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CHAPTER III: CURRENCY OPTION GREENSHOE MARKETS

An option is a financial instrument that gives the holder, in return for the payment of a premium, the
right to buy (call option) or sell (put option) a given financial asset at a given price and at a given
time.
The call option is called "Call option".
The put option is called "Put Option".

Position Type Implications Maximum Maximum Risk

Gain
Purchase option Right to buy the Unlimited in Premium
currency case of increase
Courses
Buy Put option Right to sell the Very high Premium
currency
Purchase option Obligation to Premium High in the
sell currency on event of a rise in
exercise prices
Sale
Put option Obligation to Premium Very high
buy the currency
on exercise

A- Participants in the options market

There are several categories of participants in the options markets. Traders or Hedgers are
exporters, importers, banks who want to protect themselves against a currency risk and international
investors who want to guarantee the value of their portfolio:
 Companies with uncertain future cash flows
 Financial institutions that profit from the market by taking risks and selling options.
 Arbitrageurs who make profits from distortions in different markets.
 Speculators who intervene in the market based on their expectation of
Volatility.

B- Characteristics of currency options.

An option in the OTC markets is a contract between two parties. This contract gives the buyer
the right, but not the obligation, to buy (call option) or sell (put option) a certain amount of currency at
a pre-determined price during a specified period of time or on a specified date. The buyer of an option
wishes to avoid a risk and the seller is willing to assume that risk.
A call option allows the buyer to buy currency A against currency B. A put option allows the
buyer to sell currency A against currency B. There is a difference between European options and
American options. For European options, the right to exercise can only be exercised on the expiration
date. For American options, the right to exercise can be used during the entire life of the options.
Option contracts have a number of characteristics.
NB: The premium is what you buy, i.e. the cost of the option.
 It is the option buyer who chooses to exercise or not to exercise his option. To have this right,
he pays the option writer a premium or option price. On the other hand, the seller of an option has the
obligation to sell or buy a certain amount of currency at the agreed price if the option buyer exercises
his option right in time. The situation of the option buyer is different from that of the option writer.
The buyer has a risk of loss limited to the amount of the premium and a probability of gain
unlimited. The option writer has a risk of unlimited loss and a probability of gain limited to the
premium. The other characteristics of an option contract are as follows:
1) The amount of the contract
In the OTC markets, the contract amount is in the order of USD 5 million; in the interbank
markets, the amounts can exceed USD 100 million.
2) Currencies processed
The currencies traded in this market are those found in the spot or forward market
3) Exercise prices
The price of the currency fixed in the contract is called the "strike price". This price is chosen
by the buyer and is usually close to the spot or forward price.
4) The premium
It is the price of the option that is paid at the beginning by the buyer to the seller. It remains a
given for the seller who, in return, undertakes to submit to the buyer's decision. This premium is
expressed as a percentage and is applied to the contract amount.
5) The due date
The duration of an option varies depending on the contract. It can be up to 5 years. The
currency delivery takes place 2 working days after the exercise date.
Options can be resold or bought back, allowing the buyer or seller to dispose of his rights and
obligations before expiration. But the option itself does not expire until it is exercised or expires.

C- Options quotations
Premiums are determined as a percentage of the transaction amount. Payment can be made in
foreign or domestic currency. Exercise prices are at the buyer's discretion for some contracts, while
they are subject to close negotiation for others.
The premium is composed of two elements: the intrinsic value and the time value.

1. The intrinsic value

Option premium = intrinsic value + time value.
The intrinsic value of the option represents the gain that the option buyer would obtain if he
immediately exercised the option contract. It is calculated differently depending on whether the option
is American or European. At expiration, the only value of the option is its intrinsic value. If at that
date it has no intrinsic value, it is zero.
 Purchase option
The intrinsic value of an American option is equal to the difference between the spot price and
the strike price because the option can be exercised at any time.
The intrinsic value of a European option is equal to the difference between the forward price
and the strike price because the option can only be exercised at maturity.
The American option: VI=CC-PE

2
 The European option: VI=CT-PE
The intrinsic value of an option is either positive or zero.
If, we have the strike price PE USD/FRF=5.0000
The forward rate is: USD/FRF=5.4800
The intrinsic value: IV = 5.4800-5.000 =0.48
CT =4.8518 VI = 4.8518-5.000 < 0 we say it is zero. This is a European option.

 Put option.
The intrinsic value of an American put option is the difference between the strike price and the
spot price: VI=PE-CC
Then the intrinsic value of a European put option is the difference between the strike price and
the forward price: VI=PE-CT.

 In-currency, out-of-currency or forward option.

An option is said to be in the money when the exchange rate is higher than the strike price
(call) or lower than the strike price (put).
An option is said to be out of the money when the exchange rate is lower than the strike price
(Call) or higher than the strike prices. (Put)
An option is said to be in the money when the exchange rate is equal to the strike price. For
example: for a call option that allows you to buy the dollar at 5,2000 FRF, if the dollar on the market
quotes 5.5000 FRF, we will say that it is an option in the money.
If, on the contrary, the dollar is worth 5.2000 FRF, it is said to be an option at the currency or at
parity.
If the dollar is 5.0150 FRF, it is said to be an out-of-the-money option.
It is obvious that an in-the-money option is more expensive than an out-of-the-money option
since it allows for a profit.

2- Time value
The time value or extrinsic value of the option is the difference between the option price and
the intrinsic value.
VT=Price-VI

The time value includes 3 components:

 The remaining term to maturity,
As the option approaches the expiration date, the time value decreases. On the expiration date
the option has a time value of zero and has only an intrinsic value.
 The interest rate differential between the currencies for the term corresponding to the maturity
of the option.
 The volatility of the underlying or support currency (this is the currency in which the option
transactions take place)
The greater the volatility and the higher the probability of the option being exercised, the
higher the premium.

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 Example: if the dollar is quoted at 5.5000FRF (USD/FRF) and the annual volatility is 12%, we
can estimate that after one year, the dollar will be traded between 5.5000 (1+0.12) and 5.5000 (1-
0.12), i.e. between 6.1600 and 4.8400.
After 2 years, the dollar will be traded between 5.5000 (1 + 0.12 x 2) and 5000 (1- 0.12 x 2).
Or between 6.18200 and 4.1800 and so on
A good estimate of the volatility is essential to determine the value of the option. An underestimation
of the volatility would lead to an underestimation of the premium and would put the option writer at
great risk.
When the annual volatility is known, the daily volatility is estimated by dividing it by the
square root of the number of annual trading sessions. That is, the number of business days.
The number of working days is estimated at 256.

So; 12% and 12% = 0.75%.

Volatility calculation; 5.5 (1 + 0.75%) and 5.5 (1 + 0.75%)

That is, 5.5413 and 5.4587.
To estimate the weekly volatility, the annual volatility is calculated as the square root of the
number of weeks in the year.
12%
√ 52 = 1.66% 5.5(1+1.66%) and 5.5(1-1.66%)
That is, 5.5913 and 5.4087.

D- The different option strategies.

The Option Strategies can respond to different market expectations of the currency's price
movement and volatility.

1- Anticipation of a rise in the underlying currency

The purchase of a call option can allow the buyer to make a profit if the increase in the
currency's price is greater than the strike price plus the premium. This can be illustrated through a
chart

Profit
0
Premium
Unlimited Gain
(Exercise price)PE

Neutral point Currency rate

Underlying

This curve explains the call buyer's position.

Profit = (currency rate) - (strike price) - (premium).

4
 The buyer of a "call" or "put" option has a risk of loss limited to the amount of the premium
paid and unlimited possibilities of gain.
In contrast, the seller of a call option has a chance of gain limited to the amount of the
premium and an unlimited risk of loss. The chart below shows the position of a call writer.

Profit

Neutral point
Premium
O

Unlimited loss
PE Underlying currency rate

Reverse situation

APPLICATION 1: EXCHANGE RATE PROTECTION AND THE PURCHASE OF

A CALL OPTION
The technique traditionally used to protect against a rising exchange rate is the purchase of call
options. It is well suited to the hypothesis of a significant rise in the currency rate. On the other hand,
in the event of a moderate rise, it is preferable to resort to the sale of put options.
On 10 October, the US pharmaceutical company Pfizer buys biochemicals from a Swiss supplier for
CHF 1,700,000 to be paid within 90 days. Fearing a rise in the value of the CHF against the dollar, the
importer decides to hedge with call options on the over-the-counter market. On 10 October the rate is
1 CHF = USD 0.8110. This means that the price of the goods in dollars is: 1700,000 x 0.8110 =
1,378,700
Pfizer chooses a 3-month European option with a strike price as close as possible to the spot price.
The price chosen is USD 0.81 and the option is priced at 3.5 cents USD per CHF, i.e. USD 0.035 per
CHF.
As the nominal value of the option is CHF 1,700,000, the dollar amount of the contract is:
1700,000x0.81= 1,377,000 USD
The premium is paid either in domestic currency or in foreign currency. The amount in USD is:
1700,000 x 0.035 = 59,500 USD. This amount corresponds to 59500/0.81=73456.8CHF

On January 10, two possibilities exist: a rise or a fall of the CHF.

CASE OF A RISE IN THE CHF

Let's assume that on 10 January the exchange rate is 1 CHF = USD 0.8630.
This increase leads Pfizer to exercise its option. It could not go to the market to buy Swiss francs more
expensive than the opportunity offered by the option contract.

5
 because the USD has fallen and he has to pay out CHF (which have become more expensive) if he
had left his position unhedged. On the basis of a strike price of 1 CHF = USD 0.81, the price of the
1,700,000 CHF is :
1,700,000 x (0.81+0.035) = 1,436,500 USD. That is, 1377,000 + 59500 = 1,436,500 USD
Without hedging, the purchase price of the Swiss francs would have been : 1700,000 x 0.8630 = USD
1467100
The importer would therefore have suffered a loss of : 1,7000,000 x (0.8630-0.8110) = USD 88400 if
he had left his position unhedged.
However, the coverage is not free. The cost of the protection is the premium that was paid when the
option was purchased, plus the spread between the strike price of the option and the spot price of the
CHF (a little higher here). If this difference is >0 it is a cost, and if it is <0 it is a gain because the
strike price makes it possible to buy cheaper than the spot price: 0.035 + (0.81 - 0.8110) = 0.0340
USD per CHF
1,700,000 x (0.035 + (0.81 - 0.8110)) = USD 57,800 of the total
So overall the use of this option has reduced the exchange losses by :
88,400 - 57,800 = USD 30,600, which would have been 88,400-59500= 28,900 if the exercise price
had been equal to the spot price on October 10.
The importer could have given himself more room to manoeuvre by purchasing not a European option
with the same maturity as his debt, but an American option with a longer maturity. Since the
American option is more expensive, the cost of hedging would have been higher, but this strategy
would have given the importer a second option if prices rose.
Indeed, instead of exercising its option, Pfizer could have bought on 10 January CHF 1 700 000 on the
spot market and simultaneously sold its call option to compensate for its purchase on 10 October. The
importer would then have incurred a loss on the spot market, but this could have been offset, at least
partially, by selling the US call option with a longer maturity.
With a spot exchange rate on January 10 of 1 CHF = USD 0.8630, the option is clearly in the money,
as it gives the possibility to buy CHF on the basis of 1 CHF = USD 0.81 while it is worth USD 0.8630
in spot.
The outcome of such a strategy, however, depends on the prices at which the option is bought and
then sold. And since this option is exactly what Pfizer needs at that time, the only potential buyer of
the option on January 10 may be its bank. And the bank will be looking to avoid a loss on this
transaction.

