1. 1 Futures and Options on Foreign Exchange Chapter Objective: This chapter discusses exchange-traded currency futures contracts, options contracts, and options on currency futures. Chapter Outline  Futures Contracts: Preliminaries  Currency Futures Markets  Basic Currency Futures Relationships  Eurodollar Interest Rate Futures Contracts  Options Contracts: Preliminaries  Currency Options Markets  Currency Futures Options 9 Chapter Nine

2. 2 9.1 Futures Contracts  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 - marked to market.  Standardizing Features: contract size, delivery month, daily resettlement - marked to market  Initial Margin: about 2-5 % of contract value, cash or T-bills held in a street name at your brokers.  Participants’ losses or profits are realized daily instead of at maturity as with a forward contract.  Because of marking to market, the futures price converges through time to the spot price on the last day of trading in the contract.

3. 3 Daily Resettlement = Marking to Market Example: On Monday morning you take a long position in SF futures contract that matures on Wednesday afternoon at $0.75/SF. 1. At the close of trading on Monday the futures price has risen to $0.755. Because of the daily settlement you receive a cash profit of $625 =125,000 x (0.755-0.75) 2. At Tuesday close the price has declined to $0.743. You must pay the $1500 loss (125,000 x [0.743-0.755]) to the other side of the contract. 3. At Wednesday close, the price drops to $0.74, and the contract matures. You pay $375 loss to the other side and take the delivery of the SF, paying the prevailing price of $0.74. You have a net loss on the contract of $1250 (625-1500-375) You can also close out your long position with an offsetting trade, if you don’t want the delivery of the SF.

4. 4 9.2 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  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.

5. 5 Currency Futures Contract Specifications

6. 6 Currency Futures Quotations (CME)

7. 7 9.3Basic 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.

8. 8 Reading a Futures Quote ($/€) Expiry month Opening price Highest price that day Highest and lowest prices over the lifetime of the contract. Number of open contracts Lowest price that day Closing price Daily Change

9. 9 Long and Short Positions in a Futures Contract

10. 10 9.4 Eurodollar Interest Rate Futures Contracts  Widely used futures contract for hedging short-term U.S. dollar interest rate risk.  The underlying asset is a hypothetical $1,000,000 90-day Eurodollar deposit—the contract is cash settled.  Traded on the CME and the Singapore International Monetary Exchange.  The contract trades in the March, June, September and December cycle.

11. 11 Reading Eurodollar Futures Quotes EURODOLLAR (CME)—$1 million; pts of 100% OpenHighLowSettleChgYield Settle Change Open Interest June 94.7194.7594.6594.68-.01 5.32 +.0147,417 Eurodollar futures prices are stated as an index number of three- month LIBOR calculated as F = 100 – LIBOR. The closing price for the July contract is 94.68 thus the implied yield is 5.32 percent = 100 – 94.68 The change was.01 percent of $1 million representing $100 on an annual basis. Since it is a 3-month contract one basis point corresponds to a $25 price change.

12. 12 9.5Currency Options-Preliminaries  Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset in the future, at prices agreed upon today.  Put options: the holder has the right, but not the obligation, to sell a given quantity of some asset in the future, at prices agreed upon  At-the-money (ATM) E = S The exercise price (E) equals the spot price (S) of the underlying asset.  In-the-money (ITM) E < S The exercise price (E) is less than the spot price (S) of the underlying asset.  Out-of-the-money (OTM) E > S The exercise price is more than the spot price of the underlying asset today.

13. 13 Currency Options Markets  Originally traded OTC  PHLX  OTC volume is much bigger than exchange volume.($130Bil. vs. $3Bil. Per day)  Trading is in six major currencies against the U.S. dollar.  Options contract sizes are half of the futures contracts

14. 14 PHLX Currency Option Specifications

15. 15 Currency Futures Options  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.

16. 16 Call Option Value at Expiry

17. 17 Pay-off to Purchaser of a Call Option on C$ for US$

18. 18 Pay-off to Writer of a Call Option on C$ for US$

19. 19 Pay-off to Purchaser of a Put Option on C$ for US$

20. 20 Pay-off to Writer of a Put Option on C$ for US$

21. 21 Call Option Hedge for $US1m to be Received in Three Months