# Chapter 5. Currency Derivatives. Lecture Outline. Forward Market How MNCs Use Forward Contracts Non-Deliverable Forward Contracts

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1 Chapter 5 Currency Derivatives Lecture Outline Forward Market How MNCs Use Forward Contracts Non-Deliverable Forward Contracts Currency Futures Market Contract Specifications Trading Futures Comparison of Currency Futures and Forward Contracts Pricing Currency Futures Credit Risk of Currency Futures Contracts Speculation with Currency Futures How Firms Use Currency Futures Closing Out a Futures Position Trading Platforms for Currency Futures Currency Options Market Options Exchanges Over-the-Counter Market Currency Call Options Factors Affecting Call Option Premiums How Firms Use Currency Call Options Speculating with Currency Call Options Currency Put Options Factors Affecting Currency Put Option Premiums Hedging with Currency Put Options Speculating with Currency Put Options Contingency Graphs for Currency Options Conditional Currency Options European Currency Options 50

4 Chapter 5: Currency Derivatives 53 Profit per unit on exercising the option = \$.21 Premium paid per unit = \$.04 Net profit per unit = \$.17 Net profit for one option = 31,250 units \$.17 = \$5, Speculating with Currency Put Options. Bulldog, Inc., has sold Australian dollar put options at a premium of \$.01 per unit, and an exercise price of \$.76 per unit. It has forecasted the Australian dollar s lowest level over the period of concern as shown in the following table. Determine the net profit (or loss) per unit to Bulldog, Inc., if each level occurs and the put options are exercised at that time. Possible Value Net Profit (Loss) to of Australian Dollar Bulldog, Inc. if Value Occurs \$.72 \$ Speculating with Currency Call Options. Randy Rudecki purchased a call option on British pounds for \$.02 per unit. The strike price was \$1.45 and the spot rate at the time the option was exercised was \$1.46. Assume there are 31,250 units in a British pound option. What was Randy s net profit on this option? Profit per unit on exercising the option = \$.01 Premium paid per unit = \$.02 Net profit per unit = \$.01 Net profit per option = 31,250 units ( \$.01) = \$ Speculating with Currency Call Options. Bama Corp. has sold British pound call options for speculative purposes. The option premium was \$.06 per unit, and the exercise price was \$1.58. Bama will purchase the pounds on the day the options are exercised (if the options are exercised) in order to fulfill its obligation. In the following table, fill in the net profit (or loss) to Bama Corp. if the listed spot rate exists at the time the purchaser of the call options considers exercising them.

5 54 International Financial Management Possible Spot Rate at the Net Profit (Loss) per Time Purchaser of Call Option Unit to Bama Corporation Considers Exercising Them if Spot Rate Occurs \$1.53 \$ Currency Put Option Premiums. List the factors that affect currency put options and briefly explain the relationship that exists for each. These factors are listed below: The lower the existing spot rate relative to the strike price, the greater is the put option value, other things equal. The longer the period prior to the expiration date, the greater is the put option value, other things equal. The greater the variability of the currency, the greater is the put option value, other things equal. 8. Speculating with Currency Put Options. Auburn Co. has purchased Canadian dollar put options for speculative purposes. Each option was purchased for a premium of \$.02 per unit, with an exercise price of \$.86 per unit. Auburn Co. will purchase the Canadian dollars just before it exercises the options (if it is feasible to exercise the options). It plans to wait until the expiration date before deciding whether to exercise the options. In the following table, fill in the net profit (or loss) per unit to Auburn Co. based on the listed possible spot rates of the Canadian dollar on the expiration date. Possible Spot Rate Net Profit (Loss) per Unit of Canadian Dollar to Auburn Corporation on Expiration Date if Spot Rate Occurs \$.76 \$ Currency Call Option Premiums. List the factors that affect currency call option premiums and briefly explain the relationship that exists for each. Do you think an at-the-money call option in euros has a higher or lower premium than an at-the-money call option in Mexican pesos (assuming the expiration date and the total dollar value represented by each option are the same for both options)?