CASE OF A FALL IN THE CHF

Let's assume that the CHF exchange rate on January 10 is 1 CHF = USD 0.7640.
This drop leads the importer to give up his option and to buy the Swiss francs (which have become
cheaper in USD terms) at spot prices on 10 January. He then obtains: 1700,000 x 0.7640 = 1,298,800
USD
This represents a cost after taking into account the premium paid :
1 2S8 800 + 59 500 = 1 358 300 USD (59 500 = 1 700 000 x 0.035)
Again, if he had purchased an American option with a maturity longer than the debt, the importer
could have considered selling it instead of abandoning it. However, the profit from this transaction
would not have been very large, as the option is out of the money at the time of the maturity of the
claim (0.7640 on 10 January), with a spot price of CHF below the strike price (USD 0.81).

6
Reminder:
A call option is said to be in the money if the underlying asset (here the CHF/USD rate) is higher than
the strike price (USD 0.81). The buyer of the option can therefore exercise it at a profit.
A call option is said to be out of the money if the underlying asset (here the CHF/USD rate) is lower
than the strike price (USD 0.81). The buyer of the option cannot therefore exercise it at a profit.
A call option is said to be at-the-money if the underlying asset (in this case the CHF/USD rate) is
equal to the strike price (USD 0.81). The buyer of the option neither gains nor loses if he exercises the
option.
Profile of the gains and losses associated with the purchase of the call option

0.8110 = spot price on October 10 0.81 exercise price

Exchange rate at Gain or loss in USD on

USD gain or loss on USD gain or loss on debt
maturity the value of the debt
purchase of call covered by call option purchase
for 1 CHF option
1 CHF = USD 0,8110- 0.72-0.035-0.81=- 0,0910 -0,035= +0,056
0.7200 0,7200=+0,0910 0.035 (because no
exercise)
1 CHF=USD 0,8110 -0,7500= 0,75-0,035-0,81=- 0,0610 -0,035= +0,026
0.7500 +0,0510 0,035
(because no exercise)
1 CHF=USD 0.776 0,811 – 0,776= + 0,035 0,776- 0,035-0,81¨=- 0,035 – 0,035=0
0,035
1 CHF=USD 0,8110 - 0,7800= 0.78-0.035-0.81=- 0,0310 -0,035= -0,004
0.7800 +0,0310 0.035 (because no
exercise)
1 CHF = USD 0,8110 - 0,8100= 0,81-0,035-0,81=- 0,0010 -0,035= -0,034
0.8100 +0,0010 0,035
1CHF= USD 0,8110-0,8400=-0,0290 0,84-0,035-0,81=- -0,0290 -0,005= -0,034
0,8400 0,005
1 CHF=USD 0,8110 -0,8700= - 0,87-0,035- -0,0590 +0,025= -0,034
0.8700 0,0590 0,81=+0,025

The graph shows the overall result of the operation, with the earnings profile of the call option
purchase in bold, the earnings profile of the CHF debt alone in dotted line and the profile of the
covered debt in thin line.

7
 The offset between-0.034 and-0.035 is 0.001, which corresponds to 0.811-0.81.
If the rate x is less than 0.81 the value of the hedged debt is :
Option loss + Debt gain - 0.035 + (0.811 - x) = 0.776 - x (maximum gain 0.776)
If the rate x is greater than 0.81 the value of the hedged debt is :
(Option loss or gain) + (Debt gain or loss) = (- 0.035 + (x - 0.81)) + (0.811 - x) = - 0.034
Crossing point between the covered debt profile and the x-axis :
Gain = 0 if 0.776 - x = 0 or x = 0.776

2- Anticipation of a decline in the underlying currency

The buyer of a put option anticipates a decline in the underlying currency. The position is
shown in the graph below.

Profit

Unlimited earnings
PE

Neutral point Underlying currency rate

0
Profit = PE - C. currency - premium

This situation is the opposite of a put option writer who may be

8
Appreciated in the graph below:

Profit

Premium

PE Underlying currency rate

Unlimited loss

The sellers of a put option have a chance of gain limited to the amount of the premium and an
unlimited risk of loss.

APPLICATION 2. PROTECTION AGAINST THE FALL OF THE EXCHANGE

RATE AND THE PURCHASE OF A PUT OPTION
The technique traditionally used to protect against a falling exchange rate is the purchase of put
options. This technique is well suited to the hypothesis of a significant drop in the currency rate. On
the other hand, in the case of a moderate decline, the sale of call options can be considered.
On September 1er General Motors (an American company) exports cars to Canada. It has a receivable
of CAD 4,000,000 with two months to maturity. Fearing a fall in the Canadian currency against the
USD, the treasurer of General Motors decides to hedge with European options on the OTC market. On
er
September 1 the spot rate is 1 CAD = USD 0.9280. The value of the goods in USD is
4000000x0.9280= 3712 000 USD
Profile of gains and losses associated with the unhedged CAD claim

