1 / 31

Foreign Currency Options

Foreign Currency Options. Chapter Seven Eiteman, Stonehill, and Moffett. Hedging vs speculation. firms hedge make money on their core competency reduce risk writing a covered option firms do not speculate options are not a core competency speculation tries to make a return from risk.

amato
Download Presentation

Foreign Currency Options

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Foreign Currency Options Chapter Seven Eiteman, Stonehill, and Moffett Chapter Seven - Derivatives

  2. Hedging vs speculation • firms hedge • make money on their core competency • reduce risk • writing a covered option • firms do not speculate • options are not a core competency • speculation tries to make a return from risk Chapter Seven - Derivatives

  3. Quick review forward contracts • Negotiable contracts • Price, forward rate is contracted • Amount, how much foreign exchange will be exchange for domestic currency • Term, when delivery will be made • Contract is deliverable according to terms • Will not be able to get out of the contract Chapter Seven - Derivatives

  4. Currency futures contracts • standardized contract terms • amount of foreign exchange standardized • $ 100,000 Canadian, £ 62.500, • Peso 500,000, ¥ 12,500,00, Euro 1,000,000 • exchange rate fixed at contract time • delivery dates standardized by the exchange • March, June, September, December • 6 mos Chicago Mercantile Exchange • contracts expire two business days prior to the 3rd Wednesday of the delivery month • Contract is reversible Chapter Seven - Derivatives

  5. Futures contracts • Short position (selling a future) • Fix price to deliver fx @ 1.0337 • To deliver 100,000 cd • Delivery Dec 15, 2007 • Long position (buying a future) • Fix priced to take delivery fx @ 1.0337 • To take delivery 100,000 cd Chapter Seven - Derivatives

  6. Market makers in currency futures • international monetary market (IMM) • London international financial futures exchange (LIFFE) • Chicago Mercantile Exchange • New York mercantile exchange • Singapore international monetary exchange (SIMEX) Chapter Seven - Derivatives

  7. Trading specifics • commissions small (less than 0.5%) • margin requirements typically 2% to 3% contracted amount • both sides of contract guaranteed by exchange • contracts marked to market daily Chapter Seven - Derivatives

  8. long one June euro contract • contracted June delivery of 1,000,000 Euros • spot price 0.9737 / dollar or 0.9737 * 1,000,000 = 973,700 usd at contract • initial margin paid in when contracted • e.g. 2% on Euro contract 20,000 usd • maintenance margin • e.g. 1% on Euro contract 10,000 usd Chapter Seven - Derivatives

  9. marking to market 1st day • e.g. tomorrows settlement price 0.9817 • (0.9817 - 0.9737) * 1,000,000 = 8,000 • futures price is now 0.9817 • long the future (wanting euros) • margin account = 20,000 - 8,000 = 12,000 • short the future (wanting dollars) • margin account = 20,000 + 8,000 = 28,000 Chapter Seven - Derivatives

  10. marking to market 2nd day • e.g., next days settlement price 0.9867 • (0.9867 - 0.9817) * 1,000,000 = 5,000 • futures price is now 0.9867 • long the future (wanting euros) • margin account = 12,000 - 5,000 = 7,000 • margin call - buyer of the future must bump up his margin • short the future (wanting dollars) • margin account = 28,000 + 5,000 = 33,000 Chapter Seven - Derivatives

  11. Futures contract expires (long side of contract) • e.g. last settlement price 1.0017 • net change in margin (1.0017 - 0.9737) * 1,000,000 = 28,000 • final futures price 1.0017 • long the future (wanting euros) • net change in margin account + 28,000 • pays ( -1,001,700 + 28,000) = -973,700 dollars • receives +1,000,000 euros Chapter Seven - Derivatives

  12. Futures contract expires(short side of contract) • last settlement price 1.0017 • net change in margin (0.9737 - 1.0017) * 1,000,000 = -28,000 • final futures price 1.0017 • short the future (wanting dollars) • net change in margin account -28,000 • pays -1,000,000 euros • receives (1,001,777 - 28,000) = 973,700 dollars Chapter Seven - Derivatives

  13. Futures • marking to market reduces(illimanates) default risk • daily resettlement confines risk to one day’s price movements • large daily movements in price will result in • trading halt • margin call during trading halt • trader want to terminate the contract • will take the opposite contract • if long two contracts, will go short two contracts • cost is the interest paid on margins Chapter Seven - Derivatives

  14. Comparison to forwards • forward contracts • flexible • higher default risk • fixed into contract • Must deliver on expiration • futures contracts • standardized • much lower default risk • reversible Chapter Seven - Derivatives

  15. Options - characteristics • American option can be exercised anytime up to the expiration date • European option can only be exercise at the expiration date • in-the-money - option which if exercised will make money • out-of-the-money - option which if exercised will lose money Chapter Seven - Derivatives

  16. Options - types • Call option • option to buy currency • fixed price (exercise price, strike price) • expiration date • Put option • option to sell currency • fixed price (exercise price, strike price) • expiration date Chapter Seven - Derivatives

  17. Over-the-counter Market • written by banks • usd against pounds, euros, cd, yen • usually written in round lots; • 1, 2, 3, 5, 10 million • banks willing to write variable options • amount • exercise (strike) price • maturity date • less liquid than traded option Chapter Seven - Derivatives

  18. Options on organized exchanges • Standardized contracts • amount fixed • maturity dates • Auction markets • Philadelphia exchange • London International Financial Futures Exchange Chapter Seven - Derivatives

  19. Options - over-the-counter Market • written by banks • usd against pounds, euros, cd, yen • usually written in round lots; • 1, 2, 3, 5, 10 million • banks willing to write variable options • amount • exercise (strike) price • maturity date • less liquid than traded option Chapter Seven - Derivatives

  20. Call characteristics • e exchange rate • x exercise price • sdx standard deviation of exchange rate Chapter Seven - Derivatives

  21. Long a call option c Call out of the money when e < x Call in the money when e > x e x Chapter Seven - Derivatives

  22. Short the Call Option Chapter Seven - Derivatives

  23. Market Value of the Call Chapter Seven - Derivatives

  24. Valuation • exercise price (negative) • exchange rate (positive) • volatility (positive) • term to maturity (positive) • risk-free rate of return (positive) Chapter Seven - Derivatives

  25. Value of the Exercised Call Chapter Seven - Derivatives

  26. Long a call option c market value of the call exercised value of the call e x Chapter Seven - Derivatives

  27. Long a put option P Call out of the money when e > x Call in the money when e < x e x Chapter Seven - Derivatives

  28. Short the Put Option Chapter Seven - Derivatives

  29. Market Value of the Put Chapter Seven - Derivatives

  30. Value of the Exercised Put Chapter Seven - Derivatives

  31. Long the Put Option Chapter Seven - Derivatives

More Related