6 Chapter 5: Currency Derivatives 55 These factors are listed below: The higher the existing spot rate relative to the strike price, the greater is the call option value, other things equal. The longer the period prior to the expiration date, the greater is the call option value, other things equal. The greater the variability of the currency, the greater is the call option value, other things equal. The at-the-money call option in euros should have a lower premium because the euro should have less volatility than the peso (assuming that the expected volatility of the euro is lower than that of the peso). 10. Speculating with Currency Call Options. LSU Corp. purchased Canadian dollar call options for speculative purposes. If these options are exercised, LSU will immediately sell the Canadian dollars in the spot market. Each option was purchased for a premium of \$.03 per unit, with an exercise price of \$.75. LSU plans to wait until the expiration date before deciding whether to exercise the options. Of course, LSU will exercise the options at that time only if it is feasible to do so. In the following table, fill in the net profit (or loss) per unit to LSU Corp. based on the listed possible spot rates of the Canadian dollar on the expiration date. Possible Spot Rate Net Profit (Loss) per of Canadian Dollar Unit to LSU Corporation on Expiration Date if Spot Rate Occurs \$.76 \$ Speculating With Currency Options. When should a speculator purchase a call option on Australian dollars? When should a speculator purchase a put option on Australian dollars? Speculators should purchase a call option on Australian dollars if they expect the Australian dollar value to appreciate substantially over the period specified by the option contract. Speculators should purchase a put option on Australian dollars if they expect the Australian dollar value to depreciate substantially over the period specified by the option contract. 12. Speculating with Currency Futures. Assume that a March futures contract on Mexican pesos was available in January for \$.09 per unit. Also assume that forward contracts were available for the same settlement date at a price of \$.092 per peso. How could speculators capitalize on this situation, assuming zero transaction costs? How would such speculative activity affect the difference between the forward contract price and the futures price? Speculators could purchase peso futures for \$.09 per unit, and simultaneously sell pesos forward at \$.092 per unit. When the pesos are received (as a result of the futures position)

7 56 International Financial Management on the settlement date, the speculators would sell the pesos to fulfill their forward contract obligation. This strategy results in a \$.002 per unit profit. As many speculators capitalize on the strategy described above, they would place upward pressure on futures prices and downward pressure on forward prices. Thus, the difference between the forward contract price and futures price would be reduced or eliminated. 13. Hedging With Currency Options. When would a U.S. firm consider purchasing a call option on euros for hedging? When would a U.S. firm consider purchasing a put option on euros for hedging? A call option can hedge a firm s future payables denominated in euros. It effectively locks in the maximum price to be paid for euros. A put option on euros can hedge a U.S. firm s future receivables denominated in euros. It effectively locks in the minimum price at which it can exchange euros received. 14. Hedging with Currency Derivatives. Assume that the transactions listed in the first column of the following table are anticipated by U.S. firms that have no other foreign transactions. Place an X in the table wherever you see possible ways to hedge each of the transactions. a. Georgetown Co. plans to purchase Japanese goods denominated in yen. b. Harvard, Inc., sold goods to Japan, denominated in yen. c. Yale Corp. has a subsidiary in Australia that will be remitting funds to the U.S. parent. d. Brown, Inc., needs to pay off existing loans that are denominated in Canadian dollars. e. Princeton Co. may purchase a company in Japan in the near future (but the deal may not go through). Forward Contract Futures Contract Options Contract Forward Forward Buy Sell Purchase Purchase Purchase Sale Futures Futures Calls Puts a. X X X b. X X X c. X X X d. X X X e. X 15. Effects of a Forward Contract. How can a forward contract backfire? If the spot rate of the foreign currency at the time of the transaction is worth less than the forward rate that was negotiated, or is worth more than the forward rate that was negotiated, the forward contract has backfired. 16. Price Movements of Currency Futures. Assume that on November 1, the spot rate of the British pound was \$1.58 and the price on a December futures contract was \$1.59. Assume that the pound depreciated during November so that by November 30 it was worth \$1.51. a. What do you think happened to the futures price over the month of November? Why?

