1. 1 CHAPTER 7 CURRENCY FUTURES AND OPTIONS MARKETS CHAPTER OVERVIEW I.FUTURES CONTRACTS II.CURRENCY OPTIONS

2. 2 PART I. FUTURES CONTRACTS I.CURRENCY FUTURES A.Background 1.Long history 2.Extremely volatile due to information driven nature 3.Price Discovery Role

3. 3 FUTURES CONTRACTS B. 1972: Chicago Mercantile Exchange opens the 1.Purpose: provides an outlet for currency speculators and hedgers 2.International Monetary Market (IMM) Board of Directors sets delivery dates

4. 4 FUTURES CONTRACTS C.Futures Contract Definition: contracts written requiring 1. standard quantity of an available currency 2.at a fixed exchange rate 3. at a set delivery date.

5. 5 FUTURES CONTRACTS: 1. British pound 2. Canadian dollar 3. Euro 4. Swiss franc 5. Japanese yen 6. Mexican peso 7. Australian dollar 8.Brazilian real 9.Czech koruna 10.Hungarian florint 11.Norwegian krone 12.Polish zloty 13.Russian ruble 14.South African rand 15.New Zealand $ 16.Swedish krona D.Available in

6. 6 FUTURES CONTRACTS E.Transaction costs: commission payment to a floor trader commission payment to a floor trader F.Leverage is high 1.)Initial margin required is relatively low (less than 2% of contract value).

7. 7 FUTURES CONTRACTS: SAFEGUARDS G.What are the market’s built-in safeguards? 1.Contracts set to a daily price limit restricting maximum daily price movements. 2.If limit is reached, a margin call may be necessary to maintain a minimum margin.

8. 8 FUTURES CONTRACTS: SAFEGUARDS 3.Marking to Market 4. Eliminating default CME may step in to complete the transaction if either side defaults 5. Delivery cancelled CME allows for offsetting transactions cancelling delivery or purchase of the currency

9. 9 FUTURES CONTRACTS H.Global futures exchanges: 1.I.M.M. International Monetary Market 2.L.I.F.F.E.London International Financial Futures Exchange 3.C.B.O.T. Chicago Board of Trade 4. S.I.M.E.X.Singapore International Monetary Exchange 5.D.T.B. Deutsche Termin Bourse 6.H.K.F.E. Hong Kong Futures Exchange

10. 10 FUTURES CONTRACTS 1. Trading Locations 2.Regulation 3. Frequency of delivery 4. Size of contract 5. Transaction Costs 6. Quotes 7. Margins 8. Credit risk I.Forward vs. Futures Contracts Basic differences:

11. 11 FUTURES CONTRACTS Advantages of futures: 1. High leverage(2%) 2. Easy liquidation 3. Well- organized and stable market. Disadvantages of futures: 1. Limited to 7 currencies currencies 2. Limited dates of delivery of delivery 3. Rigid contract sizes. sizes. J. Why would you use them?

12. PART II CURRENCY OPTIONS

13. 13 Part II. CURRENCY OPTIONS I.OPTIONS A. Currency options 1.offer another product to hedge exchange rate risk. 2.first offered on Philadelphia Exchange (PHLX).

14. 14 CURRENCY OPTIONS B. Definition: a contract from a writer ( the seller) that gives 1.the right not the obligation to the holder (the buyer)to buy or sell 2.a standard amount of an available currency at 3.a fixed exchange rate for a fixed time period.

15. 15 CURRENCY OPTIONS C.Two Types: Based on Exercise Dates 1.American exercise date may occur any time up to the expiration date. 2.European exercise date occurs only at the expiration date and not before.

16. 16 CURRENCY OPTIONS D.Exercise Price (exchange rate) 1. Sometimes known as the strike price. 2.The exchange rate at which the option holder can buy or sell the contracted currency.

17. 17 CURRENCY OPTIONS E.Types of Currency Options 1.Calls give the holder the right to buy a certain amount of currency at a fixed exchange rate. 2.Puts give the holder the right to sell a certain amount of currency at a fixed exchange rate.

18. 18 CURRENCY OPTIONS F.Status of an option 1.In-the-money Call:Spot > strike Put:Spot < strike 2.Out-of-the-money Call:Spot < strike Put:Spot > strike 3.At-the-money Spot = the strike

19. 19 CURRENCY OPTIONS G.What is the premium? 1.the price of an option that the writer charges the buyer 2. consider it a risk premium to the writer

20. 20 CURRENCY OPTIONS H. Why Use Currency Options? 1.For the firm hedging foreign exchange risk with Future event is very uncertain gains. 2.For speculators - profit from favorable exchange rate changes.

21. 21 CURRENCY OPTIONS I. Using Forward or Futures Contracts Forward or futures contracts are more suitable for hedging a known amount of foreign currency flow. Examples: accounts payable/receivables

22. 22 Options Sample Problems Ford buys a Franc put option (contract size: FF250,000) at a premium of $.01/FF. If the exercise price is $.21 and the spot at expiration is $.216, what is Ford’s profit (loss)?

23. 23 SOLUTION REVENUES: Sell at.21 COSTS:If exercised Buy at.216 Premium +.01 Total.226 Loss: If exercised:$4,000 Loss: If not exercised: $2,500 (= the original premium)