Chapter 5:

Currency
Derivatives
 Forward Market

• The forward market facilitates the trading

of forward contracts on currencies.
• A forward contract is an agreement
between a corporation and a 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.
 Forward Market
• As with the case of spot rates, there is a
bid/ask spread on forward rates.
• For example, a bank may set up a contract
with one firm agreeing to sell the firm
Singapore dollars 90 days from now at $.510
per Singapore dollar. This represents 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
$.505 per Singapore dollar.
 Forward Market

• Forward rates may also contain a premium

or discount.
¤ If the forward rate exceeds the existing
spot rate, it contains a premium.
¤ If the forward rate is less than the existing
spot rate, it contains a discount.
 Forward Market

• The difference between the forward rate

(F) and the spot rate (S) at a given point in
time is measured by the premium:

• where p represents the forward premium,

or the percentage by which the forward
rate exceeds the spot rate.
 Forward Market

• If the euro’s spot rate is $1.03, and its one-

year forward rate has a forward premium
of 2 percent, the one-year forward rate is:
 Forward Market
• If the euro’s one-year forward rate is quoted at
$1.0506 and the euro’s spot rate is quoted at
$1.03, the euro’s forward premium is:

• When the forward rate is less than the

prevailing spot rate, the forward premium is
negative, and the forward rate exhibits a
discount.
 Forward Market
• Annualized forward premium/discount :
 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.
 Using Forward Contracts for
Swap Transactions
• Soho, Inc., needs to invest 1 million Chilean pesos in its
Chilean subsidiary for the production 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, and it uses a
one-year forward contract for this purpose:
• 1. Today: The bank should withdraw dollars from Soho’s
U.S. account, convert the dollars to 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.
 Currency Futures Market

• Currency futures contracts specify a

standard volume of a particular currency to
be exchanged on a specific settlement
date.
• Often, they are used by MNCs to hedge
their currency positions, and, mostly, by
speculators who hope to capitalize on their
expectations of exchange rate movements.
 Efficiency of Currency Futures
Market
• If the currency futures market is efficient,
the futures price for a currency at any given
point in time should reflect all available
information. That is, it should represent an
unbiased estimate of the respective
currency’s spot rate on the settlement date.
 Speculations: Currency
Futures Market
Speculators often sell currency futures when
they expect the underlying currency to
depreciate, and vice versa.
 Hedge: Currency Futures
Market
• Currency futures may be purchased by
MNCs to hedge foreign currency payables,
or sold to hedge receivables.
April June 17
4
1. Expect to receive 2. Receive 500,000
500,000 pesos. pesos as expected.
Contract to sell
500,000 pesos 3. Sell the pesos at
@ $.09/peso on the locked-in rate.
June 17.
 Closing Out a Futures Position:
Currency Futures Market
• Holders, for any reason, if don’t want to stuck
with the futures, can close out their positions
by selling similar futures contracts. Sellers
may also close out their positions by
purchasing similar contracts.
January 10 February 15 March 19
1. Contract to 2. Contract to 3. Incurs $3000
buy sell loss from
A$100,000 A$100,000 offsetting
@ $.53/A$ @ $.50/A$ positions in
($53,000) on ($50,000) on futures
March 19. March 19. contracts.
 Currency Options Market

• A currency option is another type of

contract that can be purchased or sold by
speculators and firms.
• The standard options that are traded on an
exchange through brokers are guaranteed,
but require margin maintenance.
• Currency options are classified as either
calls or puts.
 Currency Call Options

• A currency call option grants the holder

the right to buy a specific currency at a
specific price (called the exercise or strike
price) within a specific period of time.
• This strategy is somewhat similar to that
used by purchasers of futures contracts,
but the futures contracts require an
obligation, while the currency option does
not.
 Currency Call Options

• Option owners can sell or exercise their

options. They can also choose to let their
options expire. At most, they will lose the
premiums they paid for their options.
 Currency Call Options
• A call option is said to be
¤ in the money if spot rate > strike
price,
¤ at the money if spot rate = strike
price,
¤ out of the money
if spot rate < 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
 Factors Affecting Currency all
Option Premium
• The premium on a call option represents
the cost of having the right to buy the
underlying currency at a specified price.
For MNCs that use currency call options
to hedge, the premium reflects a cost of
insurance or protection to the MNCs.
 Factors Affecting Currency Call
Option Premium
• The call option premium (referred to as C) is
primarily influenced by three factors:

• Call option premiums will be higher when:

¤ (spot price – strike price) is larger;
¤ the time to expiration date is longer; and
¤ the variability of the currency is greater.
NOTE: where S -X represents the difference between the spot exchange
rate (S) and the strike or exercise price (X), T represents the time to
maturity, and σ represents the volatility of the currency, as measured
by the standard deviation of the movements in the currency.
 Some Uses of Call Option
• Hedge payables by the MNCs
¤ MNCs can purchase call options on a currency to
hedge future payables.
• Hedge Project Building/Target Bidding for any
particular venture (e.g. project acquisition)
¤ U.S.-based MNCs that bid for foreign projects may
purchase call options to lock in the dollar cost of
the potential expenses (if the MNC does not win
the bid, it can let the option just expire)
 Currency Put Option

• The owner of a currency put option

receives 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.
 Currency Put Options
• A put option is said to be
¤ in the money if spot rate < strike
price,
¤ at the money if spot rate = strike
price,
¤ out of the money
if spot rate > 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
 Factors Affecting Currency Put
Option Premiums
• The put option premium (referred to as P) is
primarily influenced by three factors:

• Put option premiums will be higher when:

¤ (strike price – spot rate) is larger;
¤ the time to expiration date is longer; and
¤ the variability of the currency is greater.
• NOTE: where S - X represents the difference between the spot
exchange rate (S) and the strike or exercise price (X), T represents the
time to maturity, and σ represents the volatility of the currency
 Some Uses of Put Option
• Hedging with Currency Put Option
¤ Corporations (particularly exporters) can use
currency put options.