10/13/2011
Futures and Options
on Foreign Exchange
7
Chapter Seven
Chapter Objective:
This chapter discusses exchange-traded currency
futures and options
p
contracts.
7-0
Chapter Outline
Currency futures and Currency options
contracts:
Mechanics / how do they work?
Quote interpretation
Pricing
Applications
Applications
Hedging
Speculation
7-1
1
10/13/2011
Futures Contracts: Preliminaries

A futures contract is like a forward contract:


It specifies that a certain currency will be
exchanged for another at a specified time in the
future at prices specified today.
A futures contract is different from a forward
contract:

Futures are standardized contracts trading on
organized exchanges with daily resettlement
through a clearinghouse.
7-2
Futures Contract : Basics


Contract specifying a standard quantity of a particular
currency to be exchanged on a specific settlement date.
Buy futures today: Agree to take delivery of the currency
on (a future) settlement date:



Sell futures today: Agree to deliver the currency on (a
future)) settlement date:



To hedge: Avoid uncertainty involved in buying FX at a future date. (eg.,
cover future FX payables)
To speculate: Make a bet that future spot rate > current futures price
To hedge: Avoid uncertainty involved in selling FX at a future date. (eg.,
cover future FX receivables)
To speculate: Make a bet that future spot rate < current futures price
Futures contracts are also available on:

Agricultural products and livestock / Metals and petroleum / Interest rates /
Stock market indices
2
10/13/2011
Futures Contracts: Characteristics

Standardizing Features:





Exchange Traded
Contract Size
Delivery Month
Daily resettlement
Margin: Called performance bonds (about 2
percentt off contract
t t value,
l cashh or T-bills
T bill held
h ld in
i
a street name at your brokerage).


Initial Margin
Maintenance Margin
7-4
Basic Difference Between Forward and
Futures Contract
Market for Forward Contract
Market for Futures Contract
1. Traded via telephone network
2. Individually tailored size
3. Any agreed upon delivery date
4. Settlement occurs as agreed upon
5. Transaction costs: bid-ask basis
6. Margin: not required
7. Credit risk: borne by each party
1. Traded face to face, in the exchange
2. Standardized size
3. Specified delivery date
4. Daily settlement, marked to market
5. Transaction costs: brokerage fee
6. Margin: required
7. Credit risk: exchange acts as clearing
house
3
10/13/2011
Currency Futures Markets


The Chicago Mercantile Exchange (CME) is by
far the largest.
Others include:




The Philadelphia Board of Trade (PBOT)
The MidAmerica Commodities Exchange
Th Tokyo
The
T k International
I t
ti l Financial
Fi
i l Futures
F t
Exchange
E h
The London International Financial Futures Exchange
7-6
The Chicago Mercantile Exchange




Expiry cycle: March, June, September,
December.
Delivery date third Wednesday of delivery
month.
Last trading day is the second business day
preceding
di the
h ddelivery
li
day.
d
CME hours 7:20 a.m. to 2:00 p.m. CST.
7-7
4
10/13/2011
Contract Size for Currency Futures
Contract Specification for
Currency Futures
5
10/13/2011
Futures Contract: Daily Settlement
Process
At the end of each day:
• The day’s closing price is compared to previous day’s closing
price
i to
t determine
d t
i loss/gain
l / i for
f th
thatt day
d
• The gain is added to (loss is subtracted from) the margin
balance
• If current margin balance is more than maintenance margin you
can withdraw the difference
• If current margin balance is below maintenance margin you get
a margin call, so that you increase your margin balance up to
i iti l margin
initial
i
• A new contract based on the current day’s closing price
replaces the old contract based on previous day’s closing price
• This process is repeated at the end of each closing day till
settlement date
Sample FX Futures Price Quotes: CME
6
10/13/2011
Reading Currency Futures Quotes
OPEN
HIGH
LOW
SETTLE
CHG
OPEN
INT
.0028
.0025
172,396
2,266
Euro/US Dollar (CME)—€125,000; $ per €
Mar
Jun
1.4748
1.4737
1.4830
1.4818
1.4700
1.4693
1.4777
1.4763
Closing price
Expiry
month
Daily Change
Opening price
Lowest price that day
Number of open contracts
Highest price that day
7-12
Basic Currency Futures Relationships



