Chapter

Currency Derivatives
 Chapter Objectives

• To explain how forward contracts are used to hedge

based on anticipated exchange rate movements;
• To explain how currency futures contracts are used
to speculate or hedge based on anticipated exchange
rate movements; and
• To explain how currency options contracts are used
to speculate or hedge based on anticipated exchange
rate movements.
 Forward Market

• 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.
• When MNCs anticipate future need or future receipt of a
foreign currency, they can set up forward contracts to
lock in the exchange rate.
• Forward contracts are not normally used by consumers or
small firms.
 Forward Market
• If the forward rate exceeds the existing spot rate, it
contains a premium. If it is less than the existing spot
rate, it contains a discount.
Suppose: spot rate = $/£ 1.681, and
90-day forward rate = $/£1.677.
forward = $1.677 - $1.681 x 360 = -0.95%
discount $1.681 90
• The premium (or discount) reflects the difference
between the home interest rate and the foreign interest
rate, so as to prevent arbitrage (Ch. 7).
 Long and Short Forward Positions
 If you have agreed to sell anything (spot or forward),
you are “short”, you are taking a short position.
 If you have agreed to buy anything (forward or spot),
you are “long”.
 If you have agreed to sell FX forward, you are short.
 If you have agreed to buy FX forward, you are long.
 Payoff Profiles
profit

If you agree to sell anything

in the future at a set price and
the spot price later falls then
you gain.

0 S180($/¥)
If you agree to sell anything
F180($/¥) = .009524 in the future at a set price
and the spot price later rises
then you lose.

loss Short position

 Payoff Profiles
profit
short position

Whether the
payoff profile
slopes up or down
depends upon
whether you use
0 S180(¥/$) the direct or
indirect quote:
F180(¥/$) = 105
F180(¥/$) = 105 or
F180($/¥)
= .009524.
-F180(¥/$)
loss
 Payoff Profiles
profit
short position

0 S180(¥/$)

F180(¥/$) = 105

When the short entered into this forward contract,

-F180(¥/$) he agreed to sell ¥ in 180 days at F180(¥/$) = 105
loss
 Payoff Profiles
profit
short position

15¥

0 S180(¥/$)
120
F180(¥/$) = 105
If, in 180 days, S180(¥/$) = 120, the short will make a
profit by buying ¥ at S180(¥/$) = 120 in the spot market
-F180(¥/$) and delivering ¥ at F180(¥/$) = 105 to fulfill his forward
loss
contract.
 Payoff Profiles
profit Since this is a zero-sum game,
F180(¥/$) short position
the long position payoff is the
opposite of the short.

0 S180(¥/$)

F180(¥/$) = 105

-F180(¥/$) Long position

loss
 Payoff Profiles
profit The long in this forward contract agreed to BUY
-F180(¥/$) ¥ in 180 days at F180(¥/$) = 105
If, in 180 days, S180(¥/$) = 120, the long will
lose by having to buy ¥ at F180(¥/$) = 105 and
delivering ¥ at S180(¥/$) = 120.
0 S180(¥/$)
120
F180(¥/$) = 105
–15¥
Long position
loss
 Forward Market

• Non-deliverable forward contracts (NDFs) are

forward contracts whereby the currencies are not
actually exchanged. Instead, a net payment is made
by one party to the other based on the contracted
rate and the market exchange rate on the day of
settlement.
• While the NDF does not involve delivery, it can
effectively hedge future foreign currency cash flows
that are anticipated by the MNC.
 Currency Futures Market

• Currency futures contracts are contracts specifying

a standard volume of a particular currency to be
exchanged on a specific settlement date, typically the
third Wednesdays in March, June, September, and
December.
• The contracts can be traded by firms or individuals
on the trading floor of an exchange, on automated
trading systems, or over the counter.
 Currency Futures Market

• The contracts are guaranteed by the exchange

clearinghouse, and requirement margins are imposed to
cover fluctuations in value.
• Corporations that have open positions in foreign currencies
can use futures contracts to offset such positions.
• Speculators also use them to capitalize on their expectation
of a currency’s future movement.
• Brokers who fulfill orders to buy or sell futures contracts
earn a transaction fee in the form of a bid/ask spread.
 Currency Futures Markets
 The Chicago Mercantile Exchange (CME) is by
far the largest.
 Others include:
 The Philadelphia Board of Trade (PBOT)
 The New York Board of Trade (NYBOT)
 The Tokyo International Financial Futures Exchange
 The London International Financial Futures Exchange
(LIFFE)
 Currency Futures
www. nybot.com and www.cme.com
Norwegian Krone futures
Norwegian Krone futures
Norwegian Krone futures
 Futures Contracts: Preliminaries
 A futures contract is like a forward contract:
 It specifies that a certain currency will be
exchanged for another at a specified time in the
future at prices specified today.
 Futures Vs. Forward

