Currency Futures and Options
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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Currency Futures and Options
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Currency Futures and Options
Chapter 5
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Overview
 Examine
usage of currency futures and
options contracts
– to hedge or speculate based upon
anticipated exchange rate changes
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Futures Contracts
 Are
contracts specifying a standard
volume
 of a particular currency
 to be exchanged
 on a particular date
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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Futures Contracts
 Similar
to forward contracts
 but
 they
are not negotiated like Forward
Contracts
 Currency Futures are traded in an
Exchange
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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Futures Market
Futures vs Forward contracts
 Futures
contracts
– state amount of a currency to be
exchanged on a specific day
– standardized contracts
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Futures Market
Futures vs Forward contracts
 Forward
contracts
– state amount of a currency to be
exchanged on a specific day
– individually tailored contracts
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Currency Futures and Options
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Currency Futures
- trade through a broker
Forward Contracts
- you make the arrangement directly
with the lender
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Intl Business
 The
trading volume of currency
futures has consistently increased
over time as has growth of
international transactions - which
require buying and selling currency
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Settlement Dates
 Typical
settlement dates are
 third Wednesdays in
 March
 June
 September
 December
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Futures Market
 Pricing
currency futures
– similar to forward rate
– differs from spot rate
 changes in spot rate affects value of
futures contract
– market forces eliminate arbitrage profits
– which is to say buying at $1.50 and selling at
$1.48
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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Futures Market
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 Closing
out a futures position
– if you don’t want to wait until the
settlement date, you can “close the
position” by selling an identical futures
contract
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Futures Market
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 Closing
out a futures position
 the future price ……. Up or Down
 the price changes over time in
accordance with movements in the
spot rate

If the spot rate becomes stronger, it makes it less
attractive to hold a futures position - so you’d
want to sell so you don’t end up with a premium
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Futures Market
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 Closing
out a futures position
– in the real world,,,,,,
– most currency futures contracts are
closed out before settlement date
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Credit Risk
 Each
futures contract represents an
agreement with “The Exchange”
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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Credit Risk
 Margin
requirements reflect credit
risk
– covers fluctuations in contract value
– initial margin: $1,000 - $2,000 per
contract
 trader must add more if contract
value decreases
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Hedging
I
want to get a ride to the airport for a
business trip, I’ll book an airline limo
 Just in case the limo doesn’t come
on time, I’ll hedge my risk by having
my neighbour agree to drive me
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Hedging
 Buy
a futures contract for a currency
you need
 Done when you need to spend
money in the future, and want to lock
in the price because you are
concerned it might rise to your
disadvantage
 If you don’t need it, your broker can
sell it on the exchange
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Hedging
 Sell
a futures contract for a currency
you DO NOT need
 Done when you need to get rid of
money in the future, and want to lock
in the price because you are
concerned it might rise to your
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disadvantage
 Again, if you don’t need it, your
broker can sell it on the exchange
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Hedging
 Hedging
exchange rate exposure
– hedging by buying 90 day contracts
 e.g., a US firm orders Swiss products
 must pay SF750,000 upon delivery in
90 days
 US firm buys 90 day contract today
–locks in price to be paid for francs
in 90 days
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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Hedging
 Hedging
exchange rate exposure
– hedging by selling 90 day contracts
 US firm is to receive a payment of
SF750,000
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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Currency Futures and Options
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 based
upon anticipated changes
– buy (sell) futures contract
 expect foreign currency to appreciate
(depreciate) in value
 coordinate transaction in spot market
at settlement date
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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Currency Futures and Options
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 associated
with use of brokers
– brokers buy (sell to client) at the “bid”
price
– brokers sell (buy from client) at the
“ask” price
– broker’s profit (trader’s transaction
cost)
 difference between bid and ask prices
Bid-Ask spread = Ask - Bid
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Call Options
 Contract
grants the right to buy a
specific currency
– a) at a specific price
– b) within a specific time period
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Call Options
 Exercise
(strike) price
– agreed upon price if contract is
implemented
– “in the money”: spot rate > strike price
– “out of the money”: spot rate < strike
price
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Call Options
 Factors
affecting call option
premiums
– level of existing spot price (vs. strike
price)
 option price increases as spot price
rises
 improves chances of buying currency
at a low price
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Call Options
 Factors
affecting call option
premiums
– length of time before expiration date
 spot price has better chance to
exceed strike price
– volatility of currency price
 improves chances that spot will
exceed strike price
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Currency Futures and Options
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Currency Call Options
Hedging
 Strike
price sets maximum exchange
rate
– if exchange (spot) rate lower than strike
price:
 call option is not exercised
 currency purchased on spot market
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Currency Futures and Options
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Currency Call Options
Hedging
 Example
of corporate hedging
– US firm bids on Canadian project
 US firm will need $CD if contract
awarded
 if project would require $CD5,000,000,
firm may choose to get up to 100 call
option contracts
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Call Options


Buy call option
zero sum game
– expect currency to appreciate
 exercise option if price increases beyond
strike price
– buy at strike price and sell at spot rate
Sell (write) call option
– expect currency to decline in value
 obligated to sell a currency at a specified
price
 make money if option not exercised
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Call Options
 Example
of buying a call option
– strike price set at $0.5877 when spot
was $0.5727 per Deutsche mark
– premium paid = $0.015 (0.5877 - 0.5727)
– exercise option when spot reaches
$0.6077
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Currency Futures and Options
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Currency Call Options
Speculation
Per unit
Per Contract
$37,961.25
Selling price of
Deutsche mark
$0.6077
($.6077 x 62,500)
less purchase price
-0.5877
- 36,731.25
($.5877 x 62,500)
of Deutsche mark
less premium paid
-0.0150
- 937.50
($.015 x 62,500)
= net profit
-0.0050
$312.50
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Put Options
 Contract
grants the right to sell a
specific currency
– a) at a specific price
– b) within a specific time period
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Put Options
 Exercise
(strike) price
– agreed upon price if contract is
implemented
– “in the money”: spot rate < strike price
– “out of the money”: spot rate > strike
price
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Put Options
 Factors
affecting put option
premiums
– level of existing spot price (vs. strike
price)
 option price increases as spot price
falls
 improves chances of selling currency
at a high price
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Currency Put Options
 Factors
affecting put option
– length of time before expiration date
 spot price has better chance to fall
below strike price
– volatility of currency price
 improves chances that spot will fall
below strike
 Hedging
reduces risk exposure in
receivables
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Currency Futures and Options
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Currency Put Options
Speculation
 Example
of buying a put option
– strike price set at $0.6217 when spot
was $0.6357 per Deutsche mark
– premium paid = $0.008 (0.6357 - 0.6217)
– exercise option when spot reaches
$0.6077
declining
value
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Currency Futures and Options
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Currency Put Options
Speculation
Per unit
Selling price of
$0.6217
-0.6077
- 37,981.25
($.6077 x 62,500)
of Deutsche mark
less premium paid
$38,856.25
($.6217 x 62,500)
Deutsche mark
less purchase price
Per Contract
-0.0080
- 500.00
($.008 x 62,500)
= net profit
0.0060
$375.00
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Currency Futures and Options
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Profits with Options and
Futures
 Efficiency
of options/futures market
– efficient market eliminates conditions
permitting “abnormal” profits
– studies suggest that prices reflect all
available information
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Summary
 Futures
contract
– specifies a standard volume of a
currency to be exchanged on a
particular date
– used for hedging and speculative
purposes
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
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Currency Futures and Options
Summary
 Options
contract
– call options purchased when exchange
rate is expected to increase
– put options purchased when exchange
rate expected to fall
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson