CHAPTER 5

FOREIGN EXCHANGE DERIVATIVES

A derivative is a financial instrument whose payoff depends on the underlying

asset.

In the case of a FX derivative, the underlying asset is the foreign exchange rate(s) of
two (or more) currencies.

These instruments are commonly used for:

- Currency speculation and arbitrage or
- Hedging foreign exchange risk.

The main FX derivatives are currency futures and currency options.

International Finance (MA60) Chapter 5 / 1

1. Currency futures

Currency futures contracts are standardized and easily transferable obligation

between two parties to exchange currencies at a specified rate during a specified
delivery month:
- Standardized contract on specified underlying currencies
- In multiple standard amounts
- These contracts are purchased and traded on a regulated exchange on which
margin are posted.

Currency futures contracts are legally binding and counterparties that are still
holding the contracts on the expiration date must trade the currency pair at a specified
price on the specified delivery date.

But because currency futures contracts are marked-to-market daily, investors can
exit their obligation to buy or sell the currency prior to the contract's delivery date.
This is done by closing out the position.

Exchanges
• NYSE LIFFE (London International Financial Futures Exchange)
• EURONEXT Derivatives
• IMM (International Monetary Market) – part of CME Group (Chicago
Mercantile Market)
• SIMEX (Singapore International Monetary Exchange)
• TIFFE (Tokyo International Financial Futures Exchange)
• CFFEX (China Financial Futures Exchange) à Shanghai
• ….

EURONEXT Amsterdam Derivative markets

Euronext offers six cash-settled FX contracts listed on the Euronext Amsterdam Derivatives
Market:
Euro/Dollar Futures (FED)
Euro/Dollar Options (EDX)
British Pound/Euro Futures (FPE)
British Pound/Euro Options (PEX)
British Pound/Dollar Futures (FPD)
British Pound/Dollar Options (PDX)

Euronext’s currency derivatives have the benefits of being exchange-traded and therefore centrally
cleared through LCH Clearnet (LCH Clearnet provides clearing services for the continental business
of Euronext Derivatives Markets for a broad range of futures and options contracts covering equities,
indexes, commodities and currency derivatives) .
Source: Euronext & LCH Clearnet

International Finance (MA60) Chapter 5 / 2

(1) Characteristics of currency futures contracts

The characteristics of currency futures contracts are defined by each Exchange.

Here is an example of EUR/USD Futures listed on CME:

- Notional amount : 125.000 EUR
- Exchange rate quotation : American quotation
- Contract Month Listings: twenty months in the March quarterly cycle (Mar, Jun, Sep,
Dec)
- Last Trading Day Trading: ceases at 9:16 a.m. CT on the second business day
immediately preceding the third Wednesday of the contract month (usually Monday).
- Ticker Symbol: CME Globex Electronic Markets: 6E / CME ClearPort: EC
- Settlement : Physical delivery
- Minimum Price Fluctuation (Tick): Trading can occur in $.00005 per euro
increments
- Clearing : CME ClearPort

Comparison between futures and forward contracts

Source : EITMAN (2008), Gestion et finance internationales

International Finance (MA60) Chapter 5 / 3

(2) Position, marked to market, collateral and maintenance margin

Example:
Buy 1 EURUSD future on CME (trade date 29/2/2008 - notional amount 125.000EUR - price:
1,5185 EURUSD)

Collateral: 2835 USD

Maintenance margin: 2100 USD

Date Price Rate Contract P&L Deposit1 Margin CR USD Deposit2

EURUSD Differential Value in USD(2) (3) call
USD(1)

29/2 1,5185 189 812,5 2835 2835

3/3 1,5140 -0,0045 189 250 -562,5 2272,5 No (4) 2272,5

4/3 1,5100 -0,0040 188 750 -500 1772,5 Yes (5) 2835
1062,5

5/3 1,5130 +0,0030 189 125 +375 3210 No 375 2835

Settlement 1,5160 +0,0030 189 500 +375 3585 No 375 2835

Source : Marchés des changes, P. Fontaine, Pearson, 2011

1. Notional * future quotation

2. Notional * price differential (P&L generated by marketed to market)
3. Collateral + maintenance margin + P&L
4. No : deposit1 > 2100 USD
5. Yes : deposit1 < 2100 USD (maintenance margin amount 2835- 1772,5 =
1062.5)

