C H A P T E R 5

1. C H A P T E R 5 Currency Derivatives

2. Chapter Overview A. Forward Market B. Currency Futures Market C. Currency Options Market D. Currency Call Options E. Currency Put Options • Contingency Graphs for Currency Options

3. Chapter 5 Objectives This chapter will: A. Explain how forward contracts are used to hedge based on anticipated exchange rate movements B. Describe how currency futures contracts are used to speculate or hedge based on anticipated exchange rate movements C. Explain how currency option contracts are used to speculate or hedge based on anticipated exchange rate movements

4. A. Forward Market • How MNC’s Use Forward Contracts A forward contract specifies settlement date, forward rate and volume. • Bid/Ask Spread • No margin account (future contract use margin account for daily settlement) b. Premium or Discount on the Forward Rate a. Forward rate could be higher than spot rate – premium. O/w, it is discounted. b. Equation: F=S(1+P) or P = F/S -1 (p is the premium / discount rate) Example 1: Euro’s forward rate is $1.03 and its one year forward premium is 2%, then one year forward rate is: $1.03 *(1+0.02) = $1.0506. Example 2 (exhibit 5-1): Type of rate £ Value Maturity Forward premium/discount Spot $1.681 30 day forward rate $1.680 30 days 90 day forward rate $1.677 90days 180 day forward rate $1.672 180 days

5. A. Forward Market (cont.) • How MNC’s Use Forward Contracts c. Arbitrage Should forward rate differ from spot rate? d. Offsetting a Forward Contract: Can be offset by negotiating with the bank. e. Using Forward Contracts for Swap Transactions: • A forex swap consists of two legs: • a spot foreign exchange transaction, and • a forward foreign exchange transaction. • These two legs are executed simultaneously for the same quantity, and therefore offset each other.

6. A. Forward Market (cont.) • How MNC’s Use Forward Contracts So, Forward contract price (FYI, chapter 7) : F = forward rate S = spot rate r1 = simple interest rate of the term currency r2 = simple interest rate of the base currency T = tenor (calculated to the appropriate day count convertion)

7. B. Currency Futures Market • 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. • A futures contract is different from a forward contract (p110, exhibit 5.3): • Futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse. • US main market is: IMM (international monetary market) of Chicago, a division of CME (Chicago Mercantile Exchange).

8. Futures Contracts: Preliminaries • Standardizing Features: • Contract Size • Delivery Month • Daily resettlement • Initial Margin (about 4% of contract value, cash or T-bills held in a street name at your brokers) and your margin account value is changing (resettled) with the daily exchange rate.

9. Currency Futures Markets • The Chicago Mercantile Exchange (CME) is by far the largest. • Others include: • The Philadelphia Board of Trade (PBOT) • The MidAmerica commodities Exchange • The Tokyo International Financial Futures Exchange • The London International Financial Futures Exchange

10. The Chicago Mercantile Exchange • Expiry cycle: March, June, September, December. • Delivery date 3rd Wednesday of delivery month. • Last trading day is the second business day preceding the delivery day. • CME hours 7:20 a.m. to 2:00 p.m. CST.

11. CME After Hours • Extended-hours trading on GLOBEX runs from 2:30 p.m. to 4:00 p.m dinner break and then back at it from 6:00 p.m. to 6:00 a.m. CST. • Singapore International Monetary Exchange (SIMEX) offer interchangeable contracts. • There’s other markets, but none are close to CME and SIMEX trading volume.

12. Basic Currency Futures Relationships • Open Interest refers to the number of contracts outstanding for a particular delivery month. • Open interest is a good proxy for demand for a contract. • Some refer to open interest as the depth of the market. The breadth of the market would be how many different contracts (expiry month, currency) are outstanding.

13. Reading a Futures Quote Highest and lowest prices over the lifetime of the contract. Daily Change Closing price Lowest price that day Highest price that day Opening price Number of open contracts Expiry month

14. Example-Eurodollar Interest Rate Futures Contracts • Widely used futures contract for hedging short-term U.S. dollar interest rate risk. • The underlying asset is a hypothetical $1,000,000 90-day Eurodollar deposit—the contract is cash settled. • Traded on the CME and the Singapore International Monetary Exchange. • The contract trades in the March, June, September and December cycle.

