Lecture 9.

Futures and Options

on Foreign Exchange
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:
• Speculation: use of derivative instruments to take a position and attempt to
profit from a change in price.
• Hedging: use of derivative instruments to avoid price variation and reduce
risk.
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.
Differences between Futures and Forward
Contract
• 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.
Differences between Futures and Forward
Contract
• 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
• Futures: Bid-ask spread plus broker’s commission.
• Forward: Bid-ask spread plus indirect bank charges via compensating balance
requirements.
Futures - Trading Mechanics
• Trading is overwhelmingly conducted through electronic networks,
particularly for financial futures.
• Once a trade is agreed to, the clearinghouse enters the picture.
• Rather than having the long and short traders hold contracts with each other, the
clearinghouse becomes the seller for the long position and the buyer for the
short position.
• As such, the net position of the clearinghouse is zero.
• Most futures contracts are closed out by reversing trades.
• If you are currently long and want to undo your position, you simply instruct
your broker to enter the short side of a contract.
• Only 1% to 3% of contracts result in actual delivery of the underlying commodity.
Futures - Trading Mechanics
Trading with/without a Clearinghouse
Futures Contracts
• 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.
• Futures contract is settled-up, or marked-to-market, daily at the
settlement price, unlike one big settlement at maturity with forward
contracts.
• Maintenance margin is the established value below which a trader’s
margin may not fall.
• Reaching the maintenance margin triggers a margin call.
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.
Currency Futures Markets
• 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.
• Most CME currency futures trade in a March, June, September, and
December expiration cycle out six quarters (18 months) into the
future, with the delivery date being the third Wednesday of the
expiration month.
• The size of a currency future contract, often referred to as the
"contract size" or "lot size," is a standardized quantity of the currency
being traded.
Currency Futures Markets
• Common Contract Sizes: The contract size varies depending on the
currency pair being traded.

CME Group Currency Futures Contract Size

Currency Contract Size Currency Contract Size
Australian Dollar AUD100,000 Euro EUR125,000
Brazilian real BRL100,000 Japanese yen JPY12,500,000
British pound GBP62,500 Korean won KRW125,000,000
Canadian dollar CAD100,000 Mexican peso MXN500,000
Chinese renminbi CNY1,000,000 Swiss franc CHF125,000

Source: https://www.cmegroup.com/
Basic Currency Futures Relationships
• Information provided on quotes for CME 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 priced very similarly to forward contracts.
• The IRP model states the forward price for delivery at time T as:
1 + 𝑖$ !
𝐹! ($/𝑓) = 𝑆" ($/𝑓) !
1 + 𝑖$
• The same equation can be used to define the futures price.
CME Group Currency Futures
Contract Quotations

Source: https://www.cmegroup.com/
Examples
• Suppose a trader takes a position on April 3, 2019, in one September
2019 euro futures contract at $1.13955/€. The trader holds the position
until the last day of trading when the spot price is $1.12405/€.
• If the trader had a long position in one contract:
• A cumulative loss of -$1,937.50[= (S1.12405 - $1.13955) × €125,000] from April 3
through September 18.
• This amount would be subtracted from his margin account as a result of daily
marking-to-market.
• If the trader had a short position in one contract:
• A cumulative profit of $1,937.50 = ($1.13955 - $1.12405) x €125,000 from April 3
through September 18.
• This amount would be added to his margin account as a result of daily marking-
to-market.
Problem 1
Solution 1
• Today’s settlement price: $1.3140/€
• A balance of current performance bond account: $1,700
• Next three days’ settlement prices: $1.3126/€; $1.3133/€; 1.3049/€

A Short Position in one contract (€125,000)

• Day 1: ($1.3140/€ - $1.3126/€)×€125,000=$175; $1,700+$175=$1,875
• Day 2: ($1.3126/€ - $1.3133/€)×€125,000=-$87.5; $1,875-$87.5=$1,787.5
• Day 3: ($1.3133/€ - $1.3049/€)×€125,000=$1,050; $1787.5+$1,050=$2,837.5
Solution 1
A long position in one contract
• Day 1: ($1.3126/€ - $1.3140/€)×€125,000=-$175; $1,700-$175=$1,525
• Day 2: ($1.3133/€ - $1.3126/€)×€125,000=$87.5; $1,525+$87.5=$1,612.5
• Day 3: ($1.3049/€ - $1.3133/€)×€125,000=-$1,050; $1,612.5-$1,050=$562.5

• With only $562.50 in your performance bond account, you would experience a
margin call requesting that additional funds be added to your performance
bond account to bring the balance back up to the initial performance bond
level.
Problem 2
4. The June 2019 Mexican peso futures contract has a price of
$0.05143 per MXN. You believe the spot price in June will be $0.05795
per MXN. What speculative position would you enter into to attempt to
profit from your beliefs? Calculate your anticipated profits, assuming
you take a position in three contracts. What is the size of your profit
(loss) if the futures price is indeed an unbiased predictor of the future
spot price and this price materializes?