9 58 International Financial Management The disadvantage of a euro option is that the option itself is not free. One must pay a premium for the call option, which is above and beyond the exercise price specified in the contract at which the euro could be purchased. An MNC may use forward contracts to hedge committed transactions because it would be cheaper to use a forward contract (a premium would be paid on an option contract that has an exercise price equal to the forward rate). The MNC may use currency options contracts to hedge anticipated transactions because it has more flexibility to let the contract go unexercised if the transaction does not occur. 21. Using Currency Futures. a. How can currency futures be used by corporations? U.S. corporations that desire to lock in a price at which they can sell a foreign currency would sell currency futures. U.S. corporations that desire to lock in a price at which they can purchase a foreign currency would purchase currency futures. b. How can currency futures be used by speculators? Speculators who expect a currency to appreciate could purchase currency futures contracts for that currency. Speculators who expect a currency to depreciate could sell currency futures contracts for that currency. 22. Selling Currency Put Options. Brian Tull sold a put option on Canadian dollars for \$.03 per unit. The strike price was \$.75, and the spot rate at the time the option was exercised was \$.72. Assume Brian immediately sold off the Canadian dollars received when the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option. What was Brian s net profit on the put option? Premium received per unit = \$.03 Amount per unit received from selling C\$ = \$.72 Amount per unit paid for C\$ = \$.75 Net profit per unit = \$0 23. Forward versus Futures Contracts. Compare and contrast forward and futures contracts. Because currency futures contracts are standardized into small amounts, they can be valuable for the speculator or small firm (a commercial bank s forward contracts are more common for larger amounts). However, the standardized format of futures forces limited maturities and amounts.

14 Chapter 5: Currency Derivatives 63 Net profit per unit \$.024 \$.526 \$.574 \$.55 Future spot rate -\$ Currency Bullspreads and Bearspreads. A call option on British pounds ( ) exists with a strike price of \$1.56 and a premium of \$.08 per unit. Another call option on British pounds has a strike price of \$1.59 and a premium of \$.06 per unit. (See Appendix B in this chapter.) a. Complete the worksheet for a bullspread below. \$1.56 \$1.59 Net Value of British Pound at Option Expiration \$1.50 \$1.56 \$1.59 \$1.65 b. What is the break-even point for this bullspread? c. What is the maximum profit of this bullspread? What is the maximum loss? d. If the British pound spot rate is \$1.58 at option expiration, what is the total profit or loss for the bullspread? e. If the British pound spot rate is \$1.55 at option expiration, what is the total profit or loss for a bearspread? a. Value of British Pound at Option Expiration \$1.50 \$1.56 \$1.59 \$1.65 \$1.56 \$.08 \$.08 \$.05 +\$.01 \$1.59 +\$.06 +\$.06 +\$.06 \$.00 Net \$.02 \$.02 +\$.01 +\$.01

16 Chapter 5: Currency Derivatives 65 Net profit per unit \$1.065 \$1.065 \$1.13 \$1.1 -\$.035 Future spot rate b. The plotted points should create an upside down V shape that cuts through the horizontal (break-even) axis at \$1.065 and \$ The peak of the upside down V shape occurs at \$1.10 and reflects a net profit of \$.035. Net profit per unit \$.035 \$1.065 \$1.13 \$1.1 Future spot rate -\$ Speculating with Currency Options. Barry Egan is a currency speculator. Barry believes that the Japanese yen will fluctuate widely against the U.S. dollar in the coming month. Currently, onemonth call options on Japanese yen ( ) are available with a strike price of \$.0085 and a premium

