CURRENCY DERIVATIVES

There are two times in a mans life when he should not speculate: when he cant afford it and
when he can Mark Twain.
Chapter Learning Objectives:
To explain the forward and future market and their advantages and disadvantages.
To explain the differences between currency forwards and futures.
To describe the broad features and types of a currency options contract.
To evaluate the gains and losses of the option traders.
To discuss the Black-Scholes options pricing model and the factors influencing it.
To examine how hedgers and speculators operate in currency derivative market.
To explain currency swapping and the financial benefits derived from it.
What is a Financial Derivative?
A derivative is a financial instrument that derives or gets it value from an underlying asset like a
currency or a stock. It is in its most basic form simply a contract between two parties to
exchange value based on the action of a real good or service. Typically, the seller receives money
in exchange for an agreement to purchase or sell some good or service at some specified future
date.
The largest appeal of derivatives is that they offer some degree of leverage. Leverage is a
financial term that refers to the multiplication that happens when a small amount of money is
used to control an item of much larger value.
Derivatives offer some sort of leverage which for a small amount of money; the investor can
control a much larger value of an underlying asset. This can work both ways, though. If the
investor purchasing the derivative is correct, then more money can be made than if the
investment had been made directly into the underlying asset itself. However, if the investor is
wrong, the losses are multiplied instead and the buyer will lose the premiums for options and for
futures and forwards the losses could be much higher. Basically, financial derivatives are used
like an insurance to minimize the risk exposure but could also be used for speculative purpose
given the unbelievable amount of money could be made if an investor is correct in purchasing
the derivatives. There are derivatives available in stocks, bonds, currencies and commodities
along with some money market instruments like interest rates. Here in this chapter, we will
discuss only the currency derivatives.
CURRENCY FORWARD CONTRACT:
A currency forward contract is an agreement to purchase one currency and sell another for some
date beyond two business days. A forward contract involves no fee, and no cash changes hands
until the settlement date of the forward. A forward allows one to lock in an exchange rate today
for a future payment or receipt, thereby eliminating rate risk.
Forward contracts are tailor made to the needs of the parties who may be banks in case of
financial assets and trader or processor in case of commodities. Forward markets have flourished
as a means to reduce price uncertainty.
The advantages of a currency forward contract:
 It can be used to hedge or protect oneself from the price fluctuations on the future
commitment date to extent of 100%.
It is not applicable to pay upfront fees or margins to forward contracts and hence no initial
costs.
The disadvantages of a currency forward contract:
Forward contracts are not performance guaranteed. Hence involve counter party risk. The
investor cannot derive any gain from favorable price movements either before or on delivery
date.
Forward contracts are not traded in the secondary market; hence there is no ready liquidity.
Banks being one of the counter parties enter into reverse transactions to square positions and
hence charge huge bid-ask spread.
A currency forward contract locks one investor to a particular exchange rate, thereby insulating
him or her from exchange rate fluctuations. Even in some developing countries like India, the
forward contract has been the most popular instrument employed by corporate to cover their
exposures, and, thereby offsetting a known future cash outflow. Forward contracts are usually
available only for periods up to 12 months. Forward premiums are governed purely by demand
and supply, which provide corporate with arbitrage opportunities. The premiums in this market
are quoted till the last working day of the month.
Internationally, the forward premiums, or discounts, reflect the prevailing interest rate
differentials. Arbitrage opportunities are, therefore, limited. As a rule, a currency with a higher
interest rate trades at a discount to a currency with a lower interest rate. Since there is a forward
market available for longer periods, the forward cover for foreign exchange exposures can
stretch up to five years. The premiums, or discounts, are quoted on a month-to-month basis. That
is, from the spot date to exactly one month, or three months, or even a year.
How is this forward exchange rate calculated? It cannot depend solely on the exchange rate one
year from now because that is not known. What is known is the spot price, or the exchange rate,
today, but a forward price cannot simply equal the spot price, because money can be safely
invested to earn interest, and, thus, the future value of money is greater than its present value.
What seems reasonable is that if the current exchange rate of a quote currency with respect to a
base currency equalizes the present value of the currencies, then the forward exchange rate
should equalize the future value of the quote currency and the future value of the base currency,
otherwise, an arbitrage opportunity arises.
Calculating the Forward Exchange Rate
The future value of a currency is the present value of the currency plus the interest that it earns
over time in the country of issue. Using simple annualized interest, this can be represented as:
Future Value of Currency (FV)
t
FV=P (1+r) FV = Future Value of Currency
P = Principal
r = interest rate per year
t= number of years
For example, if the interest rate in the United States is 5%, then the future value of a dollar after
one year would be $1.05.
If the forward exchange rate equalizes the future values of the base and quote currency, then this
can represented in this equation:
Forward Exchange Rate x Future Value of Base Currency = Spot Price x Future Value of
Quote Currency. Dividing both sides by the future value of the base currency yields the
following:
Forward Exchange Rate = Spot Price x Future value of Quote currency
Future value of base currency
t
S (1+rq)
=
(1+rb)t
Here, S = Spot Price
rq = Interest Rate of Quote Currency
rb = Interest Rate of Base Currency
t = Number of Compounding Periods

Example Calculating the Forward Exchange Rate

If the spot price is 84 BDT/USD, then this means that 1 USD can be exchanged for 84 BDT
today. If the interest rate in Bangladesh is 11.5%, and the interest rate in the United States is
2.5%, then after one year, 1 dollar earning United States interest will be worth $1.025 and 84
BDT earning in Bangladesh with an interest rate of 11.5% will be worth 93.66 BDT. Thus, the
forward spot rate one year from now is equal to 93.66/1.025 or 91.375 BDT, using the above
equation.
84(1+0.115)1
U.S.D Forward Exchange Rate = = 91.375 BDT
(1+0.025)1
Thus, the forward exchange rate after 1 year, which is often expressed simply as the forward
rate, is 91.375 BDT per USD. Compared to the spot rate, Forward rate is usually trading at either
a Forward Discount (currency is expected to depreciate) or Forward Premium (currency is
expected to appreciate).
Note: S (BDT/US$) = Spot rate
F1 (BDT/US$), F3 ($/BDT), F6 ($/BDT) are 1, 3, and 6 month forward rates.
FORWARD QUOTATION:
Forward rates can be expressed in two ways: - Commercial customers are usually quoted the
actual price, otherwise known as the outright rate. In the interbank market, however, dealers
quote the forward rate only as a discount from or a premium on, the spot rate. This forward
differential is known as the swap rate.
CURRENCY FORWARD PREMIUM/DISCOUNT: [(F - S) / S] x (360/n) x 100
A foreign currency is at a forward discount if the forward rate expressed in dollars (home
currency) is below the spot rate; whereas forward premium exists if the forward rate is above the
spot rate. Hence, forward premium is the situation when the forward rate is greater than the spot
rate and forward discount is the situation when the forward rate is less than the spot rate. A
premium or discount is simply the amount by which the forward rate differs from the spot rate
and the size of the premium or discount depends on the difference in interest rates between the
two currencies. Whether the forward rate is weaker or stronger than the spot rate depends on
which currency has the higher and which has the lower interest rate. The currency with the lower
interest rate is always stronger forward than spot against the currency with the higher interest
rate.
Forward quotations may also be expressed as the percentage per annum deviation from the spot
rate. This method of quotations facilitates comparing premiums or discounts in forward market
with interest rate differentials. The percentage premiums or discount depends on which currency
is the home or base. When the home currency price for a foreign currency is used (direct quote),
the formula for the percent premium or discount is:
= (forward rate spot rate) x 360 x 100
Spot rate n
Example: If the spot rate of BDT against USD is 84 and 6 months forward rate is 88 then USD
forward annual premium rate is = [(88 84) /84] x 100 x 360/180= 9.52%.
Conversion of Swap Rates into Outright Rate:
A swap rate can be converted into an outright rate by adding the premium (in points) to or
subtracting the discounts (in points) from the spot rate. Although the swap rates do not carry plus
or minus signs, you can determine whether the forward rate is at a discount or premium using the
following rule:
When the forward bid in points is smaller than offer rate in points, the forward rate is at Rules for
calculating forward rate from spot rate -
Subtract a premium from the spot rate
Add a discount to the spot rate.
Example: The spot U.S dollar rate per GBP is 1.4690 1.4700. The dollar is quoted one month
forward as follows: 1 month 20 25 pm. The dollar is quoted forward in this example at a
premium (pm). A discount is indicated by dis.
The size of the premium is quoted in points. The US dollar/GBP rate is quoted to 4 decimal
places, and so a point is 0.0001. The premium is therefore 0.00200.0025.
Bid Ask
Spot rate 1.4690 1.4700
Subtract premium 0.0020 0.0025
Forward rate 1.4670 1.4675
Problem 6.1: Calculate the 30-day, 90-day, and 180-day forward discounts for the British
pound.
Solution: Here are the relevant rates for the pound:
Spot: 1 = $1.6220
30-day forward: 1 = $1.6180
90-day forward: 1 = $1.6086
180-day forward: 1 = $1.5949
 The 30-day forward discount is: [($1.6180 $1.6220)/$1.6220] x 12 x 100 = 2.959%
The 90-day forward discount is: [($1.6086 - $1.6220)/$1.6220] x 4 x 100 = -3.305%
The 180-day forward discount is: [($1.5949- $1.6220)/$1.6220] x 2 x 100 = -3.342%
In this case, the forward discounts at these maturities are not very small, indicating that British
interest rates are higher than U.S interest rates.
Problem 6.2: Suppose the spot and 90 day forward rates for the Indian Rupees (INR) are traded
at 1.58 BDT and 1.52 BDT, respectively. What is the forward premium or discount on the INR?
Solution: The forward premium (discount) on the INR is
[(F S)/S] x (360/n) x 100 = [(1.52 1.58)/1.58 x 4 x 100= 15.19%,
This is an annual forward discount of 15.19% of INR against BDT.
Problem 6.3: Suppose Credit Suisse quotes spot and 90-day forward rates of $0.7957-60, 8-13.
a. What are the outright 90-day forward rates that Credit Suisse is quoting?
Solution: The outright forwards are: bid rate = $0.7965 (0.7957 + 0.0008) and ask rate =
$0.7973 (0.7960 + 0.0013).
b. What is the forward discount or premium associated with buying 90-day Swiss francs?
Solution: The annualized forward premium = [(0.7973 - 0.7960)/0.7960]x 4x100= 0.65%.
c. Compute the percentage bid-ask spreads on spot and forward Swiss francs.
Solution: The bid-ask spread is calculated as follows:
Ask price - Bid price
Percent spread = x 100
Ask price
Substituting in the numbers yields a spot bid-ask spread of (0.7960 - 0.7957)/0.7960 = 0.04%.
The corresponding forward bid-ask spread is (0.7973 - 0.7965)/0.7973 = 0.10%.
Problem 6.4: From the data given below, let us calculate forward premium or discount, as it is
applicable in the case:

INR per British Pound Bid Ask

Spot Rate =>INR78.0001 INR78.2254

1 month
=>INR78.4256 INR78.5200
forward rate
3 months
=>INR77.8952 INR77.9999
forward rate
6 months
=>INR78.8925 INR78.9925
forward rate
Solution: Premium with respect to Bid price:

1 month = (78.4256 78.0001) x 12 x 100

78.0001 1

= 6.55% per annum

6 months = (78.8925 78.0001) x 12 x 100

 78.0001 6

= 2.29% per annum.

Premium with respect to Ask Price:

1 month = (78.5200 78.2254) x 12 x 100

78.2254 1

= 4.52% per annum.

6 months = (78.9925 78.2254) x 12 x 100

78.2254 6

= 1.96% per annum.

Please note that Spot rates are higher than the forward rates in the case of 3 months forward
contract. Hence, forward rates are at a discount.

Discount with respect to Bid Price:

3 months = = (77.895278.0001) x 12 x 100
78.0001 3

= .537% per annum.

Discount with respect to Ask Price:
3 months = = (77.999978.2254) x 12 x 100
78.2254 3

= 1.153% per annum.

