International Finance

Futures and Options in Forex

Bhavin Mehta 03 Devang Mehta 05 Parth Mehta 07 Ronak Parekh 15 Ankit Shah 30 Jigar Shah 34
Derivatives Market

Money!!! The means of all exchange in the global village, Money is the ultimate buying power of one who holds it. Money is very important to all and it also forms an important part of our life. As we can see in the current scenario that all goods and services are priced at a value that is money. Different countries in the world have their own currency of their money. These currency rates keep on fluctuation due to demand and supply. But moreover there are many other factors tat affect the foreign exchange rates of any particular country. Thus it has several risks involved in such type of market. Some types of risks involved in the forex market are as follows: Interest rate risk. Counter party risk. Default risk. Events of gods. Liquidity risk.

Thus, to avoid such types of risks something known as derivatives are introduced. Derivatives are nothing but only financial contracts of pre-determined fixed duration, whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities. Derivatives are risk shifting instruments. The highly used derivatives products in the forex market are classified into four types. They are as follows: 1. Forwards Contract. 2. Futures Contract. 3. Options Contract. 4. Swap Contracts. In this project we are going to detail about the two types of derivatives products which are Currency Futures and Currency Options.

Currency Futures
Futures Concept

A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. If you buy a futures contract, you are basically agreeing to buy something that a seller has not yet produced for a set price. But participating in the futures market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities - remember, buyers and sellers in the futures market primarily enter into futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the primary activity of the cash/spot market). That is why futures are used as financial instruments by not only producers and consumers but also speculators. The consensus in the investment world is that the futures market is a major financial hub, providing an outlet for intense competition among buyers and sellers and, more importantly, providing a center to manage price risks. The futures market is extremely liquid, risky and complex by nature, but it can be understood if we break down how it functions. While futures are not for the risk averse, they are useful for a wide range of people. In this tutorial, you'll learn how the futures market works, who uses futures and which strategies will make you a successful trader on the futures market. A currency futures contract provides a simultaneously right and obligation to buy and sell a particular currency at a specified future date, a specified price and a standard quantity. In other words, in currency futures market, the different currencies are sold and purchased at the specified future date, at predetermined price and of specified quantity on a particular recognized exchange. It is similar to other futures contracts like commodities, interest, rates, metals, etc. The foreign currency futures were started in the year 1972 at the International Money Market (IMM) a division of Chicago Mercantile Exchange at Chicago. The major currencies which at this exchange were launched were British pound, Canadian dollar, Deutsche marks, French francs, Japanese yen, Swiss francs, Australian dollars. The amount of each foreign currency that must be delivered for a contract varies by currency. Features of Currency Futures

As mentioned, a currency futures contract is a commitment to deliver a specified quantity of a specified currency at a specified future date and at a specified price. The principal features, in general, of the contract are as follows: A) Organized exchanges: The currency futures contracts are negotiated only on recognized/organized exchanges with a designated physical location where such trading take place. These exchanges where futures currencies transactions are done: Chicago Board of Trade, Chicago. Philadelphia Board of Trade, Philadelphia. London International Financial Futures Exchange, London. Sydney Futures Exchange, Sydney. B) Standardization: Like other futures contracts, the currency futures contract are also standardized by the respective organized exchanges on which trading are initiated. The different terms of standardization like quantity, tick size, delivery, margin, etc. C) Clearing house: After a futures contract is agreed between the two parties at the trading floor, then the agreement between A and B immediately replaced by two contracts one between A and clearing house, and other, between B and the clearing house. The clearing house is responsible for keeping the accounts margin payments, settlement of deliveries and others like information and data collection. The clearing house gives the guarantee for execution and delivery of the contracts held till their maturity. D) Marking-to-market: At the end of the trading session, all the outstanding contracts are reprised at the settlement price of that session. It means that all the futures contracts are daily settled, and profit and loss is determined on each transaction. This procedure, called marking-to-market, requires that funds change every day. The funds are added or subtracted from a mandatory margin (initial margin) that traders are required to maintain the balance in the account. E) Margins: As we know that only the members of an exchange can trade in futures contracts on the exchange, so the general public can use the services of the

members as broker to trade on their behalf for a commission. A subset of exchange members is clearing members. Every transaction is, thus, between an exchange member and the exchange clearing house.

