Chapter 7 Outline

Futures Contracts and Currency

Futures Markets
Options Contracts and Currency
Options Markets

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 Financial derivatives

Financial derivatives are a powerful tool used in business

today. They are so named because their values are derived
from underlying assets.
These instruments can be used for two very distinct
management objectives:
1 Speculation use of derivative instruments to take a
position in the expectation of a profit
2 Hedging use of derivative instruments to reduce the
risks associated with the everyday management of
corporate cash flow

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 Futures Contracts: Preliminaries

A foreign currency futures contract is an alternative to a

forward contract that calls for future delivery of a standard
amount of foreign exchange at a fixed time, place and price.
A futures contract is like a forward contract:
It specifies that a certain currency will be exchanged for
another at a specified time in the future at prices specified
today.
A futures contract is different from a forward contract:
Futures are standardized contracts trading on organized
exchanges with daily resettlement through a clearinghouse.

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 practice
The June 2005 Mexican peso futures contract has a price of
$0.08845. You believe the spot price in June will be $0.09500.
What speculative position would you enter into to attempt to
profit from your beliefs?

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Calculate your anticipated profits, assuming you take a
position in three contracts (1 contract size is 500,000 Mexican
pesos).

What is the size of your profit (loss) if the futures price is

indeed an unbiased predictor of the future spot price and this
price materializes?

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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 marked 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)

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 Standardizing Features

Contract size
Trading must be an even multiple of currency units
Currency Contract size
Australian dollar AD100,000
British pound 62,500
Canadian dollar CD100,000
Euro e125,000
Japanese yen U12,500,000
Swiss franc SF125,000

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Method of stating exchange rates
American quotes are used
Maturity date
Third Wed of Jan, Mar, Apr, Jun, Jul, Sep, Oct, Dec.
Last trading day
The 2nd business day prior to the Wed on which they
mature.
Commissions
Customers pay a commission to broker
Use of a clearinghouse as a counterparty
All contracts are agreements between the client and the
exchange clearing house

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 Collateral and maintenance margins

Marking to market is a daily settlement feature of the

currency futures exchange in which profits and losses are paid
over every day at the end of trading.
The purchaser must deposit a sum as an initial margin or
collateral (initial performance bond, about 2 percent of
contract value, cash or T-bills).
A maintenance margin is required. The value of the
contract is marked to market daily, and all changes in value
are paid in cash daily.
When your initial performance bond drops below the
maintenance level you will be required to post more money
(you receive a margin call).

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 Daily resettlement: Example

Daily cash flow in a three-day contract (date 0, 1, 2, 3) to

purchase foreign currency , is computed as follows

Day 0 1 2 3
Futures price 100 98 96 97
Marking to market pay 2 pay 2 receive 1
Final payment for delivery pay 97

(Ignoring time value), the cumulative payments from the buyer

are equal to 2+2-1+97=100 units of home currency

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Yesterday, you entered into a futures contract to buy EURO
100,000 at $1.25 per EURO. Your initial performance bond is
$3,000 and your maintenance level is $2,500. At what settle
price will you get a demand for additional funds to be posted?

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 Currency Futures Markets

In the US, the most important market for foreign currency

futures is the International Monetary Market (IMM), a division
of the Chicago Mercantile Exchange.
Others include:
The Philadelphia Board of Trade (PBOT)
The MidAmerica commodities Exchange
The Tokyo International Financial Futures Exchange
The London International Financial Futures Exchange

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 The Chicago Mercantile Exchange

Expiry cycle: March, June, September, December.

Delivery date third Wednesday of delivery month.
Last trading day is the second business day preceding the
delivery day.
CME hours 7:20 a.m. to 2:00 p.m. CST.
CME After Hours
Extended-hours trading on GLOBEX runs from 2:30
p.m. to 4:00 p.m dinner break and then back at it
from 6:00 p.m. to 6:00 a.m. CST.
The Singapore Exchange offers interchangeable
contracts.
There are other markets, but none are close to CME
and SIMEX trading volume.

