CHAPTER 5 Currency Derivatives © 2000 South-Western College Publishing 1

Chapter Objectives To explain how forward contracts are used to hedge based on anticipated exchange rate movements; To explain how currency futures contracts are used to speculate or hedge based on anticipated exchange rate movements; and To explain how currency options contracts are used to speculate or hedge based on anticipated exchange rate movements.

Forward Market A forward contract is an agreement between a corporation and a commercial bank to exchange a specified amount of a currency at a specified exchange rate (called the forward rate) on a specified date in the future. When MNCs anticipate future need or future receipt of a foreign currency, they can set up forward contracts to lock in the exchange rate. Forward contracts are not normally used by consumers or small firms.

Forward Market If the forward rate exceeds the existing spot rate, it contains a premium. If it is less than the existing spot rate, it contains a discount. Suppose spot rate = $1.681, and 90-day forward rate = $1.677. forward = $1.677 - $1.681 x 360 = – 0.95% discount $1.681 90 The premium (or discount) reflects the difference between the home interest rate and the foreign interest rate, so as to prevent arbitrage.

Forward rates

Forward Market Non-deliverable forward contracts (NDFs) are forward contracts whereby the currencies are not actually exchanged. Instead, a net payment is made by one party to the other based on the contracted rate and the market exchange rate on the day of settlement. While the NDF does not involve delivery, it can effectively hedge future foreign currency cash flows that are anticipated by the MNC.

Currency Futures Market Currency futures contracts are contracts specifying a standard volume of a particular currency to be exchanged on a specific settlement date, typically the third Wednesdays in March, June, September, and December. The contracts can be traded by firms or individuals on the trading floor of an exchange, on automated trading systems, or over the counter.

Currency Futures Market Currency futures differ from forward contracts in many ways: Size of contract ¤ Marketplace Delivery date ¤ Regulation Participants ¤ Liquidation Security deposit ¤ Transaction costs Clearing operation Normally, the price of a currency future is similar to the forward rate for a given currency and settlement date, but different from the spot rate.

Currency Futures Market Holders of futures contracts can close out their position by selling an identical futures contract. Similarly, sellers of futures contracts can close out their position by purchasing a currency futures contract with a similar settlement date. The gain or loss to the firm is dependent on the difference between the purchase price and the sale price. Most currency futures contracts are closed out before their settlement date.

Currency Futures Market The contracts are guaranteed by the exchange clearinghouse, and margin requirements are imposed to cover fluctuations in value. Corporations that have open positions in foreign currencies can use futures contracts to offset such positions. Speculators also use them to capitalize on their expectation of a currency’s future movement. Brokers who fulfill orders to buy or sell futures contracts earn a transaction fee in the form of a bid/ask spread.

Currency Options Market A currency option is another contract that can be bought or sold by speculators and firms. The standard options that are traded on an exchange through brokers are guaranteed. In contrast, the options that are tailored to the specific needs of the firm are offered by commercial banks and brokerage firms in an over-the-counter market. There are no credit guarantees for these options. Currency options are classified as either calls or puts.

Currency Call Options A currency call option grants the right to buy a specific currency at a specific price (called the exercise or strike price) within a specific period of time. A call option is in the money when the present exchange rate exceeds the strike price, at the money when the rates are equal, and out of the money otherwise. Option owners will at most lose the premiums they paid for their options.

Currency Call Options Premiums of call options vary due to: the level of existing spot price relative to strike price, the length of time before the expiration date, and the potential variability of the currency. Corporations can use currency call options to cover their foreign currency positions. Unlike a futures or forward contract, if the anticipated need does not arise, the firm can choose to let the options contract expire. The firm can also sell or exercise the option.

Currency Call Options Individuals may also speculate in the currency options market based on their expectations of the future movements in a particular currency. When brokerage fees are ignored, the currency call buyer’s gain will be the seller’s loss if both parties begin and close out their positions at the same time. The purchaser of a call option will break even when the spot rate at which the currency is sold is equal to the strike price plus the option premium.

