0% found this document useful (0 votes)

8 views34 pages

Understanding Currency Derivatives

This chapter discusses currency derivatives, focusing on forward contracts, currency futures, and options, which are used by individuals and multinational corporations (MNCs) for speculation and hedging against exchange rate risks. MNCs utilize forward contracts to lock in exchange rates for future transactions, thereby managing their exposure to currency fluctuations. The chapter also covers the mechanics of forward rates, including bid/ask spreads, premiums, discounts, and the impact of interest rate differentials on pricing.

Uploaded by

Thanh Thuy

We take content rights seriously. If you suspect this is your content, claim it here.

Available Formats

Download as PDF, TXT or read online on Scribd

0% found this document useful (0 votes)

8 views34 pages

Understanding Currency Derivatives

Uploaded by

Thanh Thuy

We take content rights seriously. If you suspect this is your content, claim it here.

Available Formats

Download as PDF, TXT or read online on Scribd

5

Currency Derivatives

CHAPTER A currency derivative is a contract whose price is partially derived from

OBJECTIVES the value of the underlying currency that it represents. Some individuals
The specific objectives
and financial firms take positions in currency derivatives to speculate on
of this chapter are to future exchange rate movements. Multinational corporations (MNCs) often
describe the character- take positions in currency derivatives to hedge their exposure to exchange
istics and use of:
rate risk. Their managers must understand how these derivatives can be
■ Forward contracts
used to achieve corporate goals.
■ Currency futures
contracts

■ Currency call
5-1 Forward Market
options contracts The forward market facilitates the trading of forward contracts on currencies. A forward
contract is an agreement between a corporation and a financial institution (such as a
■ Currency put option
contracts
commercial bank) to exchange a specified amount of a currency at a specified exchange rate
(called the forward rate) on a specified date in the future. When MNCs anticipate a future
need for or the future receipt of some foreign currency, they can set up forward contracts
to lock in the rate at which they can purchase or sell that currency. Nearly all large MNCs
use forward contracts to some extent. Some MNCs have forward contracts outstanding
worth more than $100 million to hedge various positions.
Because forward contracts accommodate large corporations, the forward transaction
will often be valued at $1 million or more. By contrast, consumers and small firms rarely
use forward contracts. In cases where a bank does not know a corporation well (or does
not fully trust it), the bank may request that the corporation make an initial deposit as
assurance that it intends to fulfill its obligation. Such a deposit, called a compensating
balance, typically does not pay interest.
The most common forward contracts are for 30, 60, 90, 180, and 360 days, although
other periods are available. Forward contracts can also be customized to the specific needs
of the MNC. If an MNC wants a forward contract that allows it to exchange dollars for
1.2 million euros in 53 days, a financial institution will accommodate such a request. The
forward rate of a given currency will usually vary with the length (number of days) of the
forward period.

5-1a How MNCs Use Forward Contracts

Multinational corporations use forward contracts to hedge their imports. They can lock in
the rate at which they obtain a currency needed to purchase those imports.

131
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
132 Part 1: The International Financial Environment

EXAMPLE Turz, Inc., is an MNC based in Chicago that will need 1 million Singapore dollars in 90 days to purchase
Singapore imports. It can buy this currency for immediate delivery at the spot rate of $0.50 per Singapore
dollar (S$). At this spot rate, the firm would need $500,000 (calculated as S$1,000,000 3 $0.50 per Singapore
dollar). It could wait 90 days and then exchange U.S. dollars for Singapore dollars at the spot rate existing at
that time, but Turz does not know what that rate will be. If the rate rises to $0.60 in those 90 days, then Turz
will need $600,000 (that is, S$1,000,000 3 $0.60 per Singapore dollar), or an additional outlay of $100,000 due
solely to the Singapore dollar’s appreciation.
To avoid exposure to such exchange rate risk, Turz can lock in the rate it will pay for Singapore dollars
90 days from now without having to exchange U.S. dollars for Singapore dollars immediately. Specifically, the
firm can negotiate a forward contract with a bank to purchase S$1,000,000 90 days forward. ●

The ability of a forward contract to lock in an exchange rate can create an opportunity
cost in some cases.

EXAMPLE Assume that in the previous example Turz negotiated a 90-day forward rate of $0.50 to purchase S$1,000,000.
If the spot rate in 90 days is $0.47, then Turz will have paid $0.03 per unit or $30,000 (1,000,000 units 3 $0.03)
more for the Singapore dollars than if it did not have a forward contract. ●

Corporations also use the forward market to lock in the rate at which they can sell
foreign currencies. This strategy is used to hedge against the possibility of those currencies
depreciating over time.

EXAMPLE Scanlon, Inc., which is based in Virginia, exports products to a French firm and will receive payment of
€400,000 in four months. It can lock in the amount of dollars to be received from this transaction by selling
euros forward. That is, Scanlon can negotiate a forward contract with a bank to sell the €400,000 for U.S. dol-
lars at a specified forward rate today. Assume the prevailing four-month forward rate on euros is $1.10. In
four months, Scanlon will exchange its €400,000 for $440,000 (calculated as €400,000 3 $1.10 5 $440,000). ●

5-1b Bank Quotations on Forward Rates

Just as many large banks serve as intermediaries for spot transactions in the foreign
exchange market, so they also serve as intermediaries for forward transactions. These banks
accommodate orders by MNCs to purchase a specific amount of a currency at a future time
and at a specified (forward) exchange rate. They also accommodate orders by MNCs to sell
a specific amount of currency at a future time and at a specified (forward) exchange rate.

Bid/Ask Spread Like spot rates, forward rates have a bid/ask spread. For example, a
bank may set up a contract with one firm agreeing to sell the firm Singapore dollars 90 days
from now at $0.510 per Singapore dollar; this is the ask rate. At the same time, the firm
may agree to purchase (bid) Singapore dollars 90 days from now from some other firm at
$0.505 per Singapore dollar.
The spread can be measured on a percentage basis, just as it is for spot rates (see Chapter 3
for details). Thus the bid/ask spread of the 90-day forward rate described in the previous para-
graph can be measured as:
Bid/ask spread of 90-day forward rate of Singapore dollar
5 ($0.510 2 $0.505)/$0.510 5 0.98%
The spread for a particular currency tends to be wider for forward contracts that have
an obligation further into the future. For example, the bid/ask spread on a one-year forward
rate is usually higher than that on a 90-day contract, and a three-year forward contract
will usually have a higher spread than does a one-year forward contract. The market for
shorter-term forward contracts tends to be more liquid, which means that banks can more
easily create offsetting positions for a given forward contract. For instance, a bank that

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Chapter 5: Currency Derivatives 133

accommodates a 90-day forward purchase request on Singapore dollars may be able to

offset that position by accommodating some other MNC’s request to sell the same number
of Singapore dollars for U.S. dollars in 90 days. By satisfying these two separate requests,
the bank offsets its exposure. However, if the bank accommodates a five-year forward
purchase request on Singapore dollars, it may have more difficulty finding an MNC that
wants to sell the same amount of Singapore dollars five years forward. Therefore the bank
may quote a higher bid/ask spread for a five-year forward contract than for a one-year
forward contract, as the five-year contract leaves the bank more exposed to the risk of
appreciation in the Singapore dollar.
The spread between the bid and ask prices is wider for forward rates of currencies of
developing countries, such as Chile, Mexico, South Korea, Taiwan, and Thailand. Because
these markets have relatively few orders for forward contracts, banks face more challenges
in matching up willing buyers and sellers. The resulting lack of liquidity causes banks
to widen the bid/ask spread when quoting forward contracts. Such contracts in these
countries are generally available only for short-term horizons.

5-1c Premium or Discount on the Forward Rate

The difference between the forward rate ( F ) and the spot rate (S ) at any given time is
measured by the premium:

F 5 S (1 1 p )
where p denotes the forward premium, or the percentage by which the forward rate
exceeds the spot rate.

EXAMPLE If the euro’s spot rate is $1.40 and if its one-year forward rate has a forward premium of 2 percent, then the
one-year forward rate is calculated as follows:

F 5 S (1 1 p )
5 $1.40(1 1 0.02)
5 $1.428
Given quotations for the spot rate and the forward rate at any point in time, the premium can be deter-
mined by rearranging the previous equation:

F 5 S (1 1 p )
F /S 5 1 1 p
(F /S ) 2 1 5 p ●

EXAMPLE If the euro’s one-year forward rate is quoted at $1.428 and the euro’s spot rate is quoted at $1.40, then the
euro’s forward premium is:

(F /S ) 2 1 5 p
($1.428/$1.40) 2 1 5 p
1.02 2 1 5 0.02 or 2 percent ●

When the forward rate is less than the prevailing spot rate, the forward premium is
negative and the forward rate exhibits a discount.
EXAMPLE If the euro’s one-year forward rate is quoted at $1.35 and the euro’s spot rate is quoted at $1.40, then the
euro’s forward premium is:
(F /S ) 2 1 5 p
($1.35 /$1.40) 2 1 5 p
0.9643 2 1 520.0357 or 23.57 percent
Because p is negative, the forward rate contains a discount. ●

Exhibit 5.1 Computation of Forward Rate Premiums or Discounts

T Y P E O F E X C H A N G E R AT E F O R WA R D R AT E P R E M I U M
FOR £ VA L U E M AT U R I T Y OR DISCOUNT FOR £
Spot rate $1.681
30-day forward rate $1.680 30 days $1.680 2 $1.681 360
3 5 20.71%
$1.681 30
90-day forward rate $1.677 90 days $1.677 2 $1.681 360
3 5 20.95%
$1.681 90
180-day forward rate $1.672 180 days $1.672 2 $1.681 360
3 5 21.07%
$1.681 180

EXAMPLE Assume that the existing forward exchange rates of the British pound for various maturities are as shown in
the second column of Exhibit 5.1. These forward rates can be used to compute the forward discount on an
annualized basis, as shown in the exhibit. ●

In some situations, a firm may prefer to assess the premium or discount on an unan-
nualized basis. In this case, the value would not incorporate the formula’s fraction that
represents the number of periods per year.

Pricing Forward rates typically differ from the spot rate for any given currency because
of differences in interest rates in the foreign country versus the United States. If a currency’s
spot and forward rates were the same and if the foreign currency’s interest rate was higher
than the U.S. rate, then U.S. speculators could achieve a higher return on the foreign sav-
ings deposit than a U.S. savings deposit by following these steps: (1) purchase the foreign
currency at the spot rate, (2) invest the funds at the attractive foreign interest rate, and
(3) simultaneously sell forward contracts in that foreign currency for a future date when
the savings deposit matures. These actions would place upward pressure on the spot rate
of the foreign currency and downward pressure on the forward rate, causing the forward
rate to fall below the spot rate (exhibit a discount). When the interest rate advantage of the
foreign currency is more pronounced, the forward rate of the foreign currency will be more
pronounced. This relationship is discussed in more detail in Chapter 7.

5-1d Movements in the Forward Rate over Time

If the forward rate’s premium were constant, then over time the forward rate would move
in tandem with movements in the corresponding spot rate. For instance, if the spot rate of
the euro increased by 4 percent from a month ago until today, then the forward rate would
also have to increase by 4 percent over the same period to maintain the same premium. In
reality, the forward premium is affected by the interest rate differential between the two
countries (as explained in Chapter 7) and can change over time. Most of the movement in
a currency’s forward rate is due to movements in that currency’s spot rate.

5-1e Offsetting a Forward Contract

In some cases, an MNC may desire to offset a forward contract that it previously created.

EXAMPLE On March 10, Green Bay, Inc., hired a Canadian construction company to expand its office and agreed to pay
C$200,000 for the work on September 10. It negotiated a six-month forward contract to obtain C$200,000
at $0.70 per unit, which would be used to pay the Canadian firm in six months. On April 10, the construction
company informed Green Bay that it would not be able to perform the work as promised. In response, Green

Bay offset its existing contract by negotiating a forward contract to sell C$200,000 for the date of September
10. However, the spot rate of the Canadian dollar had decreased over the last month, such that the prevailing
forward contract price for September 10 is now $0.66. Green Bay now has a forward contract to sell C$200,000
on September 10, which offsets the other contract it has to buy C$200,000 on September 10. The forward rate
was $0.04 per unit less on its sale than on its purchase, resulting in a cost of $8,000 (C$200,000 3 $0.04). ●

If Green Bay, Inc., negotiates the forward sale with the same bank with which it negoti-
ated the forward purchase, then it may be able to request that its initial forward contract
simply be offset. The bank will charge a fee for this service, which will reflect the difference
between the forward rate at the time of the forward purchase and the forward rate at the
time of the offset. Thus the MNC cannot ignore its original obligation; rather, it must pay
a fee to offset that obligation.

5-1f Using Forward Contracts for Swap Transactions

A swap transaction involves a spot transaction along with a corresponding forward contract
that will ultimately reverse the spot transaction. Many forward contracts are negotiated
for this purpose.

EXAMPLE Soho, Inc., needs to invest 1 million Chilean pesos in its Chilean subsidiary to support the manufacture of
additional products. It wants the subsidiary to repay the pesos in one year. Soho wants to lock in the rate at
which the pesos can be converted back into dollars in one year, so it purchases a one-year forward contract
for this purpose. Soho contacts its bank and requests the following swap transaction.

1. Today. The bank should withdraw dollars from Soho’s U.S. account, convert the dollars to 1million pesos
in the spot market, and transmit the pesos to the subsidiary’s account.
2. In one year. The bank should withdraw 1 million pesos from the subsidiary’s account, convert them to
dollars at today’s forward rate, and transmit them to Soho’s U.S. account.

