MultinationalBusinessFinanceSixteenthEditionChapter7ForeignCurrencyDerivatives:FuturesandOptionsCopyright?2022,2019and2016PearsonEducation,Inc.AllRightsReservedLearningObjectives7.1 Explainhowforeigncurrencyfuturesarequoted,valued,andusedforspeculationpurposes7.2 Explorethebuyingandwritingofforeigncurrencyoptionsintermsofriskandreturn7.3 Describehowoptionvaluesarecomposedofintrinsicandtime-basedvalueelements7.4 Examinehowforeigncurrencyoptionvalueschangewithexchangeratemovements,interestratemovements,andotheroptionpricingcomponentsovertimeForeignCurrencyDerivatives(1of2)FinancialmanagementoftheMNEinthe21stcenturyinvolvesfinancialderivatives.Thesederivatives,sonamedbecausetheirvaluesarederivedfromunderlyingassets,areapowerfultoolusedinbusinesstoday.Theseinstrumentscanbeusedfortwoverydistinctmanagementobjectives:Speculation:useofderivativeinstrumentstotakeapositionintheexpectationofaprofitHedging:useofderivativeinstrumentstoreducetherisksassociatedwiththeeverydaymanagementofcorporatecashflowForeignCurrencyDerivatives(2of2)Awordofcautionbeforeproceeding:Financialderivativesarepowerfultoolsinthehandsofcarefulandcompetentfinancialmanagers.Theycanalsobedestructivedeviceswhenusedrecklesslyandcarelessly.ForeignCurrencyFutures(1of2)Aforeigncurrencyfuturescontract

isanalternativetoaforwardcontractthatcallsforfuturedeliveryofastandardamountofforeignexchangeatafixedtime,place,andprice.Itissimilartofuturescontractsthatexistforcommodities,suchascattle,lumber,andsoon.IntheUnitedStates,themostimportantmarketforforeigncurrencyfuturesistheInternationalMonetaryMarket(IMM)oftheChicagoMercantileExchange.ForeignCurrencyFutures(2of2)Contractspecificationsareestablishedbytheexchangeonwhichfuturesaretraded.Majorfeaturesthatarestandardizedare:ContractsizeMethodofstatingexchangeratesMaturitydateLasttradingdayCollateralandmaintenancemarginsSettlementCommissionsUseofaclearinghouseasacounterpartyExhibit7.1providesadescriptionoffuturescontractsfortheMexicanpeso.Exhibit7.1MexicanPeso(CME)—MXN500,000;$perMXNForlongdescription,seeslide38:Appendix1Allcontractsarefor500,000Mexicanpesos.“Open”meanstheopeningpriceontheday.“High”meansthehighpriceontheday.“Low”indicatesthelowestpriceontheday.“Settle”istheclosingpriceontheday.“Change”indicatesthechangeinthesettlepricefromthepreviousday’sclose.“High”and“Low”totherightof“Change”indicatethehighestandlowestpricesthisspecificcontract(asdefinedbyitsmaturity)hasexperiencedoveritstradinghistory.“OpenInterest”indicatesthenumberofcontractsoutstanding.UsingForeignCurrencyFuturesAspeculatorwhobuysafuturescontractislockinginthepriceatwhichshemustbuythatcurrencyonthespecifiedfuturedate.Aspeculatorwhosellsafuturescontractislockinginthepriceatwhichshemustsellthatcurrencyonthatfuturedate.ForeignCurrencyFuturesversusForwardContractsForeigncurrencyfuturescontractsdifferfromforwardcontractsinanumberofimportantways:FuturesarestandardizedintermsofsizewhileforwardscanbecustomizedFutureshavefixedmaturitieswhileforwardscanhaveanymaturity(bothtypicallyhavematuritiesofoneyearorless)TradingonfuturesoccursonorganizedexchangeswhileforwardsaretradedbetweenindividualsandbanksFutureshaveaninitialmarginthatismarkettomarketonadailybasiswhileonlyabankrelationshipisneededforaforwardFuturesarerarelydeliveredupon(settled)whileforwardsarenormallydeliveredupon(settled)ForeignCurrencyOptions

