Futures and Options on Foreign Exchange. This chapter discusses exchange-traded currency futures and options contracts.

Transcription

1 Futures and Options on Foreign Exchange 7 Chapter Seven Chapter Objective: This chapter discusses exchange-traded currency futures and options contracts. 7-0 Chapter Outline Currency futures and Currency options contracts: Mechanics / how do they work? Quote interpretation Pricing Applications Hedging Speculation 7-1 1

2 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. 7-2 Futures Contract : Basics Contract specifying a standard quantity of a particular currency to be exchanged on a specific settlement date. Buy futures today: Agree to take delivery of the currency on (a future) settlement date: To hedge: Avoid uncertainty involved in buying FX at a future date. (eg., cover future FX payables) To speculate: Make a bet that future spot rate > current futures price Sell futures today: Agree to deliver the currency on (a future) settlement date: To hedge: Avoid uncertainty involved in selling FX at a future date. (eg., cover future FX receivables) To speculate: Make a bet that future spot rate < current futures price Futures contracts are also available on: Agricultural products and livestock / Metals and petroleum / Interest rates / Stock market indices 2

3 Futures Contracts: Characteristics Standardizing Features: Exchange Traded Contract Size Delivery Month Daily resettlement Margin: Called performance bonds (about 2 percent of contract tvalue, cash or T-bills held in a street name at your brokerage). Initial Margin Maintenance Margin 7-4 Basic Difference Between Forward and Futures Contract Market for Forward Contract Market for Futures Contract 1. Traded via telephone network 1. Traded face to face, in the exchange 2. Individually tailored size 2. Standardized size 3. Any agreed upon delivery date 3. Specified delivery date 4. Settlement occurs as agreed upon 4. Daily settlement, marked to market 5. Transaction costs: bid-ask basis 5. Transaction costs: brokerage fee 6. Margin: not required 6. Margin: required 7. Credit risk: borne by each party 7. Credit risk: exchange acts as clearing house 3

4 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 ti Financial i Futures Exchange The London International Financial Futures Exchange 7-6 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

5 Contract Size for Currency Futures Contract Specification for Currency Futures 5

6 Futures Contract: Daily Settlement Process At the end of each day: The day s closing price is compared to previous day s closing price to dt determine loss/gain for that t day The gain is added to (loss is subtracted from) the margin balance If current margin balance is more than maintenance margin you can withdraw the difference If current margin balance is below maintenance margin you get a margin call, so that you increase your margin balance up to initial iti margin A new contract based on the current day s closing price replaces the old contract based on previous day s closing price This process is repeated at the end of each closing day till settlement date Sample FX Futures Price Quotes: CME 6

7 Reading Currency Futures Quotes OPEN OPEN HIGH LOW SETTLE CHG INT Euro/US Dollar (CME) 125,000; $ per Mar ,396 Jun ,266 Expiry month Opening price Highest price that day 7-12 Closing price Daily Change Lowest price that day Number of open contracts 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 ldbe how many different contracts (expiry month, currency) are outstanding

8 Reading Currency Futures Quotes OPEN HIGH LOW SETTLE CHG Euro/US Dollar (CME) 125,000; $ per OPEN INT Mar ,396 Jun ,266 Notice that open interest is greatest in the nearby contract, in this case March, In general, open interest typically decreases with term to maturity of most futures contracts. The holder of a long position is committing to pay $ per euro for 125,000 a $184, position. As there are 172,396 such contracts outstanding, this represents a notational principal of over $31.8 billion! 7-14 Long, 1 Euro Futures Contract on 10/01 Euro Futures Price Cumulative Margin Margin Date Price Change Loss/Gain Loss/Gain Balance Call Mon, 10/01 Tue, 10/ Wed, 10/ Thu, 10/ Fri, 10/ Mon, 10/

9 Short, 1 Euro Futures Contract on 10/01 Euro Futures Price Cumulative Margin Margin Date Price Change Loss/Gain Loss/Gain Balance Call Mon, 10/01 Tue, 10/ Wed, 10/ Thu, 10/ Fri, 10/ Mon, 10/ Long, 2 Euro Futures Contracts on 10/01 Date Euro Futures Price Price Cumulative Change Loss/Gain Loss/Gain Margin Balance Margin Call Mon, 10/01 Tue, 10/ Wed, 10/ Thu, 10/ Fri, 10/ Mon, 10/

