Chapter 8

Foreign Currency
Derivatives and
Swaps

Foreign Currency Derivatives

and Swaps
Financial management in the 21st century needs
to consider the use of financial derivatives
These derivatives, so named because their values
are derived from the underlying asset, are a
powerful tool used for two distinct management
objectives:
Speculation the financial manager takes a position in
the expectation of profit
Hedging the financial manager uses the instruments to
reduce the risks of the corporations cash flow

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Foreign Currency Derivatives

and Swaps
A word of caution financial derivatives are
powerful tools in the hands of careful and
competent financial managers. They can also be
very destructive devices when used recklessly.

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Foreign Currency Futures

Foreign currency futures contract is an
alternative to a forward contract
It calls for future delivery of a standard amount of
currency at a fixed time and price
These contracts are traded on exchanges with the largest
being the International Monetary Market located in the
Chicago Mercantile Exchange (CME)

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Foreign Currency Futures

Contract Specifications
1. Size of contract called the notional principal, trading in
each currency must be done in an even multiple. For
example, the Mexican Pesos in multiples of 500,000 Ps, and
Swiss Francs in multiples of 62,500 SF,.
2. Method of stating exchange rates direct on the US
dollar (US dollar price per unit of foreign currency).
3. Maturity date contracts mature on the 3rd Wednesday of
January, March, April, June, July, September, October or
December
4. Collateral the purchaser or trader must deposit an initial
margin or collateral; this requirement is similar to a
performance bond
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Foreign Currency Futures

Contract Specifications
5. Settlement The complete buy/sell or sell/buy is termed a
round turn

6. Commissions customers pay a commission to their

broker to execute a round turn and only a single price is
quoted
7. Use of a clearing house as a counterparty All contracts
are agreements between the client and the exchange
clearinghouse. Consequently clients need not worry about
the performance of a specific counterparty since the
clearing house is guaranteed by all members of the
exchange
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Using Foreign Currency Futures

Any investor wishing to speculate on movement of
a currency can pursue one of the following
strategies
Short position selling a futures contract based on view
that currency will fall in value (short= sell)
Long position purchase a futures contract based on
view that currency will rise in value (long= buy)

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Using Foreign Currency Futures

Example: Amber believes that Mexican peso will fall in
value against the $, so she sells a March futures
contract
By taking a short position (sell) on the Mexican peso,
Amber locks-in the right (through a contract) to sell
500,000 Mexican pesos at maturity at a set price above
their current spot price
Using the quotes from the table, Amber sells one March
contract for 500,000 pesos at the settle price:
0.10958$/Ps

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Exhibit 8.1: Mexican Peso (CME :Chicago

Mercantile Exchange)-MXN 500,000; $ per MXN

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Using Foreign Currency Futures

To calculate the value of Ambers position we use
the following formula
Value at maturity (Short position) = -Notional principal (Spot Futures)

Using the settle price from the table and assuming

a spot rate of 0.09500$/Ps at maturity, Ambers
profit is:
Value = - 500,000 Ps (0.09500 $/Ps -0.10958$/Ps)
= $7,290
Ambers speculation was correct, she will end up buying the
peso at $0.09500/Ps and sells at $0.10958/Ps
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Using Foreign Currency Futures

If Amber believed that the Mexican peso would
rise in value, she would take a long position (buy)
on the peso:
Value at maturity (Long position) = Notional principal (Spot Futures)

Using the settle price from the table and assuming

a spot rate of 0.11000$/Ps at maturity, Ambers
profit is:
Value = 500,000 Ps (0.11000 $/Ps - 0.10958 $/Ps) = $210

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Using Foreign Currency Futures

What if Ambers speculation was wrong with her
long position, for example, the Peso falls to
$0.0800/Ps, then:
Value = 500,000 Ps (0.08000 $/Ps - 0.10958 $/Ps) = -$14,790

She would suffer a speculative loss

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Currency Futures and Forwards

Compared

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Currency Options
A foreign currency option is a contract giving the
purchaser of the option the right but not the
obligation to buy or sell a given amount of
currency for a specified time period
The most important part of clause is the right, but not the
obligation to take an action
Two basic types of options, calls and puts
Call buyer has right to purchase currency (call: buy)
Put buyer has right to sell currency (put: sell)

The buyer of the option is the holder and the seller of the
option is termed the writer
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Foreign Currency Options

Every option has three different price elements
The strike or exercise price is the exchange rate at which
the foreign currency can be purchased or sold
The premium, the cost, price or value of the option itself
paid at time option is purchased, paid in advance. Can be
quoted as a percentage or amount
The underlying or actual spot rate in the market

There are two types of option maturities

American options may be exercised at any time during the
life of the option
European options may not be exercised until the specified
maturity date
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Foreign Currency Options

