Currency Futures and Options Markets
International Finance
Dr. A. DeMaskey
Learning Objectives
What are currency futures contacts? How are they quoted, valued, and used for hedging purposes?
How do currency futures differ from currency forwards?
What are currency option contracts? How are they quoted, valued, and used for hedging purposes?
Foreign Currency Derivatives
Financial management in the 21st century needs to consider the use of financial derivatives
These derivatives, so named because their values are derived from the underlying asset, are a powerful tool used for two distinct management objectives:
– Speculation– Hedging
Foreign Currency Derivatives
In the wrong hands, derivatives can cause a corporation to collapse (Barings, Allied Irish Bank), but used wisely they allow a financial manager the ability to plan cash flows
The financial manager must first understand the basics of the structure and pricing of these tools.
The derivatives that will be discussed are:– Foreign Currency Futures– Foreign Currency Options
Foreign Currency Futures
A foreign currency futures contract is an alternative to a forward contract.– It calls for future delivery of a standard amount
of currency at a fixed time and price.– These contracts are traded on exchanges with
the largest being the International Monetary Market located in the Chicago Mercantile Exchange.
Contract Specifications
Contract size Method of stating
exchange rate Maturity dates Last trading date
Collateral and maintenance margin
Settlement Commission Clearing Operations
Using Foreign Currency Futures
Hedging
Speculating
Forward-Futures Arbitrage
Profit or Loss from a Long Futures Hedge
Profit or Loss from a Short Futures Hedge
Forward Contracts versus Futures Contracts
Trading Regulation Frequency of delivery Size of contract Delivery date Settlement Pricing
Quotes Transaction costs Collateral Credit risk Clearing Operation
Location Liquidity
Foreign Currency Options
A foreign currency option is a contract giving the option holder the right, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period.– Call Option vs. Put Option– Holder vs. Grantor
Foreign Currency Options Terminology
Every option has three different price elements
– Strike or exercise price – Option premium – The underlying or actual
spot rate in the market There are two types of
option maturities– American options – European options
Options may also be classified as per their payouts
– At-the-money– In-the-money (ITM)– Out-of-the-money
(OTM) options
Market Structure
Over-the-Counter (OTC) Market – Main advantage is that they are tailored to purchaser– Counterparty risk exists– Mostly used by individuals and banks
Organized Exchanges – The Chicago Mercantile – Philadelphia Stock Exchange– Options Clearinghouse Corporation (OCC)
Using Foreign Currency Options
Users– Financial Firms– Corporations
Hedging Speculating
Protecting Against the Potential Appreciation of a Currency
Using a Call Option
Protecting Against the Potential Depreciation of a Currency
Using a Put Option
Option Pricing and Valuation
An option’s value consists of two parts:– Intrinsic Value– Time Value
Intrinsic Value is the amount by which an option is in-the-money.
Time Value is the amount by which an option’s value exceeds its intrinsic value.
Option Pricing Model
The value of a currency option depends on the following five variables:– Strike price relative to the spot exchange rate– Time to maturity– Relative interest rates between the two
currencies– Volatility of underlying currency– Supply and demand for specific option
Online Application
Visit the Commodity Futures Trading Commission at http://www.cftc.gov/.
The Options Clearing Corporation at http://www.optionsclearing.com/
The Chicago Mercantile Exchange provides current and historical futures and option prices at http://www.cme.com/prices/index.cfm.
The Chicago Board Options Exchange at http://www.cboe.com, and
The London International Financial Futures and Options Exchange at www.liffe.com.
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