10 Short, 3 Euro Futures Contracts on 10/01 Date Mon, 10/01 Tue, 10/02 Euro Futures Price Price Cumulative Change Loss/Gain Loss/Gain Margin Balance Margin Call Wed, 10/ Thu, 10/ Fri, 10/ Mon, 10/ Profit/Loss from Futures Trading: Formula f(t) = Futures Contract price on day t f(t+1) = Futures Contract price on day t+1 N = number of units of foreign currencies per futures contract Profit / Loss from futures contract trading on day 1 for: Buyer = [f(t) f(t+1)] * N ; Seller = - [f(t) f(t+1)] * N Margin Position on a given day for Buyer or Seller: Beginning Margin for that day + Profit/Loss for that day = Ending Margin for that day If the Ending Margin for that day is more than the Initial i Margin, then: Ending Margin Initial Margin = Excess If the Ending Margin for that day is less than the Maintenance Margin, then: Initial Margin Ending Margin = Deficit If there is a deficit for that day, the trader will receive a margin call from the exchange for the amount of the deficit 10

11 Trading irregularities Futures Markets are also a great place to launder money The zero sum nature of futures is the key to laundering the money Money Laundering: Hillary Clinton s Cattle Futures James B. Blair outside counsel to Tyson Foods Inc., Arkansas' largest employer, gets Hillary s discretionary order. Submits identical long and short trades winners losers Robert L. "Red" Bone, (Refco broker), allocates trades ex post facto

12 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 Options Contracts: Preliminaries In-the-money Call: The exercise or buying price (E) is less than the spot price (S) of the underlying asset. Put: The exercise or selling price (E) is more than the spot price (S) of the underlying asset. At-the-money Call & Put: The exercise price (E) is equal to the spot price (S) of the underlying asset. Out-of-the-money Call: The exercise or buying price (E) is more than the spot price (S) of the underlying asset. Put: The exercise or selling price (E) is less than the spot price (S) of the underlying asset

13 Currency Call Option The buyer of a currency call option is granted the right but not the obligation to buy a specific currency at a specific price (exercise or strike price) within a specific period of time (expiration date). The seller of the call must deliver the currency at the exercise price exercised against. The call option buyer pays a specific price for each call (call premium), which the seller of the call receives. Basic Call Option Pricing Relationships at Expiry If the call is in-the-money, it is worth S E. If the call is out-of-the-money, it is worthless. C = Max[S - E, 0]

14 Profit / Loss for Buyers / Sellers of Calls Call Buyer Call Seller When: In / Out Exercise? Profit / Loss Profit / Loss S > E In Yes [(S E) C]* N -[(S E) C]* N S < E Out No [- C] * N [C] * N S = Currency spot price, on expiration date E = Exercise price for call or put C = Call premium / unit P = Put premium / unit N = Number of units / contract If the spot price of the currency (S) is : more then the call exercise price (E), then the options is in the money less then the call exercise price (E), then the options is out of the money equal to the call exercise price (E), then the options is at the money Basic Option Profit Profiles Profit If the call is in-themoney, it is worth S E. If the call is out-ofthe-money, it is worthless and the c buyer of the call loses his entire investment of c. loss Owner of the call Long 1 call S E + c 0 E Out-of-the-money In-the-money

15 Basic Option Profit Profiles Profit If the call is in-themoney, the writer loses S E. If the call is out-ofthe-money, the writer keeps the option premium loss c Seller of the call E + c E Out-of-the-money In-the-money S short 1 call Example Profit Consider a call option on 31,250. The option premium is $0.25 per The exercise price is $1.50 per. $ loss $1.75 $1.50 Long 1 call on 1 pound S 15

16 Currency Put Option The buyer of a currency put option is granted the right but not the obligation to sell a specific currency at a specific price (exercise or strike price) within a specific period of time (expiration date). The seller of the put must purchase the currency at the exercise price. The put buyer pays a specific price (put premium) for each put, which the seller of the put receives Basic Put Option Pricing Relationships at Expiry If the put is in-the-money, it is worth E - S. If the put is out-of-the-money, it is worthless. P = Max[E S, 0]

