Foreign Currency Options

1
Foreign Currency Options

• Chapter Five
• Eiteman, Stonehill, and Moffett

2
Hedging vs speculation

• firms hedge
• make money on their core competency
• reduce risk
• writing a covered option
• firms do not speculate
• options are not a core competency
• speculation increases risk

3
Options - types

• Call option
• option to buy currency
• fixed price (exercise price, strike price)
• expiration date
• Put option
• option to sell currency
• fixed price (exercise price, strike price)
• expiration date

4
Over-the-counter Market

• written by banks
• usd against pounds, euros, cd, yen
• usually written in round lots
• 1, 2, 3, 5, 10 million
• banks willing to write variable options
• amount
• exercise (strike) price
• maturity date
• less liquid than traded option

5
Options on organized exchanges

• Standardized contracts
• amount fixed
• maturity dates
• Auction markets
• Philadelphia exchange
• London International Financial Futures Exchange

6
Options - over-the-counter Market

• written by banks
• usd against pounds, euros, cd, yen
• usually written in round lots
• 1, 2, 3, 5, 10 million
• banks willing to write variable options
• amount
• exercise (strike) price
• maturity date
• less liquid than traded option

7
Options - charcteristics

• American option can be exercised anytime up to
  the expiration date
• European option can only be exercise at the
  expiration date
• in-the-money - option which if exercised will
  make money
• out-of-the-money - option which if exercised
  will lose money

8
Call characteristics

• e exchange rate
• x exercise price
• sdx standard deviation of exchange rate

9
Long a call option
c
Call out of the money when e lt x
Call in the money when e gt x
e
x
10
Market Value of the Call
11
Valuation

• exercise price (negative)
• exchange rate (positive)
• volatility (positive)
• term to maturity (positive)
• risk-free rate of return (positive)

12
Value of the Exercised Call
13
Long a call option
c
market value of the call
exercised value of the call
e
x
14
Short the Call Option
15
Long a put option
P
Call out of the money when e gt x
Call in the money when e lt x
e
x
16
Market Value of the Put
17
Value of the Exercised Put
18
Long the Put Option
19
Short the Put Option
20
Currency futures contracts

• standardized contract terms
• amount of foreign exchange standardized
• 100,000 Canadian, 62.500,
• Peso 500,000, 12,500,00, Euro 1,000,000
• exchange rate fixed at contract time
• delivery dates standardized by the exchange
• March, June, September, December
• contracts expire two business days prior to the
  3rd Wednesday of the delivery month

21
Market makers in currency futures

• international monetary market (IMM)
• London international financial futures exchange
  (LIFFE)
• Chicago Board of Trade (CBOT)
• New York mercantile exchange
• Singapore international monetary exchange (SIMEX)

22
Trading specifics

• commissions small (less than 0.5)
• margin requirements typically 2 to 3 contracted
  amount
• both sides of contract guaranteed by exchange
• contracts marked to market daily

23
long one June euro contract

• contracted June delivery of 1,000,000 Euros
• contract price 0.9737 / dollar or 0.9737
  1,000,000 973,700 usd
• initial margin paid in when contracted
• e.g. 2 on Euro contract 20,000 usd
• maintenance margin
• e.g. 1 on Euro contract 10,000 usd

24
marking to market 1st day

• e.g. tomorrows settlement price 0.9817
• (0.9817 - 0.9737) 1,000,000 8,000
• futures price is now 0.9817
• long the future (wanting euros)
• margin account 20,000 - 8,000 12,000
• short the future (wanting dollars)
• margin account 20,000 8,000 28,000

25
marking to market 2nd day

• e.g., next days settlement price 0.9867
• (0.9867 - 0.9817) 1,000,000 5,000
• futures price is now 0.9867
• long the future (wanting euros)
• margin account 12,000 - 5,000 7,000
• margin call - buyer of the future must bump up
  his margin
• short the future (wanting dollars)
• margin account 28,000 5,000 33,000

26
Futures contract expires (long side of contract)

• e.g. last settlement price 1.0017
• net change in margin (1.0017 - 0.9737)
  1,000,000 28,000
• final futures price 1.0017
• long the future (wanting euros)
• net change in margin account 28,000
• pays ( -1,001,700 28,000) -973,700 dollars
• receives 1,000,000 euros

27
Futures contract expires(short side of contract)

• last settlement price 1.0017
• net change in margin (0.9737 - 1.0017)
  1,000,000 -28,000
• final futures price 1.0017
• short the future (wanting dollars)
• net change in margin account -28,000
• pays -1,000,000 euros
• receives (1,001,777 - 28,000) 973,700 dollars

28
Futures

• marking to market reduces default risk
• daily resettlement confines risk to one days
  price movements
• large daily movements in price will result in
• trading halt
• margin call during trading halt
• trader want to terminate the contract
• will take the opposite contract
• if long two contracts, will go short two
  contracts
• cost is the interest paid on margins

29
Comparison to forwards

• forward contracts
• more flexible
• higher default risk
• fixed into contract
• futures contracts
• standardized
• much lower default risk
• reversible