lesson vi: currency derivatives, an overview iv.pdfcurrency futures currency options to sum up...
TRANSCRIPT
InternationalFinancial and
Foreign ExchangeMarkets
Roadmap
Outright FwdContracts
Currency Futures
Currency Options
To Sum Up
Synthetic Fwds
Terminology
To Put It intoPractice
Lesson VI: Currency Derivatives, anOverview
Monday 27th April, 2020
InternationalFinancial and
Foreign ExchangeMarkets
Roadmap
Outright FwdContracts
Currency Futures
Currency Options
To Sum Up
Synthetic Fwds
Terminology
To Put It intoPractice
Table of Contents
Roadmap
Outright Fwd Contracts
Currency Futures
Currency Options
To Sum Up
Synthetic Fwds
Terminology
To Put It into Practice
InternationalFinancial and
Foreign ExchangeMarkets
Roadmap
Outright FwdContracts
Currency Futures
Currency Options
To Sum Up
Synthetic Fwds
Terminology
To Put It intoPractice
Roadmap
InternationalFinancial and
Foreign ExchangeMarkets
Roadmap
Outright FwdContracts
Currency Futures
Currency Options
To Sum Up
Synthetic Fwds
Terminology
To Put It intoPractice
Outright Fwd Contracts: Definition and Payoff
Outright Fwd Contracts: Tailor-made OTC agreement toexchange currencies at a pre-determined price on a futuredate.In intuitive terms, this allows to set now the price at whicha given currency will be bought or sold on a given futuredate⇒ at maturity, the payoff of a fwd depends on therealized spot rate at that time.
InternationalFinancial and
Foreign ExchangeMarkets
Roadmap
Outright FwdContracts
Currency Futures
Currency Options
To Sum Up
Synthetic Fwds
Terminology
To Put It intoPractice
Payoff Profile of a Long Fwd to Buy EUR vs USD
InternationalFinancial and
Foreign ExchangeMarkets
Roadmap
Outright FwdContracts
Currency Futures
Currency Options
To Sum Up
Synthetic Fwds
Terminology
To Put It intoPractice
Benefits and Risks of Fwds
I High FlexibilityI Not only major currenciesI Customizable maturities and notional amountsI Deliverables vs Non deliverables
I No CCTP: Higher settlement risk
I Reduced mkt liquidity
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Roadmap
Outright FwdContracts
Currency Futures
Currency Options
To Sum Up
Synthetic Fwds
Terminology
To Put It intoPractice
Futures: Definition and Comparison with Fwds
Currency Futures: standardized contracts drawn either tobuy or to sell a fixed amount of foreign currency on apre-determined date sometime in the futureUnlike fwds, however, currency futures:
I trade for standardized amounts (depending on thecurrency)
I trade for a limited number of maturity dates(typically, March, June, September and December)
I settle gains or losses on a daily basis⇒ Mark toMarket
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Currency Futures
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To Sum Up
Synthetic Fwds
Terminology
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Focus on the MtM
Futures are CCTP-based ⇒ the Clearing House requiresboth parties of a futures transaction to post margins in amargin account held at a brokerage house
I The amount of margins to be posted is typically a % ofthe notional amount
I The margins’ balance is updated daily, depending onthe market value of the contract (computed at the dailysettlement price)
I Whenever the balance falls below a pre-specifiedthreshold (maintenance level) after the daily MTM, theinvolved party will receive a margin call to postadditional money in the margin account
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MtM: Digging Deeper into Daily Mkt Practice
Suppose that, on June 1st, you bgt a GBP future contractat 1.55 USD
GBP to purchase GBP 63,000 in three months.Assume further that
I Required Initial Margin = USD 6,000
I Maintenance Margin = USD 5,000
June 1st June 2nd June 3rdSettlement Px 1.55 1.57 1.53USD Fut.Val 97,650 98,910 96,390
USD Daily PL 0 1,260 -2,520Mrg.Balance 6,000 7,260 4,740
Mrg.Call No No 260
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Synthetic Fwds
Terminology
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In more practical terms...
A futures contract is equivalent to entering a forwardcontract each day and settling each forward contractbefore opening another one.If you conversely buy (sell) a fwd contract all the gains(losses) will be eventually realized (incurred) at maturity,depending on the future realized spot rate at that time.
