FACULTY OF FINANCE & BANKING

Chapter 3
Hedging Exchange Rate Risk with
Derivatives
INTERNATIONAL FINANCE
 CHAPTER OBJECTIVES

• To explain how forward contracts are used for

hedging based on anticipated exchange rate
movements; and
• To explain how currency futures contracts and
currency options contracts are used for hedging or
speculation based on anticipated exchange rate
movements.

2
 CHAPTER CONTENTS

1. Currency Spot Market

2. Currency Forward Market
3. Currency Futures Market
4. Currency Options Market

3
1. SPOT MARET

Spot contract

A currency spot contract is a contract of buying or selling a

currency for immediate settlement (payment and delivery) on
the spot date, which is normally two business days after the
trade date.
1. SPOT MARET

➢Trade date that records and initiates the transaction, is when an

investor initiates a buy or sell order. It is the point to determine the
currency spot rate, the currency amount, and the settlement date.

➢Settlement date/Value date refers to the date on which a financial

transaction, such as a purchase or sale of currency, is finalized. It is
the point at which the contractual obligations between the buyer and
seller are fulfilled. The buyer must make payment to the seller and
the seller transfers currency to the buyer.
1. SPOT MARET
Some special cases for spot transactions:
✓Transaction date = Settlement date
TOD = T
✓Settlement date of one business day after the transaction
date
TOM = T+1
✓Settlement date of two business days after the
transaction date
SPOT/NEXT = T+2
1. SPOT MARET

1. SPOT MARET
2. FORWARD MARKET

Forward contract
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.

8
2. FORWARD MARKET

Forward contract

2nd 3rd 4th

FORWARD
October October October
T T+1 T+2 3 to 365 days

9
2. FORWARD MARKET
How MNCs use Forward Contracts
When MNCs anticipate future needs or future receipt of a
foreign currency, they set up forward contracts to lock in
the exchange rate.
▪ If MNCs have future needs → they set up forward
contracts to buy foreign currency
▪ If MNCs have future receipts → they set up forward
contracts to sell foreign currency
10
2. FORWARD MARKET

Bid/ask spread of Forward rate

Bid rate: FB Ask rate: FO

Bid/ask spread = Ask rate – Bid rate = FO – FB

% Bid/ask spread = (Ask rate – Bid rate)/ Ask rate = (FO – FB)/FO

11
2. FORWARD MARKET

Premium or Discount on the Forward Rate

F = S (1+p)
p = F/S - 1
¤ If F > S → p > 0: Forward premium.
¤ If F < S → p < 0: Forward discount.

12
2. FORWARD MARKET

Premium or Discount on the Forward Rate

p = F–S x 360
S n
where n is the number of days to maturity

6
2. FORWARD MARKET

Premium or Discount on the Forward Rate

Type of exchange rate USD/VND Forward premium/discount

Spot rate 24.600

30-days forward rate 25.000

90-days forward rate 24.800

180- days forward rate 24.000

14
2. FORWARD MARKET

Forward points
Forward points (P) are the number of basis
points/pips added to or subtracted from the current spot
rate to determine the forward rate.
Forward rate = Spot rate +/- Forward points
F = S +/- P

15
2. FORWARD MARKET

When forward points are

added to or subtracted from
the spot rate?

16
2. FORWARD MARKET

Forward points

F=S+P
Bid forward point < Ask forward point

F=S-P
Bid forward point > Ask forward point

17
2. FORWARD MARKET
Forward points
S (GBP/USD) = 1.6770 - 1.6810

Maturity Forward point Forward rate

3 months 42-44
6 months 85-88
9 months 44-42
12 months 88-85
18
2. FORWARD MARKET

Offsetting a Forward Contract

1. Cancellation

2. Extension

19
2. FORWARD MARKET

Cancellation
ABC imports goods from the U.S. firm so it has a
future receipt. ABC set up a forward contract to buy
1mio USD. However, the U.S. firm cannot execute the
contract as negotiating → ABC no longer needed to
buy USD; and requested the bank to cancel the
Forward contract.
20
 2. FORWARD MARKET

Cancellation
1. Suppose the Forward contract is executed as
negotiating.
2. To cancel the old contract, ABC booked an opposite
deal at the spot rate on the cancelation date.
3. Determine the profit/loss arising from the difference
between the forward rate and the spot rate.
21
 2. FORWARD MARKET

