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Dr. Raminder K. Luther

Summer School, Harvard University

June 27-August 12, 2011

(Lecture 4, July 7, 2011)Currency Derivatives

International Corporate Finance(MGMT S-2710)

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Day 4 Plan5 min presentations by students

Swaps and Options (FRB NY-ch 5)

Exchange traded options and Futures (FRBNY-ch6)

Risks in Forex Trading (FRB NY ch 8)Chapter 3 Content

Derivatives market

Forwards versus Futures

Features of currency optionsPricing of currency options

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Derivatives MarketDerivative = Instrument whose value is

derived from the value of another financialasset or commodity

Parties to the transaction are buyer (long)

and seller (short)Forwards, Futures, Options and Swaps are all

derivatives

More volatile than underlying assets

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Currency ForwardsAn agreement between two parties to

exchange a specified amount of onecurrency for another at a specified rate(forward rate) at a specified time in the

future.Mostly used by MNCs for future receipts or

payments or speculators and hedgers

Typical contracts are for multi-million dollars

For most of the contracts, base currency idUSD

E.g. Buy 2 million CAD fo

rward (assumedthat underlying base currency is USD)

Buyer = Long, Seller = Short

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ForwardPremiums/DiscountsIf F>S => Froward PremiumIf F Forward Discount

Annualized Forward Premium/Discount = (F-S)/S x (360/N)

Forward Premium/discount is based on theinterest differential between the twocurrencies. If the two are not equal,interest rate arbitrage can exist.

Use geometric method of interest ratedifferential instead of a

rithmetic foraccuracy.

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Non-Deliverable ForwardsIn a typical forward, the two parties

exchange the currencies as negotiated

In non-deliverable forwards, no actualdelivery of foreign currency takes place

In NDFs settlement is through net paymentby the losing party to the gaining party

Although NDFs do not involve actualdelivery, they can be used effectively for

hedging

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Currency FuturesSimilar to forwards, but standardized size

and maturities - exchanged on standard(preset) dates

Used by MNCs, hedgers and speculators

Can be traded on an exchange (like CME) orthrough an automated system (GLOBEX) orOTC.

Can be priced using forwards pricing formula

Require the establishment of a marginaccount

Marked to Market daily so eliminatesdefault risk

Most ositions are closed out before the

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Forwards versus Futures Forward Markets FuturesMarketsContract size Customized.Standardized.

Delivery date Customized.Standardized.Participants Banks, brokers, Banks,brokers,

MNCs. Public MNCs.Qualified

speculation not publicspeculation

encouraged.

encouraged.

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Forwards versus Futures Forward Markets FuturesMarketsSettle m e n t M o stly b y a ctu a l

d e live ry M o stly b y o ffset

Tra n sa ctio n -B an ks b id a sk sp rea d Brokerage

costs co m m issio n

R e g u la tio n - .S e lf re g u la tin g ,C FTC N a tio n a lFutures

.A sso cia tio n

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Currency OptionsProvides the buyer, the right but not the

obligation to buy or sell the underlyingcurrency

Seller of the option is obligated

Right to buy = Call; Right to Sell = PutBuyer pays a premium, seller receives a

premium, all require a margin

Mostly traded on PHLX or CME, also have anOTC market which may require a collateral

An option may be in-the-money , at-the-money or out-of-money.

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Currency Option ValuationCall option and Put option premium are

related

Calls and Puts are mirror images

Call Option premium is higher if:Spot Rate - Strike price is higher

Time to expiration is longer

Variability in Currency is larger

Risk Free rate is higher

Call option buyers use them to hedgepayables, put option buyers use them tohedge receivables

European Options versus American options