Answers to End of Chapter 5 Questions

1. Forward versus Futures Contracts. Compare and contrast forward and futures contracts.

ANSWER: Because currency futures contracts are standardized into small amounts, they can
be valuable for the speculator or small firm (a commercial bank’s forward contracts are more
common for larger amounts).  However, the standardized format of futures forces limited
maturities and amounts.

2. Using Currency Futures.

a. How can currency futures be used by corporations?

ANSWER: U.S. corporations that desire to lock in a price at which they can sell a foreign
currency would sell currency futures.  U.S. corporations that desire to lock in a price at which
they can purchase a foreign currency would purchase currency futures.

b. How can currency futures be used by speculators?

ANSWER: Speculators who expect a currency to appreciate could purchase currency futures
contracts for that currency.  Speculators who expect a currency to depreciate could sell
currency futures contracts for that currency.

3. Currency Options. Differentiate between a currency call option and a currency put option.

ANSWER: A currency call option provides the right to purchase a specified currency at a
specified price within a specified period of time. A currency put option provides the right to
sell a specified currency for a specified price within a specified period of time.

4. Forward Premium. Compute the forward discount or premium for the Mexican peso whose
90-day forward rate is $.102 and spot rate is $.10. State whether your answer is a discount or
premium.

ANSWER: (F - S) / S
=($.098 - $.10) / $.10 × (360/90)
= –.02, or –2%, which reflects a 8% discount

5. Effects of a Forward Contract. How can a forward contract backfire?

ANSWER: If the spot rate of the foreign currency at the time of the transaction is worth less
than the forward rate that was negotiated, or is worth more than the forward rate that was
negotiated, the forward contract has backfired.
6. Hedging With Currency Options. When would a U.S. firm consider purchasing a call
option on euros for hedging? When would a U.S. firm consider purchasing a put option on
euros for hedging?

ANSWER: A call option can hedge a firm’s future payables denominated in euros.  It
effectively locks in the maximum price to be paid for euros.

A put option on euros can hedge a U.S. firm’s future receivables denominated in euros. It
effectively locks in the minimum price at which it can exchange euros received.

7. Speculating With Currency Options. When should a speculator purchase a call option on
Australian dollars? When should a speculator purchase a put option on Australian dollars?

ANSWER: Speculators should purchase a call option on Australian dollars if they expect the
Australian dollar value to appreciate substantially over the period specified by the option
contract.

Speculators should purchase a put option on Australian dollars if they expect the Australian
dollar
value to depreciate substantially over the period specified by the option contract.

8. Currency Call Option Premiums. List the factors that affect currency call option premiums
and briefly explain the relationship that exists for each. Do you think an at-the-money call
option in euros has a higher or lower premium than an at-the-money call option in British
pounds (assuming the expiration date and the total dollar value represented by each option are
the same for both options)?

ANSWER: These factors are listed below:

· The higher the existing spot rate relative to the strike price, the greater is the call option
value, other things equal.
· The longer the period prior to the expiration date, the greater is the call option value,
other things equal.
· The greater the variability of the currency, the greater is the call option value, other
things equal.

The at-the-money call option in euros should have a lower premium because the euro should
have less volatility than the pound.

9. Currency Put Option Premiums. List the factors that affect currency put options and briefly
explain the relationship that exists for each.

ANSWER: These factors are listed below:

· The lower the existing spot rate relative to the strike price, the greater is the put option
value, other things equal.
· The longer the period prior to the expiration date, the greater is the put option value, other
things equal.
· The greater the variability of the currency, the greater is the put option value, other things
equal.
10. Speculating with Currency Call Options. Randy Rudecki purchased a call option on British
pounds for $.02 per unit.  The strike price was $1.45 and the spot rate at the time the option
was exercised was $1.46.  Assume there are 31,250 units in a British pound option.  What
was Randy’s net profit on this option?

ANSWER:

Profit per unit on exercising the option = $.01

Premium paid per unit = $.02
Net profit per unit = –$.01
Net profit per option = 31,250 units × (–$.01) = –$312.50

11. Speculating with Currency Put Options. Alice Duever purchased a put option on British
pounds for $.04 per unit.  The strike price was $1.80 and the spot rate at the time the pound
option was exercised was $1.59.  Assume there are 31,250 units in a British pound option. 
What was Alice’s net profit on the option?

ANSWER:

Profit per unit on exercising the option = $.21

Premium paid per unit = $.04
Net profit per unit = $.17
Net profit for one option = 31,250 units × $.17 = $5,312.50

12. Selling Currency Call Options. Mike Suerth sold a call option on Canadian dollars for $.01
per unit.  The strike price was $.76, and the spot rate at the time the option was exercised was
$.82. Assume Mike did not obtain Canadian dollars until the option was exercised.  Also
assume that there are 50,000 units in a Canadian dollar option.  What was Mike’s net profit
on the call option?

