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UNIT 7 CURRENCY FUTURES, OPTIONS AND SWAPS
Objectives After going through this unit, you should be able to: understand howderivatives serve as financial instruments; and

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understand the meaning and use of currency futures, currency options, and currency swaps.

Structure

7.1 7.

Introduction !urrency "utures

It is worth noting here that derivative instrument s are very important ris4) manageme nt tools. 7owever, they are widely used for speculative purposes as well.

7. .1 7. . 7.$ 7.$.1 7.$. 7.$.$ 7.+ 7.7.. 7.7 7.2 7.1

"eatures of !urrency "utures !omparison #etween "orward and "utures !ontract Important &erms relating to %ptions 'ealing in !urrency %ptions (ut)!all (arity *elationship

!urrency %ptions

!urrency ,waps ,ummary /ey 0ords ,elf) Assessment 1uestions "urther *eadings

INTRODUCTION

'erivative is an instrument that derives its value from another underlying asset or rate. 0ithout the underlying asset, a derivative would have no independent e3istence or value. 'erivative product is created by the introduction of a new security having a relationship with the underlying cash or spot mar4et. &he common derivatives are "utures, %ptions and ,waps. A "utures !ontract is an agreement to ma4e or ta4e delivery of a specified 5uantity at an agreed price on a future date in the underlying mar4et. "utures contracts e3ist in commodities, e5uities, e5uity indices, interest rates and currencies. 0e will discuss specifically currency futures. An %ption is a right but not an obligation to ma4e or ta4e delivery of a specified 5uantity of an underlying asset at an agreed price on a future date. %ption contracts also e3ist, 6ust li4e future contracts, on different underlying assets or rates such as e5uities, currencies and interest rates etc. 0e will discuss currency options in this unit. A ,wap contract represents an e3change of two streams of payments between two parties. &he three derivatives instruments are discussed in this module in sufficient detail.

!urrency "utures, %ptions and swaps

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"oreign 93change :ar4et and *is4 :anagement

And, if not used with caution, they can turn out to be very ris4y investments. It will suffice here to highlight this aspect through the story of what happened to #arings (<!, the oldest merchant ban4 of the =/. &he ban4 was placed under >administration> by the #an4 of 9ngland ?the !entral #an4 of =/@ in "ebruary 188-. &his happened because of the losses that the #arings (<! accumulated through speculation on derivatives e3ceeded its entire e5uity capital of A2.; million. %ne single rougue trader too4 positions on behalf of the ban4 in e3pectation of ma4ing huge profits. &hese positions, ta4en primarily on the Bi44ei - stoc4 inde3 futures being traded on ,ingapore International :onetary 93change ?,I:9C@, were more than A - billion when the mar4et moved against the traderDs speculative e3pectation. As a result, #arings collapsed and was ta4en over by the 'utch ban4ing and insurance company, IBE Eroup. And, the trader was prosecuted for fraudulent trading. &here are other e5ually frightening stories associated with derivative trading. Bevertheless, if used with due care and caution, they serve a useful purpose of ris4 management and price discovery.

7.

CURRENCY FUTURES

A !urrency "utures !ontract is a commitment to either ta4e delivery or give delivery of a certain amount of a foreign currency on a future date at a specified e3change rate. !urrency futures are conceptually similar to currency forward contracts. #ut they differ widely in terms of operational process. "or e3ample, A needs • 1;;; on a date sometime in near future. ,o, instead of buying this amount now and 4eeping it idle, A buys a futures contract maturing around the date when he needs • 1;;;. ,uppose this particular futures contract is 5uoting at *s -. per euro today. %nce A enters into a contract to buy •1;;; at *s -. per euro, he will have to pay neither more nor less than *s -. per euro irrespective of the actual spot rate on the date of delivery of the •1;;;. &he participants on currency futures mar4et may be traders, bro4ers or bro4ers) traders. &raders are speculators who buy and sell to ta4e positions on the mar4et for their own account. #ro4ers do not trade but enable other clients to find buyersFsellers. &hey do so by charging a commission. #ro4er)traders operate for their own account as well as for their clients. #usiness enterprises, operating through their bro4ers, buy or sell currency futures in order to cover or hedge their currency e3posures. &hey are called hedgers for this reason. %n the other hand, speculators ta4e positions in futures mar4et to ma4e profits.

7. .1

Features of Curre c! Futures"

As mentioned above, currency futures are conceptually similar to currency forwards. Get, they are different in terms of their dealing. "ollowing are the characteristic features of the currency futures that distinguish them from forward contracts:

?i@ ,tandardisation, ?ii@ %rganised e3changes, ?iii@ !learing house, ?iv@ Initial and maintenance margin, and ?v@ :ar4ing)to)mar4et process.
!urrency futures are standardised in terms of contract size, maturity date and minimum variation in their value. ,tandardiHation of siHe means that a certain minimum amount would constitute one futures contract in a particular currency. "or e3ample, a pound sterling futures has a siHe of I. -;; on !hicago :ercantile 93change ?!:9@. &his means that one can buy or sell pound sterling futures only as multiples of I. -;;. If an enterprise needs to buy I$;;;;;, it has to enter into a futures contract either to buy I -;;;; ?+ contracts of I. -;; each@ or buy I$1 -;; ?contracts@. 0hile buying or selling futures for hedging purpose an enterprise

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normally either underhedges or overheadges since the hedged amount is rarely an e3act multiple of standard contract siHe. &able 7.1 gives standard siHes of some select currency futures as they are traded on !:9. Tab#e 7$%" Sta &ar& si'es of Curre c! Futures o C(E S$ No$ 1. . $. +: -. .. Curre c! Australian dollar !anadian dollar 9uro Kapanese yen (ound sterling ,wiss franc Co tract Si'e AusA1;;;;; !anA1;;;;; 1 -;;; L1 -;;;;; I. -;; ,"r1. -;;; (i i)u) *ariatio +tic,=, A;.;;;1FAusA ?J=AA1;@ =, A;.;;;1F!anA ?J=,A 1;@ =,A;.;;;1F ?=,A1 .-;@ =,A;.;;;;;1 B?J=,A1 .-;@ =, A;.;;; FI ?J=,A 1 .- ;@ =,A;.;;;1F,"r ?J =,A1 .-;@

dollars. &he difference is A1 . .-; ?JA 11 8$7.-; ) A111.7-@. &he values of tic4s for different currencies are given in &able 7.1.

