End-of-Chapter Question Solutions 1 ____________________________________________________________
CHAPTER 5: FOREIGN CURRENCY DERIVATIVES
1. Options versus Futures. Explain the difference between foreign currency options and futures and when either might be most appropriately used. An option is a contract giving the buyer the right but not the obligation to buy or sell a given amount of foreign exchange at a fixed price for a specified time period. A future is an exchange-traded contract calling for future delivery of a standard amount of foreign currency at a fixed time, place, and price. The essence of the difference is that an option leaves the buyer with the choice of exercising or not exercising. The future requires a mandatory delivery. The future is a standardized exchange-traded contract often used as an alternative to a forward foreign exchange agreement. 2. Trading location for futures. Check the Wall Street Journal to find where in the United States foreign exchange future contracts are traded. The Wall Street Journal reports on foreign exchange futures trading for the International Monetary Market in Chicago and for the Philadelphia Stock Exchange. These are the two major U.S. markets for foreign exchange futures. 3. Futures terminology. Explain the meaning and probable significance for international business of the following contract specifications: Specific-sized contract: Trading may be conducted only in pre-established multiples of currency units. This means that a firm wishing to hedge some aspect of its foreign exchange risk is not able to match the contract size with the size of the risk. Standard method of stating exchange rates. Rates are stated in “American terms,” meaning the U.S. dollar value of the foreign currency, rather than in the more generally accepted “European terms,” meaning the foreign currency price of a U.S. dollar. This has no conceptual significance, although financial managers used to viewing exposure in European terms will find it necessary to convert to reciprocals. Standard maturity date. All contracts mature at a pre-established date, being on the third Wednesday of eight specified months. This means that a firm wishing to use foreign exchange futures to cover exchange risk will not be able to match the contract maturity with the risk maturity. Collateral and maintenance margins. An initial “margin,” meaning a cash deposit made at the time a futures contract is purchased, is required. This is an inconvenience to most firms doing international business because it means some of their cash is tied up in a non-productive manner. Forward contracts made through banks for existing business clients do not normally require an initial margin. A maintenance margin is also required, meaning that if the value of the contract is marked to market every day and if the existing margin on deposit falls below a mandatory percentage of the contract, additional margin must be deposited. This constitutes a big nuisance to a business firm because it must be prepared for a daily outflow of cash than cannot be anticipated. (Of course, on some days the cash flow would be in to the firm.) Counterparty. All futures contracts are with the clearing house of the exchange where they are traded. Consequently a firm or individual engaged in buying or selling futures contracts need not worry about the credit risk of the opposite party.
2 End-of-Chapter Question Solutions ____________________________________________________________
________________________________ 4. A futures trade. A newspaper shows the following prices for the previous day’s trading in U.S. dollar-euro currency futures: This data reports that 29,763 contracts, each contract being for €125,000, were traded for settlement on the third Wednesday of the following December . The total euro value of all contracts traded on the day for which data is reported is the product of the two numbers: 29,763 ×...
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