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Currency Futures and Options
Chapter 5
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Overview
Examine usage of currency futures and options contracts– to hedge or speculate based upon
anticipated exchange rate changes
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Currency Futures Contracts
Are contracts specifying a standard volume
of a particular currency to be exchanged on a particular date
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Currency Futures Contracts
Similar to forward contracts but they are not negotiated like Forward
Contracts Currency Futures are traded in an
Exchange
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Currency Futures Market
Futures contracts– state amount of a currency to be
exchanged on a specific day– standardized contracts
Futures vs Forward contractsFutures vs Forward contracts
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Currency Futures Market
Forward contracts– state amount of a currency to be
exchanged on a specific day– individually tailored contracts
Futures vs Forward contractsFutures vs Forward contracts
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Currency Futures
- trade through a broker
Forward Contracts
- you make the arrangement directly with the lender
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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
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Settlement Dates
Typical settlement dates are third Wednesdays in March June September December
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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
$1.48Page 142Page 142
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Currency Futures Market
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
Page 144Page 144
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Currency Futures Market
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
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Currency Futures Market
Closing out a futures position– in the real world,,,,,,– most currency futures contracts are
closed out before settlement date
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Credit Risk
Each futures contract represents an agreement with “The Exchange”
Page 144Page 144
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Credit Risk
Margin requirements reflect credit risk– covers fluctuations in contract value– initial margin: $1,000 - $2,000 per
contracttrader must add more if contract
value decreases
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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
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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
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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
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Hedging
Hedging exchange rate exposure– hedging by buying 90 day contracts
e.g., a US firm orders Swiss productsmust pay SF750,000 upon delivery in
90 daysUS firm buys 90 day contract today
– locks in price to be paid for francs in 90 days Page 145Page 145
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Hedging exchange rate exposure
– hedging by selling 90 day contractsUS firm is to receive a payment of
SF750,000
Hedging
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based upon anticipated changes– buy (sell) futures contract
expect foreign currency to appreciate (depreciate) in value
coordinate transaction in spot market at settlement date
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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 - BidBid-Ask spread = Ask - Bid
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Currency Call Options
Contract grants the right to buy a specific currency – a) at a specific price– b) within a specific time period
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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
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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
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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
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Currency Call OptionsHedging
Strike price sets maximum exchange rate– if exchange (spot) rate lower than strike
price:call option is not exercisedcurrency purchased on spot market
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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
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Currency Call Options
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 gamezero sum game
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Currency Call Options
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
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Currency Call OptionsSpeculation
Per unit Per Contract
Selling price of
Deutsche mark $0.6077
$37,961.25
($.6077 x 62,500)
less purchase price
of Deutsche mark
-0.5877 - 36,731.25
($.5877 x 62,500)
less premium paid -0.0150 - 937.50
($.015 x 62,500)
= net profit -0.0050 $312.50
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Currency Put Options
Contract grants the right to sell a specific currency – a) at a specific price– b) within a specific time period
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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
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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
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Currency Put Options Factors affecting put option
– length of time before expiration datespot 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
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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
decliningdecliningvaluevalue
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Currency Put OptionsSpeculation
Per unit Per Contract
Selling price of
Deutsche mark
$0.6217 $38,856.25
($.6217 x 62,500)
less purchase price
of Deutsche mark
-0.6077 - 37,981.25
($.6077 x 62,500)
less premium paid -0.0080 - 500.00
($.008 x 62,500)
= net profit 0.0060 $375.00
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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
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Summary
Futures contract– specifies a standard volume of a
currency to be exchanged on a particular date
– used for hedging and speculative purposes
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Summary
Options contract– call options purchased when exchange
rate is expected to increase– put options purchased when exchange
rate expected to fall