9
Without hedging, General Motors makes a gain when the Canadian dollar is above 1
CAD=USD 0.9280 (a gain of 0.1 per CAD if the rate reaches 1.0280), and a loss when it falls
below this value.
But the treasurer decides to ask his bank for a European put option with a strike price as close
as possible to the spot price.
The strike price is 93 cents (0.9300 USD), and the option price (or premium) is 2.85 cents
(0.0285 USD per CAD). Since the option's par value is CAD 4,000,000, the treasurer pays the
bank a premium of : 4,000,000 x 0.0285 = 114,000 USD
On November 1, ertwo possibilities exist: the CAD can rise or fall against the USD.
A. case of a drop or CAD
Let's assume that the CAD rate on erNovember 1 is 1 CAD = USD 0.8520.
General Motors must therefore exercise its put option at a rate of 1 CAD = USD 0.93. The
price of the Canadian dollars is : 4,000,000 x (0.93 - 0.0285) = USD 3,606,000
In the absence of hedging, the selling price of the Canadian dollars would have been equal to :
4,000,000 x 0.8520 = 3,408,000 USD
The exporter would therefore have suffered a loss of : 4,000,000 x (0.9280 -0.8520) = USD
304,000
However, the coverage is not free. The cost of the protection is the premium that was paid
when the option was purchased, plus the spread between the spot price of the CAD and the
strike price of the option (a little higher here). If this difference is >0 it is a cost, and if it is <0
it is a gain because the strike price allows you to sell for more than the spot price: 0.0285
+(0.928-0.93) = 0.0265 USD for 1 CAD
4,000,000 x (0.0235 + (0.928 - 0.93)) = $106,000 total
So overall the use of this option reduced the exchange losses by; 304,000 - 106,000 = 198,000
USD.
The exporter could have given himself more room to manoeuvre by purchasing not a
European option with the same maturity as his debt, but an American option with a longer
maturity. Since the American option is more expensive, the cost of hedging would have been
higher, but this strategy would have given the exporter a second option in the event of a price
decline.
Indeed, instead of exercising its option, General Motors could have sold CAD 4 000 000 on
the spot market on erNovember 1 and simultaneously sold its put option to offset its er
September 1 purchase. The exporter would then have incurred a loss on the spot market, but
this could have been offset, at least partially, by the sale of the put option.
If the spot exchange rate on erNovember 1 is 1 CAD = USD 0.8520, the American option is
clearly profitable, as it gives the opportunity to sell CAD on the basis of 1 CAD = USD 0.93
when it is worth USD 0.8520 at spot.
The outcome of such a strategy, however, depends on the prices at which the option is bought
and then sold. However, since this option corresponds exactly to General Motors' particular
need at that time, it is possible that the only potential buyer of the option on November 1 eris
its bank. And the bank will be looking to avoid a loss on this transaction.
A put option is said to be in the money if the underlying asset (in this case the CAD/USD
rate) is below the strike price (USD 0.93). The buyer of the option can therefore exercise it at
a profit.

10
 A put option is said to be out of the money if the underlying asset (here the CAD/USD rate)
is higher than the strike price (USD 0.93). The buyer of the option cannot therefore exercise it
at a profit.
A put option is said to be at the money if the underlying asset (in this case the CAD/USD rate)
is equal to the strike price (USD 0.93). The buyer of the option neither gains nor loses if he
exercises the option.

B. Case of an increase in the DAC

Let's assume that the CAD rate on erNovember 1 is 1 CAD=USD 0.9630.
This increase leads the exporter to abandon his option and sell the Canadian dollars for cash
on erNovember 1. He then obtains: 4,000,000 x 0.9630 = 3,852,000 USD
That is, after deduction of the premium paid: 3 852 000 -114 000 = 3 738 000 USD
which represents a net gain after taking into account the premium paid
3,738,000 - 4,000,000 x 0.9280 = 3,738,000 - 3,712,000 = 26,000 USD
Again, had the exporter purchased an American option with a longer (more distant) maturity
than the debt, the exporter could have considered reselling it instead of abandoning it.
However, the profit on this transaction would not have been very large, as the option is not in
the money at the time of the maturity of the claim (1erNovember), with a spot CAD price
higher than the strike price (USD 0.93).
The purchase of the put option is profitable as soon as the Canadian dollar falls below a level
equal to the strike price minus the premium paid, i.e. 0.93 - 0.0285 = 0.9015 USD
This rate is the break-even point of the put call strategy. But if the CAD rises above USD
0.93, the company does not exercise the option and bears the hedging cost of USD 0.0285 per
CAD.
Profile of the gains and losses associated with the purchase of the put option

This strategy therefore allows the exporter to protect himself against an unfavourable rate
change (a fall in the exchange rate of the currency in which his claim is denominated, in this
case CAD), but he can also partially benefit from a favourable change in this rate (in this case
a rise in the CAD/USD).

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Profile of gains and losses on the claim covered by the purchase of a put option
spot price = 0.2280 strike price = 0.93 USD for 1 CAD.
Gain or loss in USD USD gain or loss on the
Exchange rate at USD gain or loss on the
on the value of the claim covered by the
maturity purchase of a put option
receivable per 1 CAD purchase of a put option
-0.038 + 0.0115 =--0.0265
1 CAD = USD 0,8900 - 0,9280 = - 0,93 - 0,0285 - 0,89 = and
0.8900 0,0380 0,0115 -0,0265= 0,0285+(0,928-
0,93)
1 CAD = USD 0.9000 - 0.9280 = - 0,93 - 0,0225 - 0,90 =
-0,028 + 0,0015 = -0,0285
0.9000 0.02SO 0,0015
1 CAD =USD 0,9100-0,9230 = - 0,93 - 0,0285 - 0,91 = -
-0,018 - 0,0085 = -0,0265
0.9100 0,0180 0,0085
1 CAD = USD 0,9200- 0,9220 = - 0,93 - 0,02S5 - 0,92 =-
-0,008 - 0,0185 = -0,0265
0.9200 0,0080 0,0185
1CAD = USD 0,9300 - 0,9280 = 0,93 - 0,0285 - 0,93 =-
0,002 - 0,0285 = -0,0265
0.9300 0,0020 0,0285
0.93 - 0.02S5 - 0.94 =-
1 CAD =USD 0,9400 - 0,9220 -
0.0285 (because no 0,012 -0,0235 =-0,0165
0.9400 0,0120
exercise)
0,9500-0,9280 = 0.93 - 0.0285 - 0.95 = -
1 CAD = USD
0,0220 ' 0.0235 (because no 0,022 - 0,0285 = -0,0065
0.9500
exercise)
0.93 - 0.0285 - 0.96 = -
1 CAD =USD 0,9600-0,9230 =
0.0285 (because no 0,032 -0,0285 = +0,0035
0.9600 0,0320
exercise)
0,042 - 0,0285 = +0,0135
0.93 - 0.0235 - 0.97 = -
1 CAD = USD 0,9700-0,9230 = (and earnings above
0.0285 (because no
0.9700 0,0420 0.9700)
exercise)

The graph shows the overall result of the operation, with the profile of the gains from the
purchase of the put option in bold, the profile of the CAD claim alone in bold dotted line, and
the profile of the covered claim in thin line.

