International Corporate Finance

11th Edition
by Jeff Madura

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 5 Currency Derivatives
Chapter Objectives

§ Explain how forward contracts are used to hedge based

on anticipated exchange rate movements
§ Describe how currency futures contracts are used to
speculate or hedge based on anticipated exchange rate
movements
§ Explain how currency option contracts are used to
speculate or hedge based on anticipated exchange rate
movements

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 What is a Currency Derivative?

1. A currency derivative is a contract whose price is

derived from the value of an underlying currency.
2. Examples include forwards/futures contracts and
options contracts.
3. Derivatives are used by MNCs to:
a. Speculate on future exchange rate movements
b. Hedge exposure to exchange rate risk

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 Forward Market

n A forward contract is an agreement between a

corporation and a financial institution:
§ To exchange a specified amount of currency
§ At a specified exchange rate called the forward rate
§ On a specified date in the future

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 How MNCs Use Forward Contracts

n Hedge their imports by locking in the rate at which

they can obtain the currency
n Bid/Ask Spread is wider for less liquid currencies.
n May negotiate an offsetting trade if an MNC enters
into a forward sale and a forward purchase with the
same bank.
n Non-deliverable forward contracts (NDF) can be used
for emerging market currencies where no currency
delivery takes place at settlement, instead one party
makes a payment to the other party.
n Movements in the Forward Rate over Time – The
forward premium is influenced by the interest rate
differential between the two countries and can change
over time.
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 Premium or Discount on the Forward Rate

F = S(1 + p)
where:
F is the forward rate
S is the spot rate
p is the forward premium, or the percentage by
which the forward rate exceeds the spot rate.

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 Exhibit 5.1 Computation of Forward Rate Premiums or
Discounts

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 Currency Futures Market

n Similar to forward contracts in terms of obligation to

purchase or sell currency on a specific settlement date
in the future.
n Differ from forward contracts because futures have
standard contract specifications:
a. Standardized number of units per contract (See Exhibit 5.2)
b. Offer greater liquidity than forward contracts
c. Typically based on U.S. dollar, but may be offered on cross-
rates.
d. Commonly traded on the Chicago Mercantile Exchange
(CME).

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 Exhibit 5.2 Currency Futures Contracts Traded on the
Chicago Mercantile Exchange

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 Trading Currency Futures

n Firms or individuals can execute orders for currency

futures contracts by calling brokerage firms.
n Electronic trading platforms facilitate the trading of
currency futures. These platforms serve as a broker,
as they execute the trades desired.
n Currency futures contracts are similar to forward
contracts in that they allow a customer to lock in the
exchange rate at which a specific currency is
purchased or sold for a specific date in the future.

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 Exhibit 5.3 Comparison of the Forward and Futures Market

Source: Chicago Mercantile Exchange

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 Trading Currency Futures (cont.)

n Pricing Currency Futures - The price of currency

futures will be similar to the forward rate
n Credit Risk of Currency Futures Contracts -
To minimize its risk, the CME imposes margin
requirements to cover fluctuations in the value of a
contract, meaning that the participants must make a
deposit with their respective brokerage firms when
they take a position.

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 How Firms Use Currency Futures

n Purchasing Futures to Hedge Payables - The

purchase of futures contracts locks in the price at
which a firm can purchase a currency.
n Selling Futures to Hedge Receivables - The
sale of futures contracts locks in the price at which a
firm can sell a currency.

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 Closing Out a Futures Position

n Sellers (buyers) of currency futures can close

out their positions by buying (selling)
identical futures contracts prior to settlement.
n Most currency futures contracts are closed out
before the settlement date.

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 Exhibit 5.4 Closing Out a Futures Contract

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 Speculation with Currency Futures

1. Currency futures contracts are sometimes purchased

by speculators attempting to capitalize on their
expectation of an appreciation movement of future
contract value.

Example:
Future contract value of peso on April 4: $0.9 – speculator purchased.
If Future contract value of peso on May 9: $1.0 à the speculator will
sell the contract that he/she purchased on April 4

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 Exhibit 5.5 Source of Gains from Buying Currency
Futures

1. Currency futures are often sold by speculators who

expect that the spot rate of a currency will be less than
the rate at which they would be obligated to sell it.

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 Currency Futures Market Efficiency

1. If the currency futures market is efficient, the futures

price should reflect all available information.
2. Thus, the continual use of a particular strategy to take
positions in currency futures contracts should not lead
to abnormal profits.
3. Research has found that the currency futures market
may be inefficient. However, the patterns are not
necessarily observable until after they occur, which
means that it may be difficult to consistently generate
abnormal profits from speculating in currency futures.

