CHAPTER 7: CURRENCY FUTURES AND OPTIONS MARKETS 1

CHAPTER 7

SUGGESTED ANSWERS TO CHAPTER 7 QUESTIONS

1. On April 1, the spot price of the British pound was $1.96 and the price of the June futures
contract was $1.95. During April the pound appreciated so that by May 1 it was selling for
$2.01. What do you think happened to the price of the June pound futures contract during
April? Explain.

ANSWER. The price of the June futures contract undoubtedly rose. Heres why. The June futures price is
based on the expectations of market participants as to what the spot value of the pound will be at the date
of settlement in June. Since the spot value of the pound has risen in during April, the best prediction is
that the future level of the pound will also be higher than it was on April 1. This expectation will
undoubtedly be reflected in a June pound futures price that is higher on May 1 than it was on April 1.

2. What are the basic differences between forward and futures contracts? Between futures and
options contracts?

ANSWER. The basic differences between forward and futures contracts are described in Section 3.1. The
most important difference between these two contracts and an options contract is that a buyer of a
forward or futures contract must take delivery, while the buyer of an options contract has the right but
not the obligation to complete the contract.

3. A forward market already existed, so why was it necessary to establish currency futures and
currency options contracts?

ANSWER. A currency futures market arose because private individuals were unable to avail themselves
of the forward market. Currency options are partly a response to individuals and firms who would like to
eliminate some currency risk while at the same time preserving the possibility of earning a windfall
profit from favorable movements in the exchange rate. Options also enable firms bidding on foreign
projects to lock in the home currency value of their bid without exposing themselves to currency risk if
their bid is rejected.

4. Suppose that Texas Instruments must pay a French supplier 10 million in 90 days.

4.a. Explain how TI can use currency futures to hedge its exchange risk. How many futures
contracts will TI need to fully protect itself?

ANSWER. TI can hedge its exchange risk by buying euro futures contracts whose expiration date is the
closest to the date on which it must pay its French supplier. Given a contract size of 125,000, TI must
buy 10,000,000/125,000 = 80 futures contracts to hedge its euro payable.

4.b. Explain how TI can use currency options to hedge its exchange risk. How many options
contracts will TI need to fully protect itself?

ANSWER. TI can hedge its exchange risk by buying euro call option contracts whose expiration date is
the closest to the date on which it must pay its French supplier. Given a contract size of 62,500, TI must
buy 10,000,000/62,500 = 160 options contracts to hedge its payable.
2 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

4.c. Discuss the advantages and disadvantages of using currency futures versus currency options
to hedge TIs exchange risk.

ANSWER. A futures contract is most valuable when the quantity of foreign currency being hedged is
known, as in the case here. An option contract is most valuable when the quantity of foreign currency is
unknown. Other things being equal, therefore, TI should use futures contracts to hedge its currency risk.
However, TI must honor its futures contracts even if the spot rate at settlement is less than the futures
price. In contrast, TI can choose not to exercise currency call options if the call price exceeds the spot
price. Although this feature is an advantage of currency options, it is fully priced out in the market via
the call premium. Hence, options are not unambiguously better than futures. In this case, since the
quantity of the future French franc outflow is known, TI should use currency futures to hedge its risk.

5. Suppose that Bechtel Group wants to hedge a bid on a Japanese construction project. Because
the yen exposure is contingent on acceptance of its bid, Bechtel decides to buy a put option for
the 15 billion bid amount rather than sell it forward. To reduce its hedging cost, however,
Bechtel simultaneously sells a call option for 15 billion with the same strike price. Bechtel
reasons that it wants to protect its downside risk on the contract and is willing to sacrifice the
upside potential to collect the call premium. Comment on Bechtels hedging strategy.

