CHAPTER 7 - CURRENCY FUTURES AND OPTIONS Opening story on p. 162 of Barings, oldest bank in U.K.

, got in big trouble when one of its traders took unauthorized positions in ex hange!traded options and futures ontra ts, "ostly on the #ikkei 22$ %to k &ndex futures ontra ts ! unhedged '2(B position. )osses were lose to '1B when the "arket "o*ed unfa*orably against the trader+s spe ulati*e positions, ex eeding the bank+s entire e,uity apital, for ing bank into -ad"inistration- by the Bank of .ngland /U.K.+s entral bank0. &llustrates the extre"e danger1*olatility of deri*ati*es. Options and futures an be used to eli"inate, redu e, hedge and "anage risk, like insuran e, but an also be extre"ely spe ulati*e. 2hy33 MECHANICS OF FUTURES CONTRACTS 4ifferen es1si"ilarities between futures and forward ontra ts, see su""ary .xhibit (.1 on p. 1656 Similarities: 1. Both are derivative securities for future deli*ery1re eipt. 7gree on 8 and 9 today for future settle"ent or deli*ery in 1 week to 1: years. 2. Both are used to hedge urren y risk, interest rate risk or o""odity pri e risk. ;. &n prin ipal they are *ery si"ilar, used to a o"plish the sa"e goal of risk "anage"ent. Differences: 1. <orward ontra ts are pri*ate, usto"ized ontra ts between a bank and its lients /=#>s, exporters, i"porters, et .0 depending on the lient+s needs. ?here is no se ondary "arket for forward ontra ts sin e it is a pri*ate ontra tual agree"ent, like "ost bank loans /*s. bond0. 2. <orward ontra ts are settled at expiration, futures ontra ts are ontinually settled, daily settle"ent. ;. =ost /@:A0 of forward ontra ts are settled with deli*ery1re eipt of the asset. =ost futures ontra ts /@@A0 are settled with ash, #O? the o""odity1asset. 5. <utures "arkets ha*e daily pri e li"its. FUTURES CONTRACTS >urren y <utures >ontra ts are standardized ontra ts, with fixed, standardized ontra t sizes and fixed expiration dates, that are exc an!e"traded, i.e., traded as se urities on organized ex hanges. <utures ontra ts ha*e se ondary "arkets, an be traded "any ti"es during life of ontra t, like a bond /*s. bank loan0. %ee .xhibit (.2 on p. 16(. Contract Examples: Ben ontra ts6 C12.$" /approx '126,:::0, 8ound6 D62,$:: /approx. '1::,:::0, .uro6 E12$,::: /approx '16:,:::0, %<6 12$,::: /approx '1:6,:::0, et . .xpiration dates6 =ar h, Fune, %ept, and 4e e"ber on the ;rd 2ednesday. N#te6 &f you wanted to hedge re eipt1pay"ent of D1::,:::, you would ha*e to either do a partial hedge of D62,$:: /1 ontra t0 or -o*er!hedge- with 2 ontra ts for D12$,::: total.
1

BU% 5661$666 &nternational <inan e G >H (

8rofessor =ark F. 8erry

Initial $erf#rmance %#nd &f#rmerl' called mar!in(: ?he initial in*est"ent re,uired to establish a futures position. ?o buy one U.K. pound futures ontra t, you would ha*e to put up about ';,$::, whi h is only about ;.$A of the ontra t *alue of '1::,:::. Bou would also ha*e to keep a )maintenance mar!in*) usually (:!($A of the initial "argin. &n this ase, you ould ne*er let your a ount go below '2,6:: /about ($A of ';,$::0. &f you an+t "ake "argin all, your ontra t is li,uidated by broker. Dail' settlement &mar+ed"t#"mar+et(: <utures ontra ts are re*alued daily depending on the daily settle"ent pri e /ex!rate0. .*ery futures ontra t in*ol*es a buyer /long0 and a seller /short0. Buyer /seller0 will gain /lose0 when the settle"ent pri e rises /falls0. <utures trading is a -zero!su"- ga"e, e*ery gain is exa tly offset by a loss of the sa"e a"ount. %ee .xhibit (.5, p. 1(:, for >anadian dollar />40 futures ontra t, payoff diagra". &f the >4 rises /falls0, the buyer1long will ha*e their "argin a ount in reased /de reased0. &f the >4 falls /rises0, the seller1short will ha*e their a ount in reased /de reased0. Difference: 8rofits1losses for a futures ontra t a u"ulate on a daily basis *s. forward ontra t, where profits1losses are realized all at on e at ontra t expiration. T,O $ARTICI$ANTS IN FUTURES -. S/eculat#rs ! pure spe ulati*e bet1in*est"ent using futures ontra ts, with no business interest in the underlying o""odity1 urren y. 0. Hed!ers ! so"eone with a business1personal interest in the underlying urren y, and is using futures trading to "ini"ize, eli"inate or ontrol urren y risk, e.g., =#>s, banks, exporters, i"porters, et . &f a hedger is short /long0 and a spe ulator is long /short0, the hedger is -selling- their risk to the spe ulator. &n forward ontra ts, @:A of settle"ents in*ol*e an a tual ex hange of assets, the short /seller0 deli*ers the asset to the buyer /long0. Examples: the bank sells 4= to the U.%. i"porter at an agreed upon rate, so the i"porter an pay for "er handise. Or the bank buys Ben fro" the exporter at an agreed upon rate, so the exporter an on*ert foreign ex hange into U% dollars. &n futures ontra ts, only 1A of ontra ts are settled with the underlying asset, @@A are -settled with ash- by a )reversin! trade.) Be ause of daily settle"ent, the ontra t is a tually settled in ash ontinually throughout the ontra t. )ike buying insuran e, you get a ash settle"ent fro" your auto insuran e o"pany, not a new ar or body work. <utures ontra ts are like -side bets.- @:A of forward ontra ts in*ol*e an ex hange of urren y, the person who is short /seller0 a tually deli*ers <I to the long /buyer0. Reversin! Trade in*ol*es taking an offsetting position, whi h loses out, neutralizes, your futures position, and you exit the "arket. &f you are long /buy0, you take a short /sell0 position to lose out ! you are then selling to yourself, neutralizes your ontra t.
2