Source: !:9 &he other feature of standardiHation is maturity dates. %n !hicago :ercantile 93change ?!:9@, most of the currency futures contracts mature on third 0ednesdays of :arch, Kune, ,eptember and 'ecember. Bormally, futures contracts carry a prefi3 by name of the month of their maturity, "or e3ample, we say a :arch yen futures or a :arch euro futures or a Kune sterling futures etc. A :arch yen futures simply means that the futures contract on the currency, yen, will mature in the month of :arch and a Kune sterling futures will mature in the month of Kune. Eenerally, futures contracts are closed through reverse operations. &hat is, sellers buy bac4 or buyers sell bac4 their contracts. In case, the contacts remain open upto the maturity date, they are closed on that day. &he third aspect of standardiHation relates to minimum variation, also called >tic4>. Mariations in dollar prices of future contracts cannot be random; they are multiples of a certain minimum value. "or e3ample, this minimum variation for pound sterling is =,A;.;;; FI. In other words, the value of a pound sterling futures can vary only in terms of A1 .-; ?;.;;; 3 . -;;@. ,o the value of one tic4 is A 1 .-;, ,uppose, at any time, a pound sterling futures is 5uoting at =,A 1,78+;FI.. &his price can change to =,A I.78+ F9 or =, A1.78$2FI or =,A1.78++FI etc but not to =,A1,78+1 or A1.78$8. &he variation has to be necessarily in multiples of=,A;.;;; FI. &hus, if a sterling futures passes from =, A1,2;7; to =,A 1.72.2, the variation in the value of futures contract can be wor4ed out as follows: (rice variation J =,A?1.2;7; ) 1.72.2@ J =,A;.; ; ,o, number of tic4s J =,A;.; ; =,A;.;;; J 1;1

Malue of one tic4 J I. -;; 3 A;.;;; FI J A1 .-; &hus the va iation in the price of the sterling contract J Bumber of tic4s 3 Malue of one tic4 JA1;1 3 1 .-;JA1 . .-; &his is verified by using e3change rates directly. &he contract value passes from . -;; 3 1.2;7; ?or 11 8$7.-;@ dollars to . -;; 3 1.72.2 ?or 111.7-@
r

!urrency "utures, %ptions and swaps

+1

"oreign 93change :ar4et and *is4 :anagement

,ome currency futures e3change have daily price limits, that is, a limit as to how much the settlement price can increase or decrease from the settlement price of the previous day. In operational terms, this means that when the price limit is hit, trading will halt as a new mar4et)clearing e5uilibrium price can not be obtained. If needed, an e3change may e3pand the daily limit until a mar4et)clearing price can be established. &hus, gain or loss of a trader operating on currency futures mar4et can be calculated in two ways. ,uppose a mar4et operator has bought .; 9uro "utures !ontracts when it was trading at A1.1.8-F•. &hese futures are being 5uoted at A1.171-F• when he closes his position. 7is gain is calculated in two ways:

?i@ Bumber of contracts multiplied by the number of tic4s multiplied by the value
of one tic4. 7ere number of contracts: .; Malue of a tic4: A1 .-; ?"rom &able 7.1@ Bumber of tic4s J ?1.171- N 1 .1.8-@ J ; ;.;;;1 ,o the gain J Bumber of futures contracts 3 Bumber of tic4s 3 Malue of one tic4 J A.; 3 ; 3 1 .-; J A1-;;; or

?ii@ Bumber of contracts multiplied by contract siHe multiplied by the price
change. 7ere number of contracts: .; ,iHe of one euro contract: .1 -;;; (rice change: A1.171- ) A1.1.8- J A;.;; ; per euro
,o the gain J A.; 3 1 -;;; 3 ;.;; ; J A1-;;;

"orward contracts are tailor)made or customiHed instruments. 7owever, futures are traded on organised e3changes only. ,ome of these are !hicago :ercantile 93change, (hiladelphia #oard of &rade, <ondon International "inancial "utures 93change ?<I""9@, &o4yo International "inancial "utures 93change ?&I""9@, ,ydney "utures 93change, and ,ingapore International :onetary 93change ?,I:9C@. Molume traded on futures e3changes is smaller than that on forward mar4et. Get, trading in futures has been growing fast. #uying and selling of futures ta4es place li4e other securities on an e3change. %nce the orders and prices are confirmed, this information is sent to the !learinghouse where accounts of buyersFsellers are ad6usted. &he time ta4en on electronic system for confirmation of buyFsell order is 6ust a couple of seconds. &he base currency for prices is =, dollar. &he most traded futures are euro)dollar, yen)dollar and sterling) dollar contracts. 9uro)dollar contract is going to become most dominant one in clays to come. "or futures contracts, only one unified price is 5uoted unli4e forward mar4et where bid)as4 prices with a spread are 5uoted. 1uotations are published in financial 6ournals such as 0all ,treet Kournal. &here are two types of orders given by clients in the mar4et 4nown as limit order and mar4et order. In case of limit order, the bro4er e3ecutes the order when mar4et attains the price specified by the client or better than specified price. %n the other hand, mar4et order is e3ecuted at mar4et price. :ar4et operators pay commission to bro4ers for their services.

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In case of futures contracts, buyers and sellers do not come face)to) face. &hey operate through the clearing house. !learing house is an entity that acts as counterparty to each transaction on futures mar4et. !learing house has the

responsibility of maintaining accounts, margin payments and settlement of deliveries. A clearinghouse serves as the third party to all transactions. &hat is, the buyer of a futures contract effectively buys from the clearinghouse and the seller of a futures contract sells to the clearinghouse. &his ensures that the buyers and sellers of the futures contracts do not have to worry about the creditworthiness of the counterparty. As a result, an active and li5uid secondary mar4et develops. !learing members constitute the clearinghouse. Individual bro4ers, not being members of the clearinghouse deal through a clearing member to settle a customerDs trade. If one party to the futures deal defaults, it is the clearing member who stands in for the defaulting party. ,ubse5uently, he see4s restitution from the defaulter. &he liability of the clearinghouse is limited because futures position is mar4ed)to mar4et daily. In order to be able to operate on futures e3change; it is necessary to ma4e a deposit with the clearing house. &his deposit is 4nown as Initial or Euarantee 'epositF:argin. &his guarantee margin varies from one currency to another depending on its volatility. 7igher the volatility, larger is the margin. "or e3ample, it may be ;;; dollars for more volatile currency and 1-;; dollars for another currency with lower volatility: &he system of margin can be formula)based as well. "or e3ample, it can be e5ual to average daily volatility. &he other term associated with Initial :argin is 4nown as :aintenance margin. &his refers to the amount that has to be maintained all the time. &he balance in the margin account is not allowed to fall below this level. *ise and fall in the margin account happens because of daily changes in the value of futures contract. &he change is calculated on daily basis through the process of mar4ing)to)mar4et. &he latest rate of the day is compared with the latest rate of the previous day. In case there is variation in favour of the operator, his account is credited %n the other hand, if the variation is unfavourable, his account is debited. If the balance in the margin account falls below the maintenance margin the operator is called upon to pay up the variation margin. It must be noted that margin account maintained by the clearing house is never allowed to fall below maintenance margin. :aintenance margin is a figure lower than the initial margin. "or e3ample, an initial margin may be ;;; dollars while maintenance margin may be 1.;; dollars. %r, an initial margin may be 1.-;; dollars while maintenance margin may be 1 ;; dollars etc. &rading on futures e3change is done through mar4ing)to)mar4et process. An operator buying or selling futures contracts ma4es an initial margin deposit. As you have already learnt that this deposit may be a small percentage of the contracted amount of a currency. %n the very first day, closing rate ?settlement rate@ is compared with the buyingFselling rate and depending on the rate :ovement, the margin account of the mar4et operator is either credited or debited. Again on the ne3t day ?day @, the closing rate of day is compared with the closing rate of the previous day ?day I @. Get again, the margin account is debited or credited depending on the rate movement. &his process of comparing the closing rates every day with that of previous day and creditingFdebiting margin accounts is what constitutes mar4ing) to)mar4et. In simple terms, it means that the futures contract is repriced every day at the closing price and the difference from the closing price of the previous day is settled by creditingFdebiting the margin account. 93ample 7.1 e3plains the trading process to enable the reader to understand the steps involved. E.a)/#e 7$% ,uppose, a trader buys a 'ecember euro futures on day I when it was 5uoting at A1.1.; Feuro. 7e made an initial margin deposit of ;;; dollars. &he maintenance margin to be considered for this e3ample is 1.;; dollars.