InternationalFinancial and
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Roadmap
Outright FwdContracts
Currency Futures
Currency Options
To Sum Up
Synthetic Fwds
Terminology
To Put It intoPractice
MtM and Futures vs Fwds: a Wrap Up
I FuturesI CCTP (Clearing House) bearing the settlement risk ⇒
Margins are requiredI The amount in the margin account not only depends on
the entire path of the futures price from the initialpurchase, but also on the interest rates earned in theaccount or forgone on cash contributions to the account⇒ Marking-to-market risk
I FwdsI No CCTP: the settlement risk is faced by the two
parties involved ⇒ No margins are requiredI Gains or losses on the forward positions will be
eventually realized at the maturity of the contracts ⇒No marking-to-market risk
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Outright FwdContracts
Currency Futures
Currency Options
To Sum Up
Synthetic Fwds
Terminology
To Put It intoPractice
Payoff Profile of a Long Future to Buy EUR vsUSD
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Foreign ExchangeMarkets
Roadmap
Outright FwdContracts
Currency Futures
Currency Options
To Sum Up
Synthetic Fwds
Terminology
To Put It intoPractice
Benefits and Risks of Futures
I Low FlexibilityI Mainly major currenciesI Fixed, standardized maturities and notional amountsI Well-defined trading time and trading rules
I CCTP: No settlement risk
I High mkt liquidity
InternationalFinancial and
Foreign ExchangeMarkets
Roadmap
Outright FwdContracts
Currency Futures
Currency Options
To Sum Up
Synthetic Fwds
Terminology
To Put It intoPractice
Options: Definition and Overview
Options are derivative contracts that give the buyer theopportunity (not the obligation) to buy or to sell theunderlying asset at a given price sometime in the future(either at or up to maturity).Watch out:
I Call: right to buy
I Put: right to sell
I European Option: exercise at maturity
I American Option: exercise up to maturity
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Currency Futures
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To Sum Up
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Terminology
To Put It intoPractice
Moneyness and Intrinsic Value
Assume:
I S: market price of the underlying
I X: strike price
I Premium=0
In the Money At the Money Out the MoneyC S>X S=X S<XP S<X S=X S>X
Intrinsic Value: extent to which an option is in the money
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Terminology
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The Drivers of an Option’s Mkt Value I
I Intrinsic Value: the more the option is in the money,the higher is the option premium
I Volatility of the underlying exchange rate: the morevolatile is the underlying, the greater the chance thatthe option will be exercised (ceteris paribus)
I American vs European option type: Americanoptions are more “flexible” and consequently morevaluable than European options
I Interest rates: the higher the interest rates, the lowerthe present value of the exercise price. This shouldincrease (reduce) the mkt value of a call (put)
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Currency Futures
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To Sum Up
Synthetic Fwds
Terminology
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The Drivers of an Option’s Mkt Value II
I Forward premium/ discount: (ceteris paribus) thegreater is the fwd discount (i.e. the expected decline inthe FX value of a currency), the higher (lower) is thevalue of a put (call) option. The reverse holds for fwdpremia
I Length of the period to expiry: (ceteris paribus) thelonger the maturity, the greater the chance that theoption will move into money
InternationalFinancial and
Foreign ExchangeMarkets
Roadmap
Outright FwdContracts
Currency Futures
Currency Options
To Sum Up
Synthetic Fwds
Terminology
To Put It intoPractice
Payoff Profile of a Long Call
InternationalFinancial and
Foreign ExchangeMarkets
Roadmap
Outright FwdContracts
Currency Futures
Currency Options
To Sum Up
Synthetic Fwds
Terminology
To Put It intoPractice
Payoff Profile of a Long Put
InternationalFinancial and
Foreign ExchangeMarkets
Roadmap
Outright FwdContracts
Currency Futures
Currency Options
To Sum Up
Synthetic Fwds
Terminology
To Put It intoPractice
Benefits and Risks of Options
I Low FlexibilityI Mainly major currenciesI Fixed, standardized maturities and notional amountsI Well-defined trading time and trading rules
I CCTP: No settlement risk
I High mkt liquidity
I Optionality
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Currency Futures
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To Sum Up
Synthetic Fwds
Terminology
To Put It intoPractice
To Sum Up
Fwds Futures OptionsTrading OTC Reg. Mkts Reg. Mkts
Discretion None None Buyer’sMaturity Any Date Std Dates Std DatesNotional Any Std StdMargins None CH-Defined CH-DefinedCCTP No Yes Yes
Major Users Hedgers Speculators Both
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Flexibility vs Standardization
What is the advantage of standardization over flexibility?
