Special Topics 6:

Multinational
Finance

Introduction to
Derivatives: Options
and Futures
Professor Anthony R Sanichara
Andrews University

Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned,
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What are futures and options contracts?
➢Futures and options are known as derivative securities: Instruments whose
value is determined or derived by the value of some underlying asset (in this
case a currency pair).
➢Other types of derivatives include:
• Forward contracts
• Swaps

➢Types of derivatives traders:

• Hedgers: would like to reduce or eliminate their risk exposures (for instance
airlines would like to reduce their exposure to increases in oil prices).
• Speculators: would like to profit from taking on the risk.
• Arbitrageurs: would like to make riskless profits with no (or little) invested
capital by taking advantage of deviations between the price of the derivative
and the price implied by the underlying asset. quick transaction
A history of currency derivatives

• While currency derivatives have existed for a long time, their popularity soared
in the 1970’s. Why?
• Recall that in 1971, the Bretton Woods system of fixed exchange rates ended and
exchange rates became highly volatile.
• Under the fixed exchange rate system MNCs bore little foreign exchange rate risk
and found little use for currency derivatives.
• After the collapse of Bretton Woods, MNCs faced significant exchange rate risk
exposures to their domestic and foreign operations. Changes in exchange rates
could make foreign competitors more (or less) attractive (both at home and
abroad), increase (or decrease) the MNCs costs from foreign suppliers, decrease
(or increase) the value of foreign assets, etc.
Currency volatility post Bretton Woods
The Futures Markets
What is a Futures Contract?

➢An agreement between 2 parties to buy or sell a specific quantity of a specific

asset at a specific price at a specific time in the future.
• Specific quantity is called the contract size.
• Specific asset is called a reference asset or underlying asset (wheat, oil,
currencies).
• Specific price is called the futures prices.
• Specific time is called the expiration date or (settlement date or maturity date).
➢A futures contract is very similar to a forward contract. The major differences are
that futures are standardized contracts that are traded on a centralized exchange
whereas forwards can be customized and are traded over-the-counter (OTC).
Where are Currency Futures
Traded?

• Globally there are 19 exchanges that offer currency futures (2018)

• The CME Group based in Chicago is the biggest currency futures
exchange (measured by notional value).
• ICE Futures Europe (New York-Based Intercontinental Exchange
purchased LIFFE, the London International Financial Futures and
Options Exchange in 2013).
• Eurex based in Frankfurt and Zurich.
• Many other independent exchanges including those based in
Singapore, Sao Paolo, Bombay, Moscow, Seoul, Johannesburg, …
CME Group Futures Trading

• Currency futures trading on the CME’s

Globex electronic platform trade 23 hours
a day (there is a one-hour break at 4pm CT)
from Sunday to Friday.
• Open outcry has been discontinued for
currency futures. Open outcry happens by
traders who are physically present on the
trading pit and communicate verbally and
by hand signals.
• The CME group offers futures on a wide
range of currency pairs and occasionally
introduces (or discontinues) new (existing)
currency pairs.
• Also offers e-mini and e-micro contracts
which have smaller contract sizes. For
example, the regular EUR/USD future has a
size of €125,000. The e-mini is €62,500.
The e-micro is €12,500.
June 2020, GBP/USD, $1.288/₤

Contract
Size
₤62,500

Underlying
Asset
Great Britain Pounds (GBP)

Future
Price
$1.288

Expiration 15-June-2020 (at 9:16am CT, on the

Date second business day immediately
preceding the third Wednesday of the
contract month, usually Monday).
June 2020, GBP/USD, $1.288/₤

• The buyer agree to buy ₤62,500 on June 15, 2020 at $1.288/₤.

• The futures price changes throughout the trading the day. Meaning that
another buyer might buy a contract with the same expiration date of June
15, 2020 at $1.290/₤. This new buyer promises to buy ₤62,500 on June 15,
2020 at $1.290/₤.

• The buyer pays nothing today.

• The buyer can “sell” the futures contract prior to expiration (99% of all
cases).
• The buyer can simply wait until expiration and make delivery of
$1.288x62,500=$80,500 (1% of all cases).