ANSWER:

Premium received per unit = $.01

Amount per unit received from selling C$ = $.76
Amount per unit paid when purchasing C$ = $.82
Net profit per unit = –$.05
Net Profit = 50,000 units × (–$.05) = –$2,500

13. Selling Currency Put Options. Brian Tull sold a put option on Canadian dollars for $.03 per
unit.  The strike price was $.75, and the spot rate at the time the option was exercised was
$.72. Assume Brian immediately sold off the Canadian dollars received when the option was
exercised. Also assume that there are 50,000 units in a Canadian dollar option.  What was
Brian’s net profit on the put option?

ANSWER:

Premium received per unit = $.03

Amount per unit received from selling C$ = $.72
Amount per unit paid for C$ = $.75
Net profit per unit = $0
14. Forward versus Currency Option Contracts. What are the advantages and disadvantages
to a U.S. corporation that uses currency options on euros rather than a forward con tract on
euros to hedge its exposure in euros? Explain why an MNC use forward contracts to hedge
committed transactions and use currency options to hedge contracts that are anticipated but
not committed. Why might forward contracts be advantageous for committed transactions,
and currency options be advantageous for anticipated transactions?

ANSWER: A currency option on euros allows more flexibility since it does not commit one
to purchase or sell euros (as is the case with a euro futures or forward contract).   Yet, it does
allow the option holder to purchase or sell euros at a locked-in price.

The disadvantage of a euro option is that the option itself is not free.  One must pay a
premium for the call option, which is above and beyond the exercise price specified in the
contract at which the euro could be purchased.

An MNC may use forward contracts to hedge committed transactions because it would be
cheaper to use a forward contract (a premium would be paid on an option contract that has an
exercise price equal to the forward rate). The MNC may use currency options contracts to
hedge anticipated transactions because it has more flexibility to let the contract go
unexercised if the transaction does not occur.

15. Speculating with Currency Futures. Assume that the euro’s spot rate has moved in cycles
over time.  How might you try to use futures contracts on euros to capitalize on this
tendency?  How could you determine whether such a strategy would have been profitable in
previous periods?

ANSWER: Use recent movements in the euro to forecast future movements.  If the euro has
been strengthening, purchase futures on euros.  If the euro has been weakening, sell futures
on euros. 

A strategy’s profitability can be determined by comparing the amount paid for each contract
to the amount for which each contract was sold.

16. Hedging with Currency Derivatives. Assume that the transactions listed in the first column
of the following table are anticipated by U.S. firms that have no other foreign transactions.  
Place an “X” in the table wherever you see possible ways to hedge each of the transactions.

a. Georgetown Co. plans to purchase Japanese goods denominated in yen. 

b. Harvard, Inc., sold goods to Japan, denominated in yen.
c. Yale Corp. has a subsidiary in Australia that will be remitting funds to the U.S. parent.
d. Brown, Inc., needs to pay off existing loans that are denominated in Canadian dollars.
e. Princeton Co. may purchase a company in Japan in the near future (but the deal may not
go through).
 ANSWER:

Forward Contract Futures Contract Options Contract 

Forward Forward Buy Sell Purchase Purchase
Purchase Sale Futures Futures Calls Puts
  a. X X X
  b. X X X
  c. X X X
  d. X X X
  e.

17. Price Movements of Currency Futures. Assume that on November 1, the spot rate of the
British pound was $1.58 and the price on a December futures contract was $1.59.  Assume
that the pound depreciated during November so that by November 30 it was worth $1.51.

a. What do you think happened to the futures price over the month of November?  Why?

ANSWER: The December futures price would have decreased, because it reflects
expectations of the future spot rate as of the settlement date.  If the existing spot rate is $1.51,
the spot rate expected on the December futures settlement date is likely to be near $1.51 as
well.

b. If you had known that this would occur, would you have purchased or sold a December
futures contract in pounds on November 1?  Explain.

ANSWER: You would have sold futures at the existing futures price of $1.59.  Then as the
spot rate of the pound declined, the futures price would decline and you could close out your
futures position by purchasing a futures contract at a lower price.  Alternatively, you could
wait until the settlement date, purchase the pounds in the spot market, and fulfill the futures
obligation by delivering pounds at the price of $1.59 per pound.

18. Speculating with Currency Futures. Assume that a March futures contract on Mexican
pesos was available in January for $.09 per unit.  Also assume that forward contracts were
available for the same settlement date at a price of $.092 per peso.  How could speculators
capitalize on this situation, assuming zero transaction costs?  How would such speculative
activity affect the difference between the forward contract price and the futures price?

