Download Foreign Currency Derivatives

Foreign Currency Derivatives
 Learning Objectives
• Examine how foreign currency futures are quoted,
•
•
•
•
valued, and used for speculation purposes
Illustrate how foreign currency futures differ from
forward contracts
Analyze how foreign currency options are quoted and
used for speculation purposes
Consider the distinction between buying and writing
options in terms of whether profits and losses are
limited or unlimited
Explain how foreign currency options are valued
Copyright © 2003 Pearson Education, Inc.
Slide 7-1
Foreign Currency Derivatives


Financial management in the 21st century needs to consider the
use of financial derivatives
These derivatives, so named because their values are derived
from the underlying asset, are a powerful tool used for two
distinct management objectives:
• Speculation – the financial manager takes a position in the
•

expectation of profit
Hedging – the financial manager uses the instruments to reduce
the risks of the corporation’s cash flow
In the wrong hands, derivatives can cause a corporation to
collapse (Barings, Allied Irish Bank), but used wisely they
allow a financial manager the ability to plan cash flows
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Slide 7-2
Foreign Currency Derivatives
 The financial manager must first understand the

basics of the structure and pricing of these tools
The derivatives that will be discussed will be
• Foreign Currency Futures
• Foreign Currency Options
Copyright © 2003 Pearson Education, Inc.
Slide 7-3
Foreign Currency Futures
 A foreign currency futures contract is an alternative
to a forward contract
• It calls for future delivery of a standard amount of
currency at a fixed time and price
• These contracts are traded on exchanges with the
largest being the International Monetary Market
located in the Chicago Mercantile Exchange
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Slide 7-4
Foreign Currency Futures
 Contract Specifications
• Size of contract – called the notional principal, trading
in each currency must be done in an even multiple
• Method of stating exchange rates – “American terms”
are used; quotes are in US dollar cost per unit of
foreign currency, also known as direct quotes
• Maturity date – contracts mature on the 3rd Wednesday
of January, March, April, June, July, September,
October or December
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Slide 7-5
Foreign Currency Futures
 Contract Specifications
• Last trading day – contracts may be traded through the
second business day prior to maturity date
• Collateral & maintenance margins – the purchaser or
trader must deposit an initial margin or collateral; this
requirement is similar to a performance bond
– At the end of each trading day, the account is marked to
market and the balance in the account is either credited
if value of contracts is greater or debited if value of
contracts is less than account balance
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Slide 7-6
Foreign Currency Futures

Contract Specifications
• Settlement – only 5% of futures contracts are settled by physical
delivery, most often buyers and sellers offset their position prior
to delivery date
– The complete buy/sell or sell/buy is termed a round turn
• Commissions – customers pay a commission to their broker to
•
execute a round turn and only a single price is quoted
Use of a clearing house as a counterparty – All contracts are
agreements between the client and the exchange clearing house.
Consequently clients need not worry about the performance of a
specific counterparty since the clearing house is guaranteed by
all members of the exchange
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Slide 7-7
Using Foreign Currency Futures
 Any investor wishing to speculate on the movement
of a currency can pursue one of the following
strategies
• Short position – selling a futures contract based on
view that currency will fall in value
• Long position – purchase a futures contract based on
view that currency will rise in value
• Example: Amber McClain believes that Mexican peso
will fall in value against the US dollar, she looks at
quotes in the WSJ for Mexican peso futures
Copyright © 2003 Pearson Education, Inc.
Slide 7-8
Using Foreign Currency Futures
Maturity
Open
High
Low
Settle
Change
High
Low
Open
Interest
Mar
.10953
.10988
.10930
.10958
---
.11000
.09770
34,481
June
.10790
.10795
.10778
.10773
---
.10800
.09730
3,405
Sept
.10615
.10615
.10610
.10573
---
.10615
.09930
1,4181
All contracts are for 500,000 new Mexican pesos. “Open,” “High” and “Low”
all refer to the price on the day. “Settle” is the closing price on the day and
“Change” indicates the change in the settle price from the previous day. “High”
and “Low” to the right of Change indicates the highest and lowest prices for this
specific contact during its trading history. “Open Interest” indicates the number
of contracts outstanding
Source: Wall Street Journal, February 22, 2002, p.C13
Copyright © 2003 Pearson Education, Inc.
Slide 7-9
Using Foreign Currency Futures
 Example (cont.): Amber believes that the value of the


