Lecture 5
Chapter 8

Foreign currency derivatives

Lecture outline
Chapter 8: Foreign currency derivatives
Futures contracts Options

Chapter 9: Interest rate and currency swap
Interest rate risk management FRAs Interest rate futures (not examinable) Swaps
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Foreign Currency Derivatives
Financial management of the MNE in the 21st 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 3

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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)

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Foreign Currency Derivatives
What are they?
Forward contracts Futures contracts Options Swaps

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Foreign Currency Futures
A foreign currency (FX) 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 US, the most important market for foreign currency futures is the International Monetary Market (IMM), a division of the Chicago Mercantile