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Currency Futures and Options Markets International Corporate Finance P.V. Viswanath.

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Presentation on theme: "Currency Futures and Options Markets International Corporate Finance P.V. Viswanath."— Presentation transcript:

1 Currency Futures and Options Markets International Corporate Finance P.V. Viswanath

2 2 A forward contract The forward market is a market where participants can arrange today for a transaction to take place in the future. Thus, a firm can sell $1m. three months forward for euros at a price of $1.297 to the euro. This means that in 3 months, the firm can deliver $1m. and receive in return (1/1.297x1m.) or 771,010. This is often a personalized contract with the contract duration and contract amount arranged according to the convenience of the participants.

3 P.V. Viswanath3 A futures contract A futures contract is similar to a forward contract in that it is also nominally an arrangement for a transaction to take place in the future. However, futures contracts are standardized both in terms of duration (there are specific days when contracts mature) and amount. This makes it easier for holders of contracts to resell them.

4 P.V. Viswanath4 Futures Contracts The problem with trading forward contracts is that these contracts represent a promise of future performance. Hence A selling B a forward contract that he originally bought from C is making a representation regarding a third party that may not be known to B. The solution is to have a single party take the opposite side of all futures contracts. This is the clearing house.

5 P.V. Viswanath5 Clearing Houses If A wants to buy a futures contract from B, it is formally structured as two contracts: one, where A buys the contract from the clearing house, and another, where B sells it to the clearing house. The price at which the transaction is to take place (the futures price) is agreed between A and B. Then, if A wants to sell it to C, he simply agrees on the price with C; then two new transactions take place simultaneously – A sells his futures contract back to the clearing house, while C buys it from the futures contract. This solves the problem of knowing the credit quality of the contract partner, since its always the clearing house.

6 P.V. Viswanath6 Marking to Market However, this still leaves the clearing house open to credit risk. Thus, if A buys a futures contract worth ¥12.5m at a price of $0.9029/100 ¥ maturing Sept 2006 and the price dropped to $0.8910 after two days. Each point change is worth $12.50; hence the price of the contract has now dropped by $12.5(9029-8910) = $1487.50. If A were to close out his position now, he would owe the exchange $1487.5/per contract. In order to reduce the clearing houses exposure, A has to mark-to-market (also called daily settlement).

7 P.V. Viswanath7 Marking-to-Market At the end of every day, the contract is respecified, as it were, so that its value drops to zero. In our example, the value of the contract was zero when originally struck. Currently, the contract is worth $1487.5 to the exchange and -$1487.5 to A. This is because A has the obligation to buy ¥12.5m. at the price of $0.9029, when he could get it for $0.891 on the open market. The solution that futures markets have adopted is to effect a dollar transfer from the losing party to the gaining party at the end of each day.

8 P.V. Viswanath8 Marking-to-Market Thus if the drop in price had occurred at the end of the next day, A would have been required to pay $1487.5 to the exchange per contract. This would reset the account balance at zero at the end of each day. The maximum amount at risk would depend only on the daily volatility. Daily settlement means that a futures contract is equivalent to entering a forward contract each day and settling each forward contract before opening another forward contract.

9 P.V. Viswanath9 Currency Options An option gives the holder the right, but not the obligation to purchase or sell an underlying commodity at a pre-agreed price (the strike or exercise price). That is, options have a throw-away feature. Currency options traded on the CME are on futures contracts. On the Philadelphia Exchange, the underlying commodity is the spot currency.

10 P.V. Viswanath10 Quotes on Option Contracts On Monday, June 5, 2006, a call on the Sept Yen contract with an exercise price of $0.9000/100¥ closed at $.0205/100¥. Since the contract size is ¥12.5m, to purchase the option would require a payment of (0.0205)(125000) or $2562.5 Since the corresponding futures contract closed at $0.9030, buying the option and exercising it immediately would have resulted in a gain of (0.9030-0.9000)x125000= $375. The additional $2187.5 is for the possibility that the futures price will climb even more in the next three months.

11 P.V. Viswanath11 Option Price Determinants Intrinsic Value Volatility of Underlying exchange rate Option type (American or European) Interest rate on currency of purchase Forward Premium and Interest Differential Time to expiration

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