Module 2.

Foreign exchange Futures and Options

Chapter 7

Massey University | massey.ac.nz | 0800 MASSEY

Outline
⚫ Foreign exchange futures
⚫ Performance bond requirements
⚫ Foreign exchange options
⚫ The value of option at expiry
⚫ Lower boundaries of pricing for American options
⚫ Binomial option pricing models
⚫ The Black–Scholes option pricing model
⚫ Foreign exchange futures options
Foreign Exchange Futures
A FX futures contract is an agreement to purchase or
sell a certain amount of one currency in exchange for
another currency at a specified time in the future at a
price set today.

Positions: can go long (purchase) or go short (sell).

⚫ Traded on organized exchanges

⚫ Standardized contract size
⚫ Daily resettlement through a clearinghouse
⚫ Delivery rarely happen
Major FX Futures Markets
⚫ CME Group is the largest.
⚫ Expiry cycle: March, June, September, December.
⚫ Delivery date: 3rd Wednesday of delivery month.
⚫ Last trading day: 2nd business day preceding delivery
day

⚫ Others include:
⚫ The NASDAQ OMX Futures Exchange (NFX), formerly
the Philadelphia Board of Trade (PBOT).
⚫ The Intercontinental Exchange (ICE)
 Reading Currency Futures Quotes
OPEN
OPEN HIGH LOW SETTLE CHG INT

Euro/US Dollar (CME)—€125,000; $ per €

Mar 1.4748 1.4830 1.4700 1.4777 .0028 172,396
Jun 1.4737 1.4818 1.4693 1.4763 .0025 2,266

• Open Interest: the number of contracts outstanding,

it is a good proxy for the demand for a contract.
• The buyer is committing to pay $1.4777 per euro for
€125,000 (total contract value = $184,712.50).
Performance Bond Requirements
⚫ Initial performance bond: a small percentage of
contract value in cash or T-bills.
⚫ Maintenance bond: minimum balance in the
performance bond account, falling short will result in
receiving a margin call.
⚫ Marking-to-market: the resettlement of gains/losses
at the end of each day.
Marking-to-market
At the end of each day, trader’s gains or losses are
added to or subtracted from the trader’s account:
• if the price goes down, the long pays the short,
• if the price goes up, the short pays the long,
➢ Performance bond account balance is adjusted.

⚫ In effect, the delivery price of a futures contract is

reset at the last settlement price.
⚫ Futures price converges to the spot price at expiry.
Daily Resettlement: Example
Consider a long position in CME Euro/U.S. Dollar.
⚫ It is written on €125,000 and quoted in $ per €.
⚫ The settlement 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.
⚫ Maintenance performance bond is set at $4,000.
Suppose the euro strengthens then depreciates in dollar
terms over the next five days. The long closes out his
position at the end of day five.
 Daily Resettlement: Profit / Loss
Settle Gain/Loss Acc. Bal. Top-up? New Bal.
$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 Margin
$1.24 –$2,500 $2,750 call

At the end of this adventure, the trader has lost a total of:
$1,250 – $1,250 – $3,750 – $1,250 – $2,500 = – $7,500.
Alternatively, ($1.24/€ – $1.30/€) × €125,000 = – $7,500
Summary: Effects of the Marking-to-market
By initiating a long position at t = 0, the long commits
to pay F0 for a currency on the delivery day (T).
• At t = 1, the trader receives/pays a daily resettlement
of gains/losses of (F1-F0). The commitment to pay on
the delivery day becomes F1
• Over the contract life from T=0 to T, T cumulative
daily resettlement of gains/losses =  (Ft − Ft −1 ) = FT − F0
t =1

• The final settlement on delivery day = - FT

• Total sum of cash flow = (FT – F0) - FT= - F0, the
price that the trader promised to pay initially.
Foreign Exchange Options

A FX option gives the holder the right, but not the

obligation, to buy or sell a given quantity of a
currency in the future, at a price agreed upon today.

