McGraw-Hill/IrwinCopyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.Futures and Options on Foreign Exchange Chapter Seven7-2Chapter Outline Futures Contracts: Preliminaries Currency Futures Markets Basic Currency Futures Relationships Options Contracts: Preliminaries Currency Options Markets Currency Futures Options Basic Option Pricing Relationships at Expiry American Option Pricing Relationships European Option Pricing Relationships Binomial Option Pricing Model European Option Pricing Model Empirical Tests of Currency Option Models7-3Futures Contracts: Preliminaries A futures contract is like a forward contract in that it specifies that a certain currency will be exchanged for another at a specified time in the future at prices specified today. A futures contract is different from a forward contract in that futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse.7-4Futures Contracts: Preliminaries Standardizing features: Contract size Delivery month Daily resettlement Initial performance bond (about 2 percent of contract value, cash or T-bills, held in a street name at your brokerage)7-5Daily Resettlement: An Example Consider a long position in the CME Euro/U.S. Dollar contract. It is written on 125,000 and quoted in $ per . The strike price is $1.30 per the maturity is 3 months. At initiation of the contract, the long posts an initial performance bond of $6,500. The maintenance performance bond is $4,000.7-6Daily Resettlement: An Example With futures contracts, we have daily resettlement of gains and losses rather than one big settlement at maturity. Every trading day: If the price goes down, the long pays the short. If the price goes up, the short pays the long. After the daily resettlement, each party has a new contract at the new price with one- day-shorter maturity.7-7Performance Bond Money Each days losses are subtracted from the investors account. Each days gains are added to the account. In this example, at initiation the long posts an initial performance bond of $6,500. The maintenance level is $4,000. If this investor loses more than $2,500, he has a decision to make; he can maintain his long position only by adding more funds, and if he fails to do so his position will be closed out with an offsetting short position.7-8Daily Resettlement: An Example Over the first 3 days, the euro strengthens then depreciates in dollar terms:$1,250$1,250$1.31$1.30$1.27$3,750Gain/LossSettle= ($1.31 $1.30)125,000$7,750$6,500$2,750Account Balance= $6,500 + $1,250On day three suppose our investor keeps his long position open by posting an additional $3,750.+ $3,750 = $6,500 7-9Daily Resettlement: An Example Over the next 2 days, the long keeps losing money and closes out his position at the end of day five.$1,250 $1,250$1.31 $1.30 $1.27 $1.26 $1.24$3,750 $1,250 $2,500Gain/LossSettle$7,750 $6,500 $2,750 + $3,750 = $6,500 $5,250 $2,750Account Balance= $6,500 $1,2507-10Toting Up At the end of his adventure, our investor has three ways of computing his gains and losses: 1. Sum of daily gains and losses. $7,500 = $1,250 $1,250 $3,750 $1,250 $2,500 2. Contract size times the difference between initial contract price and last settlement price. $7,500 = ($1.24/ $1.30/) 125,000 Ending balance on the account minus beginning balance on the account, adjusted for deposits or withdrawals. $7,500 = $2,750 ($6,500 + $3,750)7-11Currency Futures Markets The CME Group (formerly Chicago Mercantile Exchange) is by far the largest currency futures market. CME hours are 7:20 a.m. to 2:00 p.m. CST Monday-Friday. Extended-hours trading takes place Sunday through Thursday (local) on GLOBEX i.e. from 5:00 p.m. to 4:00 p.m. CST the next day. The Singapore Exchange offers interchangeable contracts. There are other markets, but none are close to CME and SIMEX trading volume. Expiry cycle: March, June, September, December. The delivery date is the third Wednesday of delivery month. The last trading day is the second business day preceding the delivery day.7-12Reading Currency Futures QuotesOpen interest refers to the number of contracts outstanding for a particular delivery monthits a good proxy for demand for a contract. Notice that open interest is greatest in the nearby contract.In general, open interest typically decreases with term to maturity of most futures contracts.OPENHIGHLOWSETTLECHGOPEN INTERESTEuro/US Dollar (CME)125,000; $ per 1.47481.48301.47001.4777.0028Mar172,396 1.47371.48181.46931.4763.0025Jun2,2667-13Options Contracts: Preliminaries An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset in the future at prices agreed upon today. Calls vs. Puts: Call options give the holder the right, but not the obligation, to buy a give