FIN 645: International Financial Management Lecture 4 Futures and Options on Foreign Exchange

1. FIN 645: International Financial Management Lecture 4 Futures and Options on Foreign Exchange

2. Lecture Outline • Forward Market: A Recap • Futures Contracts: Preliminaries • Currency Futures Markets • Basic Currency Futures Relationships • Eurodollar Interest Rate Futures Contracts • Options Contracts: Preliminaries • Currency Options Markets • Currency Futures Options

3. Forward Market: A Recap • A forward contract is an agreement between a firm and a commercial bank to exchange a specified amount of a currency at a specified exchange rate (called the forward rate) on a specified date in the future. • Forward contracts are often valued at $1 million or more, and are not normally used by consumers or small firms.

4. Forward Market: A Recap • When MNCs anticipate a future need for or future receipt of a foreign currency, they can set up forward contracts to lock in the exchange rate. • The % by which the forward rate (F ) exceeds the spot rate (S) at a given point in time is called the forward premium (p). F = S (1 + p) • F exhibits a discount when p < 0.

5. Forward Market: A Recap Example: S = $1.681/£, 90-day F = $1.677/£ annualized p =F – S 360 Sn =1.677 – 1.681 360= –.95% 1.681 90 • The forward premium (discount) usually reflects the difference between the home and foreign interest rates, thus preventing arbitrage.

6. Forward Market • A swap transaction involves a spot transaction along with a corresponding forward contract that will reverse the spot transaction. • A non-deliverable forward contract (NDF) does not result in an actual exchange of currencies. Instead, one party makes a net payment to the other based on a market exchange rate on the day of settlement.

7. April 1 July 1 Expect need for 100M IRs. Negotiate an NDF to buy 100M IRs.on Jul 1. Reference index (closing rate quoted by India’s central bank) = $.0020/IRs. Buy 100M IRs.from market. Index = $.0023/ IRs.  receive $30,000 from bank due to NDF. Forward Market • An NDF (Non-Deliverable Forward Contracts) can effectively hedge future foreign currency payments or receipts: Index = $.0018/ IRs. pay $20,000 to bank.

8. Currency Futures Market • Currency futures contracts specify a standard volume of a particular currency to be exchanged on a specific settlement date. • They are used by MNCs to hedge their currency positions, and by speculators who hope to capitalize on their expectations of exchange rate movements.

9. Currency Futures Market • The contracts can be traded by firms or individuals through brokers on the trading floor of an exchange (e.g. Chicago Mercantile Exchange), automated trading systems (e.g. GLOBEX), or the over-the-counter market. • Brokers who fulfill orders to buy or sell futures contracts typically charge a commission.

10. 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: • Futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse.

11. Futures Contracts: Preliminaries • A major difference between a forward contract and a futures contract is the way the underlying asset is priced for future purchase or sale • A forward contract states a price for the future transaction • By contrast, a futures contract is settled-up or marked-to-market, daily at the settlement price • The settlement price is a price representative of futures transaction prices at the close of daily trading on the exchange.

12. Futures Contracts: Preliminaries • A buyer of a futures contract (one who holds a long position) in which the settlement price is higher (lower) than the previous day's settlement price has a positive (negative) settlement for the day.

13. Futures Contracts: Preliminaries • The change in settlement prices from one day to the next determines the settlement amount • Settlement amount is equal to the change in settlement prices per unit of the underlying asset, multiplied by the size of the contract, and equals the size of the daily settlement to be added or subtracted from the margin account • Futures trading between the long and the short is a zero-sum game

14. Futures Contracts: Preliminaries • Standardizing Features: • Contract Size • Delivery Month • Daily resettlement • Initial Margin (about 4% of contract value, cash or T-bills at your brokers).

15. 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.

16. Daily Resettlement: An Example • Currently $1 = ¥140 and it appears that the dollar is strengthening. • If you enter into a 3-month futures contract to sell ¥ at the rate of $1 = ¥150 you will make money if the yen depreciates beyond $1 = ¥150. • Let’s say the contract size is ¥12,500,000 • Your initial margin in US dollars is 4% of the contract value:

17. 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 You have lost $559.28 overnight.

18. 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. • 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.

19. Currency Futures Market • Enforced by potential arbitrage activities, the prices of currency futures are closely related to their corresponding forward rates and spot rates. • Currency futures contracts are guaranteed by the exchange clearinghouse, which in turn minimizes its own credit risk by imposing margin requirements on those market participants who take a position.

