1. FINC3240 International Finance
Chapter 5
Currency Derivatives

2. Chapter Overview A. Currency Forwards B. Currency Futures
C. Currency Options
D. Currency Swaps

3. Derivatives
A derivative contract involves no actual transfer of ownership of the underlying assets at the time the contract is initiated. A derivative represents an agreement to transfer ownership of underlying assets at a specific place, price, and time specified in the contract. Its value (or price) derives from the value of the underlying assets.
The underlying assets: stocks, bonds, interest rates, foreign exchanges, index, commodities, some derivatives, etc. 3

4. Currency Forwards
Definition: an agreement between two parties to exchange a specified amount of a currency at a specified exchange rate (forward rate) on a specified date in the future.
Terms are unique to each individual forward contract. That is, each contract is customized.
There is a risk that one party might default on its’ obligation.

5. Forward Contract Forward bid-ask spread Forward premium or discount
P represents the forward premium (discount), or the percentage by which the forward rate exceeds (less) the spot rate.

6. Forward Premium/Discount (1)
If the euro’s spot rate is $1.03, and its one-year forward rate has a forward premium of 2 percent, then the one-year forward rate is:
So, euro will appreciates !

7. Forward Premium/Discount (2)
If the euro’s one-year forward rate is quoted at $1.00 and the euro’s spot rate is quoted at $1.03, the euro’s forward premium/discount is :

8. Exhibit 5.1 Computation of Forward Rate Premiums or Discounts

9. Forwards Application
Why would MNC use Forward contracts and therefore forward rate if they expect currency exchange in the future? Why not wait till then and exchange the currency with the spot rate of that date?
To lock in the price

10. Forwards Application (1)
Buying foreign currency forward
Turz, Inc. on page 123

11. Forwards Application (2)
Selling foreign currency forward Scanlon, Inc. on page 124

12. How to cancel a forward contract
Negotiate to cancel
Offset by creating another forward contract
Green Bay, Inc on page 126

13. Forward Application (3)
The current spot exchange rate is $1.95/£ and the three-month forward rate is $1.90/£. Based on your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be $1.92/£ in three months. Suppose you have $1,000. What actions do you need to take to speculate in the forward market? What is the expected dollar profit from speculation?
Solution: you should buy £ forward now and sell £ at spot after 3 month. Your expected profit will be:
1,000/1.90= £ ; x1.92=$
Profit = $

14. Forward Application (4)
An international pension fund manager plans to sell equities denominated in Swiss Francs (CHF) and purchase an equivalent amount of equities denominated in Chinese Yuan
(CNY). He will realize net proceeds of 3 million CHF at the end of 30 days and wants to eliminate the risk that the CNY will appreciate relative to the CHF during this 30-day period. The following exhibit shows current exchange rates between the CNY, CHF, and the U.S. dollar (USD). Describe the currency transaction that manager should undertake to eliminate currency risk over the 30-day period.

15. Solution The manager will receive CHF and pay CNY after 30 days.
If CNY appreciates against CHF, he needs to pay more CHF.
He should sell 30-day forward CHF against CNY (sell 30-day forward CHF against USD and buy 30-day forward CNY against USD).
30 day forward CHF are sold for CHF = $1
30 day forward CNY are purchased for CNY = $1
(Dollars are simultaneously sold to purchase CNY)
--For every CHF held, CNY are received; thus the cross currency rate CNY/CHF is

16. In-class discussion
Soho Herbal, LTD., located in central England, is an old-line producer of herbal teas, seasonings, and medicines. Its products are marketed all over the United Kingdom and in many parts of continental Europe as well. Soho generally invoices in British pound sterling when it sells to foreign customers in order to guard against adverse exchange rate changes. Nevertheless, it has just received an order from a large wholesaler in central France for £320,000 of its products, conditional upon delivery being made in three months’ time and the order invoiced in euros. Soho’s controller, Elton Peters, is concerned with whether the pound will appreciate versus the euro over the next three months, thus eliminating all or most of the profit when the euro receivable is paid. He thinks this is an unlikely possibility, but he decides to contact the firm’s banker for suggestions about hedging the exchange rate exposure.
Mr. Peters learns from the banker that the current spot exchange rate €/£ is € Mr. Peters also learns that the three-month forward rates for the pound and the euro versus the U.S. dollar are $1.8990/£1 and $1.3154/€1, respectively. The banker offers to set up a forward hedge for selling the euro receivable for pound sterling based on the €/£ forward cross-exchange rate implicit in the forward rates against the dollar. What would you do if you were Mr. Peters?

