1. Chapter 03 Currency and Eurocurrency Derivatives Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2. Learning Objectives A. Describe derivatives markets, structure and participants. B. Describe FX forwards and futures; calculate prices. C. Describe FX options; calculate payoff and profit; distinguish between calls and puts. D. Price an FX option. 3-2

3. A1. What are Derivatives?  Derivatives are financial contracts whose cash flows and value derives from some underlying financial asset or commodity or indicator. For example, stock options provided to managers.  Underlying assets may be financial assets, commodities, currencies, etc.  Counterparties are typically known as buyer (long) and seller (short).  Forwards and Options are the most contract type 3-3

4. A2. Derivatives Markets Notional Value of Derivatives in 2007, USD Billions Exchange Traded Derivatives: Interest Rate Futures26,787 Currency Futures159 Equity Futures1,133 Interest Rate Options44,308 Currency Options133 Equity Options8,103 OTC: Currency Contracts60,091 Interest Rate contracts346,937 Equity contracts9,202 Commodity contracts7,567 Credit-default swaps42,580 Source: BIS, 2007 Statistics 3-4

5. B1. Currency Forwards  The exchange of one currency for another at a future date using a pre-determined exchange rate  At inception, the two parties—long and short—simply agree on the forward price.  At maturity, the short delivers the contracted units of the base currency and in return the long makes payment using the terms currency.  Certain currency forwards do not entail actual delivery of the foreign currency and are known as non-deliverable forwards (NDF). 3-5

6. B2. Forward Price and Forward Premium  Price is calculated using the following equation:  Premium (or discount) is calculated as follows: 3-6

7. B3. Forward Pricing Example  S = 0.02174 (INRUSD)  r = 5% (US interest rate)  r* = 10% (Indian interest rate)  t = 2 (years) 3-7

8. B4. Currency Futures  A currency futures contract is an exchange traded version of the currency forward contract.  Futures are standardized. For instance, the GBP futures traded in the Chicago Mercantile Exchange has very specific maturities (every 3 months) and size (62,500 currency units).  Futures may be priced using the forward pricing equation since futures and forwards are very similar instruments. 3-8

9. B4. Currency Futures (cont.)  Daily settlement of profits and losses in margin accounts eliminates counterparty risk  The CME lists more than 20 futures contracts in various currencies, cross- currencies and currency indexes. This list includes the major currencies—JPY, GBP, EUR and CHF—as well as emerging markets currencies such as the Chinese Renminbi, South African Rand and the Russian Ruble (CNY, ZAR and RUB respectively). 3-9

10. C1. Currency Options  Provides the right but not the obligation to purchase (or sell) the underlying or base currency at a future date at a pre-specified strike price denominated in the terms currency.  Options may be calls (allowing purchase) or puts (allowing sale).  Unlike forwards and futures, an option may only be acquired by paying a premium.  Currency options are traded in the PHLX and CME. 3-10

11. C2. Call Option Payoff & Profit Call Option: Payoff & Profit to Long (Buyer) Call Parameters: C = 0.06, X =1.25 All Values in USD At Contract InceptionCash Flows At Maturity Overall Result Currency Value at MaturityPremium Paid Exercise Price PaidValue ReceivedPayoffProfit 1.160.06No Exercise 0-0.06 1.190.06No Exercise 0-0.06 1.220.06No Exercise 0-0.06 1.250.06No Exercise 0-0.06 1.280.061.251.280.03-0.03 1.310.061.251.310.060.00 1.340.061.251.340.090.03 1.370.061.251.370.120.06 Note: Payoff & Profit to Short (Seller) is the exact opposite (that is, positive values are negative and negative values are positive) 3-11

12. C3. Call Option Diagram 3-12

13. C4. Put Option Payoff & Profit Put Option: Payoff & Profit to Long (Buyer) Call Parameters: P = 0.03, X =1.25 All Values in USD At Contract InceptionCash Flows At Maturity Overall Result Currency Value at Maturity Premium Paid Exercise Price Received Value Given UpPayoffProfit 1.160.031.251.160.090.06 1.190.031.251.190.060.03 1.220.031.251.220.030.00 1.250.03No Exercise 0-0.03 1.280.03No Exercise 0-0.03 1.310.03No Exercise 0-0.03 1.340.03No Exercise 0-0.03 1.370.03No Exercise 0-0.03 Note: Payoff & Profit to Short (Seller) is the exact opposite (that is, positive values are negative and negative values are positive) 3-13

14. C5. Put Option Diagram 3-14

15. C6. Summary of Option Payoff & Profit Summary of Option Payoff & Profits Call OptionPut Option Long (Buyer) Long pays premium upfront Long exercises by buying currency Payoff = Profit = Long gains when currency rises Long pays premium upfront Long exercises by selling currency Payoff = Profit = Long gains when currency falls Short (Seller) Short receives premium upfront Short responds to exercise by selling currency Payoff = Profit = Short gains when currency falls Short receives premium upfront Short responds to exercise by buying currency Payoff = Profit = Short gains when currency rises ),0(XSMax t  CXS t  ),0( 3-15

16. D1. Option Pricing Formula 3-16

17. D2. Option Pricing Example USE PAST DATA TO CALCULATE σ DateEURUSD% change 1/8/20081.4708n/a 1/15/20081.48040.65% 1/22/20081.4631-1.17%OBTAIN OPTION PARAMETERS 1/29/20081.47750.99%Option is 90-day option on EUR 2/5/20081.4648-0.86%X = 1.55Strike Price 2/12/20081.4584-0.44%t = 90/365Maturity 2/19/20081.47250.97% 2/26/20081.49751.69%+ 3/4/20081.52161.61% 3/11/20081.53440.84%OBTAIN CURRENCY SPOT 3/18/20081.57312.52%S = 1.5992Spot Currency 3/25/20081.5423-1.96% 4/1/20081.56151.25% CONTINUOUSLY COMPOUNDED RATES 4/8/20081.57110.61%r (USD) = 2.9% 4/15/20081.57900.51%r*(EUR) = 3.8% 4/22/20081.59921.28% Weekly σ1.20% Annual σ*SQRT(52)8.62% 3-17

18. D2. Option Pricing Example (Cont.) 3-18