Two groups of participants for Forward/Futures Markets:
Forward/future currency contracts have two broad uses: speculating and hedging. An investor
who is speculating in the currency market is called a speculator and an investor who is with the
mindset of hedging to minimize his/her currency risk exposure is called a hedger.
Speculators They take pure speculative position on currency rates, gambling on exchange
rates. A speculator should go long if he/she expects future S 6 > F6, go short if he/she expects
future S6 < F6. Pure speculators are more likely to use currency futures to take a straight,
directional view on future exchange rates in major currency pairs. This is because the exchange-
traded futures market allows positions to be highly leveraged and the standardized contracts
(price, size, maturity) create the liquidity to allow speculators to trade contracts before their
expiry date.
The limited number of currency pairs available, and their standard size and limited settlement
dates are factors which all contribute to the liquidity of futures contracts and make them
attractive to speculators. However, these are the very qualities that make currency futures
unattractive to clients wishing to hedge a precise currency exposure.
Hedgers Investors/companies who are exposed to currency risk could hedge a desired currency
to minimize their currency risk exposure. Hedging allows Multinational companies to control
and manage revenues and payments. Forward/future FX is the product of choice for currency
hedgers. These hedgers fall into three broad categories.
1. Corporate and retail clients with underlying business reasons to use FX are typically risk
averse. They like the comfort of a fixed future revenue stream from international transactions.
For example, when a BD exporter will receive USD in 60 days time, the future value of that
USD in terms of BDT can be fixed now by entering into a forward FX deal with a bank to sell it
USD for BDT in 60 days time at a pre-agreed rate.
2. International portfolio managers may also use forward FX for much the same reasonto secure
the value of future investment returns (e.g. foreign currency denominated bond coupon
payments.
3. Banks also do use forward FX contracts mainly for liquidity management. They combine a
forward FX trade with a spot FX trade to create a two-leg deal called an FX swap which we will
learn in the later part of this chapter.
Example of a Speculative Forward Position:
If you find a 6 months forward quote of F6 (BDT/$) =88, but you believe the then spot (S 6) will
probably not be exactly 88 BDT, but you can lock in now to buy or sell at 88 BDT. If you firmly
believe S6 will be > 88 BDT, you go LONG, buy BDT forward, and lock in at 88, expecting S
>88 in 6 months. Hopefully, you buy at F6 = 88 (guaranteed rate) and sell at S6 > 88 in 6 months,
make profit of (S6 - 88). After 6 months if the BDT is exchanged for 90 against 1 USD, then the
speculator will make 2 BDT per USD.
If you believe S6 < 88 BDT, you go SHORT, sell BDT forward, and lock in to sell at 88, if S 6 <
88, you can buy spot at < 88, say it is trading at 86 BDT after six months and sell forward at 88,
and make 2 BDT profit per USD.
So, if a Bangladeshi trader thinks that after six months the then spot rate would be less than the
expected forward rate of 88 BDT (the S6 < F6; 88 BDT), so takes a SHORT position, sells
US$100000 (one hundred thousand dollars) equivalent to BDT 8800000 forward in 6 months
against the US$, based on belief that USD would depreciate against the BDT. In that case, the S 6
would be <88 BDT and the speculator should take a short position. If S 6 < F6, trader will make
money. For example, if S6 = 86 BDT, trader can buy BDT spot at 86 and sell BDT forward at 88,
make money: 88 86 = 2 BDT per dollar. So by investing 8800000 BDT the speculator will
make 200000 BDT profit or 2 BDT profit per 88 BDT or $1. If trader is wrong and S 6 > F6, then
he/she will lose money. If S 6 =88.75 then he/she has to buy at 88.75 and sell at 88; for a loss of
75 paisa per USD, incurring a loss of 75000 BDT with his/her 8.8 million BDT investment.
[Note: We have assumed a forward/future contract size of $100000 here.]
Forward Exchange Market in Bangladesh
Forward exchange transactions both outright and swaps constitute an important element in
the developed financial market. Unfortunately in Bangladesh, these financial instruments havent
yet received the same kind of importance that could be used to minimize the risk exposure
associated with international transactions. One reason is the general indifference of the
merchants with regard to the risks arising from fluctuation of exchange rates. Another is the
continuous upward trend exchange value of U.S dollar which is the target currency for most of
the exporters. Since USD appreciation helps exporters and for that reason they have very little
incentives to use any instruments from the derivative market since they always expect the
direction of USD is up and the importers also very easily pass on the rising dollar value to the
end users which means consumers in Bangladesh bear the full brunt out of the depreciation of
BDT. This was more so when the Bangladesh bank maintained a fixed exchange rate of taka via
US dollar until 31st May 2003.
Forward exchange transactions are either outright or swap. An outright involves forward
purchase or sale of a currency at a forward exchange rate which expresses the actual price of one
currency against another for delivery on a specified value date.
In Bangladesh forward rates are quoted as outright because it is easily understood by the
customers and the officials working in the forex departments. However, as the volume of
transactions picks up and exchange rates become more responsive to the changes in the
international markets, it will be convenient to use margin in forward quotations. Besides, it is
the margin which is more relevant in the swap market.
CURRENCY FUTURE MARKET:
A foreign currency future (Forex future) is a forward contract with standardized features,
including quantities and settlement dates and is exchange-traded, that is, traded on organized
exchanges rather than over the counter. Foreign exchange futures contracts are for standardized
foreign currency amounts, terminated at standardized times, and have minimum allowable price
moves (called "ticks") between trades. Foreign exchange futures contracts are traded on the
market floor of several exchanges around the world. For example, they are traded on the Chicago
Mercantile Exchange (the "Merc"), the Tokyo International Financial Futures Exchange (TIFFE),
the Sydney Futures Exchange, the New Zealand Futures Exchange, the MidAmerican
Commodities Exchange, the New York Futures Exchange, and the Singapore International
Monetary Exchange (SIMEX).The Chicago Mercantile Exchange (CME) is the biggest and most
important market in the world for foreign exchange futures contracts.
Because futures are standardized contracts, there is greater price transparency and liquidity than
with forward contracts and, thus, they can be canceled or offset by purchasing or selling an
offsetting contract. Indeed, most future contracts are terminated before the settlement date,
because speculators have no interest in the actual delivery of currency but are only interested in
the profits that they hope to make when they close out their position.
Although standardization gives futures contracts most of their advantages over forward contracts,
they may not serve the needs of some parties, especially businesses with specialized needs.
CME Standardized sizes: GBP 62,500, AUD 100,000, EUR 125,000, JPY 12.5M
CME expiration dates: Mar, June, Sep, and Dec + Two nearby months
Margin account: amount of money you deposit with a broker to cover your possible losses involved
in a futures/forward contract.
Most Active Currency Futures Contracts: Specifications

Margin Requirements
Security Size Minimum price fluctuation Initial Maintenance
AUD AUD 100,000 .0001 (USD 10.00) USD 1,890 USD 1,400
BRR BRR 100,000 .0001 (USD 10.00) USD 9,800 USD 7,000
CAD CAD 100,000 .0001 (USD 10.00) USD 1,316 USD 975
CHF CHF 125,000 .0001 (USD 12.50) USD 2,700 USD 2,000
GBP GBP 62,500 .0002 (USD 12.50) USD 1,452 USD 1,075
JPY JPY 12,500,000 .000001 (USD 12.50) USD 2,700 USD 2,000
MXP MXP 500,000 .000025 (USD 12.50) USD 3,125 USD 2,500
EUR EUR 125,000 .0001 (USD 12.50) USD 2,565 USD 1,900
Table 6.1
Why do we care about futures or forward contracts? In order to answer this question, we must
understand that the primary goal of currency risk management is to change the risk-return profile
of a cash position (or portfolio) to suit given investment objectives. It involves one of three
alternatives: preserving value, limiting opportunity losses, and enhancing returns. Futures and
forward contracts are effective in meeting these risk management objectives because they can be
used as cost-efficient substitutes or proxies for a cash market position. The determination of the
proper equivalency ratio is critical to the use of futures or forwards as a cash market proxy,
regardless of whether this ratio will be applied to a hedge, an income enhancement strategy or a
speculative position.

Comparison of Futures and Forward Contracts

Futures Forward

Amount Standardized Negotiated

Delivery Date Standardized Negotiated

Counter-party Clearinghouse Bank

Collateral Margin account Negotiated

Market Auction market Dealer market

Costs Brokerage and exchange fees Bid-ask spread

Secondary market Very liquid Highly illiquid

Regulation Government Self-regulated

Location Central exchange floor Worldwide

Table 6.2
Futures contracts are netted out through a clearinghouse, so that a clearinghouse stands on the
other side of every transaction. This characteristic of futures markets stimulates active secondary
markets since a buyer and a seller do not have to evaluate one another's creditworthiness. The
presence of a liquid clearing house substantially reduces the credit risk associated with all
forward contracts. The clearing house makes a trader only responsible for his/her net positions.
The clearinghouse is composed of clearing members. Clearing members are brokerage firms that
satisfy legal and financial requirements set by the government and the exchange. Individual
brokers who are not clearing members must deal through a clearing member to clear a customer's
transaction. In the event of default of one side of a futures transaction, the clearing member
stands in for the defaulting party, and seeks restitution from that party. Given this structure, it is
logical that the clearinghouse requires some collateral from clearing members. This collateral
requirement is called margin requirement.
Futures transaction procedure

Figure 6.1

As we have studied some of the features of currency future market is better that currency forward
market; still future market has some disadvantages as well.
Advantages and disadvantages of future markets

Economic advantages of futures markets

Increased (economic) A central marketplace integrates the various segments of a

efficiency market; the availability of standardized contracts increases
the liquidity of the market.
Increased availability Future market provides price, volume, and open interest
of information (outstanding contracts) information; they also act to
discover the market clearing price.

User-specific advantages of futures markets

Reduced transaction Commissions, bid-offered spreads and costs of effecting a short sale are
costs smaller than those for cash markets
Reduced credit-risk The clearing house acts as counterparty to all transactions; the
exposures requirement to provide margin largely eliminates performance risk
 (counterparty risk)
Ability to create Allow the creation of cash and futures positions that would be
synthetic securities prohibitively expensive in the cash markets alone
Allow for hedging Leverage or gearing on futures contracts allows hedging or speculative
and speculation activity to take place with minimal (additional) investment
Price disclosure Centralized marketplace provides transparency of pricing

Disadvantages of future markets

Possibility of price squeezes
Require a cash deposit to collateralize
the position
Require the position holder to pay out
on losses on a daily, mark-to-market
basis
Imperfect hedging
The risk that a few individuals take control of
available supply, thus driving prices above
fundamental value
Affect the cash flow of the transaction since margin
requirements are unpredictable
Create timing mismatches between losses and gains
on hedging transactions
Behaviour of cash and futures markets do not fully
correspond over the short term

Problem 6.5: Suppose today's exchange rate is $1.05/. The six-month interest rates on dollars
and euros are 6 percent and 3 percent, respectively. The six-month forward rate is $1.0478. A
foreign exchange advisory service has predicted that the euro will appreciate to $1.0790 within
six months. How would you use forward contracts to profit in the above situation?
Solution: By buying euros forward for six months and selling them in the spot market, you can
lock in an expected profit of $0.0312, (1.0790 1.04780) per euro bought forward. This is a
semi-annual return of 2.98% (0.0312/1.0478). Whether this profit materializes depends on the
accuracy of the advisory service's forecast.
b. How would you use money market instruments (borrowing and lending) to profit?
Solution: By borrowing dollars at 6% (3% semiannually), converting them to euros in the spot
market, investing the euros at 3% (1.5% semiannually), selling the euro proceeds at an expected
price of $1.0790/ , and repaying the dollar loan, you will earn an expected semiannual return of
1.30%: Return per dollar borrowed = (1/1.05) x 1.015 x 1.0790 - 1.03 = 1.30%.
c. Which alternatives (forward contracts or money market instruments) would you prefer? Why?
Solution: The return per dollar in the forward market is substantially higher than the return using
the money market speculation. Other things being equal, therefore, the forward market
speculation would be preferred.
CURRENCY OPTIONS
An option is a financial derivative contract that provides a party the right to buy or sell an
underlying asset at a fixed price by a certain time in the future. The party holding the right is the
option buyer, the party granting the right is the option seller (Underwriter). There are two types
of options, a call and a put. A call is an option granting the right to buy the underlying asset; a
put is an option granting the right to sell the underlying asset. To obtain this right, the option
buyer pays the seller a sum of money, commonly referred to as the option price. On occation, this
option price is called the option premium which is paid when the option contract is initiated.
The fixed price at which the option holder can buy or sell the underlying asset is called the
exercise price or strike price. The use of this right to buy or sell the underlying asset is referred to
as exercise or exercising the option. Like all derivative contracts, an option has an expiration
date, giving rise to the notion of an options time to expiration. When the expiration date arrives,
an option that is not exercised simply expires. What happens at exercise depends on whether the
option is a call or a put. If the buyer is exercising a call, she pays the exercise price and receives
either the underlying or an equivalent cash settlement. On the opposite side of the transaction is
the seller, who receives the exercise price from the buyer and delivers the underlying, or
alternatively, pays an equivalent cash settlement. If the buyer is exercising a put, she/he delivers
the underlying asset and receives the exercise price or an equivalent cash settlement. The seller,
therefore, receives the underlying and must pay the exercise price or the equivalent cash
settlement.
Remember, a currency option gives the buyer of the option the right, but not the obligation, to
buy or sell a specified amount of foreign currency at a specified price, called the exercise price
or strike price, at any time up to a specified expiration date. Currency options differ from
currency futures because they do not have to be closed outthe option holder can just let the
option expire if it is not profitable. In contrast, at the expiration of a futures contract, the futures
buyer would have to accept delivery of the currency, and the futures seller would have to actually
deliver the currency, unless it is a cash-settled contract, in which case the seller would have to
pay to the buyer the equivalent value in a specified currency.
A call option allows the holder the right but not the obligation to buy currency at the exercise
price whereas a put option allows the holder the right to sell currency at the exercise price.

