Financial Market Lecture Reaction

Can you provide me your thoughts on the posted lecture below:

The topic of currency derivatives is the generic term covering Forward Contracts, Futures Contracts, Options and Swaps. They are called that because their value is derived from the value of something else.

Most of you have probably heard of futures and options, perhaps in other contexts such as with agricultural commodities. Money is simply another commodity -- no different in concept than red-wheat or pork bellies or oil.

What is a commodity? It is something of which all units are identical. When we talk about Japanese yen, we do not care which yen we get ... all Japanese yen are functionally identical. Think of it this way, when you get a dollar bill in change do you care which specific dollar bill (by serial number) you got? Most likely not.

The same thing is true of red-wheat -- one grain (or bushel) is functionally identical to any other grain or bushel. When two things are perfect substitutes for each other, they are "fungible." Dollar bills are fungible -- each dollar bill is a perfect substitute for any other dollar bill.

Derivatives involve two parties - the "writer" and the "holder." In some limited circumstances, you could be the writer such as if you wrote calls or puts on sticks you own (see options discussion below). The writer is the party that creates the derivative. The entity that acquires the derivative is the holder. Most of the time when you are involved with derivatives, you are the holder.

Forward Contracts are a common form of derivative. With a Forward Contract, two parties agree to exchange a specific amount of two currencies at a specific future date at a pre-agreed exchange rate. We might enter into a Forward Contract to deliver $1,000,000 on December 2, 2001 in exchange for Euro 1,135,400.

A Forward Contract is negotiated between the two parties and contains whatever terms and conditions to which they agree. The maturity date is whatever date they want and the amount of currency is whatever they agree to. Because each Forward Contract is unique, there generally is no secondary market for them. The only way to get out of a Forward Contract is for the two parties to agree to cancel the contract. Because the amounts to be exchanged are (by definition) of equivalent value, no payment is made by either party to the other when the contract is established. Because circumstances change after the contract is made, a payment may be needed to get the other party to agree to cancel the deal.

You are probably familiar with the fundamental idea behind Forward Contracts, in business we use negotiated purchase orders for future deliveries of custom orders for things. A Forward Contract can be thought of as a non-cancelable purchase order for some currency, to be paid COD with another currency.

A Forward Contract is a legally binding contract. Each party must perform its obligations. Because of this, it is important to carefully select your counter-party. You must be certain that the counter-party will perform. Usually, a Forward Contract involving currency is between a business and a bank, but it can be between two businesses or between two banks. Of course, to the other party, you are the counter-party and your creditworthiness and ability to perform will be assessed by that party. With a Forward Contract there is always counter-party risk -- that is, there is always some possibility the other side will default. Your ability to legally enforce the contract is a critical protection ... but with careful selection of the counter-party that risk can be minimized.

A Futures Contract is similar to a Forward Contract in that the amount of the currency to be delivered and the maturity date is established in the contract. It differs in that the Futures Contract is standardized and the amount of currency required to acquire the contract varies based on market conditions. All Futures Contracts are for the same amount of money in the foreign currency. For example, all Futures Contracts traded on the Chicago Mercantile Exchange are for 125,000 Euros. Futures Contracts mature at a standard time as well. The most active currency trading futures have 4 maturities a year - on the third Wednesday of March, June, September and December. A few have more frequent maturities.

According to the Chicago Mercantile Exchange:

"A contract month identifies the month and year in which the futures or options contract ceases to exist. It is also known as the "delivery month," because the seller of a contract must be prepared to deliver the specified amount of foreign currency to the buyer if the seller has not canceled the obligation with an offsetting purchase. This delivery procedure ensures that the futures price converges with the cash market price in the delivery month.

