1 Foreign Currency Derivatives Markets International Financial Management Dr. A. DeMaskey

2 Learning Objectives What are currency futures and options contracts? What is the difference between spot, forward, futures and option types of foreign exchange financial instruments? How can currency futures and options be used to manage currency risk and to speculate on future currency movements? How is the value of currency options determined?

3 Foreign Currency Derivatives Financial management in the 21st century needs to consider the use of financial derivatives These derivatives, so named because their values are derived from the underlying asset, are a powerful tool used for two distinct management objectives: –Speculation –Hedging

4 Foreign Currency Derivatives In the wrong hands, derivatives can cause a corporation to collapse (Barings, Allied Irish Bank), but used wisely they allow a financial manager the ability to plan cash flows The financial manager must first understand the basics of the structure and pricing of these tools. The derivatives that will be discussed are: –Foreign Currency Futures –Foreign Currency Options

5 Foreign Currency Futures A foreign currency futures contract is an alternative to a forward contract. –It calls for future delivery of a standard amount of currency at a fixed time and price. –These contracts are traded on exchanges with the largest being the International Monetary Market located in the Chicago Mercantile Exchange.

6 Contract Specifications Contract size Method of stating exchange rate Maturity dates Last trading date Collateral and maintenance margin Settlement Commission Clearing Operations

7 Using Foreign Currency Futures Hedging Speculating Forward-Futures Arbitrage

8 Profit or Loss from a Long Futures Hedge

9 Profit or Loss from a Short Futures Hedge

10 Forward Contracts versus Futures Contracts Trading Regulation Frequency of delivery Size of contract Delivery date Settlement Pricing Quotes Transaction costs Collateral Credit risk Clearing Operation Location Liquidity

11 Foreign Currency Options A foreign currency option is a contract giving the option holder 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. –Call Option vs. Put Option –Holder vs. Grantor

12 Foreign Currency Options Terminology Every option has three different price elements –Strike or exercise price –Option premium –The underlying or actual spot rate in the market There are two types of option maturities –American options –European options Options may also be classified as per their payouts –At-the-money –In-the-money (ITM) –Out-of-the-money (OTM) options

13 Market Structure Over-the-Counter (OTC) Market –Main advantage is that they are tailored to purchaser –Counterparty risk exists –Mostly used by individuals and banks Organized Exchanges –The Chicago Mercantile –Philadelphia Stock Exchange –Options Clearinghouse Corporation (OCC)

14 Using Foreign Currency Options Users – Financial Firms – Corporations Hedging Speculating

15 Protecting Against the Potential Appreciation of a Currency Using a Call Option

16 Protecting Against the Potential Depreciation of a Currency Using a Put Option

17 Option Pricing and Valuation An option’s value consists of two parts: –Intrinsic Value –Time Value Intrinsic Value is the amount by which an option is in-the-money. Time Value is the amount by which an option’s value exceeds its intrinsic value.

18 Option Pricing Model The value of a currency option depends on the following five variables: –Strike price relative to the spot exchange rate –Time to maturity –Relative interest rates between the two currencies –Volatility of underlying currency –Supply and demand for specific option