CHAPTER 7

FUTURES AND OPTIONS ON FOREIGN

EXCHANGE
 Introduction

• Futures and options contracts can be very risky investments when used for
speculative purposes.

• Nevertheless, they are also important risk-management tools.

• Exchange-traded currency futures contracts, options contracts, and options on

currency futures are useful for both speculating on foreign exchange price
movements and hedging exchange rate uncertainty.
Futures Contracts: Some Preliminaries

Trading Location
Futures: Traded competitively on organized exchanges.
Forward: Traded by bank dealers via a network of telephones and computerized dealing systems.
Contractual Size
Futures: Standardized amount of the underlying asset.
Forward: Tailor-made to the needs of the participant.
Settlement
Futures: Daily settlement, or making-to-market, done by the futures clearinghouse through the
participant's performance bond account.
Forward: Participant buys or sells the contractual amount of the underlying asset from the bank
at maturity at the forward (contractual) price.
Expiration Date
Futures: Standardized delivery dates.
Forward: Tailor-made delivery date that meets the needs of the investor.
Delivery
Futures: Delivery of the underlying asset is seldom made. Usually a reversing trade is transacted
to exit the market.
Forward: Delivery of the underlying asset is commonly made.
Trading Costs
Futures: Bid-ask spread plus broker's commission.
Forward: Bid-ask spread plus indirect bank charges via compensating balance requirements.
Exhibit 7.1 Differences between Futures and Forward Contracts
 Currency Futures Markets

• On May 16, 1972, trading in currency futures contracts began at the Chicago
Mercantile Exchange (CME).

• Regular trading in CME currency futures contracts takes place each business day
from 7:20 A.M. to 2:00 P.M. Chicago time. Additional CME currency futures trading
takes place Sunday through Thursday on the GLOBEX trading system from 5:00 P.M.
to 4:00 P.M. Chicago time the next day.

• In addition to the CME, currency futures trading takes place on the Intercontinental
Exchange (ICE) Futures U.S., the Mexican Derivatives Exchange, the BM&F
Exchange in Brazil, the Budapest Commodity Exchange, and the Derivatives Market
Division of the Korea Exchange.
 Basic Currency Futures Relationships

• Exhibit 7.2 shows quotations for CME futures contracts. For each delivery month
for each currency, we see the opening price quotation, the high and the low quotes
for the trading day (in this case June 5, 2013), the settlement price, and the open
interest.
• In general, open interest typically decreases with the term-to-maturity of most
futures contracts.

Open High Low Settle Change Open interest

Currency Futures
British Pound (CME)-£62,500; $ per £
June 1.5312 1.5409 1.529 1.5401 0.0097 204,470
Sept 1.5295 1.54 1.5283 1.5392 0.0097 5,434
Euro (CME)-€125,000; $ per €
June 1.3084 1.3118 1.3054 1.3087 0.0005 223,380
Sept 1.3089 1.3126 1.3062 1.3094 0.0005 16,814

Exhibit 7.2 CME Group Currency Futures Contract Quotations

 Basic Currency Futures Relationships

Example 7.1: Reading Futures Quotations

As an example of reading futures quotations, let' s use the September 2013 British pound contract.
From Exhibit 7.2, we see that on Wednesday, June 5, 2013, the contract opened for trading at a price
of $1.5400/£, and traded in the range of $1.5283/£ (low) to $1.5400/£ (high) throughout the day. The
settlement ("closing") price was $1.5392/£. The open interest, or the number of September 2013
contracts outstanding, was 5,434.
At the settlement price of $1.5392, the holder of a long position in one contract is committing himself
to paying $96,200 for £62,500 on the delivery day, September 18, 2013, if he actually takes delivery.
Note that the settlement price increased $0.0097 from the previous day. That is, it increased from
$1.5295/£ to $1.5392/£. Both the buyer and the seller of the contract would have their accounts marked-
to-market by the change in the settlement prices. That is, one holding a long position from the previous
day would have $606.25 =($0.0097 x £62,500) added to his performance bond account and the short
would have $606.25 subtracted from his account.
 Basic Currency Futures Relationships

Example 7.1: Reading Futures Quotations

Even though marking-to-market is an important economic difference between the operation of the
futures market and the forward market, it hass little effect on the pricing of futures contracts as opposed
to the way forward contracts are priced. To see this, note the pattern of forward prices from the Exchange
Rates presented in Exhibit 5.4 in Chapter 5. They go from a spot price of $1.5405/ to $1.5402 (1-month) to
$1.5396 (3-months) to $1.5389 (6-months). To the extent that forward prices are an unbiased predictor
of future spot exchange rates, the market is anticipating the U.S. dollar to appreciate over the next six
month relative to the pound. Similarly, we see an appreciating pattern of the U.S. dollar from the pattern
of settlement prices for the futures contracts: $1.5401 (June) to $1.5392 (September). It is also noteworthy
that both the forward and the futures contracts together display a chronological pattern. For example,
the June futures contract price (with a delivery date of June 19) and the September futures contract price
(with a delivery date of September 18) surround the 1-month forward contract price (with a value date
of July 9) and the 3-month forward contract price (with a value date of September 9); these coupled with
the 6-month forward contract price (with a value date of December 9) display an essential consistent
pattern: $1.5405, $1.5401, $1.5402, $1.5396, and $1.5389 appreciating from June to December. Thus,
both the forward market and the futures market are useful for price discovery, or obtaining the market's
forecast of the spot exchange rate at different future dates.
 Basic Currency Futures Relationships

