Foreign Currency Derivatives

Types of Forex Derivatives

• Forwards

• Futures

• Options

• Swaps

Currency Forwards

• Traded over-the-counter (OTC)

• No commissions or margin requirements

• Customized

• Illiquid

• Delivery of currency upon settlement

• Potential counterparty risk

Currency Futures

• Traded on commodity exchanges (e.g. CME, LIFFE)

• Standardized contracts: size, maturity, margins

• Commissions and margin (initial and maintenance) requirements

• Liquid

• Normally no delivery on settlement

• Minimal counterparty risk

Currency Options

• Traded OTC

• Customizable

• Two types: calls and puts

• Price is the premium on the option

• Right, not an obligation to exercise

• Asymmetric risk profile (i.e. gains and losses are not linear)

• American and European styles of options

• Potential counterparty risk

Profit and Loss Profile for the Buyer of a Call

Profit and Loss Profile for a Seller of a Call

Profit and Loss Profile for the Buyer of a Put

Profit and Loss Profile for the Seller of a Put

What determines the value (price) of an option?

• Six factors determine the price of an option:– Spot rate– Time to maturity– Forward rate– Domestic interest rate– Foreign interest rate– Volatility

Which of these factors do we know and which do we not know?

Intrinsic, time, and total value of a call option

When should a financial manager use options for hedging?

• When he/she expects the foreign currency to move in their favor:

– For a receivable (A/R) this is foreign currency appreciation

– For a payable (A/P) this is foreign currency depreciation

• And

• When he/she expects the foreign currency to move enough in their favor to recoup the cost (premium) of the option:

– Calculate the option breakeven exchange rate against other hedging alternatives

Should currency derivatives be used for speculation by non-financial firms?