Open Interest refers to the number of contracts
outstanding for a particular delivery month.
Open interest is a good proxy for demand for a
contract.
Some refer to open interest as the depth of the
market.
k Th
The breadth
b d h off the
h market
k would
ld be
b
how many different contracts (expiry month,
currency) are outstanding.
7-13
7
10/13/2011
Reading Currency Futures Quotes
OPEN
HIGH
LOW
SETTLE
CHG
OPEN
INT
.0028
.0025
172,396
2,266
Euro/US Dollar (CME)—€125,000; $ per €
Mar
Jun
1.4748
1.4737
1.4830
1.4818
1.4700
1.4693
1.4777
1.4763
•Notice that open interest is greatest in the nearby contract, in this
case March,
March 2008.
2008 In general
general, open interest typically decreases with
term to maturity of most futures contracts.
• The holder of a long position is committing to pay $1.4777 per euro
for €125,000—a $184,712.50 position.
• As there are 172,396 such contracts outstanding, this represents a
notational principal of over $31.8 billion!
7-14
Long, 1 Euro Futures Contract on 10/01
Date
Mon, 10/01
Tue, 10/02
Euro
Futures
Price
Price
Cumulative Margin
Change Loss/Gain Loss/Gain Balance
1.4763
1.4785
Margin
Call
3240.00
0.00
0.0022
275.00
275.00
3515.00
0.00
Wed, 10/03
1.4692
-0.0093
-1162.50
-887.50
3240.00
887.50
Thu, 10/04
1.4835
0.0143
1787.50
900.00
5027.50
0.00
Fri, 10/05
1.4637
-0.0198
-2475.00
-1575.00
2552.50
0.00
Mon, 10/08
1.4711
0.0074
925.00
-650.00
3477.50
0.00
8
10/13/2011
Short, 1 Euro Futures Contract on 10/01
Date
Mon, 10/01
Tue, 10/02
Euro
Futures
Price
Price
Cumulative Margin
Change Loss/Gain Loss/Gain Balance
1.4763
1.4785
Margin
Call
3240.00
0.00
0.0022
-275.00
-275.00
2965.00
0.00
Wed, 10/03
1.4692
-0.0093
1162.50
887.50
4127.50
0.00
Thu, 10/04
1.4835
0.0143
-1787.50
-900.00
3240.00
900.00
Fri, 10/05
1.4637
-0.0198
2475.00
1575.00
5715.00
0.00
Mon, 10/08
1.4711
0.0074
-925.00
650.00
4790.00
0.00
Long, 2 Euro Futures Contracts on 10/01
Date
Mon, 10/01
Tue, 10/02
Euro
Futures
Price
Price
Cumulative Margin
Change Loss/Gain Loss/Gain Balance
1.4763
1.4785
Margin
Call
6480.00
0.00
0.0022
550.00
550.00
7030.00
0.00
-0.0093
-2325.00
-1775.00
6480.00
1775.00
Wed, 10/03
1.4692
Thu, 10/04
1.4835
0.0143
3575.00
1800.00
10055.00
0.00
Fri, 10/05
1.4637
-0.0198
-4950.00
-3150.00
5105.00
0.00
Mon, 10/08
1.4711
0.0074
1850.00
-1300.00
6955.00
0.00
9
10/13/2011
Short, 3 Euro Futures Contracts on 10/01
Date
Mon, 10/01
Tue, 10/02
Euro
Futures
Price
Price
Cumulative Margin
Change Loss/Gain Loss/Gain Balance
1.4763
1.4785
Margin
Call
9720.00
0.00
0.0022
-825.00
-825.00
8895.00
0.00
Wed, 10/03
1.4692
-0.0093
3487.50
2662.50
12382.50
0.00
Thu, 10/04
1.4835
0.0143
-5362.50
-2700.00
9720.00
2700.00
Fri, 10/05
1.4637
-0.0198
7425.00
4725.00
17145.00
0.00
Mon, 10/08
1.4711
0.0074
-2775.00
1950.00
14370.00
0.00
Profit/Loss from Futures Trading:
Formula
f(t) = Futures Contract price on day t
f(t+1) = Futures Contract price on day t+1
N = number of units of foreign currencies per futures contract
Profit / Loss from futures contract trading on day 1 for:
Buyer = [f(t) – f(t+1)] * N ; Seller = - [f(t) – f(t+1)] * N
Margin Position on a given day for Buyer or Seller:
Beginning Margin for that day + Profit/Loss for that day
= Ending Margin for that day
Iff the
h Ending
di Margin
i for
f that
h day
d is
i more than
h the
h Initial
i i l Margin,
i then:
h
Ending Margin – Initial Margin = Excess
If the Ending Margin for that day is less than the Maintenance Margin, then:
Initial Margin – Ending Margin = Deficit
If there is a deficit for that day, the trader will receive a margin call from the
exchange for the amount of the deficit
10
10/13/2011
Trading irregularities

Futures Markets are also a great place to launder
money

The zero sum nature of futures is the key to
laundering the money.
7-20
Money Laundering: Hillary
Clinton’s Cattle Futures
James B. Blair
outside counsel to
Tyson Foods Inc.,
Arkansas' largest
employer,
l
gets
t
Hillary’s
discretionary
order.
winners
losers
Submits
identical long
and short trades
Robert L. "Red" Bone,
(Refco broker), allocates
trades ex post facto.
7-21
11
10/13/2011
Options Contracts: Preliminaries