BU% 5661$666 &nternational <inan e G >H (

8rofessor =ark F. 8erry

%in e urren y futures ontra t expire on only four days per year /third 2ed. in =ar, Fune, %ept, 4e 0, re*ersing trades allows a hedger to ti"e their own expiration of the ontra t to oin ide with the underlying business a ti*ity ! e.g. exporting, i"porting. >o""ission6 7s low as '1$ per urren y futures ontra t, whi h in ludes starting and ending the position, -round!trip- o""ission. Je*ersing trade is in luded. <utures ex hanges like >=. a t as third party )clearin! #uses) to fa ilitate futures trading. Buyers and sellers trade through the learinghouse as a third party, and do not ha*e to deal dire tly with ea h other. ?raders do not then ha*e to e*aluate the reditworthiness of the other party to the transa tions. ?he >learing =e"bers guarantee the trades, "onitor and "aintain the "argin a ounts, and indi*idual traders are prote ted fro" default. Dail' $rice 1imit ! feature of <utures, not <orward ontra ts. ->ir uit breaker- to li"it large losses in one day, set by the ex hange. &f the settle"ent pri e hanges by the daily pri e li"it, trading is stopped until the next day. =ost urren y futures ha*e no li"its, "any interest rate futures ha*e a 2:: point li"it. )i*e attle and hog futures li"its are '.:;1lb., butter is '.:$1lb., "ilk is '.($ per hundredweight. Usin! Currenc' Futures f#r Hed!in! K= has to pay E1:" in three "onths for a deli*ery of parts fro" Ker"any in*oi ed in euros. 2orried3 O*er the next three "onths6 'LLLLLL and E LLLLLL . <or exa"ple, suppose the spot ex!rate is '1.2$1E and re"ains onstant for ; "onths, the parts will ost '12,$::,::: /'1.2$1E x E1:"0. &f the euro appre iates by 5A o*er the next three "onths, the ex!rate will be LLLLLLL and the parts will now ost LLLLLLLLL, an in rease of LLLLLLLLL. %uppose that ;!"onth euro futures ontra ts are pri ed at '1.2$$:1E. .uro ontra ts are for E12$,:::, so K= would need M: ontra ts to o*er the E1:" /E1: " 1 E12$,::: N M:0. K= would take a LLLLLLLLL position to hedge against the euro LLLLLLLLLL. %ettle"ent will be in ash, not euros.

1#n!
$r#fit
F56 7 -.088634

234 S/#t Rate at Ex/irati#n &56 da's(

1#ss

S #rt
;

