Currency Futures & Options Markets

1. Currency Futures & Options Markets

2. Objectives: to Understand • How currency futures and options contracts are used to manage currency risk & to speculate on future currency movements • The nature of currency futures and options contracts and • The difference between futures & options contracts • The factors that determine the value of an option Fred Thompson

3. Currency Risk

4. Definition • Currency Risk = Variability in the value of an exposure caused by uncertainty about exchange rate changes. Fred Thompson

5. Currency Risk • Degree of risk is a function of 2 variables • Volatility of exchange rates • Amount of exposure • Degree of Risk • Low = rate fixed, low exposure • High = rate volatile, high exposure Fred Thompson

6. What Happens if the Yen falls? Fred Thompson

7. Long and Short Exposures • A person that is, for example, long the pound, has pound denominated assets that exceed in value their pound denominated liabilities. • A person that is short the pound, has pound denominated liabilities that exceed in value their pound denominated assets. Fred Thompson

8. What is an exposure? • Liabilities > assets = net exposure (short) • If you are borrowing Yen to buy $ denominated assets? Are you short or long? • Who is long? • Who is long on $? Who is short? Fred Thompson

9. Hedging • To hedge a foreign exchange exposure, one takes an equal and opposite position from that of the exposure. • For example, if folks are long the pound, they would have to take an offsetting short position to hedge their exposure. • One who is long in a market is betting on an increase in the value of the thing, whereas with a short position they are betting on a fall in its value. Fred Thompson

10. You Can Hedge with Financial Derivatives! • Contracts that derive their value from some underlying asset • Forwards • Futures • Options • Swaps Fred Thompson

11. For example • Vanilla bond -- coupon and principal • First stage decomposition • Second stage decomposition • Options • What assets underlie currency derivatives? Fred Thompson

12. Currency Futures

13. Currency Futures • Traded on centralized exchanges (illustrated in Figure 1 later) • Highly standardized contracts • Size [A&C$100K, £62.5k, €125k, ¥12.5m] & maturity [delivery date] • Clearinghouse as counter-party • High leverage instrument • Daily settlement • Margin requirements Fred Thompson

14. Currency Futures • Performance Bond or Initial Margin: The customer must put up funds to guarantee the fulfillment of the contract - cash, letter of credit, Treasuries. • Maintenance Performance Bond or Margin: The minimum amount the performance bond can fall to before being fully replenished. • Mark-to-the-market: A daily settlement procedure that marks profits or losses incurred on the futures to the customer’s margin account. Fred Thompson

15. Sample Performance Bond RequirementsFrom the CME, 15 March 2000 Fred Thompson

16. How an Order is Executed (Figure from the CME)

17. Example A US manufacturing company has a division that operates in Mexico. At the end of June the parent company anticipates that the foreign division will have profits of 4 million Mexican pesos (P) to repatriate. The parent company has a foreign exchange exposure, as the dollar value of the profits will rise and fall with changes in the exchange value between the P and the dollar. Fred Thompson

18. Example, continued • The firm is long the peso, so to hedge its exposure it will go short [sell P] in the futures market. • The face amount of each peso future contract is P500,000, so the firm will go short 8 contracts. • If the peso depreciates, the dollar value of its Mexican division’s profits falls, but the futures account generates profits, at least partially offsetting the loss. The opposite holds for an appreciation of the peso. Fred Thompson

19. Gain Underlying Long Position Change spot value Change in futures price Futures Position Loss

20. Example, continued • The previous diagram can be used to illustrate the effect of a change in the value of the peso. • An increase in the value of the peso increases the dollar value of the underlying long position and decreases the value of the futures position. • A decrease in the value of the peso decreases the value of the underlying position and increases the value of the futures position. Fred Thompson

21. Example, continued • On the 25th, the spot rate opens at 0.10660 ($/P) while the price on a P future opens at 0.10310. • The market closes at 0.10635 and 0.10258 respectively. • The loss on the underlying position is: • (0.10635-0.10660)P4 mil. = -$1,000 • The gain on the futures position is: • (0.10310-0.10258)8P500,000=$2,080 Fred Thompson

22. Gain and Loss on Underlying and Futures Position Day 1 Underlying Long Position P4 million Gain $2,080 Change spot value -0.00025 Change in futures price -0.00052 $1,000 Futures Position P500,000 x 8 Loss

23. Example, continued • On the 28th, the spot rate moves to 0.10670 ($/P) and the price on a P future to 0.10285. • The gain on the underlying position is: • (0.10670-0.10635)P4 mil. = $1,400 • The loss on the futures position is: • (0.10258-0.10285)8P500,000=-$1,080 Fred Thompson

24. Gain and Loss on Underlying and Futures Position Day 2 Underlying Long Position P4 million Gain $1,400 0.00032 Change spot value 0.00035 Change in futures price $1,080 Futures Position P500,000 x 8 Loss

25. Example, continued • On the 29th, the spot rate moves to 0.10680 ($/P) and the price on a P future to 0.10290. • The gain on the underlying position is: • (0.10680-0.10670)P4 mil. = $400 • The loss on the futures position is: • (0.10285-0.10290)8P500,000=-$200 Fred Thompson

