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Questions and Answers
What is the buyer's right in a currency call option?
To buy the underlying asset at the strike rate.
When will the call buyer use the strike rate to buy the underlying asset?
When the spot rate is greater than the strike rate.
What is the gross saving when the probable spot rate at maturity is AUD1.5740?
AUD0.0315
What is the net saving when the probable spot rate at maturity is AUD1.5925?
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What is the break-even point (BEP) for the call buyer?
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What will the buyer of the call do when the spot rate is lower than the strike rate?
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What is the seller of the currency call option committed to do?
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What happens to the buyer's option when the spot rate is greater than the strike rate?
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What is the premium paid by the buyer of the call option?
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What is the net saving when the probable spot rate at maturity is AUD1.6638?
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Study Notes
Management of Foreign Currency Transactions
- One side of foreign currency transactions can be covered using a derivative in denominated corporate cash flows.
- When expecting foreign currency (FC) to appreciate, get a derivative to buy FC in the future and secure the local currency (LC) receipts.
- When expecting FC to depreciate, get a derivative to sell FC in the future and secure LC payments.
Types of Derivatives
- Forward
- Option
- Futures
- Swap
Where to Find Information about Derivatives
- Chicago Mercantile Exchange (http://www.cmegroup.com/trading/products/)
- The Intercontinental Exchange – New York (https://www.theice.com/products/Futures-Options/FX)
- Tokyo Financial Exchange Inc (https://www.tfx.co.jp/en/about_tfx/outline/outline01.html)
- ASX derivatives (http://www.asx.com.au/prices/asx-futures.htm)
Forward Market
- A forward contract is an agreement between a firm and a commercial bank to exchange a specified amount of currency at a specified exchange rate (forward rate) on a specified date in the future.
- Forward exchange rates are contracted today, but with delivery and settlement of foreign currency in the future.
- Forward contracts give protection against unexpected, adverse exchange rate movements.
Organised Exchange
- A platform for trading where buyers and sellers meet.
- Clearing House settles the transactions.
- Every contract has standard features such as type of product, size of contract, delivery dates, maturity period, life cycle, and margin requirements.
Currency Futures Market
- Futures contracts are similar to forward contracts but are traded in organized exchanges and have daily marking-to-market.
- Futures contracts are like a bundle of consecutive one-day forward contracts.
How Firms Use Currency Futures
- Purchasing Futures to Hedge Payables: locks in the price at which a firm can purchase a foreign currency.
- Selling Futures to Hedge Receivables: locks in the price at which a firm can sell a currency.
Hedging with Futures
- Example: Mark, an Australian investor, sold 2 USD futures contracts to hedge his USD200,000 receivables. The agreed futures rate was AUD1.3340/USD.
Speculation with Futures
- Example: Isabella, an Australian foreign exchange trader, predicted that USD will appreciate against AUD and purchased 10 USD futures contracts to capitalize on the trend.
Foreign Currency Options
- Every option has three different price elements: exercise or strike price (K), premium, and underlying or actual spot exchange rate (S).
- Factors affecting currency option premium: spot price relative to the strike price, length of time before expiration, and volatility of the currency.
Buyer and Seller of Currency Call Options
- Buyer of a call option has the right to buy the underline asset at the strike rate and will use the strike rate to buy when the spot rate is greater than the strike rate.
- Seller of a call option commits to sell the underline asset at the strike rate and will sell the asset at the spot rate when the spot rate is lower than the strike rate.
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Description
Learn about managing foreign currency transactions using derivatives, including forward, option, futures, and swap contracts, and how to secure local currency receipts and payments.