BU% 5661$666 &nternational <inan e G >H (

8rofessor =ark F. 8erry

%uppose the euro is '1.;:1E in ; "onths. K= will separately6 a0 settle the futures ontra ts, and b0 buy the euros in the spot "arket. a. Kain on futures /'1.;: G '1.2$$0 x E1:" N O'5$:,::: profit. b. 8ur hase E1: "illion P '1.;: per euro N /'1;,:::,:::0 #et ost of buying the euros6 !'1;" /spot0 O '.5$" /futures0 profit N '12.$$" /or '1.2$$1E0 %uppose the euro is '1.2:1E in ; "onths. K= will separately6 a0 settle the futures ontra ts, and b0 buy the euros in the spot "arket. a. )oss on futures /'1.2: G '1.2$$0 x E1:" N !'$$:,::: loss. b. 8ur hase E1:" P '1.2: N /'12,:::,:::0 #et ost of buying the euros6 !'12" /spot0 ! '.$$" /futures0 loss N '12.$$" /or '1.2$$1E0 CONC1USION: 2ith futures ontra ts at '1.2$$1E, K= guarantees an ex!rate of '1.2$$1E and a total ost of '12.$$", regardless of what happens to the euro. .*en though K= lo ks in an ex!rate of '1.2$$, it doesnQt a tually buy euros at that rate. &t will buy the 1:" euros in the spot "arket in three "onths and at the sa"e ti"e, settle the futures ontra t in >7%H. &f K= entered into a forward ontra t at '1.2$$1E, then it would a tually buy the euros at '1.2$$. F#r9ard c#ntracts: )o k in a rate, settle"ent in urren y /buy or sell foreign ex hange0 Futures c#ntracts: )o k in a rate, settle"ent in ash CURRENC: FUTURES MAR;ETS >urren y futures started trading in 1@(2 at the >hi ago =er antile .x hange />=.0, whi h opened in 1M@M /largest futures ex hange in U.%., 6 produ t areas6 sto k indexes, interest rates, urren y, weather, o""odities and real estate0 2hy then for urren y futures3 7 tually, trading in "any deri*ati*e "arkets started to explode in the 1@(:s. 1. <ixed ex hanges rates until 1@(; "eant no urren y risk. 2. &nterest rates were fixed by federal law for sa*ings a ounts /Jeg. 90 and he king a ounts /i N :A0, and so"e "ortgages /led to -points-0. ;. &nflation was low and stable, 2!;A in the 1@$:s, 1@6:s and early 1@(:s. 5. &nterest rates on ?!bills were low and stable 1!2A. $. 8ri e of oil was low and stable. . ono"i and finan ial *olatility in reased dra"ati ally in the 1@(:s. <ixed ex!rates were abandoned, started to float. Je,. 9 was e*entually repealed. &nflation and interest rates rose and be a"e *olatile in the 1@(:s. Oil pri es doubled and tripled in the two oil sho ks of the 1@(:s /1@(5!($ and 1@(@!M:0. )ed to an explosion in the deri*ati*e "arkets for futures ontra ts. Je ent hanges6 .uro, Jeal, and "any ross!rate ontra ts are now a*ailable for .uro *s. B8, Ben and %< /15 ross!rate ontra ts0. %ee 2%F handout and >=. website6 http611www. "e. o"1. 7t >=., urren y futures are traded daily /=!<0 fro" (62: a.". to 2 p.". >urren y futures also trade on >=.+s
5

BU% 5661$666 &nternational <inan e G >H (

8rofessor =ark F. 8erry

K)OB.I ele troni trading syste" /introdu ed in 1@@20, al"ost 25!(. =ost urren y futures ontra ts start trading on K)OB.I at $ p.". /$6:: on %undays0 and go until 5 p.". the next day, one hour losing for s heduled daily "aintenan e. 7l"ost all >=. produ ts now trade on K)OB.I. >urren y option ontra ts start trading on K)OB.I at 26;:p", but then stop trading at (6:$ a.". while >=. is open. >urren y futures also traded at the <inan ial .x hange in #B>, =exi o, Brazil, Budapest and Korea. CURRENC: FUTURES RE1ATIONSHI$S %ee the inside ba k o*er and .xhibit (.; on p. 16M to understand how urren y ontra ts are reported at >=.. >ontra ts are always stated in 7"eri an ter"s, with the ' on top, i.e. '1C, '1E, '1D, et . Reason: )ong position is always the buyer, short position is always the seller, and you are always going long /buying C0 or short /selling C0 on the <OJ.&K# >UJJ.#>B, not the U%4 /'0. 2hen the Ben gets stronger /weaker0, the ex!rate gets larger /s"aller0. 8ri es ,uoted are Open, High, )ow, %ettle, >hange /fro" settle on the pre*ious day to settle next day0, )ifeti"e High and )ow, and the Open &nterest. #oti e for Ben, it is ,uoted as ' per C1::, and for =exi an peso it is ' per =I#1:. Jeason6 % R C11M1', and therefore % N ':.::M5($1C, so they "ultiply x 1::, and it would be ,uoted as ':.M5($1C1::. O/en Interest: ?he nu"ber of outstanding ontra ts /long and short0, a "easure of de"and. =ost interest is in the near<' c#ntract, the one expiring next /=ar h0. Howe*er, as we got loser to expiration, /=ar h 16, 2::$0, open interest would approa h zero, as traders took re*ersing trades to lose out positions. %ee .xa"ple (.1, p. 16@ ! Jeading <utures 9uotations6 Fune 2::$ >' />40 futures opened at '.M:(M1>4, settled at '.M:$5. <ro" the >hange olu"n, we know that pri e fell !'.::2; fro" the pre*ious day /'.M:(( to '.M:$50, N >41::,::: x '!.::2;1>4 N '2;:. 4aily settle"ent, "arked!to!"arket would "ean that the shorts /longs0 would ha*e '2;: added to /subtra ted fro"0 their a ount. )ifeti"e High /':.M5@$0 and )ow /'.(1$:0 for the Fune 2::$ ontra t, Open &nterest /M,(52 ontra ts outstanding0. #ote that the sa"e pattern e"erges in both the forward "arket and the futures "arkets for the >4, it is expe ted to appre iate, U% ' depre iates, see .xhibit $.5 on p. 11$ for forward ex!rates. .*en though the "e hani s of the forward and futures "arkets are slightly different, they are both effi ient "arkets for deter"ining the expe ted future *alue of urren y. F#r9ard ;: days '.M:;(1>4 @: days .M:5; 1M: days .M:$( Futures &n#t exactl' =6* 56* ->6 da's( ':.M:561>4 .M:$5 .M:(:

BU% 5661$666 &nternational <inan e G >H (

8rofessor =ark F. 8erry

Exam/le ?.0 #n /. -?66 %uppose a spe ulator takes a position on =ar h ; for one Fune 2::$ ontra t at '.M:$51>4. &f the a tual spot ex!rate in Fune 2::$ turns out to be '.(@::1>4. ?he profit1loss would be /'.M:$51>4 ! '.(@::1>40 x >41::,::: N '1$5: gain or /'1$5:0 loss. %in e the >4 fell below '.M:$5, /see .xhibit (.50, the short would gain '1$5: and the long would lose '1$5:. 7 tually, the profits1losses would a u"ulate ontinually during the ; "onths, and '1$5: would be the net gain1loss during the holding period. ?he buyer /long0 has agreed to buy 1::,::: >4s for 'M:,$5: but an only sell the" in Fune at the spot rate for '(@,:::, loss of '1$5:. ?he seller /short0 has agreed to sell 1::,::: >4s for 'M:,$5: and an buy the" at the spot rate for '(@,:::, profit of '1$5:. 2hat if the ex!rate turns outs to be '.M2::1>4 in Fune 2::$3 ?hen the long profits /'.M2:: ! '.M:$50 x >41::,::: N '156: and the short loses '156:. <or hedgers, they ha*e lo ked into the '.M:$51>4 ex! rate and an either buy >4 or sell >4 at that fixed, guaranteed rate. EURODO11AR INTEREST RATE FUTURES 7l"ost $:A of all futures ontra ts are for debt /bond0 ontra ts, indi ating that the risk "ost often hedged is interest rate risk. One of the "ost popular futures ontra t is the .urodollar <utures ontra t, see .xhibit (.$ on p. 1(1, "ore than M" outstanding ontra ts, out to 4e e"ber 2:11. Je"e"ber pre*ious exa"ple of a bank exposed to interest rate risk be ause the "aturity of loans S "aturity of deposits. 2orried about3 &nterest rates rising. 2hy3 .urodollar futures ontra ts are for a .urodollar ?i"e 4eposit ha*ing a prin ipal *alue of '1,:::,:::, with a three!"onth "aturity at the @:!day )&BOJ interest rate, for =ar h, Fune, %ept. and 4e . expiration. >ontra ts are settled in ash, not a tual bank >4s. 8ri es /<0 are stated as6 F 7 -66 " 1I%OR &="m#nt rate(. N#te #n /. -?- t at Settle 7 -66 @ :ld. .xa"ple (.;, p. 1(2, pri es are ,uoted as of =ar h 5, 2::$. <or Fune 2::$, ; "onths in the future, )&BOJ is expe ted to be ;.55A, resulting in a settle pri e for Fune 2::$ futures ontra ts /<0 of @6.$6 /1:: G ;.550. >ontra ts are used to hedge against interest rate risk /or spe ulate0. &f you are worried about int. rates falling /rising0 as a lender1sa*er1in*estor /borrower0, you go )O#K /%HOJ?0 on .urodollar futures 8J&>.%. ?hat is, to hedge interest rate risk, you take a position and go long or short, on the 8J&>. of .urodollar deposits, NOT long or short on interest rates. %a"e for long!ter" interest rate risk using ?!bond futures ontra ts, you go long1short on ?!bond pri es. =ini"u" pri e hange is 1 basis point /bp0, whi h is .:::1 or .:1A. 1:: basis points N 1A N .:1. &f interest rate hange fro" $.::A to $.1:A that is a O1: bp hange. &f interest rates hange fro" ;.5$A to ;.2$A, that is a !2: bp hange. <or e*ery one basis point hange, the ontra t *alue hanges by '2$. $r#fit31#ss 7 A %asis $#ints x 208 1#!ic6 1B8 /.:1A or .:::10 x '1" / ontra t a"ount0 N '1:: annually, so for @:!day )&BOJ, it would be '2$ /'1:: 1 50 for ; "onths.
6

