Chapter 5

1

Chapter 5

Currency Derivatives

Source: http://www.mcdonalds.com/corp/invest/pub/2006_Annual_Report.htmlMcDonald’s Corporation 2006, Annual Report, p 46 2

Source: http://www.mcdonalds.com/corp/invest/pub/2006_Annual_Report.htmlMcDonald’s Corporation 2006, Annual Report, p 36

3

Agree today on a price to be paid in thefuture for a specified amount of foreign

currency at a specified delivery date

When you enter into a Forward Contract, four important things must be agreed upon:

• Whether you will buy or sell the foreign currency• How much of the foreign currency is involved• The exchange rate• When the exchange will take place

Forward Contracts

4

Suppose an American tourist plans togo to England six months (180 days)

from today and he plans to spend$1,000 while he is there.

1. Buy £’s today at the current spot rate of S0 = $1.48/ £

How many £’s will he get?

1000148,.

£676

What choices does he have for gettingthe £’s he will need?

5

2. Buy £’s with a Forward Contract today at the current forward rate of F180 = $1.44/£

3. Wait six months and buy £’s at the thencurrent spot rate

Which of the three is the best course of action?

He will not know until six months from todaybut he must make a decision today.

$1,$1. /

00044 £

£694

6

Today’s Spot Rate (S) and Today’s Forward Rate (F)

F = S(1 + p)p is the forward premium as a percentage

In the previous example:

%7.248.1$04.0$

48.1$48.1$44.1$

SSF

1SF

p

A negative number indicates a Forward DiscountA positive number indicates a Forward Premium

(rates are direct from American point of view)

Frequently calculated as an annual rate, but we won’t in this class

Chapter 5

7

The Forward Rate is better for buying the foreign currency than the current Spot Rate

(in direct quotations, the ForwardRate is less than the Spot Rate)

Forward Discount

Forward PremiumThe Forward Rate is worse for buying the foreign

currency than the current Spot Rate (in direct quotations, the Forward Rate is more

than the Spot Rate)

8

What influences today’s Forward Rate (F180)?

A major influence is what people today expectthe Spot Rate (S180 ) to be 180 days from now

Suppose todayF180 = $1.50/£ > $1.40/£ = E[S180]

What will happen in the market for £ Forward Contracts under these conditions?

The 180-day Forward Rate of $1.50/£ willdecrease until it is equal to E[S180 ]

Later in the semester we will investigate otherfactors which influence today’s Forward Rates

More people will want to sell £’s at $1.50/£ than will want to buy them at that price

A surplus will exist

9

Currencies Monday, July 9, 2007

U.S.- dollar foreign-exchange rates in late New York trading

US$ vs----- Mon ----- YTD chg

Country/currency In US$ per US$ (%)

Europe

UK pound 2.0150 0.4963 - 2.81-mos forward 2.0140 0.4965 - 2.83-mos forward 2.0121 0.4970 - 2.76-mos forward 2.0083 0.4979 -2.5

Tuesday, July 10, 2007

On Monday, what was the market expecting thevalue of the $ to do over the next 180 days?

The $ will appreciate against the £ over thenext 6 months (180 days)

Wall Street Journal

Spot Rate

10

On Tuesday, October 6, 1998, the spot rate for the yen was ¥130.18/$. The next day the

spot rate dropped to ¥120.55/$.

Wednesday’s Wall Street Journal reported that some analysts were predicting “the U.S. currency

could rally to ¥140/$ in six months”. Wednesday’s 6-month forward rate was

¥117.45/$. Assume you believed the analysts’ prediction and you had $500. How could you

have used a forward contract to make a profit?Should you “buy” or “sell” yen at the forward

rate of ¥117.45/$?

¥ vs $

11

To apply the rule “buy low and sell high”, think in terms of $/¥ rather than ¥/$

Spot market in 6 months: ¥140/$ = $0.007143/¥6-months forward rate: ¥117.45/$ = $0.008514/¥

Sell yen forward at $0.008514/¥ anticipating being able to buy yen in six months at $0.007143/¥

CAUTION

12

Sell ¥ forward 6 months at a rate of ¥117.45/$

How many ¥?

