Futures and Options On Foreign Exchange: All Rights Reserved

Futures and Options on Foreign Exchange
Chapter 7
Copyright © 2018 by the McGraw-Hill Companies, Inc.
All rights reserved.
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
• American Option Pricing Relationships
• European Option Pricing Relationships
• Binomial Option Pricing Model
• European Option Pricing Model
• Empirical Tests of Currency Option Models
• Summary
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved. 7-2
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.
Futures Contracts: Preliminaries (continued)
• 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)
Currency Futures Markets
• The CME Group (formerly Chicago Mercantile Exchange) is by far the
largest currency futures market.
• 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.
EXHIBIT 7.3 CME Group Currency Futures Contract Quotations
Daily Resettlement
• 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.
– If the price goes up, the short pays the long.
• After the daily resettlement, each party has a new
contract at the new price with one-day-shorter
maturity.
Daily Resettlement: An Example
• Consider a long position in a CME British pound futures contract.
• It is written on £62,500 and price is quoted in dollars and cents per £,
out to 4 decimal points.
• The minimum price increment is $0.0001 per British pound
(corresponds to $6.25/contract)
• We went long the futures contract at a price of $1.3000 per £.
• At initiation of the contract, the long posts an initial performance
bond of $1,625.
• The maintenance performance bond is $1,300.
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 $1,625.
• The maintenance level is $1,300.
– If this investor loses more than $325, 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.
Daily Resettlement: first 3 days
• Over the first 3 days, the pound strengthens then
depreciates in dollar terms:
Settle Gain/Loss Account Balance
$1.3010 $62.50 $1,687.50 = $1,625 + $62.50
= ($1.3010/£ – $1.3000/£) × £62,500
$1.2980 –$187.50 $1,500
$1.2948 –$200.00 $1,300
On day three we receive a margin call, having lost $325.
Toting Up
•At the end of this adventure, we have three ways of
computing gains and losses:
1. Sum of daily gains and losses.
– $325 = $62.50 – $187.50 – $200
2. Contract size times the difference between initial contract
price and last settlement price.
– $325 = ($1.2948/£ – $1.3000/£) × £62,500
3. Ending balance on the account minus beginning balance on
the account, adjusted for deposits or withdrawals.
– $325 = $1,300 – $1,625
Options Contracts: Calls vs. Puts
• 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.
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.
• Moneyness
– If immediate exercise is profitable, an option is “in the
money.”
– Out of the money options can still have value.
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
Basic Option Pricing Relationships at Expiry
• At expiry, an American option is worth the same as a

European option with the same characteristics.
• If the call is in-the-money, it is worth ST – E.
• If the call is out-of-the-money, it is worthless.
CaT = CeT = Max[ST – E, 0]
• If the put is in-the-money, it is worth E – ST.
• If the put is out-of-the-money, it is worthless.
PaT = PeT = Max[E – ST, 0]
Basic Call Option Profit Profiles a l l
c
Profit 1
n g
If the call is in- Lo
the-money, it is
worth ST – E.
If the call is out-
of-the-money, it
is worthless, and
the buyer of the ST
Sh
call loses his –c0
E + c0
or
t1
entire investment E
ca
of c0.
ll
Loss Out-of-the-money In-the-money
Out-of-the-money In-the-money
Basic Put 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 – p0 ST
the buyer of the Long 1 put
put loses his E – p0
entire investment
of p0.
E
In-the-money
In-the-money Out-of-the-money
Out-of-the-money
Loss
Market Value, Time Value, and Intrinsic Value for an
American Call
Profit
The red line shows

lue Long 1 call
the payoff at Va
maturity, not profit, r ket
of a call option. Ma
Note that even an Intrinsic value