17 66 International Financial Management of \$.0007 per unit. One-month put options on Japanese yen are available with a strike price of \$.0084 and a premium of \$.0005 per unit. One option contract on Japanese yen contains 6.25 million yen. (See Appendix B in this chapter.) a. Describe how Barry Egan could utilize these options to speculate on the movement of the Japanese yen. b. Assume Barry decides to construct a long strangle in yen. What are the break-even points of this strangle? c. What is Barry s total profit or loss if the value of the yen in one month is \$.0070? d. What is Barry s total profit or loss if the value of the yen in one month is \$.0090? b. Since Barry seems uncertain as to the direction of the yen fluctuation, he could construct a long straddle using the call and put option. The long strangle would become profitable if the yen either depreciates or appreciates substantially. c. Lower BE point = \$.0084 (\$ \$.0005) = \$.0072 Upper BE point = \$ (\$ \$.0005) = \$.0097 c. Per Unit Per Contract Selling Price of \$.0084 \$52,500 (\$ million units) Purchase price of ,750 (\$ million units) Premium paid for call option ,375 (\$ million units) Premium paid for put option ,125 (\$ million units) = Net profit \$.0002 \$1,250 (\$ million units) d. Per Unit Per Contract Selling Price of \$.0090 \$56,250 (\$ million units) Purchase price of ,125 (\$ million units) Premium paid for call option ,375 (\$ million units) Premium paid for put option ,125 (\$ million units) = Net profit \$.0007 \$4,375 (\$ million units) 32. Currency Straddles. Reska, Inc., has constructed a long euro straddle. A call option on euros with an exercise price of \$1.10 has a premium of \$.025 per unit. A euro put option has a premium of \$.017 per unit. Some possible euro values at option expiration are shown in the following table. (See Appendix B in this chapter.) Call Put Net Value of Euro at Option Expiration \$.90 \$1.05 \$1.50 \$2.00

18 Chapter 5: Currency Derivatives 67 a. Complete the worksheet and determine the net profit per unit to Reska Inc. for each possible future spot rate. b. Determine the break-even point(s) of the long straddle. What are the break-even points of a short straddle using these options? a. Value of Euro at Option Expiration \$.90 \$1.05 \$1.50 \$2.00 Call \$.025 \$.025 +\$.375 +\$.875 Put +\$.183 +\$.033 \$.017 \$.017 Net +\$.158 +\$.008 +\$.358 +\$.858 b. The break-even points for a long straddle can be found by subtracting and adding both premiums to the exercise price. Thus, the break-even points are located at future euro spot values of \$1.10 (\$ \$.017) = \$1.058 and \$ (\$ \$.017) = \$ The breakeven points for a short straddle are also \$1.058 and \$ Currency Strangles. For the following options available on Australian dollars (A\$), construct a worksheet and contingency graph for a long strangle. Locate the break-even points for this strangle. (See Appendix B in this chapter.) Put option strike price = \$.67 Call option strike price = \$.65 Put option premium = \$.01 per unit Call option premium = \$.02 per unit Note that the put strike price exceeds the call strike price in this case. Value of Australian dollar at Option Expiration \$.60 \$.65 \$.67 \$.70 Own a Call \$.02 \$.02 \$.00 +\$.03 Own a Put +\$.06 +\$.01 \$.01 \$.01 Net +\$.04 \$.01 \$.01 +\$.02 The plotted points should create a U shape that cuts through the horizontal (break-even) axis at \$.64 and \$.68. The bottom of the U shape occurs from \$.65 to \$.67 and reflects a net profit of \$.01.

