Chapter 4
Currency Futures and Options Markets
Currency Futures
What Is a Currency Future?
Marking to Market: An Example
Futures Contracts versus Forward Contracts
Payoff Profiles on Currency Futures
The Link between the Futures and Forward Markets
Currency Options
What Is a Currency Option?
Exchange-Traded Options
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Quotation Conventions and Market Organization
Determinants of the Market Values of Currency Options
Over-the-Counter (OTC) Options
Payoff Profiles for Currency Options
Forwards, Futures, and Options Compared: A Summary
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Currency Futures: What Is a Currency Future?
1. Currency futures are standardized contracts that trade on the floor of a future
exchange.
(1) Buyers and sellers, brokers, clearing corporation of a future
exchange
(2) Currency futures markets
For example: the International Money Market (IMM) of the Chicago
Mercantile Exchange
the COMEX commodities exchange in New York
the Chicago Board of Trade
the London International Financial Futures Exchange (LIFFE)
2. Currency futures contracts are traded in
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(1) a few value dates
For example: At the Chicago IMM, there are four value dates of contracts:
the third Wednesday in the months March, June, September, and
December. (delivery of the underlying foreign currency occurs 2 business
days after the contract matures)
(2) specific sizes
For example: ￡62,500, Can$ 100,000, etc. (refers to Figure 4.1)
(3) Figure 4.1
Currency Futures Quotations on the International Money
Market of the Chicago Mercantile Exchange, February 17, 1994
◎ future prices of foreign currencies are quoted as U.S. dollar
equivalents (as U.S. dollars per unit of foreign exchange)
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◎ open, high, low, settle, change, lifetime high, lifetime low, open
interest
◎ To convert these per-unit prices into futures contract prices it is
necessary to multiply the prices in the table by the contract amounts.
For example: the price of one Japanese yen March contract is
$0.009593/￥ * ￥12,500,000 = $ 119,912.50
◎If we assume risk neutrality, the per-unit price of futures equals
the market’s expected future spot rate of the foreign currency. It is
changes in the market’s expected future spot exchange rate that
drive futures contract prices up and down.
3. Margin
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(1) Both buyers and sellers of currency futures must post a margin and
pay a transaction fee.
(2) Maintenance level: Margins must be supplemented by contract
holders and brokerage houses if the amount in a margin account falls
below a certain level, called the maintenance level.
For example: the IMM’s required minimum margin on British pounds is
currently $2,000 per contract, and its maintenance level is $1,500.
(3) Marking to Market: Margin adjustment is done on a daily basis and is
called marking to market.
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Marking to Market: An Example
1. Table 4.1 Settlements on a Pound Futures Contract
(1) If the market value of the contract valued at the settle price falls more
than $500, the full amount of the decline in value must be added to the
clients’ and the brokers’ margin accounts.
(2) Declines in contract values which is small enough to leave more than
$1,500 of equity do not require action.
(3) Increases in the values of contracts are added to margin accounts and
can be withdrawn.
2. When the buyer’s account is adjusted up, the seller’s account is adjusted
down the same amount.
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Futures Contracts versus Forward Contracts
1. Margin Requirement
(1) For forward contracts: Types of clients
◎ Interbank transactions and transactions with large corporate
clients: Banks require no margin
◎ Clients with a credit line: Banks are likely to reduce the credit
line
◎ Clients without a credit line: Banks require a margin account and
the margin may be called
(2) What instruments will be accepted as margin
◎ Forward contracts: Very flexible
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◎ Futures contracts: A substantial part of initial margin may be
accepted in the form of securities, such as treasury bills, but
subsequent maintenance payments are typically in cash. (which
could be viewed as an opportunity cost associated with futures
contracts)
2. Foreign Exchange Risk with futures contracts
(1)Most of the foreign exchange risk is removed.
The possible gain in a futures contract will compensate for the
higher-than-expected spot exchange rate in the future.
(2) Marking-to-market risk
The marking-to-market risk is due to the variability in interest rates.
(3) The contract size is fixed
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The contract size of a futures contract is unlikely to correspond exactly to
a firm’s needs.
3. The flexibility in values of forward contracts and in margin maintenance,
as well as the absence of marking-to-market risk, make forwards
preferable to futures for importers, exporters, borrowers, and lenders who
wish to precisely hedge foreign exchange risk and exposure. Currency
futures are more likely to be preferred by speculators because gains on
futures contracts can be taken as cash and because the transaction costs
are small.
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Payoff Profiles on Currency Futures
1. The consequences of unanticipated changes in the spot exchange rate on the
contract value and margin account of a purchaser of Deutschemark
futures.
Table 4.2 Unanticipated Changes in Spot Rates and Futures to Buy
Deutschemarks.
Figure 4.2 Payoff Profile on Purchase of Deutschemark Futures
(1) the market’s expected future spot rate: DM1.80/$ in the usual
European terms
the futures market price: $0.5556/DM (= 1÷DM1.80/$)
