Futures and Options on Foreign Exchange

Chapter 7
Copyright © 2018 by the McGraw-Hill Companies, Inc.
All rights reserved.
 Chapter 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
 Futures Contracts: Preliminaries
• There are markets (exchanges) that trade
commodities or securities for future deliveries,
such as CME and Bursa Malaysia Derivatives.
• 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.
Futures Contracts: Preliminaries

• Standardizing features:
– Contract size
– Delivery month
– Daily resettlement (marked-to-market)
• Initial performance bond (about 2 percent
of contract value, cash or T-bills)
 Daily 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 €
(American term).
• 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.
 Daily 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.
(Why?)
– 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.
 Performance Bond Money
• Each day’s losses are subtracted from the
investor’s account.
• Each day’s 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.
 Daily Resettlement: An Example
• The followings are the price of euro in dollar
as quoted in CME for 5-day trading:
Settle Gain/Loss Account Balance
$1.31 $1,250 = ($1.31 –$7,750
$1.30)×125,000
= $6,500 + $1,250
$1.30 –$1,250 $6,500
$1.27 –$3,750 $2,750 + $3,750 = $6,500
On day three suppose our investor keeps his long
position open by posting an additional $3,750.
 Daily Resettlement: An Example
• Over the next 2 days, the long keeps losing money
and closes out his position at the end of day five.

Settle Gain/Loss Account Balance

$1.31 $1,250 $7,750
$1.30 –$1,250 $6,500
$1.27 –$3,750 $2,750 + $3,750 = $6,500
$1.26 –$1,250 $5,250 = $6,500 – $1,250
$1.24 –$2,500 $2,750
•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
3. Ending balance on the account minus
beginning balance on the account, adjusted for
deposits or withdrawals.
– $7,500 = $2,750 – ($6,500 + $3,750)
Options Contracts: Preliminaries
• An option is a contract that 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.
• The holder can exercise his right at the exercise price (E)
• But holder must pay premium to get this right
• Calls vs. Puts:
– Call options give 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 upon today.
– Put options give the holder the right, but not the
obligation, to sell a given quantity of some asset at
some time in the future at prices agreed upon today.
 Options Contracts: Preliminaries
• European versus American options:
– European options can only be exercised on the expiration
date while American options can be exercised at any time
up to and including the expiration date.
– American options are usually worth more than European
options, other things equal.
• Moneyness
– If immediate exercise is profitable, an option is “in the
money.”
– Out of the money options can still have value (in the case
of American option)
PHLX Currency Option Specifications
Currency Contract Size
Australian dollar AUD 10,000
British pound GBP 10,000
Canadian dollar CAD 10,000
Euro EUR 10,000
Japanese yen JPY 1,000,000
Mexican peso MXN 100,000
New Zealand dollar NZD 10,000
Norwegian krone NOK 100,000
South African rand ZAR 100,000
Swedish krona SEK 100,000
Swiss franc CHF 10,000
 Basic Option Pricing
Relationships at Expiry
• At expiry, an American option is worth the same as a
European option with the same characteristics.
• If the call is in-the-money (that is ST > E), it is worth ST – E.
• If the call is out-of-the-money, it is worthless.
CaT = CeT = Max[ST – E, 0]
• If the put is in-the-money (E > ST ), it is worth E – ST.
• If the put is out-of-the-money, it is worthless.
PaT = PeT = Max[E – ST, 0]
 Basic Option Profit Profiles
Profit
If the call is in-
the-money, it is
worth ST – E.
If the call is out-
of-the-money, it
is worthless, and
the buyer (long) ST
of the call loses –c0
E + c0
his entire E
investment of c0,
which is the Out-of-the-money In-the-money
premium paid to
seller. Loss
 Basic Option Profit Profiles
Profit
If the put is in-
the-money, it is E – p
0
worth E – ST. The
maximum gain is
E – p0.
If the put is out- Short 1 put
of-the-money, it
is worthless, and ST
– p0
the buyer of the Long 1 put
put loses his E – p0
entire investment
of p0. E
In-the-money Out-of-the-money
Loss
 Example
• You buy a call option on Euro which has a
premium of 4.41 cents per Euro. The
exercise price of this option is $1.22 per
Euro. If spot rate at expiration (say 1 year)
is $1.2625 per euro, what would you do?
 Example
• E = $1.22
• St = $1.2625
• Premium = 4.41
• S>E , so option is in-the-money, so
exercise it!
• How much will be the profit?
1.2625 – 1.22 = $0.0425 per euro minus the FV
of premium that is paid today. (for example,
what if interest rate is 5%?)
 Time Value and Intrinsic Value of Option in
American Option

