INTERNATIONAL FINANCE:

Topic 6:

Foreign Currency
Futures and Options

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 Chapter 20

Foreign Currency
Futures and
Options
adapted by Uwe Walz
Slides prepared by

April Knill, Ph.D., Florida State University

 The Basics of Futures Contracts
Futures
Allow to buy and sell specific amounts of
foreign currency at an agreed-upon price
determined on a given future day
Traded on an exchange
Standardized, smaller amounts (e.g., 12.5M,
125,000, C$100,000)
Fixed maturities (e.g., 30, 60, 90, 180, 360
days)
Credit risk
Futures brokerage firms register with the Commodity
futures trading commission (CFTC) as a futures
commission merchant (FCM)
Clearing member/clearinghouse

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 The Basics of Futures Contracts

Margins
Credit risk is handled by setting up an
account called a margin account, wherein
they deposit an asset to act as collateral)
Marking to market deposit of daily
losses/profits
Maintenance margins minimum amount
that must be kept in the account to guard
against severe fluctuations in the futures
prices (for CME, about $1,500 for USD/GBP
and $4,500 for JPY/USD)

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 Futures vs forwards
Futures are standardized contract (forwards are
not)

Futures are traded on exchanges (forwards are

OTC)

Futures are marked-to market (forwards are not)

But: price of futures and forwards are essentially

the same

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 Mark to Market Valuation
Suppose it is September and you buy a December
euro futures contract

Lets assume that each contract represents

125,000

Settle price $1.3321/, initial margin $2,000 and

maintenance margin of $1,500

Question: what does mark to market mean

practically?

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 Exhibit 20.1 An Example of Marking to
Market in the Futures Market
Euro contract (125,000)

Initial Margin for

Settle Price Contract Size * F Both buyer and seller

Margin
call

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 The Basics of Futures Contracts

The pricing of futures contracts

The payoff on a forward contract: S(T)-F(t) where S(T) is
the future spot rate at maturity time T and F(t) is the
forward price at time t
The payoff on a futures contract: f(T) f(t) where f(T) is
the futures price at maturity time T and f(t) is the futures
price at time t
Why payoffs for futures can differ than those from
forwards the interest that is earned on future profits or
that must be paid on future losses in a futures contract

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 Futures Quotes
from April 21, 2011

Largest open interest in in the contract closest to maturity

Volume traded = contract size * # contracts traded

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 Chart for March 2017 EUR-USD contract

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 Example: Hedging Euro receivables
with Futures
It is mid February and Nancy foods will receive
250,000 in mid March

Suppose the bank offers the following rates

Spot rate: $1.24/
Futures rate: $1.23/

Question 1: How to hedge?

Suppose in March the rates are as follows

Spot rate: $1.35/
Price of March future at final trading date: $1.35/

Question 2: What are the final cash flows?

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 Example: Hedging Euro receivables
with Futures (2)

We receive , so we want to sell

Therefore sell (go short) 2 future contracts
Maturity is matched perfectly

Final cash flows:

Sell 250K at spot of $1.35: 250K$1.35 = $337.5K
Loss on hedge: ($1.23 - $1.35) x 250K = -$30K
Total cash flow: $307.5
Effective exchange rate: $307.5/250 = $1.23/

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 Hedging with futures: potential problems

What if you need to hedge an odd amount?

Can be covered with mini futures to some degree

What if the contract delivery date doesnt match

your receivable/payable date?
Bad luck

This results in basis risk

the price of the futures contract does not move one-for-
one with the spot exchange rate
Basis = Spot price Futures price = S(t) f(t,T)

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 Example: Hedging with basis risk
Suppose instead that current time is
January and Nancy foods will receive 250K
in early March

Suppose the bank offers the following rates

Spot rate: $1.21/
Futures rate: $1.22/

Ex-post, the March rates are as follows

Spot rate $1.33/
Price of March future at final trading date:
$1.325/ 14
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 Example: Hedging with basis risk
Solution
Sell 250K at spot of $1.33: 250K$1.33
= $332.5K
Loss on hedge: ($1.22 - $1.325) x 250K =
-$26.25K
Total cash flow: $306.25
Effective exchange rate: $306.25/250 =
$1.225/
Effective rate = futures rate + basis
$1.225 = $1.22 + ($1.33 - $1.325)

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 Intermediate Summary

Forward and futures lock in the future rate

They eliminate uncertainty

But they come at the cost of killing flexibility

This is where currency options come in

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 Basics of Foreign Currency Option
Contracts

