8.1 . Futures ContracLs po.eign cunency flutures and optionscontracts examples the new breed are of of I finangialinsrrumenrknown as derivatives.

Financialderivatives are contracts that derivetheir valuefrom someunderlyingasset (suchasa ,io.f.,.Uo"a, or curren_ reference .cy), rate(suchasa 90-dayTreasurfblUrate;,o. t a.* i.rr.t, u, the Sdzp 500 stock index). popular derivativej include-swaps, f;;..d.,"1i,,;;., and oprions. Chapter 7 discussedforward contracts, and Cha ter S aiscu.r", s*apr. This chapter describes the nature and valuation of *rr"*y frtur". ;;t"p,i"* contracts and showshow they can be used to manage. foreign exchangerisk or Lke speculativeposi tiors on currency movemenE. It atsoshows-howto .a"ua tt . p"a", of thesecontracts

275

iNNrsoN(1842)

,pn"uri" the. financial press. Appenclices anaSB'airc";;; ae l]_t-hj1 option pricing. aspects ot 8.1 FuruREs Coxiiecrs

ie-Jfi;

)e the organization

into, fle-te ce439!51n1i'ed anittre aenuery'aar.'ffi #F+**:.tf Doarool drrectors the International lvionetary ol
e to foMard nagecunency risk

TheChibago MercantileExchange (CME)provides outletfor currency air -"-f."rlfr..'in.*.."i.y specutators and for thoselookine to redu""ihea_.u.r"rr.y i"f". r*a" futures, which arecdntracts sp"cincqrrniir;^; ro. the exchanse ;;;;;;;:,es;

as theyappear

'ii.Xl,1i'"i,i,1, *fililii.li?i ;,liii!.'ili,1:lj::"X*.,',n,:** i*,'.f:*

of rhe .qrrrior,, ..orr_*r; iu,,r.". allow one to ::"]l ouecuy the neqge P-1F"9 currency risk that arisesin dealing with no:rdollar currencies. The number.otqontracts outstanding any one time is calledthe open rnrerest. at Hnvate rndl!'rduals encouraged, are ratherthan discouraged, pdrticipate the to in

M-arIet.-These contracb are pat_ temed after those for grain and commodity futures contra.,., ,t iatr't ru",l"en traded on Chicago's excbanges over 100 years_ for furures contracb are cunently availablefor the Australian _ .currency do[ar, yl, Brirish pou4d, Canadiandollar, tzech k";; ;, ;ungarian forint, lt:lg

'ffitiffi'.: coprlaits, whrle ."ii.#i.i,.qir,lffi droprr"e iT"lff#'fil;li: the U.S. do ar out

tinually experimenung with new contracts.Thosethat meet the m rcquiremenr.qre added,and thosethat do no#

nance bond aance bond call dhia Stock range (PHLX) I option interest paity tion urket trip ,rice ,lue Cunency Options <et(UCOM) ale r:rarket

ceclded by tlny swings in exchangerates. tne contracts have minimum price moves,which generally translateinto about $10-$12 per contract.At the sanietime, most exchanges"..ii"ir'i, oi* rrr"s on their contracs that restrict the rnaKimumdaily price *ou"]wh.n tniJ iit tr are reached.

ire yLdj^c91!t1:, :izes sundardiz-edgmount fore@?u-rrety rorexarnpre, by o{ t62;500, and C$i00,000, SFi125,000. Exhibir shr*.';;;;;.;; 8.1 r* some the currenciestiaded. Leverage high; margin requir"-"ii. "on.rtio* is -of t.., tf,un z{, tlrevalue. thefutures of contra-ct. leverale "lr"."e" The*J;J,h" j;;;;;;: i;;ffi; wur 9t De

of.using.the bid__ask spreads foundinihe'interbank market, traders :"--_lTf.d will vary a roundtrip-that is, onebuy ::1.i:-.::i*T]_':.. Tl!ust'^.g1n151ions ano onesell--costsaslirrleas $I5. This
costwork out to lessthan 0.02%ofthe value

additional requiremenbimpolaa"at ua"g;til margin are

ldffi;

ftffiil::

