Currency Derivatives: For Use With International Financial Management, 3e Jeff Madura and Roland

Currency Derivatives
For use with International Financial Management, 3e

Jeff Madura and Roland
Forward Market (1)
• A forward contract is an agreement
between a firm 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.
• Forward contracts are often valued at £1
million or more, and are not normally used
by consumers or small firms.

Forward Market (2)
• When MNCs anticipate a future need for or
future receipt of a foreign currency, they
can set up forward contracts to lock in the
exchange rate.
• The % by which the forward rate (F )
exceeds the spot rate (S ) at a given point in
time is called the forward premium (p ).
F = S (1 + p )
• F exhibits a discount when p < 0.

Forward Market (3)
Example S = £0.60:$1,
90-day F = £0.59:$1
F – S  360
annualized p =
S n
=
0.59 – 0.60  360 = –.017%
0.60 90
• The forward premium (discount) usually reflects the
difference between the home and foreign interest
rates, thus preventing arbitrage.

Forward Market (4)
• A swap transaction involves a spot
transaction along with a corresponding
forward contract that will reverse the spot
transaction.
• A non-deliverable forward contract (NDF)
does not result in an actual exchange of
currencies. Instead, one party makes a net
payment to the other based on a market
exchange rate on the day of settlement.

Forward Market (5)
• An NDF can effectively hedge future foreign
currency payments or receipts:
July 1
April 1
Buy 100M Chilean pesos
Expect need for 100M Chilean from market.
pesos.
Index = £.0014/peso 
Negotiate an NDF to buy 100M receive £20,000 from bank
Chilean pesos on Jul 1. due to NDF.
Reference index (closing rate
quoted by Chile’s central bank) Index = £.009/peso  pay
= £.0012/peso. £30,000 to bank.

Currency Futures Market (1)
• Currency futures contracts specify a
standard volume of a particular currency to
be exchanged on a specific settlement
date at a specified exchange rate.
• They are used by MNCs to hedge their
currency positions, and by speculators
who hope to capitalize on their
expectations of exchange rate movements.

• The contracts can be traded by firms or
individuals through brokers on the trading
floor of an exchange (e.g. Chicago
Mercantile Exchange), automated trading
systems (e.g. GLOBEX), or the over-the-
counter market.
• Brokers who fulfill orders to buy or sell
futures contracts typically charge a
commission.

Comparison of the Forward & Futures
Markets (1)
Forward Markets Futures Markets
Contract size Customized Standardized
Delivery date Customized Standardized

Participants Banks, brokers, Banks, brokers,
MNCs. Public MNCs. Qualified
speculation not public speculation
encouraged. encouraged.
Security Compensating Small security
deposit bank balances or deposit required.
credit lines needed.
Clearing Handled by Handled by
operation individual banks exchange
& brokers. clearinghouse.
Daily settlements
to market prices.
Comparison of the Forward & Futures
Markets (2)
Forward Markets Futures Markets
Marketplace Worldwide Central exchange
telephone floor with worldwide
network communications.
Regulation Self-regulating Commodity

Futures Trading
Commission,
National Futures
Association.
Liquidation Mostly settled by Mostly settled by

actual delivery. offset.
Transaction Bank’s bid/ask Negotiated

Costs spread. brokerage
fees.

• Enforced by potential arbitrage activities, the
prices of currency futures are closely related
to their corresponding forward rates and spot
rates.
• Currency futures contracts are guaranteed to
be fulfilled by the exchange clearinghouse,
which in turn minimizes its own credit risk by
imposing margin requirements on those
market participants who take a position.

Currency Futures Market
• Matches offsetting risks between buyer and
seller – THE BASIC IDEA:
Price
• 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 £.050/peso (£25,000)
@ £.056/peso from the spot market.
(£28,000) on
June 17.
3. Sell the pesos to fulfill
contract.
Gain £3,000.
• MNCs may purchase currency futures
to hedge their foreign currency
payables, or sell currency futures to
hedge their receivables.
April 4 June 17
1. Expect to receive 2. Receive 500,000 pesos
500,000 pesos. as expected.
Contract to sell
500,000 pesos @ 3. Sell the pesos at the
£.056/peso on locked-in rate.
June 17.

