CHAPTER 8

Currency Futures and Options Markets

PART I

Futures Contracts

FUTURES CONTRACTS

I. CURRENCY FUTURESA. Market History:

1. Backgrounda. Long historyb. Extremely volatile due to theirinformation driven naturec. The market plays a Price Discovery

Role for other financial markets such as the cash markets

FUTURES CONTRACTS

B. International Monetary Market (IMM) 1972: opened by the Chicago Mercantile Exchange

Purpose:

to provide a stable market for the exchange of currency futures.

FUTURES CONTRACTS

2. IMM providesa. an outlet for hedging currency

risk with futures contracts.

Definition of a Futures Contract:

contracts written requiring a standard quantity of an available currency at a fixed exchange rate at a set delivery date.

FUTURES CONTRACTS

b. Available Futures Contracts Currency/ Contract Size:

1.) British pound / 62,5002.) Canadian dollar /100,0003.) Euro / 125,0004.) Swiss franc / 125,0005.) Japanese yen / 12.5 million6.) Mexican peso / 500,0007.) Australian dollar / 100,000

FUTURES CONTRACTS

c. Transaction costs:in the form of a commission payment to

a floor trader

d. Leverage is high1.) Initial margin required is

relatively low (less than 2% of

contract value).

FUTURES CONTRACTS: SAFEGUARDS

e. Maximum price movement rules:

Contracts set daily to a price

limit that restricts maximum

daily upward and downward

movements.

FUTURES CONTRACTS: SAFEGUARDS

f. Maintenance Margins:

When the account balance falls below

the maintenance margin, a margin

call may be necessary to maintain the

minimum balance.

FUTURES CONTRACTS

g. Global futures exchanges:1.) I.M.M. International Monetary

Market2.) L.I.F.F.E.London International

Financial Futures Exchange3.) C.B.O.T. Chicago Board of Trade4.) S.I.M.E.X.Singapore International

Monetary Exchange5.) D.T.B. Deutsche Termin Bourse6.) H.K.F.E. Hong Kong Futures

Exchange

FUTURES CONTRACTS

B. Forward vs. Futures ContractsBasic differences:1. Trading Locations 6. Quotes2. Regulation 7. Margins3. Frequency of 8. Credit risk delivery 4. Size of contract 5. Transaction Costs

FUTURES CONTRACTS

Advantages of futures:

1.) Easy liquidation

2.) Well- organized and stable

market.

Disadvantages of futures:

1.) Limited to 7

currencies

2.) Limited dates

of delivery

3.) Rigid contract

sizes.

PART II

Currency Options

CURRENCY OPTIONS

I. OPTIONSA. Currency options

1. offer another method to hedge exchange rate risk.

2. first offered on PhiladelphiaExchange (PHLX).

3. HOW CURRENCY OPTIONS ARE PURCHASED

Buyers Sellers=Writers

Buy Sell Buy Sell

CALL

PUT

Premium

CURRENCY OPTIONS

4. Definition:a contract from a writer ( the seller)

that gives the right not the obligation to the holder (the buyer) to buy or sell a standard amount of an available currency at a fixed exchange rate for a fixed time period.

CURRENCY OPTIONS

5. Expiration Dates of Currency Options:

a. American

exercise date may occur anytime up to the expiration date.

b. European

exercise date occurs only at theexpiration date and not before.

6. What is the premium?

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

CURRENCY OPTIONS

7.Exercise Pricea. Sometimes known as the

strike price.

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

CURRENCY OPTIONS

c. Types of Currency Options:

1.) Calls – give the owner the right to buy the currency

2.) Puts – give the owner the right to sell the currency

CURRENCY OPTIONS

8. Status of an optiona. In-the-money

Call: Spot > strikePut: Spot < strike

b. Out-of-the-moneyCall: Spot < strikePut: Spot > strike

c. At-the-moneySpot = the strike

CURRENCY OPTIONS

9. Why Use Currency Options?1. For the firm hedging foreign

exchange risk when a future event is very uncertain.

2. For speculators

who profit from favorable exchange rate changes.