out-of-the-money ST
option has value— Time value
time value.
Loss E
European Option Pricing Relationships
Consider two investments:
1 Buy a European call option on the British pound futures
contract. The cash flow today is –Ce.
2 Replicate the upside payoff of the call by:
 Borrowing the present value of the dollar, exercise price of the
call in the U.S. at i$ , the cash flow today is
E
(1 + i$)
 Lending the present value of ST at i£, the cash flow today is
ST
–
(1 + i£)
European Option Pricing Relationships (concluded)
 When the option is in-the-money, both strategies have the same
payoff.
 When the option is out-of-the-money, it has a higher payoff than
the borrowing and lending strategy.
 Thus,
ST E
Ce > Max – ,0
(1 + i£) (1 + i$)
 Using a similar portfolio to replicate the upside potential of a put,
we can show that:
E ST
Pe > Max – ,0
(1 + i$) (1 + i£)
Binomial Option Pricing
Imagine a world where the spot exchange rate is S0($/€) = $1.50/€ today and in the
next year S1($/€) is either $1.80/€ or $1.20/€.
€10,000 will change from $15,000 to either $18,000 or $12,000.
A call option on €10,000 with strike price S0($/€) = $1.50 will payoff either $3,000 or
zero.
If S1($/€) = $1.800/€ the option is in-the-money since you can buy €10,000 (worth
$18,000 at S1($/€) = $1.80/€ ) for only $15,000.
$18,000 = €10,000 × $1.80
C1up = $3,000
€1.00
$15,000
$12,000 = €10,000 × $1.20

€1.00
C1down = $0
Binomial Option Pricing Model
We can replicate the payoffs of the call option by taking a long
position in a bond with FV = €5,000 along with the right amount of
dollar-denominated borrowing (in this case borrow the PV of $6,000).
The portfolio payoff in one period matches the option payoffs:
$9,000 – $6,000 = $3,000 = C1up
$15,000
$6,000 – $6,000 = $0 = C1down
Binomial Option Pricing Replicating Portfolio
The replicating portfolio’s dollar cost today is the sum of today’s
dollar cost of the present value of €5,000 less the cash inflow
from borrowing the present value of $6,000:
€5,000 $1.50 $6,000
× –
(1 + i€ ) €1.00 (1 + i$)
When S0($/€) = $1.50/€, i$ = 7.1%, and i€ = 5%, the most a willing
buyer should pay for the call option is $1,540.62. That’s what it
would cost him today to build a portfolio that perfectly replicates the
call option payoffs—why pay more to buy a ready-made option?
$1,540.62 = $7,142.86 − $5,602.24