ANSWER. The combination of buying a put option and selling a call option at the same strike price is
equivalent to selling 15 billion forward at a forward rate equal to the strike price on the put and call
options. That is, Bechtel is no longer holding an option; it is now holding a forward contract. If the yen
appreciates and Bechtel loses its bid, it will face an exchange loss equal to 15 billion * (actual spot rate -
exercise price).
CHAPTER 7: CURRENCY FUTURES AND OPTIONS MARKETS 3

SUGGESTED SOLUTIONS TO CHAPTER 7 PROBLEMS

1. On Monday morning, an investor takes a long position in a pound futures contract that
matures on Wednesday afternoon. The agreed-on price is $1.95 for 62,500. At the close of
trading on Monday, the futures price has risen to $1.96. At Tuesday close, the price rises
further to $1.98. At Wednesday close, the price falls to $1.955, and the contract matures. The
investor takes delivery of the pounds at the prevailing price of $1.955. Detail the daily
settlement process (see Exhibit 7.3). What will be the investor's profit (loss)?

ANSWER

Time Action Cash Flow

Monday Open Investor buys a pound futures contract None.
that matures in two days Price is $1.95
Monday Close Futures price rises to $1.96. Investor receives
Contract is marked-to-market. 62,500 * (1.96 1.95) = $625
Tuesday Close Futures price rises to $1.98. Investor receives
Contract is marked-to-market. 62,500 * (1.98 1.96) = $1,250
Wednesday Close Future price falls to $1.955. 1) Investor pays
1) Contract is marked-to-market 62,500 * (1.98 1.955) = $1,562.50
2) Investor takes delivery of 62,500. 2) Investor pays
62,500 * 1.955 = $122,187.50

Net profit is $1,785 $1,562.5 = $312.50.

2. Suppose that the forward ask price for March 20 on euros is $1.3327 at the same time the price
of IMM euro futures for delivery on March 20 is $1.3345. How could an arbitrageur profit
from this situation? What will be the arbitrageurs profit per futures contract (size is
125,000)?

ANSWER. Since the futures price exceeds the forward rate, the arbitrageur should sell futures contracts at
$1.3345 and buy euro forward in the same amount at $1.3327. The arbitrageur will earn 125,000(1.3345
- 1.3327) = $225 per euro futures contract arbitraged.

3. Suppose DEC buys a Swiss franc futures contract (size is SFr 125,000) at a price of $0.83. If the
spot rate for the Swiss franc at the date of settlement is SFr 1 = $0.8250, what is DECs gain or
loss on this contract?

ANSWER. DEC has bought Swiss francs worth $0.8250 at a price of $0.83. Thus, it has lost $0.005 per
franc for a total loss of 125,000 * 0.005 = $625.
4 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

4. On January 10, Volkswagen agrees to import auto parts worth $7 million from the U.S. The
parts will be delivered on March 4 and are payable immediately in dollars. VW decides to
hedge its dollar position by entering into IMM futures contracts. The spot rate is $1.3447/ and
the March futures price is $1.3502.

4.a. Calculate the number of futures contracts that VW must buy to offset its dollar exchange
risk on the parts contract.

ANSWER. VW can lock in a euro price for its imported parts by buying dollars in the futures market at
the current March futures price of 0.7406/$1 (1/1.3502). This is equivalent to selling euro futures
contracts. At that futures price, VW will sell 5,184,200 for $7 million. At 125,000 per futures contract,
this would entail selling 42 contracts (5,184,200/125,000 = 41.47) at a total cost of 5,250,000.

4.b. On March 4, the spot rate turns out to be $1.3452/, while the March futures price is
$1.3468/. Calculate VWs net euro gain or loss on its futures position. Compare this figure
with VWs gain or loss on its unhedged position.

ANSWER. Under its futures contract, VW has agreed to sell 5,250,000 and receive $7,088,550
(5,250,000 * 1.3502). On March 4, VW can close out its futures position by buying back 42 March euro
futures contracts (worth 5,250,000). At the current futures rate of $1.3468/, VW must pay out
$7,070,700 (5,250,000 * 1.3468). Hence, VW has a net gain of $17,850 ($7,088,550 - $7,070,700) on its
futures contract. At the current spot rate of $1.3452/, this translates into a gain of 13,269.40
(17,850/1.3452). On closing out the 42 futures contracts, VW will then buy $7 million in the spot market
at a spot rate of $1.3452/. Its net cost is 5,190,417.78 (7,000,000/1.3452 - 13,269.4).

