Download MCF Outline 6

Outline 6
6. Currency Futures and Options
6.1 Introduction
6.2 Currency Futures
6.2.1 Forward & Futures Contracts
6.2.2 Advantages / Disadvantages of Futures
6.2.3 How to Use Futures
6.3 Currency Options
6.3.1 Pricing Currency Options
6.4 How the Use of Currency Futures & Options Affects MC
Value
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Prof. R.A. Michelfelder
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6.1 Introduction
• Derivatives:
– Financial contracts or assets that derive their
value from other assets
– FX derivatives values derived from the
underlying value of a currency
– Used to manage FX risk and to take speculative
risks on currency changes
– Future, option and forward contracts are
derivatives
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6.2 Currency Futures
• Futures: contracts with standard volumes and
future delivery dates for a currency
– A futures contract is a standardized forward contract
• Volume and delivery dates are standard
• Exchange rate is fixed for the day
– Available for a limited number of currencies:
• A$, Brazil real, £, CAD$, euro, ¥, Mex. Peso, NZ$, ruble, So.
African rand, Swiss franc
• Currency options availability depends upon demand
– Number of contracts outstanding is “open interest”
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6.2 Currency Futures
• Future (continued):
– “Marked-to-market”: profit / loss on the future contract
is settled at the the end of each trading day
• Helps to ensure credit of investor along with margin req.
• After settlement, new contract is issued at prevailing price.
– High leverage; bought on margin, requirement averages
2% of the value of the contract
– Maintenance margin is the minimum margin;
• If contract incurs losses, margin account falls below maint.
margin, you must add $ to maint. margin level
– Pay commissions for futures trading – very inexpensive
– Circuit breakers exist to keep price movements within a
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Prof. R.A. Michelfelder
6.2 Currency Futures
• Future (continued):
– If prices drops below floor, trading is halted until maint.
margin requirement is met to ensure payment of losses
on the contract
– High leverage and low transactions costs encourages
participation in the currency future markets
– Futures are traded on physical exchanges with traders
interacting face-to-face
– See cme.com/prices/daily_settlement.cfm for daily
futures price data
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6.2 Currency Futures
• Currency futures trading commissions at
Chicago Mercantile Exchange:
– Retail Trader Rates (cost per round-trip trade):
Online $15.75
Broker-Assisted $46.50
– Large, Non-Member Rates:
Online $10.00
Broker-Assisted $20.00
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Multinational Corporate Finance
Prof. R.A. Michelfelder
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6.2 Currency Futures
• Future contract marked-to-market example:
– Euro contract due in December 2003:
•
•
•
•
•
•
•
•
7/7/2017
Prior Day Settle Price (10/27/03): $1.1726
Current Settle Price (10/28/03): $1.1669
Point change: -57 or –57 x $0.0001 or $0.0057
-$0.0057 x euro 125,000 = -$712
$2,025 initial margin - $712 = $1,313
Maint. Margin for euro contract = $1,500
Must add $1,500 - $1,313 = $187 to account
Daily loss is $712 + $15 commission = $727 on $2,025
investment (-35.9% in 1 day)
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Prof. R.A. Michelfelder
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6.2 Currency Futures
• Future contract marked-to-market example:
– Canadian $ contract due in December 2003:
•
•
•
•
•
•
•
7/7/2017
Prior Day Settle Price (10/27/03): $0.7606
Current Settle Price (10/28/03): $0.7617
Point change: +11 or +11 x $0.0001 or $0.0011
+$0.0011 x C$100,000 = +$110
$608 initial margin + $110 = $719
Maint. Margin for C$ = $450
Daily profit is: $110 - $15 commission or $95 on $608
investment (+15.6% in 1 day)
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Prof. R.A. Michelfelder
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6.2 Currency Futures
• Large profits / losses were generated from small
changes in the exchange rate price of the futures
contract: daily ror’s:
– 35.9% daily loss on Euro contract
– 15.6% daily profit on C$ contract
– Due to leverage: only invested $2,025 to buy 125,000
euros or $608 to buy C$100,000
– Leverage is generally less than 2% of contract value
(margins required typically $1,000-$2,000 per contract)
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Prof. R.A. Michelfelder
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6.2.1 Forward and Futures
Contracts
• Futures contracts are standardized contracts:
– March, June, September December delivery dates
– Expire 2 business days before 3rd Wednesday of
delivery month
– Currency volumes are standardized
– Standardization encourages trading
– Daily settlement reduces default risk
• Forward contracts are custom contracts with terms
only known to both parties – difficult to trade
– No daily settlement to prevent default
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Multinational Corporate Finance
Prof. R.A. Michelfelder
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Forward
Futures
Contract Size
Customized
Standardized
Delivery Date
Customized
Standardized
Security Deposit
None; bank balance
required or letter of
credit
Small security deposit
Marketplace
Telephone
Central exchange
floors
Regulation
Self-regulated
Commodity Futures
Trading Assoc.,
National Futures
Assoc.
