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Chapter Seven
Futures and Options on
Foreign Exchange

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 Chapter Outline
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Foreign Currency Derivatives Basic Option-Pricing
.

Relationships at Expiration
Forward and Futures Contracts
Basic Call Option Profit Profiles
Futures Contracts: Preliminaries
Basic Put Option Profit Profiles
Daily Resettlement
American Option-Pricing
Currency Futures Markets
Relationships
Basic Currency Futures
European Option-Pricing
Relationships
Relationships
Options Contracts
Binomial Option-Pricing Model
Currency Options Markets European Option-Pricing Formula
Currency Futures Options Empirical Tests of Currency
Options

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 Foreign Currency Derivatives
The value of derivative or contingent claim securities are
derived from or contingent upon the value of the underlying
security.
Derivative instruments can be used for two very distinct
management objectives:
投機
^• Speculation: use of derivative instruments to take a
position and attempt to profit from a change in price.
避險
• Hedging: use of derivative instruments to avoid price
霽 variation and reduce risk.

龗 foward marketisalsoaderivativemarlket
.

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 Forward and Futures Contracts
Forward and future contracts are derivative securities that
involve an agreement to buy or sell an asset in the future at
prices agreed upon today.
Key difference between forward and future contracts:
• Forward contracts are tailor-made for a client by their
international bank.
• Futures contracts are standardized contracts trading on
organized exchanges with daily resettlement through a
clearinghouse.
交易 S所

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 Differences between Futures and Forward
Contract 1

Trading Location
Futures: Traded competitively on organized exchanges.
Forward: Traded by bank dealers via a network of telephones and computerized
dealing systems.
Contractual Size
Futures: Standardized amount of the underlying asset.
Forward: Tailor-made to the needs of the participant.
Settlement
Futures: Daily settlement, or marking-to-market, done by the futures
clearinghouse through the participant's performance bond account.
Forward: Participant buys or sells the contractual amount of the underlying asset
from the bank at maturity at the forward (contractual) price.

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 Differences between Futures and Forward
Contract 2

Delivery
Futures: Delivery of the underlying asset is seldom made. Usually a reversing
trade is transacted to exit the market.
Forward: Delivery of the underlying asset is commonly made.
Trading Costs 經理⼈傭⾦
Futures: Bid-ask spread plus broker’s commission.
Forward: Bid-ask spread plus indirect bank charges via compensating balance
requirements.

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 Futures Contracts: Preliminaries 1

An initial performance bond (formerly called margin) must

be deposited into a collateral account to establish a futures
position
• Generally equal to 2% of contract value.
• Cash or T-bills may be used to meet requirement.
⼀種債券
Futures contract is settled-up, or marked-to-market, daily
at the settlement price, unlike one big settlement at maturity
with forward contracts.

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 Daily Resettlement
Every trading day:
if the price goes down:
• The long pays the short because the long had locked in a
future price that is now higher than the current price.
if the price goes up:
• The short pays the long because the long had locked in a
future price that is lower than the current price.
After the daily resettlement, a futures contract is analogous
to a new forward contract on the underlying asset at the new
settlement price with one-day-shorter maturity.

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 Currency Futures Markets 1

Trading in currency futures began at the Chicago Mercantile

Exchange (CME) on May 16, 1972
• 2 million contracts traded in 1978.
• 23 million contracts traded in March 2022 alone.
CME Group formed in 2007, through a merger between the
CME and Chicago Board of Trade (CBOT).
In 2008, CME Group acquired the New York Mercantile
Exchange (NYMEX).
Currency futures trading takes place on other exchanges,
such as the Intercontinental Exchange (ICE) Futures U.S.
and the Mexican Derivatives Exchange.

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 Currency Futures Markets 2

Most CME currency futures trade in a March, June,

September, and December expiration cycle out six quarters
into the future, with the delivery date being the third
Wednesday of the expiration month
• Last day of trading for most contracts is the second
business day prior to the delivery date.

Trading takes place Sunday through Friday on the GLOBEX

trading system from 5:00 P M to 4:00 P M Chicago time the
next day.

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 Basic Currency Futures Relationships

Information provided on quotes forCME futures contracts

includes the following:
• Opening price, high and low quotes for the trading day,
settlement price, and open interest.
• Open interest is the total number of short or long
contracts outstanding for the particular delivery month.

Futures are prices very similar to forward contracts

Recall from Chapter 6, the IRP model states the forward
price for delivery at time T as:
(1 + i$ )T
FT ($ / f ) = S0 ($ / f )
(1 + i f )T

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 Options Contracts
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.

