IFM Ch05 Derivatives Good

7/28/2019 IFM Ch05 Derivatives Good

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FINC3240

International FinanceChapter 5

Currency Derivatives

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Chapter Overview

A. Currency Forwards

B. Currency Futures

C. Currency Options

D. Currency Swaps

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Derivatives

A derivative contract involves no actual transferof ownership of the underlying assets at the timethe contract is initiated. A derivative representsan agreement to transfer ownership of underlying

assets at a specific place, price, and timespecified in the contract. Its value (or price)depends on the value of the underlying assets.

The underlying assets: stocks, bonds, interestrates, foreign exchanges, index, commodities,some derivatives, etc.

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Currency Forwards

Definition: an agreement between twoparties to exchange a specified amountof a currency at a specified exchangerate (forward rate) on a specified date inthe future.

1. Terms are unique to each individual forwardcontract. That is, each contract is customized.

2. There is a risk that one side might default on itsobligation.

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Forward Contract

Forward bid-ask spread

Forward premium or discount

P represents the forward premium (discount), or thepercentage by which the forward rate exceeds (less) thespot rate.

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Forward Premium/Discount (1)

If the euros spot rate is $1.03, and itsone-year forward rate has a forwardpremium of 2 percent, the one-year

forward rate is:

So, euro will appreciates or depreciates?

Appreciates!

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Forward Premium/Discount (2)

If the euros one-year forward rate isquoted at $1.00 and the euros spot rateis quoted at $1.03, the euros forward

premium/discount is :

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Exhibit 5.1 Computation of Forward Rate

Premiums or Discounts

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Forwards Application

Why would MNC use Forwardcontracts and therefore forward rateif they expect currency exchange in

the future? Why not wait till then andexchange the currency with the spotrate of that date?

To lock in the price

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Forwards Application (1)

Buying foreign currency forward

Turz, Inc. on page 104

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Forwards Application (2)

Selling foreign currency forward

Scanlon, Inc. on page 104

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Currency Futures

A standardized forward contract traded onan organized and regulated futures exchange.

1. Futures contracts are guaranteed by the

exchanges clearinghouse that eliminates therisk of contra-party default.

2. Each contract is standardized on the quantity,quality, delivery place, delivery date, contractexpiration date.

3. A deposit called margin is required to both

buyers and sellers. http://www.cme.com12


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Exhibit 5.2 Currency Futures Contracts Traded

on the Chicago Mercantile Exchange

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Forwards vs. Futures

1. Futures contracts trade on an organizedexchange.

2. Futures positions can be closed or transferredeasily.

3. Futures contracts have standardized terms(quantity, expiration, etc.)

4. Futures contracts are guaranteed by theclearinghouse associated with the exchange.

5. Futures are subject to daily settlement (markedto the market).

6. Margin is required to both the buyer and seller.

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Clearinghouse

Guarantees that all traders in the futuresmarkets will honor their obligations.

Act in a position of buyer to every sellerand seller to every buyer. So no defaultrisk as a counter-party to every trader.

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Margin and Daily Settlement

Initial margin ( as little as 10% of theunderlying assets value)

Maintenance margin

Marking to market: realize any loss or

profit in cash every day.

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Marking to MarketEuro Futures Buyer

bought at ($/euro) 1.4551 euro amount 125000

contract value ($) 181887.50

initial margin ratio 0.1 initial margin ($) 18188.75

Day Close Contract Value ($) Profit/Loss ($) Maintenance Margin ($) margin ratio

1 1.4565 182062.50 175.00 18363.75 0.101

2 1.4570 182125.00 62.50 18426.25 0.101

3 1.4500 181250.00 -875.00 17551.25 0.097

4 1.4535 181687.50 437.50 17988.75 0.099

5 1.3900 173750.00 -7937.50 10051.25 0.058

Euro Futures Seller

sold at ($/euro) 1.4551 euro amount 125000

contract value ($) 181887.50

initial margin ratio 0.1 initial margin ($) 18188.75

Day Close Contract Value ($) Profit/Loss ($) Maintenance Margin ($) margin ratio

1 1.4565 182062.50 -175.00 18013.75 0.099

2 1.4570 182125.00 -62.50 17951.25 0.099

3 1.4500 181250.00 875.00 18826.25 0.104

4 1.4535 181687.50 -437.50 18388.75 0.101

5 1.3900 173750.00 7937.50 26326.25 0.15217


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Closing a Position by Deliveryexample on Page 109

On Feb 10, a futures contract on 62,500British pounds with a march settlementdate is priced at $1.50 per pound. If both

buyer and seller of such a futures holdtheir positions to expiration, then after thesettlement date the buyer of this currencyfutures will receive BP62,500 and will pay

$93,750 (62500x1.5). The seller of thiscontract is obligated to deliver BP62,500and receive $93,750.

