Benefits of studying International Finance

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Benefits of studying International Finance

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Title: Benefits of studying International Finance

1
Benefits of studying International Finance

Knowledge of international finance helps two
important ways
1. Helps financial manager decide how
international events will affect a firm and steps
to be taken to exploit positive development and
insulate firm against harmful development.
2. Helps manager to anticipate events and to make
profitable decisions before the event occurs.
Events that affect the firm and manager must
anticipate are changes in exchange rates,
interest rates, inflation rates, and asset values.

2
Growing importance of International Finance

Importance of International finance springs from
increasing importance of international flow of
goods and capital.
Reason for growing importance of international
trade due to two reasons.
A liberalization of trade and investment has
occurred via reductions in tariffs, quotas,
currency controls, and other impediments to the
international flow of goods and capital. Much of
liberalization has come from the development of
free-trade areas EU, NAFTA, ASEAN etc.
An unprecedented shrinkage of economic space
has occurred via rapid improvements in
communication and transportation technologies and
cost reduction as a result. Eg. Cost of telephone
calls, cost of international Importance of
International finance springs from increasing
importance of international flow of goods and
capital.

Reason for growing importance of international
trade due to two reasons.
A liberalization of trade and investment has
occurred via reductions in tariffs, quotas,
currency controls, and other impediments to the
international flow of goods and capital. Much of
liberalization has come from the development of
free-trade areas EU, NAFTA, ASEAN etc.
An unprecedented shrinkage of economic space
has occurred via rapid improvements in
communication and transportation technologies and
cost reduction as a result. Eg. Cost of telephone
calls, cost of international travel

4
Rewards of International Trade

Increased prosperity by allowing nations to
specialize in producing goods and services at
which they are efficient, Comparative Advantage
There are more to successful international trade
than comparative advantage which is based on
productive efficiencies. That is due to
competitive advantage based on dynamic factors,
rather than static production possibilities. Eg.
Hong Kongs growth with limited resources, French
success in wine and cheese, German in beer and
finely engineered automobiles, British in
cookies, Italian success in fashion, U.S. in
entertainment, in part due to presence of
consumers in the respective countries whose
sophisticated tastes have forced firms to produce
first-class products, and after becoming
successful at home, they were able to succeed
abroad.

5
Risk of International Trade

Rewards accompany risks. Most obvious risk of
international trade arises from uncertainty about
exchange rates. Unexpected changes of exchange
rates have important impacts on sales, prices,
and profits of exporters and importers.
Country risk. This includes the risk as a result
of war, revolution, or other political or social
events a firm may not be paid for its exports.
This applies to foreign investments and to credit
granted in trade. Some times foreign buyers may
be willing but unable to pay because their
government unexpectedly imposes exchange
restrictions. Moreover, uncertainty due to
imposition or change of import tariffs or quotas,
subsidies to local producers, and non-traiff
barriers.
Practices have evolved to cope with risk. E.g.
special types of foreign exchange contracts
designed hedge or cover some of the risks from
unexpected changes in exchange rates.
Export credit insurance schemes established to
help country risk and letters of credit developed
to reduce other risks of trade.

In nutshell, more rapid growth of international
trade versus domestic trade and the expanded
international focus of investment offer adequate
reason why it is important to study international
finance.
Exchange risk has risen greatly because exchange
rates have become increasingly volatile. This has
been resulted for example, from tension in Middle
East or some other politically sensitive parts in
the world, and at times by news on economic
conditions of major country. This volatility is
measured by using coefficient of variation in the
exchange rates. Some attribute the increased
volatility to flexible exchange rate system
adopted in 1973.
In addition to the growth of international trade,
investment flow, and riskiness of international
trade and investment due to country risk and
increased volatility of exchange rates, increased
importance of MNCs has boost the importance of
international finance.

