Chapter 8

Foreign Currency Derivatives

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Foreign Currency Derivatives
• Financial management of the MNE 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
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Foreign Currency Derivatives
• Derivatives are used by firms to achieve one of more of the following individual benefits:
– Permit firms to achieve payoffs that they would not be able to achieve without derivatives, or could achieve only at greater cost – Hedge risks that otherwise would not be possible to hedge – Make underlying markets more efficient – Reduce volatility of stock returns – Minimize earnings volatility – Reduce tax liabilities – Motivate management (agency theory effect)

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Foreign Currency Futures
• A foreign currency futures contract is an alternative to a forward contract that calls for future delivery of a standard amount of foreign exchange at a fixed time, place and price. • It is similar to futures contracts that exist for commodities such as cattle, lumber, interestbearing deposits, gold, etc. • In the US, the most important market for foreign currency futures is the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange.

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8-5 .Foreign Currency Futures • Contract specifications are established by the exchange on which futures are traded. • Major features that are standardized are: – Contract size – Method of stating exchange rates – Maturity date – Last trading day – Collateral and maintenance margins – Settlement – Commissions – Use of a clearinghouse as a counterparty Copyright © 2010 Pearson Prentice Hall. All rights reserved.

8-6 . All rights reserved.Foreign Currency Futures • Foreign currency futures contracts differ from forward contracts in a number of important ways: – Futures are standardized in terms of size while forwards can be customized – Futures have fixed maturities while forwards can have any maturity (both typically have maturities of one year or less) – Trading on futures occurs on organized exchanges while forwards are traded between individuals and banks – Futures have an initial margin that is market to market on a daily basis while only a bank relationship is needed for a forward – Futures are rarely delivered upon (settled) while forwards are normally delivered upon (settled) Copyright © 2010 Pearson Prentice Hall.

to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period (until the maturity date). but not the obligation. – A call is an option to buy foreign currency – A put is an option to sell foreign currency 8-7 Copyright © 2010 Pearson Prentice Hall. . • There are two basic types of options. puts and calls. All rights reserved.Foreign Currency Options • A foreign currency option is a contract giving the option purchaser (the buyer) the right.

• Every option has three different price elements: – The exercise or strike price – the exchange rate at which the foreign currency can be purchased (call) or sold (put) – The premium – the cost. while the seller of the option is referred to as the writer or grantor. All rights reserved.Foreign Currency Options • The buyer of an option is termed the holder. or value of the option itself – The underlying or actual spot exchange rate in the market Copyright © 2010 Pearson Prentice Hall. price. 8-8 .

• The premium. . not before. or option price. All rights reserved. is the cost of the option.Foreign Currency Options • An American option gives the buyer the right to exercise the option at any time between the date of writing and the expiration or maturity date. • A European option can be exercised only on its expiration date. 8-9 Copyright © 2010 Pearson Prentice Hall.

Foreign Currency Options • An option whose exercise price is the same as the spot price of the underlying currency is said to be at-the-money (ATM). if exercised immediately is referred to as out-of-the money (OTM) 8-10 Copyright © 2010 Pearson Prentice Hall. . All rights reserved. again excluding the cost of the premium. • An option the would be profitable. excluding the cost of the premium. if exercised immediately is said to be in-the-money (ITM). • An option that would not be profitable.

• Options on organized exchanges are standardized.Foreign Currency Options • In the past three decades. but counterparty risk is substantially reduced. All rights reserved. the use of foreign currency options as a hedging tool and for speculative purposes has blossomed into a major foreign exchange activity. Copyright © 2010 Pearson Prentice Hall. • Options on the over-the-counter (OTC) market can be tailored to the specific needs of the firm but can expose the firm to counterparty risk. 8-11 .

8-12 .Foreign Currency Speculation • Speculation is an attempt to profit by trading on expectations about prices in the future. • Speculators can attempt to profit in the: – Spot market – when the speculator believes the foreign currency will appreciate in value – Forward market – when the speculator believes the spot price at some future date will differ from today’s forward price for the same date – Options markets – extensive differences in risk patters produced depending on purchase or sale of put and/or call Copyright © 2010 Pearson Prentice Hall. All rights reserved.

