Chapter 7
Chapter 7
Chapter 7
• Futures and options contracts can be very risky investments when used for
speculative purposes.
Trading Location
Futures: Traded competitively on organized exchanges.
Forward: Traded by bank dealers via a network of telephones and computerized dealing systems.
Contractual Size
Futures: Standardized amount of the underlying asset.
Forward: Tailor-made to the needs of the participant.
Settlement
Futures: Daily settlement, or making-to-market, done by the futures clearinghouse through the
participant's performance bond account.
Forward: Participant buys or sells the contractual amount of the underlying asset from the bank
at maturity at the forward (contractual) price.
Expiration Date
Futures: Standardized delivery dates.
Forward: Tailor-made delivery date that meets the needs of the investor.
Delivery
Futures: Delivery of the underlying asset is seldom made. Usually a reversing trade is transacted
to exit the market.
Forward: Delivery of the underlying asset is commonly made.
Trading Costs
Futures: Bid-ask spread plus broker's commission.
Forward: Bid-ask spread plus indirect bank charges via compensating balance requirements.
Exhibit 7.1 Differences between Futures and Forward Contracts
Currency Futures Markets
• On May 16, 1972, trading in currency futures contracts began at the Chicago
Mercantile Exchange (CME).
• Regular trading in CME currency futures contracts takes place each business day
from 7:20 A.M. to 2:00 P.M. Chicago time. Additional CME currency futures trading
takes place Sunday through Thursday on the GLOBEX trading system from 5:00 P.M.
to 4:00 P.M. Chicago time the next day.
• In addition to the CME, currency futures trading takes place on the Intercontinental
Exchange (ICE) Futures U.S., the Mexican Derivatives Exchange, the BM&F
Exchange in Brazil, the Budapest Commodity Exchange, and the Derivatives Market
Division of the Korea Exchange.
Basic Currency Futures Relationships
• Exhibit 7.2 shows quotations for CME futures contracts. For each delivery month
for each currency, we see the opening price quotation, the high and the low quotes
for the trading day (in this case June 5, 2013), the settlement price, and the open
interest.
• In general, open interest typically decreases with the term-to-maturity of most
futures contracts.
As an example of reading futures quotations, let' s use the September 2013 British pound contract.
From Exhibit 7.2, we see that on Wednesday, June 5, 2013, the contract opened for trading at a price
of $1.5400/£, and traded in the range of $1.5283/£ (low) to $1.5400/£ (high) throughout the day. The
settlement ("closing") price was $1.5392/£. The open interest, or the number of September 2013
contracts outstanding, was 5,434.
At the settlement price of $1.5392, the holder of a long position in one contract is committing himself
to paying $96,200 for £62,500 on the delivery day, September 18, 2013, if he actually takes delivery.
Note that the settlement price increased $0.0097 from the previous day. That is, it increased from
$1.5295/£ to $1.5392/£. Both the buyer and the seller of the contract would have their accounts marked-
to-market by the change in the settlement prices. That is, one holding a long position from the previous
day would have $606.25 =($0.0097 x £62,500) added to his performance bond account and the short
would have $606.25 subtracted from his account.
Basic Currency Futures Relationships
• In Chapter 6, we developed the interest rate parity (IRP) model, which states that
the forward price for delivery at time T is
(1 + 𝑟$)𝑇
FT($/i) = So($/i)
(1 + 𝑟𝑖)𝑇
Profit ($)
+
FJun($/€)
Long position
.0155
0 SSep($/€)
FSep($/€) = 1.3094
-.0155
-FJun($/€)
Exhibit 7.3 Graph of Long and Short Positions in the September 2013 Euro Futures Contract
Options Contracts: Some Preliminaries
• An option is a contract giving the owner of the right, but not the obligation, to buy
or sell a given quantity of an asset at a specified price at some time in the future.
• An option to buy the underlying asset is a call, and an option to sell the underlying
asset is a put.