International finance is synonymous with exchange
rates a large part of the study of international
finance involves exchange rates.
A variety of exchange rate exist
Bank notes-only a small proportion of overall
foreign exchange markets.
Bank draft, checks issued by banks or by
corporations
Buying and selling prices can differ by a large
percentage, usually more than 5 or 6 percent.
Difference is called spread.
Spot foreign exchange market involved with the
exchange of currencies held in different currency
denominated bank accounts.
Spot exchange rate, determined in the spot
market, is number of units of one currency per
unit of another currency in the form of bank
deposits.

8
Inter-bank Spot Market

Inter-bank foreign exchange is the largest
financial market with a turnover of almost one
trillion dollars.
The foreign exchange market is an informal
arrangement of the larger commercial banks and a
number of foreign exchange brokers. They are
linked together by telephone, telex, and a
satellite communications network called Society
for Worldwide International Financial
Telecommunication (SWIFT). Computer based
communications system based in Brussels, Belgium
links banks and brokers in every financial
centres and keep them in almost constant contact
24 hours a day.

9
Geographical Distribution of Average Daily
Foreign Exchange TurnoverApril 1992
10

Efficiency of the spot foreign exchange market is
reflected in the extremely narrow spread between
buying and selling prices can be smaller than a
tenth of a percent, , of the value of currency
exchanged, that is one fiftieth or less of the
spread faced on bank notes.
Most markets including in the US there are two
levels on which foreign exchange markets operates
A direct inter-bank level banks trade directly
with each other and all participating banks are
market-makers. Banks quote buying and selling
price to each other, known as an open bid double
auction as there is no central location of the
market and trading is continuous. Direct market
characterized as a decentralized, continuous,
open-bid, double-auction market.
An indirect level via brokers so-called
limited-orders are placed with brokers by banks.
E.g. A commercial bank place an order with a
broker to purchase 10 million at 1.5550/. The
brokers puts order on book and attempts to match
the purchase order with sell order for pounds
from other banks. Market-making banks take
positions on their own behalves and for
customers, brokers deal only for other, showing
callers their best rates inside spread, charging
a commission to both buying and selling banks.
Indirect broker-based market can be characterized
as a quasi-centralized, continuous, limit-book,
single-auction market.

11
Settlement between banks

Bank that purchased foreign currency have to pay
the bank that sold the foreign currency. The
payment generally takes place via a clearing
house an institution at which banks keep funds
that can be moved from one banks account to
anothers to settle interbank transactions. When
foreign exchange is trading against dollar, the
clearing house is called CHIPS Clearing House
Interbank Payments System, located in New York.
Bank settlement via CHIPS
CHIPS is a computerized mechanism through which
banks hold US to pay each other when buying or
selling foreign exchange. System is owned by
large New York clearing banks, over 150 members
and handled over 150,000 transactions a day,
worth hundreds of billion of .
Retail versus Interbank Spot rates
Exchange rates between interbanks determined in
the market. Exchange rates faced by the banks
clients are based on these interbank rates.
Clients are charged slightly more than the going
interbank selling rate ask rate, pay slightly
less than the interbank buying rate bid rate.
Foreign exchange rates can be given two ways.
Number of US per foreign currency unit U.S.
equivalent
Number of units of foreign currency per U.S.
European terms
Exchange Rates -Thursday, November 9, 2006
1 Sri Lanka Rupee 0.009339 US Dollar - U.S. .
Equivalent
1 US Dollar (USD) 107.080 Sri Lanka Rupee (LKR)
- European terms

12
Direct vs indirect exchange and cross exchange
rates

Compute the exchange rate between the Euro and
the British pound
Directly
Indirectly, from the exchange rate between Euro
and dollar and pound and dollar.
If no costs of transacting in foreign exchange,
no bid-ask spread.
Suppose people want to exchange Euro for pounds
or pounds for Euro
Exchange can be made directly or indirectly via
dollar
If no foreign exchange transaction costs, banks
quote a direct exchange rate between Euro and
pound, exactly equal to implicit indirect
exchange rate via dollar.
No transaction costs, find all possible exchange
rates via dollar
With transaction costs, direct exchange rates not
always equal to implicit indirect exchange rates
via dollar.

