chapter 6 currency futures and options markets. chapter overview chapter overview i.futures...

CHAPTER 6CHAPTER 6

CURRENCY CURRENCY FUTURES AND FUTURES AND

OPTIONS MARKETSOPTIONS MARKETS

CHAPTER OVERVIEWCHAPTER OVERVIEW

I.I. FUTURES CONTRACTSFUTURES CONTRACTS

II.II. CURRENCY OPTIONSCURRENCY OPTIONS

PART I.PART I.FUTURES CONTRACTSFUTURES CONTRACTS

I.I. CURRENCY FUTURESCURRENCY FUTURES

A.A. BackgroundBackground

1.1. 1972: Chicago Mercantile1972: Chicago Mercantile

Exchange opens Exchange opens International Monetary International Monetary Market. (IMM)Market. (IMM)

FUTURES CONTRACTSFUTURES CONTRACTS

2.2. IMM providesIMM provides

a.a. an outlet for hedging an outlet for hedging currency risk with futures currency risk with futures contracts.contracts.

b.b. Definition:Definition:

contracts written contracts written requiringrequiring a a standard quantitystandard quantity of an of an available available currencycurrency at a at a fixedfixed exchange rate exchange rate at a at a setset delivery datedelivery date..


c.c. Available Futures Currencies:Available Futures Currencies:

1.) British pound1.) British pound 5.) French franc5.) French franc

2.) Canadian dollar2.) Canadian dollar 6.) Japanese 6.) Japanese yenyen

3.) German mark3.) German mark 7.) Australian7.) Australian

4.) Swiss franc4.) Swiss franc dollardollar


d.d. Standard Quantity of CurrencyStandard Quantity of Currency

contract quantity sizes differ forcontract quantity sizes differ for

each of the 7 available each of the 7 available currencies.currencies.

ExampleExample

German mark = DM125,000German mark = DM125,000


e.e. Transaction costs:Transaction costs:

payment of commission to a payment of commission to a tradertrader

f.f. Leverage is highLeverage is high

1.)1.) Initial margin required isInitial margin required is

relatively low (less than relatively low (less than 2% 2% of contract value).of contract value).


g.g. Maximum price movementsMaximum price movements

1.)1.) Contracts set to a daily Contracts set to a daily priceprice

limit restricting maximum limit restricting maximum daily price movements.daily price movements.


2.)2.) If limit is reached, a marginIf limit is reached, a margin

call may be necessary to call may be necessary to

maintain a minimum margin.maintain a minimum margin.


h.h. Global futures exchanges:Global futures exchanges:

1.)1.) I.M.M. International Monetary I.M.M. International Monetary

MarketMarket

2.)2.) L.I.F.F.E.London International L.I.F.F.E.London International Financial Futures ExchangeFinancial Futures Exchange

3.)3.) C.B.O.T. Chicago Board of TradeC.B.O.T. Chicago Board of Trade


4.) 4.) S.I.M.E.X.Singapore InternationalS.I.M.E.X.Singapore International

Monetary ExchangeMonetary Exchange

5.)5.) D.T.B. Deutsche Termin BourseD.T.B. Deutsche Termin Bourse

6.)6.) H.K.F.E. Hong Kong Futures ExchangeH.K.F.E. Hong Kong Futures Exchange


B.B. Forward vs. Futures ContractsForward vs. Futures Contracts

Basic differences:Basic differences:

1. Trading Locations1. Trading Locations 6. Settlement Date6. Settlement Date

2. Regulation2. Regulation 7. Quotes7. Quotes

3. Frequency of 3. Frequency of 8. Transaction 8. Transaction delivery costsdelivery costs

4. Size of contract4. Size of contract 9. Margins9. Margins

5. Delivery dates5. Delivery dates 10. Credit risk 10. Credit risk


Advantages of Advantages of futures:futures:

1.) Smaller 1.) Smaller contract size contract size

2.) Easy 2.) Easy liquidationliquidation

3.) Well-3.) Well-organizedorganized

and stable and stable market.market.

