Professional Documents
Culture Documents
Chap 7
Chap 7
Geography
• The foreign exchange market spans the globe, with
prices moving and currencies trading somewhere every
hour of every business day.
• As the next exhibit will illustrate, the volume of currency
transactions ebbs and flows across the globe as the
major currency trading centers open and close
throughout the day.
1
4
20,000
15,000
10,000
5,000
Greenwich Mean
Time
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, www.ny.frb.org.
2
Market Participants
• The foreign exchange market consists of two tiers:
The interbank or wholesale market (multiples of
$1MM US or equivalent in transaction size)
The client or retail market (specific, smaller amounts)
Market Participants
3
Foreign Exchange Brokers
• Foreign exchange brokers are agents who facilitate
trading between dealers without themselves becoming
principals in the transaction.
• For this service, they charge a commission.
• It is a brokers business to know at any moment exactly
which dealers want to buy or sell any currency.
• Dealers use brokers for their speed, and because they
want to remain anonymous since the identity of the
participants may influence short term quotes.
10
Source: www.econ.iastate.edu/classes/econ353/tesfatsion/mish2a.htm
11
12
4
Individuals and Firms
• Firms and individuals involved in international
commercial and financial transactions
Exporters receive foreign currency for the sale of their
goods and services
Exporters use the forex market to sell foreign
currency and buy AUD
Importers use the forex market to buy foreign
currency (sell AUD) to be used for purchasing imports
13
15
5
Speculators, Arbitragers and Hedgers
16
Transactions
in the Interbank Market
• A Spot transaction in the interbank market is the
purchase of foreign exchange, with delivery and
payment between banks to take place normally, on the
second following business day.
• The date of settlement is referred to as the value date.
• In the interbank market, the standard size trade is about
U.S. $10 million.
• A bank trading room is a noisy, active place.
• The stakes are high.
• The “long term” is about 10 minutes.
• Bid-Ask spreads in the spot FX market:
– increase with FX exchange rate volatility and
– decrease with dealer competition.
17
Transactions
in the Interbank Market
• An outright forward transaction (usually called just
“forward”) requires delivery at a future value date of a
specified amount of one currency for a specified amount
of another currency.
• The exchange rate is established at the time of the
agreement, but payment and delivery are not required
until maturity.
• Forward exchange rates are usually quoted for value
dates of one, two, three, six and twelve months.
• Buying Forward and Selling Forward describe the same
transaction (the only difference is the order in which
currencies are referenced.)
18
6
Transactions
in the Interbank Market
• A swap transaction in the interbank market is the
simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates.
• Both purchase and sale are conducted with the same
counterparty.
• Some different types of swaps are:
Spot against forward
Forward-Forward
Nondeliverable Forwards (NDF)
19
Market Size
20
1000
900
Spot
800
Forwards
700 Swaps
600
500
400
300
200
100
0
1989 1992 1995 1998 2001 2004
Source: Bank for International Settlements, “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004,” September 2004, p. 9.
7
800
300
200
100
0
1989 1992 1995 1998 2001 2004
Source: Bank for International Settlements, “Triennial Central Bank Survoreign Exchange and Derivatives Market Activity in April 2004,” September 2004, p. 13.
30
20
10
0
1989 1992 1995 1998 2001 2004
Source: Bank for International Settlements, “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004,” September 2004, p. 11.
24
8
Growth of Derivatives Markets
(Figure 5.1)
700
Size of
OTC
600 Market
($ trillion) Exchange
500
400
300
200
100
0
Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08
26
9
Derivatives contracts
28
Derivatives contracts
30
10
Derivatives
32
11
Spot transaction
4-34
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies,
Inc. All rights reserved.
36
12
Delivery and settlement of
a forward contract
• When a forward contract expires, two possible
arrangements that can be used to settle the obligations
of the parties:
Delivery: the long will pay the agreed-upon price to the
short, who in turn will deliver the underlying asset to the
long (a deliverable forward contract).
Cash settlement: permits the long and the short to pay
the net cash value of the position (F-St) on the delivery
date (a cash-settled forward contract or nondeliverable
forwards NDFs).