peso will fall, so she sells a March futures contract
By taking a short position on the Mexican peso,
Amber locks-in the right to sell 500,000 Mexican
pesos at maturity at a set price above their current
spot price
Using the quotes from the table, Amber sells one
March contract for 500,000 pesos at the settle price:
$.10958/Ps
Value at maturity (Short position) = -Notional principal  (Spot – Forward)
Copyright © 2003 Pearson Education, Inc.
Slide 7-10
Using Foreign Currency Futures
 To calculate the value of Amber’s position we use the
following formula
Value at maturity (Short position) = -Notional principal  (Spot – Forward)
 Using the settle price from the table and assuming a
spot rate of $.09500/Ps at maturity, Amber’s profit is
Value = -Ps 500,000  ($0.09500/ Ps - $.10958/ Ps) = $7,290
Copyright © 2003 Pearson Education, Inc.
Slide 7-11
Using Foreign Currency Futures
 If Amber believed that the Mexican peso would rise
in value, she would take a long position on the peso
Value at maturity (Long position) = Notional principal  (Spot – Forward)
 Using the settle price from the table and assuming a
spot rate of $.11000/Ps at maturity, Amber’s profit is
Value = Ps 500,000  ($0.11000/ Ps - $.10958/ Ps) = $210
Copyright © 2003 Pearson Education, Inc.
Slide 7-12
Foreign Currency Futures Versus Forward
Contracts
Characteristic
Foreign Currency Futures
Forward Contracts
Size of Contract
Standardized contracts per currency
any size desired
Maturity
fixed maturities, longest typically
being one year
any maturity up to one
year, sometimes longer
Location
trading occurs on organized exchange
trading occurs between
individuals and banks
Pricing
open outcry process on exchange floor
prices are determined
by bid/ask quotes
Margin/Collateral
initial margin that is marked to market
on a daily basis
no explicit collateral
Settlement
rarely delivered, settlement normally takes
place through purchase of offsetting position
contract is delivered
upon, can offset position
Commissions
single commission covers purchase& sell
Trading hours
traditional exchange hours
no explicit commissions;
banks earn money
through bid/ask spread
markets open 24 hours
Counterparties
unknown, go through clearing house
parties in direct contact
Liquidity
liquid but relatively small
in total sales volume and value
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liquid and relatively large
in sales volume
Slide 7-13
Foreign Currency Options
 A foreign currency option is a contract giving the
purchaser of the option the right to buy or sell a given
amount of currency at a fixed price per unit for a
specified time period
• The most important part of clause is the “right, but not
the obligation” to take an action
• Two basic types of options, calls and puts
– Call – buyer has right to purchase currency
– Put – buyer has right to sell currency
• The buyer of the option is the holder and the seller of
the option is termed the writer
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Slide 7-14
Foreign Currency Options
 Every option has three different price elements
• The strike or exercise price is the exchange rate at
which the foreign currency can be purchased or sold
• The premium, the cost, price or value of the option
itself paid at time option is purchased
• The underlying or actual spot rate in the market
 There are two types of option maturities
• American options may be exercised at any time during
the life of the option
• European options may not be exercised until the
specified maturity date
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Slide 7-15
Foreign Currency Options
 Options may also be classified as per their payouts
• At-the-money (ATM) options have an exercise price
equal to the spot rate of the underlying currency
• In-the-money (ITM) options may be profitable,
excluding premium costs , if exercised immediately
• Out-of-the-money (OTM) options would not be
profitable, excluding the premium costs, if exercised
Copyright © 2003 Pearson Education, Inc.
Slide 7-16
Foreign Currency Options Markets
 The increased use of currency options has lead the
creation of several markets where financial managers
can access these derivative instruments
• Over-the-Counter (OTC) Market – OTC options are
most frequently written by banks for US dollars
against British pounds, Swiss francs, Japanese yen,
Canadian dollars and the euro
– Main advantage is that they are tailored to purchaser
– Counterparty risk exists
– Mostly used by individuals and banks
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Slide 7-17
Foreign Currency Options Markets
• Organized Exchanges – similar to the futures market,
currency options are traded on an organized exchange
floor
– The Chicago Mercantile and the Philadelphia Stock
Exchange serve options markets
– Clearinghouse services are provided by the Options
Clearinghouse Corporation (OCC)
Copyright © 2003 Pearson Education, Inc.
Slide 7-18
Foreign Currency Options Markets
 Table shows option prices on Swiss franc taken from the
Wall Street Journal
Calls - Last
Options &
Underlying
58.51
58.51
58.51
58.51
58.51
58.51
58.51
Strike Price
56
56 1/2
57
57 1/2
58
58 1/2
59
Aug
--1.13
0.75
0.71
0.50
0.30
Sep
----1.05
-0.66
Puts - Last
Dec
2.76
-1.74
-1.28
-1.21
Aug
0.04
0.06
0.10
0.17
0.27
0.50
0.90
Sep
0.22
0.30
0.38
0.55
0.89
0.99
1.36
Dec
1.16
-1.27
-1.81
---
Each option = 62,500 Swiss francs. The August, September and December listings are the option maturity dates
Copyright © 2003 Pearson Education, Inc.
Slide 7-19
Foreign Currency Options Markets
• The spot rate means that 58.51 cents, or $0.5851 was
the price of one Swiss franc
• The strike price means the price per franc that must
be paid for the option. The August call option of 58 ½
means $0.5850/Sfr
• The premium, or cost, of the August 58 ½ option was
0.50 per franc, or $0.0050/Sfr
– For a call option on 62,500 Swiss francs, the total cost
would be Sfr62,500 x $0.0050/Sfr = $312.50
Copyright © 2003 Pearson Education, Inc.
Slide 7-20
Foreign Currency Speculation
 Speculating in the spot market
• Hans Schmidt is a currency speculator. He is willing
to risk his money based on his view of currencies and
he may do so in the spot, forward or options market
• Assume Hans has $100,000 and he believes that the
six month spot for Swiss francs will be $0.6000/Sfr.
– Speculation in the spot market requires that view is
currency appreciation
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Slide 7-21
Foreign Currency Speculation
 Speculating in the spot market
• Hans should take the following steps
• Use the $100,000 to purchase Sfr170,910.96 today at a
spot rate of $0.5851/Sfr
• Hold the francs indefinitely, because Hans is in the
spot market he is not committed to the six month target
• When target exchange rate is reached, sell the
Sfr170,910.96 at new spot rate of $0.6000/Sfr,
receiving Sfr170,910.96 x $0.6000/Sfr = $102,546.57
• This results in a profit of $2,546.57 or 2.5% ignoring
cost of interest income and opportunity costs
Copyright © 2003 Pearson Education, Inc.
Slide 7-22
Foreign Currency Speculation

