Foreign Currency Derivatives:

Futures and Options

 Learning Objectives

• Understand how foreign currency futures are quoted,

valued, and used for speculation purposes
• Understand the buying and writing of foreign currency
options in terms of risk and return
• Examine how foreign currency option values change
with exchange rate movements and over time
• Analyze how foreign currency option values change
with price component changes
 Foreign Currency Derivatives
• Financial management of MNEs in 21st century involves
financial derivatives.
• Derivatives, so named because their values are derived from
underlying assets (stock/currency), are a powerful tool used in
business today.
• These instruments used for two very distinct mgmt objectives:
– Speculation: use of derivative instruments to take a position in the
expectation of a profit
– Hedging: use of derivative instruments to reduce the risks associated with
the everyday management of corporate cash flow

• Fincl derivatives powerful tools for careful, competent mgrs;

destructive devices if used recklessly & carelessly
So what’s their structure & pricing?
 Foreign Currency Derivatives (contd.)
• Derivatives are used by firms to achieve one of more of
the following individual benefits:
– Permit firms to achieve payoffs that they would not be able to
achieve without derivatives, or could achieve only at greater
cost
– Hedge risks that otherwise would not be possible to hedge
– Make underlying markets more efficient
– Reduce volatility of stock returns
– Minimize earnings volatility
– Reduce tax liabilities
– Motivate management (agency theory effect)
 Foreign Currency Futures

What Are Currency Futures?

• A currency future, also known as FX future, is an exchange-
traded futures contract to exchange (buy/sell) specified amount of
one currency for another at a specified date in the future at a price
(exchange rate) that is fixed on the purchase date.
• Foreign currency futures contract an alternative to a forward
contract that calls for future delivery of a std amt of foreign exchg
at a fixed time, place and price.
• Similar to futures contracts that exist for commodities (cattle,
lumber, etc.), interest-bearing deposits, gold, etc.
 Foreign Currency Futures (contd.)
Features of Currency Futures
• Contract Specs: estd by exchg on which futures are traded.
• Underlying Asset: This is the currency exchg rate that has been
specified.
• Expiration Date: This is the final settlement for cash-settled
futures. It is the date on which the currencies are exchanged for
physically delivered futures.
• Size: The sizes of all the contracts are the same.
• Margin Requirement: An initial margin is necessary to enter into a
futures contract. A maintenance margin will be established, and if
the original margin goes lower than this level, a margin call will
occur, requiring the trader or investor to deposit money over the
maintenance margin in order to re-establish the initial margin level.
 Foreign Currency Futures (contd.)
Features of Currency Futures (contd.)
• Marked-to-market: means that value of the contract revalued every
day using the closing price for the day. Thus, value of the contract
is marked to mkt daily & all changes in value are paid (settled) in
cash daily; amt to be paid called variation margin.
• Mkt price for a currency futures contract will be same regardless of
which broker is used.
• All contracts are agmts betw client & the exchg clearing house (not
betw 2 clients) which is owned & guaranteed by all members of the
exchg; no ‘counterparty risk’.
• Only around 5% of all futures contracts settled by physical delivery
of fgn exchg betw buyer & seller; futures positions closed by last
trading day thru “round turns”.
Foreign Currency Futures (contd.)
Features of Currency Futures (contd.)
Thus, standardized major features are:
– Contract size (standardized lots)
– Method of stating exchange rates
– Maturity date
– Last trading day
– Collateral and maintenance margins
– Settlement
– Commissions
– Use of a clearinghouse as a counterparty
 Mexican Peso (CME)
(MXN 500,000; $ per 10MXN)
 Foreign Currency Futures (contd.)
Currency Futures in India
• Law governing Forex mkt in India is Foreign Exchange Management Act
(FEMA); regulatory authority for Indian Forex mkt is RBI; Exchange
Traded Currency Futures mkt regulated by SEBI.
• Instruments are Rupee Currency Futures contracts where one side of the
contract is the Indian rupee.
• Contracts currently available on four INR pairs i.e., USDINR, EURINR,
GBPINR & JPYINR; contracts cash settled in INR at RBI reference rate.
• One Lot =1000 Base Currency except in JPY; i.e. 1000 USD, 1000 GBP,
1000 EUR, 100,000 JPY
• FIIs and NRIs not permitted to participate in curr futures mkt.
• The base price of the contracts on subsequent trading days will be the
daily settlement price of the previous trading day. The closing price for a
futures contract is currently calculated as the last half an hour weighted
average price of the contract.
 Foreign Currency Futures (contd.)

