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Currency Derivatives Currency Derivatives

1. The document explains how corporations use forward contracts and currency futures contracts to hedge currency risk by locking in exchange rates for future transactions. 2. Currency futures contracts are standardized and traded on exchanges, while forward contracts are customized over-the-counter agreements. 3. Speculators can also use currency futures to profit from anticipated exchange rate movements by taking long or short positions.

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Shantonu Rahman Shanto 1731521
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134 views

Currency Derivatives Currency Derivatives

1. The document explains how corporations use forward contracts and currency futures contracts to hedge currency risk by locking in exchange rates for future transactions. 2. Currency futures contracts are standardized and traded on exchanges, while forward contracts are customized over-the-counter agreements. 3. Speculators can also use currency futures to profit from anticipated exchange rate movements by taking long or short positions.

Uploaded by

Shantonu Rahman Shanto 1731521
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Currency Derivatives

Chapter Objectives
• To explain how forward contracts are used for
hedging based on anticipated exchange rate movements;
and
• To explain how currency futures contracts and currency
options contracts are used for hedging or speculation based
on anticipated exchange rate movements.
Forward Market
• The forward market facilitates the trading of forward contracts
on currencies.
• A forward contract is an agreement between a corporation and
a commercial bank to exchange a specified amount of a
currency at a specified exchange rate (called the forward rate)
on a specified date in the future.
Forward Market
 When MNCs anticipate future need or future receipt of a
foreign currency, they can set up forward contracts to lock in
the exchange rate.
 Forward contracts are often valued at $1 million or more, and
are not normally used by consumers or small firms.
 The most common forward contracts are for 30, 60, 90, 180,
and 360 days, although other periods (including longer
periods) are available.
How MNCs Use Forward
Contracts
• MNCs use forward contracts to hedge their imports. They can
lock in the rate at which
they obtain a currency needed to purchase imports.
Forward Market
• As with the case of spot rates, there is a bid/ask spread on
forward rates.
• Forward rates may also contain a premium or discount.
• F= S(1+p)
o If the forward rate exceeds the existing spot rate, it contains a premium.
o If the forward rate is less than the existing spot rate, it contains a discount.
Forward Market
• annualized forward premium/discount
= forward rate – spot rate  360
spot rate n
where n is the number of days to maturity
• Example: Suppose £ spot rate = $1.681, 90-
day £ forward rate = $1.677.
$1.677 – $1.681 x 360 = – 0.95%
$1.681 90

So, forward discount = 0.95%


Forward Market
 Arbitrage: The forward premium/discount reflects the
difference between the home interest rate and the foreign
interest rate, so as to prevent arbitrage.
 Offsetting forward contract: offset purchase with sale
 Using forward contracts for swap transaction: :A swap
transaction involves a spot transaction along with a
corresponding forward contract that will ultimately reverse the
spot transaction.
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.
• Although NDFs do not involve actual delivery, they can
effectively hedge expected foreign currency cash flows.
Currency Futures
Market
• Currency futures contracts specify a standard volume of a
particular currency to be exchanged on a specific settlement
date, typically the third Wednesdays in March, June,
September, and December.
• They are used by MNCs to hedge their currency positions,
and by speculators who hope to capitalize on their
expectations of exchange rate movements.
Currency Futures
Market
 The contracts can be traded by firms or individuals through brokers
on the trading floor of an exchange (e.g. Chicago Mercantile
Exchange), on automated trading systems (e.g. GLOBEX), or over-
the-counter.
 Available in 19 currencies
 Each contract specifies number of units
 Standardized contracts allow for more frequent trading per contract,
and therefore greater liquidity
 The typical currency future contracts as based on a currency value
in terms of US dollars.
 Cross rates contracts are also available
 Participants in the currency futures market need to establish and
maintain a margin when they take a position.
Currency Futures
Market
Forward Markets Futures Markets
Contract size Customized. Standardized.
Delivery date Customized. Standardized.
Participants Banks, brokers, Banks, brokers,
MNCs. Public MNCs. Qualified
speculation not public speculation
encouraged. encouraged.
Security Compensating Small security
deposit bank balances or deposit required.
credit lines needed.
Currency Futures
Market
Forward Markets Futures Markets
Clearing Handled by Handled by
operation individual banks exchange
& brokers. clearinghouse.
Daily settlements
to market prices.
Marketplace Worldwide Central exchange
telephone floor with global
network. communications.
Currency Futures
Market
Forward Markets Futures Markets
Regulation Self-regulating. Commodity
Futures Trading
Commission,
National Futures
Association.
Liquidation Mostly settled by Mostly settled by
actual delivery. offset.
Transaction Bank’s bid/ask Negotiated
Costs spread. brokerage fees.
Currency Futures
Market
 Normally, the price of a currency futures contract is similar to
the forward rate for a given currency and settlement date, but
differs from the spot rate when the interest rates on the two
currencies differ.
 These relationships are enforced by the potential arbitrage
activities that would occur otherwise.
 The currency futures price differs from the spot rate for the
same reasons that a forward rate differs from the spot rate.
 Strategy: follow class lecture
Currency Futures
Market
• Currency futures contracts have no credit risk since they are
guaranteed by the exchange clearing house.
• To minimize its risk in such a guarantee, the exchange
imposes margin requirements to cover fluctuations in the value
of the contracts.
Currency Futures
Market
• Speculators often sell currency futures when they expect
the underlying currency to depreciate, and vice versa.

April 4 June 17
1. Contract to sell 2. Buy 500,000 pesos
500,000 pesos @ $.08/peso
@ $.09/peso ($40,000) from the
($45,000) on spot market.
June 17. 3. Sell the pesos to
fulfill contract.
Gain $5,000.
Currency Futures
Market
• Currency futures may be purchased by MNCs to hedge foreign
currency payables, or sold to hedge receivables.

April 4 June 17
1. Expect to receive 2. Receive 500,000
500,000 pesos. pesos as expected.
Contract to sell
500,000 pesos 3. Sell the pesos at
@ $.09/peso on the locked-in rate.
June 17.
Currency Futures
Market
• Holders of futures contracts can close out their positions by
selling similar futures contracts. Sellers may also close out
their positions by purchasing similar contracts.

January 10 February 15 March 19


1. Contract to 2. Contract to 3. Incurs $3000
buy sell loss from
A$100,000 A$100,000 offsetting
@ $.53/A$ @ $.50/A$ positions in
($53,000) on ($50,000) on futures
March 19. March 19. contracts.
Currency Futures
Market
• Most currency futures contracts are closed out before their
settlement dates.
• Brokers who fulfill orders to buy or sell futures contracts earn
a transaction or brokerage fee in the form of the bid/ask
spread.
Speculation with
currency futures
Chapter Review
• Currency Futures Market
o Contract Specifications
o Comparison of Currency Futures and Forward Contracts
o Pricing Currency Futures
o Credit Risk of Currency Futures Contracts
o Speculation with Currency Futures
o How Firms Use Currency Futures
o Closing Out A Futures Position
o Transaction Costs of Currency Futures

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