F
Buyer (the long) Seller (the short)
37
Underlying
Forward rate
F 1 i 1 i
F S i, i* interest rate per annum
S 1 i* 1 i* n
1 i
If F is n-year forward rate F S
*
1 i
1 i m
If F is 12/m-month forward rate, F S
simple interest rate 1 i* m
13
Forward margin
Forward (j/i) - Spot(j/i) 360
fi 100%
Spot(j/i) n
40
Example
41
Price of Price of
underlying underlying
at maturity ST at maturity ST
14
Forward quotation on a points basis
• The forward rates are quoted in terms of points, also
referred to as cash rate (for maturity up to 1 year) and
swap rate (for two years or longer).
Bid Ask
Outright spot ¥118,27 ¥118,37
plus points (three months) -2,88 -2,87
Outright forward ¥115,39 ¥115,50
15
Figure 23.1 Spot and Forward Prices in
Foreign Exchange
47
48
16
Foreign Currency Futures
• Foreign currency futures contracts differ from forward
contracts in a number of important ways:
Futures are standardized in terms of size while forwards
can be customized
Futures have fixed maturities while forwards can have
any maturity (both typically have maturities of one year
or less)
Trading on futures occurs on organized exchanges
while forwards are traded between individuals and
banks
Futures have an initial margin that is marked to market
on a daily basis while only a bank relationship is needed
for a forward
Futures are rarely delivered upon (settled) while
49
forwards are normally delivered upon (settled)
50
17
Widely Traded Financial Futures Contracts
Marking to Market
Your balance
Initial
margin
Maint.
margin
18
loss 9$x100oz = -1,800 for 2 contracts
Marking to market
Example
A GBP futures contract at the CME on 18 Dec 2003
• Opening price $1.6002/£
• Contract value £62,500
• Standard margin: $2,000
• Maintenance level/margin: $1,500
Example
19
Day Beginning Funds Futures Price Gain/ Ending
Balance Deposited Price Change Loss Balance
0 212
1 211
2 214
3 209
4 210
5 204
6 202
Example
• 5-Jun: Purchase 2 gold futures contracts at COMEX
– Delivery in Dec
– Futures price: $400
– Quantity: 100 ounces
– Initial deposit: $2000/contract
– MM: $1500/contract
– No withdrawal on the deposit
• Estimate the margin call with respect to change in gold
price
• Calculate the profit/loss from this operation
20
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)
• There are two basic types of options, puts and calls.
A call is an option to buy foreign currency
A put is an option to sell foreign currency
• The buyer of an option is termed the holder, while the
seller of the option is referred to as the writer or grantor.
• An American option gives the buyer the right to exercise
the option at any time between the date of writing and the
expiration or maturity date.
• An European option can be exercised only on its
expiration date. 61
62
63
21
The concept of moneyness of an option
Example
65
66
22
+C
0
-C
S
X X+C
67
68
X-P
P
0
-P
-(X-P)
S
X-P X
69
23
Profit and Loss for the Buyer of a
Call Option
• Buyer of a call:
– Assume purchase of August call option on Swiss
francs with strike price of 58½ ($0.5850/SF), and a
premium of $0.005/SF
– At all spot rates below the strike price of 58.5, the
purchase of the option would choose not to exercise
because it would be cheaper to purchase SF on the
open market
– At all spot rates above the strike price, the option
purchaser would exercise the option, purchase SF at
the strike price and sell them into the market netting a
profit (less the option premium)
Profit and Loss for the Buyer of a Call strike price = agreed price to buy
Option on Swiss francs
“At the money”
Profit
(US cents/SF)
Strike price TH1: spot market price: 59.5 => agree to exercise the
“Out of the money” “In the money” long call contract to buy at 58.5 lower than spot market price => in
+ 1.00 the money (profit = 0.5, 0.5 cents per premium)
+ 0.50
Unlimited profit
0 Spot price
57.5 58.0 58.5 59.0 59.5
Limited loss
(US cents/SF)
TH2: spot market price: 58.75 => agree to exercise the
- 0.50
Break-even price contract to buy at 59.0 lower than spot market price => out
- 1.00 of the money (loss = 0.25 cents per premium)
Loss not agree to exercise the contract => out of the money =>
The buyer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot rates less
than 58.5 (“out of the money”), and an unlimited profit potential at spot rates above 58.5 cents/SF (“in the money”).
