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CHAPTER 7CHAPTER 7CURRENCY FUTURES AND CURRENCY FUTURES AND OPTIONS MARKETSOPTIONS MARKETS

CHAPTER OVERVIEWCHAPTER OVERVIEWI.I. FUTURES CONTRACTSFUTURES CONTRACTS

II.II. CURRENCY OPTIONSCURRENCY OPTIONS

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PART I.PART I.FUTURES CONTRACTSFUTURES CONTRACTS

I.I. CURRENCY FUTURESCURRENCY FUTURESA.A. BackgroundBackground

1.1. Long historyLong history2.2. Extremely volatile due to Extremely volatile due to

information driven information driven naturenature

3.3. Price Discovery RolePrice Discovery Role

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FUTURES CONTRACTSFUTURES CONTRACTS

B.B. 1972: Chicago Mercantile 1972: Chicago MercantileExchange opens theExchange opens the

1.1. Purpose: Purpose: provides an outlet for currency provides an outlet for currency speculators and hedgersspeculators and hedgers

2.2. International Monetary Market International Monetary Market (IMM)(IMM)

Board of Directors sets deliveryBoard of Directors sets deliverydatesdates

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FUTURES CONTRACTSFUTURES CONTRACTS

C.C. Futures Contract Definition:Futures Contract Definition:

contracts written requiring contracts written requiring

1. 1. standard quantitystandard quantity of an of an available available

currencycurrency

22.. at a at a fixed exchange fixed exchange raterate

3. 3. at a at a set delivery date.set delivery date.

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FUTURES CONTRACTS:FUTURES CONTRACTS:

1. British pound1. British pound

2. Canadian dollar 2. Canadian dollar

3. Euro 3. Euro

4. Swiss franc 4. Swiss franc

5. Japanese yen 5. Japanese yen

6. Mexican peso 6. Mexican peso

7. Australian dollar 7. Australian dollar

8.8. Brazilian realBrazilian real

9.9. Czech korunaCzech koruna

10.10. Hungarian florintHungarian florint

11.11. Norwegian Norwegian kronekrone

12.12. Polish zlotyPolish zloty

13.13. Russian rubleRussian ruble

14.14. South African South African randrand

15.15. New Zealand $New Zealand $

16.16. Swedish kronaSwedish krona

D.D. Available inAvailable in

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FUTURES CONTRACTSFUTURES CONTRACTS

E.E. Transaction costs:Transaction costs:

commission payment to a floor commission payment to a floor trader trader

F.F. Leverage is highLeverage is high

1.)1.) Initial margin required isInitial margin required is

relatively low (less than 2% relatively low (less than 2% ofof

contract value).contract value).

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FUTURES CONTRACTS: FUTURES CONTRACTS: SAFEGUARDSSAFEGUARDS

G.G. What are the market’s built-in What are the market’s built-in safeguards?safeguards?

1.1. Contracts set to a daily priceContracts set to a daily price

limit restricting maximum limit restricting maximum daily price movements.daily price movements.

2.2. If limit is reached, a If limit is reached, a marginmargin

callcall may be necessary to may be necessary to maintain a minimum margin.maintain a minimum margin.

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FUTURES CONTRACTS: FUTURES CONTRACTS: SAFEGUARDSSAFEGUARDS

3.3. Marking to MarketMarking to Market

4. 4. Eliminating default Eliminating default

CME may step in to complete the CME may step in to complete the transaction if either side defaultstransaction if either side defaults

5. 5. Delivery cancelledDelivery cancelled

CME allows for offsetting CME allows for offsetting transactions cancelling delivery or transactions cancelling delivery or purchase of the currencypurchase of the currency

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FUTURES CONTRACTSFUTURES CONTRACTS

H.H. Global futures exchanges:Global futures exchanges:1.1. I.M.M. International Monetary I.M.M. International Monetary MarketMarket2.2. L.I.F.F.E.London International L.I.F.F.E.London International Financial Futures ExchangeFinancial Futures Exchange3.3. C.B.O.T. Chicago Board of TradeC.B.O.T. Chicago Board of Trade4. 4. S.I.M.E.X.Singapore InternationalS.I.M.E.X.Singapore International

Monetary ExchangeMonetary Exchange5.5. D.T.B. Deutsche Termin BourseD.T.B. Deutsche Termin Bourse6.6. H.K.F.E. Hong Kong Futures H.K.F.E. Hong Kong Futures

ExchangeExchange

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FUTURES CONTRACTSFUTURES CONTRACTS

1. Trading Locations1. Trading Locations

2.2. RegulationRegulation

3. Frequency of 3. Frequency of deliverydelivery

4. Size of contract 4. Size of contract

5. Transaction Costs5. Transaction Costs

6. 6. Quotes Quotes

7. 7. MarginsMargins

8. 8. Credit riskCredit risk

I.I. Forward vs. Futures ContractsForward vs. Futures ContractsBasic differences:Basic differences:

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FUTURES CONTRACTSFUTURES CONTRACTS

Advantages of Advantages of futures:futures:

1. 1. High High leverage(2%)leverage(2%)

2. 2. Easy Easy liquidationliquidation

3. 3. Well- Well- organized organized and and stable stable market.market.