17. Currency Futures
A standardized “forward contract” traded on an organized and regulated futures exchange.
Futures contracts are guaranteed by the exchange’s clearinghouse that eliminates the risk of contra-party default.
Each contract is standardized on the quantity, quality, delivery place, delivery date, contract expiration date (3rd Wed in Mar, Jun, Sep, Dec)
A deposit called “margin” is required to both buyers and sellers 17

18. Exhibit 5.2 Currency Futures Contracts Traded on the Chicago Mercantile Exchange

19. Forwards vs. Futures Futures contracts trade on an organized exchange.
Futures positions can be closed or transferred easily.
Futures contracts have standardized terms (quantity, expiration, etc.)
Futures contracts are guaranteed by the clearinghouse associated with the exchange.
Futures are subject to daily settlement (marked to the market).
Margin is required to both the buyer and seller. 19

20. Clearinghouse
Guarantees that all traders in the futures markets will honor their obligations.
Act in a position of buyer to every seller and seller to every buyer. So no default risk as a counter-party to every trader.

21. Margin and Daily Settlement
Initial margin
$1,000 - $2,000/currency futures
Maintenance margin
if the value of the futures contract keeps on declining
Marking to market
realize any loss or profit in cash every day.

22. Marking to Market

23. Closing a Position by Delivery example on Page 129
On Feb 10, a futures contract on 62,500 British pounds with a march settlement date is priced at $1.50 per pound. If both buyer and seller of such a futures hold their positions to settlement date when the settlement price is $1.4900, then on delivery date the buyer of this currency futures will receive BP62,500 and will pay $93,125 (62500x1.4900). The seller of this contract delivers BP62,500 and receive $93,125.

24. Closing a Position by Reverse trading
example: Tacoma Co. on page 132.
Exhibit 5.4

25. Participants in Futures Markets
Hedgers: hedging, risk management
Speculators: make money by taking risk
Brokers: receive commission fee
Regulators: Futures Exchanges and Clearinghouses, the National Futures Association

26. Futures Application (1)
Spot: GBP/USD $1.4550
1-year Futures $1.4550
1-year US interest rate=5%
1-year UK interest rate=10%
Can you speculate on this information?
Yes. Purchase Pound at spot rate $ and invest in UK bonds or saving account; simultaneously sell Pound 1-year Futures (Forward) at $
What is the effect of this strategy on the exchange rate?
Upward pressure on the GBP spot rate and downward pressure on futures price.

27. Futures Application (2)
A speculator expects the British pound to appreciate in one year. He purchases a 1-year futures contract that will lock in the price at which he buys pounds at settlement date. On the settlement date, he purchases pounds at the rate specified by the futures contract and then sell these pounds at the spot rate at that time. He will profit if the spot rate after one year turns out to be higher than the rate he paid in the futures contract.

28. Futures Application (3)
Expect the foreign currency to depreciate. (Example on page 132)
On April 4, a futures contract on 500,000 Mexican pesos and a June settlement date is priced at $0.09. On April 4, speculators who expect the peso will decline sell futures contracts on pesos. On June 17 (settlement date), the spot rate of the peso is $0.08. The gain each contract on this strategy is $5,000.

29. Futures Application (3)
Purchasing Futures to hedge payables (example on page 131)
Teton Co. orders Canadian goods and will need to send C$500,000 to the Canadian exporter. Thus, Teton purchase Canadian dollar futures contracts today, thereby locking in the price to be paid for Canadian dollars at a future settlement date. By holding futures contracts, Teton does not have to worry about changes in the spot rate of the Canadian dollar over time.

30. Futures Application (4)
Selling Futures to hedge receivables (example on page 131)
Karla Co. sells futures contracts when it plans to receive a foreign currency from exporting that it will not need. It locks in the price at which it will be able to sell this currency as of the settlement date. Such an action is appropriate if Karla expects the foreign currency to depreciate against Karla’s home currency.

31. Homework 5
Chapter 5 Q&A: 1,4,17,18.
Extra: Suppose an investor bought the CAD futures contract at $ Monday morning. The close price are , , , , for the week. Draw an excel table of marking to market that looks like the one on slide # 18. Let the initial margin be $1500.