BU% 5661$666 &nternational <inan e G >H (

8rofessor =ark F. 8erry

Exam/le ?.B #f Eur#d#llar Futures Hed!e* p. 1(26 ?reasurer learns on =ar h ;, 2::$ that his1her =#> will re ei*e '2:" in Fune 2::$ fro" the sale of "er handise, and these funds will need to be in*ested for ; "onths in the "oney "arket. >urrent ;!"onth )&BOJ is 2.@$A /see .urodollar ,uote on inside book o*er of textbook0, and expe ted ;!"onth )&BOJ in Fune 2::$ a ording to futures trading is ;.55A /5@ bp higher0. ?reasurer de ides to lo k in at that rate to eli"inate interest rate risk /2orried3 &nt. rates going 4O2#, .urodollar pri es going U80, takes a )O#K position /BUB% .urodollar futures ontra ts P @6.$6 to lo k in ;.55A rate0. ?o hedge the entire a"ount of '2:", he1she buys 2: .urodollar ontra ts P '1". ?his strategy will guarantee interest in o"e for ;!"onths of '2:" x .:;55 x .2$ N '1(2,::: interest in o"e. &nterest rate risk without .urodollar futures6 <or e*ery bp /.:::10 below ;.55A, the =#> will lose '$:: in interest in o"e /'2:" x .:::1 x .2$ N '$::0. <or exa"ple, if interest rates stayed at 2.@$A in Fune :$, the =#> would re ei*e '25,$:: less in interest in o"e /'2:" x .:2@$ x .2$ N '15(,$:: *s. '1(2,::: at ;.55A0, or /5@ basis points x '$:: lost interest in o"e per bp N '25,$::0. Keneral <or"ula for 8rofit1)oss fro" ;!=onth .urodollar, 8er >ontra t6 &S " F( x -66</ x 208* where < N <utures 8ri e /%ettle0 of the >ontra t, and % N %pot 8ri e of .urodollars at .xpiration. N#te: 7n alternati*e for"ula for the profit1loss on a .urodollar ontra t is6 A %asis $#ints x 208. 7ssu"e at expiration, ;!"onth )&BOJ is only ;.1:A /what they are worried about0, 8 N @6.@: /1:: ! ;.1:0. #ow the '2:" will only generate '2:" x /;.1:A 1 50 N '1$$,::: of interest in o"e. Howe*er, there will be a profit fro" the futures ontra t to "ake up the differen e. 8rofit fro" futures N /@6.@: ! @6.$60 x 1:: bp x '2$ N 'M$: profit per ontra t x 2: ontra ts N '1(,::: profit. '1$$,::: interest in o"e O '1(,::: futures profit N '1(2,:::. Or6 ?he hange in interest rates is ;.55A to ;.1:A, whi h is a ;5 basis point hange /;.55A ! ;.1:A N . ;5A, whi h is the sa"e as ;5 basis points. Je"e"ber that one basis point N .:1A, so .;5A would be ;5 basis points.0. $r#fit 7 =B <asis /#ints C 208 7 2>86 /r#fit /er c#ntract x 06 c#ntracts 7 2-?*666 /r#fit. Main $#int6 a0 ?he ;.55A interest rate has been guaranteed with the .urodollar futures ontra t, whi h b0 then guarantees the '1(2,::: interest in o"e, regardless of what happens to interest rates. &nterest rate an fall to 1A or rise to $A, or hange to any other rate, and the rate and in o"e are guaranteed and lo ked. #o risk. #ote6 ?here are a tually 2 parts to the out o"e. 10 >o"pany in*ests at whate*er the urrent, or spot, .urodollar interest rate pre*ails in Fune :$. 20 ?he o"pany settles .urodollar futures ontra t in ash. &f "arket /spot0 .urodollar interest rates had risen abo*e ;.55A in Fune 2::$, the o"pany would ha*e gotten "ore interest in o"e than '1(2,:::, but would ha*e lost "oney on the futures ontra t, offsetting the additional interest in o"e. #o "atter what happens to "arket int. rates in Fune 2::$, the treasurer has lo ked in P ;.55A three "onths ahead of ti"e. Example: 7ssu"e at expiration, ;!"onth )&BOJ is ;.$:A, 8 N @6.$: /1:: ! ;.$:0. #ow the '2:" will generate '2:" x /;.$A x .2$ years0 N '1($,::: of interest in o"e. Howe*er, there will be a loss on
(

