CHAPTER 7 FUTURES AND OPTIONS ON FOREIGN EXCHANGE

ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. Explain the basic differences between the operation of a currency forward market and a
futures market.

Answer: The forward market is an OTC market where the forward contract for purchase or sale
of foreign currency is tailor-made between the client and its international bank. No money
changes hands until the maturity date of the contract when delivery and receipt are typically
made. A futures contract is an exchange-traded instrument with standardized features
specifying contract size and delivery date. Futures contracts are marked-to-market daily to
reflect changes in the settlement price. Delivery is seldom made in a futures market. Rather a
reversing trade is made to close out a long or short position.

2. In order for a derivatives market to function most efficiently, two types of economic agents
are needed: hedgers and speculators. Explain.

Answer: Two types of market participants are necessary for the efficient operation of a
derivatives market: speculators and hedgers. A speculator attempts to profit from a change in
the futures price. To do this, the speculator will take a long or short position in a futures contract
depending upon his expectations of future price movement. A hedger, on-the-other-hand,
desires to avoid price variation by locking in a purchase price of the underlying asset through a
long position in a futures contract or a sales price through a short position. In effect, the hedger
passes off the risk of price variation to the speculator who is better able, or at least more willing,
to bear this risk.

3. Why are most futures positions closed out through a reversing trade rather than held to
delivery?

Answer: In forward markets, approximately 90 percent of all contracts that are initially established
result in the short making delivery to the long of the asset underlying the contract. This is natural
because the terms of forward contracts are tailor-made between the long and short. By contrast,
only about one percent of currency futures contracts result in delivery. While futures contracts are
useful for speculation and hedging, their standardized delivery dates make them unlikely to
correspond to the actual future dates when foreign exchange transactions will occur. Thus, they are
generally closed out in a reversing trade. In fact, the commission that buyers and sellers pay to
transact in the futures market is a single amount that covers the round-trip transactions of initiating
and closing out the position.

4. How can the FX futures market be used for price discovery?

Answer: To the extent that FX forward prices are an unbiased predictor of future spot exchange
rates, the market anticipates whether one currency will appreciate or depreciate versus another.
Because FX futures contracts trade in an expiration cycle, different contracts expire at different
periodic dates into the future. The pattern of the prices of these contracts provides information
as to the market’s current belief about the relative future value of one currency versus another
at the scheduled expiration dates of the contracts. One will generally see a steadily
appreciating or depreciating pattern; however, it may be mixed at times. Thus, the futures
market is useful for price discovery, i.e., obtaining the market’s forecast of the spot exchange
rate at different future dates.

5. What is the major difference in the obligation of one with a long position in a futures (or
forward) contract in comparison to an options contract?

Answer: A futures (or forward) contract is a vehicle for buying or selling a stated amount of
foreign exchange at a stated price per unit at a specified time in the future. If the long holds the
contract to the delivery date, he pays the effective contractual futures (or forward) price,
regardless of whether it is an advantageous price in comparison to the spot price at the delivery
date. By contrast, an option is a contract giving the long the right to buy or sell a given quantity
of an asset at a specified price at some time in the future, but not enforcing any obligation on
him if the spot price is more favorable than the exercise price. Because the option owner does
not have to exercise the option if it is to his disadvantage, the option has a price, or premium,
whereas no price is paid at inception to enter into a futures (or forward) contract.

6. What is meant by the terminology that an option is in-, at-, or out-of-the-money?

Answer: A call (put) option with St > E (E > St) is referred to as trading in-the-money. If St  E
the option is trading at-the-money. If St < E (E < St) the call (put) option is trading out-of-the-
money.
PROBLEMS - SEE END OF LECTURE SLIDES FOR PROBLEMS

1. Yesterday, you entered into a futures contract to buy €62,500 at $1.50 per €. Your initial
performance bond is $1,500 and your maintenance level is $500. Below what settle price will be
the first time you get a demand for additional funds to be posted?

A. $1.5160 per €.

B. $1.208 per €.

C. $1.1920 per €.

D. $1.4840 per €.

Solution:

Alternative D.
Your performance bond must decrease in value from $1,500 to $500,00, therefore with $1,000. Your
initial futures contract value = $1.50 x €62,500 = $93,750. Since you bought the Euro’s – if the value of
the $ per € decrease, then you will make a loss. Now question is …. to what level must the value of the $
per € decrease for you to generate a loss of $1,000 and have to post additional funds? The value of your
contract should decrease to $92,750. Then calculate the value of $ per € on the decreased value of
$92,750 = $92,750/€62,500 = $1,4840.

