Futures and Options on Foreign Exchange

Chapter 7
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 Chapter Outline
• Futures Contracts: Preliminaries
• Currency Futures Markets
• Basic Currency Futures Relationships
• Options Contracts: Preliminaries
• Currency Options Markets
• Currency Futures Options
• Basic Option Pricing Relationships at Expiry

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 Futures Contracts: Preliminaries
• A futures contract is like a forward contract in that 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
in that futures are standardized contracts trading on
organized exchanges with daily resettlement through a
clearinghouse.

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 Futures Contracts: Preliminaries
• Standardizing features:
– Contract size
– Delivery month
– Daily resettlement
• Initial performance bond (about 2 percent of
contract value, cash or T-bills, held in a street
name at your brokerage)

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 Daily Resettlement: An Example
• Consider a long position in the Chicago Mercantile
Exchange (CME) Euro/U.S. Dollar contract.
• It is written on €125,000 and quoted in $ per €.
• The strike price is $1.30 per €. The maturity is 3
months.
• At initiation of the contract, the long posts an initial
performance bond of $6,500.
• The maintenance performance bond is $4,000.

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 Daily Resettlement: An Example
• With futures contracts, we have daily
resettlement of gains and losses rather than one
big settlement at maturity.
• Every trading day:
– If the price goes down, the long pays the short. e.g.
$1.27/Euro
– If the price goes up, the short pays the long.
e.g.$1.33/Euro
• After the daily resettlement, each party has a
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 Performance Bond Money
• Each day’s losses are subtracted from the investor’s
account.
• Each day’s gains are added to the account.
• In this example, at initiation the long posts an initial
performance bond of $6,500.
• The maintenance level is $4,000.
– If this investor loses more than $2,500, he has a decision to
make; he can maintain his long position only by adding more
funds, and if he fails to do so his position will be closed out
with an offsetting short position.
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 Daily Resettlement: An Example
• Over the first 3 days, the euro strengthens then
depreciates in dollar terms:
Settle Gain/Loss Account Balance
$1.31 $1,250 = ($1.31 –$7,750
$1.30)×125,000
= $6,500 + $1,250
$1.30 –$1,250 $6,500
$1.27 –$3,750 $2,750 + $3,750 = $6,500
On day three suppose our investor keeps his long
position open by posting an additional $3,750.
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 Daily Resettlement: An Example
• Over the next 2 days, the long keeps losing money and closes
out his position at the end of day five.

Settle Gain/Loss Account Balance

$1.31 $1,250 $7,750
$1.30 –$1,250 $6,500
$1.27 –$3,750 $2,750 + $3,750 = $6,500
$1.26 –$1,250 $5,250 = $6,500 – $1,250
$1.24 –$2,500 $2,750
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 Toting Up
•At the end of his adventure, our investor has three ways
of computing his gains and losses:
1. Sum of daily gains and losses.
– $7,500 = $1,250 – $1,250 – $3,750 – $1,250 – $2,500
2. Contract size times the difference between initial contract
price and last settlement price.
– $7,500 = ($1.24/€ – $1.30/€) × €125,000
3. Ending balance on the account minus beginning balance on
the account, adjusted for deposits or withdrawals.
– $7,500 = $2,750 – ($6,500 + $3,750)

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 Currency Futures Markets
• The CME Group (formerly Chicago Mercantile Exchange) is by far the
largest currency futures market.
• CME hours are 7:20 a.m. to 2:00 p.m. CST Monday-Friday.
• https://time.is/CST
• Extended-hours trading takes place Sunday through Thursday (local) on
GLOBEX i.e. from 5:00 p.m. to 4:00 p.m. CST the next day.
https://www.cmegroup.com/globex.html
• The Singapore Exchange offers interchangeable contracts.
• There are other markets, but none are close to CME and SIMEX trading
volume.
• Expiry cycle: March, June, September, December.
• The delivery date is the third Wednesday of delivery month.
• The last trading day is the second business day preceding the delivery day.
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 Reading Currency Futures Quotes
OPEN
OPEN HIGH LOW SETTLE CHG INTEREST
Euro/US Dollar (CME)—€125,000; $ per €
June 1.3084 1.3118 1.3054 1.3087 .0005 233,380
Sept 1.3089 1.3126 1.3062 1.3094 .0006 6,814
Open interest refers to the number of contracts outstanding for a particular delivery month—it’s a good
proxy for demand for a contract. Notice that open interest is greatest in the nearby contract.
In general, open interest typically decreases with term to maturity of most futures contracts.
Change: The change between the closing price at the end of the trading session and the closing price of the
previous trading session.

