Chapter 5

Currency Derivatives
 Chapter Objectives
• To explain how forward contracts are
used for hedging based on anticipated
exchange rate movements.
• To explain how currency futures
contracts and currency options
contracts are used for hedging or
speculation based on anticipated
exchange rate movements.
 Forward Market (1)
• A forward contract is an agreement
between a firm 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.
• Forward contracts are often valued at £1
million or more, and are not normally used
by consumers or small firms.
 Forward Market (2)
• When MNCs anticipate a future need for or
future receipt of a foreign currency, they
can set up forward contracts to lock in the
exchange rate.
• The % by which the forward rate (F )
exceeds the spot rate (S ) at a given point in
time is called the forward premium (p ).
F = S (1 + p )
• F exhibits a discount when p < 0.
 Forward Market (3)
Example S = £0.60:$1,
90-day F = £0.59:$1
F – S  360
annualized p =
S n
= 0.59 – 0.60  360 = –.017%
0.60 90
• The forward premium (discount) usually reflects the
difference between the home and foreign interest
rates, thus preventing arbitrage.
 Forward Market (4)
• A swap transaction involves a spot
transaction along with a corresponding
forward contract that will reverse the spot
transaction.
• A non-deliverable forward contract (NDF)
does not result in an actual exchange of
currencies. Instead, one party makes a net
payment to the other based on a market
exchange rate on the day of settlement.
 Forward Market (5)
• An NDF can effectively hedge future foreign
currency payments or receipts:
July 1
April 1
Buy 100M Chilean pesos
Expect need for 100M Chilean from market.
pesos.
Negotiate an NDF to buy 100M Index = £.0014/peso 
Chilean pesos on Jul 1. receive £20,000 from bank
Reference index (closing rate due to NDF.
quoted by Chile’s central bank)
= £.0012/peso.
Index = $.009/peso  pay
£30,000 to bank.
Currency Futures Market (1)
• Currency futures contracts specify a
standard volume of a particular currency
to be exchanged on a specific settlement
date at a specified exchange rate.
• They are used by MNCs to hedge their
currency positions, and by speculators
who hope to capitalize on their
expectations of exchange rate
movements.
Currency Futures Market (2)
• The contracts can be traded by firms or
individuals through brokers on the trading
floor of an exchange (e.g. Chicago
Mercantile Exchange), automated trading
systems (e.g. GLOBEX), or the over-the-
counter market.
• Brokers who fulfill orders to buy or sell
futures contracts typically charge a
commission.
 Comparison of the Forward & Futures
Markets (1)
Forward Markets Futures Markets
Contract size Customized Standardized
Delivery date Customized Standardized
Participants Banks, brokers, Banks, brokers,
MNCs. Public MNCs. Qualified
speculation not public speculation
encouraged. encouraged.
Security Compensating Small security
deposit bank balances or deposit required.
credit lines needed.
Clearing Handled by Handled by
operation individual banks exchange
& brokers. clearinghouse.
Daily settlements
to market prices.
 Comparison of the Forward & Futures
Markets (2)
Forward Markets Futures Markets
Marketplace Worldwide Central exchange
telephone floor with worldwide
network communications.
Regulation Self-regulating Commodity
Futures Trading
Commission,
National Futures
Association.
Liquidation Mostly settled by Mostly settled by
actual delivery. offset.
Transaction Bank’s bid/ask Negotiated
Costs spread. brokerage fees.
 Currency Futures Market (3)
• Enforced by potential arbitrage activities, the
prices of currency futures are closely related
to their corresponding forward rates and spot
rates.
• Currency futures contracts are guaranteed to
be fulfilled by the exchange clearinghouse,
which in turn minimizes its own credit risk by
imposing margin requirements on those
market participants who take a position.
 Currency Futures Market
• Matches offsetting risks between buyer and
seller – THE BASIC IDEA:

Price
Currency Futures Market (4)
• Speculators often sell currency futures
when they expect the underlying
currency to depreciate, and vice versa.

