The document discusses currency derivatives, including forward contracts, futures contracts, and options. It provides details on: - How forward contracts allow corporations to lock in future exchange rates for currency exchanges. - How futures contracts standardize currency amounts and settlement dates for exchange on an futures exchange. - The types of currency options (calls and puts) and how their values are determined by the relationship between the strike price and spot rate.

1. Chapter - 5
Currency Derivatives

2. Forward Market
• The forward market facilitates the trading of forward
contracts on currencies.
• A forward contract is an agreement between a corporation
and a commercial bank to exchange a specified amount of a
currency at a specified exchange rate (called the forward
rate) on a specified date in the future.
• When MNCs anticipate future need or future receipt of a
foreign currency, they can set up forward contracts to lock in
the exchange rate.

3. • But Forward contract can create an opportunity cost in
some cases.
Bid/Ask Spread
• As with the case of spot rates, there is a bid/ask spread on
forward rates.
• Forward rates may also contain a premium or discount.
– If the forward rate exceeds the existing spot rate, it
contains a premium.
– If the forward rate is less than the existing spot rate, it
contains a discount.
Forward Market

4. • Computation of forward rate:
F = S (1 +p)
• Computation of forward premium/discount:
=
forward rate – spot rate ×
360
spot rate n
where n is the number of days to maturity
• Example: Suppose, £ spot rate = $1.681,
90-day £ forward rate = $1.677.
$1.677 – $1.681 x
360 = –0.95%
$1.681 90
So, forward discount = - 0.95%
Forward Market

5. Limitations
• Illiquidity
• Counter-party risk
Forward Market
Long in Position Short in Position
• The party to the contract
who is agreeing to take
delivery of commodity.
• Buyer of currency.
• Speculator will benefit if the
price RISES.
• The party to the contract
who is agreeing to deliver the
commodity.
• Seller of currency.
• Speculator will benefit if the
price FALLS.

6. • Currency futures contracts specify a standard volume of a
particular currency to be exchanged on a specific settlement
date.
• They are used by MNCs to hedge their currency positions
and by speculators who hope to capitalize on their
expectations of exchange rate movements.
• The contracts can be traded by firms or individuals through
brokers on the trading floor of an exchange, on automated
trading systems, or over-the-counter.
Currency Futures Market

7. • Participants in the currency futures market need to establish and
maintain a margin when they take a position.
– Initial Margin: Deposit that a trader must make before
trading any futures.
– Maintenance Margin: When margin reaches a minimum
maintenance level, the trader is required to bring the margin
back to its initial level.
– Variation Margin: Additional margin required to bring an
account up to the required level.
• FORWARD MARKETS vs. FUTURES MARKETS
Currency Futures Market

8. Currency Options Market
• A currency option is another type of contract that
can be purchased or sold by speculators and firms.
• Currency options are classified as
– Call option
– Puts option

9. Currency Call Options
• A currency call option grants the holder the right to buy a
specific currency at a specific price (called the exercise or
strike price) within a specific period of time.
• A call option is
– in the money if spot rate > strike price,
– at the money if spot rate = strike price,
– out of the money if spot rate < strike price.

10. • Call option premiums will be higher when:
– (spot price - strike price) is larger;
– the time to expiration date is longer; and
– the variability of the currency is greater.
• Buyer Perspective: Who expect a foreign currency to appreciate.
 Profit = Selling Price – Buying (Strike) Price – Option
Premium
• Seller Perspective: Who expect a foreign currency to depreciate.
 Profit = Option Premium – Buying Price + Selling (Strike)
Price
Currency Call Options

11. Currency Put Options
• A currency put option grants the holder the right to sell a
specific currency at a specific price (the strike price) within
a specific period of time.
• A put option is,
– in the money if spot rate < strike price,
– at the money if spot rate = strike price,
– out of the money if spot rate > strike price.

12. • Put option premiums will be higher when:
– (strike price - spot rate) is larger;
– the time to expiration date is longer; and
– the variability of the currency is greater.
• Buyer Perspective: Who expect a foreign currency to
depreciate.
 Profit = Selling (Strike) Price – Buying Price – Option Premium
• Seller Perspective: Who expect a foreign currency to appreciate.
 Profit = Option Premium + Selling Price – Buying (Strike) Price
Currency Put Options

13. Contingency Graphs for Currency Options
+$.02
+$.04
-$.02
-$.04
0
$1.46 $1.50 $1.54
Net Profit
per Unit
Future
Spot Rate
For Buyer of £ Call Option
Strike price = $1.50
Premium = $ .02
+$.02
+$.04
-$.02
-$.04
0
$1.46 $1.50 $1.54
Net Profit
per Unit
For Seller of £ Call Option
Strike price = $1.50
Premium = $ .02

14. Contingency Graphs for Currency Options
+$.02
+$.04
-$.02
-$.04
0
$1.46 $1.50 $1.54
Net Profit
per Unit
For Seller of £ Put Option
Strike price = $1.50
Premium = $ .03
+$.02
+$.04
-$.02
-$.04
0
$1.46 $1.50 $1.54
Net Profit
per Unit
Future
Spot Rate
For Buyer of £ Put Option
Strike price = $1.50
Premium = $ .03