the market price of a futures contract: $0.5556/DM * DM125,000 =
$69,450
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(2) Fuzzy: “±” in the last column means the uncertainty in precise
payoffs.
For example: If money has been withdrawn and invested, there might be
more than the gain shown in the margin account.
2. The payoffs for the sale of futures are the numbers in the final column of
Table 4.2, with the signs reversed, and the consequent payoff profile is an
upward-sloping fuzzy line.
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The Link between the Futures and Forward Contracts
1. The interdependence between the futures and forward contracts is the result
of the action of arbitragers who can take offsetting positions in the two
markets when prices differ.
2. Arbitrage will ensure that the bid price of forward currency does not exceed
the ask price of currency futures, and vice versa.
3. The forward market can influence the futures market, and vice versa.
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Currency Options: What Is a Currency Option?
1. Unlike forward and futures contracts, currency options give the buyer the
opportunity, but not the obligation, to buy or sell at a preagreed price—the strike
price, or exercise price—in the future.
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Exchange-Traded Options: Futures Options versus Spot Options
1. Futures Options
(1) Futures options give the buyers the right but not the obligation to buy or sell
currency futures contracts at a preagreed price. Such options trade at the IMM
in Chicago.
(2) Options on futures derive their value indirectly from the expected future spot
value of the underlying currency.
2. Spot Options
(1) Spot options give the buyers the right to buy or sell the currency itself at a
preagreed price. Such options trade on the Philadelphia Exchange.
(2) Spot options derive their value directly from the expected future spot value of
the underlying currency.
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Characteristics of Spot Currency Options
1. The variety of currency options and the sizes of contracts
British pound
31,250
German mark
62,500
Australian dollar 50,000
Canadian dollar 50,000
French franc
250,000
Japanese Yen
6,250,000
Swiss franc
62,500
The European Currency Unit (ECU)
62,500
2. European Options versus American Options
(1) European options: European options can be exercised only on the maturity
date of the option. They cannot be exercised before that date.
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(2) American options: American options offer buyers more flexibility in that
they can be exercised on any date up to and including the maturity date of the
option.
3. The Expiring Months and Dates
(1) The expiring months: March, June, September, and December, plus one or
two near-term months.
(2) The expiring dates:
◎ Mid-month options: Most options expire on the Friday before the third
Wednesday of the expiry month.
◎ End-of-month (EOM) options: These expire on the last Friday of the
month.
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4. The Strike Prices
(1) The strike price (exercise price) gives the exchange rate at which the option
buyer has the right to buy or sell the foreign exchange.
(2) Call option: A call option gives the buyer the right to buy the foreign
currency at the strike price or exchange rate on the option.
(3) Put option: A put option gives the buyer the right to sell the foreign currency
at the strike price.
5. An Example
German Mark
58.60
62,500 German marks – European Style
Puts
58 Mar
Vol.
Last
600
0.26
(1) 58.60: $0.5860/DM, the spot exchange rate
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(2) 58: the strike price for this put option
(3) 0.26: the price of the option, 0.26 U.S. cents per mark
(4) For the contract of 62,500 German marks the option buyer must pay
$0.0026/DM * DM62,500 = $162.50
6. The Spot Exchange Rate versus the Strike Price
(1) For call options
In the money: the strike price < the spot rate
Out of the money: the strike price > the spot rate
At the money: the strike price = the spot rate
(2) For put options
In the money: the strike price > the spot rate
Out of the money: the strike price < the spot rate
At the money: the strike price = the spot rate
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7. The Option Premium
(1) The option premium is the amount paid for the option on each unit of
foreign currency. This premium consists of two parts: the intrinsic value, if
there is any, and the time value.
(2) The intrinsic value is how many cents per foreign currency would be gained
by exercising the option immediately.
(3) The time value is the part of the premium that comes from the possibility
that, at some point in the future, the option might have higher intrinsic value than
at that moment.
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Quotation Conventions and Market Organization
1 Quotation Conventions
Option dealers quote a bid and ask premium on each contract. A dealer must
state whether a bid or ask premium is for a call or put, whether it is for American
or European option, the strike price, and the month the option expired.
2 Margin
(1) For buyers: After the buyer has paid for an option contract, he or she has no
financial obligation. There is no need to talk about margins for buyers.
(2) For sellers (writers): The writers of a call option must stand ready, when
required, to sell the currency to the option buyer at the strike price. The option
exchange guarantees that option sellers honor their obligations to option buyers
and therefore requires option sellers to post a margin.
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Determinants of the Market Values of Currency Options
The Price of Call Options (Put Options)
Factors
Option Premium
1. Intrinsic Value

