Foreign Currency Derivatives

Futures and Options

 Notation
• S = nominal spot exchange rate (the underlying)
– S($/FC) = $ units per unit of FC currency everywhere
• F = forward exchange rate
– F($/FC) = $ units per unit of FC currency everywhere
• f = futures price
– f0,T , fT,T
• T = maturity
• k = strike price of an option
• c = price of a call
• p = price of a put
• i = risk free rate (HC, home country currency)
• i* = risk free rate (FC, foreign country currency)
 Learning Objectives
• Explain how foreign currency futures are quoted,
valued, and used for hedging/speculation
purposes
• Explore 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
– over time
– with other components
 Derivative Securities

• Securities valued in reference to underlying

assets, in this context, the exchange rate
• Purpose
– to manage currency risk (hedge) when
derivative contract offsets existing cash
contract
– to speculate on future exchange rate
movements when derivative position is
independent of any cash position
 Currency Futures
• A futures contract is a tradable obligation
to the buyer (seller) to buy (sell) a set
amount of foreign exchange at a specified
price at some future date.
– Payoff dependent of an unknown future price
 Who uses currency futures
• Hedgers
– Companies with foreign currency receivables desiring
to lock in a price at which to sell this currency could
sell futures. Companies with foreign‐currency payables
desiring to lock in a price at which they can buy the
currency could purchase currency futures
• Speculators
– if they expect a currency to appreciate, they could buy
futures contracts for that currency. Those who expect
a currency to depreciate could sell futures contracts
for that currency
 Futures and Forward contracts
• With respect to:

– Size of the contract

– Maturity
– Trading location
– Margin/collateral
– Settlement
– Commissions
– Trading hours
– Counterparties
– Liquidity

What is the difference? Can you answer?

 Why a market for Futures?
• Provide low‐cost access to payoffs similar to forward
contracts.
• IMM (International Monetary Market) division of the CME
first to offer currency future contracts in 1972
• Until 1972, speculators or hedgers could take forward
positions only through the wholesale OTC market.
– They needed to establish lines of credit with commercial banks
and also deal in large transaction sizes to benefit from low bid‐ask
spreads.
• Qualified public speculation is encouraged, differently
from the forward markets where participants are banks,
brokers and multinational companies
Exhibit 7.1 Mexican Peso (CME)
(MXN 500,000; $ per 10MXN)
 Futures Contract Specifications
• Maturity
– Expiration on the second business day before the third
Wednesday of the delivery month
• Exchange rate quotation
– American terms
• Contract size
– specifies the amount of currency traded
• E.g. CAD 100,000; GBP 62,500; EUR 125,000; JPY 12,500,000
• Margin Requirements
– initial margin: amount the investor must place in the account
when the contract is written
– maintenance: amount below which the margin account cannot
fall
– adjust for gains and losses
– losses are allowed to accumulate up to a certain level before the
margin call is issued
 Open Interest
• Open interest = # long contracts = # short contracts
– think of this as a list of names of those long and those short, the list
obviously must be equal
• Example: Jerry goes long one GBP futures contract
Kramer goes short one GBP futures contract at the same
time
– case A: neither had previously participated in the futures market
(or Jerry was already long and Kramer was already short)
• Open interest increases by 1
– case B: Jerry was previously short while Kramer was already short
or non‐participant
• Open interest remains unchanged
– case C: Jerry was previously short while Kramer was previously long
• Open interest decreases by 1
 Marking to Market
• With a forward contract, we know the foreign currency
price Ft,T is paid entirely at time T
• With a futures contract, information on how much is paid
at what time depends on the day‐to‐day movement of the
futures price
• The value of the contract is revalued on a daily basis
– This is daily marking to market
– Settlement price = day’s closing price
– Amount to be paid is the variation margin of daily marking to
market cash outflows
 Marking to Market
Example
• Ex‐post daily US dollar cash flows in a three‐day contract purchase
of foreign currency
Day 0 1 2 3
Future price (f) 100 98 96 97
Marking to Market -2 -2 +1
Margin Balance 10 8 6 7
Final payment -97

• The cash flows to the seller of the currency futures contract are the
reverse of the cash flows to the buyer
 Marking to Market
• Generalizing the marking to market cash flows (+ or -)
On day 1 f1,T – f0,T
On day 2 f2,T – f1,T
On day T fT,T – fT-1,T
Total CF fT,T – f0,T

• And at maturity fT,T = ST

• Equivalently, the cash flows to the buyer are
(fT,T – f0,T) over the life of the futures contract
– fT,T at the maturity of the futures contract
• Thus, the buyer pays f0,T over the entire life of the futures
contract
– unlike a forward contract, the exact timing of the payments is uncertain
 Marking to Market
example
• You bought CAD 100,000 at f0,T = USD 0.7600/CAD
– in the last day of trading, fT,T = USD 0.7350/CAD

