Chapter 5: Currency Derivatives

Forward Market
Forward transactions
● A forward contract is an agreement between two parties to exchange a specified
amount of a currency at a specified exchange rate - the forward rate.
● The exchange rate is established at the time of the agreement, but payment and
delivery are not required until maturity.
● Forward exchange rates are usually quoted for value dates of one, two, three, six
and twelve months.
● The forward market facilitates the trading of forward contracts on currencies.
● When MNCs anticipate a future need for or future receipt of a foreign currency, they
can set up forward contracts to lock in the rate at which they can purchase or sell a
particular foreign currency.
● The forward rate of a given curreney will typically vary with the length (number of
days) of the forward period.
How MNCs use forward contracts
● Turz. Inc., is an MNC based in Chicago that will need 1,000,000 Singapore dollars in
90 days to purchase Singapore imports.
● The spot rate is 8.50 per Singapore dollar (SS) firm would need $500,000.
● However, it does not have the funds right now to exchange for S$
● It could wait 90 days and then exchange S for S$ at the spot rate at that time.
● But Turz does not know what the spot rate will be at that time.
● If the rate rises to $.60, Turz will need $600,000 (an additional outlay of $100,000
due to the appreciation of S$)
 ● To avoid exposure to exchange rate risk, Turz can lock in the rate it will pay for S$ 90
days from now without having to exchange 8 for S$ immediately.
● Specifically, Turz can negotiate a forward contract with a bank to purchase
S$1,000,000 90 days forward.
● Suppose Bank of America (BoA) is the counterparty of Turz. what is the risk for BoA?
Bid/Ask spread
● Like spot rates, forward rates have a bid/ask spread.
● The spread between the bid and ask prices is wider for forward rates of currencies of
developing countries, such as Chile, Mexico, South Korea. Taiwan, and Thailand.
● These markets have relatively few orders for forward contracts, banks are less able
to match up willing buyers and sellers.
How to mitigate:
1. Limit the number of contracts
2. Credit limit/ Deposit/ Collateral
3. Short-term horizons.
Forward rate quotation
For large customers like MNC, the forward rates are normally negotiated: otherwise, quoted
rates.
Mostly indirect quotation.
E.g.: the 180-davs forward rate for the C$ is quoted follows:
- Spot: 1,3365-70. 180-day Swap: 23-27
The swap rate is:
- Bid rate: 1,3365 + 0,0023 = C$1.3388/$
- Ask rate: 1,3370 + 0,0027 = C$1.3397/$
Forward rate quotation

Premium or discount on the forward rate

As a rule, forward exchange rates are set at either a premium or discount of their spot rates.
If a currency's forward rate is higher in value than its spot rate, the currency being quoted at
a forward premium.
If a currency's forward rate is lower in value than its spot rate, the currency is being quoted
at a forward discount
Question
What are the forward rate premium or discount for £ if spot rate: $1.681 and:
a. 30-day forward rate: $1.680- maturity: 30 days
b. 90-day forward rate: $1.677-maturity: 90 days
c. 180-day forward rate: $1.672- maturity: 180 days
Using forward contracts for swap transactions
● A swap transaction involves a spot transaction along with a corresponding forward
contract that will ultimately reverse the spot transaction.
● Many forward contracts are negotiated for this purpose.
● Soho, Inc., needs to invest 1 million Chilean pesos in its Chilean subsidiary to
produce additional products. It want the subsidiary to repay the pesos in 1 year.
● Soho wants to lock in the rate at which the pesos can be converted back into dollars
in 1 year, and it uses a one year forward contract for this purpose.
● Soho contacts its bank and requests the following swap transaction:
● Today: The bank should withdraw dollars from Soho's U.S. account, convert the
dollars to pesos market, and transmit the pesos to the subsidiary's account.
● In one vear: The bank should withdraw 1 million pesos from the subsidiary's account,
convert them to dollars at today's forward rate, and transmit them to Soho's U.S.
account.
● Soho Inc. is not exposed to exchange rate movements due to the transaction
because it has locked in the rate at which the pesos will be converted back to dollars.
If the one-year forward rate exhibits a discount, Soho will receive fewer dollars in one
year than it invested in the subsidiary today.
● It may still be willing to engage in the swap transaction under these circumstances to
remove uncertainty about the dollars it will receive in one year.
Non-Deliverable Forward Contracts (NDF)
● Like a regular (outright) forward contract NDE represents an agreement regarding a
position in a specified amount of a specified currency, a specified exchange rate, and
a specified future settlement date.
● However, an NDF does not result in an actual exchange of the currencies at the
future date.
● That is, there is no delivery. Instead, one party makes payment to the other party
based on the exchange rate at the future date.
● Two parties agree to take opposite sides of a transaction for a set amount of money
and settle the difference between NDF price and the prevailing spot price.
● The profit or loss is calculated on the notional amount of the agreement by taking the
difference between the agreed-upon rate and the spot rate at the time of settlement.
● Most frequently quoted and settled in U.S. dollars and have become a popular
instrument since the 1990s for corporations seeking to hedge exposure to illiquid
currencies.
Application
 ● US exporter to receive 50 mil Bath from a Thai firm in 3 months. The current spot
rate is $/bath 50.
● US exporter wants to lock in the amount in $ (1mil) but can't use the outright forward
due to restriction /constraint/ illiquidity of the currency. US exporter agrees with the
bank to enter NDF at 50 bath per $ 3 months later, i.e., bank provides $1mil, US
exporter provides 50 mil bath.

