Chapter 8

Report
Chap 8
Foreign Currency Derivatives
8-1
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Financial management of the MNE in the 21st century
involves financial derivatives.

These derivatives, so named because their values are derived
from underlying assets

These instruments can be used for two very distinct
management objectives:
 Speculation – use of derivative instruments to take a position in the
expectation of a profit
 Hedging – use of derivative instruments to reduce the risks associated
with the everyday management of corporate cash flow
8-2

Derivatives are used by firms to achieve one of more
of the following individual benefits:
 Permit firms to achieve payoffs that they would not be
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able to achieve without derivatives, or could achieve only
at greater cost
Hedge risks that otherwise would not be possible to hedge
Make underlying markets more efficient
Reduce volatility of stock returns
Minimize earnings volatility
Reduce tax liabilities
Motivate management (agency theory effect)
8-3

A foreign currency futures contract is an alternative to a
forward contract that calls for future delivery of a standard
amount of foreign exchange at a fixed time, place and price.

It is similar to futures contracts that exist for commodities
such as cattle, lumber, interest-bearing deposits, gold, etc.

In the US, the most important market for foreign currency
futures is the International Monetary Market (IMM), a
division of the Chicago Mercantile Exchange.
8-4

Contract specifications are established by the exchange on which futures
are traded.

Major features that are standardized are:
 Contract size
 Method of stating exchange rates
 Maturity date
 Last trading day
 Collateral and maintenance margins
 Settlement
 Commissions
 Use of a clearinghouse as a counterparty
8-5

Foreign currency futures contracts differ from forward contracts in a
number of important ways:
 Futures are standardized in terms of size while forwards can be
customized
 Futures have fixed maturities while forwards can have any maturity
(both typically have maturities of one year or less)
 Trading on futures occurs on organized exchanges while forwards are
traded between individuals and banks
 Futures have an initial margin that is market to market on a daily basis
while only a bank relationship is needed for a forward
 Futures are rarely delivered upon (settled) while forwards are normally
delivered upon (settled)
8-6

A foreign currency option is a contract giving
the option purchaser (the buyer) the right,
but not the obligation, to buy or sell a given
amount of foreign exchange at a fixed price
per unit for a specified time period (until the
maturity date).

There are two basic types of options, puts and
calls.
 A call is an option to buy foreign currency
 A put is an option to sell foreign currency
8-7

The buyer of an option is termed the holder, while the seller
of the option is referred to as the writer or grantor.

Every option has three different price elements:
 The exercise or strike price – the exchange rate at which the foreign
currency can be purchased (call) or sold (put)
 The premium – the price, or value of the option itself
 The underlying or actual spot exchange rate in the market
8-8

An American option gives the buyer the right
to exercise the option at any time between
the date of writing and the expiration date.

A European option can be exercised only on
its expiration date, not before.

The premium, or option price, is the cost of
the option.
8-9
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An option whose exercise price is the same as the spot price
of the underlying currency is said to be at-the-money (ATM).

An option the would be profitable, excluding the cost of the
premium, if exercised immediately is said to be in-the-money
(ITM).
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An option that would not be profitable, excluding the cost of
the premium, if exercised immediately is referred to as outof-the money (OTM)
8-10
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In the past three decades, the use of foreign currency
options as a hedging tool and for speculative purposes has
blossomed into a major foreign exchange activity.

Options on the over-the-counter (OTC) market can be
tailored to the specific needs of the firm but can expose the
firm to counterparty risk.

Options on organized exchanges are standardized, the
counterparty risk is substantially reduced.
8-11