loss = 0.5 cents per premium
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
72
Profit = (Spot Rate – Strike Price) - Premium
24
Profit and Loss for the Writer of
a Call Option
• Writer of a call:
– What the holder, or buyer of an option loses, the writer
gains
– The maximum profit that the writer of the call option can
make is limited to the premium
– If the writer wrote the option naked, that is without owning
the currency, the writer would now have to buy the
currency at the spot and take the loss delivering at the
strike price
– The amount of such a loss is unlimited and increases as
the underlying currency rises
– Even if the writer already owns the currency, the writer will
experience an opportunity loss
Copyright © 2007 Pearson Addison-Wesley.
All rights reserved.
Profit and Loss for the Writer of a Call receive the premium in advance
Option on Swiss francs
Profit
“At the money”
Strike price
profit long call = loss short call
(US cents/SF)
+ 1.00
0 Spot price
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
- 0.50 Unlimited loss
- 1.00
short call
Loss
The writer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at spot
rates less than 58.5, and an unlimited loss potential at spot rates above (to the right of) 59.0 cents/SF.
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
75
Profit (loss) = Premium – (Spot Rate – Strike Price)
25
Profit and Loss for the Buyer of a
Put Option
• Buyer of a Put:
– The basic terms of this example are similar to those just
illustrated with the call
– The buyer of a put option, however, wants to be able to sell the
underlying currency at the exercise price when the market price
of that currency drops (not rises as in the case of the call option)
– If the spot price drops to $0.575/SF, the buyer of the put will
deliver francs to the writer and receive $0.585/SF
– At any exchange rate above the strike price of 58.5, the buyer of
the put would not exercise the option, and would lose only the
$0.05/SF premium
– The buyer of a put (like the buyer of the call) can never lose
more than the premium paid up front
Profit and Loss for the Buyer of a Put Option TH1: sell 58.5, paid already 0.5 for premium
on Swiss francs => receive 58 cents
Profit
“At the money”
Strike price
spot market price = 58
(US cents/SF)
“In the money” “Out of the money”
=> break-even point
+ 1.00
+ 0.50 Profit up TH2: sell 58.5, buy 57.5 => pay 0.5 for premium, price
to 58.0
0 Spot price difference = 1 => profit = 0.5 (in the money)
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
Limited loss
- 0.50
Break-even long put
price in the money -> into the contract
- 1.00
out of the money -> not into the contract
Loss
The buyer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot rates
greater than 58.5 (“out of the money”), and an unlimited profit potential at spot rates less than 58.5 cents/SF (“in the
money”) up to 58.0 cents.
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
26
Profit and Loss for the Writer of
a Put Option
• Seller (writer) of a put:
– In this case, if the spot price of francs drops below
58.5 cents per franc, the option will be exercised
– Below a price of 58.5 cents per franc, the writer will
lose more than the premium received fro writing the
option (falling below break-even)
– If the spot price is above $0.585/SF, the option will
not be exercised and the option writer will pocket the
entire premium
+ 1.00
Break-even
+ 0.50 price short put
Limited profit
0 Spot price
57.5 58.0 58.5 59.0 59.5
(US cents/SF)
Unlimited loss
- 0.50 up to 58.0
- 1.00
Loss
The writer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at spot rates
greater than 58.5, and an unlimited loss potential at spot rates less than 58.5 cents/SF up to 58.0 cents.
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.
27
Call or Put
If price
82
X
Example
Call option: exercise price: USD2000, premium C =
USD81.75.
