Chapter Overview
A. Currency Forwards B. Currency Futures C. Currency Options D. Currency Swaps
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) depends on the value of the underlying assets. The underlying assets: stocks, bonds, interest rates, foreign exchanges, index, commodities, some derivatives, etc.
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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.
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Terms are unique to each individual forward contract. That is, each contract is customized. There is a risk that one side might default on its obligation.
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2.
Forward Contract
P represents the forward premium (discount), or the percentage by which the forward rate exceeds (less) the spot rate.
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
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Currency Futures
A standardized forward contract traded on an organized and regulated futures exchange.
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Futures contracts are guaranteed by the exchanges clearinghouse that eliminates the risk of contra-party default. Each contract is standardized on the quantity, quality, delivery place, delivery date, contract expiration date. A deposit called margin is required to both buyers and sellers. http://www.cme.com
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Exhibit 5.2 Currency Futures Contracts Traded on the Chicago Mercantile Exchange
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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.
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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.
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Initial margin ( as little as 10% of the underlying assets value) Maintenance margin Marking to market: realize any loss or profit in cash every day.
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Marking to Market
Euro Futures Buyer bought at ($/euro) 1.4551 initial margin ratio Day 1 2 3 4 5 0.1 Close 1.4565 1.4570 1.4500 1.4535 1.3900 euro amount 125000 contract value ($) 181887.50 initial margin ($) 18188.75 Contract Value ($) Profit/Loss ($) Maintenance Margin ($) margin ratio 182062.50 175.00 18363.75 0.101 182125.00 62.50 18426.25 0.101 181250.00 -875.00 17551.25 0.097 181687.50 437.50 17988.75 0.099 173750.00 -7937.50 10051.25 0.058
Euro Futures Seller sold at ($/euro) 1.4551 initial margin ratio Day 1 2 3 4 5 0.1 Close 1.4565 1.4570 1.4500 1.4535 1.3900
euro amount 125000 contract value ($) 181887.50 initial margin ($) 18188.75 Contract Value ($) Profit/Loss ($) Maintenance Margin ($) margin ratio 182062.50 -175.00 18013.75 0.099 182125.00 -62.50 17951.25 0.099 181250.00 875.00 18826.25 0.104 181687.50 -437.50 18388.75 0.101 17 173750.00 7937.50 26326.25 0.152
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 expiration, then after the settlement date the buyer of this currency futures will receive BP62,500 and will pay $93,750 (62500x1.5). The seller of this contract is obligated to deliver BP62,500 and receive $93,750.
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Exhibit 5.5
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Hedgers: hedging, risk management Speculators: make money by taking risk Brokers: receive commission fee Regulators: futures exchanges and clearinghouses, the National Futures Association
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Spot=$1.4550/BP 1-year Future =$1.4550/BP 1-year US interest rate=5% 1-year UK interest rate=10%
Can you speculate on this information? Yes. Purchase Pound at spot rate $1.4550 and invest in UK bonds or saving account; simultaneously sell Pound 1-year Futures (Forward) at $1.4550. What is the effect of this strategy on the exchange rate? Upward pressure on the spot rate and downward pressure on future price.
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A speculator expects the British pound to appreciate in the future. He purchases a 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. He will profit if the pound goes up.
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Currency Options
A contract that is associated with a right to buy or sell a currency until after a specific date with a predetermined price (strike price) and amount. There are Call options and Put options.
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The buyer of a Call option has the right, not the obligation, to buy a currency. The buyer of a Put option has the right, not the obligation, to sell a currency. 26 26
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Options Features
There are always two positions in each option contract: Long for the buyer vs. Short for the seller
(1) (2) (3) (4) Buying a Call Long a Call Selling a Call Short a Call Buying a Put Long a Put Selling a Put Short a Put
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Options Features
The buyer of an option has to pay a price, option premium. The seller of an option receives the option premium.
The option premium is an immediate expense for the buyer and an immediate return for the seller, whether or not the buyer ever exercises the option.