Speculating in the forward market
• If Hans were to speculate in the forward market, his viewpoint
•
•
•
•
would be that the future spot rate will differ from the forward
rate
Today, Hans should purchase Sfr173,611.11 forward six months
at the forward quote of $0.5760/Sfr. This step requires no cash
outlay
In six months, fulfill the contract receiving Sfr173,611.11 at
$0.5760/Sfr at a cost of $100,000
Simultaneously sell the Sfr173,611.11 in the spot market at
Hans’ expected spot rate of $0.6000/Sfr, receiving Sfr173,611.11
x $0.6000/Sfr = $104,166.67
This results in a profit of $4,166.67 with no investment required
Copyright © 2003 Pearson Education, Inc.
Slide 7-23
Foreign Currency Speculation
 Speculating in the options market
• If Hans were to speculate in the options market, his
viewpoint would determine what type of option to buy
or sell
• As a buyer of a call option, Hans purchases the August
call on francs at a strike price of 58 ½ ($0.5850/Sfr)
and a premium of 0.50 or $0.0050/Sfr
• At spot rates below the strike price, Hans would not
exercise his option because he could purchase francs
cheaper on the spot market than via his call option
Copyright © 2003 Pearson Education, Inc.
Slide 7-24
Foreign Currency Speculation
 Speculating in the options market
• Hans’ only loss would be limited to the cost of the
option, or the premium ($0.0050/Sfr)
• At all spot rates above the strike of 58 ½ Hans would
exercise the option, paying only the strike price for
each Swiss franc
– If the franc were at 59 ½, Hans would exercise his
options buying Swiss francs at 58 ½ instead of 59 ½
Copyright © 2003 Pearson Education, Inc.
Slide 7-25
Foreign Currency Speculation
 Speculating in the options market
• Hans could then sell his Swiss francs on the spot
market at 59 ½ for a profit
Profit = Spot rate – (Strike price + Premium)
= $0.595/Sfr – ($0.585/Sfr + $0.005/Sfr)
= $0.005/Sfr
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Slide 7-26
Foreign Currency Speculation
 Speculating in the options market
• Hans could also wait to see if the Swiss franc
appreciates more, this is the value to the holder of a
call option – limited loss, unlimited upside
• Hans’ break-even price can also be calculated by
combining the premium cost of $0.005/Sfr with the
cost of exercising the option, $0.585/Sfr
– This matched the proceeds from exercising the option at
a price of $0.590/Sfr
Copyright © 2003 Pearson Education, Inc.
Slide 7-27
Profit & Loss for the Buyer of a Call Option
“At the money”
Strike price
Profit
(US cents/SF)
“Out of the money”
“In the money”
+ 1.00
+ 0.50
0
- 0.50
Unlimited profit
57.5
58.0
58.5
59.0
59.5
Spot price
(US cents/SF)
Limited loss
Break-even price
- 1.00
Loss
The buyer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited loss of
0.50 cents/SF at spot rates less than 58.5 (“out of the money”), and an unlimited profit
potential at spot rates above 58.5 cents/SF (“in the money”).
Copyright © 2003 Pearson Education, Inc.
Slide 7-28
Foreign Currency Speculation
 Speculating in the options market
• Hans could also write a call, if the future spot rate is
below 58 ½, then the holder of the option would not
exercise it and Hans would keep the premium
• If Hans went uncovered and the option was exercised
against him, he would have to purchase Swiss francs
on the spot market at a higher rate than he is obligated
to sell them at
• Here the writer of a call option has limited profit and
unlimited losses if uncovered
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Slide 7-29
Foreign Currency Speculation
 Speculating in the options market
• Hans’ payout on writing a call option would be
Profit = Premium – (Spot rate - Strike price)
= $0.005/Sfr – ($0.595/Sfr + $0.585/Sfr)
= - $0.005/Sfr
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Slide 7-30
Profit & Loss for the Writer of a Call Option
“At the money”
Strike price
Profit
(US cents/SF)
+ 1.00
+ 0.50
0
Break-even price
Limited profit