The Hedge Ratio
• We replicated the payoffs of the call option with a levered
position in the underlying asset (in this case, borrowing
$5,602.24 to buy €4,761.90 at the spot).
The hedge ratio of a option is the ratio of change in the
price of the option to the change in the price of the
underlying asset:
C up – C down
H=
S1up – S1 down
This ratio gives the number of units of the underlying asset we
should hold and the amount of borrowing in order to create a
replicating portfolio.
Hedge Ratio (continued)
• This practice of constructing a riskless hedge is
sometimes called delta hedging.
• The hedge ratio of a call option is positive.
– Recall from the example:
C1up – C1down $3,000 – $0 1
H= = =
S1up – S1down $18,000 – $12,000 2
The hedge ratio of a put option is negative.
These hedge ratios change through time.
Currency Futures Options
• Currency futures options are options on a currency
futures contract.
• Exercise of a currency futures option results in a long
futures position for the holder of a call or the writer
of a put.
• Exercise of a currency futures option results in a short
futures position for the seller of a call or the buyer of
a put.
• If the futures position is not offset prior to its
expiration, foreign currency will change hands.
Binomial Futures Option Pricing
A 1-period at-the-money call option on euro futures has a strike price
of F1($|€) = $1.5300/€ $1.80×1.071 $1.8360
F1($|€) = =
€1.00×1.05 €1.00
Call Option Payoff = $0.3060
$1.50×1.071 $1.5300
F1($|€) = =
€1.00×1.05 €1.00
Option Price = ? $1.20×1.071 $1.2240
F1($|€) = =
€1.00×1.05 €1.00
Option Payoff = $0
When a call futures option is exercised the holder acquires:
1. A long position in the futures contract.
2. A cash amount equal to the excess of the futures price over the strike
price. Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved. 7-27
Binomial Futures Option Pricing (continued)
Consider the portfolio: $1.80×1.071 $1.8360
Long H futures contracts F1($|€) = =
€1.00×1.05 €1.00
Short 1 futures call option
$1.50×1.071 $1.5300 Futures Call Payoff = –$0.3060
F1($|€) = =
€1.00×1.05 €1.00 Futures Payoff = H × $0.2700
Option Price = $0.1714 Portfolio Cash Flow =
H × $0.2700 – $0.3060
Portfolio is riskless when the portfolio
payoffs in the “up” state equal the payoffs in
the “down” state: $1.20×1.071 $1.2240
F1($|€) = =
H × $0.2700 – $0.3060 = –H × $0.3300 €1.00×1.05 €1.00
Futures Payoff = –H × $0.3300
The “right” amount of futures contracts is H =
0.510000. Option Payoff = $0
Portfolio Cash Flow = –H × $0.3300
Binomial Futures Option Pricing (conclusion)
$1.80×1.071 $1.8360
The payoffs of the portfolio are – F1($|€) = =
€1.00×1.05 €1.00
$0.1683 in both the up and down
states. Call Option Payoff = –$0.3060
$1.50×1.071 $1.5300 Futures Payoff = 0.510 × $0.2700
F1($|€) = =
€1.00×1.05 €1.00 Portfolio Cash Flow =
0.510 × $0.2700 – $0.3060
With futures there is no cash flow at = –$0.1683
initiation. Without an arbitrage, it must
be the case that the call option income
$1.20×1.071 $1.2240
today is equal to the present value of F1($|€) = =
$0.1683 discounted at i$ = 7.10%: €1.00×1.05 €1.00
Futures Payoff = –0.510 × $0.3300
$0.1683 Option Payoff = $0
C0 = $0.1572 = Portfolio Cash Flow =
1.071
–0.510×$0.3300 = –$0.1683
Risk Neutral Valuation
• Calculating the hedge ratio is vitally important if you are
going to use options.
– The seller needs to know the hedge ratio if he wants to
protect his profits or eliminate his downside risk.
– The buyer needs to know the hedge ratio to decide how
many options to buy.
• Knowing what the hedge ratio is isn’t especially important if
you are only trying to value options.
• Risk Neutral Valuation is a very handy shortcut to valuation.
Risk Neutral Valuation of Options: Example
We can safely assume that IRP holds: $1.5300 $1.50×(1.071)
F1($/€) = =
€1.00 €1.00×(1.05)
$1.80
$18,000 = × €10,000
€1.00
€10,000 = $15,000
$1.20
$12,000 = × €10,000
€1.00
Set the value of €10,000 bought forward at $1.5300/€ equal to the expected value of
the two possibilities shown above:
$1.5300
€10,000 × = $15,300 = q × $18,000 + (1 – q) × $12,000
€1.00
Risk Neutral Probability
Solving for q gives the risk-neutral probability of an
“up” move in the exchange rate:
$15,300 = q × $18,000 + (1 – q) × $12,000
$15,300 – $12,000
q=
$18,000 – $12,000
q = 11/20 = 0.55000
Risk Neutral Valuation of Options (continued)
Now we can value the call option as the present value (discounted at the
USD risk-free rate) of the expected value of the option payoffs,
calculated using the risk-neutral probabilities.
$1.80
$18,000 = × €10,000 ←value of €10,000
€1.00
20
$3,000= payoff of right to buy €10,000 for $15,000

/
11
€10,000 = $15,000
$1,540.62
9
/ 20
$1.20
$12,000 = × €10,000 ←value of €10,000
€1.00
$0 = payoff of right to buy €10,000 for $15,000
(11/20) × $3,000 + (9/20)×$0

