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FX Futures and Options

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					 Foreign Currency
Futures and Options
Outline
I. What is a currency futures contract?
II. The market for currency future contracts
III. Forward contracts versus futures contracts
IV. What is an option?
V. The foreign currency options market
VI. Writing foreign currency options
VII. FX option pricing and valuation
VIII. Foreign exchange options as foreign currency
     insurance
I. What is a Futures Contract? (I)
   A futures contract represents a pure bet on the
    direction of price (exchange rate) movement of
    the underlying currency

   ATTN!! The futures price is not a monetary
    amount you pay to anyone, but the variable about
    which you are betting

   Your actual gain or loss depends on the position
    taken on the market - long or short
What is a futures contract? (II)
   If you buy a futures contract (go long) and
    •   the futures price goes up  you make money
    •   the futures price goes down  you lose money

   If you sell a futures contract (go short) and
    •   the futures price goes down  you make
        money
    •   the futures price goes up  you lose money

   Open interest
What is a Futures Contract? (III)
   A futures contract is a binding agreement to pay
    up your bet on a daily basis, for every day the
    market is open and your bet is still in effect
   If you stop an FX futures bet prior to the end of
    trading on the last trade day  you are not
    obligated to buy or deliver anything
   Last trade dates  you will be legally obligated to
    acquire (if long) or to deliver (if short) the
    underlying asset on whose price you are betting,
    if contract is still in force
What is a Futures Contract? (IV)
   The size of the bet you take by opening a futures
    contract is governed by the face amount of the
    contract
   Futures long at price P0  at the end of the day
    there will be a positive or negative cash flow to
    your futures account:
        (P1 – P0) x Face value of contract
   Next business day: cash flow to your account is
       (P2 – P1) x Face value of the contract
What is a Futures Contract? (V)
Example:
  •   £62,500 futures contract opened during Day 1
      at a negotiated price of $1.4500/£
  •   the settlement prices at the end of Day 1 and
      Day 2 are

       Opening price              1.4500/£
       Settlement price, Day 1     $1.4460/£
       Settlement price, Day 2     $1.4510/£
What is a futures contract? (VI)
The respective cash flows for long and short
  positions in a single contract opened at
  $1.4500/£ are

             Long                    Short

($1.4460/£ - $1.4500/£) x £62,500    + $250
= -$250
($1.4510/£ - $1.4460/£)     x   £   - $312.50
62,500 = + $312.50
II. The market for futures contracts
    The possibility of default for forward contracts
     raises potentially serious problem for
     counterparties

    Overcoming the risk:
    1.   Making forward contracts only with people of
         high character, reputation, and credit quality
    2.   FUTURES CONTRACTS
The market for FX futures

   May 1972  International Monetary Market
    (IMM) of CME introduces trading in FX futures
   July 1986  Philadelphia Board of Trade
    introduces currency futures trading
   Other exchanges:
    •   Singapore International Monetary Exchange
    •   The Tokyo International Financial Futures Exchange
    •   The London International Financial Futures
        Exchange
Exchange-traded FX futures statistics
Currency futures on CME


   Expiry cycle:   March,    June,   September,
    December
   Delivery date 3rd Wednesday of delivery month
   Last trading day is the second business day
    preceding the delivery day
   CME hours 7:20 a.m. to 2:00 p.m. CST.
Futures contracts in Romania
   Exchange traded contracts
   Sibiu Monetary-Financial and      Commodities
    Exchange  since 1997
    •   size  132,885 contracts in 2001 and 54,046
        contracts in the first 4 months of 2002
    •   Contracts ROL/USD, ROL/EURO, EURO/USD
   Romanian Commodities Exchange  since
    1998
     • contracts Dollar BRM (ROL/USD), EURO BRM
       (ROL/EURO), EURO-USD
III. Forward versus Futures Contracts

   Dispersed versus centralized trading

   Customized versus standardized transactions

   Counterparty risks versus the clearinghouse

   Cash settlement and delivery versus marking-
    to-market
    Marking-to-market Convention (I)
        Process of updating a margin account on a daily
         basis to reflect the market value of the underlying
         position
        Example:
     •     June 15: purchase a DEM125,000 September
           DEM futures contract traded on CME; price =
           $0.50/DM.
     •     Entering the transaction  futures trading
           account with a securities or brokerage firm 
           post initial margin  assume is $5,000 (8%)
Marking-to-market Convention (II)

  •   June 16: Sept. DEM future ends the day at
      $0.498  you incur a $250 loss  the
      remaining value of your margin account =
      $4,750

