1

Currency Derivatives

(or chapter 7)


2
Agenda
How forex futures quoted & used for speculation?

Futures vs. forwards?

How forex options are quoted?

Speculate w/ forex options.

Distinction b/n buying & writing options?

How forex options are valued?

3
Forex Futures
Future delivery of standard amount of currency @ fixed time &
price. Traded @ Chicago Mercantile Exchange (CME).
Specifications:
Size notional principal, in even multiple.
Method of stating exchange rates American terms used.
Maturity date mature on 3
rd
Wed/ 01, 03, 04, 06, 07, 09, 10, or 12.
Last trading day contracts may trade through 2
nd
business day
prior to maturity.
Collateral & maintenance margins purchaser/trader must deposit
initial margin or collateral.
Daily marked-to-market
Settlement
round turn fee.
Use of a clearing house as a counterparty


4
Futures Speculation
Maturity Open High Low Settle Change High Low
Open
I nterest
Mar .10953 .10988 .10930 .10958 --- .11000 .09770 34,481
June .10790 .10795 .10778 .10773 --- .10800 .09730 3,405
Sept .10615 .10615 .10610 .10573 --- .10615 .09930 1,4181
Source: Wall Street Journal, February 22, 2002, p.C13
500,000 New Mexican pesos.

Short Position believes that the value of the Peso will fall
Long Position - believes that the value of the Peso will rise
Value at maturity (Short) = - Principal (Spot Future)
= -P
S
500,000 ($0.09500/ P
S
- $.10958/ P
S
) = $7,290,
assuming spot rate of $.09500/P
s
@ maturity.
Value at maturity (Long) = Principal (Spot Forward)
= P
S
500,000 ($0.11000/ P
S
- $.10958/ P
S
) = $210,
assuming spot rate of $.11000/P
s
@ maturity.

5
Forex Futures vs. Forwards
Characteristic Foreign Currency Futures Forward
Contract Size Standardized any size desired
Maturity fixed maturities any maturity up
up to a year
Location organized exchange b/n individuals &
banks

Pricing open outcry bid/ask quotes
Margin/Collateral daily marked to market no collateral

Settlement rarely delivered, settlement contract delivered,
through offsetting can offset position
Fees single commission for purchase& sell bid/ask spread

Trading hours exchange hours 24 hours
Counterparties through clearing house direct contact
Liquidity very liquid liquid, relatively
large market


6
Initial Margin Requirements
Held as collateral by broker.
Usually 2-4% of contract value.
Margin amount same for short & long positions.
Buyer holds a long position (seller short).
If settlement price higher than yesterday, buyer has a
positive settlement for the day.
Long position now worth more.
Exact opposite for seller (zero-sum game).

7
Open Interest
Open Interest refers to the
number of contracts
outstanding for a particular
delivery month.
Initially open interest is zero.
Increases over time, until
positions are liquidated.
Total open interest is the total
number of outstanding
positions in all the delivery
months of a futures market.

Liquidity = at least 5,000
outstanding contracts.
http://www.activetradermag.com/futuresbasics.htm

8
Reversing Trades
Rare in forward markets 90% of all contracts lead to
delivery.
Common in futures markets only 1% of contracts
lead to delivery!

9
Forex Option
Gives right but not obligation to buy/sell amount of currency
@ fixed price for given time period
Call buyer has right to purchase
Put buyer has right to sell
Buyer = holder & seller = writer.
Two option types
American: may exercise during life of option.
European: may not exercise until maturity.
Price elements
Strike (exercise price): exchange rate @ which foreign currency
can be purchased/ sold.
Premium, price of option
Spot rate

10
Forex Options
May be classified as:
At-the-money (ATM): exercise price = spot rate.
I n-the-money (I TM) options profitable, excluding
premium, if exercised immediately.
Out-of-the-money (OTM) options not profitable,
excluding premium, if exercised immediately.
Markets for derivatives:
OTC Market
Organized exchanges - Chicago Mercantile and the
Philadelphia Stock Exchange
Option Clearinghouse Corporation




11
Futures Contracts vs. Options
Futures Contract youve agreed to
purchase/sell the contract. No backing out. Can
offset/ exit by buying/selling to someone else.
Buy = long; sell = short.
Option contract that gives you the right but not
the obligation to purchase/sell something at pre-
specified terms. No commitment.

12
Forex Options Markets
Swiss Franc options (WSJ)







Call premium: SF 62,500 x $0.0050/SF = $312.50.
Options &
Underlying Strike Price Aug Sep Dec Aug Sep Dec
58.51 56 -- -- 2.76 0.04 0.22 1.16
58.51 56 1/2 -- -- -- 0.06 0.30 --
58.51 57 1.13 -- 1.74 0.10 0.38 1.27
58.51 57 1/2 0.75 -- -- 0.17 0.55 --
58.51 58 0.71 1.05 1.28 0.27 0.89 1.81
58.51 58 1/2 0.50 -- -- 0.50 0.99 --
58.51 59 0.30 0.66 1.21 0.90 1.36 --
Calls - Last Puts - Last
Each option = 62,500 Swiss francs.

13
Speculation
Assume spot rate: $0.5851/SF, 6m forward: $0.5760/SF.
Spot market
$100,000. Expect six month spot SF $0.6000/SF.
Step 1: purchase SF 170,910.96 @ spot $0.5851/SF.
Step 2: sell at target spot rate of $0.60/SF.
Forward market
Step 1: Buy forward SF173,611.11 x $0.576/SF=
$100,000.
Step 2: In 6m, fulfill forward & sell proceeds in spot
market Sfr173,611.11 x $0.6000/Sfr = $104,166.67.
Options market
Long Call, Short Call, Long Put, Short Put.