13
Zero foreign exchange transaction costs

Spot exchange rate between and S(/), the
number of US per British in the spot exchange
market
S(i/J) number of units of currency i per unit of
currency j in the spot exchange market.
Banks offering Euro for pounds at S(/) pound
per Euro must offer at least as large number of
pounds as would be obtained via indirect route.
S(/) S(/) . S(/) Alternatively, from Euro
to pound, S(/) S(/) . S(/)
Exchange rate S(/) is a cross rate exchange
rate directly between currencies when neither of
two currencies is US .
Since ,
cross rate can be computed as
Calculating cross rate is based on triangular
arbitrage. If one started with 1, he could not
end up with more than 1 or there would be an
arbitrage profit.

14
Nonzero foreign exchange transaction costs

Cost of transacting, 1. bid-ask spread, and 2.
lump-sum fee or commission on each transaction.
S(/ask) price that must be paid to the bank
to buy one pound with dollar, bank selling rate
of pounds.
S(/bid) number of dollars received from the
bank for sale of pounds for , banks bid rate
(buying rate) on pounds.
If no transaction costs,
With transaction costs,
and
Generally, and

15
Forward Foreign Exchange

Forward exchange rate rate that is contracted
today for the exchange of currencies at a
specified date in the future.
Foreign exchange net turnover by Market Segment-
April 1992

16
Forward Exchange Premium and Discounts

When required to pay more for forward delivery
than for spot delivery of a foreign currency, the
foreign currency is said to be at a forward
premium.
When a foreign currency costs less for forward
delivery, it is said to be at a forward discount.
Forward exchange rate Fn(/), n-year forward
exchange rate of dollars to pounds. Generally,
Fn(i/j), n-year forward exchange rate of currency
i to currency j.
Premium / Discount ( vs. ) ,
when value is positive, the pound is at
forward premium vis-à-vis dollar. If negative,
discount.
When forward rate and spot rate are equal, say
forward currency is flat.
Eg suppose , , and . Compute the forward premium
or discount for the 90-day and 180-day forward
pound.

Percentage premium/discount ( vs. )
or ,
pound is at a forward discount 1.286
percent per annum.
Premium / Discount ( vs. )
Suppose , ,
and
Compute the forward premium or discount for the
90-day and 180-day forward dollar.
Percentage premium/discount ( vs. )
or ,
dollar is at a forward premium of 1.301
percent per annum.
More generally, n-year premium/ discount of
currency i versus currency j is, Premium/discount
(i vs. j)

18
Example consider the following exchange rates
and calculate premium or discount on forward
foreign exchange vis-à-vis U.S. for different
forward periods
Exchange Rates Thursday, February 17, 1984
19
The New York foreign exchange selling rates below
apply to trading among banks in amounts of
1million and more, as quoted at 3 p.m. Eastern
time by Bankers Trust Co., Telerate and other
sources. Retail transactions provide fewer units
of foreign currency per dollar.

20
Forward Rates vs. Expected future spot rates

Assume speculators are risk-neutral, i.e., they
do not care about risk, and if transaction costs
in exchanging currencies are ignored, forward
exchange rates equal the markets expected future
spot rates.
That is,
This follows because if market in general
expected dollar to be trading at 1.30/ in
1-years time and the forward rate for 1 year
were 1.28/, speculators would buy dollar
forward for 1.28 and expected to make 0.02
(1.30 - 1.28) on each dollar when are sold at
1.30 each.
This would drive up forward price of dollar until
it was no longer lower than the expected future
spot rate.
Forward buying of continue until (/)
(/)
Forward selling of continue until (/)
(/)
No forward buying or selling takes place if
(/) (/)

21
Outrights and Swaps

Outright forward contract an agreement to
exchange currencies at an agreed price at a
future date
Swap has two components. Usually a spot
transaction and forward transaction in the
reverse direction, but could involve two forward
transactions or borrowing one currency and
lending another.
Swap-in Euro an agreement to buy spot and sell
forward
Swap-out Euro an agreement to sell spot and
buy forward
Forward-forward swap e.g. contract to buy for
1-month forward and sell for 2-month forward
Rollover swap involving purchase and sale are
separated by only 1 day
Definition of Swap
A swap is an agreement to buy and sell foreign
exchange at pre-specified exchange rates where
the buying and selling are separated in time, or
borrowing one currency and lending another.

