Chapter

3
Hedging Exchange Rate Risk with
Derivatives
 Chapter Objectives

• To explain how forward contracts are used

for hedging based on anticipated exchange
rate movements; and
• To explain how currency futures contracts
and currency options contracts are used for
hedging or speculation based on anticipated
exchange rate movements.

2
 Chapter Contents

• Forward Market
• Currency Futures Market
• Currency Options Market

3
 Forward Market

¤ Spot Market
¤ Forward Contract
¤ Fixed Forward Contract
¤ Non-Deliverable Forward Contracts

4
 Spot market
• The most common type of foreign exchange
transaction for immediate exchange. The market
where these transactions occurs is known as the
spot market.
• The spot exchange rate is the current market
price for exchanging one currency directly for
another.
• Foreign exchange spot contracts are agreements
between the buyers and the sellers to exchange
a specified amount of currency at the spot rate for
delivery in two business days.
5
 Spot market

• Transaction date: is the date upon which any

financial dealing occurs. It is used for
determining the spot rate of a currency, the
amount of currency and settlement date.
• Settlement date/Value date: is the date when
a spot currency transaction is final, and the
buyer must make payment to the seller while
the seller delivers currency to the buyer.

6
 Spot market

Some special cases for spot transaction:

Transaction date = Settlement date
TOD = T
Settlement date of one business day after
transaction date
TOM = T+1
Settlement date of two business days after
transaction date
SPOT/NEXT = T+2
7
 Forward Contract

• The forward market facilitates the trading of

forward contracts on currencies.
• A forward contract is an agreement between
a corporation and a commercial bank to
exchange a specified amount of a currency at
a specified exchange rate (called the forward
rate) on a specified date in the future.

8
 Forward Contract

The forward transactions settles later than the

spot. The spot transactions are specified for
delivery in two business days, while forward
transactions settle the next business day.

16 17 18
FORWARD
December December December

Today Tom Spot 3 to 365 days

9
 Forward Contract

When MNCs anticipate future need or future

receipt of a foreign currency, they can set up
forward contracts to lock in the exchange rate.
- If MNCs have future need  they set up
forward contract to buy foreign currency
- If MNCs have future receipt  they set up
forward contract to sell foreign currency

10
 Forward Contract

• Premium or Discount on the Forward Rate

The difference between the forward rate (F) and
the spot rate (S) at a given point in time is
measured by the premium/discount .
¤ If the forward rate (F) exceeds the existing
spot rate (S), it contains a premium.
¤ If the forward rate is less than the existing
spot rate, it contains a discount.

11
 Forward contract
Determining forward premium/discount

p = Forward rate – Spot rate = F- S x 360

Spot rate S n
where p represents the difference between
forward rate & spot rate by the percentage; n
represents the maturity

F > S  p > 0  Forward Premium

 F < S  p < 0  Forward Discount

12
 Forward contract

Example 1:
Suppose spot rate: S (USD/VND) = 23,412
1- year forward rate: F (USD/VND) = 23,600

23,600 – 23,412 x 360 = 0.803%

23,412 360
So, forward premium = 0.803%

13
 Forward contract

Example2
Suppose spot rate: S (GBP/USD) = 1.681
90-day forward rate: F (GBP/USD) = 1.677

1.677 – 1.681 x 360 = – 0.95%

1.681 90
So, forward discount = 0.95%

14
 Forward contract

• Forward points
Forward points (P) are the number of basis
points added to or subtracted from the
current spot rate of a currency pair to determine
the forward rate for delivery on a specific value
date.
Forward rate = Spot rate +/- Forward points
F = S +/- P

15
Forward contract

When forward points are

added to or subtracted
from the spot rate?

16
 Forward contract

F=S+P
Bid forward point < Ask forward point

F=S-P
Bid forward point > Ask forward point

17
 Forward contract

Example: Suppose S (GBP/USD) = 1.6770 - 1.6810

Maturity Forward point Forward rate

3 months 42-44 ?
6 months 85-88 ?
9 months 44-42 ?
12 months 88-85 ?

