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1 Futures and Options on Foreign Exchange Chapter Objective: This chapter discusses exchange-traded currency futures contracts, options contracts, and.

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Presentation on theme: "1 Futures and Options on Foreign Exchange Chapter Objective: This chapter discusses exchange-traded currency futures contracts, options contracts, and."— Presentation transcript:

1 1 Futures and Options on Foreign Exchange Chapter Objective: This chapter discusses exchange-traded currency futures contracts, options contracts, and options on currency futures. Chapter Outline  Futures Contracts: Preliminaries  Currency Futures Markets  Basic Currency Futures Relationships  Eurodollar Interest Rate Futures Contracts  Options Contracts: Preliminaries  Currency Options Markets  Currency Futures Options 9 Chapter Nine

2 2 9.1 Futures Contracts  A futures contract is like a forward contract: 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: Futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse - marked to market.  Standardizing Features: contract size, delivery month, daily resettlement - marked to market  Initial Margin: about 2-5 % of contract value, cash or T-bills held in a street name at your brokers.  Participants’ losses or profits are realized daily instead of at maturity as with a forward contract.  Because of marking to market, the futures price converges through time to the spot price on the last day of trading in the contract.

3 3 Daily Resettlement = Marking to Market Example: On Monday morning you take a long position in SF futures contract that matures on Wednesday afternoon at $0.75/SF. 1. At the close of trading on Monday the futures price has risen to $ Because of the daily settlement you receive a cash profit of $625 =125,000 x ( ) 2. At Tuesday close the price has declined to $ You must pay the $1500 loss (125,000 x [ ]) to the other side of the contract. 3. At Wednesday close, the price drops to $0.74, and the contract matures. You pay $375 loss to the other side and take the delivery of the SF, paying the prevailing price of $0.74. You have a net loss on the contract of $1250 ( ) You can also close out your long position with an offsetting trade, if you don’t want the delivery of the SF.

4 4 9.2 Currency Futures Markets  The Chicago Mercantile Exchange (CME) is by far the largest.  Others include: The Philadelphia Board of Trade (PBOT) The MidAmerica commodities Exchange The Tokyo International Financial Futures Exchange The London International Financial Futures Exchange  Expiry cycle: March, June, September, December.  Delivery date 3rd Wednesday of delivery month.  Last trading day is the second business day preceding the delivery day.  CME hours 7:20 a.m. to 2:00 p.m. CST.

5 5 Currency Futures Contract Specifications

6 6 Currency Futures Quotations (CME)

7 7 9.3Basic Currency Futures Relationships  Open Interest refers to the number of contracts outstanding for a particular delivery month.  Open interest is a good proxy for demand for a contract.  Some refer to open interest as the depth of the market. The breadth of the market would be how many different contracts (expiry month, currency) are outstanding.

8 8 Reading a Futures Quote ($/€) Expiry month Opening price Highest price that day Highest and lowest prices over the lifetime of the contract. Number of open contracts Lowest price that day Closing price Daily Change

9 9 Long and Short Positions in a Futures Contract

10 Eurodollar Interest Rate Futures Contracts  Widely used futures contract for hedging short-term U.S. dollar interest rate risk.  The underlying asset is a hypothetical $1,000, day Eurodollar deposit—the contract is cash settled.  Traded on the CME and the Singapore International Monetary Exchange.  The contract trades in the March, June, September and December cycle.

11 11 Reading Eurodollar Futures Quotes EURODOLLAR (CME)—$1 million; pts of 100% OpenHighLowSettleChgYield Settle Change Open Interest June ,417 Eurodollar futures prices are stated as an index number of three- month LIBOR calculated as F = 100 – LIBOR. The closing price for the July contract is thus the implied yield is 5.32 percent = 100 – The change was.01 percent of $1 million representing $100 on an annual basis. Since it is a 3-month contract one basis point corresponds to a $25 price change.

12 12 9.5Currency Options-Preliminaries  Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset in the future, at prices agreed upon today.  Put options: the holder has the right, but not the obligation, to sell a given quantity of some asset in the future, at prices agreed upon  At-the-money (ATM) E = S The exercise price (E) equals the spot price (S) of the underlying asset.  In-the-money (ITM) E < S The exercise price (E) is less than the spot price (S) of the underlying asset.  Out-of-the-money (OTM) E > S The exercise price is more than the spot price of the underlying asset today.

13 13 Currency Options Markets  Originally traded OTC  PHLX  OTC volume is much bigger than exchange volume.($130Bil. vs. $3Bil. Per day)  Trading is in six major currencies against the U.S. dollar.  Options contract sizes are half of the futures contracts

14 14 PHLX Currency Option Specifications

15 15 Currency Futures Options  Currency futures options are an option 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.

16 16 Call Option Value at Expiry

17 17 Pay-off to Purchaser of a Call Option on C$ for US$

18 18 Pay-off to Writer of a Call Option on C$ for US$

19 19 Pay-off to Purchaser of a Put Option on C$ for US$

20 20 Pay-off to Writer of a Put Option on C$ for US$

21 21 Call Option Hedge for $US1m to be Received in Three Months


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