Swaps very valuable to those investing and
borrowing in foreign currencies. E.g. one who
invests in a foreign treasury bill can use a
spot-forward swap to avoid foreign exchange risk.
Sell forward foreign currency maturity value of
the bill and at the same time, buy foreign
currency spot to pay for the bill. (swap in)
One who borrows in foreign currency can buy
forward foreign currency needed for repayment of
the loan and at the same time borrow foreign
funds on the spot market.
Growing popularity of swaps show value of swaps
to international investors and borrowers
Swaps not very useful to importers and exporters,
as payments in international trade are often
delayed
Swaps popular with banks as it is difficult to
avoid risk when making a market for many future
dates and currencies
Some dates and currencies, a bank will be long in
foreign exchange, agreed to purchase more foreign
currencies than agreed to sell.
For other dates and currencies, a bank will be
short in foreign exchange, agreed to sell more
than it has agreed to buy.
Swaps help Bank to economically reduce risk if
Bank A is long on spot and short on 30-day
forward pounds, will find another Bank B in the
opposite situation. A will sell spot and buy
forward a swap out sterling to Bank B. Both
banks balance spot-versus-forward position,
economizing on number of transaction required to
achieve the balance.

23
Forward quotations

Swap points and outright forwards
Even forward contract is outright, the convention
in the interbank market to quote all forward
rates in terms of spot rate and number of swap
points.
E.g. 180-day forward Canadian rate would
conventionally be quoted as
Spot 180-Day Swap
1.1401-17 24-28
Canadian dollars (Can) per U.S. Spot buying
rate (bid) Can1.1401 and selling rate (ask)
Can1.1417 per U.S.. Swap points, 24-28 must be
added or subtracted from spot bid and ask rates.
Need to add or subtract depends on whether two
numbers in the swap points are ascending or
descending.
E.g. when swap points are ascending, they are
added to spot rates, so that implied bid on U.S.
for 180 days forward
Can1.1401/Can0.0024/Can1.1425/

Implied ask on U.S. for 180 days forward
Can1.1417/Can0.0028/Can1.1445/
If numbers are reversed, i.e., descending, the
point are subtracted
e.g. Spot 180-Day Swap
1.1401-17 28-24
Implied bid on U.S. for 180 days forward
Can1.1401/-Can0.0028/Can1.1373/
Implied ask on U.S. for 180 days forward
Can1.1417/-Can0.0024/Can1.1393/
16 basis points in the spot spread, but implied
forward spread is 20, larger.

25
Bid Ask spreads and Forward MaturityWider
spreads of implied outright rates with increasing
forward maturities observed in the marketHaving
larger spreads on longer maturity contracts not
due to that they are riskier to the banks, but
due to increasing thinness of the forward
market.Bids and Asks on Sterling Pounds
26
Maturity Dates and Value Dates

Contracts traded on interbank forward market are
mostly even dates, 1 month, 6 month and so on
Value date of an even-dated contract, a 1-month
forward is the same day in the next month as the
value date for a currently agreed spot
transaction
E.g. forward contract is written on May 18, a day
for spot transactions are for value on May 20,
the value date for a 1-month forward is June 20,
value date for a 2- month forward is July 20 and
so on
If the future date is not a business day, the
value date is moved to the next business day

27
Currency Futures and Options Market

Futures and options on futures are derivative
assets their values derived from underlying
asset values. Futures from underlying currency,
and options on currency futures from underlying
futures contracts.
Currency futures are standardized contracts that
trade like conventional commodity futures on the
floor of a futures exchange.
Orders to buy or sell a fixed amount of foreign
currency are received by brokers or exchange
members. Orders are communicated to the floor of
the futures exchange. At the exchange, long
positions are matched with short positions.
Long positions orders to buy a currency
Short positions orders to sell
The exchange or clearing corporation guarantees
two-sided contract, contract to buy and contract
to sell.
Willingness to buy and sell moves future prices
up and down to maintain a balance between number
of buy and sell orders. Market clearing price is
reached in the future exchange.

