Foreign Currency Derivatives

Þ Financial derivatives are the financial instruments that their values are derived from underlying assets.

Þ These instruments can be used for two very distinct management objectives:

ü Speculation: take a position in the expectation of a profit

ü Hedging: reduce the risks associated with a corporate cash flow management

Foreign Currency Futures

Þ A foreign currency futures contract is a contract that calls for future delivery of a standard amount of foreign exchange at a fixed time, place and price.

Þ Contract specifications are established by the exchange on which futures are traded.

ü Contract size

ü Method of stating exchange rates

ü Maturity date

ü Maintenance margins

ü Settlement

ü Commissions

ü Use of a clearinghouse as a counterparty

Þ Difference between foreign currency futures and forward contracts:

ü Futures are standardized in terms of size while forwards can be customized

ü Futures have fixed maturities while forwards can have any maturity

ü Trading on futures occurs on organized exchanges while forwards are traded between individuals and banks

ü Futures have an initial margin that is market to market on a daily basis while only a bank relationship is needed for a forward

ü Futures are rarely delivered upon (settled) while forwards are normally delivered upon (settled)

Þ Using foreign currency futures and forwards for speculation

ü Speculators believe the spot price at some future date will differ from today’s forward price for the same date

è Take a short position if the vale of a foreign currency is expected to decline

è Take a long position if the vale of a foreign currency is expected to increase

è Example and Classroom problem:

Michael Palin buying & selling pound futures
a) / b) / c) / d)
Assumptions / Values / Values / Values / Values
Number of pounds per futures contract / 62,500 / 62,500 / 62,500 / 62,500
Maturity month / June / March / March / June
Number of contracts / 5 / 12 / 3 / 12
Did he buy or sell the futures? / buys / sells / buys / sells
Ending spot rate ($/pound) / $ 1.3980 / $ 1.4560 / $ 1.4560 / $ 1.3980
Pound futures contract, settle price ($/pound) / $ 1.4162 / $ 1.4228 / $ 1.4228 / $ 1.4162

Foreign Currency Options

Þ A foreign currency option is a contract giving the option purchaser (the buyer) 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 (until the maturity date).

Þ There are two basic types of options, puts and calls:

ü A call is an option to buy foreign currency

ü A put is an option to sell foreign currency

Þ The buyer of an option is termed the holder, while the seller of the option is referred to as the writer.

Þ Every option has three different price elements:

ü The exercise or strike price: the exchange rate at which the foreign currency can be purchased (call) or sold (put)

ü The premium: the cost, price, or value of the option itself

ü The underlying or actual spot exchange rate in the market

Þ An American option vs. a European option

ü An American option gives the buyer the right to exercise the option at any time between the date of writing and the expiration or maturity date.

ü A European option can be exercised only on its expiration date, not before.

Þ At-the-money (ATM), in-the-money (ITM) and out-of-the money (OTM)

ü An option whose exercise price is the same as the spot price of the underlying currency is said to be at-the-money (ATM).

ü An option that would be profitable, excluding the cost of the premium, if exercised immediately is said to be in-the-money (ITM).

ü An option that would not be profitable, again excluding the cost of the premium, if exercised immediately is referred to as out-of-the money (OTM)

Þ Using foreign currency options for speculation

ü Buyer of a call:

è Believe that the vale of foreign currency is going to increase

è (p103) Assume purchase of August call option on Swiss francs with strike price of 58½ ($0.5850/SF), and a premium of $0.005/SF

Ø At all spot rates below the strike price of 58.5, the purchase of the option would choose not to exercise because it would be cheaper to purchase SF on the open market

Ø At all spot rates above the strike price, the option purchaser would exercise the option, purchase SF at the strike price and sell them into the market netting a profit (less the option premium)

Ø Profit = spot rate – (strike price + premium) = $0.595/SF – ($0.585/SF + $0.005/SF)=$0.005/SF

ü Writer of a call:

è Believe that the value of foreign currency is going to decline

è What the holder, or buyer of an option loses, the writer gains

è The maximum profit that the writer of the call option can make is limited to the premium

è If the writer wrote the option naked, that is without owning the currency, the writer would now have to buy the currency at the spot and take the loss delivering at the strike price. The amount of such a loss is unlimited

ü Buyer of a Put:

è Believe that the value of foreign currency is going to decline

è The buyer of a put option, however, wants to be able to sell the underlying currency at the exercise price when the market price of that currency drops (not rises as in the case of the call option)

è If the spot price drops to $0.575/SF, the buyer of the put will deliver francs to the writer and receive $0.585/SF

è At any exchange rate above the strike price of 58.5, the buyer of the put would not exercise the option, and would lose only the $0.05/SF premium

è The buyer of a put (like the buyer of the call) can never lose more than the premium paid up front

ü Seller (writer) of a put:

è Believe that the vale of foreign currency is going to increase

è Below a price of 58.5 cents per franc, the writer will lose more than the premium received fro writing the option (falling below break-even)

è If the spot price is above $0.585/SF, the option will not be exercised and the option writer will pocket the entire premium

Þ Option Pricing and Valuation

ü The pricing of any currency option combines six elements:

è Present spot rate

è Time to maturity

è Forward rate for matching maturity

è US dollar interest rate

è Foreign currency interest rate

è Volatility (standard deviation of daily spot price movements)

ü Value (premium) of an option = Intrinsic Value + Time Value

è Intrinsic value is the financial gain if the option is exercised immediately

Ø For a call option, intrinsic value is zero when the strike price is above the market price

Ø When the spot price rises above the strike price, the intrinsic value become positive

Ø Put options behave in the opposite manner

Ø On the date of maturity, an option will have a value equal to its intrinsic value (zero time remaining means zero time value)

è The time value of an option exists because the price of the underlying currency, the spot rate, can potentially move further and further into the money between the present time and the option’s expiration date.

è Classroom problem:

Samuel Samosir wishes to speculate on the rise of the Singapore dollar versus the US dollar.
Assumptions / Values
Current spot rate (US$/Singapore dollar) / $ 0.6000
Days to maturity / 90
Expected spot rate in 90 days (US$/Singapore dollar) / $ 0.7000
Option choices on the Singapore dollar: / Call option / Put option
Strike price (US$/Singapore dollar) / $ 0.65000 / $ 0.65000
Premium (US$/Singapore dollar) / $ 0.00046 / $ 0.00003

a) Which option should Samuel buy?

b) What is Samuel's breakeven price on the option purchased in part a)?

c) What is Samuel's gross profit and net profit (including premium) if the ending spot rate is $0.70/S$?

d) What is Samuel's gross profit and net profit (including premium) if the ending spot rate is $0.80/S$?