International Corporate Finance (MGMT S-2710)

Dr. Raminder K. Luther Summer School, Harvard University June 27-August 12, 2011 (Lecture 4, July 7, 2011) Currency Derivatives

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Day 4 Plan
5 min presentations by students
Swaps and Options (FRB NY-ch 5) Exchange traded options and Futures (FRB

NY-ch6) Risks in Forex Trading (FRB NY ch 8)

Chapter 3 Content Derivatives market Forwards versus Futures Features of currency options Pricing of currency options

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Derivatives Market
Derivative = Instrument whose value is

derived from the value of another financial asset or commodity Parties to the transaction are buyer (long) and seller (short) Forwards, Futures, Options and Swaps are all derivatives More volatile than underlying assets

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Currency Forwards
An agreement between two parties to

exchange a specified amount of one currency for another at a specified rate (forward rate) at a specified time in the future. Mostly used by MNCs for future receipts or payments or speculators and hedgers Typical contracts are for multi-million dollars For most of the contracts, base currency id USD E.g. Buy 2 million CAD forward (assumed that underlying base currency is USD) RKL, International Corporate Finance RKLuther Buyer = Long, Seller = Short

Forward Premiums/Discounts
If F>S

=> Froward Premium If F<S => Forward Discount Annualized Forward Premium/Discount

= (F-S)/S x (360/N)

Forward Premium/discount is based on the

interest differential between the two currencies. If the two are not equal, interest rate arbitrage can exist. Use geometric method of interest rate differential instead of arithmetic for accuracy.

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RKL, International Corporate Finance

Non-Deliverable Forwards
In a typical forward, the two parties

exchange the currencies as negotiated In non-deliverable forwards, no actual delivery of foreign currency takes place In NDFs settlement is through net payment by the losing party to the gaining party Although NDFs do not involve actual delivery, they can be used effectively for hedging

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Currency Futures
Similar to forwards, but standardized size

and maturities - exchanged on standard (preset) dates Used by MNCs, hedgers and speculators Can be traded on an exchange (like CME) or through an automated system (GLOBEX) or OTC. Can be priced using forwards pricing formula Require the establishment of a margin account Marked to Market daily so eliminates default risk International Corporate Finance RKL, RKLuther Most positions are closed out before the

Forwards versus Futures

Markets Contract size Customized. Standardized. Delivery date Customized. Standardized. Participants Banks, brokers, brokers,

Forward Markets

Futures

Banks,
MNCs. public

Qualified

MNCs. Public speculation not encouraged.

speculation

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encouraged. RKL, International Corporate Finance

Forwards versus Futures

Forward Markets Futures Markets S e ttl m e n t e M o stl b y a ctu a l y d e l ve ry i M o stl b y o ffse t y

Tra n sa cti n o Brokerage co sts R e g u l ti n a o Fu tu re s

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B a n ks b i - a sk sp re a d d co m m i o n ssi S e l -re g u l ti g . C FTC , N a ti n a l f a n o

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A sso ci ti n . a o

Currency Options
Provides the buyer, the right but not the

obligation to buy or sell the underlying currency Seller of the option is obligated Right to buy = Call; Right to Sell = Put Buyer pays a premium, seller receives a premium, all require a margin Mostly traded on PHLX or CME, also have an OTC market which may require a collateral An option may be in-the-money , at-themoney or out-of-money.
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Currency Option Valuation

Call option and Put option premium are

related Calls and Puts are mirror images Call Option premium is higher if:

Spot Rate - Strike price is higher Time to expiration is longer Variability in Currency is larger Risk Free rate is higher

Call option buyers use them to hedge

payables, put option buyers use them to hedge receivables European Options versus American options RKL, International Corporate Finance RKLuther