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International financial
Management
Harisha.B.V.AIP(finance & control)IIMB
HARISHA.B.V.
AIP(FINANCE AND CONTROL)
IIM BANGALORE
MODULE 2
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Module 2
Foreign exchange markets-
Harisha.B.V.AIP(finance & control)IIMB
unc ons Participants
Currency derivatives
interest rate futures
Speculations.
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Foreign exchange markets
The foreign exchange market is that in whichcurrencies are bought and sold against each other.
Harisha.B.V.AIP(finance & control)IIMB
The bulk of this is accounted for a small number
of currencies US dollar,deutsche mark, yen,
pound ,Swiss franc, Canadian dollar,Dutch
guider,Italian lira,Belgian franc,euro.
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Over the counter market
Foreign exchange market is an over the countermarket.
The market s ans all the time zones of the world
Harisha.B.V.AIP(finance & control)IIMB
and function virtually round the clock,enabling atrader to offset a position created in one market
using another market.
The major ones are London, New York,Tokyo,Zurich,Frankfurt,Hong Kong, and
Singapore.
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Structure of foreign exchange
market
It is made up of
Retail market-travellers and tourists and other
Harisha.B.V.AIP(finance & control)IIMB
individuals uses this market.the total turnover andaverage size are very small.
Wholesale market- this is interbankmarket.commercial banks,investmentbanks,corporations and central bank participate.theaverage transaction and size is very large.
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Primary price markers and
secondary price makers
Primary price makers or professional dealers make
a two way market to each other and to theirclients.they will give a two way price .They makethe prices.
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First tier consists of a giant MNB deal in a largenumber currencies in large amounts and often dealdirectly with each other without using brokers.
The second tier are large banks who deal in asmaller number of currencies and use the services
of brokers more often.
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Secondary price makers
Secondary price makers are entities whichmake foreign exchange prices but do not
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MARKET).
Restaurants , hotels, shops catering to
tourists buy foreign currency in payment ofbills.
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Other important points
The spread between buying and selling prices with
secondary price makers or retail market will be
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price makers.
Foreign exchange brokers act as middle menbetween two market makers. The brokers do not
buy or sell on their own account.
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Role o central banks
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Central banks intervene in the market from
time to time to attempt to move exchange
rates in a particular direction.
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Contribution of volume
Cross border exchanges of goods and servicesaccount for a very small proportion .
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The large volume will be from capital account .
As banks usually aim to maintain square or near
square positions, a lot of turnover is simple
attributable to banks offsetting their positions.
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speculators
There is no distinct class of speculators inthe foreign exchange market.
Price makin banks often carr uncovered
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positions to profit from exchange ratemovements.
A non financial corporations which does not
hedge its foreign currency export receivableor import payable is as much a speculator.
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The mechanics of currency
trading
The international standard organization has developed three lettercodes.
USD-US DOLLAR
GBP-GREAT BRITAIN POUND
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-
CHF-SWISS FRANC
SEK-SWEDISH KRONER
CAD-CANADIAN DOLLAR
BEF-BELGIAN FRANC
NLG-DUTCH GUIDER
DEM-DEUTSCHE MARK
SAR-SAUDI RIYAL
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Inter bank dealing
A typical spot transaction
Monday 21 sep 10.45 a.m.
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an : p ease Bank B: 40-45
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Bank B is specifying a two way price, it isquoting last two digits.
Harisha.B.V.AIP(finance & control)IIMB
The actual price will be 0.8740/0.8745
The last two digits are called points or pips.
Then bank A says mine(willing to buy)
If it wants to sell then it might have said yours
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Warehousing deal and Back to
Back dealing
When Bank B gives the quote which isbased on information about the currentmarket it is called as warehousing deal.
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When B calls C and gets the quote and thengives to A .If A does a deal, B will
immediately offset it with C.this is back toback dealing.
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Short and long positions
If any bank has sold more then what it has
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bought it is said to have a net short position. If any bank has bought more then what it
has sold it is said to have a net long
position.
