Futures and Optionson Foreign ExchangeChapter Five
ChapterObjective:This chapter discusses exchange-tradedcurrency futures contracts and optionscontracts
❖Chapter Objective: ❖This chapter discusses exchange-traded currency futures contracts and options contracts
Thebasics:Derivativeinstruments There are two fundamental classes of financialinstruments: underlying and derivative instrumentsThe value and payoffs ofderivatives are derivedfrom the behavior of the underlying instrumentsPaymentsaremadeinfutureHighleverageHigh riskDerivatives can be used to speculate, or gambleon future price movements,they canalso be usedto transfer risks.Derivatives transaction is a zero-sum game
The basics: Derivative instruments ❖There are two fundamental classes of financial instruments: underlying and derivative instruments ❖The value and payoffs of derivatives are derived from the behavior of the underlying instruments. ▪ Payments are made in future. ▪ High leverage ▪ High risk ❖Derivatives can be used to speculate, or gamble on future price movements, they can also be used to transfer risks. ❖Derivatives transaction is a zero-sum game
ChapterOutlineFutures Contracts:PreliminariesCurrencyFuturesMarketsOptionsContracts:PreliminariesCurrency Options MarketsBasic Option Pricing Relationships at ExpiryBinomial Option Pricing ModelEuropeanOptionPricingModelEmpirical Tests of Currency Option Models
Chapter Outline ❖Futures Contracts: Preliminaries ❖Currency Futures Markets ❖Options Contracts: Preliminaries ❖Currency Options Markets ❖Basic Option Pricing Relationships at Expiry ❖Binomial Option Pricing Model ❖European Option Pricing Model ❖Empirical Tests of Currency Option Models
Futures Contracts:PreliminariesA futures contract is like a forwardcontract:It specifies that a certain currency will beexchanged for another at a specified timein the future at prices specified todayA futures contract is different from aforward contract (exhibit 7.1) Futures are standardized contractstradingon organized exchanges with dailyresettlement through a clearinghouse
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 (exhibit 7.1): ▪ Futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse
Futures Contracts:PreliminariesStandardizing Features: easy to resellContract Size (exhibit 7.2)Delivery MonthDaily resettlementHigh leverageInitial Margin (about 4% of contract value,cash or T-bills held at your brokers),maintenance margin
Futures Contracts: Preliminaries ❖Standardizing Features: easy to resell ▪ Contract Size (exhibit 7.2) ▪ Delivery Month ❖Daily resettlement ▪ High leverage ▪ Initial Margin (about 4% of contract value, cash or T-bills held at your brokers). ▪ maintenance margin
DailyResettlement:AnExampleSuppose you want to speculate on a rise in the$/ exchange rate (specifically you think that thedollar will appreciate)Currency perU.S.$ equivalentU.S. $WedTueTueWed1401390.007194245Japan (yen)0.0071428571431420.0069930070.0070422541-monthforward1501493-months forward0.0067114090.0066666671601590.006250.0062893086-months forwardCurrently $1 = ￥140. The 3-month forward price is $1FY150
Daily Resettlement: An Example ❖Suppose you want to speculate on a rise in the $/¥ exchange rate (specifically you think that the dollar will appreciate). Currently $1 = ¥140. The 3-month forward price is $1=¥150. Currency per U.S. $ equivalent U.S. $ Wed Tue Wed Tue Japan (yen) 0.007142857 0.007194245 140 139 1-month forward 0.006993007 0.007042254 143 142 3-months forward 0.006666667 0.006711409 150 149 6-months forward 0.00625 0.006289308 160 159
DailyResettlement:AnExampleIf you enter into a 3-month futures contractto sell Yen at the rate of $1 = ￥150 you willmake money if the Yen depreciates.The c0ntract size is ￥12,500,000Your initial margin is 4% of the contractvalue:$1$3,333.33 =.04 ×12,500,000 x150
Daily Resettlement: An Example ❖If you enter into a 3-month futures contract to sell Yen at the rate of $1 = ¥150 you will make money if the Yen depreciates. ❖ The contract size is ¥12,500,000 ❖Your initial margin is 4% of the contract value: 150 $1 $3,333.33 =.0412,500,000
DailyResettlement:AnExampleIf tomorrow, the futures rate closes at $1 :￥149, then your position's value drops.Your original agreement was to sell￥12.500.000 and receive $83.333.33But n0w ￥12.500.000 is worth $83.892.62$1$83,892.62 = 12,500,000 x149You have lost $559.28 overnight
Daily Resettlement: An Example If tomorrow, the futures rate closes at $1 = ¥149, then your position’s value drops. Your original agreement was to sell ¥12,500,000 and receive $83,333.33 But now ¥12,500,000 is worth $83,892.62 149 $1 $83,892.62 =12,500,000 You have lost $559.28 overnight
DailyResettlement:AnExampleThe$559.28comesoutofyour$3.333.33margin account, leaving $2,774.05This is short of the $3,355.70 required for a newposition.$1$3,355.70=.04x12,500,000x149Your broker will let you slide until you runthrough your maintenance margin. Then youmust post additional funds or your position willbe closed out. This is usually done with areversing trade
Daily Resettlement: An Example ❖The $559.28 comes out of your $3,333.33 margin account, leaving $2,774.05 ❖This is short of the $3,355.70 required for a new position. 149 $1 $3,355.70 = .0412,500,000 ⚫Your broker will let you slide until you run through your maintenance margin. Then you must post additional funds or your position will be closed out. This is usually done with a reversing trade