Cancellation
1. Suppose to execute the forward contract
ABC set up a forward contract to buy 1mio USD at a forward
rate of F(USD/VND) = 21,268. On 25 Sep 2023, ABC must pay:
1,000,000 * 21,268 = 21,268,000,000 VND

At maturity: S (USD/VND) = 21,258 - 21,260

22
 2. FORWARD MARKET

Cancellation
2. Book an opposite deal at a spot rate to cancel the old
contract
On 25 Sep 2023, ABC sold 1mio USD at the bid spot rate of
21,258 and received:
1,000,000 *21,258 = 21,258,000,000 VND

23
 2. FORWARD MARKET

Cancellation
3. Calculate the profit/loss arising from the difference in the
exchange rate
Changes in the exchange rate make the bank get a loss:
21,268,000,000 – 21,258,000,000 = 10,000,000 VND

→ ABC must pay VND10,000,000 to cancel the old deal.

24
2. FORWARD MARKET

Extension
ABC imports goods from the U.S. firm so it has a
future receipt. ABC set up a forward contract to buy
1mio USD. However, the U.S. firm delivered goods 1
month late → ABC needs to buy USD after 1 month;
and requested the bank to extent the Forward contract.

25
 2. FORWARD MARKET
Extension
1. Suppose the Forward contract is executed as negotiating.
2. Book the opposite deal at the spot rate to cancel the old
contract
3. Set up a new one-month forward contract by using the spot
rate and 1mth forward point
4. Determine the profit/loss arising from the difference between
the forward rate and the spot rate.
26
 2. FORWARD MARKET

Extension
1. Suppose to execute the forward contract
ABC set up a forward contract to buy 1mio USD at a forward
rate of F(USD/VND) = 21,268. On 25 Sep 2023, ABC must pay:
1,000,000 * 21,268 = 21,268,000,000 VND

At maturity: S (USD/VND) = 21,259 - 21,261

1-month Forward points = 81 - 90
27
 2. FORWARD MARKET

Extension
2. Book an opposite deal at a spot rate to cancel the old
contract
On 25 Sep 2023, ABC sold 1mio USD at the bid spot rate of
21,259 and received:
1,000,000 *21,259 = 21,259,000,000 VND

28
 2. FORWARD MARKET

Extension
3. Set up a new one-month forward contract

On 25 Sep 2023, ABC set up a new forward contract to buy

1mio USD at a forward rate of 21,351 (= 21,261 + 90)
On 25 Jan 2022, to buy 1mio USD, ABC will pay:
1,000,000 * 21,351 = 21,351,000,000 VND

29
 2. FORWARD MARKET
Extension
4. Calculate the profit/loss arising from the difference in
the exchange rate
Changes in the exchange rate make the bank get a loss:
21,268,000,000 – 21,259,000,000 = 9,000,000 VND
→ ABC must pay VND9,000,000 to cancel the old deal.
The total cost that ABC must pay for the extension is:
9,000,000 + 21,351,000,000 = 21,360,000,000 VND
30
 2. FORWARD MARKET
Exercise 1
XYZ company exporting goods to Australia will receive 500,000 AUD
in the next 3 months. To hedge exchange rate risk, XYZ sets up a 3-
month forward contract to sell AUD to the bank.
Today is 1st May, the spot rate is 16.750-16.810
Solve the Forward contract for cancellation, and extension
-On 1st Jul, S(AUD/VND): 16.950-17.080
-On 1st Aug, S(AUD/VND): 17.150-17.210
-1- month forward points is 35-50
-3-month forward points is 80-105.
31
 2. FORWARD MARKET
Exercise 2
Thang Loi JSC importing goods from Germany will pay 800.000€ in the
next 3 months. The firm sets up a 3-month forward contract to buy
800,000€.
Today is 1st June, the current spot rate is 28.150-28.280
Offset the forward contract for cancellation, and extension.
-On 1st Aug, S(EUR/VND): 28,080 – 28,110
-On 1st Sep, S(EUR/VND): 27,950 - 28,050
-1- month forward points is 60-90
-3- months forward points is 150-180
37
2. FORWARD MARKET

Non-deliverable forward contract _ NDF

A non-deliverable forward contract (NDF) is a
forward contract whereby there is no actual exchange
of currencies at the future date.
Instead, a net payment is made by one party to the
other based on the contracted rate and the exchange
rate at the settlement date.
38
3. FUTURES MARKET

Currency future contracts specify a standard volume of a

particular currency to be exchanged on a specific settlement
date.