• Most imp mkt for fgn curr futures in USA is International

Monetary Market (IMM), a division of the Chicago Mercantile
Exchange.
• In India, curr futures traded on platforms offered by exchanges
like NSE, Bombay Stock Exchange (BSE), MCX-SX; betw 9 am
– 5 pm; investor needs to open forex trading a/c with broker to
trade in live curr mkt.
Foreign Currency Futures (contd.)
Foreign Currency Futures (contd.)
 Foreign Currency Futures (contd.)
• Foreign currency futures contracts differ from forward contracts in a
number of important ways:
– Futures are standardized in terms of size while forwards can be
customized
– Futures have fixed maturities while forwards can have any maturity
(both typically have maturities of one year or less)
– Trading on futures occurs on organized exchanges while forwards are
traded between individuals and banks
– Futures have an initial margin that is market to market on a daily
basis while only a bank relationship is needed for a forward
– Futures are rarely delivered upon (settled) while forwards are
normally delivered upon (settled)
 Foreign Currency Options
• A foreign currency option is a contract giving
the option purchaser (the buyer) 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 (until the maturity date).
• There are two basic types of options, calls and
puts.
– A call is an option to buy foreign currency
– A put is an option to sell foreign currency
 Foreign Currency Options (contd.)
• The buyer of an option is termed the holder,
while the seller of the option is referred to as
the writer or grantor.
• Every option has three different price elements:
– The exercise or strike price: the exchange rate at
which the foreign currency can be purchased (call)
or sold (put)
– The premium: the cost, price, value of the option
– The underlying or actual spot exchange rate in the
market
 Foreign Currency Options (contd.)
5 Basic Things To Know About Currency Options:
• The right to buy the currency pair is called call option and the right to
sell the currency pair is called put option
• The pre-specified price is called as strike price and the date at which
the strike price is applicable is called expiration date
• The gap between the date of entering into the contract and the
expiration date (in number of days) is called time to maturity
• The buyer of the call / put option pays premium to the seller of the
call / put option. Buyer has limited loss but unlimited profits and the
reverse is true for option seller
• The asset which is bought or sold is also called as an underlying or
underlying asset and in case of currency options it is the currency pair
 Foreign Currency Options (contd.)

• An American option gives the buyer the right

to exercise the option at any time between the
date of writing and the expiration or maturity
date.
• A European option can be exercised only on
its expiration date, not before.
• The premium, or option price, is the cost of the
option.
 Foreign Currency Options (contd.)
Moneyness of Currency Options (ITM / OTM / ATM)
• When are options valuable to the buyer of option? E.g. buyer of call
option would exercise his right to buy only if spot price of the currency
pair is higher than the strike price on maturity date. Conversely, buyer
of put option would exercise his right to sell only if spot price of the
currency pair is lower than the strike price on maturity date.
Transaction costs & statutory costs also involved, but for simplicity
ignoring them now.
• In simple terms, moneyness of an option indicates whether the contract
would result in a positive cash flow (in-the-money), negative cash flow
(out-of-the-money) or zero cash flow (at-the-money) for the option
buyer at the time of exercising it. Therefore, based on moneyness,
options can be classified under 3 categories:
 Foreign Currency Options (contd.)

• An option whose exercise price is the same as the spot price

of the underlying currency is said to be at-the-money (ATM).
• An option that would be profitable, excluding the cost of the
premium, if exercised immediately is said to be in-the-money
(ITM).
• An option that would not be profitable, again excluding the
cost of the premium, if exercised immediately is referred to as
out-of-the money (OTM).
 Foreign Currency Options (contd.)
• In the money (ITM) option:
For Call Option it is ITM if the (Spot Price > Strike Price)
For Put Option it is ITM if the (Strike Price > Spot Price)
• Out of the money (OTM) option:
For Call Option it is OTM if the (Strike Price > Spot Price)
For Put Option it is OTM if the (Spot Price > Strike Price)
• At the money (ATM) option:
For Call Option and put options it is ATM if the (Market Price =
Strike Price)
Since ATM options are practically difficult, traders consider two
contiguous strikes as near the money (NTM), which is an extended
version of ATM options.
 Foreign Currency Options (contd.)

• In the past three decades, the use of foreign currency options as

a hedging tool and for speculative purposes has blossomed into
a major foreign exchange activity.
• Options on the over-the-counter (OTC) market can be tailored to
the specific needs of the firm but can expose the firm to
counterparty risk.
• Options on organized exchanges are standardized, but
counterparty risk is substantially reduced.
• Next 2 slides show published quotes for currency options.
 Rupee Currency Options

