CH 7: Futures and Options on Foreign Exchange

A Forward contract

Is a vehicle for buying or selling a stated amount of foreign exchange at a stated price per unit at a specific time in the future.

Both forward and futures contracts are classified as

Derivative or contingent claim securities because their values are derived from or contingent upon the value of the underlying security.

A futures contract is like a forward contract:

It specifies that a certain currency will be exchanged for another at a specified time in the future at prices specified today.

A future contract is different from a forward contract:

Futures are standardized contracts trading on organized exchanges with daily resettlement through a clearing house.

What are 3 standardizing features

• Contract Size

• Delivery Month (Maturity)

• Daily resettlement

An initial performance bond (Margin)

Must be deposited into a collateral account to establish a futures position. Either Cash or Treasury bills may be used to meet the performance bond requirement. Performance bond put up by the contract holder can be viewed as “Good-faith” money.

The Major difference between a forward contract and a futures contract is

The way the underlying asset is prices for future purchase/sale. Forward contract states a price for the future transaction, and the profits/losses are realized all at once at maturity. By contrast, a futures contract is settled up or market to market, daily at the settlement price.

Marking to market feature of futures markets

Market participants realize their profits or suffer their profits or suffer their losses on a day to day basis rather than all at once at maturity

Two types of market participants are necessary

1) Speculators attempt to to profit from a change in the futures price.

2) Hedgers want to avoid price variation by locking in a purchase price of the underlying asset. Passes off the risk of price variation to the speculator, who is more willing to bear this risk.

What does a clearinghouse do in a futures market

Serves as the 3rd party to all transactions. Facilitates active secondary market because the buyer and seller do not have to evaluate one another creditworthiness. Liability is limited because a contract holders position is marked to market daily. Maintains the futures performance bond accounts for the clearing members (Individual brokers).

The Chicago Mercantile Exchange (CME)

Major derivatives marketplace in Chicago

Open interest

refers to the number of short or long contracts outstanding for a particular delivery month in the derivative markets. Good proxy for demand for a contract. Referred to as the depth of the market. The breadth of the market would be how many different contracts are outstanding.

An Option

A contract giving the owner the right, but not the obligation, to buy or sell a given quantity of an asset at a specified price at some time in the future. An option is derivative or contingent.

The buyer of an option is referred to as ____ and the seller is referred to as the ____

1. Long

2. Writer (short)

Because the option buyer does not have to exercise the option if it is not advantageous for them, the option has a

Price Premium (Writer receives premium)

There are 2 types of options

A European option can be exercised only at the maturity or expiration date of the contract.

American option can be exercised at any time during the contract.

Call Options

Gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future, at prices agreed upon today.

Put Options

Gives the holder the right, but not the obligation, to sell a given quantity of some asset at some time in the future, at prices agreed upon today.

In the money

The exercise price is less than the spot price of the underlying asset

At the money

The exercise price is equal to the spot price of the underlying asset

Out of the money

The exercise price is more than the spot price of the underlying asset

Intrinsic value

The difference between the exercise price of the option and the spot price of the underlying asset

Speculative value

The difference between the option premium and the intrinsic value of the option

Options time value

The difference between the option premium and the options intrinsic value is nonnegative and is sometimes referred to as Options time value.

Options on spot foreign exchange are traded at the ____. Options on currency futures are traded at the ___

1. NASDAQ

2. CME