20. Comparison of the Forward & Futures Contracts

21. Comparison of the Forward & Futures Contracts Forward ContractsFutures Contracts Participants Banks, brokers, Banks, brokers, MNCs. Public MNCs. Qualified speculation not public speculation encouraged. encouraged. Security Compensating Small security deposit bank balances or deposit required. credit lines needed. Clearing Handled by Handled by operation individual banks exchange & brokers. clearinghouse. Daily settlements to market prices. Marketplace Worldwide Central exchange telephone floor with worldwide network communications. Regulation Self-regulating Commodity Futures Trading Commission, National Futures Association. Transaction Bank’s bid/ask Negotiated Costs spread. brokerage fees.

22. April 4 June 17 1. Contract to sell 500,000 pesos @ $.09/peso ($45,000) on June 17. 2. Buy 500,000 pesos @ $.08/peso ($40,000) from the spot market. 3. Sell the pesos to fulfill contract. Gain $5,000. Currency Futures Market • Speculators often sell currency futures when they expect the underlying currency to depreciate, and vice versa.

23. April 4 June 17 1. Expect to receive 500,000 pesos. Contract to sell 500,000 pesos @ $.09/peso on June 17. 2. Receive 500,000 pesos as expected. 3. Sell the pesos at the locked-in rate. Currency Futures Market • MNCs may purchase currency futures to hedge their foreign currency payables, or sell currency futures to hedge their receivables.

24. January 10 February 15 March 19 1. Contract to buy A$100,000 @ $.53/A$ ($53,000) on March 19. 2. Contract to sell A$100,000 @ $.50/A$ ($50,000) on March 19. 3. Incurs $3000 loss from offsetting positions in futures contracts. Currency Futures Market • Holders of futures contracts can close out their positions by selling similar futures contracts. Sellers may also close out their positions by purchasing similar contracts.

25. Currency Futures Markets • The Chicago Mercantile Exchange (CME) is by far the largest. • Others include: • The Philadelphia Board of Trade (PBOT) • The MidAmerica commodities Exchange • The Tokyo International Financial Futures Exchange • The London International Financial Futures Exchange

26. The Chicago Mercantile Exchange • Expiry cycle: March, June, September, December. • Delivery date 3rd Wednesday of delivery month. • Last trading day is the second business day preceding the delivery day. • CME hours 7:20 a.m. to 2:00 p.m. CST.

27. CME After Hours • Extended-hours trading on GLOBEX runs from 2:30 p.m. to 4:00 p.m dinner break and then back at it from 6:00 p.m. to 6:00 a.m. CST. • Singapore International Monetary Exchange (SIMEX) offer interchangeable contracts. • There’s other markets, but none are close to CME and SIMEX trading volume.

28. Basic Currency Futures Relationships • Open Interest refers to the number of contracts outstanding for a particular delivery month. • Open Interest is a good proxy for demand for a contract. • Some refer to open interest as the depth of the market. The breadth of the market would be how many different contracts (expiry month, currency) are outstanding.

29. Reading a Futures Quote Highest and lowest prices over the lifetime of the contract. Daily Change Closing price Lowest price that day Highest price that day Opening price Number of open contracts Expiry month

30. Eurodollar Interest Rate Futures Contracts • Widely used futures contract for hedging short-term U.S. dollar interest rate risk. • The underlying asset is a hypothetical $1,000,000 90-day Eurodollar deposit—the contract is cash settled. • Traded on the CME and the Singapore International Monetary Exchange. • The contract trades in the March, June, September and December cycle.

31. EURODOLLAR (CME)—$1 million; pts of 100% Open High Low Settle Chg Yield Settle Change Open Interest June 97.58 97.65 97.59 97.64 .03 2.36 -0.3 425,705 Reading Eurodollar Futures Quotes Eurodollar futures prices are stated as an index number of three-month LIBOR calculated as F = 100-LIBOR. The closing price for the July contract is 97.64, thus the three-month LIBORimplied yield is 2.36 percent = 100 – 97.64 The minimum price change is one basis point. On $1 million of face value, one basis point represents $100 on an annual basis. Since it is a 3-month contract one basis point corresponds to a $25 price change.

32. Currency Options Market • Currency options provide the right to purchase or sell currencies at specified prices. They are classified as calls or puts. • Standardized options are traded on exchanges through brokers. • Customized options offered by brokerage firms and commercial banks are traded in the over-the-counter market.

33. Options Contracts: Preliminaries • In-the-money • The exercise price is less than the prevailing spot price of the underlying asset. • At-the-money • The exercise price is equal to the prevailing spot price of the underlying asset. • Out-of-the-money • The exercise price is more than the prevailing spot price of the underlying asset.

34. Currency Call Options • A currency call option grants the holder the right to buy a specific currency at a specific price (called the exercise or strike price) within a specific period of time. • A call option is • in the money if exchange rate > strike price, • at the money if exchange rate = strike price, • out of the money if exchange rate < strike price.