• Determine the value at expiration and profit for a buyer
under two outcomes: the price of underlying at expiration
is USD1900 and 2100
• Determine the maximum profit and loss to the buyer
• Determine the breakeven price of the underlying at
expiration
• Graph the value at expiration and the profit
28
Put Option position
ST < X ST ≥ X
Option value at expiration (payoffs) PT
Long Put PT = max (0, X – ST)
X – ST (ITM) 0 *(OTM)
Short Put -PT = -max (0, X – ST)
0 ST - X
Profit P
Long Put PT – P0 = max (0, X – ST) – P0
X – ST – P0 -P0
Short Put -PT + P0
Breakeven point Maximum profit Minimum loss
Long Put ST* = X - P0 X - P0 P0
Short Put ST* = X - P0 P0 X - P0
P0 : put option premium
*/: P T cannot be worth less than zero because the option seller would have to pay the option buyer. It
cannot be worth more than zero because the buyer would not pay for a position that, an instant later, will
be worth nothing. Special case: ST = X option is treated as OTM because the option is 0 at expiration.
Example
Put option: Exercise price USD2000, premium P =
USD79.25.
• Determine the value at expiration and profit for a buyer under
two outcomes: the price of underlying at expiration is
USD1900 and 2100
• Determine the maximum profit and loss to the buyer
• Determine the breakeven price of the underlying at expiration
• Graph the value at expiration and the profit
87
29
Option Pricing and Valuation
88
Exhibit 8.8
Analysis of Call
Option on
British Pounds
with a Strike
Price = $1.70/£
89
Intrinsic Value, Time Value & Total Value for a Call Option on British
Pounds with a Strike Price of $1.70/£
Option Premium
(US cents/£)
-- Valuation on first day of 90-day maturity --
6.0
5.67
Total value
5.0
4.0 4.00
3.30
3.0
2.0 1.67
Time value Intrinsic
1.0
value
0.0
1.66 1.67 1.68 1.69 1.70 1.71 1.72 1.73 1.74
30
Intrinsic value
91
92
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93
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
31
Exhibit 8.12 Foreign Exchange Implied Volatility for Foreign Currency
Options, January 30, 2008
94
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
d 2 d1 T
P F N d1 1 E N d 2 1 e rd T
95
96
32
Currency option pricing sensitivity
Call Put
Strike price - +
Time to maturity + +
Interest differential - +
Volatility + +
Forward rates + -
Spot rates + -
97
33
Currency option pricing sensitivity
100
4.0
At-the-money (ATM)
3.0
call ($1.70 strike price)
2.0
Out-of-the-money (OTM)
1.0 call ($1.75 strike price)
0.0
90 80 70 60 50 40 30 20 10 0
Copyright © 2007 Pearson Addison-Wesley. Days remaining to maturity
All rights reserved. theta= (ct3,3/£-ct3,28)/(90-89)=0,02
102
34
Currency option pricing sensitivity
• Volatility is viewed in three ways:
Historic
Forward-looking
Implied
• Because volatilities are the only judgmental component
that the option writer contributes, they play a critical role
in the pricing of options.
• All currency pairs have historical series that contribute to
the formation of the expectations of option writers.
• In the end, the truly talented option writers are those with
the intuition and insight to price the future effectively.
• Traders who believe that volatilities will fall significantly
in the nearterm will sell (write) options now, hoping to
buy them back for a profit immediately volatilities fall,
causing option premiums to fall. 103
104
105
35
Interest Differentials and Call Option
Premiums
Option Premium (US cents/£)
8.0
A Call Option on British Pounds: Spot Rate = $1.70/£
7.0
5.0
4.0
ATM call ($1.70 strike price)
3.0
2.0
OTM call ($1.75 strike price)
1.0
0.0
-4.0 -3.0 -2.0 -1.0 0 1.0 2.0 3.0 4.0 5.0
Interest differential: iUS$ - i £ (percentage)
Copyright © 2007 Pearson Addison-Wesley.
All rights reserved.
6.0
5.0
OTM Strike rates
4.0
2.0
1.0
0.0
1.66 1.67 1.68 1.69 1.70 1.71 1.72 1.73 1.74 1.75
Copyright © 2007 Pearson Addison-Wesley.
All rights reserved. Call strike price (U.S. dollars/£)
36
Summary of Option Premium
Components
111
37
Example
Sport rate S(VND/USD) = 17,750-17,800
i$ = 4%/year
iVND = 8%/year
Today A has export receipts in USD and needs
VND for domestic payments. After 3 months, A
needs USD for import payments.
