CHAPTER 6 CURRENCY FUTURES AND OPTIONS MARKETS

CHAPTER 6 CURRENCY FUTURES AND OPTIONS MARKETS

CHAPTER OVERVIEW I. II. FUTURES CONTRACTS CURRENCY OPTIONS

PART I. FUTURES CONTRACTS I. CURRENCY FUTURES A. Background 1. 1972: Chicago Mercantile Exchange opens International Monetary Market. (IMM)

FUTURES CONTRACTS 2. IMM provides a. an outlet for hedging currency risk with futures contracts. b. Definition: contracts written requiring a standard quantity of an available currency at a fixed exchange rate at a set delivery date.

FUTURES CONTRACTS c. Available Futures Currencies: 1. ) British pound 5. ) French franc 2. ) 3. ) 4. ) 6. ) Japanese yen 7. ) Australian dollar Canadian dollar German mark Swiss franc

FUTURES CONTRACTS d. Standard Quantity of Currency contract quantity sizes differ for each of the 7 available currencies. Example German mark = DM 125, 000

FUTURES CONTRACTS e. f. Transaction costs: payment of commission to a trader Leverage is high 1. ) Initial margin required is relatively low (less than 2% of contract value).

FUTURES CONTRACTS g. Maximum price movements 1. ) Contracts set to a daily price limit restricting maximum daily price movements.

FUTURES CONTRACTS 2. ) If limit is reached, a margin call may be necessary to maintain a minimum margin.

FUTURES CONTRACTS h. Global futures exchanges: 1. ) I. M. M. International Monetary Market 2. ) L. I. F. F. E. London International Financial Futures Exchange 3. ) C. B. O. T. Chicago Board of Trade

FUTURES CONTRACTS 4. ) S. I. M. E. X. Singapore International Monetary Exchange 5. ) D. T. B. Deutsche Termin Bourse 6. ) H. K. F. E. Hong Kong Futures Exchange

FUTURES CONTRACTS B. Forward vs. Futures Contracts Basic differences: 1. Trading Locations 2. Regulation 3. Frequency of delivery costs 4. Size of contract 5. Delivery dates 6. Settlement Date 7. Quotes 8. Transaction 9. Margins 10. Credit risk

FUTURES CONTRACTS Advantages of futures: 1. ) Smaller contract size 2. ) Easy liquidation 3. ) Wellorganized and stable market. Disadvantages of futures: 1. ) Limited to 7 currencies 2. ) Limited dates of delivery 3. ) Rigid contract sizes.

PART II CURRENCY OPTIONS I. OPTIONS A. Currency options 1. offer another method to hedge exchange rate risk. 2. first offered on Philadelphia Exchange (PHLX). 3. fastest growing segment of the hedge markets.

CURRENCY OPTIONS 4. Definition: a contract from a writer ( the seller) that gives the right not the obligation to the holder (the buyer) to buy or sell a standard amount of an available currency at a fixed exchange rate for a fixed time period.

CURRENCY OPTIONS 5. Types of Currency Options: a. American exercise date may occur any time up to the expiration date. b. European exercise date occurs only at the expiration date.

CURRENCY OPTIONS 7. Exercise Price a. Sometimes known as the strike price. b. the exchange rate at which the option holder can buy or sell the contracted currency.

CURRENCY OPTIONS 8. Status of an option a. In-the-money Call: Spot > strike Put: Spot < strike b. Out-of-the-money Call: Spot < strike Put: Spot > strike c. At-the-money Spot = the strike

CURRENCY OPTIONS 9. The premium: the price of an option that the writer charges the buyer.

CURRENCY OPTIONS B. Using Currency Options 1. For the firm hedging foreign exchange risk a. With sizable unrealized gains. b. With foreign currency flows forthcoming.

CURRENCY OPTIONS 2. For speculators - profit from favorable exchange rate changes.

CURRENCY OPTIONS C. Option Pricing and Valuation 1. Value of an option equals a. Intrinsic value b. Time value

CURRENCY OPTIONS 2. Intrinsic Value the amount in-the-money 3. Time Value the amount the option is in excess of its intrinsic value.

CURRENCY OPTIONS 4. Other factors affecting the value of an option a. value rises with longer time to expiration. b. value rises when greater volatility in the exchange rate.

CURRENCY OPTIONS 5. Value is complicated by both the home and foreign interest rates.

CURRENCY OPTIONS D. Using Forward or Futures Contracts: Forward and futures contracts are more suitable for hedging a known amount of foreign currency flow.

CURRENCY OPTIONS E. Market Structure 1. Location a. Organized Exchanges b. Over-the-counter 1. ) Two levels retail and wholesale