Transactions Costs
Bank Bid-Ask Spread
Broker Fees
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6.2.2 Advantages / Disadvantages
of Futures Contracts
• Small sizes and ability to liquidate any day before
maturity are advantages over forward
• Limited currencies, rigid delivery dates, rigid
currency amounts
• Futures will only be useful for businesses with a
regular stream of cash in foreign currency
• Futures are otherwise too rigid to conform to
specific needs of a business
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Multinational Corporate Finance
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6.2.3 How to Use Currency
Futures
• Speculation:
– Expect a currency’s value to rise in the future,
buy a futures contract to lock-in the price the
currency is bought at a future date
– On the settlement date, buy the currency at
price specified by the contract
– Sell at the (hopefully) higher spot rate for a
profit
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Multinational Corporate Finance
Prof. R.A. Michelfelder
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6.2.3 How to Use Currency
Futures
• Speculation:
Currency futures are sold by speculators who
expect the spot rate of a currency to be less than
the rate they would be obligated to sell currency
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Multinational Corporate Finance
Prof. R.A. Michelfelder
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6.2.3 How to Use Currency
Futures
•
•
Speculation e.g.:
April 4 Mexican pesos 500,000 futures contract with a June
settlement date priced at $0.09
–
On April 4 speculators expect peso to decline sell futures
contracts
–
On June 17 (settlement date) the spot rate is $0.08:
1. 4/4: Contract to sell 500k pesos: $0.09 x p500,000 = $45,000
2. 6/17: Buy pesos spot: $0.08 x p500,000 = $40,000
3. Sell p500,000 for $0.09 ($45,000) to fulfill the futures contract
4. Gain on the futures position is $5,000
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6.2.3 How to Use Currency
Futures
•
Hedging: Purchasing Futures to Hedge Payables:
–
–
Purchase of the futures contract locks in the price to buy a currency
US firm orders Canadian goods and on delivery will pay Canadian
exporter C$500,000
•
•
•
Purchase 5 C$ futures contracts today to lock in the future price of buying
$C at a future settlement date
C$ currency exposure is hedged
Hedging: Purchasing Futures to Hedge Receivables:
–
–
–
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US firm sell futures contracts when it plans to receive Thai baht from
exporting goods to Thailand
Selling a futures contract, the firm locks-in the selling price of the Thai
baht at which it will be able to sell at the settlement date
The firm would do this if it expects the Thai baht to depreciate
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Prof. R.A. Michelfelder
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6.3 Currency Options
• Option:
– Right but not the obligation to sell or buy a financial
instrument at a specified price and volume up to the
expiration date
– Currency Call Option: right to buy a specified amount
of a currency at a specific price within a specific period
of time
– Currency Put Option: right to sell a currency
– Standard volumes and future delivery dates
• Open Interest: number of contracts outstanding
• Currency options contracts available for limited number of
currencies depending
on demand
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Prof. R.A. Michelfelder
6.3 Currency Options
• Option:
– The seller of the option must fulfill the contract if the
buyer desires to do so
– The option to not buy or sell has value, the buyer must
pay a premium for this privilege
– Currency option has two sides: call (right to buy foreign
currency) can be converted to a put (right to sell
domestic currency)
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Multinational Corporate Finance
Prof. R.A. Michelfelder
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6.3.1 Pricing Currency Options
•
Factors that Affect Currency Call Option Premiums:
1. Level of existing spot price relative to strike price
Higher spot rate relative to strike price, the higher the option
price
2. Length of time before the expiration date
The longer the time to expiration, the higher the chance the spot
rate > strike price
3. Potential variability of currency
Higher the var. of spot rate, the higher the chance that the spot
rate will be above the strike price – more volatile currencies have
higher call option prices
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Multinational Corporate Finance
Prof. R.A. Michelfelder
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6.3.1 Pricing Currency Options
Profit From Buying a Call at Various Spot Rates at
Termination
Profit
+
+
0
Limited Loss
_
e break-even
estrike
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6.3.1 Pricing Currency Options
Profit From Selling a Call at Various Spot Rates at
Termination
Profit
+
Profit = Call Prem.
0
_
_
e break-even
estrike
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6.3.1 Pricing Currency Options
Profit From Buying a Put at Various Spot Rates at
Termination
Profit
+
+
0
Limited Loss
_
e break-even
estrike
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Multinational Corporate Finance
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6.3.1 Pricing Currency Options
Profit From Selling a Put at Various Spot Rates at
Termination
Profit
+
0
_
Profit = Put
Premium
_
e break-even
estrike
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6.3.1 Pricing Currency Options
SEE EXHIBITS 7.5, 7.6, 7.7, and 7.8 on pp. 194-196
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6.3.1 Pricing Currency Options
• Option Price:
– Intrinsic value: difference between spot rate
and exercise or strike price
– Time value: premium above intrinsic value for
chance that the option premium can grow or
chance that an out-of-the-money option will be
in the money (grows with greater time to
expiration and volatility of spot rate)
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6.3.1 Pricing Currency Options
• Option Pricing Models:
– Will not discuss explicitly due to mathematical
complexity:
• Black-Scholes options pricing and other models:
P = f(dom. Interest rate, foreign interest rate, spot rate,
standard deviation of spot rate, option’s time to
expiration, probability of spot rate > exercise price)
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6.4 How the Use of Currency
Futures & Options Affects MC
Value
• Currency futures & options can affect the
value of a firm
– Futures can prevent the possibility that the
value of foreign currency receipts will 
because of that currency against the $
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Multinational Corporate Finance
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6.4 How the Use of Currency
Futures & Options Affects MC
Value
• Currency options:
– Offer same protection against depreciation of
currencies but allow more flexibility to
capitalize on potential appreciation of the
foreign currency, but they cost a premium,
thereby reducing a MC’s cash flows
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