Lecture 6 Currency Derivatives (1)

• the end of this session students should be able to:

 Understand the purposes of using derivatives
 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

• Essential reading incl. lecture notes:

Madura, J. and Fox, R. (2007). International Financial
Management, 1st Edition, Thomson Learning. Chap 5
Eiteman, D. K., Stonehill, A. I. and Moffett, M. H. (2006).
Multinational Business Finance, 11th Edition, Prentice Hall.
Chap 7

Dr. Baoying Lai FEM207 International Finance L6 1

Financial Derivatives
• Financial management of the MNCs in the 21st century
involves financial derivatives.
• These derivatives, so named because their values are
derived from underlying assets, are a powerful tool used
in business today.
• These instruments can be used for two very distinct
management objectives:
– Speculation – use of derivative instruments to take a position in
the expectation of a profit
– Hedging – use of derivative instruments to reduce the risks
associated with the everyday management of corporate cash
flow

Dr. Baoying Lai FEM207 International Finance L6 2

Forward Contract (1)
• 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.

• The party that has agreed to buy has a long

position.

• The party that has agreed to sell has a short

position.

Dr. Baoying Lai FEM207 International Finance L6 3

Forward Contract (2)
• When multinational corporations (MNCs) anticipate a future need for
or future receipt of a foreign currency, they can set up forward
contract to lock in the rate at which they can purchase or sell a
particular foreign currency.

• Because forward contract accommodate large corporations, the

forward transaction will often be valued for very large sums (e.g.,
£100m).

• Forward contracts normally are not used by customers or small

firms.

• In cases when a bank does not know a corporation well or fully trust
it, the bank may request that the corporation make an initial deposit
to ensure that it will fulfil its obligation.

Dr. Baoying Lai FEM207 International Finance L6 4

Forward Contract (3)
• The most common forward contracts are
for 30, 60, 90, 180, and 360 days,
although other periods (including longer
periods) are available.

• The forward rate of a given currency will

typically vary with the length (number of
days) of the forward period.
Dr. Baoying Lai FEM207 International Finance L6 5
 How MNC’s Use Forward Contracts(1)
• MNCs can use the forward contract to hedge their imports. They can
lock in the rate at which they can buy foreign currencies.

• Example 1:
Pay S$ 1 M in 90 days

UK MNCs Singapore firm

import

• Current spot rate:£0.35/S$, so need £350,000(S$1mx£0.35/S$).

However, the UK importer does not have the funds right now

• If the exchange rate rises to £0.4/S$ in 90 days, UK importer will

need £400,000(S$1mX£0.4/S$), so it will cost the UK importer
£50,000 more due to the appreciation of the Singapore dollar.

Dr. Baoying Lai FEM207 International Finance L6 6

 How MNC’s Use Forward Contracts(2)
• Example 1 (Cont’d)

• Strategy: to avoid exposure to exchange rate risk, the UK importer

can negotiate a forward contract with a bank to purchase S$1m 90
days forward and lock in the forward rate, e.g., £0.38/S$.

• However, if the spot rate in 90 days is £0.37, then the UK importer

will have paid £0.01 per unit or £10,000 (S$1m X £0.01/S$) more for
the Singapore dollars as a result of taking out a forward contract.

• But this cost can also be seen as something of an insurance

payment in that the UK importer avoided the possibility of having to
pay much more on the spot market (e.g., £0.40/S$)

Dr. Baoying Lai FEM207 International Finance L6 7

 How MNC’s Use Forward Contracts(3)
• MNCs can use the forward contract to hedge their exports. They
can lock in the rate at which they can sell foreign currencies.
• Example 2:
Export

UK MNCs French firm

receive 400,000 euros in 4 months

• Current spot rate:£0.65/euro, the UK exporter expects to receive

£260,000 (400,000 euros x £0.65/euro).

• They worry euro depreciate in 4 months, e.g., the forward rate drops
to £0.55/euro, then the UK exporter will only receive
£220,000(400,000 euro x £0.55/euro). So they will loss £40,000.