18
 Forward contract

Example: Suppose S (GBP/USD) = 1.6770 - 1.6810

Forward
Maturity Forward rate
point

3m 42-44 1.6770 + 0.0042 = 1.6810 + 0.0044 =

1.6812 1.6854
6m 85-88
9m 44-42 1.6770 – 0.0044 = 1.6810 – 0.0042 =
1.6726 1.6768
12 m 88-85

19
 Fixed Forward Contract

Cancelation

Extension

Early Termination

20
 Fixed Forward Contract - Cancellation

• Example: The contract negotiation was unsuccessful. ABC

company no longer needs to buy USD. On 25 Dec 2021,
ABC requests the bank to cancel the Forward contract.

• Solution:
1. Let the Forward deal executed as contracted
2. To cancel the old contract, ABC book an opposite deal
at the spot rate on the date we cancel.
3. Determine the profit/loss arising from the difference in
the exchange rate that is borne by the customer.

21
Fixed Forward Contract - Cancellation
1. Execute the old deal
ABC set up a forward contract to buy 1mio USD at forward
rate F (USD/VND) = 21,268. On 25 Dec 2021, ABC must
pays:
1,000,000 * 21,268 = 21,268,000,000 VND

At maturity: S (USD/VND) = 21,258 - 21,260

2. Book an opposite deal at spot rate to cancel the old
contract
On 25 Dec 2021, ABC sell 1mio USD at bid spot rate
21,258 and receives:
1,000,000 *21,258 = 21,258,000,000 VND

22
Fixed Forward Contract - Cancellation

3. Determine the profit or loss arising from the

difference in the exchange rate
Changes in the exchange rate make the bank get loss:
21,268,000,000 – 21,258,000,000 = 10,000,000 VND
 ABC needs to pay VND10,000,000 to cancel the old
deal.

23
 Fixed Forward Contract - Extension
• Example: The shipment is delayed by one month. On 25
Dec 2021, ABC requests the bank to extend the forward
contract for one month.

• Solution:
1. Let the Forward deal executed as contracted
2. Book the opposite deal at the current spot rate
3. Set up a new one month forward contract by using the
current spot rate and 1mth forward point
4. Determine the profit/loss arising from the difference in
the exchange rate that is borne by the customer
24
 Fixed Forward Contract - Extension
1. Execute the old deal
ABC set up a forward contract to buy 1mio USD at forward
rate F (USD/VND) = 21,268. On 25 Dec 2021, ABC must
pay:
1,000,000 * 21,268 = 21,268,000,000 VND

At maturity: S (USD/VND) = 21,259 - 21,261

Forward points 1 month = 81 - 90
2. Book an opposite deal at spot rate to cancel the old
contract
On 25 Dec 2021, ABC sell 1mio USD at bid spot rate
21,259 and receives:
1,000,000 *21,259 = 21,259,000,000 VND
25
Fixed Forward Contract - Extension
3. Set up a new one month forward contract
On 25 Dec 2021, ABC set up a new forward contract to
buy 1mio USD at forward rate 21,351 (= 21,261 + 90)
On 25 Jan 2022, to buy 1mio USD, ABC will pay:
1,000,000 * 21,351 = 21,351,000,000 VND

26
 Fixed Forward Contract - Extension

4. Determine the profit or loss arising from the difference

in the exchange rate
Changes in the exchange rate make the bank get loss:
21,268,000,000 – 21,259,000,000 = 9,000,000 VND
 ABC needs to pay VND9,000,000 to cancel the old
deal.
Total cost which ABC needs to pay for extension is:
9,000,000 + 21,351,000,000 = 21,360,000,000 VND

27
 Fixed Forward Contract – Early
Termination
• Example: The shipment arrived one month earlier (25 Nov
2021). Therefore, ABC requests the bank to execute the
forward contract one month earlier.