(1of5)Aforeigncurrencyoptionisacontractgivingtheoptionpurchaser(thebuyer)theright,butnottheobligation,tobuyorsellagivenamountofforeignexchangeatafixedpriceperunitforaspecifiedtimeperiod(untilthematuritydate).Therearetwobasictypesofoptions,putsandcalls.Acallisanoptiontobuyforeigncurrency.Aputisanoptiontosellforeigncurrency.Thebuyerofanoptionistermedtheholder,whiletheselleroftheoptionisreferredtoasthewriterorgrantor.ForeignCurrencyOptions(2of5)Everyoptionhasthreedifferentpriceelements:Theexerciseorstrikeprice:theexchangerateatwhichtheforeigncurrencycanbepurchased(call)orsold(put)Thepremium:thecost,price,orvalueoftheoptionTheunderlyingoractualspotexchangerateinthemarketForeignCurrencyOptions(3of5)AnAmerican

optiongivesthebuyertherighttoexercisetheoptionatanytimebetweenthedateofwritingandtheexpirationormaturitydate.AEuropean

optioncanbeexercisedonlyonitsexpirationdate,notbefore.Thepremium,oroptionprice,isthecostoftheoption.ForeignCurrencyOptions(4of5)Anoptionwhoseexercisepriceisthesameasthespotpriceoftheunderlyingcurrencyissaidtobeat-the-money(ATM).Anoptionthatwouldbeprofitable,excludingthecostofthepremium,ifexercisedimmediatelyissaidtobein-the-money(ITM).Anoptionthatwouldnotbeprofitable,againexcludingthecostofthepremium,ifexercisedimmediatelyisreferredtoasout-of-themoney(OTM).ForeignCurrencyOptions(5of5)Inthepastthreedecades,theuseofforeigncurrencyoptionsasahedgingtoolandforspeculativepurposeshasblossomedintoamajorforeignexchangeactivity.Optionsontheover-the-counter(OTC)marketcanbetailoredtothespecificneedsofthefirmbutcanexposethefirmtocounterpartyrisk.Optionsonorganizedexchangesarestandardized,butcounterpartyriskissubstantiallyreduced.Exhibit7.2showsapublishedquotefortheSwissfranc.Exhibit7.2SwissFrancOptionQuotations(U.S.cents/SF)Forlongdescription,seeslide39:Appendix2Eachoption=62,500Swissfrancs.TheAugust,September,andDecemberlistingsaretheoptionmaturitiesorexpirationdates.TableconstructedbyauthorstoillustratehowoptionquotationsareoftenpresentedinTheWallStreetJournal.BuyerofaCallBuyerofanoptiononlyexerciseshis/herrightsiftheoptionisprofitable.Inthecaseofacalloption,asthespotpriceoftheunderlyingcurrencymovesup,theholderhasthepossibilityofunlimitedprofit.Exhibit7.3showsastaticprofitandlossdiagramforthepurchaseofaSwissfranccalloption.Noticehowthepurchasermakesaprofitasthefrancappreciatesvs.thedollarbecausethepurchaserhastherighttopurchasethefrancatapre-specified/lowerpricethanthecurrentspotprice.Exhibit7.3ProfitandLossfortheBuyerofaCallOptionForlongdescription,seeslide40:Appendix3Thebuyerofacalloptionhasunlimitedprofitpotential(inthemoney),andlimitedlosspotential,theamountofthepremium(outofthemoney).OptionMarketSpeculation(1of3)Writerofacall(seeExhibit7.4):Whattheholder,orbuyerofanoptionloses,thewritergainsThemaximumprofitthatthewriterofthecalloptioncanmakeislimitedtothepremiumIfthewriterwrotetheoptionnaked,thatiswithoutowningthecurrency,thewriterwouldnowhavetobuythecurrencyatthespotandtakethelossdeliveringatthestrikepriceTheamountofsuchalossisunlimitedandincreasesastheunderlyingcurrencyrisesEvenifthewriteralreadyownsthecurrency,thewriterwillexperienceanopportunitylossExhibit7.4ProfitandLossfortheWriterofaCallOptionForlongdescription,seeslide41:Appendix4Thewriterofacalloptionhasunlimitedlosspotentialandlimitedprofitpotential,theamountofthepremium.OptionMarketSpeculation(2of3)BuyerofaPut(seeExhibit7.5):ThebasictermsofthisexamplearesimilartothosejustillustratedwiththecallThebuyerofaputoption,however,wantstobeabletoselltheunderlyingcurrencyattheexercisepricewhenthemarketpriceofthatcurrencydrops(notrisesasinthecaseofthecalloption)Ifthespotpricedropsto$0.575/SF,thebuyeroftheputwilldeliverfrancstothewriterandreceive$0.585/SFAtanyexchangerateabovethestrikepriceof58.5,thebuyeroftheputwouldnotexercisetheoption,andwouldloseonlythe$0.05/SFpremiumThebuyerofaput(likethebuyerofthecall)canneverlosemorethanthepremiumpaidupfrontExhibit7.5ProfitandLossfortheBuyerofaPutOptionForlongdescription,seeslide42:Appendix5Thebuyerofaputoptionhasnearlyunlimitedprofitpotential(inthemoney),andlimitedlosspotential,theamountofthepremium(outofthemoney).OptionMarketSpeculation(3of3)Seller(writer)ofaput(seeExhibit7.6):Inthiscase,ifthespotpriceoffrancsdropsbelow58.5centsperfranc,theoptionwillbeexercisedBelowapriceof58.5centsperfranc,thewriterwilllosemorethanthepremiumreceivedfromwritingtheoption(fallingbelowbreak-even)Ifthespotpriceisabove$0.585/SF,theoptionwillnotbeexercisedandtheoptionwriterwillpockettheentirepremiumExhibit7.6ProfitandLossfortheWriterofaPutOptionForlongdescription,seeslide43:Appendix6Thewriterofaputoptionhaslimitedprofitpotential,thepremium,andanunlimitedlosspotential.OptionPricingandValuation(1of2)Thepricingofanycurrencyoptioncombinessixelements:PresentspotrateTimetomaturityForwardrateformatchingmaturityU.S.dollarinterestrateForeigncurrencyinterestrateVolatility(standarddeviationofdailyspotpricemovements)OptionPricingandValuation(2of2)Thetotalvalue(premium)ofanoptionisequaltotheintrinsicvalueplustimevalue.Intrinsicvalueisthefinancialgainiftheoptionisexercisedimmediately.Foracalloption,intrinsicvalueiszerowhenthestrikepriceisabovethemarketpriceWhenthespotpricerisesabovethestrikeprice,theintrinsicvaluebecomespositivePutoptionsbehaveintheoppositemannerOnthedateofmaturity,anoptionwillhaveavalueequaltoitsintrinsicvalue(zerotimeremainingmeanszerotimevalue)Thetimevalueofanoptionexistsbecausethepriceoftheunderlyingcurrency,thespotrate,canpotentiallymovefurtherintothemoneybetweenthepresenttimeandtheoption’sexpirationdate.SeeExhibits7.7and7.8Exhibit7.7OptionIntrinsicValue,TimeValue,andTotalValueForlongdescription,seeslide44:Appendix7Exhibit7.8CallOptionPremiums:IntrinsicValueandTimeValueComponentsStrikeRateLeftparenthesisdollarequals1.00Poundrightparenthesis.SpotRateLeftparenthesisdollarequals1.00Poundrightparenthesis.MoneyCallPremium(U.S.centsperPound)=IntrinsicValue(U.