Dr. Baoying Lai FEM207 International Finance L6 8

 How MNC’s Use Forward Contracts(4)

• Example 2 (Cont’d)
• Strategy: the UK exporter can negotiate a
forward contract with a bank to sell the
400,000 euros for British pounds at a
specified forward rate e.g., £0.6/euro. In 4
months, the UK exporter will exchange its
400,000 euros for £240,000 (400,000 x
£0.6/euro)

Dr. Baoying Lai FEM207 International Finance L6 9

 How MNC’s Use Forward Contracts(5)
A. Bid/ask spread
• A bank agreed to sell (ask) a firm S$ in 90 days at £0.36/S$.
At the same time, the bank may agree to buy (bid) S$ in 90
days at £0.35/S$. The wider spread gives banks more profit.

B. Premium or discount on the forward rate

• Where the forward rate is at premium (discount), the foreign
currency is more (less) expensive than the current cost as
given by the spot rate.

• The forward rate is equal to the spot rate multiplied by a

premium or discount:
F=S(1+p)
Dr. Baoying Lai FEM207 International Finance L6 10
 How MNC’s Use Forward Contracts(6)
• B. Premium or discount on the forward rate (Cont’d)
• annualized 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%

Dr. Baoying Lai FEM207 International Finance L6 11

 How MNC’s Use Forward Contracts(7)
C. Arbitrage
• Forward rates typically differ from the spot rate for any given
currency. The difference is dictated by arbitrage possibilities.

• In the case of forward rates, the arbitrageur could borrow in

the country with the lower interest rate, invest in the countries
with higher interest rate and arrange conversion back into
the original currency suing the forward rate.

D. Movement in the forward rate over time

• any movement over time in the spot rate and the interest
rates of the two countries will affect the forward rate. (will be
discussed in details in lecture 7)

Dr. Baoying Lai FEM207 International Finance L6 12

 How MNC’s Use Forward Contracts(8)
• E. Offsetting a forward contract
Bank A Bank B

Original contract: Bank To close out some time

A is selling 1m pesos to Company M
later…: M takes out a forward
M at time t for an agreed contract to sell 1m pesos to
rate. (M had a forward B. so, Bank B is buying 1m
contract to buy from A) pesos from M at time t.
Closed out position:
Bank A can sell 1m pesos directly to Bank B at time t for the rate agreed between
M and B. M will have already settle with A any difference between the price with
A and the price with B.

Bank A Bank B
Dr. Baoying Lai FEM207 International Finance L6 13
 How MNC’s Use Forward Contracts(9)
• F. Using forward contacts for swap transactions

Invest 1m euros
UK MNCs French Subsidiary
Repay in one year

• Today: UK MNCs negotiate a forward contract with a bank and

specified a forward rate:

Withdraw £, convert
into euro in spot 1m euros

UK MNCs French
Bank
Convert euro into £ at Withdraw Subsidiary
specified FW rate 1m euros
• In one year: the UK MNCs is not exposed to exchange rate movements.

Dr. Baoying Lai FEM207 International Finance L6 14

Non-Deliverable Forward Contracts
• New type

• Frequently used for currency in emerging

markets

• No delivery required

• One party to the agreement makes a payment to

the other party based on the exchange rate at
the future date.
Dr. Baoying Lai FEM207 International Finance L6 15
 Foreign Currency Futures
• A foreign currency futures contract is an alternative to a
forward contract
– It calls for future delivery of a standard amount of
currency at a fixed time and price

– These contracts are traded on exchanges with the

largest being the International Monetary Market
located in the Chicago Mercantile Exchange. Others
include London International Financial Futures and
Options Exchange (LIFFE), The Chicago Board of
Trade (CBOT)