Currency futures started trading in the
International Money Market (IMM) of the Chicago
Mercantile Exchange in 1972. After that many
market opened up including, COMEX commodities
exchange in New York, Chicago Board of Trade, and
London International Finance Futures Exchange
(LIFFE)
A market to be made in currency future contracts,
it is necessary to have only a few value dates.
At the Chicago IMM, there are four value dates of
contracts third Wednesday in the month of March,
June, September, and December.
If contracts are held to maturity, delivery of
foreign currency occurs 2 business days after
contract matures to allow normal 2-day delivery
of spot currency.
Contracts are traded in specific sizes - 62,500,
Can 100,000, and so on.
Selected currencies that are traded with their
contract sizes are given below

29
Currency
Futures prices are quoted in U.S. dollar
equivalent terms. Prices per unit of foreign
currency, prices of contracts shown above the
respective quotations are the contract sizes x
exchange rates.
30

Above table shows IMM of Chicago Mercantile
Exchange, futures price of foreign currencies
quoted as U.S. dollar per unit of foreign
currencies. Forward rates on the other hand
except for British pounds are quoted in European
terms. In the case of Japanese yen, the first two
digits of the dollar price of yen are omitted.
E.g.. Contract maturing March has a settle price
of 0.009593 per Japanese yen .
To convert these per-unit prices into futures
contract prices, it is necessary to multiply the
price in the table by contract amount. E.g.
Japanese yen contract is for 12.5 million. With
settle price per yen for March delivery of
0.009593, the price of one Japanese yen March
contract is
As with forward exchange contract, if risk
neutrality is assumed, per-unit price of future
equals the markets expected future spot rate of
the foreign currency.
Otherwise, if expected spot rate were above,
speculators would buy futures, pushing the
futures price up to the expected futures spot
level. If expected spot rate were below the
futures price, speculators would sell futures
until futures price forced back to the expected
future spot rate.

Thus, changes in the markets expected future
spot rate drive futures contract prices up and
down.
Both buyers and sellers of currency futures post
a margin and pay a transaction fee.
Margin is posted in a margin account at a
brokerage house, which then posts a margin at the
clearing corporation of the exchange.
Clearing corporation then matches each buy order
with a sell order. All buy and sell orders are
guaranteed by clearing corporation.
Margin must be supplemented by contract holders
and brokerage houses if the amount in a margin
account falls below a certain level maintenance
level. IMM required a minimum margin on British
pound is currently 2000 per contract and its
maintenance level is 1500.
Margin adjustment is done on daily basis called
making to market
Example suppose on day 1, a British June
contract is bought at the opening price of
1.4700/, means one contract for 62,500 has a
market price of .
. Settle
price, price at the end of the day used for
calculating settlement with the exchange, is
1.4714/, the markets expected future spot
price for June at the end of day 1. At this
price, June pound contract to buy 62,500 is
worth

Purchase of futures contract has earned the
contract buyer
.
Assume this is left in the purchasers margin
account and added to 2000 originally placed in
the account. Suppose on day 2 the June futures
rate falls to 1.4640/. The contract is now
worth
Compared to the previous settle contract price
of 91,962.50, now there is a loss of
. When this
is adjusted in the margin account, the total will
be 1,625, and margin remains above the
maintenance level of 1500 so nothing needs to be
done. Suppose on day 3, settle price on June
falls to 1.4600. Contract is now worth
and the loss
is
This brings margin account to
, below the maintenance level
1,500. Now the contract buyer is asked to bring
the margin account up to 2,000, requiring at
least 625 be deposit in the buyers account. If
on day 4 the June futures rate settles at
1.4750, the contract is worth
. The gain
over the previous settlement of
.