Futures market
Currency Futures Market
● Futures contracts are categorized as either commodity futures or financial futures
● Currency futures contracts are contracts specifying a standard volume of a particular
currency to be exchanged on a specific settlement date.
● Currency futures contracts are similar to forward contracts in terms of their obligation
but differ fron forward contracts in the way they are traded.
● Long futures: The purchase of a futures contract
● Short futures: The sale of a futures contract. The long will realize a profit if the futures
price increases, and vice versa.
Futures vs Forward
● Exchange trading: Central exchange floor with worldwide communications vs.
telecommunications network.
● Terms: Standardized vs. Negotiable
● Price: Matched on the floor by computer vs quoted by denlers
Futures vs Forward
Contract size:
- Forward: from $1m vs Futures: standardized smaller amounts.
- If larger amounts are desired, purchase more contracts.
Small sizes facilitate trade and enhance market liquidity
Maturity: Fixed vs flexible
-Typically, futures contracts are introduced 6 months before maturities, and only have a few
maturity dates.
- Trading in futures contract stops 2 business days before the maturity of the contract.
Credit risk
Forward: Banks are willing to trade with large corporations, hedge funds, and institutional
investors. Two parties must directly assess the credit risk of their counterparties.
Futures:
Retail clients buy futures contracts from futures
brokerage firms. ✔Futures brokerage firms must register with the Commodity Futures
Trading Commission (CFTC) as a futures commission merchnt (FMC).
FMC must meet minimum capital requirements set by the exchanges and fiduciary
requirements set by the CFTC.
When a trade takes place on the exchange, the clearinghouse of the exchange acts as a
buyer to every clearing member seller and a seller to every clearing member buyer.
The clearinghouse imposes margin requirements and conducts the daily settlement process
known as marking to market that mitigates credit risk concerns.
Margin account to mitigate credit risk
Forward
No money changes hands, only cash flow at the maturity of the contract => assessing credit
risk is very important.
Futures
-The investor must deposit some assets into a marginaccount to fulfill the initial margin
requirement,
- As futures prices change, one party to the contract experiences profits, and the other
experiences losses.
-The daily profits and losses are deposited to and subtracted from the margin accounts of
the respective parties. This is the marking to market
Maintenance margin: The minimum amount that must be kept in the account to guard
against severe fluctuations in the futures prices and the losses that would be incurred by one
of the parties. When the value of the margin account reaches the maintenance margin, there
is a margin call, at which point the account must be brought back up to its initial value
Because margins are intended to control risk, their magnitude depends on the size of the
contract and the volatility of the currencies.
Marking to market: To ensure that users of futures contracts present little credit risk to the
FCMs and thus to the clearinghouse of the exchange.
Example: On Tuesday, long position in a Swiss franc futures maturing on Thursday
- Futures price $0.95 for SFr 125000
- Deposit into margin account: $2700

Futures vs Forward
Marking to market: To ensure that the users of futures contracts present little credit risk to
the FCMs and thus to the clearinghouse of the exchange.
Another example:
- Purchase E-mini S&P 500 futures contract
- Initial margin: $6,600 per contract x 2 contracts Maintenance margin: $6,000 per contract x
2 contracts
If losses are incurred, and your initial margin fell to $10,000 ($2,000 below maintenance
margin) => margin call
Either you increase account balance by $3,200 (1600x2) to bring it back to $13,200 initial
margin; Or, close one of the two contracts so maintenance margin drops to $6,000
- Or, close both.
Currency Futures Market
Normally, the price of a currency futures contract is similar to the forward rate for a given
currency and settlement date
These relationships are enforced by the potential arbitrage activities that would occur
otherwise.
● Speculators often sell curreney futures when they expect the underlying currency to
depreciate, and vice versa.
● Currency futures may be purchased by MNCs to hedge foreign currency payables or
sold to hedge receivables.
● 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
● Most currency futures contracts are closed out before their settlement dates.