 A futures contract is different from a forward

contract:
 Futures are standardized contracts trading on organized
exchanges through a clearinghouse (i.e. CME)
 Forwards are negotiable contracts trading on a network
of dealers (over-the-counter.)
 Futures Vs. Forward

 A futures contract is different from a forward

contract in the way the underlying asset is priced
for future purchase or sale
 A forward contract states a price for the future
transaction and no cash changes hands until delivery
time of the asset.
 By contrast, a futures contract is marked-to-market
daily at the settlement price and there is an initial
margin requirement.
 Futures Vs. Forward
 A futures contract is different from a forward
contract:
 Futures contracts are usually offset before settlement
date.
 Forward contracts are usually delivered.
 Futures Vs. Forwards: A Summary Table
Futures Forwards
Default Risk: Borne by Clearinghouse Borne by Counter-Parties
What to Trade: Standardized Negotiable
The Futures/Forward Agreed on at Time Agreed on at Time
Price of Trade Then, of Trade. Payment at
Marked-to-Market Contract Termination
Where to Trade: Standardized Negotiable
When to Trade: Standardized Negotiable
Liquidity Risk: Clearinghouse Makes it Cannot Exit as Easily:
Easy to Exit Commitment Must Make an Entire
New Contrtact
How Much to Trade: Standardized Negotiable

What Type to Trade: Standardized Negotiable

Margin Required Collateral is negotiable
Delivery Usually offset Usually takes place
 Futures Contracts: Preliminaries
 A buyer of a futures contract (one who holds a long
position) in which the settlement price is higher
(lower) than the previous day's settlement price has a
positive (negative) settlement for the day.
 Since a long position entitles the owner to purchase the
underlying asset, a higher (lower) settlement price means
the futures price of the underlying asset has increased
(decreased). Consequently, a long position in the contract
is worth more (less).
 Futures Contracts: Preliminaries
 The change in settlement prices from one day to the
next determines the settlement amount
 Settlement amount is equal to the change in settlement
prices per unit of the underlying asset, multiplied by the
size of the contract, and equals the size of the daily
settlement to be added or subtracted from the margin
account
 Futures trading between the long and the short is a zero-
sum game
 Daily Resettlement: An Example
 Suppose you want to speculate on a rise in the ¥/$
exchange rate (specifically you think that the
dollar will appreciate).
Currency per
U.S. $ equivalent U.S. $
Wed Tue Wed Tue
Japan (yen) 0.007142857 0.007194245 140 139
1-month forward 0.006993007 0.007042254 143 142
3-months forward 0.006666667 0.006711409 150 149
6-months forward 0.00625 0.006289308 160 159

Currently $1 = ¥140. The 3-month forward price is $1=¥150.

 Daily Resettlement: An Example

 Currently $1 = ¥140 and it appears that the dollar is

strengthening.
 If you enter into a 3-month futures contract to sell ¥

at the rate of $1 = ¥150 you will make money if the

yen depreciates. The contract size is ¥12,500,000
 Your initial margin is 4% of the contract value:

$1
$3,333.33 .04 ¥12,500,000 
¥150
 Daily Resettlement: An Example

If tomorrow, the futures rate closes at $1 = ¥149, then

your position’s value drops.
Your original agreement was to sell ¥12,500,000 and
receive $83,333.33
But now ¥12,500,000 is worth $83,892.62
$1
$83,892.62 ¥12,500,000 
¥149
You have lost $559.28 overnight.
 Daily Resettlement: An Example

 The $559.28 comes out of your $3,333.33 margin

account, leaving $2,774.05

Your broker will let you slide until you run through
your maintenance margin. Then you must post
additional funds or your position will be closed out.
 Options and forward contracts