If VW had not hedged its import contract, it could have bought the $7 million on March 10 at a cost of
5,203,687.18 (7,000,000/1.3452). In contrast, the projected cost based on the spot rate on January 10 is
5,252,494.94 (7,000,000/1.3327). However, the latter cost is irrelevant since VW had no opportunity
to buy March dollars at the January 10 spot rate of $1.3327/. By not hedging, VW would have paid an
extra 13,269.4 for the $7,000,000 to satisfy its dollar liability, the difference between the cost of $7
million with hedging (5,190,471.78) and the cost without hedging (5,203,687.18).

5. Citigroup sells a call option on euros (contract size is 500,000) at a premium of $0.04 per euro.
If the exercise price is $1.34 and the spot price of the euro at expiration is $1.36, what is
Citigroups profit (loss) on the call option?

ANSWER. Since the spot price of $1.36 exceeds the exercise price of $1.34, Citigroups counterparty will
exercise its call option, causing Citigroup to lose 2 per euro. Adding in the 4 call premium it received
gives Citigroup a net profit of 2 per euro on the call option for a total gain of 0.02 * 500,000 = $10,000.

6. Suppose you buy three June PHLX call options with a 90 strike price at a price of 2.3 (/).

6.a. What would be your total dollar cost for these calls, ignoring broker fees?

ANSWER. With each call option being for 62,500, the three contracts combined are for 187,500. At a
price of 2.3/, the total cost is 187,500 * $0.023 = $4,312.50.
CHAPTER 7: CURRENCY FUTURES AND OPTIONS MARKETS 5

6.b. After holding these calls for 60 days, you sell them for 3.8 (/). What is your net profit on
the contracts assuming that brokerage fees on both entry and exit were $5 per contract and
that your opportunity cost was 8% per annum on the money tied up in the premium?

ANSWER. The net profit would be 1.5/ (3.8 - 2.3) for a total profit before expenses of $2,812.50 (0.015
* 187,500). Brokerage fees totaled $10 per contract or $30 overall. The opportunity cost would be
$4,312.50 * 0.08 * 60/365 = $56.71. After deducting these expenses (which total $86.71), the net profit
is $2,725.79.

7. A trader executes a bear spread on the Japanese yen consisting of a long PHLX 103 March
put and a short PHLX 101 March put.

7.a. If the price of the 103 put is 2.81 (100ths of /), while the price of the 101 put is 1.6 (100ths
of /), what is the net cost of the bear spread?

ANSWER. Going long on the 103 March put costs 0.0281/ while going short on the 101 March put
yields 0.016/. The net cost is therefore 0.0121/ (0.028 - 0.016). On a contract of 6,250,000, this is
equivalent to $756.25.

7.b. What is the maximum amount the trader can make on the bear spread in the event the yen
depreciates against the dollar?

ANSWER. To begin, the 103 March put gives the trader the right but not the obligation to sell yen at a
price of 1.03/. Similarly, the 101 March put gives the buyer the right but not the obligation to sell yen
at a price of 1.01/. If the yen falls to 1.01/ or below, the trader will earn the maximum spread of
0.02/. After paying the cost of the bear spread, the trader will net 0.079/ (0.02 - 0.0121), or
$493.75 on a 6,250,000 contract.

7.c. Redo your answers to parts a and b assuming the trader executes a bull spread consisting
of a long PHLX 97 March call priced at 0.0321/ and a short PHLX 103 March call priced
at 0.0196/. What is the trader's maximum profit? Maximum loss?

ANSWER. In this case, the trader will pay 0.0321/ for the long 97 March call and receive 0.0196/ for
the short 103 March call. The net cost to the trader, therefore, is 0.0125/, which is also the traders
maximum potential loss. At any price of 1.03/ or greater, the trader will earn the maximum possible
spread of 0.06/. After subtracting off the cost of the bull spread, the trader will net 0.0475/, or
$2,968.75 per 6,250,000 contract.
6 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

8. Apex Corporation must pay its Japanese supplier 125 million in three months. It is thinking
of buying 20 yen call options (contract size is 6.25 million) at a strike price of $0.00800 to
protect against the risk of a rising yen. The premium is 0.015 cents per yen. Alternatively, Apex
could buy 10 three-month yen futures contracts (contract size is 12.5 million) at a price of
$0.007940 per yen. The current spot rate is 1 = $0.007823. Suppose Apexs treasurer believes
that the most likely value for the yen in 90 days is $0.007900, but the yen could go as high as
$0.008400 or as low as $0.007500.