Currency Put Options A currency put option grants the right to sell a specific currency at a specific price (the strike price) within a specific period of time. A put option is in the money when the present exchange rate is less than the strike price, at the money when the rates are equal, and out of the money otherwise. Since option owners are not obligated to exercise their options, they will at most lose the premiums they paid.

Currency Put Options Premiums of put options vary due to: the level of existing spot price relative to strike price, the length of time before the expiration date, and the potential variability of the currency. Corporations can use currency put options to cover their foreign currency positions. Individuals may also speculate with currency put options based on their expectations of the future movements in a particular currency.

Currency Put Options For volatile currencies, one possible speculative strategy is to purchase a straddle, which represents both a put option and a call option at the same exercise price. By purchasing both options, the speculator may gain if the currency moves substantially in either direction, or if it moves in one direction followed by the other.

Contingency Graphs for Call Options $1.46 $1.50 $1.54 - $.02 - $.04 - $.06 +$.06 +$.04 +$.02 Net profit per unit Future spot rate For purchasers of British pound call options exercise price = $1.50 premium = $0.02 $1.46 $1.50 $1.54 - $.02 - $.04 - $.06 +$.06 +$.04 +$.02 Net profit per unit Future spot rate For sellers of British pound call options exercise price = $1.50 premium = $0.02

Contingency Graphs for Put Options $1.46 $1.50 $1.54 - $.02 - $.04 - $.06 +$.06 +$.04 +$.02 Net profit per unit Future spot rate For purchasers of British pound put options exercise price = $1.50 premium = $0.03 $1.46 $1.50 $1.54 - $.02 - $.04 - $.06 +$.06 +$.04 +$.02 Net profit per unit Future spot rate For sellers of British pound put options exercise price = $1.50 premium = $0.03

Conditional Currency Options Some options are structured with the premium conditioned on the actual movement in the currency’s value over the period of concern. For example, suppose a conditional put option on British pounds has an exercise price of $1.70, and a so-called trigger of $1.74. The premium will have to be paid only if the pound’s value exceeds the trigger value. The payment of the premium is avoided conditionally at the cost of a higher premium.

Conditional Currency Options Option Type Exercise Price Trigger Premium basic put $1.70 - $0.02 conditional put $1.70 $1.74 $0.04 $1.66 $1.68 $1.70 $1.72 $1.74 $1.76 $1.78 $1.80 $1.82 Spot Rate Effective Exchange Rate Basic Put Conditional Put

European Currency Options European-style currency options are similar to American-style options except that they can only be exercised on the expiration date. For firms that purchase options to hedge future foreign currency cash flows, this loss in terms of flexibility is probably not an issue. Hence, if their premiums are lower, European-style currency options may be preferred.

Efficiency of Currency Futures and Options If foreign exchange markets are efficient, speculation in the currency futures and/or currency options markets should not consistently generate abnormally large profits. A speculative strategy requires the speculator to incur risk. On the other hand, corporations use the futures and options markets to reduce their exposure to fluctuating exchange rates.

Impact of Currency Derivatives on an MNC’s Value Currency futures Currency options E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = the weighted average cost of capital of the U.S. parent

Chapter Review Forward Market How MNCs Use Forward Contracts Premium or Discount on the Forward Rate Non-Deliverable Forward Contracts

Chapter Review Currency Futures Market Comparison of Currency Futures and Forward Contracts Pricing Currency Futures Closing Out a Futures Position Credit Risk of Currency Futures Contracts Corporate Use of Currency Futures Speculation with Currency Futures Transaction Costs of Currency Futures

Chapter Review Currency Options Market Currency Call Options Factors Affecting Call Option Premiums Hedging with Currency Call Options Speculating with Currency Call Options Break-Even Point from Speculation Currency Put Options Factors Affecting Put Option Premiums Hedging with Currency Put Options Speculating with Currency Put Options Speculating with Combined Put and Call Options

Chapter Review Contingency Graphs for Options Conditional Currency Options European Currency Options Efficiency of Currency Futures and Options How the Use of Currency Futures and Options Affects an MNC’s Value