1. Muhammad Danish | www.knowledgedep.blogspot.com | www.facebook.com/mdanishsaqi/
Roll No. 119467
Section: B, Semester: 4th
2. Q1: Define the currency derivatives? What are their types also differentiate
between Forward and Future Contracts:
A derivative is a security with a price that is dependent upon or derived from one or more
underlying assets. The derivative itself is a contract between two or more parties based upon the
asset or assets. Its value is determined by fluctuations in the underlying asset. The most common
underlying assets include stocks, bonds, commodities, currencies, interest rates and market
Currency Derivatives are Future and Options contracts which you can buy or sell specific
quantity of a particular currency pair at a future date. It is similar to the Stock Futures and
Options but the underlying happens to be currency pair instead of Stocks. A currency
derivative can be structured as a currency option, currency forward, currency future, currency
swap, or currency warrant.
Types of currency derivatives
1. Forward Currency:
A forward contract is an agreement between two parties a buyer and a seller to
purchase or sell something at a later date at a price agreed upon today. Forward contracts,
sometimes called forward commitments, are very common in everyone life. Any type of
contractual agreement that calls for the future purchase of a good or service at a price
agreed upon today and without the right of cancellation is a forward contract.
2. Future Currency:
A futures contract is an agreement between two parties a buyer and a seller – to
buy or sell something at a future date. The contact trades on a futures exchange and is
subject to a daily settlement procedure. Future contracts evolved out of forward contracts
and possess many of the same characteristics. Unlike forward contracts, futures contracts
trade on organized exchanges, called future markets. Future contacts also differ from
forward contacts in that they are subject to a daily settlement procedure. In the daily
settlement, investors who incur losses pay them every day to investors who make profits.
3. Options Currency:
Options are of two types’calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or before a
given future date. Puts give the buyer the right, but not the obligation to sell a given
quantity of the underlying asset at a given price on or before a given date.
3. 4. Swaps Currency:
Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are interest rate swaps and currency swaps.
5. Warrant Currency:
Apart from the commonly used short-dated options which have a maximum
maturity period of one year, there exist certain long-dated options as well, known
as warrants. These are generally traded over the counter.
Differentiate between Forward and Future Contracts:
Size of contracts Tailored to individual needs. Standardized
Delivery date Tailored to individual needs. Standardized
Participants Banks, brokers, and multinational
Public speculation not encouraged.
Banks, brokers, and multinational
Qualified public speculation not
Security deposit None as such, but compensating
bank balances or lines of credit
Small security deposit required.
Clearing operation Handling contingent on individual
banks and brokers. No separate
clearing house function.
Handled by exchange clearing
house. Daily settlements to the
Marketplace Telecommunications network. Central exchange floor with
Regulation Self-regulating Commodity Futures Trading
Commission; National Futures
Liquidation Most settled by actual delivery.
Some by offset, at a cost.
Most by offset, very few by
Transaction costs Set by “spread” between banks’
buy and sell prices.
Negotiated brokerage fees.
4. Q2: Define the currency call and put options. Also discuss the factors
effecting the currency call option and put option premiums:
A currency option is a contract that grants the buyer the right, but not the obligation, to
buy or sell a specified currency at a specified exchange rate on or before a specified date. For
this right, a premium is paid to the seller, the amount of which varies depending on the number
of contracts if the option is bought on an exchange or on the nominal amount of the option if it is
done on the over-the-counter market.
Call options provide the holder the right to purchase an underlying asset at a specified
price for a certain period of time. If the stock fails to meet the strike price before the expiration
date, the option expires and becomes worthless. Investors buy calls when they think the share
price of the underlying security will rise or sell a call if they think it will fall.
Put options give the holder the right to sell an underlying asset at a specified price .The
seller of the put option is obligated to buy the stock at the strike price. Put options can be
exercised at any time before the option expires. Investors buy puts if they think the share price of
the underlying stock will fall, or sell one if they think it will rise.
The factors affecting the currency call option and put option premiums:
1. Underlying Price:
The most influential factor on an option premium is the current market price of
the underlying asset. In general, as the price of the underlying increases, call prices
increase and put prices decrease. Conversely, as the price of the underlying decreases,
call prices decrease and put prices increase.
