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Multinational Financial Management Alan Shapiro 7th EditionJ.Wiley & SonsPower Points byJoseph F. Greco, Ph.D.California State University, Fullerton

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CHAPTER 8

CURRENCY FUTURES AND OPTIONS MARKETS

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CHAPTER OVERVIEWI. FUTURES CONTRACTSII. CURRENCY OPTIONS

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PART I.FUTURES CONTRACTS

I.CURRENCY FUTURESA. Background

1. 1972: Chicago Mercantile

Exchange opens International Monetary Market. (IMM)

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FUTURES CONTRACTS

2. IMM providesa. an outlet for hedging currency

risk with futures contracts.b. Definition of futures contracts:

contracts written requiring• a standard quantity of an available currency• at a fixed exchange rate • at a set delivery date.

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FUTURES CONTRACTS

c. Available Futures Currencies:

1.) British pound 5.) Euro

2.) Canadian dollar 6.) Japanese yen3.) Deutsche mark 7.) Australian dollar4.) Swiss franc

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FUTURES CONTRACTS

d. Standard Contract Sizes:contract sizes differ for each of the 7 available currencies.

Examples:Euro = 125,000

British Pound = 62,500

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FUTURES CONTRACTS

e. Transaction costs:payment of commission to a

traderf. Leverage is high

1.) Initial margin required isrelatively low (e.g. less

than .02% of sterling contract value).

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FUTURES CONTRACTS

g. Maximum price movements1.) Contracts set to a daily

price limit restricting maximum daily

price movements.

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FUTURES CONTRACTS

2.) If limit is reached, a margin

call may be necessary to

maintain a minimum

margin.

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FUTURES CONTRACTS

h. Global futures exchanges that are competitors to the IMM:

1.) Deutsche Termin Bourse

2.) L.I.F.F.E.London International Financial Futures Exchange

3.) C.B.O.T. Chicago Board of Trade

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FUTURES CONTRACTS

4.) S.I.M.E.X.Singapore International

Monetary Exchange

5.) H.K.F.E. Hong Kong Futures

Exchange

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FUTURES CONTRACTSB. Forward vs. Futures Contracts

Basic differences:1. Trading Locations 6. Settlement

Date2. Regulation 7. Quotes3. Frequency of 8. Transaction

delivery costs 4. Size of contract 9. Margins5. Delivery dates 10. Credit risk

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FUTURES CONTRACTSAdvantages of futures:

1.) Smaller contract size

2.) Easy liquidation

3.) Well- organizedand stable

market.

Disadvantages of futures:

1.) Limited to 7 currencies

2.) Limited dates of delivery

3.) Rigid contract sizes.

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PART IICURRENCY OPTIONS

I. OPTIONSA. Currency options

1. offer another method to hedge exchange rate

risk.2. first offered on Philadelphia

Exchange (PHLX).3. fastest growing segment of

the hedge markets.

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CURRENCY OPTIONS

4. Definition:a contract from a writer ( the seller)

that gives the right not the obligation to the holder (the buyer) to buy or sell a standard amount of an available currency at a fixed exchange rate for a fixed time period.

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CURRENCY OPTIONS

5. Types of Currency Options:a. Americanexercise date may occur anytime up to the expiration date.b. Europeanexercise date occurs only at theexpiration date.

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CURRENCY OPTIONS

7. Exercise Pricea. Sometimes known as the

strike price.b. the exchange rate at

which the option holder can buy or sell the contracted currency.

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CURRENCY OPTIONS

8. Status of an optiona. In-the-money

Call: Spot > strikePut: Spot < strike

b. Out-of-the-moneyCall: Spot < strikePut: Spot > strike

c. At-the-moneySpot = the strike

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CURRENCY OPTIONS

9. The premium: the price of

an

option that the writer

charges the buyer.

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CURRENCY OPTIONSB. When to Use Currency Options

1. For the firm hedging foreignexchange risk

a. With sizable unrealized gains.

b. With foreign currency flows forthcoming.

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CURRENCY OPTIONS

2. For speculators- profit from favorable

exchange rate changes.

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CURRENCY OPTIONS

C. Option Pricing and Valuation

1. Value of an option equals

a. Intrinsic value

b. Time value

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CURRENCY OPTIONS

2. Intrinsic Valuethe amount in-the-money

3. Time Valuethe amount the option is inexcess of its intrinsic value.

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4. Other factors affecting the value of an optiona. value rises with longer

time to expiration.b. value rises when

greater volatility in the exchange rate.

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CURRENCY OPTIONS

5. Value is complicated by both

the home and foreign interest

rates.

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CURRENCY OPTIONS

D. Using Forward or Futures Contracts:

Forward and futures contracts are more suitable for hedging a known amount of foreign currency flow.

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CURRENCY OPTIONS

E. Market Structure1. Location

a. Organized Exchangesb. Over-the-counter

1.) Two levelsretail and wholesale