international banking and trade finance

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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson

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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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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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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

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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

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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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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”

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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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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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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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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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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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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

international banking and trade finance

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