These transactions do not expose Soho to exchange rate movements because the company has locked in
the rate at which the pesos will be converted back to dollars. However, if the one-year forward rate exhibits
a discount, then Soho will receive fewer dollars later than it invested in the subsidiary today. Even so, the
firm may still be willing to engage in the swap transaction so that it can be certain about how many dollars
it will receive in one year. ●

5-1g Non-deliverable Forward Contracts

A non-deliverable forward contract (NDF) is often used to hedge currencies in emerging
markets. Like a regular forward contract, an NDF is an agreement regarding a position in
a specified amount of a specified currency, a specified exchange rate, and a specified future
settlement date. However, an NDF does not result in an actual exchange of the currencies
at the future date; that is, there is no delivery. Instead, one party to the agreement makes a
payment to the other party based on the exchange rate at the future date.

EXAMPLE Jackson, Inc., an MNC based in Wyoming, determines as of April 1 that it will need 100 million Chilean pesos
to purchase supplies on July 1. It can negotiate an NDF with a local bank as follows. The NDF will specify the
currency (Chilean peso); the settlement date (90 days from now); and a reference rate, which identifies the
type of exchange rate that will be marked to market at the settlement. Specifically, the NDF will contain the
following information:

■ Buy 100 million Chilean pesos.

■ Settlement date: July 1.
■ Reference index: Chilean peso’s closing exchange rate (in dollars) quoted by Chile’s central bank in
90 days.

Assume that the Chilean peso (which is the reference index) is currently valued at $0.0020, so the dollar
amount of the position is $200,000 at the time of the agreement. At the time of the settlement date (July 1),
the value of the reference index is determined, and then a payment is made from one party to another in
settlement. For example, if the peso value increases to $0.0023 by July 1, the value of the position specified in
the NDF will be $230,000 ($0.0023 3 100 million pesos). Because the value of Jackson’s NDF position is $30,000
higher than when the agreement was created, Jackson will receive a payment of $30,000 from the bank.
Recall that Jackson needs 100 million pesos to buy imports. Because the peso’s spot rate rose from April 1
to July 1, the company will need to pay $30,000 more for the imports than if it had paid for them on April 1.
At the same time, however, Jackson will have received a payment of $30,000 due to its NDF. Thus the NDF
hedged the exchange rate risk.
Now suppose that, instead of rising, the Chilean peso had depreciated to $0.0018. Then Jackson’s position in its
NDF would have been valued at $180,000 (100 million pesos 3 $0.0018) at the settlement date, which is $20,000
less than the value when the agreement was created. In this case, Jackson would have owed the bank $20,000
at that time. However, the decline in the spot rate of the peso also means that Jackson would pay $20,000 less
for the imports than if it had paid for them on April 1. Thus an offsetting effect occurs in this example as well. ●

WEB The preceding examples demonstrate that, even though an NDF does not involve delivery,
[Link]
it can effectively hedge the future foreign currency payments anticipated by an MNC.
Various aspects of
Because an NDF can specify that payments between the two parties be made in dollars
derivatives trading
or some other available currency, firms can also use NDFs to hedge existing positions of
such as new products,
foreign currencies that are not convertible. Consider an MNC that expects to receive a
strategies, and market
payment in a foreign currency that cannot be converted into dollars. The MNC may use
analyses.
this currency to make purchases in the local country, but it may nonetheless desire to hedge
against a decline in the value of that currency over the period before it receives payment.
WEB In this case, the MNC takes a sell position in an NDF and uses the closing exchange rate of
that currency (as of the settlement date) as the reference index. If the currency depreciates
[Link]
against the dollar over time, then the firm will receive the difference between the dollar
Time series on financial
value of the position when the NDF contract was created and the dollar value of the position
futures and option
as of the settlement date. It will therefore receive a payment in dollars from the NDF to
prices. The site also
offset any depreciation in the currency over the period of concern.
enables the user to
generate charts of
historical prices. 5-2 Currency Futures Market
Currency futures contracts are contracts specifying a standard volume of a particular
currency to be exchanged on a specific settlement date. Thus currency futures contracts
are similar to forward contracts in terms of their obligation, but they differ from forward
contracts in how they are traded. These contracts are frequently used by MNCs to hedge
their foreign currency positions. In addition, they are traded by speculators who hope
to capitalize on their expectations of exchange rate movements. A buyer of a currency
futures contract locks in the exchange rate to be paid for a foreign currency at a future
time. Alternatively, a seller of a currency futures contract locks in the exchange rate at
which a foreign currency can be exchanged for the home currency. In the United States,
currency futures contracts are purchased to lock in the amount of dollars needed to obtain
a specified amount of a particular foreign currency; they are sold to lock in the amount
of dollars to be received from selling a specified amount of a particular foreign currency.

5-2a Contract Specifications

Most currency futures are traded on the Chicago Mercantile Exchange (CME), which is
part of CME Group. Currency futures are available for 20 currencies at the CME. Each
contract specifies a standardized number of units, as shown in Exhibit 5.2. The use of
standardized contracts allows for more frequent trading per contract and hence for greater

Exhibit 5.2 Currency Futures Contracts Traded on the Chicago Mercantile Exchange

CURRENCY UNITS PER CONTR AC T

Australian dollar 100,000
Brazilian real 100,000
British pound 62,500
Canadian dollar 100,000
Chilean peso 50,000,000
Chinese yuan 1,000,000
Czech koruna 4,000,000
Euro 125,000
Hungarian forint 30,000,000
Indian rupee 5,000,000
Israeli shekel 1,000,000
Japanese yen 12,500,000
Korean won 125,000,000
Mexican peso 500,000
New Zealand dollar 100,000
Norwegian krone 2,000,000
Polish zloty 500,000
Russian ruble 2,500,000
South African rand 500,000
Swedish krona 2,000,000
Swiss franc 125,000
Turkish lira 1,000,000

liquidity. For some currencies, the CME offers “E-mini” futures contracts, which specify
half the number of units of a typical standardized contract. The CME also offers futures
contracts on cross exchange rates (between two non-dollar currencies).
The typical currency futures contract is based on a currency value stated in terms of
U.S. dollars. However, futures contracts are also available on some cross rates, such as the
exchange rate between the Australian dollar and the Canadian dollar. Thus speculators who
expect that the Australian dollar will move substantially against the Canadian dollar can
take a futures position to capitalize on their expectations. In addition, Australian firms that
have exposure in Canadian dollars or Canadian firms that have exposure in Australian dol-
lars may use this type of futures contract to hedge their exposure. See [Link]
for more information about futures on cross exchange rates.
Currency futures contracts usually specify the third Wednesday in March, June,
September, or December as the settlement date. An over-the-counter currency futures
market is also available, where financial intermediaries facilitate the trading of currency
futures contracts with other settlement dates.

5-2b Trading Currency Futures

Firms or individuals can execute orders for currency futures contracts by calling brokerage
firms that serve as intermediaries. The order to buy or sell a currency futures contract for
a specific currency and a specific settlement date is communicated to the brokerage firm,
which in turn communicates the order to the CME.
For example, some U.S. firms purchase futures contracts on Mexican pesos with a
December settlement date in an effort to hedge their future payables. At the same time,

other U.S. firms sell futures contracts on Mexican pesos with a December settlement date
with the intention of hedging their future receivables.
Futures contract orders submitted to the CME are executed electronically by Globex, a
computerized platform that matches buy and sell orders for each standardized contract.
Globex operates more than 23 hours of each weekday (it is closed from 4:15 p.m. to 5:00 p.m.).

EXAMPLE Assume that, as of February 10, a futures contract on 62,500 British pounds with a March settlement date
is priced at $1.50 per pound. The buyer of this currency futures contract will receive £62,500 on the March
settlement date and will pay $93,750 for the pounds (computed as £62,500 3 $1.50 per pound plus a com-
mission paid to the broker). The seller of this contract is obligated to sell £62,500 at a price of $1.50 per pound
and therefore will receive $93,750 on the settlement date, minus the commission that it owes the broker. ●

Trading Platforms for Currency Futures The trading of currency futures is

facilitated by electronic trading platforms, which serve as brokers by executing the desired
trades. The platform typically sets quotes for currency futures based on an ask price at
which one can buy a specified currency for a specified settlement date and a bid price
at which one can sell a specified currency. Users of the platforms incur a fee in the form of
the difference between the bid and ask prices.

5-2c Credit Risk of Currency Futures Contracts

Each currency futures contract represents an agreement between a client and the exchange
clearinghouse, even though the exchange has not taken a position in the transaction. To illus-
trate, assume you call a broker to request the purchase of a British pound futures contract
with a March settlement date. Meanwhile, another person unrelated to you calls a broker to
request the sale of a similar futures contract. Neither party needs to worry about the credit
risk of the counterparty, because the exchange clearinghouse assumes this risk: It assures
that you will receive whatever is owed to you as a result of your currency futures position.
To minimize its risk in such a guarantee, the CME imposes margin requirements to
cover fluctuations in the value of a contract. In other words, participants must make a
deposit with their respective brokerage firms when taking a position. The initial margin
requirement is typically between $1,000 and $2,000 per currency futures contract. If the
value of the futures contract declines over time, however, the buyer may be asked to main-
tain an additional margin, called the “maintenance margin.”

5-2d Comparing Currency Futures and Forward Contracts

Currency futures contracts are similar to forward contracts in that they allow a customer
to lock in the exchange rate at which a specific currency is purchased or sold for a spe-
cific date in the future. Nevertheless, these types of contracts also differ in some ways, as
summarized in Exhibit 5.3. Currency futures contracts are sold on an exchange through
a computerized trading platform, whereas each forward contract is negotiated between a
firm and a commercial bank over a telecommunications network. Because currency futures
contracts are standardized, they are not as easily tailored to the firm’s particular needs.
Corporations that have established relationships with large banks tend to use forward
contracts rather than futures contracts because forward contracts are tailored to the precise
amount of currency to be purchased (or sold) and the preferred forward date. In contrast, small
firms and individuals who do not have established relationships with large banks (or who prefer
to trade in smaller amounts) tend to use currency futures contracts. Margin requirements are
not always required for forward contracts because of the more personal nature of the agree-
ment; that is, the bank knows the MNC it is dealing with and may trust it to fulfill its obligation.

Exhibit 5.3 Comparison of the Forward and Futures Markets

F O R WA R D FUTURES
Size of contract Tailored to individual needs. Standardized.
Delivery date Tailored to individual needs. Standardized.
Participants Banks, brokers, and multinational companies. Banks, brokers, and multinational companies.
Public speculation not encouraged. Qualified public speculation encouraged.
Security deposit None as such, but compensating bank balances or Small security deposit required.
lines of credit required.
Clearing operation Handling contingent on individual banks and Handled by exchange clearinghouse. Daily
brokers. No separate clearinghouse function. settlements to the market price.
Marketplace Telecommunications network. Globex computerized trading platform with
worldwide communications.
Regulation Self-regulating. Commodity Futures Trading Commission; National
Futures Association.
Liquidation Most settled by actual delivery; some by offset, Most by offset; very few settled by delivery.
but at a cost.
Transaction costs Set by the spread between the bank’s buy and sell Negotiated brokerage fees.
prices.

Source: Chicago Mercantile Exchange.

Pricing Currency Futures Both the forward rate of a currency and the price of cur-
rency futures change over time primarily in response to changes in the currency’s spot
rate. In fact, the price of currency futures is usually similar to the forward rate for a given
currency and settlement date. This relationship is enforced by the potential activity that
would occur if significant discrepancies arose.

EXAMPLE Assume that the currency futures price on the British pound is $1.50 and that forward contracts for a similar
period are available for $1.48. Firms may attempt to purchase forward contracts and simultaneously sell
currency futures contracts. If they can exactly match the settlement dates of the two contracts, they can
generate guaranteed profits of $0.02 per unit. These actions will place downward pressure on the currency
futures price. The futures contract and forward contracts of a given currency and settlement date should have
the same price, or else guaranteed profits are possible (assuming no transaction costs). ●

5-2e How MNCs Use Currency Futures

MNCs that have open positions in foreign currencies can consider purchasing or selling
futures contracts to offset their positions.

Purchasing Futures to Hedge Payables The purchase of futures contracts locks

in the price at which a firm can purchase a currency.

EXAMPLE Rochester Co. orders Canadian goods; upon delivery, it will need to send C$500,000 to the Canadian exporter.
Recognizing this fact, Rochester purchases Canadian dollar futures contracts today, thereby locking in the
price to be paid for Canadian dollars at a future settlement date. By holding futures contracts, Rochester does
not have to worry about changes in the spot rate of the Canadian dollar over time. ●

Selling Futures to Hedge Receivables The sale of futures contracts locks in the
price at which a firm can sell a currency.

EXAMPLE Karla Co. sells futures contracts when its exports are paid for in a currency that it will not need (Karla accepts
a foreign currency at the importer’s request). By selling a futures contract, Karla Co. locks in the price at which
it will be able to sell this currency on the settlement date. This action is especially appropriate if Karla expects
the foreign currency to depreciate against its home currency. ●

The use of futures contracts to cover, or hedge, a firm’s currency positions is described
more thoroughly in Chapter 11.
Closing Out a Futures Position If a firm buys a currency futures contract but
decides before the settlement date that it no longer wants to maintain its position, it can
close out that position by selling an identical futures contract. The gain or loss to the firm
from its previous futures position will depend on the price of purchasing futures versus
selling futures.