April 4 June 17
1. Contract to sell 2. Buy 500,000 pesos @
500,000 pesos £.050/peso (£25,000)
@ £.056/peso from the spot market.
(£28,000) on
June 17.
3. Sell the pesos to fulfill
contract.
Gain £3,000.
Currency Futures Market (5)
• MNCs may purchase currency futures
to hedge their foreign currency
payables, or sell currency futures to
hedge their receivables.
April 4 June 17
1. Expect to receive 2. Receive 500,000 pesos
500,000 pesos. as expected.
Contract to sell
500,000 pesos @ 3. Sell the pesos at the
£.056/peso on locked-in rate.
June 17.
Currency Futures Market (6)
• 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

1. Contract to 2. Contract to 3. No further
buy sell A$100,000 payments to be
A$100,000 @ @ £.31/A$ made no matter
£.33/A$ (£31,000) on what the current
(£33,000) on March 19. Will rate.
March 19. have paid
£2,000
Currency Futures Market (6)
 Currency Options Market
• Currency options provide the right but NOT
the obligation to purchase or sell currencies
at specified (strike) prices. They are
classified as calls (right to buy a currency)
or puts (right to sell a currency.
• Standardized options are traded on
exchanges through brokers.
• Customized options offered by brokerage
firms and commercial banks are traded in
the over-the-counter market.
 Currency Call Options (1)
• The specified price is called the exercise or strike price
within a specific period of time.
• A call (right to buy) option is
– in the money if a claim can be made

– at the money if currency price = strike price

– out of the money if a claim cannot be made

 Currency Options (2)
• Option owners can sell or exercise their
options, or let their options expire.
• Firms may purchase currency call options
to hedge payables, project bidding, or target
bidding.
• Firms may purchase currency put options to
hedge receivables, interest earned or sales
of assets.
From the FT October

Philadelphia SE £/$ Options £31,250 The right to

$ cents per £ buy a call at
Strike Calls Puts a low strike
Price Dec Jan Dec Jan price is
1.400 8.49 8.50 0.07 0.12
1.450 3.61 4.20 0.11 0.83
more
1.525 0.03 0.74 3.82 4.73 expensive

Spot $1.4845:£1
Buy and sell a Dec Call Option for
31,250 units x 8.49¢ = $2653.12 @1.400
31,250 units x 3.61¢ = $1128.13 @1.450
31,250 units x 0.03¢ = $937.5 @1.525

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From the FT October

Philadelphia SE £/$ Options £31,250 The right to

$ cents per £ buy a put at
Strike Calls Puts a low strike
Price Dec Jan Dec Jan price is less
1.400 8.49 8.50 0.07 0.12
1.450 3.61 4.20 0.11 0.83
expensive
1.525 0.03 0.74 3.82 4.73

Spot $1.4845:£1
Buy and sell a Dec Put Option for
31,250 units x 0.07¢ = $21.88 @1.400
31,250 units x 0.11¢ = $34.38 @1.450
31,250 units x 8.82¢ = $2662.5 @1.525

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 Effective buying and selling price

Philadelphia SE £/$ Options £31,250

$ cents per £
Strike Calls Puts
Price Dec Jan Dec Jan
1.400 8.49 8.50 0.07 0.12
1.450 3.61 4.20 0.11 0.83

Dec effective call prices per £

$1.400 + $0.0849 = $1.4849
$1.450 + $0.0361 = $1.4861*
Dec effective put prices per £
$1.400 - $0.0007 = $1.3993*
$1.450 - $0.0011 = $1.4489

*cheaper but less advantageous

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 Increasing the term

Philadelphia SE £/$ Options £31,250

$ cents per £
Strike Calls Puts
Price Dec Jan Dec Jan
1.400 8.49 8.50 0.07 0.12
1.450 3.61 4.20 0.11 0.83

Increase term (time) >> increase uncertainty >> increase in option premium…
Price
Call strike

Put strike
time

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Intrinsic and time value of premiums

Philadelphia SE £/$ Options £31,250

$ cents per £
Strike Calls Puts
Price Dec Jan Dec Jan
1.400 8.49 8.50 0.07 0.12
1.450 3.61 4.20 0.11 0.83