33
The margin account becomes 2,937.50 and the
contract owner can either withdraw 937.50 or use
it for margin on another future contract.
Assuming that it has been withdrawn, this example
can be summarized as

As with risk neutrality futures price equals
markets expected future spot exchange rate,
futures can be considered as daily bets on the
value of expected future spot exchange rate,
where bets are settled each day.
When buyers margin account is adjusted up,
sellers account is adjusted down by the same
amount.

34
Futures contract versus Forward contracts

There is a daily settlement of bets on futures.
Therefore, a futures contract is equivalent to
entering a forward contract each day and settling
each forward contract before opening another one,
where forwards and futures are for the same
future delivery date.
Forward market no formal and universal
arrangement for settling up as expected future
spot rate and consequent forward contract value
move up and down.
No formal and universal margin requirement
In case of inter-bank transactions and
transactions with large corporate clients, banks
require no margin, make no adjustment for
day-to-day movements in exchange rates, and
simply wait to settle up at the originally
contracted rate.
Procedure for maintaining the margin on a forward
contract depends on the banks relationship with
the customer. Margin may be called on customers
without credit line (facilities), requiring
supplementary funds to be deposited in the margin
account if a large, unfavourable movement in the
exchange rate occurs.
In deciding whether to call for supplementing of
margin accounts, usually banks consider
possibility of their customers honouring forward
contracts.

When banks calling margin, they are very flexible
about what they will accept as margin, stocks,
bonds and other instruments.
With forward contracts, no opportunity cost of
margin requirements, but an opportunity cost with
future contracts, specially when contract prices
have fallen, and substantial cash payments
consequently been made into margin account.
Unlike the case of forward contract, when buyer
of a futures contract wants to take delivery of
foreign currency, it is bought at going spot
exchange rate at the time of delivery.
E.g. suppose a future contract buyer needs
British in August and buys a September pound
futures contract. August, when pounds are needed,
the contract is sold back to the exchange, and
are bought on the spot exchange market at
whatever exchange rate exists on the day in
August when the pounds are wanted.
Most of the foreign exchange risk is still
removed here, because if has unexpectedly
increase in value from the time of buying future
contract, there will be a gain in the margin
account.

The amount in the margin account or amount paid
to maintain it depends on the entire path of the
futures price from initial purchase, and on
interest rate earned in the account or interest
forgone on cash contribution to the account.
The risk as a result of variability of interest
rate called marking-to-market risk, and this
makes futures riskier than forward contracts.
Problem with using futures contracts to reduce
foreign exchange risk contract size unlikely to
match to a firms needs. E.g. if a firm needs
50,000, the closest is to buy one 62,500
contract. But forward contract with banks can be
taken for any desired amount.
Flexibility in values of forward contracts and in
margin maintenance, absence of marking-to-market
risk, makes forward contract preferable to
futures especially for importers, exporters,
borrowers and lenders who wish to precisely hedge
foreign exchange risk and exposure.

Currency futures are more likely to preferred by
speculators because gains on futures contract can
be taken as cash and transaction costs are small.
With forward contracts, necessary to buy an
off-setting contract for same maturity to lock in
a profit and wait for maturity before settling
the contract and taking gain.
Open interest indicates the extent to which
futures are used to speculate rather than to
hedge. It refers to number of outstanding
two-sided contracts at any given time.

38
Currency Option

Forward and currency futures contracts must be
honoured by both parties. No option allowing a
party to settle only if it is to that partys
advantage.
Unlike forward and futures contracts, currency
options give buyer the opportunity, but not the
obligation, to buy or sell at a pre-agreed price
strike price or exercise price in the future.
Allows buyer who purchases options, the option or
right either to trade at the rate or price stated
in the contract, if it is to the advantage of the
options buyer or if not, to let the option
expire, if that would be better. Thus, options
have a throwaway feature.