8.a. Diagram Apexs gains and losses on the call option position and the futures position within
its range of expected prices (see Exhibit 8.4). Ignore transaction costs and margins.

ANSWER. In the following calculations, note that the current spot rate is irrelevant. When a spot rate is
referred to, it is the spot rate in 90 days. If Apex buys the call options, it must pay a call premium of
0.00015 * 125,000,000 = $18,750. If the yen settles at its minimum value, Apex will not exercise the
option and it loses the call premium. But if the yen settles at its maximum value of $0.008400, Apex will
exercise at $0.008000 and earn $0.0004/1 for a total gain of 0.0004 * 125,000,000 = $50,000. Apexs
net gain will be $50,000 - $18,750 = $31,250.

PROFIT (LOSS) ON APEX CORPORATION'S FUTURES AND OPTIONS POSITIONS

$60,000 $57,500

$40,000
$31,25
0
$20,000

79.4
81.5
$0
t(o
l s
s)

75 76 77 78 79 80 81 82 83 84
r
Pof

Yen price ($0.0000 omitted)

($20,000) ($18,750)
Profit (loss) on call option position

($40,000)
Profit (loss) on futures
position
($60,000)
CHAPTER 7: CURRENCY FUTURES AND OPTIONS MARKETS 7

Contract Yen Price

Option 75 79.4 81.5 84
Inflow --- --- $1,018,750 $1,050,000
Outflow
Call Premium -$18,750 -$18,750 -$18,750 -$1,000,000
Exercise Cost --- --- -$1,000,000 -$18,750
Profit -$18,750 -$18,750 $0 $31,250
Futures
Inflow $937,500 $992,500 $1,000,000 $1,050,000
Outflow -$992,500 -$992,500 -$992,500 -$992,500
Profit -$55,000 $0 $7,500 $57,500

As the diagram and table show, Apex can use a futures contract to lock in a price of $0.007940/ at a
total cost of 0.007940 * 125,000,000 = $992,500. If the yen settles at its minimum value, Apex will lose
$0.007940 - $0.007500 = $0.000440/ (remember it is buying yen at 0.007940, when the spot price is
only 0.007500), for a total loss on the futures contract of 0.00044 * 125,000,000 = $55,000. On the other
hand, if the yen appreciates to $0.008400, Apex will earn $0.008400 - $0.007940 = $0.000460/ for a
total gain on the futures contracts of 0.000460 * 125,000,000 = $57,500.

8.b. Calculate what Apex would gain or lose on the option and futures positions if the yen settled
at its most likely value.

ANSWER. If the yen settles at its most likely price of $0.007900, Apex will not exercise its call option
and will lose the call premium of $18,750. If Apex hedges with futures, it will have to buy yen at a price
of $0.007940 when the spot rate is $0.0079. This will cost Apex $0.000040/, for a total futures contract
cost of 0.000040 * 125,000,000 = $5,000.

8.c. What is Apexs break-even future spot price on the option contract? On the futures contract?

ANSWER. On the option contract, the spot rate will have to rise to the exercise price plus the call
premium for Apex to break even on the contract, or $0.008000 + $0.000150 = $0.008150. In the case of
the futures contract, break-even occurs when the spot rate equals the futures rate, or $0.007940.

8.d. Calculate and diagram the corresponding profit-and-loss and break-even positions on the
futures and options contracts for the sellers of these contracts.

ANSWER. The sellers profit-and-loss and break-even positions on the futures and options contracts will
be the mirror image of Apexs position on these contracts. For example, the sellers of the futures contract
will breakeven at a future spot price of 1 = $0.007940, while the options sellers will breakeven at a
future spot rate of 1 = $0.008150. Similarly, if the yen settles at its minimum value, the options sellers
will earn the call premium of $18,750 and the futures sellers will earn $55,000. But if the yen settles at
its maximum value of $0.008400, the options sellers will lose $31,250 and the futures sellers will lose
$57,500.