1. Currency Futures and Options

2. Spot Exchange Rates Spot transactions are done immediately. A spot rate is the current domestic currency price of a foreign currency Spot transactions are done immediately. A spot rate is the current domestic currency price of a foreign currency

3. Transaction Volume Spot market volume is small relative to total currency volume

4. Forward Contracts Forward contracts are purchases/sales of currencies to be delivered at a specific forward date (30,90,180, or 360 days) Forward contracts are purchases/sales of currencies to be delivered at a specific forward date (30,90,180, or 360 days) Example Example CAD/USD.7641 1 month.7583 3 months.7563 6 months.7537 12 months.7525

5. Forward Contracts Microsoft anticipates labor expenses from Canadian operations (payable in Canadian Dollars) in 30 Days. Microsoft anticipates labor expenses from Canadian operations (payable in Canadian Dollars) in 30 Days. A Canadian Prescription Drug Importer is expecting a shipment of Viagra from Pfizer in 30 days (payment due in dollars) Suppose that the current CAD/USD exchange rate is.7641. Microsoft would be worried about the dollar depreciating while the Canadian importer worries about the dollar appreciating.

6. Forward Contracts Commercial Bank Microsoft approaches a commercial bank with an offer to buy Canadian dollars forward 30 days The Canadian drug importer approaches a commercial bank with an offer to sell Canadian dollars forward 30 days The bank negotiates a price of.7583 per CAD for 1M CAD

7. On Settlement day, Microsoft buys 1M CAD for.7583 apiece and saves (.7668 -.7583)*1M = $8,500 On Settlement day, the drug importer sells 1M CAD for.7583 apiece and loses (.7583 -.7668)*1M = $8,500

8. Non-Deliverable Forwards Note that the currencies need not actually be delivered. A non-deliverable forward specifies that only the profits/losses will be exchanged on settlement day. Note that the currencies need not actually be delivered. A non-deliverable forward specifies that only the profits/losses will be exchanged on settlement day.

9. Forward Premiums/Discounts In the previous example: In the previous example: CAD =.7641 30 Day =.7583 Forward Premium =.7583 -.7641.7641 100 360 30 Annualized =-9.1% The 30 Day CAD is selling at a discount of 9.1%

10. Futures Contracts Forward contracts are written on an individual basis. Futures are standardized, traded commodities (Chicago Mercantile Exchange) Forward contracts are written on an individual basis. Futures are standardized, traded commodities (Chicago Mercantile Exchange) JPY: 12,500,000 Yen JPY: 12,500,000 Yen GBP: 62,500 Pounds GBP: 62,500 Pounds Euro: 125,000 Euro Euro: 125,000 Euro CAD: 100,000 Canadian Dollars CAD: 100,000 Canadian Dollars Therefore, to make the previous trade (buy 1M CAD, you would purchase 10 futures contracts) Therefore, to make the previous trade (buy 1M CAD, you would purchase 10 futures contracts)

11. Futures Contracts Chicago Mercantile Exchange Microsoft makes an offer to buy 10, 30 Day Futures Contracts The Canadian drug importer makes an offer to sell 10, 30 day Futures contracts The CME simultaneously buys 10 contracts from Microsoft and sells 10 contracts from the drug importer

12. Futures Quotes StrikeOpenHighLowSettle Pt Chge VolumeInterest Feb05.7600.7615.7559.7570+17035008993 Mar05.7850.7900.7800.7825-150334 Apr05-----------------------UNCH---------- CAD 100,000 Settlement DateChange From Prior Day (in Pips) Opening, High, Low, and Closing Price Contracts Outstanding (000s) Total Contracts bought/sold that day

13. Pricing Currency Forwards/Futures Consider the following investment strategy: Borrow $1,000 in the US Convert the $s to Euros Invest the Euros in European Bonds Convert the proceeds from the Euro bonds back to dollars Profit = Proceeds from Euro Bonds less Repayment of initial loan plus interest i = 6% e = $1.35/E i* = 4% e’ = $1.40/E

14. Pricing Currency Forwards/Futures Consider the following investment strategy: Borrow $1,000 in the US E741 (1.04) = E770 i = 6% e = $1.35/E i* = 4% e’ = $1.40/E $1000 1.35 = (E770.31)(1.40) = $1,078 E741 Profit = $1,078 - $1,000(1.06) = $18

