Future Contracts & Currency Option

8/6/2019 Future Contracts & Currency Option

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Multinational Financial

ManagementAlan Shapiro

7thEdition

J.Wiley & SonsPower Points by

Joseph F. Greco, Ph.D.

California State University, Fullerton


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CHAPTER OVERVIEW

I. FUTURES CONTRACTS

II. CURRENCYOPTIONS


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PART I.FUTURESCONTRACTSI.CURRENCYFUTURES

A. Background1. 1972: Chicago Mercantile

Exchange

opens International MonetaryMarket. (IMM)


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FUTURESCONTRACTS

2. IMM provides

a. an outlet for hedging currencyrisk with futures contracts.

b. Definition of futures contracts:

contracts written requiring a standard quantity of an available currency

at a fixed exchange rate

at a set delivery date.


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FUTURESCONTRACTS

c. Available Futures Currencies:

1.) British pound 5.) Euro

2.) Canadian dollar 6.) Japanese yen

3.) Deutsche mark 7.) Australian dollar

4.) Swiss franc


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FUTURESCONTRACTS

d. Standard Contract Sizes:

contract sizes differ for each ofthe 7 available currencies.

Examples:Euro = 125,000

British Pound = 62,500


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FUTURESCONTRACTS

e. Transaction costs:

payment of commission to atrader

f. Leverage is high

1.) Initial margin required is

relatively low (e.g. less than.02% of sterling contractvalue).


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FUTURESCONTRACTS

g. Maximum price movements

1.) Contracts set to a dailyprice limit restrictingmaximum daily price

movements.


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FUTURESCONTRACTS

2.) If limit is reached, a margin

call may be necessary to

maintain a minimum margin.


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FUTURESCONTRACTS

h. Global futures exchanges that

are competitors to the IMM:1.) Deutsche Termin Bourse

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

Financial Futures Exchange3.) C.B.O.T. Chicago Board of Trade


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FUTURESCONTRACTS

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

Monetary Exchange

5.) H.K.F.E. Hong Kong Futures Exchange


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FUTURESCONTRACTS

B. Forward vs. Futures Contracts

Basic differences:1. Trading Locations 6. Settlement

Date

2. Regulation 7. Quotes

3. Frequency of 8. Transaction

delivery costs

4. Size of contract 9. Margins

5. Delivery dates 10. Credit risk


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FUTURESCONTRACTS

Advantages of futures:

1.) Smaller

contract size

2.) Easy liquidation

3.) Well- organized

and stablemarket.

Disadvantages of futures:

1.) Limited to 7

currencies

2.) Limited dates

of delivery

3.) Rigid contractsizes.


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PART IICURRENCYOPTIONS

I.OPTIONS

A. Currency options1. offer another method to

hedge exchange rate risk.

2. first offered on PhiladelphiaExchange (PHLX).

3. fastest growing segment ofthe hedge markets.


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CURRENCYOPTIONS

4. Definition:

a contract from a writer ( the seller) thatgives the right not the obligation to theholder (the buyer) to buy or sell a standardamount of an available currency at a fixed

exchange rate for a fixed time period.


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CURRENCYOPTIONS

5. Types of Currency Options:

a. Americanexercise date may occur anytime up to the expiration date.

b. Europeanexercise date occurs only at the

expiration date.


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CURRENCYOPTIONS

7. Exercise Price

a. Sometimes known as thestrike price.

b. the exchange rate at

which the option holdercan buy or sell thecontracted currency.


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CURRENCYOPTIONS

9. The premium: the price of an

option that the writer charges

the buyer.


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CURRENCYOPTIONSB. When to Use Currency Options

1. For the firm hedging foreignexchange risk

a. With sizable unrealized gains.

b. With foreign currency flowsforthcoming.


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CURRENCYOPTIONS

2. For speculators

- profit from favorableexchange rate changes.


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CURRENCYOPTIONS

C. Option Pricing and Valuation

1. Value of an option equalsa. Intrinsic value

b. Time value


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CURRENCYOPTIONS

2. Intrinsic Value

the amount in-the-money

3. Time Value

the amount the option is inexcess of its intrinsic value.


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CURRENCYOPTIONS

4. Other factors affecting the

value of an optiona. value rises with longer

time to expiration.

b. value rises when greatervolatility in the exchangerate.


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CURRENCYOPTIONS

5. Value is complicated by boththe home and foreign interest

rates.


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CURRENCYOPTIONS

D. Using Forward or Futures

Contracts:Forward and futures contractsare more suitable for hedging a

known amount of foreigncurrency flow.


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CURRENCYOPTIONS

E. Market Structure

1. Locationa. Organized Exchanges

b. Over-the-counter

1.) Two levels

retail and wholesale

Future Contracts & Currency Option

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