Currency Futures

1
Currency Futures Options Markets
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Objectives to Understand

• How currency futures and options contracts are
  used to manage currency risk to speculate on
  future currency movements
• The nature of currency futures and options
  contracts and
• The difference between futures options
  contracts
• The factors that determine the value of an option

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Currency Risk
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Definition

• Currency Risk Variability in the value of an
  exposure caused by uncertainty about exchange
  rate changes.

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Currency Risk

• Degree of risk is a function of 2 variables
• Volatility of exchange rates
• Amount of exposure
• Degree of Risk
• Low rate fixed, low exposure
• High rate volatile, high exposure

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What Happens if the Yen falls?
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Long and Short Exposures

• A person that is, for example, long the pound,
  has pound denominated assets that exceed in value
  their pound denominated liabilities.
• A person that is short the pound, has pound
  denominated liabilities that exceed in value
  their pound denominated assets.

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What is an exposure?

• Liabilities assets net exposure (short)
• If you are borrowing Yen to buy denominated
  assets? Are you short or long?
• Who is long?
• Who is long on ? Who is short?

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Hedging

• To hedge a foreign exchange exposure, one takes
  an equal and opposite position from that of the
  exposure.
• For example, if folks are long the pound, they
  would have to take an offsetting short position
  to hedge their exposure.
• One who is long in a market is betting on an
  increase in the value of the thing, whereas with
  a short position they are betting on a fall in
  its value.

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You Can Hedge with Financial Derivatives!

• Contracts that derive their value from some
  underlying asset
• Forwards
• Futures
• Options
• Swaps

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For example

• Vanilla bond -- coupon and principal
• First stage decomposition
• Second stage decomposition
• Options
• What assets underlie currency derivatives?

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Currency Futures
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Currency Futures

• Traded on centralized exchanges (illustrated in
  Figure 1 later)
• Highly standardized contracts
• Size AC100K, 62.5k, 125k, 12.5m maturity
  delivery date
• Clearinghouse as counter-party
• High leverage instrument
• Daily settlement
• Margin requirements

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Currency Futures

• Performance Bond or Initial Margin The customer
  must put up funds to guarantee the fulfillment of
  the contract - cash, letter of credit,
  Treasuries.
• Maintenance Performance Bond or Margin The
  minimum amount the performance bond can fall to
  before being fully replenished.
• Mark-to-the-market A daily settlement procedure
  that marks profits or losses incurred on the
  futures to the customers margin account.

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Sample Performance Bond RequirementsFrom the
CME, 15 March 2000
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How an Order is Executed (Figure from the CME)
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Example

• A US manufacturing company has a division that
  operates in Mexico. At the end of June the
  parent company anticipates that the foreign
  division will have profits of 4 million Mexican
  pesos (P) to repatriate.
• The parent company has a foreign exchange
  exposure, as the dollar value of the profits will
  rise and fall with changes in the exchange value
  between the P and the dollar.

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Example, continued

• The firm is long the peso, so to hedge its
  exposure it will go short sell P in the futures
  market.
• The face amount of each peso future contract is
  P500,000, so the firm will go short 8 contracts.
• If the peso depreciates, the dollar value of its
  Mexican divisions profits falls, but the futures
  account generates profits, at least partially
  offsetting the loss. The opposite holds for an
  appreciation of the peso.

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Gain
Underlying Long Position
Change spot value
Change in futures price
Futures Position
Loss
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Example, continued

• The previous diagram can be used to illustrate
  the effect of a change in the value of the peso.
  
• An increase in the value of the peso increases
  the dollar value of the underlying long position
  and decreases the value of the futures position.
• A decrease in the value of the peso decreases the
  value of the underlying position and increases
  the value of the futures position.

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Example, continued

• On the 25th, the spot rate opens at 0.10660 (/P)
  while the price on a P future opens at 0.10310.
• The market closes at 0.10635 and 0.10258
  respectively.
• The loss on the underlying position is
• (0.10635-0.10660)?P4 mil. -1,000
• The gain on the futures position is
• (0.10310-0.10258)?8?P500,0002,080

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Gain and Loss on Underlying and Futures
Position Day 1
Underlying Long Position P4 million
Gain
2,080
Change spot value
-0.00025
Change in futures price
-0.00052
1,000
Futures Position P500,000 x 8
Loss
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Example, continued

• On the 28th, the spot rate moves to 0.10670 (/P)
  and the price on a P future to 0.10285.
• The gain on the underlying position is
• (0.10670-0.10635)?P4 mil. 1,400
• The loss on the futures position is
• (0.10258-0.10285)?8?P500,000-1,080