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Call
- Right to buy the underlying (i.e. to exercise the option) - Pays the premium Right to sell the underlying (i.e. to exercise the option) - Pays the premium
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- Obligation to deliver the underlying, if buyer exercises the option - Receives the premium - Obligation to buy the underlying, if buyer exercises the option - Receives the premium
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Put
Moneyness
Call
Exercise price < Present price
Put
Exercise price > Present price
In-the-money (ITM)
At-the-money (ATM)
Out-of-the-money (OTM)
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Options Exchanges
Chicago Mercantile Exchange Chicago Board Options Exchange Over-the-counter market (contracts are customized)
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Hedge payables (Example on page 116) Pike Co. orders Australian goods and makes a payment in Australian dollars (A$) upon delivery. This company can buy an A$ call option that locks in a maximum rate. If the A$s value remains below the strike price, Pike can purchase A$ at the prevailing spot rate and simply let its call option expire. If the A$s value rises above the strike price, Pike will execute the option and buy A$ at the strike price.
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A payment in A$1,000,000 will be delivered at the end of June. On March 1, an option on A$500,000 that expires on June 28 has a strike price of A$1.1000/$. Pike Co. buys 2 A$ Call options on March 1 and pay $100 premium for each option.
On June 28,
If the spot rate is A$1.0000/$, Pike purchases A$ at the prevailing spot rate, A$1.000/$, and simply let its call options expire. If the spot rate is A$1.2050, Pike executes the options and 37 buy A$ at the strike price, A$1.1000/$.
ABC Co. will receive payment in C$2,000,000 at the end of September. On March 1, an option on C$500,000 that expires on September 28 has a strike price of C$1.5300/$. ABC Co. buy 4 C$ Put options on March 1 and pay $100 premium for each option.
On September 28,
If the spot rate is C$1.4500/$, Pike executes the options and sell C$ at the strike price, CA1.5300/$. If the spot rate is C$1.6000/$, ABC sells C$ at the prevailing spot rate, A$1.6000/$, and simply let its call options expire.
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Spot rate on June,1 =$1.3900 Call option premium=$0.012/BP Strike price=$1.4000/BP Settlement date=December, 31 Contract amount=31,250 BP No brokerage fees. One investor buy one Call option on June, 1.
Just before expiration, spot rate=$1.4100/BP. Q1: Will the investor exercise the Call option? Yes. He exercises the Call option and then sell pounds with spot rate of $1.3000/BP. Q2: What is his profit/loss? 39 See the tables in the textbook
Call option premium=$0.03/C$ Strike price=$0.75/C$ Fill in the net profit(or loss) per unit based on the listed possible spot rates of the C$ on the expiration date.
Possible spot rate of C$ on expiration date $0.76 0.78 0.80 0.82 0.85 0.87 net Profit (loss)/C$ -0.02 0.00 0.02 0.04 0.07 0.09
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Spot rate on June,1 =$1.3900 Put option premium=$0.04/BP Strike price=$1.4000/BP Settlement date=December, 31 Contract amount=31,250 BP No brokerage fees. One investor buy one Put option on June, 1.
Just before expiration, spot rate=$1.3000/BP. Q1: Will the investor exercise the Put option? Yes. He will buy pounds from spot market at $1.3000/BP and then execute the put option. Q2: What is his profit/loss? See the tables in the textbook
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Put option premium=$0.02/C$ Strike price=$0.86/C$ Fill in the net profit(or loss) per unit based on the listed possible spot rates of the C$ on the expiration date.
Possible spot rate of C$ on expiration date $0.76 0.79 0.84 0.87 0.89 0.91 net Profit (loss)/C$ 0.08 0.05 0.00 -0.02 -0.02 -0.02
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American-style options: can be exercised before or on the expiration date. European-style options: must be exercised on the expiration date.
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Currency Swap
An agreement in which one party provides a certain principal in one currency to its counterparty in exchange for another currency, pays fixed or floating rate of interest on the currency it receives, and exchange the principal at the maturity of the contract.
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SWAP Application
Spot rate= $1.2500/euro r = 10% in US, r =8% in EU. Party A exchange 1 million euro for 1.25 million $. Contract tenor is five years. The interest is paid every year.
Principal USD Euro 1,250,000 1,000,000
Year
Fixed rate in USD Fixed rate in Euro Party A USD Euro
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10% 8.0%
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10% 8.0% -125,000 80,000
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10% 8.0% -125,000 80,000
4
10% 8.0% -125,000 80,000
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10% 8.0% -1,375,000 1,080,000
1,250,000 -1,000,000
-125,000 80,000
Party B
USD Euro
-1,250,000 1,000,000
125,000 -80,000
125,000 -80,000
125,000 -80,000
125,000 -80,000
1,375,000 -1,080,000 45
Homework
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