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Currency derivatives

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I have prepared this slide to use in my class for my International Finance students at Universiti Utara Malaysia.

I have prepared this slide to use in my class for my International Finance students at Universiti Utara Malaysia.

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    Currency derivatives Currency derivatives Presentation Transcript

    • Currency Derivatives
    • What are Derivatives• Derivatives are financial contracts whose cash flows andvalue derives from some underlying financial asset orcommodity or indicator. For example, stock optionsprovided to managers.• Underlying assets may be financial assets, commodities,currencies, etc.• Counterparties are typically known as buyer (long) andseller (short).• Forwards and Options are the most contract type20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr2
    • Currency Forwards• The exchange of one currency for another at a futuredate using a pre-determined exchange rate• At inception, the two parties—long and short—simply agreeon the forward price.• At maturity, the short delivers the contracted units of thebase currency and in return the long makes paymentusing the terms currency.• Certain currency forwards do not entail actual delivery ofthe foreign currency and are known as non-deliverableforwards (NDF).20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr3
    • Currency Forwards• Example 3.2… page 54 – 5520-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr4
    • Currency ForwardsTerms to remember• Underlying asset– Units of base currency• Maturity– Delivery date for the currency• Forward price– Units of the terms/payment currency per unit of base currency20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr5
    • Currency ForwardsMarket structure• Currency forwards are traded in the interbank markets• Outright forwards are different from foreign exchangeswaps (to discuss later)• Forward markets are private and normally parties oftransactions are known to each other• Banks are the key players in such market, MNCsparticipate through banks• Most transactions are large, exceeding USD 10 million.• Often, online systems are used to help speedier andsynchronized trades20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr6
    • Currency ForwardsForward price• Notations– Price of the base currency in the spot market, 𝑆– Forward price of the base currency, 𝐹– Domestic interest rate, 𝑟– Foreign interest rate, 𝑟∗– Maturity of the forward contract, 𝑡• Suppose you want to obtain one unit of base currency20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr7
    • Currency ForwardsForward price• Suppose you want to obtain one unit of base currency attime 𝑡.• You have two alternatives:• Alternative A: buy the currency using forward contract– Pay the forward price, 𝐹, at time 𝑡.• Alternative B: borrow money to buy the currency today,deposit in bank until time 𝑡.– Borrow 𝑆 at interest rate 𝑟, use it to buy the base currency– Deposit the base currency and earn at 𝑟∗ until time 𝑡.20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr8
    • Currency ForwardsForward price• In equilibrium, alternative A and B should cost the sameand following relationship must be satisfied:𝐹 = 𝑆 ×1 + 𝑟1 + 𝑟∗𝑡• Rearranging the equation:𝐹𝑆=1 + 𝑟1 + 𝑟∗𝑡• If 𝑟∗> 𝑟, then𝐹𝑆< 1, and 𝐹 < 𝑆; in this case, forwardpremium, 𝐹𝑃 =𝐹𝑆− 1 =1+𝑟1+𝑟∗𝑡− 1• Thus, if 𝑟∗> 𝑟, forward premium is negative (forwarddiscount) and if 𝑟 > 𝑟∗, forward premium is positive.20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr9
    • Currency ForwardsForward price• Example 3.3… page 56 – 57.• Problem 5… page 77.20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr10
    • Currency ForwardsCounterparty risk in forward contracts• Nonperformance by any of the two parties in the forwardcontract results in the presence of counterparty risk ordefault risk.• MNCs conduct due diligence on their counterpartiesprior to engaging in forward contracts.• Despite the presence of such risk, forward contracts areattractive because of its advantage of customization interms of currency, size, and maturity.20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr11
    • Currency ForwardsCounterparty risk in forward contracts• Example 3.4… page 57• Problem 2… page 7720-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr12
    • Currency Futures• Participants of forward market is limited to large institutionsand MNCs due to the problem of counterparty riskassociated with forward contracts.• Futures markets satisfy the demand for similar derivativecontracts of the parties left outside the forward market.• A futures contract– is an exchange traded version of the forward contract– is standardized with specific maturity and size– allows wider range of players for its relatively small size comparedto forward contracts– offers anonymity20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr13
    • Currency FuturesMarket structure• Chicago Mercantile Exchange (CME) is the marketleader in currency futures.• These exchanges provide– infrastructure– clearing functions• Trading may occur– on the trading floor of the exchange– electronically or virtually around the clock• Settlement procedure may vary– actual delivery– cash settlement20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr14
    • Currency FuturesDaily settlement• Futures are traded anonymously• Hence, some sort of collateral, or third party guarantee isnecessary for trading to take place• Consequently, both the long and the short in the futurestransaction must set up margin accounts (also calledperformance bonds) at their brokerages• Margin accounts are cash accounts to protect concernedparties against default.• These margin accounts serve as collateral20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr15