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Gain and Loss on Underlying and Futures
Position Day 2
Underlying Long Position P4 million
Gain
1,400
0.00032
Change spot value
0.00035
Change in futures price
1,080
Futures Position P500,000 x 8
Loss
25
Example, continued

• On the 29th, the spot rate moves to 0.10680 (/P)
  and the price on a P future to 0.10290.
• The gain on the underlying position is
• (0.10680-0.10670)?P4 mil. 400
• The loss on the futures position is
• (0.10285-0.10290)?8?P500,000-200

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Gain and Loss on Underlying and Futures
Position Day 3
Underlying Long Position P4 million
Gain
400
0.0001
Change spot value
0.00005
Change in futures price
200
Futures Position P500,000 x 8
Loss
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Example, continued

• For the three days considered, the underlying
  position gained 800 in value and the futures
  contracts yielded 800.
• The hedge was not perfect as the daily losses on
  the futures were less than the gains on the
  underlying position (day 2 and 3), and the daily
  gains on the futures exceeded the losses on the
  underlying position (day 1).
• In this example, the imperfect hedge yielded
  additional gains.

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Example, continued

• Suppose you wanted to close the futures position
  (without making delivery of the currency).
• The position is simply reversed. That is, you
  would go long 8 P futures, reversing your current
  position and closing out your account.
  offsetting trade

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Additional Information

• For additional information on currency futures,
  visit the following sites
• The Chicago Mercantile exchange
• The Futures Industry Institute

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Currency Options
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Currency Options

• A currency option is a contract that gives the
  owner the right, but not the obligation, to buy
  or sell a currency at a specified price at or
  during a given time.
• Call Option An option that gives the owner the
  right to buy a currency.
• Put Option An option that gives the owner the
  right to sell a currency.
• How are currency options simultaneously both put
  call options?

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Currency Options

• American Option An option that can be exercised
  any time before or on the expiration date.
• European Option An option that can only be
  exercised on the expiration date.

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Currency Options

• Exercise or Strike Price The price (spot
  exchange rate) at which the option may be
  exercised.
• Option Premium The amount that must be paid to
  purchase the option contract.
• Break-Even The point at which exercising the
  option exactly matches the premium paid.

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Currency Options

• If the spot rate has not yet reached the exercise
  price Sis said to be out of the money.
• If the spot rate equals the exercise price SX,
  the option is said to be at the money.
• If the spot rate has surpassed the exercise price
  SX, the option is said to be in the money.

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Call Option

• The holder of a call option expects the
  underlying currency to appreciate in value.
• Consider 4 call options on the euro, with a
  strike price of 152 (/) and a premium of 0.94
  (both cents per ).
• The face amount of a euro option is 62,500.
• The total premium is
• 0.0094462,5002,350.

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Call Option Hypothetical Pay-Off
Profit
Payoff Profile
1,400
152
152.5
0
Spot Rate
148.15
152.94
153.5
-1,100
Break-Even
-2,350
Out-of- the-money
Loss
At
In-the-money
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Put Option

• The holder of a put option expects the underlying
  currency to depreciate in value.
• Consider 8 put options on the euro with a strike
  of 150 (/) and a premium of 1.95 (both cents
  per ).
• The face amount of a euro option is 62,500.
• The total premium is
• 0.0195862,5009,750.

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Put Option Hypothetical payoff at a spot rate
of 148.15
Profit
Payoff Profile
Break-Even
148.05
150
0
Spot Rate
148.15
-500
-9,750
Loss
In-the-money
At
Out-of-the-money
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Option Pricing Valuation

• Value of a call option at maturity
• S-X, where S-X0 otherwise value is zero,
  Intrinsic value
• Value of a call option prior to maturity
• Intrinsic value Time value
• Time Value is a function of
• Time to expiration, volatility, domestic
  foreign interest rate differentials