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 Basic Currency Futures Relationships

Open Interest refers to the number of contracts

outstanding for a particular delivery month.

Open interest is a good proxy for demand for a contract.

Some refer to open interest as the depth of the market.

The breadth of the market would be how many different
contracts (expiry month, currency) are outstanding.

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 LIFETIME OPEN
OPEN HIGH LOW SETTLE CHG HIGH LOW INT

Euro/US Dollar (CME)125,000; $ per

Mar 1.3136 1.3167 1.3098 1.3112 -.0025 1.3687 1.1363 159,822
Jun 1.3170 1.3193 1.3126 1.3140 -.0025 1.3699 1.1750 10,096

Expiry month Closing price Highest and lowest

prices over the life
Daily Change
Opening price Lowest price that day of the contract.
Highest price that day Number of open contracts

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 Options Contracts: Preliminaries

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).

Calls vs. Puts

Call options gives the holder the right, but not the
obligation, to buy a given quantity of some asset at some
time in the future, at prices agreed upon today.
Put options gives the holder the right, but not the
obligation, to sell a given quantity of some asset at some
time in the future, at prices agreed upon today.

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 Options Contracts: Preliminaries

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, or value of the option itself
The underlying or actual spot exchange rate in the market

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 European vs. American options

European options can only be exercised on the

expiration date.
American options can be exercised at any time up to
and including the expiration date.
Since this option to exercise early generally has value,
American options are usually worth more than European
options, other things equal.

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 Moneyness

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 the 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).
Moneyness for calls and puts?

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 The total value (premium) of an option is equal to the
intrinsic value plus 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
At 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 and further into the money between the present time
and the options expiration date.
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 practice

Assume that a call option has an exercise price of

$1.50/. At a spot price of $1.45/, the call option has
an intrinsic value of

Assume that a call option has an exercise price of

$1.50/. At a spot price of $1.55/, the call option has
an intrinsic value of

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PHLX Currency Option Specifications

Currency Contract size

Australian dollar AD50,000
British pound 31,250
Canadian dollar CD50,000
Euro e62,500
Japanese yen U6,250,000
Swiss franc SF62,500

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 Basic Option Pricing Relationships at Expiry

At expiry, an American call option is worth the same as a

European option with the same characteristics.
If the call is in-the-money, it is worth ST E.
If the call is out-of-the-money, it is worthless.

CaT = CeT = Max[ST E, 0]

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 At expiry, an American put option is worth the same as a
European option with the same characteristics.
If the put is in-the-money, it is worth E ST .
If the put is out-of-the-money, it is worthless.

PaT = PeT = Max[E ST , 0]

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You just bought a Dec GBP call option with an exercise price
of $1.20/. At expiration, the value of the call option is

1 if the spot rate is $1.30/

2 if the spot rate is $1.20/

3 if the spot rate is $1.10/

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You just bought a Mar EUR put option with an exercise price
of $1.35/e. At expiration, the value of the put option is

1 if the spot rate is $1.40/e

2 if the spot rate is $1.35/e

3 if the spot rate is $1.30/e

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 Profit

Long 1 call

ST
c0
E + c0
E
Out-of-the-money In-the-money
loss

If the call is in-the-money, it is worth ST E.

If the call is out-of-the-money, it is worthless and the buyer of

the call loses his entire investment of c0 .
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 Profit

c0

ST
E + c0
E
short 1
loss Out-of-the-money In-the-money call

If the call is in-the-money, the writer loses ST E.

If the call is out-of-the-money, the writer keeps the option

premium.

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 Profit

E p0

p0 ST
E p0 long 1 put
E
In-the-money Out-of-the-money
loss
If the put is in-the-money, it is worth E ST . The Maximum
gain is E p0

If the put is out-of-the-money, it is worthless and the buyer of

the put loses his entire investment of p0
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 Profit

p0

ST
E p0 short 1 put
E
E + p0
loss
If the put is in-the-money, it is worth E ST . The Maximum
loss is E + p0

If the put is out-of-the-money, it is worthless and the seller of

the put kept the option premium of p0 .
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 Profit Example

Long 1 call
on 1 pound

$0.25 ST
$1.75
$1.50
loss
Consider a call option on 31,250.
The option premium is $0.25 per pound
The exercise price is $1.50 per pound.