  •   June 17: Sept. future falls to $0.495  the
      new value of the contract = $61,875  the
      remaining value of your margin account =
      $4,375 (= 87.5% of the initial margin -
      maintenance margin)
Marking-to-market-convention (III)
 •   June 18: Sept. DEM futures falls to $0.489 
     margin account = $3,625  the broker will
     issue a margin call for $1,375 (variation margin)
     to restore the initial margin of $5,000

 •   Consider now a happier case: DEM appreciates
     to $0.51/$  the broker will credit your margin
     account for $1,250 (equal to the $0.01 gain on
     DM125,000), bringing the total to $6,250 
     these excess margin funds could be withdrawn
     and put to some other use
Payoff Profiles for Currency Futures and
Forward Contracts (I)
   Long forward DEM contract: Ft,T(price) =
    $0.50/DEM  at maturity, the value of the
    contract is:
    V1 = N x (ST – Ft,T) = DEM1 x (ST - $0.50/DEM)

   Short forward DEM contract:  Ft,T(price) =
    $0.48/DEM  at maturity, the value of the
    contract is:
    V3 = N x (ST – Ft,T) = DEM1 x (ST - $0.48/DEM)
Payoff Profiles for Currency Forwards and
Futures (II)
Forward Pricing and Futures Pricing

   Price of a forward or futures contract prior to
    maturity – more difficult issue
   In theory, forward and futures prices reflect
    several factors:
     • Expectations of rates in the future

     • Risk   premiums reflecting uncertainty about
       expectations
     • Pricing errors as result of a failure from rational
       expectations about the future
     • Pricing errors that result from unexpected events
The Cost-of-carry Model (I)
   Cost of carry = opportunity cost that would be
    borne by an investor if the asset underlying a
    forward contract were actually bought and held
    rather than the forward contract itself

   The model relates the forward price of the
    underlying asset to its spot (or current) price,
    plus the cost of storage (in FX, the physical
    costs of storage are zero)
The Cost-of-carry Model (II)
   What matters is the financial cost of interest
    forgone on the currency we borrow, offset by the
    interest earned on the currency we hold in storage

       Ft,T = St x (1 + c)T
        Ft,T = the forward price of an asset T years into
         the future
        S T = the current spot price for the asset

        c = the annual cost of carry, expressed as a

         fraction of the asset’s spot price
        T = years to maturity
Futures pricing and the Marking-to-Market
Convention (I)
   A futures contract traded on an organized
    exchange requires an initial margin from the buyer
    (or seller) plus a commitment to supply additional
    margin if the contract falls in value (or accumulate
    additional margin if the contract rises in value)
     • Speculators expected the futures contract to
       accumulate cash over its life  futures prices
       > forward prices
     • Speculators expected the futures contract to
       require margin calls over its life  futures
       prices < forward prices
Futures pricing and the Marking-to-Market
Convention (II)
   Two more additional issues:
    1.   Marking-to-market feature of futures contracts
         imposes a cash-flow risk that is not present with
         forward contracts  this risk should decrease
         the attractiveness of futures relative to forwards

    2.   Futures contracts are traded on exchanges that
         enhance their liquidity relative to forward
         contracts  this factor should increase the
         attractiveness of futures relative to forwards
Futures pricing and the Marking-to-Market
Convention (III)

   Overall, the theoretical relationship between
    futures and forward prices is ambiguous



   Empirical evidence  futures and forward
    prices for foreign exchange are not statistically
    different from each other
Deciding on Futures versus Forwards
   Depends on the purpose and scale of the
    transaction
   Hedgers  if similar prices, will prefer
    interbank forward contracts (if access to the
    market exists)
   Speculators:
    •   Short-term    speculator        exchange-traded
        futures contracts
    •   Larger-scale speculators  interbank market,
        but more likely the trade is in spot contracts
IV. What is an Option?
   Unique type of financial contract with a
    throwaway feature  they give you the
    right, but not the obligation, to do
    something
   No daily cash flows on the long side of an
    option
   Limited potential loss on a long position
   Call versus put options
   American versus European options
What is an Option? (II)
   A call on spot  a contract between a buyer
    and a writer whereby the buyer pays a price
    (the premium) to the writer in order to
    acquire the right, but not the obligation, to
    purchase a given amount (size) of one
    currency from the writer at purchase price
    (exercise price, strike price) stated in terms
    of a second currency
What is an Option? (III)
Example: CME December 2001 call option on
  GBP31,250; exercise price = $1.50/GBP;
  premium = $322
 American option: you can buy GBP31,250 at
  any time before the Saturday prior to the third
  Wednesday in December 2001
   European option: you can buy GBP31,250 only
    on the Saturday prior to the third Wednesday
    in December 2001
What is an Option (IV)
   A put on spot  a contract between a buyer
    and a writer whereby the buyer pays a price
    (the premium) to the writer in order to
    acquire the right, but not the obligation, to
    sell a given amount (size) of one currency
    from the writer at purchase price (exercise
    price, strike price) stated in terms of a
    second currency
What is an Option? (V)
Example: CME June 2001 put option on
  JPY1,000,000; exercise price = JPY150/$;
  premium = $320
 American option: you can sell JPY1,000,000 at
  any time before the Saturday prior to the third
  Wednesday in June 2001