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Closing a Position by

Reverse trading

example: Tacoma Co. on page 113.

Exhibit 5.5

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Participants in Futures Markets

Hedgers: hedging, risk management

Speculators: make money by taking risk

Brokers: receive commission fee

Regulators: futures exchanges andclearinghouses, the National FuturesAssociation

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Futures Application (1)

Spot=$1.4550/BP

1-year Future =$1.4550/BP

1-year US interest rate=5%

1-year UK interest rate=10%

Can you speculate on this information?

Yes. Purchase Pound at spot rate $1.4550 and invest in UKbonds or saving account; simultaneously sell Pound 1-yearFutures (Forward) at $1.4550.

What is the effect of this strategy on the exchange rate?

Upward pressure on the spot rate and downward pressureon future price.

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Expect the foreign currency to appreciate.(Example on page 111)

A speculator expects the British pound toappreciate in the future. He purchases a futurescontract that will lock in the price at which hebuys pounds at settlement date. On thesettlement date, he purchases pounds at the rate

specified by the futures contract and then sellthese pounds at the spot rate. He will profit if thepound goes up.

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Expect the foreign currency to depreciate.(Example on page 111)

On April 4, a futures contract on 500,000Mexican pesos and a June settlement date ispriced at $0.09. On April 4, speculators whoexpect the peso will decline sell futures contractson pesos. On June 17 (settlement date), the spot

rate of the peso is $0.08. The gain on thisstrategy is $5,000.

$0.09/p*p500000-$0.08/p*p500000=$500023


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Purchasing Futures to hedge payables (exampleon page 112)

Teton Co. orders Canadian goods and will need tosend C$500,000 to the Canadian exporter. Thus,Teton purchase Canadian dollar futures contractstoday, thereby locking in the price to be paid forCanadian dollars at a future settlement date. By

holding futures contracts, Teton does not have toworry about changes in the spot rate of theCanadian dollar over time.

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Selling Futures to hedge receivables (example onpage 113)

Karla Co. sells futures contracts when it plans toreceive a foreign currency from exporting that itwill not need. It locks in the price at which it willbe able to sell this currency as of the settlementdate. Such an action is appropriate if Karla

expects the foreign currency to depreciateagainst Karlas home currency.

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Currency Options

A contract that is associated with a rightto buy or sell a currency until after aspecific date with a predetermined price

(strike price) and amount. There are Calloptions and Put options.

1. The buyer of a Call option has the right, not the

obligation, to buy a currency.

2. The buyer of a Put option has the right, not theobligation, to sell a currency.

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Options Features

There are always two positions in eachoption contract:

Long for the buyer vs. Short for the seller

(1) Buying a Call Long a Call

(2) Selling a Call Short a Call

(3) Buying a Put Long a Put

(4) Selling a Put Short a Put

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Options Features

The buyer of an option has to pay aprice, option premium. The seller of anoption receives the option premium.

The option premium is an immediateexpense for the buyer and an immediatereturn for the seller, whether or not thebuyer ever exercises the option.

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Long vs. Short

Buyer (Long) Seller (Short)

Call

- Right to buy theunderlying (i.e. toexercise the option)

- Pays the premium

- Obligation to deliver theunderlying, if buyerexercises the option

- Receives the premium

Put

- Right to sell theunderlying (i.e. toexercise the option)

- Pays the premium

- Obligation to buy theunderlying, if buyerexercises the option

- Receives the premium

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Moneyness

Call Put

In-the-money(ITM)

Exercise price

Present price

At-the-money(ATM)

Exercise price=

Present price

Exercise price=

Present price

Out-of-the-money(OTM)

Exercise price>

Present price

Exercise price


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Options Exchanges

Chicago Mercantile Exchange

Chicago Board Options Exchange

Over-the-counter market (contractsare customized)

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Contingency (payoff) Graphs for

Currency Options

1. Contingency Graph for a Buyer of aCall Option

2. Contingency Graph for a Seller of aCall Option

3. Contingency Graph for a Buyer of aPut Option

4. Contingency Graph for a Seller of aPut Option

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C i G h f C O i


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Insert exhibit 5.6 page 123

Contingency Graphs for Currency Options

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Currency Call Options

Factors Affecting Currency CallOption Premiums

a. Level of existing spot price relative to strike

price

b. Length of time before the expiration date

c. Potential variability of currency

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Currency Put Options

Factors Affecting Currency PutOption Premiums

a. Level of existing spot price relative to strike

price

b. Length of time before the expiration date

c. Potential variability of currency

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Call Options Application (1)

Hedge payables (Example on page 116)

Pike Co. orders Australian goods and makes apayment in Australian dollars (A$) upon delivery.This company can buy an A$ call option thatlocks in a maximum rate. If the A$s valueremains below the strike price, Pike can purchaseA$ at the prevailing spot rate and simply let its

call option expire. If the A$s value rises abovethe strike price, Pike will execute the option andbuy A$ at the strike price.