Options market
Currency Options
A foreign currency option is a contract giving the purchaser of the option the right to buy or
sell a given amount of currency at a fixed price per unit for a specified time period.
It is the "right, but not the obligation" to take a action
Two basie types of options, calls and puts
Call-buyer has right to purchase currency Put-buyer has right to sell currency
● The buyer of the option is the holder, and the seller of the option is termed the writer
● Foreign Currency Options
Every option has three different price elements
● The strike or exercise price (X) is the exchange rate at which the foreign currency
can be purchased or sold
● The premium (P), the cost. price or value of the option itself paid at time option is
purchased -The underlying or actual spot rate (S) in the market
There are two types of option maturities
● American options may be exercised at any time during the life of the option
● European options may not be exercised until the specified maturity date
Options may also be classified as per their payouts
● At-the-money (ATM) options have an exercise price equal to the spot rate of the
underlying currency, excluding premium costs
● In-the-money (ITM) options may be profitable, excluding premium costs, if exercised
immediately
● Out-of-the-money (OTM) options would not be profitable, excluding the premium
costs, if exercised
The increased use of currency options has led the creation of several markets where
financial managers can access these derivative instruments
- Over-the-Counter (OTC) Market – OTC options are most frequently written by banks for
US dollars against British pounds, Swiss franes, Japanese Canadian dollars and the euro.
● Main advantage is that they are tailored to purchaser
● Counterparty risk exists
● Mostly used by individuals and banks
Organized Exchanges-like the futures market, currency options are traded on an organized
exchange floor
● The Chicago Mercantile and the Philadelphia Stock Exchange serve options markets
● Clearinghouse services are provided by the Options Clearinghouse Corporation
(OCC)
The standard options that are traded on an exchange through brokers are guaranteed but
require margin maintenance
U.S. option exchanges are regulated by the Securities and Exchange Commission.
Currency Call Options
The call option premium is primarily affected by three main factors:
● The most influential factor on an option premium is the current market price of the
underlying asset. The larger S- X. 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 the call option value, other
things equal.

The put option premium is primarily affected by three main factors:

● -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.
Question
1.Randy 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?
=> The holder of a call option will exercise it if S-X>=0.
In this case, S - X = 1.46 - 1.45 = $0.01 ≥ 0; so the holder of the option will exercise it.
Net profit per £ = 1.46 - 1.45 - 0.02 -$0.01
Net profit per option = 31,250 * (-0.01)=-$312.50

2.Mike 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
Canadiandollar option. What was Mike's net profit on the call option?
=>Profit per unit on exercising the option $0.06
Premium paid per unit = $0.01
Net profit per unit -$0.05
Net profit per option =-$2,500

3.Brian 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?
=> Premium received per unit = $.03
Amount per unit received from selling CS =$.72
Amount per unit paid for CS =$.75
Net profit per unit =$0

4.Suppose you buy 03 June PHLX call options with a 90 strike price at a price of 2.3
(cent/€). What would be your total dollar cost for these calls, ignoring broker fees (with each
call option being for E62.500? After holding these calls for 60 days, you sell them for 3.8
(é/E). What is your net profit on the contracts assuming that l brokerage fees on both entry
and exit were $10 per contract and that your opportunity cost was 8% per annum (365 days)
on the money tied up in the premium?
=> With each call Option being for €62,500 , The three contracts combined are for
€187,500 . At a price of 2.3 ¢/€, The total cost is 187,500 *$0.023 = $4,312.50
The net profit would be 1.5¢/€ (3.8 - 2.3) for a total profit before expenses of
$2,812.50 (0.015 *187,500).
Brokerage fees totalled $10 per contract or $30 overall.The oppurtunity cost would
be $4,312.50*0.08*60/365 = $56.71.After deducting these expenses (which total
$86.71),the net profit is $2,725.79.

Conditional Currency Options

● A currency option may be structured such that the premium is conditioned on
the actual currency movement over the specified period (conditional
premium).
 ● Suppose a conditional put option on f has an exercise price of $1.70, and a
trigger of $1.74. The premium will have to be paid only if the f's value exceeds
the trigger value.
● X = $1.70, trigger (price) $1.74
● If S < X, exercise the option, receive $1.70 per pound. but DONT have to pay
premium.
● If X ($1.70) < S<trigger price ($1.74), then the option will not be exercised,
DON’T have to pay premium.
● If S> $1.74 trigger. MUST pay a premium of $.04 per unit. This premium >
premium that would have been paid for a basic put option. Nonetheless,
option holder will receive a high dollar amount from converting its pound
receivables in the spot market.
● Option holder must determine whether the possible advantage (avoiding the
payment of a premium under some conditions) > the possible disadvantage
(paying a higher premium than would be needed for a traditional put option on
GBP)
● The choice of a basic versus a conditional option depends on expectations
about the currency's exchange rate.
● If option holder is confident that the pound's value will not exceed $1.74 then it
should prefer the conditional currency option
Comparison of Conditional and Basic Currency Ontions