The offset between -0.0265 and -0.0285 is 0.002 which is the difference between 0.93 and
0.928
We have: uncovered claim + option = covered claim
If the rate x on 01/11 is less than 0.93 (execution of the contract) the value of the hedged
claim is :

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(Option Gain or Loss) + (Debt Gain or Loss) = ((0.93 - 0.0285) - x) + (x - 0.9280) = - 0.0265
(maximum loss).
If the rate x is higher than 0.93 (contract abandonment) the value of the hedged claim is :

Option loss + Claim gain = - 0.0285 + (x - 0.9280) = x - 0.9565 (maximum gain)

Point of intersection between the covered debt profile and the x-axis :
Gain = 0 if x-0.9565= 0, i.e. x = 0.9565 which is the break-even point.

APPLICATION 3: Random Currency Settlement Case: RFx

A company that has responded to a tender wants to hedge against an unfavourable

exchange rate development between the time it submits its bid and the time it is paid if the bid
is successful. If it does not hedge, it runs the risk that its bid will be successful and that the
foreign currency will have depreciated, thereby reducing its income. If it hedges on the
futures market and its bid is not accepted, it will be obliged to sell the currencies and
sometimes at a loss: this is why the best solution in the case of a call for tenders is to hedge
with options. The company thus hedges against a drop in currency while keeping the
possibility of benefiting from the rise.
Example 1: A French company bids for an American contract for an amount of 10
000 000 USD. The duration is 6 months and the spot rate is USD/FRF=5.5000. The premium
of a put option for the strike price is 3%. There are two possible cases:
Solution:
a) The tender is won by the company. (the company won the contract)
 The cost of buying the put option is (premium)
10,000,000 x 5.5 x 0.03 = 1,650,000 USD.
H1- It is assumed that after 6 months the cost of the dollar is equal to 5.0000FRF, she
exercises her option.
Revenue in FRF=10 00 000x5, 5=55 000 000 FRF
Net income =55 000 000-1 650 000=53 350 000 FRF
 If she had entered into a forward contract, her income would be 55,000,000 FRF
 If she had not entered into a contract or a purchase option, the income would be
50,000,000 FRF
H2- If after 6 months the dollar rate is 6.0000 FRF, the company abandons the option.
Income: 10 000 000x6=60 000 000 FRF.
Net income/60 000 000-1 650 000+58 350 000 FRF
 if she had taken out a forward contract, she would have 55,000,000 FRF
 if she had taken the option as a forward contract, she would have 58,350,000 FRF

b) The tender is not won (the company did not win the contract)
H1 - If the currency depreciates and the price is lower than the strike price, the option can be
sold in the market. The amount of the gain depends on the difference between the strike price

13
of the currency. Assuming that the currency rate was 4.9500 USD (USD/USD = 4.9500
USD).
The gain would be (5,5 - 4,95) x 10 000 000 = 5 500 000 FRF

The net gain equals 5,500,000 - 1,650,000 = 3,850,000 USD

H2 - If the exchange rate of the currency is higher than the strike price, the option becomes
worthless. The loss is limited to the premium.
.

CHAPTER IV : THE CURRENCY FUTURES MARKET

Futures markets have experienced impressive growth over the past twenty years. This
development is linked to the needs expressed by investors. The adoption of a floating
exchange rate regime following the abandonment of the Bretton Woods system led economic
14
agents to seek ways of managing exchange rate risks. The EMS crises of 1992 and 1993 only
accentuated this demand. The possibility of averting risks has helped to avoid the disruptions
that might otherwise have affected world trade. The development of financial markets and the
use of monetary policies based on interest rates (to the detriment of regulation by quantities
and administered rates) have increased interest rate risks. In this context, futures have offered
companies and investors the possibility of accessing rate guarantees and avoiding the risk of
capital loss.
The resulting control of risk has encouraged investment and the dynamism of
economies. Hedging possibilities have increased the attractiveness of government securities
by making their market more liquid, which has reduced the cost of debt for governments.
Derivatives also play an essential role in balance sheet management by allowing for more
flexible procedures than traditional backing. They also make it possible to benefit from
markets that offer interesting opportunities but are sometimes difficult to access (emerging
markets). Finally, without derivatives, structured products that meet very specific needs
would not have been possible.

Transactions in the futures markets involve forward contracts or future contracts.

Contracts that bind two parties to exchange a commodity or security for a specified quantity,
time and price in the future. In the United States, these markets have been operating since
1840 for agricultural products. The creation of futures on the financial markets began in 1972
with currency futures on the international MonetaryMarket of the Chicago Mercantile
Exchange (CME), followed by the creation of a futures market on interest rates by the
Chicago Board of Trade (CBOT) in 1972. It was not until the turn of the 1970s and 1980s
that the futures markets really took off following the change in the way US monetary policy
was conducted.

Futures markets then multiplied with the creation in 1982 of the London Financial
Futures Exchange (LIFFE) and the Paris financial futures market (MATIF), which became the
French international futures market. In Asia, the Singapore International Monetary Exchange
(SIMEX) was launched in 1983 and the Tokyo International Financial Futures Exchange
(TIFFE) in 1989.

Futures markets are used for hedging, arbitrage and speculative transactions (more
than 80% of trading volumes), which contribute to market liquidity.

15
 This chapter successively examines interest rate futures by specifying the principles of
use of futures contracts and the broad outlines of the operating procedures of organized
markets (Section 1) and currency futures (Section 2)

I- INTEREST RATE FUTURES

1. Presentation
Contracts traded in the interest rate futures markets are promises to deliver debt
securities at a price and maturity determined at the time the contracts are signed.