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Call Options Application (1)

A payment in A$1,000,000 will be delivered atthe end of June.

On March 1, an option on A$500,000 that expireson June 28 has a strike price of A$1.1000/$.

Pike Co. buys 2 A$ Call options on March 1 andpay $100 premium for each option.

On June 28,

If the spot rate is A$1.0000/$, Pike purchases A$ at theprevailing spot rate, A$1.000/$, and simply let its calloptions expire.

If the spot rate is A$1.2050, Pike executes the options and

buy A$ at the strike price, A$1.1000/$.37


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Put Options Application (1)

Hedge receivables

ABC Co. will receive payment in C$2,000,000 at the end ofSeptember.

On March 1, an option on C$500,000 that expires onSeptember 28 has a strike price of C$1.5300/$.

ABC Co. buy 4 C$ Put options on March 1 and pay $100premium for each option.

On September 28,

If the spot rate is C$1.4500/$, Pike executes the optionsand sell C$ at the strike price, CA1.5300/$.

If the spot rate is C$1.6000/$, ABC sells C$ at theprevailing spot rate, A$1.6000/$, and simply let its calloptions expire.

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Speculation with Call Options (1)example on page 118

Spot rate on June,1 =$1.3900 Call option premium=$0.012/BP

Strike price=$1.4000/BP

Settlement date=December, 31

Contract amount=31,250 BP

No brokerage fees.

One investor buy one Call option on June, 1.

Just before expiration, spot rate=$1.4100/BP.

Q1: Will the investor exercise the Call option?

Yes. He exercises the Call option and then sell pounds withspot rate of $1.3000/BP.

Q2: What is his profit/loss?

See the tables in the textbook 39


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Speculation with Call Options (2)Q&A 19

Call option premium=$0.03/C$

Strike price=$0.75/C$

Fill in the net profit(or loss) per unit based on thelisted possible spot rates of the C$ on theexpiration date.

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Possible spot rate of

C$ on expiration date net Profit (loss)/C$

$0.76 -0.02

0.78 0.000.80 0.02

0.82 0.04

0.85 0.07

0.87 0.09


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Speculation with Put Options (1)example on page 121

Spot rate on June,1 =$1.3900

Put option premium=$0.04/BP

Strike price=$1.4000/BP

Settlement date=December, 31

Contract amount=31,250 BP No brokerage fees.

One investor buy one Put option on June, 1.

Just before expiration, spot rate=$1.3000/BP.

Q1: Will the investor exercise the Put option?

Yes. He will buy pounds from spot market at $1.3000/BPand then execute the put option.

Q2: What is his profit/loss?

See the tables in the textbook41


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Speculation with Put Options (2)Q&A 20

Put option premium=$0.02/C$

Strike price=$0.86/C$

Fill in the net profit(or loss) per unit based on thelisted possible spot rates of the C$ on theexpiration date.

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Possible spot rate of

C$ on expiration date net Profit (loss)/C$

$0.76 0.08

0.79 0.050.84 0.00

0.87 -0.02

0.89 -0.02

0.91 -0.02


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American-style vs. European-style

American-style options: can beexercised before or on the expirationdate.

European-style options: must beexercised on the expiration date.

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Currency Swap

An agreement in which one party providesa certain principal in one currency to itscounterparty in exchange for another

currency, pays fixed or floating rate ofinterest on the currency it receives, andexchange the principal at the maturity ofthe contract.

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SWAP Application

Spot rate= $1.2500/euro

r = 10% in US, r =8% in EU.

Party A exchange 1 million euro for 1.25 million $.

Contract tenor is five years. The interest is paid every year.

PrincipalUSD 1,250,000

Euro 1,000,000

Year 0 1 2 3 4 5

Fixed rate in USD 10% 10% 10% 10% 10%

Fixed rate in Euro 8.0% 8.0% 8.0% 8.0% 8.0%

Party A USD 1,250,000 -125,000 -125,000 -125,000 -125,000 -1,375,000

Euro -1,000,000 80,000 80,000 80,000 80,000 1,080,000

Party B USD -1,250,000 125,000 125,000 125,000 125,000 1,375,000

Euro 1,000,000 -80,000 -80,000 -80,000 -80,000 -1,080,000

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Homework

Chapter 5 Q&A:1,2,3,4,6,7,10,11,12,13,17,21,22.

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Documents

IFM Ch05 Derivatives Good