International Finance FINA 5331 Lecture 12: Hedging currency risk… Covered Interest Rate Parity Read: Chapter 7 Aaron Smallwood Ph.D.

Currency options –An options contract can be bought/sold not only over the counter, but also on a centralized exchange. In the case of an options contract, there are several centralized exchanges including the Philadelphia Stock Exchange. –Options contracts bought and sold on exchanges are only available in certain currencies. In particular, an options contract is available for Australian $, British £, Canadian $, €, Japanese ¥, Mexican peso, New Zealand $, South African Rand, Swedish krona and Swiss franc (all against the $) on the Philadelphia Stock Exchange. –Options contracts bought and sold on exchanges are only sold in fixed lots. In particular, on the Philadelphia Stock Exchange, contracts are in 10,000 or 100,000 units of foreign currency, except the yen contracts, which are available in lots of ¥1,000,000.

Currency options…continued –Currency options sold on a centralized exchange have specific delivery dates. In particular, a currency option bought or sold on the Philadelphia Stock Exchange matures on the Friday before the third Wednesday of the expiration month. Contracts on the exchange have a trading cycle of March, June, September, and December with two additional near term monthly contracts. This implies that if it is November, then there will be options contracts available in the next two months (December and January).

Currency options –Unlike a forward contract, the culmination of the contract need not result in delivery of currency. For example, if an options contract is purchased in Canadian $, the trader never has to take delivery of Canadian $ as a result of the contract if they don’t wish to. In other words, the trader has the right, but not the obligation to take delivery of currency in the future. The trader will only use the option if the movements in future exchange rates make it profitable or cost-efficient to do so.

Speculating with call options Consider a trader that wishes to short the dollar against the euro. They can use a call option. Suppose they have access to a May call with a strike price of (all contracts are listed as cents per unit of foreign currency…except ¥, which is listed as cents per 100 units of foreign currency). Trader wishes to buy €1,000,000. This is a risky strategy (implies an appreciation of the euro relative to the current exchange rate). Suppose when the contract matures, S($/€)=$1.50. Trader WINS…How?

Profit With call option, we exercise when future exchange rate is MORE than strike price. –We buy €1,000,000 at $ –Problem, what to do with the euros? Sell them in the spot market at $1.50. We still have to pay the premium. The premium is $0.033 –Total profit: – ( )* € 1,000,000= $42,000.

Illustration per euro

Call options concluded With this call option, the maximum loss is limited: –We could lose 1,000,000*0.033=$33,000 at most. Our profits are, in theory, unlimited.

Futures Contracts: Preliminaries A futures contract is like a forward contract: –It specifies that a certain currency will be exchanged for another at a specified time in the future at prices specified today. A futures contract is different from a forward contract: –Futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse.

Futures Contracts: Preliminaries Standardizing Features: –Contract Size –Delivery Month –Daily resettlement Initial Margin (about 4% of contract value, cash or T-bills held in a street name at your brokers). Some contracts can be settled with cash instead of the specified commodity. This makes it more attractive for speculators.

Margin account At the close of each day, if you buy a contract: –Money is added to your account if the settlement price has increased. –Money is subtracted if the settlement price has fallen. At the close of each day, if you sell a contract: –Money is added to your account if the settlement price has fallen. –Money is subtracted if the settlement price has increased.

Review Speculation –If we short a currency: We profit if the currency depreciates We lose if the currency appreciates –If we are long in a currency: We profit if the currency appreciates We lose if the currency depreciates.