57.5
- 0.50
58.0
58.5
59.0
59.5
Spot price
(US cents/SF)
Unlimited loss
- 1.00
Loss
The writer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited
profit of 0.50 cents/SF at spot rates less than 58.5, and an unlimited loss potential at
spot rates above (to the right of) 59.0 cents/SF.
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Slide 7-31
Foreign Currency Speculation
 Speculating in the options market
• Hans could also buy a put, the only difference from
•
•
•
•
buying a call is that Hans now has the right to sell
currency at the strike price
If the franc drops to $0.575/Sfr Hans will deliver to the
writer of the put and receive $0.585/Sfr
The francs can be purchased on the spot market at
$0.575/Sfr
With the cost of the option being $0.005/Sfr, Hans
realizes a net gain of $0.005/Sfr
As with a call option - limited loss, unlimited gain
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Slide 7-32
Foreign Currency Speculation
 Speculating in the options market
• Hans’ payout on buying a put option would be
Profit = Strike price – (Spot rate + Premium)
= $0.585/Sfr – ($0.575/Sfr + $0.005/Sfr)
= $0.005/Sfr
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Slide 7-33
Profit & Loss for the Buyer of a Put Option
“At the money”
Strike price
Profit
(US cents/SF)
“In the money”
“Out of the money”
+ 1.00
+ 0.50
0
Profit up
to 58.0
57.5
58.5
59.0
59.5
Spot price
(US cents/SF)
Limited loss
- 0.50
- 1.00
58.0
Break-even
price
Loss
The buyer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited loss of
0.50 cents/SF at spot rates greater than 58.5 (“out of the money”), and an unlimited profit
potential at spot rates less than 58.5 cents/SF (“in the money”) up to 58.0 cents.
Copyright © 2003 Pearson Education, Inc.
Slide 7-34
Foreign Currency Speculation
 Speculating in the options market
• And of course, Hans could write a put, thereby
obliging him to purchase francs at the strike price
• If the franc drops below 58 ½ Hans will lose more than
the premium received
• If the spot rate does not fall below 58 ½ then the
option will not be exercised and Hans will keep the
premium from the option
• As with a call option - unlimited loss, limited gain
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Slide 7-35
Foreign Currency Speculation
 Speculating in the options market
• Hans’ payout on writing a put option would be
Profit = Premium – (Strike price - Spot rate)
= $0.005/Sfr – ($0.585/Sfr + $0.575/Sfr)
= - $0.005/Sfr
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Slide 7-36
Profit & Loss for the Writer of a Put Option
“At the money”
Profit
(US cents/SF)
Strike price
+ 1.00
+ 0.50
Break-even
price
Limited profit
0
57.5
58.0
58.5
59.0
59.5
Spot price
(US cents/SF)
- 0.50
- 1.00
Unlimited loss
up to 58.0
Loss
The writer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited profit of
0.50 cents/SF at spot rates greater than 58.5, and an unlimited loss potential at spot rates
less than 58.5 cents/SF up to 58.0 cents.
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Slide 7-37
Option Pricing and Valuation
 The pricing of any option combines six elements
•
•
•
•
•
•
Present spot rate, $1.70/£
Time to maturity, 90 days
Forward rate for matching maturity (90 days), $1.70/£
US dollar interest rate, 8.00% p.a.
British pound interest rate, 8.00% p.a.
Volatility, the standard deviation of daily spot rate
movement, 10.00% p.a.
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Slide 7-38
Option Pricing and Valuation
 The intrinsic value is the financial gain if the option
is exercised immediately (at-the-money)
• This value will reach zero when the option is out-ofthe-money
• When the spot rate rises above the strike price, the
option will be in-the-money
• At maturity date, the option will have a value equal to
its intrinsic value
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Slide 7-39
Option Pricing and Valuation
 When the spot rate is $1.74/£, the option is ITM and