EXAMPLE On January 10, Tacoma Co. anticipates that it will need Australian dollars (A$) in March when it orders sup-
plies from an Australian supplier. Tacoma therefore purchases a futures contract specifying A$100,000 and a
March settlement date (which is March 19 for this contract). On January 10, the futures contract is priced at
$0.53 per A$. On February 15, Tacoma realizes that it will not need to order supplies because it has reduced
its production levels; therefore, it has no need for A$ in March. It sells a futures contract on A$ with the March
settlement date to offset the contract it purchased in January. At this time, the futures contract is priced
at $0.50 per A$. On March 19 (the settlement date), Tacoma has offsetting positions in futures contracts.
However, the price when the futures contract was purchased was higher than the price when an identical
contract was sold, so Tacoma incurs a loss from these positions. Tacoma’s transactions are summarized in
Exhibit 5.4: Move from left to right along the timeline to review the transactions. Note that the example does
not incorporate margin requirements. ●
WEB
[Link] Sellers of futures contracts can close out their positions by purchasing currency futures
Provides the open price contracts with similar settlement dates. Most currency futures contracts are closed out
(price at the time the before the settlement date.
contract is first traded
for the day), high and
low prices for the day, 5-2f Speculation with Currency Futures
closing (last) price, and Speculators may purchase currency futures contracts in an attempt to capitalize on their
trading volume. expectation of a currency’s future movement.

Exhibit 5.4 Closing Out a Futures Contract

March 19
January 10 February 15 (Settlement Date)

...................................... .....................................

Step 1: Contract to Buy Step 2: Contract to Sell Step 3: Settle Contracts

$.53 per A$ $.50 per A$ $53,000 (Contract 1)

A$100,000 A$100,000 $50,000 (Contract 2)
$53,000 at the $50,000 at the $3,000 loss
settlement date settlement date

For example, suppose that speculators expect the British pound to appreciate in the
future. They can purchase a futures contract that will lock in the price at which they buy
pounds at a specified settlement date. On that date, the speculators can purchase their
pounds at the rate specified by the futures contract and then sell these pounds at the spot
rate. If the spot rate has appreciated by this time in accordance with their expectations,
then this strategy will be profitable.
Currency futures are also sold by speculators who expect that the spot rate of a currency
will be less than the rate at which they would be obligated to sell it.

EXAMPLE Suppose that, as of April 4, a futures contract specifying 500,000 Mexican pesos and a June settlement date is
priced at $0.09. On April 4, speculators who expect the peso to decline sell futures contracts on pesos. Assume
that, on June 17 (the settlement date), the spot rate of the peso is $0.08. The transactions are shown in Exhibit 5.5
(once again, the margin deposited by the speculators is not considered). The gain on the futures position is $5,000,
which represents the difference between the amount received ($45,000) when selling the pesos in accordance
with the futures contract versus the amount paid ($40,000) for those pesos in the spot market. ●

Of course, expectations are often incorrect. Because of their different expectations,

some speculators may want to purchase futures contracts whereas other speculators want
to sell those same contracts at a given point in time.

Efficiency of the Currency Futures Market If the currency futures market

is efficient, then at any time the futures price for a currency should reflect all available
information. That is, the price should represent an unbiased estimate of the currency’s
spot exchange rate on the settlement date. For this reason, the continual use of a particu-
lar strategy to take positions in currency futures contracts should not lead to abnormal
profits. Some positions will likely result in gains whereas others will result in losses, and
the gains and losses should roughly offset over time. Research has found that in some
years the futures price has been consistently higher than the corresponding spot exchange
rate at the settlement date, whereas in other years the futures price has been consistently
lower. This suggests that the currency futures market may be inefficient. Because these
unexpected patterns are seldom observable until after they occur, it is may be difficult to
consistently generate abnormal profits from speculating in currency futures.

Exhibit 5.5 Source of Gains from Buying Currency Futures

June 17
April 4 (Settlement Date)

...................................... .....................................

Step 1: Contract to Sell Step 2: Buy Pesos (Spot) Step 3: Sell the Pesos
for $45,000 to Fulﬁll
$.09 per peso $.08 per peso Futures Contract
p500,000 p500,000
$45,000 at the Pay $40,000
settlement date

5-3 Currency Options Market

Currency options provide the right to purchase or sell currencies at specified prices up to a
specified expiration date. They are available for many currencies, including the Australian
dollar, British pound, Brazilian real, Canadian dollar, euro, Japanese yen, Mexican peso,
New Zealand dollar, Russian ruble, South African rand, and Swiss franc.

5-3a Currency Options Exchanges

In late 1982, exchanges in Amsterdam, Montreal, and Philadelphia were the first to allow
trading in standardized foreign currency options. Since then, options have been offered on
the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT), which
merged in 2007 to form CME Group. Currency options are traded through the CME’s
Globex system, which operates on almost an around-the-clock schedule.
The options exchanges in the United States are regulated by several agencies, including
the Securities and Exchange Commission and the Commodity Futures Trading Commission.
Options can be purchased or sold through brokers. Although brokers typically charge a com-
mission of $30 to $60 for a single currency option, their commission per contract can be much
lower when the transaction involves multiple contracts. Brokers require that a margin be
maintained during the life of the contract. The margin is increased for clients whose option
positions have deteriorated, so as to protect brokers against possible losses if their clients do
not fulfill their obligations.

5-3b Over-the-Counter Currency Options Market

In addition to the exchanges where currency options are available, an over-the-counter mar-
ket exists through which commercial banks and brokerage firms offer currency options.
Unlike the currency options traded on an exchange, the over-the-counter market offers cur-
rency options that are tailored to the specific needs of the firm. Because these options are not
standardized, all the terms must be specified in the contracts. The number of units, desired
strike price, and expiration date can be set to match the client’s specific needs. When cur-
rency options are not standardized, however, there is less liquidity and a wider bid/ask spread.
The minimum size of currency options offered by financial institutions is approximately
$5 million. Because these transactions are conducted with a specific financial institution
rather than an exchange, there are no credit guarantees. Thus the agreement made is only
as safe as the parties involved. For this reason, financial institutions may require some col-
lateral from individuals or firms seeking to purchase or sell currency options.
Currency options are classified as either calls or puts. These options are discussed in
the next two section sections, respectively.

5-4 Currency Call Options

A currency call option grants the right to buy a specific currency at a designated price
within a specific period of time. The price at which the owner is allowed to buy that cur-
rency is known as the exercise price or strike price, and there are monthly expiration
dates for each option.
Call options are desirable when one wishes to lock in a maximum price to be paid for a
currency in the future. If the spot rate of the currency rises above the strike price, owners
of call options can “exercise” their options by purchasing the currency at the strike price,
which will be cheaper than the prevailing spot rate. This strategy is similar to that used

by purchasers of futures contracts, but the futures contract entails an obligation whereas
the currency option does not. That is, the owner can choose to let the option expire on the
expiration date without ever exercising it. Owners of expired call options will have lost the
premium they initially paid, but that is the most they can lose.
The buyer of a currency call option pays a premium, which reflects the price, to own
the option. The seller of a currency call option receives the premium paid by the buyer. In
return, the seller is obligated to accommodate the buyer in accordance with the rights of
the currency call option.
Currency options quotations are available at financial websites, the CME Group’s web-
site, and the websites of major brokers. Although currency options typically expire near the
middle of the specified month, some of them expire at the end of the month (designated as
EOM). Some options are listed as “European style,” which means that they can be exercised
only upon expiration.
A currency call option is said to be in the money when the present exchange rate exceeds
the strike price, at the money when the present exchange rate equals the strike price, and
out of the money when the present exchange rate is less than the strike price. For a given
currency and expiration date, an in-the-money call option will require a higher premium
than options that are at the money or out of the money.

5-4a Factors Affecting Currency Call Option Premiums

The premium on a call option represents the cost of having the right to buy the underly-
ing currency at a specified price. For MNCs that use currency call options as a hedging
strategy, the premium reflects a cost of insurance or protection.
The call option premium (denoted C) is primarily influenced by three factors:
C 5 f (S 2 X , T , s )
1 1 1
where S 2 X is the difference between the spot exchange rate (S ) and the strike or exer-
cise price ( X ), T denotes the time to maturity, and s (sigma) captures the currency’s vola-
tility as measured by the standard deviation of its movements. The relationships between
the call option premium and these factors can be summarized as follows:
■ Spot Price Relative to Strike Price. The higher the spot rate relative to the strike price,
the higher the option price will be. The increase is due to the greater probability
that you will be able to buy the currency at a substantially lower price than you can
sell it. This relationship can be verified by comparing the premiums of options for a
specified currency and expiration date that have different strike prices.
■ Length of Time before the Expiration Date. It is typically assumed that the spot rate is
more likely to rise higher above the strike price if it has a longer period of time to do
so. A settlement date in June allows two additional months beyond April for the spot
rate to move above the strike price, which explains why June option prices exceed
April option prices for a specific strike price. This relationship can be verified by
comparing the premiums of options for a specified currency and strike price that
have different expiration dates.
■ Volatility of the Currency. The greater the variability in the currency’s price, the greater
the likelihood that the spot rate will rise above the strike price. This explains why less
volatile currencies have lower call option prices. For example, the Canadian dollar is
more stable than most other currencies; if all other factors are similar, then Canadian
call options should be less expensive than call options on other foreign currencies.

A currency’s volatility can itself vary over time, which will affect the premiums paid on
the options for that currency. When the credit crisis intensified in the fall of 2008, specula-
tors began quickly moving their money into and out of various currencies. These actions
led to increased volatility in the foreign exchange markets and created concerns about
future volatility. As a result, option premiums increased.

5-4b How MNCs Use Currency Call Options

MNCs with open positions in foreign currencies can sometimes use currency call options
to cover these positions.
Using Call Options to Hedge Payables MNCs can purchase call options on a
currency to hedge future payables.

EXAMPLE When Pike Co. of Seattle orders Australian goods, it makes a payment in Australian dollars to the Australian
exporter upon delivery. An Australian dollar call option locks in the maximum rate at which Pike can exchange
dollars for Australian dollars. This exchange of currencies at the specified strike price on the call option con-
tract can be executed at any time before the expiration date. In essence, the call option contract specifies
the maximum price that Pike must pay to obtain these Australian imports. If the Australian dollar’s value
remains below the strike price, then Pike can purchase Australian dollars at the prevailing spot rate to pay
for its imports and simply let the call option expire. ●

Options may be more appropriate than futures or forward contracts in some situations.
For example, Intel Corp. uses options to hedge its order backlog in semiconductors. If an
order is canceled, then Intel has the flexibility to let the option contract expire. With a
forward contract, the company would be obligated to fulfill its obligation even though the
order was canceled.

Using Call Options to Hedge Project Bidding When a U.S.-based MNC bids
on foreign projects, it may purchase call options to lock in the dollar cost of the potential
expenses.

EXAMPLE Kelly Co. is an MNC based in Fort Lauderdale, Florida, that has bid on a project sponsored by the Canadian
government. If its bid is accepted, Kelly will need approximately C$500,000 to purchase Canadian materials
and services; however, it will not know whether that bid is accepted until three months from now. In this situ-
ation, Kelly will want to purchase call options with a three-month expiration date; 10 call option contracts will
cover the entire amount of potential exposure. If the bid is accepted, Kelly can use the options to purchase
the Canadian dollars needed. If the Canadian dollar has depreciated over the three-month period, Kelly will
likely let the options expire.
Assume that the exercise price on Canadian dollars is $0.70 and that the call option premium is $0.02 per
unit. Kelly will pay $1,000 per option (as there are 50,000 units per Canadian dollar option), or $10,000 for the
10 option contracts. With the options, the maximum amount necessary to purchase the C$500,000 is $350,000
(computed as $0.70 per Canadian dollar 3 C$500,000). Fewer U.S. dollars will be needed if the Canadian dollar’s
spot rate is below the exercise price at the time the Canadian dollars were purchased.
Even if Kelly’s bid is rejected, it will exercise the currency call option (selling the C$ in the spot market)
if the Canadian dollar’s spot rate exceeds the exercise price before the option expires. Any gain from this
exercising may partially or even fully offset the premium paid for the options. ●

Using Call Options to Hedge Target Bidding Firms can also use call options to
hedge a possible acquisition.

EXAMPLE Morrison Co. is attempting to acquire a French firm and has submitted its bid in euros. Morrison has
purchased call options on the euro because it will need euros to purchase the French company’s stock. The
call options hedge the U.S. firm against the risk of possible appreciation of the euro by the time the acquisi-
tion occurs. If the acquisition does not occur and the spot rate of the euro remains below the strike price,
then Morrison will let the call options expire. If the acquisition does not occur and the spot rate of the euro
exceeds the strike price, then the company can either exercise the options (and sell the euros in the spot
market) or sell the call options it is holding. Either of these actions may offset part or all of the premium
paid for the options. ●

5-4c Speculating with Currency Call Options

In the context of multinational financial management, the corporate use of currency
options is more important than their speculative use. The use of options for hedging is
discussed in detail in Chapter 11. Speculative trading is discussed here to provide more of
a background on the currency options market.
Individuals may speculate in the currency options market based on their expectation of
the future movements in a particular currency. Speculators who anticipate that a foreign
currency will appreciate can purchase call options on that currency. If the spot rate of that
currency does appreciate, then these speculators can exercise their options by purchasing
that currency at the strike price and then selling it at the prevailing spot rate.
Just as with currency futures, every buyer of a currency call option must be matched
with a seller. A seller (sometimes called a writer) of a call option is obligated to sell a
specified currency at a specified price (the strike price) up to a specified expiration date.
Speculators may want to sell their call options on a currency they expect to depreciate in
the future. The only way a currency call option will be exercised is if the spot rate is higher
than the strike price. Thus the seller of a currency call option receives the premium when
the option is purchased and can keep the entire amount if the option is not exercised. When
it appears that an option will be exercised, there will still be sellers of options, but those
options will sell for high premiums due to the high risk that the option will be exercised
at some point.
The net profit to a speculator from trading call options on a currency is based on a com-
parison of the selling price of the currency versus the exercise price paid for the currency
and the premium paid for the call option.