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 Options Contracts: Preliminaries
• An option gives the holder the right, but not the
obligation, to buy or sell a given quantity of an asset in
the future at prices agreed upon today.
• Calls vs. Puts:
– Call options give the holder the right, but not the obligation,
to buy a given quantity of some asset at some time in the
future at prices agreed upon today.
– Put options give the holder the right, but not the obligation,
to sell a given quantity of some asset at some time in the
future at prices agreed upon today.
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Foreign Currency Options
• A foreign currency option is a contract
– giving the option purchaser (the buyer) the
right,
– but not the obligation to buy or sell
– a given amount of foreign exchange
– at a fixed price per unit for a specified time
period (until the maturity date).
• Two basic types of options
– Call option: an option to buy foreign currency
– Put option: an option to sell foreign currency

– Traded on organised exchanges like Philadelphia

Stock exchange (PHLX)
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 Options Contracts: Preliminaries
• European versus American options:
– European options can only be exercised on the expiration
date while American options can be exercised at any time up
to and including the expiration date.
– American options are usually worth more than European
options, other things equal.

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 Foreign Currency Options
• The premium (option price) is the cost of the option
paid in advance by the buyer to the seller
• An option whose exercise price is the same as the
spot price of the underlying currency is said to be at-
the-money (ATM)
• An AU$ option that would be profitable if exercised
immediately is said to be in-the-money (ITM).e.g. Call
Strike = 0.76US$ and Spot = 0.78US$
• An AU$ option that would not be profitable if
exercised immediately is referred to as out-of-the
money (OTM) e.g. Call Strike = 0.76US$ and Spot =
0.75US$.
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 Foreign Currency Options
• The buyer of an option is termed the holder,
while the seller of the option is referred to as
the writer or grantor.
• Option price elements:
– The exercise or strike price – the exchange rate at
which the foreign currency can be purchased (call) or
sold (put)
– The premium – the cost, price, or value of the option
itself
– The underlying or actual spot exchange rate in the
market

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 Basic Option Profit Profiles
Profit
If the call is in-
the-money, it is
worth ST – E.
If the call is out-
of-the-money, it
is worthless, and
the buyer of the ST
call loses his –c0
E + c0
entire investment E
of c0.
Out-of-the-money In-the-money

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 Basic Option Profit Profiles
Profit
If the put is in-
the-money, it is E – p
0
worth E – ST. The
maximum gain is
E – p0.
If the put is out- Short 1 put
of-the-money, it
is worthless, and ST
– p0
the buyer of the Long 1 put
put loses his E – p0
entire investment
of p0. E
In-the-money Out-of-the-money
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PHLX Currency Option Specifications
Currency Contract Size
Australian dollar AUD 10,000
British pound GBP 10,000
Canadian dollar CAD 10,000
Euro EUR 10,000
Japanese yen JPY 1,000,000
New Zealand dollar NZD 10,000
Swiss franc CHF 10,000

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Foreign Currency Speculation Example
– Buyer of a call:
• Ian purchased November call option on Australian dollar with strike
price of 76 (US$0.7600/A$), and a premium of US$0.0101/A$
• At all spot rates below the strike price of 0.7600, Ian would choose not
to exercise. Example if spot = 0.7599 it will be cheaper to purchase A$
on the open market.
• At all spot rates above the strike price, Ian would exercise the option,
purchase A$ at the strike price and sell them into the market netting a
profit (less the option premium). Example if the spot exchange rate is
0.78 at the expiration
Profit = spot rate – (strike rate + premium)
=USD0.7800/AUD - (USD0.7600 + USD0.0101/AUD)
= USD0.0099/AUD
Note – he has to pay in US$ - US$76000. Thus he can convert his
AU$100,000 into $78,000 US$ on day of exercise of option and pay
the $76,000 + has paid the premium (0.0101x 100,000= US$1,010) in
advance. Total cost $77,010. Profit = US$990.