TYPES OF MARGINS: Initial margin. When a position is opened, the member (both long or short) has to deposit the margin with the clearinghouse as per the fixed rate by the exchange, which may vary asset to asset. Maintenance margin. Members accounts are debited or credited on a daily basis. In turn customers accounts are also required to be maintained at a certain level, usually 75% of the initial margin, is called the maintenance margin. The customer is required to deposit cash so as to bring the account back to its initial margin. Variation margin. If the initial margin falls to a pre-set level, the trader is asked to replenish his margin account to its previous (initial level). This additional margin is called variation margin. Margin call. When the balance in a traders account falls below a certain level (maintenance margin), the trader receives a margin call to deposit the amount in a specified time usually 24 hours. This is called paying the variation margin. If the trader fails to do so then his position is liquidated immediately. It should be noted that the clearinghouse imposes margin on the clearing members who, in turn, collect margin from their customers/clients. These may be members of the public or exchange members who are clearing their transactions through the clearing members. Let us explain the marking to mark with a small example. X buys a March delivery pound sterling futures on, say, Jan 15 at the price of $1.65 per British pound (BP) per contract being $103125 (62500*1.65). Next day, Jan 16, the prices increases and is settled at 1.68. In other words, X had made a profit of 3 cent pound or $1875 per contract (62500*3%). Obviously, the other party will incur loss of $1875. An amount of $1875 will be credited in X margin account and Xs account will be repriced at 1.68 or $105000.

X will immediately withdraw a cash of $1875. On the other hand, if the price has gone down then X margin account will be debited, and if the balance falls below the maintenance margin, then margin call will be made to deposit the amount by X to maintain the balance of margin account to initial margin level. Trading Process in Futures Like other futures trading, the futures currencies are also traded at the organized exchanges. The following figure exhibits the common flow diagram of how operations take place on currency futures market. Trader (Buyer) Purchase Order Member (Broker) Trader (Seller) Sales Order Member (Broker)

Transaction on the floor (Exchange) Informs Clearing House

Currency futures contract trading process (flow of transaction). Figure describes the mechanism of the flow of transactions which are taken place at the recognized exchanges. When the market is open, the transactions take place at the floor of the exchange. Beyond the opening hours, negotiations may take place through an electronic system, called GLOBEX which connects the markets of Chicago, Paris, London and others from 2:30 p.m. until 7:05 a.m. the following morning. The GLOBEX system matches purchase and sale orders for each type of currency futures contract. Orders are confirmed electronically and the traders are informed about the quantity and price of the negotiations. This

information is then sent to the clearing house which further makes the adjustments in the buyers and sellers margin accounts. Hedging with Currency Futures Exchange rates are quite volatile and unpredictable, it is possible that anticipated profit in foreign investment may be eliminated, rather even may incur loss. Thus, in order to hedge this foreign currency risk, the traders oftenly use the currency futures. For example, a long hedge (i.e., buying currency futures contracts) will protect against a rise in a foreign currency value whereas a short hedge (i.e., selling currency futures contracts) will protect against a decline in a foreign currencys value. It is noted that corporate profits are exposed to exchange risk in many situations. For example, if a trader is exporting or importing any particular product from other countries then he is exposed to foreign exchange risk. Similarly, if the firm is borrowing or lending or investing for short or long period from foreign countries, in all these situations, the firm can take long or short position in futures currency market as per requirement. The general rule for determining whether a long or short futures position will hedge a potential foreign exchange loss is: Loss from appreciating in Indian rupee Loss from depreciating in Indian rupee Short hedge Long hedge