• Because the option owner does not have to exercise the option if it is to his
advantage, the option has a price, or premium.
• A European option can be exercised only at the maturity or expiration date of the
contract, whereas an American option can be exercised at any time during the
contract.
Currency Options Markets
• Prior to 1982, all currency option contracts were over-the-counter options written
by international banks, investment banks, and brokerage houses.
• In December 1982, the Philadelphia stock Exchange (PHLX) began trading options
on foreign currency.
• The trading hours of these contracts are 9:30 A.M. to 4:00 P.M. Philadelphia time.
• The volume of OTC currency options trading is much larger than that of organized-
exchange option trading.
Currency Futures Options
• The CME Group trades American style options on most of the currency futures
contracts it offers. With these options, the underlying asset is a futures contract on
the foreign currency instead of the physical currency.
• For call options the time T expiration value per unit of foreign currency can be
stated as:
CaT = CeT = Max [ST – E, 0]
Where
CaT = the value of the American call at expiration
CeT = the value of the European call at expiration
E = the exercise price per unit of foreign currency
ST = the expiration date spot price.
ST = E + Ce
Profit
E = 130 Ce = -2.52
Profit
0 0
Loss ST(₵/EUR) ST(₵/EUR)
- Ce = -2.52 E = 130
Loss
ST = E - Pe = 130 – 1.56 ST = E - Ce
= 128.44 E - Pe =
130 – 1.56
= 128.44
- -
• American options will satisfy the following basic pricing relationships at time t prior
to expiration:
Ca ≥ Max [ST – E, 0]
And
Pa ≥ Max [E – ST, 0]
American Option-Pricing Relationships
Option value, Cat
Time value
Intrinsic value
0
E ST
Out-of-the- In-the
Money Money
Exhibit 7.9 Market Value, Time Value, and Intrinsic Value of an American Call Option
European Option-Pricing Relationships
Where
𝑙𝑛 (𝐹𝑇/𝐸) + .5 𝜎2𝑇
d1 =
𝜎 𝑇
And
d2 = d1 +𝜎 𝑇
N(d) denotes the cumulative area under the standard normal density function from -∞ to d1 (or d2). The
variable 𝜎 is the annualized volatility of the change in exchange rate ln(St+1/St).
European Option-Pricing Formula
As an example of using the European options-pricing model, consider the PHLX 130 Aug EUR
European call option that has a premium of 2.52 U.S. cents per EUR. The option will expire on
August 17, 2013 - 73 days from the quotation date, or T = 73/365 = .2000. We will use the August
forward price on June 5, 2013, as our estimate of FT ($/EUR) = $130.98. The rate is estimated as the
annualized two-month dollar LIBOR (interest rate) of 0.2340 percent on the same day. The
The valued d1 and d2 are:
𝑙𝑛 (130.98/130) + .5(.0865)2(.2000)
d1 = (.0865) .2000 = .2135
and
d1 = .2135 − (.0865) .2000 = .1748
Consequently, it can be determined that N(.2135) = .5845 and N(.1748) = .5694.
We now have everything we need to compute the model price:
Ce = [130.98(.5845) – 130(.5694)]e-(.00234)(.2000)
= [76.5578 – 74.0220](.9995)
= 2.54 cents per EUR vs. the actual market mid-price of 2.52 cents.
As wee see, the model has done a good job of valuing the EUR call.
Empirical Tests of Currency Options
• Shastri and Tandon (1985) discover many violation of the boundary relationships,
but conclude that non-simultaneous data could account for most of the violations.
• Bodurtha and Courtadon (1986) conclude that the PHLX American currency options
are efficiently priced.
• Shastri and Tandon (1986) implies that the European option-pricing model works
well in pricing American currency options.
• Barone-Adesi and Whaley (1987) also finds that the European option-pricing model
works well for pricing American currency options that are at or out-of-money, but
does not do well in pricing in-the-money calls and puts.