Download Advanced Financial Analysis: Intro and Firm Objectives

Currency Futures and Options
Markets
International Corporate Finance
P.V. Viswanath
A forward contract
 The forward market is a market where participants can
arrange today for a transaction to take place in the future.
Thus, a firm can sell $1m. three months forward for euros at
a price of $1.297 to the euro.
 This means that in 3 months, the firm can deliver $1m. and
receive in return (1/1.297x1m.) or €771,010.
 This is often a personalized contract with the contract
duration and contract amount arranged according to the
convenience of the participants.
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A futures contract
 A futures contract is similar to a forward contract in
that it is also nominally an arrangement for a
transaction to take place in the future.
 However, futures contracts are standardized both in
terms of duration (there are specific days when
contracts mature) and amount.
 This makes it easier for holders of contracts to
resell them.
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Futures Contracts
 The problem with trading forward contracts is that
these contracts represent a promise of future
performance.
 Hence A selling B a forward contract that he
originally bought from C is making a representation
regarding a third party that may not be known to B.
 The solution is to have a single party take the
opposite side of all futures contracts. This is the
clearing house.
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Clearing Houses
 If A wants to buy a futures contract from B, it is formally
structured as two contracts: one, where A buys the contract
from the clearing house, and another, where B sells it to the
clearing house. The price at which the transaction is to take
place (the futures price) is agreed between A and B.
 Then, if A wants to sell it to C, he simply agrees on the price
with C; then two new transactions take place simultaneously
– A sells his futures contract back to the clearing house,
while C buys it from the futures contract.
 This solves the problem of knowing the credit quality of the
contract partner, since it’s always the clearing house.
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Marking to Market
 However, this still leaves the clearing house open to credit
risk.
 Thus, if A buys a futures contract worth ¥12.5m at a price of
$0.9029/100 ¥ maturing Sept 2006 and the price dropped to
$0.8910 after two days.
 Each point change is worth $12.50; hence the price of the
contract has now dropped by $12.5(9029-8910) = $1487.50.
 If A were to close out his position now, he would owe the
exchange $1487.5/per contract.
 In order to reduce the clearing house’s exposure, A has to
mark-to-market (also called daily settlement).
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Marking-to-Market
 At the end of every day, the contract is respecified, as it
were, so that its value drops to zero.
 In our example, the value of the contract was zero when
originally struck.
 Currently, the contract is worth $1487.5 to the exchange and
-$1487.5 to A. This is because A has the obligation to buy
¥12.5m. at the price of $0.9029, when he could get it for
$0.891 on the open market.
 The solution that futures markets have adopted is to effect a
dollar transfer from the losing party to the gaining party at
the end of each day.
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Marking-to-Market
 Thus if the drop in price had occurred at the end of the next
day, A would have been required to pay $1487.5 to the
exchange per contract.
 This would reset the account balance at zero at the end of
each day.
 The maximum amount at risk would depend only on the
daily volatility.
 Daily settlement means that a futures contract is equivalent
to entering a forward contract each day and settling each
forward contract before opening another forward contract.
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Currency Options
 An option gives the holder the right, but not the
obligation to purchase or sell an underlying
commodity at a pre-agreed price (the strike or
exercise price).
 That is, options have a throw-away feature.
 Currency options traded on the CME are on futures
contracts. On the Philadelphia Exchange, the
underlying commodity is the spot currency.
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Quotes on Option Contracts
 On Monday, June 5, 2006, a call on the Sept Yen contract
with an exercise price of $0.9000/100¥ closed at
$.0205/100¥.
 Since the contract size is ¥12.5m, to purchase the option
would require a payment of (0.0205)(125000) or $2562.5
 Since the corresponding futures contract closed at $0.9030,
buying the option and exercising it immediately would have
resulted in a gain of (0.9030-0.9000)x125000= $375.
 The additional $2187.5 is for the possibility that the futures
price will climb even more in the next three months.
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Option Price Determinants
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Intrinsic Value
Volatility of Underlying exchange rate
Option type (American or European)
Interest rate on currency of purchase
Forward Premium and Interest Differential
Time to expiration
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