Disadvantages of Disadvantages of futures:futures:

1. Limited to 71. Limited to 7

currenciescurrencies

2. Limited dates 2. Limited dates

of deliveryof delivery

3. Rigid contract3. Rigid contract

sizes.sizes.

J. Why would you use them?J. Why would you use them?

PART IIPART II CURRENCY CURRENCY OPTIONSOPTIONS

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Part II. CURRENCY OPTIONSPart II. CURRENCY OPTIONS

I.I. OPTIONSOPTIONS

A.A. Currency options Currency options 1.1. offer another product to offer another product to

hedge exchange rate hedge exchange rate risk.risk.

2.2. first offered on Philadelphiafirst offered on PhiladelphiaExchange (PHLX).Exchange (PHLX).

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CURRENCY OPTIONSCURRENCY OPTIONS

B. Definition:B. Definition:

a contract from a writer ( the seller) a contract from a writer ( the seller) that gives that gives

1.1. the right not the obligationthe right not the obligation to the to the holder (the buyer)holder (the buyer) to buy or sell to buy or sell

2.2. a standard amount of a standard amount of an available an available currency at currency at

3.3. a fixed exchange rate for a fixed a fixed exchange rate for a fixed time period.time period.

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CURRENCY OPTIONSCURRENCY OPTIONS

C.C. Two Types: Based on Exercise Two Types: Based on Exercise Dates Dates 1.1. AmericanAmerican

exercise date may occur anyexercise date may occur anytime up to the expiration time up to the expiration

date.date.2.2. EuropeanEuropean

exercise date occurs only at exercise date occurs only at the expiration the expiration

date and not date and not before.before.

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CURRENCY OPTIONSCURRENCY OPTIONS

D.D.Exercise Price (exchange rate)Exercise Price (exchange rate)

1. 1. Sometimes known as theSometimes known as the

strike price.strike price.

2.2. The exchange rate at The exchange rate at which the which the option holder can option holder can buy or sell the buy or sell the contracted contracted currency.currency.

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CURRENCY OPTIONSCURRENCY OPTIONS

E.E. Types of Currency OptionsTypes of Currency Options

1.1. Calls give the holder the right Calls give the holder the right to to buybuy a certain amount of a certain amount of currency currency at a fixed exchange rate.at a fixed exchange rate.

2.2. Puts give the holder the right Puts give the holder the right to to sell sell a certain amount of a certain amount of currency currency at a fixed exchange rate.at a fixed exchange rate.

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CURRENCY OPTIONSCURRENCY OPTIONS

F.F. Status of an optionStatus of an option1.1. In-the-moneyIn-the-money

Call:Call: Spot > strikeSpot > strikePut:Put: Spot < strikeSpot < strike

2.2. Out-of-the-moneyOut-of-the-moneyCall:Call: Spot < strikeSpot < strikePut:Put: Spot > strikeSpot > strike

3.3. At-the-moneyAt-the-moneySpot = the strikeSpot = the strike

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CURRENCY OPTIONSCURRENCY OPTIONS

G.G. What is the premium? What is the premium?

1.1. the price of an option that the price of an option that the writer charges the the writer charges the

buyerbuyer

2. consider it a risk premium to 2. consider it a risk premium to the writerthe writer

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CURRENCY OPTIONSCURRENCY OPTIONS

H.H. Why Use Currency Options? Why Use Currency Options?1.1. For the firm hedging foreignFor the firm hedging foreign

exchange risk withexchange risk with

Future event is very uncertainFuture event is very uncertaingains.gains.

2.2. For speculatorsFor speculators- profit from favorable - profit from favorable

exchange rate changes.exchange rate changes.

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CURRENCY OPTIONSCURRENCY OPTIONS

I. Using Forward or Futures ContractsI. Using Forward or Futures Contracts

Forward or futures contracts areForward or futures contracts aremore suitable for hedging a more suitable for hedging a

knownknown amount of foreign currency amount of foreign currency flow.flow.

Examples: accounts Examples: accounts payable/receivablespayable/receivables

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Options Sample ProblemsOptions Sample Problems

Ford buys a Franc put option (contract Ford buys a Franc put option (contract size: FF250,000) at a premium of size: FF250,000) at a premium of $.01/FF. If the $.01/FF. If the exercise price is $.21 and the spot at exercise price is $.21 and the spot at expiration is $.216, what is Ford’s profit expiration is $.216, what is Ford’s profit (loss)?(loss)?

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SOLUTIONSOLUTION

REVENUES: REVENUES: Sell at .21Sell at .21

COSTS:COSTS: If exercisedIf exercised

Buy at Buy at .216.216

Premium + Premium + .01.01

TotalTotal .226.226

Loss: If exercised:Loss: If exercised: $4,000$4,000

Loss: If not exercised: Loss: If not exercised: $2,500$2,500

(= the original premium)(= the original premium)