Benefits of studying International Finance Country Risk

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					 Benefits of studying International Finance
Knowledge of international finance helps two important ways:
1. Helps financial manager decide how international events
   will affect a firm and steps to be taken to exploit positive
   development and insulate firm against harmful
2. Helps manager to anticipate events and to make profitable
   decisions before the event occurs.
   Events that affect the firm and manager must anticipate
   are; changes in exchange rates, interest rates, inflation rates,
   and asset values.
 Growing importance of International Finance
• Importance of International finance springs from increasing
  importance of international flow of goods and capital.
• Reason for growing importance of international trade due to two
   A liberalization of trade and investment has occurred via
     reductions in tariffs, quotas, currency controls, and other
     impediments to the international flow of goods and capital.
     Much of liberalization has come from the development of free-
     trade areas: EU, NAFTA, ASEAN etc.
   An unprecedented shrinkage of “economic space” has occurred
     via rapid improvements in communication and transportation
     technologies and cost reduction as a result. Eg. Cost of
     telephone calls, cost of international Importance of
     International finance springs from increasing importance of
     international flow of goods and capital.
• Reason for growing importance of international trade due to
  two reasons.
   A liberalization of trade and investment has occurred via
    reductions in tariffs, quotas, currency controls, and other
    impediments to the international flow of goods and
    capital. Much of liberalization has come from the
    development of free-trade areas: EU, NAFTA, ASEAN
   An unprecedented shrinkage of “economic space” has
    occurred via rapid improvements in communication and
    transportation technologies and cost reduction as a result.
    Eg. Cost of telephone calls, cost of international travel
  Rewards of International Trade
 Increased prosperity by allowing nations to specialize in
  producing goods and services at which they are efficient,
  Comparative Advantage
 There are more to successful international trade than
  comparative advantage which is based on productive efficiencies.
  That is due to competitive advantage based on dynamic factors,
  rather than static production possibilities. Eg. Hong Kong’s
  growth with limited resources, French success in wine and
  cheese, German in beer and finely engineered automobiles, British
  in cookies, Italian success in fashion, U.S. in entertainment, in
  part due to presence of consumers in the respective countries
  whose sophisticated tastes have forced firms to produce first-
  class products, and after becoming successful at home, they were
  able to succeed abroad.
  Risk of International Trade
 Rewards accompany risks. Most obvious risk of international trade arises
  from uncertainty about exchange rates. Unexpected changes of exchange
  rates have important impacts on sales, prices, and profits of exporters and
 Country risk. This includes the risk as a result of war, revolution, or other
  political or social events a firm may not be paid for its exports. This applies
  to foreign investments and to credit granted in trade. Some times foreign
  buyers may be willing but unable to pay because their government
  unexpectedly imposes exchange restrictions. Moreover, uncertainty due to
  imposition or change of import tariffs or quotas, subsidies to local
  producers, and non-traiff barriers.
 Practices have evolved to cope with risk. E.g. special types of foreign
  exchange contracts designed hedge or cover some of the risks from
  unexpected changes in exchange rates.
 Export credit insurance schemes established to help country risk and letters
  of credit developed to reduce other risks of trade.
 In nutshell, more rapid growth of international trade versus
  domestic trade and the expanded international focus of investment
  offer adequate reason why it is important to study international
 Exchange risk has risen greatly because exchange rates have become
  increasingly volatile. This has been resulted for example, from
  tension in Middle East or some other politically sensitive parts in
  the world, and at times by news on economic conditions of major
  country. This volatility is measured by using coefficient of
  variation in the exchange rates. Some attribute the increased
  volatility to flexible exchange rate system adopted in 1973.
 In addition to the growth of international trade, investment flow,
  and riskiness of international trade and investment due to country
  risk and increased volatility of exchange rates, increased
  importance of MNCs has boost the importance of international
 International finance is synonymous with exchange rates: a large part
  of the study of international finance involves exchange rates.
 A variety of exchange rate exist
     Bank notes-only a small proportion of overall foreign
      exchange markets.
     Bank draft, checks issued by banks or by corporations
     Buying and selling prices can differ by a large percentage,
      usually more than 5 or 6 percent. Difference is called
        Spot foreign exchange market: involved with the exchange of
         currencies held in different currency denominated bank accounts.
        Spot exchange rate, determined in the spot market, is number of
         units of one currency per unit of another currency in the form of
         bank deposits.
Inter-bank Spot Market
 Inter-bank foreign exchange is the largest financial market
  with a turnover of almost one trillion dollars.
 The foreign exchange market is an informal arrangement of the
  larger commercial banks and a number of foreign exchange
  brokers. They are linked together by telephone, telex, and a
  satellite communications network called Society for Worldwide
  International Financial Telecommunication (SWIFT).
  Computer based communications system based in Brussels,