276
EXHIEIT 8.t

CHAFTER 8,

CurrencyFuturesandOptons Markets

9.1 , Futures Conta

CONTRACT SPECIFICATIONS FOR FOREIGN C U R R E N c Y FUTURES*

Australian Dollar
Contractsize Symbol Performance bond requuementS lnitial Maintenance Minimum price change Valueof I ooint Months haded Tradinghriurs Last day of trading

British Pound

Canadian DoIlar

Euro FX

Japanese Yen

Mexican Peso

Swiss Franc

A$100,000 L62,500 c$r00,000 125,000 Yr2,5oO,OOo P500,000 SFr 125,000 AD BP CD EC MP JY sF $r,5t3 $i,r50 $0.000r (r pt.) $10.00 $1,620 $I,2r5 $2,565 $2,160 $1,875 - $1,900 $r,200 $900 $r,600 $r,500 $0.0002 $0.0001 $0.0001 $o.00ooor $0.000025 (? p!s) (l pr.) (l pr.) (t pr.) (2.5pts.) $6.25 $10.00 $12.50 $12.50 $5.00 March, September, June, December
The secondhnsine<<.1'riihh-.ti.r-1.,-,^^^r:, second businessday imrnediatelyprecedingrhe

$1,890 $1,400 $0.0001 G pr.) $12.50

7:20A.M.-2:00 pM. (CentralTime)

the delivery monrh

third Wednesday of

*Elleclive ofjune24,2005. CME as The still calls *".gir, ,"qui."*.nl i',idll'Gffi rh"
Sorrci Data collecled from Chicago Mercanlil Exchange,sWeb ste at winvcrne.com

iffiii

for specificdelivel1 rency futures conir Contracts ex?iretwc Contractsizesand I familiar wtth the 1 Forwardcontracts, c can slgn any type of rorward contract for contracts tradeonly i eo rangeol maturiti trading volume in ar price fluctuations, an Oncea tradeis bers' capital-becom futurescontract. The largelyeliminating th pon their guarantee t

txFra'iffita*teil;n

contrast, forwardC a risk that eithersiden of a sterling conrract. The low cost, along with the high degreeof leverage,has pro_ The contractsD major inducement for speculatorsto panicipaie in ihe market. called performance i Other market lide$.a and exporrers,iompinies withforeign currency assers referredto asthe initi ff:|i:"*r1ilf":::iffiffJJ"" ancewhen the contr A.lthoughvolume in the futuresmarket is still small compired pound.A performan with that in rhe because losses I of on j'wewinseeshonry,thediff";;,;;":;;;;i.%;?#.;X'hHi,'i'f; maintenanceperforr Tiil:: arbitrage. whichis $1,200 tl for Tlie CME is srill the dominant trader,but other exchanges accountbalance br also trade futures coh_ to mosrimponant competitors includei'f." io.,aon r.rten iionaf you stan wirh an initj it:T .lP 9j-g!9s3 Elghance ,.h" bond of $1,620) yc in lY"::!I"::'q- rxchalsiJLI!|E-) br'i*e" ii.,.J "i ii,a"-icBor) rhe , New trre stock Lxchange s-to-Jk (pHLX), say,$680 in value.It Id M:*il't: L Lualttsc, ehitaielnhra il;;;",?ffi,$:;riJthe #;,;; Singipore ",. "T139:!.n9 Intemarional MoneuryExchanqe (SIMID.:?egrsche Ter.mirin*r"lornl n f*""f.h,r", mancebond of $1,20( H9"e Exchinge performance tHrcrl, tr'" rraar.#; r;; des Instrumefts desrnstrumefts bond rec :l: ITg-I:*'r paris, Financiers (MAID in is, and ihe Tokyo Intemational'Financial Futures Exchanfe the The CME perio (NFFE). , cnangrng currencyvo A notablefeature the CN{E other futuresmarkets that of and , SPAN, is which stands dealsarestruck fr by brokersfaceto faceon a trading noo, otfr.. it rrr ou., ii" mancebond requirerr ,"i"pfr".r". Thereare -- - *other,moreihportant distinctions iet*e"" ti-re nrtur", ,nJro.r"ra'i""rr..,r. er performance bonds Profitsand losse Forwaid Contract versus Futures Contract rng, a practicecalled illustrated with an exa Onewayto undershnd futures contracb to compare is themwith forward contracls. a Swiss franc futures Futurescontractsarestandardized contracts t;adeorr'o.guJJ n,,r., .u.t that priceis $0.75for SFr "t,

b:,':Y+-;; 3ffilo r::5:',,:::T ;:::-P,i.nGn-l;ils.".ffi1#iil:HH:

r"y,t rranr.hra in lilJH*tiy:m,","y:*g: !1,**L?":1,* 8_"*;6+)

nd OFtigns Marke?