Straddle
● One possible speculative strategy for volatile currencies is to purchase both a
put option and a call option at the same exercise price. This is called a
straddle.
 ● By purchasing both options, the speculator may gain if the currency moves
substantially in either direction.

=> D
Q2. Quasik Corporation will be receiving 300,000 Canadian dollars (C$) in 90
days. Currently, a 90-day call option with an exercise price of $.75 and a
premium of $.01 is available. Also, a 90-day put option with an exercise price
of $.73 and a premium of $.01 is available. Quasik plans to purchase options to
hedge its receivable position. Assuming that the spot rate in 90 days is $.71,
what is the net amount received (after accounting for the option premium)
from the currency option hedge?
=> (0.73-0.01)*300.000 = 216.000
Q3. An MNC's short-term financing decisions ae satisfied in the _______
market, while its medium debt financing decisions are satisfied in the
________ market
=> international money ; international credit
Q4 Given two statements:
(A) Eurocredit market provides loans of less than one year, i.e. short-term
loans.
(B) A yen-denominated bond issued in Japan by an U.S. Company is an
example of Eurobond
=>
Q5. Crown Co. is expecting to receive 100,000 British pounds in one year.
Crown expects the spot rate of British pound to be $1.49 in a year, so it
decides to avoid exchange rate risk by hedging its receivables. The spot rate
of the pound is quoted at $1.51. The strike price of put and call options are
$1.54 and $1.53 respectively. The premium on both options is $.03. The
one-year forward rate exhibits a 2.65% premium. Assume there are no
transaction costs. What is the best possible hedging strategy and how many
U.S. dollars Crown Co. will receive under this strategy?
=> There are only two feasible choices for hedging in these circumstances: selling
pounds forward or buying a put option.
Sell pounds forward:
One-year forward rate = $1.51 × (1 + .0265) $1.55 Dollars received = 100,000 ×
$1.55= $155,000
Buy put option:
Amount received per unit = $1.54 – $.03 =$1.51 Total amount of receivables in U.S.S
= 100,000 × $1.51=$151,000
So, sell pounds torward and receive $155,000.
Q6. The premium on a euro call option is $.02. The exercise price is $1.32. The
break-even point is _____ for the for the buyer of the call, and _____ for the
seller of the call. (Assume zero transactions costs and that the buyer and
seller of the put option are speculators.)
=> Break-even point on call option to both the buyer and seller is $1.32+$.02 = $1.34
Q7. When you own _____ there is no obligation on your part; however, when
you own ____ there is an obligation on your part
=> call option ; put option
Q8.On January 1st, Madison Co. ordered raw material from Japan and agreed
to pay 100 million yen for this order on April 1st. It negotiated a 3-month
forward contract to obtain 100 million Japanese yen on that date at $.009. On
February 1st, the Japanese firm informed Madison Co. that it won't be able to
fulfill that order. The Japanese yen spot rate on February 1st is $.0087 and
2-month forward rate exhibits 3% discount. To offset its existing contract
Madison Co. will negotiate a forward contract to for the date of April 1st and
the profit/loss generated from this transaction is a U.S. dollars.
=> 2-month forward rate = $.0087 x (1 - .03) =$.0084 Profit/loss from transaction =
(100,000,000 x $.0084) - (100,000,000 x .009)= $60,000 loss.
So, sell yen; loss of $60,000
Q9. Assume that a speculator purchases a put option on British pounds (with
a strike price of $1.50) for $.05 per unit. A pound option represents 31,250
units. Assume that at the time of the purchase, the spot rate of the pound is
$1.51 and continually rises to $1.62 by the expiration date. The highest net
profit possible for the speculator based on the information above is:
=> The premium of the option is $.05 × (31,250 units) = $1,562.50. Since the option
will not be exercised, the net profit is -$1,562.50.
Q10. Which of the following is not true regarding options?
a. Options are traded on exchanges, never over-the counter.
b. Similar to futures contracts, margin requirements option traders are
normally imposed on
c. Although commissions for options are fixed per transaction, multiple contracts may
be involved in a transaction, thus lowering the commission per contract.
d. Currency options can be classified as either put or call options.
e. All of the above are true.