39
Exchange- Traded OptionsFutures Options Vs Spot
Options

At IMM in Chicago currency options are options on
currency futures. Give buyers the right but not
the obligation to buy or sell currency futures
contracts at a pre-agreed price.
Value of Options on futures prices of
underlying futures expected future spot
value of the currency. Therefore, indirectly,
value of options on futures derives from the
expected future spot value of the currency.
Currency options also traded on Philadelphia
Exchange, but spot currency. Give buyer the right
to buy or sell the currency at a pre-agreed
price. Therefore, options on spot currency derive
value directly from expected future spot value of
the currency, not indirectly via the price of
futures.
All currency options derive their value from
movements in the underlying currency.
Lets focus on direct linkage involving spot
option contract, but also applies to futures
options, as they approach maturity become more
like spot options.

40
Characteristics of Spot currency options

Options traded on the same currencies as in
futures
Size of contracts half of those of currency
futures, help expand those who can afford to
trade in option, while allowing options to use in
conjunction with futures.
European Options exercise only on the maturity
date of the option (European Style)
American Options majority of options are
American options. Offer buyers more flexibility,
can be exercised on any date up to and including
the maturity date of the option.
Expiry months for options March, June,
September, and December plus one or two near-term
months.
Call option gives buyer the right to buy
foreign currency at the strike price or exchange
rate on the option
Put option gives buyer the right to sell
foreign currency at the strike price

41
Illustration
42

Note going spot price of the German Mark is 58.60
U.S. cents, the exchange rate is 0.5860/DM. on
the spot market. From the table we see the
European style options on 62,500 marks, strike
price ranges from 56 U.S. cents per mark to 60 ½
cents per mark.
Meaning of 58 Mar option for which 600
contracts and last trading price of put option of
0.26 U.S cents per mark. This European put
option gives buyers the right to sell the mark at
58 U.S. cents. The price of the option, 0.26 U.S.
cents per mark means for the contract of 62,500
German marks the option buyer must pay . By
paying 162.50, the option buyer acquires the
right to sell 62,500 marks for 58 U.S. cents
(0.58) each at the expiry date of the option,
the Friday before the third Wednesday of March.
Since option is European style and valid only for
the expiry date.

Option will not be exercised if spot rate of mark
on the expiry date is above 0.58, because better
to sell marks spot.
If spot rate is below 0.58, the option has
value, as it gives holder the right to receive
0.58 per mark, more than its market value.
Option writer person selling the put option, who
receive 162.50 from the sale of the option.
Actually, instead of exercising the option, buyer
is likely to accept the difference between
exercise price and the going spot rate from the
option writer.
Consider the following table, 58 Mar option. It
does not say European style, the options are
American options. They can be exercised on any
date prior to maturity. We notice there 6038 call
options, and 31 put options at strike price of 58
½ U.S. cents per mark, an exchange rate of
0.5850/DM.

44
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Call option costs 0.60 U.S. cents or 0.0060 per
mark. Call option contract costs . Buyer
acquires right to buy DM62,500 for 0.5850 per
mark up to the expiry date in March for 375.
If mark is above 0.5850 on the spot market,
option will be exercised on or before expiry or
its value will be collected from the option
writer or another buyer.
If the spot value is below 0.5850, not exercise
the option and thrown away, loss is 375. Can be
thought of as an insurance premium for which
unfavourable events do not occur, and insurance
simply expires.
In the Money Call option that gives buyer the
right to buy currency at a strike exchange rate
below the spot exchange rate. Put option that
gives buyer the right to sell currency when
strike exchange rate is higher than the spot
exchange rate.

Out of the Money Call option with a strike price
above the spot exchange rate. Put option with a
strike price below the spot exchange rate.
Intrinsic Value is extent to which an option is
in the money. Intrinsic value is how many cents
per currency would be gained by exercising the
option immediately. Call options have intrinsic
value when the strike price is below the spot
rate, and put options have intrinsic value when
the strike price exceeds the spot rate.
Option Premium amount paid for the option on
each unit of foreign currency. Option premium
consists of two parts intrinsic value and time
value.
Time value possibility of having a higher
intrinsic value in future than at the moment.
At the money strike price exactly equals the
spot rate. Option premium is only option time
value.