14
For Example
Suppose that:
you have $10 m.
Wish to speculate on Euro
S = $ 0.885/ EUR, F
30
= $ 0.900/ EUR.

You expect S
30
= $ 0.844/ EUR (EUR depreciates).
Arbitrage strategy?


You expect S
30
= $ 0.944/ EUR (EUR appreciates).
Arbitrage strategy?

15
Profit & Loss Buyer of Call (Long Call)
Loss
Profit
(US cents/SF)
+ 1.00
+ 0.50
0
- 0.50
- 1.00
57.5 58.0 59.0 59.5 58.5
Limited loss
Unlimited profit
Break-even price
Strike price
OTM ITM
ATM
Spot price
(US cents/SF)
Profit = Spot rate (Strike price + Premium)
Profit = ? if Spot = $ 0.595/ SF.
C
eT
= Max[S
T
- E, 0]

16
Profit & Loss Writer of Call (Short Call)
Loss
Profit
(US cents/SF)
+ 1.00
+ 0.50
0
- 0.50
- 1.00
57.5 58.0 59.0 59.5 58.5
Limited profit
Unlimited loss
Break-even price
Strike price
ATM
Spot price
(US cents/SF)
Profit = Premium (Spot rate - Strike price).
Profit = ? if Spot = $ 0.595/ SF.

C
eT
= Max[S
T
- E, 0]

17
Profit & Loss for Buyer of Put (Long Put)
Loss
Profit
(US cents/SF)
+ 1.00
+ 0.50
0
- 0.50
- 1.00
57.5 58.0 59.0 59.5 58.5
Limited loss
Profit up
to 58.0
Strike price
In the money Out of the money
At the money
Spot price
(US cents/SF)
Break-even
price
Profit = Strike price (Spot rate + Premium)
Profit = ? if Spot = $ 0.575/ SF.


P
aT
=P
eT
=Max[E - S
T
, 0]

18
Profit & Loss for Writer of Put (Short Put)
Loss
Profit
(US cents/SF)
+ 1.00
+ 0.50
0
- 0.50
- 1.00
57.5 58.0 59.0 59.5 58.5
Unlimited loss
up to 58.0
Limited profit
Strike price
Spot price
(US cents/SF)
Break-even
price
At the money
Profit = Premium (Strike price - Spot rate)
Profit = ? if Spot = $ 0.575/ SF.


P
aT
=P
eT
=Max[E - S
T
, 0]

19
For Example
Suppose that:
You wish to speculate on fall of Yen vs. $.
Current S = Yen 120/ $ (or $.00833/Yen).
Maturity: 90 days.
Expected S
90
= Yen 140/$ (or $.00714).
Two options available:
Call on Yen Put on Yen
Strike: Yen 125/$ Yen 125/$.
(or $.008/ Yen) (or $.008/ Yen)
Premium: $.00046 $.00003

1. What option to buy?
2. Break even price on option of choice?
3. If S= Yen 140/ $, what is net profit?

20
Option Pricing
Market value = Time value + Intrinsic Value
Intrinsic Value gain if option exercised
immediately. Will reach zero when the option is
OTM. At maturity, option value = intrinsic value.
Time Value reflects a gamble that the option might
be more profitable (more in-the-money) as time
passes (i.e. before time of expiry).


21
1.69 1.70 1.71 1.72 1.73 1.68 1.67 1.66
0.0
1.0
2.0
3.0
4.0
5.0
Spot rate ($/)
Option Premium
(US cents/)
6.0
1.74
4.00
Intrinsic
value
3.30
5.67
1.67
Total value
Time value
-- Valuation on first day of 90-day maturity --
Strike Price of $1.70/
Market-, Time- & Intrinsic Value
European Call on Brit Pound

22
Option Volatility
Standard deviation of daily % changes in underlying
exchange rate, usually stated per annum, e.g. 12.6 %.
Can obtain daily volatility

Volatility estimates:
Historic.
Forward-looking.
Implied.






% 66 . 0
105 . 19
% 6 . 12
365
% 6 . 12
= =

23
Replicating Portfolio Evaluation
Suppose US$-EUR rate is S
0
($/EUR) = $1.
S
1
($/ EUR) is $1.10 or $0.90.
Consider call w/ K=$1/EUR (exercise price).
Can replicate payoffs of call w/ levered position in EUR.
Borrow PV $.90 today & buy1 EUR.
Net payoff: $0.20 or $0.
Portfolio value: so option value:
$1
$0.90
$1.10
S
0
($/EUR) S
1
($/EUR) C
1
($/EUR)
$0.10
$0
Debt
Portfolio
-$0.90
-$0.90
$0.20
$0.00
) 1 (
90 $.
1 $
$
i +

|
|
.
|

\
|
+
=
) 1 (
90 $.
1 $
2
1
$
0
i
C

24
Rogue Trading: Good Fellas
Nick Leeson @ Barings.
1995, managed to bankrupt Barings Brothers (UK).
John Rusnak @ Allied Irish Bank.
2002, lost $691 m on behalf of Allied Irish Bank
(Baltimore office).


25
Things to remember
Futures terminology.
Futures vs. Forwards.
Speculation
In spot & forward markets.
In option markets.
How forex options are quoted?
Distinction b/n buying & writing options.
How forex options are valued?