005/SF – At all spot rates below the strike price of 58. purchase SF at the strike price and sell them into the market netting a profit (less the option premium) Copyright © 2010 Pearson Prentice Hall.5850/SF). All rights reserved. the option purchaser would exercise the option.5. 8-13 . and a premium of $0.Option Market Speculation • Buyer of a call: – Assume purchase of August call option on Swiss francs with strike price of 58½ ($0. the purchase of the option would choose not to exercise because it would be cheaper to purchase SF on the open market – At all spot rates above the strike price.

the writer would now have to buy the currency at the spot and take the loss delivering at the strike price – The amount of such a loss is unlimited and increases as the underlying currency rises – Even if the writer already owns the currency. All rights reserved.Option Market Speculation • Writer of a call: – What the holder. or buyer of an option loses. the writer gains – The maximum profit that the writer of the call option can make is limited to the premium – If the writer wrote the option naked. that is without owning the currency. the writer will experience an opportunity loss 8-14 Copyright © 2010 Pearson Prentice Hall. .

Option Market Speculation • Buyer of a Put: – The basic terms of this example are similar to those just illustrated with the call – The buyer of a put option.585/SF – At any exchange rate above the strike price of 58.5. wants to be able to sell the underlying currency at the exercise price when the market price of that currency drops (not rises as in the case of the call option) – If the spot price drops to $0.05/SF premium – The buyer of a put (like the buyer of the call) can never lose more than the premium paid up front Copyright © 2010 Pearson Prentice Hall. the buyer of the put will deliver francs to the writer and receive $0. however. 8-15 .575/SF. All rights reserved. and would lose only the $0. the buyer of the put would not exercise the option.

5 cents per franc.5 cents per franc. 8-16 . the option will not be exercised and the option writer will pocket the entire premium Copyright © 2010 Pearson Prentice Hall. if the spot price of francs drops below 58. the writer will lose more than the premium received fro writing the option (falling below break-even) – If the spot price is above $0. All rights reserved.585/SF. the option will be exercised – Below a price of 58.Option Market Speculation • Seller (writer) of a put: – In this case.

8-17 . All rights reserved.Option Pricing and Valuation • The pricing of any currency option combines six elements: – Present spot rate – Time to maturity – Forward rate for matching maturity – US dollar interest rate – Foreign currency interest rate – Volatility (standard deviation of daily spot price movements) Copyright © 2010 Pearson Prentice Hall.

the spot rate. • Intrinsic value is the financial gain if the option is exercised immediately.Option Pricing and Valuation • The total value (premium) of an option is equal to the intrinsic value plus time value. can potentially move further and further into the money between the present time and the option’s expiration date. Copyright © 2010 Pearson Prentice Hall. intrinsic value is zero when the strike price is above the market price – When the spot price rises above the strike price. the intrinsic value become positive – Put options behave in the opposite manner – On the date of maturity. – For a call option. 8-18 . All rights reserved. an option will have a value equal to its intrinsic value (zero time remaining means zero time value) • The time value of an option exists because the price of the underlying currency.

8-19 . All rights reserved. the individual trader needs to know how option values – premiums – react to their various components. either for the purposes of speculation or risk management. Copyright © 2010 Pearson Prentice Hall.Currency Option Pricing Sensitivity • If currency options are to be used effectively.

8-20 . it is simply a result of the arbitrage-pricing structure of options Copyright © 2010 Pearson Prentice Hall.Currency Option Pricing Sensitivity • Forward rate sensitivity: – Standard foreign currency options are priced around the forward rate because the current spot rate and both the domestic and foreign interest rates are included in the option premium calculation – The option-pricing formula calculates a subjective probability distribution centered on the forward rate – This approach does not mean that the market expects the forward rate to be equal to the future spot rate. All rights reserved.

All rights reserved. the greater the probability of the option expiring in-the-money Copyright © 2010 Pearson Prentice Hall.Currency Option Pricing Sensitivity • Spot rate sensitivity (delta): – The sensitivity of the option premium to a small change in the spot exchange rate is called the delta Δ premium delta = Δ spot rate – The higher the delta. 8-21 .

.Currency Option Pricing Sensitivity • Time to maturity – value and deterioration (theta): – Option values increase with the length of time to maturity Δ premium theta = Δ time – A trader will normally find longer-maturity option better values. giving the trader the ability to alter an option position without suffering significant time value deterioration 8-22 Copyright © 2010 Pearson Prentice Hall. All rights reserved.

All rights reserved.Exhibit 8. 8-23 .11 Theta: Option Premium Time Value Deterioration Copyright © 2010 Pearson Prentice Hall.

All rights reserved. 8-24 .Currency Option Pricing Sensitivity • Sensitivity to volatility (lambda): – Option volatility is defined as the standard deviation of daily percentage changes in the underlying exchange rate – Volatility is important to option value because of an exchange rate’s perceived likelihood to move either into or out of the range in which the option will be exercised lambda = Δ premium Δ volatility Copyright © 2010 Pearson Prentice Hall.