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 Currency Options Markets

n Currency options provide the right to purchase or sell

currencies at specified prices.
n Options Exchanges
§ 1982 - exchanges in Amsterdam, Montreal, and Philadelphia first
allowed trading in standardized foreign currency options.
§ 2007 – CME and CBOT merged to form CME group
§ Exchanges are regulated by the SEC in the U.S.
n Over-the-counter market - Where currency options are
offered by commercial banks and brokerage firms. Unlike the
currency options traded on an exchange, the over-the-counter
market offers currency options that are tailored to the specific
needs of the firm.
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 Currency Call Options

n Grants the right to buy a specific currency at a

designated strike price or exercise price within a
specific period of time.
n If the spot rate rises above the strike price, the owner of
a call can exercise the right to buy currency at the strike
price.
n The buyer of the option pays a premium.
n If the spot exchange rate is greater than the strike price,
the option is in the money. If the spot rate is equal to
the strike price, the option is at the money. If the spot
rate is lower than the strike price, the option is out of
the money.

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 Factors Affecting Currency Call Option Premiums

The premium on a call option (C) is affected by three factors:

n Spot price relative to the strike price (S – X): The higher
the spot rate relative to the strike price, the higher the option
price will be.
n Length of time before expiration (T): The longer the time
to expiration, the higher the option price will be.
n Potential variability of currency (σ): The greater the
variability of the currency, the higher the probability that the
spot rate can rise above the strike price.

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 How Firms Use Currency Call Options

Firms can use call options to:

n hedge payables
n hedge project bidding to lock in the dollar cost of
potential expenses.
n hedge target bidding of a possible acquisition.
n Speculate on expectations of future movements in a
currency.

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 Currency Put Options

1. Grants the right to sell a currency at a specified strike

price or exercise price within a specified period of time.
2. If the spot rate falls below the strike price, the owner of a
put can exercise the right to sell currency at the strike
price.
3. The buyer of the options pays a premium.
4. If the spot exchange rate is lower than the strike price,
the option is in the money. If the spot rate is equal to the
strike price, the option is at the money. If the spot rate is
greater than the strike price, the option is out of the
money.

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 Factors Affecting Put Option Premiums

Put option premiums are affected by three factors:

n Spot rate relative to the strike price (S–X): The lower
the spot rate relative to the strike price, the higher the
probability that the option will be exercised.
n Length of time until expiration (T): The longer the
time to expiration, the greater the put option premium
n Variability of the currency (σ): The greater the
variability, the greater the probability that the option
may be exercised.

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 Hedging with Currency Put Options

1. Corporations with open positions in foreign currencies

can use currency put options in some cases to cover these
positions.
2. Some put options are deep out of the money, meaning
that the prevailing exchange rate is high above the
exercise price. These options are cheaper (have a lower
premium), as they are unlikely to be exercised because
their exercise price is too low.
3. Other put options have an exercise price that is currently
above the prevailing exchange rate and are therefore more
likely to be exercised. Consequently, these options are
more expensive.

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 Speculating with Currency Put Options

1. Individuals may speculate with currency put options

based on their expectations of the future movements in a
particular currency.
2. Speculators can attempt to profit from selling currency
put options. The seller of such options is obligated to
purchase the specified currency at the strike price from
the owner who exercises the put option.
3. The net profit to a speculator is based on the exercise
price at which the currency can be sold versus the
purchase price of the currency and the premium paid for
the put option..

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 Exhibit 5.6 Contingency Graphs for Currency Options
Call Option Put Option
Purchasers

Sellers

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 Conditional Currency Options

1. A currency option can be structured with a conditional

premium, meaning that the premium paid for the option is
conditioned on the actual movement in the currency’s value
over the period of concern.
2. Firms also use various combinations of currency options.

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 Exhibit 5.7 Comparison of Conditional and Basic
Currency Options
Put option

Purchasers

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 European Currency Options

n European-style currency options must be exercised on the

expiration date if they are to be exercised at all.
n They do not offer as much flexibility; however, this is not
relevant to some situations.
n If European-style options are available for the same
expiration date as American-style options and can be
purchased for a slightly lower premium, some corporations
may prefer them for hedging.

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 SUMMARY

§ A forward contract specifies a standard volume of a

particular currency to be exchanged on a particular date.
Such a contract can be purchased by a firm to hedge
payables or sold by a firm to hedge receivables.
§ Futures contracts on a particular currency can be purchased
by corporations that have payables in that currency and wish
to hedge against the possible appreciation of that currency.
Conversely, these contracts can be sold by corporations that
have receivables in that currency and wish to hedge against
the possible depreciation of that currency.

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 SUMMARY (Cont.)

§ Currency options are classified as call options or put

options. Call options allow the right to purchase a specified
currency at a specified exchange rate by a specified
expiration date. Put options allow the right to sell a specified
currency at a specified exchange rate by a specified
expiration date. Currency call options are commonly
purchased by corporations that have payables in a currency
that is expected to appreciate. Currency put options are
commonly purchased by corporations that have receivables
in a currency that is expected to depreciate.