&able 7. contains all relevant data.

!urrency "utures, %ptions and swaps

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"oreign 93change :ar4et and *is4 :anagement

Tab#e 7$0" Tra&i 1 Process of a Futures Co tract 2ou13t o Da! % +Curre c!" Euro- at 4%$%56078 9Sta &ar& Si'e of a euro futures : 8%0;666< Da! 2u!i 17Se##i 17 Sett#i 1 Rate Co trac t Price A1+-; .; A1+-;;; .; A1++8. .A1++-7.; A1++27.; A1+-;. .A1+-1 .; (ar1i A&just)e t (ar1i Co tributio s +=Wit3&ra>a# +?OA ;;; ;.;; ;.;; A+-; ;.;; ;.;; ;.;; 2a#a ce i (ar1i Accou t A ;;;.;; A187-.;; A18$7.-; A ;;;.;; A $;;.;; A +27.-; A --;.;;

1 buy I settle settle $ settle + settle - settle . sell OA1;;

A1.1.; A1.1.;; A1.1-87 A1.1-.. A1.1-8; A1.1.;A1.1.1;

;.;; )A -.;; )A$7.-; )A$27.-; OA$;;.;; OA127.-; OA. .-;

&he euro futures contract is bought at A1.1.; F• on the day 1. &he price drops from A1.1.; F• to A1.1.;;F• and therefore the buyer is supposed to compensate this drop. As he is bound to buy at A.1.1.; F•, any drop in the price is to be compensated by him and he is compensated for any increase above A 1.1.; F•. In other words, for a buyer of a futures contract, a drop in price results in a loss ?debit in his margin account@ and an increase in price results in a gain ?credit in his margin account@. %n the day 1, the settlement price dropped to A 1.1.;;F•. &hat is, the value of contract is reduced by A -. &his is a loss to the buyer. ,o his margin account is debited, being brought down to A187- from A ;;;. %n the day again, the settlement price goes down and the contract value falls to A1++8. .-;. &he margin account is debited again. %n the day $, the rate falls further such that the contract price is A1++-7-. #y now cumulative loss is A +-;. ,o the margin account comes down to A1--; ?J A ;;; ) A+-;@. #ut this can not be allowed since the maintenance margin is A .1.;;. &herefore, the mar4et operator is called upon to meet the margin variation and to bring the margin account bac4 to A ;;;. &hus he pays A+-; on the day $. It is to be noted that once the margin account falls below maintenance margin, it is to be brought bac4 to the level of initial margin of A ;;; and not simply to the level of maintenance margin of A1.;;. %n day + and -, the settlement prices go up and therefore, the margin account of the mar4et operator gets credited. &he balance in the margin account stands at A $;; on day + and A +27.-; on day -. &he operator is free to withdraw the amounts of A$;; and A127.-; on day + and day - respectively. If he were to do so, his margin account would show A ;;; on these days.
&he operator does not wait till the maturity and closes his futures contract on the day . by selling it at A1.1.1;Feuro. 7e receives A. .-; on the last day. Bow let us see what is the net gain or loss to this operator. 7e had bought the contract at a rate of A1.1.; F• and sold it bac4 at a rate of A1.1.1;F•. Bet gain for him is the difference between the two prices or gain per contract is A1 -;;;3?1.1..1;)1.1.; @JA1;;.

"rom this e3ample, it is clear that for the buyer of futures, there is a gain whenever rate goes up whereas he incurs loss when the rate comes down.

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0e ta4e another e3ample to e3plain the mar4ing)to)mar4et process where a mar4et operator has sold a currency futures.

E.a)/#e 7$0

A m a r 4 e t o p e r a t o r s o l d a : a r c h s t e r l i n g f u t u r e s o n d a y

1 at the rate of A1.2;..FI. 7e deposited the initial margin amount of A ;;;. <et us consider A1-;; to be the maintenance margin. &he operator 4eeps the futures contract live for 1; trading days. %n the tenth day, he closes it by a reverse operation. :ar4ing)to)mar4et process is shown through the data contained in &able 7.$. Tab#e 7$@" Tra&i 1 Process of a Futures Co tract so#& o Da! % +Curre c!" Pou & ster#i 1- at 4%$A6557B 9sta &ar& si'e a /ou & futures" B50;66< Da! +%2u!i 17Se##i 17 Sett#i 1 Rate +01 sell 1 settle settle $ settle + settle - settle . settle 7 settle 2 settle 8 settle 1; buy A1.2;.. A1.2;$. A1.2;1; A1.782; A1.788. A1.2;1+ A1.2;++ A 1.2;.+ A1.2;7 A1.2;7. A1.2;2; Co tra ct Price +@A11 81 . A11 7 -. A11 -. . A11 $7 -. A11 +7 -. A11 -2 7. A11 77 -. A11 8; ;. A11 8;. A11 87 -. A11$;; ;. )A27.-; (ar1i A&just)e t +CA;; A127.-; A1. .-; A127.-; )A1;;.;; )A11 .-; )A127.-; )A1 -.;; )A-;.;; )A -.;; )A -.;; (ar1i Co tributio s +=Wit3&ra>a# +?+;OA ;;; ;.;; ;.;; )-$7.-; ;.;; ;.;; ;.;; O- -.;; ;.;; ;.;; ;.;; 2a#a ce i (ar1i Accou t +5A ;;;.;; A 127.-; A $-;.;; A ;;;.;; A18;;.;; A1727.-; A1.;;.;; A ;;;.;; A18-;.;; A18 -.;; A18;;.;;

As pointed out earlier, for a seller of a futures contract, there is a loss when the price goes up and a gain when it comes down. %n day 1, the settlement price was A1 .2;$.F I, which was lower than the selling price of A1.2;..FI on day 1. ,o the difference of A127.-; is a gain for the operator. 7e could withdraw this amount. #ut he decides against it. &herefore, this amount got credited to his margin account, thus ta4ing the balance to A 127.-;. %n the day also, the settlement rate has come down. ,o, there is a further gain of A1. .-;. As a result, the balance in the margin account becomes A $-;. %n the third day, the settlement rate is A1.782;FI. &he gain of 127.-; ma4es the total gains go up to A-$7.-;. &his time, the operator decides to withdraw the total sum of A-$7.-; and the margin account reduces to A ;;;. "rom the day + onwards, the rate is continuously going up as a result of which there are losses to the operator. %n the days +, - and

. , h e d o e s n o t d e p o s i t m a r g i n v a r i a t i o n a n d l e t s t h e b a l a n c e

reduce to A 1.;;. 7owever, by the day 7, the cumulative loss has become A- -. &his brings down the balance in the margin account to A1+7-. #ut this cannot be allowed since maintenance margin is A1-;;. ,o, the operator is called upon to deposit A- -, thus ta4ing the balance in the margin account bac4 to A ;;;. %n the days 2, 8 and 1;, there are further losses and the margin account comes down to A18;;. &he net loss when the futures contract is closed is A27.-; as shown in the column ?+@ of &able 7.$. &his can be readily verified from the initial selling rate on day 1 and closing rate on day 1;. &he loss wor4s out to A27.-; or A. -;; 3 ?1.2;.. ) 1.2;2;@.