Disadvantages of Disadvantages of futures:futures:

1.) Limited to 71.) Limited to 7

currenciescurrencies

2.) Limited dates 2.) Limited dates

of deliveryof delivery

3.) Rigid contract3.) Rigid contract sizes.sizes.

PART IIPART IICURRENCY OPTIONSCURRENCY OPTIONS

I.I. OPTIONSOPTIONS

A.A. Currency options Currency options 1.1. offer another method to offer another method to

hedge exchange rate risk.hedge exchange rate risk.

2.2. first offered on Philadelphiafirst offered on PhiladelphiaExchange (PHLX).Exchange (PHLX).

3.3. fastest growing segment offastest growing segment ofthe hedge markets.the hedge markets.

CURRENCY OPTIONSCURRENCY OPTIONS

4. Definition:4. Definition:a contract from a writer ( the a contract from a writer ( the

seller) that gives the right not seller) that gives the right not the the obligation to the holder (the obligation to the holder (the buyer) to buyer) to buy or sell a buy or sell a standardstandard amountamount of of an an availableavailable currencycurrency at a at a fixed fixed exchange exchange rate rate for a for a fixed time fixed time period.period.


5.5. Types of Currency Options:Types of Currency Options:

a.a. AmericanAmerican

exercise date may occur anyexercise date may occur anytime up to the expiration date.time up to the expiration date.

b.b. EuropeanEuropean

exercise date occurs only at exercise date occurs only at thethe

expiration date.expiration date.


7.7. Exercise PriceExercise Price

a. a. Sometimes known as theSometimes known as the

strike price.strike price.

b.b. the exchange rate at the exchange rate at which the option holder which the option holder can buy or sell the can buy or sell the contracted currency.contracted currency.


8.8. Status of an optionStatus of an optiona.a. In-the-moneyIn-the-money

Call:Call: Spot > strikeSpot > strikePut:Put: Spot < strikeSpot < strike

b.b. Out-of-the-moneyOut-of-the-moneyCall:Call: Spot < strikeSpot < strikePut:Put: Spot > strikeSpot > strike

c.c. At-the-moneyAt-the-moneySpot = the strikeSpot = the strike


9.9. The premium: the price of anThe premium: the price of an

option that the writer charges option that the writer charges

the buyer.the buyer.


B.B. Using Currency OptionsUsing Currency Options

1.1. For the firm hedging foreignFor the firm hedging foreignexchange riskexchange risk

a. With sizable unrealized a. With sizable unrealized gains.gains.

b. With foreign currency b. With foreign currency flows flows forthcoming. forthcoming.


2.2. For speculatorsFor speculators

- profit from favorable - profit from favorable exchange rate changes.exchange rate changes.


C.C. Option Pricing and ValuationOption Pricing and Valuation

1. Value of an option equals1. Value of an option equals

a. Intrinsic valuea. Intrinsic value

b. Time valueb. Time value


2.2. Intrinsic ValueIntrinsic Value

the amount in-the-moneythe amount in-the-money

3.3. Time ValueTime Value

the amount the option is inthe amount the option is in

excess of its intrinsic value.excess of its intrinsic value.


4.4. Other factors affecting the Other factors affecting the

value of an optionvalue of an optiona.a. value rises with longer value rises with longer

time to expiration.time to expiration.b.b. value rises when greater value rises when greater

volatility in the exchange volatility in the exchange rate.rate.


5.5. Value is complicated by bothValue is complicated by both

the home and foreign interestthe home and foreign interest

rates.rates.


D. D. Using Forward or Futures Using Forward or Futures Contracts:Contracts:

Forward and futures contracts Forward and futures contracts are more suitable for hedging are more suitable for hedging

a a known amount of foreign known amount of foreign currency flow.currency flow.


E.E. Market StructureMarket Structure

1.1. LocationLocation

a. Organized Exchangesa. Organized Exchanges

b. Over-the-counterb. Over-the-counter

1.) Two levels1.) Two levels

retail and retail and wholesalewholesale

chapter 6 currency futures and options markets. chapter overview chapter overview i.futures...

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