Session 3

Learning objectivesAfter completing this you will have an

understanding of1. Financial derivatives2. Foreign currency futures3. Foreign currency options4. Foreign currency options pricing and

valuation

1. Foreign Currency Derivativesused for two very distinct management

objectives:Speculation – use of derivative instruments to take

a position in the expectation of a profitHedging – use of derivative instruments to reduce

the risks associated with the everyday management of corporate cash flow

Foreign Currency Derivativesindividual benefits:

Permit firms to achieve payoffsHedge risksMake underlying markets more efficientReduce volatility of stock returnsMinimise earnings volatilityReduce tax liabilitiesMotivate management (agency theory effect)

2. Foreign Currency Futuresfuture delivery of a standard amount of foreign

exchange at a fixed time, place and price.similar to futures contracts that exist for

commodities such as cattle, lumber, interest-bearing deposits, gold, etc.

the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange (CME).

Foreign Currency Futuresfeatures

Contract sizeMethod of stating exchange ratesMaturity dateLast trading dayCollateral and maintenance marginsSettlementCommissionsUse of a clearinghouse as a counterparty

Foreign Currency FuturesForeign currency futures contracts differ from forward

contractsterms of sizeMaturityPlace of trading initial margindelivery

Table 6.2

3. Foreign Cur Optionscontract giving the option purchaser (the

buyer) the right, but not the obligationor, to buy sell a given amount of foreign exchange at a fixed price per unit for a specified time period (until the maturity date).

There are two basic types of options, puts and calls.A call is an option to buy foreign currencyA put is an option to sell foreign currency

Foreign Currency OptionsThe buyer –holderThe seller - writer or grantor.Three different price elements:

The exercise or strike priceThe premiumThe underlying or actual spot exchange rate in

the market

Foreign Currency OptionsAn 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.

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

The premium, or option price, is the cost of the option.

Foreign Currency Options – conceptsat-the-money (ATM).

in-the-money (ITM).

out-of-the money (OTM)

Foreign Currency Options

Tradedover-the-counter (OTC)

organised exchanges are standardised

Foreign Currency Speculationprofit by trading on expectations about

prices in the future.

Speculators can attempt to profit in the:Spot marketForward marketOptions markets

Option Market SpeculationBuyer of a call:

Assume purchase of November call option on Australian dollar with strike price of 76 (US$0.7600/A$), and a premium of US$0.0101/A$

At all spot rates below the strike price of 0.7600, the purchaser of the option would choose not to exercise because it would be cheaper to purchase A$ on the open market

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

Option Market SpeculationWriter of a call:

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

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

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 and increases as the underlying currency rises

Even if the writer already owns the currency, the writer will experience an opportunity loss

Figure 6.2

Option Market SpeculationBuyer of a Put:

The basic terms of this example are similar to those just illustrated with the call

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)

If the spot price drops to US$0.7400/A$, the buyer of the put will deliver A$ to the writer and receive US$0.7600/A$

At any exchange rate above the strike price of 0.7600, the buyer of the put would not exercise the option, and would lose only the US$0.0020/A$ premium

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

Figure 6.3

Option Market SpeculationSeller (writer) of a put:

In this case, if the spot price of A$ drops below US$0.7600 per A$, the option will be exercised

Below a price of US$0.7580 per A$, the writer will lose more than the premium received for writing the option (falling below break-even)

If the spot price is above US$0.7600/A$, the option will not be exercised and the option writer will pocket the entire premium

Figure 6.4

Option Pricing and Valuationsix elements:

Present spot rate

Time to maturity

Forward rate for matching maturity

Domestic interest rate

Foreign currency interest rate

Volatility (standard deviation of daily spot price movements)