2. Strike Price:
The strike price of your call option has a big part in determining the option's
value. The lower your option's strike price, the more valuable your option is. This is
because it's more likely that the underlying stock will go above a low strike price than a
high strike price. Since your call option only earns money if the stock price goes above
the strike price, a lower strike price makes the option more valuable.
5. 3. Time until Expiration:
The time remaining in your option contract also affects its value. The longer your
option contract has before it expires, the more is it worth. A longer time period creates a
higher chance that the stock price will hit the strike price of your option. There is more
time for the market to swing up or for the underlying stock to receive unexpected good
news. If your option contract runs out of time before hitting its strike price, it becomes
4. Expected Volatility:
Volatility is the amount a stock's price goes up and down. The more volatile a
stock, the more valuable its call option. If a stock's price is bouncing up and down, it has
a greater chance of hitting your strike price. It only needs to go above your strike price
once for your call option to make money. If a stock's price has low volatility and stays
around the same point, it is less likely to hit your strike price before it expires.
5. Interest Rates
Interest rates and dividends have small, but measurable, effects on option prices.
In general, as interest rates rise, call premiums increase and put premiums decrease. This
is because of the costs associated with owning the underlying: The purchase incurs either
interest expense or lost interest income. IN either case, the buyer will have interest costs.
Dividends can affect option prices because the underlying stock's price typically
drops by the amount of any cash dividend on the ex-dividend date. As a result, if the
underlying's dividend increases, call prices will decrease and put prices will increase.
Conversely, if the underlying's dividend decreases, call prices will increase and put prices
6. Q5: Compare the IRP (Interest rate parity), PPP (Purchase power parity)
and IFE (International fisher effect) theories.
Interest rate parity is a theory in which the interest rate differential between two countries
is equal to the differential between the forward exchange rate and the spot exchange rate.
Interest Rate Parity (IRP) is a theory in which the differential between the interest rates of
two countries remains equal to the differential calculated by using the forward exchange rate and
the spot exchange rate techniques. Interest rate parity connects interest, spot exchange, and
foreign exchange rates.
Purchasing power parity (PPP) is a theory which states that exchange rates between
currencies are in equilibrium when their purchasing power is the same in each of the two
In other words, the expenditure on a similar commodity must be same in both currencies
when accounted for exchange rate. The purchasing power of each currency is determined in the
process. Description: Purchasing power parity is used worldwide to compare the income levels in
Purchasing power parity, or PPP, does not change the GDP of a country. Rather, it provides a
way to compare the GDPs of multiple countries more accurately. ... In contrast, if we convert
India's GDP into dollars at PPP exchange rates, U.S. GDP now looks only 2.3 times as large as
that of India.
International fisher effect
The international Fisher effect (sometimes referred to as Fisher's open hypothesis) is a
hypothesis in international finance that suggests differences in nominal interest rates reflect
expected changes in the spot exchange rate between countries.
Real interest rate = nominal interest rate - inflation
The Fisher effect is an economic theory proposed by economist Irving Fisher that describes the
relationship between inflation and both real and nominal interest rates. The Fisher effect states
that the real interest rate equals to the nominal interest rate minus the expected inflation rate.
The Fisher equation in financial mathematics and economics estimates the relationship
between nominal and real interest rates under inflation. It is named after Irving Fisher, who was
7. famous for his works on the theory of interest. ... In economics, this equation is used to predict
nominal and real interest rate behavior.
THEORY KEY VARIABLES OF
KEY VARIABLES OF THEORY
The forward rate of one currency with
respect to another will contain a premium
(or discount) that is determined by the
differential in interest rates between the
two countries. As a result, covered interest
arbitrage will provide a return that is no
higher than a domestic return.
change in spot
The spot rate of one currency with respect
to another will change in reaction to the
differential in inflation rates between the
two countries. Consequently, the
purchasing power for consumers when
purchasing goods in their own country will
be similar to their purchasing power when
importing goods from the foreign country.
change in spot
The spot rate of one currency with respect
to another will change in accordance with
the differential in interest rates between the
two countries. Consequently, the return on
uncovered foreign money market securities
will, on average, be no higher than the
return on domestic money market securities
from the perspective of investors in the
8. Q6: What is meant by Government Intervention in exchange rates? Also
discuss different types of Govt. Interventions:
Government Intervention in exchange rates:
“Regulatory actions taken by a government in order to affect or interfere with decisions
made by individuals, groups, or organizations regarding social and economic matters”
Government intervention is action taken by the government or international institution in
a market in order to correct market failures and to impact the economy. This is often done to
promote economic growth, increase employment, raise wages, raising or reducing prices,
promoting income equality, managing money supply and interest rates, or increasing profits.