⚫ „Call vs. Put

⚫ European vs. American style:
An American option is usually worth more than an
equivalent European option.
Moneyness and Intrinsic Value
A call option is
⚫ In-the-money when ST > E.
⚫ At-the-money when ST = E.
⚫ Out-of-the-money when ST < E.
➢ Intrinsic value at expiry: CT = Max[ST - E, 0]

A put option’s intrinsic value at expiry:

PT = Max[E - ST, 0]
The Intrinsic Value of a Call: Example
A call option on €1 has an exercise price of $1.50/€.
Ignoring the cost of this option,
Profit Long 1 call on €1

$0
$1.50 ST

Loss
Net profit/loss at expiration: Long call
Net profit
Buyer of the call
The buyer of the
call pays a Long 1 call
premium of c0
upfront.

ST
–c0
E + c0
E
Out-of-the-money In-the-money
Net loss

E = Exercise price per unit of foreign currency,

 Net profit/loss to call buyer: Example
A call option on €31,250 has an exercise price of $1.50 / €.
Call option’s premium is $0.25 per €.

Net profit Long 1 call on €31,250

–$7,812.50 ST

= €31,250×($0.25)/€ $1.75
$1.50
Net loss
Net profit/loss at expiration: Short call

Net profit Seller of the call

The writer receives
the option premium
of c0 upfront.

c0

ST
E + c0
E
Net loss short 1
Out-of-the-money In-the-money call
 Net profit/loss at expiration: put option

Net profit

The maximum
gain is E – p0. E – p0

Short 1 put
Maximum loss of
the buyer = initial ST
– p0
investment of p0. Long 1 put
E – p0

E
Net loss
American Option Pricing Relationships
The intrinsic values of American options at time t
prior to expiration (T):
Ca ≥ Max[St - E, 0]
Pa ≥ Max[E – St , 0]

Holding an interest-bearing currency can earn

interest. Therefore, we need to consider the time
value of each interest-bearing currency involved.
Compare two investment strategies:
A. Long European call on £1 priced in $, and invest the PV of
exercise price (E) in the U.S. to earn i$.
Investment today = Ce + E
(1 + i$)
➢ Payoff at maturity = Max(E, ST).

B. Buy the PV of £1 at the spot rate, invest in U.K. to earn i£:

£1
Investment today = ×St
(1 + i£)
➢ Payoff at maturity = ST regardless of option’s moneyness.
Lower Boundaries of Pricing for
European Call Options before Expiration
Strategy A is never going to be worse than Strategy B,
so A must cost more than B: E St
Ce + (1 + i ) > (1 + i )
$ £

St E
Therefore, Ce > Max – ,0
(1 + i£) (1 + i$)

1 + i$
Recall: F$/£ = S$/£×
1 + i£
FT - E
➢ Ce > Max ,0
1 + i$
Example:
Suppose the spot rate S0($/€) is $1.50/€ today. An European
call option on €10,000 has an exercise price E=$1.50/€.
Time to expiry is 1 year. i$ = 7.1%, and i€ = 5%.
What is the floor value of this call?

1.50($/€) 1.50 ($/€)

Ce > Max – ,0
(1 + 5%) (1+7.1%)

➢ Ce ≥ $0.028 (for the option on €1),

➢ The floor value of each contract of €10,000 is $280.

Lower Boundary Conditions for European
Put Options before Expiration

E St
Pe > Max – ,0
(1 + i$) (1 + i£)

Or,
E - FT
Pe > Max ,0
1 + i$
 The Value of Call before Expiry:
Market Value vs. Intrinsic Value
Profit

Long 1 call

The red line shows the

Intrinsic value
St
payoff at maturity. E

Time value
loss
Binomial Option Pricing
⚫ Suppose the spot rate is S0($/€) = $1.50/€ today
⚫ One year later, S1($/€) is either $1.80/€ or $1.20/€.
⚫ Call option on €10,000 has an exercise price E=$1.50/€.
⚫ i$ = 7.1%, and i€ = 5%.
What is the value of this call?
S1 Intrinsic value of call
S0 $1.8/€ C1up = $0.3/€
$1.5/€
$1.2/€ C1down = $0
1. Replicating Portfolio Approach
⚫ Invest x euros at i€ = 5%,
⚫ Borrow y dollars at a cost of i$ = 7.1%,
⚫ Let portfolio payoffs match the option payoffs in the end.