EXAMPLE Jim is a speculator who buys a British pound call option with a strike price of $1.40 and a December settle-
ment date. The current spot price as of that date is about $1.39. Jim pays a premium of $0.012 per unit for the
call option. Assume there are no brokerage fees. Just before the expiration date, the spot rate of the British
pound reaches $1.41. At this time, Jim exercises the call option and then immediately sells the pounds (to a
bank) at the spot rate. To determine Jim’s profit or loss, first compute his revenues from selling the currency.
Then, subtract from this amount both the purchase price of the pounds when exercising the option and the
purchase price of the option. The computations are summarized in the following table; assume that one
option contract specifies 31,250 units.

PER UNIT PER CONTR ACT

Selling price of £ $1.41 $44,063 ($1.41 3 31,250 units)
2 Purchase price of £ 21.40 243,750 ($1.40 3 31,250 units)
2 Premium paid for option 20.012 2375 ($0.012 3 31,250 units)
5 Net profit 2$0.002 2$62 (2$0.002 3 31,250 units)

Suppose that Linda was the seller of the call option purchased by Jim. Suppose also that Linda would
purchase British pounds only if the option is exercised, at which time she must provide the pounds at the
exercise price of $1.40. Using the information in this example, Linda’s net profit from selling the call option
is derived as follows.

PER UNIT PER CONTR ACT

Selling price of £ $1.40 $43,750 ($1.40 3 31,250 units)
2 Purchase price of £ 21.41 244,063 ($1.41 3 31,250 units)
1 Premium received 10.012 1375 ($0.012 3 31,250 units)
5 Net profit $0.002 $62 ($0.002 3 31,250 units)

As a second example, assume the following information:

■ Call option premium on Canadian dollars (C$) 5 $0.01 per unit.

■ Strike price 5 $0.70 .
■ One Canadian dollar option contract represents C$50,000.

A speculator who had purchased this call option decided to exercise the option shortly before the expira-
tion date, when the spot rate reached $0.74. The speculator then immediately sold the Canadian dollars in the
spot market. Given this information, the net profit to the speculator is calculated as follows.

PER UNIT PER CONTR ACT

Selling price of C$ $0.74 $37,000 ($0.74 3 50,000 units)
2 Purchase price of C$ 20.70 235,000 ($0.70 3 50,000 units)
2 Premium paid for option 20.01 2500 ($0.01 3 50,000 units)
5 Net profit $0.03 $1,500 ($0.03 3 50,000 units)

However, if the seller of the call option did not obtain Canadian dollars until the option was about to be
exercised, the net profit to the seller of this call option would be as follows.

PER UNIT PER CONTR ACT

Selling price of C$ $0.70 $35,000 ($0.70 3 50,000 units)
2 Purchase price of C$ 20.74 237,000 ($0.74 3 50,000 units)
1 Premium received 10.01 1500 ($0.01 3 50,000 units)
5 Net profit 2$0.03 2$1,500 (2$0.03 3 50,000 units)
●

When brokerage fees are ignored, the currency call purchaser’s gain will be the sell-
er’s loss. The currency call purchaser’s expenses represent the seller’s revenues, and
the purchaser’s revenues represent the seller’s expenses. Yet because it is possible for
purchasers and sellers of options to close out their positions, the relationship described
here will not hold unless both parties establish and close out their positions at the
same time.
An owner of a currency option may simply sell the option to someone else (before the
expiration date) rather than exercising it. The owner could still earn a profit because the
option premium changes over time to reflect the probability that the option will be exer-
cised and the potential profit from exercising it.

Break-Even Point from Speculation The purchaser of a call option will break
even if the revenue from selling the currency equals the payments made for the currency
(at the strike price) plus the option premium. In other words, regardless of how many units

a contract is for, a purchaser will break even if the spot rate at which the currency is sold
equals the strike price plus the option premium.

EXAMPLE Based on the information in the previous example, the strike price is $0.70 and the option premium is $0.01.
Thus, for the purchaser to break even, the spot rate at the time the call is exercised must be $0.71 (that is,
$0.70 1 $0.01). Of course, speculators will not purchase a call option if they think the spot rate will not surpass
the break-even point before the option’s expiration date. Nevertheless, calculating the break-even point is a
useful exercise for any speculator who is deciding whether to purchase a particular currency call option. ●

Contingency Graph for Speculators Buying a Call Option A contingency

graph for the buyer of a call option compares the price paid for that option to the payoffs
received under various exchange rate scenarios.

EXAMPLE A British pound call option is available with a strike price of $1.50 and a call premium of $0.02. A speculator
plans to exercise the option on the expiration date (if appropriate at that time) and then immediately sell the
pounds received in the spot market. Under these conditions, a contingency graph can be created to measure
the profit or loss per unit (see the upper diagram in Exhibit 5.6). Observe that if the future spot rate is $1.50 or
less, then the net gain per unit is 2$0.02 (ignoring transaction costs). This represents the loss of the premium
per unit paid for the option, because the option would not be exercised. At a future spot rate of $1.51, the
speculator would earn $0.01 per unit by exercising the option; considering the $0.02 premium paid, however,
the net gain would be 2$0.01.
At a future spot rate of $1.52, the speculator would earn $0.02 per unit by exercising the option, which
would offset the $0.02 premium per unit. This is the break-even point. At any rate above this point, the gain
from exercising the option would more than offset the premium, resulting in a positive net gain. The maxi-
mum loss to the speculator in this example is the premium paid for the option. ●

Contingency Graph for Speculators Selling a Call Option A contingency

graph for the seller of a call option compares the premium received from selling that option
to the payoffs made to the option’s buyer under various exchange rate scenarios.

EXAMPLE The lower diagram in Exhibit 5.6 plots the contingency graph for a speculator who sold the call option
described in the previous example; it assumes that this seller would purchase the pounds in the spot market
just as the option was exercised (ignoring transaction costs). At future spot rates of less than $1.50, the net
gain to the seller would be the premium of $0.02 per unit (because the option would not have been exercised).
If the future spot rate is $1.51, then the seller would lose $0.01 per unit on the option transaction (paying $1.51
for pounds in the spot market and selling pounds for $1.50 to fulfill the exercise request). Yet this loss would
be more than offset by the premium of $0.02 per unit received, resulting in a net gain of $0.01 per unit.
The break-even price is therefore $1.52, and the net gain to the seller of a call option becomes negative at
all higher future spot rates. Notice that the contingency graphs for the buyer and the seller of this call option
are mirror images of each other. ●

Speculation by MNCs Some financial institutions may have a division that uses cur-
rency options (and other currency derivatives) to speculate on future exchange rate move-
ments. However, most MNCs use currency derivatives for hedging and not for speculation.
Multinational corporations should use shareholder and creditor funds to pursue their goal
of being the market leader in some product or service; it would be irresponsible if the firm
instead used those funds to speculate in currency derivatives. An MNC’s board of directors
attempts to ensure that the MNC’s operations are consistent with its goals.

Exhibit 5.6 Contingency Graphs for Currency Call Options

Contingency Graph for Purchasers

of British Pound Call Options
+$.06
Exercise Price = $1.50
Net Proﬁt per Unit +$.04 Premium = $ .02

+$.02
Future Spot Rate

$1.46 $1.48 $1.50 $1.52 $1.54

–$.02

–$.04

–$.06

Contingency Graph for Sellers of

British Pound Call Options
+$.06
Exercise Price = $1.50
+$.04 Premium = $ .02
Net Proﬁt per Unit

+$.02

$1.46 $1.48 $1.50 $1.52 $1.54

–$.02
Future Spot Rate
–$.04

–$.06

5-5 Currency Put Options

The owner of a currency put option has the right to sell a currency at a specified price (the
strike price) within a specified period of time. As with currency call options, the owner
of a put option is not obligated to exercise the option. Therefore, the maximum potential
loss to the owner of the put option is the price (or premium) paid for the option contract.
The premium of a currency put option reflects the price of the option. The seller of a cur-
rency put option receives the premium paid by the buyer (owner). In return, the seller is obli-
gated to accommodate the buyer in accordance with the rights of the currency put option.
A currency put option is said to be in the money when the present exchange rate is less
than the strike price, at the money when the present exchange rate equals the strike price,
and out of the money when the present exchange rate exceeds the strike price. For a given

currency and expiration date, an in-the-money put option will require a higher premium
than options that are at the money or out of the money.

5-5a Factors Affecting Currency Put Option Premiums

The put option premium (denoted P) is primarily influenced by three factors, as the fol-
lowing equation shows:
P 5 f (S 2 X , T , s )
2 1 1
where S 2 X is the difference between the spot exchange rate and the strike or exercise
price, T is time to maturity, and s is the standard deviation of movements in the currency.
The relationships between the put option premium and these factors, which also influence
call option premiums as described previously, are summarized next.
First, the spot rate of a currency relative to the strike price is important. The lower the
spot rate relative to the strike price, the more valuable the put option will be because the
option is more likely to be exercised. Recall that just the opposite relationship held for call
options. A second factor influencing the put option premium is the length of time until
the expiration date. As with currency call options, the longer the time to expiration, the
greater the put option premium will be. A longer period is associated with a greater likeli-
hood that the currency will move into a range where it will be feasible to exercise the option.
These relationships can be verified by assessing the quotations of put option premiums for a
specified currency. A third factor that influences the put option premium is the currency’s
volatility. As with currency call options, greater variability increases the put option’s pre-
mium, again reflecting a higher probability that the option may be exercised.

5-5b How MNCs Use Currency Put Options

MNCs with open positions in foreign currencies can sometimes use currency put options
to cover these positions.

EXAMPLE Assume Duluth Co. has exported products to Canada and invoiced the products in Canadian dollars (at the
request of the Canadian importers). Duluth is concerned that the Canadian dollars it receives will depreci-
ate over time. To insulate itself against such depreciation, Duluth purchases Canadian dollar put options
that entitle the company to sell Canadian dollars at the specified strike price. In essence, Duluth locks in the
minimum rate at which it can exchange Canadian dollars for U.S. dollars over a specified period of time. If
the Canadian dollar appreciates over this period, then Duluth can let the put options expire and simply sell
the Canadian dollars it receives at the prevailing spot rate. ●

At any time, some put options are deep out of the money, meaning that the prevailing
exchange rate is high above the exercise price. These options are cheaper (have a lower
premium) because their low price makes it unlikely they will be exercised. Analogously, the
exercise price of other put options may be currently far above the prevailing exchange rate,
so that they are much more likely to be exercised; hence these options are more expensive.

EXAMPLE Cisco Systems faces a trade-off when using put options to hedge the remittance of earnings from Europe
to the United States. It can create a hedge that is cheap, but then the options can be exercised only if the
currency’s spot rate declines substantially. Alternatively, Cisco can create a hedge that can be exercised at
a more favorable exchange rate, but then the options’ premium will be higher. If Cisco’s goal in using put
options is simply to prevent a major loss if the currency weakens substantially, then it may prefer the inex-
pensive put option (low exercise price, low premium). In contrast, if its goal is to ensure that the currency

can be exchanged at a more favorable exchange rate, then Cisco should use a more expensive put option
(high exercise price, high premium). By selecting currency options with an exercise price and premium that
fits their objectives, Cisco and other MNCs can increase their value. ●

5-5c Speculating with Currency Put Options

Individuals may speculate with currency put options based on their expectations of the
future movements in a particular currency. For example, speculators who expect that the
British pound will depreciate can purchase British pound put options, which will entitle
them to sell British pounds at a specified strike price. If the pound’s spot rate depreciates
as expected, then speculators can purchase pounds at the spot rate and exercise their put
options by selling these pounds at the strike price.
Speculators can also attempt to profit from selling currency put options. The seller of such
options is obligated to purchase the specified currency at the strike price from the owner
who exercises the put option. Speculators who believe the currency will appreciate (or at
least will not depreciate) may sell a currency put option. If the currency appreciates over the
entire period, the option will not be exercised. This is an ideal situation for put option sellers:
They get to keep the premiums they received when the options were sold, yet bear no cost.
The net profit to a speculator from trading put options on a currency is based on a com-
parison of the exercise price at which the currency can be sold versus the purchase price of
the currency and the premium paid for the put option.

EXAMPLE A put option contract on British pounds specifies the following information:

■ Put option premium on British pound (£ ) 5 $0.04 per unit.

■ Strike price 5 $1.40 .
■ One option contract represents £ 31,250.

A speculator who had purchased this put option decided to exercise the option shortly before the expira-
tion date, when the spot rate of the pound was $1.30. The speculator purchased the pounds in the spot market
at that time. Given this information, the net profit to the purchaser of the put option is calculated as follows.

PER UNIT PER CONTR ACT

Selling price of £ $1.40 $43,750 ($1.40 3 31,250 units)
2 Purchase price of £ 21.30 240,625 ($1.30 3 31,250 units)
2 Premium paid for option 20.04 21,250 ($0.04 3 31,250 units)
5 Net profit $0.06 $1,875 ($0.06 3 31,250 units)

Assuming that the seller of the put option sold the pounds received immediately after the option was
exercised, the net profit to the seller of the put option is as follows.

PER UNIT PER CONTR ACT

Selling price of £ $1.30 $40,625 ($1.30 3 31,250 units)
2 Purchase price of £ 21.40 243,750 ($1.40 3 31,250 units)
1 Premium received 10.04 11,250 ($0.04 3 31,250 units)
5 Net profit 2 $0.06 2$1,875 (2$0.06 3 31,250 units)
●

In the preceding example, the seller of the put options could simply refrain from selling
the pounds (after being forced to buy them at $1.40 per pound) until the spot rate of the
pound rises. However, there is no guarantee that the pound will reverse its direction and
begin to appreciate. Unless the pounds are sold immediately, the seller’s net loss would be
still greater if the pound’s spot rate continued to fall.