The decisions involved in regards to hedging with currency futures are the choice of underlying currency, choice of the maturity of the contract, etc. SYNTHETIC FOREIGN CURRENCY FUTURES CONTRACTS. Synthetic futures currency contracts simply means that instead of going futures in the same currency, the trader may look for other currencies too. For example, US dollar denominated futures contracts can be hedged by buying or selling in another currency future or to establish a cross-currency futures spread. Suppose a treasurer expects the British pound to appreciate relative to the Japanese yen. For this, he can buy pound

futures and sell you futures, looking in a futures exchange rate between the yen and the pound sterling. This position will be profitable in the following conditions: Both the currencies British pound and Japanese yen appreciate with respect to dollar but the BP appreciates more. Both the BP and the yen depreciate with respect to dollar but the mark depreciates less. The BP appreciates relative to the dollar, and the yen depreciates relative to the dollar. It should be noted that good results will occur only if the futures positions are established in the correct proportions, i.e. each dollar value futures positions on both legs of the spread.

SETTLEMENT PROCESS AND DELIVERY. It has been observed that in most futures markets, actual physical delivery of the underlying assets is very rare and hardly it ranges from 1 % to 5%. Most often buyers and sellers offset their original position prior to delivery date by taking an opposite positions. This is because most of the futures contracts in different products are predominantly speculative instruments. For example, X purchases British pound futures and Y sells it. It leads to two contracts, first, X party and clearing house and second Y party and the clearinghouse. Assume next day X sells same contract to Z, then X is out of the picture and the clearinghouse is seller to Z and buyer from Y, and hence, this process goes on.

Currency Options
Options Concept Foreign currency options are such financial instruments which have assumed a vital importance in the financial markets all over the world. These are being widely used by different market participants like importers, exporters, traders, arbitrageurs, speculators bankers and financial institutions. They protect the holder against the risk of adverse movements in the exchange rates. Foreign currency option or simply currency option is a financial instrument that gives the option holder a right and not the obligation, to buy or sell a given amount of foreign exchange at a predetermined price also known as strike price for a specified time period i.e. until the expiration date. In other words, a foreign currency option is a contract for future delivery of a specified currency in exchange for another in which the holder (buyer) of the option has the right to buy (Call) or sell (Put) a particular currency at an agreed price (the strike or exercise price) for or within specified period. The seller of the option (writer) gets the premium from the buyer of the option for the obligation undertaken in the contract.

Example: A importer fixes his risk limit at say 108 yen with the current spot rate around 109.50, it is quite possible that the risk limit may be hit in a few days, the Japanese exporter will be committed to this rate of 108 yen per dollar and then the dollar may rise smartly to 112 or even 115 before the dollars are actually received. The exporter will certainly not feel good of the opportunity loss. Can the exporter simply fix his worst case rate at 108 yen without being committed to any rate? On the other hand, can a Japanese importer at the same time fix his worst case rate at say 111 yen without commitment to a particular rate?

The Japanese exporter can approach his bank and buy an option to sell dollars at a strike price of 108 yen say after 3 months. If the USD/JPY spot rate at expiry is below 108, the exporter will exercise the option and sell his dollars to the bank at the strike price of 108 yen. On the other hand, if the spot rate at the expiry is higher than 108, the exporter will let the option lapse (since he has no obligation) and sell the dollars to the bank at the prevailing market rate. The Japanese importer, on the other hand, buy an option to buy dollars at a strike price of 111 yen say after 3 months. If the USD/JPY spot rate at expiry is above 111 yen, the importer will exercise his option and buy his dollars from the bank at the strike price of 111 yen. However, if the spot rate is below 111 yen, the importer will let his option lapse and buy the dollars from the bank at the prevailing market rate. Basics of Currency Options Some basics of option market terminology which are frequently used in the market are: A) Types: There are two basic types of options: call option and put option. A call is an option to buy foreign currency and a put is an option to sell the foreign currency. B) Parties: The buyer of the option is termed as holder where as the seller of the option is called the writer or grantor. In other words, there are two parties in an option contract buyer and seller. If one party is buyer in a particular currency, the other party will be automatically a seller in that particular currency. C) Price Elements: Every currency option contract has three different price elements. 1. The exercise or the strike price (rate) at which the foreign currency can be purchased or sold, 2. The premium, which is the cost or price or value of the option itself and 3. The underlying or actual spot exchange rate in the currency market exists on the exercise day. Option Pricing Intrinsic value is simply the difference between the spot price and the strike price. For Put Options