MATURITY
SPOT
PRICE
Currency Option
DOMESTIC
EXERCISE Pricing Model INTEREST
PRICE
RATE

VOLATALITY FOREIGN
INTEREST
RATE
Figure 6.2: Information necessary to price a currency option.
The CME (Chicago Mercantile Exchange) Globex located in the USA, first operational in
1992, was the 1st electronic derivatives market, and is operational at all hours from Sunday
evening to Friday afternoon. When a buyer and seller agree to the price, quantity, expiration
month, and the underlying asset, the clearinghouse then assumes the obligation to buy the
sellers contract, and to sell it to the buyer. Because the clearinghouse is the trader to both
parties, they dont have to worry about performance of the contract. Furthermore, the
clearinghouse allows each trader to close out his position independently of the other.
If a trader fails to fulfill his contract, then only the clearinghouse is hurt. To prevent this from
happening, a performance bond (margin) must be posted, in the form of cash, or near-cash
equivalents, such as T-bills. The initial performance bond (or initial margin requirement) is
typically 5%-15%, with more volatile commodities requiring a higher amount. The requirements
are lower for a hedger than a speculator, because the hedger is covered. The performance bond
minimum is determined by the exchange, but the broker may set a higher amount. Furthermore,
the futures contracts are marked to market every day, and the traders account balances are
credited or debited accordingly. There is a maintenance performance bond (or maintenance
margin percentage) typically 75% of the initial requirement, so that if the account balance
drops below the maintenance requirements, then the trader will be subject to a performance
bond call (or margin call) to bring the account balance back to the original requirement. If the
trader fails to deposit more money, then the clearinghouse will offset enough contracts to bring
the balance to the required level.
Although the money deposited in a futures account is often called margin, it is not the same as
margin used to purchase stocks, because the trader is not borrowing money to buy a futures
contract, and no interest has to be paid. In fact, you don't actually buy a futures contract, you
take on a contractual obligation as a seller or buyer of the contract, which, in and of itself, costs
nothing. If you have a futures contract to purchase wheat in July, then you don't actually pay for
it until the day of the delivery, if you don't offset the contract before then. In this way, a futures
contract is like a forward contract, because the money in the account isn't used to pay for the
underlying asset until the final day of the contract. In a sense, the contract is settled every day as
the account is marked to market. The money deposited in a futures account is a good faith
deposit to insure that the trader will fulfill the obligation of the contract, which is why it is more
properly called a performance bond. The deposit in a futures account can even be in the form of
T-bills that earns interest.
Two types of options: American option (can be exercised any time at or before expiration) and
European option (can only be exercised at expiration). Due to this flexibility, American options
are more popular and also trade in Europe. Basically, European option is used for pricing an
option since it cannot be exercised before expiration. So, the interest earnings could be counted.
An option that would be profitable to exercise at the current exchange rate is said to be in-the-
money. Conversely, an out-of-the money option is one that would not be profitable to exercise
at the current exchange rate. The price at which the option is exercised is called exercise price or
strike price. An option whose exercise price is the same as the spot exchange rate is termed as at-
the-money.
If the exercise price for an option is more favorable for the option holder than the current
market price of the underlying item, the option is said to be in-the-money.
If the exercise price for option is less favorable for the option holder than the current market
price of the underlying item, the option is said to be out-of-the-money.
If the exercise price for an option is exactly the same as the current market price of the
underlying item, the option is said to be at-the-money.
CURRENCY OPTION MARKETS
Currency options were originally traded over the counter, OTC (dealer network), not on
organized exchanges. Options in OTC can be customized for the traders - maturity, contract size,
exercise price, usually in large amounts of $1m, the size of most currency trades in the spot
market.
Since 1982, currency options have been traded on the Philadelphia Stock Exchange. Option
contract sizes are mostly the same size of futures contracts, e.g., 62,500. Contracts are traded on
a March, June, Sept, Dec cycle with original maturities of 3, 6, 9, 12 months. In addition, one
and two month contracts are also traded so that there are always 1, 2 and 3 month contracts.
Also, long term option contracts are traded for 18, 24, 30, 36 months.
OTC trading ($212 billion daily) is larger than organized-exchange trading on the Philadelphia
exchange ($2.5B/day) for exchange-traded currency option contracts. Big currency traders
(banks) prefer OTC market, it operates 24 hours/day (necessary now in global market - time zone
differences in Asia, Europe/currency crises), contract size is much bigger ($1m vs. $45,000 avg.
PHLX), more efficient, lower transactions cost. PHLX limits traders to 100,000 max contracts.
Currency Future Options
The Chicago Mercantile Exchange (CME) offers American options on its currency futures
contracts. The underlying asset is a currency futures contract, not the actual currency. "Side bet
on a side bet." The cycle is the same for futures options as for futures - Mar, June, Sept and
Dec., with options traded on the two earliest months. For example, In Jan, option contracts would
trade for Jan, Feb and March expiration on March futures contracts. Contracts are now trading
for Oct, Nov and Dec expiration on December currency futures contracts. Exercise of a currency
futures option results in a LONG futures position for the Call Buyer and the Put Writer (seller)
and SHORT futures position for the Call Writer and the Put Buyer. To cancel out the futures
position before expiration, the trader can make an offsetting trade. If not, delivery or receipt of
the currency will take place.
Currency Call Option example:
Consider from an American perspective, the British Pound 6 months call options for Jan 2013
(62,500 per contract). It is quoted by adding Premium = 3.73 per ("cents per unit"), or
$.0373/, with an Exercise Price = 147/ or $1.47/. One contract costs 62,500 x $0.0373/ =
$2,331.25, which gives you the right to buy Pounds at $1.47. The option contract will make
money for a call buyer if S > 150.73 or $1.5073 ($1.47 + $.0373). You pay a premium of 3.73
per euro now, and have the right to buy GBP for 147 or $1.47.
Profit

$0.0127 Ex-Price
$1.47/ $1.52/,
0 S6 ST ($/)
$1.5073/
-$.0373 (Break Even = Ex-Price + Premium)

Loss

Suppose at expiration, S = 152 per euro, or $1.52/, you will make money, ($1.52 - $1.5073) x
62,500 = $793.75 per contract.
You have paid a premium of $2,331.25 in January that gives you the right to buy GBPs @ $1.47
on or before June 20. If the GBP sells at $1.52 on expiration, you can exercise your right to buy
@$1.47 and then sell at $1.52, for gross profits of $0.05 per Pound, or a total profit of $3,125
(62,500 x $.05). Subtracting the cost of your option premium of $2,331.25, you have a net profit
of $793.75 ($3,125 - $2,331.25). The writer (seller) of the call option would lose $793.75.
Two ways to calculate profit from call option:
1. Profit = Spot Price - (Exercise Price + Premium) x 62,500
Profit = $1.52 - ($1.47 + $0.0373) = $0.0127/ x 62,500 = $793.75 PROFIT
2. Profit = (Spot Price - Exercise Price) x 62,500 - PREMIUM
Profit = ($1.52 - $1.47) x 62,500 = $3,125 - $2,331.25 = $793.75 PROFIT
ROI: Your return on investment (ROI) would be $793.25 / $2,331.25 (Profit / Investment) =
34% for 3 months, or a 136% (34% times 4) annual ROI! You control about $92,000 worth of
Euros (62,500 x $1.47/) with only $2,331.25, or 2.5% of the underlying value of the currency.
If spot rate at expiration is only $1.45/ (or any rate < $1.47/), the option expires worthless, you
lose the premium of $2,331.255, which would be the gain to the writer (seller) of the call.
Note: If the spot rate was between $1.47 and $1.5073 at expiration, you would still exercise your
call option to minimize loss, but you would lose money. For example, if S = $1.4800/ at
expiration, you would exercise call option, but you would lose ($1.48 $1.5073) x 62,500 =
$1,706.25 by exercising call, vs. losing the entire premium of -$2,331.25 without exercising.
Now look from the underwriters perspectives: When an option buyer makes money it simply
means the underwriter has lost that amount of money. Even though the options are the right to
buy (call) or the right to sell (put) for the buyers of call and put options but not an option for the
underwriter. The underwriter is obliged by law to honour the contract if the buyer wants to
exercise it. Thats why an option buyer can lose only the option premium but can gain unlimited
amount in buying call options or limited gain in buying put options since put buyers can expect
the price to go as low as zero but call buyers can expect the price go up to unlimited amount.
Simply speaking in the option market, an option buyers gain is backed up by the loss of an
option seller which is really a zero sum game. Here in the below showing graphically the loss of
the option seller who is known as an underwriter as well.

Profit

$0.0373

$1.47 $1.5073 $1.52

0
ST ($/)

$0.0127

Loss
From the above graph we can see the underwriter lost $0.0127 per when the future spot rate
became $1.52 but he could have lost much more if the price went up further. It is known to the
underwriter that the highest amount of profit he could make is the option premium which was
$.0373 in this example but the amount of loss is quite unknown since the GBP appreciation is not
known.
Put Option for Currency
Look at a Jan 2013 put option for GBP, say it is with a strike price of $1.47 (147 cents), and a
premium of 3.33 cents (or $0.0333), contract size of 62,500. You have paid for the right to sell
GBPs for 147 cents ($1.47) in June. Total Premium is $2,081.25 per contract, (62,500 x
$0.0333), and the break-even point is 143.67 (147 3.33 cents), or $1.4367/. If you buy the
put, you will make money if spot rate for < 143.67 ($1.4367/) by June. Maximum loss is the
premium of $2,081.25. If you sell (write) the put, you will make money if spot rate S > 143.67
($1.4367/), and the maximum gain is the premium of $2,081.25.
Profit

$.0166 Ex-Price
$1.47/
0 | ST ($/)
$1.42 $1.4366
$.0333 (Break Even = Ex-Price - Premium)

Loss
If spot rate S = $1.48/ (148) at expiration, the put owner would not exercise option and lose
the premium of $2,081.25, which would be the profit for the put writer. If S = $1.4200/, gross
profit would be $1.47 - $1.42 = $0.05 x 62,500 = $3,125. Logic: You can buy 62,500 at the
spot rate of $1.42, and you have the right to sell at $1.47, for a $.05/ profit x 62,500 = $3,125.
However, you paid $2,081.25 for the right to sell GBPs at $1.47, so your net gain/profit is $3,125
$2,081.25 = $1,043.75. Or you can calculate profit in one step: ($1.4367 - $1.42) x 62,500 =
$1,043.75 Profit (or 143.67 cents 142 cents = 1.67 cents or $.0167 profit per Pound x 62,500
= $1.043.75 Total Profit.
1. Profit = [(Exercise Price - Premium) - S] x 62,500
Profit = ($1.47 - $.0333) - $1.4200 = $.0099 x 62,500 = $1,043.75 PROFIT
2. Profit = (Exercise Price - S) x 62,500 - PREMIUM
Profit = ($1.4700 - $1.4200) x 62,500 = $3,125 - $2,081.25 = $1,043.75 PROFIT
Currency option and two of its components
The intrinsic value: The amount by which an option is in the money. A call option whose
exercise price is below the current spot price of the underlying instrument, or a put option whose
exercise price is above the current spot price of the underlying instrument, is said to be in the
money.
The extrinsic value: It is the total premium of an option less the intrinsic value. It is also known
as the time value or volatility value. As the expiry time increases, the premium of an option also
increases. However, with each passing day, the rate of increase in the premium decreases.
Conversely, as an option approaches expiry, the rate of decline in its intrinsic value increases.
This decline is known as the time decay. Therefore, the more volatile a currency, the higher will
be its option value.
Problem 6.6: If you buy an American call option of BDT/USD with an exercise price of
75.15BDT and a December settlement date. The current spot price today is 74.9 BDT. Say, you
pay a premium of 0.40 BDT per unit of call option. Assume there is no brokerage fee, just before
the expiration date, the spot rate of the exchange rate reaches 75.80 BDT. What would be your
profit or loss of buying this call option? Again, how about on December 31st if the spot becomes
75.40 what would be the profit or loss? Assume per call option contract size of BDT/USD is
$100000.
Solution: Per Unit per Contract
Selling price of US$ 75.90 BDT 7590000(75.90x100000)
-- Purchase price of US$ -- 75.15 BDT 7515000(75.15x100000)

--Premium paid for option -- 0.40 BDT 40000(0.40x100000)

=Net Profit/Loss + 0.35 BDT 35000(0.35x100000).

So you will make thirty five thousand taka profit by buying one call option of $100000 size. The
above example has been shown graphically below:
Profit

0.35 TK Ex-Price
75.15BDT/$ 75.9BDT/$
0 | | ST (BDT/$)
75.55BDT/$
0.40 TK (Break Even = Ex-Price + Premium)

Loss
Again, if you buy an American put option with an exercise price of 74.15BDT and a December
settlement date. The current spot price today is 74.9 BDT. Say, you pay a premium of 0.20 BDT
per unit of put option for 6 month expiry contract. Assume there is no brokerage fee, just before
the expiration date, the spot rate of the exchange rate reaches 73.80 BDT. What would be your
profit or loss of buying this put option? Again, how about on December 31 st if the spot becomes
75.40, what would be the profit or loss? Assume per call option contract size is $100000.
Solution: Per Unit Per Contract
Selling price of US$ 74.15 BDT 7415000(74.15x100000)
-- Purchase price of US$ -- 73.80 BDT 7380000 (73.80x100000)
--Premium paid for option -- 0.20 BDT 20000 (0.20x100000)
=Net Profit/Loss + 0.15 BDT 15000 (0.15x100000)
So you will make fifteen thousand taka profit by buying one put option of $100000 size. The
above example has been shown graphically below.