7. .

Co)/ariso 2et>ee For>ar& a & Futures Co tract

As mentioned earlier, forward and futures rates are conceptually similar. #oth reflect the e3pectation of mar4et as to what e3change rate is li4ely to obtain on or around maturity date. &he differences between the two relate basically to the method of trading. &able 7.+ summariHes the ma6or differences.

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"oreign 93change :ar4et and *is4 :anagement

Tab#e 7$C" Co)/ariso 2et>ee For>ar& a & Futures Co tract S$ No$ 1, . $, +. -. .. Feature ,iHe of !ontract 1uotation :aturity <ocation of trading *ates ,ettlement Curre c! for>ar& BegotiatedF&ailor madeFcustomiHed #etween two currencies BegotiatedF&ailor madeFcustomiHed <in4age by telephoneFfa3 Bormally with bid)as4 spread Eenerally delivery of currencies Eenerally in contact with each other *ound the cloc4 Bone Bo such thing Curre c! futures ,tandardiHed Eenerally =,AFcurrency unit ,tandardiHed "utures 93change =nified rates 5uoted on the e3change In a large ma6ority, compensations through a reverse operation 'o not 4now each other. !learing house is the counterparty to each side 'uring mar4et sessions Initial and variation margins EainsFlosses settled everyday

7.

!ounterparties Begotiation hours EuaranteeF:argi n deposit :ar4ing)to) mar4et

2. 8. 1;.

7.$

CURRENCY OPTIONS

A currency option, as the name suggests, gives its holder a right and not an obligation to buy or sell or not to buy or sell a currency at a predetermined rate on or before a specified maturity date. %ptions are traded on the %ver)the)!ounter ?%&!@ mar4et as well as on organised e3changes. P&here are different categories of mar4et operators such as enterprisers ?4nown as hedgers@ who use options to cover their e3posures, ban4s that profit by speculating and arbitrageurs who profit by ta4ing advantage of price distortions on different mar4ets. 9arlier, all currency options were %&! options, written by international ban4s and investment ban4s. %&! options are tailor)made in terms of maturity length, e3ercise price and the amount of underlying currency. &hese contracts may be for as large amounts as more than one million dollar e5uivalent of underlying currency. &hey are available on all ma6or international currencies such as #ritish pound, Kapanese yen, !anadian dollar, ,wiss franc and euro; &hey are also available on some of the less traded currencies. %&! options are generally of 9uropean style. ,tandardised currency option contracts started being traded for the first time in 182 on (hiladelphia ,toc4 93change ?(7<C@. &hese options trade with :arch, Kune, ,eptember and 'ecember e3piration cycle. &hey mature on the "riday before the third 0ednesday of the e3piration month. &able 7.- contains the siHe of the underlying currency per contract. &hey are half the corresponding futures contract. &he volume of %&! currency options trading is much larger than that of e3change option trading, the former being in the range of A1;; billion per day while the latter may be 6ust about A$ to A+ billion per day.

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Tab#e 7$;" Sta &ar& Si'e of t3e O/tio Co tracts Sr$ No$ 1. . $. +. -. .. Curre c! Australian dollar #ritish pound !anadian dollar 9uro Kapanese yen ,wiss franc Sta &ar& Co tract Si'e AusA-;,;;; I$1 -; !anA-;,;;; . ,-;; L., -;,;;; ,"r. ,-;;

!urrency "utures, %ptions and swaps

Source: (7<C, ,tandard !urrency %ptions

7.$.1

I)/orta t Ter)s re#ati 1 to O/tio s

Ca## o/tio " It is the type of option that gives its holder a right to buy a currency at a pre)specified rate on or before the maturity date. Put o/tio " It is the type of option that gives its holder a right to sell a currency at a pre)specified rate on or before the maturity date. Pre)iu)" It is the initial amount that the buyer ?also called the option holder@ of the option pays up)front to the seller ?also called the option writer@ of the option. #y paying this premium, the holder ac5uires a right for himself and by receiving it, the writer ta4es an obligation upon himself to fulfil the right of the holder. Eenerally, it is a small percentage of the amount to be bought or sold under the option. 0e use notation, c, to denote premium on call option and notation, p, to denote premium on put option. E.ercise7Stri,e Price +Rate-" It is the e3change rate at which the holder of a call option can buy and the holder of a put option can sell the currency under the deal, irrespective of the actual spot rate at the time of e3ercise of option. 0e use >C> to denote e3ercise price. (aturit! Date or E./iratio Date" &he date on or up to which an option can be e3ercised. After this date, it becomes defunct and loses its validity. A)erica o/tio " 0hen the option has the possibility of being e3ercised on any date up to maturity, it is called American type. Euro/ea o/tio " 0hen an option has the possibility of being e3ercised only on the maturity date, it is called 9uropean type. *a#ue of a o/tio " An option ?whether call or put@ has either a positive value or Hero value. &his can be e3plained with e3amples. ,uppose a 9uropean call option has an e3ercise price ?C@ of *s --F•. %n the date of maturity, the spot rate ?,&@ may be more than or e5ual to or less than *s --F•.

?a@ Possibi#it! I: ,& J *s -.F•.
In this case; call option will be e3ercised by the holder of the option as he can obtain euros at *s --F• while spot price is higher. 7ere, the call option is said to have a positive value of *e 1 ?*s -. ) *s --@ or ?,,) C@

?b@ Possibi#it! II ,&. *s --F•:
In this scenario, the holder has no specific advantage in buying euro either from spot mar4et or by e3ercising his call option; 7e is indifferent between the two choices. &he value of the option is Hero.

+7

"oreign 93change :ar4et and *is4 :anagement

?c@ Possibi#it! III" ,& J *s -$F.
In this case, the holder of the option will buy euro directly from the spot mar4et by abandoning his call option. 7ere also, the call option has no value or Hero value. ,imilar scenarios can be developed to show the value of a put option.
O/tio ?i ?)o e!" An option is said to be in)money if its immediate e3ercise will give a positive value. ,o a call option is in)money if ,& Q C. &he value of such a call option is ,& ) C. <i4ewise, a put option is in) money if ,&R C. &he value of such a put option is C ) ,&. 7ere ,& means the spot rate at the time of the e3ercise of the option.

O/tio ?at?)o e!" 0hen ,& J C, an option is said to be at)money
%ption)out)of)money: An option is said to be out)of)money when it has no positive value ?4nowing that an option can have either a positive or a Hero value@. ,o a call option is out)of)money if ,&RC and a put option is out)of)money if ,&QC.

