INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Fifth Edition Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Chapter Objective: This chapter discusses exchange-traded currency futures contracts, options contracts, and options on currency futures. 7 Chapter Seven Futures and Options on Foreign Exchange 7-1

Futures Contracts: Preliminaries 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. 7-2

Futures Contracts: Preliminaries Standardizing Features: Contract Size Delivery Month Daily resettlement 7-3

Daily Resettlement: An Example Consider a long position in the CME Euro/U.S. Dollar contract. It is written on €125,000 and quoted in $ per €. The strike price is $1.30 the maturity is 3 months. At initiation of the contract, the long posts an initial performance bond of $6,500. The maintenance performance bond is $4,

Daily Resettlement: An Example Recall that an investor with a long position gains from increases in the price of the underlying asset. Our investor has agreed to BUY €125,000 at $1.30 per euro in three months time. With a forward contract, at the end of three months, if the euro was worth $1.24, he would lose $7,500 = ($1.24 – $1.30) × 125,000. If instead at maturity the euro was worth $1.35, the counterparty to his forward contract would pay him $6,250 = ($1.35 – $1.30) × 125,

Daily Resettlement: An Example With futures, we have daily resettlement of gains an losses rather than one big settlement at maturity. Every trading day: if the price goes down, the long pays the short if the price goes up, the short pays the long After the daily resettlement, each party has a new contract at the new price with one-day- shorter maturity. 7-6

Performance Bond Money Each day’s losses are subtracted from the investor’s account. Each day’s gains are added to the account. In this example, at initiation the long posts an initial performance bond of $6,500. The maintenance level is $4,000. If this investor loses more than $2,500 he has a decision to make: he can maintain his long position only by adding more funds—if he fails to do so, his position will be closed out with an offsetting short position. 7-7

Daily Resettlement: An Example Over the first 3 days, the euro strengthens then depreciates in dollar terms: $1,250 –$1,250 $1.31 $1.30 $1.27 –$3,750 Gain/LossSettle = ($1.31 – $1.30)×125,000$7,750 $6,500 $2,750 Account Balance = $6,500 + $1,250 On third day suppose our investor keeps his long position open by posting an additional $3, $3,750 = $6,

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 7-9

Reading Currency Futures Quotes OPENHIGHLOWSETTLECHG OPEN INT Euro/US Dollar (CME)—€125,000; $ per € Mar172, Jun2,266 Highest price that day Lowest price that day Closing price Daily Change Number of open contracts Expiry month Opening price 7-10

Basic 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. 7-11

Reading Currency Futures Quotes Notice that open interest is greatest in the nearby contract, in this case March, In general, open interest typically decreases with term to maturity of most futures contracts. OPENHIGHLOWSETTLECHG OPEN INT Euro/US Dollar (CME)—€125,000; $ per € Mar172, Jun2,

Basic Currency Futures Relationships The holder of a long position is committing himself to pay $ per euro for €125,000—a $184, position. As there are 172,396 such contracts outstanding, this represents a notational principal of over $31.8 billion! OPENHIGHLOWSETTLECHG OPEN INT Euro/US Dollar (CME)—€125,000; $ per € Mar172, Jun2,

Reading Currency Futures Quotes 1 + i € 1 + i $ F($/€) S($/€) = Recall from chapter 6, our interest rate parity condition: OPENHIGHLOWSETTLECHG OPEN INT Euro/US Dollar (CME)—€125,000; $ per € Mar172, Jun2,

Reading Currency Futures Quotes From March to June 2008 we should expect lower interest rates in dollar denominated accounts: if we find a higher rate in a euro denominated account, we may have found an arbitrage. OPENHIGHLOWSETTLECHG OPEN INT Euro/US Dollar (CME)—€125,000; $ per € Mar172, Jun2,

Trading irregularities Futures Markets are also a great place to launder money The zero sum nature of futures is the key to laundering the money. 7-16

James B. Blair outside counsel to Tyson Foods Inc., Arkansas' largest employer, gets Hillary’s discretionary order. Robert L. "Red" Bone, (Refco broker), allocates trades ex post facto. Submits identical long and short trades winners losers Money Laundering: Hillary Clinton’s Cattle Futures 7-17

