A Currency Call option and a Currency Put Option - Essay Example

There is very little difference between the forward and futures markets. But the differences are very important. Unlike the forward market, which is characterized by personalized contracts with no initial payment necessary, future markets have standardized contracts with at least marginal payment paid initially. This implies that the amount that is being transacted can be of any value. Future contracts specify the volume of a particular currency to be used for transactions at the specified date.

Secondly, for forwarding contracts, there is no organized exchange present in future contracts as the contracting parties directly do the transactions. Thirdly, the contract size depends on the contracting parties in the case of the forward contracts. But, for future contracts, the contract size is standardized. Fourthly, future contracts are government- regulated and bear low risk while forward contracts are unregulated and are high-risk bearing as there are chances of default. (Madura 2009, pp. 108-110) 2.

How can currency futures be used by corporations and by speculators? Speculators purchase currency futures to capitalize on their expectations about the ups and downs associated with respect to currency movement. Suppose a speculator expects an appreciation of a particular currency in the future. They can then buy future contracts and hence lock the price of that currency for a specific settlement date. On this date, they can buy their currency at a rate specified in the futures contract and sell it at the spot rate, which is less than the rate specified in the futures contract.

If the spot rate has appreciated, then they extract profit. Different expectations of the speculators guide their decisions to sell and purchase future contracts.Corporations use currency futures to hedge and thus reduce their currency risk when transacting foreign currency. For example, if a Canadian exporter is about to export US$1,000,000 worth of goods to its US customer. The exporter will face loss if there is an appreciation of the Canadian dollar against the US dollar, as he will receive payment in the US dollar.

This is where a currency future is used to reduce this risk. (Madura 2009, pp. 111-112)  The buyer contributes a premium to the seller in exchange for the option. Another difference is with respect to intrinsic value (the difference between the spot price and strike price), when the spot price is more than the strike price, then the put option is supposed to have an intrinsic value. But, when the spot price is above the strike price, then the call option is said to have built-in value.

(Madura 2009, pp.119-122)  4. How can a forward contract backfire? There is a risk involved in the transaction of a hard currency arising out of fluctuations. The forward contract may backfire under political turmoil, environmental contingencies, and unexpected decisions that have macroeconomic implications. If there appears a disparity in the maturity structure, risks associated with interest rate and liquidity arises. The issue that is important is, the behavior of interest rates but it is actually the interest rate discrepancy existent between the two different countries.

It is not as simple as managing interest rates for a single currency. Swaps are a better way to handle maturity gaps. (Madura 2009, pp. 275-280)        ReferenceMadura J. (2009). International Financial Management. Mason: South-Western Cengage Learning