Currency Futures and Options

Opening Case 6: Derivatives Risks

Do you know how many days it took for a son to lose $150 million in foreign-exchange trading that it had taken his father decades to accumulate? The answer is just 60 days. The following story illustrates how volatile the currency derivatives market was in the 1990s.

"Dad, I lost a lot of money," Zahid Ashraf, a 44-year-old from the United Arab Emirates, confessed to his ailing father, Mohammad. "Maybe no matter," the father said, recalling the conversation in court testimony. Mohammad Ashraf, who had built one of the largest gold and silver trading businesses in the Persian Gulf, then asked, "How much have you lost?" The answer - about $150 million - mattered plenty to the stunned 69-year-old family patriarch.

In 2 months of foreign-currency trading in 1996, Zahid wasted much of a fortune ($250 million) that it had taken his father decades to build. The tight-knit Ashraf family estimates that Chicago-based commodities giant Refco Inc. collected about $11 million in commissions for the trades. So they sued Refco for $75 million of their losses. The Ashrafs contended that "Refco brokers conspired Zahid Ashraf to execute massive unauthorized speculative trading in currency futures and options" and "to conceal these trades from other family members." However, after a seven-day trial in February 1999, the jury ruled against the Ashrafs, not only rejecting their claim, but also finding that the family's Eastern Trading Co. still owed Refco $14 million on Zahid's uncovered losses. Because it involved a family business whose home turf is far from the world's financial capitals, such as New York or London, the debacle transpired virtually unnoticed. But it serves as yet another reminder of hazards posed by the volatile derivatives markets of the 1990s.

Financial derivatives, such as futures, options, and swaps, are supposedly hedging instruments designed to alleviate or eliminate a variety of risks. These hedging instruments are generally considered safe for short-term purposes, but they are not risk free either. Even some reputable companies, such as Procter & Gamble, have incurred large derivative-related losses in recent years (see Case Problem 7: Regulation of Derivatives Markets). Such corporate disasters related to financial derivatives continue to be a problem in global business. As is the case with so many issues in modern society, technology is not at fault, but rather human error in its use.

Sources'. "How Currency Trading Run Amok Crushed a Family," The Wall Street Journal, Apr. 8, 1999, pp. C1, C13; and M. H. Moffett, A. I. Stonehill, and D. K. Eiteman, Fundamentals of Multinational Finance, Boston, MA. Addison-Wesley, 2003, p. 157.

Multinational companies (MNCs) normally use the spot and forward markets for international transactions. They also use currency futures, currency options, and currency futures options for various corporate functions. While speculators trade currencies in these three markets for profit, MNCs use them to cover open positions in foreign currencies.

This chapter is divided into three closely related sections. The first section discusses currency futures. With a currency futures contract, one buys or sells a specific foreign currency for delivery at a designated price in the future. The second section describes currency options. A currency option is the right to buy or sell a foreign currency at a specified price through a specified date. The third section examines currency futures options. A currency futures option is the right to buy or sell a futures contract of a foreign currency at any time for a specified period.

Global Finance in Action 6.1

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