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5
Currency Derivatives
Chapter Objectives
To explain how forward contracts
are used for hedging based on anticipated
exchange rate movements; and
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Forward Market
The forward market facilitates the trading
of forward contracts on currencies.
Forward Market
When MNCs anticipate future need for or
future receipt of a foreign currency, they
can set up forward contracts to lock in the
exchange rate.
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Forward Market
As with the case of spot rates, there is a
bid/ask spread on forward rates.
Forward Market
annualized forward premium/discount
= forward rate spot rate 360
spot rate
n
where n is the number of days to maturity
Forward Market
A non-deliverable forward contract (NDF) is
a forward contract whereby there is no
actual exchange of currencies. Instead, a
net payment is made by one party to the
other based on the contracted rate and the
market rate on the day of settlement.
Forward Market
The forward premium/discount reflects the
difference between the home interest rate
and the foreign interest rate, so as to
prevent arbitrage.
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Marketplace
Forward Markets
Handled by
individual banks
& brokers.
Worldwide
telephone
network.
Futures Markets
Handled by
exchange
clearinghouse.
Daily settlements
to market prices.
Central exchange
floor with global
communications.
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Forward Markets
Self-regulating.
Liquidation
Mostly settled by
actual delivery.
offset.
Transaction
Banks bid/ask
Costs
spread.
Futures Markets
Commodity
Futures Trading
Commission,
National Futures
Association.
Mostly settled by
Negotiated
brokerage fees.
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June 17
1. Contract to sell
500,000 pesos
@ $.09/peso
($45,000) on
June 17.
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June 17
1. Expect to receive
500,000 pesos.
Contract to sell
500,000 pesos
@ $.09/peso on
June 17.
2. Receive 500,000
pesos as expected.
3. Sell the pesos at
the locked-in rate.
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February 15
2. Contract to
sell
A$100,000
@ $.50/A$
($50,000) on
March 19.
March 19
3. Incurs $3000
loss from
offsetting
positions in
futures
contracts.
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A call option is
A put option is
Bull Spread
In futures and options trading, a strategy
in which one contract is bought and a
different contract is sold in such a manner
that the person undertaking the spread
makes a profit if the price of the
underlying asset rises. Two contracts are
used in order to limit the size of the
potential loss.
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For example, with a vertical bull call spread, you buy a call
with a lower strike price and sell a call with a higher strike
price. With a vertical bull put, you buy a put at a lower price
and sell a put at a higher price.
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Net Profit
per Unit
Net Profit
per Unit
+$.04
+$.04
+$.02
+$.02
0
$1.46
- $.02
- $.04
$1.50
$1.54
Future
Spot
Rate
Future
Spot
Rate
$1.46
$1.50
$1.54
- $.02
- $.04
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Net Profit
per Unit
Net Profit
per Unit
+$.04
+$.04
Future
Spot
Rate
+$.02
0
$1.46
$1.50
+$.02
0
$1.54
$1.46
- $.02
- $.02
- $.04
- $.04
$1.50
$1.54
Future
Spot
Rate
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Trigger
$1.74
Basic
Put
$1.76
$1.74
$1.72
$1.70
Premium
$0.02
$0.04
Conditional
Put
Conditional
Put
$1.68
$1.66
$1.66
$1.70
$1.74
$1.78
Spot
$1.82 Rate
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Efficiency of
Currency Futures and Options
If foreign exchange markets are efficient,
speculation in the currency futures and
options markets should not consistently
generate abnormally large profits.
E CF E ER
Value =
t =1
j 1
j, t
1 k
j, t
E (CFj,t )
=
expected cash flows in
currency j to be received by the U.S. parent at the
end of period t
E (ERj,t )
=
expected exchange rate at
which currency j can be converted to dollars at
the end of period t
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