Currency Derivatives

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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 InfoTrac or some other search engine 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.

Answers to End of Chapter Questions

1.Forward versus Futures Contracts. Compare and contrast forward and futures contracts.

ANSWER: Because currency futures contracts are standardized into small amounts, they can be valuable for the speculator or small firm (a commercial bank’s forward contracts are more common for larger amounts).  However, the standardized format of futures forces limited maturities and amounts.

2. Using Currency Futures.

a. How can currency futures be used by corporations?

ANSWER: U.S. corporations that desire to lock in a price at which they can sell a foreign currency would sell currency futures.  U.S. corporations that desire to lock in a price at which they can purchase a foreign currency would purchase currency futures.

b. How can currency futures be used by speculators?

ANSWER: Speculators who expect a currency to appreciate could purchase currency futures contracts for that currency.  Speculators who expect a currency to depreciate could sell currency futures contracts for that currency.

3.Currency Options. Differentiate between a currency call option and a currency put option.

ANSWER: A currency call option provides the right to purchase a specified currency at a specified price within a specified period of time. A currency put option provides the right to sell a specified currency for a specified price within a specified period of time.

4.Forward Premium. Compute the forward discount or premium for the Mexican peso whose 90-day forward rate is $.102 and spot rate is $.10. State whether your answer is a discount or premium.

ANSWER: (F - S) / S
=($.098 - $.10) / $.10 × (360/90)
= –.02, or –2%, which reflects a 8% discount...
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