5. Do problem 4 again assuming you believe the June 2019 spot price
will be $0.04491 per MXN.
Solution 2
• If you expect the Mexican peso to appreciate to $0.05795 per MXN,
you would take a long position in futures since the futures price of
$0.05143 is less than your expected spot price.
• Your anticipated profit from a long position in three contracts is:
• 3 × ($0.05795 − $0.05143) × MXN500,000 = $9,780 where MXN500,000 is the
contract size of one MXN contract.
• If the futures price is an unbiased predictor of the expected spot price,
the expected spot price is the futures price of $0.05143 per MXN. If
this spot price materializes, you will not have any profits or losses from
your long position in three futures contracts: 3 × ($0.05143 −
$0.05143) x MXN500,000 = 0.
Solution 2
• If you expect the Mexican peso to depreciate to $0.04491 per MXN,
you would take a short position in futures since the futures price of
$0.05143 is greater than your expected spot price.
• Your anticipated profit from a short position in three contracts is:
• 3 × ($0.05143 − $0.04491) × MXN500,000 = $9,780, where MXN500,000 is the
contract size of one MXN contract.
• If the futures price is an unbiased predictor of the future spot price
and this price materializes, you will not profit or lose from your short
futures position.
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.
• Call holder will exercise only if price • Put will only be exercised if the price
of underlying asset is more than of the underlying asset is less than
exercise price. the exercise price.
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.
Options Contracts: Terminologies
Market and Exercise Price Relationships
• In the money occurs when exercise would produce positive cash flow.
• Call option is in the money when the asset price is greater than the exercise
price.
• Put option is in the money when the asset price is less than the exercise price.
• Out of the money – exercise would result in a negative cash flow.
• At the money – exercise and asset prices are equal.
American and European Options
• American option allows its holder to exercise the right to purchase (if
a call) or sell (if a put) the underlying asset on or before the expiration
date.
• Generally, more valuable than European options.
• Most traded options in the United States are American-style, except foreign
currency and stock index options.
• European options allow for exercise of the option only on the
expiration date.
Examples: Stock Options
Stock Options on Microsoft, September 10, 2021
Profit and Losses on a Call Option
• October Call option on Microsoft.
• Exercise price: $300.
• Premium: $3.60 (on September 10).
• The option expires on October 1, 2021.
• If Microsoft remains below $300, the call will expire worthless.
Profit and Losses on a Call Option
• If Microsoft sells for $303 on October 1, 2021, the option will be
exercised.
• Value at expiration = Stock price − Exercise Price
• $303 − $300 = $3.00
• Profit = Value at Expiration − Original Investment
• $3.00 − $3.60 = −$0.60
• Call buyer will clear a profit if Microsoft is selling above $303.60 at the
expiration date.
Values of Options at Expiration – Call Holder
• The value of the call option at expiration equals.
ì ST - X if ST >X
Pay off to call holder = í
î 0 if ST £ X

where
• ST is the value of the stock at expiration.
• X is the exercise price.
• Call is exercised only if 𝑆! > 𝑋
Values of Options at Expiration – Call Writer
• Call writer incurs losses if the stock price is high, in which case the
writer will receive a call and will be obligated to deliver an asset
worth ST for only X dollars

ì- ( ST - X ) if ST >X
Payoff to call writer = í
î 0 if ST £ X
Payoff and Profit to Call Option at Expiration

Exercise price
Payoff and Profit to Call Writer at Expiration

Exercise price
Values of Options at Expiration—Put Holder
• Holder will not exercise the option unless the asset is worth less than
the exercise price.
• Value of a put option at expiration.
ì 0 if ST ³ X
Payoff to put holder = í
î X - ST if ST < X
Values of Options at Expiration—Put Writer
• Writing puts naked (i.e., writing a put without an offsetting short
position in the stock) exposes the writer to losses if the market falls.
• Naked, deep-out-of-the-money puts were once considered attractive ways to
generate income.
• Market crash causes writers using this strategy to suffer huge losses.
Option Versus Stock Investments
• Why would you purchase a call option rather than buy shares of stock
directly?
• Example:
• Suppose you think a stock, currently selling for $100, will appreciate.
• A 1-year maturity call option with exercise price $100 currently sells for $10,
and the interest rate is 3%.
• You have $10,000 to invest.
Option Versus Stock Investments
Strategies.
A. Invest entirely in stock.
• Buy 100 shares, each selling for $100.
B. Invest entirely in at-the-money call options.
• Buy 1,000 calls, each selling for $10.
C. Invest in call options and T-bills.
• Purchase 100 call options for $1,000.
• Invest your remaining $9,000 in 1-year T-bills, to earn 3% interest. (The bills
will grow in value from $9,000 to $9,000 × 1.03 = $9,270.).
Strategy Payoffs
Dollar Payoff
Portfolio $95 $100 $105 $110 $115 $120
Portfolio A: All stock $9,500 $10,000 $10,500 $11,000 $11,500 $12,000
Portfolio B: All options 0 0 5,000 10,000 15,000 20,000
Portfolio C: Call plus T-bills 9,270 9,270 9,770 10,270 10,770 11,270

Rate of Return
Portfolio $95 $100 $105 $110 $115 $120
Portfolio A: All stock −5.0% 0.0% 5.0% 10.0% 15.0% 20.0%
Portfolio B: All options −100.0 −100.0 −50.0 0.0 50.0 100.0
Portfolio C: Call plus T-bills −7.3 −7.3 −2.3 2.7 7.7 12.7
Rate of Return to Three Strategies
Strategy Conclusions
• An option offers leverage.
• Values respond more than proportionately to changes in stock price, as seen
in portfolio B.
• Portfolio C, T-bill-plus-option strategy, shows the insurance value of
options.
• Portfolio C’s T-bill-plus-option portfolio cannot be worth less than
$9,270 at the end of the year.
• Some return potential is sacrificed to limit downside risk.
• Portfolio C underperforms A by 9.33% when share price rises.