15. B. Currency Futures Market . Pricing Currency Futures Should future rate differ from spot rate? forward rate? . Credit Risk of currency Futures Contracts: CME imposes margin requirements. If the contract holder cannot reach the margin requirement on the daily basis, the future contract will be sold in CME.

16. B. Currency Futures Market . Credit Risk of currency Futures Contracts (cont): a. Forwards transact only when purchased and on the settlement date. • Futures are margined daily, the daily spot price of a forward with the same agreed-upon delivery price and underlying asset (based on mark to market). • The margining of futures eliminates much of this credit risk by forcing the holders to update daily to the price of an equivalent forward purchased that day. • This means that there will be very little additional money due on the final day to settle the futures contract: only the final day's gain or loss, not the gain or loss over the life of the contract. • In addition, the daily futures-settlement failure risk is borne by an exchange, rather than an individual party, further limiting credit risk in futures.

17. B. Currency Futures Market Speculating and hedging with Currency Futures a. What is the difference between speculating and hedging? b. Currency Futures Market Efficiency If the currency futures market is efficient, the futures price for a currency at any given point in time should reflect all available information. Is the currency future market efficient?

18. Short / long positions of foreign currency future contracts • Short position: when an investor believes that a foreign currency will fall in value verses US$, he can sell a foreign currency future contract. This is a short position. Value at maturity (short position) = -principal * (spot-futures) Example: Amber sells a March futures contract and locks in the right to sell 500,000 Mexican pesos at $0.10958/Ps (peso). If the spot exchange rate at maturity is $0.095/Ps, the value of Amber’s position on settlement is: Value = -Ps 500,000 * ($0.095/Ps - $0.10958/Ps) = $7,290.

19. Short / long potions of foreign currency future contracts (cont) • Long position: when an investor believes that a foreign currency will rise in value verses US$, he can buy a foreign currency future contract. This is a long position. Value at maturity (short position) = principal * (spot-futures) Example: Amber sells a March futures contract and locks in the right to sell 500,000 Mexican pesos at $0.10958/Ps (peso). If the spot exchange rate at maturity is $0.11/Ps, the value of Amber’s position on settlement is: Value = Ps 500,000 * ($0.11/Ps - $0.10958/Ps) = $210.

20. B. Currency Futures Market How Firms Use Currency Futures a. Speculation of currency futures: You expect peso to depreciate on 4/4. So you sell peso future contract (6/17) on 4/4 with future rate of $0.09/peso. And on 6/17, the spot rate is $0.08/peso. Value at maturity (short position) = -principal * (spot-futures) = - 500,000Ps *($0.08/Ps – $0.09/Ps) = $5,000.

21. B. Currency Futures Market b. Buying futures to hedge payables. Example: Firm A have c$500,000.00 payables due on 6/1. So it can purchase a future contract delivered on 6/1 to lock in the price to pay for Canadian dollars on 6/1. c. Selling Futures to Hedge Receivables Example: Firm A have c$500,000.00 receivable due on 6/1. So it can sell a future contract delivered on 6/1 to lock in the price to sell the Canadian dollars on 6/1.

22. B. Currency Futures Market Closing Out a Futures Position: Buy an offsetting contract from the market to close out a future position. Example: Firm A hold a future contract. It can sell a future contract with the same settlement date in the market to close out its initial position. How does it differ from closing out a forward position?

23. Warren Buffett’s View of Derivatives • Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses – often huge in amount – in their current earning statements without so much as a penny changing hands. The range of derivates contracts is limited by the imagination of man (or sometimes, so it seems, madman). ------------- Warren Buffett, Berkshire Hathaway Annual Report, 2002

24. The New Zealand Kiwi and Krieger • http://voter08.wordpress.com/a-brief-on-andrew-kieger-raiding-the-kiwi-dollar/ • Background: Following the US stock market crash in October 1987, the world’s currency markets moved rapidly to exit the dollar. Other currencies, including New Zealand’s (kiwi), became the subject of interest. As the world’s traders dumped dollar and bought kiwis, the value of kiwi rose rapidly. • Krieger, a trader for Bankers Trust of New York (BT) believed the Kiwi was overvalued. He took a short position on kiwi of 200m kiwi (more than the entire New Zealand money supply). His bank made $300m from this deal.

