On Foreign Exchange INTERNATIONAL FINANCIAL MANAGEMENT Chapter .

Chapter NineFutures and Optionson Foreign Exchange INTERNATIONAL9FINANCIALMANAGEMENTChapter Objective:This chapter discusses exchange-traded currencyfutures contracts, options contracts, and options oncurrency futures.Second EditionIrwin/McGraw-HillEUN / RESNICKCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Chapter Outline Futures Contracts: PreliminariesCurrency Futures MarketsBasic Currency Futures RelationshipsEurodollar Interest Rate Futures ContractsOptions Contracts: PreliminariesCurrency Options MarketsCurrency Futures OptionsIrwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Chapter Outline (continued) Basic Option Pricing Relationships at ExpiryAmerican Option Pricing RelationshipsEuropean Option Pricing RelationshipsBinomial Option Pricing ModelEuropean Option Pricing ModelEmpirical Tests of Currency Option ModelsIrwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Futures Contracts: Preliminaries A futures contract is like a forward contract: It specifies that a certain currency will beexchanged for another at a specified time in thefuture at prices specified today.A futures contract is different from a forwardcontract: Futures are standardized contracts trading onorganized exchanges with daily resettlementthrough a clearinghouse.Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Futures Contracts: Preliminaries Standardizing Features: Contract SizeDelivery MonthDaily resettlementInitial Margin (about 4% of contract value, cash orT-bills held in a street name at your brokers).Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Daily Resettlement: An Example Suppose you want to speculate on a rise in the / exchange rate (specifically you think that thedollar will appreciate).Currently 1 140. The 3-month forward price is 1 150.Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Daily Resettlement: An Example Currently 1 140 and it appears that the dollaris strengthening.If you enter into a 3-month futures contract to sell at the rate of 1 150 you will make money ifthe yen depreciates. The contract size is 12,500,000Your initial margin is 4% of the contract value:Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Daily Resettlement: An ExampleIf tomorrow, the futures rate closes at 1 149,then your position’s value drops.Your original agreement was to sell 12,500,000and receive 83,333.33But now 12,500,000 is worth 83,892.62You have lost 559.28 overnight.Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Daily Resettlement: An Example The 559.28 comes out of your 3,333.33 marginaccount, leaving 2,774.05This is short of the 3,355.70 required for a newposition. Yourbroker will let you slide until you runthrough your maintenance margin. Then you mustpost additional funds or your position will be closedout. This is usually done with a reversing trade.Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Currency Futures Markets The Chicago Mercantile Exchange (CME) is byfar the largest.Others include: The Philadelphia Board of Trade (PBOT)The MidAmerica commodities ExchangeThe Tokyo International Financial Futures ExchangeThe London International Financial Futures ExchangeIrwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

The Chicago Mercantile Exchange Expiry cycle: March, June, September, December.Delivery date 3rd Wednesday of delivery month.Last trading day is the second business daypreceding the delivery day.CME hours 7:20 a.m. to 2:00 p.m. CST.Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

