Unit-3-Foreign Exchange Derivatives-Part-II.pdf

exchange foreign

1. Foreign Currency Futures
and Options
20/05/25 Dr. Santosh Kumar, SRCC1

2. What is currency futures?
•Currencyfuturesarestandardizedcontractsthattradelikeconventionalcommodityfuturesonthefloorofafuturesexchange.
•Orderstobuyorsellafixedamountofforeigncurrencyarereceivedbybrokersorexchangemembers.Theseorders,fromcompanies,individuals,andevenmarket-makingcommercialbanks,arecommunicatedtothefloorofthefuturesexchange.
•Attheexchange,orderstobuyacurrency–longpositions–arematchedwithorderstosell–shortpositions.Theclearingcorporationguaranteestherealisationofthecontracttobuyandthecontracttosell.
•Thewillingnesstobuyversusthewillingnesstosellmovesfuturespricesupanddowntomaintainabalancebetweenthenumberofbuyandsellorders.
•Themarket-clearingpriceisreachedinthevibrant,somewhatchaoticappearingtradingpitofthefuturesexchange.
•CurrencyfuturesbegantradingintheInternationalMoneyMarket(IMM)oftheChicagoMercantileExchange(CME)in1972.
20/05/25 Dr. Santosh Kumar, SRCC2

3. Operation of currency futures
•Brokersareengagedintradingthecurrencyfuturesonbehalfofbuyersandsellersofcurrencyfutures.Thereareprimarilyfivecomponentsofcurrencyfuturestrading:
•(a)ClearingHouse:Clearinghousesettlesthefuturecontractsinforeigncurrencyandensuresthatfuturecontractishonoured.
•(b)Brokers:Theyworkforothersoncommissionbasisortheyalsoworkforthemselves.
•(c)MarginMoney:Itisveryimportantcomponentwhichensuresthatfuturecontractisrealized.Therearethreetypesofmarginmoney:MaintenanceMargin,InitialMarginandVariationMargin.
•(d)StrikePrice:Therateatwhichthecurrencywillbeboughtandsoldasperthefuturecontractatanyfuturedate.
•(e)Expirationdate:Thedateonwhichthefuturecontractwillberealized.
20/05/25 Dr. Santosh Kumar, SRCC3

4. Currency Futures and Margin Money
•MaintenanceMargin:Itisdecidedbytheclearinghouseascertainpercentageofcontractvalue.Thepercentageofmaintenancemarginisdecidedbytheclearinghousedependinguponthemarketconditionandpossibilityofdefaultingthecontract.Generallyitvariesbetween5%to18%.Thisamountisdepositedwiththeclearinghousewhilethecurrencyfuturecontractstakeplace.
•InitialMargin:Itisdecidedbythebrokeragefirmanditisinclusiveofmaintenancemargin.Itaimstoreducethedailydemandfromorcredittothebuyersandsellersofcurrencyfutures.
•VariationMargin:DependinguponvariationofpricesofcurrencyondailybasisifthevalueofInitialmargingoesbelowthemaintenancemarginthentheeithersidewillbeaskedtodepositthedifferenceamounttoensurethatinitialmarginremainsatparwithmaintenancemargin.Suchextradepositwithbrokerbysellerandbuyerisknownasvariationmargin.
20/05/25 Dr. Santosh Kumar, SRCC4

5. Operation of Variation Margin
•Supposesomeonehasfuturecontractofpurchasing£62,500atsome
futuredate.Withthesettle/strikepriceper£of$1.6002/£.
•Sothefuturecontractcoststhebuyer=$1:6002/£X£62,500=
$100,012
•Aswithforwardexchangecontracts,ifweassumeriskneutrality,the
perunitpriceoffuturesequalstheexpectedfuturespotexchange
rateoftheforeigncurrency.
•Nowsupposethemaintenancemarginforthiscontractis$1500and
initialmargin/standardmarginis$2000.Boththebuyerandseller
havetodepositwithclearinghouse$2000.
20/05/25 Dr. Santosh Kumar, SRCC5

6. Marking to Market/Operation of Variation Margin
•Markingtomarket:Thisisaprocesswherebuyerorselleraccounts
aredebitedorcreditedbasedoneverydaypriceoftheforeign
currencyandanyvariationismarketvalueofthecontract.
•Supposebyendofthefirstdayofthecontract,themarketpriceof£
is$1.6042.Thisleadstogaintothebuyerofthefuturecontractby=
($1.6042-$1.6002)/£X£62,500=$250.Thisamountwillbecredited
tobuyer’smarginturningouttobe$2250.Ontheotherhandthe
sellerofthecontractexperienceslossof$250leadingtodebitofthis
amountfromfromthemarginaccountofsellerandleavingtheseller
with$1750.
20/05/25 Dr. Santosh Kumar, SRCC6

7. •Supposebyendoftheseconddayofthecontract,themarketpriceof£is$1.6042.Thisleadstogaintothebuyerofthefuturecontractby=($1.6092-$1.6002)/£X£62,500=$562.5.Thisamountwillbecreditedtobuyer’smarginturningouttobe$2562.5.Ontheotherhandthesellerofthecontractexperienceslossof$562.5leadingtodebitofthisamountfromfromthemarginaccountofsellerandleavingthesellerwith$1437.5inhismarginaccount.Heretheadditionalmarginthatsellerofthefuturecontracthastoaddtohismarginaccountwillbe$62.5sothathismaintenancemarginremainsat$1500.
•Thiseverydaydebitandcreditprocessinmarginaccountiscalledmarkingtomarket.
•Thisextradepositof$62.5byselleroffuturecontractinhismarginaccountiscalledvariationmargin.Ifthespotpriceof£risesthenthesellerhasthepossibilitytoaddvariationmarginandifthespotpriceof£fallsthenitisthebuyerwhohasthepossibilitytoaddthevariationmargin.
•Inourexamplestandardmarginkeptabove$1500withanobjectivethatsellerandbuyerdonothavetonecessarilyaddvariationmargin.
20/05/25 Dr. Santosh Kumar, SRCC7
Marking to Market/Operation of Variation Margin

8. Pay-off profile of future contract
•Itisclearfromtheabovediscussionthatanygaintobuyerislossto
thesellerandanygaintothesellerislosstothebuyerofthefuture
contract.
•Theactualgainorlossfromthefuturecontractisdecidedbythespot
priceonthestrike/realizationdate.
•Whenthespotpriceof£ismorethanstrikepricethentherewillbe
gaintobuyerofthecontractandlosstothesellerofthefuture
contract.Ontheotherhandifthespotpriceislessthanthestrike
pricethentherewillbelosstothebuyerofthecontractandgainto
thesellerofthecontract.
20/05/25 Dr. Santosh Kumar, SRCC8

9. Pay-off profile of future contract
Realized Spot RateDifference between Realized spot
rate and strike rate
Gain/Loss
$1.6062$1.6062 -$1.6002 =$0.006$0.006/£ X $62,500 = $375
$1.6032$1.6032 -$1.6002 =$0.003$0.003/£ X $62,500 = $187.5
$1.6002$1.6002 -$1.6002 =0$0/£ X $62,500 = $0
$1.5902$1.5902 -$1.6002= -$0.01-$0.01/£ X $62,500 = -$625
$1.4902$1.4902 -$1.6002 =-$ 0.11-$0.11/£ X $62,500 = -$6,875
20/05/25 Dr. Santosh Kumar, SRCC9

10. Pay-off profile of future contract
20/05/25 Dr. Santosh Kumar, SRCC10
Gains/Loss
Difference in Spot
price and future price0-0.11-0.010.0030.006
$375
$187.5
-$6,875
-$625
Pay-off line for the
buyer of future contract

11. Sl. No.CriteriaForwardFuture
1 Size of the contractOver-the-counter (OTC)
agreements tailored to the
specific needs of the parties
involved. It is not standardized.
Standardized contracts traded on
exchanges (like CME, ICE)
2 Delivery dateTailored to individual needsStandardized such as monthly,
quarterly, halfyearlyetc.
3 ParticipantsIndividuals, banks, brokers, firms
etc.
Banks, brokers and MNCs
4 Credit RiskHigher, since there’s no
intermediary
Lower, because the exchange's
clearinghouse guarantees
settlement
5 LiquidityGenerally less liquid due to
customization and OTC nature
Typically higher, due to
standardized terms and exchange
trading
6 VolumeVery largeSmall
7 RegulationSelf-regulatingInstitutionalized regulation
8 LiquidationMost settled by actual delivery
and some by offset
Most by offset and very few by
settled by actual delivery
20/05/25 Dr. Santosh Kumar, SRCC11
Difference in Forward and future contract

12. Currency Option Contract
•Allforwardcontractsandcurrencyfuturesmustbehonoredbybothparties.Thereisnooptionallowingapartytosettleonlyifitistothatparty’sadvantage.
•Unlikeforwardandfuturescontracts,currencyoptionsgivethebuyertheopportunity,butnottheobligation,tobuyorsellatapre-agreedprice-thestrikepriceorexercisepriceinthefuture.
•Thenamesuggests,thebuyerofanoptioncontractpurchasestheoptionorrighttotradeattherateorpricestatedinthecontractifthisistotheoptionbuyer’sadvantage,buttoallowtheoptiontoexpireunexercisedifthatwouldbebetter.Thatis,optionshaveathrow-awayfeature.
20/05/25 Dr. Santosh Kumar, SRCC12

