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CHAPTER 7 Options Contracts and Currency Futures (Textbook Chapter 8)
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PART I Futures Contracts 2
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FUTURES CONTRACTS I.CURRENCY FUTURES A. Introduction: a. Definition of a Futures Contract: contractual agreement requiring three things: 1. a standard quantity of an available currency 2. at a fixed exchange rate 3. at a set delivery date. 3
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FUTURES CONTRACTS b.Available Futures Contracts: - in over 20 different currencies against the U.S. dollar - plus cross-rate contracts c.Transaction costs: in the form of a commission payment to a trader 5
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FUTURES CONTRACTS d.Leverage is high Initial margin required is relatively low (less than 2% of contract value). e. Maximum price movement rules: Contracts set daily to a price limit that restricts maximum daily upward and downward movements 6
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FUTURES CONTRACTS: SAFEGUARDS f. Maintenance Margins: When the account balance falls below the maintenance margin, a margin call may be necessary to maintain the minimum balance. 7
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FUTURES CONTRACTS g.Global futures exchanges: 1.)C.M.E. Chicago Mercantile Exchange 2.)L.I.F.F.E. London International Financial Futures Exchange 3.)S.I.M.E.X. Singapore International Monetary Exchange 4.) D.T.B. Deutsche Termin Borse 5.)H.K.F.E. Hong Kong Futures Exchange 6.)T.I.F.F.E. Tokyo International Financial Futures Exchange 8
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FUTURES CONTRACTS B.Forward vs. Futures Contracts Basic differences: 1. Trading Locations6. Quotes 2. Regulation7. Margins 3. Frequency of 8. Credit risk delivery 4. Size of contract 5. Transaction Costs 9
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FUTURES CONTRACT 12
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FUTURES CONTRACTS Advantages of futures: 1.) Easy liquidation 2.) Well- organized and stable market. Disadvantages of futures: 1.) Limited number of currencies 2.) Limited dates of delivery 3.) Rigid contract sizes. 13
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FUTURES CONTRACT Example 1: On Monday morning, you short one yen futures contract containing ¥12,500,000 at a price of $0.009433. Suppose the broker requires an initial performance bond of $4,000 and a maintenance performance bond of $3,400. The settlement prices for Monday through Thursday are $0.009542, $0.009581, $0.009375, and $0.009369, respectively. On Friday, you close out the contract at a price of $0.009394. Calculate the daily cash flows on your account. Describe any performance bond calls on your account. What is your cash balance with your broker as of the close business on Friday? Assume that you begin with an initial balance of $4,590 and that your round-trip commission was $27. 14
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FUTURES CONTRACT Example 2: Forward-Futures Arbitrage Suppose the interbank forward bid for June 18 on British pounds is US$1.8927 at the same time that the price of CME British pounds futures for delivery on June 18 is $1.8915. How could the dealer use arbitrage to profit from this situation? 15
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PART II Currency Options 16
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CURRENCY OPTIONS I.OPTIONS A. Currency options 1.offer another method to hedge exchange rate risk 2.first offered on Philadelphia Exchange (PHLX) 17
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HOW CURRENCY OPTIONS ARE PURCHASED Buyers Sellers=Writers Buy SellBuySell CALL PUT Premium 18
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CURRENCY OPTIONS 3. Definition: a contract from a writer (the seller) that gives the right – not the obligation – to the holder (the buyer) to buy or sell a standard amount of an available currency at a fixed exchange rate for a fixed time period 19
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CURRENCY OPTIONS 4.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. 20
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CURRENCY OPTIONS 5.What is the premium? the price of an option that the writer charges the buyer 6.Exercise Price a. Sometimes known as the strike price. b.The exchange rate at which the option holder can buy or sell the contracted currency. 21
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CURRENCY OPTIONS 7. Types of Currency Options: 1.)Calls – give the owner the right to buy the currency 2.)Puts – give the owner the right to sell the currency 22
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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 23
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CURRENCY OPTIONS 9. Why Use Currency Options? a.For the firm hedge foreign exchange risk when a future event is very uncertain. b.For speculators profit from favorable exchange rate changes. 24
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CURRENCY OPTIONS B. Using Currency Options 1. Call option Consider a U.S. importer with a €62,500 payment to make to a German exporter in 60 days. The importer could purchase a European call option to have the euros delivered to him at a specified exchange rate on the due date. Suppose the option premium is $0.02 per euro and the exercise price is $1.44. The importer has paid $1,250 for a €144 call option. 26
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Call option holder 27
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CURRENCY OPTIONS B. Using Currency Options 2. Put option Consider a put option at the same terms (exercise price of $1.44 and put premium of $0.02 per euro). 29
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Put option holder 30
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CURRENCY OPTIONS B. Using Currency Options 3. Currency spread allows speculators to bet on the direction of a currency but at a lower cost than buying a put or a call option alone. a. bull spread: - bet on a currency’s appreciation - involve buying a call at one strike price and selling another call at a higher strike price 32
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CURRENCY OPTIONS b. bear spread - bet on a currency’s decline - involves buying a put at one strike price and selling another put at a lower strike price 34
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CURRENCY OPTIONS C. Option Pricing and Valuation 1. Intrinsic value: the amount by which the option is in-the- money 2. Time value: the excess of the option value over its intrinsic value 36
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CURRENCY OPTIONS D. Using Forward or Futures Contracts vs Options Contracts – Example: Biogen, a U.S. company, expects to receive royalty payments totaling £1.25 million next month. It is interested in protecting these receipts against a drop in the value of the British pound. It can sell 30-day British pound futures at a price of $1.6513 per pound or it can buy pound put options with a strike price of $1.6612 at a premium of 2.0 cents per pound. The spot price of the British pound is currently $1.6560, and the pound is expected to trade in the range of $1.6250 to $1.7010. Biogen’s treasurer believes that the most likely price of the British pound in 30 days will be $1.6400. 39
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CURRENCY OPTIONS D. Using Forward or Futures Contracts vs Options Contracts – Example (con’t): a. How many futures contracts will Biogen need to protect its receipts? How many options contracts? b. Diagram Biogen’s profit and loss associated with the put option position and futures position within its range of expected exchange rates. c. Calculate what Biogen would gain or lose on the option and futures position within the range of expected future exchange rates and if the pound settled at its most likely value. 40
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CURRENCY OPTIONS D. Using Forward or Futures Contracts vs Options Contracts – Example (con’t): d. Show the total cash flow to Biogen (hedge plus the gain or loss on the hedge) using the options and futures contracts, as well as the unhedged position within the range of expected future exchange rates? e. What is Biogen’s break-even future spot price on the option contract? On the futures contract? f. Calculate the corresponding profit and loss and break-even position on the futures and options contracts for those who took the other side of these contracts. 41
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