Call option Put option

Call option gives the holder the right, Put option gives the holder the right,
but not the obligation, to buy the but not the obligation, to sell the
underlying asset. underlying asset.

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 Option Contracts: Terminologies
• Buying or selling the underlying asset via the option is
known as “exercising” the option.
• Stated price paid or received is known as the exercise or
strike price.
• Buyer of an option is often referred to as the long, and the
seller of an option is referred to as the writer (or the short).
• Premium is the price of the option contract that must be
paid upfront by the option buyer.
• European option can be exercised only at maturity or
expiration date of contract, but American option can be
exercised any time during contract.

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 Currency Options Markets
Prior to 1982, all currency options contracts were OTC
options written by international banks, investment banks, and
brokerage houses
• OTC options are tailor-made and generally for large
amounts (that is, at least $1M of currency serving as
underlying assets).
• OTC options are typically European style, and they are
often written for U.S. dollars, with the euro, British pound,
Japanese yen, Canadian dollar, and Swiss franc serving
as the underlying currency.
In December 1982, the Philadelphia Stock Exchange (PHLX)
began trading options on foreign currency. In 2008, the PHL
X was acquired by the NASDAQ OMX Group.
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 Currency Futures Options
CME Group trades European style options on several of the
currency futures contracts it offers
• With these, the underlying asset is a futures contract on the
foreign currency instead of the physical currency.
• One futures contract underlies one options contract.

Most CME futures options trade with expirations in the March,

June, September, December expiration cycle of the underlying
futures contract and three serial noncyclic months
• Options expire on the second business day prior to the third
Wednesday of the options contract month.
• Trading takes place Sunday through Friday on the GLOBEX
system from 5:00 P M to 4:00 P M Chicago time the next day.

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 Basic Option-Pricing Relationships at
Expiration 1

At expiration, a European option and an American option

(which has not been previously exercised), both with the
same exercise price, will have the same terminal value
For call options, the time T expiration value per unit of
foreign currency is stated as the following:

CaT = CeT Max[ST − E ,0]

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 Basic Option-Pricing Relationships at
Expiration 2

Call (put) option with ST  E ( E  ST ) expires in-the-money

• It will be exercised because the buyer will make money.

If ST = E , the option expires at-the-money

• It will not be exercised because no money will be made by
doing so.

If ST  E ( E  ST ), the call (put) option expires out-of-the-money

• It will not be exercised because the buyer would lose
money by doing so and is under no obligation to exercise
the option.

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 Basic Call Option Profit Profiles
If the call is in-the-money, it
is worth ST  E.
If the call is out-of-the-
money, it is worthless, and
the buyer of the call loses
his entire investment of
c0 .

Access the text alternative for slide images.

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 Basic Put Option Profit Profiles
If the put is in-the-money, it is worth E − ST . The maximum
gain is E − p0 .
If the put is out-of-the-
money, it is worthless,
and the buyer of the
put loses his entire
investment of p0 .

Access the text alternative for slide images.

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 American Option-Pricing Relationships 1

American options will satisfy the following basic pricing

relationships at time t prior to expiration:

Ca  Max  ST − E , 0 Pa  Max  E − ST , 0

The above equations state that the American call and put
premiums at time t will be at least as large as the immediate
exercise value, or the intrinsic value, of the call or put
option
A longer-term American option will have a market price at
least as large as the short-term option.

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 American Option-Pricing Relationships 2

Call option Put option

ST  E In-the-money Out-of-the-money
ST  E All-the-money All-the-money
ST  E Out-of-the-money In-the-money

Difference between the option premium and the option’s

intrinsic value is nonnegative and is sometimes referred to as
the option’s time value.

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 Market Value, Time Value, and Intrinsic
Value of an American Call Option

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 European Option-Pricing Relationships 1

Pricing boundaries for European put and call premiums are more complex
Consider two portfolios:
Portfolio A involves purchasing a European call option and lending (or investing) an
amount equal to the present value of the exercise price, E, at the U.S. interest rate,
i$ , which we assume corresponds to the length of the investment period.

• Cost of this investment is as follows: Ce + E / (1 + i$ ) .

• If ST  E , call owner will let call option expire worthless.

• If ST  E , call owner will exercise the call, and exercise value will be ST − E  0.

Portfolio B consists of lending the present value of one unit of foreign, currency, f,
at the foreign interest rate i f , which we assume corresponds to the length of
the investment period.
• Cost of this investment is Si / (1 + i f ).

