BUSFIN 4250: Ch. 5 Lecture PP

PART 2

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CALL

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A currency option

• gives the buyer the right, but not the obligation, to buy or sell a currency at a specified exchange rate.

• useful when an international transaction is uncertain, delayed, or canceled.

• can expire without being exercised. UNLIKE forward and futures contracts.

The buyer pays a

• premium. (Think price or fee.)

• The seller, or writer, must honor the contract if the buyer exercises the option.

Call option:

Right, but not the obligation to buy a foreign currency at the strike (exercise) price.

•grants the right to buy a currency at strike price X.

Put option:

Right, but not the obligation to sell a foreign currency at the strike (exercise) price.

•Strike price (X):

Exchange rate specified in the option contract

•Premium (C or P):

Price paid by the buyer for the option

•Expiration date:

Date on which the option expires

•Spot rate (S):

Current exchange rate at the decision/settlement date.

•American option:

can be exercised any time up to (and including) expiration.

are more flexible and often more widely used.

•European option:

can be exercised only on the expiration date.

American vs. European

•describes exercise rules—not where the option trades.

Exchange-traded options:

• standardized contracts on organized exchanges.

  • (organized exchange is a centralized, regulated marketplace where buyers and sellers regularly gather or connect electronically to trade financial securities like stocks, bonds, and commodities under a strict set of formal rules.)

Greater liquidity generally produces narrower bid-ask spreads

• options offer greater liquidity and lower counterparty risk

  • counterparty risk is the possibility that the counterparty may not fulfill their obligations,

•OTC options:

Customized contracts negotiated directly between parties

•Greater customization generally reduces liquidity and produces wider bid-ask spreads.

•Firms use calls to

hedge foreign-currency payables against appreciation.

At expiration: If S > X →

exercise  and buy the currency at the lower strike rate.

At expiration: If S < X →

let it expire and buy the currency at spot rate.

•ITM: In The Money

S > X

 you can make the money. This is because sell the foreign currency at a higher price in the spot market. (Buy for cheap, sell for more)

Profitable

Exercise

•ATM: At The Money

S = X

 no money can be made.

No gain
May not exercise

•OTM: Out The Money

S < X

Let expire because foreign currency can be purchased at a lower exchange rate in the spot market.

Not profitable

Let it expire

•Call profit per unit (if exercised):

Profit = S − (X + C)

S = spot rate at settlement; X = strike price; C = call premium (option price).

•Factors that increase call premiums:

•Higher spot rate relative to the strike price

•Greater currency volatility

•Longer time to expiration

Time to Maturity

Longer time → Higher premium

• More time means more chance for the price to move in favor of the

option holder.

• Example: A 6-month option will generally have a higher premium than

a 1-month option.

Volatility

Higher volatility → Higher premium

• Greater price fluctuations increase the likelihood the option will become

profitable

Strike Price Relative to Spot

In-the-money (ITM) options → Higher premium

• Out-of-the-money (OTM) options → Lower premium

• Example: If the spot price is $2 and the strike price is $1.5, the option is ITM,

and the premium is higher.

•Hedging:

Firms buy calls to establish a maximum exchange rate for future currency purchases.

•On the settlement date, if the currency appreciates,

exercise the call

•On the settlement date, if it depreciates,

let the option expire.

•Speculation:

Call buyers expect the foreign currency to appreciate

If correct, they exercise the call and earn a profit

•A call buyer profits only if

the spot rate rises above the strike price by more than the premium paid.

PUT

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•A Put option

grants the right to sell a currency at strike price X.

hedge foreign-currency receivables against depreciation.

Used when expecting the currency to depreciate over time→ S < X

–If S < X →

exercise (sell the currency at the higher strike rate).

–If S > X →

let it expire and sell the currency at the better spot rate.

•ITM:

S < X

Exercise

•ATM:

S = X

•OTM:

S > X

Expire

•Put profit per unit (if exercised):

Profit = (X − S) − P

S = Spot rate at settlement; X = Strike price; P = Put premium.

•Factors that increase put premiums:

•Higher strike price relative to the spot rate

•Greater currency volatility

•Longer time to expiration

Time to Maturity

Longer time → Higher premium

• More time = more opportunity for currency to fall below strike price

Volatility

Higher volatility → Higher premium

• Greater uncertainty increases the chance the option becomes profitable.

Spot Rate

If S < X (in the money) → Higher premium

• If S > X (out of the money) → Lower premium

•Speculation:

Put buyers are bearish—expect the foreign currency to depreciate.

Speculators buy put options when they expect the spot rate (S) will fall below

the strike price (X) by the settlement date (S < X).

• If S < X, speculators buy foreign currency at the lower spot price and sell it to the

option writer at the strike price, making a profit.

PART 1

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•A currency derivative

derives value from an underlying currency.

Main instruments: Forwards, Futures, & Options.