An option gives the holder the right, but not the
obligation, to buy or sell a given quantity of an
asset in the future, at prices agreed upon today.
Calls vs. Puts


Call options gives the holder the right, but not the
obligation to buy a given quantity of some asset at
obligation,
some time in the future, at prices agreed upon today.
Put options gives the holder the right, but not the
obligation, to sell a given quantity of some asset at
some time in the future, at prices agreed upon today.
7-22
Options Contracts: Preliminaries

In-the-money



At-the-money


Call: The exercise or buying price (E) is less than the spot price (S)
of the underlying asset.
Put: The exercise or selling price (E) is more than the spot price (S)
of the underlying asset.
Call & Put: The exercise price (E) is equal to the spot price (S) of the
underlying asset.
O
Out-of-the-money
f h


Call: The exercise or buying price (E) is more than the spot price (S)
of the underlying asset.
Put: The exercise or selling price (E) is less than the spot price (S) of
the underlying asset
7-23
12
10/13/2011
Currency Call Option



The buyer of a currency call option is granted the right
but not the obligation to buy a specific currency at a
specific price (exercise or strike price) within a specific
period of time (expiration date).
The seller of the call must deliver the currency at the
exercise price exercised against.
The
h call
ll option
i buyer
b
pays a specific
ifi price
i for
f eachh call
ll
(call premium), which the seller of the call receives.
Basic Call Option Pricing
Relationships at Expiry


If the call is in-the-money, it is worth S – E.
If the call is out-of-the-money, it is worthless.
C = Max[S - E, 0]
7-25
13
10/13/2011
Profit / Loss for Buyers / Sellers of
Calls
Call Buyer
Call Seller
Wh
When:
I / Out
In
O t
E
Exercise?
i ?
P fit / Loss
Profit
L
P fit / Loss
Profit
L
S>E
S<E
In
Out
Yes
No
[(S – E) – C] * N
[- C] * N
- [(S – E) – C] * N
[C] * N
S = Currency spot price, on expiration date
E = Exercise price for call or put
C = Call premium / unit
P=P
Putt premium
i
/ unit
it
N = Number of units / contract
If the spot price of the currency (S) is :
more then the call exercise price (E), then the options is in the money
less then the call exercise price (E), then the options is out of the money
equal to the call exercise price (E), then the options is at the money
Basic Option Profit Profiles
Profit
Owner of the call
If the call is in-themoney, it is worth
S – E.
Long 1 call
If the call is out-ofthe-money, it is
worthless and the
–c
buyer of the call
loses his entire
investment of c.
S
E + c0
E
Out-of-the-money
In-the-money
loss
7-27
14
10/13/2011
Basic Option Profit Profiles
Seller of the call
Profit
If the call is in-themoney, the writer
loses S – E.
If the call is out-ofthe-money, the writer
keeps the option
premium.
c
S
E+c
E
loss
Out-of-the-money
In-the-money
short 1
call
7-28
Example



Profit
Consider
C
id a call
ll
option on £31,250.
The option premium
is $0.25 per £
The exercise price is
$1.50 per £.
–$0.25
Long 1 call
on 1 pound
S
$1.75
$1.50
loss
7-29
15
10/13/2011
Currency Put Option



The buyer of a currency put option is granted the right
but not the obligation to sell a specific currency at a
specific price (exercise or strike price) within a specific
period of time (expiration date).
The seller of the put must purchase the currency at the
exercise price.
The
h put buyer
b
pays a specific
ifi price
i (put
(
premium)
i ) for
f
each put, which the seller of the put receives
Basic Put Option Pricing
Relationships at Expiry


If the put is in-the-money, it is worth E - S.
If the put is out-of-the-money, it is worthless.
P = Max[E – S, 0]
7-31
16
10/13/2011
Profit / Loss for Buyers / Sellers of
Puts
Put Buyer
Put Seller
When:
In / Out
Exercise ?
Profit / Loss
Profit / Loss
S>E
S<E
Out
In
No
Yes
[- P] * N
[(E – S) – P] * N
[P] * N
- [(E – S) – P] * N
S = Currency spot price, on expiration date
E = Exercise price for call or put
C = Call premium / unit
P = Put p
premium / unit
N = Number of units / contract
If the spot price of the currency (S) is :
more then the call exercise price (E), then the options is out of the money
less then the call exercise price (E), then the options is in the money
equal to the call exercise price (E), then the options is at the money
Basic Option Profit Profiles
Profit
If the put is inthe-money, it is E – p
worth E – S. The
maximum gain is
E–p
If the put is outof-the-money, it
of-the-money
is worthless and
the buyer of the
put loses his
entire investment
of p.
Owner of the put
S
–p
long 1 put
E–p
E
loss
In-the-money
Out-of-the-money
7-33
17
10/13/2011
Basic Option Profit Profiles
If the put is inthe-money, it is
worth E –ST. The
maximum loss is
–E +p
Profit
p
If the put is outof-the-money it
of-the-money,
is worthless and
the seller of the
put keeps the
option premium
–E+p
of p.
loss
Seller of the put
S
short 1 put
E–p
E
7-34
Example
Profit What is the maximum gain on this put option?
$42,187.50 = £31,250×($1.50 – $0.15)/£
$42,187.50