In-the-Money = Spot Price is below Option Strike (Exercise) Price Out-of-the Money = Spot Price is above Option Strike (Exercise) Price At-the-Money = Spot Price and Strike (Exercise) Price are the same For Call Options In-the-Money = Spot Price is above Option Strike (Exercise) Price Out-Of-the-Money = Spot Price is below Option Strike (Exercise) Price At-The Money = Spot Price and Option Strike (Exercise) Price are the same Time value is more complex. When the price of a call or put option is greater than its intrinsic value, it is because it has time value. Time value is determined by five variables: the spot or underlying currency price, the expected volatility of the underlying currency, the exercise price, time to expiration, and the difference in the "risk-free" rate of interest that can be earned by the two currencies. Time value falls toward zero as the expiration date approaches. This falling of time value toward zero as expiration approaches is nonlinear in nature, that is, the erosion of time value premium accelerates as the option approaches expiration. An option is said to be "out-of-the-money" if its price is comprised only of time value. Interest rate differentials between nations and temporary supply/demand imbalances can also have an effect on option premiums. In the final analysis, option prices (premiums) must be low enough to induce potential buyers to buy and high enough to induce potential option writers to sell. These prices result from the interaction of buyers and sellers through the auction market conducted on the trading floor of the Exchange. D) Classification: The option contract can be classified as American options and European options. In American option, the buyer has the right to exercise the option at any time between the writing date and expiration date whereas in European option, option can be only exercised only at the expiration date, and not before it. E) Option Cost: The fee that the option buyer must pay to the option writer, up-front, i.e. at the time the contract is initiated. Thus, it is called the option premium, option price or cost of the option. This is paid in advance and lapses whether option exercised of not. F) Options Payoff: The optionality characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited; however the profits are potentially unlimited. For a writer, the payoff is exactly

the opposite. His profits are limited to the option premium, however his losses are potentially unlimited. These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. We look here at the four basic payoffs. Buying call options : Long call Call options can also be used to protect against currency appreciation. As an example, American companies purchasing goods from foreign companies may incur substantial risk if, before completion of an agreed upon transaction, the currency of the seller's nation should rise in value relative to the U.S. dollar. Such a rise means more U.S. dollars than originally contemplated would be required to purchase the goods, (or purchase the amount of foreign currency needed to pay for the goods) resulting in reduced profits or even potential losses. Buying call options on the seller's currency, in this case, can provide protection or "insurance" against the risk of a rising currency. In return for the premium paid for a call option, the buyer can be assured that the specified currency can be purchased at the predetermined price. Yet, the holder of such an option has no obligation to purchase at the price guaranteed by the option. Instead, the opportunity to reduce the cost by spending fewer U.S. dollars for the goods is preserved should the currency decline in value relative to the U.S. dollar; the option would be allowed to expire without further consequence to its holder. The holder would then merely purchase (using USD) the amount of foreign currency needed to pay for the goods on at the current spot market rate, thereby using fewer dollars to purchase the foreign currency. Example: In June, an American importer wishes to purchase German goods for resale. A price of 5,000,000 Euros is negotiated for delivery in September. The American importer

