Fundamentals of Financial Management

Topics: Futures contract, Option, United States dollar Pages: 28 (10531 words) Published: April 29, 2013
Chapter 5
Currency Derivatives Lecture Outline
Forward Market
How MNCs Can Use Forward Contracts Non-Deliverable Forward Contracts

Currency Futures Market
Contract Specifications Trading Futures Comparison of Currency Futures and Forward Contracts Pricing Currency Futures Credit Risk of Currency Futures Contracts Speculation with Currency Futures How Firms Use Currency Futures Closing Out a Futures Position Transaction Costs of Currency Futures

Currency Call Options
Factors Affecting Call Option Premiums How Firms Use Currency Call Options Speculating with Currency Call Options

Currency Put Options
Factors Affecting Currency Put Option Premiums Hedging with Currency Put Options Speculating with Currency Put Options

Contingency Graphs for Currency Options Conditional Currency Options European Currency Options

Chapter Theme
This chapter provides an overview of currency derivatives, which are sometimes referred to as “speculative.” Yet, firms are increasing their use of these instruments for hedging. The chapter does give speculation some attention, since this is a good way to illustrate the use of a particular instrument based on certain expectations. However, the key is that students have an understanding why firms would consider using these instruments and under what conditions they would use them.

Topics to Stimulate Class Discussion
1. Why would a firm ever consider futures contracts instead of forward contracts? 2. What advantage do currency options offer that are not available with futures or forward contracts? 3. What are some disadvantages of currency option contracts? 4. Why do currency futures prices change over time? 5. Why do currency options prices change over time? 6. Set up several scenarios, and for each scenario, ask students to determine whether it would be better for the firm to purchase (or sell) forward contracts, futures contracts, call option contracts, or put options contracts.

Critical debate: Hedging
Proposition: MNC’s should not protect against currency changes. Investors take into account currency risks and the diversification benefits from investing in companies that conduct international business. But if these companies are going to protect themselves against one of the main sources of diversification, namely currency changes, they are in effect denying investors the opportunity to benefit from such diversification in order to protect their own positions as directors. Opposing view: Companies specialize in certain activities that generally do not include currency speculation. Derivatives enable such companies to specialize in more clearly defined risks. The protection is in any case only short term, no protection is being offered for long term changes in the value of a currency. Derivatives simply avoid distortion to profits caused by unusual changes to currency values. Such currency shocks could lead to abnormal share price movements that might adversely affect individual shareholders who have to sell for personal reasons. With whom do you agree? How should the investment community view business risk? Should shareholders be more aware of the currency risk policy of the company? Are directors protecting their own positions at the expense of the shareholder? Offer your own opinion on this issue.

ANSWER: The mian ppoint is trhat the company should heve a clearly defined foreign exchange rate policy. Annual reports states clearly the general poicy of companies. Often that they do not hedge translation risk as in this example from Renault 2004 Renault does not generally hedge its future operating cash flows in foreign currencies. The operating margin is therefore subject in the future to changes caused by exchange rate fluctuations. In this way, Renault averages out any impacts over a long period, while not assuming the risks inherent in forward currency hedging.

Often an extimate of the impact of a change in the exchange rate on operation profits will also be...
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