Session 6 Derivatives Insturnments - Forward and Option-new.PDF

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Session 6 Chapter 5 Derivative Securities for Financial Risk Management Currency futures and futures markets Learning objectives 1. To introduce various form of derivative instruments and their features...

Session 6 Chapter 5 Derivative Securities for Financial Risk Management Currency futures and futures markets Learning objectives 1. To introduce various form of derivative instruments and their features 2. To explain how forward contracts are used to hedge based on anticipated exchange rate movements 3. To describe how currency futures contracts are used to speculate or hedge based on anticipated exchange rate movements 4. To introduce option contracts and explain how option contracts are used to hedge based on anticipated exchange rate movements 5. To explain how currency option contracts are used to speculate based on anticipated exchange rate movements Financial Derivatives A derivative A financial instrument whose value is based on one or more underlying assets. A derivative A contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments are to be made between the parties Common derivative Forwards, futures, options, and swaps. Common underlying assets Commodities, stocks, bonds, interest rates and currencies. Performance of derivatives depend on both the amount and the timing of the pay-offs. Value of derivatives Depend on the values of the underlying assets 4 Uses of Derivatives Speculation: to take a position in the expectation of a profit on a future Hedging: Used to reduce the risks transaction (either buying or selling the associated with the everyday underline asset). One side of the management of foreign currency transaction is covered using a derivative in denominated corporate cash flows. advance. When expecting FC to appreciate, get a When expect to receive the foreign derivatives to buy foreign currency in the currency (FC), derivative will be used to future (Sell at the future spot and buy on sell FC in the future and secure the LC derivative). receipts. When expecting FC to depreciate, get a When expect to pay the foreign currency derivatives to sell foreign currency in the (FC) payments, derivative will be used to future (buy at the future spot and sell on buy the required FC in the future and derivative). secure the LC payments. 5 Type of derivatives Over the Exchange counter traded Forward Option Futures Option Swap Where we can find information about derivatives? http://www.cmegroup.com/trading/products/ Chicago Mercantile Exchange https://www.theice.com/products/Futures-Options/FX The Intercontinental Exchange – New York https://www.tfx.co.jp/en/about_tfx/outline/outline01.html Tokyo Financial Exchange Inc http://www.asx.com.au/prices/asx-futures.htm ASX derivatives 7 Forward Market an agreement between a firm and a commercial bank to exchange specified amount of a currency Forward contract is at a specified exchange rate called forward rate On a specified date in the future. are the rates contracted today, but forward exchange rates with delivery and settlement of foreign currency in the future Forward contract gives protection against unexpected, adverse exchange rate movements. 8 Forward/Futures contract - Example Mark, an Australian Exporter, expected to receive USD 200,000 in three months on an export consignment. He has entered into a forward contract to sell USD with a bank at USD0.7280/AUD. The day he entered into the forward, spot rate was USD0.6881/AUD. Did the AUD on premium or discount? At what percentage? Mark received the USD Today. He found today spot rate is USD0.7262/AUD. Under this given situation, what would be the AUD value he can recover by selling USD recepts? (Note: Australian banks use indirect methods to provide FX quotes) Forward/Futures contract – Example (Hedging) Before three months After three months Forward rate contracted USD0.7280/AUD ‒ He found that the market spot rate is USD0.7262/AUD. Under this given situation, what Spot rate in the market USD0.6881/AUD would be the AUD value he can recover by selling USD recepts? Does the AUD on premium or discount? At what ‒ The given quote is an indirect quote. It indicates percentage? number of USD units to exchange/sell for one AUD. The smaller amount in USD for AUD is the best. AUD is on premium ‒ Current rate USD0.7262/AUD is the best. 0.7280 − 0.6881 12 ‒ But, Mark already committed to sell (or locked × × 100 selling rate) USD0.7280 for one AUD. 0.6881 3 ‒ Therefore, he must sell on that rate. 