Currency Derivatives

Chapter 5

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Chapter Objectives
This chapter will:
A. Explain how forward contracts are used to hedge
based on anticipated exchange rate movements
B. Describe how currency futures contracts are used
to speculate or hedge based on anticipated
exchange rate movements
C. Explain how currency option contracts are used to
speculate or hedge based on anticipated exchange
rate movements

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What is a Currency Derivative?
1. A currency derivative is a contract whose price is
derived from the value of an underlying currency
2. Examples include forwards/futures contracts and
options contracts.
3. Derivatives are used by MNCs to:
a. Speculate on future exchange rate movements
b. Hedge exposure to exchange rate risk

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Forward Market
1. Agreement between a corporation and a
financial institution
2. To exchange a specified amount of
currency
3. At a specified exchange rate (called the
forward rate)
4. On a specified date in the future

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How MNCs Use Forward Contracts
1. Hedge their imports by locking in the rate at
which they can obtain the currency needed to
purchase imports
2. Bid/Ask Spread is wider for less liquid currencies
3. May negotiate an offsetting trade if an MNC
enters into a forward sale and a forward
purchase with the same bank
4. Non-deliverable forward contracts (NDF) can be
used for emerging market currencies where no
currency delivery takes place at settlement,
instead one party makes a payment to the other
party

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Premium or Discount on the Forward
Rate
F = S(1 + p)
where:
F is the forward rate
S is the spot rate
p is the percentage by which the forward rate exceeds the
spot rate.

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Currency Futures Market
1. Similar to forward contracts in terms of obligation
to purchase or sell currency on a specific
settlement date in the future
2. Differ from forward contracts because futures
have standard contract specifications:
a. Standardized number of units per contract
b. Offer greater liquidity than forward contracts
c. Typically based on U.S. dollar, but may be offered on
cross-rates
d. Commonly traded on the Chicago Mercantile Exchange
(CME)

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Exhibit 5.3 Comparison of the
Forward and Futures Market

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How Firms Use Currency Futures
1. Purchasing futures to hedge payables
2. Selling futures to hedge receivables

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Exhibit 5.5 Source of Gains from
Buying Currency Futures

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Closing out a Futures position
 A firm can close out its position on Futures
contract
 If the firm buys the futures contract, it can

close out its position by selling the same

futures contract and vice versa
 Refer to example p. 126 (Tacoma company)

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Currency Options
1. Options Exchanges or over-the-counter
market
2. European or American options
3. Barrier, exotic, vanilla
4. The option price depends on: current spot
price, strike price, the interest rate, time to
maturity, volatility of the underlying
security’s price over the life of the option

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Currency Call Options
1. Grants the right to buy currency at a
designated exercise (strike) price
2. If the spot rate rises above the strike price, the
owner of a call can exercise the right to buy
currency at the strike price
3. The buyer of the options pays a premium
4. If the spot exchange rate is greater than the
strike price, the option is in the money. If the
spot rate is equal to the strike price, the option
is at the money. If the spot rate is lower than
the strike price, the option is out of the money

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Factors Affecting Currency Call
Option Premiums
1. Spot price relative to the strike price
2. Length of time before expiration
3. Potential variability of currency

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How Firms Use Currency Call Options
1. Using call options to hedge payables
2. Using call options to hedge project bidding
3. Using call options to hedge target bidding
(hedge a possible acquisition of a foreign
firm)
4. Speculating

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Currency Put Options
1. Grants the right to sell currency at a designated
exercise (strike) price
2. If the spot rate falls below the strike price, the
owner of a put can exercise the right to sell
currency at the strike price
3. The buyer of the options pays a premium.
Maximum possible loss is the premium
4. If the spot exchange rate is lower than the strike
price, the option is in the money. If the spot rate is
equal to the strike price, the option is at the money.
If the spot rate is greater than the strike price, the
option is out of the money

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Factors Affecting Put Option
Premiums
1. Spot rate of currency relative to the strike
price
2. Length of time until expiration
3. Variability of the currency

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Contingency Graphs For Currency
Options
1. Contingency graph for a purchaser of a call
option
2. Contingency graph for a seller of a call
option
3. Contingency graph for a buyer of a put
option
4. Contingency graph for a seller of a put
option

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Exhibit 5.6 Contingency Graphs for
Currency Options

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Conditional Currency Options
 The premium is conditioned on the actual
movement in the currency’s value over the
period of concern

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Exhibit 5.7 Comparison of Conditional
and Basic Currency Options

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Speculating with combined put and
call options
 Long straddle: buy a put and a call option
with the same trike price
 Short straddle: sell a put and a call option

with the same strike price

 Bull spreads: buy a put option with a lower

exercise price and write a put option with a

higher exercise price
 Bear spreads: write a call option with a lower

exercise price and buy a call option with a

higher exercise price

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Options strategies

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Options strategies

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Bull put spreads

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Bear call spreads

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Butterfly

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Strips and straps

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