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Currency Derivatives (or chapter 7)

Currency Derivatives (or chapter 7). Agenda. How forex futures quoted & used for speculation? Futures vs. forwards? How forex options are quoted? Speculate w/ forex options. Distinction b/n buying & writing options? How forex options are valued?. Forex Futures.

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Currency Derivatives (or chapter 7)

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  1. Currency Derivatives (or chapter 7)

  2. Agenda • How forex futures quoted & used for speculation? • Futures vs. forwards? • How forex options are quoted? • Speculate w/ forex options. • Distinction b/n buying & writing options? • How forex options are valued?

  3. Forex Futures • Future delivery of standard amount of currency @ fixed time & price. Traded @ Chicago Mercantile Exchange (CME). • Specifications: • Size–notional principal, in even multiple. • Method of stating exchange rates – “American terms” used. • Maturity date –mature on 3rd Wed/ 01, 03, 04, 06, 07, 09, 10, or 12. • Last trading day – contracts may trade through 2nd business day prior to maturity. • Collateral & maintenance margins –purchaser/trader must deposit initial margin or collateral. • Daily marked-to-market • Settlement • round turn fee. • Use of a clearing house as a counterparty

  4. Futures Speculation 500,000 New Mexican pesos. Source: Wall Street Journal, February 22, 2002, p.C13 Short Position – believes that the value of the Peso will fall Long Position - believes that the value of the Peso will rise Value at maturity (Short) = - Principal  (Spot – Future) = -PS 500,000  ($0.09500/ PS - $.10958/ PS) = $7,290, assuming spot rate of $.09500/Ps @ maturity. Value at maturity (Long) = Principal  (Spot – Forward) = PS 500,000  ($0.11000/ PS - $.10958/ PS) = $210, assuming spot rate of $.11000/Ps @ maturity.

  5. Forex Futures vs. Forwards CharacteristicForeign Currency FuturesForward Contract Size Standardized any size desired Maturity fixed maturities any maturity up up to a year Location organized exchange b/n individuals & banks Pricing open outcry bid/ask quotes Margin/Collateral daily marked to market no collateral Settlement rarely delivered, settlement contract delivered, through offsetting can offset position Fees single commission for purchase& sell bid/ask spread Trading hours exchange hours 24 hours Counterparties through clearing house direct contact Liquidity very liquid liquid, relatively largemarket

  6. Initial Margin Requirements • Held as collateral by broker. • Usually 2-4% of contract value. • Margin amount same for short & long positions. • Buyer holds a long position (seller – short). • If settlement price higher than yesterday, buyer has a positive settlement for the day. • Long position now worth more. • Exact opposite for seller (zero-sum game).

  7. Open Interest • Open Interest refers to the number of contracts outstanding for a particular delivery month. • Initially open interest is zero. • Increases over time, until positions are liquidated. • Total open interest is the total number of outstanding positions in all the delivery months of a futures market. • Liquidity = at least 5,000 outstanding contracts. http://www.activetradermag.com/futuresbasics.htm

  8. Reversing Trades • Rare in forward markets –90% of all contracts lead to delivery. • Common in futures markets – only 1% of contracts lead to delivery!

  9. Forex Option • Gives right but not obligation to buy/sell amount of currency @ fixed price for given time period • Call – buyer has right to purchase • Put – buyer has right to sell • Buyer = holder & seller = writer. • Two option types • American: may exercise during life of option. • European: may not exercise until maturity. • Price elements • Strike (exercise price): exchange rate @ which foreign currency can be purchased/ sold. • Premium, price of option • Spot rate

  10. Forex Options • May be classified as: • At-the-money (ATM): exercise price = spot rate. • In-the-money (ITM) options profitable, excluding premium, if exercised immediately. • Out-of-the-money (OTM) options not profitable, excluding premium, if exercised immediately. • Markets for derivatives: • OTC Market • Organized exchanges - Chicago Mercantile and the Philadelphia Stock Exchange • Option Clearinghouse Corporation

  11. Futures Contracts vs. Options • Futures Contract – you’ve agreed to purchase/sell the contract. No backing out. Can offset/ exit by buying/selling to someone else. • Buy = long; sell = short. • Option – contract that gives you the right but not the obligation to purchase/sell something at pre-specified terms. No commitment.

  12. Forex Options Markets • Swiss Franc options (WSJ) • Call premium: SF 62,500 x $0.0050/SF = $312.50. Each option = 62,500 Swiss francs.

  13. Speculation • Assume spot rate: $0.5851/SF, 6m forward: $0.5760/SF. • Spot market • $100,000. Expect six month spot SF $0.6000/SF. • Step 1: purchase SF 170,910.96 @ spot $0.5851/SF. • Step 2: sell at target spot rate of $0.60/SF. • Forward market • Step 1: Buy forward SF173,611.11 x $0.576/SF= $100,000. • Step 2: In 6m, fulfill forward & sell proceeds in spot market Sfr173,611.11 x $0.6000/Sfr = $104,166.67. • Options market • Long Call, Short Call, Long Put, Short Put.