BU% 5661$666 &nternational <inan e G >H (

8rofessor =ark F. 8erry

the futures ontra t. )oss fro" futures N /@6.$: ! @6.$60 x 1:: bp x '2$ N !'1$: profit per ontra t x 2: ontra ts N !';,:::. '1($,::: interest in o"e ! ';,::: futures loss N '1(2,:::. Or: T e c an!e in <asis /#ints is D &=.BBE t# =.86E(* s# D x 208 7 "2-86 x 06 c#ntracts 7 "2=*666. N# matter 9 at* t e' !et 2-?0*666 #f interest inc#me* and earn =.BBE #n 206m* f#r = m#nt s. CURRENC: O$TIONS 7nother deri*ati*e se urity, deri*es *alue fro" pri e "o*e"ents of an underlying asset, without ne essarily e*er owning the asset. -%ide Bet.O/ti#n ! >ontra t that gi*es the owner the right, but not the obligation, to buy1sell a spe ifi a"ount of an asset /or urren y0 at a spe ified pri e or ex!rate /strike pri e0, on or before so"e date in the future /expiration0. Ki*es you the right to de ide later whether to buy1sell1exer ise your option. =ortgage ! you ha*e a prepay"ent option ! the right, but not the obligation, to pay off the "ortgage early / allable0. Jight of first refusal ! an option that gi*es you the right to buy an asset, real estate, "o*ie, or ?T show, before anyone else. >on*ertible bond ! you ha*e the right, but are not obligated, to on*ert your bond into sto k. Call O/ti#n " an option to BUB an underlying asset /sto k or urren y0 at an agreed upon pri e /%trike 8ri e or .xer ise 8ri e0 on or before the expiration date. %in e this option has e ono"i *alue, you ha*e to pay a pri e, alled the 8re"iu". Example: .bay was selling at ';21share /O t. 2(, 2::60, and about 6: different options were trading for .bay. <or exa"ple, for ';.$: /pre"iu"0 you ould buy one all option that would allow you to buy a share of .bay for ';: /strike 8ri e0 on or before Fanuary 1@, 2::(. Bou will exer ise the option if 8 S ';:, and you will "ake "oney if the 8 S ';;.$: /';: O ';.$:0. &f 8 U ';:, you will not exer ise the option, it will expire worthless and you will lose the pre"iu" /';.$:0. %ee diagra" below6 $a'#ff Dia!ram f#r Fanuar' 066? 2=6 E<a' call #/ti#n* $remium 7 2=.86

BU% 5661$666 &nternational <inan e G >H (

8rofessor =ark F. 8erry

8rofit

>all Buyer

';.$: ';;.$: ';:

>all Buyer

!';.$: )oss >all 2riter

)ike futures trading, option trading is a zero!su" ga"e. ?he buyer of the option pur hases it fro" the seller or the person who -writes- the all. Options are traded in units of 1:: shares. $ut O/ti#n ! gi*es the owner the right, but not the obligation to sell an underlying asset at a stated pri e on or before the expiration date. Example: .bay ';$ Fan 2::( puts are selling for ';.(: /pre"iu"0. &f you buy 1 .bay put, you will "ake "oney if .bay sto k 8 V ';1.;: /';$ G ';.(:0. Bou will exer ise if 8 V ';$, you will exer ise but lose "oney if 8 is between ';1.;: ! ';$. &f .bay 8 S ';$, put will expire worthless for buyer. $a'#ff Dia!ram f#r Fanuar' 066? 2=8 E<a' /ut #/ti#n* $remium 7 2=.?6

8ut %eller
';.( :

';1.; :
!';.(:

';$

8ut Buyer

BU% 5661$666 &nternational <inan e G >H (

8rofessor =ark F. 8erry

?wo types of options6 American / an be exer ised any ti"e at or before expiration0 and Eur#/ean / an O#)B be exer ised at expiration0. CURRENC: O$TIONS MAR;ETS >urren y options were originally traded O?> /dealer network0, not on organized ex hanges. >urren y traders were intl. banks, in*est"ent banks, brokerage houses. Options in O?> an be usto"ized for the traders ! "aturity, ontra t size, exer ise pri e, usually in large a"ounts of '1", the size of "ost urren y trades in the spot "arket. %in e 1@M2, urren y options ha*e been traded on the 8hiladelphia %to k .x hange, see .xhibit (.6 on p. 1(; for ontra ts. Option ontra t sizes are half of the futures ontra ts, e.g., D;1,2$: instead of D62,$::, approx '6:,:::. >ontra ts are traded on a =ar h, Fune, %ept, 4e y le with original "aturities of ;, 6, @, 12 "onths. &n addition, one and two "onth ontra ts are also traded so that there are always 1, 2 and ; "onth ontra ts. 7lso, long ter" option ontra ts are traded for 1M, 25, ;:, ;6 "onths. O?> trading /'11( billion daily0 is larger than organized!ex hange trading on the 8hiladelphia ex hange /'2.$B1day0 for ex hange!traded urren y option ontra ts. Big urren y traders /banks0 prefer O?> "arket, it operates 25 hours1day /ne essary now in global "arket ! ti"e zone differen es in 7sia, .urope1 urren y rises0, ontra t size is "u h bigger /'1" *s. '5$,::: a*g. 8H)I0, "ore effi ient, lower transa tions ost. 8H)I li"its traders to 1::,::: "ax ontra ts. CURRENC: FUTURES O$TIONS >=. offers /7"eri an0 options on its urren y futures ontra ts. ?he underlying asset is a urren y futures ontra t, not the a tual urren y. -%ide bet on a side bet.- ?he y le is the sa"e for futures options as for futures ! =ar, Fune, %ept and 4e ., with options traded on the two earliest "onths. Example: &n Fan, option ontra ts would trade for Fan, <eb and =ar h expiration on =ar h futures ontra ts. >ontra ts are now trading for O t, #o* and 4e expiration on 4e e"ber urren y futures ontra ts. .xer ise of a urren y futures option results in a )O#K futures position for the >all Buyer and the 8ut 2riter /seller0 and %HOJ? futures position for the >all 2riter and the 8ut Buyer. ?o an el out the futures position before expiration, the trader an "ake an offsetting trade. &f not, deli*ery or re eipt of the urren y will take pla e. CA11 O$TION ECAM$1E ?.8* /. -?8 >onsider the euro all options for Fune 2::$ /E62,$:: per ontra t0 listed in .xhibit (.(, p. 1($.
1:

BU% 5661$666 &nternational <inan e G >H (

8rofessor =ark F. 8erry

8re"iu" N 5.$@W per E /- ents per unit-0, or '.:5$@1E, with an .xer ise 8ri e N 1;:W1E or '1.;:1E. One ontra t osts E62,$:: x ':.:5$@1E N '2,M6M.($, whi h gi*es you the right to buy euros at '1.;:. ?he option ontra t will "ake "oney for a all buyer if % S 1;5.$@W or '1.;5$@ /'1.;: O '.:5$@0, see .xhibit (.M7 on p. 1(6. Bou pay a pre"iu" of 5.$@W per euro now, and ha*e the right to buy .UJ for 1;:W or '1.;:. #ote6 you an either use ents or dollars. <or exa"ple, if you use dollars6
8rofit .x!8ri e
'1.;:1E

X
!'.:5$@

X
'1.;5$@1E

% ? /'1E0

/Break .*en N .x!8ri e O 8re"iu"0

)oss

%uppose at expiration, % N 1;6W per euro, or '1.;61E, you will "ake "oney, /'1.;6 ! '1.;5$@0 x E62,$:: N 'MM1.2$ per ontra t. Bou ha*e paid a pre"iu" of '2,M6$.($ in =ar h that gi*es you the right to buy euros P '1.;: on or before Fune 25. &f the euro sells at '1.;6 on expiration, you an exer ise your right to buy P'1.;: and then sell at '1.;6, for gross profits of ':.:6 per euro, or a total profit of ';,($: /62,$:: x '.:60. %ubtra ting the ost of your option pre"iu" of '2,M6M.($, you ha*e a net profit of 'MM1.2$ /';,($: ! '2,M6M.($0. ?he writer /seller0 of the all option would lose 'MM1.2$. ?wo ways to al ulate profit fro" all option6 1. 8rofit N %pot 8ri e ! /.xer ise 8ri e O 8re"iu"0 x E62,$:: 8rofit N '1.;6 ! /'1.;: O ':.:5$@0 N ':.:1511E x E62,$:: N 2>>-.08 $ROFIT 2. 8rofit N /%pot 8ri e ! .xer ise 8ri e0 x E62,$:: ! 8J.=&U= 8rofit N /'1.;6 ! '1.;:0 x E62,$:: N ';,($: ! '2M6M.($ N 2>>-.08 $ROFIT ROI: Bour return on in*est"ent /JO&0 would be 'MM1.2$ 1 '2,M6M.($ /8rofit 1 &n*est"ent0 N ;1A for ; "onths, or a 125A annual JO&Y &llustrates le*erage. Bou ontrol about 'M1,2$: worth of euros /E62,$:: x '1.;:1E0 with only '2,M6M.($, or ;.$A of the underlying *alue of the urren y. &f spot rate at expiration is only '1.2@1E /or any rate V '1.;:1E0, the option expires worthless, you lose the pre"iu" of '2,M6M.($, whi h would be the gain to the writer /seller0 of the all. N#te: &f the spot rate was between '1.;: and '1.;5$@ at expiration, you would exer ise all to "ini"ize loss, but you would lose "oney. <or exa"ple, if % N '1.;2::1E in Fune, you would exer ise all option, but you would lose /'1.;2:: ! '1.;5$@0 x E62,$:: N !'1,61M.($ by exer ising all, *s. losing the entire pre"iu" of !'2,M6M.($ without exer ising.

