Futures and Options

on Foreign Exchange 6
Week Six

Objective:

Today’s class discusses exchange-traded currency

futures contracts, and options contracts.

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 Topics
• Futures Contracts: Preliminaries
• Currency Futures Markets
• Options Contracts: Preliminaries
• Currency Options Markets
• Basic Option Pricing Relationships at Expiry
• American Option Pricing Relationships

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 Futures Contracts: Preliminaries
• 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:
– Exchange-traded
– Has standardized features (contract size and maturity
date) ,
– With daily settlement through a clearing house
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 Forward Contract: A Review
• Recall that an investor with a long forward position
gains from increases in the price of the underlying
asset.
• Suppose an investor has agreed to BUY €125,000 at
$1.30 per euro in three months time.
• With a forward contract, at the end of three
months, if the euro was worth $1.24, he would lose
$7,500 = ($1.24 – $1.30) × 125,000.
• If instead at maturity the euro was worth $1.35, he
would gain $6,250 = ($1.35 – $1.30) × 125,000.

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 Futures Contract: Daily
Resettlement
• With futures, we have daily resettlement of
gains and losses rather than one big
settlement at maturity.
• Every trading day:
– if the price goes down, the short position gains
and the long position loses.
– if the price goes up, the long position gains and
the short position loses.

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 Daily Resettlement
• Initial performance bond (also called margin) must be
deposited in your collateral account to establish a
futures position:
– The initial performance bond is about 2 percent of the
contract value.
• Maintenance performance bond
– The maintenance performance bond is roughly 75% of the
initial performance bond.
– If the balance in the investor’s collateral account falls below
the maintenance performance bond level, additional funds
must be deposited into the account to bring it back to the
initial performance bond level.
– Otherwise, the exchange will close the investor’s position.

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 Daily Settlement: An Example
• Consider a long position in the CME Euro/U.S.
Dollar contract.
• It is written on €125,000 and quoted in $ per €.
• The futures price is $1.30 the maturity is 3
months.
• At initiation of the contract, the long posts an
initial performance bond of $6,500.
• The maintenance performance bond is $4,000.

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 Daily Settlement: An Example
• Over the first 3 days, the euro fluctuates in dollar
terms as follows:
Settle Gain/Loss Account Balance
$1.31 – $1.30)×125,000
$1,250 = ($1.31$7,750= $6,500 + $1,250
$1.30 –$1,250 $6,500
$1.27 –$3,750 $2,750+ $3,750 = $6,500
On third day suppose our investor keeps his long
position open by posting an additional $3,750.
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 Daily Settlement: An Example
• Over the next 2 days, the long keeps losing money
and closes out his position at the end of day five.
Settle Gain/Loss Account Balance
$1.31 $1,250 $7,750
$1.30 –$1,250 $6,500
$1.27 –$3,750 $2,750 + $3,750 = $6,500
$1.26 –$1,250 $5,250= $6,500 – $1,250
$1.24 –$2,500 $2,750
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 Daily Settlement: An Example
Settle Gain/Loss Account Balance
$1.30 –$– $6,500
$1.31 $1,250 $7,750
$1.30 –$1,250 $6,500
$1.27 –$3,750 $2,750 + $3,750
$1.26 –$1,250 $5,250
$1.24 –$2,500 $2,750
Total loss = – $7,500 = ($1.24 – $1.30) × 125,000
= $2,750 – ($6,500 + $3,750)
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 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

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 Reading Currency Futures Quotes
OPEN
OPEN HIGH LOW SETTLE CHG INT

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

Mar 1.4748 1.4830 1.4700 1.4777 .0028 172,39
Jun 1.4737 1.4818 1.4693 1.4763 .0025 2,2666

Expiry Closing
month price Daily Change
Opening price Lowest price that day
Highest price that day Number of open contracts
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 Options Contracts: Preliminaries
• An option gives the holder the right, but not the
obligation, to buy or sell a given quantity of an asset
in the future, at prices agreed upon today.
• 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
• 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 generally worth more
than European options, other things equal.

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 Options Contracts: Preliminaries
For holders of call (put) options:
• In-the-money
– The exercise price is less (more) than the spot price of the
underlying asset, and the option will be exercised.
• At-the-money
– The exercise price is equal to the spot price of the underlying
asset.
• Out-of-the-money
– The exercise price is more (less) than the spot price of the
underlying asset, and the option will not be exercised.

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 Currency Options Markets
• Exchange-traded currency options available on
Philadelphia Stock Exchange (PHLX)
• 1, 2, 3, 6, 9, 12 month maturity
• Over-the-counter (OTC) options are typically written
by international banks and investment banks, and are
tailor-made to the needs of the buyer.
• The volume on OTC currency options is much bigger
than that on exchange-traded currency options. (In
2004: US$117 billion per day of OTC options vs. US$2.5
billion per day of exchange-traded options.)
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PHLX Currency Option Specifications
Currency Contract Size
Australian dollar AD50,000
British pound £31,250
Canadian dollar CD50,000
Euro €62,500
Japanese yen ¥6,250,000
Swiss franc SF62,500
By contrast, OTC options are written for large amounts:
at least US$1,000,000 worth of the underlying currency.

