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9 Chapter Nine Futures and Options on Foreign Exchange Chapter Objective: This chapter discusses exchange-traded currency futures contracts, options contracts, and options on currency futures. Chapter Outline Futures Contracts: Preliminaries Currency Futures Markets

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9

Chapter Nine

Futures and Options on Foreign Exchange

Chapter Objective:

  • This chapter discusses exchange-traded currency futures contracts, options contracts, and options on currency futures.

    Chapter Outline

  • Futures Contracts: Preliminaries

  • Currency Futures Markets

  • Basic Currency Futures Relationships

  • Eurodollar Interest Rate Futures Contracts

  • Options Contracts: Preliminaries

  • Currency Options Markets

  • Currency Futures Options


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9.1 Futures Contracts

  • 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 - marked to market.

  • Standardizing Features: contract size, delivery month, daily resettlement - marked to market

  • Initial Margin: about 2-5 % of contract value, cash or T-bills held in your name at your brokers.

  • Participants’ losses or profits are realized daily instead of at maturity as with a forward contract.

  • Because of marking to market, the futures price converges through time to the spot price on the last day of trading in the contract.


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Daily Resettlement = Marking to Market

Example: On Monday morning you take a long position in SF futures contract that matures on Wednesday afternoon at $0.75/SF.

1. At the close of trading on Monday the futures price has risen to $0.755. Because of the daily settlement you receive a cash profit of

$625 =125,000 x (0.755-0.75)

2. At Tuesday close the price has declined to $0.743. You must pay the $1500 loss (125,000 x [0.743-0.755]) to the other side of the contract.

3. At Wednesday close, the price drops to $0.74, and the contract matures. You pay $375 loss to the other side and take the delivery of the SF, paying the prevailing price of $0.74. You have a net loss on the contract of $1250 (625-1500-375)

You can also close out your long position with an offsetting trade, if you don’t want the delivery of the SF.


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9.2 Currency Futures Markets

  • The Chicago Mercantile Exchange (CME) is by far the largest.

  • Others include:

    • The Philadelphia Board of Trade (PBOT)

    • The MidAmerica commodities Exchange

    • The Tokyo International Financial Futures Exchange

    • The London International Financial Futures Exchange

  • Expiry cycle: March, June, September, December.

  • Delivery date 3rd 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.


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9.3 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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Reading a Futures Quote ($/€)

Highest and lowest prices over the lifetime of the contract.

Daily Change

Closing price

Lowest price that day

Highest price that day

Opening price

Number of open contracts

Expiry month



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9.4 Eurodollar Interest Rate Futures Contracts

  • Widely used futures contract for hedging short-term U.S. dollar interest rate risk.

  • The underlying asset is a hypothetical $1,000,000 90-day Eurodollar deposit—the contract is cash settled.

  • Traded on the CME and the Singapore International Monetary Exchange.

  • The contract trades in the March, June, September and December cycle.


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EURODOLLAR (CME)—$1 million; pts of 100%

Open

High

Low

Settle

Chg

Yield

Settle Change

Open Interest

July

94.69

94.69

94.68

94.68

-.01

5.32

+.01

47,417

Reading Eurodollar Futures Quotes

Eurodollar futures prices are stated as an index number of three-month LIBOR calculated as F = 100 – LIBOR.

The closing price for the July contract is 94.68 thus the implied yield is 5.32 percent = 100 – 94.68

The change was .01 percent of $1 million representing $100 on an annual basis. Since it is a 3-month contract one basis point corresponds to a $25 price change.


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9.5 Currency Options-Preliminaries

  • An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset in e future, at prices agreed upon today

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

  • Put options: the holder has the right, but not the obligation, to sell a given quantity of some asset in the future, at prices agreed upon today.

  • 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 the option to exercise early generally has value, American options are usually worth more than European options, other things equal; they are more flexible with respect to exercise time.


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9.5 Currency Options-Preliminaries

  • At-the-money (ATM) E = S

    The exercise price (E), also known as strike price, equals the spot price (S) of the underlying asset.

  • In-the-money (ITM) E < S

    The exercise price (E) is less than the spot price (S) of the underlying asset.

  • Out-of-the-money (OTM) E > S

    The exercise price is more than the spot price of the underlying asset.


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Currency Options Markets

  • Originally traded OTC

  • PHLX

  • OTC volume is much bigger than exchange volume.($130Bil. vs. $3Bil. Per day)

  • Trading is in six major currencies against the U.S. dollar.

  • Options contract sizes are half of the futures contracts



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9.7 Currency Option Pricing Relationships at Expiry

Currency options are an option on a currency futures contract.

Exercise of a currency futures option results in a long futures position for the holder of a call or the writer of a put.

Exercise of a currency futures option results in a short futures position for the seller of a call or the buyer of a put.

If the futures position is not offset prior to its expiration, foreign currency will change hands.


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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]

  • 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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Pay-off to Purchaser of a Call Option on C$ for US$


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Pay-off to Writer of a Call Option on C$ for US$


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Pay-off to Purchaser of a Put Option on C$ for US$




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