  Belgium links banks and brokers in every financial centres and
  keep them in almost constant contact 24 hours a day.
 Geographical Distribution of Average Daily Foreign Exchange Turnover
                               April 1992
         Country        Net Turnover, Billion US$     Percentage Share
United Kingdom                    300                       27
United State                      192                       17
Japan                             126                       11
Singapore                          76                        7
Switzerland                        68                        6
Hong Kong                          61                        5
Germany                            57                        5
France                             36                        3
Australia                          30                        3
Other                             185                       16
Total                             1131                      100
 Efficiency of the spot foreign exchange market is reflected in the
  extremely narrow spread between buying and selling prices: can be
  smaller than a tenth of a percent, %, of the value of currency exchanged,
  that is one fiftieth or less of the spread faced on bank notes.
 Most markets including in the US there are two levels on which foreign
  exchange markets operates
    • A direct inter-bank level: banks trade directly with each other and all
      participating banks are market-makers. Banks quote buying and selling price to
      each other, known as an open bid double auction as there is no central location of
      the market and trading is continuous. Direct market characterized as a
      decentralized, continuous, open-bid, double-auction market.
    • An indirect level via brokers: so-called limited-orders are placed with brokers by
      banks. E.g. A commercial bank place an order with a broker to purchase £10
      million at $1.5550/£. The brokers puts order on book and attempts to match the
      purchase order with sell order for pounds from other banks. Market-making banks
      take positions on their own behalves and for customers, brokers deal only for
      other, showing callers their best rates: inside spread, charging a commission to
      both buying and selling banks. Indirect broker-based market can be characterized
      as a quasi-centralized, continuous, limit-book, single-auction market.
Settlement between banks
Bank that purchased foreign currency have to pay the bank that sold the foreign currency.
   The payment generally takes place via a clearing house; an institution at which banks
   keep funds that can be moved from one bank’s account to another’s to settle interbank
   transactions. When foreign exchange is trading against dollar, the clearing house is
   called CHIPS: Clearing House Interbank Payments System, located in New York.
Bank settlement via CHIPS
   CHIPS is a computerized mechanism through which banks hold US $ to pay each
   other when buying or selling foreign exchange. System is owned by large New York
   clearing banks, over 150 members and handled over 150,000 transactions a day, worth
   hundreds of billion of $.
Retail versus Interbank Spot rates
   Exchange rates between interbanks determined in the market. Exchange rates faced by
   the banks’ clients are based on these interbank rates. Clients are charged slightly more
   than the going interbank selling rate: ask rate, pay slightly less than the interbank
   buying rate: bid rate.
Foreign exchange rates can be given two ways.
      Number of US$ per foreign currency unit: U.S. $ equivalent
      Number of units of foreign currency per U.S. $: European terms
          Exchange Rates -Thursday, November 9, 2006
          1 Sri Lanka Rupee = 0.009339 US Dollar - U.S. $. Equivalent
          1 US Dollar (USD) = 107.080 Sri Lanka Rupee (LKR) - European terms
  Direct vs indirect exchange and cross exchange rates
 Compute the exchange rate between the Euro and the British
     Directly
     Indirectly, from the exchange rate between Euro and dollar
       and pound and dollar.
If no costs of transacting in foreign exchange, no bid-ask spread.
 Suppose people want to exchange Euro for pounds or pounds for
 Exchange can be made directly or indirectly via dollar
 If no foreign exchange transaction costs, banks quote a direct
   exchange rate between Euro and pound, exactly equal to implicit
   indirect exchange rate via dollar.
 No transaction costs, find all possible exchange rates via dollar
 With transaction costs, direct exchange rates not always equal to
   implicit indirect exchange rates via dollar.
    Zero foreign exchange transaction costs
 Spot exchange rate between $ and £ : S($/£), the number of
  US$ per British £ in the spot exchange market
 S(i/J): number of units of currency i per unit of currency j in the
  spot exchange market.
 Banks offering Euro for pounds at S(£/€) pound per Euro must
  offer at least as large number of pounds as would be obtained
  via indirect route. S(£/€) S(£/$) . S($/€) Alternatively, from
  Euro to pound, S(€/£) S(€/$) . S($/£)
 Exchange rate S(€/£) is a cross rate: exchange rate directly
  between currencies when neither of two currencies is US $.
 S i j   S i $.S $ j  Since , S $ j   1 S $ j  cross rate can be
  computed as                  S i $
                    S i j  
                                 S  j $
 Calculating cross rate is based on triangular arbitrage. If one
  started with $1, he could not end up with more than $1 or there
  would be an arbitrage profit.
 Nonzero foreign exchange transaction costs
• Cost of transacting, * 1. bid-ask spread, and 2. lump-
  sum fee or commission on each transaction.
• S($/ask£) : price that must be paid to the bank to buy
  one pound with dollar, bank selling rate of pounds.
• S($/bid£) : number of dollars received from the bank
  for sale of pounds for $, bank’s bid rate (buying rate)
  on pounds.
• If no transaction costs, S $ £   S £ $
• With transaction costs, S $ ask£   S £ 1 $ and
    S $ bid £  
                     S £ ask$

