INTERNATIONAL FINANCIAL MANAGEMENT

1. INTERNATIONAL FINANCIAL MANAGEMENT Fourth Edition EUN / RESNICK

2. Futures and Options on Foreign Exchange 7 Chapter Seven Chapter Objective: This chapter discusses exchange-traded currency futures contracts, options contracts, and options on currency futures. INTERNATIONAL FINANCIAL MANAGEMENT Fourth Edition EUN / RESNICK

3. Chapter Outline • Futures Contracts: Preliminaries • Currency Futures Markets • Basic Currency Futures Relationships • Eurodollar Interest Rate Futures Contracts • Options Contracts: Preliminaries • Currency Options Markets • Currency Futures Options

4. Futures Contracts: Preliminaries • A futures contract is like a forward contract: • It specifies that a certain currency will be exchanged for another at a specified time in the future at prices specified today. • A futures contract is different from a forward contract: • Futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse.

5. Futures Contracts: Preliminaries • Standardizing Features: • Contract Size • Delivery Month • Daily resettlement • Initial performance bond (about 2 percent of contract value, cash or T-bills held in a street name at your brokerage).

6. Daily Resettlement: An Example • Consider a long position in the CME Euro/U.S. Dollar contract. • It is written on €125,000 and quoted in $ per €. • The strike price is $1.30 the maturity is 3 months. • At initiation of the contract, the long posts an initial performance bond of $6,500. • The maintenance performance bond is $4,000.

7. Daily Resettlement: An Example • Recall that an investor with a long position gains from increases in the price of the underlying asset. • Our investor has agreed to BUY €125,000 at $1.30 per euro in three months time. • With a forward contract, at the end of three months, if the euro was worth $1.24, he would lose $7,500 = ($1.24 – $1.30) × 125,000. • If instead at maturity the euro was worth $1.35, the counterparty to his forward contract would pay him $6,250 = ($1.35 – $1.30) × 125,000.

8. Daily Resettlement: An Example • With futures, we have daily resettlement of gains an losses rather than one big settlement at maturity. • Every trading day: • if the price goes down, the long pays the short • if the price goes up, the short pays the long • After the daily resettlement, each party has a new contract at the new price with one-day-shorter maturity.

9. Performance Bond Money • Each day’s losses are subtracted from the investor’s account. • Each day’s gains are added to the account. • In this example, at initiation the long posts an initial performance bond of $6,500. • The maintenance level is $4,000. • If this investor loses more than $2,500 he has a decision to make: he can maintain his long position only by adding more funds—if he fails to do so, his position will be closed out with an offsetting short position.

10. Currency Futures Markets • The Chicago Mercantile Exchange (CME) is by far the largest. • Others include: • The Philadelphia Board of Trade (PBOT) • The MidAmerica commodities Exchange • The Tokyo International Financial Futures Exchange • The London International Financial Futures Exchange

11. The Chicago Mercantile Exchange • Expiry cycle: March, June, September, December. • Delivery date third Wednesday of delivery month. • Last trading day is the second business day preceding the delivery day. • CME hours 7:20 a.m. to 2:00 p.m. CST.

12. Basic Currency Futures Relationships • Open Interest refers to the number of contracts outstanding for a particular delivery month. • Open interest is a good proxy for demand for a contract. • Some refer to open interest as the depth of the market. The breadth of the market would be how many different contracts (expiry month, currency) are outstanding.

13. LIFETIME OPEN INT OPEN HIGH LOW SETTLE CHG HIGH LOW Euro/US Dollar (CME)—€125,000; $ per € Mar 1.3136 1.3167 1.3098 1.3112 -.0025 1.3687 1.1363 159,822 Jun 1.3170 1.3193 1.3126 1.3140 -.0025 1.3699 1.1750 10,096 Sept 1.3202 1.3225 1.3175 1.3182 -.0025 1.3711 1.1750 600 Reading Currency Futures Quotes Notice that open interest is greatest in the nearby contract, in this case March, 2005. In general, open interest typically decreases with term to maturity of most futures contracts.

