Topic 5: Foreign Exchange Futures

and Options
Lesson Objectives

• To understand the characteristics of forward and futures contracts

• To evaluate the difference between forward and futures markets

• To explain the basic concepts of options

• To learn how to calculate the option payoffs

• To identify the basic option pricing relationships

What is a Currency Derivative?

A currency derivative is a contract whose price is derived from the value of an

underlying currency.

Examples include forwards, futures contracts, swaps and option contracts.

Derivatives are used by MNCs and other market participants to:

• Speculate on future exchange rate movements

• Hedge exposure to exchange rate risk

Currency Forward Contracts

A forward contract is an agreement between a corporation and a financial

institution:

• To exchange a specified amount of currency

• At a specified exchange rate called the forward rate

• On a specified date in the future

Forward Market

• There are bid and ask rates for forward

quotes as well. Hence, we can calculate
the bid-ask spread for forward contracts.
• Higher the maturity period of the forward
contract, higher would be the bid-ask
spread.
• Bid-ask spreads are wider for less liquid
currencies or for the currencies of
developing countries.
 Problems of Forward Contracts

Problems Solutions

• Non-standard contract dimensions • Standardized contract dimension

• Default risk • Default risk is controlled by the

• Lack of liquidity clearing corporation and some

regulations

• They are liquid as they are

exchange traded
Futures Contracts: Preliminaries

• Both forward and futures contracts are derivative or contingent claim

securities because their values are derived from or contingent upon the
value of the underlying security
• Forward contract
o Tailor-made for a client by their international bank
• Futures contract
o Standardized features (e.g., contract size, maturity date, delivery
months)
o Exchange traded
Futures Contracts: Preliminaries (Continued)

• An initial performance bond (formerly called margin) must be deposited

into a collateral account to establish a futures position
o Generally equal to 2% of contract value
o Cash or T-bills may be used to meet requirement
• Major difference between forward contract and futures contract is the way
the underlying asset is priced for future purchase or sale
o Forward contract states a price for the future transaction, but futures
contract is settled-up, or marked-to-market, daily at the settlement
price
Differences between Futures and Forward Contract
 Currency Futures Contracts Traded on the
Chicago Mercantile Exchange
CURRENCY UNITS PER CONTRACT CURRENCY UNITS PER CONTRACT
Australian dollar 100,000 Korean won 125,000,000
Brazilian real 100,000
Mexican peso 500,000
British pound 62,500
New Zealand dollar 100,000
Canadian dollar 100,000
Chilean peso 50,000,000 Norwegian krone 2,000,000
Chinese yuan 1,000,000 Polish zloty 500,000
Czech koruna 4,000,000
Russian ruble 2,500,000
Euro 125,000
South African rand 500,000
Hungarian forint 30,000,000
Indian rupee 5,000,000 Swedish krona 2,000,000
Israeli shekel 1,000,000 Swiss franc 125,000
Japanese yen 12,500,000 Turkish lira 1,000,000
CME Currency Futures

https://www.cmegroup.com/trading/fx/g10.html https://www.cmegroup.com/markets/fx/g10/australian-dollar.contractSpecs.html
Basic Currency Futures Relationships
• Information provided on quotes for CME futures contracts includes the
following:
o Opening price, high and low quotes for the trading day, settlement
price, and open interest
o Open interest is the total number of short or long contracts
outstanding for the particular delivery month

• Futures are prices very similarly to forward contracts

• Recall from chapter 6, the IRP model states the forward price for delivery
at time T is:
Option Contracts: Some Preliminaries
• An option is a contract giving the owner the right, but now the obligation, to
buy or sell a given quantity of an asset at a specified price at some time in
future
o Option to buy is a call, and option to sell is a put
o Buying or selling the underlying asset via the option is know as
“exercising” the option
o Stated price paid or received is known as the exercise or striking
price
o 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)
o European option can be exercised only at maturity or expiration date
of contract, but American option can be exercised any time during
contract
 Currency Option Markets
• Prior to 1982, all currency option contracts were OTC options written by
international banks, investment banks, and brokerage houses
o OTC options are tailor-made and generally for large amounts (i.e., at
least $1m of currency serving as underlying assets)
o 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, Philadelphia Stock Exchange (PHLX) began trading

options on foreign currency

• In 2008, PHLX was acquired by NASDAQ OMX Group

 Call and put options

Call Put
(a) Initial exchange
• A call option gives the
holder the right to buy the Writer Holder Writer Holder

underlying currency. Premium (USD) Premium (USD)

AUD AUD
• A put option gives the (b) Exercise

holder the right to sell the Writer Holder Writer Holder

underlying currency. USD USD

 Option quotations

• American terms mean that the underlying exchange rate is

quoted in terms of the US dollar per unit of the other
currency.
• European terms mean that the underlying exchange rate is
quoted in terms of the other currency per unit of the US
dollar.
 Options Terminology

• The premium payment date is the date on which the premium is due.
• The settlement date is the date on which delivery of the underlying currency
is required.
• An option is naked if there is no corresponding spot position on the
underlying currency.
• Strike exchange rate is the rate at which the holder of the option can buy or
sell the underlying currency.
• Settlement exchange rate is the rate at which the underlying currency can
be bought or sold when the option is exercised.
 Options Terminology
(Continued)
• The holder of an option has a long position.
• The writer of an option has a short position.
• Expiry date is the date by or on which the option can be exercised.
• An American option can be exercised before or on the expiry date.
• A European option can be exercised on the expiry date only.
• An option is in the money if it can be exercised at gross profit
• An option is out of the money if it cannot be exercised at gross profit
• An option is at the money if the spot rate is equal to the exercise rate
 Currency option specifications

• Contract size
• Position limit
• Base currency
• Underlying currency
• Premium quotations
Calculation of Option Pay-off

SE SE
Position Action Pay-off Action Pay-off
Long call Not  0 Exercised  SE
exercised
Long put Exercised  ES Not  0
exercised
Short call Not  0 Exercised   ( S  E )
exercised
Short put Exercised   ( E  S ) Not  0
exercised
Basic Option-Pricing Relationships at Expiration
• 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:
Basic Option-Pricing Relationships at Expiration
(Continued)
• Call (put) option with ST > E (E > ST) expires in-the-money
o It will be exercised because the buyer will make money

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

o 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

o It will not be exercised because the buyer would lose money by doing
so and is under no obligation to exercise the option
American Option-Pricing Relationships
• American options will satisfy the following basic pricing relationships at time
t prior to expiration:

• 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

• Longer-term American option will have a market price at least as large as

the short-term option
American Option-Pricing Relationships
(Continued)
• Call (put) option with ST > E (E > ST) is trading in-the-money

• If ST ≅ E, the option is trading in-the-money

• If ST < E (E < ST), the call (put) option is trading out-of-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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