The basic principle of hedging is to offset losses (gains) on cash (the physical, the
underlying) with equivalent gains (losses) on futures (derivatives). For example, a company
that has to borrow USD 10,000,000 in 6 months will sell a contract. If interest rates rise
within 6 months, the company will face more onerous terms for its loan, but will receive a
gain on the position it has built up in the futures. If, on the other hand, rates fall, the
company's interest expense on its loan will be lower, but it will incur a loss on its futures
contracts.
The basic principle is to: take inverse positions on the physical and on the futures.

It is summarized in the following table:

Direction of future operation Protection against Hedging direction in the

or current position futures markets

Borrower Rate hikes Sale of contracts

Lender Rate cuts Purchase of contracts

It is the physical or cash that determines the lending and acceptance of investments. At
maturity, the interest rate guaranteed by the contract is identical to that of the physical. But in
the meantime, the prices on the contract and on the cash move in parallel.
Futures markets in which a deposit is made are potentially very speculative. It must also
be said that they naturally encourage participants to default. This is obviously the case when
one has to deliver a security (settle cash) whose value is higher than the one that was in effect
at the time of the sale of the contract (of the promise to deliver said security). For this reason,
a system is set up to ensure the security of transactions. The latter includes a clearing house
with the requirement of deposits and margin calls.
2- Clearing house, deposit and margin call

16
 The clearing house ensures the security of transactions by acting as an interface between
traders. Deposits and margin calls are the requirements that ensure the security of
transactions.
Therefore, any futures contract participant must deposit with the clearing house in
advance an amount capable of covering the maximum loss that can be recorded daily on a
contract; within the limit of daily fluctuations. When this limit is reached, the clearing house
interrupts trading to allow the replenishment of collateral deposits to cover potential losses.
Thus, the deposit is intended to cover the maximum loss during a trading session. It is
paid in cash or in government securities into an account opened with an approved
intermediary. It can be revised.
Margin calls are the difference between the clearing price of a session and that of the
previous session. They can be positive or negative. In order to cover a loss, a participant must
pay the margin call to the approved intermediary who holds his account. In the event of a
default, the position is liquidated.

I- FOREIGN EXCHANGE FUTURES

These contracts follow the same logic as interest rate futures contracts.
By buying a future contract on a currency, one takes a long position on that currency. This
operation allows a hedge for an economic agent in a short cash position (for example an
importer who has to make a payment in a foreign currency and is exposed to a risk of its
appreciation). The sale of a contract makes it possible to take a short position on this
currency. Such a transaction allows a hedge against a long position in the currency (e.g. an
exporter who has to receive a payment in a foreign currency and is afraid that the currency
will depreciate).

As in the case of interest rate futures, the contracts are standardized. For example, on
the Chicago Mercantile Exchange, we find amounts of 12.5 million yen against the dollar,
62,000 pounds against the dollar, 125,000 Swiss francs and 125,000 euros. The maturities are
also standardised, as are the quotation scales (0.01 cent per contract for the yen, the pound and
the Swiss franc, for example) and the guarantee deposits (which, it should be remembered, are
sometimes modified at the discretion of the authorities for risk limitation reasons).

The prices are quoted in foreign currencies against the dollar. Thus, for the December
Yen contract, the opening price on August 29, 2003 is $0.85 for 1,000 Yen.

17
Example 1: The Yen/USD contract on the CME international monetary market. Amount:
12.5 million Yen; delivery, 3 eWednesdays in January, March, April, June, July, September,
October, and December; price, dollar per 100Yen; minimum fluctuation (tick) $12.50
Example of currency hedging

A US importer has to pay GBP 1,000,000 under a trade contract due in September. Fearing
the appreciation of the British pound, he decides to hedge in the futures market. He has a short
position in cash (GBP cash), so he will go long on the future by buying contracts.

Given the size of his position and the size of the contracts (62,500GBP on the Chicago
Mercantile Exchange) he will proceed to buy :

= = 16 contracts

Initially, the GBP/USD spot rate is 1.4235 and the contract rate is 1.4248 (opening price on
July 29). Let's assume that at maturity the spot rate is 1.4360

Buying the currencies to hedge its debt (cancelling its short position) results in a loss of :

(1.4360-1.4235) x 1,000,000 = $12,500

In the futures market, the price of futures contracts is also 1.4360 due to the convergence
between the contract price and the physical price

The sale of the futures contracts results in a gain of :

(1.4360-1.4248) x 1,000,000 = 11,200 USD ;

The net loss will then be limited to : 12 500-11 200 = 1 300

Example 2: On September 27, you buy a Euro future with a December maturity on the IMM
at a price of 1.35 USD, the standard contract size being 125,000 EUR. You have to make an
initial deposit of USD 2,835 and the maintenance margin (minimum margin) is USD 2,100.
On 29, 30 September, 4, 6, 10 and 12 October, the futures prices are 1.30, 1.20, 1.30, 1.40,
1.50 and 1.55 respectively. You decide to close your position on October 12. Present the
evolution of your account day by day and calculate the profitability of this operation,
assuming that the transaction costs are zero for this operation.

SOLUTION
The evolution of your account day by day (the standard size of a contract is 125 000 euros) is as
follows:
Date Exchange rates Contract Gains or Margin calls Deposits Balanc

18
 Value losses e
(Margins)
27/09 1,35 168 750 - - 2 835 2 835
29/09 1,30 162 500 - 6 250 6 250 2 835 2 835
30/09 1,20 150 000 - 12 500 12 500 2 835 2 835
04/10 1,30 162 500 12 500 - 2 835 15 335
06/10 1,40 175 000 12 500 - 2 835 27 835
10/10 1,50 187 500 12 500 - 2 835 40 335
12/10 1,55 193 750 6 250 - 2 835 46 585
The profitability of this operation is as follows.
Calculation of the profitability of the futures position (purchase of the future on September 27
and sale of the future at maturity on October 12), excluding transaction costs :
r = ((46 585 – 6250 – 12 500 – 2 835) / 2 835) × 100 = 881,83 %
In fact, at the beginning one pays USD 2,835 and at the end one should pay USD 168,750
minus the USD 2,835 already deposited, that is USD 165,915. If we decide to instantly resell the euros
purchased on the spot market on October 12 at 1.55, we obtain
193,750. Overall, there is a final cash inflow of 25,000 USD for an initial cash outflow of 2,835 USD,
giving a rate of return of 881.83%.

