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Chapter - 5 Currency Derivatives

The document discusses currency derivatives including forward contracts, futures, and options. It defines each product and explains how they work. Forward contracts allow companies to lock in future exchange rates. Futures contracts standardize currency amounts and dates. Options provide the right but not obligation to buy or sell currency at a set price. Buyers of calls benefit if rates rise, while puts benefit from falling rates.

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Abhishek Mk
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226 views14 pages

Chapter - 5 Currency Derivatives

The document discusses currency derivatives including forward contracts, futures, and options. It defines each product and explains how they work. Forward contracts allow companies to lock in future exchange rates. Futures contracts standardize currency amounts and dates. Options provide the right but not obligation to buy or sell currency at a set price. Buyers of calls benefit if rates rise, while puts benefit from falling rates.

Uploaded by

Abhishek Mk
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Chapter - 5

Currency Derivatives
Forward Market
• The forward market facilitates the trading of forward
contracts on currencies.
• A forward contract is an agreement between a 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 Market
• But Forward contract can create an opportunity cost in
some cases.

Bid/Ask Spread
• As with the case of spot rates, there is a bid/ask 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.
Forward Market
• Computation of forward rate:
F = S (1 +p)
• Computation of 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%
Forward Market
Long in Position Short in Position

• The party to the contract • The party to the contract


who is agreeing to take who is agreeing to deliver the
delivery of commodity. commodity.
• Buyer of currency. • Seller of currency.
• Speculator will benefit if the • Speculator will benefit if the
price RISES. price FALLS.

Limitations
• Illiquidity
• Counter-party risk
Currency Futures Market
• Currency futures contracts specify a standard volume of a
particular currency to be exchanged on a specific settlement
date.
• 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, on automated
trading systems, or over-the-counter.
Currency Futures Market
• Participants in the currency futures market need to establish and
maintain a margin when they take a position.
– Initial Margin: Deposit that a trader must make before
trading any futures.
– Maintenance Margin: When margin reaches a minimum
maintenance level, the trader is required to bring the margin
back to its initial level.
– Variation Margin: Additional margin required to bring an
account up to the required level.

• FORWARD MARKETS vs. FUTURES MARKETS


Currency Options Market

• A currency option is another type of contract that


can be purchased or sold by speculators and firms.

• Currency options are classified as


– Call option
– Puts option
Currency Call Options

• 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
– in the money if spot rate > strike price,
– at the money if spot rate = strike price,
– out of the money if spot rate < strike price.
Currency Call Options

• Call option premiums will be higher when:


– (spot price - strike price) is larger;
– the time to expiration date is longer; and
– the variability of the currency is greater.

• Buyer Perspective: Who expect a foreign currency to appreciate.


 Profit = Selling Price – Buying (Strike) Price – Option
Premium

• Seller Perspective: Who expect a foreign currency to depreciate.


 Profit = Option Premium – Buying Price + Selling (Strike)
Price
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,


– in the money if spot rate < strike price,
– at the money if spot rate = strike price,
– out of the money if spot rate > strike price.
Currency Put Options

• Put option premiums will be higher when:


– (strike price - spot rate) is larger;
– the time to expiration date is longer; and
– the variability of the currency is greater.

• Buyer Perspective: Who expect a foreign currency to


depreciate.
 Profit = Selling (Strike) Price – Buying Price – Option Premium

• Seller Perspective: Who expect a foreign currency to appreciate.


 Profit = Option Premium + Selling Price – Buying (Strike) Price
Contingency Graphs for Currency Options
For Buyer of £ Call Option For Seller of £ Call Option
Strike price = $1.50 Strike price = $1.50
Premium = $ .02 Premium = $ .02
Net Profit Net Profit
per Unit per Unit
+$.04 +$.04

+$.02 +$.02

0 Future 0
Spot Rate
$1.46 $1.50 $1.54 $1.46 $1.50 $1.54
- $.02 - $.02

- $.04 - $.04
Contingency Graphs for Currency Options
For Buyer of £ Put Option For Seller of £ Put Option
Strike price = $1.50 Strike price = $1.50
Premium = $ .03 Premium = $ .03
Net Profit Net Profit
per Unit per Unit
+$.04 +$.04

+$.02 +$.02
Future
0 Spot Rate 0
$1.46 $1.50 $1.54 $1.46 $1.50 $1.54
- $.02 - $.02

- $.04 - $.04

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