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SWIFT
Society for World wide Interbank FinancialTelecommunication.
This is non rofit Bel ian co o erative with main
Harisha.B.V.AIP(finance & control)IIMB
and regional centers around the world connectedby data transmission lines.
When bank deals through brokers,they transmit
their buy and sell orders to a broker who showsthem to the market without revealing the identities
of the parties.
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Types of transactions
The day on which transfers are effected iscalled the settlement date or the value date.
Harisha.B.V.AIP(finance & control)IIMB
are
Spot
Forward Swap.( a combination of spot and forward)
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Value dates or settlement dates
Spot transaction is normally T+2 days. Forward contract maturities are normally 1 ,
2 3 6 9 12 months.
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Swap transaction
If a bank A purchases USD from Bank Bspot,and simultaneously enter into forwardtransaction with the same counter party tosell USD after 1 month.
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Outright forward and
forward forward swap
Forward contracts without anaccompanying spot deal are known as
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.
A one month forward purchase of USD
against GBP coupled with three monthsForward sale of USD against GBP isforward forward swap.
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Exchange rate quotations and
arbitrage
Quotation will be given either on
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units of a currency per US dollar.exampleINR 45/ USD
American terms(quotes given as number ofUS dollars per unit of currency.exampleUSD 1.6525/ GBP)
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Direct and indirect quotes
Direct quotes- it give units of the homecurrency per unit of foreign
Harisha.B.V.AIP(finance & control)IIMB
.
Indirect quotes number of units of foreign
currency per unit of the homecurrency.example USD 2.051010/ INR 100
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Bid ask spreads
A bid is the price at which dealer will buyone currency for another currency.
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currency for another currency
The difference between bid and ask is called
as spread which will the dealers margin.
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Example
USD/CHF spot: 1.4550/ 1.4560
Dealer will bu at 1.4550
Harisha.B.V.AIP(finance & control)IIMB
Dealer will sell at 1.4560
Spread = 1.4560-1.4550
Percentage spread =
(1.4560-1.4550)/1.4560* 100
Quotations are generally shortened to 1.4550/60
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Arbitrage
Arbitrage in finance refers to a set oftransactions, selling and buying or lending
Harisha.B.V.AIP(finance & control)IIMB
groups of assets ,to profit from pricediscrepancies within a market or across
markets.
Equivalent here means having identical cash
flows and risk characteristics.
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Arbitraging between banks
Though the term market rate is used there isno one single market rate among all the
Harisha.B.V.AIP(finance & control)IIMB
.
The rate will be close to each other .
Obviously such a situation gives rise to
arbitrage opportunity.
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Example
Bank A is quotingGBP/USD 1.4550/1.4560
Harisha.B.V.AIP(finance & control)IIMB
Bank B is quoting
GBP/USD 1.4538/1.4548
Here there is a possibility of arbitrage
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Example 2
Bank A
GBP/ USD 1.4550/1.4560
Harisha.B.V.AIP(finance & control)IIMB
Bank BGBP/USD 1.4545/1.4555
Here there is no arbitrage possibilities.
What is its implications?
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Inverse quotes and two point
arbitrage
BANK IN NEW YORKUSD/ AUD 1.8885/90( SPOT )
Harisha.B.V.AIP(finance & control)IIMB
BANK IN ZURICH
AUD/USD: 0.5275/0.5280(SPOT)
IS THERE ANY ARBITRAGE?
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CROSS RATES
Harisha.B.V.AIP(finance & control)IIMB
that is derived from the exchange rates ofthose currencies with a third currency is
known as a cross rate.
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Example
GBP/USD ; 1.6545/1.6552 EUR/USD: 1.3655/1.3665
Harisha.B.V.AIP(finance & control)IIMB
WHAT IS GBP/EUR?
