Currency Derivatives
Markets
Forward Market Future Market
Forward Market Future Market
Contract Customized. Standardized
size
Delivery Customized Standardized.
date
Participants Banks, brokers, MNCs. Public Banks, brokers, MNCs. Qualified
speculation not encouraged. public speculation encouraged.
Security Compensating bank balances or Small security deposit required.
deposit credit lines needed.
Marketplace Worldwide telephone network. Central exchange floor with global
communications.
Liquidation Mostly settled by actual delivery. Mostly settled by offset.
Transaction Bank’s bid/ask spread. Negotiated brokerage fees.
Costs
Forward Market
The forward market facilitates the trading of forward contracts on currencies.
A forward contract is an agreement between a MNC / 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 often valued at $1 million or more and are not normally used by
consumers or small firms.
As with the case of spot rates, there is a bid/ask to spread on forward rates.
Forward rates may also contain a premium or discount.
If the forward rate exceeds the existing spot rate, it contains a premium.
If the forward rate is less than the existing spot rate, it contains a discount.
Annualized forward premium/discount = forward rate – spot rate 360
spot rate n
where n is the number of days to maturity
Example: Suppose £ spot rate = $1.681, 90-day £ forward rate = $1.677.
$1.677 – $1.681 x 360 = – 0.95%
$1.681 90
So, forward discount = 0.95%
A non-deliverable forward contract (NDF) is a forward contract whereby there is no actual
exchange of currencies. Instead, a net payment is made by one party to the other based on the
contracted rate and the market rate on the day of settlement.
Although NDFs do not involve actual delivery, they can effectively hedge expected foreign
currency cash flows.
Currency Futures Market
Currency futures contracts specify 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.
They are used by MNCs to hedge their currency positions, and by speculators who hope to
capitalize on their expectations of exchange rate movements.
The contracts can be traded by firms or individuals through brokers on the trading floor of an
exchange (e.g. Chicago Mercantile Exchange), on automated trading systems (e.g.
GLOBEX), or over the counter.
Participants in the currency futures market need to establish and maintain a margin when
they take a position.
Normally, the price of a currency futures contract is similar to the forward rate for a given
currency and settlement date but differs from the spot rate when the interest rates on the two
currencies differ.
Currency futures contracts have no credit risk since they are guaranteed by the exchange
clearinghouse.
To minimize its risk in such a guarantee, the exchange imposes margin requirements to cover
fluctuations in the value of the contracts.
Speculators often sell currency futures when they expect the underlying currency to depreciate,
and vice versa.
April 4 June 17
Contract to sell 500,000 pesos @ $.09/peso Buy 500,000 pesos @ $.08/peso ($40,000)
($45,000) on June 17. from the spot market.
Sell the pesos to fulfill contract. Gain $5,000.
Currency futures may be purchased by MNCs to hedge foreign currency payables or sold to
hedge receivables.
April 4 June 17
Expect to receive 500,000 pesos. Contract to sell Receive 500,000 pesos as expected.
500,000 pesos @ $.09/peso on June 17. Sell the pesos at the locked-in rate
Holders of futures contracts can close out their positions by selling similar futures contracts.
Sellers may also close out their positions by purchasing similar contracts.
January 10 February 15 March 19
Contract to buy A$100,000 Contract to sell A$100,000 @ Incurs $3000 loss from
@ $.53/A$ ($53,000) on $.50/A$ ($50,000) on March offsetting positions in futures
March 19. 19. contracts.
Currency Options Market
A currency option is another type of contract that can be purchased or sold by speculators
and firms.
The standard options that are traded on an exchange through brokers are guaranteed but
require margin maintenance.
U.S. option exchanges (e.g. Chicago Board Options Exchange) are regulated by the
Securities and Exchange Commission.
In addition to the exchanges, there is an over-the-counter market where commercial banks
and brokerage firms offer customized currency options.
There are no credit guarantees for these OTC options, so some form of collateral may be
required.
Currency options are classified as either calls or puts.
Currency Call Option
A currency call option grants the holder 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
o in the money if spot rate > strike price,
o at the money if spot rate = strike price,
o out of the money if spot rate < strike price.
Option owners can sell or exercise their options. They can also choose to let their options
expire. At most, they will lose the premiums they paid for their options.
Call option premiums will be higher when:
o (spot price – strike price) is larger;
o the time to expiration date is longer; and
o the variability of the currency is greater.