• The buyer can close the contract prior to expiration by making an offsetting
trade by selling the identical contract prior to expiration.
• The two positions cancel out on the books of futures exchange.
June 2020, GBP/USD, $1.288/₤

• Assume the futures price on the same contract is now $1.300/₤.

• The buyer can offer to sell a futures contract which agrees to pay
$1.300/₤ on June 15, 2020.
• The buyer now has two positions (one is long at $1.288/₤ and the
other is short at $1.300/₤.
• On June 15, 2020 the buyer will need to pay on the first contract:
$1.288/₤ x ₤62,500=$80,500; but will receive from the second
contract: $1.300/₤ x ₤62,500=$81,250. Therefore the buyer has
locked in a profit of $750.
• When the position is offset, the exchange automatically cancels out
the two trades and the profit is registered in the account.
Differences between Forwards and Futures

Forwards Futures
Over the counter Exchange Traded
Self-regulating Regulated by the Commodity and Futures Trading Commission
Over 90% are settled by actual delivery. Less than 1% have actual delivery
Customized Contract Size Standardized Contract Size
Any delivery date Can only be delivered on specific dates a year
Settlement occurs on actual date Settlement is made daily via Mark-to-Market
Quoted in units of foreign currency per $ Quoted in $ for 1 unit of foreign currency
Transaction costs are based on bid-ask spread Transaction costs are based on broker fees
Margins are not required Margins are required
Counterparty risk exist for both sides. The Exchange assumes the counterparty risk
Margin and Marking-to-Market

• Initial Margin: Cash that must be deposited when contract is entered into.
• It ensure sufficient money in investor’s account to prevent default.
• Maintenance Margin: Minimum cash balance that must be in account at all times. If cash drops
below maintenance level, investor gets a margin call to deposit additional funds to bring account
up to the initial level.
• If cash exceeds initial level, investor can withdraw the excess.
• For the CME Group the Initial and Maintenance Margins are called the Initial Performance Bond
and the Maintenance Performance Bond, respectively.
• The Initial and Maintenance margins depend on the risk of a particular contract and are updated
as the risks change. The CME Group uses a computerized risk management program called SPAN
(Standard Portfolio Analysis of Risk).
• Marking-to-Market: Profits and losses are credited to or debited from each investor’s account at
end of each trading day (also called daily settlement). Settlement occurs at 2pm CT for currency
futures on the CME Globex.
Margin and Marking-to-Market Example
➢ On Monday morning at 9am CT, you go long one CME Euro futures
contract:
➢ Future price: €1 = $1.10
➢ Specifications for the EUR futures contract (set by the exchange):
1. Contract size: EUR 125,000.
2. Initial Margin: $2,530
3. Maintenance margin: $2,000
Margin account

DAY Future Price Profit/ Margin Balance Margin Call

Loss

Monday (9am CT) $1.100 $0 $2,530

Monday (2pm CT) $1.105 $625 $3,155

Tuesday (2pm CT) $1.100 -$625 $2,530

Wednesday (2pm CT) $1.097 -$375 $2,155

Thursday (2pm CT) $1.095 -$250 $1,905 $625

Friday (2pm CT) $1.095 $0 $2,530

How MNCs use futures to hedge

• Chicago-based Boeing agrees to purchase equipment in four months

from Mecadaq Group, a French supplier for its 787 dreamliner. The
equipment costs €2,500,000, payable in four months
• The current spot price for the Euro is: S0= $1.20/€
• 4-month futures price: F= $1.15/€
• Contract size = €125,000.

• Boeing faces exchange rate risk and would like to hedge.

• What is the position (and size) of the futures hedge? Buy 20 futures
contracts!
What Happens in Four Months?

➢If the euro drops to $1.10/€ in 4 months, what is Boeing’s hedged cost for the
equipment?
• Spot market cost: 2,500,000 × $1.10 = $2,750,000
• Futures market transaction: €2,500,000 ×($1.10 –$1.15) = $-125,000 (loss)
• Total cost to Boeing: $2,875,000. Which implies a rate of $1.15/€.

