Currency Futures &
Options Markets
Objectives: to Understand
• How currency futures and options contracts
are used to manage currency risk & to
speculate on future currency movements
• The nature of currency futures and options
contracts and
• The difference between futures & options
contracts
• The factors that determine the value of an
option
Futures
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Currency Risk
Definition
• Currency Risk = Variability in the value
of an exposure caused by uncertainty
about exchange rate changes.
Futures
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Currency Risk
• Degree of risk is a function of 2
variables
– Volatility of exchange rates
– Amount of exposure
• Degree of Risk
– Low = rate fixed, low exposure
– High = rate volatile, high exposure
Futures
Fred Thompson
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What Happens if the Yen falls?
QuickTime™ and a
TIFF (Uncompressed) decompressor
are needed to see this picture.
Futures
Fred Thompson
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Long and Short Exposures
• A person that is, for example, long the pound,
has pound denominated assets that exceed
in value their pound denominated liabilities.
• A person that is short the pound, has pound
denominated liabilities that exceed in value
their pound denominated assets.
Futures
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What is an exposure?
• Liabilities > assets = net exposure
(short)
• If you are borrowing Yen to buy $
denominated assets? Are you short or
long?
• Who is long?
• Who is long on $? Who is short?
Futures
Fred Thompson
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Hedging
• To hedge a foreign exchange exposure, one
takes an equal and opposite position from
that of the exposure.
• For example, if folks are long the pound, they
would have to take an offsetting short
position to hedge their exposure.
• One who is long in a market is betting on an
increase in the value of the thing, whereas
with a short position they are betting on a fall
in its value.
Futures
Fred Thompson
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You Can Hedge with Financial
Derivatives!
• Contracts that derive their value from
some underlying asset
– Forwards
– Futures
– Options
– Swaps
Futures
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For example
• Vanilla bond -- coupon and principal
– First stage decomposition
– Second stage decomposition
– Options
• What assets underlie currency
derivatives?
Futures
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Currency Futures
Currency Futures
• Traded on centralized exchanges (illustrated
in Figure 1 later)
• Highly standardized contracts
– Size [A&C$100K, £62.5k, €125k, ¥12.5m] &
maturity [delivery date]
• Clearinghouse as counter-party
• High leverage instrument
– Daily settlement
– Margin requirements
Futures
Fred Thompson
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Currency Futures
• Performance Bond or Initial Margin: The
customer must put up funds to guarantee the
fulfillment of the contract - cash, letter of
credit, Treasuries.
• Maintenance Performance Bond or Margin:
The minimum amount the performance bond
can fall to before being fully replenished.
• Mark-to-the-market: A daily settlement
procedure that marks profits or losses
incurred on the futures to the customer’s
margin
account.
Futures
Fred Thompson
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Sample Performance Bond Requirements
From the CME, 15 March 2000
Currency Futures
Australian Dollar
British Pound
Canadian Dollar
Deutsche Mark
Euro
Futures
Initial
Maintenance
$1,317
$975
$1,620
$1,200
$642
$475
$1,249
$925
$2,430
$1,800
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How an Order is Executed (Figure from the CME)
Example
A US manufacturing company has a division
that operates in Mexico. At the end of June
the parent company anticipates that the
foreign division will have profits of 4 million
Mexican pesos (P) to repatriate.
The parent company has a foreign exchange
exposure, as the dollar value of the profits will
rise and fall with changes in the exchange
value between the P and the dollar.
Futures
Fred Thompson
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Example, continued
• The firm is long the peso, so to hedge its
exposure it will go short [sell P] in the futures
market.
• The face amount of each peso future contract
is P500,000, so the firm will go short 8
contracts.
• If the peso depreciates, the dollar value of its
Mexican division’s profits falls, but the futures
account generates profits, at least partially
offsetting the loss. The opposite holds for an
appreciation of the peso.
Futures
Fred Thompson
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Gain
Underlying Long Position
Change spot value
Change in futures price
Futures Position
Loss
Example, continued
• The previous diagram can be used to
illustrate the effect of a change in the value of
the peso.
• An increase in the value of the peso
increases the dollar value of the underlying
long position and decreases the value of the
futures position.
• A decrease in the value of the peso
decreases the value of the underlying
position and increases the value of the
futures
position.
Futures
Fred Thompson
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Example, continued
• On the 25th, the spot rate opens at 0.10660
($/P) while the price on a P future opens at
0.10310.
• The market closes at 0.10635 and 0.10258
respectively.
• The loss on the underlying position is:
•
(0.10635-0.10660)P4 mil. = -$1,000
• The gain on the futures position is:
•
(0.10310-0.10258)8P500,000=$2,080
Futures
Fred Thompson
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Gain and Loss on Underlying and Futures Position
Day 1
Underlying Long Position
Gain
P4 million
$2,080
Change spot value
-0.00025
Change in futures price
-0.00052
$1,000
Futures Position
P500,000 x 8
Loss
Example, continued
• On the 28th, the spot rate moves to
0.10670 ($/P) and the price on a P
future to 0.10285.
