Currency Futures &

Options Markets

Objectives: to Understand
How currency futures and options contracts
are used to manage currency risk & to
speculate on future currency movements
The nature of currency futures and options
contracts and
The difference between futures & options
contracts
The factors that determine the value of an
option
Futures

Fred Thompson

Currency Risk

Definition
Currency Risk = Variability in the value
of an exposure caused by uncertainty
about exchange rate changes.

Futures

Fred Thompson

Currency Risk
Degree of risk is a function of 2
variables
Volatility of exchange rates
Amount of exposure

Degree of Risk
Low = rate fixed, low exposure
High = rate volatile, high exposure

Futures

Fred Thompson

What Happens if the Yen falls?

QuickTime and a
TIFF (Uncompressed) decompressor
are needed to see this picture.

Futures

Fred Thompson

Long and Short Exposures

A person that is, for example, long the pound,
has pound denominated assets that exceed
in value their pound denominated liabilities.
A person that is short the pound, has pound
denominated liabilities that exceed in value
their pound denominated assets.

Futures

Fred Thompson

What is an exposure?
Liabilities > assets = net exposure
(short)
If you are borrowing Yen to buy $
denominated assets? Are you short or
long?
Who is long?
Who is long on $? Who is short?
Futures

Fred Thompson

Hedging
To hedge a foreign exchange exposure, one
takes an equal and opposite position from
that of the exposure.
For example, if folks are long the pound, they
would have to take an offsetting short
position to hedge their exposure.
One who is long in a market is betting on an
increase in the value of the thing, whereas
with a short position they are betting on a fall
in its value.
Futures

Fred Thompson

You Can Hedge with Financial

Derivatives!
Contracts that derive their value from
some underlying asset
Forwards
Futures
Options
Swaps

Futures

Fred Thompson

10

For example
Vanilla bond -- coupon and principal
First stage decomposition
Second stage decomposition
Options

What assets underlie currency

derivatives?

Futures

Fred Thompson

11

Currency Futures

Currency Futures
Traded on centralized exchanges (illustrated
in Figure 1 later)
Highly standardized contracts
Size [A&C$100K, 62.5k, 125k, 12.5m] &
maturity [delivery date]

Clearinghouse as counter-party
High leverage instrument
Daily settlement
Margin requirements
Futures

Fred Thompson

13

Currency Futures
Performance Bond or Initial Margin: The
customer must put up funds to guarantee the
fulfillment of the contract - cash, letter of credit,
Treasuries.
Maintenance Performance Bond or Margin: The
minimum amount the performance bond can fall
to before being fully replenished.
Mark-to-the-market: A daily settlement
procedure that marks profits or losses incurred
on the futures to the customers margin account.
Futures

Fred Thompson

14

Sample Performance Bond Requirements

From the CME, 15 March 2000

Currency Futures
Australian Dollar
British Pound
Canadian Dollar
Deutsche Mark
Euro

Initial
Maintenance
$1,317
$975
$1,620
$1,200
$642
$475
$1,249
$925
$2,430
$1,800

Futures

Fred Thompson

15

How an Order is Executed (Figure from the CME)

Example
A US manufacturing company has a division
that operates in Mexico. At the end of June
the parent company anticipates that the
foreign division will have profits of 4 million
Mexican pesos (P) to repatriate.
The parent company has a foreign exchange
exposure, as the dollar value of the profits will
rise and fall with changes in the exchange
value between the P and the dollar.
Futures

Fred Thompson

17

Example, continued
The firm is long the peso, so to hedge its
exposure it will go short [sell P] in the futures
market.
The face amount of each peso future contract is
P500,000, so the firm will go short 8 contracts.
If the peso depreciates, the dollar value of its
Mexican divisions profits falls, but the futures
account generates profits, at least partially
offsetting the loss. The opposite holds for an
appreciation of the peso.
Futures

Fred Thompson

18

Gain

Underlying Long Position

Change spot value

Change in futures price

Futures Position
Loss

Example, continued
The previous diagram can be used to illustrate
the effect of a change in the value of the peso.
An increase in the value of the peso increases
the dollar value of the underlying long position
and decreases the value of the futures position.
A decrease in the value of the peso decreases
the value of the underlying position and
increases the value of the futures position.

Futures

Fred Thompson

20

Example, continued
On the 25th, the spot rate opens at 0.10660
($/P) while the price on a P future opens at
0.10310.
The market closes at 0.10635 and 0.10258
respectively.
The loss on the underlying position is:

(0.10635-0.10660)P4 mil. = -$1,000

The gain on the futures position is:

(0.10310-0.10258)8P500,000=$2,080
Futures

Fred Thompson

21

Gain and Loss on Underlying and Futures Position

Day 1
Underlying Long Position
Gain

P4 million

$2,080

Change spot value

-0.00025

Change in futures price

-0.00052
$1,000

Futures Position
P500,000 x 8
Loss

Example, continued
On the 28th, the spot rate moves to
0.10670 ($/P) and the price on a P
future to 0.10285.
The gain on the underlying position is:

(0.10670-0.10635)P4 mil. = $1,400

The loss on the futures position is:

(0.10258-0.10285)8P500,000=-$1,080
Futures

Fred Thompson

23

Gain and Loss on Underlying and Futures Position

Day 2
Underlying Long Position
Gain

P4 million

$1,400

0.00032 Change

spot value

0.00035

Change in futures price

$1,080

Futures Position
P500,000 x 8
Loss

Example, continued
On the 29th, the spot rate moves to
0.10680 ($/P) and the price on a P
future to 0.10290.
The gain on the underlying position is:

(0.10680-0.10670)P4 mil. = $400

The loss on the futures position is:

(0.10285-0.10290)8P500,000=-$200
Futures

Fred Thompson

25

Gain and Loss on Underlying and Futures Position

Day 3
Underlying Long Position
Gain

P4 million

$400

0.0001 Change

spot value

0.00005

Change in futures price

$200

Futures Position
P500,000 x 8
Loss

Example, continued
For the three days considered, the underlying
position gained $800 in value and the futures
contracts yielded $800.
The hedge was not perfect as the daily losses
on the futures were less than the gains on the
underlying position (day 2 and 3), and the daily
gains on the futures exceeded the losses on
the underlying position (day 1).
In this example, the imperfect hedge yielded
additional gains.
Futures

Fred Thompson

27

Example, continued
Suppose you wanted to close the
futures position (without making delivery
of the currency).
The position is simply reversed. That is,
you would go long 8 P futures, reversing
your current position and closing out
your account. [offsetting trade]
Futures

Fred Thompson

28

Additional Information
For additional information on currency
futures, visit the following sites:
The Chicago Mercantile exchange
The Futures Industry Institute

Futures

Fred Thompson

29

Currency Options

Currency Options
A currency option is a contract that gives the
owner the right, but not the obligation, to buy or
sell a currency at a specified price at or during
a given time.
Call Option: An option that gives the owner
the right to buy a currency.
Put Option: An option that gives the owner the
right to sell a currency.
How are currency options simultaneously
both put & call options?
Futures

Fred Thompson

31

Currency Options
American Option: An option that can
be exercised any time before or on the
expiration date.
European Option: An option that can
only be exercised on the expiration
date.

Futures

Fred Thompson

32

Currency Options
Exercise or Strike Price: The price (spot
exchange rate) at which the option may be
exercised.
Option Premium: The amount that must be
paid to purchase the option contract.
Break-Even: The point at which exercising
the option exactly matches the premium paid.

Futures

Fred Thompson

33

Currency Options
If the spot rate has not yet reached the
exercise price [S<X], the option cannot be
exercised and is said to be out of the
money.
If the spot rate equals the exercise price
[S=X], the option is said to be at the money.
If the spot rate has surpassed the exercise
price [S>X], the option is said to be in the
money.
Futures

Fred Thompson

34

Call Option
The holder of a call option expects the
underlying currency to appreciate in value.
Consider 4 call options on the euro, with a
strike price of 152 ($/) and a premium of
0.94 (both cents per ).
The face amount of a euro option is 62,500.
The total premium is:
$0.0094462,500=$2,350.
Futures

Fred Thompson

35

Call Option: Hypothetical Pay-Off

Profit

Payoff Profile

$1,400

152
148.15

-$1,100

152.5
152.94
Break-Even

-$2,350
Out-ofLoss
the-money At

In-the-money

153.5

Spot Rate

Put Option
The holder of a put option expects the
underlying currency to depreciate in value.
Consider 8 put options on the euro with a
strike of 150 ($/) and a premium of 1.95
(both cents per ).
The face amount of a euro option is 62,500.
The total premium is:
$0.0195862,500=$9,750.
Futures

Fred Thompson

37

Profit

Put Option: Hypothetical payoff

at a spot rate of 148.15
Payoff Profile
Break-Even

0
-$500

148.05

150

148.15

-$9,750
Loss

In-the-money At Out-of-the-money

Spot Rate

Option Pricing & Valuation

Value of a call option at maturity
S-X, where S-X>0 [otherwise value is
zero], = Intrinsic value

Value of a call option prior to maturity

Intrinsic value + Time value

Time Value is a function of:

Time to expiration, volatility, domestic &
foreign interest rate differentials
Futures

Fred Thompson

39

Comparing Futures and Options

The value of a futures contract at maturity (date t+n) to purchase one
unit of foreign currency will be:

Value

Zt,t+n

Futures

St+n

The value of the futures contract

is zero at maturity if the spot rate
at maturity is equal to the current
futures
rate.
Fred Thompson

Consider now the value of an option to purchase one unit of

foreign currency at that same price (i.e. a call option with a
strike price X equal to Zt,t+n):

Value

Futures

St+n

The value of the call option

begins increasing when the
exchange rate becomes larger
than the exercise price - when the
Fred Thompson
option
becomes in the money.