➢If the euro increases to $1.30/€ in 4 months, what is Boeing’s hedged cost for
the equipment?
• Spot market transaction: €2,500,000 × $1.30 = $3,250,000
• Futures market transaction: €2,500,000 ×($1.30 –$1.15) = $375,000 (gain)
• Total cost to Boeing: $2,875,000. Which implies a rate of $1.15/€.

➢No matter what happens to the price of the €, Boeing has locked in a cost of
$1.15/€.
Currency Options Markets
What is an Option Contract?

➢ An instrument giving the holder (buyer) the right, but not the obligation, to buy or sell a
specific quantity of a specific asset at a specific price up to a specific date:
• Specific quantity is called the contract size.
• Specific asset is called the underlying asset.
• Specific price is called the strike price (or exercise price).
• Specific date is called the expiration date.

➢ Call options give the holder the right to buy at a specific price.
➢ Put options give the holder the right to sell at a specific price.

➢ Currency options were developed in the 1980’s by the Philadelphia Stock Exchange now the
Nasdaq OMX PHLX Exchange. Big currency option markets include the PHLX, CME, Eurex, etc.
Terminology and Notation

➢American option: Can exercise any time up to and including the

expiration date.
➢European option: Can exercise only on the expiration date (PHLX
currency options are European).
➢Option premium: The price of the option
➢An option that is profitable to exercise is called in-the-money. If it is
not profitable to exercise it is out-of-the-money. An option is at-the-
money if the strike price is equal to the spot rate.
➢Notation:
• K = strike price of option.
• S = current value of foreign currency
• ST = terminal currency price (at expiration of option).
An example of a call option

• A U.S. firm purchases a June 2020 Euro 110 call option for $0.04/€.
• Contract size is €10,000.
• This means:
• U.S. firm pays $0.04 per € or $400.
• Option expires June 2020.
• Strike price of the option is €1 = $1.10.

• Examine profit to the call option buyer and call option writer (the
person who sold it to the buyer).
Profits for the option buyer (red) and seller (blue)
Profit ($)

$1,20
0 Option writer’s profit
$800
Potentially unlimited
what happening of the sellers of the call
gains
$400
Out-of-the-Money In-the-money
$0
$1.10 $1.14 $1.18 $1.22 $1.26 ST
-$400
Option premium
Potentially unlimited
Break-even losses
price
Call option profits

➢Call option buyer’s profits:

• Losses: Limited to $400 premium (can’t lose more than you invest).
• Profits: Unlimited.
➢Call buyer’s profit = max(ST–K, 0)–premium

➢Call option writer (mirror image of buyer):

• Losses: Unlimited.
• Profit: Limited to the $400 premium.
➢Call writer’s profit = min(K–ST, 0)+premium
An example of a put option

• A U.S. firm purchases a December 2020 AUD 68 put option for

$0.02/AUD.
• Contract size is AUD10,000.
• This means:
• U.S. firm pays $0.02 per AUD or $200.
• Option expires December 2020.
• Strike price of the option is AUD1 = $0.68.

• Examine profit to the put option buyer and put option writer (the
person who sold it to the buyer).
Profits for the option buyer (red) and seller
(blue)
Profit ($) Up to $6,600 of gains

$600
Option writer’s profit
$400

$200
In-the-money Out-of-the-money
$0
$0.60 $0.62 $0.64 $0.66 $0.68 ST
-$200

Up to $6,600 of losses
Put option profits

➢Put option buyer’s profits:

• Losses: Limited to $200 premium (can’t lose more than you invest).
• Profits: Limited to $6,600 (if the AUD is worth $0).
➢Call buyer’s profit = max(K-ST, 0)–premium

➢Put option writer (mirror image of buyer):

• Losses: Limited to $6,600 (if the AUD is worth $0).
• Profit: Limited to the $200 premium.
➢Put writer’s profit = min(ST-K, 0)+premium
Option Strategies
Currency Spreads