You anticipate buying ¥ in the spot market in 6 months at a rate of ¥140/$

$500(¥140/$) = ¥70,000

Enter into a forward contract

Wednesday Oct 7

Chapter 5

13

Use your $500 in the spot market to buy ¥70,000

Deliver the ¥70,000 on the forward contract and receive

70 000117 45

,.

$596

Dollar profit = $96

Six Months Later

14

Non-Deliverable Forward Contracts

Frequently used for currencies in emerging markets

Similar to Forward Contract: specified currency, specified amount, specified future settlement

date, specified rate (reference index)

Different from Forward Contract: no actual exchange of currencies in future, instead a $ payment is made based on reference index at

the settlement date

15Source: http://www.cme.com/files/renminbi_factcard.pdf 16

Specifies a standard amount of a currency to be delivered at a specified settlement date in the future at a specific price

Futures ContractsSource: http://www.cme.com/trading/prd/fx/

17

CURRENCY FUTURESFriday, April 11, 2008

June contracts opened at $0.009858/¥

OpenOpen High Low Settle Chg Interest

June 08 .9858 .9971 .9810 .9951 +.0102 176,133Sep 08 .9914 1.0010 .9855 .9991 +.0102 3,033

At the end of the trading day Friday, therewere 176,133 June contracts outstanding

Japan Yen (CME) 12.5 million; $ per 100¥CME = Chicago Mercantile Exchange

Wall Street Journal

18

Forward: Tailored to individual needsFutures: Standardized

Comparison of Forward and Futures Contracts

Size of contract

Forward: Tailored to individual needs (30, 60, 90 or 180 days)

Futures: Standardized (third Wednesday inMarch, June, September, December)

Delivery date

Chapter 5

19

Forward: Banks, brokers, MNC’s(public speculation not encouraged)

Futures: Banks, brokers, MNC’s(Qualified public speculation is encouraged)

Participants

Forward: Over the telephone, worldwideFutures: Central exchange floor with

worldwide communications

Marketplace

20

Forward: Usually none (relationship with bank) but compensating balance or line of credit sometimes required

Futures: Small security deposit required(buy on margin, subject to daily margin calls)

Security deposit(collateral)

21

Forward: Most settled by actual delivery(Some by offset, at a cost)

Futures: Most by offset (very few by delivery)

Liquidation

Forward: Set by “spread” between bank’s buy & sell prices

Futures: Negotiated brokerage fees

Transactions costs

22

Forward: Self-regulatingFutures: Commodity Futures Trading

Commission, National Futures Association

Regulation

Forward: you enter into a forward contract Futures: you buy or sell futures contracts

Terminology

23

Futures Contract

The buyer of this contract agrees to purchase 125,000 Swiss Francs on the third

Wednesday in March for$0.76(125,000) = $95,000

The seller of this contract agrees todeliver 125,000 Swiss Francs on the third

Wednesday in March and will receive$95,000

125,000 Swiss Francs per contract$0.76/SF on a March contract

January 5

24

On this investment you lost$95,000 - $92,500 = $2,500

or 2.63% of your investment

Suppose three weeks after purchasingthe contract you decide you do not

want Swiss Francs in March

Approximately 44% annual rate

Sell a March SF contract at the currentprice of $0.74/SF you would receive

0.74(125,000) = $92,500

Closing out your position

Chapter 5

25

To make money by “making a market”.

What concern does the buyer of a futurescontract have about the seller of the contract?

Why is the CME in business?

That the seller won’t deliver the foreign currency.

That the buyer won’t deliver the home currency.

What can the CME do to make sure bothparties honor the contract?

What concern does the seller of a futurescontract have about the buyer of the contract?

The CME guarantees delivery on contracts byrequiring a margin when the contract is sold.