Pre)iu) +or Price- of a o/tio " &he mar4et operator may use a thumb rule to decide the premium or price to be paid or charged for an option. It may be a small percentage of the amount of currency transacted. 7owever, it should be noted that this price depends on a number of factors in a rather comple3 way. &hese factors are:

?a@ Ti)e to )aturit!" <onger is the time to maturity, higher is the price of an
option ?whether call or put@. If the maturity is farther in time, it means there is greater uncertainty and possibility of currency rates fluctuating in wider range is more. 7ence the probability of the option being e3ercised increases. ,o the writer would demand higher premium.

?b@ *o#ati#it! of t3e e.c3a 1e rate of u &er#!i 1 curre c!" Ereater volatility
increases the probability of the spot rate going above e3ercise price for call or going below e3ercise price for put. &hat is, the probability of e3ercise of option increases with higher volatility. &herefore, the price of an option ) whether call or put ) would be higher with greater volatility of e3change rate.

?c@ T!/e of o/tio " &ypically an American type option will have greater price since
it gives greater fle3ibility of e3ercise than 9uropean type.

?d@ For>ar& /re)iu) or &iscou t" 0hen a currency is li4ely to harden ?greater
forward premium@, call option on it will have higher price. <i4ewise, when a currency is li4ely to decline ?greater forward discount@, higher will be price of a put option on it.

?e@ I terest rates o curre cies" 7igher interest rate of domestic currency means
lower present value of e3ercise price. ,o lower e3ercise price of a call ma4es it dearer as the probability of its e3ercise increases. %n the other hand, lower e3ercise price lowers the probability of a put being e3ercised. &hus higher domestic interest rate has the effect of increasing the price of call and lowering the price of put. ,imilarly, higher foreign interest rate will reduce the call premium and increase put premium.

?f@ E.ercise Price" &he call price will decrease with higher e3ercise price since its
probability of use will be less. %n the contrary, put premium will decrease with higher e3ercise price since the probability of its use will increase.

+2

Tab#e 7$5 su))ari'es t3e effect of various factors o o/tio /re)iu)$ Tab#e 7$5" I)/act of Differe t Factors o O/tio s Pre)iu) ,. Bo. 1. . $. +. -. .. 7. -. Increase in &ime to maturity Molatility "orward (remium on foreign currency "orward 'iscount on foreign currency 'omestic interest rate "oreign interest rate 93ercise price ,pot rate Impact on call premium Increase Increase Increase 'ecrease Increase 'ecrease 'ecrease Increase Impact on put premium Increase Increase 'ecrease Increase 'ecrease Increase Increase 'ecrease

0e assume that this call option is of 9uropean type. &hat is, it could be e3ercised on the date of maturity. "or different possible values of ,&, profits are calculated as given in &able 7.7.

7.$.

Dea#i 1 i Curre c! o/tio s

In the previous section, you have learnt the basics of options. Bow, we would li4e you to see how they could be used individually or in combined forms to generate gains. 'ifferent ways of using options to ma4e gain are 4nown as option strategies. 'ifferent strategies may be adopted depending on the anticipation of the mar4et with regard to the evolution of e3change rate in future. %ptions are used either in simple form or in a comple3 combination. ,imple profit strategy means that a single call or put is used. %n the other hand, a comple3 profit strategy involves buying and selling of several options with different features simultaneously. ,ome of the option strategies are discussed here.

?A@

A tici/atio of a//reciatio of u &er#!i 1 curre c!"

If a mar4et operator anticipates that the underlying currency is li4ely to appreciate, then he can buy a call option. 93ercise of call option on the maturity date ?9uropean type@ or upto the maturity date ?American type@ may result in a profit. Eain or profit resulting from a call option can be written as in e5uation ?1@. (rofit J Malue ) (remium (rof it whe re J ?,&)C@)c for ,&QC J for ,&RC )c ,& J ,pot rate at the time of e3ercise of the option C J 93ercise or stri4e e3change rate c J (remium paid to ac5uire call option. <et us illustrate this with a numerical e3ample $.$. E.a)/#e 7$@ 0e ta4e the following data: CJ A1.I.F• c J .- centsF•
.

?1.1@ ?1. @

!urrency "utures, %ptions and swaps

+8

"oreign 93change :ar4et and *is4 :anagement

Tab#e 7$7" Profit Profi#e Resu#ti 1 fro) t3e E.ercise of t3e Ca## o/tio S$ No$ l. . $ + .. 7 2 8. 1;. ST 1.1; 1.1 1 1+ 1 11 1. 1.17 1 12 1 ; 1. 1. + Profit for t3e bu!er of ca## o/tio );.; );.; ); ; ); ; ); ; -

);.;1); ;;O; ;1O;.;$O;.;--

It should be noted that as long as spot rate ?,&@ on the day of e3ercise of option is less than A1.1.F•, the option is not e3ercised and is allowed to lapse. &herefore, there is a constant loss ?negative profit@ of A ;.; -, the amount that is paid as the premium for buying the call option. %nly when ,& is greater than A1.1.F•, the option will be e3ercised. "rom the data table, we see the following results:

?i@ "or ,& R A1.1.F•, the option is not e3ercised since euro can be purchased at a
lower rate than C. &he resulting profit is negative which is e5ual to the premium paid i.e. A;.; -F•.

?ii@ At ,&Q A1.1.F•, the option will be e3ercised. ?iii@ #etween A1.1.F• R ,& R A1.12-, a part of loss is recouped. ?iv@ At ,&Q A1.12-, net profit is realiHed.
0e can say, that the buyer of call option will have a ma3imum loss limited to the premium paid but he will have unlimited profit as long as ,& moves in his favour.

&he graphical representation ?profit profile@ for the holder of call option is shown in "igure 7.1.

Note" *everse is the profit profile of the writer ?seller@ of a call option. &his simply means that the profit of the writer of a call option is limited to the amount of premium he received while his losses are unlimited. &he profit profile of the seller ?writer@ of a call option is in "igure 7. , which is nothing but a mirror image of the "igure $.1.

-;

!urrency "utures, %ptions and swaps

+2- A tici/atio of De/reciatio of U &er#!i 1 Curre c!
If a mar4et operator anticipates that underlying currency would depreciate, then he can buy a put option. 93ercise of put option on or before the maturity date may result in a profit for the operator. &he gain resulting from a put option can be as in e5uation ? @.

(rofi t wher e

J ?C ) ,&@ ) p J)p

for ,&R C for ,&Q C

? .1@ ? . @

,& J spot rate at the time of e3ercise of the option C J 93ercise or stri4e e3change rate p J (remium paid to ac5uire the put option

93ample 7.+ illustrates the use of put option: E.a)/#e 7$C

(repare profit profile for the buyer of the put option with the data given below: CJA1.7-FI p J + centsFI
Assuming this put option to be of 9uropean type, it would be e3ercised on its maturity. "or different values of ,&, profits are calculated as given in &able 7.2.