GBP/EUR bid = (GBP/USD) bid * (USD/EUR)bid
GBP/EUR ask = (GBP/USD) ask * (USD/EUR)ask
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Triangular Arbitrage
Harisha.B.V.AIP(finance & control)IIMB
GBP 1 = USD 1.96 IN NEW YORKGBP 0.2 = 1 DEM IN LONDON
2.5 DEM = USD 1 IN FRANKFURT.
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COVERED INTEREST RATE
ARBITRAGE
Spot Rate 50 Rs = 1$ Interest rate in India 8%
Harisha.B.V.AIP(finance & control)IIMB
n eres ra e n s . One year forward rate is 48 RS.
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Golden rule
If the interest rate differential is greater than
Harisha.B.V.AIP(finance & control)IIMB
e prem um or scoun . p ace e moneyin the currency that has higher rate of
interest or vice versa.
Interest rate differential = differencebetween two countries.
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Forward premium or discount
(Forward rate spot rate) / spot rate * 100 * 12/N
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Example
Spot rate RS 42.0010 = $ 1 6 month forward rate : RS 42.8020
Harisha.B.V.AIP(finance & control)IIMB
rupee=12% Annualized interest rate on 6 month dollar =
8%
Calculate the arbitrage possibilitiesassuming 1000 $ as investment.
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Swap markets exchange rate
determination
A typical swap quotations appears asfollows
Harisha.B.V.AIP(finance & control)IIMB
.
1- MONTH SWAP 15/8
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PROBLEM
USD/INR SPOT 48.75/80 2 MONTH SWAP 12/20
Harisha.B.V.AIP(finance & control)IIMB
. .
2 MONTH SWAP 20/15
FIND INR/JPY 2 MONTH OUTRIGHT
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Derivatives
A derivative is a two party contract whose value isderived from the value of an underlying asset.
The underl in asset ma be Index, stock,
Harisha.B.V.AIP(finance & control)IIMB
currency, interest rate, commodity. In finance derivatives means a financial product
which has been derived from a market .
It has no independent existence.
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Types of derivatives
Harisha.B.V.AIP(finance & control)IIMB
Futures (Forwards)
Options
Swaps ?
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MARKET CREATED PRODUCTS
USED FOR HEDGING THE PRICE VARIATION RISK
Often investors split the risk of underlying position intoseveral components and manage the risk which they dontwant to have through derivatives
Derivatives products
Harisha.B.V.AIP(finance & control)IIMB
TWO TYPES OF DERIVATIVE PRODUCTS
PRODUCTS WHICH ENSURE A FIXED PRICE(FUTURES)
PRODUCTS WHICH ELIMINATES DOWNSIDE RISKOF THE PRICE (OPTIONS)
DERIVATIVE PRODUCTS EXIST ON BOTHCOMMODITY AND FINANCIAL PRODUCTS
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Exchange-traded futures and options
standardized products
trading floor or computerized trading
virtuall no credit risk
Harisha.B.V.AIP(finance & control)IIMB
Over-the-Counter forwards, options, & swaps
often non-standard (customized) products
telephone (dealer) marketsome credit risk
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Uses of Derivatives
To hedge or insure risks; i.e., shift risk. To reflect a view on the future direction of themarket, i.e., to s eculate.
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To lock in an arbitrage profit To change the nature of an asset or liability. To change the nature of an investment without
incurring the costs of selling one portfolio andbuying another.
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Currency future
At a glance a currency future like a forwardcontract is a contract for future delivery.
A currenc future is the rice of a articular
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currency for settlement at a specified future date. The two popular future exchanges are the
Singapore international Monetary Exchange
(SIMEX) and International Money Market(Chicago, IMM).
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PRODUCTS TRADED IN FUTURES EXCHANGESPRODUCTS TRADED IN FUTURES EXCHANGES
(FINANCIAL PRODUCTS)(FINANCIAL PRODUCTS)
CURRENCY: AUSTRALIAN DOLLAR, POUND,
DEUTSCHEMARK, FINNISH CURRENCY, FRENCH
FRANC, JAPANESE YEN, NZ DOLLAR, SWISS FRANC,
Harisha.B.V.AIP(finance & control)IIMB
CROSS-CURRENCY RATE, CURRENCY INDEXINTEREST RATE: T.BILL, BONDS, EURODOLLAR,
BOND INDICES
STOCK INDEX & EQUITY CONTRACTS
MISCELLANEOUS PRODUCTS
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Features of futures contract
Futures are traded on organized exchanges.