S.centsperPound)+TimeValue(U.S.centsperPound)1.701.75In-the-money(ITM)6.37=5.00+1.371.701.70At-the-money(ATM)3.30=0.00+3.301.701.65Out-of-the-mone(OTM)1.37=0.00+1.37CurrencyOptionPricingSensitivityIfcurrencyoptionsaretobeusedeffectively,eitherforthepurposesofspeculationorriskmanagement,theindividualtraderneedstoknowhowoptionvalues(premiums)reacttotheirvariouscomponents.Sixsensitivities:TheimpactofchangingforwardratesTheimpactofchangingspotratesTheimpactoftimetomaturityTheimpactofchangingvolatilityTheimpactofchanginginterestdifferentialsTheimpactofalternativeoptionstrikepricesForwardRateSensitivityStandardforeigncurrencyoptionsarepricedaroundtheforwardratebecausethecurrentspotrateandboththedomesticandforeigninterestrates(homecurrencyandforeigncurrencyrates)areincludedintheoptionpremiumcalculation.Theforwardrateiscentraltovaluation.Theoption-pricingformulacalculatesasubjectiveprobabilitydistributioncenteredontheforwardrate.SpotRateSensitivity(delta)Ifthecurrentspotratefallsonthesideoftheoption’sstrikeprice—whichwouldinducetheoptionholdertoexercisetheoptionuponexpiration—theoptionalsohasanintrinsicvalue.Thesensitivityoftheoptionpremiumtoasmallchangeinthespotexchangerateiscalledthedelta.Deltavariesbetween+1and0foracalloptionand-1and0foraputoption.Asanoptionmovesfurtherin-the-money,deltarisestoward1.0.Asanoptionmovesfurtherout-of-the-money,deltafallstowardzero.RuleofThumb:Thehigherthedelta(deltasof.7,or.8andupareconsideredhigh)thegreatertheprobabilityoftheoptionexpiringin-the-money.TimetoMaturity:ValueandDeterioration(theta)Optionvaluesincreasewiththelengthoftimetomaturity.Theexpectedchangeintheoptionpremiumfromasmallchangeinthetimetoexpirationistermedtheta.Thetaiscalculatedasthechangeintheoptionpremiumoverthechangeintime.Thetaisbasednotonalinearrelationshipwithtime,butratherthesquarerootoftime.Optionpremiumsdeteriorateatanincreasingrateastheyapproachexpiration.RuleofThumb:Atraderwillnormallyfindlonger-maturityoptionsbettervalues,givingthetradertheabilitytoalteranoptionpositionwithoutsufferingsignificanttimevaluedeterioration.SensitivitytoVolatility(lambda)Optionvolatilityisthestandarddeviationofdailypercentagechangesintheunderlyingexchangerate.Theprimaryproblemwithvolatilityisthatthereisnosinglemethodforitscalculation.Volatilityisviewedthreeways:historic,wherethevolatilityisdrawnfromarecentperiodoftime;forward-looking,wherethehistoricvolatilityisalteredtoreflectexpectationsaboutthefutureperiodoverwhichtheoptionwillexist;andimplied,wherethevolatilityisbackedoutofthemarketpriceoftheoption.SelectedimpliedvolatilitiesforanumberofcurrencypairsarelistedinExhibit7.9.RuleofThumb:Traderswhobelievevolatilitieswillfallsignificantlyinthenear-termwillsell(write)optionsnow,hopingtobuythembackforaprofitimmediatelyaftervolatilitiesfallcausingoptionpremiumstofall.Exhibit7.9ForeignCurrencyImpliedVolatilities(Percent)Currency(cross)Symbol1week1month2month3month6month1year2year3yearEuropeaneuroE

