Session 3. Learning objectives After completing this you will have an understanding of 1. Financial...
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Transcript of Session 3. Learning objectives After completing this you will have an understanding of 1. Financial...
Learning objectivesAfter completing this you will have an
understanding of1. Financial derivatives2. Foreign currency futures3. Foreign currency options4. Foreign currency options pricing and
valuation
1. Foreign Currency Derivativesused for two very distinct management
objectives:Speculation – use of derivative instruments to take
a position in the expectation of a profitHedging – use of derivative instruments to reduce
the risks associated with the everyday management of corporate cash flow
Foreign Currency Derivativesindividual benefits:
Permit firms to achieve payoffsHedge risksMake underlying markets more efficientReduce volatility of stock returnsMinimise earnings volatilityReduce tax liabilitiesMotivate management (agency theory effect)
2. Foreign Currency Futuresfuture delivery of a standard amount of foreign
exchange at a fixed time, place and price.similar to futures contracts that exist for
commodities such as cattle, lumber, interest-bearing deposits, gold, etc.
the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange (CME).
Foreign Currency Futuresfeatures
Contract sizeMethod of stating exchange ratesMaturity dateLast trading dayCollateral and maintenance marginsSettlementCommissionsUse of a clearinghouse as a counterparty
Foreign Currency FuturesForeign currency futures contracts differ from forward
contractsterms of sizeMaturityPlace of trading initial margindelivery
3. Foreign Cur Optionscontract giving the option purchaser (the
buyer) the right, but not the obligationor, to buy 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 currencyA put is an option to sell foreign currency
Foreign Currency OptionsThe buyer –holderThe seller - writer or grantor.Three different price elements:
The exercise or strike priceThe premiumThe underlying or actual spot exchange rate in
the market
Foreign Currency OptionsAn American option gives the buyer the right
to exercise the option at any time between the date of writing and the expiration or maturity 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.
Foreign Currency Speculationprofit by trading on expectations about
prices in the future.
Speculators can attempt to profit in the:Spot marketForward marketOptions markets
Option Market SpeculationBuyer of a call:
Assume purchase of November call option on Australian dollar with strike price of 76 (US$0.7600/A$), and a premium of US$0.0101/A$
At all spot rates below the strike price of 0.7600, the purchaser of the option would choose not to exercise because it would be cheaper to purchase A$ on the open market
At all spot rates above the strike price, the option purchaser would exercise the option, purchase A$ at the strike price and sell them into the market netting a profit (less the option premium)
Option Market SpeculationWriter of a call:
What the holder, or buyer of an option loses, the writer gains
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 now have to buy the currency at the spot and take the loss delivering 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
Option Market SpeculationBuyer 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 when the market price of that currency drops (not rises as in the case of the call option)
If the spot price drops to US$0.7400/A$, the buyer of the put will deliver A$ to the writer and receive US$0.7600/A$
At any exchange rate above the strike price of 0.7600, the buyer of the put would not exercise the option, and would lose only the US$0.0020/A$ premium
The buyer of a put (like the buyer of the call) can never lose more than the premium paid up front
Option Market SpeculationSeller (writer) of a put:
In this case, if the spot price of A$ drops below US$0.7600 per A$, the option will be exercised
Below a price of US$0.7580 per A$, the writer will lose more than the premium received for writing the option (falling below break-even)
If the spot price is above US$0.7600/A$, the option will not be exercised and the option writer will pocket the entire premium
Option Pricing and Valuationsix elements:
Present spot rate
Time to maturity
Forward rate for matching maturity
Domestic interest rate
Foreign currency interest rate
Volatility (standard deviation of daily spot price movements)