33
1 Financial Management in IB Currency Derivatives
1
Financial Management in IB
Currency Derivatives
2
Currency Derivatives
FX Markets Division
FX Markets
Spot Markets Forward Markets
Currency
Futures
FX Forwards Currency-Swaps Currency
Options
Outright Transactions FX Swaps
3
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.
4
Currency Derivatives – FX Forwards
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.
5
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
rate.
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.
6
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
nt
USDt
)i1(
)i1(SFR
EUR
USD
tnt
7
Currency Derivatives – FX Forwards
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
t
)i1(
)i1(SFR
EUR
USD
tnt
8
Currency Derivatives – FX Forwards
Covered Interest Rate Parity Condition
)i1(
)i1(SFR
EUR
USD
tnt
9
Currency Derivatives – FX Forwards
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.
10
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
rate.
11
Currency Derivatives: Currency Futures
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.
12
Currency Derivatives: Currency Futures
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.
13
Currency Derivatives: Currency Futures
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.
14
Currency Derivatives: Currency Swaps
Swap
• 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.
15
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.
16
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)
17
Currency Derivatives: Currency Options
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
18
Currency Derivatives: Currency Options
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
19
Currency Derivatives: Currency Options
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
20
Currency Derivatives: Currency Options
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
21
Currency Derivatives: Currency Options
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
22
Currency Derivatives: Currency Options
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
23
Currency Derivatives: Currency Options
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
24
Currency Derivatives: Currency Options
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
25
Currency Derivatives: Currency Options
Risk Profile: Long Call
1.10 1.20 1.30
0
EUR/USD
Pro
fit
/Lo
ss
long call
26
Long & Short Call
1.10 1.20 1.30
0
EUR/USD
Pro
fit
/Lo
ss
long call
short call
Currency Derivatives: Currency Options
27
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
Currency Derivatives: Currency Options
28
Risk Profile: Long Put
1.10 1.20 1.30
0
EUR/USD
Pro
fit
/Lo
ss
long put
Currency Derivatives: Currency Options
29
Long & Short Put
1.10 1.20 1.30
0
EUR/USD
Pro
fit
/Lo
ss
long put
short put
Currency Derivatives: Currency Options
30
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
Currency Derivatives: Currency Options
31
Components of Option Pricing
Strike price
Present spot rate
Forward rate for matching maturity
USD interest rate
EUR interest rate
Volatility
Time to maturity
Currency Derivatives: Currency Options
32
Currency Derivatives: Currency Options
33
Currency Derivatives: Currency Options