Clearing houseFutures are traded through brokers.
Harisha.B.V.AIP(finance & control)IIMB
The contracts are standardized.
margins
Marking to market
Actual delivery is rare
S t f M i
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System of MarginsInitial margin : When position is opened
Variation Margin: Settlement of daily gains and losses
Maintenance Margin : Minimum balance in margin account.
Balance falls below this, margin call issued. If not met,position liquidated.
Regulators specify minimum margins between clearing
Harisha.B.V.AIP(finance & control)IIMB
members and clearinghouse. Margins at other levelsnegotiated
Margins can be deposited in cash or specified securities such
as T-bills. Interest on securities continues to accrue to owner.
Margin is a performance bond.
Levels of margins may be changed if volatility increases.
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System of Margins
With clearing house guarantee, buyer-seller need notworry about each others creditworthiness.
Harisha.B.V.AIP(finance & control)IIMB
liquidity.
Protects clearing house; enhances financial
integrity of the exchange. Credit risk issues
almost eliminated
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Futures and Forwards: A Comparison Table
Default Risk: Borne by Clearinghouse Borne by Counter-Parties
What to Trade: Standardized Negotiable
The Forward/Futures Agreed on at Time Agreed on at TimePrice of Trade Then, of Trade. Payment at
Marked-to-Market Contract Termination
Futures Forwards
Harisha.B.V.AIP(finance & control)IIMB
When to Trade: Standardized Negotiable
Liquidity Risk: Clearinghouse Makes it Cannot Exit as Easily:
Easy to Exit Commitment Must Make an Entire
New Contrtact
How Much to Trade: Standardized Negotiable
What Type to Trade: Standardized Negotiable
Margin Required Collateral is negotiable
Typical Holding Pd. Offset prior to delivery Delivery takes place
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Theoretical Futures Price
Let C denote the present value of carrying costs, St the
s ot rice, r the interest rate, and FU the futures rice
Harisha.B.V.AIP(finance & control)IIMB
,
for delivery at T, Then theoretical futures price is givenby
FUt,T = (St + C)[1 + r(T-t)]
F t d F d
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Futures and Forwards on
Currencies
A foreign currency isanalogous to a security
providing a dividend yield
Harisha.B.V.AIP(finance & control)IIMB
yield is the foreign risk-free interest rate
It follows that if rf is the
foreign risk-free interest
rate F S e r r T
f0 0=
( )
F Ser r Tf0 0=( )
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In practice futures price does not exactly equaltheoretical futures price. Reasons:
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,
2 In some cases, restrictions on short sales (Does not
apply to currency futures)
3 Non-constant interest rates
4 Mark-to-market gains/losses.
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Hedging with futures/forwards typically involves taking a position in a futuresmarket that is opposite the position already held in a cash market.
A Short (or selling) Hedge: Occurs when a firm holds a long cash position andthen sells futures/forward contracts for protection against downward price exposurein the cash market.
Hedging Fundamentals
Harisha.B.V.AIP(finance & control)IIMB
A Long (or buying) Hedge: Occurs when a firm holds a short cash position andthen buys futures/forward contracts for protection against upward price exposure inthe cash market. Also known as an anticipatory hedge.
A Cross Hedge: Occurs when the asset underlying the futures/forward contractdiffers from the product in the cash position.
Firms can hold long and short hedges simultaneously (but for different price risks).
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Options Terminology
The two parties to an option contract are theoption buyerand the option seller also calledoption writer
Call Option: A call option gives the optionbuyer the right to purchase a currency Y against
Harisha.B.V.AIP(finance & control)IIMB
a currency X at a stated price Y/X, on or beforea stated date.
Put Option: A put option gives the option buyerthe right to sell a currency Y against a currencyX at a specified price on or before a specifieddate
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Options Contracts: PreliminariesAn option gives the holder the right, but not the obligation,
to buy or sell a given quantity of an asset in the future, at
prices agreed upon today.