Profit
0.15 TK Ex-Price
73.8 TK/$ 74.15TK/$
0 | ST (BDT/$)
$73.95TK/$
0.20 TK (Break Even = Ex-Price - Premium)

Loss
Problem 6.7: Bank of America sells a 3 months call option on Euros (contract size is 125,000)
at a premium of $0.04 per euro. If the exercise price is $0.71 and the spot price of the euro at
date of expiration is $0.73, what is Bank of America's profit (loss) on the call option?
Solution: Since the spot price of $0.73 exceeds the exercise price of $0.71, Bank of America's
counterparty will exercise its call option, causing the bank to lose 2 cents per euro. Adding in the
4 cents call premium it received gives Bank of America a net profit of 2 cents per euro on the call
option for a total gain of .02 x 125,000 = $2,500.
Problem 6.8: Suppose you buy three European call options with a strike price of 0.90 Euro/USD
which matured in 2 months at a call premium of 2.3 cents / .
a. What would be your total dollar cost for these calls, ignoring broker fees?
Solution: With each call option being for 125,000, the three contracts combined are for
375,000. At a price of 2.3 cents / , the total cost is 375,000 x $ 0.0230 / = $ 8,625.
b. After holding these calls for 60 days, you sell them for 3.8 cents / . What is your net profit
on the contracts, assuming that brokerage fees on both entry and exit were $5 per contract and
that your opportunity cost was 8 percent per annum on the money tied up in the premium?
Solution: The net profit would be 1.5 cents / for a total profit before expenses of $ 5,625
[0.015 x 375000]. Brokerage fees totaled $ 10 per contract or $ 30 overall. The opportunity cost
would be $ 8,625 x 0.08 x 60 / 365 = $ 113.42. After deducting these expenses (which total $
143.42), the net profit is 5,625 143.42 = $ 5,481.58.
Binomial currency option pricing
The binomial currency option model provides a generalisable numerical method for the
valuation of currency options. The model differs from Black Scholes option pricing model, in
that it uses a discrete-time model of the varying price over time of financial instruments; the
model is thus able to handle a variety of conditions for which other models cannot be applied.
Essentially, option valuation here is via application of the risk neutrality assumption over the life
of the option, as the price of the underlying instrument evolves.
METHODOLOGY
The binomial pricing model uses a "discrete-time framework" to trace the evolution of the
option's key underlying variable via a binomial lattice (tree), for a given number of time steps
between valuation date and option expiration. Each node in the lattice represents a possible price
of the underlying, at a particular point in time. This price evolution forms the basis for the option
valuation. The valuation process is iterative, starting at each final node, and then working
backwards through the tree to the first node (valuation date), where the calculated result is the
value of the option.
Option valuation using this method is, as described, a three step process:
1) Price tree generation
2) Calculation of option value at each final node
3) Progressive calculation of option value at each earlier node; the value at the first node is the
value of the option.
The methodology is best illustrated via example.
1) The binomial price tree
The tree of prices is produced by working forward from valuation date to expiration. At each
step, it is assumed that the underlying instrument will move up or down (thats why it is called
binomial) by a specific factor of u or d per step of the tree. If S 0 is the current price, then in the
next period the price will either be S up or S down, where S up =S u and S down =Sd. The up and
down factors are calculated using the underlying volatility, , and years per time step, t:
(t)
u = exp
(-t)
d = exp =1/u
The above is the original Cox, Ross, & Rubinstein (CRR) method; there are other techniques for
generating the lattice, such as "the equal probabilities" tree.
2) Option value at each final node
At each final node of the tree -- i.e. at expiration of the option -- the option value is simply its
intrinsic, or exercise, value.
For a call: value = Max (S Exercise price, 0)
For a put: value = Max (Exercise price S, 0)
3) Option value at earlier nodes
At each earlier node, the value of the option is calculated using the risk neutrality assumption.
Under this assumption, today's fair price of a derivative security is equal to the discounted
expected value of its future payoff.
Expected value here is calculated using the option values from the later two nodes (Option up
and Option down) weighted by their respective probabilities -- "probability" p of an up move in
the underlying, and "probability" (1-p) of a down move. The expected value is then discounted at
r, the risk free rate corresponding to the life of the option. This result, the "Binomial Value", is
thus the fair price of the derivative at a particular point in time (i.e. at each node), given the
evolution in the price of the underlying to that point.
The Binomial Value is found for each node, starting at the penultimate time step, and working
back to the first node of the tree, the valuation date, where the calculated result is the value of the
option. For an American option, since the option may either be held or exercised prior to expiry,
the value at each node is: Max (Binomial Value, Exercise Value).
The Binomial Value is calculated as follows:
(r t)
Binomial Value = [ p Option up + (1-p) Option down] exp
Problem 6.9: Suppose if the spot rate between BDT and USD today is 83.5. It is expected to go
up 6% in one state and will go down 4% in second state. If the exercise prices of a 3 month
European call BDT/USD is 84.15 and the risk free rate is 12%
a. Calculate the hedge ratio
b. Calculate the current value of a call option using a one period binomial option pricing model.
c. Using the put call parity find the put premium of this option.
Solution:
a) Here, S0 = 83.50, E = 84.15
Su = S0 (1+.06) =83.50(1.06) = 88.51
Sd = S0 (1 .04) =83.50(.96) = 80.16
Cu = [Su E, 0] = {(88.51 84.15), 0} = 4.36
Cd = [Sd E, 0] = {(80.168 4.15), 0} = [ 3.99, 0] = 0
Hedge ratio: = (Cu Cd)/S0 (u d)
= (4.36 0) / 83.50(1.06 0.96) = 4.36 / 8.35 = 0.52.
The Hedge Ratio indicates the number of currency call options required to replicate one unit (in
this case, one $) of the underlying asset.
b) Here, R= 1 + r = 1+ 0.12/4 = 1.03
Pseudo probability measures:
P =R d
ud
= (1.03 0.96) / (1.06 0.96) = 0.07/0.10 = 0.70.
Current value of a call option: C = CuP +Cd (1 p)
R
= [(4.360.70) + (00.30)]/1.03=3.052/1.03=2.96 BDT/USD.
c) Using the put-call parity, we can easily find the value of the put premium using this equation,
P = E/R + C-S0.
So, Put premium = 84.15/1.03 + 2.96 83.5 = 1.1590 BDT per USD.
PUT CALL PARITY
Put Call Parity is an option pricing concept that requires the extrinsic values of call and put
options to be in equilibrium so as to prevent arbitrage. Put Call Parity is also known as the Law
of One Price.
Put Call Parity requires, mathematically, that option trading positions with similar payoff or risk
profiles (i.e. Synthetic Positions) must end up with the same profit or loss upon expiration such
that no arbitrage opportunities exist.
Problem 6.10: Assuming that the binomial pricing model holds with u=1.15 and d =0.95, if a
BDT/USD spot rate is 82.80 and the risk free rate in Bangladesh is 12%.
a. What is the current value of a European call option written on the exchange value with
exercise price of 83.85 BDT and expiration in three periods time? Here 1 period equivalent
to 1 year.
b. What would be the value of the put option if all other information remaining the same?
Solution:
a) Here R= 1+ r = 1+.12 = 1.12.
P = (1.12 0.95)/ (1.15 0.95)=0.17/0.20=0.85.
Diffusion Diagram: 125.928 [It can happen only one way]

109.503

95.22 104.027 [It can happen 3 ways]

82.8 90.46

78.660 85.936 [It can happen 3 ways]

74.727

70.990 [It can happen only one way]

We will get this value after drawing the diffusion diagram for three periods,
Suuu=125.928, Cuuu = {(Suuu E), 0} =125.928-83.85 = 42.078
Suud =104.027, Cuud = {(Suud E), 0} = 104.027-83.85 = 20.177
Sudd = 85.936, Cudd = {(Sudd E), 0} = 85.936-83.85 = 2.086
Sddd = 70.990, Cddd = {(Sddd E), 0} = (73.990-83.85), 0 = 0 [Cannot be negative.]
For three periods Binomial Option Pricing Formula is given below:
C = P3Cuuu + 3P2 (1 P)Cuud+3P (1 p)2Cudd+ (1 P)3Cddd
R3
= (.85342.078)+{3.852(1 .85) 20.177}+{3.85(1 .85)22.086}+0
(1.12)3
= 25.8411+ 6.56 +.1196
1.4049
= 23.147 BDT.
b) For Put Option Price,
Using the Put-Call parity equation we get, P = E/R3 + C S0
= 83.85 + 23.147 82.80 = 0.023 BDT.
(1.12)3
Here we can see since this option has 7 out of 8 ways of making money the put option is not very
attractive and hence a very low put premium.
[Note: Hedge Ratio = spread of option prices/ spread of possible underlying asset values.]
Hence (0 4)/ (0 8) = 4/8 = 0.5. A hedge ratio can be computed as the change in value of the
unprotected position for a given change in the exchange rate divided by the profit derived from
one futures position for the same exchange rate. Call option hedge ratios must be positive and
less than 1.0, and put option ratios must be negative, with a smaller absolute value than 1.0. A
hedge ratio of 0.70 implies that a hedged portfolio should consist of long 0.70 amount of
currency for each short call currency.
We can replicate our basic tree multiple times, where the up or down movement represents some
function of E[S], or the expected mean.
At the limit, the distribution of continuously compounded exchange rates approaches the normal
distribution (which is described in terms of a mean (expected value, in this case E[S]) and a
distribution (variance or standard deviation). This makes it equivalent to Black-Scholes model.
Black Scholes currency Option pricing:
Currency options are priced using a variation of the Black-Scholes formula. The main revision
comes from the fact that the opportunity cost to invest in a foreign currency is not the domestic
risk-free rate, as for an ordinary asset, but rather the interest rate differential (domestic minus
foreign). The intuition behind this modification is very simple: an investment in a foreign
currency costs the domestic interest rate (to finance the purchase of currency) but earns the
foreign interest rate. The Black-Scholes formula for European currency call and put options are
given by the following formulas:
C=S0.e( rf.t) . N (d1) E. e( - rd.t). N (d2),

P= E. e( - rd.t).N (-d2) S0.e( rf.t) -N ( d1), where

d1 = {In (So/E) + (rd rf + 2/2) t} and, d2 = d1 t.

t
The constants rd, rf, and are the continuously compounded riskless domestic interest rate per
unit time, the continuously compounded riskless foreign interest rate and the standard deviation
of the rate of return on the currency per unit time, respectively. N(d 1) and N(d2) represent the
cumulative normal distribution evaluated at points d1 and d2, respectively which could be found
from cumulative normal distribution table 6.4.
The well-known put-call parity relationship implies that the price of a European currency put
option, P, is given by:
C + E. e( - rd.t) = P + S0.e( rf.t)
Value of a call at expiration: CT = Max [0, S0 E]
Value of a put at expiration: PT = Max [0, E S0]
Max value of a call is the spot price: C S0
Max value of a put is the strike price PE

Min value of a call option: C S0. E( rf.t) E. e( - rd.t)

Min value of a put option: P E. e( - rd.t ) S0.e( rf.t)
Assume:
European options
No arbitrage
Price cannot be < 0 (i.e. C 0, P 0).
Note that there are six factors affecting the premium of a currency option:
i. the current exchange rate (S0)
ii. the exercise price (E)
iii. the time to expiration (t)
iv. the volatility of the exchange rate ()
v. the domestic interest rate (rd)
vi. the foreign interest rate (rf)
Table 6.3 presents the effect on the price of an option of increasing one variable while keeping all
others fixed.
Summary of Variables Affecting currency Call and Put Prices:

Effect on

Factor Call Value Put Value

Increase in currencys value Increases Decreases

Increase in Exercise Price Decreases Increases

Increase in variance of currency Increases Increases

Increase in time to expiration Increases Increases

Increase in domestic interest rates Increases Decreases

Increase in foreign interest rates Decreases Increases

Table 6.3
Table 6.3 is very easy to understand. For example, if a call currency option is exercised at some
time in the future, the payoff from the call will be the amount by which the exchange rate
exceeds the Exercise price (E). Call options on foreign currency become more valuable as the
exchange rate increases and less valuable as the strike price increases. For a put currency option,
when exercised, the payoff is the amount by which the strike price exceeds the exchange rate.
Then, put options on foreign currency become less valuable as the exchange rate increases and
become more valuable as the strike price increases. Similar arguments can be made for all the
other variables.
In addition to the above factors, the right to exercise at any time before expiration embedded in
American options has a price. Therefore, American options are always worth more than or at
least equal to their European counterparts.
Example: Using the Black-Scholes formula to price currency options.
It is September 20, 2011. IBM wants to price a European GBP put option. The GBP put option
has an exercise price of 1.62 USD/GBP and matures in 40 days. In addition, IBM has the
following information: the 40-day Euro-USD rate is 4.79%, the 40-day Euro-GBP rate is 5.83%,
the annual USD/GBP volatility during the recent past was 8%, and today's exchange rate is
1.6186 USD/GBP.
IBM summarizes all the information:
S0 = 1.6186 USD/GBP
E = 1.62 USD/GBP.
t = 40/365 = .1096.
rd = .0479.
rf = .0583.
= .08.
IBM obtains C, the call's premium, using the following steps:
(1) Calculate d1 and d2.
d1 = [ln(1.6186/1.62) + (.0479 - .0583 + .5 .082)x.1096]/(.08x.10961/2) = -0.062440,
d2 = [ln(1.6186/1.62) - (.0479 - .0583 + .5 .082)x.1096]/(.08x.10961/2) = -0.088923,
(2) Calculate N(d1) and N(d2).
IBM uses the Normal Table and draws a normal distribution. First, recall that the normal
distribution is symmetric around zero and, therefore, the Normal Table tells the area under the
right tail of the normal curve. If d1 is negative (positive), IBM will subtract (add) the .50% of the
distribution under the left tail of the normal curve to the area under obtain from the Normal
Table. In this way, IBM obtains the cumulative area N(d1).
Second, IBM looks for the cumulative normal distribution at z=-0.06244. The number obtained
is .02489. But, since d1 (z) is negative, in order to obtain the whole area under the curve up to z
=-.06244,
IBM subtracts .02489 to .50. IBM uses a similar procedure to calculate d2. Then,
N(d1=-0.06244) = .47511,
N(d2=-0.088923) = .46457.
(3) Calculate C and P.
Replacing in the Black-Scholes formula, IBM obtains:
C = e-.05830x.1096 1.6186 .47511 1.62 e-.0479x.1096 .46457 = USD .015444.
Now, using the put-call parity equation, IBM determines P:
P = .01544 - e-.05830x.1096 1.6186 + 1.62 e-.04790x.1096 = USD .01867.
Another example:
Currencies: USD/GBP
Type: GBP call (USD put)
S0 = 1.6000
E= 1.6000
rf = 11%
rd = 8%
t= 4 months = 120/360 = 1/3
= 14.1% volatility
Steps 1 & 2 calculate d1 & d2:
 1.6000
0.1412
120
ln +
0.08 - 0.11 + 360
1.6000
2
d1 =
0.141 120
360
0 + ( -0.02006 ) .33
=
0.141 x 0.57735
-0.00669
=
0.081406
= -0.08214

d 2 = d1 - t

= - 0.08241 - 0.141 120

360
= - 0.08241 - 0.081406
= - 0.16382

Steps 3 & 4 calculate N (d1) & N (d2): [From the table 6.4]

N(d1) = N(-0.0821) = N(-0.08) - 0.21[N(-0.08) N(-0.09)]

= 0.4681 - 0.21 x (0.4681-0.4641)

= 0.4673

N(d2) = N(-0.1638) = N(-0.16) - 0.38[N(-0.16) N(-0.17)]

= 0.4364 0.38 x (0.4364-0.4325)

= 0.4349
Step 5, calculate C:
C=S0.e( rf.t) . N (d1) E. e( - rd.t). N (d2)
= 1.6 e 0.11(1/3)0.4673 1.6 e 0.08(1/3)0.4349
= 0.0431 or 4.3 cents.
Practical Considerations
The Black-Scholes model assumes a constant risk-free interest rate. This constant risk-free rate
applies to all maturities. In practice, the risk-free rate has been usually approximated by the yield
of a government bond maturing with the option.
The Black-Scholes model needs as an input the annualized variance, which is forward looking
i.e., the variance from today till maturity (T). Historical estimation of the variance is very
common. It is usually better to work with log returns i.e., log(1+return). Remember to
translate the estimated variance to an annual variance. For example, suppose you use monthly
returns and your computed (monthly) variance is .0051. Then, the annualized variance is
.0051*12=0.0612, which corresponds to annual standard deviation of sqrt (.0612) =.247386 (or, 24.74%).
The cumulative normal distribution function is usually taken from a statistical table like table 6.4.
. Table 6.4
Below is shown the USD/GDP Options quote reported by Financial Times.

Table 6.5: USD/GBP Options

Problem 6.11: Suppose if the spot rate between BDT and USD is 82.5 and the exercise price of a
6 months European call of BDT/USD is 84.15 and the volatility is .24 given our interest rate is
12% and U.S. interest rate is 4.5%, what should be the call premium of this option?
Solution: d1 = {In (So/E) + (rd rf+ 2/2) t}
t
= {In (82.50/84.15) + (.12 .045+.242/2).5}
.24.5

=
.0198+.0519
.1697
= 0.1891.
N (d1) =.5753 [Assume d1=.19]
d2=d1 t=.1891 .24. 5=.1891 .1697=.0194
N (d2) =.5080 [Assume d2=.02]
r .t - r .t)
C=S0.e( f ).N (d1) E.e ( d .N (d2)
= (82.50e -.045.5 .5753)-{84.15e -.12.5 .5080}
= 46.4062 40.2587
= 6.1475 BDT.
Problem 6.12: Suppose if the spot rate between BDT and USD is 84.50 and the exercise price of
a 3 months European put option of BDT/USD is 85.15 and the volatility is .34 given our interest
rate is 12% and U.S. interest rate is 4.5%, what should be the premium of this put option?
Solution:
d1 = {In (84.5/85.15) + (0.12 .045+.342/2).25}
.34.25
= 0.1502.
So from the table 6.4 we get, N (d1) =0.56 (approximately) or N (-d1) = 0.44
d2=d1- t =0.1502 - 0.340.25=.1502-.17 = -.0198
Again from the table 6.4 we get, N (d2) =0.508 (approximately) or N (-d2) = 0.498
- r .t) r .t)
P= E. e ( d .N (-d2) S0.e ( f -N (-d1)
= (85.15e -.12.25 0.498) (84.50e -.045.25 .44)
=( 85.15x 0.9704x0.498) (84.50x 0.98881x0.44)
= 4.36 BDT.

Problem 6.13: Suppose an American importer has to pay 5 m to a British firm sometime during
the next 3 months. To hedge this the American importer buys options on the , and the option
premium is $0.0220/, for options with exercise price, E = $1.50/.
Q1. What options should the U.S importer buy?
Answer: Since the U.S importer has to make a payment, he should buy options that give him
the right to buy : Call options.
Q2. What is the cost incurred today?
Answer: 5 m.x0.0220 = $0.11 m.
Q3. What is the ceiling that the importer has set on the price of the ?
Answer: The maximum that he will have to pay for each is $.022/ + $1.50/ = $1.522/.
Q4. What is the actual amount that the importer will pay if the spot rate at the end of 3 months is
$1.46/?
Answer: Since ST < E, the options are worthless and the importer can do better by buying at the
market rate of $1.46/. Thus, his total cost, ignoring time value of the payments, is $1.46 +$.022
= $1..482/.
Q5. What is the actual amount that the importer will pay if the spot rate at the end of 3 months is
$1.55/?
Answer: Now, ST > E and therefore it is worth exercising the options. The importer will pay his
ceiling price, $1.552/.
Problem 6.14: Suppose Toyota Motor Company has to sell $50 million sometime during the next
6 months, and would like to lock in a minimum value for this. The option premium is 2 per
dollar with the exercise price (E) of 80 per USD.
Q1. What option should Toyota buy?
Answer: Since Toyota wishes to sell $, it should buy a put option on the $. This is, of course, the
same as wanting to buy , and therefore, a call option on the .
Q2. What is the cost incurred today?
Answer: $ 50 m. x 2 /$= 100 m
Q3. What is the floor that the Toyota has set on the price of the $?
Answer: The minimum that they receive for each $ is
= E - premium
= 80 - 2 = 78/$
Q4. What is the actual amount that Toyota company will receive if the spot rate at the end of 3
months is 85/$?
Answer: Since ST >E, the options are worthless and Toyota can do better by selling at the
market rate of 85/$, rather than the exercise price of 80/$. Thus, their total receipts will be
= 85/$ - 2/$
= 83/$.
Q5. What is the actual amount that they receive if the spot rate at the end of 3 months is 75/$?
Answer: Now, ST < E and therefore it is worth exercising this put option. Toyota will receive
their floor price, 80 - 2 = 78/$.
Problem 6.15: Suppose a Bangladeshi importer has to pay $5 million after 3 months. To hedge
this, the Bangladeshi importer buys an option on the USD. The option premium is 0.55BDT/$,
for options with E = 79.5 BDT/US$.
Q1. What option should the importer buy?
Answer: Since Bangladeshi importer has to make US$ payment, he should buy options that give
him the right to buy $: Call options on the US$.
Q2. What is the cost incurred today?
Answer: $5m x 0.55 = 2.75 m BDT
Q3. What is the ceiling that the BD importer has set on the price of the $?
Answer: The maximum that he will have to pay for each $ is 79.5 + 0.55 = 80.05 BDT.
Q4. What is the actual amount that the importer will pay if the spot rate at the end of 3 months is
80.5BDT/$?
Answer: Since ST>E, the options is worth exercising. The importer will pay his ceiling price of
BDT 80.05/ US$.
Q5. What is the actual amount that the importer will pay if the spot rate at the end of 3 months is
78.5BDT/$?
Answer: Since ST<E, the options is worth less. The importer can do by buying it from the market
at a rate of 78.5 BDT/US$. Thus his total cost, ignoring time value of the payments, is 78.5+0.55
= 79.05 BDT/US$.
FOREX HEDGING
Hedging refers to managing financial risk with the use of derivatives. Any investor can take a
specific position using futures contracts and options and another investor will take the opposite
position in the market to complete "the hedging transaction and ensure a certain amount of gain
on a certain trade".
One of the popular hedging methods in forex is buying and selling the same currency at the same
time and eventually making a profit out of it. Heres an explanation of how this interesting
system works, and a few tips that will help reducing the risks. And oh yes! there are risks.
The system
The trader buys and sells the same currency pair at the same time. For example, he sells
EUR/USD at 1.3300 and buys it at the same price in a separate position. When the market moves
in a specific direction with a significant distance, such as 100 pips for this pair, the trader closes
the winning position and leaves the losing one open. Lets assume EUR/USD went down to
1.3200 the trader closes the short position and leaves the long position open. He then opens
two new positions buying and selling at the new price. If the price goes back to the starting
point, 1.3300, the trader closes all three open positions the initial long position is now even,
and the two new positions balance each other. The trader won the profit of the first short position.
Hedging strategies using Futures and Options for minimizing currency risk
For minimizing currency risk, as a Bangladeshi trader you could use the following strategies:
1. If you are worried about BDT appreciating ($ depreciating) in value, (e.g. BD exporter
receiving USD in 3 months) you could do the following:
a. Go short on a USD futures contract
b. Buy a put option on USD
c. Write a call option on USD
d. Buy a put option on USD futures
e. Write a call option on USD futures
f. Enter into a forward contract to sell USD forward.
2. If you are worried about BDT depreciating ($ appreciating) in value (e.g., BD importer paying
in USD in 3 months) you could do the following:
a. Go long on a USD futures
b. Buy a call option on USD
c. Write a put option on USD
d. Buy a call option on USD futures contract
e. Write a put option on USD futures contract
f. Enter into a forward contract to buy USD forward.
Organizations use hedging to enhance the expected future cash flows and manage risk related to
particular market variables such as the price of oil or a foreign exchange rate. Most hedgers aim
for a perfect hedge to perfectly eliminate the risk. However, perfect hedges are rare because
hedgers have to know for sure the precise transaction date, delivery date and the asset price. As
this information is not always straightforward, hedgers craft proper strategies to reduce or
eliminate investment risk.
SWAPS
In finance, a swap is a derivative in which counter parties exchange cash flows of one party's
financial instrument for those of the other party's financial instrument. The benefits in question
depend on the type of financial instruments involved. For example, in the case of a swap
involving two bonds, the benefits in question can be the periodic interest (or coupon) payments
associated with the bonds. Specifically, the two counterparties agree to exchange one stream of
cash flows against another stream. These streams are called the legs of the swap. The swap
agreement defines the dates when the cash flows are to be paid and the way they are calculated.
Usually at the time when the contract is initiated at least one of these series of cash flows is
determined by a random or uncertain variable such as an interest rate, foreign exchange rate,
equity price or commodity price.
The cash flows are calculated over a notional principal amount, which is usually not exchanged
between counterparties. Consequently, swaps can be in cash or collateral.
Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in
the expected direction of underlying prices.
There are three basic motivations for swaps
1. Currency risk management
2. Commercial needs
3. Comparative Advantage
1. Currency risk management: companies use currency swaps to eliminate currency risks arising
from overseas commercial operations
a. General Motors (GM) has yen accounts receivable (AR).
b. Toyota has dollar accounts receivable.
c. GM and Toyota swap yen and dollars with each other.
2. Commercial needs (for example mortgage company):
a. The swap may be used to eliminate the interest rate risk. Assume a company has fixed rate
assets and floating rate liabilities. If interest rates rise, this company will face the interest rate
risk.
b. The company can eliminate the interest rate risk by
(1) transforming fixed rate assets into floating rate assets and
(2) transforming floating rate liabilities into fixed rate liabilities.
3. Comparative Advantage: In many instance, one company may borrow money at a lower rate
of interest in the capital market than another firm.
a. GM borrows dollars at a lower rate and transfers the funds to a British firm.
b. British firm borrows pounds at a lower rate and transfer the funds to GM.
c. This swap is possible because of market imperfections or different risks.
Corporations can reduce borrowing costs and increase control over interest rate risk and foreign
exchange exposure by using this somewhat complex, innovative financing arrangement.
Relatively new market, due to financial deregulation, integration of world financial markets, and
currency and interest rate volatility swapping market has grown significantly. Total amount of
outstanding interest rate swaps in 2004 was $128 Trillion, and $7 Trillion in currency swaps,
fastest growth was for Interest Rate Swaps. The five main currencies used in swapping: $, , ,
and SF.
Interest Rate Swap financing involves two parties (MNCs) who agree to exchange Cash Flows,
results in benefits for both parties. A single-currency interest rate swap is called an Interest
Rate Swap, and a cross-currency interest rate swap is called a Currency Swap.
Basic (plain vanilla) Interest Rate Swap involves exchanging (swapping) interest payments on
Floating-rate debt for interest payments on Fixed-rate debt, with both payments in the same
currency. Reason: One party actually wants fixed rate debt, but can get a better deal on floating
rate; the other party wants floating rate debt, but can get a better deal on fixed rate. Both parties
can gain by swapping loan payments (CFs), usually through a bank as a financial intermediary
(FI), which charges a fee to broker the transaction.
Currency Swap - One party swaps the interest payments of debt (bonds) denominated in one
currency (USD) for the interest payment of debt (bonds) denominated in another currency (SF or
GBP), usually on a "fixed-for-fixed rate" basis. Currency swap is used for cost savings on debt,
or for hedging long term currency risk.
SWAP BANK - Financial Institution (FI) in the swap business, either as dealer or broker, usually
large commercial and investment banks. Broker bank: Arranges and brokers the deal, but does
not assume any of the risk, just charges a commission/fee for structuring and servicing the swap.
Dealer bank: Bank that is willing to take a position on one side of the swap or the other, and
therefore assume some risk (interest rate or currency). Dealer would not only receive a
commission for arranging and servicing the swap, but would take a position in the swap, at least
until it sold its position later.
Example: Banks trading currency forward contracts. If they always match shorts and longs,
there is no risk, acting as brokers. For every party who want to buy BP forward from the bank,
there is a party selling BP forward to the bank. If the bank has a client who wants to sell 10m
forward (short position) in 6 months, and accepts the contract without a forward BP buyer (long),
it is exposed to currency risk by taking the long position itself. As a trader-broker, the bank can
do more business than just a broker, but involves assuming risk exposure.
EXAMPLE 6.1: FIXED-FOR-FLOATING INTEREST RATE SWAP
Bank A is AAA-rated bank in U.K., and needs a $10m cash inflow to finance 5-year, floating-
rate (based on LIBOR), Eurodollar term loans to its commercial clients. To minimize (eliminate)
interest rate risk, bank would prefer to match floating-rate debt (CDs or notes) with its expected
floating-rate assets (Eurodollar loans). Bank has two sources of debt/deposits available:
a) 5-YR FIXED-RATE BONDS @ 10% or
b) 5-YR FLOATING-RATE NOTES (FRNs) @ LIBOR
With floating rate loans and fixed rate debt, there is interest rate risk.
Therefore, bank prefers floating-rate debt, to match the floating rate loan (asset). For example, if
the bank pays LIBOR for its deposits and charges LIBOR + 2% on its loans, it will always have
a 2% spread (profit margin), whether LIBOR increases or decreases.
Company B is a BBB rated MNC in U.S., and needs $10m debt for 5 years to finance a capital
expenditure. MNC has two sources of debt available:
a) 5-YR FIXED-RATE BONDS @ 11.25% (higher risk than AAA bank)
b) 5-YR FLOATING-RATE NOTES (FRNs) @ LIBOR + .50%
With FRNs there is interest rate risk for the MNC if interest rates rise. Therefore, MNC prefers
fixed-rate debt to guarantee a fixed, stable interest expense.
Swap Bank can broker an interest rate swap deal (for a fee) with Bank A and Company B that
will benefit both counterparties. When structured properly, all three parties will benefit (Bank A,
Company B, and the swap bank).
"Risky" BBB "Safe" AAA
Company B Bank A Difference Risk Premium for Co. B
Fixed-Rate 11.25% 10% (11.25 - 10%) +1.25% Fixed-rate
Floating-Rate LIBOR +.5% LIBOR (LIBOR + .5%) - LIBOR (.50% Variable-rate)