Any amount that an owner of a put option gains is matched by the seller’s loss (and vice
versa). This relationship holds in the absence of brokerage costs and if the buyer and seller of
options enter and close their positions at the same time. Of course, there are brokerage fees for
currency options; these fees are similar in magnitude to those for currency futures contracts.

Contingency Graph for the Buyer of a Put Option A contingency graph for the
buyer of a put option compares the premium paid for that option to the payoffs received
under various exchange rate scenarios.

EXAMPLE The upper diagram in Exhibit 5.7 shows the net gains to a buyer of a British pound put option with an exercise
price of $1.50 and a premium of $0.03 per unit. If the future spot rate is greater than $1.50, then the buyer will
not exercise the option. In contrast, at a future spot rate of $1.48, the buyer will exercise the put option. In

Exhibit 5.7 Contingency Graphs for Currency Put Options

Contingency Graph for Purchasers

of British Pound Put Options
+$.06
Exercise Price = $1.50
+$.04 Premium = $ .03
Net Proﬁt per Unit

+$.02
Future Spot Rate

$1.46 $1.48 $1.50 $1.52 $1.54

–$.02

–$.04

–$.06

Contingency Graph for Sellers of

British Pound Put Options
+$.06
Exercise Price = $1.50
+$.04 Premium = $ .03
Net Proﬁt per Unit

+$.02

$1.46 $1.48 $1.50 $1.52 $1.54

–$.02
Future Spot Rate
–$.04

–$.06

that case, however, the premium of $0.03 per unit entails a net loss of $0.01 per unit. The break-even point
in this example is $1.47, as this is the future spot rate that will generate $0.03 per unit from exercising the
option to offset the $0.03 premium. At any future spot rates lower than $1.47, the buyer of the put option
will earn a positive net gain. ●

Contingency Graph for the Seller of a Put Option A contingency graph for
the seller of a put option compares the premium received from selling that option to the
payoffs made to the option’s buyer under various exchange rate scenarios. The graph is
shown as the lower graph in Exhibit 5.7 and is the mirror image of the contingency graph
for the buyer of a put option.
For various reasons, an option buyer’s net gain will not always represent an option seller’s
net loss. The buyer may be using call options to hedge a foreign currency rather than to
speculate. In that case, the buyer does not evaluate the options position taken by measuring
a net gain or loss; instead, the option is just used for protection. In addition, sellers of call
options on a currency in which they currently maintain a position will not need to purchase
that currency when an option is exercised; they can simply liquidate their position to provide
the currency to the party exercising the option.

Speculating with Combined Put and Call Options For volatile currencies, one
speculative strategy is to create a straddle, which uses both a put option and a call option
at the same exercise price. This may seem unusual, given that owning a put option is
appropriate when the currency is expected to depreciate whereas owning a call option is
appropriate when that the currency is expected to appreciate. However, it is possible that
the currency will depreciate (at which time the put is exercised) and then reverse direction
and appreciate (allowing for profits when exercising the call).
Also, a speculator might anticipate that a currency will be substantially affected by cur-
rent economic events, yet be uncertain of the effect’s direction. By purchasing both a put
option and a call option, the speculator will gain if the currency moves substantially in
either direction. Although two options are purchased and only one is exercised, the gains
could more than offset the costs.

Efficiency of the Currency Options Market If the currency options market is

efficient, then the premiums on currency options will properly reflect all available infor-
mation. Under such conditions, it may be difficult for speculators to consistently generate
abnormal profits when speculating in this market. Research has found that, when trans-
action costs are controlled for, the currency options market is efficient. Although some
trading strategies could have generated abnormal gains in specific periods, the same strate-
gies would have incurred large losses if implemented in other periods. It is always difficult
to predict which strategy will generate abnormal profits in future periods.

5-6 Other Forms of Currency Options

In addition to the currency options described previously, other forms of currency options
have been created to serve particular preferences of MNCs or speculators.

5-6a Conditional Currency Options

A currency option can be structured with a conditional premium. This means that the pre-
mium paid for the option is conditioned on the actual movement in the currency’s value
over the period of concern.

EXAMPLE Jensen Co., a U.S.-based MNC, needs to sell British pounds that it will receive in 60 days. It can negotiate a tra-
ditional currency put option on pounds in which the exercise price is $1.70 and the premium is $0.02 per unit.
Alternatively, Jensen can negotiate a conditional currency option with a commercial bank; this option
has an exercise price of $1.70 and a trigger (price) of $1.74. If the pound’s value falls below the exercise price
by the expiration date, then Jensen will exercise the option, thereby receiving $1.70 per pound; furthermore,
it will not have to pay a premium for the option.
If the pound’s value is between the exercise price ($1.70) and the trigger ($1.74), then the option will not
be exercised and Jensen will not have to pay a premium. If the pound’s value exceeds the $1.74 trigger, then
Jensen must pay a premium of $0.04 per unit. Note that this premium may be higher than the premium that
would have been paid for a basic put option. Jensen may not mind this outcome, however, because it will
receive a high dollar amount from converting its pound receivables in the spot market.
Jensen must determine whether the possible advantage of the conditional option (avoiding the payment
of a premium under some conditions) outweighs the possible disadvantage (paying a higher premium than
would be necessary with a traditional put option on British pounds). The potential advantage and disadvan-
tage are both illustrated in Exhibit 5.8. At exchange rates less than or equal to the trigger price ($1.74), the
conditional option results in a larger payment to Jensen, with the extra amount being equal to the premium
that would have been paid for the basic option. At exchange rates greater than the trigger price, the con-
ditional option results in a lower payment to Jensen because its premium of $0.04 exceeds the premium of
$0.02 per unit paid on a basic option. ●

The choice of a basic option versus a conditional option depends on expectations about
the currency’s exchange rate over the period of concern. In the previous example, if Jensen
is confident that the pound’s value will not exceed $1.74, then it should prefer the condi-
tional currency option.

Exhibit 5.8 Comparison of Conditional and Basic Currency Options

$1.76 Basic
Conditional Put Option
Put Option
$1.74
Conditional
Put Option
$1.72
Net Amount Received

$1.70

$1.68

$1.66

$1.64
Basic Put Option: Exercise Price 5 $1.70, Premium 5 $.02.
$1.62 Conditional Put Option: Exercise Price 5 $1.70, Trigger 5 $1.74,
Premium 5 $.04.
$1.60

$1.60 $1.62 $1.64 $1.66 $1.68 $1.70 $1.72 $1.74 $1.76 $1.78 $1.80
Spot Rate

Conditional currency options are also available for U.S. firms that need to purchase a
foreign currency in the near future.

EXAMPLE A conditional call option on pounds may specify an exercise price of $1.70 and a trigger of $1.67. If the pound’s
value remains above the trigger of the call option, then the buyer will not owe any premium for the call
option. However, if the pound’s value falls below the trigger, then a large premium (such as $0.04 per unit)
will be charged. Some conditional options require a premium if the trigger is reached at any time before
the expiration date; others require a premium only if the exchange rate exceeds the trigger on the actual
expiration date. ●

Firms also use various combinations of currency options. For example, a firm may pur-
chase a currency call option to hedge payables and finance the purchase of the call option
by selling a put option on the same currency.

5-6b European Currency Options

The discussion of currency options up to this point has dealt solely with so-called
American-style options. European-style currency options are also available for speculating
and hedging in the foreign exchange market. These are similar to American-style options
except that they must be exercised on the expiration date if they are to be exercised at all.
Because of this restriction, such options offer less flexibility, although that is not relevant
in some situations. For example, MNCs that purchase options to hedge future foreign cur-
rency cash flows will probably have no desire to exercise their options before the expiration
date. If European-style options are available for the same expiration date as American-style
options and can be purchased for a slightly lower premium, then some MNCs may prefer
them for hedging.

SUMMARY
■ A forward contract specifies a standard volume of a ■ Call options give the buyer the right to purchase a
particular currency to be exchanged on a particular specified currency at a specified exchange rate by a
date. Such a contract can be either purchased by a firm specified expiration date. They are used by MNCs to
to hedge payables or sold by a firm to hedge receiv- hedge future payables. They are commonly purchased
ables. A currency futures contract can be purchased by speculators who expect that the underlying cur-
by speculators who expect the currency to appreciate; rency will appreciate.
it can also be sold by speculators who expect that cur- ■ Put options give the buyer the right to sell a speci-
rency to depreciate. If the currency depreciates, then fied currency at a specified exchange rate by a speci-
the value of the futures contract declines, allowing the fied expiration date. They are used by MNCs to hedge
latter speculators to benefit when they close out their future receivables. They are commonly purchased by
positions. speculators who expect that the underlying currency
■ Futures contracts on a particular currency can be will depreciate.
purchased by corporations that have payables in that ■ Call options on a specific currency can be purchased
currency and wish to hedge against its possible appre- by speculators who expect that currency to appreci-
ciation. Conversely, these contracts can be sold by cor- ate. Put options on a specific currency can be pur-
porations that have receivables in that currency and chased by speculators who expect that currency to
wish to hedge against its possible depreciation. depreciate.

POINT/COUNTERPOINT
Should Speculators Use Currency Futures or Options?
Point Speculators should use currency futures These options, which have a high exercise price but
because they can avoid a substantial premium. To the a low premium, require a relatively small invest-
extent that they are willing to speculate, they must ment. Alternatively, speculators can buy options that
have confidence in their expectations. If they have suf- have a lower exercise price (higher premium), which
ficient confidence in their expectations, they should will likely generate a greater return if the currency
bet on their expectations without having to pay a large appreciates. Speculation involves risk. Speculators
premium to cover themselves if they are wrong. If they must recognize that their expectations may be wrong.
do not have confidence in their expectations, they While options require a premium, the premium is
should not speculate at all. worthwhile as a means to limit the potential downside
Counterpoint Speculators should use currency risk. Options enable speculators to select the degree of
options to fit the degree of their confidence. For downside risk that they are willing to tolerate.
example, if they are very confident that a currency will Who Is Correct? Use the Internet to learn more
appreciate substantially, but want to limit their invest- about this issue. Which argument do you support?
ment, they can buy deep out-of-the-money options. Offer your own opinion on this issue.

SELF-TEST
Answers are provided in Appendix A at the back of the expiration date has an exercise price of $0.71 and a pre-
text. mium of $0.02. A put option on New Zealand dollars
1. A call option on Canadian dollars with a strike at the money with a one-year expiration date has a pre-
price of $0.60 is purchased by a speculator for a premium of $0.03. You expect that the New Zealand dollar’s
mium of $0.06 per unit. Assume there are 50,000 units spot rate will rise over time and will be $0.75 in one year.
in this option contract. If the Canadian dollar’s spot a. Today Jarrod purchased call options on New
rate is $0.65 at the time the option is exercised, what Zealand dollars with a one-year expiration date.
is the net profit per unit and for one contract to the Estimate the profit or loss per unit for Jarrod at the
speculator? What would the spot rate need to be at the end of one year. (Assume that the options would be
time when the option is exercised for the speculator to exercised on the expiration date or not at all.)
break even? What is the net profit per unit to the seller
of this option? b. Today Laurie sold put options on New Zealand
dollars at the money with a one-year expiration date.
2. A put option on Australian dollars with a strike Estimate the profit or loss per unit for Laurie at the
price of $0.80 is purchased by a speculator for a pre- end of one year. (Assume that the options would be
mium of $0.02. If the Australian dollar’s spot rate is exercised on the expiration date or not at all.)
$0.74 on the expiration date, should the speculator
exercise the option on this date or let the option expire? 5. You often take speculative positions in options on
What is the net profit per unit to the speculator? What euros. One month ago, the spot rate of the euro was
is the net profit per unit to the seller of this put option? $1.49, and the one-month forward rate was $1.50. At
that time, you sold call options on euros at the money.
3. Longer-term currency options are becoming
The premium on that option was $0.02. Today is when
more popular for hedging exchange rate risk. Why do
the option will be exercised, if it is feasible to do so.
you think some firms decide to hedge by using other
techniques instead of purchasing long-term currency a. Determine your profit or loss per unit on your
options? option position if the spot rate of the euro is $1.55 today.
4. The spot rate of the New Zealand dollar is $0.70. b. Repeat part (a), but assume that the spot rate of
A call option on New Zealand dollars with a one-year the euro today is $1.48.