2. Yesterday, you entered into a futures contract to buy €62,500 at $1.50/€. Your initial margin was
$3,750 (= 0.04 × €62,500 × $1.50/€ = 4 percent of the contract value in dollars). Your
maintenance margin is $2,000 (meaning that your broker leaves you alone until your account
balance falls to below $2,000). Below what settle price (use 4 decimal places) will be the first
time you get a margin call?

A. $1.4720/€

B. $1.5280/€

C. $1.500/€

D. None of the above

Solution
Alternative A.
Your performance bond must decrease in value from $1,750 to $2,000,00. Your initial futures contract
value = $1.50 x €62,500 = $93,750. Since you bought the Euro’s – if the value of the $ per € decrease,
then you will make a loss. Now question is …. to what level must the value of the $ per € decrease for
you to generate a loss of $1,750 and have to post additional funds? The value of your contract should
decrease to $92,000. Then calculate the value of $ per € on the decreased value of $92,000 =
$92,0000/€62,500 = $1,4720.

3. Today's settlement price on a Chicago Mercantile Exchange (CME) Yen futures contract is
$0.8011/¥100. Your margin account currently has a balance of $2,000. The next three days'
settlement prices are $0.8057/¥100, $0.7996/¥100, and $0.7985/¥100. (The contractual size of
one CME Yen contract is ¥12,500,000). If you have a short position in one futures contract, the
changes in the margin account from daily marking-to-market will result in the balance of the
margin account after the third day to be

A. $1,425.

B. $2,000.

C. $2,325.

D. $3,425.

Solution:

Alternative C.
You have a short position in ¥12,500,000. Thus you sold ¥. If the value of the $ increase per ¥, then you
make a profit and vice-versa. In day one the value of the $ decreases and in days two and three the
value of the $ per ¥ increases. In day one: Decrease with .0046/¥100. Loss = -0.0046 x (12,500,000/100)
=-$575.00. In day two increase with 0.0061. Profit = 0.0061 x (12,500,000/100) =$762.50. In day three
increase with 0.0011. Profit = 0.0011 x (12,500,000/100) =$137.50.
Balance of margin account: $2,000 - $575,00 + $762.50 + $137.50 = $2,325.00
4.Suppose you observe the following 1-year interest rates, spot exchange rates and futures prices.
Futures contracts are available on €10,000. How much risk-free arbitrage profit could you make on 1
contract at maturity from this mispricing?

A. $159.22

B. $153.10

C. $439.42

D. None of the above

Solution:

Alternative A.

Compare futures price of dealer with own futures price that you calculate based on IRP:

F360($/€ = $1.45 x (1 +.04)/ €1 x (1 + .03) = 1.4641

The futures price of $1.48/€ is above the IRP futures price of $1.4641/€ - it means the forward value of
the $ per € is lower in the forward quote of the dealer than in the IRP calculations (value of € to high).
Therefore, we want to sell (i.e. take a short position in 1 futures contract on €10,000, agreeing to sell
€10,000 in 1 year for $14,800).

To hedge we will have to borrow $ at 4% interest, convert into €, invest the € at 3% and sell the € at
$1.48/€1.

First question: How much € do we have to buy now? Sufficient € to increase to €10,000 when it has to
be delivered in terms of forward contract. Therefore discount €10,000/(1+0.03) = €9,708.74. Thus we
need to borrow €9,708.74 x 1.45 = $14,077.67 to buy the €9,708.74 now.

At maturity, our investment matures and pays €10,000, which we sell for $14,800, and then we repay
our dollar borrowing with $14,640.78 ($14,077.67 x (1.04). Our risk-free profit = $159.22 = $14,800 -
$14,640.78.
5. The current spot exchange rate is $1.55 = €1.00 and the three-month forward rate is $1.60 = €1.00.
Consider a three-month American call option on €62,500 with a strike price of $1.50 = €1.00.
Immediate exercise of this option will generate an instant payoff of

A. $6,125.

B. $6,125/(1 + i$)3/12.

C. negative payoff, so exercise would not occur.

D. $3,125.

Solution:
Alternative D.

The value of the option – you can buy for $1.50 x €62,500 = $93,750. The value of the €62,500 =
$96,875. Profit = $3,125.

6. The current spot exchange rate is $1.55 = €1.00 and the three-month forward rate is $1.60 =
€1.00. Consider a three-month American call option on €62,500. For this option to be considered
at-the-money, the strike price must be

A. $1.60 = €1.00

B. $1.55 = €1.00

C. $1.55 × (1 + i$)3/12 = €1.00 × (1 + i€)3/12

D. none of the above

Solution:

Alternative B.
An option can only be at the money when the spot price and strike prices are exactly the same …
assume that no premium exists.