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Topic 6:
Foreign Currency
Futures and Options
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Chapter 20
Foreign Currency
Futures and
Options
adapted by Uwe Walz
Slides prepared by
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The Basics of Futures Contracts
Margins
Credit risk is handled by setting up an
account called a margin account, wherein
they deposit an asset to act as collateral)
Marking to market deposit of daily
losses/profits
Maintenance margins minimum amount
that must be kept in the account to guard
against severe fluctuations in the futures
prices (for CME, about $1,500 for USD/GBP
and $4,500 for JPY/USD)
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Futures vs forwards
Futures are standardized contract (forwards are
not)
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Mark to Market Valuation
Suppose it is September and you buy a December
euro futures contract
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Exhibit 20.1 An Example of Marking to
Market in the Futures Market
Euro contract (125,000)
Margin
call
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Futures Quotes
from April 21, 2011
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Chart for March 2017 EUR-USD contract
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Example: Hedging Euro receivables
with Futures
It is mid February and Nancy foods will receive
250,000 in mid March
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Example: Hedging Euro receivables
with Futures (2)
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Hedging with futures: potential problems
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Example: Hedging with basis risk
Suppose instead that current time is
January and Nancy foods will receive 250K
in early March
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Intermediate Summary
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Basics of Foreign Currency Option
Contracts
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Basics of Foreign Currency Option
Contracts
]
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Example: A Euro Call Option Against
Dollars
A particular euro call option offers the buyer the
right (but not the obligation) to purchase 1M @
$1.20/.
If the price of the > K, owner will exercise (think
coupon)
To exercise: the buyer pays ($1.20/)* 1M=$1.2M to the
seller and the seller delivers the 1M
The buyer can then turn around and sell the on the spot
market at a higher price!
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Example: A Yen Put Option Against the
Pound
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Prices of
Options on
Futures
Contracts
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Exchange-listed currency warrants
Longer-maturity foreign currency options (>1 year)
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Example: Macquarie Put Warrant
AUD put warrant against $ - maturity date of
December 15, 2016
K = $0.90/AUD; multiplier of AUD10
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FX Options and Risk Management
Transaction Risk
How to hedge?
Sell pound forward at $1.5805
Purchase put option with K =158
Minimum revenue:
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Example: Pfimerc
Solution
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Solution
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Example: Orlodge
Sep 16: Orlodge knows it has accounts
payable of CHF 750K on Wednesday, Dec 15
(in 90 days from now)
Maximum cost:
CHF750K$0.72/CHF + $11.734K= $551,734
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Example: Orlodge
Solution
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Orlodge Example: Solution
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Orlodge Example: Solution
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The Use of Options in Risk Management
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How can we price FX options?
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Determinants of FX Option Prices
Increasing the exercise price (call) it reduced the
probability that the option will be exercised so it
decreases the options value
An increase in the variance the distribution with
the larger variance yields possibly larger payoffs so
it increase the options value
Increasing the time to expiration
American increases uncertainty of spot rate
at maturity so it increases the options value
European generally increases the options
value but it depends because in-the-money
European options can lose value as time
evolves
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The more uncertainty there is the more costly is
the option
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Example: FX option pricing with
replication method
Suppose we want to price a 1-month European
call option which allows us to purchase 100
K = $1.52/
S=$1.50/
i($) = 0.5% p.m.
i() = 1% p.m.
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Example: FX option pricing
Solution
Value of replicating PF in H-state
$1.55X1.01-$Y1.005=$3
Cost of replicating PF is
$1.5029.7-$43.28=$1.27
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Exhibit 20A.1 A Two-Period
Binomial Tree
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Exhibit 20A.3 Call Option Price
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In class exercise
on topic
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Next topic
Hedging is costly.
Cant we do better simply forecasting FX rates?
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