Currency Futures and Options Markets International Corporate Finance

Currency Futures and Options Markets International Corporate Finance P. V. Viswanath

A forward contract w The forward market is a market where participants can arrange today for a transaction to take place in the future. Thus, a firm can sell $1 m. three months forward for euros at a price of $1. 297 to the euro. w This means that in 3 months, the firm can deliver $1 m. and receive in return (1/1. 297 x 1 m. ) or € 771, 010. w This is often a personalized contract with the contract duration and contract amount arranged according to the convenience of the participants. P. V. Viswanath 2

A futures contract w A futures contract is similar to a forward contract in that it is also nominally an arrangement for a transaction to take place in the future. w However, futures contracts are standardized both in terms of duration (there are specific days when contracts mature) and amount. w This makes it easier for holders of contracts to resell them. P. V. Viswanath 3

Futures Contracts w The problem with trading forward contracts is that these contracts represent a promise of future performance. w Hence A selling B a forward contract that he originally bought from C is making a representation regarding a third party that may not be known to B. w The solution is to have a single party take the opposite side of all futures contracts. This is the clearing house. P. V. Viswanath 4

Clearing Houses w If A wants to buy a futures contract from B, it is formally structured as two contracts: one, where A buys the contract from the clearing house, and another, where B sells it to the clearing house. The price at which the transaction is to take place (the futures price) is agreed between A and B. w Then, if A wants to sell it to C, he simply agrees on the price with C; then two new transactions take place simultaneously – A sells his futures contract back to the clearing house, while C buys it from the futures contract. w This solves the problem of knowing the credit quality of the contract partner, since it’s always the clearing house. P. V. Viswanath 5

Marking to Market w However, this still leaves the clearing house open to credit risk. w Thus, if A buys a futures contract worth ¥ 12. 5 m at a price of $0. 9029/100 ¥ maturing Sept 2006 and the price dropped to $0. 8910 after two days. w Each point change is worth $12. 50; hence the price of the contract has now dropped by $12. 5(9029 -8910) = $1487. 50. w If A were to close out his position now, he would owe the exchange $1487. 5/per contract. w In order to reduce the clearing house’s exposure, A has to mark-to-market (also called daily settlement). P. V. Viswanath 6

Marking-to-Market w At the end of every day, the contract is respecified, as it were, so that its value drops to zero. w In our example, the value of the contract was zero when originally struck. w Currently, the contract is worth $1487. 5 to the exchange and -$1487. 5 to A. This is because A has the obligation to buy ¥ 12. 5 m. at the price of $0. 9029, when he could get it for $0. 891 on the open market. w The solution that futures markets have adopted is to effect a dollar transfer from the losing party to the gaining party at the end of each day. P. V. Viswanath 7

Marking-to-Market w Thus if the drop in price had occurred at the end of the next day, A would have been required to pay $1487. 5 to the exchange per contract. w This would reset the account balance at zero at the end of each day. w The maximum amount at risk would depend only on the daily volatility. w Daily settlement means that a futures contract is equivalent to entering a forward contract each day and settling each forward contract before opening another forward contract. P. V. Viswanath 8

Currency Options w An option gives the holder the right, but not the obligation to purchase or sell an underlying commodity at a pre-agreed price (the strike or exercise price). w That is, options have a throw-away feature. w Currency options traded on the CME are on futures contracts. On the Philadelphia Exchange, the underlying commodity is the spot currency. P. V. Viswanath 9

Quotes on Option Contracts w On Monday, June 5, 2006, a call on the Sept Yen contract with an exercise price of $0. 9000/100¥ closed at $. 0205/100¥. w Since the contract size is ¥ 12. 5 m, to purchase the option would require a payment of (0. 0205)(125000) or $2562. 5 w Since the corresponding futures contract closed at $0. 9030, buying the option and exercising it immediately would have resulted in a gain of (0. 9030 -0. 9000)x 125000= $375. w The additional $2187. 5 is for the possibility that the futures price will climb even more in the next three months. P. V. Viswanath 10

Option Price Determinants w w w Intrinsic Value Volatility of Underlying exchange rate Option type (American or European) Interest rate on currency of purchase Forward Premium and Interest Differential Time to expiration P. V. Viswanath 11