26

If the buyer refuses, CME will sell an offsettingfutures contract for $94,375 and close out

buyer’s position and give buyer$1,500 - $625 = $875

Suppose the buyer and seller put up a margin of $1,500 on January 5 when they bought/sold

the $0.76/SF March futures contract

If the price of SF’s falls the next day to $0.755, the contract is worth only $94,375. Who might

not show up, the buyer or the seller?

CME may choose to increase the buyer’s margin by $95,000 - $94,375 = $625

27Source: http://www.mcdonalds.com/corp/invest/pub/2006_Annual_Report.html

McDonald’s Corporation 2006, Annual Report, p 36 28Source: http://www.mcdonalds.com/corp/invest/pub/2006_Annual_Report.html

McDonald’s Corporation 2006, Annual Report, p 36

29

Currency Options

Grants the right to buy a specificamount of a specific currency

The “premium” is what it costs to buy the Call Option

At a specific price (strike price or exercise price)Within a specific period of time (expires on Saturday

before third Wednesday of contract month)

“European style” can be exercisedonly on the expiration date

Call Option

Sold on exchanges and offered by commercial banks and brokerage firms

30

Why do people buy automobile insurance?

Chapter 5

31

So that if their car is in an accident, the insurance will pay for repairing the car.

32

Insurance provides protection for the car’s owner in the event something

“bad” happens to the car.

The cost of automobile insurance (the premium) depends on the total amount of coverage and the size of the deductible.

Currency options are similar to insurance in that they provide protection against

something “bad” happening to the value of a foreign currency.

33

Strike January 5Price Calls Puts

British Pound (£) Options£62,000 per contract

cents per pound

Jan Feb March Jan Feb March1500 6.06 6.23 6.50 ---- 0.16 0.44 1525 3.71 3.94 4.42 0.04 0.40 0.90 1550 1.26 2.12 2.80 0.20 1.06 1.74 1575 0.16 0.92 1.62 1.60 2.36 3.04 1600 0.14 0.34 0.86 4.01 4.26 4.76 1625 0.10 0.16 0.42 6.54 6.62 6.80

Current spot rate $1.56/£

Premium (price) for these options

34

How much did it cost on January 5 to buy aMarch Call with a strike price of $1.50?

6.5¢/£ 0.065(62,000) = $4,030

Suppose on January 5 the Premium on a March Call

with a strike price of $1.50 is 2¢/£ instead of 6.5¢/£. The spot rate on January 5 is $1.56/£. Any ideas about

how you could make money under these circumstances?

35

Buy a Call option for (2¢)(62,000) = $1,240

Step 1:

Step 2:Exercise it immediately, receive £’s at $1.50/£

$1.50(62,000) = $93,000 total cost of $1,240 + $93,000 = $94,240

Step 3:Sell £’s in spot market at $1.56 and collect

$1.56(62,000) = $96,720 profit of $96,720 - $94,240 = $2,480

with no risk

36

If markets are efficient thenpremium > spot - strike

The lower the strike price is relative to the spot rate higher premium

The longer until Call expires higher premium

The greater the variability in a currency higher premium

General Observations about Call premiums

Chapter 5

37

If the purchaser of the March Callexercises it, what is the cost of each £?

$1.50 + $0.065 = $1.565 per £

Strike Price Premium

38

It guarantees the MNC that it can buy the £’s it needs in March for no more

than $1.565 per £

How is buying the March Call option

like buying insurance for an MNC?

39

In deciding whether or not to exercise the March Call, should the owner of the Call

compare the current spot rate to

Strike price$1.50

Cost of £’s by exercising Call

or$1.565

40

?

SpotMarket

Exercise Call

Premium$4,030

January 5

41

Since the premium is a sunk cost, it should be ignored in this decision.

The owner of the Call wants to buy £’s where they are the cheapest.