Example 3:
A customer has the option :
Or buy a EUR 10,000 put option, with a strike price of USD 1.3/EUR 1 and a maturity of 90
days, for a cost of USD 0.08;
Or to sell a future on 10,000 euros with a 90-day maturity and a price equal to 1.3 USD / 1
EUR.
a) Compare the gains and losses of these two transactions as a function of the rate of the euro at
maturity (different assumptions are made that the rate ranges from 0.8 to 2, with an increase of
0.1 each time).
b) If this client is highly risk averse, what would you advise?
SOLUTION
a) The evolution of gains and losses is presented in the following table:
Case of a Put Option Case of sale of future
Course
Decision: exercise or not Gain or loss Gain or loss
0,8 Yes 4200 5000
0,9 Yes 3200 4000
1 Yes 2200 3000
1,1 Yes 1200 2000

19
 1,2 Yes 200 1000
1,3 No -800 0
1,4 No -800 -1000
1,5 No -800 -2000
1,6 No -800 -3000
1,7 No -800 -4000
1,8 No -800 -5000
1,9 No -800 -6000
2 No -800 -7000

It can be seen that both gains and losses on the future can be unlimited. Whereas with the option
contract, the loss is limited to the premium.
b) A very risk-averse client should choose an option contract. In this case, his maximum loss will
be reduced to the premium.
The use of currency futures is undeniably attractive for speculation (high leverage
effect due to low deposits). It has also met with remarkable success among institutional
investors. However, it has certain disadvantages when it comes to hedging foreign exchange
transactions. Firstly, the standardisation of contracts (amounts, maturity) does not always
allow for perfect hedging, resulting in residual foreign exchange positions. Secondly, the
contracts dealt with only concern a limited number of currencies. Hedging a currency with a
contract on another currency whose behaviour is highly correlated with the first does not
eliminate all risk (known as correlation). In addition, the daily adjustment of accounts
maintained with approved brokers constitutes an accounting and administrative constraint.
Lastly, the actual hedging rate is difficult to determine, as it must take into account foreign
exchange and financial income resulting from changes in the balances of the guarantee
accounts.

I TEST MY KNOWLEDGE
1. Distinguish between the future contract and the forward contract.
2. How to define the security deposit (initial margin)?
3. What is the margin call or maintenance margin?
4. A clearing house may require a clearing member to pay a margin call:
a) Only in the evening after closing time;
b) At any time of the day;

20
 c) At any time during the day, but only after obtaining the agreement of the other
Clearing Members.
5. When a trader fails to respond to a margin call, the Clearing Member that guarantees its
contracts must :
a) Lend him the necessary funds to meet the margin call;
b) Trust this operator;
c) Liquidate all or part of the operator's position;
d) Make him pay interest;
e) Hope that the price trend will be reversed;
f) Take guarantees from the exchange where the contracts are traded.
6. The amount of the security deposit :
a) Is set by the clearing house ;
b) Is always more important for traders who are sellers of futures contracts;
c) Is the same whether the trader is a buyer or a seller of futures contracts;
d) Varies according to the volatility of the underlying asset ;
e) May be modified by the clearing house.
TRAINING EXERCISES
Exercise I: The Options Market
Two Cameroonian importers X and Y each have a debt of USD 2,500,000 due in 30 days.
The spot exchange rate is: USD/FCFA = 550.2500. They fear an appreciation of the dollar. X
hedges by buying call options on the dollars. The premium is 10% of the contract and the spot
rate is equal to the strike price. Y hedges by buying a futures contract.

TAF. - compare the position of these importers for each of the following values of the
USD/FCFA exchange rate at maturity: 440.2000; 467.7125; 495.2250; 550.2500; 577.7625;
605.275; 609.2250.

- Plot the position of X for the different exchange rates and for 1 currency unit to be
exchanged (speculation hypothesis)

- On the same graph, deduce the curve representing the seller's position
of options.

- Determining the gain or loss on the hedging of the debt by the option contract
Exercise II: The options market
Three Cameroonian exporters X, Y and Z are each waiting for a receivable of CAD
5,000,000, due in 60 days. The spot exchange rate is: CAD/FCFA = 450.2500. They fear a
21
depreciation of the dollar. X hedges by buying dollar put options. The premium is 8% of the
contract and the spot rate is equal to the strike price. Y hedges with a forward contract while
Z, who expects the dollar to appreciate, leaves his position uncovered.

TAF. - compare the position of these exporters for each of the following CAD/FCFA
exchange rate values at maturity: 395.1250; 405.1200; 414.2300; 450.2500; 486.2700;
495.1200;

- Plot the position of X for the different exchange rates and for 1 currency unit to be
exchanged (speculation hypothesis)
- On the same graph, deduce the curve representing the seller's position
of options.
- Determine the gain or loss from hedging the receivable with the option contract

Exercise III: The choice of financing method

A Cameroonian company needs to finance 1.5 billion CFA francs for a period of 6
years. It has to choose between two borrowing possibilities. The conditions of the first
possibility are as follows:

- Borrow 1/3 of the amount in the local financial market at an interest rate of 18%. The
rest is mobilized on the American and German markets up to 60% and 40%
respectively;
- On the German market, 1EURO = 714.53 FCFA the interest rate is 16%. We
suppose that after 2 years, we will have 1EURO = 688,5 F. and after 4 years 1EURO
= 725,5250 F.
- On the American market 1USD = 745.6 FCFA, the interest rate is 17%. We suppose
that after 2 years we will have 1USD = 735.68 F and after 4 years, 1USD = 768.68 F.
The second option is to issue 15,000 bonds of 100,000 francs each at an interest rate of
17%. The bonds for the first two years are sold on the local market, those for years 3 and
4 on the German market and the rest on the American market.

