Foreign Currency Derivatives

1
Currency Derivatives (or chapter 7)
2
Agenda

• How forex futures quoted used for speculation?
• Futures vs. forwards?
• How forex options are quoted?
• Speculate w/ forex options.
• Distinction b/n buying writing options?
• How forex options are valued?

3
Forex Futures

• Future delivery of standard amount of currency _at_
  fixed time price. Traded _at_ Chicago Mercantile
  Exchange (CME).
• Specifications
• Size notional principal, in even multiple.
• Method of stating exchange rates American
  terms used.
• Maturity date mature on 3rd Wed/ 01, 03, 04, 06,
  07, 09, 10, or 12.
• Last trading day contracts may trade through
  2nd business day prior to maturity.
• Collateral maintenance margins
  purchaser/trader must deposit initial margin or
  collateral.
• Daily marked-to-market
• Settlement
• round turn fee.
• Use of a clearing house as a counterparty

4
Futures Speculation
500,000 New Mexican pesos.
Maturity Open High Low Settle Change High Low Open Interest
Mar .10953 .10988 .10930 .10958 --- .11000 .09770 34,481
June .10790 .10795 .10778 .10773 --- .10800 .09730 3,405
Sept .10615 .10615 .10610 .10573 --- .10615 .09930 1,4181
Source Wall Street Journal, February 22, 2002,
p.C13
Short Position believes that the value of the
Peso will fall Long Position - believes that the
value of the Peso will rise
Value at maturity (Short) - Principal ? (Spot
Future) -PS 500,000 ? (0.09500/ PS -
.10958/ PS) 7,290, assuming spot rate of
.09500/Ps _at_ maturity.
Value at maturity (Long) Principal ? (Spot
Forward) PS 500,000 ? (0.11000/ PS -
.10958/ PS) 210, assuming spot rate of
.11000/Ps _at_ maturity.
5
Forex Futures vs. Forwards
Characteristic Foreign Currency Futures Forward
Contract Size Standardized any size desired
Maturity fixed maturities any maturity up
up to a year
Location organized exchange b/n individuals
banks
Pricing open outcry bid/ask quotes
Margin/Collateral daily marked to market no
collateral
Settlement rarely delivered, settlement
contract delivered, through
offsetting can offset position
Fees single commission for purchase
sell bid/ask spread
Trading hours exchange hours 24 hours
Counterparties through clearing house direct
contact
Liquidity very liquid liquid, relatively
large market
6
Initial Margin Requirements

• Held as collateral by broker.
• Usually 2-4 of contract value.
• Margin amount same for short long positions.
• Buyer holds a long position (seller short).
• If settlement price higher than yesterday, buyer
  has a positive settlement for the day.
• Long position now worth more.
• Exact opposite for seller (zero-sum game).

7
Open Interest

• Open Interest refers to the number of contracts
  outstanding for a particular delivery month.
• Initially open interest is zero.
• Increases over time, until positions are
  liquidated.
• Total open interest is the total number of
  outstanding positions in all the delivery months
  of a futures market.
• Liquidity at least 5,000 outstanding contracts.

http//www.activetradermag.com/futuresbasics.htm
8
Reversing Trades

• Rare in forward markets 90 of all contracts
  lead to delivery.
• Common in futures markets only 1 of contracts
  lead to delivery!

9
Forex Option

• Gives right but not obligation to buy/sell amount
  of currency _at_ fixed price for given time period
• Call buyer has right to purchase
• Put buyer has right to sell
• Buyer holder seller writer.
• Two option types
• American may exercise during life of option.
• European may not exercise until maturity.
• Price elements
• Strike (exercise price) exchange rate _at_ which
  foreign currency can be purchased/ sold.
• Premium, price of option
• Spot rate

10
Forex Options

• May be classified as
• At-the-money (ATM) exercise price spot rate.
• In-the-money (ITM) options profitable, excluding
  premium, if exercised immediately.
• Out-of-the-money (OTM) options not profitable,
  excluding premium, if exercised immediately.
• Markets for derivatives
• OTC Market
• Organized exchanges - Chicago Mercantile and the
  Philadelphia Stock Exchange
• Option Clearinghouse Corporation

11
Futures Contracts vs. Options

• Futures Contract youve agreed to purchase/sell
  the contract. No backing out. Can offset/ exit
  by buying/selling to someone else.
• Buy long sell short.
• Option contract that gives you the right but
  not the obligation to purchase/sell something at
  pre-specified terms. No commitment.

12
Forex Options Markets

• Swiss Franc options (WSJ)
• Call premium SF 62,500 x 0.0050/SF 312.50.

