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,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,Click to edit Master title style,2013 Pearson Education,Inc.All rights reserved.,8-,*,Chapter,8,Foreign Currency Derivatives and Swaps,Foreign Currency Derivatives and Swaps,Financial management of the MNE in the 21,st,century involves,financial derivatives,.,These derivatives,so named because their values are derived from underlying assets,are a powerful tool used in business today.,These instruments can be used for two very distinct management objectives:,Speculation,use of derivative instruments to take a position in the expectation of a profit,Hedging,use of derivative instruments to reduce the risks associated with the everyday management of corporate cash flow,0,Foreign Currency Derivatives,Derivatives are used by firms to achieve one of more of the following individual benefits:,Permit firms to achieve payoffs that they would not be able to achieve without derivatives,or could achieve only at greater cost,Hedge risks that otherwise would not be possible to hedge,Make underlying markets more efficient,Reduce volatility of stock returns,Minimize earnings volatility,Reduce tax liabilities,Motivate management(agency theory effect),0,Foreign Currency Futures,A,foreign currency futures contract,is an alternative to a forward contract that calls for future delivery of a standard amount of foreign exchange at a fixed time,place and price.,It is similar to futures contracts that exist for commodities such as cattle,lumber,interest-bearing deposits,gold,etc.,In the U.S.,the most important market for foreign currency futures is the International Monetary Market(IMM),a division of the Chicago Mercantile Exchange.,0,Foreign Currency Futures,Contract specifications are established by the exchange on which futures are traded.,Major features that are standardized are:,Contract size,Method of stating exchange rates,Maturity date,Last trading day,Collateral and maintenance margins,Settlement,Commissions,Use of a clearinghouse as a counterparty,Exhibit 8.1 is an excellent description of futures contracts for the Mexican peso,0,Exhibit,8.1,Mexican Peso(CME)-MXN 500,000;$per 10MXN,Foreign Currency Futures,Foreign currency futures contracts differ from forward contracts in a number of important ways:,Futures are standardized in terms of size while forwards can be customized,Futures have fixed maturities while forwards can have any maturity(both typically have maturities of one year or less),Trading on futures occurs on organized exchanges while forwards are traded between individuals and banks,Futures have an initial margin that is market to market on a daily basis while only a bank relationship is needed for a forward,Futures are rarely delivered upon(settled)while forwards are normally delivered upon(settled),0,Foreign Currency Options,A,foreign currency option,is a contract giving the option purchaser(the buyer)the right,but not the obligation,to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period(until the maturity date).,There are two basic types of options,puts,and,calls,.,A call is an option to buy foreign currency,A put is an option to sell foreign currency,0,Foreign Currency Options,The buyer of an option is termed the,holder,while the seller of the option is referred to as the,writer,or,grantor,.,Every option has three different price elements:,The,exercise,or,strike,price the exchange rate at which the foreign currency can be purchased(call)or sold(put),The,premium,the cost,price,or value of the option itself,The underlying or actual spot exchange rate in the market,0,Foreign Currency Options,An,American,option gives the buyer the right to exercise the option at any time between the date of writing and the expiration or maturity date.,A,European,option can be exercised only on its expiration date,not before.,The premium,or option price,is the cost of the option.,0,Foreign Currency Options,An option whose exercise price is the same as the spot price of the underlying currency is said to be,at-the-money,(ATM).,An option that would be profitable,excluding the cost of the premium,if exercised immediately is said to be,in-the-money,(ITM).,An option that would not be profitable,again excluding the cost of the premium,if exercised immediately is referred to as,out-of-the money,(OTM).,0,Foreign Currency Options,In the past three decades,the use of foreign currency options as a hedging tool and for speculative purposes has blossomed into a major foreign exchange activity.,Options on the over-the-counter(OTC)market can be tailored to the specific needs of the firm but can expose the firm to,counterparty risk,.,Options on organized exchanges are standardized,but counterparty risk is substantially reduced.,Exhibit 8.2 shows a published quote for the Swiss Franc.,0,Exhibit,8.2,Swiss Franc Option Quotations(U.S.cents/SF),Buyer of a Call Option,Buyer of an option only exercises his/her rights if
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