• In Chapter 6, we developed the interest rate parity (IRP) model, which states that
the forward price for delivery at time T is

(1 + 𝑟$)𝑇
FT($/i) = So($/i)
(1 + 𝑟𝑖)𝑇

• We will use the same equation to define the futures price.

 Basic Currency Futures Relationships
Example 7.2: Speculating and Hedging with Currency Futures
Suppose a trader takes a position on June 5, 2013 in one September 2013 euro futures contract at $1.3094/€.
The trader holds the position until the last day of trading when the spot price is $1.2939/€. This also will
be the final settlement price because of price convergence. The trader's profit or loss depends upon
whether he had a long or short position in the September euro contract. If the trader had a long position,
and he was a speculator with no underlying position in euros, he would have a cumulative loss of
-$1,937.50 [=($1.2939 - $1.3094) x €125,000] from June 5 through September 18. This amount would be
substracted from his margin account as a result of daily marking-to-market. If he takes delivery, he will
pay out-of-pocket $161,737.50 for the €125,000 (which have a spot market value of $161,737.50). The
effective cost, however, is $163,675 (=$161,737.50 + $1,937.50), including the amount subtracted from
the margin money. Alternatively, as a hedger desiring to acquire €125,000 on September 18 for $1.3094/€,
our trader has locked in a purchase price of $163,675 from a long position in the September futures.
contract.
If the trader had taken a short position, and he was a speculator with no underlying position in euros, he
would have a cumulative profit of $1,937.50 [=($1.3094 - $1.2939) x €125,000] from June 5 through September
18. This amount would be added to his margin account as a result of daily marking-to-market. If he makes
delivery, he will receive $161,737.50 for the €125,000 (which also cost $161,737.50 in the spot market). The
effective amount he receives, however, is $163,675 (=$161,737.50 + $1,937.50), including the amount
added to his margin account. Alternatively, as a hedger desiring to sell €125,000 on September 18 for
$1.3094/€, our trader has locked in a sales price of $163,675 from a short position in September futures
contract. Exhibit 7.3 graphs these long and short futures positions.
Basic Currency Futures Relationships

Profit ($)
+

FJun($/€)
Long position

.0155

0 SSep($/€)

FSep($/€) = 1.3094
-.0155

-FJun($/€)

Exhibit 7.3 Graph of Long and Short Positions in the September 2013 Euro Futures Contract
 Options Contracts: Some Preliminaries

• An option is a contract giving the owner of the right, but not the obligation, to buy
or sell a given quantity of an asset at a specified price at some time in the future.

• An option to buy the underlying asset is a call, and an option to sell the underlying
asset is a put.

• Because the option owner does not have to exercise the option if it is to his
advantage, the option has a price, or premium.

• A European option can be exercised only at the maturity or expiration date of the
contract, whereas an American option can be exercised at any time during the
contract.
 Currency Options Markets

• Prior to 1982, all currency option contracts were over-the-counter options written
by international banks, investment banks, and brokerage houses.

• In December 1982, the Philadelphia stock Exchange (PHLX) began trading options
on foreign currency.

• The trading hours of these contracts are 9:30 A.M. to 4:00 P.M. Philadelphia time.

• The volume of OTC currency options trading is much larger than that of organized-
exchange option trading.
 Currency Futures Options

• The CME Group trades American style options on most of the currency futures
contracts it offers. With these options, the underlying asset is a futures contract on
the foreign currency instead of the physical currency.

• Options on currency futures behave very similarly to options on the physical

currency since the futures price converges to the spot price as the futures contracts
nears maturity.
 Basic Option-Pricing Relationships at Expiration

• For call options the time T expiration value per unit of foreign currency can be
stated as:
CaT = CeT = Max [ST – E, 0]

Where
CaT = the value of the American call at expiration
CeT = the value of the European call at expiration
E = the exercise price per unit of foreign currency
ST = the expiration date spot price.