If spot < $1.50 do not exercise March call

If spot > $1.50 exercise March call

Strike price$1.50

42

On January 5 an MNC bought a March call option because it must pay £’s in March to

one of its British suppliers. The Call’s strike price was $1.50/£. It is now the

Saturday before the third Wednesday in March and the spot rate is $1.53.

Should the Call be exercised ?

Chapter 5

43

?

SpotMarket

Exercise Call

strike price $1.50

Saturday before

third Wednesday

in March

$1.53

Premium$4,030

January 5

44

Calculate the total cost of the £’s if theMNC exercises the Call

( $1.50 + 6.5¢ )(62,000) = $93,000 + $4,030 =$97,030

Compare this to the total cost of the £’s if the MNCdoes not exercise the Call

Buying £’s in the spot market will cost($1.53)(62,000) = $94,860

Total cost of not exercising the Call is$94,860 + $4,030 = $98,890

Remember that the MNC had to pay the $4,030even if it does not exercise the option

45

?

SpotMarket $98,890

Exercise Call

$97,030

Saturday before

third Wednesday

in March

Premium$4,030

January 5

46

Exercising the Call is less expensivethan not exercising it by

$98,890 - $97,030 = $1,860

Or, ignoring the premium (sunk cost)$94,860 - $93,000 = $1,860

47

Suppose it is January 5 when the MNC is considering whether or not to purchase the March Call with a strike price of $1.50, and it

forecasts the March spot rate to be $1.53

Should the MNC purchase the March

Call or go uncovered ?

48

? Uncovered forecast spot rate

$1.53

Exercise Call

strike price $1.50

BuyCall

Premium 6.5 ¢

January 5

PayToll

Chapter 5

49

Cost of the £’s if MNC purchasesand exercises the Call

($1.50 + 6.5¢)(62,000) = $93,000 + $4,030 =$97,030

Cost of the £’s if the MNC goesuncovered and forecast is correct

($1.53)(62,000) = $94,860

50

?

Uncovered $94,860

Exercise Call

$97,030

January 5

By going uncovered, MNC anticipatesbuying £’s at a lower cost, thus saving

$97,030 - $94,860 = $2,170 RISK

PayToll

51

1. MNC must deliver the foreigncurrency in the future

2. MNC feels spot will rise abovestrike + premium

1. MNC has the foreign currency on hand andwants to make an additional return on it

2. MNC feels spot will go below the strike price(so the owner of the Call will not exercise it)

Under what circumstances would an MNC be interested in buying a Call option?

Under what circumstances would an MNC be interested in selling a Call option?

52

Sell a Call, receive $4,030 and hope Callis never exercised so he gets to keep

the entire $4,030 as profit

A speculator hopes to profit from changes inthe exchange rate. He does not currently

have the foreign currency, does not need topay foreign currency in the future and willnot receive foreign currency in the future

Speculators

Suppose a speculator thinks £’s will depreciate.

Would the speculator want to buy or sell a Call?

53

Speculator must buy £’s in spot market at $1.53 for $1.53(62,000) = $94,860

Delivers £’s and receives$1.50(62,000) = $93,000 for a profit of$93,000 + $4,030 - $94,860 = $2,170

What happens if the spot rate is $1.53 and the Call is exercised?

54

1. He feels spot will rise above strike + premium

1. He feels spot will fall below the strike price and the Call will never be

exercised so the entire premium is profit

Under what circumstances would a speculator be interested in

buying a Call option?

Under what circumstances would a speculator be interested in

selling a Call option?

