CHAPTER 6

CHAPTER 6CHAPTER 6

CURRENCY CURRENCY FUTURES AND FUTURES AND

OPTIONS MARKETSOPTIONS MARKETS

CHAPTER OVERVIEWCHAPTER OVERVIEW

I.I. FUTURES CONTRACTSFUTURES CONTRACTSII.II. CURRENCY OPTIONSCURRENCY OPTIONS

PART I.PART I.FUTURES CONTRACTSFUTURES CONTRACTS

I.I. CURRENCY FUTURESCURRENCY FUTURESA.A. BackgroundBackground

1.1. 1972: Chicago Mercantile1972: Chicago MercantileExchange opens Exchange opens International Monetary International Monetary Market. (IMM)Market. (IMM)

FUTURES CONTRACTSFUTURES CONTRACTS

2.2. IMM providesIMM providesa.a. an outlet for hedging an outlet for hedging currency risk with futures currency risk with futures contracts.contracts.b.b. Definition:Definition:contracts written contracts written requiringrequiring a a standard standard quantityquantity of an of an available available currencycurrency at a at a fixedfixed exchange rate exchange rate at a at a setset delivery datedelivery date..


c.c. Available Futures Currencies:Available Futures Currencies:

1.) British pound1.) British pound 5.) French franc5.) French franc2.) Canadian dollar2.) Canadian dollar 6.) Japanese 6.) Japanese yenyen3.) German mark3.) German mark 7.) Australian7.) Australian4.) Swiss franc4.) Swiss franc dollardollar


d.d. Standard Quantity of CurrencyStandard Quantity of Currencycontract quantity sizes differ forcontract quantity sizes differ foreach of the 7 available each of the 7 available currencies.currencies.ExampleExampleGerman mark = DM125,000German mark = DM125,000


e.e. Transaction costs:Transaction costs:payment of commission to a payment of commission to a tradertrader

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

relatively low (less than relatively low (less than 2% 2% of contract value).of contract value).


g.g. Maximum price movementsMaximum price movements1.)1.) Contracts set to a daily Contracts set to a daily

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


2.)2.) If limit is reached, a marginIf limit is reached, a margin

call may be necessary to call may be necessary to

maintain a minimum margin.maintain a minimum margin.


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 Trade


4.) 4.) S.I.M.E.X.Singapore InternationalS.I.M.E.X.Singapore International

Monetary ExchangeMonetary Exchange

5.)5.) D.T.B. Deutsche Termin BourseD.T.B. Deutsche Termin Bourse

6.)6.) H.K.F.E. Hong Kong Futures ExchangeH.K.F.E. Hong Kong Futures Exchange


B.B. Forward vs. Futures ContractsForward vs. Futures ContractsBasic differences:Basic differences:1. Trading Locations1. Trading Locations 6. Settlement Date6. Settlement Date2. Regulation2. Regulation 7. Quotes7. Quotes3. Frequency of 3. Frequency of 8. Transaction 8. Transaction delivery costsdelivery costs4. Size of contract4. Size of contract 9. Margins9. Margins5. Delivery dates5. Delivery dates 10. Credit risk 10. Credit risk


Advantages of Advantages of futures:futures:1.) Smaller 1.) Smaller contract sizecontract size2.) Easy 2.) Easy liquidationliquidation3.) Well-3.) Well- organizedorganizedand stable and stable market.market.

Disadvantages of Disadvantages of futures:futures:1.) Limited to 71.) Limited to 7

currenciescurrencies2.) Limited dates 2.) Limited dates

of deliveryof delivery3.) Rigid contract3.) Rigid contract

sizes.sizes.

PART IIPART IICURRENCY OPTIONSCURRENCY OPTIONS

I.I. OPTIONSOPTIONSA.A. Currency options Currency options 1.1. offer another method to offer another method to hedge hedge exchange rate risk.exchange rate risk.2.2. first offered on Philadelphiafirst offered on PhiladelphiaExchange (PHLX).Exchange (PHLX).3.3. fastest growing segment offastest growing segment ofthe hedge markets.the hedge markets.

CURRENCY OPTIONSCURRENCY OPTIONS

4. Definition:4. Definition:a contract from a writer ( the a contract from a writer ( the seller) that seller) that gives the right not gives the right not the obligation to the obligation to the holder (the the holder (the buyer) to buy or sell a buyer) to buy or sell a standardstandard amountamount of of an an availableavailable currencycurrency at a at a fixed exchange fixed exchange rate rate for a for a fixed time period.fixed time period.


5.5. Types of Currency Options:Types of Currency Options:a.a. AmericanAmericanexercise date may occur anyexercise date may occur anytime up to the expiration date.time up to the expiration date.b.b. EuropeanEuropeanexercise date occurs only at theexercise date occurs only at theexpiration date.expiration date.


7.7. Exercise PriceExercise Pricea. 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 buy or sell the can buy or sell the contracted currency.contracted currency.


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


9.9. The premium: the price of anThe premium: the price of an

option that the writer charges option that the writer charges the buyer.the buyer.

CURRENCY OPTIONSCURRENCY OPTIONSB.B. Using Currency OptionsUsing Currency Options

1.1. For the firm hedging foreignFor the firm hedging foreignexchange riskexchange risk

a. With sizable unrealized gains.a. With sizable unrealized gains.b. With foreign currency flows b. With foreign currency flows forthcoming.forthcoming.


2.2. For speculatorsFor speculators- profit from favorable - profit from favorable exchange rate changes.exchange rate changes.


C.C. Option Pricing and ValuationOption Pricing and Valuation1. Value of an option equals1. Value of an option equals

a. Intrinsic valuea. Intrinsic valueb. Time valueb. Time value


2.2. Intrinsic ValueIntrinsic Valuethe amount in-the-moneythe amount in-the-money

3.3. Time ValueTime Valuethe amount the option is inthe amount the option is inexcess of its intrinsic value.excess of its intrinsic value.


4.4. Other factors affecting the Other factors affecting the value of an optionvalue of an optiona.a. value rises with longer value rises with longer

time to expiration.time to expiration.b.b. value rises when greater value rises when greater

volatility in the exchange volatility in the exchange rate.rate.


5.5. Value is complicated by bothValue is complicated by boththe home and foreign interestthe home and foreign interestrates.rates.


D. D. Using Forward or Futures Using Forward or Futures Contracts:Contracts:Forward and futures contracts Forward and futures contracts are more suitable for hedging are more suitable for hedging

a a known amount of foreign known amount of foreign currency flow.currency flow.


E.E. Market StructureMarket Structure1.1. LocationLocation

a. Organized Exchangesa. Organized Exchangesb. Over-the-counterb. Over-the-counter

1.) Two levels1.) Two levelsretail and retail and

wholesalewholesale

CHAPTER 6

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