QUESTIONS AND APPLICATIONS

1. Forward versus Futures Contracts and the spot rate at the time the pound option was
Compare and contrast forward and futures contracts. exercised was $1.59. Assume there are 31,250 units in
2. Using Currency Futures a British pound option. What was Alice’s net profit on
the option?
a. How can corporations use currency futures?
12. Selling Currency Call Options Mike Suerth
b. How can speculators use currency futures? sold a call option on Canadian dollars for $0.01 per
3. Currency Options Differentiate between a cur- unit. The strike price was $0.76, and the spot rate at
rency call option and a currency put option. the time the option was exercised was $0.82. Assume
4. Forward Premium Compute the forward Mike did not obtain Canadian dollars until the option
discount or premium for the Mexican peso whose was exercised. Also assume that there are 50,000 units
90-day forward rate is $0.102 and spot rate is $0.10. in a Canadian dollar option. What was Mike’s net
State whether your answer is a discount or premium. profit on the call option?
5. Effects of a Forward Contract How can a 13. Selling Currency Put Options Brian Tull
forward contract backfire? sold a put option on Canadian dollars for $0.03 per
unit. The strike price was $0.75, and the spot rate at
6. Hedging with Currency Options When
the time the option was exercised was $0.72. Assume
would a U.S. firm consider purchasing a call option on
Brian immediately sold the Canadian dollars received
euros for hedging? When would a U.S. firm consider
when the option was exercised. Also assume that there
purchasing a put option on euros for hedging?
are 50,000 units in a Canadian dollar option. What
7. Speculating with Currency Options was Brian’s net profit on the put option?
When should a speculator purchase a call option on
14. Forward versus Currency Option
Australian dollars? When should a speculator pur-
Contracts What are the advantages and disadvan-
chase a put option on Australian dollars?
tages to a U.S. corporation that uses currency options
8. Currency Call Option Premiums List the on euros rather than a forward contract on euros to
factors that affect currency call option premiums, and hedge its exposure in euros? Explain why an MNC
briefly explain the relationship that exists for each. Do might use forward contracts to hedge committed
you think an at-the-money call option in euros has a transactions and use currency options to hedge con-
higher or lower premium than an at-the-money call tracts that are anticipated but not committed. Why
option in Mexican pesos (assuming the expiration date might forward contracts be advantageous for commit-
and the total dollar value represented by each option ted transactions, and currency options be advanta-
are the same for both options)? geous for anticipated transactions?
9. Currency Put Option Premiums List the fac- 15. Speculating with Currency Futures
tors that affect currency put option premiums, and Assume that the euro’s spot rate has moved in cycles
briefly explain the relationship that exists for each. over time. How might you try to use futures contracts
10. Speculating with Currency Call Options on euros to capitalize on this tendency? How could
Randy Rudecki purchased a call option on British you determine whether such a strategy would have
pounds for $0.02 per unit. The strike price was $1.45, and been profitable in previous periods?
the spot rate at the time the option was exercised was 16. Hedging with Currency Derivatives
$1.46. Assume there are 31,250 units in a British pound Assume that the transactions listed in the first column
option. What was Randy’s net profit on this option? of the following table are anticipated by U.S. firms that
11. Speculating with Currency Put Options have no other foreign transactions. Place an “X” in the
Alice Duever purchased a put option on British table wherever you see possible ways to hedge each of
pounds for $0.04 per unit. The strike price was $1.80, the transactions.

F O R WA R D C O N T R A C T FUTURES CONTR ACT OP TIONS CONTR AC T

F O R WA R D F O R WA R D BUY SELL PURCHASE PURCHASE
PURCHASE SALE FUTURES FUTURES A CALL A PUT
a. Georgetown Co. plans
to purchase Japanese
goods denominated
in yen.
b. Harvard, Inc., will sell
goods in Japan, denomi-
nated in yen.
c. Yale Corp. has a subsid-
iary 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 pur-
chase a company in Japan
in the near future (but the
deal may not go through).

17. Price Movements of Currency Futures spot market. Each option was purchased for a pre-
Assume that on November 1, the spot rate of the mium of $0.03 per unit, with an exercise price of $0.75.
British pound was $1.58 and the price on a December LSU plans to wait until the expiration date before
futures contract was $1.59. Assume that the pound deciding whether to exercise the options. Of course,
depreciated during November so that by November 30 LSU will exercise the options at that time only if it is
it was worth $1.51. feasible to do so. In the following table, fill in the net
a. What do you think happened to the futures price profit (or loss) per unit to LSU Corp. based on the
over the month of November? Why? listed possible spot rates of the Canadian dollar on
the expiration date.
b. If you had known that this would occur, would
you have purchased or sold a December futures con- P O S S I B L E S P O T R AT E O F NE T PROFIT
tract in pounds on November 1? Explain. CANADIAN DOL L AR ON (LOSS) PER UNIT
E X P I R AT I O N D AT E T O L S U C O R P.
18. Speculating with Currency Futures
$0.76
Assume that a March futures contract on Mexican
pesos was available in January for $0.09 per unit. Also 0.78
assume that forward contracts were available for the 0.80
same settlement date at a price of $0.092 per peso. 0.82
How could speculators capitalize on this situation, 0.85
assuming zero transaction costs? How would such 0.87
speculative activity affect the difference between the
forward contract price and the futures price? 20. Speculating with Currency Put Options
19. Speculating with Currency Call Options Auburn Co. has purchased Canadian dollar put
LSU Corp. purchased Canadian dollar call options for options for speculative purposes. Each option was
speculative purposes. If these options are exercised, purchased for a premium of $0.02 per unit, with
LSU will immediately sell the Canadian dollars in the an exercise price of $0.86 per unit. Auburn Co. will

purchase the Canadian dollars just before it exercises NE T PROFIT (LOSS) TO BULLDOG, INC.
the options (if it is feasible to exercise the options). It I F VA L U E O C C U R S
plans to wait until the expiration date before deciding
$0.72
whether to exercise the options. In the following table,
0.73
fill in the net profit (or loss) per unit to Auburn Co.
based on the listed possible spot rates of the Canadian 0.74
dollar on the expiration date. 0.75
0.76
P O S S I B L E S P O T R AT E NE T PROFIT
OF CA N A DIA N DOL L A R (LOSS) PER UNIT
O N E X P I R AT I O N D AT E TO AUBURN CO. 23. Hedging with Currency Derivatives A
$0.76 U.S. professional football team plans to play an exhibi-
tion game in the United Kingdom next year. Assume
0.79
that all expenses will be paid by the British govern-
0.84
ment, and that the team will receive a check for 1
0.87 million pounds. The team anticipates that the pound
0.89 will depreciate substantially by the scheduled date of
0.91 the game. In addition, the National Football League
must approve the deal, and approval (or disapproval)
21. Speculating with Currency Call Options will not occur for three months. How can the team
Bama Corp. has sold British pound call options for hedge its position? What is there to lose by waiting
speculative purposes. The option premium was $0.06 three months to see if the exhibition game is approved
per unit, and the exercise price was $1.58. Bama before hedging?
will purchase the pounds on the day the options are
exercised (if the options are exercised) to fulfill its Advanced Questions
obligation. In the following table, fill in the net profit
(or loss) to Bama Corp. if the listed spot rate exists at 24. Risk of Currency Futures Currency futures
the time the purchaser of the call options considers markets are commonly used as a means of capitalizing
exercising them. on shifts in currency values, because the value of a
futures contract tends to move in line with the change
P O S S I B L E S P O T R AT E AT in the corresponding currency value. Recently, many
THE TIME PURCHASER OF NE T PROFIT currencies have appreciated against the dollar. Most
CAL L OP TIONS CONSIDERS (LOSS) PER UNIT speculators anticipated that these currencies would
E X ERCISING THEM T O B A M A C O R P.
continue to strengthen and took large buy positions
$1.53 in currency futures. However, the Fed intervened in
1.55 the foreign exchange market by immediately selling
1.57 foreign currencies in exchange for dollars, causing
1.60 an abrupt decline in the values of foreign currencies
(as the dollar strengthened). Participants that had
1.62
purchased currency futures contracts incurred large
1.64 losses. One prominent trader responded to the effects
1.68 of the Fed’s intervention by immediately selling 300
futures contracts on British pounds (with a value of
22. Speculating with Currency Put Options about $30 million). Such actions caused even more
Bulldog, Inc., has sold Australian dollar put options at panic in the futures market.
a premium of $0.01 per unit, and an exercise price of
$0.76 per unit. It has forecasted the Australian dollar’s a. Explain why the central bank’s intervention
lowest level over the period of concern as shown in the caused such panic among currency futures traders
following table. Determine the net profit (or loss) per with buy positions.
unit to Bulldog, Inc., if each level occurs and the put b. Explain why the prominent trader’s willingness
options are exercised at that time. to sell 300 pound futures contracts at the going market

rate aroused such concern. What might this action sig- b. Assume that Myrtle Beach Co. uses a currency
nal to other traders? options contract to hedge rather than a forward
c. Explain why speculators with short (sell) posi- contract. If the company purchased a currency call
tions could benefit as a result of the central bank’s option contract at the money on Singapore dollars this
intervention. afternoon, would its total U.S. dollar cash outflows be
more than, less than, or the same as the total U.S. dol-
d. Some traders with buy positions may have lar cash outflows if it had purchased a currency call
responded immediately to the central bank’s intervention option contract at the money this morning? Explain.
by selling futures contracts. Why would some speculators
with buy positions leave their positions unchanged or 27. Currency Straddles Reska, Inc., has constructed
even increase their positions by purchasing more futures a long euro straddle. A call option on euros with an
contracts in response to the central bank’s intervention? exercise price of $1.10 has a premium of $0.025 per unit.
A euro put option has a premium of $0.017 per unit.
25. Estimating Profits from Currency Some possible euro values at option expiration are shown
Futures and Options One year ago, you sold a put in the following table. (See Appendix B in this chapter.)
option on 100,000 euros with an expiration date of
one year. You received a premium on the put option VA L U E O F E U R O AT O P T I O N E X P I R AT I O N
of $0.04 per unit; the exercise price was $1.22. Assume $0.90 $ 1. 0 5 $ 1. 5 0 $2.00
that one year ago, the spot rate of the euro was $1.20,
Call
the one-year forward rate exhibited a discount of
2 percent, and the one-year futures price was the same Put
as the one-year forward rate. From one year ago to Net
today, the euro depreciated against the dollar by
4 percent. Today the put option will be exercised (if it a. Complete the worksheet and determine the net
is feasible for the buyer to do so). profit per unit to Reska, Inc., for each possible future
spot rate.
a. Determine the total dollar amount of your profit
or loss from your position in the put option. b. Determine the break-even point(s) of the long
straddle. What are the break-even points of a short
b. Now assume that instead of taking a position in straddle using these options?
the put option one year ago, you sold a futures contract
on 100,000 euros with a settlement date of one year. 28. Currency Straddles Refer to the previous
Determine the total dollar amount of your profit or loss. question, but assume that the call and put option pre-
miums are $0.02 per unit and $0.015 per unit, respec-
26. Impact of Information on Currency tively. (See Appendix B in this chapter.)
Futures and Options Prices Myrtle Beach
Co. purchases imports that have a price of 400,000 a. Construct a contingency graph for a long euro
Singapore dollars, and it has to pay for the imports straddle.
in 90 days. It can purchase a 90-day forward con- b. Construct a contingency graph for a short euro
tract on Singapore dollars at $0.50 or purchase a call straddle.
option contract on Singapore dollars with an exer- 29. Currency Option Contingency Graphs
cise price of $0.50. This morning, the spot rate of the (See Appendix B in this chapter.) The current spot rate
Singapore dollar was $0.50. At noon, the central bank of the Singapore dollar (S$) is $0.50. The following
of Singapore raised interest rates, while there was no option information is available:
change in interest rates in the United States. These
actions immediately increased the degree of uncer- ■ Call option premium on Singapore dollar (S$) 5 $0.015.
tainty surrounding the future value of the Singapore ■ Put option premium on Singapore dollar (S$) 5 $0.009.
dollar over the next three months. The Singapore dol- ■ Call and put option strike price 5 $0.55.
■ One option contract represents S$70,000.
lar’s spot rate remained at $0.50 throughout the day.
a. Myrtle Beach Co. is convinced that the Singapore Construct a contingency graph for a short strad-
dollar will definitely appreciate substantially over the dle using these options.
next 90 days. Would a call option hedge or a forward 30. Speculating with Currency Straddles
hedge be more appropriate given its opinion? Maggie Hawthorne is a currency speculator. She has

noticed that recently the euro has appreciated substan- premiums are $0.035 per unit and $0.025 per unit,
tially against the U.S. dollar. The current exchange respectively. (See Appendix B in this chapter.)
rate of the euro is $1.15. After reading a variety of arti- a. Construct a contingency graph for a long pound
cles on the subject, Maggie believes that the euro will strangle.
continue to fluctuate substantially in the months to
b. Construct a contingency graph for a short pound
come. Although most forecasters expect that the euro
strangle.
will depreciate against the dollar in the near future,
Maggie thinks that there is also a good possibility 33. Currency Strangles The following informa-
of further appreciation. Currently, a call option on tion is currently available for Canadian dollar (C$)
euros is available with an exercise price of $1.17 and a options (see Appendix B in this chapter):
premium of $0.04. A euro put option with an exercise ■ Put option exercise price 5 $0.75.
price of $1.17 and a premium of $0.03 is also available. ■ Put option premium 5 $0.014 per unit.
(See Appendix B in this chapter.) ■ Call option exercise price 5 $0.76.
a. Describe how Maggie could use straddles to spec- ■ Call option premium 5 $0.01 per unit.
ulate on the euro’s value. ■ One option contract represents C$50,000.
b. At option expiration, the value of the euro is $1.30. a. What is the maximum possible gain that the pur-
What is Maggie’s total profit or loss from a long straddle chaser of a strangle can achieve using these options?
position?
b. What is the maximum possible loss that the
c. What is Maggie’s total profit or loss from a long writer of a strangle can incur?
straddle position if the value of the euro is $1.05 at
c. Locate the break-even point(s) of the strangle.
option expiration?
d. What is Maggie’s total profit or loss from a long 34. Currency Strangles For the following options
straddle position if the value of the euro at option available on Australian dollars (A$), construct a
expiration is still $1.15? worksheet and contingency graph for a long strangle.
Locate the break-even points for this strangle. (See
e. Given your answers to parts (b) through (d), when Appendix B in this chapter.)
is it advantageous for a speculator to engage in a long
straddle? When is it advantageous to engage in a short ■ Put option strike price 5 $0.67.
straddle? ■ Call option strike price 5 $0.65.
■ Put option premium 5 $0.01 per unit.
31. Currency Strangles (See Appendix B in this ■ Call option premium 5 $0.02 per unit.
chapter.) Assume the following options are currently
available for British pounds (£): 35. Speculating with Currency Options Barry
■ Call option premium on British pounds 5 $0.04 per unit. Egan is a currency speculator. Barry believes that the
■ Put option premium on British pounds 5 $0.03 per unit. Japanese yen will fluctuate widely against the U.S. dol-
■ Call option strike price 5 $1.56. lar in the coming month. Currently, one-month call
■ Put option strike price 5 $1.53. options on Japanese yen (¥) are available with a strike
■ One option contract represents £31,250. price of $0.0085 and a premium of $0.0007 per unit.
One-month put options on Japanese yen are available
a. Construct a worksheet for a long strangle using with a strike price of $0.0084 and a premium of $0.0005
these options. per unit. One option contract on Japanese yen contains
b. Determine the break-even point(s) for a strangle. ¥6.25 million. (See Appendix B in this chapter.)
c. If the spot price of the pound at option expiration a. Describe how Barry could utilize these options to
is $1.55, what is the total profit or loss to the strangle speculate on the movement of the Japanese yen.
buyer? b. Assume Barry decides to construct a long strangle
d. If the spot price of the pound at option expiration in yen. What are the break-even points of this strangle?
is $1.50, what is the total profit or loss to the strangle c. What is Barry’s total profit or loss if the value of
writer? the yen in one month is $0.0070?
32. Currency Strangles Refer to the previous d. What is Barry’s total profit or loss if the value of
question, but assume that the call and put option the yen in one month is $0.0090?