has an intrinsic value of $1.74 - $1.70/£, or 4 cents
per pound
When the spot rate is $1.70/£, the option is ATM and
its intrinsic value is $1.70 - $1.70/£, or zero cents per
pound
When the spot rate is is $1.66/£, the option is OTM
and has no intrinsic value, only a fool would exercise
this option
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Slide 7-40
Option Pricing and Valuation
Option Premium
(US cents/£)
Strike Price of $1.70/£
-- Valuation on first day of 90-day maturity --
6.0
5.67
Total value
5.0
4.00
4.0
3.30
3.0
2.0
1.67
Time value
Intrinsic
value
1.0
0.0
1.66
1.67
1.68
1.69
1.70
1.71
1.72
1.73
1.74
Spot rate ($/£)
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Slide 7-41
Option Pricing and Valuation
 The time value of the option exists because the price
of the underlying currency can potentially move
further into the money between today and maturity
• In the exhibit, time value is shown as the area between
total value and intrinsic value
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Slide 7-42
Option Pricing and Valuation
 Option volatility is defined as the standard deviation
of the daily percentage changes in the underlying
exchange rate
• It is the most important variable because of the
exchange rate’s perceived likelihood to move either in
or out of the range in which the option would be
exercised
• Volatility is stated per annum
• Example: 12.6% p.a. volatility would have to be
converted for a single day as follows
12.6% 12.6%