• A currency spread allows speculators to bet on the direction of a

currency but at a lower cost than buying a put or a call option alone.
• There are many types of currency spreads but the two most basic
spreads are:
• Bull spread: a bet that the underlying currency will increase.
• Buy call option with a low strike price, K1 and sell call option with a
high strike price, K2.
• Bear spread: a bet that the underlying currency will decrease.
• Sell call option with a low strike price, K1 and buy a call option with a
high strike price, K2.
Profits for bull and bear spreads (in red) buying
calls (in blue) and writing calls (in green)

Profi Profi
t t

K2
K K ST K1 ST
1 2

Bull spread Bear spread

Example of a bull spread

• Suppose an investor takes the following Swiss Franc (CHF) bull spread
position:
• Buy a CHF June 2020 call with a $0.95 strike price for $0.02.
• Sell a CHF June 2020 call with a $0.98 strike price for $0.02.

• Contract size = CHF10,000

• What is the maximum profit?

• What is the maximum loss?
• What is the breakeven price?
Payoffs for the CHF bull spread strategy
USDCHF Spot Payoff from long call Payoff from short call Initial cash flow Profit

St≤0.95 -$0.02 $0.02 $0 $0

0.95<St<0.98 $(St-0.95)x10,000-$0.02 $0+$0.02 $0 $(St-0.95)x10,000

St≥0.98 $(St-0.95)x10,000-$0.02 $(0.98-St)x10,000+$0.02 $0 $0.03x10,000

• Maximum profit = $300 (if ST  $0.98)

• Maximum loss = $0 (if ST  $0.95)
• The strategy breaks even no matter the spot exchange rate.
Currency Option Pricing
Option pricing

• There are two components to currency option prices:

• Intrinsic value:
• Amount by which option is in-the-money.
• Intrinsic value of call = max(S - K, 0)
• Intrinsic value of put = max(K - S, 0)
• Time value:
• Reflects the possibility that option could finish in-the-money before it expires and
depends on:
• Volatility of underlying asset:
• More volatile a currency is, the more likely it is to finish in-the-money, therefore it has
more time value.
• Time until option expires:
• More time there is until expiration, the more time it has to finish in-the-money.
• Option value = intrinsic value + time value
Intrinsic and time value for a call option
Payoff

Time Value

Intrinsic Value = S - K

Intrinsic Value = 0
Example

• Suppose the British pound is at $1.30. A 6-month call option with a

strike price of $1.25 has a price of $0.07 (per GBP).
• What are the intrinsic and time values?
• Intrinsic value: max(1.30 – 1.25, 0) = $0.05
• Time value: $0.02
Garman-Kohlhagen Model

• Finding the intrinsic value of an option is simple but the time value is not.
• An adaptation of the famous Black-Scholes model is the Garman-Kohlhagen model
∗
𝑐𝑡 = 𝑆0 𝑒 −𝑟 𝑇 𝑁 𝑑1 − 𝐾𝑒 −𝑟𝑇 𝑁 𝑑2 𝑆 𝜎2
𝐿𝑛 𝐾0 + 𝑟 − 𝑟 ∗ + 2 𝑇
𝑑1 =
−𝑟 ∗ 𝑇
𝜎 𝑇
𝑝𝑡 = 𝐾𝑒 −𝑟𝑇 𝑁 −𝑑2 − 𝑆0 𝑒 𝑁 −𝑑1
𝑑2 = 𝑑1 − 𝜎 𝑇

• c(t) = time t price of call option that expires at t+T and p(t)=time t price of put option that expires at t+T
• S(t) = currency price at time t and K is the exercise (strike) price
• r* = annualized foreign interest rate and r = annualized domestic interest rate.
•  = expected standard deviation (volatility) of foreign currency, annualized.
• N() = cumulative standard normal distribution (area to left of d). In Excel the function is NORMSDIST().
Example

• Suppose we have the following 6-month European call option on the

Swiss Franc.
• S(0) = $1.01
• K = $0.97
• r = 2.25% (6-month rate, annualized)
• r* = -0.75% (6-month rate, annualized) (Note: in 2019, the Swiss National Bank had
negative interest rates).
•  = 0.0645 (annualized volatility of USDCHF)
• What is the price of this CHF call option? c=$0.0571
• IMPORTANT: the spot rate must be expressed as $ per 1 unit of
foreign currency.