26. Gain and Loss on Underlying and Futures Position Day 3 Underlying Long Position P4 million Gain $400 0.0001 Change spot value 0.00005 Change in futures price $200 Futures Position P500,000 x 8 Loss

27. Example, continued • For the three days considered, the underlying position gained $800 in value and the futures contracts yielded $800. • The hedge was not perfect as the daily losses on the futures were less than the gains on the underlying position (day 2 and 3), and the daily gains on the futures exceeded the losses on the underlying position (day 1). • In this example, the imperfect hedge yielded additional gains. Fred Thompson

28. Example, continued • Suppose you wanted to close the futures position (without making delivery of the currency). • The position is simply reversed. That is, you would go long 8 P futures, reversing your current position and closing out your account. [offsetting trade] Fred Thompson

29. Additional Information For additional information on currency futures, visit the following sites: • The Chicago Mercantile exchange • The Futures Industry Institute Fred Thompson

30. Currency Options

31. Currency Options • A currency option is a contract that gives the owner the right, but not the obligation, to buy or sell a currency at a specified price at or during a given time. • Call Option: An option that gives the owner the right to buy a currency. • Put Option: An option that gives the owner the right to sell a currency. • How are currency options simultaneously both put & call options? Fred Thompson

32. Currency Options • American Option: An option that can be exercised any time before or on the expiration date. • European Option: An option that can only be exercised on the expiration date. Fred Thompson

33. Currency Options • Exercise or Strike Price: The price (spot exchange rate) at which the option may be exercised. • Option Premium: The amount that must be paid to purchase the option contract. • Break-Even: The point at which exercising the option exactly matches the premium paid. Fred Thompson

34. Currency Options • If the spot rate has not yet reached the exercise price [S<X], the option cannot be exercised and is said to be “out of the money.” • If the spot rate equals the exercise price [S=X], the option is said to be “at the money.” • If the spot rate has surpassed the exercise price [S>X], the option is said to be “in the money.” Fred Thompson

35. Call Option • The holder of a call option expects the underlying currency to appreciate in value. • Consider 4 call options on the euro, with a strike price of 152 ($/€) and a premium of 0.94 (both cents per €). • The face amount of a euro option is €62,500. • The total premium is: $0.0094·4·€62,500=$2,350. Fred Thompson

36. Call Option: Hypothetical Pay-Off Profit Payoff Profile $1,400 152 152.5 0 Spot Rate 148.15 152.94 153.5 -$1,100 Break-Even -$2,350 Out-of- the-money Loss At In-the-money

37. Put Option • The holder of a put option expects the underlying currency to depreciate in value. • Consider 8 put options on the euro with a strike of 150 ($/€) and a premium of 1.95 (both cents per €). • The face amount of a euro option is €62,500. • The total premium is: $0.0195·8·€62,500=$9,750. Fred Thompson

38. Put Option: Hypothetical payoff at a spot rate of 148.15 Profit Payoff Profile Break-Even 148.05 150 0 Spot Rate 148.15 -$500 -$9,750 Loss In-the-money At Out-of-the-money

39. Option Pricing & Valuation • Value of a call option at maturity • S-X, where S-X>0 [otherwise value is zero], = Intrinsic value • Value of a call option prior to maturity • Intrinsic value + Time value Time Value is a function of: Time to expiration, volatility, domestic & foreign interest rate differentials Fred Thompson

40. Comparing Futures and Options The value of a futures contract at maturity (date t+n) to purchase one unit of foreign currency will be: Value 0 St+n Zt,t+n The value of the futures contract is zero at maturity if the spot rate at maturity is equal to the current futures rate.

41. Consider now the value of an option to purchase one unit of foreign currency at that same price (i.e. a ‘call option’ with a strike price X equal to Zt,t+n): Value 0 St+n X The value of the call option begins increasing when the exchange rate becomes larger than the exercise price - when the option becomes ‘in the money.’

42. But we’re missing something. While a futures contract has an expected return of zero, the value of the option looks like it is always positive… Value 0 St+n X

43. Hence, anyone taking the opposite side of the transaction (‘writing’ the option) will demand a premium (C) that makes the expected value zero once again: Value 0 St+n X C Regardless of the outcome, the option’s value is reduced everywhere by the certain payment of its premium.

44. The value of an option to sell one unit of foreign currency (a ‘put’ option) at a strike price equal to a corresponding futures contract price will have similar properties: Value 0 St+n X

45. Swaps

46. Foreign Currency Swaps A currency swap is an exchange of debt-service obligations denominated in one currency for the service on an agreed upon principal amount of debt denominated in another currency. A currency swap is often the low-cost way of obtaining a liability in a currency in which a firm has difficulty borrowing. A pair of firms simply borrow in currencies they have relative advantage borrowing in, and then trade the obligations of their respective loans, thereby effectively borrowing in their desired currency.

47. Dell computers would like to borrow in Swiss Francs to hedge its ongoing cash flows from that country… Dell SFr

48. Nestle would like to borrow in Dollars to hedge its sales to the U.S... Dell Nestle $ SFr

49. But both firms are relatively unknown to the respective credit markets, and thus anticipate unfavorable borrowing terms. Dell Nestle $ SFr

50. But an investment bank comes along and suggests that each borrow in the credit markets that are comfortable with them... Dell Nestle I-Bank $ SFr