Futures and Options on Foreign Exchange

Chapter 7
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 Chapter Outline
Futures Contracts: Some American Option-Pricing
Preliminaries Relationships
Currency Futures Markets European Option-Pricing
Basic Currency Futures Relationships
Relationships Binomial Option-Pricing
Options Contracts: Some Model
Preliminaries European Option-Pricing
Currency Options Markets Model
Currency Futures Options Empirical Tests of Currency
Options
Basic Option-Pricing
Relationships at Expiration Summary

© McGraw Hill 7-2

 Futures Contracts: Preliminaries 1

Both forward and futures contracts are derivative or

contingent claim securities because their values are
derived from or contingent upon the value of the
underlying security
Forward contract
• Tailor-made for a client by their international bank
Futures contract
• Standardized features (e.g., contract size, maturity
date, delivery months)
• Exchange traded
© McGraw Hill 7-3
 Futures Contracts: Preliminaries 2

An initial performance bond (formerly called margin) must

be deposited into a collateral account to establish a futures
position
• Generally equal to 2% of contract value
• Cash or T-bills may be used to meet requirement
Major difference between forward contract and futures
contract is the way the underlying asset is priced for future
purchase or sale
• Forward contract states a price for the future transaction,
but futures contract is settled-up, or marked-to-market,
daily at the settlement price
© McGraw Hill 7-4
Differences between Futures and Forward
Contract
Trading Location
Futures: Traded competitively on organized exchanges.
Forward: Traded by bank dealers via a network of telephones and computerized dealing systems.
Contractual Size
Futures: Standardized amount of the underlying asset.
Forward: Tailor-made to the needs of the participant.

Settlement
Futures: Daily settlement, or marking-to-market, done by the futures clearinghouse through the
participant's performance bond account.
Forward: Participant buys or sells the contractual amount of the underlying asset from the bank at
maturity at the forward (contractual) price.

Expiration Date
Futures: Standardized delivery dates.
Forward: Tailor-made delivery date that meets the needs of the investor.

Delivery
Futures: Delivery of the underlying asset is seldom made. Usually a reversing trade is transacted to
exit the market.
Forward: Delivery of the underlying asset is commonly made.
Trading Costs
Futures: Bid-ask spread plus broker’s commission.
Forward: Bid-ask spread plus indirect bank charges via compensating balance requirements.

© McGraw Hill 7-5

 Currency Futures Markets 1

Trading in currency futures began at the Chicago

Mercantile Exchange (CME) on May 16, 1972
• 2 million contracts traded in 1978
• 230 million contracts traded in 2018
CME Group formed in 2007, through a merger
between the CME and Chicago Board of Trade
(CBOT)
In 2008, CME Group acquired the New York
Mercantile Exchange (NYMEX)

© McGraw Hill 7-6

 Currency Futures Markets 2

Most CME currency futures trade in a March, June,

September, and December expiration cycle out six
quarters into the future, with the delivery date being
the third Wednesday of the expiration month
• Last day of trading for most contracts is the second
business day prior to the delivery date
Trading takes place Sunday through Friday on the
GLOBEX trading system from 5:00 PM to 4:00 PM
Chicago time the next day
Currency futures trading takes place on other
exchanges, in addition to the CME
© McGraw Hill 7-7
 Basic Currency Futures Relationships
Information provided on quotes for CME futures contracts includes the
following:
• Opening price, high and low quotes for the trading day, settlement price,
and open interest
• Open interest is the total number of short or long contracts outstanding for
the particular delivery month

Futures are prices very similar to forward contracts

Recall from Chapter 6, the IRP model states the forward price for
delivery at time T as:

(1 + i $ )T
FT ($ / f) = S0 ($ / f)
(1 + i f )T

© McGraw Hill 7-8

 Option Contracts: Some Preliminaries
An option is a contract giving the owner the right, but not the
obligation, to buy or sell a given quantity of an asset at a
specified price at some time in the future
• Option to buy is a call, and option to sell is a put
• Buying or selling the underlying asset via the option is known
as “exercising” the option
• Stated price paid or received is known as the exercise or
striking price
• Buyer of an option is often referred to as the long, and the
seller of an option is referred to as the writer (or the short)
• European option can be exercised only at maturity or
expiration date of contract, but American option can be
exercised any time during contract
© McGraw Hill 7-9
 Currency Option Markets
Prior to 1982, all currency option contracts were OTC options
written by international banks, investment banks, and brokerage
houses
• OTC options are tailor-made and generally for large amounts
(i.e., at least $1M of currency serving as underlying assets)
• OTC options are typically European style, and they are often
written for U.S. dollars, with the euro, British pound, Japanese
yen, Canadian dollar, and Swiss franc serving as the
underlying currency
In December 1982, the Philadelphia Stock Exchange (PHLX)
began trading options on foreign currency
In 2008, the PHLX was acquired by the NASDAQ OMX Group