35. Currency Call Options • Option owners can sell or exercise their options, or let their options expire. • Call option premiums will be higher when: • (spot price – strike price) is larger; • the time to expiration date is longer; and • the variability of the currency is greater. • Firms may purchase currency call options to hedge payables, project bidding, or target bidding.

36. Currency Call Options • Speculators may purchase call options on a currency that they expect to appreciate. • Profit = selling(spot)price – optionpremium – buying(strike)price • At breakeven, profit = 0. • They may also sell (write) call options on a currency that they expect to depreciate. • Profit = optionpremium – buying(spot)price + selling(strike)price

37. Currency Put Options • A currency put option grants the holder the right to sell a specific currency at a specific price (the strike price) within a specific period of time. • A put option is • in the money if exchange rate < strike price, • at the money if exchange rate = strike price, • out of the money if exchange rate > strike price.

38. Currency Put Options • Put option premiums will be higher when: • (strike price – spot rate) is larger; • the time to expiration date is longer; and • the variability of the currency is greater. • Firms may purchase currency put options to hedge future receivables.

39. Currency Put Options • Speculators may purchase put options on a currency that they expect to depreciate. • Profit =selling (strike) price – buying price – option premium • They may also sell (write) put options on a currency that they expect to appreciate. • Profit = option premium + selling price – buying (strike) price

40. Combined Currency Put Option and Call Option • One possible speculative strategy for volatile currencies is to purchase both a put option and a call option at the same exercise price. This is called a straddle. • By purchasing both options, the speculator may gain if the currency moves substantially in either direction, or if it moves in one direction followed by the other.

41. Efficiency of Currency Futures and Options • If foreign exchange markets are efficient, speculation in the currency futures and options markets should not consistently generate abnormally large profits.

42. Options Contracts: Preliminaries • European vs. American options • European options can only be exercised on the expiration date. • American options can be exercised at any time up to and including the expiration date. • Since this option to exercise early generally has value, American options are usually worth more than European options, other things equal.

43. Options Contracts: Preliminaries • Intrinsic Value • The difference between the exercise price of the option and the spot price of the underlying asset. • Speculative Value • The difference between the option premium and the intrinsic value of the option. Option Premium Intrinsic Value Speculative Value + =

44. Currency Options Markets • PHLX • HKFE • 20-hour trading day. • OTC volume is much bigger than exchange volume. • Trading is in seven major currencies plus the euro against the U.S. dollar.

45. For Buyer of £ Call Option For Seller of £ Call Option Strike price = $1.50 Premium = $ .02 Strike price = $1.50 Premium = $ .02 Net Profit per Unit Net Profit per Unit +$.04 +$.04 Future Spot Rate +$.02 +$.02 0 0 $1.46 $1.50 $1.54 $1.46 $1.50 $1.54 –$.02 Future Spot Rate –$.02 –$.04 –$.04 Contingency Graphs for Currency Options

46. For Buyer of £ Put Option For Seller of £ Put Option Strike price = $1.50 Premium = $ .03 Strike price = $1.50 Premium = $ .03 Net Profit per Unit Net Profit per Unit +$.04 +$.04 Future Spot Rate +$.02 +$.02 0 0 $1.46 $1.50 $1.54 $1.46 $1.50 $1.54 –$.02 –$.02 Future Spot Rate –$.04 –$.04 Contingency Graphs for Currency Options

47. Conditional Currency Options • A currency option may be structured such that the premium is conditioned on the actual currency movement over the period of concern. • Suppose a conditional put option on £ has an exercise price of $1.70, and a trigger of $1.74. The premium will have to be paid only if the £’s value exceeds the trigger value.

48. $1.78 Basic Put $1.76 $1.74 Conditional Put Conditional Put Net Amount Received $1.72 $1.70 $1.68 $1.66 Spot Rate $1.66 $1.70 $1.74 $1.78 $1.82 Conditional Currency Options Option TypeExercise PriceTriggerPremium basic put $1.70 - $0.02 conditional put $1.70 $1.74 $0.04

49. Conditional Currency Options • Similarly, a conditional call option on £ may specify an exercise price of $1.70, and a trigger of $1.67. The premium will have to be paid only if the £’s value falls below the trigger value. • In both cases, the payment of the premium is avoided conditionally at the cost of a higher premium.

50. Basic Option Pricing Relationships at Expiry • At expiry, an American call option is worth the same as a European option with the same characteristics. • If the call is in-the-money, it is worth ST – E. • If the call is out-of-the-money, it is worthless. CaT = CeT= Max[ST - E, 0]