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International Finance FINA 5331 Lecture 9: Hedging currency risk Read: Chapter 7 (125-129) Aaron Smallwood Ph.D. Review: Forward contracts Let’s consider aspects of deliverable forward contracts:
Hedging currency risk
Read: Chapter 7 (125-129)
Aaron Smallwood Ph.D.
These are pure cash settlement contracts.
The buyer/seller never takes delivery of the underlying asset.
Non-deliverable forward contracts are available in yuan:
Nanyang Commercial bank.
Examples: If we are short RMB, we can sell USD and buy RMB.
If we are short $, we can sell RMB and buy $.
At the close of each day, if you buy a contract:
At the close of each day, if you sell a contract:
Suppose we want to short the euro…
Sell one June euro contract. Suppose we acquired the euro contract at the final settlement price...$1.3351.
Suppose on December 17: S($/€)=$1.20.
WE WIN!!!! How.
Over the course of the contract, money will be added to our account:
($1.3351-$1.20)*125,000 = $16,887.50.
NOTE, if you were long in the euro, you would have to pay this amount.
To settle, we have to sell euros…What if we don’t have them?
We use a simple “reversing trade”
Buy euros for $1.20
Sell euros for $1.20
KEEP THE MONEY IN THE MARGIN
Suppose a trader needs £250,000 in September. They can buy 4 futures contracts.
Suppose they obtain the contracts at the opening price ($1.5226).
Suppose on September 15, S($/£)=$2.00…
They will buy pounds at $2.00…Cost $500,000.
However, money has been added to their margin account over the life of the contract
Total cost to the trader:
$500,000 - $119,350 = $380,650.
Futures contracts are inconvenient from a hedging point of view.
An options contract can be bought/sold not only over the counter, but also on a centralized exchange. In the case of an options contract, there are several centralized exchanges including the Philadelphia Stock Exchange.
Options contracts bought and sold on exchanges are only available in certain currencies. In particular, an options contract is available for Australian dollars, British pounds, Canadian dollars, euros, Japanese yen, and Swiss franc (all against the $) on the Philadelphia Stock Exchange.
Options contracts bought and sold on exchanges are only sold in fixed lots. In particular, on the Philadelphia Stock Exchange, currency options are available in the following denominations:
A$ 50,000 £31,250
C$ 50,000 €62,500
¥ 6,250,000 CHF 62,500
Currency options sold on a centralized exchange have specific delivery dates. In particular, a currency option bought or sold on the Philadelphia Stock Exchange matures on the Friday before the third Wednesday of the expiration month. Contracts on the exchange have a trading cycle of March, June, September, and December with two additional near term monthly contracts. This implies that if it is November, then there will be options contracts available in the next two months (December and January).
Unlike a forward contract, the culmination of the contract need not result in delivery of currency. For example, if an options contract is purchased in Canadian $, the trader never has to take delivery of Canadian $ as a result of the contract if they don’t wish to. In other words, the trader has the right, but not the obligation to take delivery of currency in the future. The trader will only use the option if the movements in future exchange rates make it profitable or cost-efficient to do so.