Currency Derivatives...Currency Derivatives: Currency Futures Currency Futures • Currency Futures...

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Financial Management in IB

Currency Derivatives

FX Markets Division

FX Markets

Spot Markets Forward Markets

Currency

Futures

FX Forwards Currency-Swaps Currency

Options

Outright Transactions FX Swaps

Currency Derivatives – FX Forwards

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.

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.

The premium (or discount) reflects the difference

between the home interest rate and the foreign

interest rate, so as to prevent covered interest

arbitrage.

Currency Derivatives - FX Forwards

Covered Interest Arbitrage

Covered interest arbitrage tends to force a relationship between

the interest rates of two countries and their forward exchange

2 Strategies of Covered Interest Arbitrage:

Borrowing Euros and lending US Dollars

Borrowing US Dollars and lending Euros

In response to the imbalance in demand and supply resulting

from such arbitrage activity, the rates will adjust very quickly.

Currency Derivatives - FX Forwards

Borrowing Euros and lending US Dollars

Costs in Euros: K . (1+iEUR)

Revenues in Euros: K . St . (1+iUSD) . 1/FRt+n

Equilibrium:

0)i1(KFR

1)i1(SK EUR

)i1(SFR

Borrowing US Dollars and lending Euros

Costs in US Dollars: K . (1+iUSD)

Revenues in US Dollars: K . 1/St . (1+iEUR) . FRt+n

Equilibrium:

0)i1(KFR)i1(S

1K USDntEUR

)i1(SFR

Covered Interest Rate Parity Condition

)i1(SFR

Non Deliverable Forward Contracts

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.

Currency Derivatives: Currency Futures

Currency Futures

• Currency Futures are contracts specifying a standard volume of a

particular currency to be exchanged on a specific settlement date.

• The contracts can be traded by firms or individuals on the trading

floor of an exchange or on automated trading systems.

• Currency Futures are standardized.

• Normally, the price of a currency future is similar to the forward rate

for a given currency and settlement date, but different from the spot

Currency Futures

• Holders of futures contracts can close out their position by selling

an identical futures contract. Similarly, sellers of futures contracts

can close out their position by purchasing a currency futures

contract with a similar settlement date.

• The gain or loss to the firm is dependent on the difference between

the purchase price and the sale price.

• Most currency futures contracts are closed out before their

settlement date.

• The contracts are guaranteed by the exchange clearinghouse, and

margin requirements are imposed to cover fluctuations in value.

• At the end of each business day gains and losses are calculated

for all open positions.

Currency Futures

• 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.

Example

• Euro / US Dollar Futures - LIFFE

Unit of trading: EUR 20,000

Quotation: In US dollars per EUR 100

(USD 0.01 represents USD 200 per contract)

Minimum price movement (tick size and value): USD 0.01 (USD 2)

Last trading day: 13.00 Amsterdam time on the third Friday of the

delivery month, provided this is a business day. If it is not, the

previous business day will be the last day of trading.

Settlement: Cash settlement, based on the value of the €/$ rate set

by EuroFX at 13.00 Amsterdam time.

Currency Derivatives: Currency Swaps

• A swap is a negotiated agreement between two parties to

exchange cash flows at specified intervals (payment dates) during

the agreed-upon life of the contract (maturity or tenor). Entering a

swap typically does not require the payment of a fee.

• An interest rate swap is an agreement to exchange interest rate

cash flows, calculated on a notional principal amount, at specified

intervals (payment dates) during the life of the agreement.

• A cross-currency swap is an interest rate swap in which the cash

flows are in different currencies.

Currency Derivatives: Currency Swaps

Cross Currency Swap

• Upon initiation of a cross-currency swap, the counterparties make

an initial exchange of notional principals in the two currencies.

• During the life of the swap, each party pays interest (in the

currency of the principal received) to the other.

• At the maturity of the swap, the parties make a final exchange of

the initial principal amounts, reversing the initial exchange at the

same spot rate.

• A cross-currency swap is sometimes confused with a traditional FX

swap, which is simply a spot currency transaction that will be

reversed at a predetermined date with an offsetting forward

transaction.

Currency Derivatives: Currency Options

Option purchaser (buyer, holder)

has a RIGHT, NOT the OBLIGATION to buy/sell

given amount of underlying currency

at fixed price = strike/exercise price

on specified expiration day/time period

pays option premium = price of the option (contract)

Option seller (writer, grantor)

has the OBLIGATION to sell/buy

given amount of underlying currency

at fixed price = strike/exercise price

on specified expiration day/time period

if the option buyer exercises his right

receives option premium

Basic types of options

CALL => buying underlying currency

Holder has a RIGHT, NOT the OBLIGATION to buy

Writer has the OBLIGATION to sell

PUT => selling underlying currency

Holder has a RIGHT, NOT the OBLIGATION to sell

Writer has the OBLIGATION to buy

The option HOLDER can

Use his option

Buy in case of a call option

Sell in case of a put option

Sell his option

Close long position with short one

The same exercise price, expiration day, amount.

Do not use the option right at all

Cost – option premium to the writer/grantor

The option WRITER has to

Sell underlying currency in case of a call option

If the holder of the call option exercises his right

Buy underlying currency in case of a put option

If the holder of the put option exercises his right

Option styles

AMERICAN OPTION

Holder can exercise (use) it on any day since its purchase till the expiration

(maturity) day

EUROPEAN OPTION

Buyer has the right to use the option ONLY on the expiration day, NOT

BEFORE

Options are traded on

ORGANIZED EXCHANGES

CBOE Chicago Board Options Exchange

LIFFE London International Financial Futures Exchange

On the OVER-THE-COUNTER (OTC) MARKET

Options are written by banks, are NOT standardized

Basic option positions

Long call

Right to buy underlying currency

Long put

Right to sell underlying currency

Short call

Obligation to sell underlying currency

Short put

Obligation to buy underlying currency

I. Open Position (Speculative example)

a) Buying Call Option on EUR against USD

Option premium: 3.00%

Underlying currency: 100,000 €

Strike price: EUR/USD 1.20

Spot rate: EUR/USD 1.20

Maturity: 3 months

Risk Profile: Long Call

1.10 1.20 1.30

EUR/USD

long call

Long & Short Call

1.10 1.20 1.30

EUR/USD

long call

short call

I. Open Position (Speculative example)

b) Buying Put Option on EUR against USD

Option premium: 3.00%

Underlying currency: 100,000 €

Strike price: EUR/USD 1.20

Spot rate: EUR/USD 1.20

Maturity: 3 months

Risk Profile: Long Put

1.10 1.20 1.30

EUR/USD

long put

Long & Short Put

1.10 1.20 1.30

EUR/USD

long put

short put

Pricing and evaluation of the options

Total Value (premium) of the option consists of 2 components:

Intrinsic Value – a gain if the option is traded immediately

Time Value - which takes into consideration a further possible change of

the market

Formula:

Total Value = Intrinsic value + Time Value

Components of Option Pricing

Strike price

Present spot rate

Forward rate for matching maturity

USD interest rate

EUR interest rate

Volatility

Time to maturity

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