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 Profit
For a contract

Long 1 call
on 31,250

$7,812.50 ST
$1.75
$1.50
loss

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 What is the Maximum loss on this call option?

At what exchange rate do you break even?

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 Profit
$42,187.50

$4,687.50 ST
$1.35 Long 1 put
$1.50 on 31,250
loss
Consider a put option on 31,250.
The option premium is $0.15 per pound
The exercise price is $1.50 per pound.

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 What is the Maximum gain on this put option?

At what exchange rate do you break even?

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 practice
From the perspective of the writer of a put option written
on e62,500. If the strike price is $1.25/e, and the option
premium is $1,875, at what exchange rate do you start to lose
money?

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 Suppose that you buy a e1,000,000 call option against
dollars with a strike price of $1.2750/e. Describe this option
as the right to sell a specific amount of dollars for euros at a
particular exchange rate of euros per dollar. Why is this latter
option a dollar put option against the euro?

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 European Option boundary

Consider two investments

1 Buy a European call option on the British pound futures
contract. The cash flow today is Ce
2
R
Replicate the upside payoff of the call by

L
Borrowing the present value of the exercise price of
E
the call in the U.S. at i$ the cash flow today is 1+i $
Lending the present value of St at i the cash flow
St
today is 1+i

Why are we doing this?

Lets look at the payoff in different state of the world and
appeal the principle of no arbitrage

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When the option is in-the-money both strategies have the
same payoff.
When the option is out-of-the-money it has a higher payoff
than the borrowing and lending strategy.
Thus:  
St E
Ce Max ,0
1 + i 1 + i$
Using a similar portfolio to replicate the upside potential of a
put, we can show that:
 
E St
Pe Max ,0
1 + i$ 1 + i

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Recall interest rate parity (IRP)

1 + i$ F ($/)
=
1 + i S($/)
so we can rewrite
 
F E
Ce Max ,0
1 + i$ 1 + i$
Using a similar portfolio to replicate the upside potential of a
put, we can show that:
 
E F
Pe Max ,0
1 + i$ 1 + i$

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Assume that the dollar-euro spot rate is $1.2801 and the
six-month forward rate is $1.2864. The annual U.S. dollar rate
is 5% and the Euro rate is 4%. The minimum price that a
six-month European call option with a striking price of $1.25
should sell for in a rational market is

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 American Option boundary

We would also like to know the value of options before expiry.

With an American option, you can do everything that you can
do with a European option AND you can exercise prior to
expirythis option to exercise early has value, thus:

Ca > Ce ; and
Ca Max[St E, 0].
Pa > Pe ; and
Pa Max[E St , 0].

This must be true. And we can find a tighter bound...

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 American Option boundary

A tighter bound...
 
St E
Ca Max , St E, 0
1 + i 1 + i$
 
E St
Pa Max , E St , 0
1 + i$ 1 + i

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Assume that the dollar-euro spot rate is $1.2801 and the
six-month forward rate is $1.2864. The annual U.S. dollar rate
is 5% and the Euro rate is 4%. The minimum price that a
six-month American call option with a striking price of $1.25
should sell for in a rational market is

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 Put-Call parity

No arbitrage relationship;
links the common strike price of $/, dollar prices of
European-style put and call options at that strike price, and
the U.S. interest rate.

F = E + (C P ) [1 + i$ ]

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 practice problem

It is Thursday, Sep 16, and we have the following information:

Spot rate: $0.7142/SF

90-day forward rate: $0.7114/SF
U.S. dollar interest rate: 3.75% p.a.
Swiss franc interest rate: 5.33% p.a.
Option data for December contracts ($/SF):

strike call put

0.70 0.0255 0.0142

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What is the synthetic forward rate obtained by buying a call
and writing a put?