13. Characteristics of Currency Option Contract
•Incurrencyoptiontherearefewcharacteristics:
•(a)StrikePrice:Therateatwhichboththepartiesagreetobuyandselltheforeigncurrencyiscalledstrikeprice.
•(b)ExpirationDate:Thedatewhentheoptioncontracthastoberealizedisknownasexpirationdate.Iftheoptioncontractisnotrealizedonexpirationdatethenafterthatoptioncontracthasnovalue.
•(c)OptionPremium:Itisthepricethatonehastopaytopurchasetherighttobuyorrighttosell.
•(d)IntheMoney:Forcalloptionwhenthespotrate/priceismorethanstrikepricethenthereissaidtooccurIntheMoney.Similarlyforputoptionwhenthespotrate/priceislessthanthestrikepricethenthereissaidtooccurInthemoney.
•(e)OutoftheMoney:Forcalloptionwhenthespotrate/priceislessthanstrikepricethenthereissaidtooccurOutoftheMoney.Similarlyforputoptionwhenthespotrate/priceismorethanthestrikepricethenthereissaidtooccurOutofthemoney.
20/05/25 Dr. Santosh Kumar, SRCC13

14. Characteristics of Currency Option Contract
•(f)EuropeanOption:Itisthecurrencyoptioncontract,whichisrealizedonlyonexpirationdateandnotbeforethat.
•(g)AmericanOption:Itisthecurrencyoptioncontract,whichisrealizedeitheronexpirationdateandbeforetheexpirationdate.
•(h)CallOption:Itisthecurrencyoptioncontract,wheretherighttoexercisethefuturecontractlieswiththebuyerofthecurrency.Itisanoptionwherethebuyerofthecurrencyhastherighttobuybutnottheobligationtobuy.
•(i)PutOption:Itisthecurrencyoptioncontract,wheretherighttoexercisethefuturecontractlieswiththesellerofthecurrency.Itisanoptionwherethesellerofthecurrencyhastherighttosellbutnottheobligationtosell.
20/05/25 Dr. Santosh Kumar, SRCC14

15. Pay-off in Currency Option Contract
•The gain of option buyer is loss of option seller and vice versa.
•Ifitisacalloptionthentherighttobuylieswithbuyerofthe
currencyandhencethereisunlimitedgainsandsimultaneously
thereisunlimitedlosstothesellerofcurrency.
•However,ifthespotpriceofthecurrencyislowerthenthestrike
pricethenbuyerwillnotrealisethecontractandhencehislossis
limitedtooptionpremium.Thereforethegaintosellerofthe
currencyislimitedtooptionpremium.
•Thispayoffprofilecanbeillustratedwithadiagramasfollows:
20/05/25 Dr. Santosh Kumar, SRCC15

16. Pay-off in Currency Call Option Contract
20/05/25 Dr. Santosh Kumar, SRCC16

17. Pay-off in Currency Put Option Contract
20/05/25 Dr. Santosh Kumar, SRCC17

18. Factors Affecting Option Contract
•Intrinsicvalue:Thepremiumonanoptioncanbeconsideredtobemadeupofthetimevalueandtheintrinsicvalue.Intrinsicvaluestandsforgainmadeoutofcalloptionorputoption.Therefore,themoretheoptionisinthemoney(i.e.thehigheristheintrinsicvalue)thehigheristheoptionpremium.
•Volatilityoftheunderlyingexchangerate:Ceterisparibus,themorevolatileistheunderlyingrate,thegreaterthechancethatanoptionwillbeexercisedtothebenefitofthebuyerandtothecostoftheseller
•AmericanorEuropeanoptiontype:ThegreaterflexibilityofAmericanthanEuropeanoptionsmeansbuyerswillnotpaymoreforaEuropeanoptionthanforanAmericanoptionofthesamestrikepriceandmaturity.Indeed,foragivenstrikeprice,exchangeratevolatilityandperiodtoexpiration,AmericanoptionsaretypicallymorevaluablethanEuropeanoptions.
20/05/25 Dr. Santosh Kumar, SRCC18

19. Factors Affecting Option Contract
•Interestrateoncurrencyofpurchase:Thehighertheinterestrateonthecurrencypaidforanoption,theloweristhepresentvalueoftheexerciseprice.Ahigherinterestrateincreasesthemarketvalueofacallandreducesthemarketvalueofaput.
•Theforwardpremium/discountorinterestdifferential:Becauseofverydifferentratesofinflation,imbalancesoftrade,andsoon,therecanbetrendsinexchangeratesthataretoanextentpredictable.
•Lengthofperiodtoexpiration:Ceterisparibus,thelongerthematurityperiodoftheoption,thegreateristhechancethatatsometimetheexchangeratewillmoveabovethestrikepriceofacallorbelowthestrikepriceofaput.
20/05/25 Dr. Santosh Kumar, SRCC19