• They are used by MNCs to hedge exchange rate risk,

and by speculators who hope to capitalize on their
expectations of exchange rate movements
39
3. FUTURES MARKET
Future contract Specifications
1. Marketplace
The contracts can be traded by firms or individuals through the
brokers on the central exchange floor with global
communications:
- Chicago Mercantile Exchange _CME
- London International Financial Futures Exchange
- Tokyo International Financial Futures Exchange
- Singapore International Monetary Exchange 40
3. FUTURES MARKET

Future contract Specifications

2. Currency
Currency futures commonly are strong currencies.
3. Contract size
Each contract specifies a standardized number of units to be
delivered under one contract.
4. Delivery date
Specify the third Wednesdays in March, June, September, and
December.
41
3. FUTURES MARKET
Future contract Specifications

42
3. FUTURES MARKET
Future contract Specifications
Contract size/Trading unit EURO 125.000
Price Quote USD per EURO
Minimum Price Fluctuation 0.0001
Delivery months Mar, Jun, Sep, Dec
Trading hours 7.20 am – 2.pm
Last day 7.20 pm – 9.16 am
Last day of trading Two business days before the Third Wednesday
of the contract month
Delivery date Third Wednesday of the contract month
43
3. FUTURES MARKET
Future contract Specifications
5. Exchange Clearinghouse
A clearinghouse is an intermediary between a buyer and a seller
in a financial market. It validates and finalizes the transaction,
ensuring that both the buyer and the seller honor their contractual
obligations.

To mitigate default risk in futures trading, clearinghouses impose

margin requirements.
44
3. FUTURES MARKET
Future contract Specifications
5. Exchange Clearinghouse

45
3. FUTURES MARKET
Margin Requirements
• Initial Margin
- This is the initial amount of money that a trader must place in an
account to open a futures position
- The initial margin is established by the exchange and is a percentage
of the value of a future contract (3-4%).
• Maintenance Margin
- Maintenance Margin < Initial Margin
- This is the minimum amount that a trader must maintain in the
account at any given time. 46
3. FUTURES MARKET
Margin Requirements

•Margin call
If the funds in the margin account fall below a maintenance
margin, additional funds must be deposited immediately to bring
the account back up to the initial margin. The process is known as
margin call.

47
3. FUTURES MARKET
Mark to Market _ MTM
•All futures traders’ positions are marked to market on a daily
basis.
•Every day, the difference between the previous closing price and
the current closing price is added or deducted from the trader’s
margin account.
•Losses will reduce the margin account and profits will increase
the margin account.

48
 3. FUTURES MARKET

Mark to
Market
_ MTM

49
3. FUTURES MARKET
Mark to Market _ MTM
Exercise 1
On 1st July, a trader set up a future contract to purchase GBP at an
exchange rate of $1.52/GBP.
•Initial margin is $2,000
•Maintenance margin level is $1,500
•Contract size is 62,500 GBP

50
 3. FUTURES MARKET
Mark to Market _ MTM
Date Settlement Contract MTM Account Call
price Value (Profit/ Loss) Balance Margin

1/7 1.5200

At the end of 1/7 1.5400

At the end of 2/7 1.5240

At the end of 3/7 1.4900

At the end of 4/7 1.5150

51
3. FUTURES MARKET
Pricing Currency Futures
The price of a currency futures contract is like the forward rate for a
given currency and settlement date.
Example:
- Currency futures price on GBP is $1.7
- Currency forward rate on GBP is $1.68
→ Firms can purchase forward contracts at a forward rate of $1.68
and sell futures contracts at $1.7 at the same settlement date.
→ On the settlement date of two contracts, firms can get profits of
$0.02
55
3. FUTURES MARKET
How Firms Use Currency Futures

❖ Purchasing Futures to hedge payables

4th June 17th September

1. Anticipate to pay 500,000 2. Buy the pesos at the
pesos. Contract to buy locked-in rate.
500,000 pesos at $0.09/peso 3. Pay 500,000 pesos
on September 17th.