• PaT = PeT = Max [E – ST, 0]

Where P denotes the value of the put at expiration.
 Basic Option-Pricing Relationships at Expiration

Example 7.3: Expiration Value of a European Call Option

Consider the PHLX 130 Aug EUR European call option.
This option has a current premium, Ce , of 2.52 cents per EUR. The exercise price is 130 cents per EUR and it expires
on August 17, 2013. Suppose that at expiration the spot rate is $1.3425/EUR. In this event, the call option has an
exercise value of 134.25 - 130 = 4.25 cents per each of the EUR10,000 of the contract, or $425. That is, the call owner
can buy EUR10,000, worth $13,425 (= EUR10,000 x $1.3425) in the sport market, for $13,000 (= EUR10,000 x $1.30).
On the other hand, if the spot rate is 1.2807/EUR at expiration, the call option has a negative exercise value, 128.07 -
130 = - 1.93 cents per EUR. The call buyer is under no obligation to exercie the option if it is to his disadvantage, so
he should not. He should let it expire worthless, or with zero value. His loss is limited to the option premium paid
of 2.52 cents per EUR, or $252 [= EUR 10,000 x $0.0252] for the contract.
Exhibit 7.7A graphs the 130 Aug EUR call option from the buyer's perspective and Exhibit 7.7B graphs it from the call
writer's perspective at expiration. Note that the two graphs are mirror images of one another. The call buyer can
lose no more than the call premium but theoretically has an unlimited profit potential. The call writer can profit
by no more than the call premium but theoretically can lose an unlimited amount. At an expiration spot price of
ST = E + Ce = 130 + 2.52 = 132.52 cents per EUR, both the call buyer and writer break even, that is, neither earns nor
losses anything.
The speculative possibilities of a long position in a call are clearly evident from Exhibit 7.7. Anytime the speculator
believes that will be in excess of the breakeven point, he will establish a long position in the call. The speculator
who is correct realizes a profit. If the speculator is incorrect in his forecast, the loss will be limited to the premium
paid. Alternatively, if the speculator believes that will be less than the breakeven point, a short position in the call
will yield a profit, the largest amount being the call premium received from the buyer. If the speculator is incorrect,
very large losses can result if ST is much larger than the breakeven point.
 Basic Option-Pricing Relationships at Expiration

Profit (₵) Profit (₵)

+ +

ST = E + Ce
Profit
E = 130 Ce = -2.52
Profit
0 0
Loss ST(₵/EUR) ST(₵/EUR)
- Ce = -2.52 E = 130

Loss

ST = E + Ce = 130 + 2.52 = 132.52

- -

Out-of-the- At-the- In-the Out-of-the- At-the- In-the

Money Money Money Money Money Money

Exhibit 7.7B Graph of 130 August EUR Call Option:

Exhibit 7.7A Graph of 130 August EUR Call Option:
Writer’s Perspective
Buyer’s Perspective
 Basic Option-Pricing Relationships at Expiration

Example 7.4: Expiration Value of a European Put Option

Consider the 130 Aug EUR European put, which has a current premium, Pe,
of 1.56 cents per EUR. If ST is $1.2807/EUR, the put contract has an exercise value of 130 - 128.07 = 1.93 cents per EUR
for each of the EUR10,000 of the contract, or $193. That is, the put owner can sell EUR10,000, worth $12,807 (= EUR
10,000 x $1.2807) in the spot market, for $13,000 (= EUR10,000 x $1.30). If ST = $1.3425/EUR, the exercise value is 130
-134.25 = -4.25 cents per EUR. The put buyer would rationally not exercise the put; in other words, he should let it
expire worthless with zero value. His loss is limited to the option premium paid of 1.56 cents per EUR, or $156 [=
EUR10,000 x $0.0156] for the contract.
Exhibit 7.8A graphs the 130 Aug EUR put from the buyer's perspective and Exhibit 7.7B graphs it from the put writer's
perspective at expiration. The two graphs are mirror images of one another. The put buyer can lose no more than the
put premium and the put writer can profit by no more than the premium. The put buyer can earn a maximum profit
of E - Pe= 130 - 1.56 = 128.44 cents per EUR if the terminal spot exchange rate is an unrealistic $0/EUR. The put
writer's maximum loss is 128.44 cents per EUR. Additionally, at ST = E + Pe = 128.44 cents per EUR, the put
buyer and writer both break even; neither loses nor earns anything.
The speculative possibilities of a long position in a put are clearly evident from Exhibit 7.8. Anytime the speculator
believes that ST will be less than the breakeven point, he will establish a long position in the put. If the speculator is
correct, he will realize a profit. If the speculator is incorrect in his forecast, the loss will be limited to the premium
paid. Alternatively, if the speculator believes that ST will be in excess of the breakeven point, a short position in the put
will yeild a positive profit, the largest amount being the put premium received from the buyer. If the speculator is
incorrect, very large losses can result if ST is much smaller than the breakeven point.
 Basic Option-Pricing Relationships at Expiration

Profit (₵) Profit (₵)