Firms with open positions in foreign currencies may use currency call options to cover those
positions.
They may purchase currency call options
o to hedge future payables;
o to hedge potential expenses when bidding on projects; and
o to hedge potential costs when attempting to acquire other firms.
Speculators who expect a foreign currency to appreciate can purchase call options on that
currency.
Profit = selling price – buying (strike) price – option premium
They may also sell (write) call options on a currency that they expect to depreciate.
Profit = option premium – buying price + selling (strike) price
The purchaser of a call option will break even when
Selling price = buying (strike) price + option premium
The seller (writer) of a call option will break even when
Buying price = selling (strike) price + option premium
Speculating with Currency Call Options
Jim who buys a British pound with Strike price of $1.40 and Dec settlement date. The Spot
price is $1.39. The premium is $.012 per unit of call option. Just before the expiration date
the spot rate of British pound become $1.41. Jim immediately sells the pound in the market.
Determine Jim’s Profit or loss. Assume that one option contract is £ 31250 units.
Per unit Per Contract
Selling price of pound $1.41 $44,063 [$1.41 * 31250 units]
- Purchase price of pound ($1.40) - $43,750 [$1.40 * 31250 units]
- Premium paid for option ($0.012) - $375 [$0.012 * 31250 units]
=Net profit ($.002) - 62 [-$0.002 * 31250 units]
Speculating with Currency Call Options
Jim who buys a British pound with Strike price of $1.40 and Dec settlement date. The Spot price
is $1.39. The premium is $.012 per unit of call option. Just before the expiration date the spot
rate of British pound become $1.41. Jim immediately sells the pound in the market. Determine
Jim’s Profit or loss. Assume that one option contract is £ 31250 units.
Assume that Linda was the seller of the call option purchased by Jim. And Lind is bound to
provide the British pound if the option is exercised by Jim. Determine Linda’s Profit or loss.
Per unit Per Contract
Selling price of pound $1.140 $43,750 [$1.40 * 31250 units]
- Purchase price of pound ($1.41) - $44,063 [$1.41 * 31250 units]
Premium Received $0.012) $375 [$0.012 * 31250 units]
=Net profit $.002 62 [-$0.002 * 31250 units]
Currency Put Options
A currency put option grants the holder the right to sell a specific currency at a specific
price (the strike price) within a specific period of time.
A put option is
o in the money if spot rate < strike price,
o at the money if spot rate = strike price,
o out of the money if spot rate > strike price.
Put option premiums will be higher when:
o (strike price – spot rate) is larger;
o the time to expiration date is longer; and
o the variability of the currency is greater.
Corporations with open foreign currency positions may use currency put options to cover
their positions.
o For example, firms may purchase put options to hedge future receivables.
Speculators who expect a foreign currency to depreciate can purchase put options on that
currency.
Profit = Selling (strike) price – buying price – option premium
They may also sell (write) put options on a currency that they expect to appreciate.
Profit = option premium + selling price – buying (strike) price
Speculating with Currency Put Options
Jim who buys a put option on British pound with Strike price of $1.40 and Dec settlement
date. The premium is $.04 per unit of put option. Just before the expiration date the spot
rate of British pound become $1.30. Jim immediately purchased the pound in the spot
market. Determine Jim’s Profit or loss. Assume that one option contract is £31250 units.
Per unit Per Contract
Selling price of pound $1.40 $43,750 [$1.40 * 31250 units]
- Purchase price of pound ($1.30) - $40,625 [$1.30 * 31250 units]
- Premium paid for option ($0.04) - $1250 [$0.04 * 31250 units]
=Net profit $.06 $1875 [$.06 * 31250 units]
Speculating with Currency Put Options
Jim who buys a put option on British pound with Strike price of $1.40 and Dec settlement
date. The premium is $.04 per unit of put option. Just before the expiration date the spot rate
of British pound become $1.40. Jim immediately purchased the pound in the spot market.
Assume that one option contract is £31250 units. For the seller, the payoff will be.
Per unit Per Contract
Selling price of pound $1.30 $40,625 [$1.30 * 31250 units]
- Purchase price of pound ($1.40) - $43,750 [$1.40 * 31250 units]
Premium Received $0.04 $1250 [$0.04 * 31250 units]
=Net profit ($.06) -$1875 [-$.06 * 31250 units]