36. Currency Bull Spreads and Bear Spreads (unannualized). A call option on pesos was available
A call option on British pounds (£) exists with a with an exercise price that was equal to the spot rate.
strike price of $1.56 and a premium of $0.08 per unit. In addition, a put option on pesos was available with
Another call option on British pounds has a strike an exercise price equal to the spot rate. The premium
price of $1.59 and a premium of $0.06 per unit. (See on each of these options was 3 percent of the spot rate
Appendix B in this chapter.) Complete the worksheet at that time. On September 2, the option expired.
for a bull spread below. Go to [Link] (or any website that has foreign
exchange rate quotations) and determine the direct
VA L U E O F B R I T I S H P O U N D AT
quote of the Mexican peso. You exercised the option
O P T I O N E X P I R AT I O N
on this date if it was feasible to do so.
$ 1. 5 0 $ 1. 5 6 $ 1. 5 9 $ 1. 6 5
a. What was your net profit per unit if you had pur-
Call @ $1.56 chased the call option?
Call @ $1.59
b. What was your net profit per unit if you had pur-
Net chased the put option?
a. What is the break-even point for this bull spread? c. What was your net profit per unit if you had pur-
b. What is the maximum profit of this bull spread? chased a futures contract on July 2 that had a settle-
What is the maximum loss? ment date of September 2?
c. If the British pound spot rate is $1.58 at option d. What was your net profit per unit if you sold a
expiration, what is the total profit or loss for the bull futures contract on July 2 that had a settlement date of
spread? September 2?
d. If the British pound spot rate is $1.55 at option expi- 39. Uncertainty and Option Premiums This
ration, what is the total profit or loss for a bear spread? morning, a Canadian dollar call option contract
has a $0.71 strike price, a premium of $0.02, and an
37. Bull Spreads and Bear Spreads Two British
expiration date of one month from now. This after-
pound (£) put options are available with exercise prices
noon, news about international economic condi-
of $1.60 and $1.62. The premiums associated with these
tions increased the level of uncertainty surrounding
options are $0.03 and $0.04 per unit, respectively. (See
the Canadian dollar. However, the spot rate of the
Appendix B in this chapter.)
Canadian dollar was still $0.71. Would the premium of
a. Describe how a bull spread can be constructed the call option contract be higher than, lower than, or
using these put options. What is the difference equal to $0.02 this afternoon? Explain.
between using put options versus call options to con-
40. Uncertainty and Option Premiums At
struct a bull spread?
10:30 a.m., the media reported news that the Mexican
b. Complete the following worksheet. government’s political problems had decreased, which
VA L U E O F B R I T I S H P O U N D AT
reduced the expected volatility of the Mexican peso
O P T I O N E X P I R AT I O N against the dollar over the next month. The spot
rate of the Mexican peso was $0.13 as of 10 a.m. and
$ 1. 5 5 $ 1. 6 0 $ 1. 6 2 $ 1. 6 7
remained at that level all morning. At 10 a.m., Hilton
Put @ $1.60 Head Co. purchased a call option at the money on
Put @ $1.62 1 million Mexican pesos with an expiration date one
Net month from now. At 11:00 a.m., Rhode Island Co.
purchased a call option at the money on 1 million
c. At option expiration, the spot rate of the pound is pesos with an expiration date one month from now.
$1.60. What is the bull spreader’s total gain or loss? Did Hilton Head Co. pay more, less, or the same as
d. At option expiration, the spot rate of the pound is Rhode Island Co. for the options? Briefly explain.
$1.58. What is the bear spreader’s total gain or loss? 41. Speculating with Currency Futures
38. Profits from Using Currency Options Assume that one year ago, the spot rate of the British
and Futures On July 2, the two-month futures rate pound was $1.70, and the one-year futures contract of
of the Mexican peso contained a 2 percent discount the British pound exhibited a discount of 6 percent.

At that time, you sold futures contracts on pounds, Likewise, the one-year forward rate of the A$
representing a total of £1,000,000. From one year ago remained at $0.89 on this day and was not affected
to today, the pound’s value depreciated against the by the announcement. Do you think the premium
dollar by 4 percent. Determine the total dollar amount charged on a one-year A$ currency option increased,
of your profit or loss from your futures contract. decreased, or remained the same on this day in
42. Speculating with Currency Options The response to the announcement? Briefly explain.
spot rate of the New Zealand dollar is $0.77. A call
option on New Zealand dollars with a one-year expira- Critical Thinking
tion date has an exercise price of $0.78 and a premium Pricing of Currency Options Review the logic
of $0.04. A put option on New Zealand dollars at the regarding how currency options are priced. Consider a
money with a one-year expiration date has a premium speculator who plans to purchase currency options for
of $0.03. You expect that the New Zealand dollar’s spot the option at the money on whatever currency has the
rate will decline over time and will be $0.71 in one year. lowest premium. He also plans to sell currency options
a. Today, Dawn purchased call options on New for the option at the money on whatever currency
Zealand dollars with a one-year expiration date. has the highest premium. Another speculator uses a
Estimate her profit or loss per unit at the end of one strategy of purchasing call options on Australian dol-
year. (Assume that the options would be exercised on lars at the money whenever the premium is relatively
the expiration date or not at all.) low (compared to the historical premiums that existed
b. Today, Mark sold put options on New Zealand for this type of option). She also sells call options at
dollars at the money with a one-year expiration date. the money on Australian dollars at the money. Write
Estimate his profit or loss per unit at the end of one a short essay describing your opinion about the likely
year. (Assume that the options would be exercised on success of these strategies.
the expiration date or not at all.)
Discussion in the Boardroom
43. Impact of Expected Volatility on
Currency Option Premiums Assume that This exercise can be found in Appendix E at the back
Australia’s central bank announced plans to stabilize of this textbook.
the Australian dollar (A$) in the foreign exchange
markets. In response to this announcement, the
Running Your Own MNC
expected volatility of the A$ declined immediately. This exercise can be found in the International Financial
However, the spot rate of the A$ remained at $0.89 on Management MindTap. Go to [Link] for
this day, and was not affected by the announcement. more information.

BLADES, INC., CASE

Use of Currency Derivative Instruments
Blades, Inc. needs to order supplies two months ahead payables position because it is uncomfortable leaving
of the delivery date. It is considering an order from a the position open given the historical volatility of the
Japanese supplier that requires a payment of 12.5 million yen. Nevertheless, the firm would be willing to remain
yen payable as of the delivery date. Blades has two choices: unhedged if the yen becomes more stable someday.
■ Purchase two call options contracts (because each Ben Holt, Blades’ chief financial officer (CFO), prefers
option contract represents 6,250,000 yen). the flexibility that options offer over forward contracts
or futures contracts because he can let the options expire
■ Purchase one futures contract (which represents 12.5 if the yen depreciates. He would like to use an exercise
million yen). price that is about 5 percent above the existing spot rate to
The futures price on yen has historically exhibited ensure that Blades will have to pay no more than 5 percent
a slight discount from the existing spot rate. However, above the existing spot rate for a transaction two months
Blades would like to use currency options to hedge pay- beyond its order date, as long as the option premium is
ables in Japanese yen for transactions two months in no more than 1.6 percent of the price that the firm would
advance. The company would prefer hedging its yen have to pay per unit when exercising the option.

In general, options on the yen have required a pre- As an analyst for Blades, you have been asked to offer
mium of about 1.5 percent of the total transaction amount insight on how to hedge. Use a spreadsheet to support
that would be paid if the option is exercised. For example, your analysis of questions 4 and 6.
recently the yen spot rate was $0.0072, and the firm pur-
1. If Blades uses call options to hedge its yen pay-
chased a call option with an exercise price of $0.00756,
ables, should it use the call option with the exercise
which is 5 percent above the existing spot rate. The pre-
price of $0.00756 or the call option with the exercise
mium for this option was $0.0001134, which is 1.5 percent
price of $0.00792? Describe the trade-off.
of the price to be paid per yen if the option is exercised.
A recent event created more uncertainty about the 2. Should Blades allow its yen position to be
yen’s future value, although it did not affect the spot rate unhedged? Describe the trade-off.
or the forward or futures rate of the yen. Specifically, the
3. Assume that some speculators attempt to capi-
yen’s spot rate was still $0.0072, but the option premium
talize on their expectation of the yen’s movement
for a call option with an exercise price of $0.00756 fell
over the two months between the order and delivery
to $0.0001512.
dates by either buying or selling yen futures now
An alternative call option is available with an expira-
and buying or selling yen at the future spot rate.
tion date of two months from now; it has a premium of
Given this information, what is the expectation
$0.0001134 (which is the size of the premium that would
regarding the order date of the yen spot rate by the
have existed for the option desired before the event), but
delivery date? (Your answer should consist of one
it is for a call option with an exercise price of $0.00792.
number.)
The following table summarizes the option and
futures information available to Blades. 4. Assume that the firm shares the market con-
sensus regarding the future yen spot rate. Given this
BEFORE expectation and given that the firm makes a decision
EVENT AF TER EVENT
(that is, option, futures contract, or remain unhedged)
Spot rate $0.0072 $0.0072 $0.0072 purely on a cost basis, what would be its optimal
Option Information choice?
Exercise price ($) $0.00756 $0.00792
5. Will the choice you made as to the optimal hedg-
Exercise price 5% 10%
ing strategy in question 4 definitely turn out to be
(% above spot)
the lowest-cost alternative in terms of actual costs
Option premium per $0.0001512 $0.0001134
incurred? Why or why not?
yen ($)
Option premium 2.0% 1.5% 6. Now assume that you have determined that
(% of exercise price) the historical standard deviation of the yen is about
Total premium ($) $1,890.00 $1,417.50 $0.0005. Based on your assessment, you believe it is
Amount paid for yen $94,500 $99,000 highly unlikely that the future spot rate will be more
if option is exer- than two standard deviations above the expected spot
cised (not including rate by the delivery date. Also assume that the futures
premium) price remains at its current level of $0.006912. Based
Futures Contract Information on this expectation of the future spot rate, what is the
Futures price $0.006912 optimal hedge for the firm?

SMALL BUSINESS DILEMMA

Use of Currency Futures and Options by the Sports Exports Company
The Sports Exports Company receives British pounds 1. How can the Sports Exports Company use cur-
each month as payment for the footballs that it exports. rency futures contracts to hedge against exchange rate
It anticipates that the pound will depreciate over time risk? Are there any limitations when using currency
against the U.S. dollar. futures contracts that would prevent the firm from

locking in a specific exchange rate at which it can 4. Jim Logan, owner of the Sports Exports Company,
sell all the pounds it expects to receive in each of the is concerned that the pound may depreciate substan-
upcoming months? tially over the next month, but he also believes that
2. How can the Sports Exports Company use cur- the pound could appreciate substantially if specific
rency options to hedge against exchange rate risk? situations occur. Should Logan use currency futures
or currency options to hedge the exchange rate risk? Is
3. Are there any limitations when using currency there any disadvantage when selecting this method for
options contracts that would prevent the Sports hedging?
Exports Company from locking in a specific exchange
rate at which it can sell all the pounds it expects to
receive in each of the upcoming months?

INTERNET/EXCEL EXERCISES
The website of the Chicago Mercantile Exchange 2. Does it appear that futures prices among curren-
([Link]) provides information about cur- cies (for the closest settlement date) are changing in
rency futures and options. the same direction? Explain.
1. Use this website to review the prevailing prices of 3. If you purchase a British pound futures contract
currency futures contracts. Do today’s futures prices with the closest settlement date, what is the futures
(for contracts with the closest settlement date) gener- price? Given that a contract is based on £62,500, what
ally reflect an increase or a decrease from the day is the dollar amount you will need at the settlement
before? Is there any news today that might explain the date to fulfill the contract?
change in the futures prices?