Options Contracts: Preliminaries An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset in the future, at prices agreed upon today. Calls vs. Puts Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future, at prices agreed upon today. Put options gives the holder the right, but not the obligation, to sell a given quantity of some asset at some time in the future, at prices agreed upon today. 7-18

Options Contracts: Preliminaries European vs. American options European options can only be exercised on the expiration date. American options can be exercised at any time up to and including the expiration date. Since this option to exercise early generally has value, American options are usually worth more than European options, other things equal. 7-19

Options Contracts: Preliminaries In-the-money The exercise price is less than the spot price of the underlying asset. At-the-money The exercise price is equal to the spot price of the underlying asset. Out-of-the-money The exercise price is more than the spot price of the underlying asset. 7-20

Options Contracts: Preliminaries Intrinsic Value The difference between the exercise price of the option and the spot price of the underlying asset. Speculative Value The difference between the option premium and the intrinsic value of the option. Option Premium = Intrinsic Value Speculative Value

PHLX Currency Option Specifications CurrencyContract Size Australian dollarAD10,000 British pound£10,000 Canadian dollarCAD10,000 Euro€10,000 Japanese yen¥1,000,000 Swiss francSF10,

Basic Option Pricing Relationships at Expiry At expiry, an American call option is worth the same as a European option with the same characteristics. If the call is in-the-money, it is worth S T – E. If the call is out-of-the-money, it is worthless. C aT = C eT = Max[S T - E, 0] 7-23

Basic Option Pricing Relationships at Expiry At expiry, an American put option is worth the same as a European option with the same characteristics. If the put is in-the-money, it is worth E - S T. If the put is out-of-the-money, it is worthless. P aT = P eT = Max[E – S T, 0] 7-24

Basic Option Profit Profiles E STST Profit loss –c0–c0 E + c 0 Long 1 call If the call is in-the- money, it is worth S T – E. If the call is out-of- the-money, it is worthless and the buyer of the call loses his entire investment of c 0. In-the-moneyOut-of-the-money Owner of the call 7-25

Basic Option Profit Profiles E STST Profit loss c0c0 E + c 0 short 1 call If the call is in-the- money, the writer loses S T – E. If the call is out-of- the-money, the writer keeps the option premium. In-the-moneyOut-of-the-money Seller of the call 7-26

Basic Option Profit Profiles E STST Profit loss – p 0 E – p 0 long 1 put E – p 0 If the put is in- the-money, it is worth E – S T. The maximum gain is E – p 0 If the put is out- of-the-money, it is worthless and the buyer of the put loses his entire investment of p 0. Out-of-the-moneyIn-the-money Owner of the put 7-27

Basic Option Profit Profiles E STST Profit loss p 0 E – p 0 short 1 put – E + p 0 If the put is in- the-money, it is worth E –S T. The maximum loss is – E + p 0 If the put is out- of-the-money, it is worthless and the seller of the put keeps the option premium of p 0. Seller of the put 7-28

Example $1.50 STST Profit loss –$0.25 $1.75 Long 1 call on 1 pound Consider a call option on €31,250. The option premium is $0.25 per € The exercise price is $1.50 per €. 7-29

Example $1.50 STST Profit loss –$7, $1.75 Long 1 call on €31,250 Consider a call option on €31,250. The option premium is $0.25 per € The exercise price is $1.50 per €. 7-30

Example $1.50 STST Profit loss $42, $1.35 Long 1 put on €31,250 Consider a put option on €31,250. The option premium is $0.15 per € The exercise price is $1.50 per euro. What is the maximum gain on this put option? At what exchange rate do you break even? –$4, $42, = €31,250×($1.50 – $0.15)/€ $4, = €31,250×($0.15)/€ 7-31

American Option Pricing Relationships With an American option, you can do everything that you can do with a European option AND you can exercise prior to expiry— this option to exercise early has value, thus: C aT > C eT = Max[S T - E, 0] P aT > P eT = Max[E - S T, 0] 7-32