Dr. Baoying Lai FEM207 International Finance L6 16

 Contract Specifications (1)
– Size of contract – called the notional principal, trading
in each currency must be done in an even multiple
– Maturity date – contracts have maturity dates.
– Last trading day – contracts may be traded through
the second business day prior to maturity date
– Initial & maintenance margins – the purchaser or
trader must deposit an initial margin or collateral; this
requirement is similar to a performance bond as well
as keep to the terms of the maintenance margin.
• At the end of each trading day, the account is
marked to market and the balance in the account
is either credited if value of contracts is greater or
debited if value of contracts is less than account
balance
Dr. Baoying Lai FEM207 International Finance L6 17
 Contract Specifications (2)
– Settlement – only 5% of futures contracts are settled
by physical delivery, most often buyers and sellers
offset their position prior to delivery date
• The complete buy/sell or sell/buy is termed a round turn
– Commissions – customers pay a commission to their
broker to execute a round turn and only a single price
is quoted
– Use of a clearing house as a counterparty – All
contracts are agreements between the client and the
exchange clearing house. Consequently clients need
not worry about the performance of a specific
counterparty since the clearing house is guaranteed
by all members of the exchange
Dr. Baoying Lai FEM207 International Finance L6 18
 Foreign Currency Futures Versus
Forward Contracts
Characteristic Foreign Currency Futures Forward Contracts
Size of Contract Standardized Tailored to individual needs

Delivery date standardized Tailored to individual needs

Participants Banks, brokers and multinational Bank, brokers, and multinational

companies. Qualified public speculation companies. Qualified public
encouraged speculation not encouraged

Security deposit Small security deposit required None as such, but compensating
bank balances or lines of credit
required

Clearing operation Handled by exchange clearing house. Daily
settlement to the market place
Market place Central exchange floor with worldwide
communication
Regulation Commodity Future Trading Commission;
National Future Association
Liquidation Most by offset, very few by delivery
Handling contingent on individual
banks and brokers. No separate
clearing house function
Over the telephone worldwide
Self-regulating
Most settled by actual delivery. Some
by offset, at a cost

Dr.Transaction
Baoying Laicosts Negotiated brokerage
FEM207 fees
International Finance L6 Set by ‘spread’ between bank’s
19buy
and sell prices
 Currency Future Market
• Normally, the price of a currency futures contract is similar to the
forward rate for a given currency and settlement date, but differs
from the spot rate when the interest rates on the two currencies
differ.

• These relationships are enforced by the potential arbitrage activities

that would occur otherwise.

• Currency futures contracts have no credit risk since they are

guaranteed by the exchange clearinghouse.

• To minimize its risk in such a guarantee, the exchange imposes

margin requirements to cover fluctuations in the value of the
contracts.

Dr. Baoying Lai FEM207 International Finance L6 20

 Speculation with Currency Future (1)

• 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 @ $.08/peso
@ $.09/peso ($40,000) from the
($45,000) on spot market.
June 17. 3. Sell the pesos to
fulfill contract.
Dr. Baoying Lai FEM207 International Finance L6Gain $5,000. 21
 Hedge with Currency Future (2)
• Currency futures may be purchased by
MNCs to hedge foreign currency payables,
or sold to hedge receivables.

April 4 June 17
1. Expect to receive 2. Receive 500,000
500,000 pesos. pesos as expected.
Contract to sell
500,000 pesos 3. Sell the pesos at
@ $.09/peso on the locked-in rate.
June 17.
Dr. Baoying Lai FEM207 International Finance L6 22
 Closing Out a Futures Position (1)
• 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. Incurs $3000
buy sell loss from
A$100,000 A$100,000 offsetting
@ $.53/A$ @ $.50/A$ positions in
($53,000) on ($50,000) on futures
March
Dr. Baoying Lai 19. FEM207March 19.
International Finance L6 contracts. 23
 Closing Out a Futures Position (2)
• Most currency futures contracts are closed
out before their settlement dates.

• Brokers who fulfill orders to buy or sell

futures contracts earn a transaction or
brokerage fee in the form of the bid/ask
spread.

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