Question A
Introduction
Currency risk arises due to fluctuations of the currency as a result of supply and demand of the currency. Any business or companies that carry out operations in another country is subject to currency risk. Currency risk management helps to cushion the business against any adverse effects of currency fluctuations. Exchange rate movements may result to a gain to the business or a loss. Due to the uncertainty involved in predicting the effects of currency fluctuations, businesses tend to engage in currency management options.
There are various methods that can be used in managing currency risk. Forward foreign exchange, also known as forward contracts, is the contract between two parties in which the value of the contract in the future is agreed today. The price of the contract is agreed upon today. The contract does not involve intermediaries. The parties to the contract have the option of defaulting due to lack of intermediaries . Currency option is another method used in managing currency risk. A currency option gives the vendor the right to acquire or sell a foreign asset or liability at a specified exchange rate at some future point. The options contract is classified into two . The call option gives the holder the right to buy and the put alternative the right to sell the asset or liability. However, the holder is not under an obligation to exercise the right. In this case, we are going to focus on the use of currency option in managing currency risk.
Example
Exercise price Calls Puts
.82 USD/CAD - 0.21
.84 USD/CAD 1.58 0.68
Solution
Incase ABC Limited decides to use the first option, 0.82 USD/CAD, there is no option to buy. The only option available in this case is the put option. The total premium cost, also known as option price, incurred will be equal to:
USD 0.0021*300M = USD 0.63M.
After the 90 day period, ABC Limited has two options. The option can either be exercised or not exercised. In case the option is exercised, the option is said to be in the money. When the option is in the money, the exercise value is higher than the value of the security. In case the option is not exercised, the option is said not to be in the money.
The situations at t+90 days are shown in the following table.
In case St< 0.84 USD/CAD in case St > 0.84USD/CAD
Option (.84-St) CAD 300M 0
+ St CAD 300M St CAD 300M
Total USD 252M St CAD 300M
The value 252 is obtained from 0.84 * 300 = 252. This is the amount of USD they will obtain if they exchange at a rate of 0.84 and below but the maximum amount at that rate is 252.
Therefore, the cash flows, which are expected in 90 days, are:
USD 249,960,000 in case St < .84 USD/CAD
St CAD 300M-2.04M in case St > .84 USD/CAD
St represents the spot price of the asset at a particular time, t.
249,960,000 is obtained from the difference between 252M- 2.04M = 249.96M. Where 2.04M = 300M * 0.68
The pay off diagram for the above scenario is as follows.
USD 249,960,000 is the minimum amount of money ABC Limited should transfer. It represents the worst case scenario as a result of fluctuations in the currency exchange rate. In case St > .84 USD/CAD, the option is out of the money. This implies that it will not be exercised. This is because ABC Limited will receive a higher amount than the CAD 300M. However, the amount ABC Limited will transfer is still uncertain as long as the amount does not go below the minimum amount set, USD 249,960,000.
Question B
A future derivative is an agreement to buy or sell a certain quantity of foreign currency for delivery at a future date, at a given exchange rate. Unlike the forward markets, future markets require a broker who negotiates the terms of the contract for a specified amount of foreign exchange at an optimum rate . Future contracts involve payment of transaction costs, which is referred to as the margin deposit. A forward contract is payable upon maturity while a future contract can be paid anytime between the time of making the contract and the maturity time of the contract. Future contracts transactions are traded on a structured exchange market.
With the help of the closest settlement date, an Australian Dollar contract, the volume of transactions is 185,246. The open interest using the settlement data is 180,346. The information on the futures price was accessed on 20th June 2013. The price of the Australian Dollar Contract is different from the price of the previous day. A summary of the future price of the Australian Dollar contract is shown in the following table.
The prior day settlement price, 19th June 2013, for the Australian Dollar contract was .9281. This represented a volume of 145,030 transactions with an open interest rate of 178,473. This shows that the price of the Australian Dollar Contract does not remain constant. The price fluctuates depending on the prevailing exchange rate.
The change in the futures price can be explained by the quantity of information existing in the market regarding the future spot price. The future spot price is the intrinsic value of a security in the foreign exchange market. In case new information is released into the market, the future spot price will change. Information is regarded as very crucial in determining the security's price. In case new information is released into the market regarding the future spot price, there is a likelihood of price change in the future spot price. The foreign exchange market adjusts depending on the information released. The future spot price will be more volatile when there is a lot of information than in situations of little or no information. The risk attitude of the investor can also help to explain the changes in the futures price in the foreign exchange market. Risk adverse investors hold a balanced position in dollars.
The change in the settlement futures price of the Australian Dollar contract can be due to variations in demand and supply of dollars. The cause is known as the market forces of demand and supply. In some situations, the demand for the dollar is very high such that it exceeds the supply. In such a scenario, the dollar price will go up. Consequently, the exchange rate will also go up. This leads to a change in the settlement price of the future contracts. The case also applies to the Australian Dollar Contract. Inflation is the main reason which affects the exchange rate fluctuations. In case there are expectations that there will be inflation in the future, people will tend to minimize the risks associated with the foreign exchange risk. As a result, there is a discrepancy between the demand and supply of the foreign currencies.
A change in the future prices of future contract can be due to uncertainty in the foreign exchange market. The foreign exchange market is an international set-up of markets and institutions which deal in buying and selling of foreign currencies. The foreign exchange markets are found in various countries. The markets are interconnected to each other electronically by the use of telephone cables and computer terminals . There is a high degree of improbability in the foreign exchange market. All the players in the foreign exchange market cannot predict with certainty the likely outcome in the future. The main players in the foreign exchange market are the exporters, importers, investors, speculators and money launderers. Each player in the foreign exchange market aims at maximizing gains and minimizing losses due to differences in the exchange charge of different countries. The uncertainty in the foreign exchange market creates volatility in the exchange rates. The volatility will still be experienced even in situations where there is no new information released into the market.
Psychological factors are another main cause for changes in the prices of future prices in the Chicago Mercantile Exchange market. The human mind is the guiding factor in the foreign exchange market trading. All players in the foreign exchange make an investment and trading decisions based on their own perception. Human mind influences the human characteristics of an investor. Fear is the main human behavior which has an effect on the price movements in the foreign exchange market. Fear may lead to a reduction in future prices. Buying and selling decisions are based on fear and not rational decisions. In most cases, fear leads to a reduction in the future prices. Greed also plays a considerable role in shaping the price of the futures price. Some investors or players will want to buy stock out of influence rather than on rational valuation. Greed often leads to an increase in prices.
A contract based on 100,000 Australian dollars will require a settlement point change of 0.9156. The total amount of US Dollars required for the contract is USD 91,560. The settlement date will be on September 2013.
References
CME Group. (2013, June). PRELIMINARY PRICES. Retrieved from ftp://ftp.cmegroup.com/pub/settle/stlcur
Hull, J. (2009). Options, Futures and Other Derivatives. New York: Prentice Hall Higher Education.
Schinasi, G. J. (2000). Modern Banking and Otc Derivatives Markets: The Transformation of Global Finance and Its Implications for Systemic Risk. Washington: International Monetary Fund.
Weithers, T. (2011). Foreign Exchange: A Practical Guide to the FX Markets. New York: John Wiley & Sons.
Whaley, R. E. (2007). Derivatives: Markets, Valuation, and Risk Management. New York: John Wiley & Sons.