TAF: Knowing that all loans are repayable in constant annual installments,

- Provide amortization schedules for each borrowing opportunity.

- Deduce the best possibility for the firm.
- Assess the impact of exchange rate variations on the company's results and make the
appropriate accounting entries

Exercise IV: The choice of financing method

A Cameroonian firm has a financing requirement of CFAF 2 billion. It has to choose
between three borrowing possibilities.

- Borrow on the Canadian market at an interest rate of 18% for a period of 6 years;

22
 - Borrow on the American market at a rate of 17% for a period of 7 years;
- Issue 20,000 bonds of 100,000 francs each at an interest rate of 15% repayable in
seven years. The bonds for the first three years are sold in the franc zone countries;
those for years 4 and 5 on the Canadian market and the rest on the American market.

The forecasts for exchange rate changes are as follows:

USD/FCFA CAD/FCFA

Spot prices 508,1250 452,8550

After 2 years 521,3500 458,1250

After 4 years 498,1250 454,1250

After 5 years 530,1350 450,3500

TAF: Knowing that all loans are repayable in constant annual installments,
- Provide amortization schedules for each borrowing opportunity.
- Deduce the best possibility for the firm.
- Assess the impact of exchange rate fluctuations on the company's results and make the
appropriate accounting entries.

Exercise V: Tendering
Two European firms (F1 and F2) each bid for a USD 6 million tender on the US
market, with an execution period of 5 months. The USD/EURO spot rate is 0.7850. To hedge
against the exchange rate risk, F1 opts for USD/EURO put options while F2 chooses a
forward contract. The premium for a USD/EURO option is 4% and the strike price is equal to
the spot rate.

TAF: conduct a comparative analysis of the situation of the two firms for each of the
assumptions related to the following cases
1 ercase: both firms lose the bids
- assumption 1: USD/EURO=0.7450
- assumption 2: USD/EURO=0.8850
- assumption 3: USD/EURO=0.7850
2er cases: both firms win their own bid
- assumption 1: USD/EURO=0.7350
- assumption 2: USD/EURO=0.8920

23
 Exercise VI: Foreign exchange
After completing your Masters in SECO, you are enrolled in a Canadian University.
The tuition fee is 6,000 CAD, payable after 3 months. The spot exchange rate is CAD/FCFA
= 435.1350. Your parents fear a rise in the CAD and protect themselves by buying call
options on this currency. The premium paid is 4% of the contract.

TAF: What would be their position at maturity for each of the following assumptions:
Hypothesis 1: CAD/FCFA = 425.3500
Hypothesis 2: CAD/FCFA = 432.2550
Hypothesis 3: CAD/FCFA = 435.1350
Hypothesis 4: CAD/FCFA = 440.1850
Exercise VII: Eurocredit
To finance the budget deficit, the Director of the Treasury of your country needs 10
billion CFA francs. He can mobilize this sum on the American and Canadian markets up to
50% on each market, at the same interest rate of 16%. The loan is repayable in 5 years on the
American market and in 6 years on the Canadian market in constant annual instalments. The
forecasts on exchange rate variations are as follows:
USD/FCFA CAD/FCFA

Spot prices 548,1250 452,8550

After 2 years 561,3500 458,1250

After 3 years 542,1250 454,1250

After 4 years 560,1350 450,3500

TAF: - Present the loan amortization schedule on each market,

- Assess the impact of exchange rate changes on the Treasury's debt service.
-
Exercise VIII: Arbitration
- define arbitration,
- under what conditions triangular arbitration is possible
Let the following quotations apply:
- USD/EURO = 0.9020
- CAD/USD = 0.9850
You are an arbitrageur and you have 2,000,000 euros in this market. What would be
your attitude for each of the following hypotheses :
H1: CAD/EURO=0.8250; H2: CAD/EURO=0.8884; H3: CAD/EURO=0.9150.

24
EXERCISE IX: THE SWAP
Three pension fund managers (G1, G2, G3) based in Europe want to grow their financial
reserves through Treasury bonds for five years of maturity starting in January 2002. Each
manager would like to invest an amount of 15 million euro. On the European market, the
semi-annual coupon is 5.75%, while it is 6% on the American market. Manager G1, who does
not want to take any currency risk, invests in the European market. Managers G2 and G3,
having benefited from the interest rate differential between the two markets, invest in the US
market. The exchange rate between the euro and the dollar at the base period is
USD/EUR=0.7500. Manager G2, who fears a fall in the dollar, enters into a swap with his
bank to hedge this risk, whereas manager G3, who expects the dollar to rise over the period,
leaves his position unhedged.

TAF: a) Outline the financial flows between manager G2 and his bank;
b) How do you compare the position of the three managers over the life of the investment
if the exchange rate between the two currencies fluctuates as follows:

Periods USD/EUR

January 2002 - June 2002 0,7580

July 2002 - December 2002 0,7610

January 2003 - June 2003 0,7620

July 2003 - December 2003 0,7405

January 2004 - June 2004 0,7320

July 2004 - December 2004 0,7260

January 2005 - June 2005 0,7150

July 2005 - December 2005 0,7120

January 2006 - June 2006 0,7010

July 2006 - December 2006 0,7005

REFERENCES.
Yves, S. and Sébastien, R. (2013), "Finance internationale et gestion des risques", 7 eed,
Economica, Paris

Fontaine, P. and Hamet, J. (2011), "Les marchés financiers internationaux", 3 eedn, PUF,
Paris.

25
Arvisenet, P. (2004), "Finance Internationale", Dunod, Paris.

Arvisenet, P. and Schwob, T. (1990), "Finance internationale, marchés et techniques",

Hachette, Paris.

26