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Foreign Currency Speculation Example
– Buyer of a call:

-0.0100

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Foreign Currency Speculation Example
• Speculating in the option market
• Buyer of a Put:
– The buyer of a put option wants to be able to sell the underlying
currency at the exercise price when the market price of that currency
drops
– Ian purchased November put option on AUD with strike price
USD0.7600/AUD, and a premium of USD0.0020/AUD
– If the spot price drops to USD0.7400/AUD, the buyer of the put will
deliver AUD to the writer and receive USD0.7600/AUD
– At any exchange rate above the strike price of USD0.7600, the buyer
of the put would not exercise the option, and would lose only the
USD0.0020/AUD premium
– The buyer of a put (like the buyer of the call) can never lose more than
the premium paid up front

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Foreign Currency Speculation Example
• Speculating in the option market - Buyer of a Put:

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PROBLEM 1 TO ANSWER – please note
that we only use these type of problems for this lecture. Not end-of-
chapter problems
1. Yesterday, you entered into a futures contract to buy €62,500 at $1.50 per €. Your initial performance bond is $1,500
and your maintenance level is $500. Below what settle price will you for the first time get a demand for additional funds
to be posted? Show all your calculations

A. $1.5160 per €.

B. $1.208 per €.

C. $1.1920 per €.

D. $1.4840 per €.

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 PROBLEM 2 TO ANSWER

2. Yesterday, you entered into a futures contract to buy €62,500 at $1.50/€. Your initial margin was $3,750 (= 0.04 ×
€62,500 × $1.50/€ = 4 percent of the contract value in dollars). Your maintenance margin is $2,000. Below what settle
price (use 4 decimal places) will you for the first time get a margin call? Show all your calculations.

A. $1.4720/€

B. $1.5280/€

C. $1.500/€

D. None of the above

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 PROBLEM 3 TO ANSWER

3. Today's settlement price on a Chicago Mercantile Exchange (CME) Yen futures contract is $0.8011/¥100. Your margin
account currently has a balance of $2,000. The next three days' settlement prices are $0.8057/¥100, $0.7996/¥100, and
$0.7985/¥100. (The contractual size of one CME Yen contract is ¥12,500,000). If you have a short position in one futures
contract, the changes in the margin account from daily marking-to-market will result in the balance of the margin
account after the third day to be? Show all your calculations.

A. $1,425.

B. $2,000.

C. $2,325.

D. $3,425.

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 PROBLEM 4 TO ANSWER

4. Suppose you observe the following 1-year interest rates, spot exchange rates and futures prices. Futures contracts are
available on €10,000. How much risk-free arbitrage profit could you make on 1 contract at maturity from this mispricing?
Show all your calculations.

A. $159.22

B. $153.10

C. $439.42

D. None of the above

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 PROBLEM 5 TO ANSWER

5. The current spot exchange rate is $1.55 = €1.00 and the three-month forward rate is $1.60 = €1.00. Consider a three-month
American call option on €62,500 with a strike price of $1.50 = €1.00. Immediate exercise of this option will generate an instant
payoff of

A. $6,125.

B. $6,125/(1 + i$)3/12.

C. negative payoff, so exercise would not occur.

D. $3,125.

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 PROBLEM 6 TO ANSWER

6. The current spot exchange rate is $1.55 = €1.00 and the three-month forward rate is $1.60 = €1.00. Consider a three-
month American call option on €62,500. For this option to be considered at-the-money, the strike price must be

A. $1.60 = €1.00

B. $1.55 = €1.00

C. $1.55 × (1 + i$)3/12 = €1.00 × (1 + i€)3/12

D. none of the above

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