C0 = $1,540.62 =
1.071 Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved. 7-33
Duality of Calls and Puts on Currencies
The value of a call option on The value of a put option on
€10,000 with a strike price of $15,000 with a strike price of
$15,000 is $1,540.62 €10,000 is also $1,540.62
Call $15,000 Call Put $15,000 Put

Option Option Option Option
Seller €10,000 Owner Seller €10,000 Owner
If the options finish in-the-money they have the same cash flows. So
they should have the same value today.
Test Your Intuition
Use risk neutral valuation to find the value of a put
option on $15,000 with a strike price of €10,000.
Hint: Given that we just found the value of a call option
on €10,000 with a strike price of $15,000 to be
$1,540.62, this should be easy in the sense that we
already know the right answer.
$1.50
As before, i$ = 7.1%, i€ = 5%, S0($/€) =
€1.00
$1.50×1.071 $1.5300
F1($/€) = =
€1.00×1.05 €1.00
Test Your Intuition (continued)
$1.50×1.071 $1.5300
F1($/€) = =
€1.00×1.05 €1.00
€1.00
6
/17 €12,500 = × $15,000 ←€ value of $15,000
$1.20 when S1 =
€10,000 = $15,000 $1.20/€
11
/17 €1.00
€8,333.33 = × $15,000 ←€ value of $15,000
$1.80 when S1 =
€1.00
$15,000 × = €9,803.92 $1.80/€
$1.5300
€ 9,803.92 = q × €12,500 + (1 – q) × €8,333.33
€9,803.92– €8,333.33
q= q = 6/17
€12,500 – €8,333.33
Test Your Intuition
€1.00
(concluded)
€12,500 = × $15,000 ←value of $15,000
$1.20
€0 = payoff of right to sell $15,000 for €10,000

€10,000 = $15,000
6
/17
€1,027.08 €1.00
€8,333.33 = × $15,000 ←value of $15,000
$1.80
11
/17
€1,666.67= payoff of right to sell $15,000 for €10,000
6
/17× €0 + (11/17)×€1,666.67
€P0 = €1,027.08 =
1.05
$P0 = $1,540.62 = €1,027.08 × $1.50

€1.00
Risk Neutral Valuation Practice
Use risk neutral valuation to value a PUT option on £8,000 with a strike price of €10,000.
S0(£/€) = £0.80/€, i£ = 15½% and i€ = 5%
2
€10,666.67
In the next year, there are two possibilities: 9/2 up
S1(£/€) = £1.00/€ or p1 = €0
S1(£/€) = £0.75/€
€10,000
Step 1: Calculate risk neutral probabilities. 13/
2 2
Step 2: Calculate option value as the present value of the
expected value of the option payoffs. €8,000
down
p1 = €2,000
€9,090.91 = q × €10,666.67+ (1 – q) × €8,000
13
/22 × €2,000
q = €9,090.91– €8,000 = 9/22 p0 = €1,125.54=
€10,666.67– €8,000 1.05
Risk Neutral Valuation Practice (continued)
Check your work by finding the value of an at-the-money 1-period call option on €10,000 with a
strike of £8,000.
S0(£/€) = £0.80/€, i£ = 15½%, i€ = 5%, so F1(£/€) = £0.8800/€
In the next year, there are two possibilities: £1.00
£10,000 = × €10,000
S1(£/€) = £1.00/€ or S1(£/€) = £0.75/€ €1.00
.5 2
0
cu1 = £2,000
£0.80 = max[0, £10,000 − £8,000]
€10,000 × = £8,000
€1.00
0.4
c0 = £900.43 8
q × c1u + (1 – q) × c1d £0.75