Value of portfolio at T=1:

$ value of euro – repay of $ debt C1($/€)

1.8x(1+ i €) – y(1+ i$) 0.3

S0
$1.5/€
1.2x(1+ i €) – y(1+ i$) 0
Replicating Portfolio Valuation
1.8 x (1+0.05)– y(1+0.071) = $0.3 (1)
1.2 x (1+0.05)– y(1+0.071) = 0 (2)

Solve and get: x = €0.4762 and y = $0.5602

Value of call = the cost for setting up this portfolio today

= €0.4762×$1.5/€ – $0.5602 = $0.1541

➢ Value of each contract (call on €10,000) = $1,541.

 2. Risk-neutral Valuation Approach
S0 = $1.50/€ , i$ = 7.1% and i€ = 5%.
If IRP holds:
S1
$1.8/€ F1($/€) =
S0 with a probability of q $1.50×(1.071)
$1.5/€
$1.2/€ €1.00×(1.05)
with a prob. of (1 - q)
= $1.53/€

Set expected S1 = F1, then:

$1.53 = q × $1.8 + (1 – q) × $1.2

Solve and get: q = 0.55

 Risk-neutral Valuation
Intrinsic value of call at T = 1
T=0 $0.3 (55% chance)

$1.5/€
$0 (45% chance)

• Value of call = PV(expected FV of option payoffs)

0.55×$0.3 + (1–0.55)×0
C0 = = $0.1541
1.071

• The total value of a call on €10,000 = $1,541.

Risk-neutral Valuation: Formula
FT − S0  d
q=
S0  ( u − d )
where u = SuT / S0
and d = SdT / S0

1.53 − 1.50  0.8

q= = 0.55
1.50  (1.2 − 0.8)
Black–Scholes Option Pricing Model
For an European call on a foreign exchange:
− ri T − r$ T
c = S0e  N(d1 ) − Ee  N(d 2 )
ln(FT / E ) + 0.5σ 2 T
d1 = d 2 = d1 −  T
 T
and FT = S0e( r$ −ri ) T
( continuous compounding version of IRP )
E = Exercise price per unit of foreign currency,
N(d) = Probability that a standardized, normally distributed,
random variable will be less than or equal to d.
S and E are expressed in direct quotes from the US perspective.
Black–Scholes Option Pricing Model
For an European put written on a foreign exchange:

p = Ee − r$T  N(−d 2 ) − S0e − ri T  N( −d1 )

ln(FT / E ) + 0.5σ 2 T d 2 = d1 −  T
d1 =
 T

N(d) is a probability statistics

N(-d)=0.5 – [N(d) – 0.5]

and FT = S0e( r$ −ri ) T (sup pose IRP holds)

The Black–Scholes Option Pricing: Example
Suppose a one-year at-the-money European call
option on the euro has an exercise price of €1 = $1.5.
Assume the euro-dollar exchange rate has a standard
deviation of 9% per annum; r$ = 7.1%; r€ = 5%.
Using IRP:
FT = S0(1+ r$)/(1+r€) = 1.5×1.071/1.05 = $1.53 /€

ln(FT /E ) + 0.5σ 2 T ln(1.53/1.5) + 0.5  0.092  1

d1 = = = 0.2650
σ T 0.09  1
Example (cont.)

d 2 = d1 −  T = 0.2650 − 0.09  1 = 0.1750

Using the standard normal distribution stats table:

N(d1) = N(0.2650) = 0.6045
N(d2) = N(0.1750) = 0.5695

c = S0 e − ri T  N(d1 ) − Ee − r$T  N(d 2 )

= 1.5e−0.051  0.6045 − 1.50e−0.0711  0.5695
= $0.0668
FX Futures Option
Futures option is an option on a futures contract.
⚫ On exercising the option:
➢ The holder of a call, or the writer of a put, ends up with
having a long position in currency futures, plus a cash
amount equal to the most recent settlement price of
futures minus the option’s exercise price (FT - E).
➢ The writer of a call, or the holder of a put, ends up with
having a short position in currency futures, plus a cash
amount equal to (E - FT).
Homework:
Questions: 1, 5.
Problems: 1, 2, 4, 8-12

Useful reference:
Options, Futures, and Other Derivatives.
By John C. Hull (Call no. 332.645 Hul).
Next week:
Interest rate and currency swaps