• Solution:
1. Let the Forward deal executed as contracted
2. On 25Nov 2021, ABC buy 1mio USD at current spot rate
3. ABC book an opposite forward deal to cancel the old
deal using the current spot rate and 1mth forward points
4. Determine the profit/loss arising from the difference in
the exchange rate that is borne by the customer
28
 Fixed Forward Contract - Early
Termination
1. Execute the old deal
Suppose that ABC buy 1mio USD at forward rate F
(USD/VND) = 21,268. On 25 Dec 2021, ABC must pays:
1,000,000 * 21,268 = 21,268,000,000 VND
On 25 Nov 2021:
 S(USD/VND) = 21,241 - 21,243
 1 month Forward point USD/VND = 81 – 90

2. Buy 1mio USD at spot rate on 25 Nov 2021

ABC buy 1mio USD at ask spot rate 21,243 and must pays:
1,000,000 * 21,243 = 21,243,000,000 VND

29
 Fixed Forward Contract - Early
Termination
3. Book an opposite forward deal to cancel the old deal
On 25 Nov 2021, ABC set up an opposite deal - one
month forward contract to sell 1mio USD at forward rate
21,322 (= 21,241 + 81)
On 25 Dec 2021, ABC receives:
1,000,000 * 21,322 = 21,322,000,000 VND

30
 Fixed Forward Contract - Early
Termination
4. Determine the profit or loss arising from the difference
in the exchange rate
Changes in the exchange rate make the bank get profit:
21,322,000,000 – 21,268,000,000 = 54,000,000 VND
 The bank needs to pay back VND54,000,000 to cancel
the old deal
Total cost which ABC needs to pay for early termination is:
21,243,000,000 – 54,000,000 = 21,189,000,000 VND

31
 Fixed Forward Contract
Exercise 1
XYZ company exporting goods to Australia will receive
500,000 AUD in the next 3 months. XYZ sets up a 3-
months forward contract to sell AUD to the bank.
Today is 1st May, the current spot rate is 16.750-16.810
Fixed Forward contract for cancellation, extension and
early termination
-On 1st Jul, S(AUD/VND): 16.950-17.080
-On 1st Aug, S(AUD/VND): 17.150-17.210
-One month forward points is 35-50
- Three months forward points is 80-105.
32
 Exercise 1 - Cancellation
1. Execute the old deal
XYZ set up a forward contract to sell 500,000 AUD at
forward rate F (AUD/VND) = 16,750 + 80 = 16,830.
On 1st Aug, ABC receives:
500,000 * 16,830 = 8,415,000,000 VND

2. Book an opposite deal at spot rate to cancel the old

contract
On 1st Aug, XYZ buy 500,000USD at ask spot rate 17,210
and pays:
500,000 * 17,210 = 8,605,000,000 VND

33
 Exercise 1 - Cancellation

3. Determine the profit or loss arising from the

difference in the exchange rate
Change in the exchange rate make the bank get loss:
8,605,000,000 – 8,415,000,000 = 190,000,000 VND
 XYZ needs to pay VND190,000,000 to cancel the
old deal.

34
 Exercise 1 - Extension
1. Execute the old deal
XYZ set up a forward contract to sell 500,000 AUD at
forward rate F (AUD/VND) = 16,750 + 80 = 16,830.
On 1st Aug, XYZ receives:
500,000 * 16,830 = 8,415,000,000 VND

2. Book an opposite deal at spot rate to cancel the old

contract
On 1st Aug, XYZ buy 500,000USD at ask spot rate 17,210
and pays:
500,000 * 17,210 = 8,605,000,000 VND

35
 Exercise 1 - Extension

3. Set up a new one month forward contract

On 1st Aug, XYZ set up a new one month forward
contract to sell AUD at forward rate 17,185 (= 17,150 +
35)
On 1st Sep, XYZ sells 500,000 AUD and receives:
500,000 * 17,185 = 8,592,500,000 VND

36
 Exercise 1 - Extension

4. Determine the profit or loss arising from the difference

in the exchange rate
Changes in the exchange rate make the bank get profit:
8,605,000,000 – 8,415,000,000 = 190,000,000 VND
 XYZ needs to pay VND190,000,000 to cancel the old
deal.
For extension, XYZ receive total amount of money:
8,592,500,000 - 190,000,000 = 8,402,500,000 VND

37
 Exercise 1 – Early termination
1. Execute the old deal
XYZ set up a forward contract to sell 500,000 AUD at
forward rate F (AUD/VND) = 16,750 + 80 = 16,830.
On 1st Aug, XYZ receives:
500,000 * 16,830 = 8,415,000,000 VND