    • Currency FuturesDaily settlement• The margin account balances must be more than sufficientto cover any changes in contract value• It is difficult to cover against default arising out of alarge change in the price of underlying currency over alonger period• However, price changes in any given day would besignificantly less compared to that over the contract life• This is why futures exchanges require accounts to besettled every day.20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr16
    • Currency FuturesDaily settlement• Initial deposit in the margin account is called initial margin• At the end of each trading day, change in value of thefutures contract is calculated by(current day’s close – previous day’s close)• If the contract value increases– fund is transferred from short’s account to long’s account• If the contract value decreases– fund is transferred from long’s account to short’s account• The clearing house of the exchange facilitates these transfers• An alternative term used to denote such daily settlement– mark to market20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr17
    • Currency FuturesDaily settlement• If the margin accounts are allowed to contain too low balance,it may fail to provide protection when price declines sharply• A minimum balance of the account is required to maintain– maintenance margin• Maintenance margin is lower than the initial margin• If the balance of a margin account falls below themaintenance margin, it triggers additional funds arerequested to deposit– margin call• If the margin call is ignored, the remaining funds are usedto close out the futures position20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr18
    • Currency FuturesDaily settlement• Futures are similar to forward contracts• Cash flows in futures are also quite similar to forwardcontracts with only one difference– cash flows of futures are settled every day, whereas that offorward contract is settled only once at maturity• The sum total of daily settlements in futures should beequal to the final settlement of an equivalent forwardcontract20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr19
    • Currency FuturesDaily settlement• Example 3.5…page 60• An MNC enters into futures contract to buy CAD @USD 0.90• Initial margin is USD 0.60• Maintenance margin is USD 0.03• Days remaining before contract maturity, 4 days• Calculate cash flows per unit of foreign currency.20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr20
    • Currency FuturesDaily settlement20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr21Day PriceLong ShortRemarksChange Balance CF Change Balance CF0 0.90 0.06 -0.06 0.06 -0.06 Initial margin1 0.92 +0.02 0.08 -0.02 0.042 0.94 +0.02 0.10 -0.02 0.02 Margin call0.06 -0.04 Call met3 0.91 -0.03 0.07 +0.03 0.094 0.89 -0.02 0.05 +0.05 +0.02 0.11 +0.11 Close-0.89 +0.89 Delivery-0.90 +0.90 Total
    • Currency FuturesDaily settlement• Problem 4… page 77 (assignment)20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr22
    • Currency FuturesDaily settlement• Actual futures prices are widely disseminated• Futures contracts are essentially similar to forwardcontracts• We can use currency forward pricing formula to calculatefutures price, using annual compounding convention𝐹 = 𝑆 ×1 + 𝑟1 + 𝑟∗𝑡or using LIBOR convention𝐹 = 𝑆 ×1 + 𝑟𝑡1 + 𝑟∗ 𝑡20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr23
    • Currency FuturesDaily settlement• Example 3.6… page 61• Problem 6… page 7720-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr24
    • Futures vs. Forward Pricesin the Currency Markets• Currency markets offer simultaneous trading of forward andfutures• Forwards are traded in interbank market• Futures are traded in exchanges like CME• Difference of forward and futures price of the samecurrency often brings the opportunity to exploit such pricediscrepancy• Electronic trading systems such as BARX and Globex aswell as computerized program trading help many institutionsto make profit in this way• However, in equilibrium, futures price should be equal toforward price20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr25
    • Currency Options• An instrument that provides the long the right to purchase orsell the underlying/base currency– at a prespecified strike price denominated in the terms currency– at a future date• only at maturity (European style options)• at or prior to maturity (American style options)• Right to purchase is provided by call options• Right to sell is provided by put options• Unlike forward/futures, options are more flexible because– future purchase/sale of the underlying asset is optional20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr26
    • Currency OptionsOptions parameters and terminology• Options give the holder the flexibility of taking one of twoactions as appropriate• Financial options: the underlying asset is any financialasset like a foreign currency• Real options: business situations that provide flexibilitythat brings the ability of increasing cash flows by makingproper choice• Underlying asset: commodity, instrument, index, orcurrency that is bought or sold using the option20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr27
    • Currency OptionsOptions parameters and terminology• Strike price/exercise price: contractual price at which theunderlying asset is bought or sold using the option• Maturity is finite, majority expiring in 6 months– option’s value diminishes with each passing day– this is why options are often called ‘wasting assets’– ‘American options’ can be exercised at any point in time priorto maturity– ‘European options’ can be exercised only at maturity20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr28
    • Currency OptionsOptions parameters and terminology• Option premium: at the time of making the contract, optionholder pays a premium to the option seller.• A rational option holder will exercise the option only if itis profitable• Hence, option holder cannot lose money from the option• However, the counterparty or the option seller loses moneywhenever the option is exercised• The option premium is the compensation for such loss ofthe option seller20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr29