CME After Hours Extended-hours trading on GLOBEX runs from2:30 p.m. to 4:00 p.m dinner break and then backat it from 6:00 p.m. to 6:00 a.m. CST.Singapore International Monetary Exchange(SIMEX) offer interchangeable contracts.There’s other markets, but none are close to CMEand SIMEX trading volume.Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Basic CurrencyFutures Relationships Open Interest refers to the number of contractsoutstanding for a particular delivery month.Open interest is a good proxy for demand for acontract.Some refer to open interest as the depth of themarket. The breadth of the market would be howmany different contracts (expiry month, currency)are outstanding.Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Reading a Futures QuoteHighest and lowestDaily Change prices over theClosing pricelifetime of theLowest price that daycontract.Highest price that dayOpening priceNumber of open contractsExpiry monthIrwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Eurodollar Interest RateFutures Contracts Widely used futures contract for hedging shortterm U.S. dollar interest rate risk.The underlying asset is a hypothetical 1,000,00090-day Eurodollar deposit—the contract is cashsettled.Traded on the CME and the SingaporeInternational Monetary Exchange.The contract trades in the March, June, Septemberand December cycle.Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Reading Eurodollar Futures QuotesEURODOLLAR (CME)— 1 million; pts of 100%JulyOpenHighLowSettleChgYieldSettle 17 .01Eurodollar futures prices are stated as an index number of three-monthLIBOR calculated as F 100-LIBOR.The closing price for the July contract is 94.68 thus the implied yield is5.32 percent 100 – 98.68The change was .01 percent of 1 million representing 100 on anannual basis. Since it is a 3-month contract one basis point correspondsto a 25 price change.Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Options Contracts: Preliminaries An option gives the holder the right, but not theobligation, to buy or sell a given quantity of anasset in the future, at prices agreed upon today.Calls vs. Puts Call options gives the holder the right, but not theobligation, to buy a given quantity of some asset atsome time in the future, at prices agreed upon today.Put options gives the holder the right, but not theobligation, to sell a given quantity of some asset atsome time in the future, at prices agreed upon today.Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Options Contracts: Preliminaries European vs. American options European options can only be exercised on theexpiration date.American options can be exercised at any time up toand including the expiration date.Since this option to exercise early generally has value,American options are usually worth more thanEuropean options, other things equal.Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Options Contracts: Preliminaries In-the-money At-the-money The exercise price is less than the spot price of theunderlying asset.The exercise price is equal to the spot price of theunderlying asset.Out-of-the-money The exercise price is more than the spot price of theunderlying asset.Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Options Contracts: Preliminaries Intrinsic Value The difference between the exercise price of the optionand the spot price of the underlying asset.Speculative Value The difference between the option premium and theintrinsic value of the option.OptionPremiumIrwin/McGraw-Hill IntrinsicValue SpeculativeValueCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Currency Options Markets PHLXHKFE20-hour trading day.OTC volume is much bigger than exchangevolume.Trading is in seven major currencies plus the euroagainst the U.S. dollar.Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

PHLX Currency Option Specifications62,500Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Currency Futures Options Are an option on a currency futures contract.Exercise of a currency futures option results in along futures position for the holder of a call or thewriter of a put.Exercise of a currency futures option results in ashort futures position for the seller of a call or thebuyer of a put.If the futures position is not offset prior to itsexpiration, foreign currency will change hands.Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Basic Option PricingRelationships at Expiry At expiry, an American call option is worth thesame as a European option with the samecharacteristics.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]Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Basic Option PricingRelationships at Expiry At expiry, an American put option is worth thesame as a European option with the samecharacteristics.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]Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Basic Option Profit ProfilesCaT CeT Max[ST - E, 0]profitEE CSTlossIrwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Basic Option Profit ProfilesCaT CeT Max[ST - E, 0]profitEE CSTlossIrwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Basic Option Profit ProfilesPaT PeT Max[E - ST, 0]profitSTE-pElossIrwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Basic Option Profit ProfilesCaT CeT Max[ST - E, 0]profitE-pESTlossIrwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

American Option PricingRelationships With an American option, you can do everythingthat you can do with a European option—thisoption to exercise early has value.CaT CeT Max[ST - E, 0]PaT PeT Max[E - ST, 0]Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Market Value, Time Value andIntrinsic Value for an American CallCaT Max[ST - E, 0]ProfitMarket ValueTime valueIntrinsic aw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

European Option Pricing RelationshipsConsider two investments1Buy a call option on the British pound futurescontract. The cash flow today is -Ce2Replicate the upside payoff of the call by12Borrowing the present value of the exercise price ofthe call in the U.S. at i The cash flow today isE /(1 i )Lending the present value of ST at i The cash flow is- ST /(1 i )Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

European Option Pricing RelationshipsWhen the option is in-the-money both strategieshave the same payoff.When the option is out-of-the-money it has ahigher payoff the borrowing and lendingstrategy.Thus:Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

European Option Pricing RelationshipsUsing a similar portfolio to replicate the upsidepotential of a put, we can show that:Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Binomial Option Pricing ModelImagine a simple world where the dollar-euroexchange rate is S0( / ) 1 today and in thenext year, S1( / ) is either 1.1 or .90.S0( / )S1( / ) 1.10 1 .90Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.

Binomial Option Pricing Model A call option on the euro with exercise priceS0( / ) 1 will have the following payoffs.S0( / )S1( / )C1( / ) 1.10 .10 .90 0 1Irwin/McGraw-HillCopyright 2001 by The McGraw-Hill Companies, Inc. All rightsreserved.