 In the case of forward contracts, we convert a future uncertain

outcome to a fixed, predetermined rate
 Sometimes this is beneficial, but if subsequently the exchange
rate moves in our favor, there is an opportunity loss
 What we really want is a situation where we can have forward
cover and the opportunity to gain if the outcome is to our
advantage – we want the cake and eat it too
 Solution - options
 Options Contracts: Preliminaries
 An option gives the holder the right, but not the
obligation, to buy or sell a given quantity of an asset in
the future, at prices agreed upon today.
 Call vs. Put
 Call option gives the holder the right, but not the obligation, to
buy a given quantity of some asset at some time in the future,
at prices agreed upon today.
 Put option gives the holder the right, but not the obligation, to
sell a given quantity of some asset at some time in the future,
at prices agreed upon today.
Currency options – FT (from CME)
 Options Contracts: Preliminaries
 European vs. American options
 European options can only be exercised on the
expiration date.
 American options can be exercised at any time up to
and including the expiration date.
 Since this option to exercise early generally has value,
American options are usually worth more than
European options, other things equal.
 Options Contracts: Preliminaries
 In-the-money
 Options would worth something if exercised now.
 At-the-money
 The exercise price is equal to the spot price of the
underlying asset.
 Out-of-the-money
 Options would be worthless if exercised now.
 Currency Call Options
• A currency call option grants the right to buy a
specific currency at a specific price (called the exercise
or strike price) within a specific period of time.
• A call option is in the money when the present
exchange rate exceeds the strike price, at the money
when the rates are equal, and out of the money
otherwise.
• Option owners will at most lose the premiums they
paid for their options.
 Option Market Speculation
 Buyer of a call:
 Assume purchase of August call option on Swiss francs with
strike price of 58½ ($0.5850/SF), and a premium of $0.005/SF
 At all spot rates below the strike price of 58.5, the purchase of
the option would choose not to exercise because it would be
cheaper to purchase SF on the open market
 At all spot rates above the strike price, the option purchaser
would exercise the option, purchase SF at the strike price and
sell them into the market netting a profit (less the option
premium)
 Profit and Loss for the Buyer of a Call
Option on Swiss francs
Profit Strike price
(US cents/SF) “At the money”

+ 1.00
“Out of the money” “In the money”
+ 0.50
Unlimited profit

0 Spot price
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
Limited loss
- 0.50
Break-even price
- 1.00

Loss
The buyer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot rates
less than 58.5 (“out of the money”), and an unlimited profit potential at spot rates above 58.5 cents/SF (“in the
money”).
 Option Market Speculation
 Writer of a call:
 What the holder, or buyer of an option loses, the writer gains
 The maximum profit that the writer of the call option can
make is limited to the premium
 If the writer wrote the option naked, that is without owning
the currency, the writer would now have to buy the currency
at the spot and take the loss delivering at the strike price
 The amount of such a loss is unlimited and increases as the
underlying currency rises
 Even if the writer already owns the currency, the writer will
experience an opportunity loss
 Profit and Loss for the Writer of a Call
Option on Swiss francs
Profit “At the money”
(US cents/SF) Strike price
+ 1.00

+ 0.50 Break-even price

Limited profit

0 Spot price
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
- 0.50 Unlimited loss

- 1.00

Loss

The writer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at
spot rates less than 58.5, and an unlimited loss potential at spot rates above (to the right of) 59.0 cents/SF.
 Currency Call Options
• Premiums of call options vary due to:
 the level of existing spot price relative to strike price,
 the length of time before the expiration date, and
 the potential variability of the currency.

• Corporations can use currency call options to cover

their foreign currency positions.
• Unlike a futures or forward contract, if the anticipated
need does not arise, the firm can choose to let the
options contract expire. The firm can also sell or
exercise the option.
 Currency Call Options
• Individuals may also speculate in the currency options
market based on their expectations of the future
movements in a particular currency.
• When brokerage fees are ignored, the currency call
buyer’s gain will be the seller’s loss if both parties
begin and close out their positions at the same time.
• The purchaser of a call option will break even when
the spot rate at which the currency is sold is equal to
the strike price plus the option premium.
 Currency Put Options
• A currency put option grants the right to sell a specific
currency at a specific price (strike price) within a
specific period of time.
• A put option is in the money when the present
exchange rate is less than the strike price, at the money
when the rates are equal, and out of the money
otherwise.
• Since option owners are not obligated to exercise their
options, they will at most lose the premiums they paid.
 Option Market Speculation
 Buyer of a Put:
 The basic terms of this example are similar to those just
illustrated with the call
 The buyer of a put option, however, wants to be able to sell the
underlying currency at the exercise price when the market price
of that currency drops (not rises as in the case of the call option)
 If the spot price drops to $0.575/SF, the buyer of the put will
deliver francs to the writer and receive $0.585/SF
 At any exchange rate above the strike price of 58.5, the buyer of
the put would not exercise the option, and would lose only the
$0.05/SF premium
 The buyer of a put (like the buyer of the call) can never lose more
than the premium paid up front
 Profit and Loss for the Buyer of a Put
Option on Swiss francs
“At the money”
Profit Strike price
(US cents/SF)
+ 1.00 “In the money” “Out of the money”

+ 0.50 Profit up
to 58.0
0 Spot price
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
Limited loss
- 0.50
Break-even
price
- 1.00

Loss
The buyer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot
rates greater than 58.5 (“out of the money”), and an unlimited profit potential at spot rates less than 58.5
cents/SF (“in the money”) up to 58.0 cents.
 Option Market Speculation
 Seller (writer) of a put:
 In this case, if the spot price of francs drops below 58.5 cents per
franc, the option will be exercised
 Below a price of 58.5 cents per franc, the writer will lose more
than the premium received fro writing the option (falling below
break-even)
 If the spot price is above $0.585/SF, the option will not be
exercised and the option writer will pocket the entire premium
 Profit and Loss for the Writer of a Put
Option on Swiss francs
“At the money”
Profit
Strike price
(US cents/SF)
+ 1.00
Break-even
+ 0.50 price
Limited profit
0 Spot price
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
Unlimited loss
- 0.50 up to 58.0

- 1.00

Loss
The writer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at spot rates
greater than 58.5, and an unlimited loss potential at spot rates less than 58.5 cents/SF up to 58.0 cents.
 Currency Put Options
• Premiums of put options vary due to:
 the level of existing spot price relative to strike price,
 the length of time before the expiration date, and
 the potential variability of the currency.