Gives the buyer the right, but not the

obligation to buy (call) or sell (put) a specific
amount of foreign currency for domestic currency
at a specific forex rate

Price is called the option premium

Strike/exercise price (K)- contractual FX rate
Intrinsic value revenue from exercising an
option
In the money/out of the money/at-the-money
Call option: max[S-K,0]
Put option: max[K-S,0]

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 Basics of Foreign Currency Option
Contracts
]

Traded by money center banks and exchanges

European vs. American options: European

options can only be exercised on maturity
date; Americans can be exercised anytime
(i.e., early exercise is permitted)

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 Example: A Euro Call Option Against
Dollars
A particular euro call option offers the buyer the
right (but not the obligation) to purchase 1M @
$1.20/.
If the price of the > K, owner will exercise (think
coupon)
To exercise: the buyer pays ($1.20/)* 1M=$1.2M to the
seller and the seller delivers the 1M
The buyer can then turn around and sell the on the spot
market at a higher price!

For example, if the spot is, lets say, $1.25/, the

revenue is:
[($1.25/)-($1.20/)]* 1M = $50,000 (intrinsic value of
option, NOT the profit
Thus buyer could simply accept $50,000 from seller if the
parties prefer

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 Example: A Yen Put Option Against the
Pound

A particular yen put option offers the buyer the right

(but not the obligation) to sell 100M @ 0.6494/100.

If the price of the 100 < K, owner will exercise (think

insurance)
To exercise: the buyer delivers 100M to the seller
The seller must pay (0.6494/100)* 100M = 649,400

For example, lets say the spot at exercise is

0.6000/100.
The revenue then is:
[(0.6494/100)-(0.6000/100)]* 100M = 49,400 (intrinsic
value of option, NOT the profit)
Thus buyer could simply accept 49,400 from seller if the parties
prefer
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 Trading of options
Mostly traded by banks in the interbank market or
the OTC market
Typically European convention in OTC market
CFs either exchanged or cash settlement
Considerable counterparty risk managed by exposure
limits
Currency options on the NASDAQ OMX PHLX
Mostly options on spot currencies vs U.S. Dollar
Expiration months: March, June, September and
December
Last trading day is the third Friday of expiring month
European-exercise type but settlement is in dollars
Options Clearing Corporation serves as clearinghouse

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 Prices of
Options on
Futures
Contracts

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 Exchange-listed currency warrants
Longer-maturity foreign currency options (>1 year)

Issued by major corporations

Actively traded on exchanges such as the American Stock
Exchange, London Stock Exchange, and Australian Stock
Exchange

American-style option contracts

Issuers include AT&T, Ford, Goldman Sachs, General Electric,

etc.
Not taking on currency risk likely hedged in OTC market
Buying an option at wholesale price and selling at retail price

Allow retail investors and small corporations too small to

participate in OTC market to purchase L/T currency options

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 Example: Macquarie Put Warrant
AUD put warrant against $ - maturity date of
December 15, 2016
K = $0.90/AUD; multiplier of AUD10

Payoff of put warrant specified in contract as:

Max [0,(K-S)/S]*Multiplier

Suppose spot at maturity is $0.85/AUD, the

payoff then is:
([($0.90/AUD)($0.85/AUD)]/ $0.85/AUD) * 10
= $0.59

Since the actual spot exchange rate at maturity

was $1.0233/AUD, the holder of the warrant at
maturity received no payoff.
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 FX Options and Risk Management:
Takeovers

A bidding situation at Bagwell Construction U.S.

company wants to bid on a building in Tokyo (in
yen)
Transaction risk since bid is in yen
Cant use forward hedge because if they dont win, it
would be a liability regardless!
Option allows flexibility in case they dont win!
Using options to hedge transaction risk
Forward/futures contracts dont allow you to benefit from the
up side
Allows a hedge but maintains the upside potential from favorable
exchange rate changes

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 FX Options and Risk Management
Transaction Risk

Forward/futures contracts lock in rates

Dont allow you to benefit from the up

side

Option hedges FX risk

But you retain flexibility

Lets look at some examples

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 Example: Pfimerc

Oct 1: Pfimerc knows it will receive 500K

on Friday Mar 19 (in 170 days from now)

Consider the following data

S($/) = 1.5834
F($/) = 1.5805
i($) = 0.2% p.a.
i() = 0.4% p.a.
Option prices (in $ cents)
K = 158, C = 5 and P = 4.81
K = 159, C= 4.52, P = 5.33
20-27
K = 160, C = 4.08 and P = 5.89
2012 Pearson Education, Inc. All rights reserved.
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 Example: Pfimerc
Solution

How to hedge?
Sell pound forward at $1.5805
Purchase put option with K =158

Current cost of option:

$0.0481/500K = $24.05K

Cost of option at maturity:

$24.5K(1+0.002(170/360))=$24.073K

Minimum revenue:
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 Example: Pfimerc
Solution

What is effective strike price after cost?

