,INTERNATIONAL FINANCIAL MANAGEMENT,EUN / RESNICK,Second Edition,9,Chapter Nine,Futures and Options on Foreign Exchange,Chapter Objective: This chapter discusses exchange-traded currency futures contracts, options contracts, and options on currency futures.,Chapter Outline,Futures Contracts: Preliminaries Currency Futures Markets Basic Currency Futures Relationships Eurodollar Interest Rate Futures Contracts Options Contracts: Preliminaries Currency Options Markets Currency Futures Options,Chapter Outline (continued),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 Models,Futures Contracts: Preliminaries,A futures contract is like a forward contract: 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: Futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse.,Futures Contracts: Preliminaries,Standardizing Features: Contract Size Delivery Month Daily resettlement Initial Margin (about 4% of contract value, cash or T-bills held in a street name at your brokers).,Daily Resettlement: An Example,Suppose you want to speculate on a rise in the $/ exchange rate (specifically you think that the dollar will appreciate).,Currently $1 = 140. The 3-month forward price is $1=150.,Daily Resettlement: An Example,Currently $1 = 140 and it appears that the dollar is strengthening. If you enter into a 3-month futures contract to sell at the rate of $1 = 150 you will make money if the yen depreciates. The contract size is 12,500,000 Your initial margin is 4% of the contract value:,Daily Resettlement: An Example,If tomorrow, the futures rate closes at $1 = 149, then your positions value drops. Your original agreement was to sell 12,500,000 and receive $83,333.33 But now 12,500,000 is worth $83,892.62,You have lost $559.28 overnight.,Daily Resettlement: An Example,The $559.28 comes out of your $3,333.33 margin account, leaving $2,774.05 This is short of the $3,355.70 required for a new position.,Your broker will let you slide until you run through your maintenance margin. Then you must post additional funds or your position will be closed out. This is usually done with a reversing trade.,Currency Futures Markets,The Chicago Mercantile Exchange (CME) is by far the largest. Others include: The Philadelphia Board of Trade (PBOT) The MidAmerica commodities Exchange The Tokyo International Financial Futures Exchange The London International Financial Futures Exchange,The Chicago Mercantile Exchange,Expiry cycle: March, June, September, December. Delivery date 3rd Wednesday of delivery month. Last trading day is the second business day preceding the delivery day. CME hours 7:20 a.m. to 2:00 p.m. CST.,CME After Hours,Extended-hours trading on GLOBEX runs from 2:30 p.m. to 4:00 p.m dinner break and then back at it from 6:00 p.m. to 6:00 a.m. CST. Singapore International Monetary Exchange (SIMEX) offer interchangeable contracts. Theres other markets, but none are close to CME and SIMEX trading volume.,Basic Currency Futures Relationships,Open Interest refers to the number of contracts outstanding for a particular delivery month. Open interest is a good proxy for demand for a contract. Some refer to open interest as the depth of the market. The breadth of the market would be how many different contracts (expiry month, currency) are outstanding.,Reading a Futures Quote,Expiry month,Opening price,Highest price that day,Lowest price that day,Closing price,Daily Change,Highest and lowest prices over the lifetime of the contract.,Number of open contracts,Eurodollar Interest Rate Futures Contracts,Widely used futures contract for hedging short-term U.S. dollar interest rate risk. The underlying asset is a hypothetical $1,000,000 90-day Eurodollar depositthe contract is cash settled. Traded on the CME and the Singapore International Monetary Exchange. The contract trades in the March, June, September and December cycle.,Reading Eurodollar Futures Quotes,Eurodollar futures prices are stated as an index number of three-month LIBOR calculated as F = 100-LIBOR.,The closing price for the July contract is 94.68 thus the implied yield is 5.32 percent = 100 98.68,The change was .01 percent of $1 million representing $100 on an annual basis. Since it is a 3-month contract one basis point corresponds to a $25 price change.,Options 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 gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future, at prices agreed up