8.1 , Fututes Contracts

2a7

can o 000

Swiss Franc
SFr125,000 SF

75 l0 t025.
t5.,

$I,890 $ r,.100 $0.0001 (r pL) $r2.50

d Wednesday of

leeal cou't";,;; counterparty;;;;,both ;;"-T-.:L^cuand se er rc the buyer of the 6rt,,,o. ^^-**^* .rL- -_:_L-- _ largely eliminating the defauii risks of trading. pon their

dil;;ilfi *::::"::::::*:::1i:Fj--,"-b.*i'.fr

trading volume in availablecontn leadinS superior to liquidiry, smaller priceflucruarions, lo*., tru.,rltJiuli and ffir; exchange,s clearing house.-_backed memby rtsmem_ uv rLs ^:llT:9:,,h. bers' 3:::,1,'lj:: capital-becomes the

ptsg!!125,000 priced us. aoi[i. in ::y:: :T9: :.Y.in ec range ot maturities available.With.

hand,areprivatedeals between inaivrJuafririo two cansrSn tlpe of contract any thev_agree Forexample, i"di;j;;; on. rwo'#.r. ;lrlii'x forwardcontractfor 20,000in i0 iro!,}, . ;;;ili;:;; However, cME rou1d.
only_a flw standardizedcontracts traded; ""a " the

,rp.: ,uuluui",-u;i;#il'il;;;ormtes oadinq. B:-glt contracts, the other :h: on of contracts rorward *itr, nnit_

onl;rrn- case theCME,rhemosracdvely the of traded cur_ 3:":1"::*"9:tr:^Zdates are for rencyruturesconuacts March, June,September,.and December delivef comrac* expiretwo business befor.irt. ,itira w.Jn""i"r"r davs i." a"ir"..y--o",ri. Contract sizes maturiries standardized,." and are il;;;;;;;in the rnarket are

:'i::j'T:'J"j;l;

contrast, a fi everage,has proet. Other market n curTencyassets I with that in the foreign exchange ret are linked by rade futures cohlon Intemational lBoT), the Niw ), ihe Singapore TB) in Frankfurt, des Instrumentg 'titures Exchanga : deals are siruck lhone. There are narkets.

,, i.r,r.a ir_ because losses the fuures co_ntracr_the of on balance the accountfallsbelow the in maintenance performance bond (formerlyrefened," ,; ,h; ;il;;;";;rgi"), whichis.$1,200 for_the pound. Atthar,i.i ."ougf, U to the "".t"""],rr:r" to bnng, it.up to thetnitial perforinanc. "aded U"iJ.'no, suppose :::y:b*T. with an initial you start balance $1,770 ($150in excess the.initial of "*-ple, of i"rid;;;; bondof$I,620)in youraccount por.md ona futures contra., .nJfo* .o.rouct loses, say $680 il ft is now g1,090,which is $rro belorvthe'-#inrenanceperfor_ "31-o:: $-l?P, r.9g-1rst add $:30 to your.a.cul.rr.,iio m"et tr," rruIurl initiat flt:b::l :f perlcirmance "'"" ure --$dd; bond .!9oge requirerienii$r,zzo

The conrractspecifications Exhibit.g.Lhovi;;;;n in -r"r"A require,ments (now called performance bonds bv the CME). if,. p.rf.iliri"e'bond (previously referredto asthe initial rnargin) snowshow much money must be in the accountbal_ ance when the contractis enteredimo. This amount is $1,620 in the case of the pound. perfonnance A

contract is a private deal between two panies is 6Fio *r. tl,.i.i,r",Jal;;; ;ilr. # ff ,:#,'"1ffi':;::J#jesand subi the

bondcall (form".lyr.f"..l;;;;;irr"ii"olu)