Options may also be classified as per their payouts
At-the-money (ATM) options have an exercise price
equal to the spot rate of the underlying currency
In-the-money (ITM) options may be profitable,
excluding premium costs, if exercised immediately
Out-of-the-money (OTM) options would not be
profitable, excluding the premium costs, if exercised

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Foreign Currency Options

Markets
Several markets where financial managers can access
these derivative instruments
Over-the-Counter (OTC)options are written by
banks for US $ against British, Swiss, yen,
Canadian, and the euro currencies.
Organized Exchanges similar to the futures
market, currency options are traded on an organized
exchange floors such as:
The Chicago Mercantile and the Philadelphia Stock
Exchange
Clearinghouse services are provided by the Options
Clearinghouse Corporation (OCC)
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Exhibit 8.2 Swiss Franc Option

Quotations (U.S. Cents/SF)

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Foreign Currency Options

Markets
In August, the spot rate was 58.51 cents, or
$0.5851 was the price of one Swiss franc
The strike price means the price per franc that
must be paid for the option. The August call option
means 0.5850 $/Sfr
The premium, or cost, of the August option was
0.50 US cent per franc, or 0.0050 $/Sfr
For a call option on 62,500 Swiss francs (one contract),
the cost would be: Sfr62,500 x 0.0050 $/Sfr = $312.50

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Buyer of a Call option

The option owner, the holder, has the right to
exercise when its profitable, which means that only
when the option is in the money
When the price of the underlying currency moves
up, the holder has possibility of unlimited profit
Option can still be exercised at break-even (at-themoney) to recoup the premium
The buyer of a call option has attractive combination: limited
loss and unlimited profits
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Buyer of a Call option

Hans is a currency speculator in Zurich. Suppose
that he bought the August call option. Suppose
the spot exchange at maturity becomes
$0.595/Sfr, then he will exercise the option and
buy the franc at 0.585 and sell it at 0.595. The
value or profit for each contract:
Value = Spot rate (Strike price + Premium)
= 0.595 $/Sfr (0.585 $/Sfr + 0.005 $/Sfr)
=0.005$/Sfr

Here the profit equals the cost, see next exhibit

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Exhibit 8.3 Profit and Loss for the

Buyer of a Call Option

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Writer (seller) of a Call Option

What the holder loses, the writer gains (see
exhibit 8.4)
The limited loss for the buyer means limited
profit for the seller (writer will keep the
premium)
The unlimited profit for the buyer means
unlimited loss for the writer

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Writer (seller) of a Call Option

For example, suppose that the spot price is
$0.605/Sfr, then the writer will experience:

Value = Premium (Spot rate - Strike price)

= 0.005 $/Sfr (0.605 $/Sfr - 0.585 $/Sfr )
= - 0.015 $/Sfr

So the writer has the disadvantage: limited profit

(premium) and unlimited losses
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Exhibit 8.4 Profit and Loss for the

Writer of a Call Option

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Buyer of a Put
Buyer of a Put: (see Exhibit 8.5)

The buyer of a put wants to be able to sell the

underlying currency at the exercise price when
the market price of that currency drops
The buyer of a put (like the buyer of the call) can
never lose more than the premium paid up front
Limited maximum loss (premium) and profit
(exercise price minus premium)

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Exhibit 8.5 Profit and Loss for the

Buyer of a Put Option

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Buyer of a Put
For example, suppose that the spot price falls
to $0.575/Sfr, Hans (who bought a put option)
will buy francs at this price and sell it to the
writer at $0.585/Sfr:
Value = Strike price (Spot rate + Premium)
= 0.585 $/Sfr (0.575 $/Sfr + 0.005 $/Sfr)
=0.005$/Sfr

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Writer of a Put
Seller (writer) of a put: (see Exhibit 8.6)
The option will be exercised if the spot price of
francs drops below $0.585/SF
Below a price of $0.58/SF (break-even), the
writer will lose more than the premium received
from writing the option
Above $0.585/SF, the option will not be exercised
and the option writer will pocket the entire
premium
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Writer of a Put
For example, suppose that the spot price is
$0.575/Sfr, then the writer will experience:
Value = Premium (Strike price - Premium)
= 0.005 $/Sfr (0.585 $/Sfr + 0.575 $/Sfr)
= - 0.005$/Sfr

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Exhibit 8.6 Profit and Loss for the

Writer of a Put Option

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Option Pricing and Valuation

The pricing of any currency option combines six
elements:
Present spot rate
Time to maturity
Forward rate for matching maturity
U.S. dollar interest rate
Foreign currency interest rate
Volatility (standard deviation of daily spot price
movements)

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