• Cumulative marking-to-market cash flows =

CAD100,000 x (USD0.7350 – 0.7600/CAD) = - USD2,500

• Immediate payment at the contract maturity =

CAD100,000 x (USD0.7350/CAD) = -USD73,500

• Total payment = -USD(2,500+73,500) = -76,000 or

CAD100,000 x (USD0.7600/CAD) = -USD76,000
 Other characteristics
of futures contracts
• Low default risk
– contract between individual and exchange
• No counterparty risk
– critical if agents do not have the proper credit rating
– credibility/commitment established through the use of
margin
• Settlement
– futures contracts are typically closed out with an
offsetting (reversing) position
• an agent with a long position in a futures contract is obligated
to buy forex at some date in the future
• the position is reversed by selling a futures contract on the
same currency with the same delivery date
 Payoffs for a long and a short position
at maturity
• The buyer is said to have a long position, while the seller
is said to be short
$ Profit
$ Profit
+ f0,T

0 f0,T f0,T
ST $/FC ST $/FC
‐

‐f0,T
buy futures sell futures
 Arbitrage between the futures and
forward markets
• Forward ask price for March 20 on CHF is $0.7127
• Futures price of the IMM March 20 CFH futures contract is
$0.7145
• Buy CFH 125,000 in the forward market at $0.7127
• Sell 1 futures contract (CHF 125,000) at $0.7145
• On March 20, profit = ($0.7145‐ 0.7127)(125,000)=$225
• Note that there is no risk here:
– arbitrageur takes delivery of the CHF in the forward market and
sells them in the futures market
– arbitrage will tend to force the forward price up and/or the
futures price down
 Speculating with futures contracts
• Very attractive for speculation
– High leverage possibility, very high liquidity, low transaction costs,
large body of information on the price behavior
• Often entered without an underlying cash position.
• Bearish on the currency: sell a futures CHF contract and
buy it back at a lower price once expectations are realized
• Bullish on the currency: buy a futures CHF contract and
sell it at a higher price once the currencies have moved in
the expected direction
– In either case, speculators can close out their position if their
expectations do not materialize
 Hedging with futures contracts

• To offset an underlying cash position, expecting that the

profits on the future contract will offset those in the cash
market.
• Short hedge: a long position (i.e. a receivable) in the spot
market and simultaneously a short position in futures
market
Long hedge: a short position (i.e. a payable) in the spot
market and a long position in futures market
 Potential problems
in hedging with futures
• Mismatch
– contract size
– maturity dates
– currency
• If all uncertainty in the total payoff is eliminated, the
hedge is said to be perfect
• A forward hedge is in fact a perfect hedge
– easy to match the size, timing and currency of the underlying
exposure
• No such guarantees in the case of futures because of the
mismatch
 Currency Options
• A currency option gives the holder the right but
not the obligation to buy (a call option) or to sell
(a put option) a designated quantity of foreign
currency at a specified price (exchange rate)
called the strike price, at or before a designated
expiration date
– The underlying asset is the foreign currency
 Currency Options
• We refer to selling an option as “writing an
option”
• the buyer of the option pays a premium for the
right to buy (call) or sell (put) a currency
• the seller of a call (put) option receives a
premium and must sell (buy) the currency if the
buyer exercises his option
 Who uses currency options

• Option position is a hedge

– option + cash position in the underlying
• or speculation
– no cash counterpart to the option position
 Option market
• First offered on the Philadelphia exchange (PHLX) in 1982
– Prior to that date, they were over‐the counter options
written by international banks, investment banks for
large amounts (at least $1 million of the underlying)
• Three types of currency options
– OTC option contracts
– Traded spot currency option contracts
– Currency futures option contracts

