Foreign Currency Options
Chapter Seven
Eiteman, Stonehill, and Moffett
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Chapter Seven - Derivatives
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Hedging vs speculation
 firms hedge
 make money on their core competency
 reduce risk
 writing a covered option
 firms do not speculate
 options are not a core competency
 speculation tries to make a return from
risk
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Quick review forward contracts
 Negotiable contracts
 Price, forward rate is contracted
 Amount, how much foreign exchange will
be exchange for domestic currency
 Term, when delivery will be made
 Contract is deliverable according to
terms
 Will not be able to get out of the
contract
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Currency futures contracts
 standardized contract terms
 amount of foreign exchange standardized
 $ 100,000 Canadian, £ 62.500,
 Peso 500,000, ¥ 12,500,00, Euro 1,000,000
 exchange rate fixed at contract time
 delivery dates standardized by the exchange
 March, June, September, December
 6 mos Chicago Mercantile Exchange
 contracts expire two business days prior to the
3rd Wednesday of the delivery month
 Contract is reversible
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Futures contracts
 Short position (selling a future)
 Fix price to deliver fx @ 1.0337
 To deliver 100,000 cd
 Delivery Dec 15, 2007
 Long position (buying a future)
 Fix priced to take delivery fx @ 1.0337
 To take delivery 100,000 cd
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Market makers in currency
futures
 international monetary market (IMM)
 London international financial futures
exchange (LIFFE)
 Chicago Mercantile Exchange
 New York mercantile exchange
 Singapore international monetary
exchange (SIMEX)
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Trading specifics
 commissions small (less than 0.5%)
 margin requirements typically 2% to
3% contracted amount
 both sides of contract guaranteed by
exchange
 contracts marked to market daily
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long one June euro contract
 contracted June delivery of 1,000,000
Euros
 spot price 0.9737 / dollar or 0.9737 *
1,000,000 = 973,700 usd at contract
 initial margin paid in when contracted
 e.g. 2% on Euro contract 20,000 usd
 maintenance margin
 e.g.
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1% on Euro contract 10,000 usd
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marking to market
1st day
 e.g. tomorrows settlement price 0.9817
 (0.9817 - 0.9737) * 1,000,000 = 8,000
 futures price is now 0.9817
 long the future (wanting euros)
 margin account = 20,000 - 8,000 = 12,000
 short the future (wanting dollars)
 margin account = 20,000 + 8,000 = 28,000
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marking to market 2nd day
 e.g., next days settlement price 0.9867
 (0.9867 - 0.9817) * 1,000,000 = 5,000
 futures price is now 0.9867
 long the future (wanting euros)
 margin account = 12,000 - 5,000 = 7,000
 margin call - buyer of the future must bump up
his margin
 short the future (wanting dollars)
 margin account = 28,000 + 5,000 = 33,000
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Futures contract expires
(long side of contract)
 e.g. last settlement price 1.0017
 net change in margin (1.0017 - 0.9737)
* 1,000,000 = 28,000
 final futures price 1.0017
 long the future (wanting euros)
 net change in margin account
+
28,000
 pays ( -1,001,700 + 28,000) = -973,700
dollars
 receives +1,000,000 euros
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Futures contract expires
(short side of contract)
 last settlement price 1.0017
 net change in margin (0.9737 - 1.0017)
* 1,000,000 = -28,000
 final futures price 1.0017
 short the future (wanting dollars)
 net change in margin account
28,000
 pays -1,000,000 euros
 receives (1,001,777 - 28,000) =
973,700 dollars
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Futures
 marking to market reduces(illimanates)
default risk
 daily resettlement confines risk to one day’s
price movements
 large daily movements in price will result in
 trading halt
 margin call during trading halt
 trader want to terminate the contract
 will take the opposite contract
 if long two contracts, will go short two contracts
 cost is the interest paid on margins
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Comparison to forwards
 forward contracts




flexible
higher default risk
fixed into contract
Must deliver on expiration
 futures contracts
 standardized
 much lower default risk
 reversible
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Options - characteristics
 American option can be exercised
anytime up to the expiration date
 European option can only be exercise
at the expiration date
 in-the-money - option which if
exercised will make money
 out-of-the-money - option which if
exercised will lose money
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Options - types
 Call option
 option to buy currency
 fixed price (exercise price, strike price)
 expiration date
 Put option
 option to sell currency
 fixed price (exercise price, strike price)
 expiration date
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Over-the-counter Market
 written by banks
 usd against pounds, euros, cd, yen
 usually written in round lots;
 1, 2, 3, 5, 10 million
 banks willing to write variable options
 amount
 exercise (strike) price
 maturity date
 less liquid than traded option
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Options on organized
exchanges
 Standardized contracts
 amount fixed
 maturity dates
 Auction markets
 Philadelphia exchange
 London International Financial Futures
Exchange
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Options over-the-counter Market
 written by banks
 usd against pounds, euros, cd, yen
 usually written in round lots;
 1, 2, 3, 5, 10 million
 banks willing to write variable options
 amount
 exercise (strike) price
 maturity date
 less liquid than traded option
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Call characteristics
e
exchange rate
x
exercise price
 sdx
standard deviation of
exchange rate
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Long a call option
c
Call out of the money
when e < x
x
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Chapter Seven - Derivatives
Call in the money
when e > x
e
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Short the Call Option
C
X
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S
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Market Value of the Call

Ct  C ( e, sd e, x, krf ,  )
C
 0
e
C
 0

C
 0
 sd e
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C
 0
 k rf
C
 0
 x
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Valuation





exercise price (negative)
exchange rate (positive)
volatility (positive)
term to maturity (positive)
risk-free rate of return (positive)
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Value of the Exercised Call
If
et  x,
Px , t  0
(out of the money), or
If
et  x,
C x , t  ( et  x )  n  C0  0
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Long a call option
c
market value
of the call
x
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exercised value
of the call
e
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Long a put option
P
Call out of the money
when e > x
Call in the money
when e < x
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x
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e
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Short the Put Option
X
S
P
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Market Value of the Put
Pt  P ( e, sd e, x, k rf ,  )
 P
 0
e
 P
 0
 sd e
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P
 0

P
 0
 k rf
 P
 0
 x
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Value of the Exercised Put
If
et  x,
Px , t  0
(out of the money), or
If
et  x,
Px , t  ( x  et )  n  P0  0
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Long the Put Option
P
X
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S
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