2. Sell 500,000 AUD at spot rate

On 1st Jul, XYZ sell 500,000 AUD at bid spot rate 16,950
and receives:
500,000 * 16,950 = 8,475,000,000 VND

38
 Exercise 1 – Early termination

3. Book an opposite forward deal to cancel the old deal

On 1st Jul, XYZ sets up an opposite deal - one month
forward contract to buy 500,000 AUD at forward rate
17,130 (= 17,080 + 50)
On 1st Aug, XYZ pays:
500,000 * 17,130 = 8,565,000,000 VND

39
 Exercise 1 – Early termination

4. Determine the profit or loss arising from the difference

in the exchange rate
Changes in the exchange rate make the bank get loss:
8,565,000,000 – 8,415,000,000 = 150,000,000 VND
 XYZ needs to pay VND150,000,000 to cancel the old
deal
For early termination, XYZ receives total amount of money:
8,475,000,000 - 150,000,000 = 8,325,000,000 VND

40
 Fixed Forward Contract
Exercise 2
Thang Loi JSC importing goods from Germany will pay
800.000€ in the next 3 months. Firm sets up a 3-month
forward contract to buy 800,000€.
Today is 1st Jun, the current spot rate is 28.150-28.280
Fixed forward contract for: cancellation, extension and
early termination.
-On 1st Aug, S(EUR/VND): 28,080 – 28,110
-On 1st Sep, S(EUR/VND): 27,950 - 28,050
-One month forward points is 60-90
- Three months forward points is 150-180
41
 Non – deliverable Forward contract
NDF

• A non-deliverable forward contract (NDF) is a

forward contract whereby there is no actual
exchange of currencies. Instead, a net payment
is made by one party to the other based on the
contracted rate and the market rate on the day of
settlement.
• Although NDFs do not involve actual delivery,
they can effectively hedge expected foreign
currency cash flows.
42
 Currency Futures Market

¤ Currency Future Contract

¤ Contract Specifications
¤ Comparison to Forward Contracts
¤ Credit Risk of Currency Futures Contracts
¤ Pricing Currency Futures
¤ How Firms Use Currency Futures
¤ Speculation with Currency Futures
¤ Closing Out A Futures Position

43
 Currency Futures Contracts

Currency futures contracts is an agreement between

two parties – a buyer and a seller to purchase or sell
a standard volume of particular currency at a specific
date in the future for a pre-determined price.

 A buyer of a currency futures contract locks in the

exchange rate to be paid for a foreign currency at a
future point in time.
 A seller of a currency futures contract locks in the
exchange rate at which a foreign currency can be
exchanged for the home currency.
44
 Currency Futures contract
Specification
1. The contracts can be traded by firms or
individuals through brokers on the trading floor of an
exchange, on automated trading systems with
worldwide communications.
o The Chicago Mercantile Exchange (CME)
o The London International Financial Futures
Exchange
o The Tokyo International Financial Futures
Exchange
o The Singapore International Monetary Exchange
45
 Currency Futures contract
Specification
2. Currency futures
Currency futures commonly are strong currencies.
3. Contract size
Each contract specifies a standardized number of
units to be delivered under one contract.
4. Settlement date/Expiration date
Specify the third Wednesdays in March, June,
September, and December

46
Currency Futures contract Specification
Currency Futures Contracts Traded on the CME

47
Currency Futures contract Specification
Contract size/Trading unit EURO 125.000
Price Quote USD per EURO
Minimum Price Fluctuation 0.0001
Delivery months Mar, Jun, Sep, Dec
Trading hours 7.20 am – 2.pm
Last day 7.20 pm – 9.16 am
Last day of trading Two business days before the Third
Wednesday of the contract month

Delivery date Third Wednesday of the contract

month
48
 Currency Futures contract
Specification
5. Clearinghouse: is an intermediary between the buyer and
the seller in financial market. It validates and finalizes the
transaction, ensuring that both the buyer and the seller
honor their contractual obligations.