• 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. No further
buy sell A$100,000 payments to be
A$100,000 @ @ £.31/A$ made no matter
£.33/A$ (£31,000) on what the current
(£33,000) on March 19. Will rate.
March 19. have paid
£2,000
Currency Options Market
• Currency options provide the right but NOT
the obligation to purchase or sell currencies at
specified (strike) prices. They are classified as
calls (right to buy a currency) or puts (right to
sell a currency.
• Standardized options are traded on
exchanges through brokers.
• Customized options offered by brokerage
firms and commercial banks are traded in the
over-the-counter market.
Currency Call Options (1)
• The specified price is called the exercise or strike price
within a specific period of time.
• A call (right to buy) option is
– in the money if a claim can be made
– at the money if currency price = strike

price
– out of the money if a claim cannot be made

Currency Options (2)
• Option owners can sell or exercise their
options, or let their options expire.
• Firms may purchase currency call options
to hedge payables, project bidding, or target
bidding.
• Firms may purchase currency put options to
hedge receivables, interest earned or sales
of assets.

From the FT October
Philadelphia SE £/$ Options £31,250 The right to

$ cents per £ buy a call at
Strike Calls Puts a low strike
Price Dec Jan Dec Jan price is
1.400 8.49 8.50 0.07 0.12
1.450 3.61 4.20 0.11 0.83 more
1.525 0.03 0.74 3.82 4.73 expensive
Spot $1.4845:£1
Buy and sell a Dec Call Option for
31,250 units x 8.49¢ = $2653.12 @1.400
31,250 units x 3.61¢ = $1128.13 @1.450
31,250 units x 0.03¢ = $937.5 @1.525
For use with International Financial Management, 3e 20

From the FT October
Philadelphia SE £/$ Options £31,250 The right to

$ cents per £
Strike Calls Puts
buy a put at
Price Dec Jan Dec Jan a low strike
1.400 8.49 8.50 0.07 0.12 price is less
1.450 3.61 4.20 0.11 0.83 expensive
1.525 0.03 0.74 3.82 4.73
Spot $1.4845:£1
Buy and sell a Dec Put Option for
31,250 units x 0.07¢ = $21.88 @1.400
31,250 units x 0.11¢ = $34.38 @1.450
31,250 units x 8.82¢ = $2662.5 @1.525

Jeff Madura and Roland Fox 9781408079812 21
© Cengage Learning EMEA 2014
Effective buying and selling price
Philadelphia SE £/$ Options £31,250

$ cents per £
Strike Calls Puts
Price Dec Jan Dec Jan
1.400 8.49 8.50 0.07 0.12
1.450 3.61 4.20 0.11 0.83
Dec effective call prices per £

$1.400 + $0.0849 = $1.4849
$1.450 + $0.0361 = $1.4861*
Dec effective put prices per £
$1.400 - $0.0007 = $1.3993*
$1.450 - $0.0011 = $1.4489
*cheaper but less advantageous

Increasing the term

$ cents per £
Strike Calls Puts
1.400 8.49 8.50 0.07 0.12
1.450 3.61 4.20 0.11 0.83
Increase term (time) >> increase uncertainty >> increase in option premium…
Price
Call strike
Put strike
time
Intrinsic and time value of premiums

$ cents per £
Strike Calls Puts
1.400 8.49 8.50 0.07 0.12
1.450 3.61 4.20 0.11 0.83
Spot $1.4845:£1
If out of the money,
Dec effective call prices per £ this is 0.00. There will
$1.400 + $0.0849 = $1.4849 just be a time element
– there will always be
¢/£ a a time element
Intrinsic element 1.4845 - 1.4000 = 8.45
Time element 0.04
Actual Premium 8.49
Contingency or position diagrams
do not exercise exercise
net value
+
0 1.45
- out-of-the-money in-the-money
-8.00 cents Future spot
Call option on £’s net profit or loss at maturity for purchaser
e.g. call (buy) at 1.45, premium 8.00¢
$s per £
maturity (spot) prices: 1.40 1.50 1.60
exercise? N Y Y
spot – strike ~ 0.05 0.15
less premium 0.08 0.08 0.08
net position (0.08) (0.03) 0.07

Contingency or position diagram
profit
Sell or written call
 

Future
loss buy call  spot
= premium
= strike price
= strike price + premium



26
Contingency or position diagrams
exercise do not exercise
net value
+
0
1.55
- in-the-money out of-the-money
-6.00 cents Put option on £’s net profit or loss at maturity forFuture spot
purchaser
e.g. put (sell) at 1.55, premium 6.00¢
$ per £
maturity (spot) prices ($): 1.40 1.50 1.60 Remember, you
exercise? Y Y N cannot lose more
strike - spot 0.15 0.05 ~ than your premium!
less premium 0.06 0.06 0.06
net position 0.09 (0.01) (0.06)