Data Source: NSE

 Rupee Currency Options (contd.)
Like in case of currency futures, the currency options on rupee
pairs are also available on the same four pairs. How do you trade
currency options?
• If you expect the dollar to strengthen versus the rupee, you can
buy a call option on the USDINR. You can select the strike price
based on your view.
• Similarly, if you are expecting the dollar to weaken versus the
rupee, you can buy a put option on the USDINR.
• In case of options, while the lot size is denominated in the
international currency value, the premiums are denominated in
Indian rupees.
 Dissecting A Currency Options Contract
What does this live currency options chart
represent?
• The contract is a call option (right to buy) the
USDINR contract expiring on 28th August
having a strike price of Rs.71.50.
• The price of the call option (option premium)
is Rs.0.0725. It can be seen that the price has
fallen sharply during the day due to
strengthening of the INR during the day.
• Two traded values here: The traded value
represents the total lots multiplied by the lot
size multiplied by the strike price. The other
definition of value is premium value which is
much lower.
• Open interest shows the number of lots of the
specific contract that are still open in the
market at this point of time.
• All currency options are, by default, European
options; meaning they can only be exercised
Data Source: NSE on the date of expiry. They can be reversed
at any time before that.
Swiss Franc Option Quotations
(U.S. cents/SF)
 Buyer of a Call Option
• Buyer of an option only exercises his/her rights if the option is
profitable.
• In the case of a call option, as the spot price of the underlying
currency moves up, the holder has the possibility of unlimited
profit.
• Next slide shows a static profit and loss diagram for the purchase
of a Swiss Franc Call Option. Notice how the purchaser makes a
profit as the franc appreciates vs. the dollar because the purchaser
has the right to purchase the franc at a pre-specified/lower price
than the current spot price.
Profit & Loss for Buyer of Call Option
 Option Market Speculation
Writer of a call (see next slide):
– What the holder, or buyer of an option loses, the writer gains
– The maximum profit that the writer of the call option can make
is limited to the premium
– If the writer wrote the option naked, that is without owning the
currency, the writer would now have to buy the currency at the
spot and take the loss delivering at the strike price
– The amount of such a loss is unlimited and increases as the
underlying currency rises
– Even if the writer already owns the currency, the writer will
experience an opportunity loss
Profit & Loss for Writer of Call Option
 Option Market Speculation (contd.)
Buyer of a Put (see next slide):
– The basic terms of this example are similar to those just illustrated with the
call

– The buyer of a put option, however, wants to be able to sell the underlying
currency at the exercise price when the market price of that currency drops
(not rises as in the case of the call option)

– If the spot price drops to $0.575/SF, the buyer of the put will deliver francs
to the writer and receive $0.585/SF

– At any exchange rate above the strike price of $0.585, the buyer of the put
would not exercise the option, and would lose only the $0.05/SF premium

– The buyer of a put (like the buyer of the call) can never lose more than the
premium paid up front
Profit & Loss for Buyer of Put Option
 Option Market Speculation (contd.)
• Seller (writer) of a put (see next slide):
– In this case, if the spot price of francs drops below
58.5 cents per franc, the option will be exercised
– Below a price of 58.5 cents per franc, the writer will
lose more than the premium received from writing
the option (falling below break-even)
– If the spot price is above $0.585/SF, the option will
not be exercised and the option writer will pocket
the entire premium
Profit & Loss for Writer of Put Option
 Option Pricing and Valuation

The pricing of any currency option combines 6

elements:
– Present spot rate
– Time to maturity
– Forward rate for matching maturity
– Home currency interest rate
– Foreign currency interest rate
– Volatility (standard deviation of daily spot price
movements)
 Option Pricing & Valuation (contd.)
• The total value (premium) of an option is equal to the sum of 2
components, intrinsic value & time value.
i.e. Total value (premium) of option = Intrinsic value + Time value
• Intrinsic value is the financial gain if the option is exercised immediately.
– For a call option, intrinsic value is zero when the strike price is above
the market price
– When the spot price rises above the strike price, the intrinsic value
become positive
– Put options behave in the opposite manner
– On the date of maturity, an option will have a value equal to its
intrinsic value (zero time remaining means zero time value)
• The time value of an option exists because the price of the underlying
currency, the spot rate, can potentially move further into the money
between the present time and the option’s expiration date.
 Option Pricing & Valuation (contd.)
• Intrinsic value is fairly straight-forward because it is measured by moneyness.
The residual value in option premium is the time value. Time value of the option is
one of the most imp concepts & helps in options trading.
Illustration: The USDINR September call option of 70 strike price is quoting at a
premium of Rs.0.80 when the USDINR spot price is at Rs.70.60. What is the
intrinsic value & time value of the option?

In this case, intrinsic value of call = (Spot – Strike) = (70.60 – 70) = Rs.0.60

Time Value (residual value) = (Option prem–Intrinsic Value) = (0.80 – 0.60)

= 0.20

• While the intrinsic value of the option above is based on moneyness, the time value
is based on time to expiry and the volatility of the stock price. From the above we
can conclude 3 things about pricing of options:
1. ITM options have intrinsic value and time value
2. ATM/NTM options have larger proportion of time value than intrinsic value
3. OTM options have only time value and zero intrinsic value
Option Intrinsic Value, Time Value
& Total Value
Call Option Premiums: Intrinsic
Value & Time Value Components
Options Pricing: Black & Scholes Model
Ø Uses a 5 factor model to value options, as shown below:
Black and Scholes When the variable How it impacts the call How it impacts the put
Variable moves up? option value? option value?

