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International Banking and Trade Finance Chpt 5 Currency Futures and Options Chapter 5 Overview Examine usage of currency futures and options contracts to hedge or speculate based upon anticipated exchange rate changes Currency Futures Contracts Are contracts specifying a standard volume

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International Banking

and Trade Finance

Chpt

5


Currency Futures and Options

Chapter 5


Overview

  • Examine usage of currency futures and options contracts

    • to hedge or speculate based upon anticipated exchange rate changes


Currency Futures Contracts

  • Are contracts specifying a standard volume

  • of a particular currency

  • to be exchanged

  • on a particular date

Page 141


Currency Futures Contracts

  • Similar to forward contracts

  • but

  • they are not negotiated like Forward Contracts

  • Currency Futures are traded in an Exchange

Page 141


Currency Futures Market

Futures vs Forward contracts

  • Futures contracts

    • state amount of a currency to be exchanged on a specific day

    • standardized contracts


Currency Futures Market

Futures vs Forward contracts

  • Forward contracts

    • state amount of a currency to be exchanged on a specific day

    • individually tailored contracts


Currency Futures

- trade through a broker

Forward Contracts

- you make the arrangement directly with the lender


Intl Business

  • The trading volume of currency futures has consistently increased over time as has growth of international transactions - which require buying and selling currency


Settlement Dates

  • Typical settlement dates are

  • third Wednesdays in

  • March

  • June

  • September

  • December


Currency Futures Market

  • Pricing currency futures

    • similar to forward rate

    • differs from spot rate

  • changes in spot rate affects value of futures contract

    • market forces eliminate arbitrage profits

    • which is to say buying at $1.50 and selling at $1.48

Page 142


Currency Futures Market

Page 144

  • Closing out a futures position

    • if you don’t want to wait until the settlement date, you can “close the position” by selling an identical futures contract


Currency Futures Market

Page 144

  • Closing out a futures position

  • the future price ……. Up or Down

  • the price changes over time in accordance with movements in the spot rate

  • If the spot rate becomes stronger, it makes it less attractive to hold a futures position - so you’d want to sell so you don’t end up with a premium


Currency Futures Market

Page 144

  • Closing out a futures position

    • in the real world,,,,,,

    • most currency futures contracts are closed out before settlement date


Credit Risk

  • Each futures contract represents an agreement with “The Exchange”

Page 144


Credit Risk

  • Margin requirements reflect credit risk

    • covers fluctuations in contract value

    • initial margin: $1,000 - $2,000 per contract

      • trader must add more if contract value decreases


Hedging

  • I want to get a ride to the airport for a business trip, I’ll book an airline limo

  • Just in case the limo doesn’t come on time, I’ll hedge my risk by having my neighbour agree to drive me


Hedging

  • Buy a futures contract for a currency you need

  • Done when you need to spend money in the future, and want to lock in the price because you are concerned it might rise to your disadvantage

  • If you don’t need it, your broker can sell it on the exchange


Hedging

  • Sell a futures contract for a currency you DO NOT need

  • Done when you need to get rid of money in the future, and want to lock in the price because you are concerned it might rise to your disadvantage

  • Again, if you don’t need it, your broker can sell it on the exchange

Page 145


Hedging

  • Hedging exchange rate exposure

    • hedging by buying 90 day contracts

      • e.g., a US firm orders Swiss products

      • must pay SF750,000 upon delivery in 90 days

      • US firm buys 90 day contract today

        • locks in price to be paid for francs in 90 days

Page 145


Hedging

  • Hedging exchange rate exposure

    • hedging by selling 90 day contracts

      • US firm is to receive a payment of SF750,000

Page 145


S p e c u l a t i o n

  • based upon anticipated changes

    • buy (sell) futures contract

      • expect foreign currency to appreciate (depreciate) in value

      • coordinate transaction in spot market at settlement date

Page 145


Transaction costs

  • associated with use of brokers

    • brokers buy (sell to client) at the “bid” price

    • brokers sell (buy from client) at the “ask” price

    • broker’s profit (trader’s transaction cost)

      • difference between bid and ask prices

Bid-Ask spread = Ask - Bid


Currency Call Options

  • Contract grants the right to buy a specific currency

    • a) at a specific price

    • b) within a specific time period


Currency Call Options

  • Exercise (strike) price

    • agreed upon price if contract is implemented

    • “in the money”: spot rate > strike price

    • “out of the money”: spot rate < strike price


Currency Call Options

  • Factors affecting call option premiums

    • level of existing spot price (vs. strike price)

      • option price increases as spot price rises

      • improves chances of buying currency at a low price


Currency Call Options

  • Factors affecting call option premiums

    • length of time before expiration date

      • spot price has better chance to exceed strike price

    • volatility of currency price

      • improves chances that spot will exceed strike price


Currency Call OptionsHedging

  • Strike price sets maximum exchange rate

    • if exchange (spot) rate lower than strike price:

      • call option is not exercised

      • currency purchased on spot market


Currency Call OptionsHedging

  • Example of corporate hedging

    • US firm bids on Canadian project

      • US firm will need $CD if contract awarded

      • if project would require $CD5,000,000, firm may choose to get up to 100 call option contracts


Currency Call Options

S p e c u l a t i o n

  • Buy call option

    • expect currency to appreciate

      • exercise option if price increases beyond strike price

    • buy at strike price and sell at spot rate

  • Sell (write) call option

    • expect currency to decline in value

      • obligated to sell a currency at a specified price

      • make money if option not exercised

zero sum game


Currency Call Options

S p e c u l a t i o n

  • Example of buying a call option

    • strike price set at $0.5877 when spot was $0.5727 per Deutsche mark

    • premium paid = $0.015 (0.5877 - 0.5727)

    • exercise option when spot reaches $0.6077


Currency Call OptionsSpeculation


Currency Put Options

  • Contract grants the right to sell a specific currency

    • a) at a specific price

    • b) within a specific time period


Currency Put Options

  • Exercise (strike) price

    • agreed upon price if contract is implemented

    • “in the money”: spot rate < strike price

    • “out of the money”: spot rate > strike price


Currency Put Options

  • Factors affecting put option premiums

    • level of existing spot price (vs. strike price)

      • option price increases as spot price falls

      • improves chances of selling currency at a high price


Currency Put Options

  • Factors affecting put option

    • length of time before expiration date

      • spot price has better chance to fall below strike price

    • volatility of currency price

      • improves chances that spot will fall below strike

  • Hedging reduces risk exposure in receivables


Currency Put OptionsSpeculation

  • Example of buying a put option

    • strike price set at $0.6217 when spot was $0.6357 per Deutsche mark

    • premium paid = $0.008 (0.6357 - 0.6217)

    • exercise option when spot reaches $0.6077

declining

value


Currency Put OptionsSpeculation


Profits with Options and Futures

  • Efficiency of options/futures market

    • efficient market eliminates conditions permitting “abnormal” profits

    • studies suggest that prices reflect all available information


Summary

  • Futures contract

    • specifies a standard volume of a currency to be exchanged on a particular date

    • used for hedging and speculative purposes


Summary

  • Options contract

    • call options purchased when exchange rate is expected to increase

    • put options purchased when exchange rate expected to fall


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