Tab#e 7$A" Profit Profi#e Resu#ti 1 fro) t3e E.ercise of Put O/tio Sr$ No$ ST 1..1..7 1:.8 1.71 1.7 1.71.72 1.2; Profit for t3e 2u!er of Put o/tio ;.;. ;.;+ ;.; ;.;; ) ;.;1 ) ;.;+ ) ;.;+ ) ;.;+

$ + . 7 2

8

1.2

) ;.;+

-1

"oreign 93change :ar4et and *is4 :anagement

"rom the profit figures of &able 7.2, it is clear that the put option is not e3ercised as long as the spot rate is greater than A1.7-FI. In this situation, the option is allowed to lapse, which results into a constant loss ?negative profit@ of A ;.;+FI. &his loss e5uals to the premium paid. %n the other hand, the option would be e3ercised when the spot rate is less than A1.7-. &he following conclusions can be stated:

?i@ "or ,&Q A1.7-FI, the put option is not e3ercised since pound sterling can be sold
at a higher rate than the option e3ercise rate, C. &he result is a net loss ?negative profit@, which is e5ual to the premium paid.

?ii@ At ,& R A1.7-FI, the put option would be e3ercised. ?iii@ #etween A1.7- Q ,&Q A1.71, a part of loss is recouped. ?iv@ At ,& R A1.71FI, net profit is earned.
0e can say that the buyer of put option will have a ma3imum loss limited to the premium paid but he will have unlimited profit so long as , & moves in his favour. &hese profits are limited by the possibility of ,& becoming Hero. &he profit profile of the holder a put option is shown in "igure 7.$.

Bote: *everse is the profit profile of the writer ?seller@ of a put option. &hat is, the profit of the writer of a put option is limited to the amount of premium he received while his loss is unlimited. "igure $.+ presents the profit profile of the writer of a put option which is a mirror image of the "igure $.$.

0e have learnt how a mar4et operator can use simple option strategies, using a single option, to ma4e profits: 7owever, the use of options to ma4e gains can be done in much more comple3 way, by ma4ing different combinations. ,ome possible combinations can be as follows:

?i@ #uying a call and a put simultaneously ?ii@ ,elling a call and a put simultaneously

#uying or selling two options of the same category ?either call or put@ but with different e3ercise prices

!urrency "utures, %ptions and swaps

?iii@ #uying two calls ?puts@ with middle e3ercise price and selling
simultaneously one call ?put@ with lower and another call ?put@ with higher e3ercise price 7ere, we will ta4e an e3ample of buying a call and put simultaneously. &his strategy is 4nown as straddle. 93ample 7.- illustrates this comple3 strategy. E.a)/#e 7$;" 'raw the profit profile of a mar4et operator who has bought a call and a put ?straddle@ with the following features: CcJ CpJ A1.7-;FI c J A;.;;$FI, p J A;.;;8FI (rofit data for different values of ,& are given in &able $.8 and profit profile is given in figure 7.-. Tab#e 7$D" Profit Profi#e >it3 a Stra&&#e +i 47 BST 1.$; 1.$$ 1.$. 1.$2 1.7+; 1.7+1 1.7+ 1.7+$ 1.7++ 1.7+1.7+. 1.7+7 1.7+2 1.7+8 1.7-; 1.7-1 1.71.7-$ 1.7-+ 1.7-. 1.7-8 1.7. 1.7.Eai 7#oss o Ca## ) ;.;;$ ) ;.;;$ ) ;.;;$ ) ;.;;$ ) ;.;;$ ) ;.;;$ ) ;.;;$ ) ;.;;$ ) ;.;;$ ) ;.;;$ ) ;.;;$ ) ;.;;$ ) ;.;;$ ) ;.;;$ ) ;.;;$ ) ;.;; ) ;.;;1 ;.;;; ;.;;1 ;.;;$ ;.;;. ;.;;8 ;.;1 Eai 7Foss o /ut ;.;11 ;.;;2 ;.;;;.;;$ ;.;;1 ;.;;; ) ;.;;1 ) ;.;; ) ;.;;$ ) ;.;;+ ) ;.;;) ;.;;. ) ;.;;7 ) ;.;;2 ) ;.;;8 ) ;.;;8 ) ;.;;8 ) ;.;;8 ) ;.;;8 ) ;.;;8 ) ;.;;8 ) ;.;;8 ) ;.;;8 Net 1ai 7#oss ;.;;2 ;.;;;.;; ;.;;; ) ;.;; ) ;.;;$ ) ;.;;+ ) ;.;;) ;.;;. ) ;.;;7 ) ;.;;2 ) ;.;;8 ) ;.;1; ) ;.; II ) ;.;1 ) ;.;11 ) ;.;1; ) ;.;;8 ) ;.;;2 ) ;.;;. ) ;.;;$ ;.;;; ;.;;$

-$

"oreign 93change :ar4et and *is4 :anagement

7.$.$

Put?Ca## Parit! Re#atio s3i/

0e have already seen how option premia are dependent on several factors, ,o far, we have not said anything regarding the relationship between the premia paid for call and put respectively. Are they independent of each other or does there e3ist a lin4age between the twoS &he answer is that there e3ists a relationship between the two. 0ithout going into the comple3ity of mathematical derivation, it would be worthwhile to 4now the e5uation ma4ing this lin4age. &he e5uation for a 9uropean type of a call or a put option having the same e3ercise price and the same maturity is given by e5uation ?$@. pJcO#hC)#f.,; or p J c O #hTC),tU 0here #h J 1 1Oth.&F$. ; #f J 1 1Otf.&F$. ; ?$. @ , ?$.1@

,

,;: spot rate on the day the option is boughtFsold. ,f, &he forward rate corresponding to the maturity of the option. th. 'omestic ?home@ currency interest rate tf: "oreign currency interest rate &: :aturity period in number of days p, c and C have their usual meaning. &o illustrate this relationship, we ta4e a numerical e3ample. E.a)/#e 7$5 0ith the data as given below, find the call option premium p J A;.;$8FI, C J A1.7+FI $)m forward rate, ,f J A1.7.FI $)m dollar rate th J 2 per cent p.a. 0e use the parity e5uation to find the value of c. &hat is,

( J cO#h TC),f U 1 ;.;$8Jc O 1 O ;.;2 3 8;F$.; T1.7+)1.7.U c J ;.;$8O;.; F1.; J ;.;$8 O ;.;1.8. c J A;.;-2.FI -+ 7.+

CURRENCY SWAPS

,waps are nothing but an e3change of two payment streams. ,waps can be r ar anged either directly between two parties or through a third party li4e a ban4 or a financial

institution. ,wap mar4et has been developing at a fast pace in the last two decades, A currency swap enables the substitution of one debt denominated in one currency at a fi3ed or floating rate to a debt denominated in another currency at a fi3ed or floating rate. It enables both parties to draw benefit from the differences of interest rates e3isting on segmented mar4ets. &hus, currency swaps can be fi3ed)to)fi3ed type as well as fi3ed)to)floating type. "inancial institutions play very important role in swap deals. &hrough swaps, they enable their customers who are generally enterprises to get loans and ma4e deposits in the currency of their ?i.e. customersD@ choice. A financial institution ?"I@ may act as a bro4er or a counterparty or an intermediary. "igures 7.., 7.7 and 7.2 respectively depict the three roles of an "I.

as credit ris4, mar4et ris4 and default ris4. In its role as a counterparty, "l tries to arrange another swap having symmetrical features against another client so as to balance and reduce its own ris4. "or e3ample, an "I having entered into euro )=, dollar fi3ed) to)fi3ed swap with company A will try to find another company # that would li4e to enter into =, dollar) euro fi3ed)to)fi3ed swap, involving the same amount and for the same duration. 0hile acting as an intermediary, the "I plays the role of a counterparty as well as a bro4er at the same time. In a swap deal, an "I may gain about ;.;to ;.1- per cent or - to 1- basis points.