56
3. FUTURES MARKET
How Firms Use Currency Futures

❖ Selling Futures to hedge receivables

4th June 17th September

1. Expect to receive 500,000 2. Receive 450,000$
pesos. Contract to sell
500,000 pesos at $0.09/peso 3. Sell the pesos at the
on September 17th. locked-in rate.

57
3. FUTURES MARKET
How Firms Use Currency Futures

❖ Purchasing Futures to speculate on currency to appreciate

4th June 17th September

1. Set up a Future contract 2. Buy the pesos to fulfill
to buy 500,000 pesos at future contract.
$0.09/peso on September 3. Sell 500,000 pesos at a spot
17th. rate of $0.1/peso and receive
$50,000.
Gain $5,000
58
3. FUTURES MARKET
How Firms Use Currency Futures
❖ Selling Futures to speculate on currency to depreciate
4th June
1. Set up a Future contract to
sell 500,000 pesos at
$0.09/peso on September
17th.
17th September
2. Buy 500,000 pesos at a spot
rate of $0.08/peso & pay
$40,000.
3. Sell the pesos to fulfill future
contract & receive $45,000
Gain $5,000
59
3. FUTURES MARKET
Closing Out A Futures Position
• 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.
• Buyers of futures contracts can close out their positions by
selling similar futures contracts. Sellers may close out
their positions by purchasing similar contracts.
60
 Closing Out A Futures Position
• On 10th Jan, ABC firm anticipates a payable of AUD on
19th Mar. ABC set up a futures contract to buy A$100,000
3. FUTURES MARKET at a price of $0.53/AUD. On 15th Feb, ABC realized that
it had no need for AUD in March. To close out this
futures position, ABC sells a futures contract on AUD at
the settlement date.

61
4. OPTIONS MARKET
Option contract

A currency option is a contract that gives the buyer the right,

but not the obligation, to buy or sell a certain currency at a
specified exchange rate on or before a specified date.

For this right, the buyer must pay a premium (C) to the seller
62
4. OPTIONS MARKET

Option contract
• The standard options that are traded on an exchange through
brokers are guaranteed but require margin maintenance.
• In addition to the exchanges, there is an over-the-counter
(OTC) market where commercial banks and brokerage firms
offer customized currency options.
• There are no credit guarantees for these OTC options, so some
form of collateral may be required.
23
4. OPTIONS MARKET
Option Contract

Currency
Options

Call Put
Options Options
 Currency Call Options

A currency call option grants the right to buy a

specific currency at a designated price (called the
exercise or strike price) within a specific period of
time.

65
 Currency Call Options

THE BUYER
THE SELLER
- Have the right to buy or not - Have to sell the currency if the
buy the currency buyer executes the call option.

Premium

66
 Currency Call Options
A firm anticipates the need for USD to import goods. It establishes
to purchase currency call options at a strike price of 1.45
USD/GBP
On the expiration date, the spot rate fluctuates as follows:
The spot rate S(USD/GBP) = 1.5
The spot rate S(USD/GBP) = 1.45
The spot rate S(USD/GBP) = 1.3
How will the firm decide? Does it execute the option contract or
not? 67
 Currency Call Options
Currency call
options

Spot rate > strike Spot rate < strike Spot rate = strike
price →The buyers price →The buyers price →The buyers
execute the right don’t execute the can do or not do
(get profit) right (get loss) (get break-even)

Out of the money – At the money -

In the money - ITM
OTM ATM
68
 Currency Call Options
Factors Affecting Currency Call Option Premiums
The premium on a call option represents the cost of having the right to buy the
underlying currency at a specified price.