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 Basic Option Pricing
Relationships at Expiration
• At expiration, 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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 Basic Option Pricing
Relationships at Expiration
• At expiration, 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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 Basic Option Profit Profiles
Profit Owner of the call
If the call is in-
the-money, it is Long 1 call
worth ST – E.
If the call is out-
of-the-money, it is
worthless and the ST
–c0
buyer of the call E + c0
loses his entire E
investment of c0.
Out-of-the-money In-the-money
loss
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 Basic Option Profit Profiles
Profit Seller of the call
If the call is in-the-
money, the writer
loses ST – E.
If the call is out-of- c0
the-money, the
writer keeps the ST
option premium.
E + c0
E
short 1
Out-of-the-money In-the-money call
loss
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 Basic Option Profit Profiles
Profit Owner of the put
If the put is in-
the-money, it is E – p
0
worth E – ST. The
maximum gain is
E – p0
If the put is out-
of-the-money, it is
ST
worthless and the – p0
buyer of the put E – p0 long 1 put
loses his entire
investment of p0. E
In-the-money Out-of-the-money
loss
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 Basic Option Profit Profiles
Profit Seller of the put
If the put is in-the-
money, it is worth
E –ST. The
maximum loss is –
E + p0
If the put is out-of- p0
the-money, it is
ST
worthless and the
seller of the put E – p0 short 1 put
keeps the option E
premium of p0.
– E + p0
loss
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 Example
Profit
 Consider a call
option on €31,250.
 The option Long 1 call
premium is $0.25 on € 1
per €
 The exercise price
is $1.50 per €.–$0.25 ST

$1.75
$1.50

loss
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 Example
Profit What is the maximum gain on this put option?

 Consider a put $1.35 $42,187.50 = €31,250×($1.50 – $0.15)/€

option on
€31,250. What is the maximum loss?asdfaasdfadfa
 The option $4,687.50 = €31,250×($0.15)/€
premium is $0.15
per €
 The exercise –$0.15 ST
price is $1.50 per $1.35 Long 1 put
euro. on € 1
$1.50

loss
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 American Option Pricing
Relationships
• American call and put premium at time t will
be at least as large as the immediate exercise
value, or intrinsic value, of the call or put
option
Cat > Max[St - E, 0]

Pat > Max[E - St, 0]

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 Market Value, Time Value and Intrinsic
Value for an American Call
Profit

The red line shows Long 1 call

the payoff at
maturity, not profit,
of a call option.
Note that even an Intrinsic value
out-of-the-money ST
option has value— Time value
time value.
Out-of-the-money In-the-money
loss E
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 Market Value, Time Value & Intrinsic
Value for an American Call
• Why is time value > 0? Or, why are investors
willing to pay more than the immediate
exercise value for an option?

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 Exercise 1
• Assume today’s settlement price on a CME GBP futures
contract is $1.8050/£. You have a short position in one
contract. The size of the contract is £62,500. Your
performance bond account currently has a balance of
$2,200. The next three days’ settlement prices are
$1.8058, $1.8011, and $1.7995.
1. Calculate the daily changes in the performance bond
account from daily marking-to-market and the balance
of the performance bond account after the third day.
 Exercise 2
• Using the quotations in Exhibit 7.3, calculate
the face value of the open interest in the
September 2013 Swiss franc futures contract.

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 Exercise 3
• Suppose that the September 2010 Mexican peso futures
contract has a price of $0.77275 per 10 MXN. You believe the
spot price in September will be $0.83800 per 10 MXN. The
contract size of one MXN contract is MXN500,000.
1. What speculative position would you enter into to attempt to
profit from your beliefs?
2. Calculate your anticipated profits, assuming you take a position in
three contracts.
3. 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?
 Exercise 4
• Assume that the Japanese yen is trading at a
spot price of 92.04 cents per 100 yen. Further
assume that the premium of an American call
(put) option with a striking price of 93 is 2.10
(2.20) cents. Calculate the intrinsic value and
the time value of the call and put options.
 Exercise: Mini Case
• A speculator is considering the purchase of five three-month
Japanese yen call options with a striking price of 96 cents per 100
yen. The premium is 1.35 cents per 100 yen. The spot price is
95.28 cents per 100 yen and the 90-day forward rate is 95.71
cents. The speculator believes the yen will appreciate to $1.00 per
100 yen over the next three months. As the speculator’s assistant,
you have been asked to prepare the following:
1. Graph the call option cash flow schedule.
2. Determine the speculator’s profit if the yen appreciates to
$1.00/100 yen.
3. Determine the speculator’s profit if the yen only appreciates to the
forward rate.
4. Determine the future spot price at which the speculator will only
break even.
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 End of Week 6

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