Module 2

Session 2: Currency Derivatives

Session Overview
A. Forward Market
B. Currency Futures Market
C. Currency Long and Short Positions
D. Payoff Profiles
C. Currency Options Market
D. Currency Call Options
E. Currency Put Options
F. Contingency Graphs for Currency Options
Currency Forward Market
 Currency Derivatives are contracts whose price is
partially derived from the value of the underlying
currency it represents

 An MNC normally take positions in currency

derivatives to hedge their position against exchange
rate risk

 A Forward contract is an agreement between an

MNC and a Bank to exchange a specified amount of
a currency at a specified exchange rate (called the
forward rate) on a specified date in future.
Currency Forward Market
 Import = Payables = Buying of Foreign Currency

 Export = Receivables = Selling Foreign Currency

 Forward Rate Equation F = S (1+P)

 1. If F > S = Premium, 2. If F < S = Discount

 Interest Rate Parity Theorem
 Numerical Example
Currency Futures Market
 Currency Futures are exactly similar to Forward
Contracts in terms of obligation, but differ in the way
they are traded

 Contract Specifications

 Trading Futures – Stock Exchange – Initial Margin

– Future Rates

 Comparison of Currency Futures and Forward

Contracts
Forward Market Vs Future Market
1. Trading Location

2. Contractual Size

3. Security Deposit

4. Expiration/Delivery Date

5. Regulation

6. Participants
Currency Call Options
 An option gives the holder the right, but not the
obligation, to buy or sell a given quantity of an
asset in the future, at prices agreed upon today.

Calls vs. Puts

 Call options gives the holder the right, but not the
obligation, to buy a given quantity of some asset
at some time in the future at a fixed price today
 Put options gives the holder the right, but not the
obligation, to sell a given quantity of some asset
at some time in the future at a fixed price today
Currency Call Options – Basic Terms

1) In-the-money - The exercise price is less than

the spot price of the underlying asset.

2) At-the-money - The exercise price is equal to

the spot price of the underlying asset.

3) Out-of-the-money - The exercise price is

more than the spot price of the underlying
asset.
Currency Call Options – Basic Terms
European vs. American options

 European options can only be exercised on the

expiration date.

 American options can be exercised at any time up to

and including the expiration date.

 Since this option to exercise early generally has

value, American options are usually worth more than
European options, other things equal.
D. Currency Call Options
2. How Firms Use Currency Call Options
a. Using Call Options to Hedge
Payables
b. Using Call Options to Hedge Project
Bidding
c. Using Call Options to Hedge Target
Bidding
F. Contingency Graphs for Currency
Options
1. Contingency Graph for a Purchaser of a
Call Option
2. Contingency Graph for a Seller of a Call
Option
3. Contingency Graph for a Buyer of a Put
Option
4. Contingency Graph for a Seller of a Put
Option
 Contingency Graphs for Currency Options

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