49
Comparison to Forward Contracts

50
 Credit Risk of Currency
Futures Contracts
• Currency futures contracts have no credit risk
since they are guaranteed by the exchange
clearinghouse.
• To minimize its risk in such a guarantee, the
exchange imposes margin requirements to
cover fluctuations in the value of the contracts.
• Participants in the currency futures market
need to establish and maintain a margin when
they take a position.

51
 Margin Requirements

• Initial Margin: is the amount a trader must

deposit into his margin account when
establishing a position.
• Beyond the initial margin, if the equity in the
margin account falls below a maintenance
margin level, additional funds must be deposited
to bring the account back up to the initial margin
level. The process is known as margin call.

52
 Mark to market - MTM

• All futures traders’ positions are marked to

market daily, commonly at the end of every day.
• It means everyday, difference between previous
closing price and current closing price is added
to, or deducted from the trader’s margin account.
• Losses will reduce margin account and profits
will increase margin account.

53
 Mark to market - MTM
Margin account

Initial Margin

Fluctuation

Maintenance
Margin Level
Call Margin
Call Margin

Settlement date
54
 Mark to market - MTM
Example
On 1st Jul, A trader set up a future contract to
purchase GBP at an exchange rate of $1.47/GBP.
• Initial margin is $2,000
• Maintenance margin level is $1,500
• Contract size is 62,500 GBP
The value of this contract is
62,500 x 1.47 = $91,875

55
 Mark to market - MTM
Example
Date Settleme Contract MTM Account Call
nt price Value (Profit/ Balance Margin
Loss)

1/7 1.4700 91,875 +2,000

At the 1.4714 91,962.5 + 87.5 +2,087.5

end of 1/7
At the 1.4640 91,500 - 462.5 +1,625
end of 2/7
At the 1.4600 91,250 - 250.0 +1,375 +625
end of 3/7
At the 1.4750 92,187.5 + 937.5 +2,000 - 937.5
end of 4/7
56
 Pricing Currency Futures
• The price of a currency futures contract is similar
to the forward rate for a given currency and
settlement date.
Example:
- Currency futures price on GBP is $1.7
- Currency forward rate on GBP is $1.68
 Firms can purchase forward contracts at forward
rate $1.68 and sell futures contracts at $1.7 at the
same settlement date
 On settlement date of two contracts, firms can get
profits of $0.02
57
 Pricing Currency Futures

• The currency futures price differs from the spot

rate if there were significant discrepancies
between the interest rates on two currencies.
• These relationships are enforced by the
potential arbitrage activities that would occur
otherwise.

58
 Pricing Currency Futures

The higher foreign interest rate would provide a

higher yield on the investment in currency futures
contracts.
59
 How Firms Use Currency Futures

Purchasing Futures to hedge payables

Purchasing futures contracts helps MNCs to
hedge foreign currency payables and lock in the
price at which they can purchase a foreign
currency.
4th April 17th June
1. Anticipate to pay 2. Buy the pesos at the
500,000 pesos. Contract locked-in rate.
to buy 500,000 pesos at 3. Pay 500,000 pesos
$0.09/peso on June 17.

60
 How Firms Use Currency Futures

Selling futures to hedge receivables

Selling currency futures helps MNCs to hedge
foreign currency receivables and lock in the price
at which they can sell a foreign currency.
4th April 17th June
1. Expect to receive 2. Receive 500,000
500,000 pesos. Contract pesos as expected.
to sell 500,000 pesos at
$0.09/peso on 17th Jun. 3. Sell the pesos at the
locked-in rate.

61
 Speculation with Currency
Futures Contracts

Speculators often purchase currency futures

when they expect the underlying currency to
appreciate.

4th April 17th June

1. A futures contract to 2. Buy the pesos to fulfill
buy 500,000 pesos at contract
$0.09/peso ($45,000)
3. Sell 500,000 pesos at spot
on 17th June.
rate $0.1/peso ($50,000)
in the spot market.
Gain $5,000.
62
 Speculation with Currency
Futures Contracts

Speculators often sell currency futures when

they expect the underlying currency to
depreciate.