17 Profit / Loss for Buyers / Sellers of Puts Put Buyer Put Seller When: In / Out Exercise? Profit / Loss Profit / Loss S > E Out No [- P] * N [P] * N S < E In Yes [(E S) P]* N -[(E S) P]* N S = Currency spot price, on expiration date E = Exercise price for call or put C = Call premium / unit P = Put premium / unit N = Number of units / contract If the spot price of the currency (S) is : more then the call exercise price (E), then the options is out of the money less then the call exercise price (E), then the options is in the money equal to the call exercise price (E), then the options is at the money Basic Option Profit Profiles Profit If the put is inthe-money, it is E p worth E S. The maximum gain is E p If the put is out- of-the-money, it is worthless and p the buyer of the put loses his entire investment of p. loss 7-33 Owner of the put S E p long 1 put E In-the-money Out-of-the-money 17

18 Basic Option Profit Profiles Profit If the put is inthe-money, it is worth E S T. The maximum loss is E + p If the put is out- p of-the-money, it is worthless and the seller of the put keeps the option premium of p. E + p loss 7-34 Seller of the put E p E S short 1 put Example Profit What is the maximum gain on this put option? $42, $42, = 31,250 ($1.50 $0.15)/ Consider a put At what exchange rate do you break even? option on 31,250. The option premium is $0.15 per The exercise price is $1.50 per pound. loss 7-35 $4, S $1.35 Long 1 put $1.50 on 31,250 $4, = 31,250 ($0.15)/ 18

19 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 7-36 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 7-38 Currency Contract Size Australian dollar AD10,000 British pound 10,000 Canadian dollar CAD10,000 Euro 10, Japanese yen 1,000,000 Swiss franc SF10,000 Currency Option Specifications

21 Sample FX Options Price Quotes Currency Call Option: An Example Suppose on 1/30/20XX (See attached quote) : March call options on euros with a strike price $1.45 are selling for $ This option allows you to buy E 10,000 by the third Wednesday of March at a price of $1.45. The total price for one contract is: 10,000 * $ = $398. March call options on Euros with a strike price $1.48 are selling for $ This option allows you to buy E 10,000 by the third Wednesday of March at a price of $1.45. The total price for one contract is: 10,000 * $ = $222 Given that the current price of euro is , are these call options in or out of the money? How can you loose or make money from this position? 21

22 Currency Put Option: An Example Suppose on 1/30/20XX (See attached quote) : January put options on yens with a strike price $ are selling for $ This option allows you to sell Y 1,000,000 by the third Wednesday of January at a price of $ The total price for one contract is: 1,000,000 * $ = $45. March put options on yens with a strike price $ are selling for $ This option allows you to buy Y 1,000,000 by the third Wednesday of March at a price of $ The total price for one contract is: 1,000,000 * $ = $216. Given that the current price of yen is $ , are these put options in or out of the money? How can you loose or make money from this position? American & European Options European options can only be exercised on the expiration i 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

23 American & European Option Pricing Relationships With an American call (C a ) or put (P a ) option, you can do everything that you can do with a European call (C e ) or put (P e ) option AND you can exercise prior to expiry this option to exercise early has value, thus: C a > C e P a > P e 7-44 SPECULATION: Spot, Futures, Forward and Option strategies If a speculator believes that a foreign currency will increase in price: Spot Market: Borrow home currency, buy FX now, put the money in a foreign currency bank account Forward Market: Buy forward contract Futures Market: Buy futures contract Options Market: Buy Call Options: Buy the right to buy FX from the seller at what you believe is a low price Sell Put Options: Sell the right to sell FX to you at what you believe is a low price 23

24 SPECULATION: Spot, Futures, Forward and Option strategies If a speculator believes that a foreign currency will decrease in price: Spot Market: Borrow foreign currency, sell FX now, put the money in a domestic currency bank account Forward Market: Sell forward contract Futures Market: Sell futures contract Options Market: Buy Put Options: Buy the right to sell FX to the the dealer at what you believe is a high price Sell Call options: Sell the right to buy FX from you at what you believe to be a high price 24