Chapter 5 FIN 454

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A currency derivative is a contract whose price is derived from the value of an underlying currency. This includes forwards/futures contracts and options contract. MNC use derivatives to -- Speculate on future exchange rate movements. Hedge exposure to exchange rate risk. A forward contract is an agreement between a corporation and a financial institution: To exchange a specified amount of currency. At a specified exchange rate called the forward rate. On a specified date in the future time. Multinational corporations use forwards contracts to -- Lock in the rate at which they obtain a foreign currency needed to import. Lock in the rate at which they can sell a foreign currency needed to remit their cash flows from exports. Features -- Used by most corporation. Often valued at $1 million or more. 30, 60, 90, 180, and 360 days. Opportunity costs in some cases. ?𝒊? − ??𝒌 ?𝒑??𝒂? = ??𝒌 ?𝒂?? − ?𝒊? ?𝒂?? ??𝒌 ?𝒂?? The spread is going to be wider for those currencies that are less liquid and for an obligation further into the future. The premium or discount on the forward rate used the formula : 𝐹 = 𝑆 (1+ ? ) A positive P is premium, while a negative P is in discount. Forward rate typically differs from the spot rate for any given currency because of the difference in interest rates in the foreign country vs. the US. Most of the movements arise due to the movement in the currency's spot rate. Offsetting a Forward Contract - May negotiate an offsetting trade if an MNC enters into a forward sale and a forward purchase with the same bank. Banks charge a fee for the service which reflect the difference between the forward rate at the time of the forward purchase and the forward rate at the time of the offset. Using Forward Contracts for Swap Transaction - Involves a spot transaction with a corresponding forward contract that will ultimately reverse the spot transaction. Purchase the foreign currency at the spot rate. Invest the funds at the attractive foreign interest rate. Simultaneously sell forward contract in that foreign currency for a future date when the savings deposit matures. Non-deliverable Forward Contracts (NDF) - No currency delivery but the transfer of profits/loss takes place at settlement. Can be used for emerging market currencies. Futures Market -- Similar to forward contracts in terms of obligation to purchase or sell currency on a specific settlement date in the future but differ from forward contracts in how they are traded. Contracts Specifications -- o Standardized number of units per contract. o Offer greater liquidity that forward contracts. o Typically based on U.S. dollar but may be offered on cross-rates. o Commonly traded on the Chicago Mercantile Exchange (CME). Credit Risk of Currency Futures Contracts -- o No credit risk as exchange clearinghouse assumes the risks. o Require initial margin (typically $1,000 to 2,000 per contract) and maintenance margin.
How Firms Use Currency Futures -- o Purchasing Futures to Hedge Payables - The purchase of futures contracts locks in the price at which a firm can purchase a currency. o Selling Futures to Hedge Receivables - The sale of futures contracts locks in the price at which a firm can sell a currency. o Closing Out a Futures Position - Sellers (buyers) of currency futures can close out their position by buying (selling) identical futures contracts prior to settlement. Most currency futures contracts are closed out before the settlement date. Efficiency of the Currency Futures Market - o If the currency futures market is efficient, the future price should reflect all available information. o Thus, the continual use of a particular strategy to take positions in currency futures contracts should not lead to abnormal profits. o Research has found that the currency futures market may be inefficient. However, the patters are not necessarily observable until after they occur, which means that it may be difficult to consistently generate abnormal profits from speculating in currency futures. FORWARD FUTURES Size of contract Tailored to individual needs. Standardized. Delivery date Tailored to individual needs. Standardized. Participants Banks, brokers, and multinational companies. Public speculation not encouraged. Banks, brokers, and multinational companies. Qualified public speculation encouraged. Security deposit None as such, but compensating bank balances or lines of credit required. Small security deposit required. Clearing operation Handling contingent on individual banks and brokers. No separate clearinghouse function. Handled by exchange clearinghouse. Daily settlements to the market price. Marketplace Telecommunications network. Globex computerized trading platform with worldwide communications. Regulation Self-regulating. Commodity Futures Trading Commission; National Futures Association. Liquidation Most settled by actual delivery; some by offset, but at a cost. Most by offset; very few settled by delivery. Transaction costs Set by the spread between the bank's buy and sell prices. Negotiated brokerage fees. Currency Call Options - Grants the right to buy a specific currency at a designed strike price or exercise price within a specific period. If the spot rises above the strike price, the owner of a call can exercise the right to buy a currency at the strike price. The buyer of the option pays a premium. 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.
𝐶𝑎?? ???𝑖?? ????𝑖?? = 𝑀𝑎𝑥(𝑆 − 𝑋, 0) − ????𝑖?? o Break even if the revenue from selling the currency equals the payments made for the currency plus the option premium. Factors that Affect the Currency Call Option Premiums - - o The premium on a call option is affected by three factors -- ? = ?(? − 𝑿, ?, 𝜹) o Spot price relative to the strike price (S -X) -- The higher the spot rate relative to the strike price, the higher the option price will be. o Length of Time Before Expiration (T) - The longer the time to expiration, the higher the option price will be. o Volatility of the Currency ( σ) - The greater the variability of the currency, the higher the probability that the spot rate can rise above the strike price. How Firms Use Currency Call Options - o Using call options to hedge payables. o Using call options to hedge project bidding to lock in the dollar cost of potential expenses. o Using call options to hedge target bidding of a possible acquisition. A contingency graph for the buyer of a call option compares the price paid for that option to the payoffs received under various exchange rate scenarios. A contingency graph for the seller of a call option compares the premium received from selling that option to the payoff made to the option's buyer under various exchange rate scenarios. Currency Put Options - Grants the right to sell a currency at a specified strike price or exercise price within a specified period of time. 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. The buyer of the options pays a premium. 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 . o ??? ???𝑖?? ????𝑖?? = 𝑀𝑎𝑥(𝑋 − 𝑆, 0) − ????𝑖?? Factors Affecting Put Option Premium -- o Affected by three factors - 𝑷 = ?(? − 𝑿, ?, 𝜹) o Spot rate relative to the strike price (S − X): The lower the spot rate relative to the strike price, the higher the probability that the option will be exercised. o Length of time until expiration (T): The longer the time to expiration, the greater the put option premium. o Variability of the currency (σ): The greater the variability, the greater the probability that the option may be exercised. Speculating with Combined Put and Call Options - o Straddle - Uses both a put option and a call option at the same exercise price. Good for when speculators expect strong movement in one direction or the other. Efficiency of the Currency Options Market (Both Call and Put Options) - o Research has found that, when transaction costs are controlled for, the currency options market is efficient. o It is difficult to predict which strategy will generate abnormal profits in future periods. The contingency graph compares premium paid for put option to the payoffs received under various rate scenarios. Compares premium received for put option to the payoff made under various scenario Other Forms of Currency Options:
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