April 4 June 17
1. A futures contract to 2. Buy 500,000 pesos at
sell 500,000 pesos at $0.08/peso ($40,000)
$0.09/peso ($45,000) from the spot market.
on June 17. 3. Sell the pesos to fulfill
contract.
Gain $5,000.

63
 Closing Out A Futures Position

• Most currency futures contracts are closed out

before their settlement dates.
• Brokers who fulfill orders to buy or sell futures
contracts earn a transaction or brokerage fee in
the form of the bid/ask spread.
• Holders of futures contracts can close out their
positions by selling similar futures contracts.
Sellers may also close out their positions by
purchasing similar contracts.

64
 Closing Out A Futures Position
Example:
On 10th Jan, ABC firm anticipates that it will need AUD in 19th
Mar. ABC purchases a futures contract specifying A$100,000
at price of $0.53/AUD. On 15th Feb, ABC realizes that it has
no need for AUD in March. To close out this futures position,
ABC sells a futures contract on AUD at the settlement date.

65
 Currency Options Market

• Currency Options Contracts

• Currency Call Options
• Currency Put Options
• Contingency Graphs for Currency Options
• Speculative Strategy on Currency Options
• Conditional Currency Options

66
 Currency Options Contracts

A currency option is a contract that gives the

buyer the right, but not the obligation, to buy or
sell a certain currency at a specified exchange
rate on or before a specified date in the future.

• For this right, the buyer must pay a premium (C)

• Currency options allow firms/speculators to
hedge currency risk or to speculate on currency
moves.
67
 Currency Options Contracts
• The standard options are traded on an exchange
through brokers and require margin maintenance.
• In addition to the exchanges, there is an over-the-
counter market where commercial banks and
brokerage firms offer customized currency
options.
• There are no credit guarantees for these OTC
options, so some form of collateral may be
required.

68
Currency Options Contracts

Currency
Options

Call Put
Options Options

69
 Currency Call Options

A currency call option grants the

holder the right, but not the
obligation to buy a specific
currency at a specified price
(called the exercise or strike
price) within a specific period of
time.

70
 Currency Call Options
A firm anticipates his needs on USD to import goods.
It establishes to purchase a currency call options at
strike price of 1.45 USD/GBP
On the expiration date, the spot rate fluctuates as
follows:
- The spot rate S(USD/GBP) = 1.5
- The spot rate S(USD/GBP) = 1.45
- The spot rate S(USD/GBP) = 1.3
How will the firm decide? Does it exercise the right
or not?
71
 Currency Call Options

The holder
exercises his right In the money
if spot rate > strike - ITM
price

The holder does

Out of the
not exercise his
Currency money –
right if spot rate <
call OTM
strike price
options
The holder can do At the
or not if spot rate money -
= strike price ATM

72
 Currency Call Options

Factors Affecting Currency Call Option Premiums

• The premium on a call option represents the
cost of having the right to buy the underlying
currency at a specified price.
• The options buyer have right to exercise their
options or not but they will pay the premiums to
the seller.

73
 Currency Call Options

Factors Affecting Currency Call Option Premiums

Call option premium is influenced by

Length of time
Spot price relative Potential variability
before the
to strike price of currency
expiration date
• The higher the • The longer the • The greater the
spot rate relative time to expiration variability of
to the strike date, the higher currency, the
price, the higher the option price higher the option
the option price will be price will be
will be

74
 Currency Call Options
How firm use currency call options
• Firms with open positions in foreign currencies
may use currency call options to cover those
positions.
• They may purchase currency call options
¤ to hedge future payables;
¤ to hedge potential expenses when bidding
on projects; and
¤ to hedge potential costs when attempting to
acquire other firms.
75
 Currency Call Options

Speculating with currency call options

• Speculators can purchase call options on a
foreign currency that they expect to appreciate.
• They will exercise their options if the spot rate >
the strike price

Profit = Selling price (spot rate) – Buying price

(strike price) – Option premium

76
 Currency Call Options

Speculating with currency call options

• Speculators may also sell call options on a
currency that they expect to depreciate.

