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Chapter 5
Currency Derivatives
Lecture Outline
Forward Market
How MNCs Use Forward Contracts
Non-Deliverable Forward Contracts
Currency Futures Market
Contract Specifications
Trading Currency Futures
Trading Platforms for Currency Futures
Comparison to Forward Contracts
Pricing Currency Futures
Credit Risk of Currency Futures Contracts
How Firms Use Currency Futures
Closing Out a Futures Position
Speculation with Currency Futures
Currency Options Market
Options Exchanges
Over-the-Counter Market
Currency Call Options
Factors Affecting Call Option Premiums
How Firms Use Currency Call Options
Speculating with Currency Call Options
Currency Put Options
Factors Affecting Currency Put Option Premiums
Hedging with Currency Put Options
Speculating with Currency Put Options
Contingency Graphs for Currency Options
Conditional Currency Options
European Currency OptionsChapter Theme
This chapter provides an overview of currency derivatives, which are sometimes referred to as
“speculative.” Yet, firms are increasing their use of these instruments for hedging purposes. The chapter
does give speculation some attention, since this is a good way to illustrate the use of a particular
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
instrument based on certain expectations. However, the key is that students have an understanding why
firms would consider using these instruments and under what conditions they would use them.
Topics to Stimulate Class Discussion
1. What advantage do currency options offer that are not available with futures or forward contracts?
2. What are some disadvantages of currency option contracts?
3. Why do currency futures prices change over time?
4. Why do currency options prices change over time?
5. Set up several scenarios and for each scenario, ask students to determine whether it would be better
for the firm to purchase (or sell) forward contracts, futures contracts, call option contracts, or put
options contracts.
POINT/COUNTER-POINT:
Should Speculators Use Currency Futures or Options?
POINT: Speculators should use currency futures because they can avoid a substantial premium. To the
extent that they are willing to speculate, they must have confidence in their expectations. If they have
sufficient confidence in their expectations, they should bet on their expectations without having to pay a
large premium to cover themselves if they are wrong. If they do not have confidence in their expectations,
they should not speculate at all.
COUNTER-POINT: Speculators should use currency options to fit the degree of their confidence. For
example, if they are very confident that a currency will appreciate substantially, but want to limit their
investment, they can buy deep out-of-the-money options. These options have a high exercise price but a
low premium, and therefore require a small investment. Alternatively, they can buy options that have a
lower exercise price (higher premium), which will likely generate a greater return if the currency
appreciates. Speculation involves risk. Speculators must recognize that their expectations may be wrong.
While options require a premium, the premium is worthwhile to limit the potential downside risk. Options
enable speculators to select the degree of downside risk that they are willing to tolerate.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
ANSWER: By comparing futures with options, students should recognize the tradeoff that is formed by
the two opposing arguments. The choice of options versus futures may depend on the probability
distribution of future exchange rate movements. Speculators who are confident that the exchange rate will
appreciate, with very little risk of depreciation, may be more willing to buy futures than call options,
because they do not need to insure against depreciation. However, speculators who expect appreciation
but want to cover against possible depreciation may be willing to buy call options so that their downside
risk is limited to what they pay for the call option.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