                                          1                                    1
• Generally,         S i askj                   and   S i bidj  
                                     S  j bidi                         S  j aski
Forward Foreign Exchange
Forward exchange rate: rate that is contracted today
  for the exchange of currencies at a specified date in
  the future.
   Foreign exchange net turnover by Market Segment- April 1992
     Market Segment Turnover, Billion US. $ Percentage share

     Spot market                      393.7              47
     Forward                          384.4              46
      Outright                         58.5               7
      Swaps                           324.3              39
     Futures                            9.5               1
     Options                           37.7               5
     Total turnover                   832.0             100
Forward Exchange Premium and Discounts
 When required to pay more for forward delivery than for spot
  delivery of a foreign currency, the foreign currency is said to
  be at a forward premium.
 When a foreign currency costs less for forward delivery, it is
  said to be at a forward discount.
 Forward exchange rate: Fn($/£), n-year forward exchange
  rate of dollars to pounds. Generally, Fn(i/j), n-year forward
  exchange rate of currency i to currency j.
  Premium / Discount (£ vs. $) ,  Fn $ £   S $ £  when value is
                                        nS $ £ 
  positive, the pound is at forward premium vis-à-vis dollar. If
  negative, discount.
 When forward rate and spot rate are equal, say forward
  currency is flat.
 Eg: suppose , , and . Compute the forward premium or
  discount for the 90-day and 180-day forward pound.
                                                 1.465  1.4780
• Percentage premium/discount (£ vs. $)                         100  1.286
                                                 (1 / 2) 1.4780
  or ,  1.465  1.4780  365 100  1.286 pound is at a forward
             1.4780       180
  discount 1.286 percent per annum.
• Premium / Discount ($ vs. £)  Fn £ $  S £ $
                                             nS £ $
• Suppose , F1 4 £ $  £0.6791 / $ F1 2 £ $  £0.6810 / $ and
    S £ $  £0.6766 / $
• Compute the forward premium or discount for the 90-day and
  180-day forward dollar.
                                          0.6810  0.6766
• Percentage premium/discount ($ vs. £)                  100  1.301
                                                 (1 / 2)  0.6766
   or ,  0.6810  0.6766  365 100  1.301dollar is at a forward
                0.6766      180
  premium of 1.301 percent per annum.
• More generally, n-year premium/ discount of currency i versus
  currency j is, Premium/discount (i vs. j)  Fn  j i   S  j i 
                                                       nS  j i 
Example: consider the following exchange rates and calculate
premium or discount on forward foreign exchange vis-à-vis
U.S. $ for different forward periods

                       Exchange Rates
                 Thursday, February 17, 1984
 Country               U.S. $ equivalent   Currency per U.S.$
 Britain (Pound) ….           1.4780               .6766
 30-day forward ….            1.4761               .6775
 90-day forward ….            1.4725               .6791
 180-day forward …            1.4685               .6810
The New York foreign exchange selling rates below apply to
trading among banks in amounts of $1million and more, as
quoted at 3 p.m. Eastern time by Bankers Trust Co., Telerate
and other sources. Retail transactions provide fewer units of
foreign currency per dollar.

   Currency         Premium or              Forward Period
                      Discount    30 Days      90 Days   180 Days
Pound Sterling   £ discount        -1.54        -1.49        -1.29
                 U.S. $ premium    +1.60        +1.48        +1.30
  Forward Rates vs. Expected future spot rates
  Assume speculators are risk-neutral, i.e., they do not care
  about risk, and if transaction costs in exchanging currencies
  are ignored, forward exchange rates equal the market’s
  expected future spot rates.
  That is, Fn i j   Sn i j 

 This follows because if market in general expected dollar to be
  trading at €1.30/$ in 1-year’s time and the forward rate for 1
  year were €1.28/$, speculators would buy dollar forward for
  €1.28 and expected to make €0.02 (€1.30 - €1.28) on each
  dollar when $ are sold at €1.30 each.
 This would drive up forward price of dollar until it was no
  longer lower than the expected future spot rate.
 Forward buying of $ continue until Fn (€/$)  Sn (€/$)

