1. 1 Currency Derivatives (or chapter 7)

2. 2 Agenda  How forex futures quoted & used for speculation?  Futures vs. forwards?  How forex options are quoted?  Speculate w/ forex options.  Distinction b/n buying & writing options?  How forex options are valued?

3. 3 Forex Futures  Future delivery of standard amount of currency @ fixed time & price. Traded @ Chicago Mercantile Exchange (CME).  Specifications: Size –notional principal, in even multiple. Method of stating exchange rates – “American terms” used. Maturity date –mature on 3 rd Wed/ 01, 03, 04, 06, 07, 09, 10, or 12. Last trading day – contracts may trade through 2 nd business day prior to maturity. Collateral & maintenance margins –purchaser/trader must deposit initial margin or collateral. –Daily marked-to-market Settlement –round turn fee. Use of a clearing house as a counterparty

4. 4 Futures Speculation MaturityOpenHighLowSettleChangeHighLow Open Interest Mar.10953.10988.10930.10958---.11000.0977034,481 June.10790.10795.10778.10773---.10800.097303,405 Sept.10615.10610.10573---.10615.099301,4181 Source: Wall Street Journal, February 22, 2002, p.C13 500,000 New Mexican pesos. Short Position – believes that the value of the Peso will fall Long Position - believes that the value of the Peso will rise Value at maturity (Short) = - Principal  (Spot – Future) = -P S 500,000  ($0.09500/ P S - $.10958/ P S ) = $7,290, assuming spot rate of $.09500/P s @ maturity. Value at maturity (Long) = Principal  (Spot – Forward) = P S 500,000  ($0.11000/ P S - $.10958/ P S ) = $210, assuming spot rate of $.11000/P s @ maturity.

5. 5 Forex Futures vs. Forwards CharacteristicForeign Currency FuturesForward Contract Size Standardized any size desired Maturityfixed maturitiesany maturity up up to a year Locationorganized exchangeb/n individuals & banks Pricingopen outcry bid/ask quotes Margin/Collateraldaily marked to marketno collateral Settlementrarely delivered, settlement contract delivered, through offsettingcan offset position Feessingle commission for purchase& sellbid/ask spread Trading hoursexchange hours24 hours Counterpartiesthrough clearing housedirect contact Liquidityvery liquid liquid, relatively large market

6. 6 Initial Margin Requirements  Held as collateral by broker.  Usually 2-4% of contract value.  Margin amount same for short & long positions.  Buyer holds a long position (seller – short).  If settlement price higher than yesterday, buyer has a positive settlement for the day.  Long position now worth more.  Exact opposite for seller (zero-sum game).

7. 7 Open Interest Open Interest refers to the number of contracts outstanding for a particular delivery month. Initially open interest is zero. Increases over time, until positions are liquidated. Total open interest is the total number of outstanding positions in all the delivery months of a futures market. Liquidity = at least 5,000 outstanding contracts. http://www.activetradermag.com/futuresbasics.htm

8. 8 Reversing Trades  Rare in forward markets –90% of all contracts lead to delivery.  Common in futures markets – only 1% of contracts lead to delivery!

9. 9 Forex Option  Gives right but not obligation to buy/sell amount of currency @ fixed price for given time period Call – buyer has right to purchase Put – buyer has right to sell Buyer = holder & seller = writer.  Two option types American: may exercise during life of option. European: may not exercise until maturity.  Price elements Strike (exercise price): exchange rate @ which foreign currency can be purchased/ sold. Premium, price of option Spot rate

10. 10 Forex Options  May be classified as: At-the-money (ATM): exercise price = spot rate. In-the-money (ITM) options profitable, excluding premium, if exercised immediately. Out-of-the-money (OTM) options not profitable, excluding premium, if exercised immediately.  Markets for derivatives: OTC Market Organized exchanges - Chicago Mercantile and the Philadelphia Stock Exchange –Option Clearinghouse Corporation

11. 11 Futures Contracts vs. Options  Futures Contract – you’ve agreed to purchase/sell the contract. No backing out. Can offset/ exit by buying/selling to someone else. Buy = long; sell = short.  Option – contract that gives you the right but not the obligation to purchase/sell something at pre- specified terms. No commitment.

12. 12 Forex Options Markets  Swiss Franc options (WSJ)  Call premium: SF 62,500 x $0.0050/SF = $312.50. Each option = 62,500 Swiss francs.

13. 13 Speculation  Assume spot rate: $0.5851/SF, 6m forward: $0.5760/SF.  Spot market $100,000. Expect six month spot SF $0.6000/SF. Step 1: purchase SF 170,910.96 @ spot $0.5851/SF. Step 2: sell at target spot rate of $0.60/SF.  Forward market Step 1: Buy forward SF173,611.11 x $0.576/SF= $100,000. Step 2: In 6m, fulfill forward & sell proceeds in spot market Sfr173,611.11 x $0.6000/Sfr = $104,166.67.  Options market Long Call, Short Call, Long Put, Short Put.