In contrast, B needs USD for import payments
at present and in 3 months, B receives USD
from the export contract and will sell this export
receipt for VND.
112
114
38
Firm USD AUD
AA 10% 7%
BB 9% 8%
115
116
39
Hedging using forward
John Hull
John Hull
John Hull
40
Foreign currency speculation
• Speculation is an attempt to profit by trading on
expectations about prices in the future.
• Speculators can attempt to profit in the:
Spot market – when the speculator believes the
foreign currency will appreciate in value
Forward market – when the speculator believes the
spot price at some future date will differ from today’s
forward price for the same date
Futures market – if a speculator buys a futures
contract, they are locking in the price at which they
must buy that currency on the specified future date or
vice versa.
Options markets – extensive differences in risk
patterns produced depending on purchase or sale of
put and/or call. 121
122
a) b)
Assumptions Values Values
Initial investment (funds available) $10,000,000 $10,000,000
Current spot rate (US$/€) $0.8850 $0.8850
30-day forward rate (US$/€) $0.9000 $0.9000
Expected spot rate in 30 days (US$/€) $0.8440 $0.9440
123
41
Speculation using futures
124
125
John Hull
126
John Hull
42
Arbitrage
• Spatial/Two-point arbitrage
• Triangular/Three-point arbitrage
127
Spatial/Two-point arbitrage
h and f are any two currencies.
sh/f : the exchange rate of currency f with currency h in H
financial centre (price of currency f in terms of currency h).
sf/h : the exchange rate of currency h with currency f in F
financial centre
The consistency/neutrality condition: sh/f . Sf/h = 1
sh/f .sf/h ≠ 1: arbitrage opportunity
• Foreign exchange arbitrage is the act of profiting from
differences between the exchange rates of foreign exchange.
• Spatial arbitrage refers to an arbitrage transaction that is
conducted in two different markets, or seperated by space.
128
Example
129
43
Example
• Example:
Bank C Bid Ask Bank D Bid Ask
NZ$ $.635 $.640 NZ$ $.645 $.650
Buy NZ$ from Bank C @ $.640, and sell it to
Bank D @ $.645. Profit = $.005/NZ$.
Example
London £0.6064-80/€
Frankfurt €1.6244-59/£
Define arbitrage opportunity?
131
Three-point/triangular arbitrage
h, f and m are any three currencies.
sf/m : price of currency m in terms of currency f.
sh/f : price of currency f in terms of currency h.
sh/m: price of currency m in terms of currency h.
The cross rate: sf/m= sh/m/sh/f
With sh/f = 1/sf/n, we have sf/m= sh/m/sh/f = sf/h.sh/m
With sf/m= 1/sm/f, we have sf/m= sf/h.sh/m or 1/sm/f = sf/h .sh/m
Then sf/h . sh/m .sm/f= 1 or sh/m . sm/f . sf/h=1
The consistency/neutrality condition: sf/m= sf/h.sh/m
sf/m /sf/h ≠ sh/m: arbitrage opportunity
44
Example
Barclays Bank quotes $1.6410/£
Deutsche Bank quotes €1.3510/£
Citibank quotes $1.3223/€
Calculate arbitrage profit of a market trader with
$1,000,000.
133
Example
• Example: Bid Ask
British pound (£) $1.60/£ $1.61/£
Malaysian ringgit (MYR) $.200/MYR $.202/MYR
£ MYR8.1/£ MYR8.2/£
Buy £ @ $1.61, convert @ MYR8.1/£, then sell MYR @
$.200. Profit = $.01/£. (MYR8.1/£$0.2/MYR=$1.62/£)
Example
Bid Ask
£ $1.60/£ $1.61/£
MYR $.200/MYR $.202/MYR
£ MYR8.1/£ MYR8.2/£
$
Value of MYR in $
Exchange MYR for $ at Value of £ in $
$0.2/MYR Buy £ for $ at $1.61/£
(MYR50310=$10062) ($10000=£6221)
MYR £
Value of £ in MYR
Exchange £ for MYR at MYR8.1/£
(£6221=MYR50310)
45