• The gain on the underlying position is:
•
(0.10670-0.10635)P4 mil. = $1,400
• The loss on the futures position is:
•
(0.10258-0.10285)8P500,000=-$1,080
Futures
Fred Thompson
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Gain and Loss on Underlying and Futures Position
Day 2
Underlying Long Position
Gain
P4 million
$1,400
0.00032 Change
spot value
0.00035
Change in futures price
$1,080
Futures Position
P500,000 x 8
Loss
Example, continued
• On the 29th, the spot rate moves to
0.10680 ($/P) and the price on a P
future to 0.10290.
• The gain on the underlying position is:
•
(0.10680-0.10670)P4 mil. = $400
• The loss on the futures position is:
•
(0.10285-0.10290)8P500,000=-$200
Futures
Fred Thompson
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Gain and Loss on Underlying and Futures Position
Day 3
Underlying Long Position
Gain
P4 million
$400
0.0001
Change spot value
0.00005
Change in futures price
$200
Futures Position
P500,000 x 8
Loss
Example, continued
• For the three days considered, the underlying
position gained $800 in value and the futures
contracts yielded $800.
• The hedge was not perfect as the daily losses
on the futures were less than the gains on the
underlying position (day 2 and 3), and the
daily gains on the futures exceeded the
losses on the underlying position (day 1).
• In this example, the imperfect hedge yielded
additional gains.
Futures
Fred Thompson
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Example, continued
• Suppose you wanted to close the
futures position (without making delivery
of the currency).
• The position is simply reversed. That is,
you would go long 8 P futures, reversing
your current position and closing out
your account. [offsetting trade]
Futures
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Additional Information
For additional information on currency
futures, visit the following sites:
• The Chicago Mercantile exchange
• The Futures Industry Institute
Futures
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Currency Options
Currency Options
• A currency option is a contract that gives the
owner the right, but not the obligation, to buy
or sell a currency at a specified price at or
during a given time.
• Call Option: An option that gives the owner
the right to buy a currency.
• Put Option: An option that gives the owner
the right to sell a currency.
• How are currency options simultaneously
both put & call options?
Futures
Fred Thompson
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Currency Options
• American Option: An option that can
be exercised any time before or on the
expiration date.
• European Option: An option that can
only be exercised on the expiration
date.
Futures
Fred Thompson
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Currency Options
• Exercise or Strike Price: The price (spot
exchange rate) at which the option may be
exercised.
• Option Premium: The amount that must be
paid to purchase the option contract.
• Break-Even: The point at which exercising
the option exactly matches the premium paid.
Futures
Fred Thompson
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Currency Options
• If the spot rate has not yet reached the
exercise price [S<X], the option cannot be
exercised and is said to be “out of the
money.”
• If the spot rate equals the exercise price
[S=X], the option is said to be “at the money.”
• If the spot rate has surpassed the exercise
price [S>X], the option is said to be “in the
money.”
Futures
Fred Thompson
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Call Option
• The holder of a call option expects the
underlying currency to appreciate in value.
• Consider 4 call options on the euro, with a
strike price of 152 ($/€) and a premium of
0.94 (both cents per €).
• The face amount of a euro option is €62,500.
• The total premium is:
$0.0094·4·€62,500=$2,350.
Futures
Fred Thompson
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Call Option: Hypothetical Pay-Off
Profit
Payoff Profile
$1,400
152
152.5
0
148.15
-$1,100
152.94
Break-Even
-$2,350
Out-ofLoss
the-money At
In-the-money
153.5
Spot Rate
Put Option
• The holder of a put option expects the
underlying currency to depreciate in value.
• Consider 8 put options on the euro with a
strike of 150 ($/€) and a premium of 1.95
(both cents per €).
• The face amount of a euro option is €62,500.
• The total premium is:
$0.0195·8·€62,500=$9,750.
Futures
Fred Thompson
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Profit
Put Option: Hypothetical payoff
at a spot rate of 148.15
Payoff Profile
Break-Even
148.05
0
-$500
150
148.15
-$9,750
Loss
In-the-money At Out-of-the-money
Spot Rate
Option Pricing & Valuation
• Value of a call option at maturity
– S-X, where S-X>0 [otherwise value is
zero], = Intrinsic value
• Value of a call option prior to maturity
– Intrinsic value + Time value
Time Value is a function of:
Time to expiration, volatility, domestic &
foreign interest rate differentials
Futures
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Comparing Futures and Options
The value of a futures contract at maturity (date t+n) to purchase one
unit of foreign currency will be:
Value
0
Zt,t+n
St+n
The value of the futures contract
is zero at maturity if the spot rate
at maturity is equal to the current
futures rate.
Consider now the value of an option to purchase one unit of
foreign currency at that same price (i.e. a ‘call option’ with a
strike price X equal to Zt,t+n):
Value
0
X
St+n
The value of the call option
begins increasing when the
exchange rate becomes larger
than the exercise price - when the
option becomes ‘in the money.’
