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
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 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.

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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)

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 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.

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EXHIBIT 7.3 CME Group Currency Futures Contract Quotations

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 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.

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 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.

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 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.

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 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.
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 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

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 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.

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 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.

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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

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 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]

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 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
–c0

Sh
call loses his E + c0

or
entire investment

t1
E
of c0.

ca
ll
Loss Out-of-the-money In-the-money
Out-of-the-money In-the-money
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 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
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 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.

Out-of-the-money In-the-money
Out-of-the-money In-the-money

Loss E
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