Foreign Exchange: Currency Spread and Options

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Table of Contents

International Corporate Finance
Definition
Foreign Currency Derivatives
Bid or Ask Spread
Currency Options
References

International Corporate Finance

Establishing the number of Yuan payable to purchase reams of paper worth 100,000 US dollars from China when the present exchange rate is 6.5766 US dollars per Chinese Yuan.

Definition

Foreign Exchange refers to the contract to sell or buy a specific amount of currency in return for another. The delivery and settlement takes place at a specified time and rate of exchange or price. Foreign exchanges have no particular physical centre of exchange. The trade is mainly conducted by banks. The foreign exchange markets provide a system that converge sellers and buyers and supply information on prices and the exchange activities of players (Eiteman, Stonehill, and Moffett, 2010).

Foreign Currency Derivatives

Foreign currency derivatives refer to financial derivatives whose advantage is pegged on the exchange rates of foreign currencies. The instruments are used for speculation and hedging foreign exchange exposure.

Spot Contract

This refers to an agreement to sell or buy a currency for delivery. The payment or settlement is made at the spot date. This is usually two business days following the trade date (Eiteman, Stonehill, and Moffett, 2010). The payment and delivery rate is known as the spot rate or price. Where there lays an option for immediate payment, the spot contract would be the most suitable. The buyer will need 15205.4253 Chinese Yuan to purchase US$100000 worth reams of paper. Settlement for the contract would take place within two working days.

Forward Contract

A forward contract refers to an agreement to sell or buy a particular asset at a predetermined future date and at a rate agreed upon presently (Eiteman, Stonehill, and Moffett, 2010). Suppose the buyer wants to purchase the reams of paper thirty days from now. Assuming that a Chinese company has $100000 worth reams of paper, which it wishes to sell thirty days from now. Both participants can agree on a forward contract. Suppose the parties settle for a sale price of $102000 in thirty days, they will have entered into a forward contract. In thirty days, the buyer and seller have an obligation to honour their respective duties at the set price (Reh, 2013).

Future Contract

Futures refer to standardized contracts where those involved go into an agreement to purchase or buy a specific asset that has a standardized quality and quantity. The present price is used while delivery and payment is made on a future date. Future contracts are entered into in future exchange. The seller and buyer are said to be “long” and “short” respectively since the seller expects the price to go down in future while the buyer hopes it will rise (Butler, 2004).

Bid or Ask Spread

The bid refers to the largest amount that a bidder or buyer is willing to pay for an asset. The ask or offer price refers to the price stated by the seller of a currency or any other asset. The variance between the bid and ask prices is known as the bid-ask spread or simply the spread (Carbaugh, 2004).

Illustration: Currency Spread

Supposing the present USD/CYN bid price is 6.5766 and the present ask price is 6.6000, it implies that one can sell USD/CYN at 6.5766 and acquire it at 6.6000. The difference between the two quotations is the spread (0.0234).

If the USD/CYN currency pair is trading at 65.766/100.0000, this implies that the bid price for USD/CYN is 65.766 and the ask price is 100.0000. Therefore, the holders of United States dollars can sell one United States dollar for 100.0000 Chinese Yuan and investors have to part with 100.0000 Chinese Yuans for every United States dollar.

Currency Options

Currency Options is a contract that gives a currency bearer the right as opposed to the duty of selling or buying a currency at a particular exchange rate within a specified time frame. The broker receives a premium for the right to be granted. The premium will fluctuate in respect to the volume of contracts bought. Currency options are suitable for covering against weird exchange rate movements. A call option is the right to acquire a currency or an asset at a set price and date (Carbaugh, 2004). A put option is the right to give out an asset or currency at a particular agreed price and date. Investors hedge against exchange rate exposure by buying a put or call currency option (International Investing, 2012).

Illustration: Currency Option

Suppose the trader expects the USD/CYN exchange rate to increase from 6.5766 to 6.6 in thirty days. This implies that the Chinese Yuan will be more expensive for the United States trader to acquire. The trader would, therefore, prefer to purchase a call option on USD/CYN in order to stand a benefit from the rise in USD/CYN exchange rate. If the trader expects the USD/CYN exchange rate to decline, for instance from 6.5766 to 6.5000 in thirty days, he or she would acquire US$100000 now and enter into a put option. On the expiry of thirty days, the trader would dispose the 100000 US dollars at the rate of 6.5766 dollar per Yuan that amounts to 15205.4253 Chinese Yuan. The trader would pay less in the put option scenario as opposed to the amount payable at the thirty days spot rate (15384.6153 Chinese Yuan).

References

Butler, K. (2004). Multinational finance (3rd ed.). Mason, OH: Thompson South-Western.

Carbaugh, R. J. (2004). International Economics (9th Ed.). Mason, OH: Thomson.

Eiteman, D., Stonehill, A., & Moffett, M. (2010). Multinational Business Finance (12th Ed.). Upper Saddle River, NJ: Prentice Hall.

International Investing. (2012). In U.S. Security and Exchange Commission. Web.

Reh, J. (2013). Cost- benefit analysis. Web.

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