19 68 International Financial Management Net profit per unit \$.64 \$.64 \$.68 \$.65 \$.67 Future spot rate -\$.01 The break-even points for a strangle where the put option exercise price exceeds the call option exercise price can be obtained by subtracting the difference in premiums from the call option strike price and by adding the difference in premiums to the put option strike price: Lower BE = \$.65 (\$.02 \$.01) = \$.64 Upper BE = \$.67 + (\$.02 \$.01) = \$ Impact of Information on Currency Futures and Options Prices. Myrtle Beach Co. purchases imports that have a price of 400,000 Singapore dollars and it has to pay for the imports in 90 days. It can purchase a 90-day forward contract on Singapore dollars at \$.50 or purchase a call option contract on Singapore dollars with an exercise price of \$.50 to cover its payables. This morning, the spot rate of the Singapore dollar was \$.50. At noon, the central bank of Singapore raised interest rates, while there was no change in interest rates in the U.S. These actions immediately increased the degree of uncertainty surrounding the future value of the Singapore dollar over the next three months. The Singapore dollar s spot rate remained at \$.50 throughout the day. a. Myrtle Beach Co. is convinced that the Singapore dollar will definitely appreciate substantially over the next 90 days. Would a call option hedge or forward hedge be more appropriate given its opinion? A forward hedge would be more appropriate, because it can lock in payment at \$.50 per unit with either method, but it does not have to pay a premium when using the forward rate. It will not benefit from the flexibility of the call option since it is convinced that the Singapore dollar will appreciate. b. Assume that Myrtle Beach uses a currency options contract to hedge rather than a forward contract. If Myrtle Beach Co. purchased a currency call option contract at the money on Singapore dollars this afternoon, would its total U.S. dollar cash outflows be MORE THAN,

21 70 International Financial Management The forward rate one year ago was equal to: \$1.20 (1.02) = \$ So the futures rate is \$ The gain per unit is \$1.176 \$1.152 = \$.024 and the total gain is \$ ,000 = \$2, Currency Straddles. Refer to the previous question, but assume that the call and put option premiums are \$.035 per unit and \$.025 per unit, respectively. (See Appendix B in this chapter.) c. Construct a contingency graph for a long pound straddle. d. Construct a contingency graph for a short pound straddle. a. The plotted points should create a U shape that cuts through the horizontal (break-even) axis at \$1.47 and \$1.62. The bottom of the U shape occurs from \$1.53 to \$1.56 and reflects a net profit of \$.06. Net profit per unit \$1.47 \$1.47 \$1.62 \$1.5 \$1.5 Future spot rate -\$.06 b. The plotted points should create an upside down U shape that cuts through the horizontal (break-even) axis at \$1.47 and \$1.62. The peak of the upside down U shape occurs at from \$1.53 to \$1.56 and reflects a net profit of \$.06.

22 Chapter 5: Currency Derivatives 71 Net profit per unit \$.06 \$1.47 \$1.62 \$1.5 \$1.5 Future spot rate -\$ Risk of Currency Futures. Currency futures markets are commonly used as a means of capitalizing on shifts in currency values, because the value of a futures contract tends to move in line with the change in the corresponding currency value. Recently, many currencies appreciated against the dollar. Most speculators anticipated that these currencies would continue to strengthen and took large buy positions in currency futures. However, the Fed intervened in the foreign exchange market by immediately selling foreign currencies in exchange for dollars, causing an abrupt decline in the values of foreign currencies (as the dollar strengthened). Participants that had purchased currency futures contracts incurred large losses. One floor broker responded to the effects of the Fed s intervention by immediately selling 300 futures contracts on British pounds (with a value of about \$30 million). Such actions caused even more panic in the futures market. a. Explain why the central bank s intervention caused such panic among currency futures traders with buy positions. Futures prices on pounds rose in tandem with the value of the pound. However, when central banks intervened to support the dollar, the value of the pound declined, and so did values of futures contracts on pounds. So traders with long (buy) positions in these contracts experienced losses because the contract values declined. b. Explain why the floor broker s willingness to sell 300 pound futures contracts at the going market rate aroused such concern. What might this action signal to other brokers? Normally, this order would have been sold in pieces. This action could signal a desperate situation in which many investors sell futures contracts at any price, which places more downward pressure on currency future prices, and could cause a crisis. c. Explain why speculators with short (sell) positions could benefit as a result of the central bank s intervention.

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