At settlement, 189 812,5 USD you owe, are split as follows:

• Paid: 2835 (collateral)+ 1062, 5 (maintenance margin) USD

• Received : 375 + 375 USD
• Balance paid at settlement : 189 500 USD – 2835 USD = 186 665 USD
• Total paid : 189 812,5 USD

Return on initial investment (2835 USD):

If EURUSD spot rate = 1,5185
• Loss : 750 - 1062,5 = - 312,5 USD
• Return : (- 312,5 /2835) x 100 = - 11,02%
• % underlying spot rate (direct quotation) : ((Final rate – Initial rate)/ Initial
rate) x 100 = 0,1646%
• Leverage: a small change in the underlying generate a great loss.

International Finance (MA60) Chapter 5 / 4

(3) Price of a CCY future and basis

Future price

1+ 𝑖 𝐷
F=Sx[ ]
1+𝑖 𝐹

Example:
1 year EURUSD future
Spot EURUSD: 1,5
Annual USD interest rate: 3%
Annual EUR interest rate: 5%

F = 1,5 x [1,03/1,05] = 1,4714

Basis and basis risk

The spot price and the futures price do not always converge. The amount by which the
two quantities differ measures the value of the basis risk.

B=F-S

International Finance (MA60) Chapter 5 / 5

(4) Hedging and speculating with currency futures

Reminder
- Buy a ccy future (long position) : we have an obligation to buy ccy
- Sell a ccy future (short position) : we have an obligation to sell ccy

FX risk hedging
A US importer needs EUR to buy merchandise (payment in 3 months):
- He can buy a 3 months EURUSD future (long position)
- The exchange rate is fixed as in a forward contract

A US exporter is expecting a payment in EUR in 6 months’ time:

- He can sell a 6 months EURUSD future (short position)

Speculation
Spot rate EURCAD : 1.47741 (26/2/2016)
Euro/Canadian Dollar Futures Quotes (contract unit : 125 000 EUR) :
Prior
Month Charts Last Change Settle Open High Low Volume Hi / Low Limit Updated

MAR 16:33:19 CT
Show Price Chart 1.4790 +0.0004 1.4786 1.4919 1.4949 1.4772 163 1.5186 / 1.4386
2016 26 Feb 2016

Source : cmegroup.com

If a trader thinks that the CAD is going to appreciate against EUR in March.
- Buy CAD today and sell later (March) when CAD has risen
- If CAD has appreciated, he will make a profit (=notional amount x (Future price –
spot price at maturity).
- Otherwise, he will have to liquidate his position and record a loss.

If a trader thinks that the CAD is going to depreciate against EUR in March.
- Sell CAD today and buy later (March) when CAD has fallen
- If CAD has depreciated, he will make a profit (=notional amount x (Future price –
spot price at maturity)
- Otherwise, he will have to liquidate his position and record a loss.

International Finance (MA60) Chapter 5 / 6

2. Currency options

(1) Definition and characteristics

Definition
A foreign exchange option (FX option or currency option) is
a derivative financial instrument that gives the right but not the obligation to exchange
money denominated in one currency into another currency at a pre-agreed exchange
rate on a specified date. There are 2 types of options1:
- Call option: gives a right to buy
- Put option: gives the right to sell

The holder of the FX option can exercise the option or not (uses his right to buy or
sell). The writer or grantor must execute the contract.

Characteristics of FX options
- Notional amount: amount of the contract
- Strike price: FX rate at which the currency is bought or sold
- Premium: price of the option
- Underlying: spot rate
- Trade date: date at which the contract is concluded
- Maturity date/expiration date: date at which the option expires

American and European options

- American options can be exercised anytime between trade date and maturity
date
- European options can only be exercised at maturity date

OTC and Exchange-traded options

- OTC: Over the counter options, the premium is a % of the notional amount
- Exchange-traded options: the premium is quoted in currency units

1
These are “Vanilla options” but there are other options much more complex called “exotic options” such as
Barrier options, Asian options, Digital options and Compound options.