Consider a put
option on £31,250.
The option premium
is $0.15 per £
At what exchange rate do you break even?
S
–$4,687.50
$1.35

The exercise price is
$1.50 per pound.
loss
$1.50
Long 1 put
on £31,250
$4,687.50 = £31,250×($0.15)/€
7-35
18
10/13/2011
Options Contracts: Preliminaries

Intrinsic Value


The difference between the exercise price of the
option and the spot price of the underlying asset.
Speculative Value

The difference between the option premium and the
intrinsic value of the option
option.
Option
Premium
=
Intrinsic
Value
+
Speculative
Value
7-36
Currency Options Markets





PHLX
HKFE
20-hour trading day.
OTC volume is much bigger than exchange
volume.
Trading is in six major currencies against the
U.S. dollar.
7-37
19
10/13/2011
PHLX Currency Option
Specifications
Currency
C
Australian dollar
British pound
Canadian dollar
Euro
Japanese yen
Swiss franc
Contract Si
C
Size
AD10,000
£10,000
CAD10,000
€10 000
€10,000
¥1,000,000
SF10,000
http://www.phlx.com/products/xdc_specs.htm
7-38
Currency Option Specifications
7-39
20
10/13/2011
Sample FX Options Price Quotes
Currency Call Option: An Example

Suppose on 1/30/20XX (See attached quote) :




M h call
March
ll options
ti
on euros with
ith a strike
t ik price
i $1.45
$1 45 are selling
lli for
f
$0.0398. This option allows you to buy E 10,000 by the third
Wednesday of March at a price of $1.45. The total price for one
contract is: 10,000 * $0.0398 = $398.
March call options on Euros with a strike price $1.48 are selling for
$0.0222. This option allows you to buy E 10,000 by the third
Wednesday of March at a price of $1.45.
$1 45 The total price for one
contract is: 10,000 * $0.0222 = $222
Given that the current price of euro is 1.4744, are these call
options in or out of the money ?
How can you loose or make money from this position?
21
10/13/2011
Currency Put Option: An Example

Suppose on 1/30/20XX (See attached quote) :
J
January
putt options
ti
on yens with
ith a strike
t ik price
i $0.0091
$0 0091 are selling
lli for
f
$0.000045. This option allows you to sell Y 1,000,000 by the third
Wednesday of January at a price of $0.000045. The total price for
one contract is: 1,000,000 * $ 0.000045 = $45.
March put options on yens with a strike price $0.0093 are selling for
$0.000216. This option allows you to buy Y 1,000,000 by the third
Wednesday of March at a price of $0.000216.
$0 000216 The total price for one
contract is: 1,000,000 * $ 0.000216 = $216.




Given that the current price of yen is $0.009204, are these
put options in or out of the money ?
How can you loose or make money from this position?
American & European Options



European options can only be exercised on the
expiration
i i date.
d
American options can be exercised at any time up to
and including the expiration date.
Since this option to exercise early generally has value,
American options are usually worth more than
European options,
i
other
h things
hi
equal.
l
7-43
22
10/13/2011
American & European Option Pricing
Relationships

With an American call (Ca) or put (Pa) option,
you can do everything that you can do with a
European call (Ce) or put (Pe) option AND you
can exercise prior to expiry—this option to
exercise early has value, thus:
Ca > Ce
Pa > Pe
7-44
SPECULATION: Spot, Futures,
Forward and Option strategies
If a speculator believes that a foreign currency
will increase in price:




Spot Market: Borrow home currency, buy FX now,
put the money in a foreign currency bank account
Forward Market: Buy forward contract
Futures Market: Buy futures contract
Options Market:


Buy Call Options: Buy the right to buy FX from the seller at
what you believe is a low price
Sell Put Options: Sell the right to sell FX to you at what you
believe is a low price
23
10/13/2011
SPECULATION: Spot, Futures,
Forward and Option strategies
If a speculator believes that a foreign currency will
decrease in price:




Spot Market: Borrow foreign currency, sell FX now, put
the money in a domestic currency bank account
Forward Market: Sell forward contract
Futures Market: Sell futures contract
Options Market:


Buy Put Options: Buy the right to sell FX to the the dealer at what
you believe is a high price
Sell Call options: Sell the right to buy FX from you at what you
believe to be a high price
24