But were missing something. While a futures contract has an

expected return of zero, the value of the option looks like it is
always positive

Value

Futures

Fred Thompson

St+n

Hence, anyone taking the opposite side of the transaction

(writing the option) will demand a premium (C) that makes the
expected value zero once again:

Value

Futures

St+n

Regardless of the outcome,

the options value is reduced
everywhere by the certain
payment of its premium.
Fred Thompson

The value of an option to sell one unit of foreign currency (a

put option) at a strike price equal to a corresponding futures
contract price will have similar properties:

Value

Futures

Fred Thompson

St+n

Swaps

Foreign Currency Swaps

A currency swap is an exchange of debt-service
obligations denominated in one currency for the
service on an agreed upon principal amount of debt
denominated in another currency.
A currency swap is often the low-cost way of
obtaining a liability in a currency in which a firm has
difficulty borrowing.
A pair of firms simply borrow in currencies they have
relative advantage borrowing in, and then trade the
obligations of their respective loans, thereby
effectivelyFutures
borrowing in their
desired
currency.
Fred
Thompson

Dell computers would like to borrow in Swiss Francs

to hedge its ongoing cash flows from that country

Dell

SFr
Futures

Fred Thompson

Nestle would like to borrow in Dollars to hedge its

sales to the U.S...

Dell

Nestle

$
Futures

SFr
Fred Thompson

But both firms are relatively unknown to the respective

credit markets, and thus anticipate unfavorable
borrowing terms.

Dell

Nestle

$
Futures

SFr
Fred Thompson

But an investment bank comes along and suggests

that each borrow in the credit markets that are
comfortable with them...

Dell

$
Futures

Nestle

I-Bank
Fred Thompson

SFr

and then the investment bank will give them

sufficient cash flows each period to cover the
obligations of these loans...

Dell

Nestle

$
$
Futures

Sfr
I-Bank
Fred Thompson

SFr

in return for making the payments in the foreign

currency that exactly match the other firms
obligations.

Dell

Nestle
Sfr

$
$
Futures

Sfr
I-Bank
Fred Thompson

SFr

In other words, the swap effectively completes the

market. Giving each firm access to the foreign debt
market at reasonable terms.

Dell

Nestle
Sfr

$
$
Futures

Sfr
I-Bank
Fred Thompson

SFr

The All-In Cost of a Swap

Clearly, the relative magnitudes of the respective
payments determine each firms ultimate cost of
borrowing.
This cost is called the all-in cost. It is the effective
interest rate the firm ends up paying on the money
that it raised.
It is the discount rate that equates the NPV of future
interest and principal payments to the net proceeds
received by the issuer.

IRR

Futures

Fred Thompson

Swaps vs. Forwards

Notice that on a one-year loan, a currency swap is
no different than a one-year forward contract.
In fact, a currency swap can really be thought of as
a firm taking a domestic currency loan and
purchasing a series of forward contracts to convert
the payments into known foreign currency
obligations.
The implied forward rates need not equal the actual
forward rates, but taken as a whole, should
resemble an average forward rate over the term of
the loan.
Futures
Fred Thompson

Comparative Borrowing Advantage

Swaps only exist because there are market
imperfections. If firms can access foreign and
domestic debt markets at equal cost, clearly swaps
are redundant.
One important reason that currency swaps are so
useful is that firms engaged in a swap need not
each have an absolute borrowing advantage in the
currency in which they borrow vis-a-vis the
counterparty.
In fact, it is quite likely that Nestle has better
access to both the U.S. and Swiss debt markets
than Dell. Comparative Advantage
Futures
Fred Thompson

Key Points
1. A firm wishing to hedge foreign currency exposure has five
main financial hedging tools which facilitate doing so: forward
contracts, money market hedges, futures contracts, foreign
currency options, and currency swaps.
2. Forward contracts have the benefit of being tailor-made,
with quantities and timing matched to the needs of the firm.
Forward contracts are typically quite costly over longer
horizons, as the market becomes highly illiquid.
3. Money market hedges are equally flexible, but depend on a
firm having equal access to domestic and foreign credit
markets.

Futures

Fred Thompson

Key Points
4. Futures contracts, traded on highly liquid exchanges, have
the benefit that they can be sold on the market before the
maturity date. As a result, futures contracts are particularly
useful for hedging exposures whose maturity is uncertain.
5. On the other hand, futures contracts are standardized in
terms of timing and quantities, and therefore they rarely offer a
perfect hedge.
6. Options contracts allow a firm to hedge against movements
in one direction while retaining exposure in the other.
7. Options are particularly useful in hedging exposures that are
highly uncertain with respect to timing and magnitude.

Futures

Fred Thompson

Key Points
8. Currency swaps offer firms the ability to borrow against
long-term foreign currency exposures when access to foreign
debt markets is costly.
9. Currency swaps converts a domestic liability into a
foreign one via what are effectively a bundle of long-dated
forward contracts between two firms.
10. The effective cost of a currency swap is its all-in cost the effective rate of interest that the firm ends up paying on
the constructed foreign liability.
11. Currency swaps require only that firms have differential
relative - rather than absolute - advantage in accessing debt
markets.

Futures

Fred Thompson