 Forward selling of $ continue until Fn(€/$)  Sn (€/$)

 No forward buying or selling takes place if Fn(€/$)  Sn (€/$)
                  Outrights and Swaps
• Outright forward contract: an agreement to exchange currencies at an
  agreed price at a future date
• Swap has two components. Usually a spot transaction and forward
  transaction in the reverse direction, but could involve two forward
  transactions or borrowing one currency and lending another.
• Swap-in Euro: an agreement to buy € spot and sell € forward
• Swap-out Euro: an agreement to sell € spot and buy € forward
• Forward-forward swap: e.g. contract to buy € for 1-month forward and
  sell € for 2-month forward
• Rollover: swap involving purchase and sale are separated by only 1 day
                   Definition of Swap
   A swap is an agreement to buy and sell foreign
   exchange at pre-specified exchange rates where the
   buying and selling are separated in time, or borrowing
   one currency and lending another.
• Swaps – very valuable to those investing and borrowing in foreign currencies.
  E.g. one who invests in a foreign treasury bill can use a spot-forward swap to
  avoid foreign exchange risk. Sell forward foreign currency maturity value of
  the bill and at the same time, buy foreign currency spot to pay for the bill.
  (swap in)
• One who borrows in foreign currency can buy forward foreign currency needed
  for repayment of the loan and at the same time borrow foreign funds on the
  spot market.
• Growing popularity of swaps show value of swaps to international investors
  and borrowers
• Swaps not very useful to importers and exporters, as payments in
  international trade are often delayed
• Swaps popular with banks as it is difficult to avoid risk when making a
  market for many future dates and currencies
• Some dates and currencies, a bank will be long in foreign exchange, agreed to
  purchase more foreign currencies than agreed to sell.
• For other dates and currencies, a bank will be short in foreign exchange,
  agreed to sell more than it has agreed to buy.
• Swaps help Bank to economically reduce risk; if Bank A is long on spot £ and
  short on 30-day forward pounds, will find another Bank B in the opposite
  situation. A will sell £ spot and buy £ forward – a swap out sterling – to
  Bank B. Both banks balance spot-versus-forward position, economizing on
  number of transaction required to achieve the balance.
Forward quotations
    Swap points and outright forwards
   Even forward contract is outright, the convention in the interbank
    market to quote all forward rates in terms of spot rate and number of
    swap points.
   E.g. 180-day forward Canadian rate would conventionally be quoted
                   Spot            180-Day Swap
               1.1401-17                24-28
   Canadian dollars (Can$) per U.S.$: Spot buying rate (bid) Can$1.1401
    and selling rate (ask) Can$1.1417 per U.S.$. Swap points, 24-28 must
    be added or subtracted from spot bid and ask rates. Need to add or
    subtract depends on whether two numbers in the swap points are
    ascending or descending.
   E.g. when swap points are ascending, they are added to spot rates, so
    that implied bid on U.S.$ for 180 days forward:
 Implied ask on U.S.$ for 180 days forward:
 If numbers are reversed, i.e., descending, the point are
 e.g.       Spot                     180-Day Swap
          1.1401-17                       28-24
 Implied bid on U.S.$ for 180 days forward:
 Implied ask on U.S.$ for 180 days forward:
 16 basis points in the spot spread, but implied forward
  spread is 20, larger.
Bid – Ask spreads and Forward Maturity
Wider spreads of implied outright rates with increasing forward
maturities observed in the market
Having larger spreads on longer maturity contracts not due to
that they are riskier to the banks, but due to increasing thinness
of the forward market.
Bids and Asks on Sterling Pounds
                                    U.S. $/£