© McGraw Hill 7-10

 Currency Futures Options
CME Group trades European style options on several of the
currency futures contracts it offers
• With these, the underlying asset is a futures contract on the
foreign currency instead of the physical currency
• One futures contract underlies one options contract
Most CME futures options trade with expirations in the March,
June, September, December expiration cycle of the underlying
futures contract and three serial noncycle months
• Options expire on the second business day prior to the third
Wednesday of the options contract month
• Trading takes place Sunday through Friday on the GLOBEX
system from 5:00 PM to 4:00 PM Chicago time the next day
© McGraw Hill 7-11
 Basic Option-Pricing Relationships at
Expiration 1

At expiration, a European option and an American option

(which has not been previously exercised), both with the
same exercise price, will have the same terminal value
For call options, the time T expiration value per unit of
foreign currency is stated as the following:

CaT = CeT Max [ST - E,0 ]

© McGraw Hill 7-12

 Basic Option-Pricing Relationships at
Expiration 2

Call (put) option with ST > E (E > ST) expires in-the-money

• It will be exercised because the buyer will make money
If ST = E, the option expires at-the-money
• It will not be exercised because no money will be made
by doing so
If ST < E (E < ST), the call (put) option expires out-of-the-
money
• It will not be exercised because the buyer would lose
money by doing so and is under no obligation to exercise
the option

© McGraw Hill 7-13

 American Option-Pricing Relationships 1

American options will satisfy the following basic pricing

relationships at time t prior to expiration:

# ! ! "#$ [%" – &' 0] #! ! "#$ [% – &" ' 0]

The above equations state that the American call and put
premiums at time t will be at least as large as the
immediate exercise value, or the intrinsic value, of the call
or put option
A longer-term American option will have a market price at
least as large as the short-term option

© McGraw Hill 7-14

 American Option-Pricing Relationships 2

Call (put) option with ST > E (E > ST) is trading in-

the-money
If ST ≅ E, the option is trading in-the-money
If ST < E (E < ST), the call (put) option is trading
out-of-the-money
Difference between the option premium and the
option’s intrinsic value is nonnegative and is
sometimes referred to as the option’s time value

© McGraw Hill 7-15

Market Value, Time Value, and Intrinsic Value
of an American Call Option

Access the text alternative for slide images. © McGraw Hill 7-16
 European Option-Pricing Relationships 1

Pricing boundaries for European put and call premiums are more complex
Consider two portfolios:
• Portfolio A involves purchasing a European call option and lending (or investing) an
amount equal to the present value of the exercise price, E, at the U.S. interest rate, i$,
which we assume corresponds to the length of the investment period

• Cost of this investment is as follows: Ce + E / (1 + i$)

• If ST ≤ E, call owner will let call option expire worthless
• If ST > E, call owner will exercise the call, and exercise value will be ST – E > 0
• Portfolio B consists of lending the present value of one unit of foreign currency, f, at
the foreign interest rate, if, which we assume corresponds to the length of the
investment period
• Cost of this investment is St /(1 + if)

© McGraw Hill 7-17

Equation for a European Call Option Lower
Boundary

Current Time Expiration

ST £ E ST > E

Portfolio A:
-Ce
Buy Call 0 St - E
Lend PV of E at i$.
E E
-E / (1 + i $ )
E ST
-Ce - E / (1 + i $ )

Portfolio B:

Lend PV of one unit of currency f

-St/(1 + if) ST ST
at rate if

© McGraw Hill 7-18

 European Option-Pricing Relationships 2

!"#$#%$&'("$)#*$%+,&-)$.,/#-(%&0()'(#1#2'))#3,#-%'.,4#
&(#5,))#0(%#$&#),$5&#$5#*6.7#$5#-(%&0()'(#8/#'*-)9'":#
&7,#0())(2'":;
é (ST ) E ù
Ce ³ Max ê – ,0ú
ë (1+ i f ) (1+ i $ ) û

<'*')$%)9/#'&#.$"#3,#57(2"#&7$&#&7,#)(2,%#3(6"4$%9#
-%'.'":#%,)$&'("57'-#0(%#$#=6%(-,$"#-6&#'5;

é E St ù
Pe ³ Max ê – ,0ú
ë (1+ i $ ) (1+ i f ) û
© McGraw Hill 7-19
 European Option-Pricing Relationships 3

Based on the two equations from the preceding slide, it can

be determined that, when all else remains the same, the
call premium, Ce (put premium, Pe) will increase:
• The larger (smaller) is the exchange rate, St
• The smaller (larger) is the exercise price, E
• The smaller (larger) is the foreign interest rate, if
• The larger (smaller) is the dollar interest rate, i$
• The larger (smaller) i$ is relative to if

© McGraw Hill 7-20

 European Call and Put Prices on Spot
Foreign Exchange
Equations 7.6 and 7.7 (see slide 19) may be
restated as the following:

é ($! –%& ) ù
'" ³ ()* %ê + 0ú
ë (1 +%, # ) û

é ($ – %! ) ù
&" ³ '() *ê + 0ú
ë (1 +*, # ) û

© McGraw Hill 7-21

 European Option-Pricing Valuation: Example 7.5
EXAMPLE 7.5: European Option-Pricing Valuation
Let’s see if Equations 7.8 and 7.9 actually hold for the 112 Sep EUR European
call and the 112 Sep EUR European put options we considered. The last day of
trading for both of these options is September 20, 2019, or in 179 days from
March 25, 2019, the options quotation date. On that date, the 6-month dollar
LIBOR (interest) rate was 2.673%. Thus, (1 + /$) is [1 + .02673(179/360)] =
1.0133. We will use the September futures price of $1.1487/EUR on March 25,
2019, for Fr .Thus, for the 112 Sep EUR call,
3.78 > Max [(114.87 ‒ 112)/(1.0133), 0] = Max [2.83, 0] = 2.83.
Thus, the lower boundary relationship on the European call premium holds. For
the 112 Sep EUR put,
.94 > Max [(112 ‒ 114.87)/(1.0133), 0] = Max[‒2.83, 0] = 0.
Thus, the lower boundary relationship on the European put premium holds as
well.

© McGraw Hill 7-22

 Binomial Option-Pricing Model 1

Binomial option-pricing model provides an exact pricing formula for a

European call or put
• In this case, binomial model assumes that at the end of the option
period, the underlying foreign exchange has either appreciated one
step upward or depreciated one step downward from its initial value
• Objective is to value the PHLX 112 Sep EUR European call
• Option is quoted at a premium of 3.78 cents
• Current spot price of the EUR in American terms is S0 = 113.14 cents
• Estimate of the option’s volatility is σ = 6.18%
• Last day of trading in the call option is in 179 days on 9/20/19
• At the end of the option period, the EUR will have appreciated to
SuT = S0 ⋅ u or depreciated to SdT = S0 ⋅ d

© McGraw Hill 7-23

PHLX World Currency Options Quotations
NASDAQ OMX
Calls Puts
PHLX Options
Japanese Yen
1,000,000 J.Yen-100ths of a cent per unit.
109 Jun 1.56 1.30
110 Jun 1.05 1.78
111 Jun .66 2.38
112 Jun .39 3.10
109 Sep 1.86 2.32
110 Sep 1.40 2.89
111 Sep 1.03 3.53
112 Sep .74 4.24
Euro 113.14
10,000 Euro-cents per unit.
111 Jun 3.41 .41
111.5 Jun 3.01 .50
112 Jun 2.63 .62
112.5 Jun 2.28 .75
113 Jun 1.94 .91
111 Sep 4.54 .72
112 Sep 3.78 .94
113 Sep 3.09 1.23
114 Sep 2.47 1.59
115 Sep 1.92 2.04

© McGraw Hill 7-24

 Binomial Option-Pricing Model 2

Binomial option-pricing model relies on the risk-neutral probabilities of the

underlying asset increasing and decreasing in value
Risk-neutral probability of the EUR appreciating is:
q = (F - S × d) S ( u - d )
T 0 0

Use September EUR futures price on 3/25/19 as estimate of FT($/EUR) =

$1.1487
• Therefore, q = (114.87 –108.35 ) (118.14 –108.35 ) = 0.666

Binomial call option premium is determined by:

C = [qC + (1 - q ) C ] (1 + i )
0 uT dT $

= éë.666 ( 6.14 ) + .334 ( 0 ) ùû (1.0133)

= 4.04 cents per EUR

© McGraw Hill 7-25

Schematic of Binomial Option-Pricing
Example

Access the text alternative for slide images. © McGraw Hill 7-26
 European Option-Pricing Formula
When the number of subperiods into which the option
period is subdivided goes to infinity, the European call and
put pricing formulas presented (below) are obtained
Exact European call and put pricing formulas:
-i$T
Ce = St e -if T N (d1 ) – Ee N (d 2 )

Pe = Ee -i T N (–d2 ) – St e -if T N (–d1 )

$

Invoking IRP allows us to restate these as follows:

Ce = [FT N (d1 ) – EN (d2 )]e -i T $

Pe = [EN (–d2 ) – FT N (–d1 )]e -i T $

© McGraw Hill 7-27

 Empirical Tests of Currency Options
Shastri and Tandon (1985)
• Discover many violations of the boundary relationships
(discussed in this chapter), but conclude that
nonsimultaneous data could account for most violations
Shastri and Tandon (1986)
• Conclude the European option-pricing model works well in
pricing American currency options
Barone-Adesi and Whaley (1987)
• Find the European option-pricing model works well for pricing
American currency options that are at or out-of-the-money,
but does not do well in pricing in-the-money calls and pits

© McGraw Hill 7-28

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© 2021 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw Hill.