Currency Futures and Options Markets

International Finance
Dr. A. DeMaskey

Learning Objectives
What are currency futures contacts? How are they quoted, valued, and used for hedging purposes? How do currency futures differ from currency forwards? What are currency option contracts? How are they quoted, valued, and used for hedging purposes?

Foreign Currency Derivatives

Financial management in the 21st century needs to consider the use of financial derivatives These derivatives, so named because their values are derived from the underlying asset, are a powerful tool used for two distinct management objectives:

Speculation Hedging

Foreign Currency Derivatives

In the wrong hands, derivatives can cause a corporation to collapse (Barings, Allied Irish Bank), but used wisely they allow a financial manager the ability to plan cash flows The financial manager must first understand the basics of the structure and pricing of these tools. The derivatives that will be discussed are:

Foreign Currency Futures Foreign Currency Options

Foreign Currency Futures

A foreign currency futures contract is an alternative to a forward contract.

It calls for future delivery of a standard amount of currency at a fixed time and price. These contracts are traded on exchanges with the largest being the International Monetary Market located in the Chicago Mercantile Exchange.

Contract Specifications

Contract size Method of stating exchange rate Maturity dates Last trading date

Collateral and maintenance margin Settlement Commission Clearing Operations

Using Foreign Currency Futures

Hedging Speculating Forward-Futures Arbitrage

Profit or Loss from a Long Futures Hedge

Profit or Loss from a Short Futures Hedge

Forward Contracts versus Futures Contracts

Trading Regulation Frequency of delivery Size of contract Delivery date Settlement Pricing

Quotes Transaction costs Collateral Credit risk Clearing Operation Location Liquidity

Foreign Currency Options

A foreign currency option is a contract giving the option holder the right, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period.

Call Option vs. Put Option Holder vs. Grantor

Foreign Currency Options Terminology

Every option has three different price elements

Options may also be classified as per their payouts

Strike or exercise price Option premium The underlying or actual spot rate in the market

At-the-money In-the-money (ITM) Out-of-the-money (OTM) options

There are two types of option maturities

American options European options

Market Structure

Over-the-Counter (OTC) Market

Main advantage is that they are tailored to purchaser Counterparty risk exists Mostly used by individuals and banks The Chicago Mercantile Philadelphia Stock Exchange Options Clearinghouse Corporation (OCC)

Organized Exchanges

Using Foreign Currency Options

Users

Financial Firms Corporations

Hedging Speculating

Protecting Against the Potential Appreciation of a Currency Using a Call Option

Protecting Against the Potential Depreciation of a Currency Using a Put Option

Option Pricing and Valuation

An options value consists of two parts:

Intrinsic Value Time Value

Intrinsic Value is the amount by which an option is in-the-money. Time Value is the amount by which an options value exceeds its intrinsic value.

Option Pricing Model

The value of a currency option depends on the following five variables:

Strike price relative to the spot exchange rate Time to maturity Relative interest rates between the two currencies Volatility of underlying currency Supply and demand for specific option

Online Application

Visit the Commodity Futures Trading Commission at http://www.cftc.gov/. The Options Clearing Corporation at http://www.optionsclearing.com/ The Chicago Mercantile Exchange provides current and historical futures and option prices at http://www.cme.com/prices/index.cfm. The Chicago Board Options Exchange at http://www.cboe.com, and The London International Financial Futures and Options Exchange at www.liffe.com.