Type of exchange   Bank Buys Sterling          Bank Sells Sterling    Spread
                        (Bids)                      (Asks)           (Points)
Spot                    1.4780                       1.4785             5
30-day forward          1.4761                       1.4768             7
90-day forward          1.4725                       1.4735            10
180-day forward         1.4685                       1.4700            15
Maturity Dates and Value Dates
• Contracts traded on interbank forward market are mostly
  even dates, 1 month, 6 month and so on
• Value date of an even-dated contract, a 1-month forward is
  the same day in the next month as the value date for a
  currently agreed spot transaction
• E.g. forward contract is written on May 18, a day for spot
  transactions are for value on May 20, the value date for a 1-
  month forward is June 20, value date for a 2- month forward
  is July 20 and so on
• If the future date is not a business day, the value date is
  moved to the next business day
Currency Futures and Options Market
   Futures and options on futures are derivative assets: their
    values derived from underlying asset values. Futures from
    underlying currency, and options on currency futures from
                   underlying futurescontracts.
• Currency futures are standardized contracts that trade like
  conventional commodity futures on the floor of a futures exchange.
• Orders to buy or sell a fixed amount of foreign currency are received by
  brokers or exchange members. Orders are communicated to the floor of
  the futures exchange. At the exchange, long positions are matched with
  short positions.
• Long positions: orders to buy a currency
• Short positions: orders to sell
• The exchange or clearing corporation guarantees two-sided contract,
  contract to buy and contract to sell.
• Willingness to buy and sell moves future prices up and down to
  maintain a balance between number of buy and sell orders. Market
  clearing price is reached in the future exchange.
• Currency futures started trading in the International Money
  Market (IMM) of the Chicago Mercantile Exchange in 1972.
  After that many market opened up including, COMEX
  commodities exchange in New York, Chicago Board of Trade, and
  London International Finance Futures Exchange (LIFFE)
• A market to be made in currency future contracts, it is necessary
  to have only a few value dates. At the Chicago IMM, there are
  four value dates of contracts: third Wednesday in the month of
  March, June, September, and December.
• If contracts are held to maturity, delivery of foreign currency
  occurs 2 business days after contract matures to allow normal 2-
  day delivery of spot currency.
• Contracts are traded in specific sizes - £62,500, Can$ 100,000,
  and so on.
• Selected currencies that are traded with their contract sizes are
  given below
                                                                       Lifetime          Open
          Open       High       Low       Settle    Change      High              Low

                   JAPAN YEN (CME) – 12.5 million yen; $ per yen (.00)
 Mar      .9645      .9680     .9580      .9593     -.0052      .9930         .8700      93,575
June      .9672      .9708     .9616      .9628     -.0053      .9945         .8540       8,404
Sept      .9675      .9695     .9670      .9672     -.0056      .9895         .8942         838
                    BRITISH POUND (CME) – 62500 pds.; $ per pound
 Mar     1.4746     1.4796     1.4720     1.4764    +.0022     1.5550        1.3950      40,094
June     1.4700     1.4738     1.4670     1.4714    +.0024     1.5300        1.4350       2,540
Sept     1.4640     1.4670     1.4630     1.4676    +.0026     1.4950        1.4570         437
                  CANADIAN DOLLAR (CME) – 100,000 dlrs.; $ per Can $
 Mar      .7408      .7484     .7480      .7474     + .0072     .7860         .7394      37,947
June      .7419      .7485     .7419      .7468     + .0072     .7805         .7365       2,829
Sept      .7435      .7460     .7435      .7465     + .0072     .7740         .7330         669
Dec       .7430      .7455     .7430      .7463     +.0072      .7670         .7290         577

       Futures prices are quoted in U.S. dollar equivalent terms. Prices per unit of
       foreign currency, prices of contracts shown above the respective quotations
       are the contract sizes x exchange rates.
Above table shows IMM of Chicago Mercantile Exchange, futures price
   of foreign currencies quoted as U.S. dollar per unit of foreign
   currencies. Forward rates on the other hand except for British
   pounds are quoted in European terms. In the case of Japanese yen,
   the first two digits of the dollar price of yen are omitted. E.g..
   Contract maturing March has a settle price of $0.009593 per
   Japanese yen           .
To convert these per-unit prices into futures contract prices, it is
   necessary to multiply the price in the table by contract amount. E.g.
   Japanese yen contract is for ¥12.5 million. With settle price per yen
   for March delivery of $0.009593, the price of one Japanese yen
   March contract is $0.009593 / ¥  ¥12,500,000  $119,912.5 0
 As with forward exchange contract, if risk neutrality is assumed,
   per-unit price of future equals the market’s expected future spot rate
   of the foreign currency.
 Otherwise, if expected spot rate were above, speculators would buy
   futures, pushing the futures price up to the expected futures spot
   level. If expected spot rate were below the futures price, speculators
   would sell futures until futures price forced back to the expected
   future spot rate.
 Thus, changes in the market’s expected future spot rate drive futures contract
  prices up and down.
 Both buyers and sellers of currency futures post a margin and pay a
  transaction fee.
 Margin is posted in a margin account at a brokerage house, which then posts a
  margin at the clearing corporation of the exchange.
 Clearing corporation then matches each buy order with a sell order. All buy
  and sell orders are guaranteed by clearing corporation.
 Margin must be supplemented by contract holders and brokerage houses if the
  amount in a margin account falls below a certain level: maintenance level.
  IMM required a minimum margin on British pound is currently $2000 per
  contract and its maintenance level is $1500.
 Margin adjustment is done on daily basis called making to market
  Example: suppose on day 1, a British £ June contract is bought at the opening
  price of $1.4700/£, means one contract for £62,500 has a market price of
 $1.4700 / £  £62,500  $91,875. Settle price, price at the end of the day used for
  calculating settlement with the exchange, is $1.4714/£, the market’s expected
  future spot price for June at the end of day 1. At this price, June pound
  contract to buy £62,500 is worth $1.4714 / £  £62,500  $91,962.50
Purchase of £ futures contract has earned the contract buyer
 $91,962.50  $91,875  $87.50 .
Assume this is left in the purchaser’s margin account and added to
$2000 originally placed in the account. Suppose on day 2 the June £
futures rate falls to $1.4640/£. The contract is now worth
  $1.4640 / £  £62,500  $91,500
Compared to the previous settle contract price of $91,962.50, now
there is a loss of $91,500  $91,962.50  $462.50 . When this is adjusted
in the margin account, the total will be $1,625, and margin remains
above the maintenance level of $1500 so nothing needs to be done.
Suppose on day 3, settle price on June £ falls to $1.4600. Contract is
now worth $1.4600 / £  £62,500  $91,250 and the loss is
$91,250  $91,500  $250
This brings margin account to $1,625  $250  $1,375 , below the
maintenance level $1,500. Now the contract buyer is asked to bring
the margin account up to $2,000, requiring at least $625 be deposit in
the buyer’s account. If on day 4 the June futures rate settles at
$1.4750, the contract is worth: $1.4750 / £  £62,500  $92,187.50 .
The gain over the previous settlement of $92,187.50  $91,250  $937.50 .
The margin account becomes $2,937.50 and the contract owner can
either withdraw $937.50 or use it for margin on another future contract.
Assuming that it has been withdrawn, this example can be summarized
      Day     Opening or     Contract Price    Margin          Margin         Margin
              Settle Price                    Adjustment   Contribution (+)   Account
                                                            Withdrawal (-)
  1 Opening    $1.4700/£      $91,875.00          0          +$2,000.00       $2,000.00
  1 Settle     $1.4714/£      $91,962.50       +$87.50            0           $2087.50
  2 Settle     $1.4640/£      $91,500.00      -$462.50            0           $1,625.00
  3 Settle     $1.4600/£      $91,250.00      -$250.00        +$625.00        $2,000.00
  4 Settle     $1.4750/£      $91,187.50      +$937.50        -$937.50        $2,000.00

  As with risk neutrality futures price equals market’s expected future
 spot exchange rate, futures can be considered as daily bets on the value
 of expected future spot exchange rate, where bets are settled each day.
  When buyer’s margin account is adjusted up, seller’s account is
 adjusted down by the same amount.
   Futures contract versus Forward contracts
 There is a daily settlement of bets on futures. Therefore, a futures contract
  is equivalent to entering a forward contract each day and settling each
  forward contract before opening another one, where forwards and futures
  are for the same future delivery date.
 Forward market no formal and universal arrangement for settling up as
  expected future spot rate and consequent forward contract value move up
  and down.
 No formal and universal margin requirement
 In case of inter-bank transactions and transactions with large corporate
  clients, banks require no margin, make no adjustment for day-to-day
  movements in exchange rates, and simply wait to settle up at the
  originally contracted rate.
 Procedure for maintaining the margin on a forward contract depends on
  the bank’s relationship with the customer. Margin may be called on
  customers without credit line (facilities), requiring supplementary funds to
  be deposited in the margin account if a large, unfavourable movement in
  the exchange rate occurs.
 In deciding whether to call for supplementing of margin accounts, usually
  banks consider possibility of their customers honouring forward contracts.
• When banks calling margin, they are very flexible about what
  they will accept as margin, stocks, bonds and other instruments.
• With forward contracts, no opportunity cost of margin
  requirements, but an opportunity cost with future contracts,
  specially when contract prices have fallen, and substantial cash
  payments consequently been made into margin account.
• Unlike the case of forward contract, when buyer of a futures
  contract wants to take delivery of foreign currency, it is bought at
  going spot exchange rate at the time of delivery.
• E.g. suppose a future contract buyer needs British £ in August
  and buys a September pound futures contract. August, when
  pounds are needed, the contract is sold back to the exchange, and
  £ are bought on the spot exchange market at whatever exchange
  rate exists on the day in August when the pounds are wanted.
• Most of the foreign exchange risk is still removed here, because if
  £ has unexpectedly increase in value from the time of buying
  future contract, there will be a gain in the margin account.
 The amount in the margin account or amount paid to
  maintain it depends on the entire path of the futures price
  from initial purchase, and on interest rate earned in the
  account or interest forgone on cash contribution to the
 The risk as a result of variability of interest rate called
  marking-to-market risk, and this makes futures riskier than
  forward contracts.
 Problem with using futures contracts to reduce foreign
  exchange risk: contract size unlikely to match to a firm’s
  needs. E.g. if a firm needs £50,000, the closest is to buy one
  £62,500 contract. But forward contract with banks can be
  taken for any desired amount.
 Flexibility in values of forward contracts and in margin
  maintenance, absence of marking-to-market risk, makes
  forward contract preferable to futures especially for
  importers, exporters, borrowers and lenders who wish to
  precisely hedge foreign exchange risk and exposure.
 Currency futures are more likely to preferred by speculators
  because gains on futures contract can be taken as cash and
  transaction costs are small.
 With forward contracts, necessary to buy an off-setting contract
  for same maturity to lock in a profit and wait for maturity before
  settling the contract and taking gain.
 Open interest indicates the extent to which futures are used to
  speculate rather than to hedge. It refers to number of
  outstanding two-sided contracts at any given time.
                        Currency Option