Buyer of a call:
 Assume purchase of August call option on Swiss francs
with strike price of 58½ ($0.5850/SF), and a premium of
$0.005/SF
At the expiration day,
 At all spot rates below the strike price of 58.5, the
purchase of the option would choose not to exercise
because it would be cheaper to purchase SF on the open
market
 At all spot rates above the strike price, the option
purchaser would exercise the option, purchase SF at the
strike price and sell them into the market netting a profit
(less the option premium)
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Speculation is an attempt to profit by trading on
expectations about prices in the future.
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Speculators can attempt to profit in the:
 Spot market – when the speculator believes the foreign currency will
appreciate in value
 Forward market – when the speculator believes the spot price at some
future date will differ from today’s forward price for the same date
 Options markets – extensive differences in risk pattens produced
depending on purchase or sale of put and/or call
8-15
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Writer of a call:
 The maximum profit that the writer of the call option can make is
limited to the premium
 If the writer wrote the option naked, that is without owning the
currency, the writer would have to buy the currency at the spot at the
expiration day and take the loss to deliver at the strike price
 The amount of such a loss is unlimited and increases as the underlying
currency rises
 Even if the writer already owns the currency, the writer will experience
an opportunity loss
8-16
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Buyer of a Put:
 The basic terms of this example are similar to those just illustrated with the
call
 The buyer of a put option, however, wants to be able to sell the underlying
currency at the exercise price $0.585/SF when the market price of that
currency drops
 If the spot price drops to $0.575/SF, the buyer of the put will deliver francs to
the writer and receive $0.585/SF
 At any exchange rate above the strike price of 58.5, the buyer of the put would
not exercise the option, and would lose only the $0.005/SF premium
 The buyer of a put (like the buyer of the call) can never lose more than the
premium paid up front
8-17
8-18
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Seller (writer) of a put:
 In this case, if the spot price of francs drops below
58.5 cents per franc, the option will be exercised
 Below a price of 58.0 cents per franc, the writer
will lose more than the premium received from
writing the option (falling below break-even)
 If the spot price is above $0.585/SF, the option will
not be exercised and the option writer will pocket
the entire premium
8-19
8-20
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The pricing of any currency option combines
six elements:
 Present spot rate
 Time to maturity
 Forward rate for matching maturity
 US dollar interest rate
 Foreign currency interest rate
 Volatility (standard deviation of daily spot price
movements)
8-21
The total value (premium) of an option is equal to the intrinsic value plus time
value.
 Intrinsic value is the financial gain if the option is exercised immediately.
 For a call option, intrinsic value is zero when the strike price is above the
market price
 When the spot price rises above the strike price, the intrinsic value become
positive
 Put options behave in the opposite manner
 On the date of maturity, an option will have a value equal to its intrinsic value
(zero time remaining means zero time value)
 The time value of an option exists because the price of the underlying currency,
the spot rate, can potentially move further and further into the money between
the present time and the option’s expiration date.
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8-22
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If currency options are to be used effectively,
either for the purposes of speculation or risk
management, the individual trader needs to
know how option values – premiums – react
to their various components.
8-23
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Forward rate sensitivity:
 Standard foreign currency options are priced around the forward rate
because the current spot rate and both the domestic and foreign
interest rates are included in the option premium calculation
 The option-pricing formula calculates a subjective probability
distribution centered on the forward rate
 This approach does not mean that the market expects the forward
rate to be equal to the future spot rate, it is simply a result of the
arbitrage-pricing structure of options
8-24
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Spot rate sensitivity (delta):
 The sensitivity of the option premium to a small
change in the spot exchange rate is called the
delta
delta = Δ premium
Δ spot rate
 The higher the delta, the greater the probability
of the option expiring in-the-money
8-25
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Time to maturity – value and deterioration
(theta):
 Option values increase with the length of time to
maturity
theta =
Δ premium
Δ time
 A trader will normally find longer-maturity option
better values, giving the trader the ability to alter
an option position without suffering significant
time value deterioration
8-26
8-27
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Sensitivity to volatility (lambda):
 Option volatility is defined as the standard deviation of daily
percentage changes in the underlying exchange rate
 Volatility is important to option value because of an exchange rate’s
perceived likelihood to move either into or out of the range in which
the option will be exercised
lambda = Δ premium
Δ volatility
8-28
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Volatility is viewed in three ways:
 Historic
 Forward-looking
 Implied
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Because volatilities are the only judgmental component that the option writer
contributes, they play a critical role in the pricing of options.
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All currency pairs have historical series that contribute to the formation of the
expectations of option writers.
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In the end, the truly talented option writers are those with the intuition and
insight to price the future effectively.
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Traders who believe that volatilities will fall significantly in the near-term will
sell (write) options now, hoping to buy them back for a profit immediately
volatilities fall, causing option premiums to fall.
8-29
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Sensitivity to changing interest rate differentials (rho and phi):
 Currency option prices and values are focused on the forward rate
 The forward rate is in turn based on the theory of Interest Rate Parity
 Interest rate changes in either currency will alter the forward rate, which
in turn will alter the option’s premium or value
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A trader who is purchasing a call option on foreign currency should do so
before the domestic interest rate rises. This timing will allow the trader to
purchase the option before its price increases.
8-30
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The expected change in the option premium from a small
change in the domestic interest rate (home currency) is the
term rho.
Δ premium
rho = Δ US $ interest rate
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The expected change in the option premium from a small
change in the foreign interest rate (foreign currency) is
termed phi.
phi = Δ premium
Δ foreign interest rate
8-31
8-32
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The sixth and final element that is important
to option valuation is the selection of the
actual strike price.
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A firm must make a choice as per the strike
price it wishes to use in constructing an
option (OTC market).
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Consideration must be given to the tradeoff
between strike prices and premiums. See
next slide.
8-33
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8-35
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In his 2002 letter to shareholders, what does
Warren Buffett seem to fear most about
financial derivatives?
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In his 2007 letter to shareholders, what does
Warren Buffett admit that he and Charlie had
done?
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Do you think there is an underlying
consistency in his viewpoint on the proper
use of derivatives?
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