QSD 0.75%
The key to an interest-rate swap is the QSD (Quality Spread Differential), the difference or
spread between fixed interest rates (Risky - Safe), and variable interest rates (Risky - Safe). Co.
B would have to pay 1.25% more than Bank A for fixed rate debt, but only .50% more for
variable rate. The QSD is 0.75%, reflecting the difference, or additional default risk premium on
fixed rate debt for MNC. The yield curve for fixed-rate risky debt is much steeper than for safe
debt, since with fixed-rate debt lenders will:
1) Not have an opportunity to adjust (raise) the rate once fixed,
2) Not have the opportunity to cancel the debt if the company gets in trouble, and
3) Not be able to change the terms of the loan.
All of these would be possible under floating-rate agreements, and lenders therefore have to
"lock-in" a high default risk premium for fixed-rate debt at the beginning of the loan.
When a QSD exists, it represents the potential gains from swapping if both parties get together,
through the swap bank. Here is one example of how the 0.75% QSD can be split up: Bank A will
save .375% per year in interest savings (or $37,500 per year for 5 years for $10m) and the MNC
will save .25% in the form of interest rate savings (or $25,000 per year for 5 years), and the swap
bank earns .125% per year profit on $10m to arrange the deal (or $12,500 per year for 5 years).
Or there is $75,000 in annual savings ($10m x 0.75%) to split 3 ways: $37,500, $25,000 and
$12,500 every year, or $375,000 in total savings over 5 years ($187,500, $125,000 and $62,500).
Without the swap, Bank A will pay variable-rate @ LIBOR, and Co. B will pay fixed-rate @
11.25%. With the swap, Bank A will pay all-in-cost (interest expense, transactions cost, service
charges) interest expense of LIBOR - .375% (saving .375%) and Co. B will pay all-in-cost
interest expense of 11% (saving .25%).
Here is how:
Instead of actually issuing the type of debt they really want, each party issues the opposite of
what they want, and then they swap CFs. Instead of variable debt at LIBOR, Bank A issues
fixed-rate Eurodollar bonds at 10%. Instead of issuing fixed rate at 11.25%, Co. B issues
variable-rate debt at LIBOR + .50%. The parties issue the debt that they don't want, and make
interest payments directly to the bondholders for 5 years. The swap bank then arranges the
following CF payments:
1. Co. B pays 10.50% fixed-rate interest (on $10m) to the Swap Bank, and the bank passes on
10.375% interest payment to Bank A in U.K.
(Swap bank makes the difference = 10.50% 10.375% = .125%).
2. Bank A pays LIBOR on $10m to the Swap Bank and they pass on LIBOR to Company B.
As a result, here is the net position of each party:
Bank A

Pays -10% fixed-rate interest to bondholders

Pays variable-rate -LIBOR interest to Swap Bank
Receives +10.375% fixed interest rate from Swap Bank
NET INTEREST = PAY LIBOR - .375% variable rate (w/swap), vs. LIBOR (w/o swap)
Company B
Pays variable-rate (LIBOR + .5%) to bondholders
Pays -10.50% fixed-rate to Swap Bank
Receives +(LIBOR) from Swap Bank
NET INTEREST = PAY 11.00% Fixed Rate (w/swap), vs. 11.25% (w/o swap)
Swap Bank
Receives 10.50% fixed-rate from Co. B
Pays 10.375% to Bank A (Net of +.125% on fixed-rate debt)
Receives LIBOR from Bank A
Pays LIBOR to Co. B
NET INCOME = .125%
Net result: Bank A borrows $10m at LIBOR - .375% instead of LIBOR, gets a variable-rate, and
saves 0.375% per year interest rate, or $37,500 per year in interest expense ($187,500 over 5
years).
Co. B borrows $10m at 11% instead of 11.25%, gets a fixed rate, and saves .25% per year in
interest rate, or $25,000 per year in interest expense ($125,000 over 5 years).
Swap Bank makes .125% per year on $10m to arrange the deal, or $12,500 per year ($62,500)
total.
Outcome: Gains from swapping: WIN-WIN-WIN for all three parties.
Note: All interest payments/CFs are in USD. Actually, only the net difference in dollar CFs
actually needs to be exchanged, NOT the gross amount. Example: Suppose that when the first
payment is due LIBOR = 8%.
Swap Bank could arrange a Currency Swap to:
1) Eliminate the long-term currency risk for both MNCs (transaction exposure), and
2) Reduce interest expense for both companies.
Each company has a "comparative advantage" at raising money in its home country, so each
MNC would issue debt domestically at a savings of 1% compared to the foreign MNC raising
funds (U.S. company raises $52m in U.S. at 8%, vs. 9% for the German MNC; German company
raises 40m in Germany at 6%, vs. 7% for the U.S. MNC).
Problem 6.16: Bank A and company B have been offered the following rates per annum on a $20
million 5-year loan:
Fixed rate Floating rate
Bank A: 12.0% LIBOR + 0.1%
Company B: 13.4% LIBOR + 0.6%
Bank A requires a floating-rate loan; company B requires a fixed-rate loan. Design a swap that
will net a swap bank, acting as an intermediary will receive 0.1% per annum commission and the
rest savings must appear equally attractive to both bank A and company B.
Solution: Company B pays 1.4% per annum more than Bank A in the fixed-rate markets and
only 0.5% per annum more in the floating-rate markets. Therefore, company B has a comparative
advantage in floating-rate markets but wants to borrow from the fixed rate markets. Bank A, on
the other hand, has a comparative advantage in fixed-rate markets, but wants to borrow from the
floating-rate markets. This leads to a swap being negotiated.

Company B Bank A Difference Risk Premium for Co. B

Fixed-Rate 13.40% 12% (13.40 - 12) +1.40% Fixed-rate
Floating-Rate LIBOR +.6% LIBOR+.1% (LIBOR + .6%) (LIBOR+.1%) (.50% Variable-rate)

QSD 0.90%
Since the swap bank would get 0.1% per annum, and the rest benefit should be equally attractive
to both companies, each of them should be better off by 0.4% per annum. This means that Bank
A will borrow at LIBOR + 0.1% 0.4% = LIBOR 0.3% and company B will borrow at 13.4%
0.4% = 13% per annum.
Bank A has these three sets of interest rate cash flows:
1. It pays fixed rate of 12% per annum to its outside lenders.
2. It receives 12.3% per annum from the bank.
3. It pays LIBOR to the bank.
Company B has these three sets of interest rate cash flows:
1. It pays floating rate of LIBOR +0.6% to its outside lenders.
2. It receives LIBOR from the bank.
3. It pays 12.4% to the bank.
The swap agreement is illustrated schematically below.
Bank A:
Pays -12% per annum to its outside lenders.
Pays variable rate LIBOR interest to Swap Bank
Receives +12.3% per annum from the Bank
NET INTEREST = PAY LIBOR - .30% variable rate (w/swap), vs. LIBOR +0.1% (w/o swap)
Company B:
Pays -12.4% to the Bank
Pays variable-rate (LIBOR+.6%) interest to its outside lenders
Receives LIBOR from the Swap Bank
NET INTEREST = PAY 13% Fixed rate (w/swap), vs. 13.40% (w/o swap)
Swap Bank
Receives 12.40% fixed-rate from Co. B
Pays 12.30% to Bank A (Net of +.10% on fixed-rate debt)
Receives LIBOR from Bank A
Pays LIBOR to Co. B
NET INCOME = .10%
Net result: Bank A borrows $20m at LIBOR - .30% instead of LIBOR+.1%, gets a variable-rate,
and saves 0.40% per year interest rate, or $80,000 per year in interest expense ($400,000 over 5
years).
Company B borrows $20m at 13% instead of 13.40%, gets a fixed rate, and saves .40% per year
in interest rate, or $80000 per year in interest expense ($400,000 over 5 years).
Swap Bank makes .10% per year on $20m to arrange the deal, or $20,000 per year (total
$100,000 for five years).
Financial benefits created by swap transactions
Consider the following statements:
1. A company with the highest credit rating, AAA, will pay less to raise funds under identical
terms and conditions than a less creditworthy company with a lower rating, say, BBB. The
incremental borrowing premium paid by a BBB company, which it will be convenient to
 refer to as a Credit quality spread, is greater in relation to fixed interest rate borrowings
than it is for floating rate borrowings and this spread increases with maturity.
2. The counterparty making fixed rate payments in a swap is predominantly the less
creditworthy participant.
3. Companies have been able to lower their nominal funding costs by using swaps in
conjunction with credit quality spreads.
These statements are fully consistent with the objective data provided by swap transactions and
they help to explain the Too good to be true feeling that is sometimes expressed regarding
swaps.
Currency swaps differ from interest swaps on the following counts:
1. An exchange of payments in two currencies.
2. Not only exchange of interest, but also an exchange of principal amounts.
3. Unlike interest rate swaps, currency swaps are not off balance sheet instruments since they
involve exchange of principal at the end of the period.
4. The interest payments at various intervals are calculated either at a fixed interest rate or a
floating rate index as agreed between the parties.
5. Currency swaps can also use two fixed interest rates for the two different currencies -
different from the interest rate swaps.
6. The agreed exchange rate need not be related to the market.
7. The principal amounts can be exchanged even at the start of the swap.
Currency swap not only saves interest expense, but locks in three exchange rates and
eliminates exchange rate risk:
1. Principal sums are exchanged now at the current ex-rate, $52m/40m = $1.30/.
2. The contractual (implicit) exchange rate for the annual payments would be $1.733/, since
the payments exchanged are: $4.16m / 2.40m = $1.7330/.
3. The implied exchange at maturity for the last interest payment and principal payment is
$56.16m ($52m principal + $4.16m interest) / 42.40m (40m principal + 2.40m interest) =
$1.3245 /. Therefore, the currency swap locks in a fixed exchange rate for YRS 1-4 and
another ex-rate for YR 5, and there is no currency risk.
Plain Vanilla Foreign Currency Swap

The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan
in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an
interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and
end of the swap. The two specified principal amounts are set so as to be approximately equal to one
another, given the exchange rate at the time the swap is initiated.

