Lecture - Currency derivatives. After completing this chapter, students will be able to: To explain how forward contracts are used for hedging based on anticipated exchange rate movements; and to explain how currency futures contracts and currency options contracts are used for hedging or speculation based on anticipated exchange rate movements. | Currency Derivatives 6 Lecture Chapter Objectives To explain how forward contracts are used for hedging based on anticipated exchange rate movements; and To explain how currency futures contracts and currency options contracts are used for hedging or speculation based on anticipated exchange rate movements. Forward Market A forward contract is an agreement between a firm and a commercial bank to exchange a specified amount of a currency at a specified exchange rate (called the forward rate) on a specified date in the future. Forward contracts are often valued at $1 million or more, and are not normally used by consumers or small firms. Forward Market When MNCs anticipate a future need for or future receipt of a foreign currency, they can set up forward contracts to lock in the exchange rate. The % by which the forward rate (F ) exceeds the spot rate (S ) at a given point in time is called the forward premium (p ). F = S (1 + p ) F exhibits a discount when p < 0. Forward Market Example | Currency Derivatives 6 Lecture Chapter Objectives To explain how forward contracts are used for hedging based on anticipated exchange rate movements; and To explain how currency futures contracts and currency options contracts are used for hedging or speculation based on anticipated exchange rate movements. Forward Market A forward contract is an agreement between a firm and a commercial bank to exchange a specified amount of a currency at a specified exchange rate (called the forward rate) on a specified date in the future. Forward contracts are often valued at $1 million or more, and are not normally used by consumers or small firms. Forward Market When MNCs anticipate a future need for or future receipt of a foreign currency, they can set up forward contracts to lock in the exchange rate. The % by which the forward rate (F ) exceeds the spot rate (S ) at a given point in time is called the forward premium (p ). F = S (1 + p ) F exhibits a discount when p < 0. Forward Market Example S = $£, 90-day F = $£ annualized p = F – S 360 S n = – 360 = –.95% 90 The forward premium (discount) usually reflects the difference between the home and foreign interest rates, thus preventing arbitrage. Forward Market A swap transaction involves a spot transaction along with a corresponding forward contract that will reverse the spot transaction. A non-deliverable forward contract (NDF) does not result in an actual exchange of currencies. Instead, one party makes a net payment to the other based on a market exchange rate on the day of settlement. Forward Market An NDF can effectively hedge future foreign currency payments or receipts: Expect need for 100M Chilean pesos. Negotiate an NDF to buy 100M Chilean pesos on Jul 1. Reference index (closing rate quoted by Chile’s central bank) = $.0020/peso. April 1 Buy 100M Chilean pesos from market. July 1 Index = $.0023/peso receive $30,000 from bank due to NDF. Index = $.0018/peso pay $20,000 to bank.
