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This chapter explain how forward contracts are used to hedge based on anticipated exchange rate movements, describe how currency futures contracts are used to speculate or hedge based on anticipated exchange rate movements, explain how currency option contracts are used to speculate or hedge based on anticipated exchange rate movements. | 1 1 2 5 Currency Derivatives Explain how forward contracts are used to hedge based on anticipated exchange rate movements Describe how currency futures contracts are used to speculate or hedge based on anticipated exchange rate movements Explain how currency option contracts are used to speculate or hedge based on anticipated exchange rate movements 2 Chapter Objectives 2 3 What is a Currency Derivative? A currency derivative is a contract whose price is derived from the value of an underlying currency. Examples include forwards/futures contracts and options contracts. Derivatives are used by MNCs to: Speculate on future exchange rate movements Hedge exposure to exchange rate risk 4 Forward Market A forward contract is an agreement between a corporation and a financial institution: To exchange a specified amount of currency At a specified exchange rate called the forward rate On a specified date in the future 5 How MNCs Use Forward Contracts Hedge their imports by locking in the rate at which they can obtain the currency Bid/Ask Spread is wider for less liquid currencies. May negotiate an offsetting trade if an MNC enters into a forward sale and a forward purchase with the same bank. Non-deliverable forward contracts (NDF) can be used for emerging market currencies where no currency delivery takes place at settlement, instead one party makes a payment to the other party. 6 Premium or Discount on the Forward Rate F = S(1 + p) where: F is the forward rate S is the spot rate p is the forward premium, or the percentage by which the forward rate exceeds the spot rate. 7 Exhibit 5.1 Computation of Forward Rate Premiums or Discounts 8 Premium or Discount on the Forward Rate Arbitrage – If the forward rate was the same as the spot rate, arbitrage would be possible. Movements in the Forward Rate over Time – The forward premium is influenced by the interest rate differential between the two countries and can change over time. Offsetting a Forward Contract – An MNC can offset | 1 1 2 5 Currency Derivatives Explain how forward contracts are used to hedge based on anticipated exchange rate movements Describe how currency futures contracts are used to speculate or hedge based on anticipated exchange rate movements Explain how currency option contracts are used to speculate or hedge based on anticipated exchange rate movements 2 Chapter Objectives 2 3 What is a Currency Derivative? A currency derivative is a contract whose price is derived from the value of an underlying currency. Examples include forwards/futures contracts and options contracts. Derivatives are used by MNCs to: Speculate on future exchange rate movements Hedge exposure to exchange rate risk 4 Forward Market A forward contract is an agreement between a corporation and a financial institution: To exchange a specified amount of currency At a specified exchange rate called the forward rate On a specified date in the future 5 How MNCs Use Forward Contracts Hedge their imports by locking in the rate