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 Equation for a European Call Option
Lower Boundary

Curent Time Expiration

ST  E ST  E
Portfolio A :
Buy Call −C e 0 St − E
− E / (1 + i$ ) E E
Lend PV of E at i$ .
−Ce − E / (1 + i$ ) E ST
Portfolio B :

Lend PV of one unit of − St / (1 + i f ) ST ST

currency f at rate i f

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 European Option-Pricing Relationships 2

In a rational marketplace, portfolio A will be priced to sell for

at least as much as portfolio B, implying the following:

 S E 
Ce  Max  T
− ,0 
 (1 + i f ) (1 + i$ ) 

Similarly, it can be shown that the lower boundary pricing

relationship for a European put is:
 E St 
Pe  Max  − ,0 
 (1 + i$ ) (1 + i f ) 

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 European Option-Pricing Relationships 3

Based on the two equations from the preceding slide, it can be

determined that, when all else remains the same, the call
premium Ce (put premium, Pe ) will increase:

• The larger (smaller) is the exchange rate, St .

• The smaller (larger) is the exercise price, E.
• The smaller (larger) is the foreign interest rate, i f .

• The larger (smaller) is the dollar interest rate, i$ .

• The larger (smaller) i$ is relative to i f .

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 European Call and Put Prices on Spot
Foreign Exchange
Equations 7.6 and 7.7 (see slide 24) may be restated as the
following:

 ( FT – E ) 
Ce  Max  , 0
 (1 + i$ ) 

 ( E – FT ) 
Pe  Max  , 0
 (1 + i$ ) 

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 Binomial Option-Pricing Model 1

Binomial option-pricing model provides an exact pricing formula for a European call
or put
In this case, binomial model assumes that at the end of the option period, the
underlying foreign exchange has either appreciated one step upward or
depreciated one step downward from its initial value
Objective is to value the PHLX 112 Sep EUR European call
• Option is quoted at a premium of 3.78 cents.
• Current spot price of the EUR in American terms is S0 = 113.14 cents

• Estimate of the option’s volatility is  = 6.18%.

• Last day of trading in the call option is in 179 days on 9/20/19.
• At the end of the option period, the EUR will have appreciated to SuT = S0 .u
or depreciated to Sd = S0 .d .

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 PHLX World Currency Options Quotations
NASDAQOMXPHLX Options Calls Puts
Japanese Yen
1,000,000 J.Yen-100ths of a cent per unit.
109 Jun 1.56 1.30
110 Jun 1.05 1.78
111 Jun .66 2.38
112 Jun .39 3.10
109 Sep 1.86 2.32
110 Sep 1.40 2.89
111 Sep 1.03 3.53
112 Sep .74 4.24
Euro 113.14
10,000 Euro-cents per unit.
111 Jun 3.41 .41
111.5 Jun 3.01 .50
112 Jun 2.63 .62
112.5 Jun 2.28 .75
113 Jun 1.94 .91
111 Sep 4.54 .72
112 Sep 3.78 .94
113 Sep 3.09 1.23
114 Sep 2.47 1.59
115 Sep 1.92 2.04

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 Binomial Option-Pricing Model 2

Binomial option-pricing model relies on the risk-neutral probabilities of the

underlying asset increasing and decreasing in value
Risk-neutral probability of the EUR appreciating is:
q = (F − S  d ) S (u − d )
T 0 0

Use September EUR futures price on 3/25/19 as estimate of F $/EUR = $ 1.1487T

• Therefore, q = (114.87−108.35)/(118.14−108.35)=0.666

Binomial call option premium is determined by:

C = [qC + (1 − q ) C ] (1 + i )
0 uT dT $

= ? 666 ( 6.14 ) + .334 ( 0 )  (1.0133)

= 4.04 cents per EUR

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 Schematic of Binomial Option-Pricing
Example

Access the text alternative for slide images.

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 European Option-Pricing Formula
When the number of subperiods into which the option period
is subdivided goes to infinity, the European call and put
pricing formulas presented (below) are obtained
Exact European call and put pricing formulas:

( ) – Ee ( )
−i T −i T
f $
Ce = S t e N d1 N d2

(? d ) (? d )
−i T −i T
$ f
Pe = Ee N 2
St e N 1

Invoking IRP allows us to restate these as follows:

[
C e = FT N d 1 ( ) – EN ( d )]e − i$T
2

− i$T
[ (? d )
Pe = EN 2
FT N (– d )]e
1

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 Empirical Tests of Currency Options
Brenner et al. (2001)
• Illiquid options are priced lower than similar options traded
on an exchange.
Hoque et al. (2008)
• Currency options prices generally do not violate conditions
such as put-call parity when transaction costs are
incorporated.

Poitras et al. (2009)

• Estimated the early exercise premium for American
currency options traded on the PHLX were about 5.03% on
average for put options and 4.60% for call options.

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