CH 7 CURRENCY DERIVATIVES* Financial Products: Primary Products (their values are determined by their own cash flows. Stocks, Bonds, Currencies, etc) vs Derivative Products (forward contracts, futures, options, swaps, insurance products, etc)* Derivatives are effective hedging and speculative tools depending on trader’sposition, taking an open position vs. covering their position of the underlyingprimary products. * CURRENCY FORWARD MARKET: OTC, BUY OR SELL FORWARD*CURRENCY FUTURES: CONTRACTS FOR SPECIFIC QUANTITIES OF GIVENCURRENCIES: THE EXCH RATE IS FIXED AT THE TIME THE CONTRACT ISENTERED INTO. ~ Conceptually the same as currency forward contracts*IMPORTANT DIFFERENCES BETWEEN FORWARD AND FUTURES: 1. OTC vs. Exchange (CME open hours 7:20am to 2pm CST) 2. The futures industry is regulated by the government, while the forward isself-regulated or the banking industry regulations. Futures contracts areStandardized while the forward contracts are customized: A. REGULATION (CFTC vs. SEC) B. PRICE FLUCTUATIONS or daily price limit. When the price limit is hit,trading will halt. C. CONTRACT SIZE D. DELIVERY DATE: the third Wednesday of the expiration month for CME 3. AVAILABLE FOR A FEW MAJOR CURRENCIES 4. TRADERS CHARGE MINIMAL COMMISSIONS for the round-trip. 5. A CLEARING HOUSE: a futures market serves as a clearing house, where allthe orders are collected and cleared. CME, SIMEX, PBOT 6. MARGIN REQUIREMENTS (AVERAGE ABOUT 2% OF THE VALUE OF THEFUTURES CONTRACT) => HIGH LEVERAGE, initial margin, maintenance margin(75% of the initial), and variation margin. - MARGIN: your equity or % of the value of investments financed byequityExample: 100% margin=no borrowing, 60% margin=can borrow up to 40%,stock margin- VARIATION MARGIN: equity amount to be added to the margin account to bring it back to the initial margin (2%). 7. MARKING TO MARKET (DAILY SETTLEMENT): Practice of taking a profit orloss at the end of each trading day to prevent any trader from building up ahuge loss, which cannot be covered. Example: Short (Long) in 3 contracts of December 15th, 2010 SFFutures with an initial margin to meet the 2% requied+$500 (+$300). f1day,10am CST=$.6230/SF, f1day settlement price at 1:45pm CST=.6270, f2daysettlement price at 1:45pm=.6340, f3day settlement price at1:45pm=.6120. See Futures Settlement Excel Exercise on the web. 8. OFFSETTING TRADE (reversing trade): Closing out a futures contractposition by taking an opposite of the initial trading position. * Open Interest =# of outstanding futures contracts yet to be closed out, Zero-sum game = (gain (loss) from a long position = loss (gain) from a shortposition, Total gain from a long position = f3 – f1 10am, Total gain from a shortposition =f1 10am – f3 => Exactly the same as the forward contract for the 3day period. Why then do we need the daily settlement? To prevent anyonebuilding up a (huge) paper loss which cannot be covered. In order for theperson to keep the position with sustained loss, (s)he has to keep adding hiscash (equity).* CURRENCY OPTION: THE RIGHT TO BUY OR TO SELL THE CONTRACTEDCURRENCIES AT THE SPECIFIED PRICES AT THE EXPIRATION DATE.Options? An option gives the owner (holder) the right, no obligations. Since anoption is valuable as it does not do any harm to the holder, while the ownermay benefit from it, you need to pay for it. The price of an option is calledoption premium like insurance premium. An option provides a price (exchangerate) guarantee, either the highest (maximum) purchase price guarantee bysetting the ceiling in case of call options or the lowest (minimum) selling priceguarantee by setting the floor in case of put options. The holder of a call maypossibly enjoy savings by avoiding paying (too) much when the price of theunderlying product (or currency for currency options) rises (sharply). Theholder of a put may be able to sell the product (currency) for a higher price(exchange rate) if the future market price is depressed and falls below theexercise price.Options give the owner two prices to choose from, either the exercise (strike)price (K) or the market price and the holder can choose the price (s)he prefersand either exercises (uses) the option at K or not exercises the option andtransacts (buy or sell) at the market price. If anyone purchases an option for ahedging purpose with the guaranteed price, the owner in fact prefers NOTusing the option to the situation where (s)he needs to use the option. It is like adriver purchases a car insurance policy for a piece of mind, but does not reallywant to run into an accident, even if (s)he gets the insurance protection onlywhen the accident occurs and (s)he might have wasted the insurance premiumwith no accident happens. The protection is given to avoid a disastroussituation and no one would like to be in a disastrous situation in the first place.If you buy an option for a speculative purposes, however, you prefer a situationwhere the option becomes valuable. It is like have a car insurance onsomebody else’s car and you can claim the insurance payment when theperson runs into an accident. You may pray for the accident to happen! HOW DOES IT WORK? Recall the forward contract example in Chap. 3 with anaccount payable of 1 million BPs in 90 days => We need to secure (buy) 1million BPs in 90 days to make the payment. There are 3 alternatives to dothis. 1) Buy today 1 million BPs at So = $1.71/£. You need to spend 1.71 milliondollars TODAY while you don’t need 1 million BPs for a while. You lose intereston 1.71 million dollars (may earn £ interest, however). 2) Buy later. There aretwo ways you can buy 1 million BPs. First, you can buy at S1. In this case, youare exposed to uncertain exchange rates. You may be lucky to have muchlower S1 at $1.6/£ as well as spending money (dollars) in the future. However, you maynot be that lucky as S1 can become $2.0/£. In sum, you are exposed to theexchange rate risk. There is a way to make a purchase of the BPs in the futureand avoid the exchange rate risk. That is either a forward contract or BPfutures contract. 3) Finally, we can consider options.1) What type of an