid)

Question 39

what is covered interest arbitrage

Answer 39

• Defined:
  – The process of capitalising on the interest rate differential
  between two countries while covering your exchange rate risk with
  a forward contract.
• Consists of two parts:
  – Interest arbitrage: the process of capitalising on the difference
  between interest rates between two countries.
  – Covered: hedging the position against foreign exchange risk.
• Realignment due to covered interest arbitrage causes
  market realignment.
• Timing of realignment may require several transactions
  before realignment is completed.

Question 40

what is interest rate parity?

Answer 40

Theory suggesting that the forward rate differs from the spot
rate by an amount that reflects the interest differential
between two currencies.
When market forces cause interest rates and exchange rates to
adjust such that covered interest arbitrage is no longer feasible,
the result is an equilibrium state known as IRP.

Question 41

comparing arbitrage strategies

Answer 41

▪ Below the IRP line: points X
and Y
▪ For points to the right of the IRP line, investors in the home country should
consider using covered interest arbitrage, since a return higher than the home interest rate (ih) is achievable.
▪ Points above the IRP line: point Z
▪ Domestic investors would achieve a lower return on a foreign investment than on a domestic one.

Question 42

equilibrium, interpretation,

interest rate parity

Answer 42

Equilibrium
* As investors and firms take advantage of such
opportunities, the points will tend to move toward the IRP
line.
* Covered interest arbitrage should continue until the
interest rate parity relationship holds.
Interpretation of Interest Rate Parity
* Interest rate parity does not imply that investors from
different countries will earn the same returns.
Does Interest Rate Parity Hold?
* Compare the forward rate (or discount) with interest rate
quotations occurring at the same time. Due to limitations
in access to data, it is difficult to obtain quotations that
reflect the same point in time.

Question 43

what are the considerations when assesing interest rate parity

Answer 43

Political risk
* A crisis in the foreign country could cause its government
to restrict any exchange of the local currency for other
currencies.
Differential tax laws
* Covered interest arbitrage might be feasible when
considering before-tax returns but not necessarily when
considering after-tax returns.
Transaction costs
* The actual point reflecting the interest rate differential
and forward rate premium must be farther from the IRP
line to make covered interest arbitrage worthwhile.

Question 44

how is there variation for forward premiums

Answer 44

Explaining changes in the forward rate
* The forward rate is indirectly affected by all the factors
that can affect the spot rate (S) over time, including
inflation differentials, interest rate differentials, etc.
Forward Premiums across Maturities
* The annualised interest rate differential between two
countries can vary among debt maturities, and so will
the annualized forward premiums.
Changes in Forward
Premiums over Time
The relationship between
interest rate differentials
and the forward premium
over time, when interest
rate parity holds. The
forward premium must
adjust to existing interest
rate conditions if interest
rate parity holds.

Question 45

comparison of arbitrage effects

Answer 45

Arbitrage tends to allow for a more orderly foreign
exchange market.
* The threat of locational arbitrage ensures that quoted
exchange rates are similar across banks in different locations.
* The threat of triangular arbitrage ensures that cross exchange
rates are properly set.
* The threat of covered interest arbitrage ensures that forward
exchange rates are properly set. Any discrepancy will trigger
arbitrage, which should eliminate the discrepancy.
How arbitrage reduces transaction costs
* Locational arbitrage limits the differences in a spot exchange
rate quotation across locations, while covered interest arbitrage
ensures that the forward rate is properly priced. Thus, an
MNC’s managers should be able to avoid excessive
transaction costs.

Question 46

how do warrants differ from options?

Answer 46

Warrants and options are both a form of derivative instrument. They derive their value from an
underlying instrument such as a share or an index.

Key differences include:
* Warrant trades are settled on CHESS, whereas options trades are settled by the Australian
Clearing House (ASX Clear)
* Option terms are standardised and set by ASX, whereas the terms of warrant series are set by the
issuer and vary from one warrant to another
* Warrants are issued by a third party (e.g., a bank) while options are listed by ASX
* Result (Key difference): Warrant holders are exposed to the credit risk of the issuer, while ASX
Clear guarantees the performance of option contracts

Question 47

type of FX derivative listed on the ASX

what is a MINI

Answer 47

• MINIs are a currency tracking product that provide investors with leveraged exposure to a number of currency
  pairs. MINIs are similar in nature to CFDs as they do not have an expiry date and track the underlying currency on a one for one basis.
• They also contain an in-built stop loss to ensure you cannot lose more than your initial outlay.
• Currency MINI longs give traders leveraged exposure to the Australian Dollar (AUD) rising against a selected currency.
• Conversely Currency MINI shorts give traders leveraged exposure to the AUD falling against a
  selected currency

Question 48

call and put warrants

Answer 48

• Currency warrants allow exchange of foreign currency for AUD by a specific expiry date.
• The value of warrants changes with the AUD/USD exchange rate.
• Call warrants benefit from an increase in the exchange rate.
• Put warrants benefit from a decrease in the exchange rate.
• Warrants are similar to exchange-traded options but are issued by a warrant issuer, not the ASX.
• Provide leveraged exposure to AUD/USD exchange rate movements.
• Carry risk of issuer not fulfilling obligations.
• Margins are not required; warrants can only be sold to close an existing position.

Question 49

what are currency exchange traded funds (ETFs)

Answer 49

• Currency ETFs can provide investors with the opportunity to gain exposure to the performance of selected
  foreign currencies.
• Currency ETFs are non-leveraged and are generally lower in cost when compared to
  holding a foreign currency account with a bank.
• Currency ETFs are available over the Australian / United States dollar (ASX code is USD), Australian / British Pound (ASX code POU) and the Australian / Euro (EEU). They are also offered by ANZ e.g., ZCNH
  (for the Renminbi).

NOTE: Many of these products move in and out of being offered on the ASX and others have no active trading! See the trading volumes after clicking on the product
codes.