•Firms use derivatives to

hedge (protect) exchange-rate risk.

•Speculators use derivatives to

profit from expected currency movements.

speculate on future exchange rate movements.

How?

watch the forward premium or discount to anticipate future

currency movements.

A premium may signal an expected appreciation, while a discount may

signal a depreciation, presenting a buy or sell opportunity

Forward Contract

an agreement between a company and a financial

institution, typically a bank, to exchange a fixed amount of currency at a

predetermined rate on a specified future date.

Forward Contracts Key Characteristics PT 1

•Locks in an exchange rate for a future transaction

•Private agreement between two parties, often a firm and a bank

•Traded in the over-the-counter (OTC) market

Forward Contracts Key Characteristics PT 2

•Customized by amount and settlement date

•Subject to counterparty risk (risk party will not honor agreement)

Forward Contracts Key Characteristics PT 3

• Primarily used by large corporations; typical size: $1 million+

• Banks may require a deposit from unfamiliar or high-risk clients

• Common maturities are 30, 60, 90, 180, and 360 days, but other maturity

dates can be negotiated with banks.

Spot Rate vs. Forward Rate

• Exchange rate for a transaction occurring immediately (within 2 days)

• Exchange rate agreed upon today for a future transaction

  • Supply and demand influence both

•Forward premium:

Forward rate > spot rate

may signal expected appreciation of the foreign currency

•Forward discount:

Forward rate < spot rate

may signal expected depreciation of the foreign currency

•Importer with a foreign-currency payable:

Buy the currency forward to protect against its appreciation.

•Exporter with a foreign-currency receivable:

Sell the currency forward to protect against its depreciation.

Hedging with Forwards Goal

•Goal: Eliminate uncertainty about the future exchange rate

manage currency risk from exports, imports,and foreign investments

• Protects against unfavorable exchange rate movements

Payables:

Risk if the foreign currency appreciates

Forward premium: Hedge against payables (avoid currency appreciation

risk)

Receivables:

Risk if the foreign currency depreciates

Forward discount: Hedge against receivables (avoid currency depreciation

risk).

Closing Out A Forward

•Negotiate an offsetting forward contract with the same amount and settlement date.

•Reverse the original position.

•Forward contracts are relatively illiquid because they are customized and traded in the OTC market.

Currency Futures BELOW, Forward ABOVE

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Currency Futures

•Standardized contracts in terms of the contract size & settlement dates

•Traded on organized exchange such as Chicago Mercantile Exchange (CME)

•The clearinghouse (think: middle man) guarantees contract performance and greatly reduces counterparty risk.

Currency Futures Features PT 1

• Standardized terms: contract size, delivery date, and expiration.

• Only the exchange rate is negotiated (usually quoted in USD).

Currency Futures Features PT 2

• Common settlement: 3rd Wednesday of March, June, Sept, Dec.

• Available for 20+ currencies – Exhibit 5.2 on the next slide represent selected

future contract.

Margin & Marking to Market

•Initial margin required (A deposit required to open a futures position.)

•A maintenance margin required (The minimum account balance that must be maintained.)

•A margin call occurs when

the margin balance falls below the maintenance level

All futures trades are cleared through a

clearinghouse, eliminating

counterparty risk.

Daily settlement of gains/losses through

margin accounts prevents large,

unexpected losses.

Futures markets are regulated by agencies like the

CFTC (Commodity

Futures Trading Commission) in the U.S.

• Ensures fairness, transparency, and market stability.

Why Maintain a Margin Account?

• A margin account is required to buy or sell a futures contract.

• It serves as collateral to cover potential losses.

• Ensures that traders can meet their daily obligations as prices fluctuate.

• If a trader’s deposit account balance falls bellow a certain level, he/she will

receive a margin call. Let’s see how it works

Margin Call: How it works?

• At the end of each trading day, your position is marked to market.

• If losses reduce your balance below the maintenance margin, you receive a

margin call.

• You must add funds to restore the account to the initial margin level.

Importer with a payable:

Buy currency futures.

To hedge payables, MNCs buy futures to protect against a possible

appreciation of the foreign currency

•Exporter with a receivable:

Sell currency futures.

To hedge receivables, MNCs sell futures to guard against a possible

depreciation of the foreign currency

Multinational corporations (MNCs) use futures to

hedge against foreign exchange

risk, unlike speculators who seek profit.

Speculation with Futures: •Expect the foreign currency to appreciate:

Buy futures.

Speculation with Futures:

•Expect the foreign currency to depreciate: Sell futures

Diff: Forward

•OTC

•Customized

•Counterparty risk

• Less liquid

Diff: Futures

•Exchange-traded

•Standardized

•Clearinghouse guarantee

•More liquid

Closing Out Futures

• Futures positions can be offset before the expiration date to avoid taking a

delivery.

• To offset a position, the trader must take out an opposite and equal position

to neutralize the first contract.