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 Binomial Option Pricing Model
The binomial option pricing model assumes that the price
of the underlying asset follows a binomial distribution
that is, the asset price in each period can move only up or
down by a specified amount
Imagine a world where the spot exchange rate is
S0 ($/e) = $1.50/e, today, and in the next year S1 ($/e)
is either $1.80/e, or $1.20/e.
e10,000 will change from $15,000 to either $18,000 or
$12,000.
A call option on e10,000 with strike price
S0 ($/e) = $1.50 will payoff either $3,000 or zero.
If S1 ($/e) = $1.800/e, the option is in-the-money since
you can buy e10,000 (worth $18,000 at
S1 ($/e) = $1.80/e) for only $15,000.

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 Binomial Option Pricing Model

S1u = $18, 000 = e10, 000 $1.80

e

C1u = Max[$18, 000 $15, 000, 0] = $3, 000

$15, 000@
@

= $12, 000 = e10, 000

@
$1.20
RS1d
@ e
C1d = Max[$12, 000 $15, 000, 0] = $0

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 Binomial Option Pricing Model
We can replicate the payoffs of the call option by taking a
long position in a bond with value of e5,000 in the future
along with the right amount of dollar-denominated
borrowing (in this case borrow the value of $6,000 in the
future).
The portfolio payoff in one period matches the option
payoffs:

$9, 000 $6, 000 = $3, 000 = C1u



C0
@
@
@
R$6, 000 $6, 000
@ = $0 = C1d
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 Binomial Option Pricing Model

With continuously compounding interest rate, the

replicating portfolios dollar cost today is the sum of
todays dollar cost of the present value of e5,000 less the
cash inflow from borrowing the present value of $6,000:
e5, 000 $1.50 $6, 000

eie e1.00 e i$
When S0 ($/e) = $1.50/e, i$ = 7.1%, and ie = 5%, the
most a willing buyer should pay for the call option is
$1,545.45. Thats what it would cost him today to build a
portfolio that perfectly replicates the call option payoffs.

$1, 545.45 = $7, 134.22 $5, 588.77

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 The Binomial Solution

Generally, how do we find a replicating portfolio consisting

of investing units of foreign currency and B units of
domestic currency, such that the portfolio imitates the
option whether the spot rate rises or falls?
Assuming continuously compounding, if the length of
a period is T , the interest factor per period is eid T at
home and eif T abroad
uS denotes when the rate (price) goes up, and dS
denotes when the rate (price) goes down

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 The Binomial Solution (contd)

Stock price tree: Corresponding tree for

the value of the option:

uS Cu
 

S@ C@
@ @
@ @
RdS
@ @RCd
The value of the replicating portfolio at time T , with spot rate
ST , is
ST eif T + B eid T

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 The Binomial Solution (contd)

At the rates (prices) ST = uS and ST = dS, a replicating

portfolio will satisfy

( uSeif T ) + (B eid T ) = Cu

( dSeif T ) + (B eid T ) = Cd
Solving for and B gives

Cu Cd
= eif T
S(u d)
uC d dCu
B = eid T
ud

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 The Binomial Solution (contd)

The cost of creating the option today is the cash flow

required to buy/invest the currencies. Thus, the cost of
the option is S + B
 e(id if )T d u e(id if )T 
S + B = eid T Cu + Cd (1)
ud ud
The no-arbitrage condition is

u > e(id if )T > d (2)

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 Risk-Neutral Pricing
(id if )T (id if )T
We can interpret the terms e ud d and ue
ud
as
probabilities
Let
e(id if )T d
p = (3)
ud
Then equation (1) can then be written as

C = eid T [p Cu + (1 p )Cd ] (4)

If we use p to compute the expected undiscounted spot

rate
p uS + (1 p )dS = e(id if )T S = FT (5)
 Where p is the risk-neutral probability of an increase
in the spot rate

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 Lets verify

What is the ?

What is the B?

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 Lets verify

What is the p ?

What is the C0 ?

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