FOREIGN CURRENCY DERIVATIVES:

FUTURES AND OPTIONS

CHAPTER 7
 Explain how foreign currency futures are
Explain quoted, valued, and used for speculation
purposes

Explore the buying and writing of foreign

Explore currency options in terms of risk and return

LEARNING
OBJECTIVES Examine how foreign currency option values
Examine change with exchange rate movements and
over time

Analyze how foreign currency option values

Analyze change with price component changes
A derivative is a contract between two or more
parties whose value is based on an agreed-upon
underlying financial asset, index, or security.
Common underlying instruments include: bonds,
commodities, currencies, interest rates, market
indexes, and stocks.

Futures contracts, forward

contracts, options, swaps, and warrants WHAT ARE
FINANCIAL
DERIVATIVES?
Financial derivatives are so named because their
values are derived from underlying assets.

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 • These instruments can be used for two
very distinct objectives:
• Speculation – use of derivative
instruments to take a position in the
PURPOSES OF expectation of a profit
FINANCIAL • Hedging – use of derivative
instruments to reduce the risks
DERIVATIVES associated with the everyday
management of corporate cash flow
 firms to achieve payoffs that they would not be able to achieve without derivatives, or could achieve only
Permit at greater cost

Hedge risks that otherwise would not be possible to hedge

Make underlying markets more efficient

Reduce volatility of stock returns

Minimize earnings volatility

Reduce tax liabilities

Motivate management (agency theory effect)

BENEFITS OF DERIVATIVES
 A foreign currency futures contract is an
alternative to a forward contract that calls
for future delivery of a standard amount of
foreign exchange at a fixed time, place, and Foreign
price (i.e., exchange rate).
Currency
Futures
It is similar to futures contracts that exist for
commodities such as cattle, lumber, interest-
bearing deposits, gold, etc.

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 • Contract specifications are established by the
exchange on which futures are traded.
• Major features that are standardized are:
• Contract size

Foreign • Method of stating exchange rates

• Maturity date
Currency • Last trading day
Futures • Collateral and maintenance margins
• Settlement
• Commissions
• Use of a clearinghouse as a counterparty
Mexican Peso (CME)-MXN 500,000; $ per 10MXN
 • 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
Foreign of one year or less)

Currency • Trading on futures occurs on organized

exchanges while forwards are traded between
Futures 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
Just 5%• Futures are rarely delivered upon (settled) while
forwards are normally delivered upon (settled)
CHECK YOUR UNDERSTANDING

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 how much in the
balance of the margin account after the
third day?
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 • 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
Foreign exchange at a fixed price per unit for a
specified time period (until the maturity
Currency date).
Options • 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 the holder; the
seller is referred to as the writer or
grantor.
• Options have three different price
Foreign elements:
• The exercise or strike price – the exchange
Currency rate at which the foreign currency can be
purchased (call) or sold (put)
Options • The premium – the cost, price, or value of
the option itself
• The underlying or actual spot exchange rate
in the market
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. Foreign
Currency
A European option can be Options
exercised only on its
expiration date, not before.
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 option that would be profitable, Foreign

excluding the cost of the premium, if
exercised immediately is said to be in-
Currency
the-money (ITM). Options
An option that would not be profitable,
excluding the cost of the premium, if
exercised immediately is referred to as
out-of-the money (OTM).
In the past three decades, the use of
foreign currency options as a hedging
tool and for speculative purposes has
become a major foreign exchange
activity.
Options on the over-the-counter
(OTC) market can be tailored to the Foreign
specific needs of the firm but can Currency
expose the firm to counterparty risk.
Options
Options on organized exchanges are
standardized, but counterparty risk is
substantially reduced.
Swiss Franc Option Quotations (U.S. cents/SF)
Buyer of an option only exercises his/her
rights if the option is profitable.

In the case of a call option, as the spot price

of the underlying currency moves up, the Buyer of a
holder has the possibility of unlimited
profit. St-K, St infinity Call Option
Loss= Co

The purchaser makes a profit as the franc

appreciates vs. the dollar – this is because
the purchaser has the right to purchase the
franc at a pre-specified, and in this case,
lower price than the current spot price.
Profit and Loss for the Buyer 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
Option • If the writer wrote the option naked, that is
Market without owning the currency, the writer
would now have to buy the currency at the
Speculation 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
Profit and Loss for the Writer of a Call 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
Option currency drops (not rises as in the case of the call
option)
Market • If the spot price drops to $0.575/SF, the buyer of
the put will deliver francs to the writer and
Speculation 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
 • Seller (writer) of a put:
• If the spot price of francs drops
below 58.5 cents per franc, the
option will be exercised
Option • Below a price of 58.5 cents per franc,
Market the writer will lose more than the
premium received from writing the
Speculation 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
Profit and Loss for the Writer of a Put Option
 Assume the following options are
currently available for British pounds (£ ):
• Call option premium on British pounds =
$0.04 per unit
• Put option premium on British pounds =
$0.03 per unit
CHECK YOUR • Call option strike price = GBP/USD 1.56
• Put option strike price = GBP/USD 1.53
UNDERSTANDING • One option contract represents £ 31,250
• Spot rate = GBP/USD 1.49
a) What type of derivative should the
speculator enter into? Why?
b) Construct a graph representing the
speculator’s expected payoff on his
chosen type of derivative.
 • Price of currency options has six
elements
• Present spot rate
• Time to maturity
Option Pricing • Forward rate for matching maturity
and Valuation • U.S. dollar interest rate
• Foreign currency interest rate
• Volatility (standard deviation of daily
spot price movements)
 • The total value (premium) of an option is equal
to the intrinsic value plus time value.
• Intrinsic value is the financial gain if the option
is exercised immediately.
• For a call option, intrinsic value is zero
when the strike price is above the market
price out-of-the market