For example, Company C, a U.S. firm, and Company D, a European firm, enter into a five-year currency
swap for $50 million. Let's assume the exchange rate at the time is $1.25 per euro (e.g. the dollar is
worth 0.80 euro). First, the firms will exchange principals. So, Company C pays $50 million, and Company
D pays 40 million euros. This satisfies each company's need for funds denominated in another currency
(which is the reason for the swap).
 Figure 2: Cash flows for a plain vanilla currency swap, Step 1.

Then, at intervals specified in the swap agreement, the parties will exchange interest payments
on their respective principal amounts. To keep things simple, let's say they make these payments
annually, beginning one year from the exchange of principal. Because Company C has borrowed
euros, it must pay interest in euros based on a euro interest rate. Likewise, Company D, which
borrowed dollars, will pay interest in dollars, based on a dollar interest rate. For this example,
let's say the agreed-upon dollar-denominated interest rate is 8.25%, and the euro-denominated
interest rate is 3.5%. Thus, each year, Company C pays 40,000,000 euros * 3.50% = 1,400,000
euros to Company D. Company D will pay Company C $50,000,000 * 8.25% = $4,125,000.

Risks for the swap bank in the swap market

1. Interest rate risk, from a change in interest rates before the bank finds an opposing
counterparty for the other side of an interest rate swap. Swap banks that are traders stand ready
to take just one side of the swap now, and then later find a client for the other side.
2. Basis risk, when the floating rates are NOT pegged to the same index. Example: One
counterparty's payments are pegged to LIBOR and the other to the U.S. T-Bill rate. When the
two interest rate indexes do not move perfectly together, the swap could periodically be less
profitable, or even unprofitable for the bank.
3. Exchange rate risk, like interest rate risk, from changes in exchange rates during the time it
takes to offset the position with an opposing counterparty.
4. Mismatch risk, from a mismatch with respect to the size of the principal sums of the two
counterparties, the maturity date, or the debt service dates.
5. Political risk, from foreign exchange controls or taxes on capital flows, other political
problems that affect the swap, resulting in loss of profits for the bank.
To facilitate trading and make the swap market more efficient, there is an international swap
organization, International Swaps and Derivatives Association (ISDA), which acts to coordinate
swap activities, disseminate information, etc. The ISDA has developed two standard swap
agreements/contracts, one for int. rate swaps and one for currency swaps, that outline the terms
and conditions of a standard swap, address issues like default, early termination, etc.
FOOD FOR THOUGHT: Do we need the derivative market in Bangladesh?
SUMMARY:
A derivative is a financial instrument that offers a return based on the return of some other
underlying asset. In this sense, its return is derived from another instrument hence, the name.
As the defination states, a derivatives performance is based on the performance of an underlying
asset. This underlying asset is often referred to simply as the underlying. It trades in a market in
which buyers and sellers meet and decide on a price.; the seller then delivers the asset to the
buyer and receives payment. The price for immediate purchase of the underlying asset is called
the spot price. A derivative has a defined and limited life. A derivative contract initiates on a
certain date and terminates on a later date which is known as expiry date.
Derivative markets serve a variety of purposes in global social and economic systems. One of the
primary functions of future markets is price discovery. But options work in a slightly different
manner. Options are used in a different form of hedging that permits the holder to protect against
loss while allowing participation in gains if prices move favorably. Options do not so much
reveal prices as they reveal volatality. Perhaps the most important purpose of derivative market is
risk management. We define risk management as the process of identifying the desired level of
risk, identifying the actual level of risk, and altering the latter to equal the former. Often this
process is described as hedging, which generally refers to the reduction, and in some cases the
elimination of risk. On the other side is the process called speculation. Traditional discussions of
derivatives refer to hedging and speculation as complementary activities. In general, hedgers
seek to eliminate risk and need speculators to assume risk, but such is not always the case.
There are many participants in currency derivative market. For example, the central banks,
multinational companies, international banks, institutional investors, and currency speculators. A
forward contract protects oneself from the price fluctuations on the future commitment date to
extent of 100%. A future currency contract where one buys or sells a specific foreign currency
for delivery at a designated price in the future. Future currency contract is standardized whereas
forward contract can be made according to the other partys demand. For example, a CAD/USD
(Canadian dollar/U.S. dollar) futures contract traded on the Chicago Mercantile Exchange
(CME) has a contract size of C$100,000, whereas A EUR/USD contract on the CME has a size
of E$125,000. Currency option gives the holder of the option the right to buy or sell a foreign
currency at a specific price through a specified date. The holder of the option is by no means
obliged to exercise the option.
In practice, 98% of futures contracts are terminated before delivery, because they are nullified by
opposing trades. Hedgers buy and sell currency futures contracts to protect the home currency
value of foreign-currency denominated assets and liabilities. Speculators buy and sell currency
futures contracts for profit from exchange rates movements. A currency call option gives the
buyer the right, but not the obligation, to buy a particular foreign currency at any specified price
during the life of the option. On the other hand, a currency put option gives the buyer the right,
but not the obligation, to sell a particular foreign currency at any specified price during the life of
the option. For the currency option buyer the risk of loss is limited to the extent of losing
premiums but for the underwriter the loss could be unlimited especially on currency call option.
An option is said to be in the money if it would be profitable to exercise it at the current spot
rate. An option is said to be out of the money if it would not be profitable to exercise it at the
current spot rate. An option is said to be at the money if the strike price of any call or put option
equals the current spot rate. Intrinsic Value is the difference between the exchange rate of the
underlying currency and the strike price of a currency option. Currency option pricing could be
calculated using binomial option pricing model or Black-Scholes formula.
CASE STUDY 1: Could the government of Bangladesh use the derivative market to avert
the current economic situation?
The Awami league won national election with an absolute majority on December 29, 2008 as
part of a larger electoral alliance and took oath on January 6 th 2009. Before that almost two years
the country was under the rule of caretaker government. From the chart below we could see
during that time period an abrupt price hike and a crash of oil prices occurred in the international
oil market. It is very important to check the dates since June 2008 to January 2009 we have seen
the price went as high as almost $134 to as low as a price of only $39; the same time our present
government took office. At that time it was well known to our government that load shedding of
electricity is one of the main problems they have to solve as soon as possible.
To solve the problem the government took some short, mid, and long term projects given a mid
size (300 MW) power plant takes more than three years to go into operation. So as a short term
measure the government opted for quick rental power plant which takes only 3-6 months to set
up. Now the question is since the government already made up the mind at that time it will go for
quick rental to fix the crisis as soon as possible, should they not ensure the supply of fuel at a
price which is cost effective? If they did purchase the call options of crude oil derivatives when
they came to power in the beginning of 2009 and the price of crude oil was around $40 per barrel
then they could pay just $5-$10 call premium for $45 strike price which will have a ceiling price
of around $50 or even as high as $60 for a longer period and so it wont cause any negative
impact on our import bill where now this fiscal year it is doubling our import cost since the price
now crossed well above $100 per barrel.