Calls vs. Puts
Harisha.B.V.AIP(finance & control)IIMB
Call options gives the holder the right, but not theobligation, to buy a given quantity of some asset at sometime in the future, at prices agreed upon today.
Put options gives the holder the right, but not theobligation, to sell a given quantity of some asset at sometime in the future, at prices agreed upon today.
Options Terminology
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Options Terminology
A call option is said to be at-the-money ifCurrent Spot Price (St ) = Strike Price (X),
in-the-money if St > X and out-of-the-money if
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St< X
A put option is said to be at-the-money if
St = X, in-the-money if St < X and out-of-the-money if St > X
In the money options have positive intrinsicvalue; at-the-money and out-of-the moneyoptions have zero intrinsic value.
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Options Contracts: Preliminaries
European vs. American options
Harisha.B.V.AIP(finance & control)IIMB
European options can only be exercised on the
expiration date.
American options can be exercised at any time up
to and including the expiration date.
Since this option to exercise early generally has
value, American options are usually worth more
than European options, other things equal.
A CALL OPTION
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A trader buys a call option on US dollar with a strike price of
Rs.46.50 and pays a premium of Rs.1.50. The current spot rate, St,
is Rs.45.50. His gain/loss at time T when the option expires
depends upon the value of the spot rate, ST, at that time :
ST Gain(+)/Loss(-)44.5000 -Rs.1.50
45.0000 -Rs.1.50
Harisha.B.V.AIP(finance & control)IIMB
45.5000 -Rs.1.50
46.0000 -Rs.1.50
46.5000 -Rs.1.50
47.0000 -Rs.1.00
47.5000 -Rs.0.5048.0000 Rs.0.0048.5000 +Rs.0.5049.0000 +Rs.1.00
49.5000 +Rs.1.50
PUT OPTION
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A trader buys a put option on pound sterling at a strike price of$1.7500, for a premium of $0.07 per sterling. The spot rate at the
time is $1.7465. At expiry, his gains/losses are as follows :
ST Gain(+)/Loss(-)1.6000 +$0.0800
1.6300 +$0.0500
Harisha.B.V.AIP(finance & control)IIMB
. .
1.6600 +$0.02001.6800 $0.0000
1.6900 -$0.0100
1.7300 -$0.0500
1.7500 -$0.0700
1.7700 -$0.0700
1.8000 -$0.0700
Option Payoff
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Option Payoff
LONG CALL SHORTCALL
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LONG PUT SHORT PUT
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The BSOPM Formula
dNSdNeKpdNeKdNSc
rT
rT
=
=
102
210
)()()()(
Harisha.B.V.AIP(finance & control)IIMB
where N(di) = the cumulative standard normal distributionfunction, evaluated at d
i, and:
TdT
TrKS
d
T
TrKSd
=
+
=
++
=
1
0
2
01
)2/2()/ln(
)2/()/ln(
where
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Black scholes
C = S N(d1) - E e -rtN(d2)
C = CALL VALUE
Harisha.B.V.AIP(finance & control)IIMB
r = RISK-FREE RATE
S = CURRENT MARKET PRICE
t = TIME TO EXPIRATION
E = EXERCISE PRICE
N(d) = Cumulative normal probability density function d1 = {ln(S/E) + (r + 0.5 VAR) t} / {SD * SQRT(t)}
d2 = d1 - {SD * SQRT(t)}
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Computing Volatility
Find the daily return of the stock over a period Rt = ln(Pt/Pt-1)
Find the Standard Deviation of daily returns as computed in
Harisha.B.V.AIP(finance & control)IIMB
the above step This is standard deviation of daily return
To annualise the standard deviation of daily return,
SD (daily return) * SQRT(250)
where 250 refers to number of trading days in a year.