    • Currency OptionsMarket structure• The Philadelphia Stock Exchange (PHLX) pioneeredtrading in foreign currency options• At present, PHLX and CME are the mainexchanges• Popularity of exchange traded currency options is lessthan that of currency futures20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr30
    • Currency OptionsOption exercise and cash flows• Payoff equals cash flow at maturity, also called grossprofit, or maturity cash flow• Profit equals payoff net of premium, also called net profitor net cash flow.• Steps:– Determine the cash flow at inception, based on premium– Estimate the payoff, which is the difference between spot priceand exercise price– Calculate the profit, by deducting premium from the payoff20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr31
    • Currency OptionsOption exercise and cash flows: call option• A purchases a European style currency call option fromB by paying a premium of USD0.06. The underlyingasset is EUR 1. The option expires in 3 months, and hasa strike price of USD1.25.• Calculate the payoff and profit to the long, if the currencyvalue at maturity is USD 1.34.• Answer:– payoff is 0.09 to the long– profit is 0.03 to the long20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr32
    • Currency OptionsOption exercise and cash flows: call option• Calculate payoff and profit to the long for different values of the currency atmaturity.20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr33Call Option: Payoff & Profit to Long (Buyer)Call Parameters: C = 0.06, X =1.25All Values in USDAt ContractInception Cash Flows At MaturityOverallResultCurrencyValue atMaturity Premium Paid Exercise Price Paid Value Received Payoff Profit1.16 0.06 No Exercise No Exercise 0 -0.061.19 0.06 No Exercise No Exercise 0 -0.061.22 0.06 No Exercise No Exercise 0 -0.061.25 0.06 No Exercise No Exercise 0 -0.061.28 0.06 1.25 1.28 0.03 -0.031.31 0.06 1.25 1.31 0.06 0.001.34 0.06 1.25 1.34 0.09 0.031.37 0.06 1.25 1.37 0.12 0.06Note: Payoff & Profit to Short (Seller) is the exact opposite (that is, positive values arenegative and negative values are positive)
    • Currency OptionsOption exercise and cash flows: call option• Graphically show the payoff and profit to the long for different values of the currency at maturity.20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr34
    • Currency OptionsOption exercise and cash flows: put option• P purchases a European style currency put option fromQ by paying a premium of USD0.03. The underlyingasset is EUR 1. The option expires in 3 months, and hasa strike price of USD1.25.• Calculate the payoff and profit to the long, if the currencyvalue at maturity is USD 1.16.• Answer:– payoff is 0.09 to the long– profit is 0.06 to the long20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr35
    • Currency OptionsOption exercise and cash flows: put option• Calculate payoff and profit to the long for different values of the currency at maturity.20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr36Put Option: Payoff & Profit to Long (Buyer)Call Parameters: P = 0.03, X =1.25All Values in USDAt ContractInception Cash Flows At MaturityOverallResultCurrencyValue atMaturity Premium PaidExercise PriceReceived Value Given Up Payoff Profit1.16 0.03 1.25 1.16 0.09 0.061.19 0.03 1.25 1.19 0.06 0.031.22 0.03 1.25 1.22 0.03 0.001.25 0.03 No Exercise No Exercise 0 -0.031.28 0.03 No Exercise No Exercise 0 -0.031.31 0.03 No Exercise No Exercise 0 -0.031.34 0.03 No Exercise No Exercise 0 -0.031.37 0.03 No Exercise No Exercise 0 -0.03Note: Payoff & Profit to Short (Seller) is the exact opposite (that is, positive valuesare negative and negative values are positive)
    • Currency OptionsOption exercise and cash flows: put option• Graphically show the payoff and profit to the long for different values of the currency at maturity.20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr37
    • Currency OptionsOption exercise and cash flows: call vs. put option20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr38
    • Currency OptionsSummary of option payoffs and profits• Notations:𝑆𝑡 = price of underlying asset at maturity𝑋 = option strike or exercise price𝐶 = call premium𝑃 = put premium• Call options are exercised when𝑆𝑡 > 𝑋• Put options are exercised when𝑆𝑡 < 𝑋20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr39
    • Currency OptionsSummary of option payoffs and profits20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr40
    • Currency OptionsSummary of option payoffs and profits20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr41
    • Currency OptionsSummary of option payoffs and profits20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr42
    • Currency OptionsSummary of option payoffs and profits20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr43
    • Currency OptionsSummary of option payoffs and profits20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr44
    • Currency OptionsSummary of option payoffs and profits20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr45
    • Currency OptionsSummary of option payoffs and profits20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr46
    • Currency OptionsSummary of option payoffs and profits20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr47
    • Currency OptionsSummary of option payoffs and profits20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr48
    • Currency OptionsSummary of option payoffs and profits20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr49
    • Currency OptionsFactors affecting call option prices20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr50• Value of underlying asset, (𝑺)• Strike price (𝑿)• Maturity (𝒕)– Time value– both for call and put• Volatility (𝝈)– Both for call and put• Domestic currency interest rate (𝒓)• Foreign currency interest rate (𝒓∗)
    • Currency OptionsPricing call and put options20-Apr-13Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr51• Value of underlying asset, (𝑆)• Strike price (𝑋)• Maturity (𝑡)• Volatility (𝜎)• Domestic currency interest rate (𝑟)• Foreign currency interest rate (𝑟∗)• 𝑒 = 2.7182818283• 𝑁(. ) is the cumulative distributionfunction of the standard normaldistribution.,2*ln,),()(122121*tddandTtrrXSdwheredNXedNSeC rttr rttrSeXeCP  *