+ +
E - Pe =
130 – 1.56
= 128.44

Profit E = 130 Pe = -1.56

Profit
0 0
Loss ST(₵/EUR) ST(₵/EUR)
- Pe = -1.56 E = 130
Loss

ST = E - Pe = 130 – 1.56 ST = E - Ce
= 128.44 E - Pe =
130 – 1.56
= 128.44
- -

Out-of-the- At-the- In-the Out-of-the- At-the- In-the

Money Money Money Money Money Money

Exhibit 7.8B Graph of 130 August EUR Put Option:

Exhibit 7.8A Graph of 130 August EUR Put Option:
Writer’s Perspective
Buyer’s Perspective
 American Option-Pricing Relationships

• American options will satisfy the following basic pricing relationships at time t prior
to expiration:
Ca ≥ Max [ST – E, 0]
And
Pa ≥ Max [E – ST, 0]
American Option-Pricing Relationships
Option value, Cat

Value of call option

ST – E

Time value

Intrinsic value

0
E ST

Out-of-the- In-the
Money Money

Exhibit 7.9 Market Value, Time Value, and Intrinsic Value of an American Call Option
 European Option-Pricing Relationships

• European call and put prices on spot foreign exchange:

(𝐹𝑇 – 𝐸 )
Ce ≥ Max ,0
(1 + 𝑟$)
And
(𝐸 – 𝐹𝑇)
Pe ≥ Max ,0
(1 + 𝑟$)

• Example 7.5: European Option-Pricing Valuation

Let's see if the equations above hold for the 130 Aug EUR European call and the 130 Aug EUR
European put options we considered. Both of these options expire on August 17, 2013, or in
73 days. The 2-month dollar LIBOR (interest) rate is 0.2340 percent. Thus, (1 + r$) is ([1 +
.002340 (73/360)] = 1.00047. We will use the August forward price of $1.3098 for 𝐹𝑇.
Thus, for the 130 Aug EUR call,
2.52 ≥ Max [(130.98 - 130)/(1.00047), 0] = Max [.98, 0] = .98
Thus, the lower boundary relationship on the European call premium holds. For the 130 Aug
EUR put,
1.56 ≥ Max [(130 - 130.98)/1.00047), 0] = Max [-.98, 0] = 0
Thus, the lower boundary relationship on the European put premium holds as well
 Binomial Option-Pricing Model

• The binomial call price can be expressed as:

C0 = [FT . h – E ((S0 . u/E)(h – 1 ) + 1)]/(1 + r$)
Where
h = (CuT – CdT)/S0(u – d) is the risk-free hedge ratio.
 European Option-Pricing Formula

• European call and put pricing formulas are:

Ce = [FT N(d1) – EN(d2)]e-r$T
And
Pe = [EN(-d2) – FT N(-d1)]e-r$T

Where
𝑙𝑛 (𝐹𝑇/𝐸) + .5 𝜎2𝑇
d1 =
𝜎 𝑇
And
d2 = d1 +𝜎 𝑇
N(d) denotes the cumulative area under the standard normal density function from -∞ to d1 (or d2). The
variable 𝜎 is the annualized volatility of the change in exchange rate ln(St+1/St).
 European Option-Pricing Formula

Example 7.6: The European Option-Pricing Model

As an example of using the European options-pricing model, consider the PHLX 130 Aug EUR
European call option that has a premium of 2.52 U.S. cents per EUR. The option will expire on
August 17, 2013 - 73 days from the quotation date, or T = 73/365 = .2000. We will use the August
forward price on June 5, 2013, as our estimate of FT ($/EUR) = $130.98. The rate is estimated as the
annualized two-month dollar LIBOR (interest rate) of 0.2340 percent on the same day. The
The valued d1 and d2 are:
𝑙𝑛 (130.98/130) + .5(.0865)2(.2000)
d1 = (.0865) .2000 = .2135
and
d1 = .2135 − (.0865) .2000 = .1748
Consequently, it can be determined that N(.2135) = .5845 and N(.1748) = .5694.
We now have everything we need to compute the model price:
Ce = [130.98(.5845) – 130(.5694)]e-(.00234)(.2000)
= [76.5578 – 74.0220](.9995)
= 2.54 cents per EUR vs. the actual market mid-price of 2.52 cents.
As wee see, the model has done a good job of valuing the EUR call.
 Empirical Tests of Currency Options

• Shastri and Tandon (1985) discover many violation of the boundary relationships,
but conclude that non-simultaneous data could account for most of the violations.

• Bodurtha and Courtadon (1986) conclude that the PHLX American currency options
are efficiently priced.

• Shastri and Tandon (1986) implies that the European option-pricing model works
well in pricing American currency options.

• Barone-Adesi and Whaley (1987) also finds that the European option-pricing model
works well for pricing American currency options that are at or out-of-money, but
does not do well in pricing in-the-money calls and puts.