0hen an "I acts as a bro4er only, it is not a counterparty in the deal. It searches for counterparties and facilitates negotiations while preserving the anonymity of counterparties. %n the other hand, when an "I acts as a counterparty, it incurs various ris4s such

&wo enterprises having re5uirements of capital in

two different currencies can enter into a swap deal. 0e, try to understand the process of swap deals through two e3amples, one fi3ed)to)fi3ed and the other fi3ed)to)floating type swap respectively.

!urrency "utures, %ptions and swaps

?A@

Fi.e&?to?fi.e& rate Curre c! S>a/s"

In a fi3ed)to)fi3ed swap, the two parties want to borrow at a fi3ed rate of interest. &he swap deal enables them to get the desired currency at a favourable rate. 93ample 7.7 illustrates a fi3ed)to)fi3ed swap deal.

--

"oreign 93change :ar4et and *is4 :anagement

E.a)/#e 7$7 A 9uropean company, 999, needs =, dollar loan but it is not rated very favourably on dollar loan mar4et. <i4ewise another company, AAA, needs euro loan while it does not have good rating on euro loan mar4et. &he mar4et rates available for the two companies are as follows: EEE 'ollar rate 9uro rate 7 per cent 2.- per cent AAA . per cent Differe ce 1 per cent ?;.-@ per 8 per cent cent Bet difference: 1.- per cent

"rom the rates as listed above, it is clear that the company 999 has relative advantage of ;.- per cent on euro mar4et whereas company AAA has relative advantage of 1 per cent on dollar mar4et. &he net difference is 1.- ?J 1 ) ?);.-@@ per cent. &he two companies can borrow in the currencies of their respective advantages and share the difference of 1.- per cent between them through a swap deal. 7ow is it doneS !ompany 999, which actually needs dollar financing borrows in euro mar4et at 2.per cent. !ompany AAA, which actually needs euro loan borrows in dollar mar4et at . per cent. After borrowing, they e3change their principals. 0hat it means is that company 999 gives to the company AAA the sum borrowed in euros while AAA gives to 999 the e5uivalent dollars. In order to effect this swap, an e3change rate is defined. &he rate can be the average of buying and selling rates or some other realistic rate around this average.
&he two companies also negotiate and decide the interest that each will pay to the other. <et us say it is decided that 999 will pay .. - per cent on dollar amount to AAA and will receive 2.- per cent from AAA on euro amount as shown in "igure 7.8.

&hus, the respective rates of the two companies will wor4 out as follows: Bet rate to be paid by 999 J 2.- per cent paid to the mar4et O .. - per cent paid to AAA) 2.- per cent received from AAA.

J .. - per cent
Bet rate to be paid by AAA J . per cent paid to the mar4et O 2.- per cent paid to

999 ) .. - per cent received from 999 J 2. - per cent.
&his swap deal has ensured two things ?i@ both companies have got the loans in their desired currencies and ?ii@ both companies are paying lower interest rates than they would have paid on borrowing directly from the mar4et in the desired currency. 999 is paying a net interest of .. - per cent instead of 7 per cent, thus saving V per cent <i4ewise, AAA is paying a net rate of 2. - per cent instead of 8 per cent, while saving $Fa per cent. &he two companies have shared e5ually the net difference of 1.per cent between themselves. It is not always necessary that the savings be shared in e5ual proportion. "or e3ample, if the net interest were ..-; per cent for 999 and 2 per cent for AAA, then the savings would be shared in a ratio of 1: . &here can be

-.

any other ratio as well, depending on how the two companies negotiate the deal.

It is to be noted here that this swap deal did not have any intermediary. In case there. had been an intermediary, the gains made in terms of interest rate reduction would have been less for each party simply because a small part of the gains would be shared by the intermediary also. In the end, the principals between the two companies are re)e3changed who, in turn, pay bac4 to the mar4et. &his e3ample illustrates that a swap deal has enabled one company to e3change a debt denominated in euros at a fi3ed rate into another debt, denominated in dollars, at a fi3ed rate and the reverse operation for the other company. It may be noted that a swap deal offers a good deal of fle3ibility in terms of interest rate and maturity date etc.

?#@ Fi.e&?to?f#oati 1 curre c! s>a/
&he steps to be followed in the fi3ed)to)floating rate swap are the same as in fi3edto)fi3ed swap. 7ere the only difference is that one currency has fi3ed rate while the other has floating rate. In the case of fi3ed)to)fi3ed swap discussed above, we did not bring in any intermediary. It was possible for the two companies to go through an intermediary to ma4e the deal. Bow, in the case of fi3ed)to) floating swap, let us assume that the deal is done through an intermediary financial institution. &he problem with the swap deal done directly between two enterprises as illustrated above is that it is very time)consuming and e3pensive to establish. #oth parties have to spend time in searching for a counterparty which needs financial resources e3actly matched by the needs of the other. &he search may be fruitless in the end. ,o the deal can be done 5uic4ly through an intermediary financial institution. 93ample 7.2 illustrates this point. E.a)/#e 7$A

it 2.$ per cent fi3ed rate whereas company AAA will pay a fi3ed ate of 2.+ per cent to the ban4 and receive <I#%* from it. &he net rate paid by each company and profit received by the ban4 can be, wor4ed out as given below. &he swap deal is depicted by "igure 7.1;.

&he 9uropean company, 999, can raise loan at fi3ed rate in 9uropean mar4et but prefers to obtain dollar funding at floating rate. It can do so by entering into a swap deal with another company, AAA, which is better placed on floating rate mar4et but prefers a fi3ed rate euro loan. &he rates available to the two companies are:

"rom the rates, it is obvious that company 999 has relative advantage of ;.- per cent on fi3ed rate mar4et whereas company AAA has a relative advantage of ;.7 per cent on floating rate mar4et. &he net difference of 1. ?;.7 ) ?);.-@@ per cent is available to be shared between the two companies and intermediary ban4. !ompany 999 which actually needs floating dollar rate financing, borrows euros at a fi3ed rate of 2.- per cent. !ompany AAA which actually needs fi3ed rate euro financing borrows dollars at <I#%* O ;.1 per cent. &hen, the two companies enter into swap deal with an intermediary ban4. &he swap contracts stipulate that company 999 will pay floating rate of <I#%* O ;.1 to the ban4 and receive from

!urrency "utures, %ptions and swaps

-7

"oreign 93change :ar4et and *is4 :anagement

Bet rate to be paid by 999 J 2.- per cent paid to mar4et ) 2.$ received from intermediary ban4 O ?<I#%* O ;.1@ per cent paid to intermediary ban4