ANSWER: Speculators could purchase peso futures for $.09 per unit, and simultaneously
sell pesos forward at $.092 per unit.  When the pesos are received (as a result of the futures
position) on the settlement date, the speculators would sell the pesos to fulfill their forward
contract obligation.  This strategy results in a $.002 per unit profit.

As many speculators capitalize on the strategy described above, they would place upward
pressure on futures prices and downward pressure on forward prices.  Thus, the difference
between the forward contract price and futures price would be reduced or eliminated.
19. Speculating with Currency Call Options. LSU Corp. purchased Canadian dollar call
options for speculative purposes.  If these options are exercised, LSU will immediately sell
the Canadian dollars in the spot market.  Each option was purchased for a premium of $.03
per unit, with an exercise price of $.75.  LSU plans to wait until the expiration date before
deciding whether to exercise the options.  Of course, LSU will exercise the options at that
time only if it is feasible to do so.  In the following table, fill in the net profit (or loss) per unit
to LSU Corp. based on the listed possible spot rates of the Canadian dollar on the expiration
date.

ANSWER:

Possible Spot Rate Net Profit (Loss) per

of Canadian Dollar Unit to LSU Corporation
on Expiration Date if Spot Rate Occurs
$.76 –$.02
.78 .00
.80 .02
.82 .04
.85 .07
.87 .09

20. Speculating with Currency Put Options. Auburn Co. has purchased Canadian dollar put
options for speculative purposes.  Each option was purchased for a premium of $.02 per unit,
with an exercise price of $.86 per unit.  Auburn Co. will purchase the Canadian dollars just
before it exercises the options (if it is feasible to exercise the options).  It plans to wait until
the expiration date before deciding whether to exercise the options.  In the following table,
fill in the net profit (or loss) per unit to Auburn Co. based on the listed possible spot rates of
the Canadian dollar on the expiration date.

ANSWER:

Possible Spot Rate Net Profit (Loss) per Unit

of Canadian Dollar to Auburn Corporation
on Expiration Date if Spot Rate Occurs
$.76 $.08
.79 .05
.84 .00
.87 –.02
.89 –.02
.91 –.02

21. Speculating with Currency Call Options. Bama Corp. has sold British pound call options
for speculative purposes.  The option premium was $.06 per unit, and the exercise price was
$1.58.  Bama will purchase the pounds on the day the options are exercised (if the options are
exercised) in order to fulfill its obligation.  In the following table, fill in the net profit (or loss)
to Bama Corp. if the listed spot rate exists at the time the purchaser of the call options
considers exercising them.
 ANSWER:

Possible Spot Rate at the Net Profit (Loss) per

Time Purchaser of Call Option Unit to Bama Corporation
Considers Exercising Them if Spot Rate Occurs
$1.53 $.06
1.55 .06
1.57 .06
1.60 .04
1.62 .02
1.64 .00
1.68 –.04

22. Speculating with Currency Put Options. Bulldog, Inc., has sold Australian dollar put
options at a premium of $.01 per unit, and an exercise price of $.76 per unit.  It has forecasted
the Australian dollar’s lowest level over the period of concern as shown in the following
table.  Determine the net profit (or loss) per unit to Bulldog, Inc., if each level occurs and the
put options are exercised at that time.

ANSWER:

Possible Value Net Profit (Loss) to

of Australian Dollar Bulldog, Inc. if Value Occurs
$.72 –$.03
.73 –.02
.74 –.01
.75 .00
.76 .01

23. Hedging with Currency Derivatives. A U.S. professional football team plans to play an
exhibition game in the United Kingdom next year.  Assume that all expenses will be paid by
the British government, and that the team will receive a check for 1 million pounds. The team
anticipates that the pound will depreciate substantially by the scheduled date of the game.  In
addition, the National Football League must approve the deal, and approval (or disapproval)
will not occur for three months.  How can the team hedge its position?  What is there to lose
by waiting three months to see if the exhibition game is approved before hedging?

ANSWER: The team could purchase put options on pounds in order to lock in the amount at
which it could convert the 1 million pounds to dollars.  The expiration date of the put option
should correspond to the date in which the team would receive the 1 million pounds.  If the
deal is not approved, the team could let the put options expire.

If the team waits three months, option prices will have changed by then.  If the pound has
depreciated over this three-month period, put options with the same exercise price would
command higher premiums.  Therefore, the team may wish to purchase put options
immediately. The team could also consider selling futures contracts on pounds, but it would
be obligated to exchange pounds for dollars in the future, even if the deal is not approved.
Advanced Questions

24. Risk of Currency Futures. Currency futures markets are commonly used as a means of
capitalizing on shifts in currency values, because the value of a futures contract tends to move
in line with the change in the corresponding currency value. Recently, many currencies
appreciated against the dollar. Most speculators anticipated that these currencies would
continue to strengthen and took large buy positions in currency futures. However, the Fed
intervened in the foreign exchange market by immediately selling foreign currencies in
exchange for dollars, causing an abrupt decline in the values of foreign currencies (as the
dollar strengthened). Participants that had purchased currency futures contracts incurred large
losses. One floor broker responded to the effects of the Fed's intervention by immediately
selling 300 futures contracts on British pounds (with a value of about $30 million). Such
actions caused even more panic in the futures market.

a. Explain why the central bank’s intervention caused such panic among currency futures
traders with buy positions.