Chapter 5

55

Buyer does not exercise the Call Seller: entire premium is profit

If $1.35 < spot < $1.40 the buyer recoups part of the Call’s 5¢ premium by purchasing the

foreign currency in the spot market

If spot < $1.35 the buyer recoups more than Call’s 5¢ premium by purchasing

foreign currency in spot market

Suppose the strike price of a Call Option is $1.40/£ and the premium is 5¢

General Conclusions

spot < $1.40If spot < strike

56

Buyer exercises Call and recoups some of the Call’s premium

Seller’s profit is only part of the premium

Buyer exercises Call and recoups more than the 5¢ premium

Seller loses all of the premium and more if the foreign currency must be purchased in the spot market

$1.40 < spot < $1.45

If strike < spot < strike + premium

$1.45 < spot

If strike + premium < spot

57

Contingency Graph

Consider a Call Option with a strike price of $1.40/ £ and a premium of 5¢

This is a picture of the “profit/loss” position of a speculator buying or selling a Call

Option or a Put Option. The magnitude of the profit or loss depends on what the strike

price is and can be shown “per unit” of the foreign currency or for the entire size of the

contract.

58

Net Profitper Unit

Spot Rate$1.40 $1.450¢

- 5¢

in the money spot > strike

at the money

out of the money

spot < strike

Buyer of Call

59

Net Profitper Unit

Spot Rate$1.40 $1.450¢

+ 5¢

Seller of Call

60

Grants the right to sell a specificamount of a specific currency

The “premium” is what it costs to buy a Put Option

At a specific price (strike price or exercise price)

Within a specific period of time (expires on Saturday before third Wednesday of contract month)

Put Option

Chapter 5

61

Strike January 5Price Calls Puts

British Pound (£) Options£62,000 per contract

cents per pound

Jan Feb March Jan Feb March1500 6.06 6.23 6.50 - 0.16 0.44 1525 3.71 3.94 4.42 0.04 0.40 0.90 1550 1.26 2.12 2.80 0.20 1.06 1.74 1575 0.16 0.92 1.62 1.60 2.36 3.04 1600 0.14 0.34 0.86 4.01 4.26 4.76 1625 0.10 0.16 0.42 6.54 6.62 7.00

Current spot rate $1.56/£62

How much would it cost to buy a March Put with a strike price of $1.625?

The premium is 7¢/£ $0.07(62,000) = $4,340

Suppose on January 5 thepremium on a March Put with astrike price of $1.625 was 4¢/£

instead of 7¢/£. The spot rate at that time was $1.56/£. Any ideas about how you could make money under these

circumstances?

63

Step 1:Buy Put option for (4¢)(62,000) = $2,480

Or $1.625 - ($1.56 + $0.04) = $0.025/£

With NO RISK

Step 2:Buy £’s in spot market at $1.56 for

$1.56(62,000) = $96,720 total cost is $96,720 + $2,480 = $99,200

Step 3:Exercise Put deliver £’s and receive

$1.625(62,000) = $100,750 profit = $100,750 - $99,200 = $1,550

64

If Markets are efficient thenpremium > strike - spot

The lower the spot price is relative tothe strike price higher premium

The longer until put expires higher premium

The greater the variability in a currency higher premium

General Observations about Put premiums

65

If the purchaser of the March Put witha strike price of $1.625 exercises it,

how much will he actually receive foreach £ he sells?

$1.625 - $0.07 = $1.555 per £

Strike Price Premium66

It guarantees the MNC that it can sell the £’s it receives in March for a

minimum of $1.555 per £

How is buying the March Put option like buying insurance for an MNC?

Chapter 5

67

In deciding whether or not to exercise the March Put, should the owner of the Put

compare the current spot rate to

Strike price$1.625

Received for £’s by exercising Put

or$1.555

68

?

SpotMarket

Exercise Put

Premium$4,340

January 5

69

The owner wants to sell £’s where he receivesthe most for each £. Since the premium is a

sunk cost, it should be ignored when makingthis decision.

If spot < $1.625 exercise March Put

If spot > $1.625 do not exercise March Put

Strike price$1.625

70

On January 5 an MNC bought a March Put optionbecause it will receive £’s in March from one

of its British customers. The Put’s strike priceis $1.625/£. It is the Saturday before the third

Wednesday in March and the spot rate is $1.58.

Should the Put be exercised ?