Market Value, Time Value and Intrinsic Value for an American Call E STST Profit loss Long 1 call The red line shows the payoff at maturity, not profit, of a call option. Note that even an out- of-the-money option has value—time value. Intrinsic value Time value Market Value In-the-moneyOut-of-the-money 7-33

European Option Pricing Relationships Consider two investments 1 Buy a European call option on the British pound futures contract. The cash flow today is –C e 2 Replicate the upside payoff of the call by 1 Borrowing the present value of the dollar exercise price of the call in the U.S. at i $ E (1 + i $ ) The cash flow today is 2 Lending the present value of S T at i £ STST (1 + i £ ) The cash flow today is – 7-34

European Option Pricing Relationships When the option is in-the-money both strategies have the same payoff. When the option is out-of-the-money it has a higher payoff than the borrowing and lending strategy. Thus: C e > Max STST E (1 + i £ )(1 + i $ ) –,

European Option Pricing Relationships Using a similar portfolio to replicate the upside potential of a put, we can show that: P e > Max STST E (1 + i £ )(1 + i $ ) –,

Binomial Option Pricing Model The most important lesson from the binomial option pricing model is: the replicating portfolio intuition. the replicating portfolio intuition. Many derivative securities can be valued by valuing portfolios of primitive securities when those portfolios have the same payoffs as the derivative securities. 7-37

The Hedge Ratio In the example just previous, we replicated the payoffs of the call option with a levered position in the underlying asset. (In this case, borrowing dollars to buy euro at the spot.) This ratio gives the number of units of the underlying asset we should hold for each call option we sell in order to create a riskless hedge. The hedge ratio of a option is the ratio of change in the price of the option to the change in the price of the underlying asset: H = C – C S 1 – S 1 downup downup 7-38

Hedge Ratio This practice of the construction of a riskless hedge is called delta hedging. The delta of a call option is positive. Recall from the example: The delta of a put option is negative. Deltas change through time. H = C – C S 1 – S 1 downup downup $0.375 – $0 $1.875 – $1.20 $0.375 $ == = 7-39

Take-Away Lessons Convert future values from one currency to another using forward exchange rates. Convert present values using spot exchange rates. Discount future values to present values using the correct interest rate, e.g. i $ discounts dollar amounts and i € discounts amounts in euro. To find the risk-neutral probability, set the forward price derived from IRP equal to the expected value of the payoffs. To find the option value discount the expected value of the option payoffs calculated using the risk neutral probabilities at the correct risk free rate. 7-40

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. 7-41

Currency Futures Options Why a derivative on a derivative? Transactions costs and liquidity. For some assets, the futures contract can have lower transactions costs and greater liquidity than the underlying asset. Tax consequences matter as well, and for some users an option contract on a future is more tax efficient. The proof is in the fact that they exist. 7-42

Option Pricing Find the value of an at-the-money call and a put on €1 with Strike Price = $1.50 i $ = 3% i € = 2% u = 1.25 d =.8 $1.50 $1.875 = 1.25 × $1.50 $1.20 = 0.8 × $1.50 $0.375 = Call payoff $0 =Call payoff $0 = Put payoff $0.30 = Put payoff.4662× $0.375 C 0 = 1.03 = $ × $0.30 P 0 = 1.03 = $ –.80 p = 1.25 – 0.80 = P 0 = $ C 0 = $

Hedging a Call Using the Spot Market We want to sell call options. How many units of the underlying asset should we hold to form a riskless portfolio? $1.50 $1.875 = 1.25 × $1.50 $1.20 = 0.8 × $1.50 $0.375 = Call payoff $0 = Call payoff $0.375 – $0  = $1.875 – $1.20 = 5/9 Sell 1 call option; buy 5/9 of the underlying asset to form a riskless portfolio. If the underlying is indivisible, buy 5 units of the underlying and sell 9 calls. 7-44