observes that the current spot exchange rate is .9775 per Euro making the contract worth $4,887,500 U.S. Dollars. A decision is made to protect against an adverse movement of the Euro by purchasing 80 PHLX standardized EUR/USD call options (5,000,000 62,500 Euros per contract) with a strike price of $.98 per Euro, for expiration in September. With the for premium (cost per option) at 2.25 U.S. cents per Euro, the importer would pay a total of $112,500 for the 80 standardized option contracts ($.0225 x 62,500 Euros = $1,406 per contract x 80 contracts). In exchange for the premium, the importer is guaranteed to be able to purchase the Euros at a price of $.98, even if the Euro appreciates above $.98 before expiration. If the EURO declines in value below the exercise price of $.98 the original purchase price would actually require fewer U.S. dollars than was initially required and the option would not be exercised. Purchasing Put Options to Protect Against a Decline in Currency Values A currency put option guarantees its owner the right, but not the obligation, to sell currency at a pre-agreed exercise price within a specified time period. It follows that the option holder will realize a profit if the spot market price of the currency is below the option exercise price by an amount greater than the premium paid. Put options can be used to protect or "insure" against currency price declines. As an example, a Swiss exporter of goods to the U.S. may well find it advantageous to purchase put options on U.S. dollars in connection with a specific sale of goods. The Swiss seller of goods will be at risk for any decline in the value of U.S. dollars relative to the Swiss Franc. Ideally, the seller would like to eliminate this risk and retain the ability to receive more Swiss Francs for the merchandise if the U.S. dollar should rise in value.

Example: During the month of December a Swiss company agrees to sell 115,000,000 Swiss Francs (CHF) worth of merchandise to an American buyer for delivery in March. At the time of the agreement, 1 U.S. dollar can be exchanged for 1.405 Swiss Francs. Thus, a contract is agreed upon to sell the goods for 81,850,534 U.S. dollars (115,000,000 CHF 1.405 CHF). In order to protect against the risk of a decline in the U.S. dollar relative to the Swiss Franc, the seller decides to purchase 1,309 ($81,850,534 CHF 62,500 per contract) December 1.400 put options on the U.S. dollar. The strike price is U.S. cents per Swiss Franc, so the Swiss manufacturer in selecting the at theMoney- put strike would look for the March 71 strike price (the 71 strike, expressed in U.S. cents per Swiss Franc is the equivalent of CHF 1.40 per USD). The premium for one put option is 1.57 U.S. cents per Swiss Franc or $981.25 per contract, for a total premium payment of $1,284,456 (CHF 62,500 per contract x .0157 x 1,309 contracts). For the cost of the premium, the exporter is guaranteed that the 81,850,534 U.S. dollars received from the sale of merchandise can be exchanged for a minimum of 1.40 CHF per U.S. dollar, until the option expires in March. If the U.S. dollar should increase in value above the current rate the option contract would not be necessary since more Swiss Francs would be realized upon the sale of the goods thus benefiting from a favorable currency move.

Writing Foreign Currency Options Since the sale of options results in the payment of a premium to the seller of the option, it is possible to sell options in order to achieve a potentially attractive rate of return. Of course, since the writing of call options on currencies places an obligation on the option writer, considerable risk accompanies such a strategy. Writing calls on a currency can be done on a "covered" basis by holders of currency positions. It should be recognized that the writing of options limits the potential gains available in the event of a sharply rising currency. This could be considered an opportunity cost."

The strategy of selling options against assets already held is called "covered" writing. The writer of an option is obligated, if the option is exercised, to perform according to the terms of the option contract: to deliver the required number of units of the underlying currency at the option exercise price if the option is a call, or to purchase the required number of units at the option exercise price if the option is a put. The investor considering writing options should clearly understand that the holder of an American style option can exercise his rights under the option at any time. Moreover, once a writer has been assigned a notice of exercise, he may no longer liquidate his option position by an offsetting purchase. In general, covered writing strategies afford the investor additional income, as generated by the premium taken in from the sale of the call and establishes a measure of "downside protection" a cushion against a decline in value of the underlying assets as determined by the amount of option premium which the writer receives. In exchange for these benefits (income & limited downside protection), the writer forgoes the opportunity to profit should the underlying asset increase in value beyond the exercise price of the option written. Graphically, the risk/reward relationship of writing uncovered options can be depicted as follows:

Foreign Currency Option Market In the last decade the foreign currency options have been frequently used as a hedging tool and for speculative trading processes, specifically in the developed countries like USA, UK, Japan, Germany, etc. A number of commercial banks and other capital markets offer flexible foreign currency options on transactions of one million US dollar or more. The bank market or OTC as it is called, offers customer-tailored options on all major trading currencies for any time period upto one year, hence, provide a useful tool or alternative to futures or forwards contracts. Options are traded on over-the-counter (OTC) markets as well as on organized markets. Thus, the currency options market is divided into two different types. Over-the-counter Options Market (OTC): Multinational companies and large commercial international banks have recognized the flexibility of options for many years. The OTC market today is open only to the large firms since it involves amounts in millions of dollars. The average maturity of OTC options ranges from two to six months and very few options are written for more than one year. Since this market is of customized nature, the terms and conditions of the contract are negotiated between the holder and the writer of the option. The main advantage of OTC markets is that the clients can make the contracts as per their specified needs concerning to the period, price and amount. Exchange-Traded Currency Options Market: apart from the options traded at the OTC market, they are also traded today on a number of organized exchanges worldwide. The first such trading commenced in 1982 by Philadelphia Stock Exchange (PHLX). Since then the size of this market has grown up very rapidly, and major currencies traded are the Australian dollar, British pound, Canadian dollar, German mark, Japanese yen, French franc, Swiss franc, US dollar, etc. Exchange traded options are settled through a clearing house, hence, the buyers do not deal directly with the seller rather through an

agency. The clearing house is the counter party to every option contract and it guarantees the fulfillment of the contracts. For example, in case of Philadelphia Stock Exchange (PHLX), clearing house services are rendered by Options Clearing Corporation (OCC). Trading in currency options (w.r.t Philadelphia Stock Exchange) Standardized Options The currencies options contracts are standardized in nature, and settle upon exercise in the actual physical currency. For e.g. in the Philadelphia Stock Exchange there is a list of six dollar-based standardized currency option contracts i.e. Contract size The amounts of currency controlled by the various currency options contracts are geared to the needs of the widest possible range of participants. Following are the sizes of Philadelphia Stock Exchange expressed in units of currency for each option: Currency Option U.S. dollar / Australian dollar U.S. dollar / British pound U.S. dollar / Canadian dollar U.S. dollar / Euro U.S. dollar / Japanese yen U.S. dollar / Swiss franc Units 50,000 AUD 31,250 GBP 50,000 CAD 62,500 EUR 6,250,000 JPY 62,500 CHF

Exercise style American- and European-style exercise options are available. Expiration/Last Trading Day Expiration, which is also the last day of trading, occurs on both a quarterly and consecutive monthly cycle. That is, currency options are available for trading with fixed quarterly months of March, June, September and December with two additional near-term months. For Example: After December

expiration, trading is available in options which expire in January, February, March, June, September, and December. Options cease trading and expire on the Friday preceding the third Wednesday of the expiration month. Exercise Prices Exercise prices are expressed in terms of U.S. cents per unit of foreign currency. Thus, a call option on Euros with an exercise price of 97 would give the option buyer the right to buy Euros at 97 us cents per Euro. It is important that available exercise prices relate closely to prevailing currency values. Therefore, exercise prices are set at certain intervals surrounding the current spot or market price for a particular currency. When significant price changes take place, additional options with new exercise prices are listed and commence trading. Strike price intervals vary for the different expiration time frames. They are narrower for the near term and wider for the long-term options. Premium Quotation Premiums for dollar-based options are quoted in U.S. cents per unit of the underlying currency (with the exception of Japanese yen which are quoted in hundredths of a cent). Example: A premium of 0.97 for a given Euro option is ($.0097) per Euro. Since each option is for 62,500 Euros, the total option premium would be $606.25 (62,500 x $ . 0097). Delivery and Settlement The PHLX trades currency options that are physically settled - the exchange of one currency for another. Physically settled currency options are not automatically exercised at expiration, but rather the buyer must submit exercise instructions to his/her broker dealer. Subsequently, a writer or "short" will be assigned which will result in the physical delivery of currency between the two clearing members. Customers should check with their clearing firm as to the various alternatives available for settling delivery obligations.