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 Foreign Exchange Rates and Quotations

Most foreign exchange transactions involve the

US dollar.
Professional dealers and brokers may state
foreign exchange quotations in one of two
ways:
Suppose USD is home currency
n Direct method: the USD (home) price of a unit of
foreign currency
n Indirect method: the foreign currency price of one
USD (home currency)

33
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 Foreign Exchange Rates and Quotations

Change of spot rates:

For Direct Quote:
S1 – S0 S1
ef = △% = ————— = —— - 1
S0 S0
For Indirect Quote:
S0 – S1 S0
ef = △% = ————— = —— - 1
S1 S1

34
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 FX Forward Contract Quotes

Outright forward quotations

Example: Price of GBP and SFR in New York

Maturity GBP/USD USD/SFR

(direct quote, in USD) (indirect quote, in SFR)

Bid Ask ASK BID

spot 2.0015 2.0030 0.6963 0.6969
1-month 1.9996 2.0013 0.6967 0.6974
3-month 1.9989 2.0008 0.6972 0.6982
6-month 1.9973 1.9995 0.6986 0.7006

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 FX Forward Contract Quotes

Forward premium or discount formula:

For Direct Quote:
Forward – Spot 12
% premium or discount = ————————— X ——— X 100
Spot n
For Indirect Quote:
Spot - Forward 12
% premium or discount = ————————— X ——— X 100
Forward n
# Where n is the number of months in the contract. This n may
also be the number of days, in which case the numerator is 360.
36
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 Forward and Spot rates over time

37
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 Forward and Spot rates over time

Maturity GBP/USD USD/SFR

Bid Ask Bid ask
spot 2.0015 2.0030 0.6963 0.6969
On Jan.1t 3-month 1.9996 2.0013 0.6967 0.6974

On Feb. 1st: Maturity GBP/USD USD/SFR

Bid Ask Bid ask
spot 2.0018 2.0032 0.6971 0.6977
3-month 2.0015 2.0032 0.6965 0.6974
38
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 Calculating cross rates

2 cases:
n One quote (simple case)
n Bid/ask quotes (complicated case)

Simple case (one quote):

n USD/VND = 17849 à VND=1/17849 USD
n JPY/VND= 204.70à VND=1/204.70 JPY
n So: 1/17849 USD = 1/204.70 JPY
Or USD/JPY =[1/204.70] / [1/17849] = 87.16

39
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 Calculating cross rates

Complicated case (bid/ask quotes):

1. Intermediate currency is the quoted
currency
2. Intermediate currency is term and
quoted currency
3. Intermediate currency is term
currency

40
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 Calculating cross rates

1. Intermediate currency is the quoted currency

Example
E(USD/VND)=(a,b)
E(USD/JPY)=(c,d)
à E(JPY/VND)=(x,y)=?

Example 1a: A Vietnamese importer wants to buy JPY to pay for imported
goods from Japan will be applied a forex rate as follows:
The importer sell VND, buy JPY: at rate (y)=?
Step 1: Importer sell VND buy USD at rate: (b)
Step 2: Importer sell USD buy JPY at rate: (c)
Step 3: So y is calculated by:
y= JPY/VND =(USD/VND) : (USD/JPY) =b:c
y=b/c
41
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 Calculating cross rates

Example
E(USD/VND)=(a,b)
E(USD/JPY)=(c,d)
à E(JPY/VND)=(x,y)=?
Example 1b: A Vietnamese exporter wants to sell JPY received
from exporting goods to Japan will be applied a forex rate as
follows:
The exporter sell JPY, buy VND: at rate (x)=?
Step 1: Exporter sell JPY buy USD at rate: (d)
Step 2: Importer sell USD buy VND at rate: (a)
Step 3: So x is calculated by:
x =JPY/VND = (USD/VND) : (USD/JPY) =a:d
x=a/d
è Cross rate is: E(JPY/VND) = (a/d, b/c)

42
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 Calculating cross rates

E(USD/VND)=(a,b)
E(USD/JPY)=(c,d)
à E(JPY/VND)=(x,y)=?

Fast method:
JPY/VND = USD/VND : USD/JPY = (a,b) : (c,d)

x= min à x= a/d
y=max à y= b/c

43
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 Calculating cross rates

2. Intermediate currency is term and

quoted currency
E(USD/VND)=(a,b) và E(GBP/USD)=(c,d)
à E(GPB/VND)=(x,y)?

3. Intermediate currency is term

currency
E(AUD/USD)=(a,b) và E(GBP/USD)=(c,d)
à E(GBP/AUD)=(x,y)?

44
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 End-chapter
QUESTIONS AND APPLICATIONS

§ Chapter 4: Question 20

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 End-chapter
QUESTIONS AND APPLICATIONS

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 End-chapter
QUESTIONS AND APPLICATIONS

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48 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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