Chapter 7 - Foreign Currency Derivatives: Futures and Options

What are financial derivatives?

Instruments whose values are derived from underlying assets, used for speculation and hedging.

What are the two objectives of using derivatives?

Speculation and hedging.

Why is pricing of financial derivatives crucial?

They are powerful tools when used correctly but can be destructive if misused.

What is a foreign currency futures contract?

A standardized contract calling for future delivery of a set amount of currency at a fixed price and time.

How do futures differ from forward contracts?

Futures are traded on exchanges, are standardized, and involve daily margin adjustments.

Where are the largest foreign currency futures traded?

International Monetary Market at the Chicago Mercantile Exchange (CME).

What are the key standardized features of futures contracts?

• Contract size (notional principal)

• Exchange rate quotation (American terms, i.e. the US$ price of one foreign currency)

• Maturity date (third Wednesday of specified months)

• Last trading day (second business day before maturity)

• Collateral and maintenance margins

• Settlement through a clearinghouse

What is a clearinghouse?

Ensure party receives correct settlement.

What is a short position in futures trading?

Selling a futures contract when expecting the currency value to decrease.

What is a long position in futures trading?

Buying a futures contract when expecting the currency value to increase.

How do you calculate the payoff for a short position?

Payoff= −Notional Principal×(Spot Rate at Maturity−Futures Price)

How do you calculate the payoff for a long position?

Payoff = Notional Principal × (Spot Rate at Maturity - Futures Price)

What is a foreign currency option?

A contract granting the right (but not the obligation) to buy or sell currency at a set price before a specific date.

What are the two types of options?

• Call option: Right to buy currency.

• Put option: Right to sell currency.

Who are the parties involved in an options contract?

• Holder (buyer): Has the right to exercise the option.

• Writer (seller): Grants the option and collects the premium.

What are the three key price elements of an option?

1. Strike (exercise) price (K) – Exchange rate at which currency can be bought/sold.

2. Spot exchange rate (S) – Current market rate.

3. Option premium (c or p) – Cost of purchasing the option.

What is the difference between American and European options?

• American options: Can be exercised at any time before expiration.

• European options: Can only be exercised on the expiration date.

How are options classified based on their payout?

• At-the-money (ATM): Strike price = Spot rate.

• In-the-money (ITM): Option would be profitable if exercised.

• Out-of-the-money (OTM): Option would not be profitable if exercised.

When does the buyer of a call option make a profit?

If the spot price of the currency rises above the strike price - premium paid.

What is the maximum loss for a call option buyer?

The premium paid.

What is the maximum loss for a put option buyer?

The premium paid.

How does a call option writer (seller) make a profit?

By collecting the premium if the option is not exercised.

What is the risk for a call option writer?

Losses are unlimited if they do not own the underlying currency.

When does a put option writer (seller) lose money?

If the spot price of the currency falls below the break-even point.

What does "Zero-Sum Game" mean in options trading?

A zero-sum game means that one trader's gain is another trader's loss. In the context of options:

• If the option holder (buyer) makes a profit, the writer (seller) incurs a loss of the same amount.

• If the holder loses, the writer gains the premium collected.

What are the six elements affecting option pricing?

• Spot rate

• Time to maturity

• Forward rate

• U.S. dollar interest rate

• Foreign currency interest rate

• Volatility (standard deviation of spot price movements)

How does volatility affect options?

Higher volatility increases option premiums.

What is intrinsic value in options?

The profit if the option were exercised immediately.

What is time value in options?

The additional premium due to the possibility of future favorable price movements.

What is the total value (premium) of an option?

The intrinsic value plus time value.

What is the intrinsic value of a call option when K > S0?

Zero

What is the intrinsic value when K < S0?

Positive

What is an option delta?

The sensitivity in the premium to the spot price value.

What can call options delta be in between?

0 - 1

What does a delta of 0.50 for a call option?

If the currency goes up by 1 unit the price of your call with go up by 0.5

What can put options delta be in between?

-1 - 0

What does a delta of -.30 mean for a put option?

As the currency decreases by one unit the price of the put will increase 0.3 units.

What is the rule of thumb for deltas?

The higher the delta the greater the probability of the option expiring in the money.

How do changes in spot rate impact option premiums?

• Call option premium rises when spot rate increases.

• Put option premium rises when spot rate decreases.

How does time to maturity impact option value?

• More time = higher premium (due to uncertainty).

• As time decreases, time value approaches zero.

What is the impact of changing interest rates?

• Higher domestic interest rates increase call option premiums.

• Higher foreign interest rates decrease call option premiums.

How do changing forward rates impact option sensitivity?

The forward rate is a key factor in pricing currency options because it incorporates the spot rate and interest rate differentials. Changes in the forward rate impact an option’s value in several ways:

What are the main differences between futures and forward contracts?

• Futures: Standardized, exchange-traded, involve margin calls.

• Forwards: Customized, over-the-counter (OTC), no margin requirements.

Why are futures rarely delivered upon?

They are usually closed out before expiration.

Why do firms use derivatives?

• Achieve payoffs not possible otherwise.

• Hedge risks efficiently.

• Improve market efficiency.

• Reduce volatility in stock returns.

• Minimize earnings fluctuations.

• Reduce tax liabilities.

• Align management incentives.