11

BU% 5661$666 &nternational <inan e G >H (

8rofessor =ark F. 8erry

$UT O$TION FOR CURRENC: )ook at the Fune put option for .uro in .xhibit (.( /p. 1($0, with a strike pri e of '1.;: /1;: ents0, and a pre"iu" of :.@5 ents /or ':.::@50, ontra t size of E62,$::. Bou ha*e paid for the right to sell .uros for 1;: ents /'1.;:0 in Fune. ?otal 8re"iu" is '$M(.$: per ontra t, /E62,$:: x ':.::@50, and the break!e*en point is 12@.:6W /1;: G :.@5 ents0, or '1.2@:61E /see .xhibit (.@7 on p. 1(M0. &f you buy the put, you will "ake "oney if spot rate for E V 12@.:6W /'1.2@:61E0 by Fune. =ax loss is pre"iu" of ':.::@5 x 62,$:: N !'$M(.$:. &f you sell /write0 the put, you will "ake "oney if spot rate % S 12@.:6W, and the "ax gain is the pre"iu" of '$M(.$: /see .xhibit (.@B0. &f spot rate % N '1.;:2$ /1;:.2$W0 on expiration, the put owner would not exer ise option and lose the pre"iu" of '$M(.$, whi h would be the profit for the put writer. &f % N '1.2M:(1E, gross profit would be '1.;: ! '1.2M:( N ':.:1@; x E62,$:: N '1,2:6.2$. )ogi 6 Bou an buy E62,$:: at the spot rate of '1.2M:(, and you ha*e the right to sell at '1.;:, for a '.:1@;1E profit x 62,$:: N '1,2:6.2$. Howe*er, you paid '$M(.$: for the right to sell .uros at '1.;:, so your net gain1profit is '1,2:6.2$ G '$M(.$: N '61M.($. Or you an al ulate profit in one step6 /'1.2@:6 ! '1.2M:(0 x E62,$:: N '61M.($ 8rofit /or 12@.:6 ents G 12M.:( ents N .@@ ents or '.::@@ profit per .uro x E62,$:: N '61M.($ ?otal 8rofit. 1. 8rofit N Z/.xer ise 8ri e ! 8re"iu"0 ! %[ x E62,$:: 8rofit N /'1.;: ! '.::@50 ! '1.2M:( N '.::@@ x E62,$:: N 2D->.?8 $ROFIT 2. 8rofit N /.xer ise 8ri e ! %0 x E62,$:: ! 8J.=&U= 8rofit N /'1.;: ! '1.2M:(0 x E62,$:: N '1,2:6.2$ ! '$M(.$: N 2D->.?8 $ROFIT

HEDGING STRATEGIES USING FUTURES AND O$TIONS f#r CURRENC: RIS; <or urren y risk, you ould use the following strategies. 1. &f you are worried about E /.UJ0 falling /' rising0 in *alue, e.g. U% .xporter re ei*ing .UJ in ; "onths, you ould go the following6 a. Ko short on a .UJ futures ontra t b. Buy a put option on .UJ . 2rite a all option on .UJ d. Buy a put option on .UJ futures e. 2rite a all option on .UJ futures f. .nter into a forward ontra t to sell .UJ forward 2. &f you are worried about .UJ rising in *alue /' falling0, e.g., U.%. &"porter paying in .UJ in ; "onths, you ould do the following6

12

BU% 5661$666 &nternational <inan e G >H (

8rofessor =ark F. 8erry

a. Ko long on a .UJ futures b. Buy a all option on .UJ . 2rite a put option on .UJ d. Buy a all option on .UJ futures ontra t e. 2rite a put option on .UJ futures ontra t f. .nter into a forward ontra t to buy .UJ forward
Updated: February 19, 2014

1;

BU% 5661$666 &nternational <inan e G >H (

8rofessor =ark F. 8erry