Formulas for Currency Options
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Formulas for Currency Options
dNeSdNKep
dNKedNeSc
TrrT
rTTr
f
f
=
=
)()(
)()(
102
210
Harisha.B.V.AIP(finance & control)IIMB
T
TfrrKSd
Tf
rr
d
+
=
++
=
)2/2()/ln(
n
0
2
0
1
where
Alternative Formulas
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Alternative Formulas
F S e r r Tf
0 0=
( )
UsingdKNdNFec rT = 210 )]()([
Harisha.B.V.AIP(finance & control)IIMB
TddT
TKFd
dNFdKNep rT
=
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Elementary Option Strategies
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Elementary Option Strategies
Spread Strategies
Bullish Call Spread: Consists of selling the call with the higherstrike price and buying the call with the lower strike price
Bearish Call spread: If the investor expects the foreign currencyto depreciate, he can adopt the reverse strategy viz. buy the
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Bullish Put Spread: Consists of selling puts with higher strikeand buying puts with lower strike
Bearish Put Spread: Opposite of Bullish Put Spread
These strategies, involving options with same maturity butdifferent strike prices are called vertical or price spreads
Bull Spread Using Calls
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ull Sp ead Using Calls
Profit
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K1 K2
ST
Bull Spread Using Puts
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p g
Profit
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K1 K2 ST
Butterfly Spreads
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Butterfly Spreads
This is an extension of the idea of vertical spreads. Suppose
the current spot rate NZD/USD is 0.6000. The call options with
same expiry date are available :
Strike Premium
0.58 0.07
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0.62 0.03
0.66 0.01
A butterfly spread is boughtby buying two calls with the
middle strike price of 0.62, and writing one call each with strikeprices on either side, here, 0.58 and 0.66. The profit table is as
below :
Butterfly Spread Using Calls
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f y p g
Profit
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K1 K3 STK2
Butterfly Spread Using Puts
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f y p g
Profit
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K1 K3 STK2
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Elementary Option StrategiesStraddles and Strangles Volatility Bets
A long straddle consists of buying a call and a putboth with identical strikes and maturity. Usually bothare at-the-money.
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A long strangle consists of buying an out-of-the-money call and an out-of-the-money put
Both are bets that the underlying price is going to
make a strong move up or down I.e. market is goingto be more volatile.
Delta
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Theta.
Delta
Delta (D) is the rate of change of the option price with
respect to the underlying
Theta of a derivative or ortfolio of
derivatives) is the rate of change of the value withrespect to the passage of time
The theta of a call or put is usually negative. This
means that, if time passes with the price of theunderlying asset and its volatility remaining the
same, the value of the option declines
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Gamma
Gamma () is the rate of change of delta ()
with respect to the price of the underlying
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asset
Gamma is greatest for options that are close
to the money
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Vega
Vega () is the rate of change of the value
of a derivatives portfolio with respect tovolatility
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Vega tends to be greatest for options that
are close to the money
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Rho
Rho is the rate of change of thevalue of a derivative with respect to
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For currency options there are 2
rhos
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Forward Rate Agreements (FRAs)
A FRA is a forward contract on an interest rate (not on abond, or a loan).
The buyer of a FRA profits from an increase in interest
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. .
The buyer effectivelyhas agreed to borrow an amount ofmoney in the future at the stated forward (contract) rate. Theseller has effectively locked in a lending rate.
FRAs are cash settled.
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Forward Rate Agreements (FRAs)
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Only the difference in interest rates is paid. The principal
is not exchanged.
FRAs are cash settled.
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An Example of an FRA
A firm sells a 5X8 FRA, with a NP of $300MM, and acontract rate of 5.8% (3-mo. forward LIBOR).
On the settlement date (five months hence), 3 mo.
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spo s . .
There are 91 days in the contract period (8-5=3months), and a year is defined to be 360 days.
Five months hence, the firm receives:
Source- debousfky
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FRA Example (continued)
$524,077.11, which is calculated as:
-
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=
, , . .
1+[(0.051)(91/360)]
, , . - .
1+[(0.051)(91/360)](300,000,000)(0.058-0.051)(91/360)
1+[(0.051)(91/360)]300000000*(.058-.051)(91/360)
1+(.051*91/360)
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