• Corporations can use currency put options to cover

their foreign currency positions.
• Individuals may also speculate with currency put
options based on their expectations of the future
movements in a particular currency.
 Example
 Jim is a speculator who buys a British Pound call
option from Linda with a strike price of $1.40 and
a December settlement date. The current spot rate
is about $1.39 and Jim pays a premium of $.012
per unit for the call option. Just before expiration,
the spot rate reaches $1.41
 What is the profit? One contract equals £ 31 250
 Profit and loss

Jim Per unit Per contract

Selling price of £ 1,41 44 063
Purchase price of £ 1,40 43 750
Premium paid for option 0,012 375
Net profit -63

Linda
Selling price of £ 1,40 43 750
Purchase price of £ 1,41 44 063
Premium received 0,012 375
Net profit 63
Options Contracts: Preliminaries
 Intrinsic Value
 The difference between the exercise price of the option and
the spot price of the underlying asset.
 Time Value
 The difference between the option premium and the
intrinsic value of the option.

Option Intrinsic + Time

=
Premium Value Value
Intrinsic Value, Time Value, and Total Value
of a Call Option on British Pounds with a
Strike Price of $1.70
 Basic Option Pricing
Relationships at Expiry
 At expiry, an American call option is worth the
same as a European option with the same
characteristics.
 If the call is in-the-money, it is worth S – X.
T
 If the call is out-of-the-money, it is worthless.

CaT = CeT = Max[ST - X, 0]

 Basic Option Pricing
Relationships at Expiry
 At expiry, an American put option is worth the
same as a European option with the same
characteristics.
 If the put is in-the-money, it is worth X - S .
T
 If the put is out-of-the-money, it is worthless.

PaT = PeT = Max[X - ST, 0]

 Option pricing
 The Black-Scholes option-pricing model applied to
currencies often goes by the name of the Garman -
Kohlhagen model as these authors were the first to publish
a closed form model
 This model alleviates the restrictive assumption used in the Black
Scholes model that borrowing and lending is performed at the
same risk free rate.
 In the foreign exchange market there is no reason that the risk free
rate should be identical in each country
 The risk free foreign interest rate in this case can be thought of as
a continuous dividend yield being paid on the foreign currency
 Garman - Kohlhagen
 Model assumptions include:
 the option can only be exercised on the expiry date
(European style);
 there are no taxes, margins or transaction costs;
 the risk free interest rates (domestic and foreign) are
constant;
 the price volatility of the underlying instrument is
constant; and
 the price movements of the underlying instrument
follow a lognormal distribution.
 Garman - Kohlhagen

 rf T
Call pricing : C  S  e  N ( d 1 )  X  e  rT  N ( d 2 )

ln( S / X )  ( r  r f   2 / 2)  T
where : d1 
 T
d 2 d 1  σ T
 Garman - Kohlhagen

Using Put - call parity :

 rf T
C  P S  e  X  e  rT

we get put currency option pricing :

 rf T
Puts : P  X  e  rT  N ( d 2 )  S  e  N ( d1 )
 Garman - Kohlhagen
 Suppose we have
 Spot exchange rate S = $0,92/€
 Exercise rate X = $0,9/€
 Standard deviation σ = 10 %
 Dollar interest rate r = 6 %
 Euro denominated interest rate rc = 3,2 %
 Time to expiration: 365 days
Garman - Kohlhagen
Spot rate S 0,9200
Exercise rate X 0,9000
Risk free foreign rc 3,20 %
Risk free domestic r 6,00 %
Volatility (SD) σ 10,00 %
E 2,718282
Time to expiration days 365
Time to expiration T 1,000

d1 0,549789
d2 0,449789
N(d1) 0,708768
N(d2) 0,673569
N(-d1) 0,291232
N(-d2) 0,326431

Call option value 0,0606

Put option value 0,0172
 Impact of Currency Derivatives
on an MNC’s Value
Currency futures
Currency options

m 
n 
 j 1

 E CFj , t  E ER j , t   

Value =   
t =1 1  kt 

 


E (CFj,t ) = expected cash flows in currency j to be received

by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = the weighted average cost of capital of the U.S. parent