Madura: International Financial Management
Forward Market
Chapter
5
Currency Derivatives
South-Western/Thomson Learning © 2003
How MNCs use Forward Contract?
• 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 contracts are usually used by
large firms.
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Forward Market
• 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.
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South-Western/Thomson Learning © 2003
Chapter 5
• 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.
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How MNCs use Forward Contract?
Problem situation for Blades:
• Blades Inc. will import raw materials from
Thailand in 90 days. For this Blades Inc.
needs 10,00,000 Thai Baht in 90 days.
• Since spot rate is $0.5 against 1 Baht, Blades
need $5,00,000.
• Blades expect exchange rate to be $0.7 in 90
days.
• Blades will require $7,00,000 incurring a loss
of $2,00,000.
Solution: Forward Contract.
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Forward Market
• 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%
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Madura: International Financial Management Chapter 5

Non-Deliverable Forward Contract Non-Deliverable Forward Contract

• No exchange of currency.
• Blades Inc determines on April 1 that it will
• Instead, a net payment is made by one need 100m Chilean Peso on July 1. It
party to the other based on the contracted negotiates NDF with a local bank.
rate and the market rate on the day of
• On April exchange rate is p1=$0.002.
settlement.
• On July exchange rate is p1=$.0023.
• Almost like insurance for buyers.
• Blades need $30,000 additional on July1 due
• Although NDFs do not involve actual
to depreciation in $.
delivery, they can effectively hedge
expected foreign currency cash flows. • Bank will pay $30,000 on July 1 to Blades Inc.

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Currency Futures Market Currency Futures Market

• Currency futures contracts specify a • The contracts can be traded by firms or

standard volume of a particular currency to
be exchanged on a specific settlement date
on a specific price.
• They are used by MNCs to hedge their
currency positions, and by speculators
who hope to capitalize on their
expectations of exchange rate movements.
individuals through brokers on the trading
floor of an exchange (e.g. Chicago Mercantile
Exchange), on automated trading systems
(e.g. GLOBEX), or over-the-counter.
• Buyer ˃Broker of the Buyer ˃Broker of the
seller ˃Seller.

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Speculations in Currency Futures

Speculations in Currency Futures
Market
Market
• Speculators often sell currency futures • Currency futures may be purchased by
when they expect the underlying currency MNCs to hedge foreign currency payables,
to depreciate, and vice versa. or sold to hedge receivables.
April 4 June 17 April 4 June 17
1. Contract to sell 2. Buy 500,000 pesos 1. Expect to receive 2. Receive 500,000
500,000 pesos @ $.08/peso 500,000 pesos. pesos as expected.
@ $.09/peso ($40,000) from the Contract to sell
($45,000) on spot market. 500,000 pesos 3. Sell the pesos at
June 17. @ $.09/peso on the locked-in rate.
3. Sell the pesos to
fulfill contract. June 17.
Gain $5,000.
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Madura: International Financial Management Chapter 5

Closing out a futures positions Currency Futures Market

• Holders of futures contracts can close out • Most currency futures contracts are
their positions by selling similar futures closed out before their settlement dates.
contracts. Sellers may also close out their • Brokers who fulfill orders to buy or sell
positions by purchasing similar contracts. futures contracts earn a transaction or
January 10 February 15 March 19 brokerage fee in the form of the bid/ask
1. Contract to 2. Contract to 3. Incurs $3000 spread.
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 19. March 19. contracts.
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Currency Options Market

• A currency options is a contract that
allows the holder of the contract the right
to buy or sell a specific currency at a
designated price within a range of time
period.
• Offered by both currency exchange and
commercial banks.
• The number of units, desired strike price
and expiration dates can be tailored as per
requirements of the clients.
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When to use the options
• If the Spot rate of the desired currency
rises above the Strike price or Exercise
price, the holder will use the options.
• Exercise price is the exchange rate at
which the holder of the options is
allowed to buy or sell the currency.
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Types of currency options Currency Call Options

• Currency calls options. • A currency call option grants the holder

the right to buy a specific currency at a
• Currency puts options. 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.
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Madura: International Financial Management Chapter 5

Currency Call Options MNCs and Currency Call Options

• Option owners can sell or exercise their
options. They can also choose to let their
options expire. At most, they will lose the
premiums they paid for their 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.
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• Firms with open positions in foreign
currencies may use currency call options
to cover those positions.
• They may purchase currency call options
¤ to hedge future payables;
¤ to hedge potential expenses when bidding
on projects; and
¤ to hedge potential costs when attempting
to acquire other firms.
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Speculations in Currency Call Currency Call Options

Options BreakEven
• Speculators who expect a foreign • The purchaser of a call option will break
currency to appreciate can purchase call even when
options on that currency. selling price = buying (strike) price
¤ Profit = selling price – buying (strike) price + option premium
– option premium • The seller (writer) of a call option will
• They may also sell (write) call options on a break even when
currency that they expect to depreciate. buying price = selling (strike) price
¤ Profit = option premium – buying price + option premium
+ selling (strike) price
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Currency Put Options 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.
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• 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.
• Corporations with open foreign currency
positions may use currency put options to
cover their positions.
¤ For example, firms may purchase put
options to hedge future receivables.
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Madura: International Financial Management
Currency Put Options
• Speculators who expect a foreign
currency to depreciate can purchase put
options on that currency.
¤ Profit = selling (strike) price – buying price
– option premium
• They may also sell (write) put options on a
currency that they expect to appreciate.
¤ Profit = option premium + selling price
– buying (strike) price
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South-Western/Thomson Learning © 2003
Chapter 5
Currency Put Options
• 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, or if it
moves in one direction followed by the
other.
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