• The two components of an option premium

are the intrinsic value and the time value.
• The intrinsic value is the difference
between the underlying's price and the
strike price.
• By definition, the only options that have
intrinsic value are those that are in-the-
money.
 Time Value and Intrinsic Value of Option in
American Option
• Any premium that is in excess of the option's intrinsic
value is referred to as time value.
• For example, assume a call option has a total premium
of $9.00. If the option has an intrinsic value of $7.00, its
time value would be $2.00 ($9.00 - $7.00 = $2.00).
• In general, the more time to expiration, the greater the
time value of the option. investors are willing to pay a
higher premium for more time, since time increases the
likelihood that the position can become profitable.
• Time value decreases over time and decays to zero at
expiration.
Interest Rate & Currency Swaps
Chapter Fourteen
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved.
 Definitions
• In a swap, two counterparties agree to a
contractual arrangement wherein they
agree to exchange cash flows at periodic
intervals.
• There are two types of interest rate swaps:
– Single currency interest rate swap
• “Plain vanilla” fixed-for-floating swaps are often
just called interest rate swaps.
– Cross-Currency interest rate swap
• This is often called a currency swap; fixed for fixed
rate debt service in two (or more) currencies.
 Size of the Swap Market
• In 2004 the notational principal of:
Interest rate swaps was $127,570 billion USD.
Currency swaps was $7,033 billion USD
• The most popular currencies are:
– U.S. dollar
– Japanese yen
– Euro
– Swiss franc
– British pound sterling
 The Swap Bank
• A swap bank is a generic term to describe a
financial institution that facilitates swaps
between counterparties.
• The swap bank can serve as either a broker or a
dealer.
– As a broker, the swap bank matches
counterparties but does not assume any of
the risks of the swap.
– As a dealer, the swap bank stands ready to
accept either side of a currency swap, and
then later lay off their risk, or match it with a
counterparty.
 Swap Market Quotations
• Swap banks will tailor the terms of interest
rate and currency swaps to customers’
needs
• They also make a market in “plain vanilla”
swaps and provide quotes for these. Since
the swap banks are dealers for these
swaps, there is a bid-ask spread.
An Example of an Interest Rate Swap
• Consider this example of a “plain vanilla”
interest rate swap.
• Bank A is a AAA-rated international bank
located in the U.K. and wishes to raise
$10,000,000 to finance floating-rate
Eurodollar loans.
– Bank A is considering issuing 5-year fixed-rate
Eurodollar bonds at 10 percent.
– It would make more sense to for the bank to issue
floating-rate notes at LIBOR to finance floating-rate
Eurodollar loans.
An Example of an Interest Rate Swap
• Firm B is a BBB-rated U.S. company.
It needs $10,000,000 to finance an
investment with a five-year economic
life.
– Firm B is considering issuing 5-year fixed-rate
Eurodollar bonds at 11.75 percent.
– Alternatively, firm B can raise the money by
issuing 5-year floating-rate notes at LIBOR +
½ percent.
– Firm B would prefer to borrow at a fixed rate.
 An Example of an Interest Rate Swap
The borrowing opportunities of the two
firms are:
Company B Bank A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR

And both are in need of $10,000,000

An Example of an Interest Rate
Swap
Swap The swap bank makes
this offer to Bank A:
Bank You pay LIBOR – 1/8
10 3/8%
% per year on $10
LIBOR – 1/8% million for 5 years and
Bank we will pay you 10
3/8% on $10 million for
A
5 years
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
 An Example of an Interest Rate
Swap
½% of $10,000,000 Here’s what’s in it for Bank A:
Swap
= $50,000. That’s They can borrow externally at
quite a cost savings 10% fixed and have a net
Bank borrowing position of
per year for 5 years. 10 3/8%
-10 3/8 + 10 + (LIBOR – 1/8) =
LIBOR – 1/8%
LIBOR – ½ % which is ½ %
Bank better than they can borrow
10% floating without a swap.
A

COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
 An Example of an Interest Rate
Swap
The swap bank makes this
offer to company B: You Swap
pay us 10½% per year on Bank
$10 million for 5 years and 10 ½%
we will pay you LIBOR – ¼
% per year on $10 million LIBOR – ¼%
for 5 years. Company
B

COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
 An Example of an Interest Rate
Swap
Here’s what’s in it for B: ½ % of $10,000,000 =
Swap $50,000 that’s quite a
Bank cost savings per year
They can borrow externally at for 5 years.
10 ½%
LIBOR + ½ % and have a net
LIBOR – ¼%
borrowing position of
Company LIBOR
10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25%
which is ½% better than they can borrow floating. + ½%
B

COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
 An Example of an Interest Rate
Swap
¼% of $10 million =
The swap bank makes Swap $25,000 per year for 5
money too. years.
Bank
10 3/8% 10 ½%

LIBOR – 1/8% LIBOR – ¼%

Bank LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8
Company
A 10 ½ - 10 3/8 = 1/8 B
¼
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
An Example of an Interest Rate Swap
The swap bank makes ¼%

Swap
Bank
10 3/8% 10 ½%

LIBOR – 1/8% LIBOR – ¼%

Bank Company
A B
A saves ½% B saves ½%
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
An Example of a Currency Swap
• Suppose a U.S. MNC wants to finance a
£10,000,000 expansion of a British plant.
• They could borrow dollars in the U.S.
where they are well known and exchange
for dollars for pounds.
– This will give them exchange rate risk:
financing a sterling project with dollars.
• They could borrow pounds in the
international bond market, but pay a
premium since they are not as well known
abroad.
An Example of a Currency Swap
• If they can find a British MNC with a
mirror-image financing need they may
both benefit from a swap.
• If the spot exchange rate is S0($/£) =
$1.60/£, the U.S. firm needs to find a
British firm wanting to finance dollar
borrowing in the amount of $16,000,000.
 An Example of a Currency Swap
Consider two firms A and B: firm A is a U.S.–based
multinational and firm B is a U.K.–based
multinational.
Both firms wish to finance a project in each other’s
country of the same size. Their borrowing
opportunities are given in the table below.
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
An Example of a Currency Swap

Swap
Bank
$8% $9.4%

£11% £12%
$8% Firm Firm £12%
A B

$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
 An Example of a Currency Swap
A’s net position is to Swap
borrow at £11%
Bank
$8% $9.4%

£11% £12%
$8% Firm Firm £12%
A B
A saves
£.6% $ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
 An Example of a Currency Swap
B’s net position is to Swap
borrow at $9.4%
Bank
$8% $9.4%

£11% £12%
$8% Firm Firm £12%
A B

$ £ B saves
$.6%
Company A 8.0% 11.6%
Company B 10.0% 12.0%
 An Example of a Currency Swap
1.4% of $16 million
The swap bank makes Swap financed with 1% of £10
money too: million per year for 5
Bank years.
$8% $9.4%

£11% £12%
$8% Firm At S0($/£) = $1.60/£, that is a Firm £12%
gain of $64,000 per year for
A 5 years.
B
The swap bank faces
$224,000 $ £ exchange rate risk, but
–$160,000 Company A 8.0% 11.6% maybe they can lay it
off (in another swap).
$64,000 Company B 10.0% 12.0%
 The QSD
• The Quality Spread Differential represents the
potential gains from the swap that can be shared
between the counterparties and the swap bank.
• There is no reason to presume that the gains will
be shared equally.
• In the above example, company B is less credit-
worthy than bank A, so they probably would
have gotten less of the QSD, in order to
compensate the swap bank for the default risk.
 The QSD
• QSD is the difference between default risk
premium of fixed-rate and the floating rate.
• For example, in the interest rate swap
example previously,
QSD = (11.75 – 10) – (LIBOR + .5 – LIBOR)
= 1.75 – 0.5 = 1.25%
 Risks of Interest Rate
and Currency Swaps
• Interest Rate Risk
– Interest rates might move against the swap
bank after it has only gotten half of a swap on
the books, or if it has an unhedged position.
• Basis Risk
– If the floating rates of the two counterparties
are not pegged to the same index.
• Exchange rate Risk
– In the example of a currency swap given
earlier, the swap bank would be worse off if
the pound appreciated.
 Risks of Interest Rate
and Currency Swaps (continued)
• Credit Risk
– This is the major risk faced by a swap dealer—
the risk that a counter party will default on its
end of the swap.
• Mismatch Risk
– It’s hard to find a counterparty that wants to
borrow the right amount of money for the right
amount of time.
• Sovereign Risk
– The risk that a country will impose exchange
rate restrictions that will interfere with
performance on the swap.
 Swap Market Efficiency
• In an efficient market with lots of
competition and no barriers to capital
flows, the cost savings arguments through
QSD should have be arbitraged away.
• Then why interest rate swaps keeps on
developing?
 Swap Market Efficiency
• Swaps offer market completeness and that has
accounted for their existence and growth. Not all
types of financing are available for all borrowers.
• Swaps assist in tailoring financing to the type
desired by a particular borrower. Since not all
types of debt instruments are available to all
types of borrowers, both counterparties can
benefit (as well as the swap dealer) through
financing that is more suitable for their asset
maturity structures.