1. Currency Futures and Options Markets Chapter 7

2. 2 PART I. FUTURES CONTRACTS I.CURRENCY FUTURES A.Background 1.Long history 2.Extremely volatile due to information driven nature 3.Price Discovery Role

3. 3 FUTURES CONTRACTS B. 1972: Chicago Mercantile Exchange opens the International Monetary Market. (IMM) Purpose:

4. 4 FUTURES CONTRACTS 2.IMM provides a.an outlet for hedging currency risk with futures contracts. Definition: contracts written requiring 1. standard quantity of an available currency 2. at a fixed exchange rate 3. at a set delivery date.

5. 5 FUTURES CONTRACTS b.Available Futures Currencies/Contract Size: (p. 211) 1.) British pound/ 62,500 2.) Canadian dollar /100,000 3.) Euro / 125,000 4.) Swiss franc / 125,000 5.) Japanese yen / 12.5 million 6.) Mexican peso / 500,000 7.) Australian dollar / 100,000

6. 6 FUTURES CONTRACTS c.Transaction costs: commission payment to a floor trader commission payment to a floor trader d.Leverage is high 1.)Initial margin required is relatively low (less than 2% of contract value).

7. 7 ADBPCDECJYMPSF Size100,00062,500100,000125,00012,500,000500,000125,000 IM1,4851,3506082,0252,0253,1251,452 MM1,1001,0004501,5001,5002,5001,075 TradeMarchJuneSeptDec Hrs7:20AMTo2:00PM P.211

8. 8 FUTURES CONTRACTS: SAFEGUARDS e.What are the safeguards? 1.)Contracts set to a daily price limit restricting maximum daily price movements. 2.)If limit is reached, a margin call may be necessary to maintain a minimum margin.

9. 9 FUTURES CONTRACTS: SAFEGUARDS 3.)Marking to Market 4.) Eliminating default 5.) Delivery cancelled

10. 10 FUTURES CONTRACTS g.Global futures exchanges: 1.)I.M.M. International Monetary Market 2.)L.I.F.F.E.London International Financial Futures Exchange 3.)C.B.O.T. Chicago Board of Trade 4.) S.I.M.E.X.Singapore International Monetary Exchange 5.)D.T.B. Deutsche Termin Bourse 6.)H.K.F.E. Hong Kong Futures Exchange

11. 11 FUTURES CONTRACTS (p.214) B.Forward vs. Futures Contracts Basic differences: 1. Trading Locations6. Quotes 2. Regulation7. Margins 3. Frequency of 8. Credit risk delivery delivery 4. Size of contract 5. Transaction Costs

12. 12 FUTURES CONTRACTS: Why would you use them? Advantages of futures: *1.)High leverage(2%) 2.) Easy liquidation 3.) Well- organized and stable market. Disadvantages of futures: 1.) Limited to 7 currencies 2.) Limited dates of delivery 3.) Rigid contract sizes.

13. CURRENCY OPTIONS PART II

14. 14 CURRENCY OPTIONS I.OPTIONS A. Currency options 1.offer another product to hedge exchange rate risk. 2.first offered on Philadelphia Exchange (PHLX).

15. 15 CURRENCY OPTIONS BuyersSellers=Writers Buy SellBuySell CALL PUT Premium

16. 16 CURRENCY OPTIONS 4. Definition: a contract from a writer ( the seller) that gives a.the right not the obligation to the holder (the buyer)to buy or sell b.a standard amount of an available currency at c.a fixed exchange rate for a fixed time period.

17. 17 CURRENCY OPTIONS 5.Two Types: Expiration Dates of Currency Options a.American exercise date may occur any time up to the expiration date. b.European exercise date occurs only at the expiration date and not before.

18. 18 CURRENCY OPTIONS 7.Exercise Price (exchange rate) a. Sometimes known as the strike price. B.The exchange rate at which the option holder can buy or sell the contracted currency.

19. 19 CURRENCY OPTIONS c.Types of Currency Options (whether you can buy or sell): 1.)Calls 2.)Puts

20. 20 CURRENCY OPTIONS 8.Status of an option a.In-the-money Call:Spot > strike Put:Spot < strike b.Out-of-the-money Call:Spot < strike Put:Spot > strike c.At-the-money Spot = the strike

21. 21 CURRENCY OPTIONS 9.What is the premium: the price of an option that the writer charges the buyer.

22. 22 CURRENCY OPTIONS B. Why Use Currency Options? 1.For the firm hedging foreign exchange risk with Future event is very uncertain gains. 2.For speculators - profit from favorable exchange rate changes.

23. 23 CURRENCY OPTIONS C. Using Forward or Futures Contracts Forward or futures contracts are more suitable for hedging a known amount of foreign currency flow. Examples: accounts payable/rec

24. 24 Options Sample Problems Ford buys a Franc put option (contract size: FF250,000) at a premium of $.01/FF. If the exercise price is $.21 and the spot at expiration is $.216, what is Ford’s profit (loss)? Ford buys a Franc put option (contract size: FF250,000) at a premium of $.01/FF. If the exercise price is $.21 and the spot at expiration is $.216, what is Ford’s profit (loss)?

25. 25 SOLUTION REVENUES: Sell at.21 COSTS:If exercised Buy at.216 Premium +.01 Total.226 Loss: If exercised:$4,000 Loss: If not exercised: $2,500 (the original premium)