Contingency or position diagram
profit
 sell put
 

Future
 buy put spot
loss
= premium
 = strike price
 = strike price + premium


Options as a Hedging Tool
(UK investor in $’s)
probability
density
Put type protection future spot
probability
Density
call type protection future spot

Range forward or cylinder contract
e.g. Mr W a UK investor is expecting ¥ revenues...
UK purchase put on ¥’s desired rate & UK sell ¥’s call on higher rate
Often same premium so...no net cost.
  future spot £’s:¥
£0.005 £0.006
Gains protection against ¥ selling less than £0.005 with put in return
for sacrificing ¥ selling more than £0.006
30
e.g. Mr W a UK investor is expecting ¥ revenues...
UK purchase put on ¥’s lower rate & UK sell ¥’s call on higher rate
probability To avoid Mr W
this… sacrifices this
density

£0.005 £0.006
Gains protection against ¥ buying less than £0.005 with put in return
for sacrificing ¥ buying more than £0.006

e.g. Mr W a UK investor is expecting ¥ costs...
UK purchase call on ¥’s at desired rate & UK sell ¥’s put on lower rate
£0.005 £0.006
Gains protection against ¥ costing more than £0.006 with call in return
for sacrificing ¥ paying less than £0.005
32
Conditional Currency Options
• A currency option may be structured

such that the premium is conditioned on
the actual currency movement over the
period of concern.
• Suppose a conditional put option on £
has an exercise price of $1.70, and a
trigger of $1.74. The premium will have
to be paid only if the £’s value exceeds
the trigger value.
Jeff Madura and Roland Fox 9781408079812
Conditional Currency Options
dollar unfavourable dollar favourable

conditional option conditional option
Profit pays more more expensive
Value of dollar
-£0.03
Loss £0. 57 -£0.04

£0. 60
£0. 62
Exhibit 5.11 Comparison of Conditional

and Basic Currency Options

Conditional Currency Options (3)
• Similarly, a conditional call option on $

may specify an exercise price of £0.60,
and a trigger of £0.58. 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.

European Currency Options
• European-style currency options are
similar to American-style options except
that they can only be exercised on the
expiration date.
• For firms that purchase options to hedge
future cash flows, this loss in flexibility is
probably not an issue. Hence, if their
premiums are lower, European-style
currency options may be preferred.
Efficiency of
Currency Futures and Options
• If foreign exchange markets are
efficient, speculation in the currency
futures and options markets should
not consistently generate abnormally
large profits.


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Currency Derivatives

For use with International Financial Management, 3e

For use with International Financial Management, 3e

For use with International Financial Management, 3e

For use with International Financial Management, 3e

For use with International Financial Management, 3e

For use with International Financial Management, 3e

For use with International Financial Management, 3e

For use with International Financial Management, 3e

Delivery date Customized Standardized

Regulation Self-regulating Commodity

Liquidation Mostly settled by Mostly settled by

Transaction Bank’s bid/ask Negotiated

For use with International Financial Management, 3e

For use with International Financial Management, 3e

For use with International Financial Management, 3e

January 10 February 15 March 19

– at the money if currency price = strike

– out of the money if a claim cannot be made

For use with International Financial Management, 3e

For use with International Financial Management, 3e

Philadelphia SE £/$ Options £31,250 The right to

For use with International Financial Management, 3e 20

Philadelphia SE £/$ Options £31,250 The right to

For use with International Financial Management, 3e

Philadelphia SE £/$ Options £31,250

Dec effective call prices per £

*cheaper but less advantageous

Philadelphia SE £/$ Options £31,250

Philadelphia SE £/$ Options £31,250

For use with International Financial Management, 3e

For use with International Financial Management, 3e

For use with International Financial Management, 3e

call type protection future spot

For use with International Financial Management, 3e

  future spot £’s:¥

  future spot £’s:¥

For use with International Financial Management, 3e

  future spot £’s:¥

• A currency option may be structured

dollar unfavourable dollar favourable

Loss £0. 57 -£0.04

Exhibit 5.11 Comparison of Conditional

For use with International Financial Management, 3e

• Similarly, a conditional call option on $

For use with International Financial Management, 3e

For use with International Financial Management, 3e

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