International Finance (MA60) Chapter 5 / 7

Example: EURO/ US dollar options quoted on Euronext Amsterdam
EURO / US DOLLAR OPTIONS (EDX)
Unit of trading 100
Quotation US dollars per € 100
Minimum price movement (tick size and value) Central Order Book and Large-in-Scale Facility: $
0.01 ($1 per contract)
Last trading day Trading ceases at 14:15 CET on the third Friday of the
expiry month. In the event that the third Friday is not
a business day, the Last Trading Day shall normally
be the last business day preceding the third Friday
Exchange delivery Settlement Price (EDSP) Price determined on the Last
Trading Day based on the EUR/USD rate set by the
European Central Bank at 14:15 CET and rounded to
four decimal places.
Last update Mon, 01/02/2016
Trading Hours Central Order Book 09:00 – 17:30 CET
Large in Scale Facility: 07:00 – 18:30 CET
Trading platform UTP
Full contract specification and related documentsContract Specifications Currency derivatives as from
19 June 2015Euronext Wholesale Facilities
Algorithm Central order book applies a price-time trading
algorithm with priority given to the first order at the
best price. Depending on the outcome of the Liquidity
Provider auction, in certain classes Price/Time
preferencing can be active, which means that Primary
Market Makers (PMM) have a right to a certain
percentage of the turnover traded at the PMM’s best
bid or offer
Wholesale service Large-in-Scale Facility. See the “Euronext Wholesale
Facilities” document for the minimum size thresholds
Clearing LCH.Clearnet S.A.
Exercise day Exercise until 19:45 CET on Last Trading Day only
Expiry months 1, 2, 3 monthly; 6, 9, 12 months quarterly (of the
March, June, September, December cycle)
Option style European style
Holders of long positions are only entitled to exercise
their options on the expiration date.
Settlement Cash Settlement based on the EDSP
Settlement day First business day after the Last Trading Day
Contract Size € 10,000

On the Last Trading Day, in-the-money options are automatically exercised, unless contrary instructions
are received from the client/member. Please check the exact exercise rules with your broker.

Source: derivatives.euronext.com

International Finance (MA60) Chapter 5 / 8

(2) Profit and loss

BUY a EURUSD CALL

A US importer wants to hedge his FX risk (appreciation of EUR). To do so, he can buy
a CALL.
- Premium: 0,10 (1000 USD)
- Strike: 1,40
- Trade date: 7 September 2010
- Maturity date : 7 June 2011
- Notional amount : 10 000 EUR

At maturity
- If spot rate > 1, 40 -> option is ITM, profit is unlimited
- If spot rate < 1, 40 -> option is OTM, loss is limited to the value of the
premium. Indeed, the importer will not exercise the CALL and will buy EUR at
the current spot rate.

Profit and loss diagram Profit = [(Spot - Strike) x notional] - prime

ATM (at the money): strike = spot rate

ITM (in the money): option gives a profit if exercised (without taking into account the
premium)
OTM (out the money): option gives a profit if exercised.

Remark: the diagram of the seller of a call is symmetrical (profit is limited to the
premium and loss is unlimited).

International Finance (MA60) Chapter 5 / 9

BUY a EURUSD PUT

A US exporter wants to hedge his FX risk (depreciation of EUR). To do so, he can buy
a PUT.
- Premium: 0,10 ( 1000 USD)
- Strike: 1,40
- Trade date: 7 September 2010
- Maturity date : 7 June 2011
- Notional amount : 10 000 EUR

At maturity
- If spot rate < 1, 40 -> option is ITM, profit is unlimited
- If spot rate > 1, 40 -> option is OTM, loss is limited to the value of the premium.
Indeed, the exporter will not exercise the PUT and will buy EUR at the current
spot rate.