25. C. Currency Options Market: 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. • A buyer of an option: holder; A seller of an option: writer or grantor. • The premium or option price is the cost of the option, paid in advance by the buyer to the seller.

26. C. Currency Options Market: Preliminaries • An option whose exercise price is the same as the spot price of the underlying currency is at the money (ATM); An option that would be profitable, excluding the cost of the premium, is in the money; An option that would not be profitable, excluding the cost of the premium, is out of the money. • Calls vs. Puts • Call options 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 options 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.

27. 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.

28. Currency Options Markets • PHLX: • NASDAQ OMX PHLX (Philadelphia Stock Exchange) trades more than 2,600 equity options, sector index options and U.S. dollar-settled options on major currencies. PHLX offers a combination of cutting-edge electronic and floor-based options trading. • Nasdaq: http://www.nasdaq.com/includes/swiss-franc-specifications.stm • Morning star: http://quote.morningstar.com/Option/Options.aspx?Ticker=fxf • HKFE: Hong Kong Futures Exchange. • 20-hour trading day. • OTC volume is much bigger than exchange volume. • Trading is in seven major currencies plus the euro against the U.S. dollar.

29. Currency Options Markets • Option pricing model: • The original option pricing model was developed by Black and Scholes in 1973. • Book: Option Pricing Models and Volatility Using Excel-VBA (Wiley Finance) (Excel: alt + F11)

30. D. Currency Call Options 1. Factors Affecting Currency Call Option Premiums a. Level of existing spot price relative to strike price b. Length of time before the expiration date c. Potential variability of currency C = f(S-X, T, σ) + + + X: Strike price (exercise price) S: Stock price T: Length of time before the expiration date σ : Volatility of the currency

31. Basic Option Profit Profiles Can you tell where is in the money, at the money and out of money? Long 1 call profit ST E+C (break even point) E loss E: Exercise price or strike price; c: call option premium (price of the call option); St: spot rate

32. Market Value, Time Value and Intrinsic Value for an American Call (FYI) Profit ST - E Market Value Time value Intrinsic value ST E Out-of-the-money In-the-money E: Exercise price or strike price; St: spot rate loss

33. D. Currency Call Options 2. How Firms Use Currency Call Options a. Using Call Options to Hedge Payables b. Using Call Options to Hedge Project Bidding c. Using Call Options to Hedge Target Bidding

34. D. Currency Call Options 3. Speculating with Currency Call Options Profit = Spot rate – (strike price + premium) Example (p118). • Jim is a speculator . He buys a British pound call option with a strike of $1.4 and a December settlement date. Current spot price as of that date is $1.39. He pays a premium of $0.12 per unit for the call option. Just before the expiration date, the spot rate of the British pound is $1.41.At that time, he exercises the call option and sells the pounds at the spot rate to a bank. One option contract specifies 31,250 units. What is Jim’s profit or loss? • Assume Linda is the seller of the call option. What is Linda’s profit or loss?

35. D. Currency Call Options 4. Writer of a Call Profit = premium – (Spot rate – strike price )

36. E. Currency Put Options 1. Factors Affecting Currency Put Option Premiums P = f(S-X, T, σ) - + + X: Strike price (exercise price) S: Stock price T: Length of time before the expiration date σ : Volatility of the currency

37. Basic Option Profit Profiles Can you tell where is in the money, at the money and out of money? profit long 1 put ST E – p (break even point) E loss E: Exercise price; p: put option premium (price of the put option); St: stock price

38. E. Currency Put Options 2. Hedging with Currency Put Options 3. Speculating with Currency Put Options Profit = strike price – (spot rate + premium) Example (p121): A speculator bought a put option (Put premium on £ = $0.04 / unit, X=$1.4, One contract specifies £31,250 ) He exercise the option shortly before expiration, when the spot rate of the pound was $1.30. What is his profit? What is the profit of the seller?

39. E. Currency Put Options – Writer of a Put Profit (loss) = Premium – (Strike price – spot rate) Can you tell where is in the money, at the money and out of money?

40. HW • 4, 10, 11, 12, 13, 18, 19,20,24, 25. • 24 and 25 will be discussed in class.