International Banking and Trade Finance

1. International Banking and Trade Finance Chpt 5

2. Currency Futures and Options Chapter 5

3. Overview • Examine usage of currency futures and options contracts • to hedge or speculate based upon anticipated exchange rate changes

4. Currency Futures Contracts • Are contracts specifying a standard volume • of a particular currency • to be exchanged • on a particular date Page 141

5. Currency Futures Contracts • Similar to forward contracts • but • they are not negotiated like Forward Contracts • Currency Futures are traded in an Exchange Page 141

6. Currency Futures Market Futures vs Forward contracts • Futures contracts • state amount of a currency to be exchanged on a specific day • standardized contracts

7. Currency Futures Market Futures vs Forward contracts • Forward contracts • state amount of a currency to be exchanged on a specific day • individually tailored contracts

8. Currency Futures - trade through a broker Forward Contracts - you make the arrangement directly with the lender

9. Intl Business • The trading volume of currency futures has consistently increased over time as has growth of international transactions - which require buying and selling currency

10. Settlement Dates • Typical settlement dates are • third Wednesdays in • March • June • September • December

11. Currency Futures Market • Pricing currency futures • similar to forward rate • differs from spot rate • changes in spot rate affects value of futures contract • market forces eliminate arbitrage profits • which is to say buying at $1.50 and selling at $1.48 Page 142

12. Currency Futures Market Page 144 • Closing out a futures position • if you don’t want to wait until the settlement date, you can “close the position” by selling an identical futures contract

13. Currency Futures Market Page 144 • Closing out a futures position • the future price ……. Up or Down • the price changes over time in accordance with movements in the spot rate • If the spot rate becomes stronger, it makes it less attractive to hold a futures position - so you’d want to sell so you don’t end up with a premium

14. Currency Futures Market Page 144 • Closing out a futures position • in the real world,,,,,, • most currency futures contracts are closed out before settlement date

15. Credit Risk • Each futures contract represents an agreement with “The Exchange” Page 144

16. Credit Risk • Margin requirements reflect credit risk • covers fluctuations in contract value • initial margin: $1,000 - $2,000 per contract • trader must add more if contract value decreases

17. Hedging • I want to get a ride to the airport for a business trip, I’ll book an airline limo • Just in case the limo doesn’t come on time, I’ll hedge my risk by having my neighbour agree to drive me

18. Hedging • Buy a futures contract for a currency you need • Done when you need to spend money in the future, and want to lock in the price because you are concerned it might rise to your disadvantage • If you don’t need it, your broker can sell it on the exchange

19. Hedging • Sell a futures contract for a currency you DO NOT need • Done when you need to get rid of money in the future, and want to lock in the price because you are concerned it might rise to your disadvantage • Again, if you don’t need it, your broker can sell it on the exchange Page 145

20. Hedging • Hedging exchange rate exposure • hedging by buying 90 day contracts • e.g., a US firm orders Swiss products • must pay SF750,000 upon delivery in 90 days • US firm buys 90 day contract today • locks in price to be paid for francs in 90 days Page 145

21. Hedging • Hedging exchange rate exposure • hedging by selling 90 day contracts • US firm is to receive a payment of SF750,000 Page 145

22. S p e c u l a t i o n • based upon anticipated changes • buy (sell) futures contract • expect foreign currency to appreciate (depreciate) in value • coordinate transaction in spot market at settlement date Page 145

23. Transaction costs • associated with use of brokers • brokers buy (sell to client) at the “bid” price • brokers sell (buy from client) at the “ask” price • broker’s profit (trader’s transaction cost) • difference between bid and ask prices Bid-Ask spread = Ask - Bid

24. Currency Call Options • Contract grants the right to buy a specific currency • a) at a specific price • b) within a specific time period

25. Currency Call Options • Exercise (strike) price • agreed upon price if contract is implemented • “in the money”: spot rate > strike price • “out of the money”: spot rate < strike price

26. Currency Call Options • Factors affecting call option premiums • level of existing spot price (vs. strike price) • option price increases as spot price rises • improves chances of buying currency at a low price

27. Currency Call Options • Factors affecting call option premiums • length of time before expiration date • spot price has better chance to exceed strike price • volatility of currency price • improves chances that spot will exceed strike price

28. Currency Call OptionsHedging • Strike price sets maximum exchange rate • if exchange (spot) rate lower than strike price: • call option is not exercised • currency purchased on spot market

29. Currency Call OptionsHedging • Example of corporate hedging • US firm bids on Canadian project • US firm will need $CD if contract awarded • if project would require $CD5,000,000, firm may choose to get up to 100 call option contracts

30. Currency Call Options S p e c u l a t i o n • Buy call option • expect currency to appreciate • exercise option if price increases beyond strike price • buy at strike price and sell at spot rate • Sell (write) call option • expect currency to decline in value • obligated to sell a currency at a specified price • make money if option not exercised zero sum game

31. Currency Call Options S p e c u l a t i o n • Example of buying a call option • strike price set at $0.5877 when spot was $0.5727 per Deutsche mark • premium paid = $0.015 (0.5877 - 0.5727) • exercise option when spot reaches $0.6077

32. Currency Call OptionsSpeculation

33. Currency Put Options • Contract grants the right to sell a specific currency • a) at a specific price • b) within a specific time period

34. Currency Put Options • Exercise (strike) price • agreed upon price if contract is implemented • “in the money”: spot rate < strike price • “out of the money”: spot rate > strike price

35. Currency Put Options • Factors affecting put option premiums • level of existing spot price (vs. strike price) • option price increases as spot price falls • improves chances of selling currency at a high price

36. Currency Put Options • Factors affecting put option • length of time before expiration date • spot price has better chance to fall below strike price • volatility of currency price • improves chances that spot will fall below strike • Hedging reduces risk exposure in receivables

37. Currency Put OptionsSpeculation • Example of buying a put option • strike price set at $0.6217 when spot was $0.6357 per Deutsche mark • premium paid = $0.008 (0.6357 - 0.6217) • exercise option when spot reaches $0.6077 declining value

38. Currency Put OptionsSpeculation

39. Profits with Options and Futures • Efficiency of options/futures market • efficient market eliminates conditions permitting “abnormal” profits • studies suggest that prices reflect all available information

40. Summary • Futures contract • specifies a standard volume of a currency to be exchanged on a particular date • used for hedging and speculative purposes

41. Summary • Options contract • call options purchased when exchange rate is expected to increase • put options purchased when exchange rate expected to fall