Spot Price of FX rate Moves Up Option value increases Option value decreases

Strike Price of option Moves Up Option value decreases Option value increases

Interest rate diff Moves Up Option value increases Option value decreases

Time to expiry Moves Up Option value increases Option value increases

Volatility Moves Up Option value increases Option value increases

It is only in case of volatility & time to expiry where the call and the put options
on currency pairs are impacted in similar manner. That is because volatility &
time make the call and put valuable as they increase. In case of currency option,
we look at the movement of interest rate differential. In case of USDINR, we track
the movement of the Indian interest rate – US interest rates.
 Currency Option Pricing Sensitivity
• If currency options are to be used effectively, either for
the purposes of speculation or risk management, the
individual trader needs to know how option values
(premiums) react to their various components.
• Six sensitivities:
1. The impact of changing forward rates
2. The impact of changing spot rates
3. The impact of time to maturity
4. The impact of changing volatility
5. The impact of changing interest differentials
6. The impact of alternative option strike prices
 Forward Rate Sensitivity

• Standard foreign currency options are priced around the

forward rate because the current spot rate and both the
domestic and foreign interest rates (home currency and foreign
currency rates) are included in the option premium calculation.
• The forward rate is central to valuation of the option.
• The option-pricing formula calculates a subjective probability
distribution centered on the forward rate (does not mean that
the mkt expects the forward rate to be equal to the future spot
rate).
Option Pricing Components:
Five Option Greeks
 Spot Rate Sensitivity (delta)
• If the current spot rate falls on the side of the option’s strike
price—which would induce the option holder to exercise the
option upon expiration—the option also has an intrinsic value.
• The sensitivity of the option premium to a small change in the
spot exchange rate is called the delta.
• Delta varies between +1 and 0 for a call option and -1 and 0 for a
put option.
• As an option moves further in-the-money, delta rises toward 1.0.
As an option moves further out-of-the-money, delta falls toward
zero.
• Rule of Thumb: The higher the delta (deltas of .7, or .8 and up
are considered high) the greater the probability of the option
expiring in-the-money.
 Time to Maturity: Value &
Deterioration (theta)
• Option values increase with the length of time to maturity. The expected
change in the option premium from a small change in the time to
expiration is termed theta.
• Theta is calculated as the change in the option premium over the change
in time. Theta is based not on a linear relationship with time, but rather
the square root of time.
• Option premiums deteriorate at an increasing rate as they approach
expiration.
• Rule of Thumb: A trader will normally find longer-maturity options
better values, giving the trader the ability to alter an option position
without suffering significant time value deterioration.
 Sensitivity to Volatility (lambda)
• Option volatility is the standard deviation of daily percentage changes in the
underlying exchange rate; imp b’coz an exchg rate’s perceived likelihood to
move either into or out of the range in which the option would be exercised.
• If exchg rate’s volatility is rising, & therefore the risk of option being exercised is
increasing, the option premium (price) would be increasing.
• The primary problem with volatility is that there is no single method for its
calculation; determined subjectively. Volatility is viewed three ways:
– historic, where the volatility is drawn from a recent period of time;
– forward-looking, where the historic volatility is altered to reflect expectations
about the future period over which the option will exist; and
– implied, where the volatility is backed out of the market price of the option.
• Rule of Thumb: Traders who believe volatilities will fall significantly in the
near-term will sell (write) options now, hoping to buy them back for a profit
immediately after volatilities fall causing option premiums to fall.
Foreign Currency Implied
Volatilities (percent)
 Sensitivity to Changing Interest
Rate Differentials (rho & phi)
• Currency option prices & values focused on fwd rate which, in turn,
based on theory of IRP, so intt rate changes in either currency will
alter fwd rate which, in turn, will alter option’s prem or value.
• The expected change in the option premium from a small change in
the domestic interest rate (home currency) is termed rho.
• The expected change in the option premium from a small change in
the foreign interest rate (foreign currency) is termed phi.
• Rule of Thumb: A trader who is purchasing a call option on
foreign currency should do so before the domestic interest rate rises.
This will allow the trader to purchase the option before its price
increases.
 Alternative Strike Prices & Option
Premiums

• A firm purchasing an option in the over-the-counter market

may choose its own strike rate.
• Options with strike rates that are already in-the-money will
have both intrinsic and time value elements.
• Options with strike rates that are out-of-the-money will have
only a time value component.