Profit = Option premium – Buying price (strike

price) + Selling price (spot rate)

77
 Currency Call Options

Example:
A speculator buys a GBP call option at a
strike price of $1.35
On the expiration date, the current spot rate is
$1.43
Premium for this call option is $0.012 per unit
Call option contract size: $31,250

78
 Currency Call Options
Example:
For the buyer, on the expiration date, the current
spot rate ($1.43) > the strike price ($1.35)
 Speculator exercises this call option at the strike
price, then selling currency at the spot rate to gain
profit
Per unit Per contract
Purchase currency - $1.35 - $1.35 x 31,250 = - $42,187.5
Sell currency + $1.43 + $1.43 x 31,250 = $44,687.5
Premium - $0.012 - $0.012 x 31,250 = - $375
Net profit + $0.068 + $0.068 x 31,250 = $2,125

79
 Currency Call Options
Example:
For the seller, since the buyer exercises this call
option so the seller has to provide GBP at the strike
price ($1.35) on the expiration date.
 Net profit from selling this call option is derived
here:
Per unit Per contract
Sell currency + $1.35 + $1.35 x 31,250 = $42,187.5
Purchase currency - $1.43 - $1.43 x 31,250 = - $44,687.5
Premium received + $0.012 + $0.012 x 31,250 = + $375
Net profit - $0.068 - $0.068 x 31,250 = - $2,125

80
 Currency Call Options

Break-Even point from Speculation

• The buyer of a call option will break even when
Selling price = Buying price (strike price)
+ option premium
• The seller of a call option will break even when
Buying price = Selling price (strike price)
+ option premium

81
 Currency Put Options

A currency put option grants the

holder the right, but not the
obligation to sell a specific
currency at a specific price (the
strike price) within a specific
period of time.

82
 Currency Put Options
A firm has a receipt USD from exporting goods. It
establishes to purchase a currency put options at
strike price of 1.45 USD/GBP
On the expiration date, the spot rate fluctuates as
follows:
- The spot rate S(USD/GBP) = 1.5
- The spot rate S(USD/GBP) = 1.45
- The spot rate S(USD/GBP) = 1.3
How will the firm decide? Does it exercise the right
or not?
83
 Currency Put Options

The holder
exercises his right In the money
if spot rate < strike - ITM
price

The holder does

Out of the
not exercise his
Currency money –
right if spot rate >
put OTM
strike price
options
The holder can do At the
or not if spot rate money -
= strike price ATM

84
 Currency Put Options

Factors Affecting Currency Put Option Premiums

Put option premium is influenced by the same
factors as Call option premium
Length of time
Spot price relative Potential variability
before the
to strike price of currency
expiration date
• The higher the • The longer the • The greater the
spot rate relative time to expiration variability of
to the strike date, the higher currency, the
price, the higher the option price higher the option
the option price will be price will be
will be

85
 Currency Put Options

How firm use currency put options

• Firms with open positions in foreign
currencies may use currency put options to
cover those positions.
• They may purchase currency call options
¤ to hedge future receivables;

86
 Currency Put Options

Speculating with currency put options

• Speculators can purchase put options on a
foreign currency that they expect to depreciate.
• They will exercise their options if the spot rate <
the strike price

Profit = Selling price (spot rate) – Buying price

(strike price) – Option premium

87
 Currency Put Options

Speculating with currency put options

• Speculators may also sell put options on a
currency that they expect to appreciate.

Profit = Option premium – Buying price (strike

price) + Selling price (spot rate)

88
 Currency Put Options

Example:
A speculator buys a GBP put option at a strike
price of $1.35
On the expiration date, the current spot rate is
$1.23
Premium for this put option is $0.01 per unit
Call option contract size: $31,250

89
 Currency Put Options
Example:
For the buyer, on the expiration date, the current
spot rate ($1.23) < the strike price ($1.35)
 Speculator purchase currency at the spot rate
then exercises this put option at the strike price to
gain profit
Per unit Per contract
Purchase currency - $1.23 - $1.23 x 31,250 = - $38,437.5
Sell currency + $1.35 + $1.35 x 31,250 = $42,187.5
Premium - $0.01 - $0.01 x 31,250 = - $312.5
Net profit + $0.11 + $0.11 x 31,250 = $3,437.5