 Forward and currency futures contracts must be honoured by
  both parties. No option allowing a party to settle only if it is
  to that party’s advantage.
 Unlike forward and futures contracts, currency options give
  buyer the opportunity, but not the obligation, to buy or sell
  at a pre-agreed price – strike price or exercise price – in the
 Allows buyer who purchases options, the option or right
  either to trade at the rate or price stated in the contract, if it
  is to the advantage of the option’s buyer or if not, to let the
  option expire, if that would be better. Thus, options have a
  throwaway feature.
 Exchange- Traded Options
 Futures Options Vs Spot Options
 At IMM in Chicago currency options are options on currency futures.
  Give buyers the right but not the obligation to buy or sell currency futures
  contracts at a pre-agreed price.
 Value of Options on futures         prices of underlying futures
  expected future spot value of the currency. Therefore, indirectly, value of
  options on futures derives from the expected future spot value of the
 Currency options also traded on Philadelphia Exchange, but spot
  currency. Give buyer the right to buy or sell the currency at a pre-agreed
  price. Therefore, options on spot currency derive value directly from
  expected future spot value of the currency, not indirectly via the price of
 All currency options derive their value from movements in the underlying
 Lets focus on direct linkage involving spot option contract, but also
  applies to futures options, as they approach maturity become more like
  spot options.
Characteristics of Spot currency options
 Options traded on the same currencies as in futures
 Size of contracts – half of those of currency futures, help expand
  those who can afford to trade in option, while allowing options to
  use in conjunction with futures.
 European Options: exercise only on the maturity date of the
  option (European Style)
 American Options: majority of options are American options.
  Offer buyers more flexibility, can be exercised on any date up to
  and including the maturity date of the option.
 Expiry months for options – March, June, September, and
  December plus one or two near-term months.
 Call option – gives buyer the right to buy foreign currency at the
  strike price or exchange rate on the option
 Put option – gives buyer the right to sell foreign currency at the
  strike price
                   PHILADELPHIA EXCHANGE
                             Calls                 Puts
                      Vol.           Last   Vol.          Last
German Mark
62,500 German Marks – European Style
   56       Jun        …              …      25           0.53
   57       Mar        …              …      25           0.09
  57 ½      Mar        …              …     765           0.13
   58       Mar        …              …     600           0.26
  58 ½      Mar       100            0.37    …             …
   59       Mar       556            0.31    …             …
  59 ½      Mar       110            0.19    …             …
  60 ½      Mar        60            0.05    …             …
Note going spot price of the German Mark is 58.60 U.S.
 cents, the exchange rate is $0.5860/DM. on the spot market.
 From the table we see the European style options on 62,500
 marks, strike price ranges from 56 U.S. cents per mark to 60
 ½ cents per mark.
Meaning of “58 Mar” option for which 600 contracts and
 last trading price of put option of 0.26 U.S cents per mark.
 This European put option gives buyers the right to sell the
 mark at 58 U.S. cents. The price of the option, 0.26 U.S.
 cents per mark means: for the contract of 62,500 German
 marks the option buyer must pay . By paying $162.50, the
 option buyer acquires the right to sell 62,500 marks for 58
 U.S. cents ($0.58) each at the expiry date of the option, the
 Friday before the third Wednesday of March. Since option is
 European style and valid only for the expiry date.
Option will not be exercised if spot rate of mark on the expiry
 date is above $0.58, because better to sell marks spot.
If spot rate is below $0.58, the option has value, as it gives
 holder the right to receive $0.58 per mark, more than its
 market value.
Option writer: person selling the put option, who receive
 $162.50 from the sale of the option. Actually, instead of
 exercising the option, buyer is likely to accept the difference
 between exercise price and the going spot rate from the option
Consider the following table, “58 Mar” option. It does not
 say “European style”, the options are American options. They
 can be exercised on any date prior to maturity. We notice
 there 6038 call options, and 31 put options at strike price of
 58 ½ U.S. cents per mark, an exchange rate of $0.5850/DM.
                                       Calls                 Puts
                              Vol.             Last   Vol.          Last
German Mark
62,500 German Marks – cents per unit.
56           Mar                       40      2.75     …            …
56           Apr                        5      2.36   1030          0.18
56           Jun                       …        …      150          0.49
56 ½         Apr                       …        …      46           0.22
57           Mar                       31      1.76     …            …
57           Jun                        5      1.95   1209          0.78
57 ½         Mar                      100      1.07    160          0.13
57 ½         Apr                       …        …      360          0.48
58           Mar                      207      0.85    32           0.26
58           Apr                       …        …     1027          0.71
58           Jun                       18      1.57    27           1.15
58 ½         Mar                     6038      0.60    31           0.39
58 ½         Apr                       …        …      360          0.89
59           Mar                      406      0.36    28           0.66
59           Apr                      913      0.71     …            …
59 ½         Mar                      296      0.20     …            …
59 ½         Apr                       32      0.51     …            …
60           Mar                      130      0.11     …            …
60           Apr                      546      0.40     …            …
60           Jun                        2      0.78     …            …
60 ½         Apr                       …        …       5           2.24
61           Apr                     1350      0.18     …            …
61           Jun                     5900      0.39     …            …
Call option costs 0.60 U.S. cents or $0.0060 per mark. Call
 option contract costs . Buyer acquires right to buy
 DM62,500 for $0.5850 per mark up to the expiry date in
 March for $375.
If mark is above $0.5850 on the spot market, option will be
 exercised on or before expiry or its value will be collected from
 the option writer or another buyer.
If the spot value is below $0.5850, not exercise the option
 and thrown away, loss is $375. Can be thought of as an
 insurance premium for which unfavourable events do not
 occur, and insurance simply expires.
In the Money: Call option that gives buyer the right to buy
 currency at a strike exchange rate below the spot exchange
 rate. Put option that gives buyer the right to sell currency
 when strike exchange rate is higher than the spot exchange
Out of the Money: Call option with a strike price above the
 spot exchange rate. Put option with a strike price below the
 spot exchange rate.
Intrinsic Value: is extent to which an option is in the money.
 Intrinsic value is how many cents per currency would be
 gained by exercising the option immediately. Call options
 have intrinsic value when the strike price is below the spot
 rate, and put options have intrinsic value when the strike
 price exceeds the spot rate.
Option Premium: amount paid for the option on each unit of
 foreign currency. Option premium consists of two parts:
 intrinsic value and time value.
Time value: possibility of having a higher intrinsic value in
 future than at the moment.
At the money: strike price exactly equals the spot rate. Option
 premium is only option time value.
Determinants of the Market Values of Currency Options:
Factors influencing the price of an option:

   Intrinsic value
   Volatility of the spot or futures exchange rate
   Length of period to expiration
   American or European option type
   Interest rate on currency of purchase
   Forward premium/discount or interest differential
   Forwards, Futures, and Options compared
                          Forward Contracts            Currency Futures                       Currency Options

Delivery discretion   None                      None                              Buyer’s discretion. Seller must honour if
                                                                                       buyer exercises.
Maturity date         Any date                  Third Wednesday of March,         Friday before third Wednesday of March,
                                                     June,      September,   or        June, September, or December on
Maximum length        Several years                  December                          regular options. Last Friday of month
                                                12 months                              on end-of-month (EOM) options.
Contracted amount     Any value                 £62,500, Can$ 100,000 etc.        9 months
                                                Can sell via exchange             £31,250, Can$ 50,000 etc.
Secondary market      Must offset with bank     Formal fixed sum per contract,    Can sell via exchange
                                                     e.g. $2,000. Daily marking   No margin for buyer who pays for
Margin requirement    Informal; often line of        to market.                        contract. Seller posts 130% of
                           credit or 5-10% on   Outright                               premium plus lump sum varying with
                           account              Futures clearing corporation           intrinsic value.
Contract variety      Swap or outright          Primarily speculators.            Outright
                                                                                  Options clearing corporation.
Guarantor             None                                                        Hedgers and speculators

Major users           Primarily hedgers

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