1. Futures and Options on Foreign Exchange Chapter 7 (165-179)

2. Lecture Objectives Futures Contracts: Preliminaries Currency Futures Markets Basic Currency Futures Relationships Options Contracts: Preliminaries Currency Options Markets Currency Futures Options Basic Option Pricing Relationships at Expiry

3. Global Futures and Options Volume Source: Futures Industry Association

4. Top 7 Derivative Exchanges Source: Futures Industry Association

5. Top 5 Most Actively Traded Contracts Worldwide Source: Futures Industry Association

6. Survey of Derivative Usage From the Wharton School derivative survey Survey of 350 US firms (ended 1998) Firms were selected randomly, grouped by size into large capitalization (capitalization greater than 250 million), medium capitalization (between 50 and 250 million), and small (less than 50 million)

7. Percentage of Firms that Use Derivatives

8. Reasons for Preferring Forwards Reasons to Prefer Forwards to Options Frequency Forwards are better suited to expenses 63% Currency options are excessively expensive 35% Firm lacks knowledge required to use currency options 8%

9. 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. http://www.pbs.org/itvs/openoutcry/thepit.html http://www.youtube.com/watch?v=VwfCwG1-y60&NR=1

10. Futures Contracts: Preliminaries Standardizing Features: Contract Size Delivery Month Daily resettlement Initial performance bond (about 2% of contract value, cash or T-bills held in a street name at your brokerage).

11. 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 $4,000.

12. 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. 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) × 125,000.

13. Daily Resettlement: An Example With futures, we have daily resettlement of gains and 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

14. 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.

15. Daily Resettlement: An Example Over the first 3 days, the euro strengthens, and then depreciates in dollar terms: $1,250* –$1,250 $1.31 $1.30 $1.27 –$3,750 Gain/LossSettle $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 $3,750. Note: * =($1.31-$1.30)x 125,000 {+ $3,750 = $6,500}

16. Daily Resettlement: An Example Over the next 2 days, the long keeps losing money and closes out his position at the end of day five. $1,250 –$1,250 $1.31 $1.30 $1.27 $1.26 $1.24 –$3,750 –$1,250 –$2,500 Gain/LossSettle $7,750 $6,500 $2,750 + $3,750 = $6,500 $5,250 $2,750 Account Balance = $6,500 – $1,250

17. Daily Resettlement: An Example At the end of his adventures, our investor has three ways of computing his gains and losses: Sum of daily gains and losses – $7,500 = $1,250 – $1,250 – $3,750 – $1,250 – $2,500 Contract size times the difference between initial contract price and last settlement price. – $7,500 = ($1.24/€ – $1.30/€) × €125,000 Ending balance on account minus beginning balance on account, adjusted for deposits or withdrawals. – $7,500 = $2,750 – ($6,500 + $3,750)

18. Daily Resettlement: An Example Total loss = – $7,500 $1,250 –$1,250 $1.31 $1.30 $1.27 $1.26 $1.24 –$3,750 –$1,250 –$2,500 Gain/LossSettle $7,750 $6,500 $2,750 + $3,750 $5,250 $2,750 Account Balance = $2,750 – ($6,500 + $3,750) –$–$1.30$6,500 = ($1.24 – $1.30) × 125,000

19. Currency Futures Markets The Chicago Mercantile Exchange (CME) is by far the largest. Others include: The Philadelphia Board of Trade (PBOT) The Tokyo International Financial Futures Exchange The London International Financial Futures Exchange Singapore International Monetary Exchange (SIMEX)

20. The Chicago Mercantile Exchange Expiry cycle: March, June, September, December. Delivery date 3rd Wednesday of delivery month. Last trading day is the second business day preceding the delivery day. CME hours 7:20 a.m. to 2:00 p.m. CST. Extended-hours trading on GLOBEX runs from 2:30 p.m. to 4:00 p.m. dinner break and then back at it from 6:00 p.m. to 6:00 a.m. CST.

21. 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.

22. Reading Currency Futures Quotes OPENHIGHLOWSETTLECHG OPEN INT Euro/US Dollar (CME)—€125,000; $ per € 1.47481.48301.47001.4777.0028Mar 172,396 1.47371.48181.46931.4763.0025Jun 2,266 Highest price that day Lowest price that day Closing price Daily Change Number of open contracts Expiry month Opening price

23. Reading Currency Futures Quotes Notice that open interest is greatest in the nearby contract, in this case March, 2008. In general, open interest typically decreases with term to maturity of most futures contracts. OPENHIGHLOWSETTLECHG OPEN INT Euro/US Dollar (CME)—€125,000; $ per € 1.47481.48301.47001.4777.0028Mar172,396 1.47371.48181.46931.4763.0025Jun2,266

24. Basic Currency Futures Relationships The holder of a long position is committing himself to pay $1.4777 per euro for €125,000—a $184,712.50 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 € 1.47481.48301.47001.4777.0028Mar172,396 1.47371.48181.46931.4763.0025Jun2,266

25. 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.

26. 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.

27. 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.

28. Option 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 +

29. Currency Options Markets PHLX HKFE 20-hour trading day. OTC volume is much bigger than exchange volume. Trading is in six major currencies against the U.S. dollar.

30. PHLX Currency Option Specifications CurrencyContract Size Australian dollarAD50,000 British pound£31,250 Canadian dollarCD50,000 Euro€62,500 Japanese yen¥6,250,000 Swiss francSF62,500

31. 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]

32. 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]

33. 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

34. 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

35. 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

36. 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, the writer loses 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

37. 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 pound The exercise price is $1.50 per pound.

38. Example $1.50 STST Profit loss –$7,812.50 $1.75 Long 1 call on £31,250 Consider a call option on £31,250. The option premium is $0.25 per pound The exercise price is $1.50 per pound.

39. Example $1.50 STST Profit loss $42,187.50 $1.35 Long 1 put on £31,250 Consider a put option on £31,250. The option premium is $0.15 per pound The exercise price is $1.50 per pound. What is the maximum gain on this put option? At what exchange rate do you break even? –$4,687.50 $42,187.50 = £31,250×($1.50 – $0.15)/£ $4,687.50 = £31,250×($0.15)/£

40. 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

41. Example For a call on Euro with strike price k = US¢/€ 91.5. The intrinsic value is 5¢ if the spot rate is 96.5¢. Time value is 1¢ if the market price is 6¢. The intrinsic value is 0 if the spot rate is 88¢ (or any other price equal to or below 91.5¢). Time value is 2¢ if market price is 2. For put with strike price k = US¢/€ 91.5. The intrinsic value is 0 if the spot rate is 96.5¢. Time value is 2 if the market price is 2¢. The intrinsic value is 3.5¢ if the spot rate is 88¢. Time value is 1.5¢ if market price is 5.

42. Learning outcomes Discuss the similarities and differences between forward and futures. Explain the difference between hedgers and speculators Explain why most futures positions are closed out through a reversing trade rather than held to delivery Define the call and put options; the rights of the buyers and obligations of the sellers Explain the differences between European and American options Know the basic option pricing relationships at expiration Basic option profit profiles (all four of them) Know how to calculate the intrinsic value and time value of the options Know how to calculate the profit/loss of long/short call and put speculative positions (for example, see the numerical examples done in class)