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Comparing Futures and Options
The value of a futures contract at maturity (date
tn) to purchase one unit of foreign currency
will be
Value
0
Stn
Zt,tn
The value of the futures contract is zero at
maturity if the spot rate at maturity is equal to
the current futures rate.
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Consider now the value of an option to purchase
one unit of foreign currency at that same price
(i.e. a call option with a strike price X equal
to Zt,tn)
Value
0
Stn
X
The value of the call option begins increasing
when the exchange rate becomes larger than the
exercise price - when the option becomes in the
money.
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But were missing something. While a futures
contract has an expected return of zero, the
value of the option looks like it is always
positive
Value
0
Stn
X
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Hence, anyone taking the opposite side of the
transaction (writing the option) will demand a
premium (C) that makes the expected value zero
once again
Value
0
Stn
X
C
Regardless of the outcome, the options value is
reduced everywhere by the certain payment of its
premium.
44
The value of an option to sell one unit of
foreign currency (a put option) at a strike
price equal to a corresponding futures contract
price will have similar properties
Value
0
Stn
X
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Swaps
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Foreign Currency Swaps
A currency swap is an exchange of debt-service
obligations denominated in one currency for the
service on an agreed upon principal amount of
debt denominated in another currency. A
currency swap is often the low-cost way of
obtaining a liability in a currency in which a
firm has difficulty borrowing. A pair of firms
simply borrow in currencies they have relative
advantage borrowing in, and then trade the
obligations of their respective loans, thereby
effectively borrowing in their desired currency.
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Dell computers would like to borrow in Swiss
Francs to hedge its ongoing cash flows from that
country
Dell
SFr
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Nestle would like to borrow in Dollars to hedge
its sales to the U.S...
Dell
Nestle
SFr

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But both firms are relatively unknown to the
respective credit markets, and thus anticipate
unfavorable borrowing terms.
Dell
Nestle
SFr

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But an investment bank comes along and suggests
that each borrow in the credit markets that are
comfortable with them...
Dell
Nestle
I-Bank
SFr

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and then the investment bank will give them
sufficient cash flows each period to cover the
obligations of these loans...
Dell
Nestle

Sfr
I-Bank
SFr

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in return for making the payments in the foreign
currency that exactly match the other firms
obligations.
Dell
Nestle
Sfr


Sfr
I-Bank
SFr

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In other words, the swap effectively completes
the market. Giving each firm access to the
foreign debt market at reasonable terms.
Dell
Nestle
Sfr


Sfr
I-Bank
SFr

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The All-In Cost of a Swap
Clearly, the relative magnitudes of the
respective payments determine each firms
ultimate cost of borrowing. This cost is called
the all-in cost. It is the effective interest
rate the firm ends up paying on the money that it
raised. It is the discount rate that equates
the NPV of future interest and principal payments
to the net proceeds received by the issuer.
IRR
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Swaps vs. Forwards
Notice that on a one-year loan, a currency swap
is no different than a one-year forward
contract. In fact, a currency swap can really be
thought of as a firm taking a domestic currency
loan and purchasing a series of forward contracts
to convert the payments into known foreign
currency obligations. The implied forward rates
need not equal the actual forward rates, but
taken as a whole, should resemble an average
forward rate over the term of the loan.
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Comparative Borrowing Advantage
Swaps only exist because there are market
imperfections. If firms can access foreign and
domestic debt markets at equal cost, clearly
swaps are redundant. One important reason that
currency swaps are so useful is that firms
engaged in a swap need not each have an absolute
borrowing advantage in the currency in which they
borrow vis-a-vis the counterparty. In fact, it
is quite likely that Nestle has better access to
both the U.S. and Swiss debt markets than Dell.
Comparative Advantage
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Key Points
1. A firm wishing to hedge foreign currency
exposure has five main financial hedging tools
which facilitate doing so forward contracts,
money market hedges, futures contracts, foreign
currency options, and currency swaps. 2. Forward
contracts have the benefit of being tailor-made,
with quantities and timing matched to the needs
of the firm. Forward contracts are typically
quite costly over longer horizons, as the market
becomes highly illiquid. 3. Money market hedges
are equally flexible, but depend on a firm having
equal access to domestic and foreign credit
markets.
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Key Points
4. Futures contracts, traded on highly liquid
exchanges, have the benefit that they can be sold
on the market before the maturity date. As a
result, futures contracts are particularly useful
for hedging exposures whose maturity is
uncertain. 5. On the other hand, futures
contracts are standardized in terms of timing and
quantities, and therefore they rarely offer a
perfect hedge. 6. Options contracts allow a firm
to hedge against movements in one direction while
retaining exposure in the other. 7. Options are
particularly useful in hedging exposures that are
highly uncertain with respect to timing and
magnitude.
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Key Points
8. Currency swaps offer firms the ability to
borrow against long-term foreign currency
exposures when access to foreign debt markets is
costly. 9. Currency swaps converts a domestic
liability into a foreign one via what are
effectively a bundle of long-dated forward
contracts between two firms. 10. The effective
cost of a currency swap is its all-in cost -
the effective rate of interest that the firm ends
up paying on the constructed foreign
liability. 11. Currency swaps require only that
firms have differential relative - rather than
absolute - advantage in accessing debt markets.