• 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
Exhibit 7.2 Swiss Franc Option
Quotations (U.S. cents/SF)
 Option Contract Specifications
• Exchange rate quotation
– American terms
• Maturity
– Mid‐month
• Saturday following the third Friday of the expiration month
• Consecutive calendar month
– Long‐term options
• European‐style exercise only
• Fewer contract months (quarterly)
• Contract size
– specifies the amount of currency traded
• E.g. CAD 50,000, GBP 31,250; EUR 62,500; JPY 6,250,000
 Option Contract Specifications
• Margin Requirements
– long positions in currency options do not require
posting a margin
• 100% of the option premium paid in advance by the long
position holder, no commitment during the life of the option.
– short positions require posting a margin
• Default risk is very small
– all contracts are guaranteed by the Options Clearing
Corporation
 Option Contracts Vocabulary
• Strike price (exercise price)
– fixed price, specified in contract, set by the exchange
around prevailing spot rate
k = strike price ($/FC), S = spot price ($/FC)
• Generally, HC/FC if traded outside the US
• European options
– exercisable only at expiration
• American options
– exercisable on or before expiration (added feature not
worth much)
 Moneyness
• in the money (ITM) = positive value if exercised today
for a call, this means S>k
for a put, this means S<k
• at the money (ATM) = zero value if exercised today
(S=k)
• out of the money (OTM) = negative value if exercised
today
for a call, this means S<k
for a put, this means S>k
Profit–loss profiles for an option trader
similar to exhibits 7.3+4+5+6 in textbook
 Using Options ‐ Long call
• A long call position is established when the
investor purchases a call. Call premium is the
maximum that can be lost, while the gain is
theoretically unlimited
– a speculator who is bullish on a currency could
purchase the currency itself, a forward contract, a
futures contract or a call option
• Expectation: the buyer hopes for a maximum
upward movement in the value of the currency
• Also used by hedgers to protect a short position in
a currency, i.e. a payable
 Using Options ‐ Short call
• A short call position represents an obligation to the
seller (the writer) of the option to sell the currency at
the strike price. For this commitment, compensation
is the premium
• Covered if seller is also long the underlying asset
Expectation: the covered seller wishes no (or little)
price movement to occur, otherwise loss from the
underlying
• Naked or uncovered if the seller has no position in the
underlying asset to deliver → much riskier (margin)
Expectation: the naked writer expects currency to
remain constant or fall
 Example
Call option profit diagram
• Jerry and Kramer are speculators with opposite
expectations on the movement of the GBP
• Jerry purchases a Mar 150 £ call (31,250 £ units)
for 4.00 cents per unit
‐ initial cost = (31,250)(0.04) = $1,250
• Kramer writes a Mar 150 £ call (31,250 £ units)
for 4.00 cents per unit
‐ initial receipt = $ 1,250
 Example
Call option profit diagram
• At expiration, if the spot price of the £ is less than
$1.50, the option will not be exercised
‐ Jerry’s loss will be $ 1,250
‐ Kramer’s profit will be $ 1,250
• If the spot price of the £ is greater than $1.50, the
option will be exercised
‐ Jerry receives (S‐1.50)(31,250) ‐ $ 1,250
‐ Kramer receives $ 1,250 ‐ (S‐1.50)(31,250)
• One side’s gain is other side’s loss
 Using Options ‐ Long put
• A long put position gives the holder an option to
sell at a fixed price. Put premium is the maximum
that can be lost if currency values rise
appreciably. Currency values would have to fall
beyond the strike price minus the put premium
for a profit to be realized.
• Expectation: the buyer intends to capitalize from
a downward movement in the value of the
currency
• Also used by hedgers to protect a long position in
a currency, i.e. a receivable
 Using Options ‐ Short put
• A short put position creates an obligation on the seller
(the writer) of the option to buy the currency at the
strike price. For this commitment, compensation is the
premium
Expectation: the writer expects the currency to remain
the same or rise.
• Covered if seller is also short the underlying asset
• Naked or uncovered if the seller has no position in the
underlying asset → a large loss (a margin deposit is
required)
 Example
Put option profit diagram
• Jerry and Kramer are speculators with opposite
expectations on the movement of the GBP
• Jerry purchases a Mar 150 £ put (31,250 £ units )
for 6.00 cents per unit
‐ initial cost = (31,250)(0.06) = $1,875
• Kramer writes a Mar 150 £ put (31,250 £ units)
for 6.00 cents per unit
‐ initial receipt = $ 1,875
 Example
Put option profit diagram
• At expiration, if the spot price of the £ is greater
than $1.50, the option will not be exercised
‐ Jerry’s loss will be $ 1,875
‐ Kramer’s profit will be $ 1,875
• If the spot price of the £ is less than $1.50, the
option will be exercised
‐ Jerry receives (1.50‐S)(31,250) ‐ $ 1,875
‐ Kramer receives $ 1,875 ‐ (1.50‐S)(31,250)
• One side’s gain is other side’s loss
 A synthetic long forward
• Consider a portfolio containing a call minus a put both
struck at k=35¢, same expiration date. Payoff from this
portfolio is
If ST= 32 33 34 35 36 37 38
then -pT= -3 -2 -1 0 0 0 0
and cT= 0 0 0 0 1 2 3
Total cT-pT -3 -2 -1 0 1 2 3
The payoff from buying a forward at 35 (profit ST‐35)
If ST= 32 33 34 35 36 37 38
then ST-35 -3 -2 -1 0 1 2 3
 Synthetic forwards
Put‐Call Parity
• Synthetic forwards
– Long forward = [long call + short put]
– Short forward = [short call + long put]
• Put‐call parity: a fundamental arbitrage relationship
linking prices of options and forwards (for European
options)
• Note that put‐call parity does not hold between two
options
– if the strike prices are not equal
– if expiration dates are not equal
• From arbitrage
– A forward or futures contract can be synthetically
reproduced in the option markets
 Option Pricing
• Intrinsic value: the value of the option if it is
exercised today
– cT = Max [ST‐k, 0]
at expiration, a call option exercised only if ITM
→ spot rate > strike price
– pT = Max [k‐ST, 0]
at expiration, a put option exercised only if ITM
→ spot rate < strike price
• At expiration, a European option and an American
option (not previously exercised) with same strike
price will have same terminal value
 Time value
• Time value: excess of option value over intrinsic value
Additional value embedded in option resulting from
potential further gains if option moves further into the
money.
• Total option value ( reflected in the premium)
= Intrinsic value + time value