ANSWER: Futures prices on pounds rose in tandem with the value of the pound. However,
when central banks intervened to support the dollar, the value of the pound declined, and so
did values of futures contracts on pounds. So traders with long (buy) positions in these
contracts experienced losses because the contract values declined.

b. Explain why the floor broker’s willingness to sell 300 pound futures contracts at the
going market rate aroused such concern. What might this action signal to other brokers?

ANSWER: Normally, this order would have been sold in pieces. This action could signal a
desperate situation in which many investors sell futures contracts at any price, which places
more downward pressure on currency future prices, and could cause a crisis.

c. Explain why speculators with short (sell) positions could benefit as a result of the central
bank’s intervention.

ANSWER: The central bank intervention placed downward pressure on the pound and other
European currencies. Thus, the values of futures contracts on these currencies declined.
Traders that had short positions in futures would benefit because they could now close out
their short positions by purchasing the same contracts that they had sold earlier. Since the
prices of futures contracts declined, they would purchase the contracts for a lower price than
the price at which they initially sold the contracts.

d. Some traders with buy positions may have responded immediately to the central bank’s
intervention by selling futures contracts. Why would some speculators with buy
positions leave their positions unchanged or even increase their positions by purchasing
more futures contracts in response to the central bank’s intervention?

ANSWER: Central bank intervention sometimes has only a temporary effect on exchange
rates. Thus, the European currencies could strengthen after a temporary effect caused by
central bank intervention. Traders have to predict whether natural market forces will
ultimately overwhelm any pressure induced as a result of central bank intervention.
25. Currency Straddles. Reska, Inc., has constructed a long euro straddle. A call option on euros
with an exercise price of $1.10 has a premium of $.025 per unit. A euro put option has a
premium of $.017 per unit. Some possible euro values at option expiration are shown in the
following table. (See Appendix B in this chapter.)

Value of Euro at Option Expiration

$.90 $1.05 $1.50 $2.00
Call
Put
Net

a. Complete the worksheet and determine the net profit per unit to Reska Inc. for each
possible future spot rate.
b. Determine the break-even point(s) of the long straddle. What are the break-even points of
a short straddle using these options?

ANSWER:
a.

Value of Euro at Option Expiration

$.90 $1.05 $1.50 $2.00
Call –$.025 –$.025 +$.375 +$.875
Put +$.183 +$.033 –$.017 –$.017
Net +$.158 +$.008 +$.358 +$.858

b. The break-even points for a long straddle can be found by subtracting and adding both
premiums to the exercise price. Thus, the break-even points are located at future euro
spot values of $1.10 – ($.025 + $.017) = $1.058 and $1.10 + ($.025 + $.017) = $1.142.
The breakeven points for a short straddle are also $1.058 and $1.142.

26. Currency Straddles. Refer to the previous question, but assume that the call and put option
premiums are $.02 per unit and $.015 per unit, respectively. (See Appendix B in this chapter.)

a. Construct a contingency graph for a long euro straddle.

b. Construct a contingency graph for a short euro straddle.

ANSWER:

a. The plotted points should create a V shape that cuts through the horizontal (break-even)
axis at $1.065 and $1.135. The bottom point of the V shape occurs at $1.10, and reflects a
net profit of –$.035.
 Net profit per unit

$1.065

$1.065 $1.135

$1.10

Future spot rate

-$.035

b. The plotted points should create an upside down V shape that cuts through the horizontal
(break-even) axis at $1.065 and $1.135. The peak of the upside down V shape occurs at
$1.10 and reflects a net profit of $.035.

Net profit per unit

$.035

$1.065 $1.135

$1.10 Future spot rate

-$1.065
 27. Currency Option Contingency Graphs. (See Appendix B in this chapter.) The current spot
rate of the Singapore dollar (S$) is $.50. The following option information is available:

 Call option premium on Singapore dollar (S$) = $.015

 Put option premium on Singapore dollar (S$) = $.009
 Call and put option strike price = $.55
 One option contract represents S$70,000

Construct a contingency graph for a short straddle using these options.

ANSWER: The plotted points should create an upside down V shape that cuts through the
horizontal (break-even) axis at $.526 and $.574. The peak of the upside down V shape occurs
at $.55 and reflects a net profit of $.024.

Net profit per unit

$.024

$.526 $.574

$.55 Future spot rate

-$.526