J ?<I#%* O ;.$@ Bet rate to be paid by AAA J ?<I#%* O ;.1@ per cent paid to mar4et ) <I#%* per cent received from intermediary ban4 O 2.+ per cent paid to intermediary ban4 J 2.- per cent Bet gain of the ban4 J 2.+ per cent received from AAA ) 2.$ per cent paid to 999 O ?<I#%* O ;.1@ per cent received from 999 ) <I#%* per cent paid to AAA J ;. per cent 0e see the savings of 1, per cent have been shared by the three entities: ;.- per cent each by company 999 and company AAA respectively, and ;. per cent by the intermediary. 999 is paying floating rate of <I#%* O ;.$ instead of <I#%* O ;.2 which it would have had to pay without swap deal. <i4ewise, AAA is paying a fi3ed rate of 2.- per cent rather than 8 per cent that it would have been re5uired to pay if it were to borrow euros at fi3ed rate on its own. &he ban4 has earned ;. per cent for its services in the deal.

7.-

SU((ARY

'erivative is an instrument that derives its value from an underlying asset or rate. !ommon derivatives are "utures, %ptions and ,waps: A futures contract is an agreement to ma4e or ta4e delivery of a specified 5uantity of an underlying asset at an agreed price on a future date. "or currency futures, the underlying asset is an amount of foreign currency. An option is a right but not an obligation to ma4e or ta4e delivery of a specified 5uantity of an underlying asset ?for e3ample, an amount of foreign currency@ at an agreed price on a future date. A ,wap contract represents an e3change of two streams of payments between two parties. &he specific features of futures contract consist of ?a@ ,tandardisation in terms of siHe, maturity and variation in the value, ?b@ &rading on organised e3changes, ?c@ !learing house, acting as a counterparty ?d@ Initial and maintenance margin and ?f@ :ar4ing)to)mar4et process. "utures contracts have standard siHes and well)defined maturity dates. A large ma6ority of mar4et participants close their positions on futures through reverse operations before their maturity date arrives, thus avoiding physical delivery of assets. &ic4 is the minimum variation in the price of the underlying asset. <arger variations can be only as multiples of tic4s. "or futures contracts, only one uni5ue price is 5uoted unli4e forwards where price is 5uoted with buy)sell spread. !learing house acts as counterparty to each transaction on futures e3change. !learing house has the responsibility of maintaining accounts, margin payments and settlement of deliveries. 9very operator buying or selling futures has to deposit an initial margin, also 4nown as guarantee deposit. &rading on futures e3change is done through the process of mar4ing)to)mar4et which means that a futures contract is repriced every day at its closing price. %ptions are of two types, 4nown as call and put option respectively. !all option gives its holder a right to buy an asset ?currency@ at a prespecified rate on or before the maturity date. (ut option gives its holder a right to sell an asset ?currency@ at a prespecified rate on or before the maturity date. (remium is the amount that the buyer ?holder@ of an option pays upfront to the seller ?writer@ of the option. &he terms e3ercise price and stri4e price are used synonymously. 93ercise price is the e3change rate at which the holder of a call option can buy and the holder of a put option can sell the currency under the deal. :aturity date is the date up to which or on which an option can be e3ercised. An American type option can he e3ercised on any date up to the maturity date. A 9uropean type option can be

-2

e3ercised only on the maturity date. An option is in)money if its immediate e3ercise will give a positive value. An option is out)of) money if it has no positive value. An option is at)money when spot price is e5ual to stri4e price. (rofit resulting from a call option is given by the following e5uation: (rofit J,&)C)c J)c
for ,& Q C for , & R C

.@ (repa
re a table and a graph of the profit profil e of the buyer of a call optio n with follo wing featur es:

(rofit resulting from a put option is given by the following e5uation: (rofit J C ) ,& ) p for ,& R C J ) p for ,&QC (ut)call parity relationship is given below:

p

J c O #h,.C ) #11.,@@ JcO#h TC) ,f.U

A ,wap is an e3change of two payment streams. A ,wap deal can be either fi3edto)fi3ed or fi3ed)to)floating type.

7..

GEY WORDS

Derivative" A financial instrument that derives its value from an underlying asset or a rate.

Futures" A derivative instrument which entails an agreement to ma4e or ta4e delivery of a specified 5uantity of an underlying asset on a future date at an agreed price. O/tio " A 'erivative instrument giving a right to its holder but not an obligation to buy or sell a specified 5uantity of an underlying asset on or upto a specified future date. Ca## o/tio " An option that gives its holder a right to buy an underlying asset. (ut option: An option that gives its holder a right to sell an underlying asset. S>a/" It is a contract involving an e3change of two streams of payments between two parties.

7.7

SEFF?ASSESS(ENT HUESTIONS

1@ 93plain the meaning of a derivative. @ 93plain with an e3ample mar4ing)to)mar4et process in case of futures trading. $@ 0rite the relationship between premia charged for a call and a put
option respectively.

+@ 'escribe a swap deal with an illustration. -@ A 'ecember yen futures is bought when it was 5uoting at A;.;;28;;Fyen.
&he settling rates on day 1, day , day $, day +, and day - were A;.;;22, A;.;;27, A;.;;2.-, A;.;;2- and A;.;;2+- respectively. %n the day ., the futures contract was closed through a reverse operation when it was 5uoting at A;.;;2+Fyen. 0rite the variation in the contract price and find the net loss or gain when the futures contract was closed on the day .. !onsider the standard siHe of the yen futures to bed L1 .- million.

!urrency "utures, %ptions and swaps

-8

"oreign 93change :ar4et and *is4 :anagement

!urrent spot rate: *s +$FA 93ercise price: *s +$.-;FA !all premium: *s 1. ;FA

7@ 'evelop a swap strategy for two companies I!% and =,!% with the 4nowledge
that I!% wants a floating rate dollar debt while =,!% wants a fi3ed rate rupee debt. Assume your own data. An intermediary ban4 wants to ma4e a gain of ;. per cent for itself to wor4 out a swap deal. "ind the net rates the two companies would pay for their desired borrowings, if they were to benefit e5ually in terms of lower interest rates.

7.2

FURTIER READINES

Apte, (. E. ?188-@, >International "inancial :anagement>, &ata :cEraw)7ill (ublishing !ompany <td, Bew 'elhi, #halla, M. /., WInternational "inancial :anagementX, ,ultan !hand Y !o., Bew 'elhi. Kain, (. /., Kosette (eyrard and ,urendra ,. Gadav ?1882@, International Financial Management, :acmillan India <td., Bew 'elhi. :aurice '. <evi ?188.@, WInternational FinanceX, :cEraw)7ill Inc. ,hapiro, Alan !. ?1888@, WMultinational Financial ManagementX, Kohn 0iley Y ,ons, Inc, Bew Gor4. Gadav, ,urendra ,., (. /. Kain and :a3 (eyrard ? ;;1@, "oreign 93change :ar4ets: =nderstanding 'erivatives and %ther Instruments, :acmillan India <td., Bew 'elhi.

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