The more homogeneous (and the fewer) are the contracts,the higher is the market depth
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Synthetic Fwds
Terminology
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Building a Synthetic Fwd: Step 1
Suppose that, at time t0, you decide to:
I Buy a Call on the USDEUR exchange rate (premium: C)
I Sell a Put on the USDEUR exchange rate (premium: P)
Suppose further that the 2 options have:
I The same maturity: tTI The same strike price: X USD
EUR
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Step 1: Profit and Loss at Maturity
Deal CFt0 CFtT CFtTif S < X if S > X
Long Call -C 0 SUSDEUR
-XUSDEUR
Short Put P SUSDEUR
-XUSDEUR
0
Total P-C SUSDEUR
-XUSDEUR
SUSDEUR
-XUSDEUR
Under both scenarios, the total CF at maturity will thusbe SUSD
EUR-XUSD
EUR.
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In Simpler Terms...
Notice that this is equivalent to the payoff of a fwdcontract drawn to purchase EUR with USD at maturity. Inalternative terms, at maturity there will be a USD cashoutflow together with a corresponding EUR inflow.
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Building a Synthetic Fwd: Step 2
SUSDEUR
-XUSDEUR
is practically equivalent to:
I A cash outflow: -XUSDEUR
I Combined with a cash inflow: SUSDEUR
Let’s put it all together
I Cash outflow at maturity ⇒ USD-denominated ⇒conceivable as the repayment of aUSD-denominated loan (originally stipulated at t0)
I Cash inflow at maturity ⇒ EUR-denominated ⇒conceivable as the proceeds of a EUR-denominatedinvestment (originally stipulated at t0)
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Step 2: Profit and Loss at Maturity
Deal CFt0 CFtT CFtTif S < X if S > X
LoanXUSD
EUR
(1+rUSD)T-XUSD
EUR-XUSD
EUR
Inv −SUSDEUR
(1+rEUR)TSUSD
EURSUSD
EUR
TotXUSD
EUR
(1+rUSD)T−
SUSDEUR
(1+rEUR)TSUSD
EUR-XUSD
EURSUSD
EUR-XUSD
EUR
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The Put-Call-Fwd Parity
Given that
P − C = SUSDEUR
-XUSDEUR
and
XUSDEUR
(1+rUSD)T−
SUSDEUR
(1+rEUR)T= SUSD
EUR-XUSD
EUR
It must be that
P − C =XUSD
EUR
(1+rUSD)T−
SUSDEUR
(1+rEUR)T
Put-Call-Fwd Parity
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Terminology
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Currency Fwds, Futures and Options
I Currency Fwds: tailor-made agreement to exchangecurrencies at a pre-determined price on a future date
I Currency Futures: standardized contracts drawneither to buy or to sell a fixed amount of foreigncurrency on a pre-determined date sometime in thefuture
I Currency Options: derivative contracts that give thebuyer the opportunity to buy or to sell the underlyingasset at a given price sometime in the future
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Currency Futures
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To Sum Up
Synthetic Fwds
Terminology
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Over The Counter
OTC market: Widespread aggregation of dealers whomake markets in many different securities. Unlike anexchange on which trading takes place at one physicallocation, OTC trading occurs through telephone or computernegotiations between buyers and sellers.
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Market Maker
Market Maker: liquidity providing intermediary that quotesboth buying and selling prices for a given financialinstrument on a continuous basis.
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To Put It into Practice I
6.1: A put option on Australian dollars with a strike price ofUSD 0.80 is purchased by a speculator for a premium ofUSD 0.02. If the Australian dollars spot rate is USD 0.74 onthe expiration date, should the speculator exercise the optionon this date or let the option expire?Draw the buyer’s and the seller’s payoff charts.
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To Put It into Practice II6.2:A call option on Canadian dollars with a strike price ofUSD 0.60 is purchased by a speculator for a premium ofUSD 0.06 per unit. Assume each option calls for the deliveryof 50,000 CAD.
I If the Canadian dollar’s spot rate is USD 0.65 at thetime the option is exercised, what is the net profit tothe speculator?
I What would the spot rate need to be at the time theoption is exercised for the speculator to break even?
I What is the net profit to the seller of this option?I Draw the buyer’s and the seller’s payoff charts.
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To Put It into Practice III
6.3: Given the information below (investment period 1 yr),find the put premium
CallC1C2
Premium 0.01 C1
CallC1C2
Strike 0.63 C1
PutC1C2
Strike 0.63 C1
rC1 0.055rC2 0.075
S0C1C2
0.625