1 Multinational Financial Management Alan Shapiro 7 th Edition J.Wiley & Sons Power Points by Joseph F. Greco, Ph.D. California State University, Fullerton

2 CHAPTER 8 CURRENCY FUTURES AND OPTIONS MARKETS

3 CHAPTER OVERVIEW I.FUTURES CONTRACTS II.CURRENCY OPTIONS

4 PART I. FUTURES CONTRACTS I.CURRENCY FUTURES A.Background : Chicago Mercantile Exchange opens International Monetary Market. (IMM)

5 FUTURES CONTRACTS 2.IMM provides a.an outlet for hedging currency risk with futures contracts. b.Definition of futures contracts: contracts written requiring a standard quantity of an available currency at a fixed exchange rate at a set delivery date.

6 FUTURES CONTRACTS c.Available Futures Currencies: 1.) British pound5.) Euro 2.) Canadian dollar6.) Japanese yen 3.) Deutsche mark7.) Australian dollar 4.) Swiss franc

7 FUTURES CONTRACTS d.Standard Contract Sizes: contract sizes differ for each of the 7 available currencies. Examples: Euro = 125,000 British Pound = 62,500

8 FUTURES CONTRACTS e.Transaction costs: payment of commission to a trader f.Leverage is high 1.)Initial margin required is relatively low (e.g. less than.02% of sterling contract value).

9 FUTURES CONTRACTS g.Maximum price movements 1.)Contracts set to a daily price limit restricting maximum daily price movements.

10 FUTURES CONTRACTS 2.)If limit is reached, a margin call may be necessary to maintain a minimum margin.

11 FUTURES CONTRACTS h.Global futures exchanges that are competitors to the IMM: 1.)Deutsche Termin Bourse 2.)L.I.F.F.E.London International Financial Futures Exchange 3.)C.B.O.T. Chicago Board of Trade

12 FUTURES CONTRACTS 4.) S.I.M.E.X.Singapore International Monetary Exchange 5.)H.K.F.E. Hong Kong Futures Exchange

13 FUTURES CONTRACTS B.Forward vs. Futures Contracts Basic differences: 1. Trading Locations6. Settlement Date 2. Regulation7. Quotes 3. Frequency of 8. Transaction delivery costs 4. Size of contract9. Margins 5. Delivery dates 10. Credit risk

14 FUTURES CONTRACTS Advantages of futures: 1.) Smaller contract size 2.) Easy liquidation 3.) Well-organized and stable market. Disadvantages of futures: 1.) Limited to 7 currencies 2.) Limited dates of delivery 3.) Rigid contract sizes.

15 PART II CURRENCY OPTIONS I.OPTIONS A. Currency options 1.offer another method to hedge exchange rate risk. 2.first offered on Philadelphia Exchange (PHLX). 3.fastest growing segment of the hedge markets.

16 CURRENCY OPTIONS 4. Definition: a contract from a writer ( the seller) that gives the right not the obligation to the holder (the buyer) to buy or sell a standard amount of an available currency at a fixed exchange rate for a fixed time period.

17 CURRENCY OPTIONS 5.Types of Currency Options: a.American exercise date may occur any time up to the expiration date. b.European exercise date occurs only at the expiration date.

18 CURRENCY OPTIONS 7.Exercise Price a. Sometimes known as the strike price. b.the exchange rate at which the option holder can buy or sell the contracted currency.

19 CURRENCY OPTIONS 8.Status of an option a.In-the-money Call:Spot > strike Put:Spot < strike b.Out-of-the-money Call:Spot < strike Put:Spot > strike c.At-the-money Spot = the strike

20 CURRENCY OPTIONS 9.The premium: the price of an option that the writer charges the buyer.

21 CURRENCY OPTIONS B.When to Use Currency Options 1.For the firm hedging foreign exchange risk a. With sizable unrealized gains. b. With foreign currency flows forthcoming.

22 CURRENCY OPTIONS 2.For speculators - profit from favorable exchange rate changes.

23 CURRENCY OPTIONS C.Option Pricing and Valuation 1. Value of an option equals a. Intrinsic value b. Time value

24 CURRENCY OPTIONS 2.Intrinsic Value the amount in-the-money 3.Time Value the amount the option is in excess of its intrinsic value.

25 CURRENCY OPTIONS 4.Other factors affecting the value of an option a.value rises with longer time to expiration. b.value rises when greater volatility in the exchange rate.

26 CURRENCY OPTIONS 5.Value is complicated by both the home and foreign interest rates.

27 CURRENCY OPTIONS D. Using Forward or Futures Contracts: Forward and futures contracts are more suitable for hedging a known amount of foreign currency flow.

28 CURRENCY OPTIONS E.Market Structure 1.Location a. Organized Exchanges b. Over-the-counter 1.) Two levels retail and wholesale