Spot rate relative to Length of time before Potential variability of

strike price the expiration date currency
The larger the spot rate The longer the time to The greater the
relative to the strike expiration date, the variability of currency,
price, the higher the higher the option price the higher the option
option price will be will be price will be
69
 Currency Call Options

How firms use currency call options

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.
70
 Currency Call Options
Speculating with currency call options
• Speculators will purchase call options on a currency that they
expect to appreciate.
Profit = Selling price (spot rate) – Buying (strike) price – Option
premium

• Speculators may sell call options on a currency that they expect to

depreciate.
Profit = Option premium – Buying price (spot rate) + Selling
(strike) price
 Currency Call Options

Speculating with currency call options

Example
A speculator buys a GBP call option at a strike price of $1.35.
On the expiration date, the current spot rate is $1.43/GBP
The premium is $0.012 per unit
Call option contract size: 31,250 GBP
 Currency Call Options

Break-Event point from Speculation

• The buyer of a call option will break even when

Selling price = Buying price (strike price) + Option premium

• The seller of a call option will break even when

Buying price = Selling price (strike price) + Option premium
 Currency Put Options

A currency put option grants the right to sell a

specific currency at a designated price (called the
exercise or strike price) within a specific period of
time.

76
 Currency Put Options

THE BUYER
THE SELLER
- Have the right to sell or not - Have to buy the currency if the
sell the currency buyer executes the put option.

Premium

77
 Currency Put Options
A firm anticipates the receivable USD from export goods. It
establishes to purchase currency put options at a strike price of 1.45
USD/GBP
On the expiration date, the spot rate fluctuates as follows:
The spot rate S(USD/GBP) = 1.5
The spot rate S(USD/GBP) = 1.45
The spot rate S(USD/GBP) = 1.3
How will the firm decide? Does it execute the option contract or
not? 78
 Currency Put Options
Currency put
options

Spot rate < strike Spot rate > strike Spot rate = strike
price →The buyers price →The buyers price →The buyers
execute the right don’t execute the can do or not do
(get profit) right (get loss) (get break-even)

Out of the money – At the money -

In the money - ITM
OTM ATM
79
 Currency Put Options
Factors Affecting Currency Put Option Premiums
The premium on a put option represents the cost of having the right to sell the
underlying currency at a specified price.

Spot rate relative to Length of time before Potential variability of

strike price the expiration date currency
The larger the spot rate The longer the time to The greater the
relative to the strike expiration date, the variability of currency,
price, the higher the higher the option price the higher the option
option price will be will be price will be
80
 Currency Put Options

How firms use currency put options

Firms with open positions in foreign currencies may use
currency put options to cover those positions.
They may purchase currency put options
¤ to hedge future receivables;

81
 Currency Put Options
Speculating with currency put options
• Speculators will purchase put options on a currency that they
expect to depreciate.
Profit = Selling (strike) price – Buying price (spot rate) – Option
premium

• Speculators may sell put options on a currency that they expect to

appreciate.
Profit = Option premium – Buying (strike) price + Selling price
(spot rate)
 Currency Put Options

Speculating with currency call options

Example
A speculator buys a GBP put option at a strike price of $1.35.
On the expiration date, the current spot rate is $1.23/GBP
The premium is $0.01 per unit
Call option contract size: 31,250 GBP
Contingency Graphs for Currency Options
Long Short
position – position –
Purchase Sell
currency currency
call call
options options
currency currency
put put
options options
 Contingency Graphs For Currency Options
For long position

34
 Contingency Graphs For Currency Options
For short position

34
 Conditional Currency Options

A basic put option on

GBP at the strike price of • GBP’s value < $1.70→ exercise put
option to receive $1.70 and paid the
$1.70 and the premium premium of $0.02.
of $0.02

• GBP’s value < $1.70 → exercise put option to

A conditional put option receive $1.7 and not to pay the premium
on GBP at the strike • $1.70 < GBP’s value < $1.74 → do not
price of $1.70, and a exercise put option and not to pay the premium
• GBP’s value > $1.74 → do not exercise put
trigger of $1.74. option but pay the premium $0.04

89
 Conditional Currency Options
Option Type Exercise Price Trigger Premium
Basic put $1.70 - $0.02
Conditional put $1.70 $1.74 $0.04
$1.78 Basic
Net Amount Received

$1.76 Put
$1.74
Conditional Conditional
$1.72 Put
Put
$1.70
$1.68
$1.66
Spot
Rate
$1.66 $1.70 $1.74 $1.78 $1.82
90
 Conditional Currency Options

• Similarly, a conditional call option on £ may specify an

exercise price of $1.70 and a trigger of $1.67. 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.

91