,rward contracb. Lfutures markets

L.of."JJtten requirehigh_ er performance bondson morevolatit"*.a"ay.ao.ltoJr.----'. ,,- Profis and losses futurescontracts paid of are overeveryday ing, a practicecalledmarking to niarket. ri"', a.iry-.air"-riri, at the end of trad_ -t"t i"",u.. can bestbe ilustraredwirh an examole. luesday O-n -"rri.,g,-Thursday to.,gporirionin a Swissfranc futurescontrabttliat matures ". " on "iiii"*i". aftemooi: The agreed_on priceis $0.75for SFr125,000. legin, their,.,rerto. To musl+!-oJiin" t i" "".ou.,, "r,

;fi ;ilr;iliffi1lT'frff 1p,{N,l'hl,;#Ji;;ffi ffiTTl'fi:trI#}:li mance bond requirements by the CMEar" -iu-".q set

rne LIvrts penodically revisesits perlbrmance bond requirements in line with r volatiliries using a computerized risk :1"""q :lTg*q ;i;; "d;;;;;; "*;;

;j39:;i,iz;;:

CHAPTER Cunency 8. Futures Options and Markets

8,1 , Futures Conta

futures.conrracr the with pri.. _prevailing contracts set to zeroat the end of eich "is,O;:;.'iir., is tradingday
^, __4t

.ffi jt"::*'$ ii:it$3;f ili{i:ix;::"1!;Tl.::ff ,"t**i:li;

,iil"lr*" of rhefurures
'$0.743. Wednesday close,the price hasdecline8to The inr

initial performance bond of $1,g90.Ar the closeof trading on li:esday the futures price has risen to $0.755. Because daily seui;.;;;,;;;?;ilgs occur. Firsr, the :f

commission. 8.2 Exhibir a",.il.,h1t#ry2l3,[:x,"tJ .:l'::"t37r Daily

settlement reduces a"f",itt *f. the "iir,I.",

takes delivery of the Swissfrancs, payrng the prevailing pri* iO.Z+. The investor has had a net loss on the contracr "f b"f.;;;y;;;i.

j; idZ."iJx"lilr;,xj[iJH"","*1"1,;f:*;#ii:t:l:ffi:i
ExHtBtr 8.3

tiJ$; tn. oir,; l^t:?99]::: i o.olz5'," lrrr,obo ",r,",,ia" ;il#,"lTHfll'j

FutUfes Contra a companys longpo ally takedelivery I of futuresconttacts on tion. The two positi( receives its profit i between forwardan

Br
C(

sez5 + $625.-g-1,500.+ = $i.890) tt..tos"of $875 ar w.an"lalli,Li"ing o.d". in torn"., ir.,t Ir'.Lt:9?9.:l*loerformance^bond:,r,r," i""*i".rv"rilj'firvi ua to add$875 ro nts account to maintain
his futures contract.

"ii'""l""*"' r&'*-pL, i"..'a"a,9r,r, r.*n il*f"ff ;fy#":ffi1"l' ffiT:i mancebondcaribilJff illl"!*::i.j.T,;*i,iX?[H:'*ffi :i:$:: ffi mance bondof $r,400. nerformance call*""ia His bond ii-# ($r,890

tractedfrom theinvestorb account. iriar"", i."l*r *irr a'ni.rriprotitabre An position would be forcedinto defaultafter--onty ;.d"yb;'.rG ;'.#'i,ili, 0"r", allowedto build up hugelosses leadto onelarge that default the'Jrne Irr,..",.u,ur", (u, at ,h"

;:il'fi :"'[?"1?*:H;:?f;TL.i,?,::*s"l,"x]l;m:r;"l:t
l. Trading: Forwardcodtracu FuturcscontracG 2. Regulation: The forward marl The IMM is rcgulr 3. Frequency Del of Moie rhar 90%ol By contrast, t less 4. Sizeof Contract: Forwardcontmctr contracson the f Futurescontncts 5. DeliveryDate: Banksoffer forwa IMM futuresconr 6. Settlement: Forwardcontract Futurescontiact l valuesmay be wi market. 7. Quotes: Forwad pricesgr FuturescontEc& 8. Transaction Cost Costsof forward Futulescontractr 9. Margins: Marginsarenot r Marginsare rcqu 10. Credit Risk: The credit risk is for eachcustome ( The Exchange's . reducing credit r