Profit and loss diagram Profit = [(Strike - Spot) x notional] - prime

Remark: the diagram of the seller of a PUT is symmetrical (profit is limited to the
premium and loss is unlimited).

International Finance (MA60) Chapter 5 / 10

(3) Option pricing: intrinsic value and time value of an option

An option premium has 2 components: an intrinsic value and a time value.

Intrinsic value

The intrinsic value is the difference between the underlying's price and the strike price.
CALL: Max (0; S-Strike) = 0 if S ≤ Strike (option is OTM or ATM)
= (S-Strike) if S > Strike (option is ITM)

PUT: Max (0; Strike-S) =0 if S ≥ Strike (option is OTM or ATM)

= (Strike-S) if S < strike (option is ITM)

Time value

The time value is the speculative value of an option (expectation that the underlying
spot rate will move “above” the strike price. Here are some characteristics of the time
value:

- The time value increases with the volatility

- The time value increases with uncertainty
- The further away from the maturity, the higher the time value is
- If the spot rate moves far away from the strike price, the time value decreases

Remark

At maturity, the option value is equal to its intrinsic value because the time value is
equal to 0.

International Finance (MA60) Chapter 5 / 11

(4) Option pricing: Black-Scholes and Garman-Kohlhagen

Black-Scholes (1973) was the first model used to calculate the theoretical value of a
European stock option.

Garman and Kohlhagen adapted this model to currency options in 1983.

1. Black & Scholes

Variables
Calculation date (t)
Underlying rate (S)

Parameters
Strike price (K)
Composed interest rate (r)
Composed dividend rate (q)
Maturity date (T)
Volatility of the underlying (σ)

Value of a CALL with a maturity date (τ = T – t)

C = exp ( - q.τ ) . S . N( d1 ) - exp ( - r.τ ) . K . N( d2 )

With
d1 = [ Ln( S/K ) + ( ( r-q + 0.5σ² ).τ )] / ( σ√τ )
d2 = [ Ln( S/K ) + ( ( r-q - 0.5σ² ).τ )] / ( σ√τ ) = d1 - ( σ√τ )

N(.) normal cumulative density function

N( d1 ) = ∫ [ ((1 / ( √2п )) . exp( -z²/2 ) ] dz, integral function calculated between –inf
and d1

Value of a PUT with a maturity date ( τ = T – t)

P = - exp ( - q.τ ) . S . N( - d1 ) + exp ( - r.τ ) . K . N( - d2 )

International Finance (MA60) Chapter 5 / 12

2. Garman-Kohlhagen
When a currency is kept as a financial asset, it brings a revenue similar to a dividend
which is equal to the composed interest rate of the currency bought. Short currency
positions have a borrowing cost equal to the composed interest rate of the currency
sold.
For example if you buy a call EUR/USD:
- you buy EUR and receive a EUR interest rate on your EUR position and
- sell short USD: you borrow (at a USD interest rate) to sell USD short.

In 1983 Garman and Kohlhagen adapted Black and Scholes model to currency options.

Variables
Calculation date (t)
Underlying rate (S)

Parameters
Strike price (K)
Composed interest rate of the sold currency (r)
Composed interest rate of the bought currency (rf)
Maturity date (T)
Volatility of the underlying (σ)

Value of a CALL with maturity date (τ = T – t)

C = exp ( - rf.τ ) . S . N( d1 ) - exp ( - r.τ ) . K . N( d2 )

With
d1 = [ Ln( S/K ) + ( ( r-rf + 0.5σ² ).τ )] / ( σ√τ )
d2 = [ Ln( S/K ) + ( ( r-rf - 0.5σ² ).τ )] / ( σ√τ ) = d1 - ( σ√τ )

N(.) normal cumulative density function

N( d1 ) = ∫ [ ((1 / ( √2п )) . exp( -z²/2 ) ] dz, integral function calculated between –inf
and d1

Value of a PUT with maturity date (τ = T – t)

P = - exp ( - rf.τ ) . S . N( - d1 ) + exp ( - r.τ ) . K . N( - d2 )

Example

CALL GBP/EUR : Strike 1.80 ; GBPEUR spot rate 1.60 ; EUR interest rate 8% ; GBP
interest rate 11% ; time to maturity 182.5 days

Value of the CALL 0.02136 EUR.

