Ch. 7 - Futures and Options

2 objectives of foreign currency swaps

• Speculation

• Hedging

Speculation

Use of derivative instruments to take a position in the expectation of a profit

Hedging

Use of derivative instruments to reduce risks associated with the everyda management of corporate cash flow

Foreign currency futures

Alternative to a forward contract that calls for future delivery of a standard amount of foreign exchange at a fixed time, place and price

Marked-to-market

• Value of contract is revealsed using the closing price for the day

• Value of the contract is marked to market daily - all changes in value are paid in cash daily

Foreign currency option

Contract giving the option purchaser (the buyer) the right, but not the obligation to buy/sell a given amount of foreign exchange at a fixed price per unit for a specified time period (until maturity)

Call

Option to buy foreign currency

Put

Option to sell foreign currency

Holder

Buyer of an option

Writer

Seller of a option

Price Elements

• Exercise price

• Premium

• Underlying/actual spot exchange rate in the market

American Option

Gives the buyer the right to exercise the option at any time between date of writing and expiration on maturity date

European Option

Gives the buyer the right to exercise the option only on its expiration date, not before

Premium

Option price or cost of option

At the money

Option whose exercise price is the same as the spot price of the underlying currency

In the money

Option that would be profitable, excluding premium cost, if exercised immediately

Out the money

Option that would not be profitable, excluding the cost of the premium, if exercised immediately

OTC Market Options

• Most frequently written by banks for USD against GDP, CAD, JPY, CHF, or EUR

Advantage of OTC options

They are tailored to specific needs of the firm in terms of notional principal, strike price, and maturity

Options on Organized Exchanges

Settled through a clearning house, which essentially eliminates counterparty risk

Options on OTC market can be tailored to the specific needs of the firm but can expose the firm to __________ ______

counterparty risk

If the writer wrote the option naked (without owning the currency), the writer would now have to ____________

buy the currency at the spot and take the loss delivering at the strike price

The pricing of any currency option combines 6 elements

• Present spot rate

• Time to maturity

• Forward rate for matching maturity

• USD interest rate

• Foreign Currency interest rate

• Volatility

Total value (premium) of an option is equal to:

the intrinsic value + time value

Intrinsic Value

Financial Gain if option exercised immediately

• Call option: intrinsic value is 0 when strike price>market price

  • When spot price rises above strike price, instrinsic value becomes positive

• Put option: intrinsic value is 0 when market price>strike price

6 sensitivities

1. Impact of changing forward rates

2. Impact of changing spot rates

3. Impact of time to maturity

4. Impact of changing volaility

5. Impact of changing interest differentials

6. Impact of alternative option strike prices

Standard foreign currency options are priced around the forward rate because…

the current spot rate and both the domestic and foreign interest rates are included in the option premium calculation

Delta

Sensitivity (expected change) of the option premium to a small change in the spot exchange rate

Delta varies between:

Call: +1/0

Put: -1/0

The higher the delta….

the greater the probability of the option expiring in-the-money

Theta

Expected change in the option premium for a small change in the time to expiration

Rule of Thumb for Theta

A trader will normally find longer-maturity options for better values, giving the trader the ability to alter an option position without suffering significant time value deterioration

Lambda

Expected change in the option premium for a small change in volatility

3 ways of looking at volatility

• Historic: drawn from a recent period of time

• Forward-looking: historic volatility is altered to reflect expectation about the future period over which the option will exist

• Implied: Where volaility is backed out of the market price of the option

Rule of Thumb for Lambda

Traders who believe volatilities will fall significantly in the near-term will sell (write) options now, hoping to buy them back for a profit immediately after volailities fall, causing option premiums to fall

Rho

Expected change in the option premium from a small change in the domestic interest rate

Phi

Expected change in the option premium from a small change in the foreign interest rate

Rule of Thumb of Rho and Phi

A trader who is purchasing a call option on foreign currency should do so before the domestic interest rate rises. This will allow the trader to purchase the option before its price increases.

Derivatives are used by firms to achieve one of these:

• Permit firms to achieve payoffs that they would not be able to without derivatives

• Hedge risks that otherwise would not be possible to hedge

• Make underlying markets more efficient

• Reduce volatility of stock returns

• Minimize earnings volatility

• Reduce tax liabilities

• Motivate management (agency theory effect)