15. Uncovered Interest Parity $1 1 e (1+i*) e (1+i*)e’ e (1+i*)e’ (1+i*)e’ e Profit = - (1+i) = 0

16. Uncovered Interest Parity (1+i*)e’ (1+i*)e’ e Profit = - (1+i) = 0 EXPECT Uncovered parity suggests that you shouldn’t EXPECT to make money this way! expected This is the expected future exchange rate i – i* = Expected Change in the Exchange Rate 6% – 4% = 2% (An expected 2% dollar depreciation) Expected e’ = $1.35/E (1.02) = $1.38

17. Covered Interest Parity You could eliminate all your risk by “locking in” your future exchange rate with a futures contract Borrow $1,000 in the US, Buy a futures contract for $1,078 at $1.40/E E741 (1.04) = E770 i = 6% e = $1.35/E F i* = 4% F = $1.40/E $1000 1.35 = (E770.31)(1.40) = $1,078 E741 Profit = $1,078 - $1,000(1.06) = $18

18. Covered Interest Parity (1+i*)F (1+i*)F e Profit = - (1+i) = 0 Covered parity is a zero arbitrage condition between spot and forward rates This is the futures/forward rate i – i* = Forward Premium/Discount Given the 2% interest differential, Forward/Futures should be selling at a 2% premium (= $1.38)

19. Forward rates as Predictors of the Future? Forward Premium/Discount = i – i* = Covered Interest Parity Expected Percentage Change in Spot Rate Uncovered Interest Parity Forward Premium/Discount = Expected Percentage Change in Spot Rate

20. Currency Options With options, you have the right to buy/sell currency, but not the requirement With options, you have the right to buy/sell currency, but not the requirement Call: The right to buy at a specific “strike price” Call: The right to buy at a specific “strike price” Put: The right to sell at a specific “strike price” Put: The right to sell at a specific “strike price” The option belongs to the buyer of the contract. If you sell a put, you are REQUIRED to buy if the holder of the put chooses to exercise the option. The option belongs to the buyer of the contract. If you sell a put, you are REQUIRED to buy if the holder of the put chooses to exercise the option. The buyer must pay an up front price for the contract The buyer must pay an up front price for the contract

21. Reading Options Quotes (Call Option) Date/StrikeOpenHighLowSettle Pt Chge VolumeInterest Feb057600.0008.0012.0006.0007+31250 Mar057700.0003.0005.0002.0003-5310 CAD 100,000 Settlement Date and Strike Price Daily Price Movements (per CAD):.0001 = $10 per contract Change From Previous Day (in Pips) Contracts Traded/ Outstanding (000s)

22. Payout from a Call Suppose you buy a 30 day call on 125,000 Euros at a strike price of $1.20 For spot rates less than $1.20, the option is worthless (“out of the money”) If the spot rate is $1.25, your profit is ($.05)*($125,000) = $6,250

23. Pricing a Call Option If the future price of a Euro is $1.25 at expiration (30 days from now) with certainty, the contract guarantees a $6,250 payout in 30 days ($.05 per Euro). Suppose the interest rate is currently 5% If the future price of a Euro is $1.25 at expiration (30 days from now) with certainty, the contract guarantees a $6,250 payout in 30 days ($.05 per Euro). Suppose the interest rate is currently 5% Call Price = Present Value of $6,250 in one month = $6,250/(1.05) = $5,952.38 (.047 per Euro) = $6,250/(1.05) = $5,952.38 (.047 per Euro) A call option price should be positively related to the (expected) future exchange rate and negatively related to the interest rate A call option price should be positively related to the (expected) future exchange rate and negatively related to the interest rate.

24. Pricing a Call Option If the future price of a Euro has a 50% chance of decreasing to $1 and a 50% chance of increasing to $1.50 at expiration (30 days from now). Suppose the interest rate is currently 5% If the future price of a Euro has a 50% chance of decreasing to $1 and a 50% chance of increasing to $1.50 at expiration (30 days from now). Suppose the interest rate is currently 5% Expected Payout = (.5)($0) + (.5)($.30*125,000) = $18,750 Call Price = Present Value of $18,750 in one month = $18,750/(1.05) = $17,857.14 (.143 per Euro) = $18,750/(1.05) = $17,857.14 (.143 per Euro) A call option price should be positively related to the variance of the exchange rate.

