Lecture Session 8_currency Derivatives

Module 2 Session 2: Currency Derivatives

Session Overview A. Forward Market B. Currency Futures Market C. Currency Long and Short Positions D. Payoff Profiles C. Currency Options Market D. Currency Call Options E. Currency Put Options F. Contingency Graphs for Currency Options

Currency Forward Market 

Currency Derivatives are contracts whose price is partially derived from the value of the underlying currency it represents

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An MNC normally take positions in currency derivatives to hedge their position against exchange rate risk

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A Forward contract is an agreement between an MNC and a Bank to exchange a specified amount of a currency at a specified exchange rate (called the forward rate) on a specified date in future.

Currency Forward Market 

Import = Payables = Buying of Foreign Currency

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Export = Receivables = Selling Foreign Currency

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Forward Rate Equation

F = S (1+P)

1. If F > S = Premium, 2. If F < S = Discount  Interest Rate Parity Theorem  Numerical Example 

Currency Futures Market 

Currency Futures are exactly similar to Forward Contracts in terms of obligation, but differ in the way they are traded

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Contract Specifications

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Trading Futures – Stock Exchange – Initial Margin – Future Rates

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Comparison of Currency Futures and Forward Contracts

Forward Market Vs Future Market 1.

Trading Location

2.

Contractual Size

3.

Security Deposit

4.

Expiration/Delivery Date

5.

Regulation

6.

Participants

Currency Call Options 

An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset in the future, at prices agreed upon today.

Calls vs. Puts Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future at a fixed price today  Put options gives the holder the right, but not the obligation, to sell a given quantity of some asset at some time in the future at a fixed price today 

Currency Call Options – Basic Terms 1)

In-the-money - The exercise price is less than the spot price of the underlying asset.

2)

At-the-money - The exercise price is equal to the spot price of the underlying asset.

3)

Out-of-the-money - The exercise price is more than the spot price of the underlying asset.

Currency Call Options – Basic Terms European vs. American options 

European options can only be exercised on the expiration date.

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American options can be exercised at any time up to and including the expiration date.

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Since this option to exercise early generally has value, American options are usually worth more than European options, other things equal.

D. Currency Call Options 2. How Firms Use Currency Call Options a. Using Call Options to Hedge Payables b. Using Call Options to Hedge Project Bidding c. Using Call Options to Hedge Target Bidding

F. Contingency Graphs for Currency Options 1. Contingency Graph for a Purchaser Call Option 2. Contingency Graph for a Seller of a Option 3. Contingency Graph for a Buyer of a Option 4. Contingency Graph for a Seller of a Option

of a Call Put Put

Contingency Graphs for Currency Options

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