 0.66% daily vola tility
365 19.105
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Slide 7-43
Option Pricing and Valuation
 For our $1.70/£ call option, an increase in annual
volatility of 1 percentage point will increase the
option premium from $0.033/£ to $0 .036/£
• The marginal change in option premium is equal to the
change in option premium itself divided by the change
in volatility
 premium $0.036  $0.033

 0.30
 volatilit y
.11  .10
Copyright © 2003 Pearson Education, Inc.
Slide 7-44
Option Pricing and Valuation
 The primary problem with volatility is that it is

unobservable, there is no single correct method for its
calculation
Thus, volatility is viewed in three ways
• Historic – normally measured as the percentage
movement in the spot rate on a daily basis, or other
time period
• Forward-looking – a trader may adjust recent historic
volatilities for expected market swings
• Implied – calculated by backing out of the market
option premium
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Slide 7-45
Summary of Learning Objectives
 A foreign currency futures contract is an exchange-

traded agreement calling for future delivery of a
standard amount of foreign currency at a fixed time,
place and price
Foreign currency futures contracts are in reality
standardized forward contracts. Unlike forward
contracts, however, trading occurs on the floor of an
organized exchange. They also require collateral and
are normally settled through the purchase of an
offsetting position
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Slide 7-46
Summary of Learning Objectives
 Futures differ from forward contracts by size of

contract, maturity, location of trading, pricing ,
collateral/margin requirements, method of settlement,
commissions, trading hours, counterparties and
liquidity
Financial managers typically prefer foreign currency
forwards over futures out of simplicity of use and
position maintenance. Financial speculators prefer
futures over forwards because of the liquidity of the
market
Copyright © 2003 Pearson Education, Inc.
Slide 7-47
Summary of Learning Objectives



Foreign currency options are financial contracts that give the
holder the right, but not the obligation, to buy or sell a
specified amount of currency at a predetermined price on or
before a specified maturity date
The use of currency options as a speculative device for a buyer
arise from the fact that an option gains in value as the
underlying currency rises or falls. The amount of loss when
the underlying currency moves opposite the desired direction
is limited to the premium of the option
The use of currency options as a speculative device for a seller
arise from the option premium. If the option expires out-ofthe-money, the writer has earned and retains the entire
premium
Copyright © 2003 Pearson Education, Inc.
Slide 7-48
Summary of Learning Objectives

Speculation is an attempt to profit by trading on expectations
about prices in the future.
• In the foreign exchange market, one speculates by taking
•


position on a currency and then closing that position after the
exchange rate has moved.
A profit results only if the rate moves in the direction that was
expected
Currency option valuation is a complex combination of the
current spot rate, the specific strike price, the forward rate,
currency volatility and time to maturity
The total value of an option is the sum of its intrinsic and time
value.
• Intrinsic value depends on the relationship between the option’s
strike price and the spot rate at any single point in time, whereas
time value estimates how the intrinsic value may change prior to
the option’s maturity
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Slide 7-49