71

?Spot

Market$1.58

Exercise Put

strike price $1.625

Saturday before

third Wednesday

in March

Premium$4,340

January 5

72

Compare this to the total revenue from the sale ofthe £’s if the NMC does not exercise the Put

and sells them in the spot market

$1.58(62,000) = $97,960from selling £’s in the spot market

Total revenue if MNC sells £’s in spot marketinstead of exercising Put is$97,960 - $4,340 = $93,620

Remember that the NMC had to pay the $4,340premium even if it does not exercise the option

Calculate the total revenue the MNC receivesfrom selling £’s if it exercises the Put

( $1.625 - 7¢ )(62,000) = $100,750 - $4,340 =$96,410

Chapter 5

73

?Spot

Market$93,620

Exercise Put

$96,410

Premium$4,340

January 5Saturday

before

third Wednesday

in March

74

Exercising the Put generated more revenuethan selling the £’s in the spot market by

$96,410 - $93,620 = $2,790

Or, ignoring the premium (sunk cost)$100,750 - $97,960 = $2,790

75

Suppose it is January 5 when the MNC is considering whether or not to purchase the

March Put with a strike price of $1.625/£, and it forecasts the March spot rate to be $1.58/£

Should the MNC purchase the March Put or go uncovered ?

76

?Uncovered

forecast spot rate

$1.58

Exercise Put

strike price $1.625

BuyPut

Premium7¢

January 5

PayToll

77

Revenue from selling the £’s if MNCpurchases a Put and exercises it.

Revenue from selling the £’s if the MNC goesuncovered and its forecast is correct

($1.58)(62,000) = $97,960

($1.625 - 7¢ )(62,000) = $100,750 - $4,340 =$96,410

78

?

Uncovered $97,960

Exercise Put

$96,410

January 5

The MNC anticipates receiving more revenue by going uncoveredthan from selling £’s by exercising

the Put $97,960 - $96,410 = $1,550 RISK

PayToll

Chapter 5

79

1. It will receive foreign currency in the future2. It feels spot will fall below strike - premium

NOTE: If MNC feels spot will rise above strike,buying a Call option is a better hedge

1. It will deliver foreign currency in the future2. It feels (strike - premium) < spot < strike

Under what circumstances would an MNC be interested

in buying a Put option?

Under what circumstances would an MNC be interested

in selling a Put option?

80

RECALL: A speculator hopes to profit from changes in the exchange rate. He does not

currently have the foreign currency, does not need to pay foreign currency in the future and will not receive foreign currency in the future

1. He feels spot will fall below strike - premium

1. He feels spot will rise above strike and thePut will never be exercised so

the entire premium is profit

Under what circumstances would a speculator be interested in buying a Put option?

Under what circumstances would a speculator be interested in selling a Put option?

81

Buyer does not exercise Put Seller: entire premium is profitIf $1.60 < spot < $1.66 the buyer recoups part of the 6¢ premium by selling foreign

currency in spot market

If $1.66 < spot the buyer recoups more than the 6¢ premium by selling foreign

currency in spot market

Suppose the strike price is $1.60/£and the premium is 6¢

General Conclusions

$1.60 < spotIf strike < spot

82

Buyer exercises Put and recoups some of the 6¢ premium

Seller’s profit is only part of the 6¢ premium

Buyer exercises Put and recoups more than the 6¢ premium

Seller loses all of the 6¢ premium and more if the foreign currency must be sold in the spot market

$1.54 < spot < $1.60

If strike - premium < spot < strike

spot < $1.54

If spot < strike - premium

83

Contingency Graphfor Put Options

Net Profitper Unit

Spot Rate$1.54 $1.600¢

- 6¢

Buyer of Put

in the money spot < strike

at the money

out of the money

spot > strike

strike price is $1.60/£ and the premium is 6¢

84

Net Profitper Unit

Spot Rate$1.54 $1.600¢

+ 6¢

Seller of Put

Chapter 5

85

On Tuesday, October 6, 1998, the spot rate for the yen was ¥130.18/$ . The next day the

spot rate dropped to ¥120.55/$.On Tuesday, the yen options prices as

reported in the Wall Street Journal were as follows:

