Multinational Financial Management Alan Shapiro 7th Edition J.Wiley & Sons Power Points by Joseph F Greco, Ph.D California State University, Fullerton CHAPTER CURRENCY FUTURES AND OPTIONS MARKETS CHAPTER OVERVIEW I II FUTURES CONTRACTS CURRENCY OPTIONS PART I FUTURES CONTRACTS I CURRENCY FUTURES A Background 1972: Chicago Mercantile Exchange opens International Monetary (IMM) Market FUTURES CONTRACTS IMM provides a an outlet for hedging currency risk with futures contracts b Definition of futures contracts: contracts written requiring • a standard quantity of an available currency • at a fixed exchange rate • at a set delivery date FUTURES CONTRACTS c Available Futures Currencies: 1.) British pound 5.) Euro 2.) Canadian dollar 3.) Deutsche mark dollar 4.) Swiss franc 6.) Japanese yen 7.) Australian FUTURES CONTRACTS d Standard Contract Sizes: contract sizes differ for each of the available currencies Examples: Euro = 125,000 British Pound = 62,500 FUTURES CONTRACTS e Transaction costs: payment of commission to a trader f Leverage is high 1.) Initial margin required is relatively low (e.g less than 02% of sterling contract value) FUTURES CONTRACTS g Maximum price movements 1.) Contracts set to a daily price limit restricting maximum daily price movements FUTURES CONTRACTS 2.) If limit is reached, a margin call may be necessary to maintain a minimum margin 10 FUTURES CONTRACTS Advantages of futures: 1.) Smaller contract size 2.) Easy liquidation 3.) Well-organized and stable market Disadvantages of futures: 1.) Limited to currencies 2.) Limited dates of delivery 3.) Rigid contract sizes 14 PART II CURRENCY OPTIONS I OPTIONS A Currency options offer another method to hedge exchange rate risk first offered on Philadelphia Exchange (PHLX) fastest growing segment of the hedge markets 15 CURRENCY OPTIONS Definition: a contract from a writer ( the seller) that gives the right not the obligation to the holder (the buyer) to buy or sell a standard amount of an available currency at a fixed exchange rate for a fixed time period 16 CURRENCY OPTIONS Types of Currency Options: a American exercise date may occur any time up to the expiration date b European exercise date occurs only at the expiration date 17 CURRENCY OPTIONS Exercise Price a Sometimes known as the strike price b the exchange rate at which the option holder can buy or sell the contracted currency 18 CURRENCY OPTIONS Status of an option a In-the-money Call: Spot > strike Put: Spot < strike b Out-of-the-money c At-the-money Call: Spot < strike Put: Spot > strike Spot = the strike 19 CURRENCY OPTIONS The premium: the price of an option that the writer charges the buyer 20 CURRENCY OPTIONS B When to Use Currency Options For the firm hedging foreign exchange risk a With sizable unrealized gains b With foreign currency flows forthcoming 21 CURRENCY OPTIONS For speculators - profit from favorable exchange rate changes 22 CURRENCY OPTIONS C Option Pricing and Valuation Value of an option equals a Intrinsic value b Time value 23 CURRENCY OPTIONS Intrinsic Value the amount in-the-money Time Value the amount the option is in excess of its intrinsic value 24 CURRENCY OPTIONS Other factors affecting the value of an option a value rises with longer time to expiration b value rises when greater volatility in the exchange rate 25 CURRENCY OPTIONS Value is complicated by both the home and foreign interest rates 26 CURRENCY OPTIONS D Using Forward or Futures Contracts: Forward and futures contracts are more suitable for hedging a known amount of foreign currency flow 27 CURRENCY OPTIONS E Market Structure Location a Organized Exchanges b Over-the-counter 1.) Two levels retail and wholesale 28 ... competitors to the IMM: 1.) Deutsche Termin Bourse 2.) L.I.F.F.E.London International Futures Exchange Financial 3.) C.B.O.T Chicago Board of Trade 11 FUTURES CONTRACTS 4.) S.I.M.E.X.Singapore International