International Finance (MA60) Chapter 5 / 13

(5) Greeks

The greeks measure of the sensitivity of an option’s price to different factors. The four
most commonly used greeks: delta, gamma, theta and vega.
Delta Measures the exposure of option price to movement of underlying spot rate (0-1)
Gamma Measures the exposure of the option delta to the movement of the underlying
Theta Measures the exposure of the option price to the passage of time
Vega Measures the exposure of the option price to changes in volatility of the underlying
Rho Measures the sensitivity of the option price to a change in domestic interest rate
Phi Measures the sensitivity of the option price to a change in foreign interest rate

Example
90 days GBPUSD CALL
Strike: 1,70
Premium (P0) : 0,033 USD

When the option is ATM (the underlying rate is equal to the strike), the delta is equal
to 0,5

If the spot rate moves from 1,70 to 1,71, the option is in the money, it’s value increase.
The Prime (Pt) is now worth 0,039. The delta is 0.6

𝛥 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 0,039 − 0,033

𝐷𝑒𝑙𝑡𝑎 = = = 0.6
𝛥 𝑠𝑝𝑜𝑡 1,71 − 1,70

The delta of a call varies between 0 and 1. When the delta is high, there is a high
probability that the option will be ITM at maturity.
If the option is ATM, delta of a call = 0.5
If the option is ITM, delta of a call > 0.5
If the option is OTM, delta of a call < 0.5

The premium (price of the option) varies with the number of days. The original
number of days is 90 days (n=90 and P0 = 0,033 USD); the following days n = 89
and the premium has lost value: P =0, 0328 USD.

𝛥 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 0,033−0,0328
𝑇ℎ𝑒𝑡𝑎 = = 𝑥 100 = 0,02 𝑐𝑒𝑛𝑡𝑠 (Loss of 0,02 cents)
𝛥 𝑡𝑖𝑚𝑒 90−89

The option loses most of its value during the last 30 days. For example, from n=15 to
n=14

𝛥 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 0,0137−0,0132
𝑇ℎ𝑒𝑡𝑎 = 𝛥 𝑡𝑖𝑚𝑒
= 90−89
𝑥 100 = 0,05 𝑐𝑒𝑛𝑡𝑠 (Loss of 0,05 cents).

International Finance (MA60) Chapter 5 / 14

(6) Option strategies

Basic strategies
- Buy a call
- Buy a put
- Sell a call
- Sell a put

Examples of combined strategies

- Straddle : buy a call and a put with the same strike
- Strangle : buy a call and a put with a strike < strike of the call
- Spread : buy 2 calls
▪ bull call spread : buy a call and buy another call with Strike > initial strike
▪ bear call spread : buy a call and buy another call with Strike < initial strike

- Butterfly : buy 2 call and sell 2 call

International Finance (MA60) Chapter 5 / 15

3. Exercises

• Expliquer la notion de produit dérivé et de sous-jacent. Donner un exemple d’un

produit dérivé de taux de change.
• Quels sont les différences entre un contrat forward et un future de devises ?
• Expliquer les caractéristiques d’un future de devises.
• Comment un exportateur peut-il se couvrir du risque de change à l’aide d’un
future ?
• Comment un importateur peut-il se couvrir du risque de change à l’aide d’un
future ?
• Qu’est-ce qu’un call ?
• Qu’est-ce qu’un put ?
• Expliquer la couverture du risque de change à l’aide d’un call. A quoi ressemble
le profil de P&L (profit & loss) pour l’acheteur.
• Expliquer la couverture du risque de change à l’aide d’un put. A quoi ressemble
le profil de P&L (profit & loss) pour l’acheteur.

International Finance (MA60) Chapter 5 / 16