90
 Currency Put Options
Example:
For the seller, since the buyer exercises this put
option so the seller has to purchase GBP at the
strike price ($1.35) on the expiration date.
 Net profit from selling this put option is derived
here:
Per unit Per contract
Purchase currency - $1.35 - $1.35 x 31,250 = - $42,187.5
Sell currency + $1.23 - $1.23 x 31,250 = + $38,437.5
Premium received + $0.01 + $0.01 x 31,250 = + $312.5
Net profit - $0.11 - $0.11 x 31,250 = -$3,437.5

91
Contingency Graphs for Currency Options

Long position Short position

– Purchase – Sell

currency currency
call options call options

currency currency
put options put options

92
Contingency Graphs for Currency Options
For long position

93
Contingency Graphs for Currency Options
For short position

94
 Speculative strategies on options

Straddle
• Long straddle: Purchase both a put option and a
call option at the same strike price
• Short straddle: Sell both a put option and a call
option at the same strike price
Strangle
• Long strangle: Purchase both a put option and a
call option at the different strike price.
• Short strangle: Sell both a put option and a call
option at the different strike price

95
Speculative strategies on options

Example for Long Straddle

A speculator purchases both a call and put
option at the strike price X = $1.05/EUR.
Call option premium: C = $0,03/EUR
Put option premium: P = $0,02/EUR
Option contract size is 62.500 EUR

96
 Speculative strategies on options
The strike price X = $1.05/EUR.
Call option premium: C = $0,03/EUR
Put option premium: P = $0,02/EUR
Spot rate EUR/USD on the expiration date

0,95 1,00 1,05 1,10 1,15 1,20

Buy call - 0,03 - 0,03 - 0,03 0,02 0,07 0,12
option

Buy put 0,08 0,03 - 0,02 - 0,02 - 0,02 - 0,02

option

Net 0,05 0,00 - 0,05 0,00 0,05 0,10

profit/unit

97
 Speculative strategies on options

Example for Long Straddle

98
Speculative strategies on options

Example for Long Strangle

A speculator purchases both a call option at
the strike price XC = $1.15/EUR and a put
option at the strike price XP = $1.05/EUR.
Call option premium: C = $0,025/EUR
Put option premium: P = $0,02/EUR
Option contract size is 62.500 EUR

99
 Speculative strategies on options
Call option: XC = $1.15/EUR and premium C = $0,03/EUR
Put option: XP = $1.05/EUR and premium P = $0,02/EUR

Spot rate EUR/USD on the expiration date

0,95 1,00 1,05 1,10 1,15 1,20

Buy call - 0,025 - 0,025 - 0,025 -0,025 -0,025 0,025
option

Buy put 0,08 0,03 - 0,02 - 0,02 - 0,02 - 0,02

option

Net 0,055 0,005 - 0,045 - 0,045 - 0,045 0,005

profit/unit

100
 Speculative strategies on options

Example for Long Straddle

101
 Conditional Currency Options

A basic put option • GBP’s value < $1.70

exercise put option to receive
on GBP at the $1.70 and paid the premium
strike price of $1.70 of $0.02.
and the premium of
$0.02

• GBP’s value < $1.70  exercise put

A conditional put option to receive $1.7 and not to pay the
premium
option on GBP at • $1.70 < GBP’s value < $1.74  do not
the strike price of exercise put option and not to pay the
premium
$1.70, and a trigger • GBP’s value > $1.74  do not exercise
of $1.74. put option but pay the premium $0.04

102
 Conditional Currency Options
Option Type Exercise Price Trigger Premium
basic put $1.70 - $0.02
conditional put $1.70 $1.74 $0.04

$1.78 Basic
Net Amount Received

$1.76 Put
$1.74
Conditional Conditional
$1.72 Put
Put
$1.70
$1.68
$1.66
Spot
Rate
$1.66 $1.70 $1.74 $1.78 $1.82
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 Conditional Currency Options

• Similarly, a conditional call option on GBP

may specify an exercise price of $1.70, and a
trigger of $1.67. The premium will have to be
paid only if the GBP’s value falls below the
trigger value.
• In both cases, the payment of the premium is
avoided conditionally at the cost of a higher
premium.

104