Chapter 7 Currency Futures and Options Markets

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CHAPTER 7 CURRENCY FUTURES AND OPTIONS MARKETS
This chapter describes foreign currency futures and options contracts and shows how they can be used to manage foreign exchange risk or take speculative positions on currency movements. It also shows how to read the prices of these contracts as they appear in the financial press.

SUGGESTED ANSWERS TO CHAPTER 7 QUESTIONS
1. On April 1, the spot price of the British pound was $1.86 and the price of the June futures contract was $1.85. During April the pound appreciated, so that by May 1 it was selling for $1.91. What do you think happened to the price of the June pound futures contract during April? Explain.

ANSWER . The price of the June futures contract undoubtedly rose. Here's why. The June futures price is based on the expectations of market participants as to what the spot value of the pound will be at the date of settlement in June. Since the spot value of the pound has risen in during April, the best prediction is that the future level of the pound will also be higher than it was on April 1. This expectation will be undoubtedly be reflected in a June pound futures price that is higher on May 1 than it was on April 1. 2. a. Suppose that Texas Instruments must pay a French supplier FF 10 million in 90 days. Explain how TI can use currency futures to hedge its exchange risk. How many futures contracts will TI need to fully protect itself?

ANSWER. TI can hedge its exchange risk by buying French franc futures contracts whose expiration date is the closest to the date on which it must pay its French supplier. Given a contract size of FF 250,000, TI will need to buy 10,000,000/250,000 = 40 futures contracts to hedge its payable. b. Explain how TI can use currency options to hedge its exchange risk. How many options contracts will TI need to fully protect itself?

ANSWER . TI can hedge its exchange risk by buying franc call options contracts whose expiration date is the closest to the date on which it must pay its French supplier. Given a contract size of FF 250,000, TI will need to buy 10,000,000/250,000 = 40 options contracts to hedge its payable. c. Discuss the advantages and disadvantages of using currency futures versus currency options to hedge TI's exchange risk.

ANSWER . A futures contract is most valuable when the quantity of foreign currency being hedged is known, as in the case here. An option contract is most valuable when the quantity of foreign currency is unknown. Other things being equal, therefore, TI should use futures contracts to hedge its currency risk. However, TI must honor its futures contracts even if the spot rate at settlement is less than the futures price. In contrast, TI can choose not to exercise currency call options if the call price exceeds the spot price. Although this feature is an advantage of currency options, it is fully priced out in the market via the call premium. Hence, options are not unambiguously better than futures. In this case, since the quantity of the future French franc outflow is known, TI should use currency futures to hedge its risk.

CHAPTER 7: CURRENCY FUTURES AND OPTIONS MARKETS 3.

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A forward market already existed, so why was it necessary to establish currency futures and currency options contracts?

ANSWER. A currency futures market arose because private individuals were unable to avail themselves of the forward market. Currency options are partly a response to individuals and firms who would like to eliminate some currency risk while at the same time preserving the possibility of earning a windfall profit from favorable movements in the exchange rate. Options also enable firms bidding on foreign projects to lock in the home currency value of their bid without exposing themselves to currency risk if their bid is rejected. 4. What are the basic differences between forward and futures contracts? Between futures and options contracts?

ANSWER . The basic differences between forward and...
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