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Multinational Financial Management Alan Shapiro 7th EditionJ.Wiley & SonsPower Points byJoseph F. Greco, Ph.D.California State University, Fullerton

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CHAPTER 8

CURRENCY FUTURES AND OPTIONS MARKETS

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CHAPTER OVERVIEWI. FUTURES CONTRACTSII. CURRENCY OPTIONS

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PART I.FUTURES CONTRACTS

I.CURRENCY FUTURESA. Background1. 1972: Chicago MercantileExchange opens International Monetary Market. (IMM)

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FUTURES CONTRACTS2. IMM provides

a. an outlet for hedging currency risk with futures contracts.b. Definition of futures contracts:contracts written requiring

• a standard quantity of an available currency• at a fixed exchange rate • at a set delivery date.

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FUTURES CONTRACTS

c. Available Futures Currencies:1.) British pound 5.) Euro2.) Canadian dollar 6.) Japanese yen3.) Deutsche mark 7.) Australian dollar4.) Swiss franc

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FUTURES CONTRACTSd. Standard Contract Sizes:contract sizes differ for each of the 7 available currencies. Examples:Euro = 125,000

British Pound = 62,500

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FUTURES CONTRACTSe. Transaction costs:

payment of commission to a trader

f. Leverage is high1.) Initial margin required is

relatively low (e.g. less than .02% of sterling contract value).

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FUTURES CONTRACTSg. Maximum price movements

1.) Contracts set to a daily price limit restricting maximum daily price movements.

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FUTURES CONTRACTS

2.) If limit is reached, a margin

call may be necessary to maintain a minimum

margin.

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FUTURES CONTRACTSh. Global futures exchanges that

are competitors to the IMM:1.) Deutsche Termin Bourse2.) L.I.F.F.E.London International Financial Futures Exchange3.) C.B.O.T. Chicago Board of Trade

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FUTURES CONTRACTS

4.) S.I.M.E.X.Singapore InternationalMonetary Exchange

5.) H.K.F.E. Hong Kong Futures Exchange

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FUTURES CONTRACTSB. Forward vs. Futures Contracts

Basic differences:1. Trading Locations 6. Settlement Date2. Regulation 7. Quotes3. Frequency of 8. Transaction

delivery costs 4. Size of contract 9. Margins5. Delivery dates 10. Credit risk

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FUTURES CONTRACTSAdvantages of futures:

1.) Smaller contract size2.) Easy liquidation 3.) Well- organizedand stable market.

Disadvantages of futures:1.) Limited to 7

currencies2.) Limited dates

of delivery3.) Rigid contract

sizes.

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PART IICURRENCY OPTIONS

I. OPTIONSA. Currency options 1. offer another method to hedge exchange rate risk.2. first offered on PhiladelphiaExchange (PHLX).3. fastest growing segment ofthe hedge markets.

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CURRENCY OPTIONS4. Definition:

a contract from a writer ( the seller) that gives the right not the obligation to the holder (the buyer) to buy or sell a standard amount of an available currency at a fixed exchange rate for a fixed time period.

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CURRENCY OPTIONS5. Types of Currency Options:

a. Americanexercise date may occur anytime up to the expiration date.b. Europeanexercise date occurs only at theexpiration date.

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CURRENCY OPTIONS7. Exercise Pricea. Sometimes known as thestrike price.b. the exchange rate at which the option holder can buy or sell the contracted currency.

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CURRENCY OPTIONS8. Status of an option

a. In-the-moneyCall: Spot > strikePut: Spot < strike

b. Out-of-the-moneyCall: Spot < strikePut: Spot > strike

c. At-the-moneySpot = the strike

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CURRENCY OPTIONS

9. The premium: the price of an

option that the writer charges the buyer.

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CURRENCY OPTIONSB. When to Use Currency Options

1. For the firm hedging foreignexchange risk

a. With sizable unrealized gains.b. With foreign currency flows forthcoming.

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CURRENCY OPTIONS

2. For speculators- profit from favorable

exchange rate changes.

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CURRENCY OPTIONS

C. Option Pricing and Valuation

1. Value of an option equals

a. Intrinsic valueb. Time value

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CURRENCY OPTIONS2. Intrinsic Valuethe amount in-the-money

3. Time Valuethe amount the option is inexcess of its intrinsic value.

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CURRENCY OPTIONS

4. Other factors affecting the value of an optiona. value rises with longer

time to expiration.b. value rises when greater volatility in the exchange rate.

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CURRENCY OPTIONS

5. Value is complicated by both

the home and foreign interest

rates.

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CURRENCY OPTIONS

D. Using Forward or Futures Contracts:

Forward and futures contracts are more suitable for hedging a known amount of foreign currency flow.

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CURRENCY OPTIONS

E. Market Structure1. Locationa. Organized Exchangesb. Over-the-counter1.) Two levelsretail and wholesale