• Everything else being equal, time value is a positive

function of:
1) time to expiration
2) volatility
Exhibit 7.7 Option Intrinsic Value, Time
Value, and Total Value
 Exhibit 7.8 Call Option Premiums:
Intrinsic Value and Time Value Components
 Example 1
• Spot price for CHF = $0.6352
• Mar 64 CHF Call priced at $.0085
‐ the option to buy CHF at $0.64 costs $0.0085
‐ the intrinsic value is
max[ (0.6352 ‐ 0.64),0] = 0
‐ therefore the time value is
$0.0085 ‐ 0 = $0.0085
• a call option with zero intrinsic value is an out of the
money option
 Example 2
• Spot price for CHF = $0.6352
• Jan 64 CHF Call priced at $.0012
‐ the option to buy CHF at $0.64 costs $0.0012
‐ the intrinsic value is
max[ (0.6352 ‐ 0.64),0] = 0
‐ therefore the time value is
$0.0012 ‐ 0 = $0.0012
• a call option with zero intrinsic value is an out of the
money option
 Same strike price
Examples 1 and 2
• Note that the Mar 64 CHF call is priced higher
than the Jan 64 call
• Both options are OTM (zero intrinsic value)
• The Mar 64 option has two months to expiration,
the Jan 64 is about to expire
• more time higher time premium
 Example 3
• Spot price for CHF = $0.6352
• Mar 66 CHF Call priced at $.0030
‐ the option to buy CHF at $0.66 costs $0.0030
‐ the intrinsic value is
max[ (0.6352 ‐ 0.66),0] = 0
‐ therefore the time value is
$0.0030 ‐ 0 = $0.0030
• a call option with zero intrinsic value is an out of the
money option
 Same expiration
Example 1 and 3
• Note that the Mar 64 CHF call is priced higher
than the Mar 66 call
• Both options are OTM (zero intrinsic value)
• But there is a higher probability that the spot
price of the CHF will increase beyond $0.64 than
beyond $0.66 in the time remaining.
 Example 4
• Spot price for CHF = $0.6352
• Jan 63 CHF Call priced at $.0070
‐ the option to buy CHF at $0.63 costs $0.0070
‐ the intrinsic value is
max[ (0.6352 ‐ 0.63),0] = $0.0052
‐ therefore the time value is
$0.0070 ‐ 0.0052 = $0.0018
• a call option with positive intrinsic value is an in the
money option
 Example 5
• Spot price for CHF = $0.6352
• Jan 63 CHF Put priced at $.0003
‐ the option to sell CHF at $0.63 costs $0.0003
‐ the intrinsic value is
max[ (0.63 ‐ 0.6352),0] = $0
‐ therefore the time value is
$0.0003 ‐ 0 = $0.0003
• the put option with zero intrinsic value is an out of the
money option
 Example 6
• Spot price for CHF = $0.6352
• Jan 65 CHF Put priced at $.0157
‐ the option to sell CHF at $0.65 costs $0.0157
‐ the intrinsic value is
max[ (0.65 ‐ 0.6352),0] = $0.0148
‐ therefore the time value is
$0.0157 ‐ 0.0148 = $0.0009
• this put option is an in the money option
 Currency option valuation
• Therefore, the value of a currency option is a function of
– S = spot exchange rate
– k = strike price
– i = domestic (HC) risk‐free rate
– i*= foreign (FC) risk free interest rate
– σ = exchange rate volatility
– T = maturity
• 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 listed in exhibit 7.10 of the textbook