But we’re missing something. While a futures contract has an
expected return of zero, the value of the option looks like it is
always positive…
Value
0
X
St+n
Hence, anyone taking the opposite side of the transaction
(‘writing’ the option) will demand a premium (C) that makes the
expected value zero once again:
Value
0
C
X
St+n
Regardless of the outcome,
the option’s value is reduced
everywhere by the certain
payment of its premium.
The value of an option to sell one unit of foreign currency (a
‘put’ option) at a strike price equal to a corresponding futures
contract price will have similar properties:
Value
0
X
St+n
Swaps
Foreign Currency Swaps
A currency swap is an exchange of debt-service
obligations denominated in one currency for the
service on an agreed upon principal amount of debt
denominated in another currency.
A currency swap is often the low-cost way of
obtaining a liability in a currency in which a firm has
difficulty borrowing.
A pair of firms simply borrow in currencies they have
relative advantage borrowing in, and then trade the
obligations of their respective loans, thereby
effectively borrowing in their desired currency.
Dell computers would like to borrow in Swiss Francs
to hedge its ongoing cash flows from that country…
Dell
SFr
Nestle would like to borrow in Dollars to hedge its
sales to the U.S...
Dell
$
Nestle
SFr
But both firms are relatively unknown to the respective
credit markets, and thus anticipate unfavorable
borrowing terms.
Dell
$
Nestle
SFr
But an investment bank comes along and suggests
that each borrow in the credit markets that are
comfortable with them...
Dell
$
Nestle
I-Bank
SFr
…and then the investment bank will give them
sufficient cash flows each period to cover the
obligations of these loans...
Dell
Nestle
$
$
Sfr
I-Bank
SFr
…in return for making the payments in the foreign
currency that exactly match the other firm’s
obligations.
Dell
Nestle
Sfr
$
$
$
Sfr
I-Bank
SFr
In other words, the swap effectively ‘completes the
market’. Giving each firm access to the foreign debt
market at reasonable terms.
Dell
Nestle
Sfr
$
$
$
Sfr
I-Bank
SFr
The All-In Cost of a Swap
Clearly, the relative magnitudes of the respective
payments determine each firm’s ultimate cost of
borrowing.
This cost is called the ‘all-in cost’. It is the effective
interest rate the firm ends up paying on the money
that it raised.
It is the discount rate that equates the NPV of future
interest and principal payments to the net proceeds
received by the issuer.
IRR
Swaps vs. Forwards
Notice that on a one-year loan, a currency swap is
no different than a one-year forward contract.
In fact, a currency swap can really be thought of as
a firm taking a domestic currency loan and
purchasing a series of forward contracts to convert
the payments into known foreign currency
obligations.
The implied forward rates need not equal the actual
forward rates, but taken as a whole, should
resemble an average forward rate over the term of
the loan.
Comparative Borrowing Advantage
Swaps only exist because there are market
imperfections. If firms can access foreign and
domestic debt markets at equal cost, clearly swaps
are redundant.
One important reason that currency swaps are so
useful is that firms engaged in a swap need not
each have an absolute borrowing advantage in the
currency in which they borrow vis-a-vis the
counterparty.
In fact, it is quite likely that Nestle has better
access to both the U.S. and Swiss debt markets
than Dell. Comparative Advantage
Key Points
1. A firm wishing to hedge foreign currency exposure has five
main financial hedging tools which facilitate doing so: forward
contracts, money market hedges, futures contracts, foreign
currency options, and currency swaps.
2. Forward contracts have the benefit of being tailor-made,
with quantities and timing matched to the needs of the firm.
Forward contracts are typically quite costly over longer
horizons, as the market becomes highly illiquid.
3. Money market hedges are equally flexible, but depend on a
firm having equal access to domestic and foreign credit
markets.
Key Points
4. Futures contracts, traded on highly liquid exchanges, have
the benefit that they can be sold on the market before the
maturity date. As a result, futures contracts are particularly
useful for hedging exposures whose maturity is uncertain.
5. On the other hand, futures contracts are standardized in
terms of timing and quantities, and therefore they rarely offer a
perfect hedge.
6. Options contracts allow a firm to hedge against movements
in one direction while retaining exposure in the other.
7. Options are particularly useful in hedging exposures that are
highly uncertain with respect to timing and magnitude.
Key Points
8. Currency swaps offer firms the ability to borrow against
long-term foreign currency exposures when access to foreign
debt markets is costly.
9. Currency swaps converts a domestic liability into a
foreign one via what are effectively a bundle of long-dated
forward contracts between two firms.
10. The effective cost of a currency swap is its ‘all-in cost’ the effective rate of interest that the firm ends up paying on
the constructed foreign liability.
11. Currency swaps require only that firms have differential
relative - rather than absolute - advantage in accessing debt
markets.