.o",.r.o relativeto forward

ExHrBrr 8.2

}.lllx.AypLE oF DArLy SETTLEMENT wr rH A FUTURES oNTRACT C

ActioD

ash Flow
None

Tuesdaymoming

Tues&y clole Wednesday close Thurs&y close

Investor bu}s SFr futurcs contract th_di maturesin ' two days.Frice is $O.75, Futures price risesto $0.755. Position is marked to markt. Fururesprice drops to $0.743. Position is marked to market. Futuresprice drops to $0.7,1. (l) Connact is marked to market_ (2) lnvesto! takesdelivery of SFr 125,000.

Investor receives 125,000 (0.755- 0.75) = $625 x Investbr pa)s 125,000 (0.755 0.7,t3): gr,500 x (I) tnvestor pays 125,000x (0.743- 0.7a) = $375 ,-, (2, rnvestor pays l25,ooo x 0.74 : $g2,5oo Net losson the fururescontract= $1,250

andOptionsMarkets resday, futures the occur.Fi6r, the ls cond, the existing itor recelves Rew a ue of the futures stormust pay the rd trade in the old the pdce drops to" the other side and 0.74. The investor ) before palng his relative to forward ' recelveany gains r addedto or subprcfitable position r being allowed to rntract matures(as ecided to keep his havehad a perforaintenanceperfor, $875 ($1,8e0+ rg in order to meet : had to add $875 Futurescontracts alsobe closedoutwirh an offsetting trade. for can example, if a.companys long positionin eurofurureshasprovedto be profitable,it neednoiliter, d.l*:" the-euros whenrhe.contract matures. nath"r, th" companycansell *.Y..:1f" "f tuturescontracts a like amounr,ofuros prior to the maiurity on just of the long posi tion. The two positionscancelon the booksoI the futuresexchange, and the coipany receives its profit in dollars. Exhibit g.3 summarizes these an'd other differences betweenforward and futures contracs.

2'r9

ExHrBrT 8.3

BASIc DIFFERENcEs BETWEEN FORWARD AND FUTUREs CoNTRAcrs

6. Settlemebt:

l. Trading: Forwardcontracts uadedby telephone telex. are or Futurescontncts aretradedin a compedrive arena. 2. Regulation: The forward market is self-regulating. The IMM-is regulatedby the Commodity FuturesTrading Commission. ^ 3. Frequency of Delivery: More than 90%ofall forwardconrracrs seded by actualdelivena are By con-rrast, rhan 1% of rhe IMM futures contractsare settled Uy delivery. less . 4. Sizeof Contract: Forward contractsare individually tairoredand tend to be much rarger than th standardized conuacts the fururesmarket. on Futures contractsarestandardizedin terms oI cuitency amount. 5. DeliveryDate: Bank offer forwardcontracts deliveryon any date. for IMM fururs conuacts are availablef<irdelivery Ln only a few specified daresa year.

rlow

- O.75)= $625

- 0.743) $r,500 - 0.74)= 9375 $92,500 = contract $1,250

9. MargiDs: Margins are not required in the forrvard market. Margins are required of all panicipants in the firtures market, 10. Credit Risk:

Forward contract settlementoccursoo the date agreedon betweenthe bank and the customer, Futures contract setdementsare madedailyvia the Exchange,s Clearing Housq gains on position va.lues may be.withdra*rr and lossesare collecteddaily Thii practice isLown * m"rting to market. 7. Quotes: Forward prices gencrally are quoEd in Europednrcrms (unis oflocal curreqcy pcr U.S.dollar). Futurs contractsite quoted in American t"*o 14o[.rs p". ot1efotetn currency u!it). ^ 8. Transaction Coss: Costsof forward contractsare basedon bid-asl< spread. Futurescontractsenrail brokeragefeesfor buy and sell orders.

The credit risk is bome by eachparty to a forward contract, Credit lhrits musr therefore: e set b for eachcustomer.

House becornes opposire to each fie side futures contract, thereby !t""ring lT-:IYltj: creditrisk subsranrially. reducing