U

R8.17.47.47.47.88.59.09.3JapaneseyenJ

P

Y12.311.411.111.011.011.211.812.7SwissfrancC

H

F8.98.48.48.48.99.59.89.9BritishpoundG

B

P7.77.37.27.17.37.57.98.2CanadiandollarC

A

D6.46.46.36.46.77.17.47.6AustraliandollarA

U

D11.210.710.510.310.410.610.811.0Britishpound/euroG

B

P

E

U

R6.76.46.56.46.87.37.67.8Euro/JapaneseyenE

U

R

J

P

Y11.611.111.211.311.812.613.414.1Note:Theseimpliedvolatilityratesareaveragesofmid-levelratesforbidandask“at-moneyquotations”onselectedcurrenciesat11a.m.onthelastbusinessdayofthemonth,September30,2013.Source:FederalReserveBankofNewYork.SensitivitytoChangingInterestRateDifferentials(rhoandphi)Theexpectedchangeintheoptionpremiumfromasmallchangeinthedomesticinterestrate(homecurrency)istermedrho.Theexpectedchangeintheoptionpremiumfromasmallchangeintheforeigninterestrate(foreigncurrency)istermedphi.RuleofThumb:Atraderwhoispurchasingacalloptiononforeigncurrencyshoulddosobeforethedomesticinterestraterises.Thiswillallowthetradertopurchasetheoptionbeforeitspriceincreases.AlternativeStrikePricesandOptionPremiumsAfirmpurchasinganoptionintheover-the-countermarketmaychooseitsownstrikerate.Optionswithstrikeratesthatarealreadyin-the-moneywillhavebothintrinsicandtimevalueelements.Optionswithstrikeratesthatareout-of-the-moneywillhaveonlyatimevaluecomponent.Exhibit7.10brieflysummarizesthevarious“Greek”elementsandimpactsdiscussedintheprevioussections.Exhibit7.10SummaryofOptionPremiumComponentsGreekDefinitionInterpretationDeltaExpectedchangeintheoptionpremiumforasmallchangeinthespotrateThehigherthedelta,themorelikelytheoptionwillmovein-the-moneyThetaExpectedchangeintheoptionpremiumforasmallchangeintimetoexpirationPremiumsarerelativelyinsensitiveuntilthefinal30orsodaysLambdaExpectedchangeintheoptionpremiumforasmallchangeinvolatilityPremiumsrisewithincreasesinvolatilityRhoExpectedchangeintheoptionpremiumforasmallchangeinthedomesticinterestrateIncreasesindomesticinterestratescauseincreasingcalloptionpremiumsPhiExpectedchangeintheoptionpremiumforasmallchangeintheforeigninterestrateIncreasesinforeigninterestratescausedecreasingcalloptionpremiumsCopyrightThisworkisprotectedbyUnitedStatescopyrightlawsandisprovidedsolelyfortheuseofinstructorsinteachingtheircoursesandassessingstudentlearning.Disseminationorsaleofanypartofthiswork(includingontheWorldWideWeb)willdestroytheintegrityoftheworkandisnotpermitted.Theworkandmaterialsfromitshouldneverbemadeavailabletostudentsexceptbyinstructorsusingtheaccompanyingtextintheirclasses.Allrecipientsofthisworkareexpectedtoabidebytheserestrictionsandtohonortheintendedpedagogicalpurposesandtheneedsofotherinstructorswhorelyonthesematerials.Appendix1LongDescriptionforExhibit7.1Thetablehasninecolumns,fromlefttorightarematurity,open,high,low,settle,change,lifetimehigh,lifetimelow,andopeninterest.Thetablereadsasfollows:Maturity,March:Open,0.10953;High,0.10988;Low,0.1093;Settle,10958;Change,blank;LifetimeHigh,0.11;LifetimeLow,0.0977;andOpenInterest,34481.Maturity,June:Open,0.1079;High,0.10795;Low,0.10778;Settle,1.10773;Change,blank;LifetimeHigh,0.108;LifetimeLow,0.0973;andOpenInterest,3405.Maturity,September:Open,0.10615;High,0.10615;Low,0.1061;Settle,0.10573;Change,blank;LifetimeHigh,0.10615;LifetimeLow,0.0993;andOpenInterest,1481.ReturntopresentationAppendix2LongDescriptionforExhibit7.2Thetableofquotationshaseightcolumnsforthefollowinginformationfromlefttoright:optionandunderlying,strikeprice,callslastAugust,callslastSeptember,callslastDecember,putslastAugust,putslastSeptember,putslastDecember.Thetablereadsasfollows:OptionandUnderlying,58.51;StrikePrice,56;CallslastAugust,notapplicable;CallslastSeptember,notapplicable;CallslastDecember,2.76;PutslastAugust,0.04;PutslastSeptember,0.22;andPutslastDecember,1.16.OptionandUnderlying,58.51;StrikePrice,56.5;CallslastAugust,notapplicable;CallslastSeptember,notapplicable;CallslastDecember,notapplicable;PutslastAugust,0.06;PutslastSeptember,0.3;andPutslastDecember,notapplicable.OptionandUnderlying,58.51;StrikePrice,57;CallslastAugust,1.13;CallslastSeptember,notapplicable;CallslastDecember,1.74;PutslastAugust,0.1;PutslastSeptember,0.38;andPutslastDecember,1.27.OptionandUnderlying,58.51;StrikePrice,57.5;CallslastAugust,0.75;CallslastSeptember,notapplicable;CallslastDecember,notapplicable;PutslastAugust,0.17;PutslastSeptember,0.55;andPutslastDecember,notapplicable.OptionandUnderlying,58.51;StrikePrice,58;CallslastAugust,0.71;CallslastSeptember,1.05;CallslastDecember,1.28;PutslastAugust,0.27;PutslastSeptember,0.89;andPutslastDecember,1.81.OptionandUnderlying,58.51;StrikePrice,58.5;CallslastAugust,0.5;CallslastSeptember,notapplicable;CallslastDecember,notapplicable;PutslastAugust,0.5;PutslastSeptember,0.99;andPutslastDecember,notapplicable.OptionandUnderlying,58.51;StrikePrice,59;CallslastAugust,0.3;CallslastSeptember,0.66;CallslastDecember,1.21;PutslastAugust,0.9;PutslastSeptember,1.36;andPutslastDecember,notapplicable.OptionandUnderlying,58.51;StrikePrice,59.5;CallslastAugust,0.15;CallslastSeptember,0.4;CallslastDecember,notapplicable;PutslastAugust,2.32;PutslastSeptember,notapplicable;andPutslastDecember,notapplicable.OptionandUnderlying,58.51;StrikePrice,60;CallslastAugust,notapplicable;CallslastSeptember,0.31;CallslastDecember,notapplicable;PutslastAugust,2.32;PutslastSeptember,2.62;andPutslastDecember,3.3.ReturntopresentationAppendix3LongDescriptionforExhibit7.3Thegraphofprofitandlossforthebuyerofacallhastwoparts.Thefirstpartextendshorizontallyrightwardfrom(0.555,negative0.005)to(0.585,negative0.005).Foraspotrateunder0.585,thebuyerincursalimitedloss.Thebuyerisoutofthemoney.Thesecondpartofthegraphrisesdiagonallyfrom(0.585,negative0.005)through(0.590,0).Thegraphchangesatthespotrateof0.585.Thisrateisknownasthestrikepriceorstrikerate.Atthestrikeprice,thebuyerisatthemoney.Forspotratesgreaterthan0.585,thegraphrises,indicatingthatthebuyerisinthemoneywithunlimitedpotentialforprofit.Thepointwherethegraphrisesthroughthehorizontalaxisindicatesthespotratethatcorrespondstozeroprofit.Thisrateisknownasthebreakevenrate.Thebreakevenrateequalsstrikepluspremiumequals0.585plus0.005equals0.590.ReturntopresentationAppendix4LongDescriptionforExhibit7.4Thegraphofpro