¥ vs $

86

Japanese Yen (CME) Tuesday, Oct 6, 199812,500,000 yen; cents per 100 yen

Calls - Settle Puts - SettleStrikePrice Oct Nov Dec Oct Nov Dec7600 1.49 2.39 2.87 0.28 1.19 1.677650 1.12 2.11 2.59 0.42 1.40 1.897700 0.83 1.85 2.35 0.62 1.64 2.147750 0.60 1.60 2.12 …. …. ….7800 0.42 1.40 1.91 1.21 …. 2.697850 0.28 …. 1.71 …. …. ….

What should you have done on Tuesday in order to benefit from what happened

on Wednesday?

Strike price 7600 means $0.007600/¥

87

Should you use a Call or a Put?

Should you buy a call or sell a call?

Tuesday

CALLBUY

HINT: ¥120.55/$ = $0.008295/¥ tomorrow

88

Step 1: Exercise the Oct Call Optioncost: $0.007600(12,500,000) = $95,000

Step 2: Sell ¥12,500,000 in the spot market at the current spot rate of $0.008295/¥

Receive: $0.008295(12,500,000) = $103,687.50

Profit: $103,687.50 - $95,000 - $1,862.50 = $6,825

Buy an October Call Option with a strike price of $0.0076/¥ for a premium of 1.49¢ per 100¥

cost: $0.0149(125,000) = $1,862.50

Tuesday

Wednesday

89

Conditional Currency Option

Currency Option with a conditional premium:

Payment of the premium is conditioned on the actual movement of the spot rate

EXAMPLE:

£ Put Option with a strike price of $1.60 and a conditional premium of 4¢ with a trigger of

$1.66. If the future spot rate is $1.66 or lower, the buyer does not pay the premium.

90

Spot Rate$1.60 $1.66

$99,200

$100,440

Net Amount Received

$102,920

$97,960

Normal Put Option 2¢ premium

Chapter 5

91

STRADDLE

If a currency is highly volatile, a speculator maybuy both a Call (anticipating appreciation) and a

Put (anticipating depreciation)

Spot may move strongly in onedirection and profit on that option

may exceed premium on the other option

Spot rate may fluctuate enough toexercise both and profit on both

92

Forward Contracts:Forward Premium

Futures Contractsmargin

CallOptions

PutOptions

Arbitrage ContingencyGraph

Building Blocks for FINC 445

Skills:CommunicationProblem Solving

Motives:Involved in foreign financial markets

Familiar Setting:U.S. grocery store

Buyer vs seller

Currency Conversion:The basics, value, appreciate, depreciate, purchasing power

Spot Market:Bid & ask rates, direct &

indirect, cross rates, arbitrage

Bank participation in foreign exchange

markets

Trade Agreements:U.S.-Canada, NAFTA,

Mercosur, FTAA, CAFTA, Mexico, EU, GATT, WTO

FX Systems:Euro, Dollarization, Floating Exchange

Rate System

Balance of Payments:Current AccountCapital Account

Official Reserve Acct

Trade Issues:Japan & China,

deficits, surpluses, trading partners

Economic Factors:Inflation, national income,

interest rates, trade barriers, capital controls

IntlAgencies:World Bank

IMF

Problem of Scarcity:Comparative Advantage

Interdependence

Economic Systems:Capitalism, Socialism

Communism

Goal of Corp:Max. wealth of shareholders

EthicalConsiderations

MNC vs domestic

firm

Risk of doing business

internationally

PV of MNC’s

cashflows

PerfectMarkets:

labor

interest

Exchange Rate Determination:Exports and imports

pair of currency marketssupply, demand, equilibrium

Adjustment of Market Equilibrium:Inflation, interest rates, income levels,

expectations about future exchange rates

Speculating on anticipated exchange

rate movement

MNC’s and consumersInvestors

Central BanksSpeculators