Different types of Govt. Interventions
There are basically two types of Government interventions as under:
Direct currency intervention is generally defined as foreign exchange transactions that are
conducted by the monetary authority and aimed at influencing the exchange rate. Depending on
whether it changes the monetary base or not, currency intervention could be distinguished
between sterilized intervention and non-sterilized intervention, respectively.
Sterilized intervention is a policy that attempts to influence the exchange rate without changing
the monetary base. The procedure is a combination of two transactions. First, the central bank
conducts a no sterilized intervention by buying (selling) foreign currency bonds using domestic
currency that it issues. Then the central bank “sterilizes” the effects on the monetary base by
selling (buying) a corresponding quantity of domestic-currency-denominated bonds to soak up
the initial increase (decrease) of the domestic currency. The net effect of the two operations is
the same as a swap of domestic-currency bonds for foreign-currency bonds with no change in
the money supply. With sterilization, any purchase of foreign exchange is accompanied by an
equal-valued sale of domestic bonds, and vice versa.
9. For example, desiring to decrease the exchange rate/price of domestic currency without changing
the monetary base, authorities purchase foreign-currency bonds, the same action as in the last
section. After this action, in order to keep the monetary base, governments conduct a new
transaction, selling an equal amount of domestic-currency bonds, so that the total money supply
is back to the original level.
Non-sterilized intervention is a policy that alters the monetary base. Specifically, authorities
affect the exchange rate through purchasing or selling foreign money or bonds with domestic
For example, aiming at decreasing the exchange rate/price of the domestic currency, authorities
could purchase foreign currency bonds. During this transaction, extra supply of domestic
currency will drag down domestic currency price, and extra demand of foreign currency will
push up foreign currency price. As a result, the exchange rate drops.
Indirect currency intervention is a policy that influences the exchange rate indirectly. Some
examples are capitalcontrols (taxes or restrictions on international transactions in assets), and
exchange controls (the restriction of trade in currencies).Those policies may lead to
inefficiencies or reduce market confidence, but can be used as an emergency damage control.
10. Q7: Define the term International Arbitrage? Explain different types of
The term international arbitrage refers to the practice of simultaneously buying and
selling a foreign security on two different exchanges. International arbitrage is profitable when
pricing inefficiencies occur due to factors such as timing and exchange rates.
While stock exchanges are considered efficient markets, there are instances when the
mispricing of one or more securities provides the opportunity for profits through techniques such
as international arbitrage. This approach requires the trader to monitor the price of securities on
two or more exchanges located throughout the world.
Explain different types of international arbitrageurs:
As applied to foreign exchange and international money markets arbitrage takes three
Covered interest arbitrage
1. Locational arbitrage:
Locational arbitrage is possible when a banks buying price ( Bid Price) is higher than
another banks selling price ( ask Price) for the same currency.
Bank c bid ask bank d bid ask
NZ$ $.635 $.640 NZ$ $.645 $.650
Buy NZ$ From Bank C @ $.640 and Sell It To Bank D @ $.645. Profit = $.005/NZ$.
2. Triangular arbitrage:
11. When the actual cross exchange rate between two currencies differ from spot rate. The process of
taking one currency and converting it into another currency only to convert it back to original
British pound $ 1.60 $ 1.61
Malaysian Ringgit (MYR) $ .200 $ .202
Pound MYR 8.1 MYR 8.2
Buy Pound @ $ 1.61 Convert @ MYR8.1 than Sell MYR @ $.200 Profit = $.01 Pound.
3. Covered interest arbitrage:
Covered interest arbitrage is the process of capitalizing on the interest rate differential
between two countries while covering for exchange rate risk. The logic of the term covered
interest arbitrage become clear when it is broken into two parts interest arbitrage and covered.
Interest arbitrage refers to the process of capitalization on the difference between interest rates
between two countries. On the other hand covered refers to hedging your position against
exchange rate risk. Covered interest arbitrage involving investment dominated in different
currencies using forward covered to reduce or eliminate currency risk.