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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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Presentation Transcript
slide1

International Banking

and Trade Finance

Chpt

5

overview
Overview
  • Examine usage of currency futures and options contracts
    • to hedge or speculate based upon anticipated exchange rate changes
currency futures contracts
Currency Futures Contracts
  • Are contracts specifying a standard volume
  • of a particular currency
  • to be exchanged
  • on a particular date

Page 141

currency futures contracts5
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
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 market7
Currency Futures Market

Futures vs Forward contracts

  • Forward contracts
    • state amount of a currency to be exchanged on a specific day
    • individually tailored contracts
slide8

Currency Futures

- trade through a broker

Forward Contracts

- you make the arrangement directly with the lender

intl business
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
Settlement Dates
  • Typical settlement dates are
  • third Wednesdays in
  • March
  • June
  • September
  • December
currency futures market11
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 market12
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 market13
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 market14
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
Credit Risk
  • Each futures contract represents an agreement with “The Exchange”

Page 144

credit risk16
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
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
hedging18
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
hedging19
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

hedging20
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

hedging21
Hedging
  • Hedging exchange rate exposure
    • hedging by selling 90 day contracts
      • US firm is to receive a payment of SF750,000

Page 145

slide22

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

slide23

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
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 options25
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 options26
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 options27
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 options hedging
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 options hedging29
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 options30
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 options31
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 put options
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 options34
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 options35
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 options36
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 options speculation
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

profits with options and futures
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
Summary
  • Futures contract
    • specifies a standard volume of a currency to be exchanged on a particular date
    • used for hedging and speculative purposes
summary41
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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