c0 = £7,500 = × €10,000
€1.00
1 + r₤
£.88/€ − £.75/€ c1d = £0
q = 0.5200 = = max[0, £7,500 − £8,000]
£1.0/€ − £.75/€
0.52 × £2,000 + 0.48 × £0
c0 = = £900.43 = €1,125.54 × £0.80/€
1.155
Things to be Careful About
• Convert future values from one currency to another using
forward exchange rates.
• Convert present values using spot exchange rates.
• Discount future values to present values using the correct
interest rate, e.g. i$ discounts dollar amounts and i€ discounts
amounts in euro.
• To find the risk-neutral probability, set the forward price
derived from IRP equal to the expected value of the payoffs
calculated using q and solve for q.
• To find the option value discount the expected value of the
option payoffs calculated using the risk neutral probabilities at
the correct risk free rate.
Black–Scholes Pricing Formulae
The Black-Scholes formulae for the price of a European call and a put written
on currency are:
 ri T  r$T
c  S 0e  N(d1 )  Ee  N(d 2 )
 r$T
p  [ E  N( d 2 )  FT  N( d1 )]e
 FT  1 2
ln    σ T
 E 2
d1 
 T
d 2  d1   T
N(d) = Probability that a standardized, normally distributed,
random variable will be less than or equal to d.
Black–Scholes Pricing Formula
Use the European option pricing formula to find the value of a six-month call option on
Japanese yen.
The strike price is $1 = ¥100. The volatility is 25 percent per annum; r$ = 5.5% and r¥ =
6%.
F  S t e ( r$  r£ )T  (1 / 100)e (.055.06) 0.50  1 / 100.2503
 1 / 100.2503 
  .5(0.25) .5
2
ln 
ln( F / E )  .5 T
2
1 / 100   .0025  0.156
d1      0.074246
 T .25 .5 0.1768
d 2  d1   T  0.074246  .25 .5  0.10253
C e  [ F  N (d1 )  E  N (d 2 )]e  r$T
C e  [1 / 100.2503  N (0.074246)  (1 / 100)  N (0.10253)]e 0.0550.5
C e  $0.006137
Summary
• Forward, futures, and options contracts are derivative securities.
– Their value is derived from the value of the asset that underlies these
securities.
• Forward and futures contracts are similar instruments, but there are
differences.
– Both are contracts to buy or sell a certain quantity of a specific underlying
asset at some specific price in the future.
– Futures contracts, however, are exchange-traded, and there
are standardized features that distinguish them from the tailor-made terms of
forward contracts.
– The two main standardized features are contract size and maturity date.
– Futures contracts are marked-to-market on a daily basis at the new settlement
price.
Summary (continued)
• A futures market requires speculators and hedgers to effectively
operate. Hedgers attempt to avoid the risk of price change of the
underlying asset, and speculators attempt to profit from anticipating
the direction of future price changes.
• The CME Group and the NASDAQ OMX Futures Exchange are the
two largest currency futures exchanges.
• The pricing equation typically used to price currency futures is the
IRP relationship, which is also used to price currency forward
contracts.
Summary (concluded)
• An option is the right, but not the obligation, to buy or sell
the underlying asset for a stated price over a stated time
period.
– Call options give the owner the right to buy, put options the right
to sell.
– American options can be exercised at any time during their life;
European options can only be exercised at maturity.
• Exchange-traded options with standardized features are
traded on two exchanges.
– Options on spot foreign exchange are traded at the NASDAQ
OMX PHLX, and options on currency futures are traded at the
CME.

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Futures and Options on Foreign Exchange

• At expiry, an American option is worth the same as a

The red line shows

Note that even an Intrinsic value

$12,000 = €10,000 × $1.20

$9,000 – $6,000 = $3,000 = C1up

$6,000 – $6,000 = $0 = C1down

$1,540.62 = $7,142.86 − $5,602.24

$3,000= payoff of right to buy €10,000 for $15,000

(11/20) × $3,000 + (9/20)×$0

Call $15,000 Call Put $15,000 Put

€0 = payoff of right to sell $15,000 for €10,000

$P0 = $1,540.62 = €1,027.08 × $1.50

q × c1u + (1 – q) × c1d £0.75

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