Currency Derivatives or chapter 7 Agenda

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 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 3 rd Wed/ 01, 03, 04, 06, 07, 09, 10, or 12. Last trading day – contracts may trade through 2 nd 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

Futures Speculation 500, 000 New Mexican pesos. Maturity Open High Low Settle Change High Low Open Interest Mar . 10953 . 10988 . 10930 . 10958 --- . 11000 . 09770 34, 481 June . 10790 . 10795 . 10778 . 10773 --- . 10800 . 09730 3, 405 Sept . 10615 . 10610 . 10573 --- . 10615 . 09930 1, 4181 Source: Wall Street Journal, February 22, 2002, p. C 13 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.

Forex Futures vs. Forwards Characteristic Foreign Currency Futures Forward Contract Size Maturity Standardized fixed maturities Location organized exchange any size desired any maturity up up to a year b/n individuals & banks Pricing open outcry bid/ask quotes Margin/Collateral daily marked to market no collateral Settlement rarely delivered, settlement through offsetting contract delivered, 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, relatively large market

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).

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

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

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 § Price elements • American: may exercise during life of option. • European: may not exercise until maturity. • Strike (exercise price): exchange rate @ which foreign currency • • can be purchased/ sold. Premium, price of option Spot rate

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

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 prespecified terms. No commitment.

Forex Options Markets § Swiss Franc options (WSJ) Each option = 62, 500 Swiss francs. § Call premium: SF 62, 500 x $0. 0050/SF = $312. 50.

Speculation § Assume spot rate: $0. 5851/SF, 6 m 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 SF 173, 611. 11 x $0. 576/SF= • $100, 000. Step 2: In 6 m, fulfill forward & sell proceeds in spot market Sfr 173, 611. 11 x $0. 6000/Sfr = $104, 166. 67. § Options market • Long Call, Short Call, Long Put, Short Put.

For Example… § Suppose that: • you have $10 m. • Wish to speculate on Euro • S = $ 0. 885/ EUR, F 30 = $ 0. 900/ EUR. – You expect S 30 = $ 0. 844/ EUR (EUR depreciates). – Arbitrage strategy? – You expect S 30 = $ 0. 944/ EUR (EUR appreciates). – Arbitrage strategy?

Profit & Loss Buyer of Call (Long Call) ATM Strike price Profit (US cents/SF) OTM Ce. T = Max[ST - E, 0] ITM + 1. 00 + 0. 50 0 - 0. 50 Unlimited profit 57. 5 58. 0 Limited loss 58. 5 59. 0 59. 5 Spot price (US cents/SF) Break-even price - 1. 00 Loss Profit = Spot rate – (Strike price + Premium) Profit = ? if Spot = $ 0. 595/ SF. 15

Profit & Loss Writer of Call (Short Call) ATM Strike price Profit (US cents/SF) Ce. T = Max[ST - E, 0] + 1. 00 + 0. 50 0 Break-even price Limited profit 57. 5 58. 0 58. 5 59. 0 - 0. 50 59. 5 Spot price (US cents/SF) Unlimited loss - 1. 00 Loss Profit = Premium – (Spot rate - Strike price). Profit = ? if Spot = $ 0. 595/ SF. 16

Profit & Loss for Buyer of Put (Long Put) “At the money” Strike price Profit (US cents/SF) “In the money” Pa. T=Pe. T=Max[E - ST, 0] “Out of the money” + 1. 00 + 0. 50 0 Profit up to 58. 0 57. 5 58. 0 58. 5 - 0. 50 - 1. 00 59. 5 Limited loss Spot price (US cents/SF) Break-even price Loss Profit = Strike price – (Spot rate + Premium) Profit = ? if Spot = $ 0. 575/ SF. 17

Profit & Loss for Writer of Put (Short Put) “At the money” Profit (US cents/SF) Strike price Pa. T=Pe. T=Max[E - ST, 0] + 1. 00 + 0. 50 0 Break-even price 57. 5 58. 0 Limited profit 58. 5 59. 0 59. 5 Spot price (US cents/SF) - 0. 50 - 1. 00 Unlimited loss up to 58. 0 Loss Profit = Premium – (Strike price - Spot rate) Profit = ? if Spot = $ 0. 575/ SF. 18

For Example… § Suppose that: • • • You wish to speculate on fall of Yen vs. $. Current S = Yen 120/ $ (or $. 00833/Yen). Maturity: 90 days. Expected S 90 = Yen 140/$ (or $. 00714). Two options available: Call on Yen Put on Yen – Strike: – Premium: Yen 125/$ (or $. 008/ Yen) $. 00046 1. What option to buy? 2. Break even price on option of choice? 3. If S= Yen 140/ $, what is net profit? Yen 125/$. (or $. 008/ Yen) $. 00003

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).

Market-, Time- & Intrinsic Value Option Premium (US cents/£) 6. 0 Strike Price of $1. 70/£ -- Valuation on first day of 90 -day maturity -5. 67 Total value 5. 0 4. 0 3. 30 3. 0 2. 0 1. 67 Time value Intrinsic value 1. 0 0. 0 1. 66 1. 67 European Call on Brit Pound 1. 68 1. 69 1. 70 1. 71 1. 72 1. 73 1. 74 Spot rate ($/£) 21

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.

Replicating Portfolio Evaluation § § § § Suppose US$-EUR rate is S 0($/EUR) = $1. S 1($/ 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 & buy 1 EUR. Net payoff: $0. 20 or $0. Portfolio value: so option value: S 0($/EUR) S 1($/EUR) C 1($/EUR) Debt Portfolio $1. 10 $0. 10 -$0. 90 $0. 20 $0. 90 $0 -$0. 90 $0. 00 $1

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).

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?