Each option 62,500 Swiss francs.
13
Speculation

• Assume spot rate 0.5851/SF, 6m forward
  0.5760/SF.
• Spot market
• 100,000. Expect six month spot SF 0.6000/SF.
• Step 1 purchase SF 170,910.96 _at_ spot 0.5851/SF.
• Step 2 sell at target spot rate of 0.60/SF.
• Forward market
• Step 1 Buy forward SF173,611.11 x 0.576/SF
  100,000.
• Step 2 In 6m, fulfill forward sell proceeds in
  spot market Sfr173,611.11 x 0.6000/Sfr
  104,166.67.
• Options market
• Long Call, Short Call, Long Put, Short Put.

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For Example

• Suppose that
• you have 10 m.
• Wish to speculate on Euro
• S 0.885/ EUR, F30 0.900/ EUR.
• You expect S30 0.844/ EUR (EUR depreciates).
• Arbitrage strategy?
• You expect S30 0.944/ EUR (EUR appreciates).
• Arbitrage strategy?

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Profit Loss Buyer of Call (Long Call)
CeT MaxST - E, 0
Profit (US cents/SF)
1.00
0.50
0
Spot price (US cents/SF)
57.5
58.0
59.0
59.5
58.5
- 0.50
- 1.00
Loss
Profit Spot rate (Strike price
Premium) Profit ? if Spot 0.595/ SF.
16
Profit Loss Writer of Call (Short Call)
CeT MaxST - E, 0
Profit (US cents/SF)
1.00
0.50
0
Spot price (US cents/SF)
57.5
58.0
59.0
59.5
58.5
- 0.50
- 1.00
Loss
Profit Premium (Spot rate - Strike
price). Profit ? if Spot 0.595/ SF.

17
Profit Loss for Buyer of Put (Long Put)
PaTPeTMaxE - ST, 0
Profit (US cents/SF)
1.00
0.50
0
Spot price (US cents/SF)
57.5
58.0
59.0
59.5
58.5
- 0.50
- 1.00
Loss
Profit Strike price (Spot rate
Premium) Profit ? if Spot 0.575/ SF.

18
Profit Loss for Writer of Put (Short Put)
At the money
Profit (US cents/SF)
PaTPeTMaxE - ST, 0
1.00
0.50
0
Spot price (US cents/SF)
57.5
58.0
59.0
59.5
58.5
- 0.50
- 1.00
Loss
Profit Premium (Strike price - Spot
rate) Profit ? if Spot 0.575/ SF.

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For Example

• Suppose that
• You wish to speculate on fall of Yen vs. .
• Current S Yen 120/ (or .00833/Yen).
• Maturity 90 days.
• Expected S90 Yen 140/ (or .00714).
• Two options available
• Call on Yen Put on Yen
• Strike Yen 125/ Yen 125/.
• (or .008/ Yen) (or .008/
  Yen)
• Premium .00046
  .00003
• What option to buy?
• Break even price on option of choice?
• If S Yen 140/ , what is net profit?

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Option Pricing

• Market value Time value Intrinsic Value
• Intrinsic Value gain if option exercised
  immediately. Will reach zero when the option is
  OTM. At maturity, option value intrinsic value.
• Time Value reflects a gamble that the option
  might be more profitable (more in-the-money) as
  time passes (i.e. before time of expiry).

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Market-, Time- Intrinsic Value
Option Premium (US cents/)
6.0
5.0
4.0
3.0
2.0
1.0
0.0
1.69
1.70
1.71
1.72
1.73
1.68
1.67
1.66
1.74
Spot rate (/)
European Call on Brit Pound
22
Option Volatility

• Standard deviation of daily changes in
  underlying exchange rate, usually stated per
  annum, e.g. 12.6 .
• Can obtain daily volatility
• Volatility estimates
• Historic.
• Forward-looking.
• Implied.

23
Replicating Portfolio Evaluation

• Suppose US-EUR rate is S0(/EUR) 1.
• S1(/ EUR) is 1.10 or 0.90.
• Consider call w/ K1/EUR (exercise price).
• Can replicate payoffs of call w/ levered position
  in EUR.
• Borrow PV .90 today buy1 EUR.
• Net payoff 0.20 or 0.
• Portfolio value so option value

Portfolio
S1(/EUR)
Debt
C1(/EUR)
S0(/EUR)
1.10
0.10
-0.90
0.20
1
0
-0.90
0.00
0.90
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Rogue Trading Good Fellas

• Nick Leeson _at_ Barings.
• 1995, managed to bankrupt Barings Brothers (UK).
• John Rusnak _at_ Allied Irish Bank.
• 2002, lost 691 m on behalf of Allied Irish Bank
  (Baltimore office).

25
Things to remember

• Futures terminology.
• Futures vs. Forwards.
• Speculation
• In spot forward markets.
• In option markets.
• How forex options are quoted?
• Distinction b/n buying writing options.
• How forex options are valued?