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Foreign Currency Options
Chapter Seven
Eiteman, Stonehill, and Moffett
04/20/23 1Chapter Seven - Derivatives
Hedging vs speculation
firms hedge make money on their core competency reduce risk writing a covered option
firms do not speculate options are not a core competency speculation tries to make a return from
risk
04/20/23 2Chapter Seven - Derivatives
Quick review forward contracts
Negotiable contracts Price, forward rate is contracted Amount, how much foreign exchange will
be exchange for domestic currency Term, when delivery will be made
Contract is deliverable according to terms Will not be able to get out of the
contract
04/20/23 Chapter Seven - Derivatives 3
Currency futures contracts standardized contract terms
amount of foreign exchange standardized $ 100,000 Canadian, £ 62.500, Peso 500,000, ¥ 12,500,00, Euro 1,000,000
exchange rate fixed at contract time delivery dates standardized by the exchange
March, June, September, December 6 mos Chicago Mercantile Exchange
contracts expire two business days prior to the 3rd Wednesday of the delivery month
Contract is reversible
04/20/23 4Chapter Seven - Derivatives
Futures contracts
Short position (selling a future) Fix price to deliver fx @ 1.0337 To deliver 100,000 cd Delivery Dec 15, 2007
Long position (buying a future) Fix priced to take delivery fx @ 1.0337 To take delivery 100,000 cd
04/20/23 Chapter Seven - Derivatives 5
Market makers in currency futures
international monetary market (IMM) London international financial futures
exchange (LIFFE) Chicago Mercantile Exchange New York mercantile exchange Singapore international monetary
exchange (SIMEX)
04/20/23 6Chapter Seven - Derivatives
Trading specifics
commissions small (less than 0.5%) margin requirements typically 2% to
3% contracted amount both sides of contract guaranteed by
exchange contracts marked to market daily
04/20/23 7Chapter Seven - Derivatives
long one June euro contract
contracted June delivery of 1,000,000 Euros
spot price 0.9737 / dollar or 0.9737 * 1,000,000 = 973,700 usd at contract
initial margin paid in when contracted e.g. 2% on Euro contract 20,000 usd
maintenance margin e.g. 1% on Euro contract 10,000 usd
04/20/23 8Chapter Seven - Derivatives
marking to market 1st day e.g. tomorrows settlement price 0.9817
(0.9817 - 0.9737) * 1,000,000 = 8,000 futures price is now 0.9817
long the future (wanting euros) margin account = 20,000 - 8,000 = 12,000
short the future (wanting dollars) margin account = 20,000 + 8,000 = 28,000
04/20/23 9Chapter Seven - Derivatives
marking to market 2nd day e.g., next days settlement price 0.9867
(0.9867 - 0.9817) * 1,000,000 = 5,000 futures price is now 0.9867
long the future (wanting euros) margin account = 12,000 - 5,000 = 7,000 margin call - buyer of the future must bump up
his margin
short the future (wanting dollars) margin account = 28,000 + 5,000 = 33,000
04/20/23 10Chapter Seven - Derivatives
Futures contract expires (long side of contract) e.g. last settlement price 1.0017
net change in margin (1.0017 - 0.9737) * 1,000,000 = 28,000
final futures price 1.0017 long the future (wanting euros)
net change in margin account + 28,000
pays ( -1,001,700 + 28,000) = -973,700 dollars
receives +1,000,000 euros
04/20/23 11Chapter Seven - Derivatives
Futures contract expires(short side of contract) last settlement price 1.0017
net change in margin (0.9737 - 1.0017) * 1,000,000 = -28,000
final futures price 1.0017 short the future (wanting dollars)
net change in margin account -28,000 pays -1,000,000 euros receives (1,001,777 - 28,000) = 973,700
dollars
04/20/23 12Chapter Seven - Derivatives
Futures marking to market reduces(illimanates)
default risk daily resettlement confines risk to one day’s
price movements large daily movements in price will result in
trading halt margin call during trading halt
trader want to terminate the contract will take the opposite contract if long two contracts, will go short two contracts
cost is the interest paid on margins
04/20/23 13Chapter Seven - Derivatives
Comparison to forwards forward contracts
flexible higher default risk fixed into contract Must deliver on expiration
futures contracts standardized much lower default risk reversible
04/20/23 14Chapter Seven - Derivatives
Options - characteristics American option can be exercised
anytime up to the expiration date European option can only be exercise
at the expiration date in-the-money - option which if
exercised will make money out-of-the-money - option which if
exercised will lose money
04/20/23 15Chapter Seven - Derivatives
Options - types Call option
option to buy currency fixed price (exercise price, strike price) expiration date
Put option option to sell currency fixed price (exercise price, strike price) expiration date
04/20/23 16Chapter Seven - Derivatives
Over-the-counter Market written by banks
usd against pounds, euros, cd, yen usually written in round lots;
1, 2, 3, 5, 10 million banks willing to write variable options
amount exercise (strike) price maturity date
less liquid than traded option
04/20/23 17Chapter Seven - Derivatives
Options on organized exchanges
Standardized contracts amount fixed maturity dates
Auction markets Philadelphia exchange London International Financial Futures
Exchange
04/20/23 18Chapter Seven - Derivatives
Options - over-the-counter Market written by banks
usd against pounds, euros, cd, yen usually written in round lots;
1, 2, 3, 5, 10 million banks willing to write variable options
amount exercise (strike) price maturity date
less liquid than traded option
04/20/23 19Chapter Seven - Derivatives
Call characteristics
e exchange rate x exercise price sdx standard deviation of exchange
rate
04/20/23 20Chapter Seven - Derivatives
Long a call option
e
c
x
Call out of the moneywhen e < x
Call in the moneywhen e > x
04/20/23 21Chapter Seven - Derivatives
Short the Call Option
C
SX
04/20/23 22Chapter Seven - Derivatives
Market Value of the Call
),,,( , rfet kxsdeCC
0e
C0
C
0
esd
C0
x
C
0
rfk
C
04/20/23 23Chapter Seven - Derivatives
Valuation
exercise price (negative) exchange rate (positive) volatility (positive) term to maturity (positive) risk-free rate of return (positive)
04/20/23 24Chapter Seven - Derivatives
Value of the Exercised Call
0)(
,
),(
0,
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CnxeC
xeIf
ormoneytheofout
PxeIf
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txt
04/20/23 25Chapter Seven - Derivatives
Long a call option
e
c
x
exercised valueof the call
market valueof the call
04/20/23 26Chapter Seven - Derivatives
Long a put option
e
P
x
Call out of the moneywhen e > x
Call in the moneywhen e < x
04/20/23 27Chapter Seven - Derivatives
Short the Put Option
P
SX
04/20/23 28Chapter Seven - Derivatives
Market Value of the Put
),,,( , rfet kxsdePP
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P 0P
0
esd
P0
x
P
0
rfk
P
04/20/23 29Chapter Seven - Derivatives
Value of the Exercised Put
0)(
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),(
0,
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PnexP
xeIf
ormoneytheofout
PxeIf
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txt
04/20/23 30Chapter Seven - Derivatives
Long the Put Option
P
SX
04/20/23 31Chapter Seven - Derivatives