25. Black - Scholes

26. Payout from a Put Suppose you buy a put on 125,000 Euros at a strike price of $1.20 Suppose you buy a put on 125,000 Euros at a strike price of $1.20 For spot rates greater than $1.20, the option is worthless (“out of the money”) For spot rates greater than $1.20, the option is worthless (“out of the money”) For example, if the spot rate is $1.15, your profit is For example, if the spot rate is $1.15, your profit is ($.05)*($125,000) = $6,250

27. Pricing Puts Consider two investment portfolios Consider two investment portfolios Portfolio #1 Buy a call option for E100 at a strike price of $1.20 (expiration in 1 year) Buy a 1 year Treasury with a face value of $120 Portfolio #2 Buy a Put option on E100 at a strike price of $1.20 (expiration of 1 year) Hold E100 in cash These two portfolios will generate the same 1 year profit (in $s) for every possible value of the exchange rate!!

28. Suppose the exchange rate is $1.25/E Suppose the exchange rate is $1.25/E Portfolio #1 Buy a call option for E100 at a strike price of $1.20 (expiration in 1 year) Buy a 1 year Treasury with a face value of $120 Portfolio #2 Buy a Put option on E100 at a strike price of $1.20 (expiration of 1 year) Hold E100 in cash Payout = ($.05)(100) + $120 Payout = $0 + $125 Call Payout Bond Payout Put Payout Value of Euros

29. Suppose the exchange rate is $1.10/E Suppose the exchange rate is $1.10/E Portfolio #1 Buy a call option for E100 at a strike price of $1.20 (expiration in 1 year) Buy a 1 year Treasury with a face value of $120 Portfolio #2 Buy a Put option on E100 at a strike price of $1.20 (expiration of 1 year) Hold E100 in cash Payout = $0 + $120 Payout = ($.10)(100) + $110 Call Payout Bond Payout Put Payout Value of Euros

30. Two portfolios with equal returns should have equal cost Two portfolios with equal returns should have equal cost Portfolio #1 Buy a call option for E100 at a strike price of $1.20 (expiration in 1 year) Buy a 1 year Treasury with a face value of $120 Portfolio #2 Buy a Put option on E100 at a strike price of $1.20 (expiration of 1 year) Hold E100 in cash Cost (per Euro) = Put Price + exchange rate = Call Price + Strike Price (1+i) Cost (per Euro)

31. Put/Call Parity Call Price + Strike Price (1+i) = Put Price + exchange rate Given the price of a call option, the current exchange rate and the current interest rate, we can price a put.

32. Currency Swaps Currency swaps are contracts to convert known income/payment streams from one currency to another – think of them as a portfolio of forwards with varying maturities/strikes Currency swaps are contracts to convert known income/payment streams from one currency to another – think of them as a portfolio of forwards with varying maturities/strikes As with forward contracts, swaps are individualized and not traded. As with forward contracts, swaps are individualized and not traded.

33. Currency Swaps Suppose that IBM wishes to raise funds by issuing a 5 year Swiss Franc denominated Eurobond with a face value of CHF 100,000 and fixed annual coupon payments of 6%. Up front, IBM receives CHF 100,000. IBM plans on using the proceeds to finance domestic operations Suppose that IBM wishes to raise funds by issuing a 5 year Swiss Franc denominated Eurobond with a face value of CHF 100,000 and fixed annual coupon payments of 6%. Up front, IBM receives CHF 100,000. IBM plans on using the proceeds to finance domestic operations

34. Currency Swaps 0 Yrs 5 Yrs 1 Yrs 2 Yrs 3 Yrs 4 Yrs IBM Collects CHF 100,000 IBM owes CHF 106,000 IBM owes CHF 6,000 IBM owes CHF 6,000 IBM owes CHF 6,000 IBM owes CHF 6,000 IBM Wishes to hedge its currency exposure

35. Currency Swaps 0 Yrs 5 Yrs 1 Yrs 2 Yrs 3 Yrs 4 Yrs IBM Sells CHF 100,000 @.844 IBM buys CHF 106,000 @.836 IBM buys CHF 6,000 @.845 IBM buys CHF 6,000 @.830 IBM buys CHF 6,000 @.800 IBM buys CHF 6,000 @.840 IBM enters into a swap agreement with This swap is very similar to buying/selling six separate futures contracts and is priced in a similar fashion