14. LIFETIME OPEN INT OPEN HIGH LOW SETTLE CHG HIGH LOW Euro/US Dollar (CME)—€125,000; $ per € Mar 1.3136 1.3167 1.3098 1.3112 -.0025 1.3687 1.1363 159,822 Jun 1.3170 1.3193 1.3126 1.3140 -.0025 1.3699 1.1750 10,096 Sept 1.3202 1.3225 1.3175 1.3182 -.0025 1.3711 1.1750 600 Reading Currency Futures Quotes From June 15 to September 21, 2005 (the actual delivery dates of these contracts) we should expect higher interest rates in dollar denominated accounts: if we find a higher rate in a euro denominated account, we may have found an arbitrage.

15. Options Contracts: Preliminaries • An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset in the future, at prices agreed upon today. • Calls vs. Puts • Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future, at prices agreed upon today. • Put options gives the holder the right, but not the obligation, to sell a given quantity of some asset at some time in the future, at prices agreed upon today.

16. Options Contracts: Preliminaries • European vs. American options • European options can only be exercised on the expiration date. • American options can be exercised at any time up to and including the expiration date. • Since this option to exercise early generally has value, American options are usually worth more than European options, other things equal.

17. Options Contracts: Preliminaries • In-the-money • The exercise price is less than the spot price of the underlying asset. • At-the-money • The exercise price is equal to the spot price of the underlying asset. • Out-of-the-money • The exercise price is more than the spot price of the underlying asset.

18. Options Contracts: Preliminaries • Intrinsic Value • The difference between the exercise price of the option and the spot price of the underlying asset. • Speculative Value • The difference between the option premium and the intrinsic value of the option. Option Premium Intrinsic Value Speculative Value + =

19. Currency Options Markets • PHLX • HKFE • 20-hour trading day. • OTC volume is much bigger than exchange volume. • Trading is in six major currencies against the U.S. dollar.

20. PHLX Currency Option Specifications

21. Out-of-the-money In-the-money Basic Option Profit Profiles Profit If the call is in-the-money, it is worth ST – E. If the call is out-of-the-money, it is worthless and the buyer of the call loses his entire investment of c0. Long 1 call ST –c0 E + c0 E loss

22. E + c0 Out-of-the-money In-the-money E Basic Option Profit Profiles Profit If the call is in-the-money, the writer loses ST – E. If the call is out-of-the-money, the writer keeps the option premium. c0 ST short 1 call loss

23. E – p0 In-the-money Out-of-the-money E Basic Option Profit Profiles Profit If the put is in-the-money, it is worth E– ST. The maximum gain is E – p0 If the put is out-of-the-money, it is worthless and the buyer of the put loses his entire investment of p0. E – p0 ST – p0 long 1 put loss

24. E – p0 E Basic Option Profit Profiles Profit If the put is in-the-money, it is worth E–ST. The maximum loss is – E + p0 If the put is out-of-the-money, it is worthless and the seller of the put keeps the option premium of p0. p0 ST short 1 put – E + p0 loss

25. $1.75 Example Profit • Consider a call option on £31,250. • The option premium is $0.25 per pound • The exercise price is $1.50 per pound. Long 1 call on 1 pound ST –$0.25 $1.50 loss

26. $1.75 Example Profit • Consider a call option on £31,250. • The option premium is $0.25 per pound • The exercise price is $1.50 per pound. Long 1 call on £31,250 ST –$7,812.50 $1.50 loss

27. –$4,687.50 $1.35 Example Profit What is the maximum gain on this put option? At what exchange rate do you break even? $42,187.50 = £31,250×($1.50 – $0.15)/£ $42,187.50 • Consider a put option on £31,250. • The option premium is $0.15 per pound • The exercise price is $1.50 per pound. ST Long 1 put on £31,250 $1.50 $4,687.50 = £31,250×($0.15)/£ loss

28. Option Value Determinants Call Put 1. Exchange rate + – 2. Exercise price – + 3. Interest rate in U.S. + – 4. Interest rate in other country + – 5. Variability in exchange rate + + 6. Expiration date + + The value of a call option C0 must fall within max (S0 – E, 0) <C0<S0. The precise position will depend on the above factors.

29. End Chapter Seven