  14. For Example… • Suppose that: • you have $10 m. • Wish to speculate on Euro • S = $ 0.885/ EUR, F30 = $ 0.900/ EUR. • You expect S30 = $ 0.844/ EUR (EUR depreciates). • Arbitrage strategy? • You expect S30 = $ 0.944/ EUR (EUR appreciates). • Arbitrage strategy?

  15. ATM Strike price OTM ITM Unlimited profit Limited loss Break-even price Profit & Loss Buyer of Call (Long Call) CeT = Max[ST - E, 0] Profit (US cents/SF) + 1.00 + 0.50 0 Spot price (US cents/SF) 57.5 58.0 58.5 59.0 59.5 - 0.50 - 1.00 Loss Profit = Spot rate – (Strike price + Premium) Profit = ? if Spot = $ 0.595/ SF.

  16. ATM Strike price Break-even price Limited profit Unlimited loss Profit & Loss Writer of Call (Short Call) CeT = Max[ST - E, 0] Profit (US cents/SF) + 1.00 + 0.50 0 Spot price (US cents/SF) 57.5 58.0 58.5 59.0 59.5 - 0.50 - 1.00 Loss Profit = Premium – (Spot rate - Strike price). Profit = ? if Spot = $ 0.595/ SF.

  17. “At the money” Strike price “In the money” “Out of the money” Profit up to 58.0 Limited loss Break-even price Profit & Loss for Buyer of Put (Long Put) PaT=PeT=Max[E - ST, 0] Profit (US cents/SF) + 1.00 + 0.50 0 Spot price (US cents/SF) 57.5 58.0 58.5 59.0 59.5 - 0.50 - 1.00 Loss Profit = Strike price – (Spot rate + Premium) Profit = ? if Spot = $ 0.575/ SF.

  18. Strike price Break-even price Limited profit Unlimited loss up to 58.0 Profit & Loss for Writer of Put (Short Put) “At the money” Profit (US cents/SF) PaT=PeT=Max[E - ST, 0] + 1.00 + 0.50 0 Spot price (US cents/SF) 57.5 58.0 58.5 59.0 59.5 - 0.50 - 1.00 Loss Profit = Premium – (Strike price - Spot rate) Profit = ? if Spot = $ 0.575/ SF.

  19. For Example… • Suppose that: • You wish to speculate on fall of Yen vs. $. • Current S = Yen 120/ $ (or $.00833/Yen). • Maturity: 90 days. • Expected S90 = Yen 140/$ (or $.00714). • Two options available: Call on YenPut on Yen • Strike: Yen 125/$ Yen 125/$. (or $.008/ Yen) (or $.008/ Yen) • Premium: $.00046 $.00003 • What option to buy? • Break even price on option of choice? • If S= Yen 140/ $, what is net profit?

  20. Option Pricing • Market value = Time value + Intrinsic Value • Intrinsic Value –gain if option exercised immediately. Will reach zero when the option is OTM. At maturity, option value = intrinsic value. • Time Value– reflects a gamble that the option might be more profitable (more in-the-money) as time passes (i.e. before time of expiry).

  21. Market-, Time- & Intrinsic Value Strike Price of $1.70/£ -- Valuation on first day of 90-day maturity -- 5.67 Total value 4.00 3.30 1.67 Time value Intrinsic value Option Premium (US cents/£) 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1.66 1.67 1.68 1.69 1.70 1.71 1.72 1.73 1.74 Spot rate ($/£) European Call on Brit Pound

  22. Option Volatility • Standard deviation of daily % changes in underlying exchange rate, usually stated per annum, e.g. 12.6 %. • Can obtain daily volatility • Volatility estimates: • Historic. • Forward-looking. • Implied.

  23. Replicating Portfolio Evaluation • Suppose US$-EUR rate is S0($/EUR) = $1. • S1($/ EUR) is $1.10 or $0.90. • Consider call w/ K=$1/EUR (exercise price). • Can replicate payoffs of call w/ levered position in EUR. • Borrow PV $.90 today & buy1 EUR. • Net payoff: $0.20 or $0. • Portfolio value: so option value: Portfolio S1($/EUR) Debt C1($/EUR) S0($/EUR) $1.10 $0.10 -$0.90 $0.20 $1 $0 -$0.90 $0.00 $0.90

  24. Rogue Trading: Good Fellas… • Nick Leeson @ Barings. • 1995, managed to bankrupt Barings Brothers (UK). • John Rusnak @ Allied Irish Bank. • 2002, lost $691 m on behalf of Allied Irish Bank (Baltimore office).

  25. Things to remember • Futures terminology. • Futures vs. Forwards. • Speculation • In spot & forward markets. • In option markets. • How forex options are quoted? • Distinction b/n buying & writing options. • How forex options are valued?

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