Currency Futures and Currency Futures and Options MarketsOptions Markets

Chapter 7Chapter 7

22

PART I.PART I.FUTURES CONTRACTSFUTURES CONTRACTS

I.I. CURRENCY FUTURESCURRENCY FUTURESA.A. BackgroundBackground

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

to to information driven information driven naturenature

3.3. Price Discovery RolePrice Discovery Role

33

FUTURES CONTRACTSFUTURES CONTRACTS

B.B. 1972: Chicago Mercantile1972: Chicago MercantileExchange opens theExchange opens the

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

Purpose: Purpose:

44

FUTURES CONTRACTSFUTURES CONTRACTS

2.2. IMM providesIMM providesa.a. an outlet for hedging currencyan outlet for hedging currencyrisk with futures contracts.risk with futures contracts.Definition:Definition:contracts written requiring contracts written requiring 1. 1. standard quantitystandard quantity of an of an available available currencycurrency22. . at a at a fixed exchange ratefixed exchange rate 3. at a 3. at a set delivery date.set delivery date.

55

FUTURES CONTRACTSFUTURES CONTRACTS

b.b. Available Futures Currencies/Contract Available Futures Currencies/Contract Size: (p. 211)Size: (p. 211)

1.) British pound1.) British pound / 62,500/ 62,500

2.) Canadian dollar /100,0002.) Canadian dollar /100,000

3.) Euro / 125,0003.) Euro / 125,000

4.) Swiss franc / 4.) Swiss franc / 125,000125,000 5.) 5.) Japanese yen / 12.5 millionJapanese yen / 12.5 million

6.) Mexican peso / 500,0006.) Mexican peso / 500,000

7.) Australian dollar / 100,0007.) Australian dollar / 100,000

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FUTURES CONTRACTSFUTURES CONTRACTS

c.c. Transaction costs:Transaction costs:

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

d.d. Leverage is highLeverage is high1.)1.) Initial margin required isInitial margin required is

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

contract value).contract value).

77

ADAD BPBP CDCD ECEC JYJY MPMP SFSF

SizeSize 100,100,

00000062,62,

500500100,100,

000000125,125,

00000012,12,

500,500,

000000

500,500,

000000125,125,

000000

IMIM 1,481,4855

1,3501,350 608608 2,022,0255

2,022,0255

3,123,1255

1,451,4522

MMMM 1,101,1000

1,0001,000 450450 1,501,5000

1,501,5000

2,502,5000

1,071,0755

TradTradee

MarcMarchh

JuneJune SeptSept DecDec

HrsHrs 7:207:20 AMAM ToTo 2:002:00 PMPM

P.21P.2111

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FUTURES CONTRACTS: FUTURES CONTRACTS: SAFEGUARDSSAFEGUARDS

e.e. What are the safeguards?What are the 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 maintain a minimum

margin.margin.

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FUTURES CONTRACTS: FUTURES CONTRACTS: SAFEGUARDSSAFEGUARDS

3.)3.) Marking to MarketMarking to Market

4.) Eliminating default4.) Eliminating default

5.) Delivery cancelled5.) Delivery cancelled

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FUTURES CONTRACTSFUTURES CONTRACTS

g.g. 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

1111

FUTURES CONTRACTS FUTURES CONTRACTS (p.214)(p.214)

B.B. Forward vs. Futures ContractsForward vs. Futures ContractsBasic differences:Basic differences:1. Trading Locations1. Trading Locations 6. Quotes6. Quotes2. Regulation2. Regulation 7. Margins7. Margins3. Frequency of 3. Frequency of 8. Credit risk8. Credit risk deliverydelivery 4. Size of contract 4. Size of contract 5. Transaction Costs5. Transaction Costs

1212

FUTURES CONTRACTS: FUTURES CONTRACTS: Why would you use Why would you use them?them?Advantages of Advantages of

futures:futures:*1.)*1.) High High

leverage(2%)leverage(2%)

2.) Easy liquidation2.) Easy liquidation

3.) Well- organized 3.) Well- organized and stable and 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.

CURRENCY CURRENCY OPTIONSOPTIONS

PART IIPART II

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CURRENCY OPTIONSCURRENCY OPTIONS

I.I. OPTIONSOPTIONS

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

hedge exchange rate risk.hedge exchange rate risk.

2.2. first offered on first offered on PhiladelphiaPhiladelphia

Exchange (PHLX).Exchange (PHLX).

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CURRENCY OPTIONSCURRENCY OPTIONS

BuyersBuyers Sellers=WritersSellers=Writers

Buy Sell Buy Sell

CALL

PUT

Premium

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CURRENCY OPTIONSCURRENCY OPTIONS

4. Definition:4. Definition:

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

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

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

c.c. a fixed exchange rate for a fixed timea fixed exchange rate for a fixed timeperiod.period.

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CURRENCY OPTIONSCURRENCY OPTIONS

5.5. Two Types: Expiration Dates of Two Types: Expiration Dates of Currency Currency OptionsOptions

a.a. AmericanAmerican

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

b.b. EuropeanEuropean

exercise date occurs only at exercise date occurs only at the expiration date and not the expiration date and not before.before.

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CURRENCY OPTIONSCURRENCY OPTIONS

7.7. Exercise Price (exchange Exercise Price (exchange rate)rate)

a. a. Sometimes known as theSometimes known as the

strike price.strike price.

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

1919

CURRENCY OPTIONSCURRENCY OPTIONS

c.c. Types of Currency Types of Currency Options Options (whether (whether you can you can buy or sell):buy or sell):

1.)1.) CallsCalls

2.)2.) PutsPuts

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CURRENCY OPTIONSCURRENCY OPTIONS

8.8. Status of an optionStatus of an optiona.a. In-the-moneyIn-the-money

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

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

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

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CURRENCY OPTIONSCURRENCY OPTIONS

9.9. What is the premium:What is the premium: the the price of an option that the price of an option that the writer charges the buyer.writer charges the buyer.

2222

CURRENCY OPTIONSCURRENCY OPTIONS

B.B. 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

C. Using Forward or Futures ContractsC. 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 payable/recExamples: accounts payable/rec

2424

Options Sample Options Sample ProblemsProblems

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

2525

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)