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent article online that describes an actual a search term to ensure that the online articles are
international finance application or a real-world exam- recent:
ple about a specific MNC’s actions that reinforces one 1. company AND forward contract
or more concepts covered in this chapter.
If your class has an online component, your profes- 2. Inc. AND forward contract
sor may ask you to post your summary there and pro- 3. company AND currency futures
vide the web link of the article so that other students 4. Inc. AND currency futures
can access it. If your class is live, your professor may
5. company AND currency options
ask you to summarize your application in class. Your
professor may assign specific students to complete this 6. Inc. AND currency options
assignment for this chapter, or may allow any students 7. forward market
to do the assignment on a volunteer basis. 8. currency futures market
For recent online articles and real-world examples
applied to this chapter, consider using the follow- 9. currency options market
ing search terms and include the prevailing year as 10. currency derivatives

Forward Exchange Rate Explained
No ratings yet
Forward Exchange Rate Explained
6 pages
Understanding Forward Contracts in Currency
No ratings yet
Understanding Forward Contracts in Currency
6 pages
Overview of Currency Derivatives
No ratings yet
Overview of Currency Derivatives
9 pages
Understanding Currency Derivatives
No ratings yet
Understanding Currency Derivatives
22 pages
Managing Foreign Exchange Exposure
No ratings yet
Managing Foreign Exchange Exposure
27 pages
Currency Derivatives Overview
No ratings yet
Currency Derivatives Overview
47 pages
Lecture 4 - 2026
No ratings yet
Lecture 4 - 2026
28 pages
Understanding Forward Market Hedging
No ratings yet
Understanding Forward Market Hedging
9 pages
Currency Derivatives and Forward Contracts
No ratings yet
Currency Derivatives and Forward Contracts
70 pages
Currency Derivatives: Forward & Futures
No ratings yet
Currency Derivatives: Forward & Futures
48 pages
Chap 5 Currency Derivatives
No ratings yet
Chap 5 Currency Derivatives
25 pages
Currency Derivatives for MNCs
No ratings yet
Currency Derivatives for MNCs
55 pages
Understanding Currency Derivatives
No ratings yet
Understanding Currency Derivatives
38 pages
Hedging Currency Risk with Forwards
No ratings yet
Hedging Currency Risk with Forwards
55 pages
Currency Derivatives: Forward & Futures
No ratings yet
Currency Derivatives: Forward & Futures
26 pages
Management of Currency Risk
No ratings yet
Management of Currency Risk
81 pages
Understanding Currency Derivatives
No ratings yet
Understanding Currency Derivatives
19 pages
FX Market Overview and Key Calculations
No ratings yet
FX Market Overview and Key Calculations
9 pages
Lecture 4. International Financial Markets
No ratings yet
Lecture 4. International Financial Markets
36 pages
FX Forward Contracts Explained
No ratings yet
FX Forward Contracts Explained
12 pages
Currency Derivatives and Risk Management
No ratings yet
Currency Derivatives and Risk Management
75 pages
Understanding Currency Derivatives
No ratings yet
Understanding Currency Derivatives
24 pages
Understanding Currency Risks and Futures
No ratings yet
Understanding Currency Risks and Futures
39 pages
Derivatives and Exchange Rates Overview
No ratings yet
Derivatives and Exchange Rates Overview
25 pages
Understanding Currency Spreads and Futures
No ratings yet
Understanding Currency Spreads and Futures
4 pages
Understanding Currency Derivatives
No ratings yet
Understanding Currency Derivatives
46 pages
Forward Exchange Contracts Explained
100% (1)
Forward Exchange Contracts Explained
4 pages
Overview of International Financial Markets
No ratings yet
Overview of International Financial Markets
34 pages
Understanding Currency Derivatives
No ratings yet
Understanding Currency Derivatives
40 pages
Foreign Exchange Market Overview
No ratings yet
Foreign Exchange Market Overview
18 pages
Overview of Currency Derivatives
No ratings yet
Overview of Currency Derivatives
33 pages
Understanding Currency Derivatives
No ratings yet
Understanding Currency Derivatives
10 pages
Understanding Foreign Exchange Basics
No ratings yet
Understanding Foreign Exchange Basics
32 pages
Currency Derivatives
No ratings yet
Currency Derivatives
33 pages
Understanding Forward Contracts in Finance
No ratings yet
Understanding Forward Contracts in Finance
8 pages
Overview of the Foreign Exchange Market
No ratings yet
Overview of the Foreign Exchange Market
26 pages
Currency Derivatives Overview
No ratings yet
Currency Derivatives Overview
14 pages
TY Bcom - International Economics Notes
No ratings yet
TY Bcom - International Economics Notes
12 pages
Unit 1 Spot Forward Market
No ratings yet
Unit 1 Spot Forward Market
17 pages
Spot, Forward & Futures Markets Explained
No ratings yet
Spot, Forward & Futures Markets Explained
9 pages
Overview of Major Forex Markets
No ratings yet
Overview of Major Forex Markets
36 pages
Currency Derivatives: Futures & Forwards
100% (1)
Currency Derivatives: Futures & Forwards
13 pages
Understanding Currency Derivatives
No ratings yet
Understanding Currency Derivatives
28 pages
Understanding Forward and Futures Markets
No ratings yet
Understanding Forward and Futures Markets
29 pages
Understanding Forward Contracts in Finance
No ratings yet
Understanding Forward Contracts in Finance
8 pages
Foreign Exchange Market Overview
No ratings yet
Foreign Exchange Market Overview
18 pages
Understanding Foreign Currency Transactions
No ratings yet
Understanding Foreign Currency Transactions
11 pages
Madura C5
No ratings yet
Madura C5
38 pages
Currency Futures and Derivatives Overview
No ratings yet
Currency Futures and Derivatives Overview
22 pages
Understanding Currency Derivatives Basics
No ratings yet
Understanding Currency Derivatives Basics
43 pages
Understanding Currency Derivatives Basics
No ratings yet
Understanding Currency Derivatives Basics
38 pages
Overview of Currency Derivatives
No ratings yet
Overview of Currency Derivatives
73 pages
Currency Exchange Risks in Bangladesh
100% (1)
Currency Exchange Risks in Bangladesh
11 pages
Understanding Currency Derivatives
No ratings yet
Understanding Currency Derivatives
35 pages
Understanding Currency Derivatives
No ratings yet
Understanding Currency Derivatives
5 pages
Currency Derivatives Overview
100% (4)
Currency Derivatives Overview
7 pages
Chapter 2
No ratings yet
Chapter 2
18 pages
Chapter 5
No ratings yet
Chapter 5
30 pages
Module 3
No ratings yet
Module 3
9 pages
Design Thinking Gallery Walk Guide
No ratings yet
Design Thinking Gallery Walk Guide
14 pages
Overview of International Financial Markets
No ratings yet
Overview of International Financial Markets
32 pages
Government Influence on Exchange Rates
No ratings yet
Government Influence on Exchange Rates
30 pages
Total Test Bank for International Finance
No ratings yet
Total Test Bank for International Finance
78 pages
Karachi Gas Bill Summary for Jan 2025
No ratings yet
Karachi Gas Bill Summary for Jan 2025
1 page
AIOU Economics Assignments Guide
No ratings yet
AIOU Economics Assignments Guide
4 pages
South African Labour Law Overview
No ratings yet
South African Labour Law Overview
53 pages
Enhancing Digital Financial Literacy in Malaysia
No ratings yet
Enhancing Digital Financial Literacy in Malaysia
22 pages
Stormfiber Billing Summary for October 2024
No ratings yet
Stormfiber Billing Summary for October 2024
1 page
Musk's Twitter Takeover and Poison Pill Strategy
No ratings yet
Musk's Twitter Takeover and Poison Pill Strategy
6 pages
Bangalore Electricity Account Summary
No ratings yet
Bangalore Electricity Account Summary
2 pages
Capital Structure Theories Overview
No ratings yet
Capital Structure Theories Overview
8 pages
Estimating Domestic Income in Economics
No ratings yet
Estimating Domestic Income in Economics
24 pages
Loan Agreement for TZS 49 Million
No ratings yet
Loan Agreement for TZS 49 Million
2 pages
Classic Economic Growth Theories Explained
No ratings yet
Classic Economic Growth Theories Explained
2 pages
PET Preforms Manufacturing Project Report
100% (1)
PET Preforms Manufacturing Project Report
21 pages
Report PT Sri Rejeki Isman TBK Dan Entitas Anak Per 31 Mar 2024 Final Signed
No ratings yet
Report PT Sri Rejeki Isman TBK Dan Entitas Anak Per 31 Mar 2024 Final Signed
105 pages
Tax Types for Various Services Analysis
No ratings yet
Tax Types for Various Services Analysis
1 page
CFA Level II Invoice Details 2024
No ratings yet
CFA Level II Invoice Details 2024
1 page
Law of Traders by Tsinuel
No ratings yet
Law of Traders by Tsinuel
80 pages
Entrepreneurship Development Q&A Guide
No ratings yet
Entrepreneurship Development Q&A Guide
6 pages
Blitzcaling Ou La Croissance Éclair (Reid Hoffman, Yeh Chris) (Z-Library)
No ratings yet
Blitzcaling Ou La Croissance Éclair (Reid Hoffman, Yeh Chris) (Z-Library)
290 pages
Essential Components of a Business Plan
No ratings yet
Essential Components of a Business Plan
5 pages
Advanced Financial Accounting 10th Edition Christensen Ebook & Testbank
No ratings yet
Advanced Financial Accounting 10th Edition Christensen Ebook & Testbank
215 pages
Sanitary & Hardware Store Project Report
No ratings yet
Sanitary & Hardware Store Project Report
7 pages
Railway Conduct Rules Test Questions
No ratings yet
Railway Conduct Rules Test Questions
11 pages
Present Value Table for Finance
No ratings yet
Present Value Table for Finance
2 pages
Invest in US Stocks from India: A Guide
No ratings yet
Invest in US Stocks from India: A Guide
11 pages
Nippon India Small Cap Fund Direct Plan
No ratings yet
Nippon India Small Cap Fund Direct Plan
2 pages
Understanding Fungible FSI in Mumbai
No ratings yet
Understanding Fungible FSI in Mumbai
2 pages
Solar Proposal For Dinesh Rudra at 1 Coombah Court 3138 VIC (EaIrIcHkgw)
No ratings yet
Solar Proposal For Dinesh Rudra at 1 Coombah Court 3138 VIC (EaIrIcHkgw)
20 pages
Tax Masterclass in Karachi 2022
No ratings yet
Tax Masterclass in Karachi 2022
4 pages
Indifference Curve Analysis in Economics
No ratings yet
Indifference Curve Analysis in Economics
41 pages
ActewAGL Bill Payment Details
No ratings yet
ActewAGL Bill Payment Details
4 pages

Understanding Currency Derivatives

Uploaded by

Understanding Currency Derivatives

Uploaded by

5

CHAPTER A currency derivative is a contract whose price is partially derived from

5-1a How MNCs Use Forward Contracts

5-1b Bank Quotations on Forward Rates

accommodates a 90-day forward purchase request on Singapore dollars may be able to

5-1c Premium or Discount on the Forward Rate

Exhibit 5.1 Computation of Forward Rate Premiums or Discounts

5-1d Movements in the Forward Rate over Time

5-1e Offsetting a Forward Contract

5-1f Using Forward Contracts for Swap Transactions

5-1g Non-deliverable Forward Contracts

■ Buy 100 million Chilean pesos.

5-2a Contract Specifications

CURRENCY UNITS PER CONTR AC T

5-2b Trading Currency Futures

Trading Platforms for Currency Futures The trading of currency futures is

5-2c Credit Risk of Currency Futures Contracts

5-2d Comparing Currency Futures and Forward Contracts

Exhibit 5.3 Comparison of the Forward and Futures Markets

Source: Chicago Mercantile Exchange.

5-2e How MNCs Use Currency Futures

Purchasing Futures to Hedge Payables The purchase of futures contracts locks

Exhibit 5.4 Closing Out a Futures Contract

Step 1: Contract to Buy Step 2: Contract to Sell Step 3: Settle Contracts

$.53 per A$ $.50 per A$ $53,000 (Contract 1)

Of course, expectations are often incorrect. Because of their different expectations,

Efficiency of the Currency Futures Market If the currency futures market

Exhibit 5.5 Source of Gains from Buying Currency Futures

5-3 Currency Options Market

5-3a Currency Options Exchanges

5-3b Over-the-Counter Currency Options Market

5-4 Currency Call Options

5-4a Factors Affecting Currency Call Option Premiums

5-4b How MNCs Use Currency Call Options

5-4c Speculating with Currency Call Options

PER UNIT PER CONTR ACT

PER UNIT PER CONTR ACT

As a second example, assume the following information:

■ Call option premium on Canadian dollars (C$) 5 $0.01 per unit.

PER UNIT PER CONTR ACT

PER UNIT PER CONTR ACT

Contingency Graph for Speculators Buying a Call Option A contingency

Contingency Graph for Speculators Selling a Call Option A contingency

Exhibit 5.6 Contingency Graphs for Currency Call Options

Contingency Graph for Purchasers

$1.46 $1.48 $1.50 $1.52 $1.54

Contingency Graph for Sellers of

$1.46 $1.48 $1.50 $1.52 $1.54

5-5 Currency Put Options

5-5a Factors Affecting Currency Put Option Premiums

5-5b How MNCs Use Currency Put Options

5-5c Speculating with Currency Put Options

■ Put option premium on British pound (£ ) 5 $0.04 per unit.

PER UNIT PER CONTR ACT

PER UNIT PER CONTR ACT

Exhibit 5.7 Contingency Graphs for Currency Put Options

Contingency Graph for Purchasers

$1.46 $1.48 $1.50 $1.52 $1.54

Contingency Graph for Sellers of

$1.46 $1.48 $1.50 $1.52 $1.54

Efficiency of the Currency Options Market If the currency options market is

5-6 Other Forms of Currency Options

5-6a Conditional Currency Options

Exhibit 5.8 Comparison of Conditional and Basic Currency Options

5-6b European Currency Options

QUESTIONS AND APPLICATIONS

F O R WA R D C O N T R A C T FUTURES CONTR ACT OP TIONS CONTR AC T

BLADES, INC., CASE

SMALL BUSINESS DILEMMA

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

You might also like