   European option: you can sell JPY1,000,000
    only on the Saturday prior to the third
    Wednesday in June 2001
    V. Currency Options Markets

   PHLX
   HKFE
   20-hour trading day
   OTC volume is much bigger than exchange
    volume
   Trading is in seven major currencies plus
    the euro against the U.S. dollar.
Exchange traded FX options
OTC traded FX options
    Currency Options Contracts - example (PSE)

   Contract type: European-style call option on PSE

   Underlying asset: GBP

   Expiration date: Third Wednesday in December

   Exercise price: $1.45/£ spot rate

   Contract size: £31,250
Option contracts in Romania
   Exchange traded contracts only on currency
    futures
   Sibiu Exchange (Bursa Financiar-Monetara si
    de Marfuri Sibiu)  since 1999
    •   contracts  futures ROL/USD, ROL/EURO,
        EURO/USD, USD/JPY
   Romanian Mercantile Exchange        (Bursa
    Romana de Marfuri)  since 2000
    •   contracts     ROL/USD,     EURO/USD,
        ROL/EURO
VI. Writing FX Options
   The writer of a FX option is an a different
    position form the buyer of the option

   The writer is a source of credit risk once the
    premium has been paid

   Writing options is a form of risk-exposure
    management of importance equal to that of
    buying options
VII. FX Options Pricing and Valuation
   In the money (ITM)
    •   A call/put option on spot (futures) is in the money
        if the current spot rate (futures price) is
      higher/lower than the option exercise price
   Out of the money (OTM)
    •   A call/put option on spot (futures) is out of the
        money if the current spot rate (futures price) is
       lower/higher than the option exercise price
   At the money (ATM)
    •   A call/put option on spot (futures) is at the money
        if the current spot rate (futures price) is equal to
        the option exercise price
Payoff profiles for options
   Buyer of an option  limited loss, unlimited
    profit
   Writer of an option  unlimited loss, limited
    profit
   Example:
    1. Call option on DEM; strike price = 58.5 US
       cents/DEM; premium = 5 US cents/DEM
    2. Put option on DEM; strike price = 58.5 US
      cents/DEM; premium = 5 US cents/DEM
Payoff profile for buyer of a call option
Payoff profile for writer of a call option
Payoff profile for buyer of a put option
Payoff profile for writer of a put option
Basic Option Pricing Relationships at Expiry

   At expiry, an American call option is worth the
    same as a European option with the same
    characteristics.
              CaT = CeT = Max[ST - E, 0]

   Call in-the-money  ST – E

   Call out-of-the-money  worthless
Basic Option Pricing Relationships at Expiry

   At expiry, an American put option is worth the
    same as a European option with the same
    characteristics
              PaT = PeT = Max[E - ST, 0]

   Put in-the-money  E – ST

   Put out-of-the-money  worthless.
Option Pricing and Valuation
The price (premium) of an option has two
  components:
   Intrinsic value  the amount the option is in the
    money
   Time value  the option premium minus the
    intrinsic value


       Option      Intrinsic          Time
                 =              +
      Premium       Value             Value
Option Pricing and Valuation
Example:
    $1.25 call on GBP is priced at $0.30 when
    the spot price is $1.27
   Intrinsic value = Spot price - Strike price
                   = $1.27 - $1.25 = $0.02
   Time value    = Premium - Intrinsic value
                  = $0.03 - $0.02 = $0.01
Total Value of a Call Option




                 Total value



                  Time value   Intrinsic value
Option price determinants
    Premium rises if :      Call    Put
  1. Exchange rate           +        –

  2. Exercise price          –       +

  3. Interest rate in HC        +       –

  4. Interest rate in FC     -       +

  5. Volatility              +       +

 6. Expiration date         +       +
VII. FX Options as Foreign Currency Insurance

   For hedging, FX options can be viewed as
    exchange rate insurance
   FX put options on spot  floor price on the
    domestic currency value of foreign exchange:
    Floor price = Exercise price of put – Put premium

   FX call options on spot  ceiling price on the
    domestic currency value of foreign exchange:
    Ceiling price = Exercise price of call + Call
    premium

				
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