Currency Option Pricing Sensitivity • Volatility is viewed in three ways: – Historic – Forward-looking – Implied • Because volatilities are the only judgmental component that the option writer contributes. the truly talented option writers are those with the intuition and insight to price the future effectively. All rights reserved. • All currency pairs have historical series that contribute to the formation of the expectations of option writers. 8-25 Copyright © 2010 Pearson Prentice Hall. causing option premiums to fall. hoping to buy them back for a profit immediately volatilities fall. • In the end. • Traders who believe that volatilities will fall significantly in the near-term will sell (write) options now. . they play a critical role in the pricing of options.

All rights reserved. This timing will allow the trader to purchase the option before its price increases.Currency Option Pricing Sensitivity • Sensitivity to changing interest rate differentials (rho and phi): – Currency option prices and values are focused on the forward rate – The forward rate is in turn based on the theory of Interest Rate Parity – Interest rate changes in either currency will alter the forward rate. Copyright © 2010 Pearson Prentice Hall. which in turn will alter the option’s premium or value • A trader who is purchasing a call option on foreign currency should do so before the domestic interest rate rises. 8-26 .

8-27 . All rights reserved. Δ premium rho = Δ US $ interest rate • The expected change in the option premium from a small change in the foreign interest rate (foreign currency) is termed phi. Δ premium phi = Δ foreign interest rate Copyright © 2010 Pearson Prentice Hall.Currency Option Pricing Sensitivity • The expected change in the option premium from a small change in the domestic interest rate (home currency) is the term rho.

Exhibit 8. 8-28 .13 Interest Differentials and Call Option Premiums Copyright © 2010 Pearson Prentice Hall. All rights reserved.

All rights reserved. 8-29 Copyright © 2010 Pearson Prentice Hall. • A firm must make a choice as per the strike price it wishes to use in constructing an option (OTC market). • Consideration must be given to the tradeoff between strike prices and premiums. .Currency Option Pricing Sensitivity • The sixth and final element that is important to option valuation is the selection of the actual strike price.

8-30 . All rights reserved.14 Option Premiums for Alternative Strike Rates Copyright © 2010 Pearson Prentice Hall.Exhibit 8.

8-31 . All rights reserved.Exhibit 8.15 Summary of Option Premium Components Copyright © 2010 Pearson Prentice Hall.

All rights reserved. what does Warren Buffett seem to fear most about financial derivatives? • In his 2007 letter to shareholders. what does Warren Buffett admit that he and Charlie had done? • Do you think there is an underlying consistency in his viewpoint on the proper use of derivatives? 8-32 Copyright © 2010 Pearson Prentice Hall.Mini-Case Questions: Warren Buffett’s Love-Hate Relationship with Derivatives • In his 2002 letter to shareholders. .

All rights reserved. .Chapter 8 Additional Chapter Exhibits Copyright © 2010 Pearson Prentice Hall.

Exhibit 8. US$/Peso (CME) Copyright © 2010 Pearson Prentice Hall.1 Mexican Peso Futures. All rights reserved. 8-34 .

All rights reserved. 8-35 .2 Currency Futures and Forwards Compared Copyright © 2010 Pearson Prentice Hall.Exhibit 8.

Exhibit 8. cents/SF) Copyright © 2010 Pearson Prentice Hall.S.3 Swiss Franc Option Quotations (U. 8-36 . All rights reserved.

8-37 .Exhibit 8.4 Buying a Call Option on Swiss Francs Copyright © 2010 Pearson Prentice Hall. All rights reserved.

All rights reserved. 8-38 .Exhibit 8.5 Selling a Call Option on Swiss Francs Copyright © 2010 Pearson Prentice Hall.

Exhibit 8.6 Buying a Put Option on Swiss Francs Copyright © 2010 Pearson Prentice Hall. 8-39 . All rights reserved.

All rights reserved. 8-40 .7 Selling a Put Option on Swiss Francs Copyright © 2010 Pearson Prentice Hall.Exhibit 8.

Exhibit 8.8 Analysis of Call Option on British Pounds with a Strike Price = $1.70/£ Copyright © 2010 Pearson Prentice Hall. All rights reserved. 8-41 .

and Total Value Components of the 90-Day Call Option on British Pounds at Varying Spot Exchange Rates Copyright © 2010 Pearson Prentice Hall. 8-42 .9 The Intrinsic. All rights reserved. Time.Exhibit 8.

8-43 .10 Decomposing Call Option Premiums: Intrinsic Value and Time Value Copyright © 2010 Pearson Prentice Hall.Exhibit 8. All rights reserved.

12 Foreign Exchange Implied Volatility for Foreign Currency Options. 8-44 .Exhibit 8. 2008 Copyright © 2010 Pearson Prentice Hall. January 30. All rights reserved.