 ()
2. Volatility of the Spot Rate

 ()
3. Length of Period to Expiration

 ()
4. Flexibility of Options*

 ()
5. Interest Rate on Currency of Purchase**

 ()
6. The Forward Premium***

 ()
The Forward Discount

 ()
Interest Differential

 ()
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* For a given strike price, exchange-rate volatility, and period to expiration, American
options are typically more valuable than European options.
** The higher the interest rate on the currency paid for an option, the lower the present
value of the exercise price. A lower exercise price increases the market value of a
call and reduces the market value of a put.
*** The more the currency is expected to increase in value, that is, the currency tends
to trade at a forward premium, the higher the market value of a call option and the
lower the market value of a put option on that currency. Relatively high interest rate
suggests an expected decline in the value of the currency and , consequently, an
increased chance that a put will be exercised.
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Over-the-Counter (OTC) Options
1 Many over-the-counter options written by banks are contingent upon such outcomes
as whether a corporate takeover or bid on a foreign project is accepted. That is,
the buyer of the option purchases the opportunity to buy a foreign currency at a
given strike exchange rate if, for example, a particular takeover occurs.
2 An option that is contingent upon completion of a takeover might be cheaper than a
traditional exchange-traded option because the writer of a call contingent on
completion of a takeover or a bid on a foreign project does not deliver foreign
exchange if the foreign currency increases in value but the deal is not completed.
3 The bank gains because it reinsures by buying an exchange-issued call option to
cover the call it has written, and the exchange call increases in value without the
need to deliver the foreign currency if the takeover offer is rejected.
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Payoff Profiles for Currency Options
1. Payoff Profile for Call Option Buyers
Table 4.3 and Figure 4.4
2. Payoff Profile for Call Option Writers
Table 4.3 and Figure 4.5
3. Payoff Profile for Put Option Buyers
Table 4.4 and Figure 4.6
4. Payoff Profile for Put Option Writers
Table 4.4 and Figure 4.7
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Forwards, Futures, and Options Compared: A Summary
Table 4.5. Forwards, Futures, and Options Compared
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