Hedging a Call Using the Spot Market Call finishes in-the-money, so we must buy an additional €4 at $ Cost = 4 × $1.875 = $7.50 Cash inflow call exercise = 9 × $1.50 = $13.50 Portfolio cash flow = $6.00 S 0 ($|€) = $1.50/€ T = 0 Cash Flows T = 1 S 1 ($|€) = $1.875 S 1 ($|€) = $1.20 Call finishes out-of-the-money, so we can sell our now-surplus €5 at $1.20. Cash inflow = 5 × $1.20 = $6.00 Handy thing to notice: $ × 1.03 = $6.00 Write 9 calls: Cash inflow = 9 × $ = $ Portfolio cash flow today = –$ $0.375 – $0  = $1.875 – $1.20 = 5/9 Go long PV of €5. Cost today = € × = $ $1.50 €1.00 C 1 = $.375 C 1 = $0 7-45

Hedging a Put Using the Spot Market We want to sell put options. How many units of the underlying asset should we hold to form a riskless portfolio? S 0 ($|€) = $1.50/€ Put payoff = $0.0 Put payoff = $0.30 $0 – $0.30  = $1.875 – $1.20 = – 4/9 Sell 1 put option; short sell 4/9 of the underlying asset to form a riskless portfolio. If the underlying is indivisible, short 4 units of the underlying and sell 9 puts. S 1 ($|€) = $1.875 S 1 ($|€) = $

Hedging a Put Using the Spot Market Put finishes out-of-the-money. To repay loan buy €4 at $ Cost = 4 × $1.875 = $7.50 Option cash inflow = 0 Portfolio cash flow = $7.50 T = 0 Cash Flows T = 1 put finishes in-the-money, so we must buy 9 units of underlying at $1.50 each = 9×1.50 = $13.50 use 4 units to cover short sale, sell remaining 5 units at $1.20 = $6.00 Portfolio cash flow = $7.50 Handy thing to notice: $ × 1.03 = $7.50 Write 9 puts: Cash inflow = 9 × $ = $ Portfolio Inflow today = $ Borrow the PV of €4 at i € = 2%. Inflow = $0 – $0.30  = $1.875 – $1.20 = – 4/9 € × = $ $1.50 €1.00 S 1 ($|€) = $1.20 S 1 ($|€) = $1.875 S 0 ($|€) = $1.50/€ 7-47

Hedging a Call Using Futures Futures contracts matures: buy 5 units at forward price. Cost = 5× $ = $ Call finishes out-of-the-money, so we sell our 5 units of underlying at $1.20. Cash inflow = 5 × $1.20 = $6.00 Portfolio cash flow = –$ Handy thing to notice: $ × 1.03 = $ Write 9 calls: Cash inflow = 9 × $ = $ Portfolio cash flow today = $ Go long 5 futures contracts. Cost today = 0 Forward Price = × = $ $1.50 €1.00 Call finishes in-the-money, we must buy 4 additional units of underlying at S 1 ($/€) = $ Cost = 4 × $1.875 = $7.50 Option cash inflow = 9 × $1.50 = $13.50 Portfolio cash flow = –$ Futures contracts matures: buy 5 units at forward price. Cost = 5× $ = $ S 1 ($|€) = $1.875 S 0 ($|€) = $1.50/€ S 1 ($|€) = $

Hedging a Put Using Futures Put finishes out-of-the-money. Option cash flow = 0 Portfolio cash flow = –$ Put finishes in-the-money, we must buy €9 at $1.50/€ = 9×1.50 = $13.50 Futures contracts matures: sell €4 at forward price $1.5147/€ 4× $ = $ sell remaining €5 at $1.20 = $6.00 Portfolio cash flow = –$ Handy thing to notice: $ × 1.03 = $ Write 9 puts: Cash inflow = 9 × $ = $ Portfolio Inflow today = $ Go short 4 futures contracts. Cost today = 0 Forward Price = × = $ $1.50 €1.00 Futures contracts matures: sell €5 at forward price. Loss = 4× [$1.875 – $1.5147] = $ S 1 ($|€) = $1.875 S 0 ($|€) = $1.50/€ S 1 ($|€) = $