$765,927/500K = $1.5318

At what future spot rate is Pfimerc

indifferent between put and forward?

FV option cost: $0.04811.00094 = $0.0482

S* - $0.0482 = $1.5805
S* = $1.6287/

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 Solution

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 Example: Orlodge
Sep 16: Orlodge knows it has accounts
payable of CHF 750K on Wednesday, Dec 15
(in 90 days from now)

Consider the following data

S($/CHF) = 0.7142
F($/CHF) = 0.7114
i(S) = 3.75% p.a.
i(CHF) = 5.33% p.a.
Option prices (in $ cents)
K = 70, C = 2.55 and P = 1.42
K = 72, C= 1.55, P = 2.40
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 Example: Orlodge
Solution
How to hedge?
Buy CHF forward at $0.7114
Purchase call option with K =72

Current cost of option:

$0.0155/CHFCHF750K = $11.625K

Cost of option at maturity:

$11.625K(1+0.0375(90/360))=$11.734K

Maximum cost:
CHF750K$0.72/CHF + $11.734K= $551,734
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 Example: Orlodge
Solution

What is effective strike price after cost?

$551,734/CHF750K = $0.7356

At what future spot rate is Pfimerc

indifferent between put and forward?

FV option cost: $0.01551.0094 = $0.0156

S* + $0.0156 = $0.7114
S* = $0.6958/CHF

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 Orlodge Example: Solution

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 Orlodge Example: Solution

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 The Use of Options in Risk Management

Speculating with options you can sell

insurance if buying it seems too expensive
Speculating on receivables
Sell a call option
Generates $ revenue, which enhances $ return
Dangerous though in that one loses protection against
downside risk
Speculating on foreign currency liabilities
Sell a foreign currency put option
If future forex rate > K, you are forced to buy at market and
that is more expensive
If future forex rate < K, you are forced to buy at K BUT you
earned revenue so as long as it doesnt increase too much,
its okay

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 How can we price FX options?

Options valuation Black and Scholes

(1973): Intuition
The intrinsic value of an option if the owner
exercises it, will it make money (in/at/out of
the money)?
The time value of an option the part of the
options value attributed to the time left to
expiry
Option price=Time value + intrinsic value

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 Determinants of FX Option Prices
Increasing the exercise price (call) it reduced the
probability that the option will be exercised so it
decreases the options value
An increase in the variance the distribution with
the larger variance yields possibly larger payoffs so
it increase the options value
Increasing the time to expiration
American increases uncertainty of spot rate
at maturity so it increases the options value
European generally increases the options
value but it depends because in-the-money
European options can lose value as time
evolves

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 The more uncertainty there is the more costly is
the option

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 Example: FX option pricing with
replication method
Suppose we want to price a 1-month European
call option which allows us to purchase 100
K = $1.52/
S=$1.50/
i($) = 0.5% p.m.
i() = 1% p.m.

Suppose that in 1 month, the spot rate is either

S(H) = $1.55/
S(L) = $1.45/

What is the price of the option?

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 Example: FX option pricing
Solution
Payoff of option in H state
($1.55 - $1.52)100 = $3

Payoff of option in L state

($1.45 - $1.52)100 = -$7 => so payoff is 0

Suppose we borrow $Y and invest X today

Cost: $1.5X - $Y

Thats it we have 2 equations with 2

unknowns

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 Example: FX option pricing
Solution
Value of replicating PF in H-state
$1.55X1.01-$Y1.005=$3

Value of replicating PF in L-state

$1.45X1.01-$Y1.005=$0

Solving the two equations yield

$Y=$43.28
X=29.70

Cost of replicating PF is
$1.5029.7-$43.28=$1.27

Because of law of 1 price, this is the cost of the option!

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 Exhibit 20A.1 A Two-Period
Binomial Tree

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 Exhibit 20A.3 Call Option Price

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 In class exercise
on topic

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 Next topic

Hedging is costly.
Cant we do better simply forecasting FX rates?

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