14. 14 For Example…  Suppose that: you have $10 m. Wish to speculate on Euro S = $ 0.885/ EUR, F 30 = $ 0.900/ EUR. –You expect S 30 = $ 0.844/ EUR (EUR depreciates). –Arbitrage strategy? –You expect S 30 = $ 0.944/ EUR (EUR appreciates). –Arbitrage strategy?

15. 15 Profit & Loss Buyer of Call (Long Call) Loss Profit (US cents/SF) + 1.00 + 0.50 0 - 0.50 - 1.00 57.558.059.059.558.5 Limited loss Unlimited profit Break-even price Strike price OTMITM ATM Spot price (US cents/SF) Profit = Spot rate – (Strike price + Premium) Profit = ? if Spot = $ 0.595/ SF. C eT = Max[S T - E, 0]

16. 16 Profit & Loss Writer of Call (Short Call) Loss Profit (US cents/SF) + 1.00 + 0.50 0 - 0.50 - 1.00 57.558.059.059.558.5 Limited profit Unlimited loss Break-even price Strike price ATM Spot price (US cents/SF) Profit = Premium – (Spot rate - Strike price). Profit = ? if Spot = $ 0.595/ SF. C eT = Max[S T - E, 0]

17. 17 Profit & Loss for Buyer of Put (Long Put) Loss Profit (US cents/SF) + 1.00 + 0.50 0 - 0.50 - 1.00 57.558.059.059.558.5 Limited loss Profit up to 58.0 Strike price “In the money”“Out of the money” “At the money” Spot price (US cents/SF) Break-even price Profit = Strike price – (Spot rate + Premium) Profit = ? if Spot = $ 0.575/ SF. P aT =P eT =Max[E - S T, 0]

18. 18 Profit & Loss for Writer of Put (Short Put) Loss Profit (US cents/SF) + 1.00 + 0.50 0 - 0.50 - 1.00 57.558.059.059.558.5 Unlimited loss up to 58.0 Limited profit Strike price Spot price (US cents/SF) Break-even price “At the money” Profit = Premium – (Strike price - Spot rate) Profit = ? if Spot = $ 0.575/ SF. P aT =P eT =Max[E - S T, 0]

19. 19 For Example…  Suppose that: You wish to speculate on fall of Yen vs. $. Current S = Yen 120/ $ (or $.00833/Yen). Maturity: 90 days. Expected S 90 = Yen 140/$ (or $.00714). Two options available: Call on YenPut on Yen –Strike: Yen 125/$Yen 125/$. (or $.008/ Yen) (or $.008/ Yen) –Premium: $.00046 $.00003 1.What option to buy? 2.Break even price on option of choice? 3.If S= Yen 140/ $, what is net profit?

20. 20 Option Pricing  Market value = Time value + Intrinsic Value  Intrinsic Value –gain if option exercised immediately. Will reach zero when the option is OTM. At maturity, option value = intrinsic value.  Time Value – reflects a gamble that the option might be more profitable (more in-the-money) as time passes (i.e. before time of expiry).

21. 21 1.691.701.711.721.731.681.671.66 0.0 1.0 2.0 3.0 4.0 5.0 Spot rate ($/£) Option Premium (US cents/£) 6.0 1.74 4.00 Intrinsic value 3.30 5.67 1.67 Total value Time value -- Valuation on first day of 90-day maturity -- Strike Price of $1.70/£ Market-, Time- & Intrinsic Value European Call on Brit Pound

22. 22 Option Volatility  Standard deviation of daily % changes in underlying exchange rate, usually stated per annum, e.g. 12.6 %. Can obtain daily volatility  Volatility estimates: Historic. Forward-looking. Implied.

23. 23 Replicating Portfolio Evaluation  Suppose US$-EUR rate is S 0 ($/EUR) = $1.  S 1 ($/ EUR) is $1.10 or $0.90.  Consider call w/ K=$1/EUR (exercise price).  Can replicate payoffs of call w/ levered position in EUR.  Borrow PV $.90 today & buy1 EUR.  Net payoff: $0.20 or $0.  Portfolio value: so option value: $1 $0.90 $1.10 S 0 ($/EUR) S 1 ($/EUR) C 1 ($/EUR) $0.10 $0 Debt Portfolio -$0.90 $0.20 $0.00

24. 24 Rogue Trading: Good Fellas…  Nick Leeson @ Barings. 1995, managed to bankrupt Barings Brothers (UK).  John Rusnak @ Allied Irish Bank. 2002, lost $691 m on behalf of Allied Irish Bank (Baltimore office).

25. 25 Things to remember  Futures terminology.  Futures vs. Forwards.  Speculation In spot & forward markets. In option markets.  How forex options are quoted?  Distinction b/n buying & writing options.  How forex options are valued?