Multinational Financial

Management
Alan Shapiro

7th Edition

Power Points by
J.Wiley
&
Sons
Joseph F. Greco, Ph.D.
California State University, Fullerton
1

CHAPTER 8
CURRENCY FUTURES
AND OPTIONS
MARKETS

CHAPTER OVERVIEW
I.
II.

FUTURES CONTRACTS
CURRENCY OPTIONS

PART I.
FUTURES CONTRACTS

I. CURRENCY FUTURES
A. Background
1. 1972: Chicago Mercantile
Exchange
opens International Monetary
(IMM)

Market.

FUTURES CONTRACTS
2. IMM provides
a. an outlet for hedging currency
risk with futures contracts.
b. Definition of futures contracts:
contracts written requiring
a standard quantity of an available currency
at a fixed exchange rate
at a set delivery date.

FUTURES CONTRACTS
c. Available Futures
Currencies:
1.) British pound 5.) Euro
2.) Canadian dollar
3.) Deutsche mark
dollar
4.) Swiss franc

6.) Japanese yen

7.) Australian

FUTURES CONTRACTS
d. Standard Contract Sizes:
contract sizes differ for each of
the 7 available currencies.

Examples:
Euro = 125,000
British Pound = 62,500
7

FUTURES CONTRACTS
e.

Transaction costs:
payment of commission to a
trader
f.
Leverage is high
1.) Initial margin required is
relatively low (e.g. less than
.02% of sterling
contract
value).
8

FUTURES CONTRACTS
g.

Maximum price movements

1.) Contracts set to a daily
price limit restricting
maximum daily price
movements.

FUTURES CONTRACTS
2.) If limit is reached, a margin
call may be necessary to
maintain a minimum margin.

10

FUTURES CONTRACTS
h. Global futures exchanges that
are competitors to the IMM:
1.) Deutsche Termin Bourse
2.) L.I.F.F.E.London International
Futures Exchange

Financial

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

11

FUTURES CONTRACTS
4.)

S.I.M.E.X.Singapore International
Monetary Exchange

5.)

H.K.F.E. Hong Kong Futures Exchange

12

FUTURES CONTRACTS
B. Forward vs. Futures Contracts
Basic differences:
1. Trading Locations
6. Settlement Date
2. Regulation
7. Quotes
3. Frequency of 8. Transaction
delivery costs
4. Size of contract
9. Margins
5. Delivery dates
10. Credit risk

13

FUTURES CONTRACTS
Advantages of
futures:

1.) Smaller
contract size
2.) Easy liquidation
3.) Well-organized
and stable
market.

Disadvantages of
futures:

1.) Limited to 7
currencies
2.) Limited dates
of delivery
3.) Rigid contract
sizes.
14

PART II
CURRENCY OPTIONS

I. OPTIONS
A. Currency options
1. offer another method to
hedge exchange rate risk.
2. first offered on Philadelphia
Exchange (PHLX).
3. fastest growing segment of
the hedge markets.
15

CURRENCY OPTIONS
4. Definition:
a contract from a writer ( the seller)
that
gives the right not the obligation
to the holder (the buyer) to buy or sell a
standard
amount of
an available
currency at a fixed
exchange rate for
a fixed time period.

16

CURRENCY OPTIONS
5. Types of Currency Options:
a. American
exercise date may occur any
time up to the expiration date.
b. European
exercise date occurs only at the
expiration date.
17

CURRENCY OPTIONS
7. Exercise Price
a.
Sometimes known as the
strike price.
b. the exchange rate at which
the option holder can buy or sell
the
contracted currency.

18

CURRENCY OPTIONS
8.

Status of an option
a. In-the-money
Call: Spot > strike
Put: Spot < strike

b.

Out-of-the-money

c.

At-the-money

Call: Spot < strike

Put: Spot > strike
Spot = the strike
19

CURRENCY OPTIONS
9. The premium: the price of
an
option that the writer
charges

the buyer.

20

CURRENCY OPTIONS
B. When to Use Currency Options
1. For the firm hedging foreign
exchange risk
a. With sizable unrealized gains.
b. With foreign currency flows
forthcoming.
21

CURRENCY OPTIONS
2. For speculators
- profit from favorable
exchange rate changes.

22

CURRENCY OPTIONS
C. Option Pricing and Valuation
1. Value of an option equals
a. Intrinsic value
b. Time value

23

CURRENCY OPTIONS
2. Intrinsic Value
the amount in-the-money
3. Time Value
the amount the option is in
excess of its intrinsic value.
24

CURRENCY OPTIONS
4.

Other factors affecting the

value of an option
a. value rises with longer
time to expiration.
b. value rises when greater
volatility in the
exchange
rate.
25

CURRENCY OPTIONS
5.

Value is complicated by both

the home and foreign
interest
rates.
26

CURRENCY OPTIONS
D. Using Forward or Futures
Contracts:
Forward and futures
contracts are more suitable for
hedging a
known amount
of foreign
currency flow.
27

CURRENCY OPTIONS
E.

Market Structure
1. Location
a. Organized Exchanges
b. Over-the-counter
1.) Two levels
retail and wholesale
28