𝐴𝑈𝐷 = −23.19% AGAINST USD 200,000𝑈𝑆𝐷 × 𝑈𝑆𝐷0.7280 = 𝐴𝑈𝐷274,725.27 Jeff Madura, International Financial Management, 14 th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, 10 copied or duplicated, or posted to a publicly accessible website, in whole or in part. Currency Futures Market A foreign currency futures contract is an alternative to a forward contract that calls for future delivery of Standardized number of units per contract at a fixed time (in a specific settlement date), place and price. Currency futures contracts are similar to forward contracts in terms of obligation to purchase or sell currency on a specific settlement date in the future. Comparison of the Forward and Futures Market FORWARD FUTURES Size of contract Tailored to individual needs. Standardized. Delivery date Tailored to individual needs. Standardized. Participants Banks, brokers, and multinational companies. Public Banks, brokers, and multinational companies. speculation not encouraged. Qualified public speculation encouraged. Security deposit None as such, but compensating bank balances or lines Small security deposit required. of credit required. Clearing operation Handling contingent on individual banks and brokers. No Handled by exchange clearinghouse. Daily separate clearinghouse function. settlements to the market price. Marketplace Telecommunications network. Globex computerized trading platform with worldwide communications. Regulation Self-regulating. Commodity Futures Trading Commission; National Futures Association. Liquidation Most settled by actual delivery; some by offset, but at a Most by offset; very few settled by delivery. cost. Transaction costs Set by the spread between the bank's buy and sell prices. Negotiated brokerage fees. Source: Chicago Mercantile Exchange. Jeff Madura, International Financial Management, 14 th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, 12 copied or duplicated, or posted to a publicly accessible website, in whole or in part. Currency Futures Market Credit risk and the futures contract solution Forwards are a pure credit instrument The futures contract solution Forwards are a zero-sum game, so that A futures exchange clearinghouse takes one party always has an incentive to one side of every transaction (and makes default sure that its exposures cancel one another) Initial and maintenance margins ensure settlement Contracts are marked-to-market daily (daily adjustment of futures prices traded in the market depending on the spot exchange rates). 13 How organised exchange work Dealers A PLATFORM FOR TRADING Buyers will buy the Sellers will sell the contract contract Clearing House Every contracts has standard Features Such as Type of product Size of contract Delivery dates Maturity period Life cycle Margin requirements ect How organised exchange work ‘T’ want to sell Dealers USD600,000 -will sell 6 ‘A’ want to buy contracts USD400,000 -will buy 4 contracts Futures ‘W’ want to sell USD500,000 -will sell 5 ‘B’ want to buy contracts USD700,000 USD Contract -will buy 7 contracts (Size USD100,000) ‘X’ want to sell USD300,000- -will sell 3 ‘C’ want to buy Contracts USD750,000- -will buy 7 or 8 ‘Z’ want to sell contracts USD175,000- -will sell 1 or 2contracts Currency Futures Market Futures contracts are similar to forward contracts Futures contracts are like a bundle of consecutive one-day forward contracts Futures and forwards are nearly identical in their ability to hedge risk Not like the forward contract, futures contracts are traded in the organized exchanges and daily marking-to-market How Firms Use Currency Futures Hedging with forwards/futures Purchasing Futures to Hedge Payables - The purchase of futures contracts locks in the price at which a firm can purchase a foreign currency (at the date of foreign currency payment settlement, the firm can use the agreed futures rate to buy foreign currency). Selling Futures to Hedge Receivables - The sale of futures contracts locks in the price at which a firm can sell a currency (When foreign currency receipts collected, futures rates can be used sell the foreign currency) 17 Hedging with futures Example Mark is an Australian investor who expected USD200,000 in three months. He sold 2 USD futures contracts (USD100,000) which mature in the same day which USD receiving. The agreed futures rate was AUD1.3340/USD. The probable out come Marks had a foreign exchange future position (USD200,000). Motive is to be sure the local currency proceed on selling USD. Mark must sell USD200,000 in three months at AUD1.3340/USD (whether the spot rate in three months is higher or lower than the agreed futures rate), No matter what would happen in the FX market, the futures contracts guarantee him an exchange rate of AUD1.3340/USD in three months Mark can collect USD200,000×AUD1.3340/USD=AUD266,800 in three months time Since, futures contract is going to lock the selling rate, Mark will not either gain on appreciation of USD or loss on depreciating USD. 18 Speculation with futures- an example Action Probable outcome Isabella is an Australian foreign ‒ Isabella do not have a future foreign exchange trader. She predicted that currency position. USD will appreciate against AUD in ‒ Motive is to make profit on buying and coming months. selling USD in the future. ‒ At the maturity, she will use futures To capitalise the predicted trend, contracts to buy USD and sell USD at the Isabella purchased 10 USD futures spot rate at the date. contracts (each contract carry 100,000 ‒ The profit on speculation will be depend USD units). on the spot rate at the maturity (selling rate) and agreed futures rate (buying rate) The futures rate was AUD1.1234/USD. today. The futures contacts will mature in two ‒ If the market spot rate is heading opposite direction, Isabella would sell months time. equal number of futures contracts to close out her buying positions. Jeff Madura, International Financial Management, 14 th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, 19 copied or duplicated, or posted to a publicly accessible website, in whole or in part. Currency Futures Market How Firms Use Currency Futures -Closing Out a Futures Position Sellers (buyers) of currency futures can close out their positions by buying (selling) identical futures contracts prior to settlement. Most currency futures contracts are closed out before the settlement date. Speculation with futures ▪Efficiency of the currency futures market ▪ If the currency futures market is efficient, the futures price should reflect all available information. ▪ Thus, the continual use of a particular strategy to take positions in currency futures contracts should not lead to abnormal profits. ▪ Research has found that the currency futures market may be inefficient. However, the patterns are not necessarily observable until after they occur, which means that it may be difficult to consistently generate abnormal profits from speculating in currency futures. Hedging with forwards and futures Exchange-traded futures contracts are standardized and may not provide a perfect hedge if they do not match the underlying exposure’s in… Maturity – The maturity date of the futures contract is different to the transaction completion date. Currency – Futures contract may not be available on the transaction currency contract size – The standard size of the contract may not allow to hedge the exact transaction amount (under-hedge or over-hedge) Currency Options Market A foreign currency option is a contract which gives the option buyer (the holder) a right, but not an obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit within a specified time period (until the maturity date) There are two basic types of options, puts and calls. Buyer of a call option has a right but not an obligation to buy a foreign currency on the agreed/strike/exercise rate Buyer of a put option has a right but not an obligation to sell a foreign currency on the agreed/strike/exercise rate Main parties involved Option buyer/holder: the person who purchased the option Option seller/writer/guarantor: The person who sold the option Foreign Currency Options – How options work? Call Option Seller of a call option Buyer of a call option has commit to sell the Receive Premium Pay the right to buy the underline assets at the underline assets at the strike rate Commit Right Right to strike rate If buyer use the option at to sell buy If KS, If buyer use the option otherwise will ignore it Types of Option American option Bermuda option European option -can be exercised only -can only be exercised -can be exercised on predetermined at the end of its life, at anytime during its life dates, typically every its maturity month Currency Options Market Over-the-Counter Market Organized exchange Where commercial banks and Organized exchanged traded option brokerage firms offer customized contract are standardized and not currency options. tailor made There are no credit guarantees for These options are issued through these OTC options, so some form of brokers (guaranteed) but require collateral may be required. margin maintenance The over-the-counter market offers currency options that are tailored to the specific needs of the firm 26 Foreign Currency Options Every option has three different price elements; The exercise or strike price (K) – the exchange rate at which the foreign currency can be purchased (call) or sold (put) The premium – the cost, price, or value of the option itself The underlying or actual spot exchange rate (S) in the market Foreign Currency Options Factors Affecting Currency Option Premium: Factor Call option Put Option Spot price relative to Positive - The higher the spot rate Negative - The lower the spot rate relative to the strike price (S − X): relative to the strike price, the higher the strike price, the higher the probability that the option price will be. the option will be exercised. Length of time before Positive - The longer the time to Positive - The longer the time to expiration, the expiration (T): expiration, the higher the option price greater the put option premium. will be. Volatility of the Positive - The greater the variability of Positive - The greater the variability, the greater Currency(σ): the currency, the higher the probability the probability that the option may be that the spot rate can rise above the exercised. strike price. Example: Buyer of Currency Call Options Assume purchase of August call option on Swiss francs with strike price of