However, the vast majority of market participants close out their positions before delivery time approaches. In fact, only a very small percentage of futures transactions reach delivery. " (Source: retrieved 7/21/2001 from http://www.cme.com/market/cfot/howto/process/con.html now a dead link)

Because the contracts are standardized, futures contracts are traded on exchanges such as the Chicago Mercantile Exchange. The exchange guarantees performance of the contract, essentially eliminating counter-party risk. To do this, the exchange closely watches trading and "marks to market" each account each day. That means that holders of contracts must cover loss of value of contracts (if that happens) in cash as a way to ensure the contract holder performs. The CME puts this as:

" Daily mark-to-market - At the CME, your position is balanced each and every day. In addition to the protection that this marking-to-market provides, it also allows for positions to be held for a longer period of time than may be allowed with other FX trading platforms." " (Source: retrieved 7/21/2001 from http://www.cme.com/market/cfot/howto/process/con.html now a dead link)

Futures contracts are available only in the most popular currency combinations.

So, although less risky than Forward Contracts, Futures Contracts are far less flexible and may not be available in specific combinations. As with Forward Contracts, Futures Contracts are legally binding on both parties and each must perform its obligations. The only way to get rid of your obligation as the holder of a futures contract is to sell your contract in the market in which you bought it. If you hold it at maturity, you will be asked to perform.

Options involve the right of one party to compel the other party to perform or to not enforce the contract. We can characterize options several ways.

A "put" gives the holder the right, but not the obligation, to compel the counter-party to buy the optioned item from the holder at a specified price. A "call" is the opposite -- it gives the holder the right, but not the obligation, to compel the counter-party to sell the optioned item to the holder at a specified price.

Options can be either negotiated or traded. Negotiated options can be customized to the situation. Traded options involve standardized contracts.

An option has a price. That is, the holder pays the counter-party for the option. The price depends on a number of factors that include (1) the difference between the option price (called the "strike price") and the current (spot) price, (2) length of time to the expiration of the option, (3) volatility of the spot price, and (4) interest rates levels. For the most part, we will be referring to traded options in our discussions.

When the spot price for the currency is greater than the strike price plus the option's cost, the option is said to be "in the money" and it is profitable to exercise the option. You can not buy an in the money option. Any option you buy will be out of the money at the time you buy it. Why? Because if that were not true, the transaction would be riskless and arbitrageurs would buy them until the cost of the option rose to make the option out of the money. Market efficiency essentially prevents that from happening.

Options come in two styles -- American and European. The names refer to the terms, not to where the option is traded. American style options can be exercised anytime before they mature. European options can be exercised only on the date of maturity.

What happens with an option? Suppose you want to buy an American style call option for Euro 125,000. The Exercise Price is E1 = US$1.0542 and the option cost is US$.0316. The option is out of the money unless the Euro appreciates to at least E1 = US$1.0858. Unless the value of the Euro is at least $1.0542, you would not exercise the option and you would be out .0316 x 125,000 = $3,950. With the value E1 >$1.0542 <$1.0858 you would still lose by exercising the option, but less than just letting it expire. Only if the exchange rate moves such that E1 > $1.0858 would you make a profit exercising the option.

When someone writes a call option on an asset they do not own (which is legal), we call that a "naked call." Naked calls are the most dangerous type of option to write ... if it is called, you must buy the asset to deliver it regardless of what that costs you ... and it will always cost you more than the proceeds of the option. Writing a call option on an asset you do own is termed a "covered call" is a technique used by some investors to enhance the return on their portfolios. Writing a call option is almost always done with an expectation it will not be exercised ... after all, it would only be exercised if the spot price of the asset is higher than the exercise price of the option.

Writing put options is considered defensive. It is a way to protect against decline in asset value.

The last type of derivative is the Swap. Swaps tend to be highly complex transactions that involve sophisticated parties. A Swap could involve exchanging fixed rate interest payments for variable rate interest payments. Almost always, a bank acts as the intermediary for this type of transaction. The party wanting the fixed rate seeks to reduce its risk. The party seeking the variable rates seeks to reduce the expected value of the cost of the interest payments.

Another example would be exchanging payments in one currency for those of another. An American company might have borrowed U.S. dollars to finance an operation in Mexico. A Mexican company might have borrowed Mexican pesos to finance an operation in the U.S. It makes sense for them to swap as much of the debts as possible so that the currency earnings from each investment can directly be used to repay the borrowing, thereby avoiding exchange rate risk. The American company would use peso earnings from its Mexican operation to repay the peso denominated debt it assumed in the Swap and vice versa.

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