Currency Derivatives

Account receivable: dollar value can go up or down over time

1M euros → $1/euro → 1M euros

1M euros → $1.5/euro → 1.5M euros

If the expected price of the euro is more than actual price then you will gain, if it is less than the actual, you will lose money

Derivatives are contracts between two parties to exchange the underlying asset in the future

  • gold bar

  • anything valuable

  • value determined by the future price of another asset

A currency forward contract is an agreement between two parties to buy a given amount of currency at a future date at a price fixed on today (forward rate)

  • Forward price: 1,000 dollars = 1,300 euros = (1300/1000) 1.30 dollar per euro

  • flexibility to customize, only if other party agrees to the terms

Terms and conditions are standardized:

  • Underlying currency (US$, C$, ￡, ￥, €, A$)

  • Contract size (￡62,500, ￥12,500,000, €125,000)

  • Maturity (Third Wednesday of March, June, September, and December)

Mark to market: to settle gains and losses in the margin account on a daily basis

Long position: Buying a futures contract with expectation that currency will rise in value

  • betting on the increase of the underlying asset (selling)

Short position: Selling a futures contract with expectation that currency will fall in value

  • betting on the drop of the underlying asset (buying)

Break even point is the future price = no gain or loss

Market price is better than the futures price, so you become a seller

An option gives the buyer the right, but not the obligation to trade a foreign currency

  • called a strike price, at a future date

  • favorable change in the exchange rate

  • pay a certain premium

Call: an option to buy foreign currency

Put: option to sell foreign currency

X-intercept is future price

We study currency options to remove exchange rate risks

You will have the option to buy the underlying option

Long position - buyer

Short position - seller

If market price is greater than strike price you will make money as the buyer

In the money - you can make money

At the money - break even

Out of money - you will lose money if you sell your options

Market price less than strike price - exercise options

Opposite dont

and for seller position flip

European option - exercised only on its expiration date

American option - at any time between the date of writing and the expiration or maturity date

  • more flexibility to exercise options

  • premiums are higher because you get more protection

AR euros/billion

1 per euro → 1 billion

1.2 per euro → 1.2 billion