AUD1.5425/CHF, and a premium of AUD0.05/CHF At all spot rates below the strike price of AUD1.5425/CHF, the buyer of the option would choose not to exercise because it would be cheaper to buy CHF on the open market spot rate At all spot rates above the strike price, the option buyer would exercise the option to buy CHF at the strike price and sell them into the market netting a profit (less the option premium) Buyer : Currency Call Options Probable spot rate at the AUD1.4425 AUD1.5025 AUD1.5425 AUD1.5740 AUD1.5925 AUD1.6638 AUD1.7452 maturity-may sell (S) Strike Rate-right to buy (K) (AUD1.5425) (AUD1.5425) (AUD1.5425) (AUD1.5425) (AUD1.5425) (AUD1.5425) (AUD1.5425) Selected choice If S>K, will use option to buy, otherwise ignore Gross Saving Paid Premium (AUD0.05) (AUD0.05) (AUD0.05) (AUD0.05) (AUD0.05) (AUD0.05) (AUD0.05) Net – The call buyer has the right to buy on the strike rate. At the maturity he can use either spot rate or strike rate what ever the lowest to buy the underline asset. He will use the strike rate to buy when spot rate is greater than the strike. Buyer : Currency Call Options SK, CALL is in the money money at the money Probable spot rate at the AUD1.4425 AUD1.5025 AUD1.5425 AUD1.5740 AUD1.5925 AUD1.6638 maturity-may sell (S) Strike Rate-right to buy (K) (AUD1.5425) (AUD1.5425) (AUD1.5425) (AUD1.5425) (AUD1.5425) (AUD1.5425) If S>K, will use option to buy, Ignore Ignore Ignore USE USE USE otherwise ignore Gross Saving AUD0.0315 AUD0.0500 AUD0.1213 Paid Premium (AUD0.05) (AUD0.05) (AUD0.05) (AUD0.05) (AUD0.05) (AUD0.05) Net (AUD0.05) (AUD0.05) (AUD0.05) (AUD0.0185) 0 AUD0.0713 BEP(SPOT)=Strike+Premium(Call) – The call buyer has the right to buy on the strike rate. At the maturity he can use either spot rate or strike rate what ever the lowest to buy the underline asset. He will use the strike rate to buy when spot rate is greater than the strike. Seller of the Currency Call Options Probable spot rate at the AUD1.4425 AUD1.5025 AUD1.5425 AUD1.5740 AUD1.5925 AUD1.6638 maturity-may buy (S) Strike Rate-commit to sell (K) (AUD1.5425) (AUD1.5425) (AUD1.5425) (AUD1.5425) (AUD1.5425) (AUD1.5425) If S>K, buyer will use the option to Buyer of the call will ignore the option since the Since the spot rate is greater than the strike rate buy (so seller must sell the spot rate is lower. Seller do not need to sell the call buyer will use the call option to buy underline underline assets) otherwise underline assets assets and seller must sell ignore Gross Saving (AUD0.0315) (AUD0.0500) (AUD0.1213) Received Premium AUD0.05 AUD0.05 AUD0.05 AUD0.05 AUD0.05 AUD0.05 Net AUD0.05 AUD0.05 AUD0.05 AUD0.0185 0 (AUD0.0713) Outcome UNLIMITED LOSSES DEPENDING ON THE SPOT RATE AT MATURITY BREAK- LIMITED GAIN EVEN=BEP(SPO TO THE T)=Strike PREMIUM Premium(Call) – The call buyer has the right to buy on the strike rate. So, call seller must sell the underline assets if buyer use the call option. Profit and Loss for the Writer(Seller) of a Call Option Writer (seller) of a call: When the holder (buyer) of an option loses, the seller gains Seller’s maximum profit is limited to the premium If the seller (writer) wrote the option naked (without owning the currency), the seller have to buy the currency at the spot and take the loss on delivering at the strike price Seller’s loss is unlimited and increases as the underlying currency rises Even if the writer already owns the currency, the writer will experience an opportunity loss Eiteman, Stonehill and Moffett (2008) Multinational Business Finance, 11 th Edition), Put option Put option buyer can secure a right to sell the underline assets (foreign currency) on the strike rate at the maturity of the contract by paying the premium in advance to the seller of the call. Put option seller commit to buy the underline assets (foreign currency) on the strike rate at the maturity. Buyer : Currency put option Assume purchase of August put option on Canadian dollar with strike price of AUD1.7925/GBP, and a premium of AUD0.06/GBP The buyer of a put option, however, wants to be able to sell the underlying currency at the exercise price when the spot rate of that currency drops At all spot rates above the strike price of AUD1.7925/GBP, the buyer of put option would choose not to exercise because it would be profitable to sell GBP on the open market Put option buyer can secure a right to sell the underline assets (foreign currency) on the strike rate at the maturity of the contract by paying the premium in advance to the seller of the call. Put option seller commit to buy the underline assets (foreign currency) on the strike rate at the maturity. The buyer of a put (like the buyer of the call) can never lose more than the premium paid up front Buyer : Currency Put Options Probable spot rate at the maturity -may AUD1.6525 AUD1.6925 AUD1.7325 AUD1.7925 AUD1.8458 AUD1.8837 buy Strike Rate – right to sell AUD1.7925 AUD1.7925 AUD1.7925 AUD1.7925 AUD1.7925 AUD1.7925 Selected choice (if S

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