1. Foreign Currency Options Chapter Seven Eiteman, Stonehill, and Moffett 11/21/20151Chapter Seven - Derivatives

2. Hedging vs speculation  firms hedge make money on their core competency reduce risk writing a covered option  firms do not speculate options are not a core competency speculation tries to make a return from risk 11/21/20152Chapter Seven - Derivatives

3. Quick review forward contracts  Negotiable contracts Price, forward rate is contracted Amount, how much foreign exchange will be exchange for domestic currency Term, when delivery will be made  Contract is deliverable according to terms Will not be able to get out of the contract 11/21/2015Chapter Seven - Derivatives3

4. Currency futures contracts  standardized contract terms amount of foreign exchange standardized  $ 100,000 Canadian, £ 62.500,  Peso 500,000, ¥ 12,500,00, Euro 1,000,000 exchange rate fixed at contract time delivery dates standardized by the exchange  March, June, September, December 6 mos Chicago Mercantile Exchange  contracts expire two business days prior to the 3rd Wednesday of the delivery month  Contract is reversible 11/21/20154Chapter Seven - Derivatives

5. Futures contracts  Short position (selling a future) Fix price to deliver fx @ 1.0337 To deliver 100,000 cd Delivery Dec 15, 2007  Long position (buying a future) Fix priced to take delivery fx @ 1.0337 To take delivery 100,000 cd 11/21/2015Chapter Seven - Derivatives5

6. Market makers in currency futures  international monetary market (IMM)  London international financial futures exchange (LIFFE)  Chicago Mercantile Exchange  New York mercantile exchange  Singapore international monetary exchange (SIMEX) 11/21/20156Chapter Seven - Derivatives

7. Trading specifics  commissions small (less than 0.5%)  margin requirements typically 2% to 3% contracted amount  both sides of contract guaranteed by exchange  contracts marked to market daily 11/21/20157Chapter Seven - Derivatives

8. long one June euro contract  contracted June delivery of 1,000,000 Euros  spot price 0.9737 / dollar or 0.9737 * 1,000,000 = 973,700 usd at contract  initial margin paid in when contracted e.g. 2% on Euro contract 20,000 usd  maintenance margin e.g. 1% on Euro contract 10,000 usd 11/21/20158Chapter Seven - Derivatives

9. marking to market 1st day  e.g. tomorrows settlement price 0.9817 (0.9817 - 0.9737) * 1,000,000 = 8,000 futures price is now 0.9817  long the future (wanting euros) margin account = 20,000 - 8,000 = 12,000  short the future (wanting dollars) margin account = 20,000 + 8,000 = 28,000 11/21/20159Chapter Seven - Derivatives

10. marking to market 2nd day  e.g., next days settlement price 0.9867 (0.9867 - 0.9817) * 1,000,000 = 5,000 futures price is now 0.9867  long the future (wanting euros) margin account = 12,000 - 5,000 = 7,000 margin call - buyer of the future must bump up his margin  short the future (wanting dollars) margin account = 28,000 + 5,000 = 33,000 11/21/201510Chapter Seven - Derivatives

11. Futures contract expires (long side of contract)  e.g. last settlement price 1.0017 net change in margin (1.0017 - 0.9737) * 1,000,000 = 28,000 final futures price 1.0017  long the future (wanting euros) net change in margin account + 28,000 pays ( -1,001,700 + 28,000) = -973,700 dollars receives +1,000,000 euros 11/21/201511Chapter Seven - Derivatives

12. Futures contract expires (short side of contract)  last settlement price 1.0017 net change in margin (0.9737 - 1.0017) * 1,000,000 = -28,000 final futures price 1.0017  short the future (wanting dollars) net change in margin account - 28,000 pays -1,000,000 euros receives (1,001,777 - 28,000) = 973,700 dollars 11/21/201512Chapter Seven - Derivatives

13. Futures  marking to market reduces(illimanates) default risk daily resettlement confines risk to one day’s price movements large daily movements in price will result in  trading halt  margin call during trading halt  trader want to terminate the contract will take the opposite contract if long two contracts, will go short two contracts  cost is the interest paid on margins 11/21/201513Chapter Seven - Derivatives

14. Comparison to forwards  forward contracts flexible higher default risk fixed into contract Must deliver on expiration  futures contracts standardized much lower default risk reversible 11/21/201514Chapter Seven - Derivatives

15. Options - characteristics  American option can be exercised anytime up to the expiration date  European option can only be exercise at the expiration date  in-the-money - option which if exercised will make money  out-of-the-money - option which if exercised will lose money 11/21/201515Chapter Seven - Derivatives

16. Options - types  Call option option to buy currency fixed price (exercise price, strike price) expiration date  Put option option to sell currency fixed price (exercise price, strike price) expiration date 11/21/201516Chapter Seven - Derivatives

17. Over-the-counter Market  written by banks usd against pounds, euros, cd, yen  usually written in round lots; 1, 2, 3, 5, 10 million  banks willing to write variable options amount exercise (strike) price maturity date  less liquid than traded option 11/21/201517Chapter Seven - Derivatives

18. Options on organized exchanges  Standardized contracts amount fixed maturity dates  Auction markets Philadelphia exchange London International Financial Futures Exchange 11/21/201518Chapter Seven - Derivatives

19. Options - over-the-counter Market  written by banks usd against pounds, euros, cd, yen  usually written in round lots; 1, 2, 3, 5, 10 million  banks willing to write variable options amount exercise (strike) price maturity date  less liquid than traded option 11/21/201519Chapter Seven - Derivatives

20. Call characteristics  e exchange rate  x exercise price  sd x standard deviation of exchange rate 11/21/201520Chapter Seven - Derivatives

21. Long a call option e c x Call out of the money when e < x Call in the money when e > x 11/21/201521Chapter Seven - Derivatives

22. Short the Call Option 11/21/201522Chapter Seven - Derivatives

23. Market Value of the Call 11/21/201523Chapter Seven - Derivatives

24. Valuation  exercise price (negative)  exchange rate (positive)  volatility (positive)  term to maturity (positive)  risk-free rate of return (positive) 11/21/201524Chapter Seven - Derivatives

25. Value of the Exercised Call 11/21/201525Chapter Seven - Derivatives

26. Long a call option e c x exercised value of the call market value of the call 11/21/201526Chapter Seven - Derivatives

27. Long a put option e P x Call out of the money when e > x Call in the money when e < x 11/21/201527Chapter Seven - Derivatives

28. Short the Put Option 11/21/201528Chapter Seven - Derivatives

29. Market Value of the Put 11/21/201529Chapter Seven - Derivatives

30. Value of the Exercised Put 11/21/201530Chapter Seven - Derivatives

31. Long the Put Option 11/21/201531Chapter Seven - Derivatives