Foreign Currency Derivatives Markets

1
Foreign Currency Derivatives Markets

• International Financial Management

Dr. A. DeMaskey
2
Learning Objectives

• What are currency futures and options contracts?
• What is the difference between spot, forward,
  futures and option types of foreign exchange
  financial instruments?
• How can currency futures and options be used to
  manage currency risk and to speculate on future
  currency movements?
• How is the value of currency options determined?

3
Foreign Currency Derivatives

• Financial management in the 21st century needs to
  consider the use of financial derivatives
• These derivatives, so named because their values
  are derived from the underlying asset, are a
  powerful tool used for two distinct management
  objectives
• Speculation
• Hedging

4
Foreign Currency Derivatives

• In the wrong hands, derivatives can cause a
  corporation to collapse (Barings, Allied Irish
  Bank), but used wisely they allow a financial
  manager the ability to plan cash flows
• The financial manager must first understand the
  basics of the structure and pricing of these
  tools.
• The derivatives that will be discussed are
• Foreign Currency Futures
• Foreign Currency Options

5
Foreign Currency Futures

• A foreign currency futures contract is an
  alternative to a forward contract.
• It calls for future delivery of a standard amount
  of currency at a fixed time and price.
• These contracts are traded on exchanges with the
  largest being the International Monetary Market
  located in the Chicago Mercantile Exchange.

6
Contract Specifications

• Contract size
• Method of stating exchange rate
• Maturity dates
• Last trading date

• Collateral and maintenance margin
• Settlement
• Commission
• Clearing Operations

7
Using Foreign Currency Futures

• Hedging
• Speculating
• Forward-Futures Arbitrage

8
Profit or Loss from a Long Futures Hedge
9
Profit or Loss from a Short Futures Hedge
10
Forward Contracts versus Futures Contracts

• Trading
• Regulation
• Frequency of delivery
• Size of contract
• Delivery date
• Settlement
• Pricing

• Quotes
• Transaction costs
• Collateral
• Credit risk
• Clearing Operation Location
• Liquidity

11
Foreign Currency Options

• A foreign currency option is a contract giving
  the option holder the right, but not the
  obligation, to buy or sell a given amount of
  foreign exchange at a fixed price per unit for a
  specified time period.
• Call Option vs. Put Option
• Holder vs. Grantor

12
Foreign Currency Options Terminology

• Every option has three different price elements
• Strike or exercise price
• Option premium
• The underlying or actual spot rate in the market
• There are two types of option maturities
• American options
• European options

• Options may also be classified as per their
  payouts
• At-the-money
• In-the-money (ITM)
• Out-of-the-money (OTM) options

13
Market Structure

• Over-the-Counter (OTC) Market
• Main advantage is that they are tailored to
  purchaser
• Counterparty risk exists
• Mostly used by individuals and banks
• Organized Exchanges
• The Chicago Mercantile
• Philadelphia Stock Exchange
• Options Clearinghouse Corporation (OCC)

14
Using Foreign Currency Options

• Users
• Financial Firms
• Corporations
• Hedging
• Speculating

15
Protecting Against the Potential Appreciation of
a Currency Using a Call Option
16
Protecting Against the Potential Depreciation of
a Currency Using a Put Option
17
Option Pricing and Valuation

• An options value consists of two parts
• Intrinsic Value
• Time Value
• Intrinsic Value is the amount by which an option
  is in-the-money.
• Time Value is the amount by which an options
  value exceeds its intrinsic value.

18
Option Pricing Model

• The value of a currency option depends on the
  following five variables
• Strike price relative to the spot exchange rate
• Time to maturity
• Relative interest rates between the two
  currencies
• Volatility of underlying currency
• Supply and demand for specific option