If the government used the commodity derivative market in January, 2009 and hedged other
commodities like soya bean, wheat, cotton which Bangladesh is totally depended on foreign
imports then we could have avoided the double digit inflation (March, 2012) which is causing
now all the other problems like liquidity crisis, credit crunch, and reduction in private investment
which translates higher unemployment and takas depreciation. Given the current oil market
price of $120 per barrel, it is now not suitable to buy call options since the price almost hit the
record level. The same goes for the other importing commodities. Now lets look at why did we
suddenly end up to these present economic situation? Most blame goes to the sky rocketing price
of oil and other commodities that we must import but could the government not do anything
about it? However, the ineptness the government or the Bangladesh Bank has shown by not
using any available international financial instruments to minimize the risk exposure of our
aggregate economy is simply mind-boggling. The government seemed to have embarked on the
rental plant road without a clear idea about its finances, logistics and consequences. Now they
are trying to cut the subsidy by raising the oil price, gas price, electricity price, and bus fare
which is inviting more inflation and the excuse they are claiming that the blowout in subsidy is
due to unforeseen increases in the prices of petroleum products and not due to policy lapses. The
government must remember in this modern age there are lots of advanced financial instruments
available and by establishing a Financial Engineering Department it could very easily use those
advanced tools to minimize the risk exposure of our aggregate national economy. It is true the
government doesnt have any control over international oil prices but there is no restriction on
the government in using the derivative market to lock in a price that is affordable to most of us.
Question 1: How using the financial derivative instruments in 2009 could help the country to
avert the current financial problem? Explain please.
Question 2: What could be the reason behind a sharp fall in petroleum price is January, 2009?
Question 3: Why shouldnt we buy call options of petroleum now? How buying put options will
affect the risk exposure?
Question 4: How establishing a financial engineering department would help Bangladesh to
minimize the international financial risk exposure?
CASE STUDY 2: Currency swaps among SAARC countries.
Delhi shelves deal
Shakhawat Hossain, New Age (Bangladesh)
New Delhi has shelved a proposal on currency swap among the countries of South Asian
Association for Regional Cooperation, sources at Bangladesh Bank said.
The government of India is yet to endorse the proposed framework on currency swap as agreed
by the central bank governors of the SAARC nations at a meeting in Washington last September.
India had also agreed to contribute initial investment of US$ 2 billion to get the currency swap
scheme operational.
Officials of the Reserve Bank of India informed the BB officials that the document was still
under consideration of the government of India for approval until last month, said the BB
officials.
The currency swap deal among the SAARC countries was first recommended at 16th SAARC
Summit in Bhutan in 2010 to tackle short term liquidity crisis of foreign currencies.
The deal would make import payments of the SAARC countries a lot easier. As a member,
countries could exchange their currencies with other member countries struggling with inflation,
poverty, inequality and employment.
At present, the US dollar is used for the purpose of imports and the exports.
The proposed deal is expected to be highlighted in the upcoming meeting of the finance
ministers of the SAARC countries in Dhaka.
The ministry of finance officials who are organizing the two-day event on January 29-30 said the
issue has already been included in the agenda along with reduction of sensitive lists and ways to
boost investments in SAARC countries.
Dhaka is optimistic about a positive outcome on the currency swap as it is facing shortage of
foreign currency due to growing import payments.
Bangladeshs annual import payments to India stood at more than $4 billion. It would be a relief
for the BB if the payment can be paid in local currency.
Earlier, BB had sought opinions of the different ministries and divisions on the currency swap.
The finance ministry welcomes the move and suggested that the interest rate should be around 2
per cent.
The BB officials pointed out that most of the Asian countries were less vulnerable than many
countries in Europe and America during the global economic crisis in 2009 because of good
financial system.
Several currency swap agreements were signed in 2000 among East Asian countries for tackling
financial risks.
New Delhi last month struck a $15 billion currency swap deal with Tokyo. It was an expansion
of a $3 billion accord that expired earlier this year.
Question 1: How introducing currency swap would help the SAARC countries to increase trade?
Question 2: Write down the pros and cons of signing this deal for Bangladesh.
Question 3: Should we just confine it to only SAARC member states or include China as well?
Question 4: Write down the risks involved in currency swap and explain it please.
CASE STUDY 3: Companies cut loose from currency derivatives
4 Mar, 2008, 0307 hrs IST, Sugata Ghosh, TNN
March 4 (India Times). MUMBAI. Corporates are walking out of currency derivatives. In the
past few weeks, more than 100 companies have cancelled their derivative contracts with banks to
cut their losses. The fear of large derivative hits has suddenly deepened following the abnormal
surge in currencies like the Swiss franc and yen against the dollar.
Amid a relentless dollar hammering in the international markets, these currencies have
appreciated 3-4% against the greenback in the past one week a swing big enough to wipe out
much of what companies had earned from these deals.
Between June and September 2007, there were a flurry of deals as corporates entered into swap
contracts to convert their liability into Swiss francs and yen.
(It looked irresistible: since interest rates on these currencies were significantly lower, converting
local loans into these currencies was a quick way to cut cost, and improve profits.) The bet
turned sour when the currencies began to rise. Today, many banks are advising their clients to
exit these deals.
Its no longer wise to keep on punting. A large number of contracts are expiring between April
and July. The loss could be bigger if you keep the positions open, said a senior banker who has
advised 50% of his clients to cancel the deals.
On expiry, a corporate has to pay the difference in the liability that has been swapped with the
bank. As exchange rates have moved, chances are they will have to fork out much more than
what they had thought when the contracts were signed.
In many cases corporates also did an option contract to protect the risk on such swaps. However,
these call options were conditional risk protection products. For instance, a contract might say
that as long as the Swiss franc (CHF) does not appreciate beyond 1.05 against the dollar (i.e.,
USD 1 = CHF 1.05), the corporate can buy Swiss franc at a rate of USD 1 = CHF 1.20.
If the exchange rate breaches 1.05 CHF/USD say, touches 1.03 (which it did on Monday)
the corporate will no longer get Swiss franc at 1.20 CHF/USD; then, it will have to buy from the
market which has turned more expensive. Even as late as September 2007, few thought the
Swiss franc would touch 1.03 CHF/USD.
At any point in the life of the derivative contract (be it a swap or an option), bankers take note of
the mark-to-market position that the corporate is faced with. Even if a contract expires in July, a
corporate may be facing a mark-to-market loss of USD 2 million today. This means that in July it
will have to pay the bank USD 2 million more than what it had calculated a year ago.
If the market miraculously improves (i.e., Swiss franc and yen fall sharply) in the next four
months, the corporate will be out of the woods in July when it has to make the final payment to
the bank. But today that looks unlikely. Given the bearish outlook on dollar, not many corporates
are willing to hold on to their bets.
A mark-to-market loss hits corporates in another way. When a corporate is out of money (say,
down by USD 2 million in the mark-to-market position), the bank often asks the corporate to
furnish extra cash collateral. Since the corporate is sitting on a loss position, the bank becomes
extra careful in protecting its own books.
This mostly is the case for small and mid-cap corporates. At times the banks derivatives sales
team persuades the banks risk-management division to increase the credit limit to the corporate.
But, this is unlikely to be accepted if liquidity is tight as is the case now.
If the bank is also a lender to the corporate, it quickly prunes the working capital limit. In other
words, if a corporate is not big enough or look even a little shaky, banks do (may be, rightly so)
what is required to protect its exposure.
But when things look grim and unlikely to change dramatically, the wisest thing may be to book
losses and exit before its too late. Today, many corporates are doing just that.
Question 1: Explain the speculation undertaken by the corporations described in the article.
What kind of a distribution for St (CHF/USD) they had in mind?
Question 2: Explain the logic behind the senior banker who advised 50% of his clients to cancel
the deals.
Question 3: Explain the conditional call options used by many corporations. What kind of
insurance did they provide? Why were they used instead of the traditional call options?
Question 4: Explain how the mark-to-market works and how it affected the corporations
described in this article.
Question 5: Obviously, when one trader goes long, another goes short. Given the tone of the
article, describing a bearish outlook for the dollar, why would anybody take the other side?
TRUE/FALSE
1. Currency forwards could be used to hedge against abrupt price fluctuations.
2. Hedgers take pure speculative position on currency.
3. Currency futures are government regulated whereas forward is self-regulated.
4. A currency call option gives the buyer the right to buy the currency at the spot price.
5. A currency put option gives the buyer the right to sell the currency at exercise price.
6. The higher the volatility the higher the premium for a currency option.
7. The Black-Scholes option pricing model assumes a constant risk-free interest rate.
8. An importer should buy a put option to minimize currency risk.
9. There is no risk for the Swap bank in the Swap market.
10. Bangladesh has a well established currency derivative market.
MULTIPLE CHOICE QUESTIONS:
1. In the forward market
a) Market participants agree to buy or sell foreign currency in the future at prices agreed-upon
today.
b) Market participants agree to buy (not sell) foreign currencies in the future at prices agreed-
upon today.
c) Market participants pay today for a specific amount of foreign currency to be received in the
future.
d) Market participants agree to buy and sell fixed amounts of foreign currency at spot prices that
will prevail in the future.
2. Consider a trader who takes a long position in a six-month forward contract on British
pounds. The forward rate is $1.75 = 1.00; the contract size is 62,500. At the maturity of
the contract the spot exchange rate is $1.65 = 1.00
a) The trader has lost $625. b) The trader has made $625.
c) The trader has lost $6250. d) The trader has made $6250.
3. Suppose that Bangladesh inflation is 13%; inflation in Japan is only 1% and the spot
exchange rate is 1 BDT = 1 Yen. What is your estimate of the exchange rate expected to
prevail in 3 years?
a) 1 BDT = 1.40 Yen b) 1.40 BDT = 1 Yen c) 0.70 BDT = 1 Yen d) None
4. Suppose interest rate in Bangladesh is 12% when the spot exchange rate is $ 1 = 77 BDT
and the interest rates in USA is 5% per year. What must be one year forward rate
according to interest rate parity theory?
a) $1 = 81.35 BDT b) $1 = 79.5 BDT c) $1= 82.5 BDT d) None
5. Suppose interest rates in the U.S. are 5% when the spot exchange rate is $0.75 = 1 and
the interest rate in France is 8% per year. What must the one-year forward exchange rate
be?
a) $0.7292 = 1 b) $0.75 = 1 c) $0.7714 = 1 d) $0.81 = 1
6. Suppose you observe the following exchange rates: S($/) = 0.85 (i.e. 1 = $.85) The one-
year forward rate is F1($/) = 0.935 (i.e. 1 = $.935) The risk-free interest rate in the U.S. is
5% and in Germany it is 2%. How can a dollar-based investor make money?
a) Borrow dollars in the U.S., exchange for euros, invest in Germany, enter into a one-year
forward contract; in one year, translate the euros back into dollars at the forward rate.
b) Borrow euros, translate into dollars at the spot, invest in the U.S. at 5% for one year. At the
end of the year, translate part of your dollar investment back into euros at the forward rate to
repay your euro debt.
c) There are no profitable arbitrage opportunities
d) a & b both.
7. A call option
a) is a contract to buy a certain quantity of a specific underlying asset at a specific price at a
specified date in the future.
b) gives the holder the right, but not the obligation, to sell the underlying asset for a stated price
over a stated time period.
c) is an exchange traded contract to buy a certain quantity of a specific underlying asset at some
specific price at a specified date in the future
d) gives the holder the right, but not the obligation, to buy the underlying asset for a stated price
over a stated time period.
8. Consider a trader who opens a short futures position. The contract size is 62,500, the
maturity is six months, and the initial price is $1.50 = 1. The next day, the settlement price
is $1.60 = 1. What is the amount of his gain or loss?
a) $6,250 gain b) $6,250 loss c) No loss d) No gain
9. Use the binomial option pricing model to estimate the value of the following call option.
Maturity is one year; the risk-free rate is 10% per annum. The stock is worth $50 today
and in one year the stock will be worth $60 or $40. The exercise price of the option is $50.
a) $6.82 b) $0 c) $13.64 d) $11.12
10. Suppose you wish to speculate on a rise in the value of the Japanese Yen. If you are
correct and the value of the Yen does indeed rise in the future against BDT:
a) you would profit with a SHORT position in a futures contract on the Yen
b) you would profit with a LONG position in a futures contract on the Yen
c) you should hedge your position to make money from yen
d) none of the above
11. For two otherwise-identical put options, the more valuable put option will have
a) a lower strike b) the higher strike c) a larger spot price d) None
12. Which of the following is the most likely strategy for a Bangladeshi firm that will be
receiving Swiss francs in the future and desires to avoid exchange rate risk? (Assume the
firm has no offsetting position in francs)
a) purchase a call options on frans
b) sell a future contracts on frans
c) obtain a forward contract to purchase frans forward
d) all of the above are appropriate strategies
13. Which of the following is true?
a) Most forward contracts between firms and banks are for speculative purposes.
b) Most future contracts represent a conservative approach by firms to hedge foreign trade.
c) The forward contracts offered by banks have maturities for only four possible dates in the
future.
d) none of the above

14. A UK corporation has purchased currency call options to hedge a 70,000 dollar payable.
The premium is 0.015 and the exercise price of the option is 0.54. If the spot rate at the
time of maturity is 0.59, what is the total amount paid by the corporation if it acts
rationally?
a) 36,750 b) 37,800 c) 1,050 d) 38,850

15. Options are exercised when they are --------.

a) in the money b) at the money c) out of the money d)
unknown
16. A speculator in the future market wishing to lock in a price in which they could -----a
foreign currency will -----a future contract.
a) sell; buy b) buy; sell c) sell; sell d) buy; buy
17. The premium of a currency put option will increase if:
a) the volatility of the underlying asset goes up.
b) the time to maturity goes up.
c) the spot rate declines.
d) none of the above.
18. European currency options can be exercised _______; American currency options can
be exercised _______.
a) any time up to the expiration date; any time up to the expiration date
b) any time up to the expiration date; only on the expiration date
c) only on the expiration date; only on the expiration date
d) only on the expiration date; any time up to the expiration date
19. Speculators in currency futures markets are .
a) covered by options contracts c) usually making profits
b) covered by future contracts d) greatly exposed to exchange rate risk
20. Hedging strategy is done due to
a) Minimizing risk exposure c) ) save commission on transaction
b) Speculating and making money d) All of the above.
21. A currency swap bank is usually .
a) an end user c) a currency speculator
b) a financial liability d) a financial intermediary
22. The current U.S dollar- yen spot rate is 120 yen/$. If the 180 day forward exchange rate
is 125 yen/ $then the yen is selling at a per annum -------- of ------------.
a) discount; 8% b) discount; 1.57% c) premium; 8% d) premium; 1.57%
23. For all parties involved, which of the following financial instrument is not an example
of a forward commitment?
a) Swap b) options c) futures d) forward
24. The spot rate for the Singapore dollar is 0.320. The 30-day forward rate is 0.325. The
forward rate contains an annualized __________ of ___________%.
a) Discount; -18.75 b) premium; 18.75 c) premium; 1.76 d) premium; 18.46
25. The most likely reason derivative markets have flourished is that:
a) derivatives are easy to understand and use.
b) derivatives have relatively low transaction costs
c) the pricing of derivatives is relatively straightforward.
d) derivatives has very little risk
26. The put-call parity theorem
a) represents the proper relationship between put and call prices.
b) allows for arbitrage opportunities if violated.
c) may be violated by small amounts, but not enough to earn arbitrage profits, once transaction
costs are considered.
d) all of the above.

SHORT ANSWER QUESTIONS:

1. What is a currency forward contract? What are the advantages and disadvantages of currency
forward contract?
2. How to calculate forward contract? Give an example please.
3. How to calculate currency forward premium and discount? Example please.
4. Who are hedgers and speculators?
5. What is a currency future market?
6. Write down the differences between currency futures and forwards.
7. What is an option? How does call option differ from put option?
8. What is an American option and European option?
9. What is currency swap? Why did Swap market grow so exponentially?
10. What are the risks involved for the Swap bank or swap dealer?
LONG ANSWER QUESTIONS:
1. Describe how currency futures contracts are used to speculate based on anticipated exchange
rate movements? What are the factors on which the value of an options contract depends?
2. How do the speculators and hedgers operate in the currency option market?
3. How can a Bangladeshi importer and exporter hedge in the currency market to protect him/her
from the abrupt currency movement?
4. Explain the situation in which a speculator can take a position in option market and make
profit.
5. A call option on American dollars with a strike price of 85 BDT is purchased by a speculator
for a premium of BDT 1.25 per dollar. Assume there are $100000 in this option contract. If the
US dollar spot rate is 87.5 BDT at the time the option is exercised, what is the net profit per unit
and for one contract to the speculator? What the spot rate needed to be at the time the option is
exercised for the speculator to break even? What could be the highest profit per unit to the seller
of this option? Show your answer by sketching diagrams.
6. Suppose a Bangladeshi exporter is expecting to receive $5 million sometime in the next three
months from an American importer. To hedge this, the Bangladeshi exporter buys an option on
the US$. The premium is 0.65 BDT/US$, for options with Exercise price = 84.5 BDT/US$.
a) What option should he buy?
b) What is the cost incurred today by the Bangladeshi exporter?
c) What is the ceiling that the exporter has set on the price of US$?
d) What is the actual amount that the exporter will receive if the spot rate at the end of three
months is 85.5 BDT/US$?
e) What is the actual amount that the BD exporter will receive if the spot rate at the end of three
months is 79.5 BDT/US$?
f) Should the American importer also buy an option? Why or why not?
7. If the spot price is 82.5BDT/US$ and the 3 months European call option exercise price is
84.25BDT/US$. If our interest rate is 13% and U.S. interest rate is 4% and given the standard
deviation, is 0.141, what should be the price of this European call option?
8. If the spot price is 82.5BDT/US$ and the 3 months European put option exercise price is
81.75BDT/US$. If our interest rate is 12% and U.S. interest rate is 5% and given the standard
deviation, is 0.181, what should be the price of this European put option?
9. What are the financial benefits created by the swap transactions? How currency swaps differ
from interest swaps?
10. Companies A and B have been offered the following rates per annum on a $20 million 5-year
loan:
Fixed rate Floating rate
Company A: 12.0%, LIBOR + 0.3%
Company B: 13.8%, LIBOR + 0.9%
Company A requires a floating-rate loan; company B requires a fixed-rate loan. Design a swap
that will net a bank 0.1% per annum and that will appear equally attractive to both companies.
How much will each party save by swapping in the next 5 years?