Option Pricing • When the spot price rises above the strike
price, the intrinsic value become positive
and Valuation • Put options behave in the opposite manner
• On the date of maturity, an option will have
a value equal to its intrinsic value (zero time
remaining means zero time value)
• The time value of an option exists because the
price of the underlying currency, the spot rate,
can potentially move further and further into
the money between the present time and the
option’s expiration date.
Option Intrinsic Value, Time Value, and Total Value
Time value = 0 at
maturity date
Intrinsic value = 0 (out of
the money)

At the money: start to have intrinsic value

Call Option Premiums: Intrinsic Value and Time Value Components
 • If currency options are to be used
effectively, either for the purposes of
speculation or risk management, the
individual trader needs to know how
option values – premiums – react to their
various components.
Currency • Six sensitivities:
1. The impact of changing forward
Option Pricing rates
Sensitivity 2.
3.
The impact of changing spot rates
The impact of time to maturity
4. The impact of changing volatility
5. The impact of changing interest
differentials
6. The impact of alternative option
strike prices
 • Standard foreign currency
options are priced around the
forward rate because the current
spot rate and both the domestic
and foreign interest rates (home
Forward Rate currency and foreign currency
rates) are included in the option
Sensitivity premium calculation.
• The forward rate is central to
valuation.
• The option-pricing formula
calculates a subjective probability
distribution centered on the
forward rate.
 • If the current spot rate falls on the side
of the option’s strike price—which
would induce the option holder to
exercise the option upon expiration—
the option also has an intrinsic value.
• The sensitivity of the option premium to
Spot Rate a small change in the spot exchange rate
is called the delta.
Sensitivity • Delta varies between +1 and 0 for a call
(delta) option and -1 and 0 for a put option.
• As an option moves further in-the-
money, delta rises toward 1.0. As an
option moves further out-of-the-money,
delta falls toward zero.
• Rule of Thumb: The higher the delta
(deltas of .7, or .8 and up are considered
high) the greater the probability of the
option expiring in-the-money.
 • Option values increase with the length
of time to maturity. The expected
change in the option premium from a
small change in the time to expiration
is termed theta.
Time to • Theta is calculated as the change in the
Maturity: option premium over the change in
time. Theta is based not on a linear
Value and relationship with time, but rather the
Deterioration square root of time.
• Option premiums deteriorate at an
(theta) increasing rate as they approach
expiration.
• Rule of Thumb: A trader will normally
find longer-maturity options better
values, giving the trader the ability to
alter an option position without
suffering significant time value
deterioration.
 • Option volatility is the standard deviation of
daily percentage changes in the underlying
exchange rate.
• The primary problem with volatility is that
there is no single method for its calculation.
Volatility is viewed three ways:
• historic, where the volatility is drawn
from a recent period of time;
Sensitivity • forward-looking, where the historic
volatility is altered to reflect
expectations about the future period
to Volatility over which the option will exist; and
• implied, where the volatility is backed
(lambda) out of the market price of the option.
Selected implied volatilities for a
number of currency pairs are listed in
Exhibit 7.9.
• Rule of Thumb: Traders who believe
volatilities will fall significantly in the near-
term will sell (write) options now, hoping to
buy them back for a profit immediately after
volatilities fall causing option premiums to
fall.
Foreign Currency Implied
Volatilities (percent)
 • The expected change in the option
premium from a small change in
the domestic interest rate (home
currency) is termed rho.Positive effect on call

Sensitivity to premium, negative effect on

put option

• The expected change in the option

Changing premium from a small change in
Interest Rate the foreign interest rate (foreign
Differentials currency) is termed phi. Negative
on put
on call, positive

(rho and phi) • Rule of Thumb: A trader who is

purchasing a call option on foreign
currency should do so before the
domestic interest rate rises. This
will allow the trader to purchase
the option before its price
increases.
Alternative • A firm purchasing an option in the
over-the-counter market may
Strike choose its own strike rate.
• Options with strike rates that are
Prices and already in-the-money will have both
intrinsic and time value elements.
Option • Options with strike rates that are
out-of-the-money will have only a
Premiums time value component.
Summary of Option Premium Components