Spot $1.4845:£1
If out of the money,
this is 0.00. There
Dec effective call prices per £ will just be a time
$1.400 + $0.0849 = $1.4849 element – there will
¢/£ always be a a time
Intrinsic element 1.4845 - 1.4000 = 8.45 element
Time element 0.04
Actual Premium 8.49

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 Contingency or position diagrams
do not exercise exercise
net value 1.45
+
0

-8.00 cents Future spot

- out-of-the-money in-the-money

Call option on £’s net profit or loss at maturity for purchaser

e.g. call (buy) at 1.45, premium 8.00¢
$s per £
maturity (spot) prices: 1.40 1.50 1.60
exercise? N Y Y
spot – strike ~ 0.05 0.15
less premium 0.08 0.08 0.08
net position (0.08) (0.03) 0.07

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Contingency or position diagram

profit
Sell or written call
 

Future
buy call  spot
loss


= premium
 = strike price
 = strike price + premium

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 Contingency or position diagrams
exercise do not exercise
net value 1.55
+
0

-6.00 cents Future spot

- in-the-money out of-the-money

Put option on £’s net profit or loss at maturity for purchaser

e.g. put (sell) at 1.55, premium 6.00¢

$ per £
maturity (spot) prices ($): 1.40 1.50 1.60 Remember, you
exercise? Y Y N cannot lose more
strike - spot 0.15 0.05 ~ than your premium!
less premium 0.06 0.06 0.06
net position 0.09 (0.01) (0.06)

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Contingency or position diagram

profit
 sell put
 


Future
 buy put spot
loss


= premium
 = strike price
 = strike price + premium

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Options as a Hedging Tool
(UK investor in $’s)

probability
density
Put type protection future spot

probability
Density

call type protection future spot

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Range forward or cylinder contract
e.g. Mr W a UK investor is expecting ¥ revenues...

UK purchase put on ¥’s desired rate & UK sell ¥’s call on higher rate
Often same premium so...no net cost.

  future spot £’s:¥

£0.005 £0.006

Gains protection against ¥ selling less than £0.005 with put in return
for sacrificing ¥ selling more than £0.006
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Range forward or cylinder contract
e.g. Mr W a UK investor is expecting ¥ revenues...

UK purchase put on ¥’s lower rate & UK sell ¥’s call on higher rate
Often same premium so...no net cost.
Mr W
To avoid
probability this…
sacrifices
density this

  future spot £’s:¥

£0.005 £0.006

Gains protection against ¥ buying less than £0.005 with put in return
for sacrificing ¥ buying more than £0.006

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Range forward or cylinder contract
e.g. Mr W a UK investor is expecting ¥ costs...

UK purchase call on ¥’s at desired rate & UK sell ¥’s put on lower rate
Often same premium so...no net cost.

  future spot £’s:¥

£0.005 £0.006

Gains protection against ¥ costing more than £0.006 with call in return
for sacrificing ¥ paying less than £0.005
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 Conditional Currency Options

• A currency option may be structured

such that the premium is conditioned on
the actual currency movement over the
period of concern.
• Suppose a conditional put option on £
has an exercise price of $1.70, and a
trigger of $1.74. The premium will have
to be paid only if the £’s value exceeds
the trigger value.
 Conditional Currency Options

dollar unfavourable dollar favourable

conditional option conditional option
Profit pays more more expensive

Value of dollar
-£0.03

Loss £0. 57 -£0.04

£0. 60
£0. 62

Exhibit 5.11 Comparison of Conditional

and Basic Currency Options
Conditional Currency Options (3)

• Similarly, a conditional call option on $

may specify an exercise price of £0.60,
and a trigger of £0.58. The premium will
have to be paid only if the £’s value falls
below the trigger value.
• In both cases, the payment of the
premium is avoided conditionally at the
cost of a higher premium.
European Currency Options
• European-style currency options are
similar to American-style options except
that they can only be exercised on the
expiration date.
• For firms that purchase options to hedge
future cash flows, this loss in flexibility is
probably not an issue. Hence, if their
premiums are lower, European-style
currency options may be preferred.
 Efficiency of
Currency Futures and Options
• If foreign exchange markets are
efficient, speculation in the currency
futures and options markets should
not consistently generate abnormally
large profits.