Title | 10.09.2021 Currency Derivatives |
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Author | ewrte wet |
Course | International Financial and Macroeconomic Policy |
Institution | Harvard University |
Pages | 5 |
File Size | 170.5 KB |
File Type | |
Total Downloads | 49 |
Total Views | 143 |
currency derivatives notes on futures, options, call, and put contracts...
10.09.2021 Currency Derivatives
In this chapter I will need to know what are: 1. Forward contracts 2. Currency future contracts 3. Currency options contracts And how these contracts are used to “speculate” “hedge” based on anticipated exchange rate movements. Speculate: financial transactions that has substantial risk of losing value. Hedge: Using financial instruments or market strategies to offset risks of unfavorable price movements.
Used by speculators also firms to cover risks of their foreign currency position.
Forward Market Market place that offers financial instruments that are priced in advance for future deliver, typically referenced as the foreign exchange rate market but also can be applied to commodities, interest rates and securities.
How MNCs use forward contracts MNCs use forward contracts in their exports between an importer and exporter for a fixed amount of their currencies are exchanged for another. They can lock in the rate at which they obtain currency needed for purchase imports. Forward contracts provide a hedge for currency exchange rate fluctuations that are unfavorable.
Examples A company needs 1,000,000 Singaporean dollars in 90 days to purchase Singaporean imports. It can buy Singaporean dollars immediately at a spot rate of 0.35 pounds per Singaporean dollars. At this spot rate, this company will need 350000Pounds (1000000 * 0.35). But the company doesn’t have these funds right now. The spot rate in the future 90 days is unknown and has the risk the rise for example to 0.45 pounds per Singaporean dollars. (1000000 * 0.4 = 400000 pounds) that’s 50,000 pounds extra due to appreciation of the dollar currency. To avoid this risk, the company can negotiate a contract (forward contract) to purchase the Singaporean currency at today’s exchange rate and pay in 90 days due date from a bank. This is an example of a MNC using forward contract, they use it to be able to receive imports, do business, earn funds and be able to pay the exchange currency by due date with the fixed spot rate of today. Corporations also use forward markets to lock in prices of spot rate to hedge against currency depreciation over time to sell with profit.
Terminology used in forward contract calculations Bid/Ask spread This spread is the difference between what is asked by a seller I.E $5, and what a buy (bidder) wants to buy ($4.50). Currency bids ask spread is very small, and very liquid because cash is the most liquid asset in the world. Wider spreads gives more profit. Premium or discount on forward rate Forward premium is when the foreign currency is more expensive than the currency cost as given by the spot rate. Forward discount is when the foreign currency is less expensive than current cost as given by spot rate. Premium and discount rates are usually expressed as a percentage movement from current spot price. How to calculate forward rate Forward rate is calculated by: F = S (1+P) F = forward rate S = Spot rate P = Forward premium + or discount – expressed as 0.05 or 5% etc… Examples calculate forward rate Euro spot rate 0.7 euros, one year forward rate premium 2%, the one year forward rate is F = S (1+P) F= 0.7 (1+0.02) = 0.714 Euros Premium can be determined by rearranging the formula: F = S (1+P) F/S= 1+P P = F/S – 1 Example calculate premium rate One year euro forward rate 0.714 euros, spot rate euro 0.7, premium is: P = F/S – 1 P = 0.714/0.7 – 1 P = 0.02 or 2% (if P is negative, then premium is a discount)
Ways to ending a contract (Forward contract offsetting) A common way to end a contract in the financial markets by that a company A owes 1 million pesos at some future point in time, as a future contract to buy from bank A, this contract can be ended if Bank B wants to buy the contract of 1 million pesos without involvement of company A. Negotiating fees can occur, the fees should not be more than cost of closing out.
Theory on Forward Contracts Arbitrage Movements in forward rate over time
Offsetting forward contracts
Examples
Using forward contracts for “swap transactions” Examples Non-deliverable forward contracts
Currency futures market Currency futures are futures contracts for currencies that specify the price of exchanging one currency for another at a future date. Futures contracts differ from forward contract in the way they are traded. And are commonly used by MNC to hedge foreign currency positions. Futures are traded by speculators who hope to capitalize on their expectations of exchange rate movements. Buyers of futures contract lock in the exchange rate to be paid for a foreign currency at a point in time. Alternatively, a seller of currency futures contract locks in the exchange rate at which a foreign currency can be exchanged for home currency.
Trading futures Firms or individuals can execute orders for currency futures contracts by calling brokerage firms that serve as intermediaries. Firstly, participants in currency futures market take a position by establishing an initial margin which may represent as little as 10% and the margin is subject to a variation margin which is intended to accumulate enough funds to back the futures position.
Differences between Futures and Forward contracts
Market place
Forward Tailored Tailored Banks, brokers, MNC, public speculators Non, however line of credits compensation for banks required Contingent on individual banks and brokers. No separate clearing house Over telephone worldwide
Regulations
Self-regulating
Size of contract Delivery date Participants Security deposits
Clearing operation
Futures standardized Standardized Banks, brokers, MNC, qualified public speculators Small security deposit required
Handled by exchange clearing house. Daily settlements to the market price. Central exchange floor with worldwide communications Commodity futures trading commission; national futures association
Liquidation
Transaction costs
Mostly settled by actual delivery, some by offset at a cost Set by “spread” between bank’s buy and sell prices
Weak points: Arbitrage; movements in forward rates over time, Offsetting contracts Forward contracts on swap transactions Non-deliverable forward contracts
Most by offset, few by delivery.
Negotiated broker fees...